Full text of Federal Open Market Committee Meeting Minutes, Transcripts, and Other Documents : Meeting, February 1-2, 2000 : Transcript

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Meeting of the Federal Open Market Committee
February 1-2, 2000
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, February 1,
2000, at 2:30 p.m. and continued on Wednesday, February 2, 2000, at 9:00 a.m.
PRESENT:
Mr. Greenspan, Chairman
Mr. McDonough, Vice Chairman
Mr. Broaddus
Mr. Ferguson
Mr. Gramlich
Mr. Guynn
Mr. Jordan
Mr. Kelley
Mr. Meyer
Mr. Parry
Mr. Hoenig, Ms. Minehan, Messrs. Moskow and Poole, Alternate Members
of the Federal Open Market Committee
Messrs. Boehne, McTeer, and Stern, Presidents of the Federal Reserve Banks of
Philadelphia, Dallas, and Minneapolis respectively
Mr. Kohn, Secretary and Economist
Mr. Bernard, Deputy Secretary
Ms. Fox, Assistant Secretary
Mr. Gillum, Assistant Secretary
Mr. Mattingly, General Counsel
Mr. Baxter, Deputy General Counsel
Ms. Johnson, Economist
Mr. Prell, Economist
Mr. Beebe, Ms. Cumming, Messrs. Eisenbeis, Goodfriend, Howard, Lindsey,
Reinhart, Simpson, Sniderman, and Stockton, Associate Economists
Mr. Fisher, Manager, System Open Market Account

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Mr. Winn, 1/ Assistant to the Board, Office of Board Members,
Board of Governors
Mr. Ettin, Deputy Director, Division of Research and Statistics,
Board of Governors
Messrs. Madigan and Slifman, Associate Directors, Divisions of Monetary Affairs
and Research and Statistics respectively, Board of Governors
Messrs. Oliner and Whitesell, Assistant Directors, Divisions of Research and
Statistics and Monetary Affairs respectively, Board of Governors
Mr. Small, 2/ Section Chief, Division of Monetary Affairs, Board of
Governors
Messrs. Brayton, 2/ Morton, 3/ and Rosine, 3/ Senior Economists, Divisions of
Research and Statistics, International Finance, and Research and
Statistics respectively, Board of Governors
Ms. Garrett and Mr. Hooker, 3/ Economists, Division of Monetary
Affairs, Board of Governors
Ms. Low, Open Market Secretariat Assistant, Division of Monetary Affairs,
Board of Governors
Ms. Browne, Messrs. Hakkio and Hunter, Ms. Krieger, Messrs. Lang, Rasche,
Rolnick, and Rosenblum, Senior Vice Presidents, Federal Reserve Banks of
Boston, Kansas City, Chicago, New York, Philadelphia, St. Louis,
Minneapolis, and Dallas respectively

__________________________
1/ Attended Tuesday’s session only.
2/ Attended portion of meeting relating to the staff presentation of policy alternatives.
3/ Attended portion of meeting relating to the Committee's review of the economic outlook and
consideration of its money and debt ranges for 2000.

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Transcript of Federal Open Market Committee Meeting of
February 1-2, 2000
February 1, 2000—Afternoon Session
CHAIRMAN GREENSPAN. Happy New Year everybody! Happy Millennium!
MS. MINEHAN. Happy post-Y2K!
CHAIRMAN GREENSPAN. With those insightful remarks, I will turn the floor over
to Governor Ferguson.
MR. FERGUSON. Thank you very much. The first order of business today is to elect
a Chairman who will serve until the first scheduled meeting in the year of 2001. So, let me open
the floor for nominations. Are there any nominations? Governor Kelley.
MR. KELLEY. Thank you. After long and careful consideration, it is my honor to
place in nomination the names of Alan Greenspan for Chairman and William McDonough for
Vice Chairman.
MR. FERGUSON. Is there a second?
SPEAKER(?). Second.
MR. FERGUSON. Thank you. I’m glad someone seconded it! Are there any
objections to those two nominations? Hearing no objections, I will declare the vote unanimous.
Let me congratulate the two of you!
CHAIRMAN GREENSPAN. I always appreciate the democratic process! [Laughter]
VICE CHAIRMAN MCDONOUGH. And I support that view of democracy and the
procedures that elected us, Mr. Chairman.
CHAIRMAN GREENSPAN. Thank you. The next item on the agenda is to elect
staff officers, and I will ask Norm Bernard to read the list.

4

MR. BERNARD. The proposed slate of staff officers is as follows:
Secretary and Economist, Donald Kohn;
Deputy Secretary, Normand Bernard;
Assistant Secretaries, Lynn Fox and Gary Gillum;
General Counsel, Virgil Mattingly;
Deputy General Counsel, Thomas Baxter;
Economists, Karen Johnson and Michael Prell;
Associate Economists from the Board:
David Howard, David Lindsey, Vincent Reinhart,
Thomas Simpson, and David Stockton;
Associate Economists from the Federal Reserve Banks:
Jack Beebe, proposed by President Parry;
Christine Cumming, proposed by President McDonough;
Robert Eisenbeis, proposed by President Guynn;
Marvin Goodfriend, proposed by President Broaddus; and
Mark Sniderman, proposed by President Jordan.
CHAIRMAN GREENSPAN. Are there any objections to anyone on that list? If not,
would somebody like to move the slate?
VICE CHAIRMAN MCDONOUGH. I move the slate.
CHAIRMAN GREENSPAN. Is there a second?
SPEAKER(?). Second.
CHAIRMAN GREENSPAN. Without objection. Thank you very much. The next
item on the agenda, as you know, is the selection of a Federal Reserve Bank to execute
transactions for the System Open Market Account. Would somebody like to propose a bank?
MR. FERGUSON.

I move that we select the Federal Reserve Bank of New York.

CHAIRMAN GREENSPAN. Is there a second?
MR. KELLEY. Second.
CHAIRMAN GREENSPAN. Objections? Without objection, so ordered. The next
item on the agenda is the selection of a Manager of the System Open Market Account. Are there
nominations?

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VICE CHAIRMAN MCDONOUGH. I nominate Peter Fisher, Mr. Chairman, as
Manager of the System Open Market Account.
CHAIRMAN GREENSPAN. Is there a second?
MR. FERGUSON. I second it.
CHAIRMAN GREENSPAN. Without objection, so ordered. I wish to state,
however, that the directors of the Federal Reserve Bank of New York are required under our
rules to confirm that choice. I trust you are sufficiently nervous! [Laughter]
MR. FISHER. Yes, sir.
CHAIRMAN GREENSPAN. We have proposed changes to the Authorization for
Domestic Open Market Operations. Peter, would you review them very briefly for us?
MR. FISHER. Members of the Committee will recall, as Norm Bernard’s memo
spelled out, that the authority to sell options on RPs, which the Committee granted the Desk on a
temporary basis last August, will expire at the end of this month. The authority to do reverse
RPs and the liberalization of the “Guidelines for the Conduct of System Operations in Federal
Agency Issues” put in place at the same time will run through the end of April, however. The
latter two authorizations will be on the agenda for the Committee to discuss at its March
meeting.
MR. BERNARD. There is also the added paragraph relating to the Chairman’s
latitude to make intermeeting adjustments to policy in exceptional circumstances. The suggested
wording is that set forth in Governor Ferguson’s memorandum of December 17, 1999, which
was discussed at the December FOMC meeting.
CHAIRMAN GREENSPAN. Comments? Would somebody like to move the
proposal?

6

VICE CHAIRMAN MCDONOUGH. Move approval.
SPEAKER(?). Second.
CHAIRMAN GREENSPAN. Without objection. The next item is the review of the
foreign currency instruments, which I presume is a wholly routine item. Is that correct?
MR. FISHER. Yes.
CHAIRMAN GREENSPAN. Unless somebody has any objection, would somebody
move renewal of those instruments?
VICE CHAIRMAN MCDONOUGH. So move.
CHAIRMAN GREENSPAN. Second?
MR. FERGUSON. Second.
MR. KOHN. Mr. Chairman, I think President Broaddus-MR. BROADDUS. I am going to vote in opposition of their renewal for the same
reasons I have in the past.
CHAIRMAN GREENSPAN. The Secretary will please register that President
Broaddus voted in opposition. The next item on the agenda is the Program for Security of
FOMC Information. Does anyone have any comment on the memorandum we received on this?
If not, would somebody like to move approval?
MR. FERGUSON. I move that.
CHAIRMAN GREENSPAN. Second?
VICE CHAIRMAN MCDONOUGH. Second.
CHAIRMAN GREENSPAN. Without objection.

7

MR. BERNARD. Mr. Chairman, I presume that what is being approved would
include the revisions that were noted in the memo that was just circulated. Perhaps all members
have not seen that. Except for item number 6 in that memo, the others will be implemented.
CHAIRMAN GREENSPAN. The next item on the agenda is the approval of the
proposed changes in the Federal Open Market Committee’s Rules and Procedures. It is a routine
matter involving the inclusion of communication by “electronic means” as an acceptable form
for communication between the Secretary and the members of the Committee, and I presume that
no one has any comments. If you do, speak up. If not, would somebody like to move that?
VICE CHAIRMAN MCDONOUGH. Move approval.
CHAIRMAN GREENSPAN. Second?
MR. FERGUSON. Second.
CHAIRMAN GREENSPAN. Without objection. We will now move to the regular
formal meeting agenda. I ask for approval of the minutes of our December meeting.
MR. FERGUSON. So moved.
CHAIRMAN GREENSPAN. Without objection. Peter Fisher.
MR. FISHER. Thank you, Mr. Chairman. I will be referring to the package of charts
with the peach Class II cover on it, beginning as usual with the chart on forward deposit rates. 1
The top panel depicts U.S. forward rates and current 3-month rates. As
you can see there, forward rates backed up from the time of your December
meeting through early January and then flattened out a bit, even as the
current 3-month deposit rate--the black line--remained quite steady. Then,
with the noticeable exception of the spike in the 6-month forward rate, the
solid red line--that spike being a true data point--these rates generally moved
sideways from the time of the Chairman’s speech on January 13 at the
Economic Club of New York through last Friday. The movements in these

1

A copy of the charts used by Mr. Fisher is appended to this transcript. (Appendix 1)

8

rates seemed to reflect noise rather than any specific developments we could
point to.
By the time we reached mid-January, the markets had already pretty
much priced in an expectation of about 50 basis points of tightening
sometime during the first quarter of this year. Now, the release of the GDP
and ECI data on Friday did affect the forward rates a bit, as the 9-month
forward rate shown at the very top right of the chart backed up almost 20
basis points. However, the April fed funds futures contract backed up only
about 9 basis points from a rate of 5.97 to 6.06 percent. The fed funds
futures isn’t shown here, but to give you the flavor, I’d say that the market
had pretty much built in its expectations of a first-quarter tightening by the
middle of January. My point is that the data releases on Friday changed the
outlook beyond the first quarter somewhat, but did not change very
profoundly the sense of the Committee’s likely actions during the first
quarter.
In contrast a bit, while European forward rates also drifted up, as
shown in the middle panel in blue, once we got to January these rates leveled
out to a considerable extent and remained that way until the 27th when the
euro closed below dollar parity for the first time. You can see the uptick at
that time in all the rates. Particularly noticeable is how much the current 3month deposit rate, the black line, moved in the expectation that the ECB
might need to respond in some way.
In the bottom panel, you can see that Japanese rates also rose a bit from
late December through early January, and then began to drift off after midJanuary. There had been a fair amount of talk in Tokyo in late December and
early January about the need for the Bank of Japan to develop an exit strategy
from its zero interest rate policy. But around mid-January Bank of Japan
officials, both in reports and in comments, began to express more anxiety
regarding the fact that the self-sustaining recovery was not in sight. This
seemed to be confirmed by the very weak consumption data that came out
last Friday. But from the middle of January onward, as you can see, the
forward rates in Japan began to fall back to their low levels.
Turning to the next page, there was rather more excitement in the
Treasury bond market. In the top panel you can see 2-, 5-, 10-, and 30-year
Treasury yields as they have traded since October 1st. The bottom panel
depicts various spreads within the yield curve--the 2- to 5-year in green, the
5- to 10-year in blue, and the 10- to 30-year in red.
Treasury yields were rising from late November and continued to rise
after your last meeting, but they too began to move sideways roughly from
January 13th forward. In this case, in addition to the Chairman’s speech on

9

that day, Secretary Summers announced the final plans for the buyback
program to repurchase outstanding Treasury debt. In his remarks and the
press release he suggested they would be buying as much as $30 billion in
the year 2000, most of that probably at the long end. That should be seen
against the backdrop of expectations already in the market, before the
buybacks came into play, that the Treasury’s net paydown of securities in the
first half of this year would be something on the order of $150 to $200
billion.
With that shift in the bond supply outlook being emphasized in the
market, you can see in the bottom panel how quickly the 10- and 30-year
spread began to invert after the January 13th announcement. The drama came
last Friday with the release of the GDP and ECI data. Prior to that date, there
really had been two contending camps in the market. One saw the inversion
of the yield curve as a temporary phenomenon, expecting the curve to
steepen again once this Committee began to tighten over the course of the
first quarter. They were thus taking short positions in the long end. A
different camp expected the inversion of the yield curve to continue. They
expected it to flatten when this Committee began its widely expected
tightening. They anticipated a reduction in Treasury supply at the long end
but an increasing agency and corporate supply in the short end. And it was
also their sense that a late cycle firming by the central bank should slow
activity and foster a rally in the bond market. Thus, they took long positions
in the long end of the bond market.
Last Friday, the initial reaction seemed to favor the first camp as the
yield curve backed up, and some in that camp seem to have been tempted to
double up their positions. But then the yield curve began to go down rather
quickly again, and they were caught scrambling to cover their shorts, which
caused a fair bit of see-sawing in the yield curve all day on Friday. Bid-ask
spreads in the market on Friday were not as wide as the widest we saw in
October 1998, but during the course of the day they were comparable to the
averages of October 1998. So, bid-ask spreads widened out quite a bit.
You can see in the bottom panel the profound impact that last Friday’s
new data had on the 5- to 10-year and the 10- to 30-year spread. The only
upward slope left in the coupon curve is in the 2- to 5-year sector. As this
position adjustment washes through the market, I think we are increasingly
going to see a flat Treasury curve, with conversations in the market
increasingly turning to whether this is just a Treasury supply story or a
fundamental story in some way.
The next page depicts some domestic yield curve comparisons. In the
upper left is the Treasury yield curve from last October 5th, showing the
closing rates after the Committee’s October meeting and those as of yesterday.

10

In the upper right is the interest rate swap curve. The lower left panel has
Fannie Mae yields and the lower right those on Ford Motor Company debt.
While they are all at different levels, the spreads to Treasuries are really
very little changed from October. Only the 30-year swap spread is discernibly
wider than in October. All other domestic spreads to Treasuries have
narrowed slightly or are unchanged from October 5th. The short ends of each
of these other domestic curves are noticeably steep, but they are less steep
than they were in October. And they are all quite flat now from 5 to 30 years
and from 10 to 30 years. My own sense is that the Treasury yield curve has a
very powerful influence on these other curves, the habit of trading at certain
spreads. So, while I don’t want to overstate the importance of the Treasury
supply story, I would not want to understate it either. However, none of these
yield curves suggests to me that the rest of the domestic interest rate market is
expecting a sudden outbreak of inflation. I don’t think they would be trading
at such a flat long-end spread even in thin markets.
A rather different picture emerges on the next page where our yield
curve is compared to other national government yield curves. As you can see
in the top two panels, U.S. and Canadian yield curves are really quite similar,
with Canadians yields just a bit below U. S. Treasury yields, as they have
been since the fall. But in the bottom two panels you can see the rather
dramatic differences between our yield curve and those of the United
Kingdom and Germany.
The United Kingdom is everyone’s poster child for the impact on a
government bond market of a firm to tightening central bank policy and a
shrinking government issuance of long-term debt. Those who are wondering
how long a rally we can get in our bond market have in the back of their
minds this picture of the U.K. yield curve.
In contrast is the rather steep continental curve, the German yield
curve; relative to last October it provides a striking contrast to the U.K. and
U.S. yield curves. I don’t think the difference between their yield curve and
ours is a first-order cause of the weakness of the euro over the last few days,
but it is certainly a contributing one, given that the differentials have
continued to widen in the dollar’s favor since last October.
The chart on the next page depicts from the beginning of October to
date the percent change in selected currencies against the dollar. This
highlights how much of an outlier the euro is. As you can see, the Brazilian
real and the Canadian dollar have been firming against the dollar, the Japanese
yen and the Mexican peso have been trading around zero, and the euro has
weakened profoundly over the last few days.

11

One of the most anticipated events of January 2000, I would guess after
all the hoop-la about the Y2K bug, was the expected rally in the euro. It was
so widely anticipated that there was no one left to make it happen!
Institutional investors have been buying euro assets and running them on an
unhedged basis mostly in the currency market, hoping for the euro rally to
give them a greater kick in their investments. In the last few days, as we came
to the end of January, these investors ran out of patience and began hedging
those exposures in rather vast amounts, rushing to hedge the unhedged. I was
given some advice once by someone in the market that the history of
exchange rate volatility is the history of successive new classes of actors
learning how to hedge and how not to hedge.
Turning to the next page and our open market operations, you can see
that the movements in the three key reserve factors since December 15th
required us to add a total of $70 billion in reserves from that point forward.
You can also see how, after the turn of the year, the Treasury balance and
currency in circulation began to drop off very quickly, causing the whole
position of reserve factors to reverse.
On the next page is a bar graph showing how our operations at the turn
of the year were structured to help us meet this buildup and then to pull back
rather quickly. The dark blue portions of the bars represent the RPs that we
already had in place as of the 15th of December; the green-dashed portions are
those that we put on starting on the 15th. The yellow portions indicate the
forward RPs we executed in our effort to put in some additional reserves
around the year-end. The red negative parts are the matched sales that we
conducted during the first half of January as we tried to get our position back
in balance. But overall, the rather large amount of RPs that we had put on the
book and rolled off rather quickly in January worked rather well.
I included the charts on the next page to show you the interest rate
behavior at the short end of the money market that we saw around year-end.
The top panel has comparable data for last year’s turn from December 1998 to
January 1999. The effective fed funds rate is the green line, the Treasury RP
rate the blue line, the target fed funds rate the black line, and the morning fed
funds rate at the time we operate the red line.
You can see at the bottom how we did this year. We had a much softer
market several days before the year-end and then rather less volatility in
January once we got through the turn of the year. What led to the rather
profound softness those days before the year-end is in part a mystery, but as
best we can judge we think that the scarcity of Treasury collateral was a major
factor that pulled repo rates down and had some influence on the funds rate.
In addition, however, there was a widespread perception in the market that we
were flooding the market with liquidity. Market participants had data on our

12

gross operations but not our net operations. They were not able to see the
information depicted in the first chart I showed you on the factors that were
draining reserves.
The next page shows the behavior of the funds rate and reserves in the
two maintenance periods that surrounded the year-end. In the top two panels
on the funds rate, the blue line depicts the trading range, the red horizontal
line is the daily effective rate, and the red vertical line represents one standard
deviation. In the bottom panels on the key reserve factors, the blue bar shows
the actual free reserves on the day and each black dot represents our intended
level of free reserves on the day. The red bar is the borrowing that occurred
on each day, both discount window and SLF borrowing.
Interesting from my perspective is how soft the funds rate became, as
you can see in the top left panel, on December 24, 27, 28, and 29. That
happened even though, as you can see below, we actually were leaving in
rather normal, if modest--some might even say skimpy--levels of free reserves
on each day. The amounts were quite typical, or if anything skimpy, for the
end of a maintenance period. Nonetheless, the funds market got quite soft on
those days. And, as I say, that occurred I think significantly on the perception
that we were flooding the markets, since they only saw our gross operations
and not the impact of our net operations.
Clearly, at the start of the next period that covered the year-end, we did
flood the market for the reserves in that new maintenance period on the 30th
and 31st. But as you can see, we had a negative miss on the 31st itself of more
than $2 billion. So we did not even get in as many reserves as we were
shooting for. Again, though, we subsequently were able to get the funds rate
to trade around the target level relatively quickly by draining reserves. We
got down to an historic low operating balance in the banking system of $8-1/2
billion on January 6th and still kept the funds rate reasonably well behaved.
Another way of viewing our operations during the fourth quarter of last
year through the period until this meeting is shown on the next page. You
may recall that I have used this chart before as a measure of our performance.
Each dot is a day. The horizontal axis is the deviation from the target rate-that is, the effective deviation, zero being the target and plus or minus either
side. The vertical axis is each day’s daily standard deviation in basis point
terms. As you can see, over the fourth quarter of last year and January of this
year the funds rate was reasonably well contained. As indicated by the
median values in the table in the upper right, the deviation of the effective rate
from the target in absolute terms was only 8 basis points and the standard
deviation was just 9 basis points.

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The next page shows comparable data for the previous year, October
1998 to January 1999, also covering the period of market turmoil typical of
the fourth quarter. As is apparent, we had a rather more volatile market in
1998 than we had this year.
The final page gives one more way of comparing volatility; it plots the
same data against a norm established from the two previous years. That is, the
brown box and the green box are based on data from October 1996 through
January 1997 and from October 1997 to January 1998. Fifty percent of the
observations in those two 4-month periods fell within the brown line and 25
percent within the green line; that provides a sort of base case. You can see
that in October 1998 to January 1999 we succeeded in getting only 11 percent
of the days to fall within that tight range and only 24 percent within the 50
percent range, whereas this year the comparable figures were 31 percent and
51 percent. So I guess we can say we at least lived up to our own standard for
managing the funds rate for the two year-end periods prior to 1998.
I would like to thank the Committee for giving us the tools to help us
to do this. It made a great deal of difference. I should note that the funds rate
has been firm thus far over the last two days. Those days encompassed a
month-end and a first day of the month, normally firm days in the market.
But there is also a widespread expectation of a firming in rates by the
Committee, and there is not much chance of getting the funds rate to behave
in a “normal” way in these last couple of days.
Finally, we distributed to the Committee copies of the Desk’s annual
report via our secure Web site. I hope you all had access to that as well as to
the other reports that we now make available there.
Mr. Chairman, we will need to ratify the Domestic Desk’s operations
since the last meeting. I would be happy to answer any questions.
CHAIRMAN GREENSPAN. I would just like to say that I thought the Desk handled
this very turbulent period extremely well and I found your report most informative. I am glad
that we were able to unwind ourselves from this period without any undue casualties--or at least
none of which I am aware.
MR. FISHER. Thank you very much!
MR. BOEHNE. I would second that. I think you earned an A+ for the way you
performed through this period; you and your staff deserve congratulations. I have a question,

14

even though you did so very well! [Laughter] Did you learn anything through this process that
would lead you to want to do something differently if we had a similar episode to go through in
the future?
MR. FISHER. Well, we will be bringing forward as many of those issues as we can
think of to be discussed formally at the March meeting. I will say that what was very frustrating
for us, and I am partly responsible, was the asymmetry of the information we provided. That is,
we gave the market very detailed information about our gross operations and then they got a
once-a-week snapshot of the System’s balance sheet. They thought that page represented our
operations--that it was our base. They saw our only our gross operations. There were days when
there were rumors that the Desk was flooding the market with reserves, and in fact we were
leaving them barely enough to get by. So that was very frustrating. If I had to go through a
period like that again--and maybe always, but certainly in similar circumstances--I think I would
want to be more balanced and give out information on our net operations as well as our gross
operations.
CHAIRMAN GREENSPAN. Further questions?
VICE CHAIRMAN MCDONOUGH. I would like to make a comment also to
applaud the conduct of the Desk. But since I got to drop in and watch them on occasion, I want
to note that one would have thought that this was the most relaxing period that any group of very
young people was going through. And they are very young. Peter Fisher and Sandy Krieger are
ancient compared to the average age of the staff involved! It was commendable that they
behaved as if going through this firestorm was the most normal thing in the world.
MR. FISHER. If I could--I should have mentioned it in my briefing--I would like to
thank the staff from all the other Reserve Districts, particularly those in the cash offices, that

15

provided us with a much higher level of information than usual and made some of this
forecasting a lot easier. There was a tremendous effort on the part of every Bank’s cash
operations staff, and we may be coming back to you to find out whether we shouldn’t make some
permanent improvements in the flow of information in that regard. But I want to thank staff
from the whole System for their efforts during this period.
CHAIRMAN GREENSPAN. Further questions for Peter? If not, I assume there is no
problem ratifying the actions the Desk took during the period. Would someone like to move
approval?
VICE CHAIRMAN MCDONOUGH. Move approval.
CHAIRMAN GREENSPAN. Without objection. Mike Prell, Karen Johnson, and
Dave Stockton.
MR. PRELL. Thank you, Mr. Chairman. I almost hesitate to refer you to this rather
tame set of charts after the abundance of color you have just seen. But this is what we have!
Chart 1 summarizes our forecast. But, before I get into the numbers
here, I should take note of some late-breaking news. First was the upside
surprise in the BEA’s advance estimate of fourth-quarter GDP, published on
Friday. The 5.8 percent real output increase exceeded our guess by about a
half point. However, we decided not to redo the forecast and to go with the
Greenbook numbers for this presentation. This wasn’t simply for the sake
of convenience. To be sure, BEA knew more about the fine detail of the
fourth-quarter data than we did, but the key differences between their
estimate and ours related mainly to assumptions about missing numbers.
And we were reasonably content to stick with ours for the time being.
We would have said that if BEA’s estimates proved closer to the mark,
it would have tended to argue for weaker GDP growth in the near term than
we forecast, with lesser contributions from defense purchases and inventory
investment. This morning’s release on construction put in place in
December has reinforced that argument: Construction spending now
2

A copy of the charts used by Mr. Prell, Ms. Johnson, and Mr. Stockton are appended to this transcript.
(Appendix 2).

2

16

appears to have been stronger than either BEA or we anticipated, especially
in the state and local sector, where good weather may have given a
temporary boost to building.
All things considered, however, our basic assessment still would be
that the economy is running strong enough that--absent a considerable
further tightening of financial conditions--pressures on resources will
intensify over the projection period. We’ve assumed, though, an increase in
the fed funds rate of about a point and a quarter by this fall, and on that basis
we’re projecting that real GDP will grow in the vicinity of 4 percent this
year and next. As you can see in the upper panels, we are anticipating that
domestic spending will decelerate appreciably; however, that is largely
offset by a lessening of the negative contribution to GDP growth from the
trade sector.
With potential output rising at about the same pace as actual GDP, we
expect that the unemployment rate--in the middle panel--will remain near
the recent level, in the vicinity of 4 percent.
The tightness of the labor market and other factors suggest that
inflation will generally be tending to move higher, but we’re projecting that
the price of crude oil will decline and damp the rise in overall consumer
inflation this year and next. As you can see in the bottom panels--most
easily in the table--we have PCE prices rising 2 percent, the same as in
1999, while the CPI rise slows a bit from last year’s pace. I have also
included in the chart, as the red line, a plot of the “current-methods” version
of the CPI, for those who might wish to make historical comparisons for that
series on a more consistent basis.
With that overview, let’s turn to the guts of the forecast. Chart 2
explores the financial backdrop. The top left panel shows the P/E for the
S&P 500, but with the index broken into two components: the top 50 by
market cap in each period, and the remaining 450. This may be a dubious
analytical device in some respects; however, it does illustrate that, while
investors’ craving for big-cap growth stocks--especially “tech” stocks--has
lifted the favored few to very high P/Es, even the rest of the index has
enjoyed a considerable valuation boost. The result is that, at this
aggregative level, nothing looks especially cheap by historical standards-even when the P/Es are measured, as they are here, in terms of the rosy
earnings forecasts of security analysts. We don’t have the earnings forecasts
for the full set of NASDAQ stocks, but I’m confident that, if we did, the P/E
rise for them would be only a little less startling than that shown on the basis
of trailing 12-month earnings in the right panel.

17

I won’t belabor the point, but we continue to believe that the
valuations are unrealistic and that this creates the risk of a large downward
adjustment. However, we also recognize that it is impossible to predict
when the bubble--if that’s what it is--will stop expanding, let alone burst.
Therefore, once again, we’ve taken a sort of middle position, anticipating
that stock prices simply will fluctuate around their January average as the
Fed tightens and earnings growth disappoints. That would leave priceearnings multiples not far below their recent peaks; by that measure, equity
capital would remain relatively cheap, but it probably wouldn’t be an
environment in which the new issue market was quite so receptive.
In the credit markets, the alternative measures in the middle left panel
both show that real 10-year Treasury yields have moved up considerably in
the past year or so. And the prevailing real rate levels are not low by the
standards of the past decade and a half. But, if you buy our analysis of
productivity trends, you might suspect that the equilibrium real rate has
risen in the latter half of the 1990s.
In our forecast, we have nominal bond yields rising--to around 7
percent for longer-term Treasuries. This implies some flattening of the yield
curve, shown at the right; if, however, market participants should sense that
the Fed is not in the process of reining in the emerging step-up in core
inflation, such a flattening is less likely. We have, in effect, assumed that
longer-term inflation expectations will ratchet up only a little during the
projection period.
Looking beyond the Treasury sector, the bottom panels suggest that
there has been some diminution in the froth in private credit markets since
the Russian and LTCM shocks of 1998. However, with Y2K concerns
removed, junk bond spreads have reversed a portion of their late-1998
widening--even as default rates have continued to rise. And banks, though
not reversing all of the tightening of business lending standards they did in
the wake of the 1998 turmoil, have not been firming aggressively since then;
by most reports, banks and other institutions continue to be actively seeking
lending opportunities. And we anticipate only a mild tightening of credit
availability over coming quarters because we don’t see an especially scary
deterioration in business or household debt repayment performance, given
the continuing high level of economic activity.
In sum, we’re anticipating that financing conditions will become less
accommodative of demand growth but not harshly so.
The most important element of restraint, as we see it, is the loss of
impetus to consumer spending from the stock market. As shown in the top
left panel of Chart 3, consumer sentiment according to the Michigan SRC

18

index has been trending upward since 1994. This has been a period of
strong growth in employment and income, and people have become
increasingly confident that the good times will continue to roll. The stock
market has both reflected and reinforced that sentiment. But, as indicated at
the right, our flat stock market path implies that the household wealthincome ratio will be falling. The wealth effect on consumption will
gradually move from positive to negative, and as may be seen at the middle
left, this (along with the dynamics of the accelerator effect for durables) is
expected to push PCE growth below that of disposable income by 2001.
Soaring consumer confidence and wealth also have played a role in the
housing market. As you can see at the right, perceptions of homebuying
conditions, as reported in the SRC survey, have deteriorated as mortgage
rates have risen since the end of 1998. And, as shown at the lower left, the
combination of higher rates and rising house prices has raised the ratio of
the fixed-rate mortgage payment on a new home to personal income over
this time span. Some buyers have moderated the immediate cash-flow hit
by opting for adjustable rate loans, but this avenue will become less
attractive under our monetary policy assumption. With builders whittling
down their sizable backlogs of orders, we expect that housing starts-especially singles--will be trending lower through 2001. However, with
home purchase still relatively affordable and people remaining quite
wealthy, we’re looking for only a mild contraction in residential
construction.
Chart 4 examines the outlook for business investment. We’re
projecting that real spending on equipment and software will continue
growing rapidly, while the decline in outlays for nonresidential structures
seems likely to bottom out at some point in the next two years. At the right,
you can see that the net result is total BFI growth of around 10 percent, up
from 1999, but in line with the trend of recent years.
As we indicated in the Greenbook, this might seem a remarkably
strong forecast, given the normal pattern of accelerator effects: that is, with
output growing at a pretty steady pace for several years, one might have
looked for investment to weaken. However, that effect is overridden in our
projection by the ongoing decline in the relative price of equipment-especially the sharp drop in computer prices shown in the middle left panel-and by the increased contribution of replacement investment. As reflected
in the right panel, the increasing importance of investment in computers and
other short-lived items has caused the ratio of depreciation to the size of the
capital stock to rise rapidly in this decade, implying that more and more
gross investment is needed each year simply to replace old equipment and
software. The contribution of replacement investment to spending has risen

19

by several percentage points and is projected to account for more than half
of the increase in gross E&S outlays this year and next.
As for inventories, in the bottom panels, we’re expecting that the
aggregate ratio of stocks to sales will drift lower as a consequence of
improved supply-chain management--and with some inducement from high
real interest rates. Nonfarm inventories are projected to grow a little more
than 4 percent per year--a shade faster than GDP on average, but a bit
slower than business sales.
Turning to the final segment of domestic demand, Chart 5 offers some
perspectives on the outlook for the government sector. For the federal
government, the question is whether any of the ex ante on-budget surplus
will survive. As you can see from the lower black line in the upper left
panel, we have the on-budget surplus rising to nearly $50 billion in fiscal
2001. Our assumption--depicted at the upper right--is that discretionary
spending will be held at the higher real level reached in the current fiscal
year. In part, we made this assumption on the thought that Congress and the
Administration would be constrained by less optimistic official surplus
projections, such as that of the CBO shown at the left as the red line. But
the risk is that, before a deal has been inked, the budget outlook will shift in
our direction and there will be an irresistible temptation to add more
spending or cut taxes. If so, the fiscal impetus, which we see as essentially
zero next year on our assumption, will turn out to be positive, continuing the
pattern of 1999 and 2000.
In the state and local sector, large budget surpluses also may prove a
temptation for more expansive fiscal postures. We are anticipating that the
aggregate surplus will be reduced somewhat by another year of cuts in state
income and sales taxes, shown at the right, and by a continuation of
relatively rapid growth in purchases.
Karen will now examine the influence of the external sector on the
outlook for the economy.
MS. JOHNSON. Economic activity in the rest of the world continues
to expand, and prospects for this year and next are favorable for most
regions. Moderate to vigorous real output growth around the globe poses
risks that inflationary pressures could emerge in world commodity markets,
and eventually product markets more generally, and that we could be
underestimating the upward momentum generated by the interaction of
simultaneous expansion. A possible offset to these risks is the extent to
which other countries, particularly other industrial countries, may be
beginning to experience the kind of acceleration of productivity that we

20

have seen in the past few years in the United States. As yet, the data
provide no compelling evidence that this is happening.
Your next chart presents developments in foreign exchange markets
and recent short-term interest rates for selected foreign countries. In the top
left panel, the decline in recent months in the value of the dollar relative to
the yen (the green line) is in sharp contrast to its rise relative to the euro (the
blue line). The pound (in red) has changed little against the dollar over the
past year. The net effect of these divergent moves is that the index for the
dollar relative to our major industrial country trading partners (the black
line) has declined since your meeting last June but is up on balance from a
year ago.
As can be seen in the panel on the right, three-month interest rates
have moved up for each of these regions with the exception of Japan. These
rate increases reflect a full retracing of the official rate reduction in 1999 by
the ECB and a partial retracing by the Bank of England of declines
implemented from late 1998 through mid-1999. In contrast, the Bank of
Japan has maintained its zero interest rate policy since March of last year.
Despite the absence of recent or prospective tightening by the Bank of Japan
in the near future, the yen has appreciated strongly against the dollar and the
euro.
The middle left panel shows that in terms of the dollar, the exchange
rates of Thailand and Korea have stabilized on balance since the end of
1998. The Hong Kong dollar and the Chinese renminbi have sustained their
rates at a constant value in terms of the dollar over the entire interval shown.
In contrast to the experience of industrial countries, short-term market
interest rates, reported in the panel on the right, have generally not been
rising in emerging Asia over the past six months. The exception is Korea,
line 1, where economic recovery has been particularly strong. Moreover,
spreads of dollar rates paid by these countries over U.S. Treasury rates have
been narrowing.
In the bottom left panel, the continued stability of the Argentine peso
and the relative stability of the Mexican peso over the past several months
contrast somewhat with the fluctuations of the Brazilian real. On balance
over the past six months the real is little changed as it has regained since
October some of its loss against the dollar earlier in the year. Short-term
domestic interest rates have moved down in these countries, and Brady bond
spreads of dollar rates compared with U.S. Treasury rates have narrowed
significantly.
The next chart reports stock market developments in these countries.
In most, stock market prices have risen recently, often to levels well above

21

those at the start of 1997, before the global financial crisis. In the industrial
countries, the upper left panel, European stock prices can be seen to have
risen as much or more than U.S. prices. The exception is Japan, where
equity prices have risen sharply since late 1998 but are only now about back
to their early 1997 level. Stock prices in Mexico and Brazil, on the right,
are also up sharply, especially recently. In Argentina, where recession has
been deep and prolonged, equity values have only partially recovered from
their losses since their peak in mid-1997. Equity markets in Asia, bottom
left, have also rebounded sharply, putting indexes in Hong Kong and Korea
above pre-crisis levels. Chinese stock market prices have shot up recently.
Those in Thailand are recovering, but remain below previous highs. When
expressed in dollars, the performance of stock prices in these developing
countries is not quite so impressive, but they are still up significantly.
The lower right panels compare equity pricing in Germany with that in
the United States. The black lines are the respective real yields on 10-year
bonds in the two countries, using moving weighted averages of consumer
price changes to proxy for expected inflation. The red lines are measures of
the earnings yield, the inverse of the price/earnings ratio, constructed from
twelve-month ahead forecasts of earnings. In both countries, the real
interest rate has moved up over the past year. With unchanged projected
earnings and a constant equity premium, a higher real interest rate implies a
larger discount factor for the earnings stream, a lower stock price, and
therefore a higher earnings yield; the red and black lines would in this
circumstance move together. Instead the two lines tend to move in opposite
directions, with the most recent decline in the German earnings yield even
larger than that for the United States. Stock prices are rising relative to
near-term expected earnings despite the apparently higher discount factor.
Such a development suggests that the equity risk premium that investors
require has narrowed and/or that expectations of longer-term earnings
growth have been revised upward.
Taken together, the financial variables on these two charts suggest a
favorable climate for real economic activity around the globe. High and
rising stock prices suggest significant optimism toward earnings by firms as
well as a declining cost of capital for equity financing of new investment.
Consumption is likely to be buoyed by the increased wealth implied by the
high stock valuations. Short-term interest rates and risk spreads are
generally falling in those regions most troubled during the crisis years of
1997 and 1998. Investors appear to have regained some confidence in
opportunities in those countries, and the price of risk has moderated. Of
course, investor optimism about earnings in one or more regions might
prove to be excessive, and equity risk could be underpriced. A market
correction in a major country would likely trigger similar moves elsewhere.

22

Mindful that there are both upside and downside risks, the staff has
constructed in the Greenbook an outlook for growth abroad that is quite
positive and that reflects the generally supportive global financial conditions
just reviewed. The upper left panel of your next chart compares our outlook
for the United States with that of an average for our foreign trading partners.
The rebound of activity in several regions from earlier depressed levels
resulted in average growth of more than 4 percent at an annual rate in the
first half of last year. We estimate that during the second half, foreign
growth moderated just a bit, and we look for it to be sustained at an average
annual rate of about 3-3/4 percent through the end of the forecast period--a
bit less than the Greenbook projection for U.S. growth.
By region, as you can see on the table at the right, we expect moderate
to strong growth in most areas, with the notable exception of Japan, line 1.
We remain somewhat pessimistic about the Japanese outlook as fiscal
stimulus flags, exports are restrained by the strong yen, and domestic
demand grows only slowly.
The middle panels show industrial production in industrial countries
on the left and in selected developing countries on the right. Of these
industrial countries, Canada has shown the greatest increase in production,
but there has been a clear acceleration in the index in the euro area and in
the United Kingdom in 1999. Japan has shown some signs of a recovery in
production, but output has been erratic and remains below its level in early
1998. The rebound in business confidence in the major foreign industrial
countries is evident in the lower left panel. This change in attitude should
help to foster stronger growth in domestic demand in these countries.
Among the developing countries, the recovery in Korea (the black line
in the middle right panel) has been so rapid that capturing it on the scale
would mask significant growth in Mexico and recovery in Brazil. Korean
industrial production has increased about 40 percent since January 1998.
The need for external adjustment was a driving force in the macro policy
choices made in the emerging market countries during the crisis. As can be
seen in the lower right, the developing countries in Asia (line 1) were able to
achieve a substantial aggregate external surplus in 1998, which diminished
slightly in 1999 as growth resumed and imports recovered. We expect that
continued moderate growth should lead to some further erosion of their
aggregate surplus. For the Latin American countries (line 4), the pressures
of financing an external deficit remain acute, and macro policies will need to
take this into account. Some improvement did occur last year, and we
expect a bit more this year. Nevertheless, these Latin American countries
remain vulnerable, with their policy options more limited, as a result of their
external position.

23

On balance our outlook is for buoyant activity in the rest of the world
on average over the next two years. We should continue to see a reduction
in economic slack in Asia, Europe, and Latin America. These prospects
have implications for prices that are the subject of your next chart.
One place to look for a signal of global price pressures is in the futures
markets for traded commodities, such as agricultural products and metals.
The top left panel shows soybean prices and the futures quotes at the time of
your last chart show and last Friday. Although global demand has recovered
significantly since mid-1999, actual and futures prices for soybeans have
only partially recovered from recent declines. There is some variance in
how futures prices have moved for other grains, but for the most part supply
conditions have kept prices for these commodities from moving rapidly. In
contrast, copper prices, shown on the right, are now substantially higher
than six months or one year ago. Other metals and related commodities
show similar increases. Futures prices going forward continue to show a
much slower rate of increase, however, than that recorded last year.
In light of these market developments, we are projecting that our index
of non-oil commodity prices, shown in the middle left, which rebounded
sharply at the end of 1999, will rise at about an annual rate of 4 percent this
year and a bit less next year. This contrasts with the commodity price
deflation that occurred from mid-1997 to mid-1999. Spot oil prices, shown
on the right, spiked up in 1999 as world demand recovered and as oil
producers were successful in restraining supply. As explained in the
Greenbook, we anticipate that some extension of the current agreement
among OPEC and other producers will be put in place at the end of March,
but that over time additional increases in supply will emerge, putting
downward pressure on prices. We project that the U.S. oil import price will
move back down to about $17 per barrel by the end of next year.
Some pickup in inflation abroad and the move from dollar appreciation
to a constant and then slightly depreciating dollar should impart some
additional upward pressure on U.S. prices from imports. Foreign prices
expressed in dollars are shown in the lower left panel. The non-industrial
countries, in particular, had been a source of downward pressure in 1997
and 1998. That has now reversed, and both groups of countries have been
imparting upward pressure for the past year. As can be seen on the right, we
expect core import prices, the red line, to rise moderately throughout the
forecast period, largely as a result of the contribution of foreign prices
expressed in dollars.
Your next chart summarizes the implications of the foreign outlook for
the U.S. external sector. As can be seen in the top left panel, real imports,
when measured in chained 1996 dollars, substantially exceed real exports.

24

The dots indicate the slight discrepancy between the fourth quarter numbers
released by the BEA on Friday and our Greenbook projection. Going
forward, we expect that annual real import growth over 2000 and 2001 will
exceed that of real exports by about 1-1/2 percentage points despite the
strong recovery of foreign growth and some help from the dollar.
The key relationships between relative growth rates and prices and our
trade balance are centered on core exports and imports, shown on the right.
Foreign GDP growth boosted core exports in 1999 (line 2) and should
continue to support moderate growth this year and next. Reflecting our
projected path for the dollar, relative prices (line 3) should switch from
retarding exports to stimulating them. However, U.S. GDP growth is
projected to provide a significantly larger boost to core imports (line 5) than
the analogous line for exports, owing to the historical tendency for U.S.
imports to be more sensitive to income growth than are exports. Even with
some slowing imparted by relative prices (line 6), core import growth
remains above that of core exports.
The middle left panel translates this projection for exports and imports
into contributions to real GDP growth. The positive contribution from
exports should slowly rise, on balance, through the end of 2001 while the
negative contribution of imports diminishes.
The panel on the right shows the implications of these trade
projections for the nominal current account balance (the black line) and its
ratio to GDP (the red line). We expect that the balance will exceed $400
billion in the first quarter of this year and will reach nearly $500 billion by
the end of next year. At about 4-1/2 percent of GDP, the deficit will
significantly exceed the previous low point reached in 1987.
In order to evaluate the longer-term implications of our current
estimates of the underlying trade relationships and the stronger outlook for
U.S. trend growth, we used our somewhat more aggregated long-term model
for the U.S. external sector to simulate the current account as a ratio of GDP
out to 2015. The results are shown in the bottom panels. The baseline path
(the black line) follows the Greenbook for this year and next and then
assumes that U.S. and foreign real GDP return to potential levels in the
medium-term and then grow at potential rates over the remainder of the
simulation. To provide some scope for adjustment, we put into the baseline
an ongoing 1 percent rate of depreciation of the dollar in real terms, starting
in 2002.
In the baseline, the ratio of the deficit to GDP stabilizes for a time as
U.S. growth is assumed to slow below potential and foreign output
accelerates. Once that adjustment is complete and domestic and foreign

25

output grow at trend, the ratio again deteriorates, reaching 10 percent in
2011, and would continue to do so. In the left panel, we show the
simulation results of a one-time 25 percent drop in the value of the dollar
phased in over 2002 followed by a return to the baseline assumptions. Such
a sharp drop in the exchange rate has a pronounced effect initially, and the
current account deficit recovers to 3 percent of GDP. The benefit of that
depreciation subsequently erodes, however, and the rate of worsening in the
current account ratio returns toward the baseline outcome.
The right hand panel gives the results for a simulation of a steady
depreciation of the dollar in real terms of 5 percent per year. Although such
a depreciation does not eliminate the continuous worsening of the external
balance, it slows it substantially. Under these assumptions, the current
account deficit reaches 5-1/2 percent of GDP by 2010. These simulations
suggest that quite sizable declines in the value of the dollar would be needed
for that channel alone to provide external adjustment such that the current
account stabilizes as a share of GDP.
Dave Stockton will now continue our presentation.
MR. STOCKTON. The upper panel of the next chart displays our
inflation projection. As depicted by the black line, consumer prices,
measured by the PCE chain-weight index, accelerated a percentage point
last year to 2 percent--a pace we expect to hold this year and next. That
relative stability masks what we anticipate will be some deterioration in the
underlying inflation picture. After remaining nearly unchanged at about a
1-1/2 percent pace since 1996, core PCE inflation--the red line--is projected
to drift up gradually to a bit above 2 percent over the next two years.
Food prices, the middle left panel, are not expected to exert much
influence on headline inflation. Improving export demand and rising labor
costs result in an increase in these prices that is just a bit faster than core.
By contrast, retail energy prices--the right panel--were the principal reason
for last year’s acceleration of overall PCE prices and their deceleration this
year and next contributes to the relative stability of overall PCE prices going
forward.
The slowdown of energy prices provides an offset to a variety of
influences on inflation that already have begun to turn less favorable. Core
non-oil import prices--the lower left panel--moved up last year following
three years of decline. And we anticipate continued--albeit modest--upward
pressure on import prices over the projection period.
Prices of domestically manufactured intermediate materials--the black
line in the lower right panel--also picked up last year. The rebound has been

26

driven by the strengthening of industrial activity that has accompanied the
recovery abroad, as well as by the indirect effects of higher oil prices. This
morning’s reading from the purchasing managers’ survey for January on
prices paid--the red line--suggests that upward pressures have continued
early this year.
Developments in labor markets, the subject of your next chart, also are
expected to provide some impetus to inflation over the next two years. As
shown in the upper left panel, employer costs for health insurance continued
to accelerate last year after a period of virtual stability in the mid-1990s.
Our forecast is roughly consistent with the available private surveys, which
suggest these pressures have not yet diminished and may well be
intensifying.
We also are anticipating the enactment of a one dollar increase in the
minimum wage, split evenly between October of this year and October
2001. As shown in the panel to the right, we expect these increases to exert
a relatively small effect on compensation costs over the next two years and
to be an even smaller influence on prices.
The middle two panels highlight what we believe are likely to be the
more fundamental influences on inflation over the next two years--the
tightness of labor markets and some deterioration of inflation expectations.
As indicated in the left panel, households perceive a very strong job market.
The gap between households reporting that jobs are plentiful and those
reporting that jobs are hard to get is now extremely large. With regard to
inflation expectations, the right panel, both direct survey readings and
econometric proxies for the influence of price inflation on wage setting have
become less helpful over the past year. Median one-year-ahead inflation
expectations in the Michigan survey--the black line--have moved up about
1/2 percentage point over the past year. And, distributed lags of past
consumer prices, constructed using either PCE prices or the CPI, turned up
last year and are poised to increase further in coming quarters.
The bottom line is that we are anticipating some resumption of the
uptrend in labor costs. As we have noted in recent Greenbooks, there are
serious flaws in both major measures of compensation change. The
employment cost index--the red line--excludes many types of hiring and
retention bonuses, misses the use of promotions as a means of raising
wages, and excludes stock options. Given the increasing prevalence of these
and other alternative forms of compensation, the ECI likely has
underestimated compensation costs in recent years. The nonfarm business
compensation measure--the black line--does capture “promotion creep” and
includes stock options. However, it measures stock options at their value
when exercised rather than the grant value when issued, and thus may

27

overstate the cost and distort the timing of firms’ payments for labor
services. Moreover, the nonfarm business measure is estimated with
information on benefits that is less timely than that in the ECI.
These uncertainties have made it more difficult to interpret formal
models of price determination that rely on wage data. As a consequence, we
have found ourselves leaning more heavily on models that do not involve an
explicit link to labor costs. One such model is shown in the upper panel of
chart 13. This simple reduced-form model makes core PCE a function of its
own lags; food, energy, and import prices; and the unemployment rate. The
model forecasts a step-up in core PCE inflation over the next two years,
reflecting both the tightness of labor markets and the upturn in import and
energy prices last year. The Greenbook projection also calls for some
acceleration, but not so much as projected by this model. In part, we have
shaded down our forecast on the thought that, with capacity utilization rates
still below historical averages, price pressures may remain more subdued
than suggested by the unemployment rate.
As a reminder that science--such as it is--only gets us so far in
narrowing the range of possible outcomes, I have included a 70 percent
confidence interval for the forecast of this model--the blue shaded area. It’s
constructed from stochastic simulations that account for the uncertainty
surrounding the estimates of all of the parameters of this model. As can be
seen, that interval ranges between an outcome with no acceleration in core
PCE to an acceleration that breaches 3 percent by 2001. And, even this
exercise understates the uncertainty you face by failing to account for the
uncertainty surrounding the model’s basic specification of the inflation
process.
The lower panels dispense with an analytical framework--save,
perhaps, for a crude version of supply and demand--and simply resort to
counting the frequency with which a very broad measure of prices--the GDP
price index--has accelerated on a year-over-year basis in various ranges of
resource utilization. For example, as shown in the middle left panel, when
the unemployment rate has been in the range of 6 to 7 percent, GDP prices
have accelerated 43 percent of the time. As the unemployment rate
declines, the frequency of price acceleration generally increases. The bar at
the far left shows that prices have accelerated every year in the sample when
the unemployment rate was less than or equal to 4 percent. With our
projection anticipating the unemployment rate to hover near 4 percent over
the next two years, we have clearly entered a danger zone when judged by
the historical performance of inflation.
But even this story is a bit murky. We’re expecting capacity
utilization to move up over the next two years, but to remain in the 80 to 82

28

percent interval. As indicated by the corresponding bar in the lower left
panel, that range has been associated more often than not with a pickup in
GDP prices. But the frequency of acceleration in that range--about twothirds of the time--is not nearly so high as that suggested by our forecast of
the unemployment rate. Of course, as the warning goes, past performance is
no guarantee of future outcomes. Indeed, in the second half of the 1990s--at
least through 1998--we beat the odds suggested by both the models and this
simple summary of historical behavior.
By our reckoning, one of the key factors behind the favorable
performance of recent years has been the pickup in potential output and
productivity growth--the subject of your next chart. As shown on line 1 in
the upper panel--we are expecting an acceleration of potential output to a 4
percent rate over 2000 and 2001, reflecting a larger contribution from
capital deepening--line 4. Given our investment projection, the growth of
capital services--the middle left panel--is projected to trend still higher over
the projection interval. Multifactor productivity--at the right--is expected to
continue to increase near the 1 percent pace observed in the past several
years.
The 3 percent annual rate increase that we are now projecting for
structural productivity is nearly double the pace averaged over the 1980s
and early 1990s. As has been noted around this table, it is impossible to
know just how far along we are in the process of implementing new
technologies and, consequently, what the scope is for even faster growth of
productivity. The lower panel of the exhibit plots the acceleration of
productivity--that is the change in productivity growth--measured here over
two-year intervals. As can be seen, productivity in the nonfarm business
sector, measured from either the product or the income side, has been
accelerating in recent years. In our projection, we expect actual productivity
to remain close both to the 3 percent pace observed over the past couple of
years and to our estimate of structural gains in productivity. But a further
acceleration certainly cannot be ruled out.
Your next chart updates a simulation that we have presented
previously to lay out the sensitivity of our projection to alternative
trajectories for structural productivity. As shown in the upper left panel, the
first scenario--the red line--considers the consequences of a further
acceleration of structural productivity to 4 percent by the end of 2001. In
the remaining panels, I display the economic consequences of that
acceleration using a simulation of the Board staff’s large-scale econometric
model. For purposes of this exercise, I have assumed that the federal funds
rate is held to the baseline path.
The growth of real GDP--the upper right panel--is much faster under
the more optimistic productivity assumption. Firms and households boost

29

spending on equipment, structures, and durable goods in response to the
improved future prospects. As we have noted in the past, in our model, the
boost provided to aggregate demand exceeds productivity-augmented supply
in the near term, and, in the simulation, the unemployment rate--the middle
left panel--declines to well below 4 percent. Because wages respond
sluggishly to both the tighter labor markets and the improvement in
productivity, compensation inflation--at the right--is only marginally higher
over the next two years than in the Greenbook. That sluggish behavior of
wages in the face of accelerating productivity leads to an increase in the
profit share--the lower left panel--which provides a boost to equity prices
and feeds back to stronger aggregate demand. Faster productivity growth
and the competitive pressures that follow fatter profit margins also help to
keep a lid on price inflation--the right panel. Core PCE price inflation is
projected to level out at just under 2 percent in the faster productivity
scenario.
Of course, it is possible that we have gotten carried away by the stellar
performance of productivity in the past few years. Any reliable separation
of structural from transient increases in productivity is difficult in the midst
of an ongoing expansion. The second scenario shown in the upper left panel
considers a gradual deceleration in structural productivity to about 2 percent
by the end of the forecast interval, well below the pace we believe has
prevailed in recent years but still more rapid than the 1974 to 1995 average.
Obviously, the economic outcome would be considerably less favorable
than in the Greenbook. There would be a pronounced slowing in the growth
of real GDP and a clear upturn in the unemployment rate. With productivity
slowing more rapidly than wage inflation, the profit share would drop.
Firms would raise prices more quickly in order to restore profit margins that
are squeezed by rising unit labor costs, and core PCE inflation would move
up toward 2-1/2 percent.
Mike will now complete our presentation.
MR. PRELL. Just to wrap up quickly, the final chart summarizes the
forecasts you submitted. The central tendency for real GDP growth is 3-1/2
to 3-3/4 percent, somewhat below the Greenbook number, and you see no
significant change in the unemployment rate over the course of the year, as
is the case in our forecast. Your PCE price inflation forecast is a tad lower
than ours, with a central tendency of 1-3/4 to 2 percent. We don’t yet have
the Administration’s forecast, to which we customarily compare yours in the
Humphrey-Hawkins report. My suspicion, however, is that the
Administration will be predicting less growth of GDP, with a weaker
productivity performance.
That concludes our prepared remarks, Mr. Chairman.

30

CHAIRMAN GREENSPAN. That was very well done and I think quite informative.
Questions for our colleagues? President Minehan.
MS. MINEHAN. Mike, you highlighted at the end of your remarks that you thought
the Administration’s forecast was likely to be different from yours on the growth side, possibly
because of different assumptions about productivity. It would seem that most forecasts are
different from yours on the growth side. Whether one looks at the DRI or Blue Chip forecasts or
others, almost everybody is closer to the central tendency of the Reserve Banks by this rendering
of it than to the rather optimistic growth picture that you are showing in the Greenbook. I would
be interested in any thoughts or comments you have on that.
MR. PRELL. It may just be that we are wild and crazy guys here! [Laughter]
MS. MINEHAN. I love it when you say that!
MR. PRELL. However, we tried to temper our wildness and do a little homework,
and I think Dave Stockton laid out the crux of our analysis. We’ve looked in particular at what
has been--and we expect will continue to be--rapid growth in the capital stock and the flow of
capital services. That growth does seem to have been paying off. We expect a sizable
contribution from capital deepening. We have assumed what would seem to be rather moderate
improvements in multifactor productivity, given recent performance. But there is a great deal of
uncertainty. And many forecasters are wrestling, as we are, with the question of how much of
the improvement in productivity is solid and permanent and how much reflects a transient
element, with businesses surprised by the strength of demand and thus pressing their available
resources very hard in the short run. If the improvement is more permanent than transient, they
are going to attempt to bring their work forces up into what might be considered a more normal

31

alignment with their production levels. And they may have difficulty doing that in this labor
market. But our assessment, as we look at the steadiness of the productivity gains in the last few
years and the ongoing acceleration, is that one should not attribute as much to the cyclical
elements of productivity performance as I think perhaps the average private forecaster has.
MS. MINEHAN. It is also rather interesting, though, that most of those forecasts have
assumed much less tightening than you do. The average tightening in all of the forecasts is
somewhere between 25 and 50 basis points with something on the order of 75 to 100 basis points
less in terms of growth.
MR. PRELL. I don’t have enough information on all of the individual forecasts to be
able to analyze these differences. I think the productivity assumption difference is part of the
story. It is propelling permanent income growth higher. It is affecting the stock market. Some
of the forecasts--Macro Advisors, for example, for which we have the explicit pieces--are still
anticipating a decline in stock prices, which we are not. In some instances I think these forecasts
do not have the same analysis of investments that we have, taking into account this large
component of replacement investment. Our investment forecast, I believe, is above the
consensus. And on housing we’re stronger than the consensus. Again, we’ve been above the
consensus for a while, partly on our analysis that there was a good backlog of orders and that
wealth effects might be significant. We think those conditions are still in place. So, on all
elements of private final demand we have a little stronger picture and a somewhat stronger view
of the underlying fundamentals in many instances. Now, some other folks have rising stock
prices and still have weaker demand. So it’s very hard to-CHAIRMAN GREENSPAN. That’s just inconsistent.

32

MR. PRELL. One can have different coefficients or a different view of the wealth
effects and so on. One can attribute less of the strength in consumption demand to normal
wealth effects and more to the spate of mortgage refinancing last year or to just erratic elements.
We recognize that we are above the crowd but we are hard pressed, given our analysis, to come
to the conclusion that we should be materially lower at this point.
MR. MEYER. Could I just give an interpretation of why the staff has a somewhat
different perspective from most of the private forecasts? I think the main difference is that the
staff here has a very strong view of the interaction of supply and demand. This common force of
productivity is affecting both demand and supply. I think they have been proven very accurate in
that. One doesn’t see that perspective in most of the private forecasts. So, when those
forecasters revise up their productivity growth estimates, they do not get the same demand
impact, and that changes the whole dynamic.
CHAIRMAN GREENSPAN. I think that is exactly right. In fact, the risks to the staff
forecast may very well be on the up side. The probability that their forecast is too low is by no
means negligible.
MR. PRELL. I might just say, in terms of signs of strong demand, that we have
received a preliminary reading on January auto sales. And they seem to have come in at almost
18 million units--17.9 million--for light vehicles, which is well above the rate we are anticipating
for the first quarter. So that in combination with the construction data this morning means that
we’ve had two pieces of much stronger spending data than we had built into the Greenbook
forecast.
CHAIRMAN GREENSPAN. President Jordan.

33

MR. JORDAN. Thank you. I have a few questions on the international side and then,
if I may, a question on Dave Stockton’s presentation and the simulations on Chart 15.
But first, Karen, on Chart 10: I think these kinds of simulations are interesting, but I
want to get you to say a bit more about a scenario that might at least be consistent with the
exercise that you went through here. We see a lot of references to the idea that the United States
has become a debtor nation now and that our external liabilities are growing. I’ve probably even
talked that way myself on occasion. But we know that a lot of the holdings by foreigners, the
source of the capital inflows--the counterpart to this large and maybe growing current account
deficit--consists of assets that from the perspective of these foreign investors are denominated in
dollars. We may think of some of it as debt, but to them it is an asset. And some of their
holdings are literally dollars. I would assume, the way the accounting is done, that if last year
foreigners increased their holdings of U.S. currency by $30 billion--or whatever the number was
--that it is counted as part of our debt. So, that would be part of the financing that has been going
on.
MS. JOHNSON. In the balance of payment statistics it is logged that way. It is not a
huge number but, yes, it is counted as debt.
MR. JORDAN. It is getting pretty big! Depending on what the rest of the world does
with regard to so-called dollarization, it could get quite large. I don’t know how much the
Russians alone acquired last year. The other dollar-denominated assets that foreigners hold-whether CDs or other types of deposits in our banks, mutual funds, debt securities, equities, or
other kinds of investment vehicles--are counted as part of our debt. The part that in a sense
really is our debt is what they buy of Uncle Sam’s debt or debt instruments of other governments
or corporations in the United States. That is debt, whether held by domestic or foreign investors,

34

and appropriately so. And to some extent we are on the receiving end of what on the basis of
anecdotal reports is an increasing volume of direct foreign investments of all kinds--acquisitions
of our companies including, for example, supermarket chains and banking chains, which may
increase too. Suppose we superimpose on your simulations two extremes: (1) that all of the
increase in foreign holdings of dollar-denominated assets really is Uncle Sam’s debt, or (2) the
other extreme, that it is all equity investments, portfolio investments, or direct investments of any
kind. Would we draw different conclusions about the implications for the exchange rate of the
dollar?
MS. JOHNSON. You are reading in here a step that is not truly on a piece of paper.
MR. JORDAN. I know.
MS. JOHNSON. That step is the notion that as this number gets very, very large it
would inevitably have some consequences on people’s willingness to hold dollars and would
produce a 25 percent devaluation or a 5 percent devaluation or whatever. The analysis that I
have here, the model that I am able to rely on, only works from one side of this process. And it
says: If the dollar does X, Y would be the implication for the current account balance. To
answer your question--not having any simulation to draw on but just reacting to where I think
you are going--I would say that it is true that the capital account is an important piece of the
story. The desire of foreigners to invest in the United States and to participate in the gains from
the productivity developments that have occurred in the United States does, I think, lie behind
some of the developments we are seeing here. That is most evident in the fact that through much
of the time the deficit has been widening--over the past three years, let’s say--the dollar has been
rising. That means the capital account is going in this direction at the same time that the current
account is going the other way. That might lead one to take comfort in the notion that people

35

find attractive the instruments they are buying in the United States. If we believe that the asset
valuations in U.S. financial markets are sound, there is no reason to think that is going to change
in any hurry. It will over time, taken at face value, open up a gap between GDP and GNP. That
in and of itself is no big deal, although I can imagine some politicians will make a lot of noise
about it. But in principle there is nothing about the economics of having a gap between GDP and
GNP that would be troublesome. We could well imagine that the world is making a rational and
appropriate allocation of global savings into a major economy where productivity is higher than
it is elsewhere and where capital ought to be accumulating. Some of that capital is owned by
foreigners and some of it is owned by the residents of the United States, and there is no problem.
And that could continue for some time. But I don’t think there is anything about the form that
foreign investment takes--whether it is in portfolios or in direct investments--that necessarily
assures that it will continue. That’s because if foreigners were for any reason--political,
economic, rational, or irrational--to decide that they were unhappy with their exposure to the
U.S. economy, they would avail themselves of financial instruments either to decrease that
exposure or to hedge it. One can readily hedge foreign direct investment by selling financial
assets short and view that as having protected oneself against certain kinds of exchange rate
developments or certain kinds of economic developments. It is not the case that the form in
which the capital enters the United States necessarily implies anything about future behavior.
So, while I put this forward as a warning flag--I don’t deny that--I do not think it
necessarily implies that the dollar will come under pressure tomorrow or the next day or next
year. But I would also say that there is nothing automatic about how the forms of capital inflows
will work out in the future should there be a change in investor sentiment toward holding claims
on the United States.

36

MR. JORDAN. Okay, I accept that--and there is nothing in this simulation that
suggests a change is imminent. Let me come at my question in a slightly different way, because
I’m trying to understand this better. Let’s start from the panel in the lower left where the
exercise involves an assumption that the dollar is devalued by 25 percent. My first reaction was
to say to myself, “Okay, that's a useful exercise to go through.” Then I started thinking about the
fact that if the dollar were declining by 25 percent in value over some time period, other
currencies would be rising by 25 percent against the dollar. And I can’t imagine any currency
for which that might actually happen.
MS. JOHNSON. I'll submit the euro, but I guess I'll throw that out. [Laughter]
MR. JORDAN. You'll never convince me.
CHAIRMAN GREENSPAN. The Cuban peso! [Laughter]
MS. JOHNSON. Think about the problem that the Japanese economy is confronting.
I’m personally quite pessimistic about Japan, so I don't think anything positive is going to
happen there any time soon. But all those people who are buying Japanese equities clearly feel
differently and have felt so for a while. And the people putting upward pressure on the yen feel
differently. The Japanese economy might appear to be restructuring and recovering and might
appear to offer returns down the road that will be quite attractive. Nonetheless, the Japanese
current account surplus means that exchange rates and interest rates have to be such that
Japanese investors are persuaded to acquire net claims on the rest of the world each and every
month--no matter what--going forward. That, too, is a daunting thought. One might well believe
that that is going to be hard to do after a while, if the Japanese economy begins to recover.
MR. JORDAN. Maybe the Japanese are all Ricardians! Let me ask Dave Stockton a
question about Chart 15, if I may. These are interesting scenarios. This gets back, I think, to

37

Governor Meyer’s comment on the simulation differences between other forecast models and the
staff’s model. Under your scenario 1 in the staff’s model, wouldn’t it be the case, at least with
partial analysis, that given the acceleration in productivity and the corresponding increase in real
GDP growth you would have a deceleration from the inherited rate of inflation corresponding to
that? To the extent that does not occur, then you would have to have--and I guess the model
requires this--an acceleration in nominal spending. That says that you don’t get all of the
productivity gains in a lower price level over time--a lower rate of inflation on an ongoing basis-but rather some of it produces an increase in final demand. And that increase in demand has to
be financed. So, is it implicit in this that there is an accommodative policy on our part? Either
money growth accelerates and all the credit comes along to finance the greater spending or
velocity must change. What happens to make these things come together?
MR. STOCKTON. In fact the underlying assumption here is that monetary policy
accommodates this step-up in nominal GDP. There would be an increase in money growth to go
along with that. Obviously, this is a short-run scenario. I think the simulations that are presented
in the Bluebook tried to give a flavor of the case where we are in the midst of an acceleration in
productivity and the equilibrium real funds rate has to go up along with that. This in effect says
that you could hold on for another two years and experience a period where the unemployment
rate declines even further and the inflation rate basically stays where it has been. Now, at the
end of that two years, you are not where you need to be ultimately. In some sense the funds rate
and the entire structure of interest rates will have to move higher over the longer term in order to
sustain that low inflation.
MR. JORDAN. Okay. But--and I think this is a very important point--the simulation
does not allow the real interest rate to move up to the equilibrium level because you don't let the

38

inflation rate come down. That is the way the model works. We don’t get that automatic
increase in the real rate that would come along with the deceleration of inflation, and therefore
the real rate has to rise out in the future to get things back into balance.
MR. STOCKTON. In the constant federal funds rate scenario, there is a very small
increase in the real federal funds rate just because of the slightly lower inflation rate. But your
point is exactly correct.
MR. JORDAN. Okay, thank you.
CHAIRMAN GREENSPAN. President Parry.
MR. PARRY. Karen, I have a question about Japan. Recently the Finance Ministry
indicated that it might be borrowing at 2.1 percent as opposed to issuing 10-year bonds that
would cost 1.6 percent. I have a few questions on this and I will try to sound objective in asking
them. First, is this an astute financial strategy or is it a

, given all of the financing

that they have to do? Second, is this chapter 2, so to speak, of capital injection into the banking
system, which would suggest that perhaps banks really have not turned the corner in Japan? I
must admit that it seems really--to use a neutral term--“interesting” at a time when long-term
postal savings deposits are coming due and are being renewed at .25 percent, that the Finance
Ministry is going to borrow from banks, which is a narrow private group, at 2.1 percent. It
seems to me that that would cause tremendous political problems.
MS. JOHNSON. The only information I have on this is from the New York Times
article that I read. We have talked about this among the staff and have tried to figure it out.
There are various hypotheses about how to understand what is going on, though I can't
distinguish among them. And I put into this particular stew the fact that the Bank of Japan has
announced that it will be busy selling bills into the market over the short run to absorb excess

39

liquidity. The Ministry of Finance says

that

they are trying to mobilize funds that they view as sitting around in the banking system doing
nothing. They haven't admitted that this is some sort of approach to a credit crunch situation.
They see these funds sitting there and they are going to utilize the resources. So they propose to
borrow to provide to local governments funds that they are obligated to provide under budget
provisions that already exist. In essence they are borrowing from the banking system to finance
this. The right alternative, presumably, would have been to issue more Japanese Government
Bonds (JGBs). And one might imagine that the banks would have taken these idle funds that are
being provided for them and bought JGBs at 4 basis points.
MR. PARRY. Right.
MS. JOHNSON. So, one possibility is that this is a way to give the banks a bit more
income. One might ask, as I have, whether the Ministry of Finance thinks that because this is a
relatively more attractive instrument banks will provide more financing than they would have
through the direct JGB route. If so, when all is said and done, in some sense the Ministry of
Finance is going to be able to expand the amount of financing it can do because it is not just a
one-for-one swap that will appear on the books but in effect has no policy implication. The
Ministry of Finance might actually have to do less financing in the open market as a consequence
of having issued an instrument that is particularly attractive to banks, thereby increasing the
willingness of banks to hold claims on the Japanese government. If that were the case, the
Ministry could say that, yes, it paid a bit more but actually sold more into the market. If it did
more in the JGB market than it would have otherwise--if it just has to sell as much as it has to
sell with nothing else going on--this is not a crazy scheme from the point of view of the Ministry
of Finance, I guess.

40

A couple of things about it worry me. One is that it seems to be at odds with what the
Bank of Japan is doing.

.
Another concern is that all those JGBs sitting out there are going to sell for enormous
capital losses when Japanese long-term rates really move. So they end up with a banking system
into which they have put a large amount of capital and barely gotten any effect. The banking
system is not fixed by any means. If the economy were to recover, as they deal with the cycle of
debt they are creating, this undercuts that process by putting more capital losses on the books of
Japanese banks. These instruments presumably won't be trading in the market; they won't be
marked to market and won't show capital losses. At least they won't show them any time soon
because they are going to be selling at rates that are above market for a while anyway. This may
be a way of trying to improve bank balance sheets--a way of giving them returns of 2 percent
instead of 2 basis points--because they are going to need it.

.

41

MR. PARRY. Thank you.
CHAIRMAN GREENSPAN. President Stern.
MR. STERN. Thank you. I have a question about the simulations as well, Mike. The
Greenbook shows a baseline simulation and a flat funds rate simulation. As I look at the
analysis, it seems to imply a sacrifice ratio of about one. In the Bluebook the sacrifice ratio is
much worse. I am trying to understand what causes the difference. Is it different assumptions
about credibility or about how expectations are formed? I don't know what it is.
MR. KOHN. It is a different time period. Our sacrifice ratio in the Bluebook is
calculated over a full ten years when all the lags work out. It might be very different in the short
run than over the long run.
MR. STERN. Really? But it involves a difference of .8 percentage point --a .1
difference in the unemployment rate and a .7 difference in the PCE price number.
MR. PRELL. In the short run the exchange rate dynamics exaggerate this response.
That’s probably an important element in getting an effect this big.
MR. STERN. All right. Then let me ask about the Bluebook sacrifice ratio. I don’t
know what your credibility assumption is, but it seems really high.
MR. KOHN. It is a little higher than we've had in the past, but not much. It is
consistent with the model looking out over the longer run. It is a fairly high sacrifice ratio, I
think, compared to some other models, but it is not out of the bounds. The baseline simulation
over the next two years has a 1 percent plus NAIRU gap and only a very small upward creep in
inflation. That implies a pretty high sacrifice ratio. That’s great when the unemployment rate is
below NAIRU because it doesn’t result in much upward creep in inflation. Obviously, if you
want to lower inflation, you have to be a lot above NAIRU for a long time to get inflation to

42

come down. So, this sacrifice ratio was intended to be consistent with the basic story in the
Greenbook in terms of how fast inflation would accelerate over the next few years given the
assumed output gap. It’s important to recognize that there are a lot of things going on in the
Greenbook scenario that have to do with price shocks, oil prices moving, and so forth. But this
analysis tries to abstract from that and get at the underlying slope of the Phillips curve.
MR. PRELL. One of the things we have pointed out before repeatedly in these model
simulations is that the same output path generated through a different stock market assumption
versus a different monetary policy assumption will have much larger expectational effects in the
monetary policy case. It is quite plausible that if the Fed were perceived to be doing nothing in
the face of this decline in the unemployment rate and the acceleration in prices, people's inflation
expectations would be marked up considerably. So, that change in expectations would
exaggerate the effects in this kind of scenario. But this does generate a significant decline in the
dollar on exchange markets and that exacerbates the inflationary effect.
CHAIRMAN GREENSPAN. President Poole.
MR. POOLE. I want to go back to Chart 10. Karen, it looks as though you have an
assumed exogenous change in an endogenous variable. That’s something I have spent 30 years
trying to tell my students not to do!
MS. JOHNSON. But I used a partial equilibrium model, so it's okay! [Laughter]
MR. POOLE. I'm speechless! [Laughter]
MS. JOHNSON. There is nothing about these simulations that is intended to suggest
how the dollar would react or to cause changes in the dollar. This is simply a statement that
says: If both foreign growth and U.S. growth were at potential, as best we know it, and if the

43

dollar were to follow this path, this would be the outcome of the current recovery. Nothing here
is meant to be predictive of what drives the dollar.
MR. POOLE. I guess the question is: What can one learn from such an experiment
when by its very nature, if it’s partial equilibrium, it involves a whole lot of things that don't add
up? The model that you have is now internally inconsistent.
MS. JOHNSON. What I think one can learn from this analysis is that those who
believe a return to stronger, more vigorous growth abroad will solve the external balance
problem of the United States are mistaken. Unless the parameters that relate trade to its nearterm determinants change a lot and change soon, it is not the case that a resumption of foreign
growth will have the effect of closing the U.S. external gap.
MR. PRELL. This contradicts to some degree what I was saying earlier in my
comparison of various forecasts. But, if you look at outside forecasts, many of them have the net
export balance reaching a nadir sometime this year--either flattening out or turning. And they
have had this kind of pattern for a while. We have not been able to understand why, given our
analysis of the elasticities involved. Yet people still do seem to have this notion in their minds
that strength in these foreign economies will have this result or that our import elasticity isn’t as
strong as it seems to be.
CHAIRMAN GREENSPAN. President Hoenig.
MR. HOENIG. Mike and Dave, with respect to your simulations, let me ask
something that I think has been hinted at around the edges in two or three previous questions. In
the Greenbook prepared last time for our December meeting, you had an assumed increase of 75
basis points in the funds rate in the works. In this Greenbook you have an increase of 125 basis
points. If one looks at these simulations, the analysis suggests that we are behind the curve

44

unless scenario 1 occurs. So let me ask what you think the odds are of scenario 1 materializing.
Everything else suggests that we are behind the curve.
MR. STOCKTON. I am not sure I would characterize scenario 1 in quite the same
way you have characterized it. In fact, one could argue--and I think this may be what President
Jordan was arguing--that in scenario 1 you fall further behind the curve in the sense that even
though inflation is not picking up, the unemployment rate is falling even further below its
equilibrium. Indeed, the real federal funds rate is falling even further below its long-run
equilibrium. In that scenario we are enjoying another period of sustained, strong economic
growth and low inflation. But there is still a fair amount of work to be done in scenario 1 in
terms of adjusting policy at some point down the road in order to bring the funds rate back into
equilibrium. Now, you will inherit a lower rate of inflation after going through that process,
which is certainly something that benefits you. But while it is good news for this two-year
period, there is still policy tightening to be done further down the road. That, in fact, is what
some of the longer-run Bluebook simulations are showing.
Now, in terms of the probabilities, if one were to judge the probability of scenario 1 by
the staff forecast errors of recent years, one might say that it is not entirely implausible.
[Laughter] Obviously, we think we have a relatively balanced set of risks in our forecast. But as
seen in Chart 14, the most recent observation shows that productivity is still accelerating. So, it
is not entirely clear that the probabilities are split right down the middle between scenario 1 and
scenario 2.
MR. HOENIG. That’s interesting. Thank you.
MR. MEYER. Could I just follow up on that? In judging that probability you might
want to indicate what the path of investment would have to be in the model to produce the capital

45

deepening required to achieve that scenario, given that the capital deepening is what has been
generating most of the uptick in trend productivity.
MR. STOCKTON. That is true. But in this particular scenario, that faster
productivity growth is generated in part through the more rapid multifactor productivity growth
that we’ve had. And there’s some addition to that from the capital deepening. So both of those
factors are working here.
MR. PRELL. To underscore that point, I hope all of you saw the pre-FOMC briefing
from yesterday. Our multifactor productivity trend here pales by comparison to what has been
experienced in some long periods of this country's economic history. So that could well be a
component of a better productivity performance.
MR. MEYER. Yes, but that’s almost pulling something out of the hat in a way. It
seems to me that the big story here is the increase in capital deepening. If you want to play the
story out, I think you need to trace through what would be needed to get so much more capital
deepening to produce that acceleration in productivity.
MR. PRELL. But if one thought that this investment was merely the prelude to
putting in place more efficient operations and so on, one might say the payoff in multifactor
productivity still lies ahead. If one wants to be a new wave optimist here, it is certainly possible
to come up with stories in which the assumptions are more generous. We feel that we have a
reasonably balanced scenario in our baseline forecast, obviously. We are far more optimistic
than other forecasters by and large, and yet we think this is a sensible look at the prospects.
CHAIRMAN GREENSPAN. There is an interesting interplay between what Karen
was saying and what Larry has just said. The strength of the dollar in the face of this widening
current account deficit is apparently the consequence of the increasing rate of return on facilities,

46

which is related to capital deepening. That relationship has been fairly strong, at least up until
the immediate forecast, so that there is a tie among all of these simultaneous simulations in
which lots of things are occurring. If you pull one string, the whole thing unravels.
MR. PRELL. Just to grab onto one more string, though, it is possible that the
buoyancy of the dollar has had something to do with what some might argue was a bubble
situation in the equity market. So people may have exaggerated ideas of the prospective returns
from these investments.
CHAIRMAN GREENSPAN. Foreigners?
MR. PRELL. Domestic and foreign investors. But foreigners are playing a role in
this, investing in what they perceive to be very, very profitable U.S. ventures.
CHAIRMAN GREENSPAN. Shall we break for coffee before it gets frozen?
VICE CHAIRMAN MCDONOUGH. May I add one comment related to this? Going
back to Karen's Chart 10, we have been doing a great deal of work on the current account deficit
as a percentage of GDP. In a way the work we’ve done was driven by the notion that given
almost any reasonable pattern one assumes for the world economy, the current account deficit as
a percentage of GDP continues to worsen. As one goes from deep concern to sheer terror about
that prospect, the question arises as to what can possibly be done about it. So one comes out
with questions like “what happens if there is a 25 percent devaluation?” Just about all the
analysis we have done indicates that a continuing worsening of the current account deficit is
inevitable until and if--rationally or irrationally, as Karen suggested--foreigners decide that they
don't want to hold these assets any more. Go back to Peter Fisher's presentation and look at what
has happened to the euro. Everybody who thought it was wonderful to invest unhedged in euro
assets all of a sudden decided that that wasn't such a very good idea. So over a period of a

47

couple of days the hedges went up. Nobody had to sell any of their underlying assets; they just
hedged them. That drives home the validity of the point that Karen was making. There is very
little distinction between foreign direct investment in bonds and bank deposits and anything else.
Once a foreigner decides that he doesn't like dollar assets, the derivatives market gets a very deep
and immediate opportunity to do something about it. Now, there is no way in the world that we
can predict when it might happen. But it certainly seems to me to be a very clear and present
danger. We just don't know whether it will happen eight years from now, eight days from now,
tomorrow morning, or never. The least likely prospect of all is that it will never happen. It seems
to me something that clearly has to be taken into serious consideration.
CHAIRMAN GREENSPAN. As Herb Stein said, “If things can’t continue, they
won't."
VICE CHAIRMAN MCDONOUGH. Right, they won't.
CHAIRMAN GREENSPAN. Let’s have coffee.
[Coffee break]
CHAIRMAN GREENSPAN. If there are no further questions for our colleagues,
would somebody like to start the Committee's discussion? President Jordan, do you have a
question or-MR. JORDAN. I’m just volunteering to start the discussion.
Banks in the District have reported that both commercial and consumer loan demand
remained strong in nearly all the early weeks of the new year. In the mortgage area, while
refinancing activity has dried up completely, mortgage loan applications jumped sharply in the
past two weeks, we are told. One banker said he thinks mortgage loan demand is being
stimulated by people's belief that interest rates will be higher later. We have heard quite a few

48

reports that deposit growth evaporated completely in the first few weeks of the year and, with the
cost of funds rising, that interest margins are under pressure. One large regional bank reported
that they are already in the process of putting through a round of loan repricings during this
quarter to offset partially the squeeze they are feeling on their interest margins.
A banker with a fairly good sized institution told us that bank stock mutual funds are
experiencing very substantial runoffs, which is forcing the sale of bank stocks out of these funds.
He said there are several large blocks of bank stock currently being priced for sale on the market.
He noted, based on his own experience, that foreign interest in buying U.S. banks is increasing.
From the perspective of foreign investors it is bottom-fishing time.
In motor vehicles, though we don’t have any solid numbers for January, we were told
that auto sales were very strong during the month, along the lines of what Mike Prell reported.
Steel is looking quite good and the mood of people in that industry is the best we’ve seen in at
least a couple of years. Both domestic steel consumption and production are increasing. Import
volume declined last year and appears to be continuing to fall, so orders for domestic production
have been rising. Some steel price increases have already been implemented and further
increases have been announced to go into effect April 1. So, we will have to see whether the
market can withstand those increases or not.
Let me make a couple of comments about the national economy and the global
economy in terms of the context in which we’re making policy decisions. I thought--and I'm
sure everyone will agree--that the Chairman's speech on January 13th was an outstanding
framework for thinking about the environment in which we find ourselves. It provides a basis
for a dialogue inside the System as well as outside the System about the broader implications of

49

the challenge of monetary stability. That overall concept includes what we call price stability but
encompasses much more than that. The challenge is to try to maintain some sort of equilibrium.
The message for the rest of the world is a hopeful one. Other nations may be at best in
the very early stages of experiencing the kind of productivity gains we have had over the past
several years. And if other places around the world get into the type of reinforcing virtuous
cycle that we have had, that may help them work out of some of their very deep and long-lasting
problems. But the message for us is that when the acceleration of productivity occurred, we did
not get the full effects passed through into a sustained drop in the price level. So we did not get
the automatic increase in the real interest rate that might otherwise have happened. We relied on
these other safety valves, as the speech I thought described very well. Our reliance on those
other safety valves is problematic because those things can change--whether on the fiscal side,
the labor market side, or the immigration side. And we have to be very aware that our own
policy response may be influenced heavily by the actions of others in these areas, especially on
the fiscal side.
CHAIRMAN GREENSPAN. President Parry.
MR. PARRY. Mr. Chairman, economic activity in the Twelfth District picked up at
the end of last year, widening the gap in employment growth relative to the rest of the country.
The underlying momentum is broadly based, but most notable is the strength in business services
and construction. Business services added jobs at a rapid pace both in the fourth quarter and in
the year as a whole. The fastest growing component in this sector was high-tech services. In the
state of Washington, the robust high-tech software industry registered an 11 percent increase in
jobs in 1999. In California, the high wage Internet and software service firms continue to grow
rapidly. Unpublished data indicate that in the narrow Internet service sector, average salaries are

50

approaching $100,000 a year. The intensity in the “dot-com” sector is affecting key commercial
real estate markets in the District, driving office vacancy rates down and lease rates up. In San
Jose, San Francisco, and Seattle vacancy rates are in the 3 to 5 percent range. In San Francisco,
lease rates on Class A office space increased by about 25 percent last year. The only major
markets with substantial overhang of commercial office space are in Southern California.
The District's manufacturing sector reported a small increase in jobs in the fourth
quarter despite downsizing in aerospace and weakness in high-tech employment. Within hightech manufacturing, however, there are signs of improvement, mainly in semiconductors and
other electronic equipment. In Oregon, for example, semiconductor firms are adding jobs and
Intel plans to reopen a chip plant. These developments coincide with increases in exports of
electronics from such states as Oregon and California, with much of the increase in shipments
going to East Asia.
Turning to the national economy, last Friday's GDP and inflation data certainly raised
a red flag. While it is too soon to tell if the fourth-quarter surge in GDP-based inflation
measures will persist, Friday's numbers are a serious concern. Our forecast assumes a 50 basis
point rise in the funds rate together with a flattening of stock market values and it shows real
GDP growth of 4 percent this year and 3-1/2 percent in 2001. Given that labor markets already
appear to be very tight, the obvious question for policy is whether that real GDP growth can
occur without a sustained rise in inflation. Rising productivity growth has been able to offset
any tendency for inflation to pick up steam, at least until last quarter. However, productivity
growth rates will need to rise even higher or their beneficial effects will begin to fade before too
long. While it is entirely possible that the economy has achieved a new, higher trend in
productivity growth, it is not clear how long productivity can continue to accelerate. Assuming

51

that productivity growth continues at the rapid pace of last year, our staff forecast shows an
upward trend in core CPI from just under 2 percent last year to 2-1/4 percent this year and 2-1/2
percent next year. Such a rise in inflation would be especially troublesome to me because I
would like to see it decline further below the 2 percent rate registered last year. Thank you.
CHAIRMAN GREENSPAN. President Minehan.
MS. MINEHAN. Thank you, Mr. Chairman. As we look back on 1999 in New
England, we see an economy that has recovered from the shock of the Asian crisis to its
manufacturing base. We see an economy whose construction, retail, and business and financial
services sectors have experienced healthy employment increases. And we see an economy that
seems poised for a continuation of quite solid growth.
There are some darkening clouds in the picture, however. The supply of available
labor, and not just skilled labor, seems lower than ever as evidenced by anecdotes from contacts
and by the long lines at most retail outlets even after the Christmas rush. Indeed, from 1990 to
1998 New England's labor force registered an average annual increase of zero in contrast to the
nation's growth of 1.2 percent per year over the same period. These data mask some temporal
variations, as the area experienced out-migration of labor early in the period and growth more
recently, and variations among the states as well, with the labor force growing more rapidly in
northern New England than in the southern region. But the data do highlight a picture of very
tight labor supply. Indeed, this shortage of labor is widely considered to be a key factor in
restraining regional growth. Clearly, this would seem to be a time for wages to accelerate, and
maybe they will. But for now contacts report that planned wage increases are not much higher
than in other recent years--in the range of 3 to 5 percent--though bonuses may well be
substantially more than last year. It appears that businesses have continued to cope with tight

52

labor conditions by restructuring processes, improving efficiency, training existing workers, and
investing in new technology. Indeed, at a recent meeting of the Bank’s small business New
England Advisory Council, one member stated that he had no choice but to continue investing in
technology as it was the only feasible answer to continuing labor shortages. These small firms
all reported an upswing in business over the Internet, a development they view as having
potential cost-saving or revenue-enhancing benefits. However, all viewed the problem of getting
goods to Internet buyers--so-called “fulfillment”--as a difficult challenge.
The other major cloud on the New England horizon, and the nation’s as well, involves
health care. The region's largest and one of the nation's most well-regarded HMOs was put into
receivership in January with losses that ranged from $150 million to $300 million, depending on
which news account one reads. Two states, Vermont and Rhode Island, no longer have any local
HMO coverage. Providers of services to HMOs--the hospitals in particular--are reeling from
cutbacks in Medicare due to provisions of the Balanced Budget Act, and there is real concern
that if the HMO in receivership ends up being folded, it may take a hospital or two with it.
Boston's medical care costs were growing at a pace above that of the nation prior to this
development. That trend is likely to continue if not worsen. In part this may be a regional
phenomenon, given the number of teaching hospitals in the region, all of which seem to be
particularly affected by changes in federal funding. In addition, the large HMO in question
appears to have been poorly managed, especially in the information technology area. However,
the underlying pattern of HMOs offering lowball premiums to customers in order to expand
market share, and somehow expecting to make it up on volume in an environment of rising drug
and other costs, is not unique to New England. In that regard, I would expect the increase in
benefits costs in the most recent ECI data not to be the last.

53

Aside from these worries, much about the New England economy is very upbeat. As I
noted, manufacturers have recovered from the Asian crisis, and many companies--especially fast
growth, high-tech firms--are especially upbeat. There are pressures on input prices, especially on
materials that have a petroleum base. Some attribute these pressures not only to rising oil costs
but also to greater strength in Asia. In particular, subcontractors in the Far East are charging
more or have stopped offering quantity discounts because their capacity utilization is now quite
high. But here again there is a determination to hold the line. Most of our contacts said input
prices would be rising even faster if their firms were not making a considerable effort to seek out
lower prices through strategic sourcing, global procurement negotiations, or longer contracts.
Contacts continue to believe that they cannot raise prices, particularly for commodity-type
products or for goods they are selling to large buyers like the Big Three auto manufacturers or
Wal-Mart.
Finally, real estate markets remain varied by city but are extremely tight in Boston.
Rents for Class A office space in Boston remain very high, with new supply coming on line very
slowly. On the residential side, sales volume in 1999 was about the same as in 1998, but prices
rose strongly in most markets. Limited inventories of properties for sale are the likely reason for
both the volume and the price data observed. New housing construction slowed, with permits
and construction contracts in the fourth quarter below year-earlier levels. But that may be as
much a function of constraints in the supply of construction workers and building materials as it
is a reflection of any easing of demand.
On the national scene, there clearly is no easing of demand. For some time now our
own forecasts in Boston and those of the Greenbook as well have assumed that the current
expansion would slow somewhat on its own. Sooner or later consumers would decide that they

54

didn't need or want another house or car and that they did need to increase their savings for the
future. Consumption would slow, moderating corporate profits and slowing the rise in the trade
deficit, and the stock market might even level off nicely in an atmosphere of a little less
euphoria. In short, we thought reality might just bite a little. We have been expecting something
like this for three years or so but it hasn't happened, and there aren't any signs that it will happen.
Instead, consumption is booming, confidence is high, the saving rate is even lower, the trade
deficit is higher, and consumers are borrowing more and more. And nonfarm, nonfinancial
corporate debt, while certainly still affordable, is growing rapidly and hitting rather high levels-at least relative to GDP. So I'm glad to see that in both our own forecast and that of the
Greenbook the idea that the economy will slow on its own appears to have been abandoned. The
Greenbook projects, as do we, that substantial policy tightening is necessary to bring the
economy back to a reasonable balance between demand and supply.
Various aspects of supply remain in question, however, at least in our view. The
longer-term alternatives in the Greenbook and the Bluebook have the rate of growth for potential
output at around 4 percent in the near term--the next two to five years--and a NAIRU of
somewhere around 5-1/4 percent. I must admit, though, that the Bluebook does confess to a fair
amount of uncertainty about the latter. However, as the Bluebook's alternatives so clearly
illustrate, other assumptions about potential and labor market capacity constraints are possible
and perhaps reasonable. For our part, we remain somewhat agnostic about whether productivity
will continue to grow over the next five years at the pace of the last two or three years. But we
think, at least for the near term, that the NAIRU might be lower than the Board staff’s estimate.
So with about the same amount of tightening in 2000, we have growth slowing to about our

55

estimate of potential, 3-1/2 percent or so--slower than in the Greenbook forecast--but with nearly
the same results in terms of prices and unemployment.
Of course, other assumptions are possible as well. One can take a more optimistic
view about both the growth in potential and the NAIRU and make a case that very little, if any,
tightening is needed to bring demand and supply into balance. But to take such a view would, I
believe, run an increasing risk of further imbalances. As I look at both household and corporate
balance sheets, I see growing liabilities and debt service burdens that are reasonable only when
one factors in growing market values of assets and relatively low debt service costs. It goes
without saying that this is an economy that is increasingly vulnerable to changes in market
perceptions, market prices, and interest rates. And it appears that this is an economy that
increasingly buys into the idea that things go only in one direction.
That takes me to the major risk we face when thinking about economic forecasts,
which is the risk that policy actions taken to tighten credit conditions may cause large market
reactions that not only affect U.S. balance sheets but cause foreign inflows to our markets to
decline as well. The Greenbook forecast has moved away from an assumption that policy
tightening will cause market values to decline. The stock market flattens out but does not turn
down. Personally, I think that is a reasonable assumption based on the experiences of the late
1980s and 1990s, and it figures into our own forecast as well. But in many ways, that would be
the ideal outcome. So, I think it would be wise to be a bit agnostic in that regard as well. Thank
you.
CHAIRMAN GREENSPAN. President McTeer.
MR. MCTEER. Economic growth in the Eleventh District has been strengthening
over the last few months. It turns out, after some revisions in the data, that employment growth

56

was very, very slow in the first half of last year but picked up nicely in the second half. That
pickup is expected to continue as Texas feels the lagged effect of higher oil prices. The energy
industry is showing definite signs of rebounding. Producers are more confident, thanks to
strength in Asian economies and increasing confidence in OPEC's solidarity. Most of the gain in
drilling activity has been for gas so far, but recently we are seeing some shift in emphasis toward
oil drilling. In the high-tech area, semiconductor manufacturers have been revising up their
forecasts for 2000, consistent with what Bob Parry just said.
Demand has been especially heavy for telecommunications chips. One of our
directors noted at our board meeting a couple of weeks ago that the pickup in chip demand from
Asia has been especially strong, underscoring other evidence of a rebound in Asian economies.
Both home building and commercial construction activity have been showing signs of cooling,
probably due as much to overbuilding as to higher interest rates. It seems that construction
activity has become more sensitive to growing inventories and supply/demand imbalances in
recent years. The benefits of information technology for inventory control are becoming more
pervasive in the economy. In spite of the Texas unemployment rate being near its 20-year low at
4.4 percent in November, wage gains have been moderating across a wide range of sectors.
Overall, there seems to be an absence of inflationary pressures in the Eleventh District other than
for goods whose prices are tied to oil. We've seen some easing in price pressures for sheet rock
and cement, but one of our directors noted upward pressure on the price of asphalt, reflecting the
strength in non-building construction--that is, road construction.
Turning to the national economy, my forecast is pretty close to the staff’s; the main
exception is that I see somewhat less inflation than they do. In fact, I turned in a 4 percent

57

number for real GDP growth this year, just a bit less than the staff’s 4.1 percent. That means I'm
going to be increasing my forecast and I imagine Mike Prell may be reducing his as well!
I have one piece of anecdotal information that supports the view that the economy is
very exuberant on a national basis. I took my annual trip to Vanderbilt University in Nashville
last week to speak to former Governor Daane’s class. As usual, he had me meet with a group of
Nashville businesspeople beforehand. The main conversation at lunch was whether they were
going to have to pay closer to $2500 or $3500 for scalped tickets to the Super Bowl. Those
Nashville business titans were taking their football very seriously. The Dallas business
community, incidentally, feels that some parts of the country take football too seriously!
[Laughter]
MR. POOLE. St. Louis isn't one of them!
CHAIRMAN GREENSPAN. President Moskow.
MR. MOSKOW. Thank you, Mr. Chairman. The Seventh District economy entered
the New Year with considerable momentum. To date, higher interest rates have had only a
marginal impact on the traditionally interest-sensitive sectors like autos and housing. Auto
producers expect 2000 to be the second best year ever for sales of light vehicles, following last
year’s record-setting pace. Thus far, the automakers see few signs of slowing. And reports from
our District directors indicate that sales at District auto dealers generally were brisk in January.
The numbers we heard this morning seem to bear that out.

attended the

National Automobile Dealers Association meeting in Orlando in January and reported that the
auto dealers were very upbeat and bullish about the outlook for this year.
The housing sector in the Midwest continues to outperform the nation for reasons I
don’t fully understand. The head of a distribution company that sells building materials to

58

Chicago-area construction firms told me that his customers who are residential contractors have
seen no slowing thus far and are booked for at least the next six months in the Chicago
metropolitan area.
Retailers’ sales of appliances and home furnishings are still quite strong. More
generally, the holiday shopping season was exceptionally good for most District retailers.
Inventory levels at the beginning of the year were described as rational, not excessive, thus
requiring little aggressive promotional activity in January. Also, the steel industry in particular is
benefiting from strength in autos, appliances, and other consumer durables, with steel order
books said to be solid and showing little tapering off of demand in January, similar to what Jerry
Jordan said earlier.
It is difficult, if not impossible, to find any signs of easing in our very tight labor
markets. In fact, very preliminary results from Manpower’s latest survey of hiring intentions
show net hiring strength near a 22-year high, and that’s both before and after the seasonal
adjustments that they do. These results should be treated confidentially since they won’t be
released until February 28th. Wage gains in the temporary help industry remain in the 3 to 5
percent range of the past few years but recently seem to be concentrated in the higher end of that
range. Our directors report significant or record shortages of nurses for retirement homes,
truckers, and construction workers. And in some cases these shortages are constraining activity.
For example, a major heavy-duty truck manufacturer cited the shortage of truck drivers as a
major reason for the recent softness in orders for heavy trucks at his firm.
Manufacturers generally continue to face higher prices for some of their inputs such as
energy, steel, copper, and aluminum, but they still say they cannot pass these higher costs on to
their customers. Increasingly, we are hearing that the Internet is helping to hold prices down.

59

For example, the head of a major auto company told me that they estimate that 55 percent of car
buyers now use the Internet to get information on pricing before they even enter the showroom.
Turning to the nation, despite the surprisingly strong fourth quarter, our outlook for
growth in 2000 is at nearly 4 percent. Unfortunately, like the Greenbook we see core CPI
inflation rising this year to about 2-1/2 percent and core PCE inflation to about 2 percent. There
appear to be few weak sectors in the outlook at this moment. Employment growth continues to
be strong and inventory accumulations seem reasonably balanced on the whole. Consumer
spending in 2000 seems headed for at least moderately strong growth in spite of the restraining
course of higher interest rates that we expect over the period. The high levels of the stock
market continue to propel consumers forward, and this continues to be a risk for the outlook.
Last week we convened a meeting of our Academic Advisory Council. A major topic
of discussion was growth in potential GDP. Most participants were skeptical that the growth in
potential output was as high as our estimate of 3-1/2 percent and, of course, questioned whether
the faster productivity increases were sustainable.
Our inflation outlook for 2000 envisions a ½ percentage point pickup in core inflation
with a further rise in 2001. So, regardless of which core inflation measure one uses, it’s difficult
to accept that the degree of acceleration forecast for core inflation is consistent with price
stability. And that, of course, is an area of major concern.
CHAIRMAN GREENSPAN. President Guynn.
MR. GUYNN. Thank you, Mr. Chairman. Our Southeast region is healthy and the
balanced expansion continues. The final data and the conversations that we have had with
retailers tell us that the holiday selling season was a blockbuster one that clearly exceeded
expectations and even the early estimates that we had. Tourism often gives us a good reading on

60

discretionary spending. As reported in the popular press, there was a measurable slowdown in
tourism over the special year-end period, but advanced bookings for the spring are quite strong,
suggesting that the strength we had been reporting in that sector will resume. We hear mixed
views from people we talk with about just how much of a slowdown we have been seeing in
housing. Certainly, our tightening moves and the rise in mortgage rates have had some effect,
but in most of our markets housing construction remains at high levels and the inventory of
unsold units is quite low. Nonresidential construction has actually increased somewhat. Overall
manufacturing activity in our region has shown some pickup in both production and new orders,
but that strength is attributed to domestic demand rather than to a significant pickup in exports.
Despite the recovery of many economies around the world, we are still hearing about sharp trade
imbalances as we talk to people who run our ports. They are saying the lopsided cargo trade has
caused operational problems and surcharge fees on outbound containers that are being sent back
to the U.S. empty.
Our regional payroll rose to 2-1/2 percent year over year, which reflects even more
strength than the national numbers, and labor markets feel tighter and tighter. Just last week a
new restaurant owner was telling me he had been operating at half capacity for several weeks
because of his inability to hire enough cooks and servers. And the general manager of our
told me he was now very concerned about being able to maintain their high
quality of service and their top rating because of the marginal staff he has had to hire. At the
same time, we are still being told that most employers are stubbornly trying to hold the line on
broad-based wage increases.
Over the period since our last meeting, one gets the sense that more prices have been
edging up: Prices of construction materials are up to 2 to 5 percent; copper prices are up 10

61

percent; and red meat prices are up 7 or 8 percent because of herd liquidations over the last two
winters. And those kinds of price increases are on top of the more talked about double-digit
increases in energy, health care, and pharmaceuticals that are getting people's attention and are
now working their way through the indexes. The regional economy is strong and resource and
price pressures seem to be building.
Nationally I see much the same picture. Late last year it was clear to me that the
national economy had great momentum. But the latest data, once again, have been even stronger
than I expected. I don't see much evidence yet that our earlier policy tightening moves have
more than dented the very strong consumer demand in the economy. And as most of us have
noted, the now relatively strong growth elsewhere in the world seems sure to put more pressure
on domestic producers. In addition, the Congressional temptation to spend pushes in the same
direction.
I don't like the direction of price movements reflected in the Greenbook’s baseline
forecast. Our own VAR forecast paints a similar picture. Our forecast suggests that CPI
inflation will approach 3 percent this year with virtually no probability that it will be below 2
percent. And both forecasts suggest that even several more tightening moves won't damp the
upward drift in inflation to any great degree. I believe and would even argue that we are
beginning to see the whites of inflation's eyes, and I think a further tightening is called for. It has
clearly been priced into the markets. And while validating market expectations is not our task,
this is one of those instances where not doing so would undermine our credibility. Thank you,
Mr. Chairman.
CHAIRMAN GREENSPAN. President Boehne.

62

MR. BOEHNE. Thank you, Mr. Chairman. The regional economy in the
Philadelphia District is strong. Retailing, manufacturing, and construction all are operating at
high levels. Labor markets remain tight with the amount of overtime starting to become a
political issue. The Labor Relations Committee of the Pennsylvania House of Representatives,
for example, recently held hearings on the issue of overtime for construction workers and
concluded that significant overtime reduces productivity and raises safety concerns. I believe we
will hear more about people becoming too stretched for too long in the workplace. And I think
that is going to be the next quality-of-life issue that will probably work itself into the political
campaign of 2000. Although wage increases remain generally moderate, one does hear more
stories of higher salaries being used to entice people to switch jobs.
The national economy continues to grow robustly and consumer spending in particular
is growing rapidly. Although productivity also is rising smartly, my sense is that demand is
pressing too much on supply and that unless the growth of demand moderates in coming months
the expansion will be at risk. With concern about Y2K largely behind us, we need to return to
our main task of prolonging the sustainability of this remarkable expansion. Sometimes
prolonging an expansion requires lowering interest rates, sometimes it requires holding them
steady, and sometimes, as in the current situation, it requires raising them. And our task in
coming months is to raise rates in a manner that will contribute to stability while avoiding
initiating instability.
CHAIRMAN GREENSPAN. President Broaddus.
MR. BROADDUS. The situation in our District is very similar to the one Jack Guynn
and others described for the rest of the Southeast. By all accounts economic activity has
expanded very strongly since our meeting here in December. Consumer spending was especially

63

strong in the holiday season and remained robust in January. We have had information on strong
car sales, which is consistent with the number Mike Prell mentioned earlier. Manufacturing
activity also remains robust apart from textiles. We had seen some moderation--I guess that’s
the way I would put it--in both residential and commercial construction and sales before the bad
weather. We got a whale of a moderation with the snowstorm last week! But overall, I think the
slowing has been fairly modest to this point. Some of it reflects supply constraints--shortages of
workers and construction materials. And there have been delays in some planned new
construction, including the putting in place of infrastructure, also ultimately reflecting supply
constraints.
The regional information that has struck me the most in recent weeks has to do with
labor markets and prices. I don't want to belabor the tight labor market theme any further, but
the increasing difficulty of finding qualified workers across a broad range of service and
manufacturing industries is really the key preoccupation of all our business contacts. In addition
to construction workers, nurses and teachers are in especially tight supply at the moment. And in
this environment, as Ed Boehne just mentioned for his District, we are hearing more reports of
significant wage and salary increases. In our regular monthly survey of manufacturers, most
respondents now report that they expect a much broader acceleration of wages over the next
several months than they did two or three months ago.
Regarding prices, for years now we have received innumerable reports--complaints
actually--about a lack of pricing power. Perhaps a bit different from what Cathy Minehan was
saying about New England, I have a sense that this may be eroding somewhat in our region. A
few businesspeople, and maybe more than a few, are telling us openly now that they feel they
have more pricing flexibility than they had, say, a year or so ago. I don't want to exaggerate this

64

point. Sizable price increases are still not widespread in our area, but the pricing atmosphere, if I
can put it that way, seems to be changing a bit.
As far as the national picture is concerned, our forecast is very close to the Greenbook
forecast except on inflation. On the prediction for the core PCE inflation rate, unlike Bob
McTeer, we were a little higher rather than lower. It's a strong forecast but I still think the risks
are primarily on the up side. And that's a point that seems to me to have been underscored by the
data we received on Friday and by the data released today that Mike Prell mentioned earlier.
I always have a hard time separating discussions of the economic outlook from
discussions of policy, which is a problem related to the way our meetings are organized. I find
that to be the case especially at this meeting. But in that context, I found the various simulations
in the Greenbook and the Bluebook very helpful and interesting in trying to disentangle things. I
want to make a few comments about that, but I'll wait until tomorrow after Don Kohn gives his
briefing on the Bluebook and policy alternatives. Thank you.
CHAIRMAN GREENSPAN. President Hoenig.
MR. HOENIG. Thank you, Mr. Chairman. The Tenth District economy has not
changed appreciably since our last meeting and on balance remains very healthy overall. Labor
markets do remain tight but wage pressures, though increasing, are not increasing dramatically
that we can tell. Our agricultural sector continues pretty much as it has been, with low prices and
high subsidies making the outlook for that sector appear fairly stable. One thing I might mention
about this expansion is that rural America really has shared in some of the good times. Job
growth in our region has been nearly as high as that for the nation on average and, of course, in
our scenic and recreational areas it has been substantially stronger. So, we’ve had good uniform
growth in jobs across the rural areas as well.

65

Let me talk a little bit about the oil sector. Even with the sizable increases in oil
prices, the effects on levels of activities in our region have been relatively modest so far. In
talking with our director in that industry, he said that the industry right now is still budgeting in
their capital budgets at around $18 per barrel for oil. They feel that if OPEC can manage to do
so it will maintain the price at between $20 and $30--not wanting it to go over $30 because that
will spark interest among other oil producers. So that seems to be forestalling the price. They
are watching developments, in terms of adjusting their capital budgets around those numbers and
those price levels. Unless we see an accelerating price level, his judgment is that exploration
budgets won’t increase dramatically.
Let me mention another local anecdote. The Kansas City Southern Railway runs a
railroad through Texas, Monterey, and all the way to Mexico City. I was visiting with the head
of that company last week and he told me that the volume of traffic on the railroad over the last
18 to 24 months has increased by a good 50 percent in both directions. He said it was striking
how much business capital investment was being made all along that railroad. He said that the
state of technology at the manufacturing plants was as good as it gets and that the quality of the
products coming from there was as good as it gets. Interestingly, though, he also noted that
shipments of finished goods, not just intermediate goods, are also expanding dramatically along
that route as people’s incomes and prospects improve. That may be a sign of more positive
things to come.
Let me turn to the national economy. Basically, I’m convinced that the U.S. economy
is experiencing the effects of excess demand and that, based on the evidence, pressures probably
are building. While my projections are not as strong as those of the Board staff, it’s a matter of
degree and not direction. I see a greater likelihood that this demand will increase and continue to

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outpace supply, even though the signs on the supply side are good. In my view this does put
increasing pressure on prices. And the situation is complicated a bit further by what we refer to
as “imbalances” that are also persisting, with levels of debt rising and the current account deficit
increasing as well. All this to me suggests that there is perhaps room for us to think about
increasing rates modestly as a minimum response. I’ll stop there. Thank you.
CHAIRMAN GREENSPAN. President Stern.
MR. STERN. Thank you, Mr. Chairman. The District economy remains very strong
and I won’t go into the details except to comment on a few things that have changed or are in the
process of changing in the District. There are five things that I want to mention briefly.
First, on the banking side, bankers report that they are continuing to compete
aggressively for loans but--and the “but” is that they are tightening credit standards. And they
report that they are encountering examiners who are encouraging them to tighten credit
standards. Second, a glut of office space is coming. It may be a year or two or three off but, at
least in our District, I think it’s pretty well baked in the cake right now. Third, labor markets, of
course, remain tight but we are starting to see some upcreep in the rate of increase in wages and
the frequency with which wages are going up. Fourth, as far as inflation is concerned, we run a
survey annually and this year’s results versus last year’s results show a deterioration in the
inflation outlook. More respondents expect inflation of 3 percent or more this year than was
formerly the case and more firms report that they are planning to raise prices than was the case
last year. Whether those pricing plans reflect wishful thinking or whether these firms will make
their price increases stick, of course, remains to be seen. Finally--and this is the first time I’ve
heard this comment--developers, especially residential real estate developers, are expressing

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concerns about interest rate levels and are starting to believe that the higher rates will affect their
business both this year and beyond.
At the national level, my views really haven’t changed for quite some time. I think we
are well positioned for further significant growth in the real economy. Whether it will turn out to
be 3-1/2 percent or 4 percent or even more, I don’t know. But growth in that range looks to me
to be a pretty good bet. I’m much less confident about the outlook for inflation. We may see a
meaningful acceleration of inflation but I have to say, as I’ve said before, that I’m not entirely
persuaded that labor market indicators are good precursors of likely developments on the
inflation scene. And, of course, one of the reasons for that, though not the only reason, is that we
really can’t say very much about the outlook for productivity.
CHAIRMAN GREENSPAN. Vice Chair.
VICE CHAIRMAN MCDONOUGH. Mr. Chairman, the Second District’s economy
began the new year with strong upward momentum. Despite ongoing cost increases in housing
and manufacturing, consumer price inflation has actually decelerated slightly. Unemployment
rates in New Jersey, New York State, and New York City fell to 10-year lows at year-end, while
private sector job growth accelerated to a 3.6 percent annual rate in December, up from 2.4
percent in the prior two months and 2 percent in the third quarter. Retailers indicate that sales in
January were fairly strong, with minimal effects from either New York State’s tax-free week or
from the recent snowstorm.
The general view expressed by our contacts around the District and by business
leaders who have a national and international reach is that certainly in the United States firms do
not feel that they have pricing power. So, businesses big and small have to run themselves better

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and take advantage of information technology to be able to preserve their profit margins without
the benefit of price increases.
We had a particularly interesting meeting of our Small Business and Agricultural
Advisory Committee last week. Manufacturers, in particular one who produces
and one who produces highly sophisticated
reported that they were being hurt on the cost side largely because of increased costs of
health benefits. But they said that they simply had to use better information technology because
they couldn’t pass these additional costs along in their prices. In a business that is about as
traditional as one can think of--dairy farming--the use of technology is astounding.
now has a piece of equipment on each of his 950+ cows that establishes how
much the cow is walking, how much the cow is eating, and how much the cow is producing. It
also gives 30 hours additional advance warning on whether the cow is developing a respiratory
problem so that medication can be administered earlier and, therefore, there isn’t a loss in milk
production. The fellow who runs several

has an information system that is so

incredible that he actually knew when one of his restaurants was missing 20 orders of
. The next morning he confronted the restaurant manager to ask him why he wasn’t
doing a better job. These small anecdotes would lead one to believe that the upside potential on
productivity gains may be real. Unfortunately, because it has both a supply and a demand side
effect, it doesn’t make our jobs any easier. What I view as a matter of great concern, as indicated
in the remark I made before the coffee break, is that I think we face a very clear danger from the
growing current account deficit as a percentage of GDP. If there is anything that tells us in the
Committee that we have to carry out our responsibilities wisely, steadily, and well, it is that.

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CHAIRMAN GREENSPAN. It strikes me that the cows need a privacy act!
[Laughter] Governor Ferguson.
MR. FERGUSON. It’s hard to follow that, though I might say that as Administrative
Governor I want to find out about these machines! [Laughter] The staff and I will discuss that
later.
In a more serious vein, at the end of the last meeting we stated that we would review
the incoming data very closely for signs of imbalances. The data we’ve received to date suggest
that the economy is continuing to expand at a faster pace than its potential, even if that potential
has gone up. Mike brought in the most recent data on automobile sales, which are strong. And
the recent ECI data, even though the measurements are flawed as I understand it, suggest that
vigilance is important. Similarly, the latest information regarding personal income and outlays
suggests that consumers continue to be very willing to spend beyond their incomes, giving
credibility to both the optimistic survey numbers and also to the worries that we have regarding
some imbalances. With respect to the recent GDP numbers, I think I have been well educated by
the staff and have done some independent analysis and have discovered that in fact we should be
relatively agnostic about those numbers. But they are not the only ones that suggest some
strengthening of the economy.
We had an earlier discussion regarding the forecast, and in that regard I’d just like to
make two observations. One is that the staff does expect both a shortfall in earnings and a
widening in the corporate financing gap, and implicitly some high volatility in equity markets, as
well as noticeably higher interest rates. All that suggests to me that it is not inconceivable that
expected returns on investment might weaken and, in conjunction with that, that the amount of

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investment itself might weaken. That leads to one small internal inconsistency perhaps in the
Greenbook, though I understand how they got out of it.
Similarly, the Greenbook suggested that there should be a significant increase in shortterm interest rates. But it also suggested, in spite of that, that equity markets will tread water in
the sense of ending the year pretty much at the same level as they started the year. I have a
growing concern that a placid surface may disguise some underlying turmoil. I think the
dispersion that we saw among various indices at the very beginning of the year may suggest that
this market is subject to some volatility, including significant downside corrections.
All of these considerations are not meant in any way to counter the various recitations
of strength in the economy that we have heard discussed today and will probably hear more of
during the course of the day. I, along with others, certainly do think that the risks to good
economic performance are primarily on the up side and that the equilibrium interest rates are
probably higher than the current market rates. However, as a few others have suggested, I think
we should be prepared to move policy incrementally and to use all of our tools carefully. To my
mind, President Boehne put it correctly: Our goal here is to attempt to maintain maximum
sustainable growth as well as to try to focus on price stability. I believe we are entering a
particularly challenging year, with an economy that may prove to be “interesting” in the sense of
the Chinese proverb. Thank you.
CHAIRMAN GREENSPAN. Governor Gramlich.
MR. GRAMLICH. Thank you, Mr. Chairman. Our staff always serves us well and I
believe they have done so particularly this time. I appreciate the inflation-targeting exercise
done in the Bluebook, and I think there's a lot we can learn from it. As you all know, I have
recently become interested in this approach to monetary policy as a possible means of dealing

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with policy in an age of productivity shocks. I tried to put some of my thinking into words in a
speech that I gave earlier this month. Reactions from around the building were interesting.
Some like inflation targeting; some do not. Some say, what's the big deal, we already do it.
Others say there is no way we can ever do it. I am fortified by this consensus, [Laughter] and
unlike Al Broaddus, I cannot wait until tomorrow to talk about the Bluebook! [Laughter] I find
it so exciting that I’m going to try to draw three lessons from that exercise.
The first lesson, I think, is a fairly obvious one. Since the unemployment rate is now
well below the structural estimate of NAIRU, incipient inflationary pressures are out there,
pressures that should be counteracted by a fairly sharp, early rise in the funds rate. This is
something I think we’ve all more or less suspected for a while now, but the staff exercise is still
valuable in showing just how high a funds rate is required to stabilize inflation--something like 7
percent. Of course, this assumes that the models are literally correct and we may not want to
assume that. But I think we should take note of the general point.
The second lesson is that preemption is good. Again, we have all suspected that, but
the staff exercise shows that the inflation-targeting funds rate has to rise another full percentage
point or so if we wait to see actual acceleration, and hence get behind the curve. Waiting will
lead to larger variations in the funds rate. An ounce of prevention is worth a pound of cure.
The third point is that in the present circumstances reversals seem to be, at least to me,
relatively unlikely. The staff did an exercise assuming that NAIRU is 4 percent. None of the
professional forecasters that Larry Meyer recently surveyed in a paper is prepared to go that low,
though 4 percent is within the normal statistical distribution of these estimates and it is the
estimate from the recent paper by Brainard and Parry. For the sake of argument, the staff
assumes that 4 percent is the right number and then works back to the optimal monetary policy.

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They still get a funds rate rising to 6 percent in the near future. Hence, even if we make some
early tightening moves because we have an old-fashioned, out of date view of NAIRU, the
probability seems to be relatively slight that we will have to eat crow and reverse those moves.
One could also do inflation targeting from what I’ll call the pipeline method, looking
for prices that lead final goods prices. The PPI is one such measure. It rose rapidly in the third
quarter but has been pretty stable since then, and was actually decelerating in late 1999 if the
impact of oil is removed. Much the same is true for import prices. We think they are bound to
rise at some point, but at this time they seem to be relatively stable. Commodity prices have by
now reversed their downward movements and are beginning to trend up even apart from oil, and
commodity futures are up.
The Chairman has often told us that the single most important number to him is unit
labor costs based on the combination of wage costs and productivity. Here the evidence is still
very reassuring. The recent ECI number suggests that non-wage labor costs may be trending up
but still less so than the increase in labor productivity. At this point unit labor costs are rising
less rapidly than before and, in fact, they are nearly stable. Not only is this the Chairman's most
important number, I think it's also the most reassuring number in all the pile of data that we have
gotten in the intermeeting period. In an out-and-out inflationary spiral, the rabbit of wage
increases beats the turtle of productivity increases every time, but so far the turtle is ahead.
Next, let's look at what other forecasters are saying. The Blue Chip forecasters are
actually pretty mellow individuals. On average they are not predicting a rise in inflation either
for final goods or for producer goods. They are predicting some increases in interest rates, so it
seems that their inflation prediction is based on an assumed policy tightening. Presumably
without the tightening they would be predicting some acceleration. In both the Michigan and the

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Philadelphia Fed surveys forecasts for prices are also rising slightly. In this case it's impossible
to tell what monetary policy their forecasts are based on and it's hard to read the evidence.
Then let’s look at the bond markets. There the evidence could, I think, be worthy of
attention. For example, the interest rates on 10-year bonds, nominal and real, recently have
changed noticeably. Just about a year ago the TIP real yield was slightly below 4 percent and the
nominal yield was about 4-1/2 percent. The noticeably skittish bond market was at that time
building in very little inflation premium. Now the real yield has gone up to about 4.3 percent,
and even with its latest drop, the nominal yield is all the way up to 6.6 percent on 10-year bonds.
The bond market is now building in a pretty hefty inflation premium, presumably due to current
inflation of 2.3 percent or so--a major change from last year. The potential undoing of the flight
to quality around the turn of the year may partially complicate this analysis, as would the
Treasury buyback program. But rising expectations of inflation must be a prominent factor. The
obvious implication is that inflation may be returning as a key economic phenomenon motivating
bond markets, something that I think none of us would like to have happen on our watch.
From an inflation-targeting perspective then, both the model and the bond market
seem to me to be a vote for tightening. The other forecasters are hard to read and I think the
pipeline method signals an abstention.
Finally, I would like to look at conditions from what I'll call an equilibrium
perspective. In a stable growth economy with inflation rates settled in at the staff’s target of
about 2 percent, the term premium on bonds should be close to zero. The real rate on TIP bonds
just alluded to above is about 4.3 percent. Most financial people think there is roughly a 40 basis
point liquidity premium for TIP bonds, given their thin market as compared to comparable
nominal bonds. Hence, the adjusted real interest rate might be 3.9 percent or so. Even with

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stable expectations of 2 percent inflation--an inflation rate that we would be lucky to achieve
according to the staff--the equilibrium level of nominal short-term rates should then be on the
order of 5.9 percent for a stable growth/stable inflation economy. Present rates are a bit south of
that and I think most of us, in view of our feeling about the balance of risks, would like that
balance to be realigned. The key question I think, as Ed Boehne mentioned, is how quickly we
realign and how gracefully we realign. Thank you.
CHAIRMAN GREENSPAN. President Poole.
MR. POOLE. Mr. Chairman, I’ll be very brief. I don't have anything to report in the
St. Louis District that adds to what we already have heard around the table. My contacts at
FedEx and UPS confirm very, very vigorous economies in Asia. Air cargo is at capacity coming
from Asia to the United States and both FedEx and UPs are talking about adding more capacity.
In the United States, both firms find that the fourth quarter was better than they anticipated. A
survey of customers and potential new customers at FedEx indicates a more vigorous spring than
had been anticipated a short time ago. So the outlook in the immediate future is very strong.
Both also report, though, that the labor situation is well under control. They see no problems
with either staffing or labor costs, no undue pressures there.
On the national picture, I would simply like to emphasize my sense that it’s a lot easier
to imagine that inflation will be a half point higher than the staff forecast than a half point lower.
CHAIRMAN GREENSPAN. Governor Meyer.
MR. MEYER. I want to share with you some observations about the outlook that
shape my views about the appropriate policy action tomorrow and the strategy that could guide
us going forward. Given the uncertainty that we face about trend growth, NAIRU, and inflation
dynamics, we’ve had to balance the risk that we might fail to take full advantage of the higher

75

trend growth and the lower NAIRU against the risk of overheating, higher inflation, and
increased economic instability. As we have probed the limits of the new possibilities, the risk of
overheating has increased.
My first observation is that the risks have now become significantly tilted toward
higher inflation. That judgment is based on the still more robust growth at the already very high
labor utilization rate, by the dissipation or reversal of the favorable relative price shocks that
have been restraining inflation, and by some signs of incipient pressure on nominal
compensation and inflation. While there have been consistent upward revisions to trend growth
and a growing appreciation of the importance of higher productivity growth in explaining recent
macroeconomic experience, the key challenge for monetary policy today derives from the
persistent imbalance between the growth in supply and demand. From the perspective of
monetary policy, the absolute value of trend growth in GDP--whether it's now 3-1/2, or 3-3/4, or
4 percent, or whatever--is less important than the relative growth rates of demand and supply.
The higher trend productivity growth appears to have had simultaneous effects on demand as
well as supply via the investment boom to take advantage of profitable opportunities and via the
consumption boom driven by the surge in equity values and perhaps expectations of higher
permanent income. I want to read a sentence from the staff memo on the FRB/US model
forecast prepared for this meeting because I think it is very telling: “With trend productivity
growth assumed to be 3.0 percent rather than 2.8 percent, real GDP growth is boosted by nearly
0.5 percentage point in 2000 and by 0.4 percentage point in 2001, holding the nominal funds rate
and the nominal exchange rate at their assumed values.” So, 0.2 percent higher productivity
growth results in 1/2 percentage point faster growth in basic demand. That's the problem I think
we are facing.

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My second observation is that we should focus more on relative growth rates than on
absolute ones, notwithstanding uncertainties in the comparison. This points to the need to
tighten despite optimism about trend productivity growth. Inflation prospects ultimately relate to
the balance between the levels of actual output and potential output, not to their relative growth
rates. I continue to believe that output has moved beyond potential and that the inflationary
consequences of this imbalance have been restrained by temporary effects associated with supply
developments, including earlier relative price shocks and, more importantly, the higher
productivity growth itself. This has allowed the economy to enjoy faster growth and a higher
level of output than is sustainable in the longer term. The policy implication is that we have to
recognize the serious possibility--in my view the likelihood--that we will need to encourage a
transition back to more sustainable macro conditions, not only in terms of relative growth rates
but ultimately in terms of relative levels.
My next observation is that the rise in interest rates necessary to balance supply and
demand and contain inflation risks may initially be smaller than usual but ultimately may be
larger in a boom featuring an increase in trend productivity growth. The temporary
disinflationary effect of the supply shock may at first limit the increase in interest rates, but given
that the productivity upturn carries with it an increase in the equilibrium real rate, the cyclical
rise in rates required to contain inflation may ultimately be larger than otherwise. Wicksell’s
framework of natural versus market rates provides a useful perspective on this development.
The recent productivity upturn implies an increase in the economy's natural rate. At unchanged
market rates the gap between natural and market rates has widened, and monetary policy has in
effect become more stimulative. Only when monetary policy moves market rates enough to
close this gap will the expansion begin to slow.

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My final observation is that I believe we still have an opportunity for a relatively
benign transition to a soft landing--if we begin the journey immediately, are prepared to
implement a series of tightening moves and, most importantly, are willing to tolerate a period of
inflation above our preferred rate.
If we are already operating beyond potential and with growth above trend, some rise in
inflation is probably inevitable as the economy makes a transition to a more sustainable set of
macro conditions. What is called for is a policy path that endeavors to achieve what I have
called a “reverse soft landing,” a transition to potential from growth above potential achieved by
a period of below-trend growth. This feat, I am compelled to admit, has never before been
successfully accomplished. It is, nevertheless, achieved with precision in the Bluebook!
[Laughter] While there are some limited signs that inflationary pressures may be building, the
inflation process still has a lot of inertia, and we may get some help from a decline in energy
prices over the next couple of years. In addition, a reverse soft landing, requiring as it does a
slowdown to below-trend growth for an extended period, is easier to achieve without recession in
a fast growth economy like today's than in the slower growth economy of the 1970s and 1980s.
CHAIRMAN GREENSPAN. Governor Kelley.
MR. KELLEY. Thank you, Mr. Chairman. The afternoon is getting on and by my
tally I am the final speaker. But let me say a few brief words, if I may, about momentum in the
economy and productivity, where the trends that have been in place for some time seem to be
continuing, and about inflation, where it seems to me a change is now potentially close at hand.
Momentum in the economy clearly remains strong. The record highs of the stock market and
consumer confidence are resulting in continuing strong consumption. Investment spending
remains high, manifested by rising durable goods orders and backlogs of unshipped goods. So

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far, housing has not collapsed--perhaps being supported by a shift to adjustable rate financing as
mortgage rates rise--and export demand is rising. If sustainable, it’s a bright outlook.
Productivity gains continue to be very strong and I believe may be enhanced further in the
upcoming period as a fallout from the Y2K episode: Millions of managers and proprietors of
economic units--large and small, profit and nonprofit--have attained a new level of awareness
and know-how in the high-tech arena. That’s truly a wonderful prospect.
But I am concerned that the price level picture may now be changing in an
unfavorable direction. As we know very well, we’ve enjoyed a superb mix of rising activity and
declining inflation. This has been made possible mainly by the surge in productivity, but
productivity gains have not done it all. There has been significant help, and many of those
helpful factors are going away. As we expanded, much of the world was in a slump until
recently. Consequently, we have seen the dollar rise, helping to hold down import prices even as
we went on a buying spree that ballooned the trade deficit but absorbed considerable excess
demand. Weak export demand also has freed domestic capacity to fill domestic demand. We’ve
enjoyed weak commodity prices and for a time collapsed energy prices. All of that has either
ceased to help us or actually turned negative, with the tenuous exception of the notoriously
capricious energy prices, which may fall again.
Domestically, as new jobs continue to be created--to our society's great benefit--our
remaining available labor pool gets thinner, less skilled, and less motivated. As demand
continues strong, the effects of that development have to show up in costs at some point and may
be doing so now. It may be too much to expect any likely level of productivity gains to carry
almost alone the burden of maintaining price level stability in the near-term environment. A
number of price series are beginning to move. Industrial commodities, the ECI, core

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PCE, the CPI, the GDP deflator, and other measures had been stable at low levels but recently
have been showing at least tentative signs of moving upward. It is too soon to declare this a
trend, but I suspect a trend may become increasingly apparent. It is still only a trickle and far
from a flood, but I believe it is now our job to insure that it is not allowed to become a flood. I
look forward to discussing how that can best be done while maintaining a healthy rate of
economic growth. Thank you.
CHAIRMAN GREENSPAN. Thank you. Let's adjourn until 9:00 tomorrow morning.
[Meeting recessed]

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February 2, 2000--Morning Session
CHAIRMAN GREENSPAN. Good morning, everyone. Before we turn to Bill
Whitesell, let me remind you that Mike Prell would appreciate receiving any changes you might
have in your individual forecasts by close of business Monday, February 7. Mr. Whitesell.
MR. WHITESELL. Thank you, Mr. Chairman. This briefing provides background for
the Committee's decision regarding the ranges for money and debt in 2000. I'll be referring to
charts and tables in the Bluebook that have been distributed separately to you this morning. 3
The Humphrey-Hawkins report of last July noted that the growth
rates of the monetary aggregates were likely to be at or above their longerterm price stability ranges in 1999 and 2000, given Committee members'
projections for nominal GDP growth. In fact, nominal GDP expanded faster
than the range of projections of Committee members last July, and the
monetary aggregates grew noticeably above their ranges. M2 expanded
6-1/4 percent last year and its velocity declined slightly on balance.
Although M2 velocity tracked the rise in its opportunity cost rather well
over the second half of the year, as shown in chart 1, that conformance with
historical relationships followed a period when movements in velocity were
not so readily explained. From the end of 1995 through mid-1999, velocity
rose and then declined, despite rather stable opportunity costs, as
conventionally measured. The demand for M2 assets over that period is not
fully understood, but we believe that it was importantly affected by
interactions with household stock market investments. Increases in velocity
up to mid-1997 were associated with strong flows into stock mutual funds,
excluding retirement accounts, suggesting substitution of equity investments
for M2 assets. As capital gains boosted stock market wealth over the next
two years, however, non-retirement flows into equity mutual funds slowed
noticeably, and M2 strengthened relative to income, perhaps reflecting some
portfolio rebalancing by households. On balance, M2 demand, while more
predictable than in the early 1990s, remains very uncertain. As regards M3,
growth for the year came to 7-1/2 percent, boosted to some extent by a
Y2K-related surge in institutional money funds and large time deposits.
Turning back to table 1, M2 growth is expected to moderate
substantially to 4-3/4 percent in 2000, despite projected growth of nominal
GDP at about 6 percent--the same as in 1999. The slowing in M2 growth

3

A copy of the charts used by Mr. Whitesell is appended to this transcript. (Appendix 3)

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owes importantly to the staff’s assumption of an increase in the federal
funds rate of 1-1/4 percentage points over this year, which should help to
induce a substantial rise in M2 velocity. The staff anticipates that the
demand for retail money funds and M2 deposits will be buoyed a little over
the year owing to disappointing returns for stock market investors.
M3 is also projected to grow substantially slower--6-1/4 percent-this year. Expansion of institutional money funds should weaken
appreciably as the buildup of corporate liquidity in late 1999 dissipates and
as investors find yields on market instruments more attractive than the
lagging returns on money funds. The managed liabilities of banks in M3
should also increase more slowly this year, as banks pare back their
extraordinary Y2K-related pace of issuance of the fourth quarter. But with
loan demand expected to remain strong over the year, M3 should continue to
grow faster than nominal GDP.
The runoff of federal debt is projected to accelerate this year,
helping to slow growth of the debt of domestic nonfinancial sectors from
6-1/2 percent in 1999 to 5-1/4 percent this year. The advance in nonfederal
debt is also expected to edge down, though to a still rapid 8-1/4 percent.
Although the gap between business capital spending and the generation of
new internal funds should widen noticeably this year, the external financing
needs of businesses will be restrained by the substantial volume of liquid
assets they accumulated in late 1999 and by a projected slower pace of
equity retirements. Household debt growth is also expected to ease
somewhat, along with home purchases and spending on durables, owing to
higher interest rates and a sluggish stock market.
Table 2 in the lower panel shows the provisional ranges for money
and debt in 2000 that you selected last July, along with an alternative that
adjusts the money ranges for faster growth of potential GDP. Since the mid1990s the Committee has chosen ranges for the monetary aggregates that are
benchmarks for money growth under conditions of long-term price stability
and historically typical velocity trends, while the range for domestic
nonfinancial debt has been aligned with the projected growth of that
aggregate. The provisional range for debt, at 3 to 7 percent, is centered not
far from the staff’s projection for debt growth in 2000 and, therefore, no
alternative setting for that range is offered for consideration.
You may wish once again to retain the provisional ranges, perhaps
as an implicit indication to the public of the low weight placed on the
monetary aggregates in formulating monetary policy. The existing ranges
might also be selected if the increases in productivity growth observed in
recent years were seen as likely to be transitory.

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On the other hand, the Humphrey-Hawkins report of last July noted
that an adjustment to the monetary ranges might be needed if the more rapid
recent pace of productivity growth persisted. In fact, with exceptional
strength in the second half of 1999, nonfarm business productivity grew an
estimated 3-1/4 percent over the last four quarters. In light of our analysis
of productivity behavior in recent years, the staff has revised upward its
estimates of the expansion of potential output. When the Committee shifted
to using price stability ranges in the mid-1990s, potential output growth was
thought to be only around 2-1/4 percent. However, the staff estimates that
potential GDP growth has averaged 3-1/2 percent over the last four years.
Adding perhaps about 1/2 percentage point of upward bias in the implicit
deflator, that would imply nominal GDP growth at a 4 percent rate under
conditions of price stability. The ranges in alternative II are adjusted
upward to be better aligned with this faster steady-state growth of nominal
GDP, assuming historically typical velocity behavior. As shown in chart 2,
M2 velocity has been stable over most of its history, while M3 velocity has
generally trended down.
The central tendency of potential output growth implied by your
forecasts for this year appears to be at about the 3-1/2 to 3-3/4 percent
expansion of real GDP you have, given the roughly unchanged
unemployment rate. This growth rate for potential, plus the estimated
inflation measurement bias, would be very close to the midpoint of the
ranges shown in alternative II. As you know, the staff has revised up its
projection for potential output growth to about 4 percent over this year and
next. Though higher than your implied potential growth estimates and those
of outside forecasters, productivity surprises have generally been to the up
side of late. These and other uncertainties are reflected in the idea of price
stability ranges rather than point estimates. Nevertheless, if you select the
adjusted ranges given in alternative II, the Humphrey-Hawkins report and
testimony could clarify that the revision reflects the faster expansion of
potential GDP observed in recent years rather than a projection of potential
growth going forward. It could also be stated that if additional information
suggests a different pace for potential GDP, the Committee could alter its
benchmark ranges again. In addition, the report could affirm that the
adjustment to the ranges does not reflect any change in your long-run goal
of stable prices and does not signify that any greater weight would be placed
on the monetary aggregates in the formulation of policy.
CHAIRMAN GREENSPAN. Questions for Bill?
MR. JORDAN. I am troubled by the idea--I know it was said last year and repeated
again here--that faster productivity growth means we should raise the money growth ranges. I

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suppose in the 19th century if we had discovered we had faster productivity growth, we would
have said we have to go out and dig gold at a faster rate. There is nothing inherent in our
objective for price stability and what we are trying to do about the purchasing power of money
that says that when we have a favorable supply shock we should raise our money growth
objectives. There’s no more reason to do that than to cut the money growth targets if we had an
adverse supply shock. We wouldn’t do that. I’m sure that back in the 1970s or the 1980s we
didn’t argue for lowering our targets. What we want to do is to view the transitory effects of the
acceleration in productivity growth in a lower reported rate of inflation or transitory decline in
the price level as an increase in the purchasing power of money. It would be a one-time decline
in the price level--I don’t want to use that “D” word. And then when the supply shock goes
away, we would return toward the sort of balanced equilibrium that we would have been in.
Also, I don’t see why it follows that leaving the money growth ranges alone communicates that
they are not important and that we have reduced the weight we give them. Why do we need to
change them to say that we are paying attention to them? And why does not changing them
mean we don’t pay attention to them?
MR. WHITESELL. Perhaps I can respond to that. I think you are absolutely right in
the case of a temporary supply shock. We would not expect the concept of some long-run steady
state condition to be altered if there were a transitory supply shock or temporary increases in
productivity. If, in fact, you believe that the productivity growth surge we have experienced over
the last four years or so is transitory and is going to go away soon, that would not be a reason to
alter long-run price stability. However, if you believe that there is a permanent component to
those increases in productivity, which I think most people do, then presumably you would be
altering your expected steady state of growth of nominal GDP. And if you believe that you need

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to have comparable growth rates of, say, M2 to your expected steady state growth of nominal
GDP to accommodate that kind of steady state expansion, then presumably you would want to be
adjusting up the long-run range for that aggregate.
MR. JORDAN. The part I am questioning is the linkage of saying we should adjust
up the nominal growth of GDP; it’s a sort of nominal spending effect. That was the point I was
getting at yesterday with regard to Dave Stockton’s simulation. To be clear about it we ought to
be explicit rather than implicitly saying that we want a monetary policy that is going to be
“accommodative” to nominal demand increases because we have a real supply-side favorable
development. If we are going to do that, then let’s also think about the implications of being
symmetric about the matter. If we were to have a surprising adverse supply shock, what would
we be doing then? Would we say “Let’s cut our money growth targets”? Probably not.
MR. KOHN. Of a permanent nature, certainly. If productivity growth shifted down,
as in 1973, in order to achieve the Federal Reserve’s goals of stable prices and maximum
employment, the FOMC at that time--though those were not the goals set forth in the Federal
Reserve Act at the time--should have shifted its targeted M2 growth rates down. The question is
what is a steady state nominal GDP growth? And when you have a steady change in the rate of
growth of productivity that is expected to persist for a while rather than be a one-time change,
consistent with what Bill said-MR. PRELL. In a sense the logic that is being applied here is the very logic that got
you to the current targets. It’s just recalibrating the targets to a new, longer-term trend.
MR. JORDAN. I would agree with what Don said if it were the case that we had the
ability to distinguish between an adverse oil shock in 1973-1974 and something that much later
on the profession came to view as a secular trend in what we call productivity. I don’t know that

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our ability to know what we are experiencing at any given time allows us to make that judgment.
The Committee certainly did not do it in the 1970s.
MR. KOHN. Not until very late, right. I think to a certain extent you can observe
what is going on. You can see things like oil shocks, dollar appreciation or depreciation, excise
taxes, or whatever that might change a price level more than you can see an ongoing change in
productivity, which I agree takes some time to recognize. This Committee has been struggling
with that for the last several years. But it has been four years since it appears in retrospect that
productivity growth changed. And I think it is true that by changing these ranges you would be
saying that your best guess is, as Bill said, that there is a permanent component to this change in
productivity and that you will have to reevaluate that on an annual basis.
CHAIRMAN GREENSPAN. Isn’t the issue here a little more limited? We are in
effect, as best I can judge, assuming that long-term M2 velocity is flat. In doing that we are
effectively engaged in estimating long-term nominal GDP. And the issue here is that if--and I
underline the word “if”--price stability is the goal defined, then what falls out is a specific range
of central tendency for M2. It strikes me that the other question is whether it is bad if prices are
declining. In other words, if we hold to where we are now in the context of rising productivity
and rising real growth--that is, keep nominal the same--we will then get declining long-term
prices. That is a different issue. And I think that’s a very legitimate question to be asking. It
comes down strictly to the question of what our goal is over the long run. And having stipulated
that, if we assume stable velocity, then the issue is what is the implicit M2 projection. I don’t
think it is any more complex than that. I don’t disagree with a word that you said, but I don’t
disagree with a word that your opponents said in this debate either. So I raise the question: Do
we really have a problem here?

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MR. MEYER. I think the issue is this: Is our goal stable money growth or stable
inflation? If your goal is stable money growth, you’ll take whatever inflation comes out of it
depending upon the productivity shocks.
CHAIRMAN GREENSPAN. That may be okay.
MR. MEYER. That may be okay. But that is not the goal, as I understand it. We
operate under a mandate of achieving price stability, which I think indicates not necessarily zero
inflation but at least a stable inflation rate. So we have to make a choice.
MR. WHITESELL. As the Chairman mentioned, given the midpoint of the existing
range of 3 percent, if we take your estimate of potential output plus a measurement bias-implying nominal GDP of 4 percent as consistent with price stability--that means you are aiming
for deflation of 1 percent per year.
MR. JORDAN. I agree that that’s an arithmetic implication. We did not start this
period with price stability. Had we started with price stability and then later found out that we
had an acceleration of productivity growth, that would have been one thing. We did not do that.
So to me an acceleration of productivity growth when we’ve started with a positive rate of
inflation, somehow measured, means we have a deceleration from that inherited rate to
something moving toward price stability. At the juncture where we are today and with concerns
like those being registered yesterday by the staff and others, I would be afraid of what the
message that we are changing the ranges would convey. Rather than communicating that we are
going to put more emphasis on achieving a higher rate of growth, it would seem to say that we
are more willing to be accommodative of an acceleration of inflation. We could all say to
ourselves that we are accommodating faster productivity growth. I might even be persuaded that

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that is the right thing to do. I think the message that would be heard is that we are
accommodating faster inflation.
CHAIRMAN GREENSPAN. Suppose we say explicitly that that is not the issue? We
can say that we are trying to find the range for price stability and that we envisage that potential
growth has risen. And, therefore, other things equal, the ranges should go up if our objective
remains where it was several years ago.
MR. JORDAN. I am sure you have the credibility to say that and be believed; I do
not. I know that people wouldn’t believe me if I said that.
CHAIRMAN GREENSPAN. I don’t believe that! In all seriousness, I do think--and I
may be wrong in this--that to the extent we raise this question, we have the capacity in the
minutes and the Humphrey-Hawkins report and in speeches we make to say that essentially
nothing has changed--that fundamentally our goal is price stability. But if potential has risen, of
necessity, unless there is a change in income velocity, our money supply goals should be
different. As you said, it’s an arithmetical truism.
MR. MEYER. I think it is easy to attribute an adjustment in the range to productivity
because nobody actually believes that our goal in setting the range is pure price stability.
Nobody believes that our goal is just price stability. So, in my view, people will not think that
we are accommodating higher inflation if we raise the range.
CHAIRMAN GREENSPAN. President Parry.
MR. PARRY. My question is related to much of the discussion that has been going
on. For alternative II, I think you said that the midpoint of 4 percent on M2 is consistent with a
shift in productivity and also our goal of price stability. So, potential output growth would be in
that 4 percent area and price stability would be defined as zero inflation. I guess what is

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troubling to me is that if nominal GDP is 4 percent, that means the goal is zero on the GDP
deflator. If we went around the table, nobody would give that number.
MR. WHITESELL. I’m not sure if this answers your question, but what we are
suggesting is that the 3-1/2 percent potential growth that has been observed-MR. PARRY. Oh, I see.
MR. WHITESELL. --that plus a ½ percent measurement bias. In other words, the
measured GDP deflator would be ½ percent, but the true inflation would be zero.
MR. PARRY. Well, if that is what the group is happy with, I’m really happy.
MR. KOHN. That’s the way the ranges have been constructed for the last five years-that is, with the same reasoning and arithmetic in mind. The Committee might want to think
about whether it wants to change that. But we were just being consistent with what the
Committee has been doing.
MR. PARRY. Okay.
CHAIRMAN GREENSPAN. President Poole.
MR. POOLE. I think being very explicit about the numbers involved would be a good
thing for us to do. Suppose we were to say that our long-term goal is 1 percent on the deflator
and that we now estimate 4 percent on real growth as potential, which adds up to 5 percent. That
would be all right with me. What I fear, however, is that without being explicit about the
inflation goal, people will read that 5 percent--given that prices have been creeping up a bit and
most of the pressures are on the up side--as indicating that we are going to accommodate
somewhat higher inflation. That is the message that we would be giving. That would be my fear
if we are not explicit.

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CHAIRMAN GREENSPAN. That is clearly the down side. There is no question that
if people were to read that as accommodating more inflation, then the argument for moving up, I
think, is unambiguous. But the point is that may not be the case, and that is the problem.
MR. POOLE. Well, as I said, if we are willing to be very explicit about what our
long-run inflation target is and what our estimate of potential growth is, then I think we can make
the argument. And I believe we should. I’ve said before that I think we should be much more
explicit about our inflation target. In my view, that would be constructive.
CHAIRMAN GREENSPAN. We are essentially saying that price stability is our goal.
You want a numerical judgment of price stability. Is that the issue?
MR. POOLE. Yes, because given what I’ll call our “revealed preference” in the way
we actually have been behaving, I think the market believes that we are perfectly satisfied with
an inflation rate somewhere in the neighborhood of where it is right now. And that’s a little
above what I would regard as zero inflation, properly measured, taking account of the biases in
the indices. My best guess is that something like 1-1/2 percent on the CPI and 1 percent on the
deflator, taking account of measurement biases, is a pretty good estimate of what zero inflation
really is. We are somewhat above that right now and I think the market believes that we are
quite happy to be somewhat above, as evidenced by our own revealed preference in terms of the
decisions we have made.
CHAIRMAN GREENSPAN. Governor Gramlich.
MR. GRAMLICH. I have not bought into changing the ranges and I have some
reluctance to do that, given the discussion we are having. But suppose we do. If we raise the
ranges for M2 and M3 by a point, tell me again what we would say about debt. Would the
reason for not changing the debt range be the reduced federal debt or what?

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MR. WHITESELL. We have never interpreted the debt range as being a long-run
price stability range. We could move to that interpretation on debt as well, if you thought that
was desirable, and make the interpretation for all three of the ranges consistent and make all of
them long-run price stability ranges. If you wanted to do that, you could have the debt range
match that of M2, because for long periods of time debt has grown at rates comparable to
nominal GDP growth. Or if you take the decline in debt velocity of the 1980s very seriously and
think that experience could be repeated in the future, you might leave the debt range right where
it is at 3 to 7 percent and interpret it as a price stability range. But that is not how we have
spoken of it in Humphrey-Hawkins reports in the past.
CHAIRMAN GREENSPAN. President Broaddus.
MR. BROADDUS. I think you said it well, Mr. Chairman. One can make a pretty
solid argument for making a change, so I don’t feel that strongly about not doing so. But if we
do, I believe there is going to be a significant communications issue, as Bill Poole and Jerry
Jordan and others have pointed out. To me, this whole discussion is a good argument for a
numerical inflation target. We have to have a clear, nominal anchor in the long run. I think that
is the key thing. So it is against that background that I would prefer to stay where we are. The
other thing that bothers me a little is that while I certainly have the sense that there has been an
increase in trend productivity growth, I am uncertain how transitory it is and exactly what its
magnitude is. So, I don’t think the argument is absolutely ironclad. And if we go that route and
try to explain it that way, that is going to involve our taking positions on things that I am not
quite ready to take a position on yet. I don’t see any particular reason to do that now.
CHAIRMAN GREENSPAN. President Guynn.

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MR. GUYNN. I would like to join Bill Poole and Al Broaddus on the comments that
you just heard. I, too, see considerable merit in moving in the direction of a more explicit
inflation target. I don’t know whether we are going to talk about that some more this morning or
not. But particularly in the absence of such a target, I believe it is much smarter to leave the
ranges alone for the moment. I think it could be distracting. We have some much more
important policy work to do and I don’t think we ought to confuse the message that we are
sending to the public at the moment.
CHAIRMAN GREENSPAN. President Hoenig.
MR. HOENIG. Mr. Chairman, changing these ranges is always a dicey issue these
days because no matter what we say or what we do, there are more interpretations than there is
reality. At the same time, I could be talked into it because I think there is a building consensus
that the rising trend in productivity improvements is real. And if, in fact, we are willing to
accept that--and there may be some who are not--then moving the targets does make some sense
in terms of their consistency with price stability. And I do agree with what Jerry Jordan was
saying about how we might have reacted to productivity shocks in earlier periods, but I think
things are a little different now. On balance, I could come down in favor of raising the ranges.
CHAIRMAN GREENSPAN. President Minehan.
MS. MINEHAN. Thank you, Mr. Chairman. I just want to go back to the question
portion of this discussion. On page 20 in the Bluebook, Don, you talk about a 2-1/4 percent
trend productivity growth as opposed to something in the high-MR. KOHN. That was trend potential output growth when the Committee first set
these targets.

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MS. MINEHAN. Oh, yes, excuse me. Is 2-1/2 percent your trend productivity
growth?
MR. WHITESELL. Currently it’s 3 percent.
MS. MINEHAN. How much of that upward revision is the result of the change in the
NIPA numbers?
MR. WHITESELL. Not very much actually, in part because the staff’s current
estimate of potential output growth in the mid-1990s--through the second quarter of 1995--is still
2-1/4 percent. The current estimate for the last four years, by contrast, is 3-1/2 percent; and then
we have 4 percent going forward. There has been a ratcheting up of potential output growth
estimates with structural productivity, so that after the second quarter of 1995 we moved from
2-1/4 to about 3-1/4 percent. At the beginning of 1998 we have potential output at 3-3/4 percent
and then beginning this year we’ve predicted that it is 4 percent.
MS. MINEHAN. So in the mid-1990s you had a potential output growth of
somewhere around 2-1/4 to 2-1/2 percent and now it is a full percentage point higher than that?
MR. WHITESELL. Our estimate is still that up to the second quarter of 1995
potential output growth was 2-1/4 percent. Starting this year we have it up 1-3/4 percentage
points higher to 4 percent.
MS. MINEHAN. Yes.
MR. PRELL. In each case, we’ve done little more than extrapolate the recent
experience for a near-term period. In thinking about what you might want to do if you adjusted
the ranges, one question would be your assumption about potential GDP growth. Would you
want to rest your assumption on the experience of the past few years--where the behavior of the
unemployment rate relative to GDP, for example, would seem consistent with potential output

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growth somewhere in the 3-1/2 percent range or a little higher? Or would you want to look
forward in the optimistic way that we have with an assumption of about 4 percent?
MS. MINEHAN. I understand exactly what you want to do. I was just trying to get a
handle on the effect of the NIPA revisions. I knew there was some effect--a few tenths of a
percentage point--from the NIPA revisions all by themselves.
MR. PRELL. A few tenths came from the change.
MS. MINEHAN. I’m just thinking about this communications issue.
MR. PRELL. Sure.
MS. MINEHAN. If any portion of this productivity change was really the fallout of
revising numbers in a better way, presumably as a result of the NIPA changes, that is something
that would help in communicating the reasons for a change.
MR. POOLE. Cathy, if I could just comment very quickly on that: It doesn’t change
nominal. What the NIPA revisions have done is to change the split between real output and
prices. So in that respect those revisions do not really bear on this issue.
MS. MINEHAN. But they did change productivity.
MR. POOLE. That’s right, but there was an offsetting change in the inflation number.
Essentially it changed the split of the nominal.
MS. MINEHAN. I realize that. That isn’t the point.
MR. PRELL. But forward-looking, relevant to thinking about the bias adjustment in
the price measure, if that were all that was going on, switching from one component to the other
in nominal GDP, then there would be a wash.
MR. WHITESELL. Back in the mid-1990s we think that perhaps the bias was closer
to a percentage point, whereas now it’s only about ½ percentage point.

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MS. MINEHAN. Now it’s about ½ percentage point, and I was thinking in terms of
looking forward, which is what these ranges are supposed to be doing. If we have a different
productivity number, in part because we think it was different in the past--because of the change
in the break between the price bias and underlying real growth--then that gives us a non-policy
oriented reason for making a change in our thinking about the growth rate in money.
That said, I think the people who have commented on the communications difficulty
have a point, particularly in an environment in which we do not think the outlook for inflation is
at all biased on the down side. It is not evenly biased; there is upward bias. Whatever we want
to say about risks, everyone around this table yesterday talked about the underlying pressures on
the economy. So I don’t think anybody is satisfied with the existing state. The inflation number
looks okay, but the direction in which it is likely to be moving is not. The difficulty in
communicating our reasoning, if we change the ranges, is that it does tend to say something
about our willingness to accommodate the conditions that exist right now--unless, as other
people have said, we want to get a lot more precise.
MR. WHITESELL. In terms of the communications issue, President Minehan, we did
inform the public last July that a change in the ranges might be coming up because of
adjustments in our assessment of productivity.
MS. MINEHAN. I know you did.
CHAIRMAN GREENSPAN. Governor Ferguson.
MR. FERGUSON. Thank you, Mr. Chairman. I walked in here being really quite
agnostic on this issue. I know it is a matter on which some people feel strongly, but I was
interested in hearing both sides. I have come to the conclusion that perhaps the better course is
just to leave well enough alone--not to make a change at this stage--for a variety of reasons. Jack

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Guynn raised one reason that to me is most important. During the course of this year, I suspect
we will be under a fair amount of scrutiny about core policy matters, and I would prefer not to
have to go into that period having to explain monetary aggregate issues, which frankly are not
terribly important to us right now.
Secondly, there is the whole issue, which also has come up, about numerical inflation
targeting. I happen to be one of those who think that the qualitative inflation target that we have
now has served us well. And I see no reason to open that debate, which I think we would have to
do in the course of reaching a decision to change the ranges.
The third thing that worries me, as I listen to this conversation, is that it will also force
us in some sense to be more explicit as a Committee about our views on productivity and the
productivity trend. And I’m not sure that I am hearing consistency among the Committee
members on those issues.
Finally, I believe there is a lesson to be learned from some of our central bank
colleagues around the world who are in a position of having to talk about and defend their
actions vis-à-vis what is happening to growth in the monetary aggregates. In particular, the
ECB, which has put more weight on money growth than perhaps it should have, is being
lambasted week by week in the newspapers for why it is allowing M3 growth to be above its
target. I think we are in a much better position in that we have clearly said we are not putting
much weight on these aggregates, and so M3 growth may or may not be above our targets. I
frankly prefer to be quite clear in our communications. We have enough other issues about
which we need to be clear. If we just leave this one alone for the course of this year, I think we
will be in much better shape, given the other things we are likely to be doing.
CHAIRMAN GREENSPAN. Vice Chair.

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VICE CHAIRMAN MCDONOUGH. I associate myself with Governor Ferguson’s
very wise remarks.
CHAIRMAN GREENSPAN. Governor Meyer.
MR. MEYER. Well, now for a different perspective, I suppose. I must say that this
has been a very interesting discussion so far and I think we have identified two issues relevant to
the target ranges. The first is whether to revise them to reflect the faster rate of growth of trend
GDP. The second is what implicit inflation target we should use to set the midpoint of the
revised range.
Alternative II deals with the first issue and I believe perpetuates the possible
misunderstanding that our inflation target is pure price stability, adjusted only for an estimate of
inflation bias. Now, I say a possible misunderstanding because the Committee has not fully
discussed its preferred inflation rate and certainly hasn’t worked to achieve a consensus on that
point. As for the strict price stability target that is implicit in the target range today, we might
ask this question: Does that really make us look like the central bank most focused on price
stability around the world or like the central bank least transparent about its inflation objective?
I think it is the latter.
I will offer an alternative III set of ranges that incorporates my view that the implicit
inflation target, set as the midpoint of the M2 growth rate, should reflect what I’ve called price
stability plus a cushion. Although there remains a lot of uncertainty about the precise value of
trend GDP growth and how it might evolve over the next several years, I think the current
monetary growth ranges are outdated and badly in need of revision. Now, I am comfortable with
the judgment reflected in alternative II that the ranges should be updated to reflect an assumption
that trend GDP growth is currently 3-1/2 percent. The Humphrey-Hawkins report and testimony

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should emphasize that the FOMC will reconsider the setting for the monetary aggregate ranges
as incoming information leads us to revise our estimate of trend real GDP growth. That is,
instead of thinking of the monetary growth ranges as being carved in stone, we should use them
as digital--subject to costless adjustments in response to the flow of new information.
Let me turn to the second issue, which is undoubtedly the more controversial one. I
think we are sending an implicit message about how we define price stability when we set the
ranges. We can try to escape from this reality, but I doubt we will be successful. Any change in
the ranges, as many people have already indicated, may result in a probing for our implicit
inflation target. Clearly, we go through this exercise very explicitly when we set the ranges. The
question is how we present it to the public: Should we blur this logic, ignore the issue entirely,
or be more transparent about it? I think the main--and maybe the only--purpose of the monetary
aggregate ranges today is as a means to offer an implicit inflation target. So perhaps we should
view today’s discussion of the ranges as an opportunity for an internal discussion about how we
should set an inflation target that is consistent with our interpretation of price stability. And we
might also look at our discussion and decision today as an opportunity for another step in the
direction of transparency.
I want to point out that, in my view, there is a subtle but very real difference between
an “explicit inflation target” and “inflation targeting.” I do not understand how a central bank
can conduct monetary policy to achieve price stability without establishing an inflation target
consistent with our interpretation of price stability. Given that we want markets to help us
achieve this target, there is also a value in being explicit about it. And I believe I can accept an
explicit inflation target without having to sign on to a specific strategy for achieving that, which
is what I interpret “inflation targeting” to be.

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Other countries that have price stability mandates and explicit numerical targets have
uniformly set ranges centered on what I’ve referred to as price stability plus a cushion. This, in
my view, is an appropriate option, in light of concern about a deterioration in cyclical
performance near zero inflation with a zero nominal interest rate valve. Therefore, I offer as
alternative III a range centered on my preferred midpoint of 5 percent. That reflects the sum of a
3-1/2 percent rate of trend growth in GDP, a ½ percentage point estimate of bias in the chain
measure of the price index for GDP, and a 1 percentage point cushion. And this suggests a 3
percent to 7 percent range. This would be a small step to take toward an explicit inflation target
and enhanced transparency, but it would be a big step for this Committee to take.
I will give you an alternative strategy here, which would be to set a central range
rather than a point, with the bottom point being consistent with pure price stability and the upper
point consistent with price stability plus a cushion. In this case, the central tendency might be 4
to 5 percent. Attaching a symmetric range about the central tendency would yield a range of 2 to
7 percent for M2. This is analogous to the Australian approach of setting a “thick” point target
of 2 to 3 percent. It has its own problems, particularly the indecision once M2 growth is inside
the central range. But it would allow us to defer a more precise setting of the midpoint until a
consensus could be reached in the Committee and perhaps until there was consultation with
Congress.
CHAIRMAN GREENSPAN. President Moskow.
MR. MOSKOW. Thank you, Mr. Chairman. This is an interesting discussion, but
from a practical standpoint I come back to exactly the same place I have been the last 11 times I
have been here when we have discussed this. And that is that we should not make any change in
the ranges. I think it would be misleading to the public for us to make a change unless there is a

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huge education program up front. As others have said, a change would give the impression that
we are placing a lot of weight on these ranges in the formulation of monetary policy and we
aren’t. I think the communications challenges are significant--not insurmountable, but very
significant--because a lot of people don’t accept the premise that the economy’s potential growth
rate is as high as many people around this table think it is these days. So we’d have to explain
that as well; otherwise people are going to think that moving these ranges up indicates that we
are going to be conducting monetary policy in a way that they would view as inflationary.
Finally, on the inflation target issue, the question is really whether we should have a
quantitative inflation target. That is a very important issue and I think it is one that should be
discussed, but in my view it should be discussed separately and not in the context of these
monetary policy ranges. It is something on which reasonable people obviously disagree. We
have disagreement around this table. I believe it is important to discuss it, but I really think it
calls for a separate discussion entirely.
CHAIRMAN GREENSPAN. President Stern.
MR. STERN. Thank you, Mr. Chairman. Well, I don’t have a lot to add. As many
people have already observed, we have discussed all of this before. In my own case, unlike in
previous discussions, I do think that today both arithmetically and substantively the case for
raising the ranges is pretty strong. But I don’t feel very strongly about it because I think there is
a communications challenge. Having said that, my guess is that the communications challenge
can be dealt with. I think market participants would get the message pretty directly if we used
the vehicles available to us. But that is just a guess or a judgment. I could be wrong about that,
so I don’t feel all that strongly about raising the ranges.
CHAIRMAN GREENSPAN. President Boehne.

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MR. BOEHNE. Governor Ferguson captured my views nearly completely and I
would like to associate myself with his comments.
CHAIRMAN GREENSPAN. Governor Kelley.
MR. KELLEY. Thank you, Mr. Chairman. After listening to this discussion, I have
to say that I have reversed the position that I came in here with this morning. The question for
me is: How permanent is this higher rate of growth that we now perceive? If it is permanent,
then I think we ought to move to alternative II. But I note that the concept of what sustainable
growth is has shifted meaningfully in the past several years. And it seems to me that it could
very well shift again, possibly in either direction. I note that, for very good reason, we are able
to recognize and, if you will, formally accept these shifts of what is sustainable only with a
considerable lag. So, if the dynamic here involves what is sustainable growth and it moves
around and we are able to perceive it with confidence only with a lag, then I think we run a
considerable risk of being out of sync a lot of the time. If we go chasing this explicitly by
moving these ranges around, I think it will be very hard to explain and very easily misunderstood
or misinterpreted by the public. And I see no compelling reason to do it.
CHAIRMAN GREENSPAN. Governor Gramlich.
MR. GRAMLICH. Thank you, Mr. Chairman. This comment is going to sound a bit
tired and I apologize for that. I think transparency is good. And as I’ve said a number of times, I
think we would be well advised to move in the general direction of inflation targeting. At some
point we might even try to agree on explicit targets. But I think right now we have bigger fights
to fight and I’d just as soon pass on this particular one and not talk about explicit targets in
connection with these monetary ranges. So I would prefer no change, alternative I.
CHAIRMAN GREENSPAN. President Jordan.

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MR. JORDAN. Thank you. In the earlier comment period, I was in the questioning
mode, so I’ll state a view on this now. We are talking about two different things back and forth
at times here--about a belief in a sustained growth in productivity and potential output and what
would be an appropriate stance of monetary policy, especially as implied by monetary growth,
versus acceleration in productivity. Those can, at least, be separated analytically in the way we
think of them. If it was a matter of a consensus that we are going to have real growth on the
order of 4 percent--through a combination of productivity gains and labor force growth--and if in
raising the ranges it could be communicated that the Committee was pro-growth, that is one
thing. And I would have a hard time objecting to that. If it is a question, though, of
accelerations and decelerations with a fair degree of uncertainty about what is happening to
productivity, then we run higher risks of miscommunicating our policy intentions.
I would be delighted, as I think everybody would be, if productivity growth
accelerated to the point where real output growth was 6 percent. But I still would not necessarily
conclude that we should very quickly change our monetary growth assumptions. That’s because
with a favorable productivity surprise, there is nothing wrong with an increase in the purchasing
power of money. There is nothing wrong with manifesting and distributing the wealth gains
through society in the idea that the dollar buys more. We know that in most sectors and
industries where productivity growth is increasing rapidly, prices are falling. And that is a good
thing. There is no reason why we should think that prices of other goods and services need to
rise faster than they otherwise would have in order to hit some statistical measure of average
price changes. So I don’t think we should rule out the idea that favorable productivity
developments can be accepted as being associated with rising purchasing power of money or a
falling price level.

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CHAIRMAN GREENSPAN. President McTeer.
MR. MCTEER. I wish Jerry hadn’t just said that!
CHAIRMAN GREENSPAN. Erase that from the record and start again! [Laughter]
MR. MCTEER. He made me have misgivings regarding what I am about to say. I
agree with Gary Stern’s ambivalence; I don’t feel strongly about this issue one way or the other.
But since I am on record as believing that productivity gains are not a transitory phenomenon
and if consistency suggests it, then I guess I would have a small preference for raising the ranges,
although I could accept deflation as a way of taking those productivity gains as well.
CHAIRMAN GREENSPAN. President Parry.
MR. PARRY. Mr. Chairman, I liked what Governor Meyer said, although I must
admit I’d probably be happier with a thinner cushion than he would. That leads me to think that
a case can be made for alternative II. But I keep coming back to the idea that we really do not
have much confidence in our forecast of the aggregates and what they mean and that, therefore, it
is probably best not to draw attention to them. So, on balance, I have a slight preference for
alternative I. In either instance, however, I think we should make it clear that we are not
targeting the aggregates and that our goal is price stability, defined in the way that we talked
about earlier.
CHAIRMAN GREENSPAN. I came into the room, having been staunchly against
doing anything with the ranges previously, at least thinking about the possibility of changing
them because, unlike a lot of you around the table, I think the productivity changes are now
unquestionably real and, if anything, still accelerating. But the arguments cited on the difficulty
of communicating the logic of a change are really quite persuasive. And since we have been so
successful in defusing interest in the ranges, the question is: What do we gain by stirring this

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issue up? And the answer is not very much except academic consistency, which is not to be
dismissed materially, but it doesn’t strike me that that has been a high priority among our set of
goals in general.
Let me just weigh in a little on this price stability question, because I think Jerry
Jordan has raised an issue that is going to become very important. It wasn’t all that long ago that
we had considerable discussions about what is the optimum price path. We talked about the
issue, for example, of price stability as a necessary condition for economic stability. That is
fundamentally the reason why we have opted for price stability--on the grounds that the risk
premiums rise on both sides of price stability and that price stability is at the lower bounds of any
evidence of risk and uncertainty almost by definition. Yet it is hard to argue the case of, say, a
highly technologically oriented economy with productivity rising very rapidly, nominal sales and
profit margins reasonably stable, but prices, however defined, falling. Remember, prices are not
easy to define in certain instances. All we can visualize are sales, profits, and income. And,
since an hour is an unambiguous unit, I guess we can measure average hourly compensation.
But price is not an unambiguous notion nor, therefore, is price stability. As we move into a hightech economy, this issue becomes a lot trickier than I think we realize. The question isn’t price
stability as an ultimate goal; it can’t be. That is a secondary issue. And it is subject to
differences in measurement, so we have to be careful about what we are doing in terms of what
our goals are and what we lock ourselves into. I think at some point we are going to have a very
interesting discussion on this issue. But at the moment, I must say that I have been persuaded by
most of you that it is a great idea to move forward, but somebody else better try to explain it
because it isn’t going to be easy! And I think it raises some very serious questions. So, as I
judge the discussion around the table, it is very clearly the desire of the large majority of people

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here to keep the ranges where they are for M2, M3, and debt, which I presume is alternative I.
Let’s vote on the total alternative accordingly. Would you read the appropriate language?
MR. BERNARD. I will be reading from page 28 in the Bluebook, the bottom half of
the page: “The Federal Open Market Committee seeks monetary and financial conditions that
will foster price stability and promote sustainable growth in output. In furtherance of these
objectives, the Committee at this meeting established ranges for growth of M2 and M3 of 1 to 5
percent and 2 to 6 percent, respectively, measured from the fourth quarter of 1999 to the fourth
quarter of 2000. The range for growth of total domestic nonfinancial debt was set at 3 to 7
percent for the year. The behavior of the monetary aggregates will continue to be evaluated in
the light of movements in their velocities and developments in prices, the economy, and financial
markets.”
CHAIRMAN GREENSPAN. Call the roll.
MR. BERNARD.
Chairman Greenspan
Vice Chairman McDonough
President Broaddus
Governor Ferguson
Governor Gramlich
President Guynn
President Jordan
Governor Kelley
Governor Meyer
President Parry

Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
No
Yes

CHAIRMAN GREENSPAN. Shall we move on to Don Kohn?
MR. KOHN. Thank you, Mr. Chairman. I shall first discuss the
simulations in the long-run scenarios section of the Bluebook, and then
consider the choices at this meeting about the stance of policy and balance
of risks to announce. The results in the first set of scenarios on Chart 3
following page 8 extending the Greenbook forecast and looking at policies
to reach alternative inflation rates depend critically on the staff assessment

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of the current state of the economy. The FOMC has, in effect, taken the
positive supply shocks stemming from the acceleration of productivity and
from the decline in oil and import prices of a few years ago importantly in
the form of added output and lower unemployment. But in the staff view,
this has left the economy operating well above the level of its long-run
potential, and now, with price shocks reversing and productivity growth
seen as accelerating only a little further, inflation is about to pick up.
Moreover, the policy tightening implemented last year is not viewed as
sufficient to eliminate that tendency. Indeed, current financial conditions
are seen as sufficiently stimulative that inflation pressures are likely to
intensify if the federal funds rate is not raised further. The effects on
demand of the rise in equity markets last year and the ongoing resurgence in
foreign economies mean that the equilibrium funds rate is expected to
continue to increase into this year. And the Greenbook baseline forecast
sees a 125 basis point tightening as necessary just to hold the unemployment
rate flat.
All three scenarios see substantial additional tightening beyond that
125 basis points as needed to keep inflation from continuing to rise. That
need arises from the judgment in the Greenbook forecast that at the end of
2001 both the unemployment rate and the real funds rate will be appreciably
below their natural or equilibrium levels. To say the least, such judgments
about the level and growth of potential supply and equilibrium interest rates
have been especially difficult to make in recent years, and a number of you
have wondered whether policy shouldn’t scale back its reliance on such
assessments. To address this question, the Bluebook also showed several
sets of simulations that compared the behavior of the economy under a
policy rule that looked only at current and past inflation with rules that also
took into account perceived output gaps. Moreover, the realized-inflation
policy-setting rule was one that determined the change in the nominal funds
rate--not its level--so that policymakers need not form a judgment about
equilibrium real interest rates.
Of course, it will always be advantageous to employ all the accurate
information you have when forming policy. But using less than what you
have in hand might work to your advantage if some of it turns out to be
wrong. [Laughter] In fact, as can be seen in Charts 4, 5 and 6, the realizedinflation rule does tolerably well in stabilizing the inflation rate and
producing reasonably good economic performance under some
circumstances. In particular, Charts 5 and 6 show that when the supply side
of the economy behaves in unexpected ways that you learn about only
slowly, the inflation rule does much better at stabilizing inflation than
basing policy on misperceptions about the trend of the growth of potential.
The rule allows supply-side surprises to show through mostly in variations
in output, which is especially advantageous for favorable supply shocks

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when inflation is already low. It can be successful in these circumstances
because it is very aggressive in leaning against actual changes in inflation,
while at the same time also paying attention to the level of inflation relative
to the Committee’s objective. However, as can be seen in Chart 7, one risk
of such a strategy is the slow response it has to an aggregate demand shock,
producing greater fluctuations in inflation and output than a rule that also
looks at realized output gaps, even when the output gap may be
misperceived.
In December, you expressed concern about the strength in aggregate
demand and the potential inflationary consequences of its tendency to
outrun increases in the economy’s long-run potential over time. With
demand and output showing few signs of moderating since then, and with
recent data on costs and prices raising questions about how long the good
news on inflation will last, the Committee’s choices about policy at this
meeting would seem to be about how much, not whether, to firm. How you
assess the uncertainties about supply and demand, and how much weight
you wish to place on estimated levels of potential output relative to
incoming inflation data, may help to shape your decision today on exactly
how much to tighten.
A 25 basis point firming accompanied by a balance of risks sentence
that suggested persisting concern about potential inflation is currently
expected by the market. That combination is the unanimous projection of
primary dealer economists. And it is roughly consistent with rates in federal
funds futures markets, where there is certainty of a 25 basis point firming at
this meeting, a small probability of a 50 basis point action, and a certainty of
at least 50 basis points of tightening by the end of your next meeting in
March. The Bluebook discussion presumed that, in light of recent data and
forecasts, you would still assess the risks to be unbalanced toward inflation
pressures if you firmed by 25 basis points. Any “relief rally” that might be
sparked by a 25 basis point firming should be limited by the balance of risk
statement and by any associated increase in the discount rate. As a
consequence, this combination should have no appreciable long-lasting
effect on longer-term interest rates and asset prices.
Judging from the yield curve, those longer-term rates now embody a
total of 1-1/4 percentage points of tightening by the end of this year, but
little further thereafter. As I already noted, in the staff forecast this path for
policy is consistent with stabilizing the unemployment rate, but not the
inflation rate. Still, the current configuration of market rates may be
acceptable to the Committee, at least until the extent of inflation risks
becomes clearer. The Committee might be uncertain enough about the
judgment that the NAIRU is substantially above the projected level of the
unemployment rate, to want to down weight its importance in its plans. At

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the same time, even with the fourth-quarter NIPA price data, longer-term
trends in inflation and costs would not yet seem to confirm the hypothesis
that the economy is operating well beyond its potential. Four-quarter
averages of most core inflation rates remain relatively stable, and the effects
of strengthening compensation on unit costs have been offset by faster
productivity.
Even if the Committee is convinced that you will need to tighten more
than 25 basis points eventually, so long as you do not see the restraint built
into the yield curve as clearly inadequate, the costs of a gradual approach to
the contemplated policy actions would seem to be small, and gradualism
would seem to have some advantages. It gives you more opportunity to
adjust the trajectory of your actions over time, based on new information
about the economy and financial markets. This flexibility might be seen as
especially valuable when there is so much uncertainty about prospective
aggregate supply, and when financial markets are volatile and their reaction
to policy difficult to predict. In the past, the Committee has deviated from
this approach primarily when expectations and psychology have moved
adversely, working against the Committee’s objectives. In the current
circumstances, long-term inflation expectations seem to remain reasonably
well anchored at moderate inflation rates. The nominal/real yield spread on
Treasuries, for example, still embodies 10-year average CPI inflation of
2-1/2 percent or less--within its range since last June although up a lot from
a year ago, as Governor Gramlich noted--with only a percentage point or so
of tightening in the yield curve. And a firm dollar on foreign exchange
markets, where the demand for dollar assets seems to match the burgeoning
supply from our current account deficit, suggests an absence of concern
among global investors about adequate policy responses to developing
inflation problems.
However, if the Committee sees the inflation risks as greater than do
the financial markets--perhaps because the Committee is putting weight on
the possibility that the sustainable unemployment rate is well above the
current rate--and believes it will need to tighten considerably more or faster
than is now built into the yield curve, it might want to raise its target federal
funds rate 50 basis points at this meeting. The Committee would be
surprising markets with that action, and would most likely prompt increases
in interest and exchange rates and a drop in equity prices. Such reactions
would not be unwanted in that they are an integral aspect of the less
accommodative financial conditions you saw as necessary to restrain real
growth and contain inflation.
The public’s interpretation and market reaction would depend
importantly on the associated balance of risks statement. A statement that
risks were balanced would suggest that the Committee saw financial

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conditions after the firming as equally likely to produce rising as stable or
falling inflation. Such an announcement would tend to limit any increase in
rates; indeed, one could not rule out a rally in capital markets--especially the
equity markets--if the symmetry were seen as an expression by the FOMC
of substantially less concern about longer-term inflation pressures than the
market now perceives.
More likely, given the strength of demand and the firmness of labor
markets, the Committee would still view the risks as unbalanced toward
higher inflation, even after a 50 basis point tightening. The response of
interest rates and asset prices to this combination could be considerable, and
markets would remain on alert, attempting to discern whether additional
tightening might be forthcoming at your next meeting. Both the response
and the volatility might be muted to some extent if the Committee also tried
to indicate in its statement that it was not necessarily contemplating another
firming at its next meeting--that is, emphasized that the timing of its next
action was highly dependent on incoming data. The Committee’s new
disclosure policy contemplated that announcements might provide such
indications, now that the official language is focused on the longer-run
economic environment instead of on the possibility of near-term policy
action.
CHAIRMAN GREENSPAN. Questions for Don?
CHAIRMAN GREENSPAN. President Parry.
MR. PARRY. Don, I’d like to hear your thoughts about how the Greenbook is
characterizing the current stance of monetary policy. In one part of the Greenbook there is a
reference to the real equilibrium funds rate as being 5 percent. I suppose that calculation
involves the PCE chain-weighted core rate less food, energy, and tobacco. Recent experience
would suggest that the inflation premium is maybe 1-1/2 percent if one’s analysis is backwardlooking and about 2 percent if it is forward-looking. That would suggest to me that the Bluebook
is saying that until the nominal funds rate reaches a level of 6-1/2 to 7 percent policy is in a
stimulative mode. Is that what the Bluebook is saying?
MR. KOHN. The Bluebook is the extension of the Greenbook forecast, and Chart 3,
immediately after page 8, is essentially saying that. It is saying in the stable inflation case--the

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middle line with dots and dashes--that the funds rate gets up to 7-1/2 percent in the next two
years. And over that period inflation rates are rising, so it’s not 2 percentage points of real
tightening, but it is about 1-1/2 percentage points of real tightening. So I think the message of
the Greenbook, which is reflected in these alternative strategies, is that policy clearly is not now
positioned to keep inflation from rising. In fact, it is not now positioned to keep inflation
pressures from intensifying in the sense that with an unchanged funds rate the unemployment
rate would likely fall further.
MR. PARRY. So with an increase of ¼ or ½ or even ¾ of a percentage point, we
would still be in a position of basically stimulating the economy and providing an environment
where inflationary pressures are likely to continue to rise?
MR. KOHN. As I was trying to say in my briefing, that depends importantly on the
weight you put on the NAIRU calculation. What you do at each meeting is important obviously,
but what the market perceives you are going to do may be even more important in terms of the
effects on economic activity. And it’s the intermediate- and longer-term interest rates that have
the most effect. So I think what is important is the trajectory that the market perceives you to be
on. That is what is going to be reflected in intermediate- and longer-term interest rates, where
we see most, though not all, of the effect on economic activity. That has effects on the dollar and
presumably on equity prices if the discount rate matters at all for equity prices these days. So,
the point here is that the market has built in approximately 125 basis points of tightening over the
next year or so, which is what the Greenbook has built in.
MR. PARRY. So if we were to move cautiously, it would be very important to
communicate clearly about the work that apparently still has to be done?

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MR. KOHN. That’s right. And I think that is what the balance of risks sentence is
designed to do. And my judgment was that a combination of a 25 basis point increase and an
unbalanced risk sentence, plus potentially a discount rate change, would tend to communicate
that. One can never be certain about how the markets are going to react.
MR. PARRY. That same communication probably would not be modified much if we
went 50 basis points?
MR. KOHN. If you went 50 basis points and had an unbalanced risks sentence, I
think that would communicate a greater sense of concern on the Committee’s part than the
market now perceives.
MR. PARRY. But not a greater sense of concern than is in the analytical work that
has been presented to us.
MR. KOHN. I agree. And what I think that would tend to communicate is that you
are putting weight on an estimate that the economy is operating well beyond potential and that
the unemployment rate needs to rise appreciably to stem inflation. The question is whether you
want to do that now or wait for some evidence that that in fact is the case. In a sense it’s a
strategy issue--whether you want to surprise the markets now with that assessment or wait until
you get some evidence.
MR. PARRY. Thank you.
CHAIRMAN GREENSPAN. Don, how comfortable do you feel about all of these
simulations when the econometric structure that they are being simulated from has not provided
a good record for judging the outcomes with respect to inflation, costs, and the like?
MR. KOHN. There is a lot of uncertainty about the supply side of the economy and I
would try to communicate that. We ran a number of other simulations and presented them in the

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Bluebook to underscore that point. But I think the staff has been catching up with this very
quickly; we might even be ahead on productivity but certainly we have been catching up very
quickly on the growth of productivity. We have modified our wage/price assessments, which in
effect is what several people were remarking on yesterday about the sacrifice ratio. That is now
higher because we see the economy in effect as a little less inflation prone in the sense that, even
taking account of supply side effects, the rate of inflation seems to be less sensitive to output
gaps than it might have been before. So I think we are moving as quickly as the data will allow
toward our best assessment of what those supply side effects are. But you are right; that
assessment is embodied in these simulations. I tried to emphasize that the results, particularly
the extent of the firming, are crucially dependent on those assessments and that there is a lot of
uncertainty about them. The Committee may want to think carefully about how much weight it
puts on them.
CHAIRMAN GREENSPAN. In the simulations, what are you doing to the statistical
discrepancy?
MR. KOHN. I don’t know. That’s an income side thing and the simulations, I
believe, are basically done on the product side.
CHAIRMAN GREENSPAN. As you know, the huge opening up of the statistical
discrepancy is creating different coefficients than one would get using the product side. And I
would submit to you that the stability of a number of the outcomes you are getting in these
simulations relative to the forecast of this discrepancy is much larger than I think we all realize.
My concern is that we be careful about this because the number of differences is not small, and
my suspicion is that the policy implications are of significance. That is important to recognize,
for example, when we raise the question about whether this productivity improvement is real.

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And, eventually, when I get to my remarks, I will try to provide some evidence that there is
something very unusual going on. The one thing we know is that the apparent marked increase
in profit margins in the fourth quarter, in the context of a relatively modest set of increases in
cost structures, makes it very difficult to get around the conclusion that productivity growth is
significantly above what the numbers are giving us basically because they are being reduced by a
widening negative statistical discrepancy. I just want to say that, as an old aficionado of building
econometric models, I know what they can do and I know what they cannot do. I am a little
concerned about the definitiveness of some of these results; they give the appearance of reality. I
submit that models that don’t forecast all that well have deficient coefficients. And then to
simulate a forecast using those coefficients gives one a sense of reality, which is at root false. I
am not saying that these are not useful exercises; they are, if we consider them not in terms of the
actual numbers they produce but in the structure of the changes that they are telling us about.
One example is the issue that Larry Meyer was raising yesterday with respect to the Wicksellian
real interest rate. Qualitatively these are important issues to discuss. But to put specific numbers
on them and say this is the number of basis points we need to move the funds rate to make the
system balanced is ludicrous. I would be laughing hilariously were it not such a serious
question, because there is just no way these models can be precise about that. Their range of
error is such that they cannot give those answers. What they tell you is direction and rough
orders of magnitude. But the presumption that small changes here and there will make a
difference I think misreads what these techniques can do.
MR. PRELL. Mr. Chairman, may I make a couple of comments? One is that I would
encourage people to look at most of these simulations in a broad sense, simply in a directional
sense. I think the message will carry even if one adjusts some of these coefficients significantly.

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On the question of the statistical discrepancy, many of the things that would be affected by that
would affect both the potential output and the aggregate demand side of the equation.
CHAIRMAN GREENSPAN. I disagree with that. That is not factually correct.
MR. PRELL. If it is a matter of mismeasurement of output growth over the recent
period, then that is something we would need to recalibrate--both in terms of our estimate of
potential as well as actual growth.
CHAIRMAN GREENSPAN. It changes the probability, in the sense of the security
one has in what the underlying rates of trend productivity are.
MR. PRELL. True.
CHAIRMAN GREENSPAN. You are assuming right now that the second derivative,
which has been positive for quite a period of time, falls to zero. You have been assuming that
for the last 3 or 4 Greenbooks and it has been-MR. PRELL. Actually, in this case we are assuming that the second derivative is
positive for the forecast period relative to the recent period and we are making no assumption
about it past 2001.
CHAIRMAN GREENSPAN. Remember you are forecasting it to fall.
MR. PRELL. That’s a very long-term assumption in the simulation, yes.
CHAIRMAN GREENSPAN. I don’t want to get into a detailed discussion on this.
It’s just that I want to make clear that there is sometimes a presumption about the accuracy of the
results these models produce, which I don’t think conveys the humility required for them. I just
want to put that on the table. If we want to have a seminar on this, I would be most delighted to
get involved in it because I think this is a very important issue.

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MR. PRELL. I take a backseat to no one in terms of humility about these models, but
I just want to close a loop on one other thing so everyone understands what we have done in the
projection. This is getting into how the sausage is made. In fact, in balancing the income and
product sides of our forecast, we actually do have a continuing widening of the statistical
discrepancy. So that’s built into our baseline forecast through 2001. The model extension, in
effect, takes some of this on board because it is deriving the structure that is carried in the future
beyond 2001 based on the structure of the judgmental Greenbook forecast.
CHAIRMAN GREENSPAN. That is the point. Suppose it is actually going in the
other direction? Look, I am not arguing. I do not disagree with the general policy focus that is
coming out of the Greenbook. I happen to think that, this year, we are going to have to move the
funds rate quite significantly higher. And the number I would put in the back of my head would
not be terribly different from where you are coming out, and a lot of that is implicit in the
intermediate period. It is just that I believe we have to be terribly careful about the notion of
what we know and what we don’t know. I am a little concerned, basically, because we can
exaggerate the extent of our knowledge very readily.
I didn’t mean to digress into that long discussion. President Jordan.
MR. JORDAN. Thank you. I, too, have a lot of reservations about the national
income accounts sets of information that we use to think about an increasingly globalized
economy. It is certainly not what we would construct if we were starting from scratch today,
given the way we see the world going. Nevertheless, it’s what we have, so we try to torture the
data in our efforts to find some useful information. I thought this was a useful set of exercises
and simulations from the standpoint that while we are all very uncertain at times about all kinds
of things, our degree of uncertainty about specific things varies a lot. Some people are quite

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certain about one thing while others are very uncertain about that same thing. So these exercises
at least allow people to be rather explicit about what they are certain about and what they are not
certain about. So from that standpoint, I think they are useful.
What occurred to me as I was looking at this was one exercise that I would have been
interested in, which was not included, involving the augmented Taylor rule that Ben McCallum
has written about--essentially what in the 1970s we would have called a Taylor rule with a
proviso clause. That would have been one additional exercise that I would have been curious
about had it been presented.
I am going to ask a question to characterize my understanding of this and you can tell
me how close or far off I am in the characterization. First, I need to digress into the frameworks
that we are looking at, because for the last three decades at least we’ve had essentially two
competing paradigms. One has to do with the supply and demand for money, somehow
measured, and the other relates to the supply and demand for output or the unemployment rate
and the NAIRU. At times the empirical experiences tended to favor one framework and at times
the other framework--going back and forth, with reasons for uncertainty about both of them.
As I looked at the different charts and listened to the narratives that went with them,
the message I took from the material was this: The greater the confidence one has in any leading
indicator--whether in a NAIRU framework, a money supply/money demand framework or
something else--the more gradualist one can afford to be in terms of smaller incremental changes
in policy actions. The less confidence one has in leading indicators, the more aggressive one has
to be. One might have to see a blip or some new information in order to take policy actions.
You might not like the characterization, but the label I would put on the simulation you called
the realized-inflation rule is the “Bunker Hill” or “whites of the eyes” approach. As soon as we

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see a blip up in inflation, bang, we move and we move aggressively. Is that a fair message to
come out with in regard to one’s confidence or uncertainty about leading indicators?
MR. KOHN. I think that is a fair message, and it is illustrated in Chart 4 to a certain
extent. I’m not sure about the gradualism part, but it certainly relates to the policy success that
you can have. Chart 4 looks at that realized-inflation rule against one that is the same as the
price-stability rule. Now, that price-stability scenario in Chart 3 is derived from the model. It
assumes that households and businesses and the Federal Reserve have at least a pretty good idea
about what is going on. They form their expectations. The Federal Reserve is assumed to have a
very good idea what is going to happen in the future as it changes the funds rate. So in a sense
this is about as well as we can do. The alternative is the case where we are not sure about what
is going to happen in the future. The inflation-rule was used there to illustrate how, if you wait
until you see inflation because you are not sure, it may not be such a bad rule to follow, provided
there are certain kind of shocks occurring in the economy--that is, the favorable supply shocks.
Secondly, as you noted President Jordan, once you see inflation--these are four quarter changes,
so it’s not just one quarter’s worth of inflation--you do need to respond fairly robustly, twice as
robustly as the Taylor rule would have you respond. If you do that in circumstances when you
are uncertain about the supply side of the economy and you’re experiencing favorable supply
shocks, the outcomes are not bad. And they are certainly better than if you act on incorrect
information. So, the basic message you took was approximately correct: That you can run a
successful policy responding ex post under certain circumstances. You have to be careful; that’s
not the case under all circumstances. It’s good to be preemptive where you know some
information. But if your policy response is more reactive, you have to get more aggressive.
CHAIRMAN GREENSPAN. President Broaddus.

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MR. BROADDUS. Don, I suppose this is half comment and half question, and it is
premised on the idea that these simulations are useful. I think they can be useful, especially in
making comparisons between particular simulations. I’m on Chart 3 and I just want to compare
the so-called baseline scenario and the stable-inflation scenario. The baseline scenario basically
incorporates the tightening assumed in the Greenbook forecast through 2000. There is no further
tightening in 2001 and then we begin to tighten further. The result shown in the bottom panel on
the page is that the PCE inflation rate is up to 3 percent, steady state. It wasn’t too long ago that
we were talking about the core CPI and I imagine its relationship has remained the same in terms
of what we used to talk about. So we’re talking about maybe 3-1/2 or 3-3/4 percent inflation on
the core CPI measure. I think that is a result that would not be acceptable to many people--if
any--around this table.
The stable-inflation scenario, though, does produce a better result; whether it would be
acceptable to everybody or not, I don’t know. But there is no difference in 2000 between that
scenario and the baseline. The difference is that in 2001 we continue the tightening. I would
have expected in order to get that much of a difference that we would have had to move more
strongly this year in order to preempt inflation expectations. It raises the question in my mind as
to whether the structure of the model takes adequate account of credibility issues and effects, and
I thought you might want to comment on that.
MR. KOHN. The structure basically assumes credibility. That is, unless the Federal
Reserve changes, the structure assumes that if you have a 2 percent target, the public knows you
have a 2 percent target. And as long as you are following the policy actions that flow from
having that target--so that you are confirming period by period the public’s perception of your
target--then those expectations are firmly anchored. What happens, and this partly follows

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through on my response to President Stern yesterday about sacrifice ratios, is that if the Fed
deviates from the actions the public expects with, say, a 2 percent target, then the public begins
to change its expectations. And that gives you different sacrifice ratios in the short run. It gives
you different effects in the short run. But the public would slowly learn that you had a 3 percent
target instead of a 2 percent target over 2001. I think part of the difference here is that while the
nominal rates aren’t that different, that’s not the case for the real rates. Because the tightening in
2001 gets a bit ahead of the rise in inflation, real rates are considerably higher in 2001, and that
is to a large extent what builds in the extra restraint.
MR. BROADDUS. That’s a good point, especially at the end of the year.
MR. KOHN. Right. So, there’s almost a percentage point of extra restraint by the end
of 2001 and that persists for the next year or so. That is a significant amount of extra restraint.
CHAIRMAN GREENSPAN. Governor Gramlich.
MR. GRAMLICH. As I said yesterday, I liked this exercise. At the same time, I think
we all should be very humble. There is actually an added dimension to the humility and it goes
to this productivity debate. I had always thought that whatever the rate of productivity, if we had
a positive shock--that is, if productivity went up--that would be good news for inflation. That
would make the economy generally less inflationary. Larry Meyer made a point yesterday that I
think is right. You’ve said this in the past, too, Mr. Chairman. If you link the supply and the
demand, that is not necessarily so. We could get a situation, as the illustration Larry gave
yesterday indicated, where a productivity shock would actually be more inflationary or, I
suppose, it could be neutral. So while we are putting our humility on the table here, I think we
also ought to be humble about that! Even if there is some change in productivity, we don’t
necessarily know what that is going to do to our price forecast.

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MR. KOHN. You can see from Chart 6 that a positive productivity shock does not
tend to lower inflation rates in the short run unless you are targeting the inflation rate very hard.
I think one needs to differentiate between very short-run effects and longer-run effects. Let’s say
in the short run that you have the productivity shock, which is consistent with Dave Stockton’s
charts yesterday. Inflation would tend to go down as profit margins are swelled, and competition
would drive prices down. Over time, however, the demand feeds back. That lowers the
unemployment rate, wages begin to catch up with the higher productivity, and we end up with a
higher equilibrium interest rate approximately equal to the size of the productivity shock. It
depends on the model, obviously. There is a short-run effect, but if we let it run on too long, we
will find ourselves in that situation.
MR. GRAMLICH. True. But also if we have forward-looking long-term markets,
such as the stock market, it could be that the demand effect gets telescoped up front into higher
consumption and investment demand.
MR. KOHN. That mechanism is in the model. Now, whether it’s sufficiently
captured in the model is a question. But the effect of the extra earnings on stock prices feeding
back on consumption--though you may think all of it has not been captured in the last couple of
years--is in the model.
CHAIRMAN GREENSPAN. President Parry.
MR. PARRY. Don, I have two comments. One, if you’re uncertain about whether the
growth is the outcome of a supply shift or a demand shift, wouldn’t a nominal income rule
dominate the Taylor rule or the inflation rule in terms of exercises like this?
MR. KOHN. If it were a price shock--a change in the price level of the old oil shock
variety that we used to study--then a nominal income rule is a way of taking part of that in

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inflation and part of it in output. In that regard it’s much the same as a Taylor rule. There might
be a different dynamic path, but I don’t think it would differ very much. But in some ways it’s a
bit like the discussion you folks were having a little while ago. If you had a nominal income rule
and you tilted up the productivity growth and kept the old nominal income, you’d start building
deflation into the economy if the starting point was price stability. So I think the kind of supply
shock that occurs matters a lot.
MR. PARRY. My other comment follows from what the Chairman said earlier. It
seems to me that it is important to keep in mind that there are standard errors in these exercises
and they are significant. I must admit that if I didn’t think that was the case, I would have been
terrified by these outcomes. Instead, I’m only scared!
CHAIRMAN GREENSPAN. Any further questions? If not let me get started. I
believe we are entering a period of considerable turbulence in financial markets. Its
characteristics are what one would expect, though we may never have experienced them, from
being on the upward slope of a general acceleration in technological applications and
accelerating output per hour. This is the old “S” curve scenario, which we have looked at
theoretically but have never observed in the past. The current economy has all the S-curve
characteristics, and I am not looking only at the macro data. We can see it in companies; we can
see it in the multiple applications of a lot of new technologies. Something very different is
happening in the way this economy is functioning. It differs from any economy that I have
observed in the past, and I have been looking at our economy every day professionally since the
summer of 1948. There has been nothing like this in my experience. It is just dramatically
different.

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Leaving aside the measures that we have for productivity, all we have to ask ourselves
is how we can reconcile the behavior of profit margins from domestic business operations in
recent years with the price patterns we have seen. Algebraically, what we get from the income
side is the same acceleration in profit margins as in productivity. I see no evidence at the
moment that the acceleration in productivity has stopped. The second derivative for the latest
data is still positive. And I am not aware of any evidence that the expansion is slowing down.
The general notion of a significant deceleration in the first quarter is an interesting
forecast, but we are one-third into the quarter at this point and I don't know what evidence
supports a slower growth forecast. Certainly, initial claims are down significantly. Orders are
quite strong. Retail markets are quite strong. And, indeed, if we were getting some slowing in
GDP growth measured either from the income side or the product side, one would presume that
it would be evidence of slowing growth in productivity. Alternatively, until the evidence
changes I think the most reasonable view is that productivity probably is still accelerating.
Indeed, if we examine the earnings estimates of security analysts, including those who look at
the earnings outlook company-by-company, the overall estimates through January are still rising
in the sense that forecasts of long-term earnings per share are still going up rapidly. This
evidence suggests that productivity-enhancing investments are still moving up.
Since what we are observing is very unusual, as I indicated at the last meeting, we
tend to get statistical acrophobia. We are not accustomed to seeing motor vehicle sales at these
levels, housing starts so high at these interest rates, or business activity so robust in virtually
every part of the economy while inflation has not moved an iota. Indeed, total unit costs in the
four quarters just ending are about as low as we have seen them in this cycle. Unit labor costs
have barely moved.

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The rise in inflation in the fourth quarter shows up wholly in profit margins. Actual unit
costs, granted the rough nature of the data, apparently declined in the fourth quarter. This is not
an inflationary price environment or an inflationary cost environment. If we look at inflation
expectations, the best measure that we have in my view is one derived by subtracting the yield on
an inflation-protected 10-year Treasury security from a so-called synthetic 10-year nominal rate
to get the best estimate of expected 10-year CPI inflation. That number is barely different today
than it was in December 1997. The implicit inflation expectation in that calculation declined
with the Asian crisis. It had recovered by the spring of last year and has been absolutely flat
since then. To be sure, the actual nominal 10-year rate has gone up compared with the real 10year rate. But that is merely a reflection of the fact that the adjustment for “on-the-run” and “offthe-run” rates, appropriately made, has raised the nominal rate by about 1/2 percentage point
since November of last year. In other words, the dramatic change between the so-called
synthetic rate and the nominal rate gives a false view of accelerated inflation expectations unless
it is properly adjusted, as is done by the staff, for the degree of illiquidity in an inflation-indexed
Treasury security vis-à-vis an appropriate nominal Treasury obligation.
It seems to me that what we have here is an acceleration of a process that would not
create a problem were it not for the wealth effect. The problem, as we have discussed in the past,
is that while potential supply increases pari passu with the rise in trend productivity, which I
believe is still accelerating, it has a more pronounced effect on demand. Obviously, rising
productivity creates higher real incomes from which expenditures can be made. But, leaving
aside the issue of whether or not the stock market is appropriately priced, rising productivity also
creates a rational upward adjustment in long-term earnings expectations which, all else equal,
will result in an increase in the value of stock market assets. Unless there is no wealth effect,

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and there are some who argue that case though, frankly, I think the evidence is overwhelming in
the other direction, there will be an increase in purchasing power over and above the increase in
supply. That has been the case in recent years. The resulting excess demand basically has been
met by an increase in our net trade deficit and by drawing on new sources of labor. The latter
have been found by draining the pool of the currently unemployed, through increases in the
participation rate, and through immigration. Both increasing net imports and drawing in new
workers obviously are safety valves that can for a time fill the gap created by excess demand; but
they cannot be drawn upon indefinitely for reasons we have discussed previously.
The high rates of return that are driving our technological boom are also attracting
dollars from abroad--or I should say increasing claims against the United States--and that has
held the dollar essentially unchanged. That process can go on for a while, but the question is
how long. Obviously, as I have noted before, the minimum unemployment rate is zero. I do not
care whether we bring the notion of a NAIRU into the analysis. The point is that there is an
ultimate limit to unemployment, and it is called zero. So, we are sitting here with an imbalance
that essentially says the wealth effect by its nature cannot persist indefinitely. To argue that it
can implies that the gap between excess demand over supply can always be filled without
creating major inflationary pressures. The point I am making does not rest on any econometric
model but merely on the proposition that there is a wealth effect on consumption and that
accelerating productivity will continue to increase expected earnings.
The question basically is: What closes the gap? What closes the gap is obviously the
real long-term interest rate, and it has been going up quite significantly. It is putting pressure on
financial markets. At the end of the day it is going to swamp the rate of discount in the stock

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market, which now is virtually zero as best I can judge. That is a slight exaggeration, but only
slight.
The problem that we have here is that monetary policy works through its effects on
overall financial markets. The presumption that a 25 basis point, a 50 basis point, or even a 75
basis point change in an overnight rate can come to grips with the supply-demand imbalance is in
my view silliness in the extreme. The overnight rate is just not tied into this process in any
direct way. What we actually do is to foster a term structure of interest rates by our policy
actions and thereby influence real long-term rates. What I am saying is algebraically equivalent
to what Larry Meyer was saying yesterday about the Wicksellian real rate and the gap. The
difference, I think, is not simply how we may view the gap between the expected equilibrium
real rate and the market rate, but how we look at this process from a disaggregated perspective.
In order to disaggregate, what we are really looking at in the real world, and not in a Wicksellian
world, is this crucial issue of the wealth effect. The policy question that confronts us in my view
is how we should influence the real long-term rate, which is the primary force involved in this
process. It is doing most of the work that we would like to think we have the power to do, but
we really don't have that kind of power except to the extent we can influence how the markets
perform.
It strikes me that what we have at this stage is a very unusual situation, which if anything
is going to become still more difficult for us. In that regard I think the answer that Don Kohn
gave is the correct one--namely, that inflation will stay down in the short run because of the
acceleration in productivity. But ultimately, if we do not solve the problem of the gap, meaning
that if the acceleration in productivity leads to continued expectations of accelerating earnings
per share, the only way to eliminate the wealth effect, which has to be eliminated, is for the

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discount rate--the market interest rate used by investors to calculate the present value of expected
earnings--to rise. I think that is in the process of occurring. And if that is the case, the
interesting issue, which really gets to the question of the longer-term effect of inflation in this
model, is why the bond market is showing no real evidence of accelerating inflation
expectations. In short, what the markets basically are saying, right or wrong, is that long-term
rates are going to rise eventually to close the gap. They may also be arguing that the current
rates are the right rates. I personally do not believe that, but that is what one has to assume is the
prevailing opinion in these markets.
The question that confronts us here is what we should do in the context of this
phenomenon. If the rate used by investors to discount future earnings has to rise as a necessary
condition for stability, the question is how we can facilitate that rise. To put the monetary policy
issue in a somewhat reversed order, as Don Kohn did, I think the crucial point here is that we
express and continue to express a general view that our goal is basically to move the funds rate
up consistently. At this point I don’t know whether we eventually will need an increase of 50
basis points, 75 basis points, 100 basis points, or 125 basis points. My guess is that the increase
is likely to be toward the upper end of that range.
In my view, the key consideration at this stage is to make certain that we do not adopt
what we used to call “symmetry.” That would be the wrong thing to do no matter what else we
do. Indeed, while I am going to argue against a 50 basis point increase, I would say that if we
were to decide on 50 basis points, we would have to do it with asymmetry. In my opinion, 50
basis points with symmetry would be a terrible mistake at this stage. It would imply that our job
is over. What we have to convey to the markets, consistent with what is clearly an acceleration

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in productivity and I think increasing turbulence in financial markets, is that we are on the scene
and that we are embarking on a routine of incremental tightening.
What is the argument against 50 basis points today? I would say the argument is
basically twofold. One is that, as a general rule in an environment like this, the last tightening
move that we make is going to be a mistake. We will not know that at that time, but it is almost
invariably a mistake. If we tighten in small incremental doses, the size of a mistake is smaller by
definition. Secondly and far more importantly, I think that our latest evaluation of the equity
premium in the stock market is that it is downright scary! I haven’t seen anything like this
before. In fact, if we use the inflated earnings expectations of the security analysts and the P/E
ratios that we have now, we get an extremely impressive equity premium. Back in 1987, you
will recall, long-term rates were going up as the stock market went up, and the market just ran
out of steam. We are in a far worse situation now than we were then.
I am concerned that, if we are too aggressive in this process of tightening, we could crack
the market and end up with a very severe problem of instability. I don't know how far we will
have to go. Indeed, I don't know how long we can continue tightening by 25 basis points. As a
sort of working hypothesis, I would argue that we should think in terms of moving at every
meeting and that we move by 25 basis point increments. We would continue on that course
unless and until it appears that we are getting behind the curve on inflation or inflation
expectations, in which case we would raise the size of the adjustment. On the other hand, we
could continue to implement our strategy if we began to see the wealth effect stabilizing and/or
the gap between supply and demand beginning to close. Unless and until that happens, we will
remain in a very unusual period that we have never experienced before. What I am arguing is
not something that is coming out of a particular simulation. All that is needed for my argument

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to be valid, as best I can judge, is that there is a wealth effect, that the market is at extremely high
valuation levels, and that we have to take action to close the supply-demand gap. I would
propose, therefore, that we move the funds rate up by 25 basis points today and that we include
in our press release the equivalent of what we used to call asymmetry. There would be a full
expectation that we will be moving again in March. If it turns out that the economic expansion is
accelerating, and indeed I have every reason to suspect that it may, that would not in itself be a
policy issue in my view. That is not what we ought to be looking at. We should be looking at the
underlying inflation pressures in the economy. And if they become larger, then I think we will
have to move faster. But for today I think it is appropriate to move 25 basis points and issue an
asymmetric statement--I don't remember the exact language we plan to use to express that.
VICE CHAIRMAN MCDONOUGH. “Balance of risks.”
CHAIRMAN GREENSPAN. The balance of risks is toward inflation. Vice Chair.
VICE CHAIRMAN MCDONOUGH. Mr. Chairman, I fully support your
recommendation, but let me make a few comments. The issue clearly is not whether we should
do nothing, but whether we should firm 25 basis points or 50 basis points. And I agree that in
either case we would have to use the balance of risks language indicating that we are more
concerned about inflation. I think we have to look at ourselves. The reality is that we are
perceived everywhere around the world as the best central bank in the business. We are highly
regarded, highly respected. And our commitment to price stability, certainly as defined by you
in speeches and testimony, is I think unquestioned anywhere. Our style is that of a strong, silent
leader, one who moves incrementally. We move 25 basis points at a time in a very systematic
way. If we were to move 50 basis points--to continue my analogy, if all of a sudden the strong,
silent leader starts beating his chest to show what a tough guy he is--what would be your

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conclusion? I believe it would be that he is scared! What do we have to be frightened about?
We can certainly go about our business in our normal way, continuing to exhibit the confidence
that we have earned by our performance. And I think that is the thing that will contribute the
most to stabilizing the economy. I agree with you fully that a working hypothesis that we will
have to have a series of tightening moves is appropriate, and I believe that that should be in the
background of our thinking. But I feel very strongly that 25 basis points combined with a
balance of risks statement toward inflation concerns is by far the right package for today. Thank
you.
CHAIRMAN GREENSPAN. President Poole.
MR. POOLE. Mr. Chairman, I certainly also support your recommendation. We are
faced with very powerful, real forces that we want to allow to run to the extent that they can in
terms of increasing productivity, employment, and real income without upsetting the inflationary
apple cart. I would like to relate your comments this morning to our discussion yesterday about
the trade deficit. The trade deficit is also part of this real adjustment that is going on in the
economy and it is not fundamentally a nominal phenomenon. The trade deficit is financing the
capital flows that are coming to this country because the rate of return is so high. And it cannot
itself be an object of our policy because it is determined by these real forces that are so unusual,
certainly in the context of postwar U.S. history and perhaps much further back than that.
I think a move of 25 basis points and a statement that the balance of risks is toward
inflation is exactly the right way to go. The market is our friend. The market, after all, has
anticipated this move. We saw interest rates rise. This federal funds futures prediction has been
in the market for four weeks or more, and we should not do anything that leaves the market
wondering what we are up to. If we were to go with 50 basis points and a balanced risk

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statement, the markets would most likely say that we have concluded that we are done. And that
is certainly not our conclusion. So we want to make the market do as much of this work as
possible, lead the way, and help us figure out what is the correct response to the incoming flow
of information. I absolutely agree that this is likely to mean a sequence of 25 basis point
increases at each meeting. It wouldn’t be correct to say in Dave Stockton's famous language “as
far as the eye can see” but, nevertheless, for quite some time. And by working cooperatively
with the market I think we will have the best chance of coming out of this without a big upset.
So, I support your recommendation 100 percent.
CHAIRMAN GREENSPAN. President Parry.
MR. PARRY. Mr. Chairman, I would prefer a 50 basis point increase in the funds rate
and also a public statement that we are focusing on heightened inflation risk in the future. My
concern is that the time period between this meeting and the next meeting on March 21st is quite
long. I might suggest something that would make me more comfortable with a 25 basis point
increase and that is that we agree to assess the situation again at the end of this month. We will
have considerably more data, certainly more data about prices. We could review those data and
see if we feel at that time that a further move is appropriate. I don't see why we have to be
constrained by a fixed calendar, which in this case involves quite a long interval between
meetings. Over the 14 years I have been with the Fed, we have found telephone meetings at
times like this to be very useful. From my perspective, though it’s certainly not one shared by
everyone here, it would reduce the possibility that we will get behind the curve.
CHAIRMAN GREENSPAN. The option of a telephone conference is always on the
table. It always has been. It’s just that we have not needed to employ it for a while. But it is
obviously there.

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MR. PARRY. Well, I think there might be a case for it this time.
CHAIRMAN GREENSPAN. The markets will tell us. President Stern.
MR. STERN. Thank you, Mr. Chairman. I support your recommendation in its
entirety. It seems to me, given the kind of technology or productivity shock that we have had,
that real interest rates need to rise. To some extent, that has occurred. My judgment is that they
need to go up more. I do not see any way we can accomplish that other than by raising the funds
rate. So, a ¼ point increase is certainly acceptable to me. I would not go beyond that and be
more aggressive, principally for considerations of uncertainty. It seems to me that we are
uncertain about the future path of productivity and we are uncertain about NAIRU. I personally
am uncertain whether the latter is a useful concept at all. And we are uncertain about the
implications of the increase in real rates that has already occurred and what the effects may turn
out to be. So, I think what you are suggesting is what we ought to do.
CHAIRMAN GREENSPAN. President Hoenig.
MR. HOENIG. Mr. Chairman, I support your proposal completely. I believe the
increased risk of inflation is there, so I think we ought to say it. Also, I am very much in favor of
25 basis points for several reasons. First, while the models show direction, I agree that they
don’t show it with precision, so I think we should proceed gradually. Secondly, we are in an
environment where core inflation has been very modest, and we need to recognize that as we
begin to pave the way for higher rates. And thirdly, some imbalances remain out there, which
we are trying to take into account, but we don’t want to shock the system either. So I think
continuing the steady path that we have been on is the appropriate approach. Therefore, I
support your recommendation.
CHAIRMAN GREENSPAN. Governor Meyer.

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MR. MEYER. Thank you, Mr. Chairman. I support your recommendation for a 25
basis point increase in the funds rate and what I will continue to call an asymmetric posture. I
also agree with you that we are likely to have to implement a series of tightenings this year; it is
likely to be appropriate to make a move at each meeting for a period of time. Given the
uncertainties about trend growth, NAIRU, and inflation dynamics, and also given the uncertainty
about the impact of our policies on financial conditions more broadly, I think there is a strong
case for a gradualist approach. I hope we will be able to use the bias in the announcement that
accompanies today’s action skillfully. By that I mean that I hope we don't undermine what I
view as very sensible expectations about the rise in the funds rate that are built into the term
structure and futures markets.
We had a lot of discussion today about uncertainty, about the structure of the economy
and inflation dynamics, and about the value of humility. I don’t want to lead a discussion
opposed to humility. [Laughter] However, I think sometimes we draw an implication here that
humility suggests inaction, though that is certainly not what you have been arguing, Mr.
Chairman. But I want to bring us back to the discussion of our monetary growth targets because
it seems to me that in a monetary growth target regime the danger of inaction is much less than
in a funds rate regime. And that, I think, is consistent with some of the points that President
Jordan was making. If productivity growth is a little higher, we will end up with a little lower
inflation; it will be somewhat limited and won't be as much of a problem. But in an interest rate
regime inaction can be very, very dangerous--and particularly dangerous in an expansion that is
driven by higher productivity, which raises real equilibrium interest rates.
I also want to comment a bit on your discussion of the role of the wealth effect. It
clearly has been very important. We go from the productivity upturn, to the wealth effect on

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consumption, to the excess of demand growth relative to supply growth. And we’ve had a lot of
discussion, not only here but in a number of other arenas, about how a declining equity premium
or higher equilibrium growth rate can raise the value of equity prices. A lot of that is a partial
equilibrium analysis. You just plug into the formula a low equity premium and voilà--higher
equity prices. That makes very little sense in a general equilibrium model, because in such a
model that wealth effect will ultimately generate increases in real interest rates that will
significantly cap and diminish the increase in equity premiums.
I think the danger that we have been facing recently is that a monetary policy that has
been somewhat slow to tighten and has allowed the economy to operate in this partial
equilibrium world. I think we are now going to see how equity prices evolve in a general
equilibrium world, and I think that is one reason why we have to be a bit cautious and gradualist.
I want to make just a few comments on what I perceive to be the consensus strategy
that is unfolding. It seems to me that what we have been talking about is being very preemptive
now in slowing the economy to trend growth, but being very reactive once we get to trend
growth and we have stabilized the unemployment rate. Then at that point we are prepared to be
very reactive and respond only to evidence of higher inflation. I have been struggling with the
issue of whether this is an appropriate strategy, or perhaps even an optimal strategy, given our
uncertainty about the output gap. If it is a sensible strategy, I think there are some gaps or details
we have to fill in. Obviously, we have to decide what the appropriate path of the funds rate is to
slow the economy to trend. But we also have to keep in mind that if we are unsuccessful in
slowing the economy to trend and, therefore, the output gap rises even further, that should affect
our policy and we should tighten by more than we otherwise would. That is, we should tighten
enough to slow the economy to below trend so that we can push the output gap back down. I

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think that is consistent with the nonlinear rule that I have discussed in the past. As uncertain as
we are about the output gap, that uncertainty about whether or not we are beyond the economy’s
potential diminishes very greatly as the output gap increases based on our best estimate of
potential.
And the third issue I think we are going to have to focus on in this strategy is just how
aggressively we should move against higher inflation. To the extent that we have down
weighted our response to increases in the output gap, when inflation rises we have to be more
aggressive than we would otherwise be. The way to think about that is that once we get to trend
growth and the unemployment rate stabilizes, we have assumed that our policy setting and
strategy are consistent with stable inflation and the output gap is basically zero. If inflation then
begins to rise, not only do we have to respond to the increase in inflation the way we ordinarily
would, we also have to revise our estimate of the output gap. That requires a more aggressive
response to inflation than would otherwise be the case.
So, those are a few thoughts that at least shape my views of the strategy going
forward.
CHAIRMAN GREENSPAN. Governor Ferguson.
MR. FERGUSON. Thank you, Mr. Chairman. I agree with both halves of your
recommendation. I think we should reinforce markets when they are right and I think they are
right in their expectations. Secondly I, like others, am moved by the uncertainties that we have
talked about, but I also recognize that inflation does not appear at this stage to be on the verge of
a virulent outbreak. So a move of 25 basis points seems to me moderate and appropriate. I think
you're absolutely right in suggesting that over time we can and will continue to look at the
reaction of markets generally, including the asset markets where I do think, as I said yesterday,

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there is likely to be some underlying turbulence. Finally, on the outlook sentence I believe the
statement that suggests the risks are balanced toward inflation is obviously the right one to use
because it does not take back all the other things that we're doing.
CHAIRMAN GREENSPAN. President Boehne.
MR. BOEHNE. I agree with your recommendation of ¼ point and I think we need to
convey the view that we have more tightening ahead of us. My best guess is that there will be a
significant amount of tightening over the coming year. There may well be a time in this series of
tightening moves where a move of ½ point is going to be appropriate. But today I think ¼ is just
right. Our basic product is one of confidence--confidence that we're going to do what is
appropriate to keep the economy on the right path. And in today's environment a 25 basis point
increase in the funds rate captures that because it indicates that, yes, we know that tightening is
appropriate. We're going to do what needs to be done. We are neither going to underreact or
overreact. I think that is important for our image as a strong, confident central bank that the
public deserves to put its confidence in.
CHAIRMAN GREENSPAN. President Broaddus.
MR. BROADDUS. Mr. Chairman, I am pretty much where Bob Parry is. This is a
tough call but, if I had my druthers, my preference would be to go the full ½ point. It would be a
very decisive move that would preempt any inflation expectations that might either be building
or likely to build in the near-term future. I recognize it would be a strong move, particularly in
the context of the need for asymmetry whatever we do; I agree fully with your point on that
score. So, I recognize that there are risks. To me the big risk is that we might get a market break
that could lead to what I would refer to as a disorderly plunge in the stock market. That would
complicate the situation and make it more difficult for us to take the kind of steps we will need to

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take. So I am able to accept the ¼ point increase this morning. But I would hope that we will do
it with what I might call “asymmetry plus.” We need that language. Also, I would hope--and I
expect you’d be inclined to do this in your testimony, which is not too far down the road--that we
will underscore the intensity with which we are watching developments and our readiness to
move more aggressively if in fact we need to do so. Also, and I hope this is not out of line, I
would hope that the Board of Governors might consider a complementary discount rate increase
in the near future. Furthermore, I agree with Bob Parry. I know that an intermeeting conference
call is always on the table but, in the context of your remarks, I hope we will watch market
developments very carefully for any signal that we should have a call.
CHAIRMAN GREENSPAN. Governor Gramlich.
MR. GRAMLICH. First, on the data point: I talked yesterday about the difference in
ten-year bonds between the nominal and the real spread. I am no match for you in developing
the synthetic yield!
CHAIRMAN GREENSPAN. I didn't do it! It was your colleagues down at the other
end of the table.
MR. GRAMLICH. I was using the chart, Exhibit 18, that the staff sends around every
Monday. And on that rendering, certainly in the last month there has been a rise in the inflation
premium. But Don Kohn did persuade me that I way overstated it yesterday. Nevertheless, it
has gone up.
The second thing I would like to say is that I tend to agree with the Bluebook
simulations on inflation targeting, humble as we are about models. And I believe that we are
likely to need a lot of tightening, and that the real question we have to deal with today is how we
get there from here.

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I will support the recommendation of a 25 basis point move with a tilt and the implicit
gradualism. I recognize the benefits of that strategy. I'm delighted to be thought of as a strong
and silent leader! [Laughter] I think you make a good point, Mr. Chairman, that the economy is
in many ways very fragile, that things could change rather abruptly, that the past record has not
been good in calling the turns, and that, therefore, there is a chance that we could overreact. In
that regard, as I thought about the tilt in connection with Roger Ferguson’s Working Group,
there is one thing I like about the tilt. It is easily reversible. If we were to raise the rate 50 basis
points, discovered we did too much and then reduced it 25 basis points, it would look as though
we didn’t know what we were doing. If we do 25 basis points with a tilt and new data come in
indicating the economy is not as strong as we thought, we can take off the tilt. Then it looks as if
we do know what we're doing and we're just looking at the data. That’s a nice advantage of the
tilt and I’m glad we are using it in this situation. So, there are a number of benefits in the
gradualism strategy. I recognize that and I support your recommendation.
Having said that, there are some costs to the gradualism strategy. We could be
moving too little and too late. There is historical precedent for that, too, and I think we ought to
keep that in mind.
CHAIRMAN GREENSPAN. President Jordan.
MR. JORDAN. Thank you. When I look out at what the financial markets are
tellingly me--or maybe more importantly not tellingly me--I see the Treasury yield curve upward
sloping a bit from two years out to five years. Beyond five years it’s downward sloping, with
corporate bond yields and mortgage rates at 8 percent. I would be hard pressed to say that those
are at the wrong levels for an environment as outlined in the Greenbook and the associated
expectations. I would feel on much firmer ground in saying that there is something wrong with

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these market levels if, given the second-half experience of 5-3/4 percent real growth and,
depending on the inflation measure, nominal spending of 7-1/2 to 8 percent, I thought it didn’t
add up. But this says to me that the market is not building in that kind of real growth plus
inflation inherited from the second half of last year through this year. So, I don’t know that
nominal interest rates need to go up. If inflation were to turn adversely and accelerate more than
seems to be built into the marketplace right now and inflation expectations were beginning to
rise, I do think it would be undesirable for real rates to go down. Then I would think that
nominal rates would need to increase.
On the front end of the curve, though, when I look at the rise in rates for securities
maturing in up to two years, it does leave me with the feeling that a 5-1/2 percent overnight
interbank rate is too low to be consistent. Just closing that gap somewhat would be the wisest
thing to do. And taking a step today, I think, is appropriate.
I have a comment, though, on this question of 50 basis points versus 25 basis points,
and that requires me to make reference to the discount rate. There was a time, and I think it is
still the case, that a movement in the funds rate with an accompanying increase in the discount
rate was interpreted as being a more lasting move as opposed to a move in the funds rate alone.
Given that, I would think a 50 basis point increase in the funds rate with a discount rate change is
too strong. And since I do consider directors’ recommendations for a discount rate increase
appropriate in this environment, I would prefer ¼ point on the funds rate knowing it is to be
accompanied by a discount rate move. In fact, I would oppose a 50 basis point change in the
funds rate either with a discount rate increase or without it.
CHAIRMAN GREENSPAN. The Board of Governors will be meeting later to vote
on the discount rate. President Guynn.

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MR. GUYNN. Thank you, Mr. Chairman. I came into the meeting with the intention
and inclination to argue for a 50 basis point tightening, and I think the staff presentations we
heard yesterday and the comments made around the table would certainly support that. I believe
there is evidence of mounting inflationary pressures. The probability of inflation moving up has
clearly increased in my view. My biggest worry was that if the consensus was to go with a 50
basis point tightening, there would be an inclination to slide back to a balanced risk statement.
And as you eloquently pointed out, that is not where we want to be.
I can support ¼ point tightening today with the balance of risks on the side of
inflationary pressures. I guess you already answered this question, but let me just say that I, too,
would really like to see the Board consider a discount rate increase. I think that gives our
directors some ownership in this policy action and reinforces the action we are taking. And in
my view there is a reasonably high probability that we will have to step up the pace in terms of
further policy actions in the meetings to come. But I support your recommendation.
CHAIRMAN GREENSPAN. President Moskow.
MR. MOSKOW. Thank you, Mr. Chairman. There was a table in today’s Wall Street
Journal. I don’t know how many people saw it, but it listed a series of possible Fed actions
today, gave the odds on them and the likely market reaction. It had all the different scenarios
we’ve talk about--an increase in the funds rate of 25 or 50 basis points, with a tilt or without, and
so on. And the last line in the table was a rate cut by the Fed. The odds were “as likely as the
Cubs winning the World Series.” [Laughter] And the likely market reaction was “holy cow!”
[Laughter] I found that very upsetting. Obviously, there is no chance we are going to lower
rates today, but Cubs fans are always optimistic!

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Mr. Chairman, I support your recommendation very strongly. I think the strategy of
incremental moves is an excellent one, supporting the markets when they are right and helping
confirm their inclinations. It seems clear that if we do not move today, that would not only
jeopardize the expansion but would also jeopardize our credibility as well, which is so important.
I should note that our outlook assumes a fed funds path that has a decidedly upward
drift over the forecast horizon. And even with that strong upward tilt, we project a deterioration
in the inflation outlook. Regardless of whether we look at the core PCE or the core CPI or all
those measures that I mentioned yesterday, inflation is still going up. So in my judgment, an
increase of 25 basis points is not going to be enough over the forecast horizon. I believe, as you
said, that we should be thinking of a series of moves to make sure that we correct the imbalance
between aggregate demand and aggregate supply. I think it’s also very important that we say
that the balance of risks is tilted to higher inflation for exactly the reasons that you explained so
articulately.
CHAIRMAN GREENSPAN. President Minehan.
MS. MINEHAN. Thank you, Mr. Chairman. One thing I came into this meeting very
determined about was that we should end with an asymmetric directive, whether we went with a
25 or a 50 basis point increase in the funds rate. So I’m glad it appears that we are going to do
that. I imagine that most people, if they gave any thought at all to what I might recommend at
this meeting, would have thought I would clearly be on the side of a 50 basis point move. But I
must admit that I’m having more frequent debates with myself, not so much on the demand side
of the equation--I don’t think anybody doubts the strength of demand--but about all the elements
of supply that are so richly portrayed in Don Kohn’s different graphs. I’m becoming much more
a believer in the view that the potential for productivity to stay flat at its current high level or to

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grow in the future is better than I thought it was. And I don’t know where the NAIRU is. As
with any forecast, all the forecasts we’ve been doing in Boston require a great deal of jiggering
after they are done to try to capture a bit of the uncertainty that I know I feel and other people
apparently feel on the supply side. I also think that the interaction with the markets presents us
with a series of risks that you talked about. I tried to incorporate some of that into my discussion
yesterday, with respect to the buildup of imbalances in terms of credit, all related to rising asset
values. So, with those two things in mind, both a sense of risk and a sense of uncertainty about
the economy’s actual capacity, I’m very comfortable with a move of 25 basis points.
CHAIRMAN GREENSPAN. Governor Kelley.
MR. KELLEY. Mr. Chairman, I support your recommendation for all the reasons that
have been expressed. I think it’s exactly the right thing to do. But I do want to say that I feel a
good deal of identification with the remarks of President Broaddus and others around the table.
CHAIRMAN GREENSPAN. President McTeer.
MR. MCTEER. I support both parts of your recommendation. As far as the future is
concerned, I hope we will keep looking at the data and make our decisions one step at a time and
not get too programmed in advance as to what we are going to do.
CHAIRMAN GREENSPAN. I guess we have heard from everybody.
MR. BERNARD. Yes.
CHAIRMAN GREENSPAN. It looks as though we have strong support for an
increase of 25 basis points and a balance of risks statement toward concerns about inflation.
MR. BERNARD. I’ll be reading from page 29 for both the balance of risks sentence
and the sentence on the federal funds rate. Only one vote is involved, encompassing both: “To
further the Committee’s long-run objectives of price stability and sustainable economic growth,

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the Committee in the immediate future seeks conditions in reserve markets consistent with
increasing the federal funds rate to an average of around 5-3/4 percent.”
And moving on to the balance of risks sentence: “Against the background of its longrun goals of price stability and sustainable economic growth and of the information currently
available, the Committee believes that the risks are weighted mainly toward conditions that may
generate heightened inflation pressures in the foreseeable future.”
CHAIRMAN GREENSPAN. Call the roll.
MR. BERNARD.
Chairman Greenspan
Vice Chairman McDonough
President Broaddus
Governor Ferguson
Governor Gramlich
President Guynn
President Jordan
Governor Kelley
Governor Meyer
President Parry

Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes

CHAIRMAN GREENSPAN. I’d like to adjourn the FOMC meeting for a few
minutes temporarily and ask the Board members to join me in my office. Subsequent to that, we
have to review the statement that we will be putting out. So, just give us a few minutes. I’m
sorry, let’s also do coffee!
[Coffee break]
CHAIRMAN GREENSPAN. The Board has voted to approve a ¼ point increase in
the discount rate to a level of 5 percent. The floor is open for comments or suggestions on the
draft press release circulated to you.
VICE CHAIRMAN MCDONOUGH. Perfect!

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SEVERAL. Perfect!
MR. BOEHNE. Absolutely perfect, Mr. Chairman.
CHAIRMAN GREENSPAN. Including the run-on sentence? [Laughter]
MR. FERGUSON. It couldn’t run on any better!
CHAIRMAN GREENSPAN. If there are no comments, then this press statement will
be released on schedule. Our next meeting is March 21, as President Parry mentioned earlier.
It’s 8 minutes and 10 seconds to noon. What’s the status of lunch?
MR. BERNARD. It should be ready within the next 10 minutes.
MR. BOEHNE. Mr. Chairman, in addition to this remarkable economy, this is a
remarkable meeting. This Committee has resisted the opportunity to talk endlessly about a press
statement. I think we ought to note that!
CHAIRMAN GREENSPAN. Why don’t we adjourn.
MS. MINEHAN. I would just like to mention for the minutes of this meeting the
passing of Frank Morris, the former President of the Federal Reserve Bank of Boston and a
participant in these Committee meetings for 20 years. He died a week or so ago. He was, to my
knowledge, an active contributor to the work of this Committee and of the Federal Reserve
System in general. And we will miss him.
CHAIRMAN GREENSPAN. Is it appropriate to put that in the minutes?
MR. KOHN. Yes.
CHAIRMAN GREENSPAN. Frank was a good friend to a large number of us around
this table.

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MS. MINEHAN. Ed Boehne mentioned last night that he was a good friend to
everybody who is in the Federal Reserve System, both retired and current employees, in terms of
his involvement with the Thrift Plan and his chairmanship of the Investment Committee.
END OF MEETING