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APPENDIX NOTES FOR FOMC MEETING February 13, 1985 Sam Y. Cross Once again the dollar opened the new year on a very strong note. In two waves--one around the turn of the year, the other in February--the dollar moved sharply higher. It has reached new peaks for the floating rate period against the German mark and records against sterling and most continental currencies. Since your last meeting, the dollar rose 10 percent against the Swiss franc, 9 percent against sterling, and about 6-7 percent against most continental currencies and the Japanese yen. An improving outlook for the real economy in the United States, together with continuing good news on the price front, has certainly benefited the dollar. In addition, market professionals have consistently been impressed by the strength of commercial- and investment-related demand for dollars coming from their customers. Concern about the economic implications of continuing large exchange-rate movements, as well as questions about the effect of declining oil price on sterling, led market participants to expect a policy response to the most recent market developments. In several countries, the authorities responded with monetary policy actions. The Bank of England took the initiative to help sterling, pushing up interest rates by reinstituting its minumum lending rate for one day. But sterling continued to weaken, and money market dealing rates rose further. In just over 2 weeks, short-term British interest rates increased 4-1/2 percentage points. In Germany, the Bundesbank raised its Lombard rate by 1/2 percentage point partly to stem continuing capital outflows and partly for technical reasons. This was followed by increases by the Netherlands Bank of its own lending rates. Central banks in Italy, France and Belgium, however, took advantage of the tendency for their currencies to strengthen against the German mark to lower their interest rates somewhat. Despite these actions market participants were of the view that the scope for major monetary policy tightening abroad was limited. European countries have still made only limited progress in reducing unemployment. as a policy tool. As a result, attention focused on intervention Around mid-January, the G-5 Finance Ministers' meeting was seen as providing an opportunity for the major countries to adopt a more active and coordinated intervention policy. In fact, the G-5 Ministers reaffirmed the 1983 Williamsburg Summit Accord on exchange market intervention. Coordinated and visible intervention operations were then conducted. The increase in intervention, together with more public discussion of intervention, for a time generated a sense of two-way risk. Since the G-5 meeting, the G-10 central banks increased their dollar intervention to sell $2-1/4 billion net, up from only about $1/2 billion during the previous four weeks. The figure for the post G-5 meeting period includes total sales of $320.4 million against marks and yen by U.S. authorities. Between your last FOMC meeting and mid-January, the United States had not intervened. After the G-5 meeting, the United States intervened on four occasions to resist renewed rises in dollar rates. In these operations $271.6 million was sold against marks and $48.8 million against yen, shared equally between the Treasury and the Federal Reserve. As for the others, the Germans sold over $700 million, the British and Japanese each sold over $200 million and all others except the Swiss sold some dollars. The French and Italians, while intervening in dollars, also operated more extensively by buying EMS currencies, yen, and ECUs. The current attitude of the other G-10 countries towards our intervention seems to range from frustration to irritation. They acknowledge U.S. concerns about our not being seen as bashing our own currency. They also recognize that the Fed is not a free agent in this matter. Also there is a view that during recent weeks the underlying situation with respect to the strength of the U.S. economy and the prospect for interest rates during this period made a rise in the dollar exchange rate perhaps inevitable. Certainly, they would like to see us intervene much more heavily, and some feel that the intervention operations we have undertaken have not been carried out in a way to get maximum attention and effect. Very broadly there is concern that the element of uncertainty introduced by the January G-5 agreement may be fizzling out unless there are some new initiatives. Other Operations Following a Philippine drawing on its standby arrangement with the IMF, the Philippines fully repaid its $45 million swap drawing with the U.S. Treasury, along with $30 million to the Bank of Japan, and $5 million to the Bank of South Korea. Also during the period since your last meeting, Argentina drew its $500 million bridge financing swap facility with the U.S. Treasury. Shortly after, in January, it repaid the drawing in two installments, using proceeds of the IMF credits under the Compensatory financing facility and a new standby arrangement. NOTES FOR FOMC MEETING February 12-13, 1985 Peter D. Sternlight Following the December meeting of the Committee, sought a further easing of reserve continuing the accommodative pressures the Desk on the banking system, trend of the previous few months. Reserve paths were drawn allowing for adjustment and seasonal borrowing of $300 million (compared with $400 million just previously), and in day-to-day execution of policy uncertainties were resolved on the accommodative side, initial Given preference for a borrowing that approach, recognizing the Committee's level of "up to $300 million". further underscored discount rate announced December 21, by the 1/2 percent cut in the reserve climate had an easy cast during the first several weeks of the period. traded mostly around 8 1/4 percent, 8 percent or even below, giving rise easing steps might be in store. in 8 3/4 percent average the Federal funds and occasionally to some sentiment that further to A bulge in the year-end slipped close the funds rate to an view as week did not dent this the rise was widely regarded as a seasonal aberration. By about mid-January, stronger monetary growth against a background of appreciably than envisaged at the Committee meeting, and economic activity evidence that the summer and early autumn lull in had given way to a renewal of sturdier the Desk's approach was to de-emphasize modified slightly the paths were still drawn growth, the extra tilt toward ease. to allow for $300 million of borrowing, execution was no longer biased to the accommodative funds continued to average of January and early in 8 1/2-3/4. This While around 8 1/4 February, percent, the rate seemed to be due in part but side. in For a time, the final days pushed up to around to unexpectedly high Treasury balances, or other factors causing reserve shortfalls, perhaps abetted by market anticipation that rates might be allowed to edge higher given the stronger money growth. days, though, In the last several with some encouragement from Desk operations, trading backed off to a range around 8 1/4-1/2. funds Yesterday, it was 8 1/4. Actual levels of adjustment and seasonal borrowing gyrated a fair amount during the period, especially in the year-end period when there were unusually large demands for excess reserves. In the two-week period ended January 2, borrowing averaged about $650 million, period, most of it in ended January 16, the year-end week. In the next two-week borrowing averaged a close-to-planned $260 million, followed by $383 million in the interval ended January 30. So far in the current period (through Sunday) the average Nonborrowed reserves exceeded the path has been about $370 million. objective by nearly $300 million in the year-end reserve period, while in the next two periods nonborrowed reserves were fairly close to path. For most of the period, absorption side, Desk operations were on the reserve countering the seasonal release of reserves that stemmed mostly from post-Christmas currency return flows and seasonal declines in required reserves. reduced by a net $4.3 billion, in bills, net sales of bills $.8 billion, and bill these net sales, Outright holdings of securities were including a market sale of $1.5 billion and notes to foreign accounts of about redemptions of $2 billion. Interspersed with the Desk provided reserves temporarily on about a dozen and a half occasions through System or customer-related repurchase agreements to cope with the uneven and sometimes unexpected behavior of factors such as the Treasury balance and Continental's discount window borrowing. There was no occasion for matched-sale/purchase transactions in the market, although they were used routinely with foreign accounts to provide an investment for part or all of the foreign repo pool. Market interest rate developments were ruled by cross currents during the intermeeting period, with only modest net changes Short-term rates pushed a little for the interval as a whole. lower in the early days of the period, continuing the decline of the previous few months, most of January. and then backed and filled without trend through A prime rate reduction from the largely prevalent 11 1/4 percent level was just getting under way at the time of the last meeting and the rate edged off, sluggishly, to 10 1/2 by mid-January as banks seemed in no big hurry to narrow the gap between the prime rate and their cost of funds. By late January and early February short-term market rates moved somewhat higher, in apparent response to higher funds rates and a perception that the System had dulled the edge of its accommodative stance a bit. In yesterday's auction of three- and six-month bills, the average issuing rates were about 8.20 and 8.28 percent, up from 7.97 and 8.15 percent just before the last meeting. Rates in the intermediate and longer term markets, which had changed relatively little in the final months of 1984 when short rates were declining noticeably, did decline appreciably in January. Market participants seemed particularly encouraged by what they regarded as good prospects for containing inflation, weakness in a view that was bolstered by oil prices and the report on fourth-quarter GNP that highlighted a strengthening of real growth at the same time the deflator was edging lower. late 1984 lull Incoming business news suggested that the was not giving way to an over-exuberant boom but just a moderate pace of expansion that did not threaten renewed inflation. As the Treasury's quarterly financing announcement date approached, near the end of January, there was an atmosphere of near-buoyancy in which the market seemed to shrug off the prospect of huge deficits and focused on the possibility that rates could work lower in an environment of subdued inflation and moderate expansion. Some participants also expressed a bit more optimism about prospects for lower budget deficits. This happy idyll was interrupted shortly after the Treasury announced its however, record $19 billion mid-quarter financing, as market participants got a sense that further easing steps were not likely near term and indeed that a slightly firmer tilt be under way. might Analysts pointed to the somewhat higher funds rate, persistence of substantial money growth, the and the sense that the Desk was not meeting reserve needs with the same alacrity as earlier. In this setting, the intermediate and longer markets gave back their earlier gains and the new Treasury issues came at rates appreciably higher than those anticipated on the January 30 announcement date. auctions Moreover, while the 3-year note was well bid, for the 10- and 30-year issues were unenthusiastic, the and just after the auctions all three new issues traded at lower prices than the bidders had paid. A little better atmosphere started to emerge late last week reflecting-a lessening of concern that policy was turning firmer, but the market gave ground again yesterday in absence of retail demand for the still ample inventories. the At yesterday's close the 3-year note was right around issue price while the 10- and 30-year issue were below in price. Special attention was given to the 10- and 30-year issues this time because of the new ability to trade the separate coupon and corpus payments in is noncallable book-entry form, for its much discussion, it full term. and also because the 30-year bond While these new features generated appears so far that demand for stripping fell short of the market's eager anticipation of a few weeks ago. Still, the long-term possibilities for trading in the stripped payments appear to offer considerable potential. to consider in (Incidentally, the Desk plans due course whether System open market operations should include these new instruments.) Taking the whole period, yields on intermediate and longer Treasury issues were about unchanged--perhaps not too bad a result considering that the Treasury was raising nearly $29 billion in the coupon market during the interval. Not much activity is 4- and 5-year reported these days in foreign targeted issues sold last fall. the Treasury's Quoted prices suggest that these issues trade at yields very near or slightly above those on the companion domestic issues, and roughly a fifth of each issue has been converted into the domestic form where liquidity greater. It these soon. is doesn't seem likely that the Treasury will sell more of market participants are mixed in As usual, their present rate Few expect to see the Fed leading rates downward, outlook. resumption of more robust growth in money measures and in economy. given the the Some do anticipate rate declines in longer maturities, though, if only because they regard real interest rates as still quite high, while the inflation outlook remains favorable. Others, more impressed with the likely strength of business and the intractability expect the higher rates more typical of a maturing of budget deficits, There is expansion. posture. also a range of views about the System's current Some believe that a slight firming was undertaken in the Others are not convinced of this and think that past couple of weeks. the market may have just overdone its earlier perception of the degree While there are occasional flirtations with of intended ease. optimism about budget prospects, the more persistent view seems to be that not too much should be expected on this front. the dollar in The strength of the foreign exchange markets also commands attention, being seen as a reason to bias policy toward the more accommodative side; but the dollar's strength is also seen by some as a source of vulnerability when a downturn in its value finally comes. At this point, I'd say the market is about priced to a funds rate around 8 1/4 - 8 1/2 percent. Finally, as most of you know, we put out for public comment last week some revised standards of capital adequacy securities dealers. for Government It has been a long and arduous process to put this together because we wanted to work with the primary dealer 7 community to build support for what is standard. I think the effort is essentially a voluntary paying off in initial comments have been positive. that at least the Of course, we'll be hearing much more detailed comment over the next couple of months, and we also expect the standards to be the subject of a Congressional Subcommittee hearing next month. Leeway Once again, reserve projections suggest that it would be desirable to have more than the standard $4 billion leeway for changing the System's outright holdings between Committee meetings. In this case, the main factors absorbing reserves would be changes in currency in circulation, vault cash, and required reserves. Most likely a $1 billion increase to $5 billion would be sufficient, but to provide greater flexibility, I would recommend a temporary $6 billion level. That would be the same temporary ceiling that has been in effect since the last meeting when we needed the flexibility on the reserve absorbing side. JLKichline February 12, 1985 CHART SHOW -- INTRODUCTION During our presentation this afternoon we will be referring to the package of chart materials distributed to you. The first chart displays the principal assumptions that underlie the staff's economic and financial forecast, a forecast that for this meeting we extended through 1986. For monetary policy, we have assumed growth of M1 of around 6-1/2 percent--which is in the upper part of the Committee's tentative long-run range--and slower expansion in 1986. These monetary assumptions and our economic forecast are thought to be consistent with short-term interest rates around current levels or somewhat higher in 1985, but those rates could be moving lower in 1986 in conjunction with the effects of our fiscal policy assumptions, which include $50 billion in deficit-reducing actions. Other assumptions we have made include moderate declines in both oil prices and the foreign exchange value of the dollar. The next chart provides additional information on the federal budget and compares the staff and recently released administration figures. In fiscal year 1985 the federal budget deficit on a unified basis is projected to be around $205 to $210 billion for both, and in the staff's estimate to decline to $189 billion in fiscal year 1986, or $11 billion above the administration's estimate. The - 2 - difference between the projections for 1986 is attributable to underlying economic assumptions, mainly our lower growth of nominal GNP. On a structural basis, measured at a 6 percent unemployment rate, the deficit narrows only a little. The bottom left panel illustrates the composition of the assumed deficit-reducing actions. In contrast to the administration's proposed outlay reductions of $50 billion, we have assumed lower defense outlays, smaller cuts in nondefense programs, and some small tax increases. Never- theless, as shown in the bottom right panel, the budget deficit in 1986 will be historically high at 4-1/2 percent of GNP. The next chart provides some information on recent developments in the economy. The top panels indicate con- tinuing expansion in employment following the summer pause, and a resumption in growth of production as inventory imbalances have been largely worked out. The industrial produc- tion index for January is estimated to have risen about 1/2 percent, similar to the rise in November and December. Consumer demands also picked up late last year as shown in the middle panels. Christmas sales were encouraged by price discounting and apparently were sufficiently good to reduce excess stocks. Auto sales recently have been on an uptrend, - 3 - with domestic sales hitting 8-1/2 million units annual rate in January. In the housing market, bottom left panel, the declines in mortgage interest rates by December had not shown through to any particular rise in activity, although we believe the irregular decline in starts through most of 1984 came to an end. For business capital spending, the expansion of outlays continues but at more moderate rates than the extraordinary gains earlier in the recovery. The bottom right panel displays new orders figures, which have been relatively weak over the past half year or so. In part the behavior of orders is a sign of moderation in domestic equipment spending, but it also reflects the substitution of imported capital goods for those produced domestically. The next chart shows the broad outlines of the staff's GNP projection. Real GNP is expected to grow at a 3-1/2 percent pace in 1985 and less next year. Domestic spending is projected to moderate as well, but more of that spending will be satisfied from domestic production than was the case in 1983 and 1984. Price performance is projected to be about the same in 1985 as last year, and with a declining dollar prices are projected to rise a little faster in 1986. The slower growth in economic activity that is projected is consistent with some further, but smaller, declines in the unemployment rate. - 4 - Mr. Prell will continue the presentation with a discussion of the staff's domestic economic and financial forecast. * * * * * * * * * * MJPrell February 12, 1985 CHART SHOW -- DOMESTIC DEVELOPMENTS The next chart portrays the forecast for consumer spending. We are projecting a further strong gain of 4-1/2% in real consumer spending during 1985, followed by a 2-1/2% increase in 1986. This slowing generally follows the pattern of real income, so that, while the personal saving rate drops back a bit from its recent higher level, it averages close to 6 percent in both years. Spending on durables has been very strong thus far in the expansion, and is projected to continue boosting outlays over the next several quarters. The 1980-82 period was one of rising unemployment and sluggish income growth, and during that period purchases of durables were especially depressed. The lower left panel shows that one result was a substantial further aging of the auto stock. The consequent replacement demand, coupled with recent declines in operating costs and increased production capacity, has led us to predict stronger auto sales, particularly in 1985. Similarly, stocks of non-auto durables per household, charted in the right panel, rose at rates well below trend during the early '80s. Although real interest rates are high, we believe the markets for non-auto durables will be strong, as positive income and employment prospects maintain a favorable sentiment toward spending. As the next chart shows, we also are projecting a strengthening in housing demand in the months ahead. Starts are expected to rise to around a 1-3/4 million unit rate, with a larger share for single-family dwellings than was the case on average in 1984. A key factor in the outlook is mortgage rates, which (as indicated in the middle left panel) have declined almost 2 percentage points on fixed rate loans since last summer. -2- We are not projecting as strong an upsurge in starts as occurred a year ago, partly because, in light of continuing weak house prices, real borrowing costs may look higher to some potential buyers than they did then. Moreover, the strength in housing in early '84 was enhanced by the aggressive marketing of adjustable rate loans, reflected in the right panel. Since that time, underwriting standards have been tightened and teaser rates have become less common; as you can see, the share of ARMs in conventional loan originations has fallen considerably. However, there probably is still a considerable pent-up demand for housing, especially for single-family homes and condos, as suggested by the bottom left panel. As the red line shows, the period since 1980 has seen the only significant drop in decades in the percent of households owning homes; furthermore, the crest of the baby boom wave is passing through the 25-to-3 4 year age group that traditionally has included many first-time buyers. The multi-family rental sector, in contrast, may face tougher going; vacancy rates--the right panel--are at a ten-year high and many additional units are under construction. Moreover, the Treasury's tax reform proposal has heightened uncertainty about whether the tax advantages that have spurred rental property investment will be maintained. The next chart addresses the financial condition of the household sector, which we believe is sound enough to support substantial further gains in spending. The upper left panel shows that, while the ratio of debt to income has moved back to earlier peak levels, the sector as a whole had a hefty cushion of financial assets even before this year's stock market gains. Moreover, an historically high percentage of consumers still feel it would be OK to borrow in order to make a big purchase. As shown in the bottom left panel, consumers have not yet experienced any real difficulty in servicing their installment debt--represented here by auto loans--although payment experience on mortgage loans has not improved since 1982--evidently reflecting mainly the combination of heavy leveraging, weak real estate prices, and still high unemployment. The final panel indicates our expecta- tion that home mortgage flows will expand only moderately over the next two years, while net consumer credit flows should diminish, mainly because of a catchup in repayments relative to extensions. Turning to the business sector, the top panel of the next chart puts recent inventory developments in a cyclical perspective. The long recession of 1981-82 was marked by a deep inventory liquidation. With recovery uncertain at first--and financing costs still high--the restocking process was initially very cautious, but it quickened as delivery times began to lengthen and businessmen began to worry about getting caught short. Then, when sales slowed last summer, they quickly cut orders and production--so that in the fourth quarter inventory accumulation dropped sharply. Although there may currently be some desire to build inventories at auto dealers and in a few other areas, the picture in the aggregate today seems to be one of reasonable balance with sales, and as indicated in the table, our projection anticipates that inventory investment will not be a significant factor either way in influencing production trends over the next two years. In contrast, fixed investment, the next chart, should remain a supporting factor in the economic expansion. As the top panel shows, we have had the strongest BFI upswing since World War II--one stronger (especially in the equipment area) than seems explicable by past relations to output growth or capital costs. One hypothesis is that there has been something of a technological revolution that has caused businesses to speed up the replacement of equipment. There is some statistical evidence that replacement investment has been unusually strong, and--as the middle panel shows--sales of high-tech equipment have indeed soared. They turned up smartly at the beginning of this cyclical upswing, and their tremendous growth since then has raised their share of total equipment spending to more than 45 percent recently. In the structures category, the right panel, commercial building evidently has been boosted by a good deal of speculative activity, often financed by loans with equity kickers or by tax-shelter syndications; meanwhile, other construction as a whole has posted a more moderate recovery. Over the months ahead, we expect to see a tapering off in investment growth, as indicated in the bottom panel. normal effects of slower output growth. This is partly the But, in addition, the leveling off of homebuilding should be accompanied by less vigor in shopping center development, while high vacancy rates should temper office building. The financial side of the business picture is covered in the next chart. The top panel indicates that, with profits expected to weaken as the growth of the economy slows, outlays for inventories and fixed capital are projected to outstrip internal funds by an increasing margin over the next two years. I perhaps should note that while large in absolute terms, this gap is moderate relative to, say, capital outlays. Our flow-of-funds forecast shows corporations able to cover this financing gap with a reduced level of borrowing--as indicated in the middle panel; this is because we've -5- assumed that the unusual absorption of outstanding equity shares through debt-financed mergers and buyouts will come gradually to a halt. There has been a lull in short-term business borrowing recently, but we expect it to resume a fairly strong growth trend soon. Consequently, although issuance of intermediate- and long-term bonds (domestically and in the Euromarket) is projected to be substantial, the ratio of loans and short-term paper to total debt continues to creep upward in our forecast. The deterioration of balance sheet structure has left businesses vulnerable to cash flow pressures if interest rates should rise sharply; as it is, as indicated in the final panel, our projection--with no such jump in rates-shows an extension of the rise in net interest payments relative to corporate income that has accompanied the heavy borrowing of the past year. The next chart focuses on the government sector. Real federal purchases are projected to decelerate over 1985 and '86, under our budgetary assumptions. In the state and local sector, spending spurted over the first three quarters of last year, especially for construction, but then slowed, and we are not looking for much impetus to aggregate demand from this sector in the period ahead. As the bottom panel indicates, the overall state and local surplus, including trust funds, is expected to remain large through 1986. However, operating surpluses are projected to shrink in 1986 after remaining sizable again this year. Many units evidently are taking advantage of stronger-than-expected revenues now to restore their cash balances and to otherwise improve their financial positions, but they likely will come under increasing pressure to undo earlier tax hikes. The upper left panel of the next chart shows that debt issuance by states and localities is projected to dip temporarily this year in light of the sector's budgetary position. Given the tightening of various rules, as well as the anticipatory borrowing surge at the end of 1984, private-purpose financing is expected to remain a bit below last year's volume. We have not assumed the adoption of proposed tax changes, which could affect this market dramatically. Federal borrowing--in the right panel--will remain heavy, continuing even in 1986 to absorb an extraordinarily large proportion of domestic credit. The bottom panel pulls together the various sectoral spending and saving flows. As you can see, gross private saving and gross private domestic investment, as a share of GNP, were at the upper end of the historical range last year, but the general contour of the recent and prospective movements is not distinctly different from past cyclical patterns. The big story--the "crowding out" story, as it were--is the size of the government deficit, its lack of normal cyclical narrowing, and the counterpart negative net foreign investment (that is, the current account deficit). In the forecast, the government deficit does not change much relative to GNP, and it is primarily a growing foreign capital inflow that provides the marginal funding for private investment as weakening profits and personal saving cut into total private domestic saving. The next chart focuses on labor market developments. Consistent with the slowing in GNP growth, we are projecting gains in payroll employment of 3 million in '85 and 2 million in '86, compared with 3-3/4 million last year. Factory payrolls are rising in the forecast, but remain below their 1979 peak, while other employment is projected to rise appreciably. The middle panel, depicting the labor force participation rate, reflects our expectation that good employment opportunities will be drawing more job seekers into the market. In addition, the movement of the baby boom cohort into the age groups with more consistent labor force attachment will tend to lift the participation rate. The lower panel indicates that we expect the unemployment rate to edge down over the coming year before leveling out as GNP growth in 1986 approximates the presumed trend rate of potential GNP growth. As you can see, the jobless rate is forecast to enter what we believe to be the vicinity of the so-called "natural rate," where labor market slack will no longer be sufficient to exert general downward pressure on wage increases. Our projection of hourly compensation increases is laid out in the top panel of the next chart. Compensation increases have slowed further in the past few quarters, and have run at about the rate of inflation. This relationship --implying unchanged real wages--is not one likely to be sustained when productivity is trending upward. However, we do not foresee any noticeable pickup in compensation growth until 1986. Inflation expectations have been moving downward, as, undoubtedly, has the prevailing concept of what constitutes a "normal" wage gain. The left panel is of interest in this regard. In major union settlements during 1981, a large share of wage increases fell in the 8 percent plus range. As the recession took hold and a number of industries experienced special difficulties related to changes in their domestic and international competitive environments, we saw a sharp diminution in the proportion of such large increases, and also a sizable number of wage freezes and cuts. By last year, despite the much improved conditions in many industries, a pattern was emerging of increases most commonly in the 0-to-4 percent range, with cuts still occurring in cases where competitive pressures were especially intense or where relative wages were out of line. Looking at the '85 bargaining calendar, it seems reasonable to expect a similar picture. As the right panel shows, wages in the non-union sector decelerated a little further in 1984; however, the gains outpaced those among unionized workers as they had in '83. The relative movement of the past two years has put only a small dent in the union-nonunion differential that had swelled over the preceding decade, and we anticipate a tendency for the recent pattern to continue. Since we have moved beyond the initial stages of recovery when output per hour worked normally records its strongest growth, we are anticipating a considerably reduced productivity offset to rising compensation. Consequently, unit labor cost increases are projected to rise from the 2 percent figure of 1984 to around 3-1/4 percent this year and somewhat more next year. Under the circumstances, we don't expect a further slowing of price inflation--as may be seen in the top panel of the next chart. Rather, prices, as measured by the index for gross business product, are projected to rise at about the same pace this year as in 1984, and then to accelerate gradually into the 4-1/2 percent area by the end of 1986. The lower left panel highlights two components of prices for which special supply influences can be especially important. Food prices appear likely to rise on average at a rate just a shade above that for prices generally. As an aside, I would note that our forecast of crop and livestock prices suggests that farm income will remain weak. From that standpoint, agricultural credit problems will not be eased. Energy prices, the black line, should be a highly constructive element in the overall inflation picture, as the decline in world oil prices more than offsets the influence of moderate increases in natural gas and electricity prices, at least until the latter part of '86. A key element in the projected acceleration of prices over the next two years is the impact of the anticipated depreciation of the dollar. As the right panel indicates, the unit value of nonpetroleum imports is projected to pick up later this year and to rise at an 8 percent annual rate through 1986. Mr. Truman will discuss further the outlook for the dollar and other international developments. JLKichline February 12, 1985 CHART SHOW -- CONCLUSION The next table presents some areas of risk and uncertainty attached to the staff forecast. This is by no means a complete listing of factors that could evolve differently from our expectations, but it is sufficient to indicate a few points of vulnerability. The staff estimates trend productivity growth over the forecast of 1-1/4 to 1-1/2 percent per year, up from the dismal 70's pace but one could argue a lower or higher rate. If, for example, the pickup in investment, reduction in government regulations, and work experience of the baby-boomers are contributing to appreciably higher trend productivity growth than estimated, we could expect larger expansion of real GNP and lower rates of inflation. Our estimate of the natural rate of unemployment--that is, the unemployment rate that would provide stable inflation in the long run--is around the middle of explicit or implicit estimates that range from below 6 to over 7 percent. If the rate is much different than our estimate, that would alter our view on the prospective rate of inflation and real GNP growth. Mr. Truman has noted risks associated with the exchange rate and oil prices. For the dollar, the appreciation of 1984 and early 1985 pushes - 2 - the domestic price and activity effects of the eventual decline into 1986 and beyond. For oil prices, a major break in the price would have important domestic price and activity impacts as well, but also produce questions about financial stability as decisions premised on much higher oil prices would become uneconomic. As to fiscal policy, our assump- tions entail aggressive actions but much more needs to be accomplished to put fiscal policy on a sustainable longerrun path. On balance, we have grappled with these issues and others in preparing the projection and have made judgments that we believe represent the most likely outcome. Clearly, however, there is much room for alternative views. The last chart presents the 1985 forecasts of Board members, Presidents, the staff and the administration. In general, the various forecasts are fairly close, with the staff figures tending to the low side for expected real GNP growth and the deflator. The forecasts presented to the Congress in July are shown in the bottom panel. E.M. Truman February 12, The on the U.S. years. As shown appreciation foreign to the of by dollar percent 1984; 7-1/2 percent so far that U.S. the in incorporated rate in the a the dollar 1985. of our forecast 8 percent, As prices. deficit panel, fourth has The and are nominal average 1980 appreciated by a the the black adjustment associated its line, for continues to widening sustainable with considerable from of of staff not four quarter after a depreciation starting the shown by smaller Consequently we have, in the appreciation account top a perspective the past trade-weighted from somewhat consumer dollar's current indefinitely. been in against of believe annual 65 appreciation during line quarter appreciation has the red fourth relative movements of the the after the divider provides remarkable currencies was further the first chart dollar's INTERNATIONAL DEVELOPMENTS SHOW -- CHART FOMC 1985 of humility, the dollar average level at an in January. The cited as an movements between panel, shown that in the in real, the and other past panel important the depicts proximate factors two differential factor determinant weighted-average differential lower one long-term interest dollar's in the the lower panel, have years has is in real, quite influenced when, been that of The value, shown long-term the on balance, It is in the value, top rates, equally particular essentially unchanged. rates: association interest dollar's this frequently exchange rates. evident. is evident especially measure of -2- on recent and prospective price developments in the United States As can be seen in the industrial countries. the United States enjoyed last margin narrowed markedly the dollar, appreciation of is shown the United in the and it left-hand misleading indicator of stronger direct However, that 1983. the further projected depreciation. to enjoy a much larger terms of wholesale or statistical edge is probably a longer-run relative price influence of movements trends because in exchange rates on commodity prices, which are more heavily represented in indexes. in the This influence is illustrated more starkly right-hand portion of the panel where changes index of commodity prices are plotted and in terms prices rose of in foreign currencies. 1983 as year-over-year change equivalent rise the the world for in terms second half of in terms of the U.S. On both bases, recovery got in The percent; foreign currencies was 32 foreign currency terms the dollar commodity underway. 1984, commodity prices declined dollar terms, while such in the Economist the dollar index was 23 of in portion of the middle is measured in However, this prices. success projected to be eliminated is States continues advantage when inflation of the year, despite in part because of the dollar's As producer considerably more inflation in 1982 and reducing consumer price panel, information present and in major foreign 1986, chart the next upper panels top panel, in in The peak the percent. sharply in percentage change was only slightly negative. A separate commodity prices, issue raised by the right hand even when translated into panel is why foreign currencies, In -3- have (1) stopped the pressures products to Contributing rising. on many of the debts, economic activity now that and the continued high (3) discourages the year, primary in order to help slowed in the United States, interest rates, which that the rate of growth of real industrial countries edged up end of 1983, is projected and remained at to continue in that increase somewhat in these countries, to about range during this are rise will essentially offset continued restraint on public expenditures the reduced stimulus Turning to panel from the U.S. external their combined current billion they had in 1981 to past account about $30 deficit shrank from more than billion We anticipate that this their forecast period. last their year, and, as $80 a group, to zero. improvement will be sustained The rate exports should continue at in the middle panel. in top We estimate that three years. a balance on merchandise trade close during the the improvements depicts the dramatic accounts during the and economy. the non-OPEC developing countries, of the next chart 3 about that Although private domestic demands forecast period. expected to and exports level of real percent, on average, by the rate last produce stock building. the major foreign in include: the moderate pace of OECD (2) growth has The bottom panel shows GNP countries that increase their production their external to service factors appear to of growth a quite in the volume of rapid pace, Meanwhile, the growth as is shown in the volume of their -4- imports depressed rates and partly as a consequence of in economic acceleration Nevertheless, growth -- is as are based on the assumption of these countries will have very limited of internal imply is adjustment process of external is adjustment significant at risks As area of risk and can be seen in forecast for imported oil two-year uncertainty, is the overall -- projection -- implies As the imported oil will with fourth has noted. the can be seen from the combined that by in the staff's quarter of have returned almost to The outcome of black line, level the important this projection the real its of the increasingly inflation 1986 chart. in our decline over consistent with the recent OPEC meeting and developments oil market. in the next or dollar, price in the nominal, is Indeed, forecast. incorporated period, as Mr. Kichline projected near-term decline spot presented specifically a 10 percent forecast the and situation, another the top panel, we have a continued erosion from complete a very early stage. Information concerning the oil key that most in many cases Moreover, far 1976-80 to additional access financing from foreign commercial banks. these facts in the significantly below that recorded These projections process in the lower panel. shown period. the a slight in these countries will the growth of real GDP remain on average from recent partly as a further catch up also rise, should -- price of U.S. in early 1979. The erosion of important changes the oil price has been in the world oil market. As associated with is shown in the -5- panel, middle diminished non-OPEC that of proportion of production generated total rate in left OPEC prices or world crude oil production. surplus capacity. year last fields. now was about barrels As 39 a day of in ability in rising overall in shown surplus the production by cushion other table, a day, capacity Saudi Arabia, to demand has barrels million a consequence, a much-reduced increases As a much represents Moreover, continued moderation 9 million particular, has oil and substantial production it production of OPEC any OPEC -- but most in softness or in non-OPEC suppliers. Against forecast percent for this U.S. rise in background, petroleum the volume imports. of quarters, largely in lower oil prices, their value Turning to goods and cyclical services, comparison expansion of outside The high our be dramatic less external booming U.S. of of debts, to trends of interacting plus the in over U.S. and experience is imports It with effects has the of project the next a our 20 eight activity imports next real goods presents and more moderately. the goods our appreciated. economy. of in we economic rises much cyclical of Although rising of both imports bottom panel imports their growth expansion rates such top panel any U.S. widely interest overall imports range explosion of equally may the U.S. response the the chart terms. of been the The has past services the of a rapid been 30 documented. rapidly the exports provides services well of and -- years. The line consequence growing strong dollar 3 -of stock and of the is shown As line 5 of in despite U.S. exports of goods, has substantially outpaced directly comparable service exports from direct U.S. that 1975 the international cycle. in real investments of cycle -- In the most sharp contrast, terms have been depressed by the effects dollar's appreciation abroad, as well as by the on profits reduced pace of lending abroad. As is shown in of goods and depressed rate recorded some moderation in their growth in receipts to be depressed in agricultural shipments but year and in chart summarizes current account balance influence on that balance of end of top line the 1980. The area in the portion of the chart shows year, and the export side, we short run by a decline in the second half of the in the staff's projection of the and estimates of the hypothetical the dollar's in the top appreciation panel dollar's indicates our presents interest rates. The effects of the the actual The vertically the end of 1980 relative rise portion labeled "fiscal the estimated direct contribution since the rough estimate of the appreciation since can be associated with the real from the influence of under the projected path of the price-adjusted dollar. shaded 1985, quarter of last On to recover in 1986. The next U.S. services 1986, projected depreciation. the dollar's expect in the fourth forecasting a we are the lower panel, recovery of real imports and in performance the of the strong dollar, the effects foreign activity and the of weak the table, that in U.S. expansion" of the U.S. fiscal -7- to expansion the interest rates. residual has As lower two years, next period. The unrealistic in earlier, pink area assumption that real unexplained the an estimate changes lower in for the end of the based upon the the -- exchange the line, projected billion by $140 indicates the deficit account almost size of in illustrates, current reaching the in changes years. recent panel the U.S. through appreciation I noted increased The widening of dollar's rates are entirely exogenous -- of the contribution of the dollar's real appreciation since the end of to 1980 projected depreciation, part because external of the table structure inflows 1983, -- but line 2 -- contrast banks, seen record of U.S. year. a wide from inflows to pace year and net transactions -- and line on the stock also 1984, was flows used in accounted corporations this some Net further in issued made trend direct estimates private as they of was in this last year. year. concentrated 1984. for of capital did increase As can substantial could well and net at at be substantial Eurobonds investment increased large years. presents in huge changed dramatically foreigners -- payments shift through 5 in little stocks securities; inflow increase page channels U.S. to rapidly the dollar's continues transactions. show the Despite earlier inflows when private Treasury The to bonds as next expanded variety of 4, in capital those 1983, line last of effect up the expected The composition In on deficit. interest built of U.S. are the continuing liabilities The that net a purchases continue this other non-bank dramatically last year, -8- largely as a result of several corporations; Official well we anticipate a drop in transactions, as transactions reduced net large in line 6, affecting takeovers by such activity this include official outflow through such channels consequence of our projection of the foreign year. lending activities reserves; we in 1985, as anticipate a partly as dollar's depreciation. Mr. Kichline will now complete our presentation. a STRICTLY CONFIDENTIAL (FR) CLASS II-FOMC Materials for Staff Presentation to the Federal Open Market Committee February 12, 1985 Principal Assumptions Monetary Policy * Growth of M1 of around 61/2 percent during 1985 and 51/2 percent in 1986. Fiscal Policy * Deficit-reducing actions of around $50 billion for FY 1986. Other * Oil prices decline 10 percent over forecast period. * Foreign exchange value of the dollar declines 8 percent per year. Federal Budget Unified Budget, Fiscal Year, Billions of Dollars 1985 1986 Staff Administration Staff Administration Outlays 941 947 976 972 Receipts 735 737 787 794 Deficit 206 210 189 178 Structural Deficit 176 n.a. 167 n.a. Deficit Deficit-Reducing Actions Percent Billions of dollars 1986 50 Total Expenditures 40 Nondefense 20 Defense 20 Tax increases 10 1978 1980 1 1984 1986 Current Indicators Nonfarm Payroll Employment Industrial Production Change, annual rate, millions of persons Index, 1967=100 3 0 3 1983 1982 1984 1982 Real Retail Sales 1983 1984 Domestic Autos Millions of units Billions of 1972 dollars V-8 6 -4 1982 1983 1984 1982 1983 1984 Real Shipments and Orders for Nondefense Capital Goods Housing Starts Millions of units Billions of 1972 dollars - 2.0 S16 Orders - - 1.4 - 1982 1983 1984 .8 - 12 Shipments 1982 1983 1984 Real GNP and Domestic Spending Change, Q4 to Q4, percent O Real Real Domestic GNP Spending Domestic Spending 8 1983 1984 1985 1983 1984 1985 1986 6.4 5.6 3.6 2.7 8.0 6.7 4.4 2.6 1986 GNP Deflator Change, Q4 to Q4, percent rnm m1 I 111 I I 111 I I I 111 I I I111 I II I I I I I I i 19b4 1~0 ........... 11 1985 i I I H1ITI~ 1983 1984 1985 1986 -4 111111 - 2 111111' 'I'll'' 111111! " " ' "' ' " ' ............. 1986 Unemployment Rate Percent - 1983 1984 1985 1986 10 Q4 Level 1983 1984 1985 1986 8.5 7.2 6.7 6.6 Real Disposable Personal Income and Consumption Change, Q4 to Q4, percent M Real DPI II Real PCE (Second bar) -6 -1 2 1980-82 Average 1983 Autos Older Than 10 Years 1984 1985 Stock of Nonauto Con sumer Durables Percent F1 Thousands of 1972 Dollars per Household -- 30 --1 20 -- 10 197011111 1980111119841111 1970 1980 1984 1969 1972 1975 1978 1981 1984 Housing Starts 1978 1980 1982 Mortgage Commitment Rate 1984 1986 Proportion of ARMs Percent - Percent 14 - 70 13 - 50 -12 1983 30 1983 1984 Homeownership and Population Percent Millions 1984 Multifamily Vacancy Rate Percent Rental Units Homeownership 65 64 - 55 - AC - -8 7 6 63 - Populatior Aged 25 to 34 62 62 - IIIIIIIIIIIIILLIIII 111111 '60 '65 '70 '75 '80 '85 1981 1982 J5 1983 1984 Household Financial Assets and Debt Percent of DPI Borrowing Sentiment Percent Percent of DPI O.K. to Use Credit -l -30 250 Financial Assets 90 k -- 20 -- 10 -1210 Debt I 1975 I I 1978 I I I 1981 I I 1984 Delinquency Rates 1981 1982 1983 1984 Selected Household Borrowing Percent Billions of dollars Home Mortgage - 200 | - -100 0 1975 1978 1981 1984 1979 1981 1983 1985 Real Inventory Investment Percent of GNP Contribution to Real GNP Growth Percent, annual rate Real GNP Growth 1982 -1.5 1983 H1 H2 6.3 6.4 1984 H1 H2 1985 1986 8.6 2.7 3.6 2.7 *Excludes cycles with troughs in 1949 and 1980. Contribution of Inventory Investment -2.1 2.5 1.7 1.7 -. 7 0 0 Cyclical Comparison of Real Business Fixed Investment Percent change from Current Cycle ..... ...... ....................... ............................. ......... .......................... ......... .. ....... .............. .... ...................................... ............... ............. ............................. Range of Previous Cyclee -4Q -2Q Trough +2Q +8Q +6Q +4Q Structures High-Tech Equipment Billions of 1972 do Billions of 1972 dollars - 70 - 60 Other 50 1978 1980 1982 1984 Commercial I 40 1978 1982 1980 1984 Real Business Fixed Investment Change, Q4 to Q4, pert il Producers' Durable Equipment M Structures (Second bar) -- 20 [rlfF~nn ................ 1983 *Excludes 1984 cycles with troughs in 1949 and 1980. 1985 i .. .q Im,,, 111p~~~riMIT1..., 1986 Nonfinancial Corporations Financing Gap Billions of dollars Capital Expenditures 400 - 300 -200 1978 1982 1980 1986 1984 Total Funds Raised Billions of dollars -100 + 0 1984 1983 1986 1985 Interest Relative to Income Short-term to Total Debt Outstanding Percent Percent SNet Interest/Profits Plus Net Interest 50 - t 35 -- 25 1978 1980 1982 1984 1986 1978 1980 1982 1984 1986 Real Federal Government Purchases Change, Q4 to Q4, 1983 1984 1986 1985 Real State and Local Government Purchases Change, Q4 to Q4, percent - I I II I I I I II I 1983 1984 I I I II I 1985 - 4 - 2 I 1986 State and Local Surplus Billions of dollars Total -Including Trust Funds Operating Surplus 1 1979. 19821 1976 1979 1982 1985 - 40 - 20 Federal Borrowing Tax-Exempt Debt Issuance Billions of dollars Billions of dollars 60 44 - 44 -1 200 44 44 44 40 - 20 -- -- 100 I 1980 1982 1984 1986 1980 I I 1982 I 1984 I I 1986 Sector Savings Flows Percent of GNP - 15 - 10 -5 +0 Payroll Employment Millions Other Manufacturing 1980 1982 1984 1986 Participation Rate Percent -"" 65 64 63 1978 1982 1980 1984 1986 Unemployment Rate Percent -10 / S6 Natural Rate 197 1978 198 1980 I 198 1982 I 198 1984 1986 1986 Compensation Per Hour Change from year earlier, Nonfarm Business Sector 1985 Wage Rates Wage Settlements 1981 1982 1986 198'3 1984 1981 1984 1983 1982 Unit Labor Costs Change from year earlier, percent Nonfarm Business Sector 1ffI~ InIR 1981 1982 1983 1984 1985 1986 Gross Business Product Prices and Unit Labor Costs Change from year earlier, Unit Labor Costs GBP Prices 1981 1982 1983 1984 1985 1986 Nonpetroleum Import Prices Food and Energy Prices Change from year earlier, nt 16 Change from year earlier, percent -- 16 8 8 Food / + 0 1981 1983 1985 + 0' 1981 1983 1985 Foreign Exchange Value of the U.S. Dollar Ratio scale, March 1973 =100 1150 S- 140 130 -120 110 Weighted Average Dollar 100 Price Adjusted Dollar Weighted Average Dollar*/ Relative Consumer Prices 90 80 1977 1979 1981 1983 Real Long-term Interest Rates** Percent 1977 1979 1981 1983 * Weighted average against or of foreign G-10 countries. ** Long-term government or public authority bond rates adjusted for expected inflation estimated by a 36-month centered moving average of actual inflation (staff forecasts where needed). Consumer Prices Change from year earlier, percent - 12 Foreign Industrial Countries* - United States 1981 1983 1985 Wholesale Prices Commodity Prices Change from year earlier, percent Change from year earlier, percent Economist Index - - 12 - Foreign Industrial Countries* \ 24 Foreign Currency** S12 + o United States U.S. Dollar 12 III 1981 1982 1983 1984 1981 1982 1983 Real GNP Change from year earlier, percent 1981 *Weighted 1983 1985 average of the six major foreign industrial countries using total 1972-76 average trade of these countries. **U.S. dollar index multiplied by the index of the weighted average value of the dollar against G-10 currencies. 1984 Non-OPEC Developing Countries External Balances Billions of dollars + 0 -30 Export and Import Growth 1981 1983 1985 Real GDP Growth Change from year earlier, percent 7 - --- Average 1976-80 ------------- 1981 1981~ 19318 1983 1985 U.S. Oil Import Price Dollars per barrel -35 -30 25 -20 1979 1981 1983 1985 Non-Communist World Crude Production Percent i Millions of barrels per day OPEC ONorth Sea and Mexico 1984 I Other Non-OPEC - iiiiiill iiiiiiii iiiiiiiiii 1979 1981 Iii! iiii_ 17.3 OPEC -100 80 North Sea and Mexico 5.9 60 Other Non-OPEC 15.7 40 TOTAL 38.9 20 2 Surplus Capacity 9.0 1983 U.S. Petroleum Imports Current dollars lillions of barrels per day Value 1979 1981 *Oil import price divided by U.S. CPI (1979 Q1=1.0). 1983 1985 Real Imports and Exports of Goods and Services Expansion Eight Quarters After The Cyclical Trough (percent) Current Cycle (to 1984 Q4) Average of 5 Past Cycles* 1975 Cycle 1. Imports of Goods and Services 23.4 17.8 2. Goods 46.1 30.6 23.6 3. Services 34.6 7.3 8.1 6.7 13.3 11.4 1.7 10.7 2.5 15.8 18.9 4. Exports of Goods and Services 5. Goods 6. Services ) Ratio scale, 1982 Q4=100 I - ----- '--- Imports of Goods and Services Real Exports of Goods and Services Real Exports of Goods and Services 1983 1984 Note: Data for 1984 04 are FR staff estimates. *Includes cycles of 1954, 1958, 1961, 1970 and 1975. 1985 1986 -- 140 Price Adjusted Dollar Ratio scale, March 1973= 100 - 140 - 130 120 -110 [. 100 cal Expansion 90 80 U.S. Current Account Seasonally adjusted, annual rate, billions of dollars Excluding Dollar Appreciation A Actual and Projected l " 1 1 : f :' i :.. .. IV I 1981 1983 I I 1985 U.S. Capital Transactions (Billions of Dollars; Net Inflows = +) 1982 1. Net Private and Official Capital Flows 2. Private Capital Flows 79 89 -16 33 90 89 -45 24 30 30 13 35 40 25 19 4. Bonds and Stocks 14 5. Direct Investment and Other Non-Bank Flows 15 -4 -8 -1 7. Statistical Discrepancy 33 10 8. Balance on Current Account -9 e Estimated P Projected 1985 p 32 U.S. Banking Offices U.S. and Foreign Official Transactions 1984 e -24 3. 6. 1983 -42 -9 20 -99 0 20 -109 Some Risks and Uncertainties Staff Estimate or Assumption Trend Productivity Growth Natural Rate of Unemployment Exchange Rate Oil Prices Fiscal Policy 114 to 1/2 percent 61/ percent 8 percent per year decline 10 percent decline over forecast period $50 billion deficit reduction Forecast Summary for 1985 Presidents Board Members Percent change, Q4 to Q4 Range Nominal GNP Real GNP 7 to 8/4 3/4 to 44 GNP Deflator 3 to 41/ Staff Administration Median Range Median 7 7 1/4 to 8 3/4 8 71/ 3 to 41/ 4 31/2 4 3/2 to 43 4 3/2 7 6V2 to 7% 7 64 33/4 8/2 Average level, Q4, percent Unemployment Rate 63 to 71/4 FOMC Projections for 1985 Reported to Congress in July 1984 Range Central Tendency Percent change, Q4 to Q4 Nominal GNP Real GNP GNP Deflator 63/4 to 91/2 2 to 4 8 to 9 3 to 3/4 31/2 to 61/2 51/4 to 51/2 61/4 to 71/4 61/2 to 7 Average level, Q4, percent Unemployment Rate FOMC Briefing S.H. Axilrod 2/12/85 A principal issue for the Committee in choosing monetary targets for 1985 is to decide how to weigh the need for enough monetary growth to encourage satisfactory economic expansion, with unemployment still relatively high, against the need to keep enough restraint on monetary growth to foster further progress toward reasonable price stability and to be perceived to be doing so by continuing gradually to lower monetary growth ranges. If a continued 4 percent rate of inflation is deemed satisfactory for 1985, there may not be much of a dilemma. But should the Cmmittee wish to make further progress in 1985, then there may be a greater dilemma, given what we now take to be the underlying rate of inflation, since that may risk leading to real growth below, say, the upper part of a 3 to 4 percent range. The growth ranges presented in alternative II might be construed as representing something of a compromise in these respects. They are, with the exception of credit, the same growth ranges adopted tentatively last summer--which contemplate reductions for M1 and M2 but not for M3 and credit. They are also relatively tight ranges in the sense that they leave little, if any, scope for realization of upward price pressures significantly greater than 4 percent, given real economic growth in the 3 to 4 percent area. This assumes, as noted in the blue book, that the trend rate of rise in the velocity of M1 is 1 to 2 percent, abstracting from the impact of interest rate movements. Such a trend rate presumes that velocity growth will be held a little under post world war II experience because deregulation will lead to a lower rate of financial innovation in the future. of the trend are correct-a big if, If that analysis and estimate of course, given the still limited experience with deregulation and the new checking and closely related accounts--then the odds are that M1 growth this year will be in the upper part of the 4 to 7 percent range given under alternative II. We believe that growth of M2 and M3 will also be close to the upper limits of their respective alternative II the blue book. ranges, as noted in With respect to credit, the tentative range adopted in midsummer does not seem attainable, except perhaps barely so if is there no unusual amount of credit at all raised for mergers and related activity this year. Thus, a higher credit range seems technically more consistent with the monetary aggregates. However, adoption of such a range does have the disadvantage of possibly signalling greater willingness by the Federal Reserve to accommodate to a still federal deficit. If the range is expansive left the same rather than raised, perhaps some mention should be made at least in the policy record that the range assumes no unusual credit expansion related to such transactions as mergers and share redemptions. The probability that the monetary aggregates under alternative II will run in the upper part, or close to the upper limits, of their ranges suggests that stronger inflationary pressures, demands for goods and services, or real than projected or expected would need to be rather promptly reflected in upward adjustments of interest rates. Indeed, the staff projection itself may entail some rise of interest rates from current levels, particularly if kept within alternative II M2 and M3 are to be ranges for the year but also perhaps consistent with projected M1 growth. The suggested growth ranges of alternative I would be an approach to targeting for 1985 that provides more leeway on the upside of the ranges. it It has certain advantages as compared with alternative II. First, would provide allowance should trend velocity for M1 be even lower than, or on the low side, of a 1-2 percent per year range. Second, there would be scope to let the Ms run strong should demand for goods and services be weaker than currently anticipated at present levels of interest rates and exchange rates, or should inflationary pressures be significantly less than now expected. Under those conditions, the lower interest rates that would be required to keep the economy growing at a reasonable pace might also be associated with a significant strengthening in demands for monetary assets. Third, as a mere technical matter, it would simply make the midpoints of the ranges closer to the most likely outcome. The alternative has important disadvantages, however. First, retaining the 1984 M1 and M2 ranges, and raising those for M3 and credit, as is proposed, might be taken as signalling a lessening of will on the part of the Fed in keeping inflation curbed. Such an interpreta- tion is more likely under current circumstances, when fiscal policy for the year 1985 is likely to be more expansive than in 1984 and when the economy does not seem especially weak. It may also serve to reinforce a view that the 4 percent rate of inflation of the past two years is an irreducible minimum, perhaps, to be followed by an upward adjustment to a higher rate. Second, the ranges for alternative I, by providing more leeway than alternative II, may delay an interest rate response in short-term markets that may be needed, at least temporarily, should demand pressures strengthen more than now expected with the potential for leading to a sustained acceleration of prices. Alternative III, which contemplates lower growth ranges than alternative II and tilts toward an actual lowering of M1 growth in 1985 relative to 1984, may well seem to be reaching a bit at this point. But something like it would need to be contemplated sooner or later if the Committee is to signal an intention to encourage a further reduction in the rate of inflation. that it Its main disadvantage, is probably premature. in my view, would be Its main advantage is that it would more firmly work toward a further abatement of inflationary expectations at the risk, however, of retarding real growth perhaps unduly in 1985 but with the potential of more sustained growth in subsequent years. A final point if I may, Mr. Chairman. Should the Committee adopt monetary growth ranges in the expectation that the outcome may be in the upper part of them, it may wish to consider indicating that to the public. Such a phrase is suggested for M1 in the proposed directive language-indicating that growth in the upper part of the range is acceptable because of growth below the midpoint in the year just past. That may be a useful way of signalling an intention, but it does not necessarily convey the crucial economic reasoning. It has the disadvantage of making it seem that so-called "base drift" is necessarily undesirable, when in practice whether it is or not depends on assessment of the changes that may be occurring in demand for money relative to GNP, the psychological state of the public, and how M1 is to be assessed relative to other monetary aggregates and domestic credit and exchange market conditions. It might be more economically pertinent to suggest Ml growth in the upper part of the range would be acceptable in view of the potential for relatively slow growth in velocity and so long as inflationary pressures remain subdued.
@FedFRASER