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January 28-29, 2003

155 of 195

Appendix 1: Materials used by Messrs. Sack, Tetlow, Croushore, and Rudebusch

January 28-29, 2003

156 of 195
Exhibit 1
The Smoothness of the Federal Funds Rate

Intended Federal Funds Rate

Percent

88% of policy actions moved in same direction
96% of policy actions were 50 bp or less

I

I

I
1989

I

I

I

1991

I
1993

Estimated Monetary Policy Rule

I

I
1995

I

I
1997

I

I
1999

I

I
2001

Policy Easing in 2001

I
2003

Percent

fft = 0.35 Tit + 0.19 yt + 0.76 fft - 1
(5.83)

(7.24)

(10.18)

ff - federal funds rate
y - output gap
itone-year GDP inflation
Estimated using real-time data from 1987
to 2000
T-statistics shown in parentheses. Rule also contains a
constant term.

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2000
2001
Vertical line denotes end of sample period.

2002

January 28-29, 2003

157 of 195
Exhibit 2

Optimal Monetary Policy: A First Pass
Defining "Optimal" Policy
*

FOMC desires to limit squared deviations of:
- inflation from a target level
- unemployment rate from its equilibrium level

*

FRB/US is the correct characterization of the economy.

*

The "optimal" policy is conditional on the model and the objectives
assumed.

Prescribed Policy Paths

"Optimal" and Estimated Policy Rules

Percent

Coefficient on:
Lagged
FF Rate

Inflation

Output
Gap

"Optimal" Rule

3.30

2.43

-0.15

Estimated Rule

0.35

0.19

0.76

Rules also contain a constant term.

Q3
2001

Q1

Q3

Q1

2002

Q3
2003

Why Is the "Optimal" Policy So Aggressive?
*

This finding hinges on three key assumptions:
1. Expectations formed as if FOMC following historical policy rule.
2. FOMC knows the structure of the economy with certainty.
3. No measurement error in macroeconomic data.

*

We evaluate the implications of relaxing each assumption in
subsequent exhibits.

Q1

Q3
2004

January 28-29, 2003

158 of 195
Exhibit 3

Forward-Looking Expectations
Implications of Forward-Looking Behavior

*

Private agents will expect the initial response of the federal funds rate to be
followed by additional policy changes.

*

Expectations will be incorporated into current asset prices and economic decisions.

*

Inertial response can have an immediate and sizable impact on economic variables.

Varying the Degree of Forward-Looking Behavior

*

Degree of forward-looking behavior governed by a single parameter, 4.

*

Expectations = ((rational expectations) + (1 - ()(VAR-based expectations)

*

) = 0 : completely backward-looking
4 = 1 : completely forward-looking

Impact of Forward-Looking Behavior

Optimal Coefficient on Lagged FF Rate
-1.0

Estimated

--

""

-

-

Coefficient on:
Output

Lagged

Gap

FF Rate

2.43

-0.15

3.51

2.42

0.08

1.01

0.60

0.87

0.35

0.19

0.76

0.8

=0

Inflation
3.30

0.4

| = 0.5

0.2

Coefficient
(0.76)

= 1.0

- 0.6
-

0.0
I

0.2

Memo:
Estimated Rule

IIll

0.4

0.6
0

0.8

1.0

Rules also contain a constant term.

January 28-29, 2003

159 of 195
Exhibit 4

Parameter Uncertainty
Implications of Additive Uncertainty

Effects of Additive Uncertainty
r-r*

I

.
*

Amount of uncertainty is not affected by
the policy decision.

*

No effect on "optimal" policy setting.

N
s

N

0

0

Effects of Parameter Uncertainty
r - r*

Output Gap

Implications of Parameter Uncertainty
-

*

Uncertainty about future economic
conditions affected by current
policy decisions.

*

Shade policy actions toward
choices that reduce uncertainty.

0

Parameter Uncertainty in a VAR

Impact of Parameter Uncertainty
Coefficient on:

* VAR captures dynamics of
key macroeconomic
variables.
* Parameter uncertainty
measured by var.-cov.
matrix of coefficients.
* Use VAR to assess effect on
"optimal" policy rule.

Inflation

Output Gap

Lagged
FF Rate

1.48

1.93

0.28

"Optimal" Rule allowing for
Parameter Uncertainty
1.22

1.62

0.45

Memo:
Estimated Rule

0.19

0.76

"Optimal" Rule ignoring
Parameter Uncertainty

0.35

Rules also contain a constant term. "Optimal" rules are approximated as
simple policy rules.

January 28-29, 2003

160 of 195
Exhibit 5

Measurement Error in Macroeconomic Data
Revisions to Real Output Growth Rate*

Revisions to Real Output Growth Rate*
Relative Frequency

0.30

Average Absolute
Revision
(percentage points)

Time Since
Initial Release

0.25
0.20

-2.1
to
-1.6

-1.6
to
-1.1

-1.1
to
-0.6

-0.6
to
-0.1

-0.1
to
0.4

0.61

1 year to 3 years

0.87

S0.0
0.9
to
1.4

1 quarter to 1 year

0.05

N
0.4
to
0.9

0.65

0.10

I
I

Release to 1 quarter

3 years to latest

1.39

0.15

1.4
to
1.9

1.9
to
2.4

Percentage Points
*Initial to one-quarter revision, one-quarter growth, expressed
at an annual rate. Data are from 1965Q3 to 2002Q2.

*One-quarter growth, expressed at an annual rate.

Unobserved Variables

Output Gap Measures*

---

*

A number of important variables are
not directly observed.

*

Estimates subject to significant error
that can be highly persistent.

* Real-time estimates
Most recent estimates

These variables include potential output,
expected inflation, and the equilibrium
real interest rate.

*

Percentage Points

'i \'
*

/'

Real-time Error
[ Std. Deviation

/

\!
I

I

1980

l

1.77

Serial Correlation 0.84
l

1983

i

f

I

I

1986

II I

1989

I

I

I

1992

I

I

I

1995

I

*Staff estimates taken from Greenbooks.

Policy Implications

Impact of Measurement Error
Coefficient on:
Output
Lagged
Inflation
Gap
FF Rate

* No effect if real-time estimate
uncorrelated with subsequent
revisions.
* In practice, large initial
estimates often revised
to be smaller.
* Under such conditions,
attenuate response to

output gap.

Optimal Policy with
No Measurement Error

3.30

2.43

-0.15

Optimal Policy with
Measurement Error

3.50

1.80

-0.16

Memo:
Estimated Rule

0.35

0.19

0.76

Rules also contain a constant term.

I

1998

January 28-29, 2003

161 of 195
Exhibit 6

Summary and Alternative Explanations

Summary of Findings
*

A simple analysis indicates that monetary policy should move more
forcefully and be less inertial than observed.

*

Investigated the sensitivity to three factors -- forward-looking behavior,
parameter uncertainty, and data measurement error.

*

None of the factors alone seems to fully explain the observed
smoothness of the federal funds rate.

*

Caveat: These factors likely interact.

Other Considerations
* Policymakers face uncertainty about
structure of model.
* Economy may demonstrate large,
discrete responses.

Institutional Aspects
*

Policy decisions are made by a
committee.

*

FOMC might seek to avoid reversals.
Frequency of Reversals*

* FOMC may be concerned about
financial fragility.

Estimated Rule

10%

Optimal Rule

51%

*Based on quarterly changes in federal funds rate from
FRB/US simulations.

January 28-29, 2003

162 of 195

Monetary Policy Inertia
Material for a presentation to the FOMC
January 28, 2003
Glenn Rudebusch
Federal Reserve Bank of San Francisco

January 28-29, 2003

163 of 195

Two Types of Monetary Policy Inertia
There is a widespread view among academic and central bank economists that monetary
policy is slowly adjusted in response to information about the economy. Such behavior is
often called "policy inertia," "gradualism," or "interest rate smoothing."
It is important to distinguish types of monetary policy inertia that operate at different
horizons:
Short-term policy inertia:
*

A week-to-week partial adjustment of the policy interest rate. For example, cutting
the funds rate by two 25-basis-point moves separated by several weeks instead of
reducing it all at once by 50 basis points.

*

Breaking up a large interest rate movement into smaller changes may help reduce
any adverse reactions in financial markets; however, this motive appears to operate
at a very short horizon.

*

Such short-term partial adjustment is often apparent, but it is essentially unrelated to
policy inertia at a quarterly frequency.

Quarterly policy inertia:
*

A quarter-to-quarter partial adjustment of the federal funds rate. For example, if the
Fed wanted to increase the funds rate by a percentage point, it would raise the rate by
only about 20 basis points per quarter for the next few quarters.

*

Quarterly monetary policy inertia is the conventional interpretation of the estimated
monetary policy rules that are widespread in the economics literature. For example,
Clarida, Gali, and Gertler (2000, pp. 157-158) describe their empirical estimates of
Fed behavior as ". . . suggesting considerable interest rate inertia: only between 10%
and 30% of a change in the [desired interest rate] is reflected in the Funds rate within
the quarterof the change." [emphasis added]

*

My discussion below refers only to the issue of quarterly gradualism in monetary
policy actions.

Although many have argued that quarterly policy inertia is an important empirical result,
my analysis, in contrast, suggests that the federal funds rate is not adjusted gradually over
several quarters but that the Fed responds promptly to a wide variety of economic
developments.

January 28-29, 2003

164 of 195

Apparent Evidence for Quarterly Policy Inertia

Policy inertia-the view that the funds rate is adjusted at a very sluggish pace over several
quarters-is apparently supported by numerous estimates of monetary policy rules.
*

These policy rules take a partial adjustment form, where the current funds rate can be
expressed as a weighted average of last quarter's actual rate and the current quarter's
desired funds rate. The parameter p-which indicates the amount of inertia-is the
weight on last quarter's funds rate level:
funds ratet = P x funds rate -1 + (1 - p) x desiredfunds rate .
t
t

*

With quarterly data, many estimates put about a ¾ weight on the lagged funds rate
(p = .75) and a ¼ weight on the desired rate. The usual interpretation of this partial
adjustment is that the Fed adjusts the funds rate only 25 percent toward its desired
level in each quarter-a very sluggish policy response.

For example, the FOMC Financial Indicators packet contains two estimated monetary
policy rules: one with and one without policy inertia.
*

Both rules set the desired funds rate on the basis of the Taylor rule, that is, in response
to current readings on the output gap and inflation rate:
desiredfunds ratet = C x output gapt + P x inflationt.

*

The estimated Taylor rule with inertia follows the actual funds rate path much more
closely than the estimated rule without inertia, which apparently supports gradualism.
Percent

10 9 -

,/

/..

6

8

-

Actual funds rate
........ Taylor rule without inertia
Taylor rule with inertia
---

'
"..*
/

5

9

6

k..

-

10

,

5

4 -

4-

3

3

2

2

1

1988

1990

1992

1994

1
1996

1998

2000

2002

January 28-29, 2003

165 of 195

Evidence against Quarterly Policy Inertia from the Yield Curve

A key implication of policy inertia: Future funds rate movements are very predictable.
*

With sluggish partial adjustment, if the funds rate typically is adjusted by only 25
percent toward its desired target in a given quarter, then the remaining 75 percent of
the adjustment will be expected to occur in future quarters.

*

Therefore, a significant amount of policy inertia implies a significant amount of
predictive information in financial markets about the future path of the funds rate.

In fact, funds rate predictability is far lower than quarterly policy inertia implies.
*

If the Fed slowly adjusted the funds rate (if, for example, p = .75), then a regression of
actual changes in the funds rate on predicted changes from financial markets
(eurodollar or fed funds futures) would yield a good fit (i.e., a moderately high R2 ).

*

Many researchers have examined this regression and found little predictive
information about the funds rate in financial markets beyond the next few months.
For example, eurodollar futures have essentially no ability to predict the quarterly
change in the funds rate three quarters ahead (an R2 of zero).

*

The chart below gives the actual path of the funds rate during the past three years and
various expected paths as of the middle of each quarter (based on fed funds futures).
Although the funds rate gradually fell in 2001, market participants anticipated few of
these declines at a 6- to 9-month horizon, as they would have under policy inertia.
Percent
- 8

8
Target federal funds rate

7
6 -

. ..............
..... ::-::......
. -

-''"

5 -

7
.........
Expected funds rate path as of
the middle of each quarter

- 6

'- ............
..

4

5
4

....

3

3 --

:::''.......'.',.
..

2 1 -

- 2
-

2000

2001

2002

1

January 28-29, 2003

166 of 195

The Illusion of Monetary Policy Inertia

How can the estimates of sluggish partial adjustment (specifically p = .75) be explained given
the low amount of funds rate predictability in financial markets?
Answer: The Fed's reaction to information and events outside the scope of the Taylor rule
could be incorrectly interpreted as sluggish policy adjustment.
*

The case for gradualism is that the Taylor rule without inertia appears to fit poorly
because there are large persistent deviations of the actual funds rate from the rule.
The Taylor rule with inertia explains these persistent deviations as a sluggish response
to output and inflation.

*

However, an alternative explanation is that the Taylor rule is an incomplete
description of Fed policymaking and that the Fed responds to other persistent
variables besides current output and inflation. Under this interpretation, the Fed does
not exhibit quarterly policy inertia.

*

These two explanations are difficult to distinguish through direct estimation; however,
the low predictability of the funds rate indicates the absence of inertia.

What "other persistent variables" does the Fed react to so that the funds rate deviates from
the Taylor rule (and induces the illusion of monetary policy inertia)?
Answer: The Taylor rule takes into account current output and inflation; however, the Fed
also responds to other information about the economy including variables that affect the
outlook and credit and financial flows.
*

During 1992 and 1993, when the funds rate was persistently below the Taylor rule
recommendations, Chairman Greenspan stressed the reaction of the Fed to a credit
crunch: "In an endeavor to defuse these financial strains, we moved short-term rates
lower in a long series of steps that ended in the late summer of 1992, and we held
them at unusually low levels through the end of 1993-both absolutely and,
importantly, relative to inflation."

*

For the period during late 1998, Governor Meyer described policy this way: "There
are three developments, each of which, I believe, contributed to this decline in the
funds rate relative to Taylor rule prescription. The first event was the dramatic
financial market turbulence, following the Russian default and devaluation. The
decline in the federal funds rate was, in my view, appropriate to offset the sharp
deterioration in financial market conditions, including wider private risk spreads,
evidence of tighter underwriting and loan terms at banks, and sharply reduced
liquidity in financial markets."

January 28-29, 2003

167 of 195

Two Unresolved Questions
1. How should the Fed's monetary policy decision-making process be modeled?
*

The Taylor rule is an incomplete description of Fed behavior, and more research is
required to characterize other influences and determinants of policy. Adding partial
adjustment to the policy rule is not a solution; instead, partial adjustment is a
misspecification that substitutes for clearer understanding of the policy process.

*

A closely related question is, What kind of lossfunction should represent Fed
behavior? Currently, the policymaker-perfect-foresight (PPF) path in the Bluebook
uses a loss function that assumes the Fed would be equally displeased with: (1) an
unemployment rate one percentage point above the natural rate, (2) an inflation rate
one percentage point above target, and (3) a 100-basis-point decrease in the quarterly
average funds rate. These equal weights place an implausibly high penalty on funds
rate volatility. However, without a substantial penalty on funds rate volatility, the
PPF path does not match the recent historical path of the funds rate, so the high
penalty may be another misspecification that is compensating for some unknown
flaw in our calculations of optimal policy.

*

If policy over the past two decades has been close to optimal, then an important
element is missing from the current specifications used by economists to construct
optimal monetary policy.

2. Should the Fed deviate from its historical behavior and become more aggressive in
changing the funds rate?
*

It may be that our economic models-without interest rate smoothing in the loss
function-are basically correct in finding that under an optimal policy, the Fed
should be more aggressive in reacting to economic news.

*

The analysis above suggests that the Fed has not been sluggish in reacting to
economic developments: It has likely set the funds rate equal to its desired rate in
each quarter. However, there remain questions about whether the desired rate should
react more forcefully to economic news, that is, whether the Fed has been too timid.

January 28-29, 2003

168 of 195

References
Short-term policy inertia:
Dotsey, Michael, and Chris Otrok. 1995. "The Rational Expectations Hypothesis of the Term
Structure, Monetary Policy and Time-Varying Term Premia," Economic Quarterly,Federal
Reserve Bank of Richmond, pp. 65-81.
Goodfriend, Marvin. 1991. "Interest Rates and the Conduct of Monetary Policy." CarnegieRochester Series on Public Policy 34, pp. 7-30.
Rudebusch, Glenn D. 1995. "Federal Reserve Interest Rate Targeting, Rational Expectations,
and the Term Structure." JournalofMonetary Economics 35, pp. 245-274.
Quarterly policy inertia:
Clarida, Richard, Jordi Gali, and Mark Gertler. 2000. "Monetary Policy Rules and
Macroeconomic Stability: Evidence and Some Theory." QuarterlyJournalof Economics 115,
pp. 147-180.
English, William, William Nelson, and Brian Sack. 2002. "Interpreting the Significance of the
Lagged Interest Rate in Estimated Monetary Policy Rules," FEDS working paper 2002-24.
Gerlach-Kristen, Petra. 2002. "Interest-Rate Smoothing: Monetary Policy Inertia or
Unobserved Variables?" manuscript, University of Basel.
Rudebusch, Glenn D. 2002. "Term Structure Evidence on Monetary Policy Inertia and Interest
Rate Smoothing." JournalofMonetary Economics 49, pp. 1161-1187.
Optimal monetary policy:
Levin, Andrew, Volker Wieland, and John C. Williams. 1999. "Robustness of Simple Monetary
Policy Rules under Model Uncertainty." In Monetary Policy Rules, ed. John B. Taylor, pp. 263299. Chicago: Chicago University Press.
Rudebusch, Glenn D. 2001. "Is the Fed Too Timid? Monetary Policy in an Uncertain World,"
Review of Economics and Statistics 83, pp. 203-217.
Rudebusch, Glenn D. 2002. "Assessing Nominal Income Rules for Monetary Policy with Model
and Data Uncertainty," Economic Journal 112, pp. 402-432.
Woodford, Michael. 1999. "Optimal Monetary Policy Inertia." The ManchesterSchool
Supplement, pp. 1-35.

-6-

January 28-29, 2003

Appendix 2: Materials used by Mr. Kos

169 of 195

January 28-29, 2003

170 of 195
Page 1

Current 3-Month Deposit Rates and Rates
Implied by Traded Forward Rate Agreements
November 1, 2002 to January 27, 2003
LIBOR Fixing

3M Forward

6M Forward

9M Forward

Europe
US
Percent

Percent

United States and Euro-area

3.5

3.5
11/6/02
FOMC
-50bps

12/5/02
ECB
-50bps

12/10/02
FOMC

3.0

3.0

2.5

2.5

2.0

2.0

1.5

1.5

1.0
Nov-02

1.0
Dec-02

Jan-03

10-Year U.S. Treasury and German Bund Yields
November 1, 2002 to January 27, 2003

Yield
4.75

4.50

Yield
4.75

11/6/02
FOMC
-50bps

12/10/02
FOMC

4.50

Germany
4.25

4.00

3.75
Nov-02

4.25

12/5/02
ECB
-50bps

Dec-02

4.00

U.S.
3.75
Jan-03

January 28-29, 2003

171 of 195
Page 2

Euro-Dollar Exchange Rate
Dollars per euro

Dollars per euro

January 1, 2002 to January 27, 2003

1.10

1.10

1.05

1.05

1.00

1.00

0.95

0.95

0.90

0.90

0.85
Jan-02

0.85
Mar-02

May-02

Jul-02

Sep-02

Nov-02

Jan-03

Dollar-Yen Exchange Rate
January 1, 2002 to January 27, 2003

Yen per dollar

Yen per dollar

135

135
Japanese Intervention

130

130

125

125

120

120

115
Jan-02

115
Mar-02

May-02

Jul-02

Sep-02

Nov-02

Trade Weighted U.S. Dollar

FRB Major
Currencies Index

Jan-03

FRB Major
Currencies Index

January 1, 1995 to January 27, 2003

115
110
105

115
Percent change in U.S. dollar vs. major components of the index 12/9/02 1/27/03: Canadian dollar -2.31%, yen -4.04%, euro -7.36%, British pound 3.51%, Swiss franc -7.68%, Australian dollar -4.64%, Mexican Peso +6.36%.

110
105

100

100

95
90

95
Daily average
since 1985

90

85

85

80

80

75
Jan-95

Jan-96

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02

75
Jan-03

January 28-29, 2003

172 of 195
Page 3

Corporate Spreads to U.S. Treasuries and Corporate Issuance Data
November 1, 2002 to January 24, 2002
High Yield

Investment-Grade
USD billions Basis Points
975
24

Basis Points
260
240

U.S. Investment Grade
Corporate Bond Index (LHS)

20

Weekly U.S. Investment Grade
Corporate Issuance (RHS)

16

220

USD millions
4000

U.S. High Yield Corporate
Bond Index (LHS)

900

Weekly U.S. High Yield
Corporate Issuance (RHS)

825

12

200

8

180
160

2000
750

4

Nov-02

Dec-02

600

1000

675

0

Source: Lehman Brothers and SDC

3000

Jan-03

Source: Merril Lynch, Reuters and Selected Dealers

Nov-02

Dec-02

0

Jan-03

Monthly Corporate Bond Spreads to U.S. Treasuries
September 3, 2002 to January 24, 2003
Basis Points

Basis Points

1000

250

800

200
U.S. Investment Grade
Corporate Bond Index (RHS)

600

150
U.S. High Yield Corporate
Bond Index (LHS)

400

Source: Merrill Lynch and Lehman Brothers

Jan-00

Apr-00

Jul-00

Oct-00

Jan-01

100
Apr-01

Jul-01

Oct-01

Jan-02

Apr-02

Jul-02

Oct-02

Jan-03

Total U.S. Corporate Debt Issuance
(Investment Grade and High Yield)
2001 to 2002

USD billions
400

USD billions
400

2001 Issuance

350

January Issuance to 1/24:
2001 $108.7 billion
2002 $84.8 billion
2003 $47 billion

2002 Issuance

300
250

350
300
250

200

200

150

150

100

100

50

50

0

0

Source: SDC

Q1

Q2

Q3

Q4

January 28-29, 2003

173 of 195
Page 4

2-Year U.S. Treasury Note
and Fed Funds Target Rate
Percent
2.2

10-Year U.S. Treasury Note
November 1, 2002-January 27, 2003

November 1, 2002-January 27, 2003
11/6/02
FOMC
-50bp

Percent Percent
2.2 4.6

12/10/02
FOMC

Percent
4.6

12/10/02
FOMC

11/6/02
FOMC
-50bp

2.0

4.4

1.8

1.8

4.2

1.6

1.6

4

1.4

3.8

3.8

1.2

3.6

3.6

2

4.4

2-Year Note

Fed Funds
Target Rate

1.4
1.2
Nov-02

Dec-02

4.2
4

Nov-02

Jan-03

Dec-02

Jan-03

Basis
Points

U.S. Treasury Yield Curve Spreads

Basis
Points

January 1, 1991 to January 27, 2003

500

500
30-year - 3-month

400

400

300

300

200

200
10-year - 2-year

100

100

10-year- 3-month

0

0
-100
Jan-91

Jan-92

Jan-93

Jan-94

Jan-95

Jan-96

Jan-97

Jan-98

S&P 500 Index
Index
950

November 1, 2002-January 27, 2003
11/6/02
FOMC
-50bp

12/10/02
FOMC

Jan-99

Jan-00

Jan-01

Jan-02

S&P 100 Volatility Index (VIX)
November 1, 2002-January 27, 2003
Index Percent
950 40

925
900

900 30

875

875 25

850

Percent
40

12/10/02
FOMC

925 35

850 20

Nov-02

Dec-02

Jan-03

-100
Jan-03

35
30

11/6/02
FOMC
-50bp

Nov-02

25
20
Dec-02

Jan-03

January 28-29, 2003

174 of 195
Page 5

Global Equity Indices

Index
11/1/02=100

Index
11/1/02=100

November 1, 2002 to January 27, 2003

112

112

Dow Jones Euro Stoxx

108

108

104

S&P 500

104

100

100

96

96

92

92

German DAX
11/6/02
FOMC
-50bps

88

12/5/02
ECB
-50bps

88

84

84

80
Nov-02

80
Dec-02

Jan-03

10-Year European Sovereign Debt Spreads over German Bunds
November 1, 2002 to January 27, 2003

Basis Points
30

25

11/6/02
FOMC
-50bps

Basis Points
30

12/5/02
ECB
-50bps

25

Italy
20

20

15

15

Spain
10

10

France
5

5

0
Nov-02

0
Dec-02

Jan-03

10-Year European Sovereign Debt Spreads over German Bunds
France
Italy
Spain

1993-99
26bps
288
247

1997-99
0.13bps
73
49

January 28-29, 2003

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Page 6

Domestic Portfolio: Permanent SOMA Holdings, Long-Term RPs, & Net Short-Term Operations
(July 2002 to February 2003. Maintenance-Period Average Values, billions of dollars)
$ Billions

$ Billions
Level of Entire Portfolio (reflects level of all net autonomous
factors plus total Fed balances, net of borrowing)

660

665

Forecast

665

655

660
655

650

650

645

645

640

640

Short-Term Operations

635

635

Long-Term RP’s

630

630

625

625

620

620

Permanent SOMA

615
19-Feb

5-Feb

22-Jan

8-Jan

25-Dec

11-Dec

27-Nov

13-Nov

30-Oct

16-Oct

2-Oct

18-Sep

4-Sep

21-Aug

610
7-Aug

24-Jul

10-Jul

Source: FRBNY

26-Jun

610

615

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Appendix 3: Materials used by Mr. Slifman, Mr. Struckmeyer, and Ms. Johnson

January 28-29, 2003

STRICTLY CONFIDENTIAL (FR) CLASS I-FOMC*

Material for

Staff Presentation on the
Economic Outlook
January 28, 2003

*Downgraded to Class II upon release of the February 2003 Monetary Policy Report.

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Chart 10

Financial Developments
Nominal Exchange Rates

Ten-Year Sovereign Bond Yields

Foreign currency/U.S. dollar

Index**

110

Weekly

Percent
Weekly

6

Germany
Major currencies*

100
4

Yen

United States
90

Euro

2
80
Japan

2001

2002

2003

70

2001

2002

2003

0

* Trade-weighted average against major foreign currencies.
**Week of January 28, 2002 = 100.

Three-Month Euro Futures Rates

Three-Month Yen Futures Rates
Percent

Percent

5.0

2.0

January 29, 2002
4.5
1.5
4.0

June 25, 2002

3.5

1.0

3.0
2.5

June 25, 2002

January 29, 2002

0.5

January 27, 2003

January 27, 2003
2002

2003

2004

2.0

Stock Prices

2002

2003

2004

0.0

U.K. Housing Prices*
Index, June 25, 2002 = 100

Weekly

Index, 2001:Q1 = 100

160
150

140

Monthly
130

140
130
DJ Euro Stoxx

120

120
110
S&P 500

110

100
90

TOPIX

100

80
2001

2002

2003

70

2001

2002

*Nationwide building society house price index.

90

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Chart 11

Foreign Outlook
Real GDP

Total Employment
Percent change, SAAR*

Index, Jan. 2001 = 100

6

110

Monthly

U.S.
Total foreign**

5
Canada

4
3

Dec.

105

100

Japan

Nov.

2

Nov.

Euro Area

95

1

2002

2003

0

2004

2001

2002

2003

90

*Years are Q4/Q4; half years are either Q2/Q4 or Q4/Q2.
**U.S. total export weights.

Orders*

Long-Term Earnings Growth Forecast - Euro Area*
Index, Jan. 2001 = 100

Percent per annum

110

18

Monthly
Nov.

Canada

100

16

90

14

80

12

Nov.
Germany

Nov.
Japan

2001

2002

2003

70

1996

1997

1998

1999

2000

2001

2002

*Manufacturing orders for Canada and Germany, private core
machinery orders for Japan.

*5-year earnings growth forecast constructed from I/B/E/S survey
of analysts.

2003 Real GDP Contributions

Real GDP Growth

Percentage points, Q4/Q4

3

Percent, SAAR*

Total Domestic Demand
Net Exports

2002
2003
2004
H2 H1 H2
2

Canada

2.6

1.3

1.3

1.9

2.6

3. Japan

1.7

0.4

0.6

0.9

2.5

2.8

3.1

3.1

5. United Kingdom
Japan

2.4

4. Canada

Euro Area

2.0

2. Euro Area
1

1. Indust. countries** 2.1

2.8

2.2

2.5

3.0

0
*Years are Q4/Q4; half years are Q2/Q4 or Q4/Q2.
**U.S. total export weights.

10

January 28-29, 2003

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Chart 12

Emerging Market Countries
Asia
Nominal Exchange Rates

Stock Market Indexes

Foreign currency/U.S. dollar Index, Jan. 5, 2001 = 100

Index, Jan. 5, 2001 = 100

110

Weekly

175

Weekly
150

105

Singapore dollar

125
Korea

100

100

Korean won
Singapore

95

75

Hong Kong

2001

2002

2003

90

50
2001

CPI Inflation

2003

Real GDP Growth

Percent, SAAR*

2002

Percent, SAAR*

2002
2003
2004
H2 H1 H2
1. Developing Asia** 0.5

1.7

1.8

2002
2003
2004
H2 H1 H2

1.8

1. Developing Asia** 3.4

of which:

5.1

5.4

5.8

of which:

2.

China

-0.9 -0.8

1.0

1.2

2.

China

7.3

7.5

7.5

7.7

3.

Korea

3.0

4.3

3.0

3.0

3.

Korea

5.1

5.1

5.4

5.5

4.

Taiwan

-1.0

1.9

1.8

1.8

4.

Taiwan

1.2

3.9

4.8

5.3

5.

Singapore

0.1

1.6

1.3

1.2

5.

Singapore

-4.5

5.2

5.8

6.8

*Years are Q4/Q4; half years are Q2/Q4 or Q4/Q2.
**U.S. total export weights.

*Years are Q4/Q4; half years are Q2/Q4 or Q4/Q2.
**U.S. total export weights.

Latin America
EMBI+ Spreads

Real GDP Growth
Percentage points

75

25

Percent, SAAR*

Weekly

2002
2003
2004
H2 H1 H2

65
20

55
Argentina

1. Latin America**

45
15

2.7

3.7

4.3

of which:

35

2.
10

15

2001

2002

2003

Mexico

2.8

3.7

4.3

5.0

3.

Brazil

2.4

1.5

2.0

2.0

4.

Brazil

25

5

2.5

Argentina

0.5

1.2

1.2

1.9

5
*Years are Q4/Q4; half years are Q2/Q4 or Q4/Q2.
**U.S. total export weights.

January 28-29, 2003

190 of 195
Chart 13

External Sector
Real Exchange Rate Outlook

Real Growth of Exports, Imports

Index, 2001:Q1 = 100

Percent change, Q4/Q4

105

10

Exports
Imports
5

Jun. 02 Greenbook
Broad Index

100
0
Jan. 03 Greenbook

-5
95
-10

2001

2002

2003

2004

90

2001

2002

2003

-15

2004

Financial Flows

Current Account
Percent

Billions of dollars

1

Billions of dollars

2001 2002p

100

1. Current account
Level

-499

-104

7

97

90

3. For. purch. U.S. sec.

-1

-393

Chng

404

361

-43

4. U.S. purch. for. sec.

-95

0

95

3

-74

-77

-100

Selected financial flows:*
-3

-300

Percent of GDP

-5

-500

-7

2. Foreign official

-700

5. Net direct investment
1996

1998

2000

2002

2004

* Projections for lines 2 through 4 incorporate TIC data through
November, and, for line 2, FRBNY data for December.

Simulation Results
(Real GDP Growth, Deviation from Baseline; Percent change, Q4/Q4)

Potential Iraq War*

Greenbook Alternative*

2003
1. Euro Area
2. Japan
3. Canada
4. Mexico
5. Taiwan
6. Korea

* Limited embargo case.

2004

-0.3
-0.7
-0.7
-0.5
-0.1
0.5

0.2
0.4
0.4
0.1
0.6
0.9

2003
1. Euro Area
2. Japan
3. Canada
4. Mexico
5. Taiwan
6. Korea

* With confidence effects.

2004

-1.3
-2.2
0.1
0.9
-2.7
-4.5

1.0
0.8
-0.7
-1.9
2.3
5.8

January 28-29, 2003

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Chart 14
1/28/03

ECONOMIC PROJECTIONS FOR 2003

FOMC
Range

Central
Tendency

Staff

-------------Percentage change, Q4 to Q4-----------Nominal GDP

4¾ to 5

4.8

(5 to 5¾)

4½ to 5½

(July 2002)

(5.6)

(4½ to 6)

3¼ to 3½

Real GDP
(July 2002)

3 to 3¾

3.6

(3½ to 4)

(4.1)

(3¼ to 4¼)

1¼ to 1½

PCE Prices
(July 2002)

1¼ to 1¾

1.3

(1½ to 1¾)

(1.4)

(1 to 2¼)

--------------Average level, Q4, percent--------------Unemployment rate

5¾ to 6

6.1

(5¼ to 5½)

5¾ to 6

(July 2002)

(5.5)

(5 to 6)

Central tendencies calculated by dropping high and low three from ranges.

January 28-29, 2003

Appendix 4: Materials used by Mr. Reinhart

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January 28-29, 2003

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Exhibit 1

Expected Federal Funds Rates*

MMS Survey
(Percentage of Respondents)

Percent

FOMC Meeting
Balance
of Risks

January

March

May

Weakness

14

14

16

Neutral

86

83

74

Inflation

0

3

10

December 9, 2002

Jan.

May Sept.
2003

Feb.

June
2004

Oct.

Feb.
2005

*Estimates from federal funds and eurodollar futures

Treasury Forward Rates
(Change Since Last FOMC Meeting)
Basis points

Commodity Prices*

Stock Prices*
120 125

Daily

120
110 115

'/

110
100
105

Gold

Oil

90 100
90

...

95
I

Oct.
1

2

3 5 7
Years Ahead

I

I

Nov.

10 20

I

Dec.

Oct.

Jan.

2002

Nov.

*October 1, 2002= 100,

Corporate Risk Spreads
F

Jan.

2002

October 1, 2002 = 100.

1200

Dec.

Basis Points
High-yield Spreads
(Selected Sectors)

Daily

Basis Point Change
Since Last FOMC

1000

Telecom/Energy

800

Other

BBB
(right sc

-163
-4

600
400

1990

1991

1992

1993

1994

Note: Solid vertical lines indicate December 9, 2002.

1995

1996

1997

1998

1999

2000

2001

2002

2003

January 28-29, 2003

194 of 195

Exhibit 2
Policymaker Perfect Foresight Strategy for Monetary Policy

Real Federal Funds Rate¹

Nominal Federal Funds Rate

Percent
-- 6

Percent

.........
- - - -

2001

2002

2003

Greenbook
1 percent inflation goal
1-1/2 percent inflation goal

2004

2005

2006

2007

2008

2001

2002

2003

2004

2005

2006

2007

2008

Civilian Unemployment Rate
Percent
6-

4

4
2001

2002

PCE Inflation (ex. food and energy)
(Four-quarter percent change)
Percent

--

2001

2002

2003

2004

-

2005

-

- --

- -

-

-

---------

2006

'"

c-

2007

The perfect foresight simulations extend the key assumptions of the staff outlook (other than the path for monetary policy) through 2008:
*potential output grows at about 3-3/4 percent per year
*the relative price of oil stabilizes at its end of 2004 level
*the exchange value of dollar measured in real terms falls at a 3 percent clip
*federal budget deficit relative to GDP declines moderately
1. The real federal funds rate is calculated as the quarterly average nominal funds rate minus the four-quarter lagged core PCE inflation
rate as a proxy for inflation expectations.

January 28-29, 2003

195 of 195
Exhibit 3
Actual Real Federal Funds Rate and
Range of Estimated Equilibrium Real Rates
Percent

Quarterly

Actual Real Funds Rate

Historical Average: 2.70
(1966Q1-2002Q4)

TIIS-Based Estimate

SCurrent

Rate
* 25 b.p. Easing

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

Note: The shaded range represents the maximum and the minimum values each quarter of four estimates of the equilibrium
real federal funds rate based on a statistical filter and the FRB/US model. Real federal funds rates employ four-quarter lagged
core PCE inflation as a proxy for inflation expectations, with the staff projection used for 2002Q4 - 2003Q1.


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102