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Strictly C onfide ntial (F.R.)
Class II – FOMC

January 26, 2001

M ONETARY P OLICY A LTERNATIVES
Recent D evelopm ents
(1)

Interest rates backed up slightly and equity markets sold off following

the annou ncement th at the FOM C had left the sta nce of policy un changed at its
December meeting.1 However, yields generally declined over subsequent days, as the
wording o f the Com mittee’s annou ncement an d weaker eco nomic da ta apparently
fostered a sense that an easing of monetary policy was imminent. Even so, the timing
and size of the FOM C’s 50 basis point cut in the target federal funds rate on January 3
surprised market participants, and many inferred that additional monetary easings
would occur sooner than they had expected. Over the entire intermeeting period,
interest rates on sh ort-term Tre asury securities an d the highest-g rade private de bt fell
substantially, in some cases by nearly a percentage point, with only a small portion of
the declines on private debt reflecting an unwinding of year-end premiums. Current
futures quotes indicate that investors place high odds on an additional 50 basis point
easing at this m eeting and an ticipate that the fede ral funds rate w ill be about 125 basis
points below its current level by year-end (chart 1). Howev er, options quotes suggest
a relatively high degree of uncertainty about this ex tended outlook.
(2)

The Committee’s action and the market’s inference about the likelihood

1. Federal funds traded at rates near the FOMC’s targets over the intermeeting period,
except on the last business day of the year. On that day, the Desk’s generous reserve
provision pushed the effective rate down to 5.41 percent, a fairly typical deviation from
target for a year-end. Since the last FOMC meeting, the Desk has redeemed $1.8 billion of
Treasury securities, mostly Treasury coupon issues, to continue bringing SOMA holdings
into conformance with the per-issue limits. In part to offset the resulting reserve drain, the
Desk purchased $3.5 billion of Treasury coupon securities in the market and $670 million of
Treasury bills from foreign custom ers. To accom modate the seasonal runo ff in currency, it
trimmed the volume of outstanding long-term RPs by $9 billion, to $13 billion.

Chart 1
Financial Market Indicators
Expected Federal Funds Rates Estimated from
Percent
Financial Futures*
December 18, 2000
January 26, 2001

Selected Treasury Yields
Percent
7.00

7.00

Daily

6.75

6.75

6.50

6.50

Two-year

6.25

6.25

6.00

6.00

5.75

5.75

5.50

5.50

Ten-year

5.25

5.25

5.00

5.00

4.75

4.75

4.50
Jan

Apr

Jul
2001

Oct

Jan

Apr

Jul
2002

4.50

Oct

Jun

Jul

Aug

Sep
2000

Oct

Nov

Dec

Jan

*Estimates from federal funds and eurodollar futures rates with an
allowance for term premia and other adjustments.

Selected Equity Indexes

Selected Private Long-Term Yields
Index(5/31/00) = 100

Daily

Wilshire 5000

Percent
130

14

120

13

110

12

100
DJIA

90

10
Corporate BBB
(right scale)

11

Sep
2000

Oct

Nov

8
7

Ten-year Swap
(right scale)

Thirty-year
Mortgage
(weekly, right scale)

70
Dec

Jan

Jun

Selected Risk Spreads*
Basis Points
800

Daily

9

10

8

Nasdaq

Aug

11

High Yield
(left scale)

9

Jul

12

Daily

80

Jun

Percent

Jul

Aug

Sep
2000

Oct

Spread of Low-Tier CP Rate
over High-Tier CP Rate*

Nov

6

Dec

Jan

Basis Points
160

Daily

2000
1998-1999
1995-1997

700

140

600

120

500

100

400

80

300

60

200

40

High Yield

BBB

20

100
Jun

Jul

Aug

Sep
2000

Oct

Nov

Dec

Jan

*These spreads are the difference between the yields on the Merrill Lynch
175 and BBB indexes and that on the Merrill Lynch AAA index.

Oct

Nov

Dec

Jan

*30-day nonfinancial, A2/P2 rate less AA rate.

Note: Solid vertical line indicates last FOMC meeting. Dashed vertical line indicates January 3 cut in target federal funds rate.

2

of future easings apparently contributed to a sense that the odd s of a prolonged
period of economic w eakness had diminished. This revision to sentim ent bolstered
equity markets, with broad equity price indexes increasing, on balance, over the
intermeeting period despite further substantial dow nward revisions to analysts’ nearterm earnings expectations. Moreover, yields on lower-tier investment-grade bonds
and junk b onds fell 35 and 116 basis poin ts, respectively. The ab atement of safe
haven demands, along with heightened prospects for a large tax cut and perhaps some
increase in inflation compensation, contributed to a sm all rise in longer-term Treasury
yields. In some segments of financial markets, however, concern s about risk appeared
to escalate. Results fro m the Janu ary Senior L oan Officer O pinion Su rvey indicate
that a majority of banks have further tightened their standard s and terms on business
loans. Moreover, risk spreads on lower-rated com mercial paper have widened
significantly since early January, as the defaults of California utilities, along with the
earlier downgrades of other prominent commercial paper issuers, seem to have
increased investo r wariness. To d ate, fallout from th e difficulties of the C alifornia
utilities has been limited, although rating agencies have announced that the debts of
some corporations and municipalities affected by the West Coast electricity situation
have been downg raded or are being mon itored for possible downgrade.
(3)

In December, overall business debt grew at a moderate pace, but the

patterns of financing continued to reflect heightened investor concern s about risk
(chart 2). Although issuance of investment-grade bonds was brisk, virtually no
equities or junk bonds were bro ught to market. Bank bu siness loans grew rapidly,
with the adv ance owing partly to lower -rated comm ercial paper issuers temporarily
drawing down lines of credit at banks to avoid paying high year-end premiums, and
comm ercial paper ou tstanding declin ed. Since the inter meeting po licy move in ea rly
January, a substantial volume of corporate bo nds, including a number o f junk bonds,

Chart 2
Financial Flows and Exchange Rates
S&P 500 Volatility*

M2 Growth
Percent
Annualized

Percent
35

14

Daily

12

p

30

10
25

8
6

20

4
15
2
10

0
1999

2000
H1

2000
Q3

O N D

1999

J

2000

*30-day rolling standard deviation of the
daily percentage change.

p - Preliminary.

Growth of Debt of Domestic Nonfinancial Sectors
Business Debt

Total Debt

Sum of Selected Components*

Percent

Annualized

Percent

14

Annualized

14

12

12

10

10

8

8

6

6
p

4

4

2

2

0
1999

2000
H1

2000
Q3

0

O N D

1999

2000
H1

2000
Q3

O N D

p - Preliminary.

*Bonds, commercial paper, and C&I loans.

Nominal Trade-Weighted Dollar Exchange Rates

Index(9/1/99) = 100
114

Daily

112
Broad
Index

110

Other Important
Trading Partners

108
106

Major
Currencies
Index

104
102
100
98

Sep

Oct Nov
1999

Dec

Jan

Feb

Mar

Apr

May

Jun
Jul
2000

Aug

Sep

Oct

Nov

Dec

Jan

Solid vertical line indicates last FOMC meeting.
Dashed vertical line indicates January 3 cut in target federal funds rate.

MARA:SF

3

has been issued in response to lower yields in more receptive markets. Business loans
have continued to advance briskly in January, likely boosted by further substitution
out of the commercial paper market. With lower-rated borrowers dissuaded by
elevated interest rates and unable to issue at maturities beyond a few days, the
outstanding amount of commercial paper has continued to run off in January. In the
household sector, consum er credit is estimated to have decelera ted sharply in
December , and bank loan data sugg est con tinued moderation early this yea r.
Mortgage grow th is estimated to have remained relatively strong, however, supp orted
by declines in m ortgage rates. Fed eral debt contin ued to contr act late last year and in
January. Data for debt growth in recent months are partial and preliminary, but on
balance it appears that nonfederal and total debt expanded at a moderate pace, similar
to that recorded in the third quarter of last year.
(4)

M2 growth p icked up sharply in Decem ber and appears to have risen

further in January. 2 The strength likely reflects in part investors’ decisions to seek the
safety and liquid ity of M2 assets, suc h as retail mon ey funds and liquid depo sits, in
response to the rise in equity market volatility in November and December. Also, the
recent declines in s hort- and inter mediate-term rates have narro wed the op portunity
cost of holding M2. M3 has grown even more rapidly than M2, boosted in part by
faster issuance of large time deposits to fund a pickup in bank credit, which
accelerated to an 11 percent annual growth rate in December. In addition,
institutional m oney funds h ave ballooned as their yields, which adjust to chan ges in
market rates with a lag, have become m ore attractive with the fall in short-term
market interest rates.
(5)

While the w eaker econom ic outlook in th e United Sta tes, along with

2. Money stock data incorporate revisions from the annual benchmark and seasonal review
and are confidential until their release on February 1.

4

lower interest rates, tended to put downward pressure on the foreign exchange value
of the dollar, economic stagnation in Japan exerted a countervailing influence. Since
the December FOMC meeting, the dollar was about unchanged, on net, against the
currencies of the major industrialized countries. The dollar lost 3 percent of its value
relative to the euro , on net, as econom ic growth in E urope cam e to be seen as likely to
outpace that in the United States. The dollar also depreciated vis-à-vis the Canadian
dollar as the momentum in domestic spending and the prospect of considerable fiscal
stimulus in Canada were thought likely to cushion the impact on Canadian exports of
softening U.S. aggregate demand. By contrast, incoming economic data for Japan
proved disappointing to hopes that economic recovery had gained a foothold, and the
dollar appreciated 4½ percent against the yen over the intermeeting period. The bleak
Japanese economic picture revived talk that the Bank of Japan may return its official
interest rate, now at ¼ percent, to zero, and money market futures rates, as well as
longer-term yields, shifted down a touch. The exchange value of the dollar rose about
1 percent against a basket of cur rencies of our other important tradin g partners.
General con cerns about th e effects on Latin A merica of a slow ing in U.S. gro wth
supported the dollar relative to the Mexican peso and the Brazilian real. The
currencies of m any Asian em erging mar ket econom ies that are viewed as especially
vulnerable to a slowing in global demand for electronic goods also slipped against the
dollar. Still, in most emerging markets, bond spread s narrowed somew hat, and prices
rose in equity m arkets. U.S. autho rities did not interv ene in foreign ex change m arkets
over the intermeeting period;

.

5
MONEY AND CREDIT AGGREGATES
(Seasonally adjusted annual percentage rates of growth)
Oct. 2000

Nov. 2000

Dec. 2000

Jan. 2001 (p)

M2

5.5

4.2

9.6

11.2

M3

4.4

4.2

12.5

15.7

3.1
-10.0
6.2

4.7
-9.2
7.9

4.6
-6.7
7.2

n.a.
n.a.
n.a.

-6.0
-5.1

2.7
4.0

14.4
11.0

7.3
4.0

4.2
4.6

0.4
0.9

5.0
5.2

19.8
18.9

Money and Credit Aggregates

Domestic nonfinancial debt
Federal
Nonfederal
Bank credit
Adjusted1
Memo:
Monetary base2
Adjusted for sweeps

1. Adjusted to remove the effects of mark-to-market accounting rules (FIN 39 and FASB
115).
2. Adjusted for discontinuities associated with changes in reserve requirements.
p -- preliminary

6

Longer-Term Strategies
(6)

This section co nsiders longer -term strategies for m onetary policy a s well

as the policy implications of several of the alternative scenarios presented in the
Greenbook. 3 All of the charts include a baseline scenario in which the Greenbook
forecast is extended through 2005 using the FRB/US model, adjusted to preserve the
key characteristics of th e econom y embod ied in the judg mental foreca st. In this
extension, poten tial supply is assum ed to expand at the same rate as in 2002, with
structural labor productivity growth continu ing at 3 percent per year. The earlier
acceleration of structural productivity had helped to hold d own price increases
because efficiency gains outpaced the lagging pickup in real wages. But with the
leveling out of structural productivity growth, this disinflationary effect wanes, and the
degree of labor market slack consistent with steady inflation (the effective NAIRU)
edges up from about 4¾ percent currently to about 5¼ percent by 2005.4 Also after
2002, the federal surplus on a NIPA basis remains roughly stable at its current value
of about 2 p ercent of GD P. The dollar is p redicted to dep reciate at a 5 percen t rate
per year in real terms, and foreign econom ic growth picks up som ewhat. Together,
these last two factors roughly stabilize the ratio of the current account deficit to GDP.
(7)

In the alternative strategies for monetary policy shown in chart 3, the

baseline policy keeps the federal funds rate unchanged at 5¾ percent beyond 2002. In
contrast to the conditions underlying the long-run scenario section of a number of
bluebook s in recent years, pote ntial supply an d aggregate d emand ar e approxim ately
in balance at the end of the Greenbook forecast in 2002, and little impetus to raise or
lower inflation rates is in the pipeline. Moreover, the real federal funds rate at that

3. See pages I-13 to I-15 of the January 2001 Greenbook.
4. Past 200 5, the effective N AIRU would b e expected to rise somew hat further and settle
in at its long -run va lue of 5½ percen t.

Chart 3
Alternative Strategies for Monetary Policy
Real Federal Funds Rate1

Nominal Federal Funds Rate
Percent

Percent

7.0

Percent

Percent

7.0

5.5

6.5

5.0

6.0

6.0

4.5

4.5

5.5

5.5

4.0

4.0

5.0

5.0

3.5

3.5

4.5

4.5

3.0

3.0

4.0

2.5

Baseline
Taylor Rule2
Price Stability

6.5

4.0

2000

2001

2002

2003

2004

2005

5.5
Baseline
Taylor Rule
Price Stability

2000

2001

2002

2003

2004

2005

5.0

2.5

Civilian Unemployment Rate
Percent

Percent

7

7
Baseline
Taylor Rule
Price Stability

6

6

5

5

4

4

3

2000

2001

2002

2003

2004

3

2005

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

Percent

2.5

2.5
Baseline
Taylor Rule
Price Stability

2.0

2.0

1.5

1.5

1.0

1.0

0.5

2000

2001

2002

2003

2004

1. The real federal funds rate is calculated as the quarterly nominal funds rate minus
the four-quarter percent change in the PCE chain-weight price index excluding food and energy.
2. The Taylor rule uses a concept of potential output corresponding to the effective NAIRU, rather than corresponding to
the long-run NAIRU as in the original specification of the Taylor rule.

2005

0.5

7

time is close to its eq uilibrium lev el (recognizing , of course, the cons iderable
uncer tainty that surroun ds this and all other aspects of our projection s).
Consequently, under this policy, the unemployment rate remains in the vicinity of the
effective NAIRU from 2002 to 2005, and core PCE inflation is little changed. The
Taylor rule policy sets the federal funds rate in response to core PCE inflation and the
gap between actual output and the level of output consistent with the effective
NAIRU.5 The equilibrium real interest rate used in the rule is that implicit in the
extended Greenboo k baseline (slightly above 4 percent), while targeted inflation is set
at 1½ perce nt. As show n by the dot-d ash lines, the path fo r the federal fund s rate
given by the Taylor rule follows the baseline assumption reasonably closely, although
the nomin al and real federa l funds rates are a b it lower in the n ear term and a bit
higher later.6 With the price stability policy, the Co mmittee p laces inflation on a path
to virtual price stability–as measured by core PCE inflation at a 1 percent rate. In
order to accomplish this objective, policy has to be tighter than the baseline at some
point. In the alternative shown, the funds rate is kept at its current 6 percent level for
a time so that the required tightness occurs early in the simulation period, and thus
inflation is on a perceptible downward track beginning in 2002.
(8)

Chart 4 presents alternative supply-side scenarios. The 4 percent

NAIRU scenario has be en designed to explain the go od perform ance of inflation in
recent years in terms of a permanently lower long-run NAIRU, rather than on the
basis of transitory effects o f accelerating pro ductivity. Again , monetary po licy is
assumed to follow a Taylo r rule, but one th at incorporate s a lower inflation target

5. In the policy rule, coefficients on the contemporan eous output and inflation gaps are
equal to ½.
6. In 2005, the Taylor rule has not yet stabilized the economy at targeted inflation and an
output gap of zero, but would do so in the longer run.

Chart 4
Alternative Supply-Side Scenarios
Real Federal Funds Rate1

Nominal Federal Funds Rate
Percent

Percent

7.0
6.5

Percent
7.0

Baseline (chart 1)
4 Percent NAIRU
Productivity Slowdown

Percent

5.5

5.5
Baseline (chart 1)
4 Percent NAIRU
Productivity Slowdown

6.5

5.0

6.0

6.0

4.5

4.5

5.5

5.5

4.0

4.0

5.0

5.0

3.5

3.5

4.5

4.5

3.0

3.0

4.0

2.5

4.0

2000

2001

2002

2003

2004

2005

2000

2001

2002

2003

5.0

2004

2005

2.5

Civilian Unemployment Rate
Percent

Percent

7

7
Baseline (chart 1)
4 Percent NAIRU
Productivity Slowdown

6

6

5

5

4

4

3

2000

2001

2002

2003

2004

3

2005

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

Percent

2.5

2.5

Baseline (chart 1)
4 Percent NAIRU
Productivity Slowdown

2.0

2.0

1.5

1.5

1.0

1.0

0.5

2000

2001

2002

2003

1. The real federal funds rate is calculated as the quarterly nominal funds rate minus
the four-quarter percent change in the PCE chain-weight price index excluding food and energy.

2004

2005

0.5

8

(1 percent) than was used in the baseline’s Taylor rule, as the Com mittee takes
advantage of the “opportun ity” of emerging slack to make further pro gress toward
price stability.7 As shown by the d ot-dash line, the federal funds rate is eased
aggressively over the next two years to limit the rise in the unemployment rate, but the
lower NAIRU means that a decline in inflation to 1 percent still can be achieved. The
productivity slowdown scenario retains the staff view of the NAIRU and the role of
changes in structural productivity growth in the inflation process, but assumes that the
rate of structural productivity growth going forward falls permanently to 1½ percent
(its 197 3-94 av erage) rather than continuing to run at 3 percent a s in the baselin e.
Slower trend growth raises the effective NAIRU sharply, which puts upward pressure
on inflation, but it also weakens demand; on balance, demand is restrained more than
potential supply relative to the baseline, lowering the equilibrium real interest rate. If
policy follows th e Taylor rule, as assu med in this sce nario, the federal fu nds rate drifts
down, but by less than the decline in the equ ilibrium real funds rate in order to check
the rise in inflation.
(9)

Chart 5 con siders the imp lications of alternative demand-side

scenarios presented in the Greenboo k, but under the assumption th at monetary
policy follows the Taylor rule. In the recession scenario (dot-d ash lines), weakne ss in
aggregate demand is more pronounced than in the baseline by enough to push the
econom y into an outr ight recession. Th e downw ard impetu s to deman d reverses fully
during 2002. As show n, the unemploymen t rate rises to 6 percent in 2002 even
though the federal funds rate is reduc ed to about 4½ percent by the end of 2001.
Even with the unemployment rate rising well above the effective NAIRU, inflation

7. The rule also incorporates a slightly lower equilibrium real interest rate that arises on
account of an increase in potential output that is not accompanied by a corresponding
increase in government spending or foreign GDP.

Chart 5
Alternative Demand-Side Scenarios
Real Federal Funds Rate1

Nominal Federal Funds Rate
Percent

Percent

7.0

Percent

Percent

7.0

5.5

6.5

5.0

6.0

6.0

4.5

4.5

5.5

5.5

4.0

4.0

5.0

5.0

3.5

3.5

4.5

4.5

3.0

3.0

4.0

2.5

Baseline (chart 1)
Recession
Growth Pause

6.5

4.0

2000

2001

2002

2003

2004

2005

5.5

Baseline (chart 1)
Recession
Growth Pause

2000

2001

2002

2003

5.0

2004

2005

2.5

Civilian Unemployment Rate
Percent

Percent

7

7
Baseline (chart 1)
Recession
Growth Pause

6

6

5

5

4

4

3

2000

2001

2002

2003

2004

3

2005

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

Percent

2.5

2.5
Baseline (chart 1)
Recession
Growth Pause

2.0

2.0

1.5

1.5

1.0

1.0

0.5

2000

2001

2002

2003

1. The real federal funds rate is calculated as the quarterly nominal funds rate minus
the four-quarter percent change in the PCE chain-weight price index excluding food and energy.

2004

2005

0.5

9

increases slightly in 2002 as lower interest rates induce a steeper drop in the exchange
value of the dollar than in the baseline, raising import prices. In the growth pause
scenario, the near-term weakness in aggregate dem and stems solely from excess
business inventories and not als o from a slow ing in final deman d, as in the baseline.
After excess inventories are worked off, the greater underlying strength in final
demand shows through to aggregate output growth. As shown by the dotted line, the
Committee lowers the federal funds rate to 5¾ percent in the current quarter but
promptly reverses this action. With final demand persistently stronger than in the
baseline scenario, after 2001 both nominal and real interest rates need to rise further.

10

Mediu m-term Projections o f M2 G rowth
(10)

This section b riefly reviews the gr owth of M 2 last year and pr esents staff

projections for the next tw o years that are consistent with the Gr eenbo ok forecast.
(See table below.) Since the mid-1990s, in contrast to earlier in that decade, the
demand for this aggregate has conformed fairly well on average with historical
relationships to opportunity cost and spending (chart 6). In that context, analysis of
the deviations of M2 grow th from projections, against the backdrop of oth er
developments in financial markets, could be helpful in understanding the evolution of
financial conditio ns and their im plications for the e conomic o utlook. Mo reover, in
the very long run, trends in M2 an d prices should be related.
Growth Rates of M 2 and M 2 Velocity
(in percent)
Actual

(11)

Projected

2000

2001

2002

M2

6.1

5½

5½

V2

0.0

-1½

0

Memo:
Nominal
GDP

6.1

3¾

5½

Even though velocity and opportunity cost have moved together on

average over recent years, significant divergences also are apparent that may be related
in part to the unusual behavior of the eq uity market. Beginning in 1996, investors
apparently be gan to view e quity returns a s quite attractive, and flows into equ ity
mutual funds surged at the exp ense of M2, with the result that velocity trended higher
through mid-1997. H owever, velocity subsequently moved back down as the further
runup of equity prices boosted stock m arket wealth appreciably relative to income,

Chart 6
Percentage points

Ratio scale

M2 Velocity and Opportunity Cost

2.2

8
M2 Velocity
(Right scale)

4

2

2.1

Opportunity Cost
(Left scale)
2.0

1

1.9
1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

Note: The scales are set to match the estimation results shown below. Opportunity cost is a two-quarter moving average of the
three-month Treasury bill rate less a weighted average of the interest rates on M2 components.
M2 Velocity
Ratio scale
See lower panel
98:Q4

97:Q3

2.1
01:Q1

Fit from 1993:Q1 - 2000:Q3
92:Q4

93:Q4

••

••

•

91:Q4

••

•• •
•
• •• •• • • •••• • •• • • •
•• • • • •
• • •••

•

90:Q4

90:Q2

••
• • •• ••
••• • • • ••
•
• • •• • • • • • ••• • • ••••
••
•
• •
•• • • ••••• • ••• •• • ••
•• •
• •• • •
• •
•

• •
• •• • •••
• • •
•• • • •
•

•

• • 1.9
•
1.7

Fit from 1959:Q2 - 1989:Q4

1.5

0.5

1

2

4

6

Opportunity Cost (percentage points, two-quarter moving average)
* The two regressions were constrained to have the same slope.
M2 Velocity
Ratio scale
2.15
97:Q3
97:Q1

2.10

98:Q2

00:Q2

96:Q3

95:Q1

96:Q1

98:Q4

99:Q4

00:Q3

95:Q3

2.05
99:Q2

02:Q2

01:Q1

94:Q3

2.00
2

2.3

2.6

2.9

3.2

Opportunity Cost (percentage points, two-quarter moving average)

MARA:RJ

11

and household s seemed to tak e steps to rebalan ce portfolios by r eallocating fund s to
assets in M2. M2 velocity has been flat over the past two years. In 2000, the damping
effect on money demand of the rise in opportunity cost appeared to be offset by the
response of households to equity market volatility and to a flat, and at times inverted,
yield curve, which gave investors little incentive to shift funds out of M2 assets and
into lo nger-m aturity capital mar ket instruments.
(12)

M2 growth is expected to moderate somewhat in 2001 as the expansion

of nominal income slows. The downshift in M2 growth is tempered, however, by the
reduction in short-term interest rates stemming from the assumed 75 basis points of
policy easing in the first quarter and by the anticipated flatness of the yield curve. In
addition, lower mortgage rates in the forecast spur a wave of mortgage refinancing
activity that pushes up M2 g rowth as mortgage servicing agen ts temporarily place the
prepayments in transaction accounts before remitting them to holders of mortgagebacked securities. Moreover, households are expected to favor M2 assets in view of
the disappoin ting returns in th e equity mar ket anticipated in the staff forecast. W ith
M2 grow th slowing co nsiderably less tha n nomin al income, M 2 velocity is projected to
fall notably this year. In 2002, the staff assumes that short-term rates hold steady and
that savers will have largely completed their adjustments to the flat yield curve and
lower expected returns on h olding equ ities. In this environm ent, M2 gro wth is
expected to level out, running at about the sam e pace as nominal incom e. Even
though inflation persists over the next two years in the staff forecast, M2 growth on
average in 2001 and 2002 is only modestly above the 4½ percent average pace that
would be associated with price stability because of shortfalls in the growth of real
output relative to that of potential. 8

8. The rate of g rowth of M 2 at price stability is deriv ed under th e assumptio n of stable
velocity by summing the staff’s estimate of potential real GDP for the next two years (about
4 perce nt) and th e residua l bias in the GDP deflator (½ percen t).

12

Short-run policy alternatives
(13)

The staff has again revised down its outlook for economic growth in the

near term, reflecting weaker expansion in aggregate dem and than previously projected
and m ore aggressiv e prod uction cutbacks to a lign inventories better with sales.
However, final demands over the forecast horizon are supported by the effects on
consumption and investment of continuing elevated structural productivity gains and
are augmented by the substantial declines in most interest rates over recent months as
well as by projected decreases in energy prices and the foreign exchange value of the
dollar. As a result, the inventory correction is completed fairly promptly, and
projected econ omic grow th resumes in the spring and picks up therea fter. Despite
the economic rebound, the sizable shortfall from potential output growth in the next
few quarters quickly pushes up the u nemployment rate to aro und 5¼ percent b y yearend. By then, though, aggregate demand is expanding at a pace just short of potential
and the unemploym ent rate edges only a bit higher over the remaind er of the forecast
period. With structural productivity growth leveling out, the rise in the
unemployment rate is seen as necessary to keep core consumer inflation rates near
current levels. A gainst this backd rop, the staff forecast assu mes only a sm all
additional c ut in th e federal fund s rate in the near term .
(14)

If the Com mittee found the staff assessment o f the outlook to be both

reasonable and acceptable, it might opt for alternative A, which would lower the
federal funds rate 25 basis points to 5¾ percent. In the context of this forecast, such
an easing leans against softness in aggregate demand while resisting an eventual pickup
of inflation in circumstances of continued pressures on labor resources. In light of
the considerable uncertainty about the prosp ects for spending, such a measured step
could be seen as striking a balan ce between tw o possible scena rios for aggrega te
demand discussed earlier–a recession and a growth pause. To be sure, the market has

13

a more substantial easing at this meeting built into interest rates, but this expectation
was shaped in part by the C ommittee’s unexpectedly a ggressive action e arlier this
month. Over a som ewhat longer horizon, the structure of interest rates incorporates
a drop in the funds rate to 4¾ percent by year-end–more than the Comm ittee may see
as likely to be necessary to restore acceptable growth. If so, it may view disappointing
markets a little as possibly fostering more sustainable and stabilizing financial
conditions. Indeed, the Committee may be concerned that another 50 basis point
action hard on the heels of the January 3 m ove risks leading investors to expect even
more ease at future meetings than currently. Such a reaction would heighten the
possibility that the stimulus emanating from financial markets would give additional
impetus to a rebound in spending that might soon be underway in any event. G iven
the lags in the effects of monetary policy, any resulting price pressures could be
difficult to contain even with a relatively quick turnaround in po licy.
(15)

If the Com mittee were to choose this altern ative, it might wa nt to retain

the current statem ent that the risks are weighted to ward econ omic wea kness, unless it
were confident tha t the econom y had stabiliz ed and moderate growth was in prosp ect.
With on ly a 25 basis poin t easing, market in terest rates probab ly would b ack up, credit
spreads wo uld widen some, and sto ck prices wou ld decline as the p olicy move fell
short of mar ket expectations a nd concern s about a pro longed perio d of econom ic
weakness re-intensified.
(16)

If the Committee thought the economy might well be weaker than in the

staff forecast, it may wish to take another substantial easing action by cutting the
federal funds rate 50 basis points at this meeting, as in alternative AN . As the
recession simulation illustrated, a substantial shortfall in demand would req uire
prompt and forceful policy action. Even if the Committee thoug ht the staff forecast
was the mo st reasonable po int estimate, it might still favor a 50 basis p oint easing if it

14

perceived that the probabilities around that outcom e were skewed toward
considerably softer demand than in that forecast. With inflation and inflation
expectations likely to remain quiescent for a while, a substantial easing to cushion
downside risks to econom ic activity is unlikely to boost materially the risk of greater
inflation pressure s. Indeed, a substan tial easing migh t also be viewed as appropria te if
the Comm ittee did not see outsized downside risks to dem and but thought price
pressures were unlikely to intensify at an unemployment rate near its current level, as
in the 4 percent NAIR U simulation earlier in this bluebook. Financial m arket
participants currently have built in high odds of a ½ percentage point cut in the funds
rate at this meeting. Although conditions in some segments of financial markets have
improved in recent weeks, developments in the commercial paper and bank loan
markets indicate that suppliers of funds remain q uite wary. Under these
circumstances, the effects of surprising the markets with a smaller easing could be
especially adverse.
(17)

The market response to a 50 basis point reduction in the federal funds

rate would depend importantly on the wording of the announcement and balance of
risks statement that accompanied the action. Retaining a statement of risks weighted
toward economic weakness would seem appropriate if, in light of the evident
softening in demand and subdued readings on price and wage inflation, the
Comm ittee saw the po ssibility of below-tren d growth a s a more serio us problem in
the foreseeable futu re than the cha nce of a rise in inflatio n. Market p articipants
expect the C ommittee to announ ce continued unbalanced risks toward ec onomic
weakness as w ell as to ease policy b y 50 basis points. S till, markets migh t rally some if
participants see th is combinatio n as confirm ing that the Fed eral Reserve inte nded to
continue to c ounter econ omic wea kness relatively agg ressively. The dollar could
weaken on foreign exchan ge markets as m ajor foreign cen tral banks are u nlikely to

15

match the System easing at this time. A statement that risks were balanced would be
justified if the Com mittee thoug ht the 100 basis p oints of easing o ver the last mo nth
were likely to be sufficient to promote a rapid return to sustainab le growth, which
would keep labor m arkets relatively tight. Such a statement would cause market
participants to reassess the prospects for future policy actions and roll back much of
the expected easing going forward. In consequence, asset prices could give back some
of their recent gains while the dollar could even strengthen a bit on foreign exchange
markets.
(18)

The Committee may choose the unchanged federal funds rate of

alternative B if it is dissatisfied with recen t rates of core inflation and wants to
establish a downward trajectory for inflation, as in the price stability scenario in the
second section of this bluebook. The rationale for this policy choice would be
strengthened if the Com mittee saw th e recent slowd own in the growth of a ggregate
demand as likely to be mo re temporary than does the staff and thus the recen t policy
easing as probably sufficient to counter the sluggishness in the econom y that emerged
recently. Regard less of the balance o f risks statement, leavin g the funds rate
unchange d would c ome as a co nsiderable surp rise to market p articipants and w ould
spark a sell-off in asset markets as participants reassessed the economic outlook and
the Comm ittee’s posture. The backup in interest rates and drop in equity prices
would prom pt still more caution on the part of loan officers and investors.
(19)

Under the Greenbook forecast, borrowing by the business and

household sectors combined over the first half of 2001 is expected to stay around the
reduced pa ce of the second half of last year. Con sumer cred it is projected to
decelerate further over the first half, largely reflecting weaker outlays on consumer
durables and some rising ca ution by ho useholds exp eriencing unc omfortable debtservicing burdens. Recent declines in mortgag e rates are expected to spur continued

16

heavy mortgage refinancing activity, mostly to reduce debt-servicing costs on existing
debt but in a number of cases also to extract some equity. Lower bond rates and an
improved tone to the corp orate bond market already hav e begun to boost issuance;
going forward, overall business borrow ing should run som ewhat above the subdu ed
pace of the latter p art of last year, when firms seemed inclined to ho ld off on their
borrowing plans. Business borro wing from banks is expected to m oderate, in part
reflecting the increased reliance on bond offerings but also the more restrictive
posture of loan officers. Debt of no nfederal sectors is p rojected to gro w at about a
6½ percent rate from D ecember to June and total deb t to grow at a 4¼ percent rate,
held dow n by paydo wns of federal d ebt.
(20)

M2 is projected to grow at a 5½ percent annual rate over the January-to-

June period under the Greenbook forecast, well above the projected 2¾ percent
growth of nominal GDP over the first half of this year. M2 growth should be
boosted relative to that of nominal incom e by the decline in short-term market rates
following the January policy easings and by a co ntinuation of the heightened
preferences of households for the more stable assets that comprise M2. Mortgage
refinancing activity also is likely to lift M2 notably over th is period. M3 is expected to
grow at a 7 percent annual rate over the January-to-June period. Growth of
institutional money funds is projected to be quite brisk as the yields on these funds lag
the downward m ove in short-term market interest rates.

Alternative Growth Rates for Key Monetary and Credit Aggregates
M2
---------------------------Alt. A’ Alt. A
Alt. B
---------------------------Monthly Growth Rates
Nov-2000
Dec-2000
Jan-2001
Feb-2001
Mar-2001
Apr-2001
May-2001
Jun-2001

M3
---------------------------Alt. A’ Alt. A
Alt. B
----------------------------

M2
M3
Debt
--------------------------Greenbook Forecast*
---------------------------

4.2
9.6
11.2
8.4
7.3
8.1
2.7
3.8

4.2
9.6
11.2
8.0
6.5
7.3
2.0
3.3

4.2
9.6
11.2
7.6
5.7
6.5
1.3
2.8

4.2
12.5
15.7
11.6
8.4
8.0
3.8
4.6

4.2
12.5
15.7
11.4
8.0
7.6
3.5
4.4

4.2
12.5
15.7
11.2
7.6
7.2
3.2
4.2

4.2
9.6
11.2
8.0
6.5
7.3
2.0
3.3

4.2
12.5
15.7
11.4
8.0
7.6
3.5
4.4

4.6
4.6
2.9
5.4
6.2
3.3
3.4
4.3

Quarterly Growth Rates
2000 Q1
2000 Q2
2000 Q3
2000 Q4
2001 Q1
2001 Q2

5.8
6.2
5.6
6.5
9.1
6.3

5.8
6.2
5.6
6.5
8.9
5.6

5.8
6.2
5.6
6.5
8.7
4.9

10.5
8.8
8.8
7.0
12.1
7.2

10.5
8.8
8.8
7.0
12.0
6.9

10.5
8.8
8.8
7.0
11.9
6.5

5.8
6.2
5.6
6.5
8.9
5.6

10.5
8.8
8.8
7.0
12.0
6.9

5.6
6.2
4.7
4.1
4.4
4.3

Growth Rate Ranges
From
To
Dec-1999 Dec-2000
Dec-2000 Jun-2001
Jan-2001 Jun-2001

6.2
7.0
6.1

6.2
6.5
5.5

6.2
5.9
4.8

8.6
8.8
7.4

8.6
8.6
7.1

8.6
8.3
6.8

6.2
6.5
5.5

8.6
8.6
7.1

5.2
4.3
4.6

1999-Q4
2000-Q4

6.3
6.1

6.3
6.1

6.3
6.1

7.7
9.1

7.7
9.1

7.7
9.1

6.3
6.1

7.7
9.1

6.8
5.3

2000-Q4 Jun-2001

7.2

6.7

6.2

9.0

8.8

8.6

6.7

8.8

4.4

1998-Q4
1999-Q4

* This forecast is consistent with nominal GDP and interest rates in the Greenbook forecast.

17

Directive and Balance-of-Risks Language
(21)

Presented below for the mem bers' consideration is draft wording for

(1) the directive and (2) the “balance of risks” sentence to be included in the press
release issued after the meeting (no t part of the directiv e).
(1) Directive Wording
The Federal Open Market Comm ittee seeks monetary and financial
conditions th at will foster price stab ility and prom ote sustainable g rowth in
output. To fu rther its long-run objectives, the Co mmittee in th e immed iate
future seeks conditions in reserve markets consistent with MAINTAINING/
INCREASING /reducing the federal funds rate AT/to an average of around
___ 6 percen t.
(2) “Balance-of-Risks” Sentence
Against the background of its long-run goals of price stability and
sustainable economic growth and of the information currently available, the
Committee believes that the risks [ARE BALANCED WITH RESPECT TO
PROSPECTS FOR BOTH GOALS] [CONTINUE TO BE WEIGHTED
MAINLY TOWARD CO NDITIONS THAT MAY GENERATE
HEIGH TENE D INFLA TION P RESSU RES] [are weighted m ainly toward
conditions that m ay generate economic w eakness] in the foreseeable future .