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APPENDIX FOMC BRIEFING - P.R. FISHER JANUARY 31 - FEBRUARY 1, 1995 Mr. Chairman: I will be referring to the three color charts on the single page distributed this morning. In describing domestic interest rate and foreign exchange markets over the period, I will try to answer two questions: First: Why have expectations for interest rate increases come down so much over the period, and Second: Why has the dollar weakened so much against the German mark? In response to the first question, I thinkthat expectations for interest rate increases have unwound so much because they were exaggerated -- at least, in part, because commonly-accepted measures of those expectations were distorted by a number of factors at the end of last year. At the end of November and into early December, the short- end of the yield curve backed-up sharply as a number of bank portfolios closed out positions in two- and three-year paper and as Orange County's financing positions and portfolio were liquidated. At the same time, market expectations for the Committee's actions implied something of an extrapolation of what was seen as the Committee's more aggressive approach in November. Moreover, these two phenomena were mutually reinforcing. Even - 2 - as market participants began to think that concerns about the implications of Orange County might prevent an increase in rates in December, market expectations for 150 basis points of tightening by May appeared to justify 2-and 3-year yields over seven and one half percent and, at the same time, short-end yields at these levels were seen as confirming expectations for a rapid increase in the Fed funds rate. Over the course of January, there has been a gradual unwinding both of expectations for Committee action and of the "hump" in the yield curve. For example, a major step in this process occurred following the release on January 13th of the weaker-than-expected retail sales. In the first two panels of charts -- depicting the rates implied by the monthly Fed Funds Futures contracts and the yield curve -- the impact of this process can particularly be seen in the shift from the green to the orange lines: shaving expectations for this meeting to a 50 basis point increase and, more significantly, lowering the pace of expected increases in the future. While most people in the market remained skeptical about either the accuracy or enduring significance of the retail sales data, it did serve to remind market participants that they were increasingly likely to face two-way risk in upcoming data - 3 releases. - This, in turn, gave confidence to those wanting to lock in the relatively high 2-to 5-year yields. Thus, despite much talk of "heavy supply," the market finally began to work down the hump in the yield curve. The release of fourth-quarter GDP last Friday, particularly the inventory investment component, provided a similar occasion: while the inventory estimate may be subject to revision, it provided both a hint of a softening of demand and a reminder of two-way risk in upcoming releases. Turning to the dollar, in my opinion, it was precisely the progressive unwinding of expectations for the Committee's actions, and of short-end yields, that began to weigh on the accumulated long-dollar positions in late December and triggered the dollar's initial decline. While the Mexican financial crisis has recently begun to weigh on the dollar, this only became a significant factor in mid-January, after the dollar's decline was already well underway. In December, I mentioned the surprising resilience of the dollar in the face of events which, earlier in the year, would have been expected to cause dollar weakness. (These included the resignation of Secretary Bentsen, the oscillations of the yield curve surrounding Orange County and the Bankers Trust supervisory announcement.) The strong demand for dollars -- both corporate and speculative -- was predicated on the numerous forecasts that - the dollar would rise in 1995. 4 - To a great extent, these the implications of the forecasts themselves were based on: rapidly flattening yield curve; the extrapolative projections of the Committee's likely actions; and the absence of any data yet indicating a slowing of the economy. Having brought forward much of the demand for dollars into early December, there were few firms seeking to buy dollars after the Committee's December meeting. In thin, holiday markets on December 28th, after the European close, the dollar was subject to an energetic effort to push it lower by triggering stop-loss orders. Given the lack of interested buyers, the dollar dropped almost 3 pfennings in less than half an hour. However, it was noted, and should be noted, that this initial drop merely returned the dollar to the levels, around 1.55 marks, where it had traded for several days after the Committee's November 75-basis point increase. The dollar's second step lower occurred as a result of a rush of demand for marks coming out of the politically- and fiscally-weak European currencies. It appears that several major intermediaries, having taken long-dollar, short-mark positions over the year-end, were caught wrong-footed by their customers' demand for marks. The quickest way to adjust their positions was to sell dollar-mark and, on January 9th, again in New York - 5 trading, the dollar fell nearly two pfennings in under 45 minutes. With the dollar having demonstrated a surprising downward momentum, and the yen eventually becoming subject to the uncertainties of the Kobe earthquake, the mark quickly came to be seen as the reserve currency of choice, rising to within a hair of its all-time high on a trade-weighted basis on January 25th. [199.40 vs. 200.40 on 10/5/92] Thus, the dollar's first two steps lower were caused by the unsustainability of the long-dollar positions, built-up in December, in the face of the decreasing extent of expectations for rate increases. But by mid-January, as the expected duration of the Mexican crisis shifted from temporary to indefinite, the Mexican situation did begin to weigh on the dollar. But there is nothing especially "Mexican" about the specific mechanisms through which the crisis has affected the dollar. First, the Mexican crisis provided a further reason for the unwinding of expectations for Committee actions -- on the assumption that the Federal Reserve would not want to make matters worse. Indeed, because of the peso's weakness, and the weakness of the Mexican financial system, foreign exchange market participants became increasingly skeptical about the prospects for the Committee to raise rates and about the prospects for the dollar to rise even in the event of a Committee action. Second, the Mexican crisis served as a catalyst for the development of an alternative, negative forecast for the dollar in 1995, which goes something like this: If emerging market economies, and Mexico in particular, are going to be a decreasing source of demand for U.S. goods and services, while the U.S. economy continues to grow strongly, then the U.S. current account deficit is likely to increase. If one combines a forecast for an increasing current account deficit with a forecast for U.S. interest rates to rise less, and less quickly, than previously assumed, it is hard to see why one would expect the dollar to move higher. Finally, last week and on Monday, the foreign exchange market has had something of a knee-jerk, negative reaction to the political back-and-forth over the Mexican aid package. Yesterday, the dollar got an initial bounce-back in early European trading on rumors of concerted central bank dollar support, indicating the nervousness of those who had taken shortdollar positions. Apparently, just as the market was getting comfortable with the idea that we were unlikely to be intervening, and short-positions were being reestablished, President Clinton's announcement hit the wires that "executive authority" would be used for the Mexican package. The scramble - 7 - to cover short positions again was made more urgent by the rumors that the ESF would be selling its marks and yen to fund the package. Looking back over the month, it seems to me that by dint of repetition, Mexico has become a bigger part of the accepted But explanation of why the dollar moved lower than is deserved. now that the dollar is lower, and the perception of Mexico as a contributing cause is widespread, the unresolved nature of the peso crisis is one of the factors holding the dollar down. In addition to the peso's weakness, the Canadian dollar has been under pressure during the past month. The markets exacted a high price from the Bank of Canada for its failure to raise rates in November in step with the Committee's 75 basis points. Their lagging rate increases, combined with market anxieties about the Canadian government's fiscal policy and the Quebec separatist referendum, brought the Canadian dollar to a 9-year low against the U.S. dollar [1.4269 1/20] and pushed 30-year Canadian interest rates up by over 50 basis points from early December. By last week, however,through repeated rate increases, the Bank of Canada seems to have persuaded the market that it will maintain the higher, short-term rates to defend the currency, stabilizing their dollar and bringing long-term rates back down. If the Committee were to raise rates, I would expect the Bank of Canada to match it with a 50 basis point increase of their own. - 8 - Turning to the Desks' operations, throughout the period, domestic operations were aimed at maintaining the existing degree of reserve pressure, with Fed funds expected to trade around 5 and one half percent, as directed by the Committee. Year-end pressures in the funds market only reached 7 percent, and by the time traders left their desks for the New Year weekend, the funds rate had touched a low of one-quarter percent. The first part of the current maintenance period required a draining of reserves as the seasonal increase in required reserves and in currency rapidly reversed themselves. Because of the expected need to return to adding reserves in upcoming maintenance periods, we met our draining needs with temporary transactions and by the redemption of 600 million dollars in 7-year Treasury notes which matured without replacement. Over the past few days, we have returned to adding reserves as a rise in the Treasury balance has introduced a temporary need, while security market settlement pressures and expectations for a policy move at the conclusion of this meeting have worked to elevate rates in the money market. Over the three maintenance periods since your last meeting, the effective Fed funds rate has averaged 5.42, 5.49, and, as of last night, 5.55 percent. -9 - Mr. Chairman, other than the 1.5 billion dollars in swap drawings by the Bank of Mexico, during the period we had no foreign exchange operations on behalf of the System's account. I would be happy to answer any questions. Monthly Effective Rates Implied by Federal Funds Futures Contracts Jan95 Feb95 Source: Bloomberg News Service U.S. Treasury Yield Curve 8.00 8.00 7.80 7.80 7.60 7.60 7.40 7.40 7.20 7.20 7.00 7.00 6.80 6.80 1 yr 2 yr 3 yr 5 yr 10 yr 30 yr Source: Bloomberg News Service U.S. Dollar - German Mark 1.60 1.58 1.56 1.54 Nov Source: Foreign Exchange Function Markets Group: FRBNY Dec 28 Jan 9 19 3 UpdatedJanuary 30, 1995 Michael J. Prell February 1, 1995 FOMC BRIEFING Anticipating that time would be short today, we sure that we hit all the crucial points Greenbook. On the to 1995. in the two parts of the assumption that we succeeded, I'll underscore the highlights tried to make just quickly of our forecast, particularly as they Peter Hooper will then comment on the external relate sector. And I'll wrap up with a summary of the forecasts you submitted for use the Humphrey-Hawkins First, assumption in report. as you know, we've changed the monetary policy for our projection, to one of a stable federal funds rate. I think we made this clear, but not reflect an abandonment let me emphasize that this change did of our basic view that further tightening is needed if you wish to avoid a deterioration in the trend of Rather, we inflation. at recent meetings shifted our assumption partly because suggested that some of you preferred to comments approach the policy decision by thinking about what would occur if you left the funds rate at the prevailing level. Indeed, for some years now, it has been our practice to base our forecast on a no-change assumption except when it was fairly clear that the Committee was substantial policy moves, funds rate or when it was our judgment anticipating that such a level would produce results that were obviously unacceptable to you. maximize the Hopefully, by exploiting this flexibility, we probability that our projections will provide a useful reference point for your discussions. One thing that made it a little easier to funds lower our baseline rate path this time was the fact that we had decided to adopt a FOMC Briefing--February 1, 1995 Michael J. tighter fiscal policy assumption. Prell In a sense, the change we've made could be characterized as conservative. for granted that the Congress will That is, while we've taken it pass a balanced budget amendment, we've assumed that this will not cause a revolution in either budgetary actions or market perceptions by the end of 1996. Our thinking is that it will be a while before ratification is assured, and that--though lip-service will be paid to implementation in the coming months--the wrangling over the particulars will permit enactment of only moderate budget cuts. To be sure, all of this is highly conjectural, but we think it moves us closer than we were before to the likely fiscal reality. On balance, these our projection of real GDP percent in 1996--about revised assumptions have caused us to growth to raise 2-1/4 percent this year and 2-1/2 a half percentage point per year faster, on average, than in the December Greenbook. The drop-off in growth that we are forecasting for this year from the 4 percent pace of 1994 obviously is substantial, and we feel kind of lonely when we look at greater growth this year, with outside forecasts--many of which have rising interest rates. And we hints at this point that shaky early estimates for anecdotes--sometimes recognize that there are any softening in demand is in train: retail sales late last year, at least, that our output forecast are reasonably balanced. income; of upbeat consumer sentiment growing rapidly enough to generate there also and some and houses. But we've persuaded ourselves, is still some supplied by industry advocates--regarding a recent weakening in demand for autos the indications only a few is a very strong tone to manufacturing and nonresidential The upside risks and signs that healthy gains include employment in spendable capital goods construction. - 2 - the risks to On the downside, FOMC Briefing--February 1, although we think most quarter was Michael J. 1995 of the inventory investment Prell in the fourth intended, the rate--which BEA guessed to be somewhat higher than we did--does not seem likely to persist unless expectations of higher prices become a much greater force than they have been to date: gearing down of the in fact, it is not hard to imagine a sharper rate of accumulation than we have could put a considerable dent in the momentum of the might also be argued that the risks in the attending the international sphere have a downside bias insofar as the prospects for our net exports will be focusing on that In any event, issue in economy. It recent developments in the near term. are concerned. Peter a few moments. even with the forecast, we believe that forecast, which rather tepid growth path we have pressures on resources will remain in the underlying rate appreciable and will result in an upward creep projection is something of an act of faith. of inflation. Again, this There has been no statistical evidence to date of a firming in the underlying trend of retail quarter 3.1 To the contrary, the fourth in the core CPI. saw a drop-off in the rate of increase report yesterday's only prices. percent on the Employment Cost Index showed an increase than we This we can't record understandably rule out realistically, given the changed" with change in the regard the to inflation. recent good news is behavior of the economy. noise in the data--and having pierced the 6 percent ago--it has encouraged those who subscribe the possibility that signaling a fundamental few months in September, and two- forecast. to the view that "the world has And of in private industry compensation over the past year-- two-tenths less than in the twelve months ended tenths less And. But. with unemployment level we assumed to be the NAIRU only a is just too early to expect that a change in the FOMC Briefing--February 1, Michael J. 1995 trend of inflation would be clearly identifiable. against rejection of our basic model at this Prell Also arguing point is the anecdotal evidence in the Beige Book and elsewhere that plainly suggests a considerably more inflationary tone to labor and product markets over the past few months. Unfortunately, though it would be nice to think that the next couple of CPI readings will settle the issue, experience--such as that in the late 1980s--shows that the emergence of pickups in inflation can be difficult to discern until the process is well advanced. Thus, we could well be in the position of having to make some difficult judgment calls for a while, utilizing all of the statistical and anecdotal information we can gather to assess the trends of wages and prices. At this point, let me turn the floor over to Peter. - 4 - February 1, 1995 Peter Hooper FOMC Briefing In recent weeks, developments in the international sphere have been more in the center stage than usual. The peso crisis and, to a lesser extent, the earthquake in Japan not only have rocked international financial markets but also affect the outlook for U.S. economic activity. I'll briefly review these events and their implications and summarize our outlook for both the global economy and the international sector of the U.S. economy. Turning first to Mexico, our baseline forecast had assumed Congressional approval of the $40 billion securities guarantee package. The multilateral support package announced yesterday is of course intended to play the same role. Given this degree of support, we projected that the peso would stabilize in the vicinity of 5.0 per dollar and that Mexican interest rates would recede enough to keep the economy from dropping into recession. At the same time, we expect that Mexico's macroeconomic stabilization program will reduce GDP growth to near zero this year, down from 3 percent in 1994, and will yield enough wage and price restraint to ensure the peso will have depreciated about 20 percent in real terms. Under these outcomes, Mexico's external deficit would be cut roughly in half this year and somewhat more next year, from the $28 billion deficit estimated for 1994. We expect most of this adjustment will fall on the United States, and will reduce U.S. net export growth by an amount equal to nearly 1/4 percent of GDP, with much of that effect coming in the first half of the year. -5 Absent the multilateral support package, - we would see a much weaker peso, higher Mexican interest rates, a significant recession in Mexico, and a greater decline in U.S. net exports--amounting to perhaps another 1/4 percent of GDP. While the United States stands to feel the largest direct effects of Mexico's impending external adjustment, other countries have already felt negative repercussions from the peso crisis. Argentina and Brazil, the two countries whose monetary systems come closest to Mexico's, have suffered substantial declines in their stock markets and some increases in interest rates. As a result, we have revised our projections of real growth in these two countries down somewhat. Assuming the Mexican situation is contained, however, we do not expect these or other Latin American economies to deteriorate further or enough to affect the United States significantly. Canada has its own external and internal deficit problems, along with a good deal of political uncertainty, and accordingly, has been vulnerable to shifts in investor confidence. In this context, it has felt some of the fallout from Mexico, with a weakening of the Canadian dollar in recent weeks that prompted the Bank of Canada to raise call money rates sharply. This monetary tightening, along with what is likely to be an austere federal budget released later this month, should take some steam out of Canada's rapid economic expansion. Some monetary firming in Canada probably would have been in order in any case, despite its continued favorable price performance. While Canada is still somewhat behind the United States on the cyclical curve as gauged by the magnitude of its potential output gap, resource utilization has tightened considerably in the industrial sector and industrial materials prices have accelerated recently. Turning next to Japan, the earthquake is expected to have disrupted transportation and other infrastructure enough to reduce GDP growth in the first quarter by roughly 1 percentage -6 - point, although this is still at best only a rough guess. Rebuilding, which will be financed in part by supplemental budgets and in part by reduced private savings, should result in a modest net gain in GDP growth later this year and in 1996. The implications for U.S. net exports could actually be a small positive in the near term, as the destruction of Kobe's port facilities will likely reduce Japanese exports more than it does U.S. exports to Japan. The net effect on U.S. GDP should be minimal however. Some transitory price pressures may arise in Japan as a result of bottlenecks created by the earthquake, but given the substantial degree of economic slack in Japan, and with GDP growth expected to be relatively moderate, underlying inflation should remain very low for the next year or two at least. In Europe, a strong cyclical recovery has been under way for over a year now. Growth of industrial production appears to have slowed a bit in the fourth quarter from its very strong pace earlier in 1994. Nevertheless, we expect GDP growth to remain strong this year as the composition of the expansion shifts from exports and inventories to final domestic demand. This shift should also stimulate demand for U.S. exports to Europe, which were surprisingly sluggish last year. With growth in the major developing countries generally expected to continue at near the strong pace recorded in 1994, the world economy is undergoing virtually a global expansion. At currently anticipated growth rates, other industrial countries are roughly one to three years behind the United States in terms of potential output gaps, with Germany closest behind and Japan furthest. Unemployment is still comfortably above estimated natural rates in most countries and the risk of near-term wage acceleration is generally low. However, manufacturing capacity utilization suggests a somewhat tighter picture. Most countries have surpassed their average -7- utilization rates of the past two decades. Last year's expansion of industrial production in Europe in particular far exceeded earlier expectations. Price pressures in industrial materials and even some final products have shown up in several countries. Absent further supply shocks, like the 1994 freeze in Brazil's coffee region, commodity price inflation should slow from last year's high, but we expect demand pressures to keep those prices rising in real terms. Overall, our expectation is that CPI inflation abroad will be slightly higher this year and next than last year, and that U.S. import prices will continue to rise a bit faster than domestic prices, at least through 1995. Abstracting from Mexico for the moment, we expect that a robust expansion of U.S. exports over the next two years will be underpinned by continued strong growth abroad and the recent and anticipated further weakening of the dollar. In our baseline forecast we have projected that the exchange value of the dollar against the G-10 currencies would decline by several percentage points over the next few months under the assumption of an unchanged federal funds rate. Relative to our December forecast, this path of the dollar, in itself, stimulates real net exports over the next two years by an amount equal to 1/2 percent of GDP. Import growth should slow from very high rates seen last year as the economy decelerates and the effects of the lower dollar show through. Nevertheless, with U.S. output remaining near capacity, the expansion of imports should just about keep pace with that of exports, yielding only a moderate uptrend in net exports. When Mexico is added to the equation, we project total net exports will decline this year but will pick up somewhat in 1996. This outlook is consistent with the U.S. current account deficit widening to the neighborhood of $200 billion by the end of this year and remaining there during 1996--an amount well in excess of 2-1/2 percent of GDP. -8 - Michael J. Prell February 1, 1995 The economic forecasts for 1995 that you submitted are As usual, we have not summarized in the handout. funds rate path for your projections. specified a federal We've only asked that, pending the outcome of this meeting, you assume that the Committee adopts what in your own view would be the optimal monetary policy. fact. Given that I can't say much about the causes of differences between your forecasts and the staff's. For whatever reasons, the vast majority of you have predicted both stronger real growth and higher inflation for this year than we have. As you can see, percent, the real GDP forecasts range from 2 to 3-1/4 with a central tendency--defined as thirds--of 2 percent to 3 percent. roughly the middle two- Your inflation forecasts range from 2-3/4 to 3-3/4 percent, with most between 3 and 3-1/2 The unemployment rates are for the most part range from 5-1/4 percent to just percent. over 6, but close to 5-1/2 percent. The law requires that the Board assess, in the Humphrey- Hawkins report, the consistency of the System's monetary policy plans with the Administration's short-run economic in the Economic Report of the yet President. published its numbers, but forecasts, as published The Administration has not judging from what we have heard, it appears that their forecasts for both growth and inflation will be within your central tendency ranges. appreciably higher, however, Their unemployment rate may be owing to an artifact of their budget preparation process, which forced them to lock in economic before the late-1994 decline in joblessness had been revealed; may find a way of revising their numbers for the Economic but if they don't, it could raise some questions. worth, though, the output-unemployment relationship tendencies looks more assumptions conventional than theirs. - 9 - they Report only, For what it's in your central February 1, 1995 Long-run Ranges Donald L. Kohn Mr. Chairman, in the interest of time, I will forego a discussion of the long-run scenarios in the blueI would, however, like to touch on one major uncer- book. tainty in the intermediate-term outlook--that for fiscal policy. A major shift in fiscal policy could greatly affect the conduct of monetary policy, and in ways that may not exactly follow the outlines of standard models. In our exercises, balancing the budget lowers equilibrium real interest rates over time by 1-1/2 percentage points, as compared to a current services baseline. In effect, this would reverse the effects of the jump in structural deficits that occurred in 1981. which evidently raised real interest rates in the 1980s. As the Committee is aware, however, the precise relationship of equilibrium rates to budget deficits is not easy to pin down. Other factors, such as financial innovation, real estate booms, or enhanced returns from capital investment, may have accounted for at least a portion of the higher real rates since the early 1980s. Even if we could be sure how much equilibrium real rates would fall as a consequence of fiscal restraint, the appropriate path for monetary policy will depend on the -2- dynamics of the responses of spenders and financial markets to the fiscal policy changes. We assumed that financial markets would catch on only gradually as deficit reduction is implemented. But bond rates could fall more sharply to new equilibrium levels once markets became convinced that future deficit reduction will in fact be implemented. If there is little anticipatory behavior in the spending of households and businesses, tighter fiscal policy can actually be stimulative for a time, as lower bond rates boost spending before actual deficit reduction measures kick in-as perhaps we saw in 1993. If the Federal Reserve were worried about inflation risks, it wouldn't want to react to falling real bond yields associated with deficit reduction by immediately lowering the federal funds rate, and in theory it might even want to run with a tighter policy than otherwise for a period. Of course, one can imagine some forward-looking spending behavior as well. Additional saving might come, for example, from government workers anticipating layoffs or social security recipients expecting their COLAs to be trimmed. The larger point is that the effects on the economy of major deficit reduction will be difficult to predict; they will depend importantly on the nature of the cuts and their credibility, and forward-looking behavior -3- will not necessarily be confined to financial markets-though it's more likely to be stronger there. In these circumstances, relatively simple and straightforward formulations for compensating monetary policy responses are likely to be wrong, and the Committee will need to assess the ongoing effects of any substantial deficit reduction carefully as they occur. Of course, money growth targets were supposed to be most useful for avoiding monetary policy mistakes in just such situations of great uncertainty about aggregate spending. Unfortunately, major doubts about the characteristics of money demand have greatly reduced the utility of such targets. Nonetheless, the Committee is required to put forward ranges for money and credit growth for the current year, and this exercise still allows the Committee an opportunity to discuss broadly what types of financial conditions it expects to be associated with its ultimate objectives for the economy. The table on page 13 of the bluebook gives the staff's projections for money and debt for 1995 and 1996 under both the greenbook baseline forecast and the alternative simulation with rising interest rates. As you can see, we expect some pickup in growth of the broad money aggregates from 1994 to 1995, despite the slowing of growth in nominal income. In large measure this reflects the effects on opportunity costs of the interest rate assumptions. Under the staff baseline, opportunity costs would narrow as deposit rates caught up with steady short-term market rates; under the alternative, opportunity costs would widen, but not as much as they did last year because a smaller rise in market rates is assumed. In addition, some special factors holding down the growth of money last year--especially the effects of declining mortgage repayments on demand depositswill not be a factor in 1995. Helping M2 and M3, a drop in FDIC insurance premiums should boost the attractiveness of deposits relative to nondeposits as a source of funds. Still, we are projecting a bit slower M2 growth than in standard models because we are assuming that capital market mutual funds will look a little better as long-term rates stabilize, and we expect adjustment of deposit offering rates by banks and thrifts to remain more sluggish than the models have built in. Debt should continue on its moderate growth path. Reduced federal government borrowing is likely to be offset by greater nonfederal debt issuance as business cash flow is squeezed by declining profit margins and as retirements of tax exempt bonds that had earlier been advance refunded taper off. Against this background, the table on page 17 presents a couple of alternatives for money and debt ranges for 1995. Alternative I continues the ranges chosen on a provisional basis last July. These ranges do encompass staff projections for money and debt under either the baseline or tighter scenario. Committee members seem to be anticipating appreciably faster growth of nominal GDP than is the staff; nonetheless, I suspect the alternative I ranges would encompass money and debt growth consistent with If there were a question, it your projections as well. would be on M3. This aggregate had a higher trend rate of growth than M2 prior to the S&L debacle and bank problems of the late 1980s. Recent strength may suggest that with depository troubles having been resolved, the tendency for M3 to undershoot M2 close. evident in recent years is drawing to a Alternative IA includes what the bluebook charac- terized as a technical adjustment to the M3 range. That is, such an adjustment would not have any implications for the stance of monetary policy or the intentions of the Committee going forward, but rather would simply recognize the shifting relationship between M3 and the other aggregates. Another option would be to delay any adjustment until July, when more data will be available to determine whether the previous relationships are in fact The 1 to 5 percent reemerging. range for M2 of alternative I also can be thought of as a benchmark for growth in this aggregate under conditions of reasonable price stability. if velocity again becomes trendless. But it would not necessarily provide much guidance on the Committee's expectations in any given year. In the current year, if the Committee were concerned about the potential for inflation to accelerate, and it wanted to signal its intention to lean against any such tendency, a lower range for M2 might be chosen. The 0 to 4 percent range of alternative II is better centered on the staff's expectation of growth consistent with rising interest rates. Presumably, the Committee wishes to see some slowing of nominal income relative to the last few years. If that requires a significant further increase in interest rates, M2 could well run close to, even below, the 1 percent pace of 1994. or February 1, 1995 Short-run policy Donald L. Kohn Mr. Chairman, I will be brief. The bluebook spelled out the rationales for leaving policy unchanged or tightening by 50 basis points. Real interest rate are now close to or even slightly above averages for the last 15 years--a period of relatively high real rates--albeit well below the peaks of 1989. At these levels, which ought to be consistent over time with some restraint on spending, a case can be made for waiting for more information about whether that restraint is taking hold before tightening further. strengthened by the straws in the wind that The case is final demand may in fact be moderating, and by the possibility that the Mexican situation could worsen and spread to other countries, contributing to financial in- stability and restraining our net exports. cost data hold open the possibility that Well-behaved price and output will slow and pres- sures on resource utilization ease before much damage has been done in terms of embedding higher inflation and inflation expectations in the economy. In these circumstances, the Federal Reserve may have breathing room to see how some of the uncertainties some seem to be working themselves out before it needs to move. The question is whether slightly restrictive levels of real interest rates are the most likely levels to accomplish the Committee's objectives. Intermediate- and longer-term real rates do embody market expectations of significant increases in short-term rates over coming quarters, and the absence of tightening eventually would tend to lower current real rates. In the staff forecast, the current level of the funds rate is not high enough to keep inflation from rising. Additional restraint--monetary or fiscal--is needed in part to offset the effects of the momentum in spending by confident households and businesses and the push later in 1995 from exports arising out of The expanding foreign demand and a lower dollar over the last year. dollar has been weak again recently, even with the favorable price data, suggesting the possibility of lingering concerns about the factors bearing on policy here and the resultant inflation outlook. Appreciable inflation risks and the need for moving policy more clearly into restrictive territory to counter them may also be seen as a result of the economy operating beyond its potential. That situation implies that economic expansion needs to slow substantially from its recent pace to limit any pickup in inflation: it may also suggest relatively small risks of overshooting--of tightening so much that the economy is pushed substantially below potential before corrective action can be taken. So far, there is little evidence from financial markets that tighter policy is constraining borrowing or the availability of credit. lems Risk spreads are very narrow, implying markets don't see probfor borrowers even with the rate increases built into yield curves. And banks continue to ease terms and conditions for loans, offsetting in part the effects of Federal Reserve tightening. Even the broader monetary aggregates have picked up in recent months, though their long-term trends remain quite damped. Growth of M2 and M3 in January was the most rapid in several years. We don't see this sort of growth being sustained, though we do expect expansion of the broad Ms to continue to exceed that of the last few years. Faster money growth, along with the strength in bank lending it has funded, may be one more indication that higher rates have not yet begun to bind significantly on borrowing and spending.
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