Full text of Federal Open Market Committee Meeting Minutes, Transcripts, and Other Documents : Meeting, July 5-6, 1995 : Presentation Materials

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APPENDIX

FOMC BRIEFING - P.R. FISHER

JULY 5-6, 1995

Mr. Chairman:
Since your last meeting, there has been more volatility in
short-term interest rates and less volatility in the dollar than
were experienced during the previous months of the year.

These

somewhat different price movements both appear to reflect
decreased risk appetites, and increased uncertainty, on the part
of market participants.

Within the continued trend toward lower rates, the back-andforth movements in June -- particularly in short-term rates and
interest rate futures -- reflected the shifting implications of
data releases and the alternating interpretations of comments by
Committee members.

With increasing uncertainty about both the

direction of the economy and the likely course of the Committee's
policy, market participants have traded the interest rate markets
with increasing anxiety and decreasing conviction.

The market's

skittishness was most recently reflected in the abrupt back-up in
rates following the release of new homes sales.

Because of the market's skittishness, I am reluctant to put
too fine a point on what has or has not been priced into the
market.

While current prices of Fed Funds futures and Euro-

dollar futures contracts are consistent with a 25 basis point

ease by the end of the month and a greater than 50 percent
probability of such a move at this meeting, I would caution
against extracting such point estimate of market expectations.
Indeed, I think that the 14 basis points of easing now in the
July Fed Funds futures contract reflects a clearing price between
a wide majority of market participants who do not, in fact,
expect an ease at this meeting and a small number who have
convinced themselves that the Committee will announce an ease in
policy tomorrow.

With somewhat different consequences, the same lack of
conviction is present in exchange markets.

Following the

concerted intervention on May 31st, the dollar traded
uneventfully in narrow ranges against the mark and the yen,
albeit gradually declining within those ranges.

Many market participants see the dollar as undervalued, and
can find little to justify a further decline.

But they also

cannot see what will cause the dollar to appreciate.

While the

German and European economies appear to be slowing, and the
Japanese economy and financial system appear to be in a dismal
state, uncertainty about the U.S. economy makes it hard to see
much upside for the dollar.

In the short-run, day-by-day market

participants see continued higher yields in European bonds and
persistent dollar selling by Japanese exporters and Asian and
European central banks as capping the dollar's upward potential

- 3

and defining the upper end of the dollar ranges around 1.42 marks
and 86 yen.

Last week the dollar experienced some choppiness and closed
toward the lower end of its ranges, just above 1.38 marks and
around 84 and a half yen.

As a result of higher-than-expected

preliminary German CPI for June, the market saw a decreasing
likelihood of a Bundesbank rate reduction.

The dollar moved up,

following the announced resolution of the auto-trade dispute and
then moved down after the Bundesbank's announced decision to
leave rates unchanged and the new homes sales data.

In my view,

this back-and-forth of the dollar last week principally reflected
the thinness of the market and the lack of conviction on the part
of market participants.

In foreign operations, as I mentioned, the Desk sold
1 billion dollars worth of marks and yen on May 31st, evenly
divided between the System and the ESF -- so for the System, we
sold 250 million dollars worth of both marks and yen.

This

operation was undertaken at the initiative of the Treasury for
the purpose of underscoring the April G-7 communique which sought
an "orderly reversal" of recent exchange rate movements.

With

our support and that of the Bundesbank, the other G-10 central
banks agreed to join the operation, which clearly surprised the
market and helped to stabilize the dollar in the run up to the
Halifax summit.

- 4

For value today, the Mexican authorities have drawn 2.5
billion dollars on the Treasury's Medium-Term facility.

This

brings to 10.5 billion dollars the total outstanding on the
Medium-Term facility, with 1 billion dollars also outstanding on
both the Treasury's and the System's short-term swaps.

On August

1st, when the short-term swaps next mature, we expect to
undertake the second of the agreed-three rollovers of the
System's swap.

In domestic operations, actual reserve needs in the period
were quite different from our initial forecast of a consistently
growing and large reserve need.

Demand for currency turned out

to be much weaker than forecast and the generally-expected higher
Treasury balances were more concentrated than anticipated.

As a

result, after an initial 4 and a half billion dollar bill pass on
May 31st, temporary operations were adequate and effective in
meeting the remaining need.

Looking forward, the combination of the weaker-than-expected
demand for currency and the Treasury's monetization of 2.5
billion dollars of SDRs to fund the Mexican drawing, puts us in
the posture of expecting to be draining reserves by the end of
July.

Mr. Chairman, I will need separate votes of the Committee to
ratify the Desk's foreign and domestic operations and I will be
happy to answer any questions.

Michael J. Prell
July 5, 1995

CHART SHOW PRESENTATION
We're going to employ the tag-team approach this
afternoon.

I'll commence the presentation with a brief overview

of the staff's economic projection.

Then, my colleagues. Tom

Simpson, Larry Slifman, and Karen Johnson, will address

some

issues that we thought might be of particular interest to the
Committee.

I'll wrap

up by unveiling the forecasts you submitted

for inclusion in the Board's Humphrey-Hawkins
Chart

report.

1 starts things off by summarizing some of the

key things we know about where the economy has been recently.
we noted in the Greenbook, while there's

a consensus among

analysts that activity slowed a lot during the
not everyone has marked GDP

optimistic view.
our assessment was
notably the drop
left.

The data

so we could not argue
Be that

second quarter,

growth down as low as the minus one-

half percent we've estimated.
far from complete,

for the period are still
vigorously for our less

as it may, what ultimately swayed us

the softness in labor market indicators--most

in production worker hours through May,

at the

Although initial claims for jobless benefits, shown at the

right, have not

risen to a level

that we would think consistent

with outright declines in employment, we hesitated to discount
the

reported slide in hours
The

remaining four

any more heavily than we did.
panels highlight the sectors

expenditure for which we have two months of data.
at the middle

left,

real

As you can see

consumer spending rose smartly in May.

However, given the weak start in April,

it would take another

large gain in June to produce more than a mediocre quarterly

CHART SHOW PRESENTATION
average increase.

July 5, 1995

Page 2

And, though the May burst of new home sales,

shown at the right, bodes well for future building activity, the
descent of single-family starts into the spring months guarantees
that residential construction will contribute a hefty negative in
second-quarter GDP.

In the lower left panel, new orders for

nondefense capital goods have been very choppy of late; and,
while shipments are up substantially, other data on aircraft and
motor vehicles suggest that the second-quarter gain in overall
equipment spending may be less than half that recorded in the
first quarter.

Finally, at the right, nonresidential

construction fell off in the latest month and appears likely to
record a less than spectacular quarterly rise.

Unfortunately, we

have only one month's full data for the volatile inventory and
net export components of GDP, so there's plenty of room for
surprise in the second-quarter GDP picture.

Thus,

I would

emphasize, again, the tentativeness of our current estimate.
Turning now to the outlook for coming quarters. Chart 2
summarizes the monetary and fiscal features of our forecast.

you know, we based our forecast on the arbitrary assumption that
the federal funds rate will be held at 6 percent into early 1996:
we assumed that it would then drift down a half percentage point,
given the slowing of inflation we expect to occur in the period
ahead and an allowance for effects of ongoing fiscal restraint on
the trend of the "natural" real rate of interest in the economy.
In long-term markets, we've predicted that the assumed
failure of the Fed to ease and incoming evidence of a pickup in
activity will push bond yields appreciably higher by year-end-and that there will be only a partial reversal of that back-up
during 1996.

CHART SHOW PRESENTATION

Page 3

July 5, 1995

We believe that the economy has received a boost over
the past couple of years from a swing toward easier credit
availability and more lenient loan terms; we are anticipating
that lenders will become more cautious in coming quarters, but
only mildly so.
Meanwhile, apart from a slight firming in the near term
in response to the projected rise in bond yields, we anticipate
that the foreign exchange value of the dollar will be little
changed through 1996.
One factor that obviously could play a role in shaping
developments with respect to interest and exchange rates is
fiscal policy.
uncertain.

The outlook for the federal budget is highly

We share the oft-expressed sentiment that the

prospects for deficit slashing seem greater now than they did a
few months ago.

However, we don't think it will be at all easy

to convert the congressional budget resolution into specific
bills that the President will sign or that have will such broad
support as to be veto-proof.

In the end, it seems likely that,

if there is to be a budget, there will have to some serious
compromising.

As you can see in the bottom panel, our assumed

fiscal '96 and

'97 deficit reductions of $30 and $25

billion, are

smaller than those contained in the budget resolution--at least
before the Congress tacks on any tax cuts, which have yet to be
spelled out.

On the other hand, our deficit reduction is much

more sizable than that recommended by President Clinton.

We've

anticipated that cuts in purchases will be modest, and that it
will be transfers and grants that provide the bulk of the
deficit-reduction.
credit for children.

We've included a tax cut, in the form of a

Chart
economy will
line

July 5,

Page 4

CHART SHOW PRESENTATION
3 describes,

in broad terms, how we think the

evolve against this backdrop.

in the top

1995

panel, outstripped final

inventory investment shot up.

GDP

growth, the

sales last

red

year, as

As expected, that pattern seems to

be reversing this year.
The GDP growth rates of 1-3/4 percent in

1995 and and

2-1/4 percent in 1996 are both below what we've assumed to be the
trend rate of expansion of potential output, which is about
percent.

2-1/2

Consequently, pressures on resources should diminish.

As the middle panels indicate, we are projecting that the
unemployment rate will inch back above 6 percent, while the
of factory use

rate

is expected to drop to below its longer-term

average of 81.3 percent.
With this decline in resource utilization, consumer
price inflation should ease back after the bulge earlier this
year.

We expect that

both the

edging south of 3 percent

overall and core CPIs will be

again by 1996.

Chart 4 sketches out the projected movements of the
I perhaps should note that we haven't

major components of GDP.
updated these graphs to

reflect the

revisions in the first-

quarter GDP data released last Friday, but those
small.

changes were

As you can see in the upper-left panel, we believe that

inventory investment

probably slowed in the

will slow further in the third.

second quarter and

By the end of the summer,

should be in reasonable alignment with sales,

stocks

and the resumption

of moderate accumulation will contribute to an acceleration of
GDP in the

fourth quarter.
This

demand.

all hinges,

of course, on the vitality of final

One key ingredient here is the response of housing to

the

July 5,

Page 5

CHART SHOW PRESENTATION

1995

Even

large decline that has occurred in mortgage rates.

discounting last week's figure on new home sales considerably,
the prospects appear good

for achieving at

least the upturn in

residential investment that is graphed at the right.
With an improvement in the housing sector, we would
expect demand for furnishings and appliances to firm.
you can see in the middle-left panel, the trend

But, as

of disposable

income growth is now slowing, in line with the weaker pace of
hiring, and so we're looking for only a limited rebound in the
growth of personal consumption expenditures

in coming quarters.

We expect that there will be a further deceleration of
business fixed investment over the second half of this year--one
that is most marked for producers' durables--the red bars--but
that

also encompasses nonresidential structures.

step-up in equipment spending is forecast
respond, with the usual lags,

A moderate

for next

year, as firms

to the firming in product demand

and the lower level of capital costs.
Government purchases will be sluggish, under our fiscal
assumptions.

Not

only will the deficit-reduction effort

federal purchases down at

a faster rate,

but the

grants will intensify the pressures on states
trim the

push

reduction in

and localities to

growth of their outlays for goods and services.
Finally, a strengthening of foreign growth should

combine with the depreciation of the dollar we have already seen
to produce a more

period.

rapid expansion of exports over the

forecast

With imports also being sucked into the U.S. at a

substantial clip, though, net exports will rise only marginally.
Still, this will be a far more favorable contribution to GDP than
the sizable negatives that we've

seen over

the past few years.

CHART SHOW PRESENTATION

Page

July 5,

1995

I've obviously given only a broad-brush treatment to
our

projection--and much of that admittedly repeats what you've

read in the Greenbook.

My colleagues now will attempt to add

some value in this presentation.

Tom will start

by fleshing out

some of our thoughts on the financial setting for the economy;
Larry will focus on some of the more interesting questions
relating to the outlook for private spending and for inflation;
and Karen will

address some issues pertaining to the prospects

for the dollar

and for the

partners.

economies of some of our key trading

Page

Thomas D. Simpson
July 5, 1995
In my comments on the financial setting for the staff
economic forecast, I will focus on:

developments on the credit

availability front; the healthy gains in stock prices thus far in
1995 and whether this represents formation of a "bubble;" and the
level of real interest rates as we enter a period of greater
fiscal restraint.
Charts 5 and 6 address credit availability.

The upper

panel of chart 5 shows that bank capital positions remain quite
comfortable by the standards of recent decades, having climbed a
good bit from the period of asset quality concerns of the late
1980s and early 1990s.

In the context of stronger capital

positions, banks have become willing lenders.

Indeed, the center

panel shows that the margin of banks more willing to make
business and consumer loans has remained sizable over the first
half of this year.

In the case of business loans, this greater

willingness seems to importantly reflect a relaxation of the very
stringent standards imposed several years ago, an observation
generally confirmed by examiners.
Consistent with the willing posture of loan officers,
spreads on business loans,

represented by the red line in the

bottom panel for small business loans, have been on a mild
downtrend over the past couple years.

Auto loan spreads have

widened some in recent months but from unusually low levels, as
auto loan rates have in fairly typical fashion lagged market rate
declines, and they remain below levels of the early 1990s.
Spreads on open market business debt,

shown at the top

of your next chart, have risen some of late as the bond marker

CHART SHOW PRESENTATION

Page 8

July

1995

has absorbed larger volumes while the paper market perhaps has
been affected by

some quarter-end pressures.

On balance,

though,

they remain fairly tight.
Meanwhile, the dramatic improvement in credit quality
in the
end.

consumer and business

sectors seems to have come to an

The red line in the middle panel shows

that consumer

loan

delinquencies appear to be turning up from very low levels,

keeping with the recent upturn in debt-service burdens, the black
line.

Looking forward, the

staff forecast

debt-service burdens rise further, as
and thus it

implies that household

shown by the broken line,

seems reasonable to expect further

increases in

delinquencies.
The bottom panel

shows net interest payments

nonfinancial corporations in relation to cash flow, along with
the delinquency

rate on business

rising last year but
forecast, they

loans.

Interest

remain relatively low and,

edge down after midyear.

delinquency rate on business

payments began

in the

staff

Accordingly, while the

loans likely will move higher

coming quarters, the increase should prove modest.
On net,

these considerations suggest that

be turning more cautious
However,

and credit will become less

should income and interest

staff forecast,

any such move to

rates unfold

lenders will
available.
line with the

stringency will be mild,

exerting only a slight drag on spending.
The tremendous
higher

records has

run-up in stock prices this year to even

raised concern about

be developing in this market
this time might
illustrates

whether a "bubble" might

and whether an easing of policy at

foster further

speculative behavior.

that share prices have

risen about

Chart

17 percent

over

CHART SHOW PRESENTATION

Page 9

July 5.

1995

the first half of this year, a period in which analysts have
generally been surprised on the upside by earnings

reports.

Spikes of that magnitude typically have not persisted for long,
although they typically have

not been reversed immediately and
The center panel

they have not been harbingers of recession.
shows that

economic profits, despite some leveling out of late,

were up nearly 25 percent in the first quarter from two years
earlier,

and the broken line shows that the staff forecast

looks

for a resumption of profits growth later this year.
In the bottom panel, the
dividend price

red line charts the S&P

ratio and shows that the current dividend yield is
rates, which

Moreover, real bond

very low historically.

I will

be discussing shortly, may be a little on the high side of
historical norms, despite
factor that might call
dividend pay-outs

for higher dividend yields.

of corporations have

earnings to finance fixed

were

Indeed, as

earnings-price ratio,
basis, has been

favored

as an

retained

investment or to buy back shares when

thought that the potential

inadequate.

However,

for these firms have been extremely low,

unusually large number

it was

over recent months,

sizable declines

returns on internal investments

the black line illustrates,

the

using earnings measured on a trailing

rising this year,

particularly low--that

is,

and its

level is

not

the P-E ratio is not particularly

high.
On balance, there are no strong reasons to believe
that,
in

in the context

stock prices

near

of the staff economic

are unsustainable.

term may be greater

analysts

appear

forecast,

However,

the

recent

risks

gains

in the

on the downside, especially since

to be more optimistic

than the

staff

the
about

CHART SHOW PRESENTATION

Page

July 5,

and we have interest rates

outlook for profits,

1995

going up, which

does not appear to be built into the market.
Turning to real interest
chart

8 plots measures of the real

key ten-year Treasury note since

rates,

the upper

panel of

rate on federal funds and the

1960.

By the standards of this

long period, the current 3 percent real federal funds
bit on the high side of historical experience.
real

rate has

In any event,

too,

remains

By the standards of the past

decade and a half, though, both real short
moderate.

The longer-term

fallen a good bit this year but it,

above longer historical averages.

rate is a

judging whether

and long

rates are

real interest

rates are

restrictive or not at any point in time depends importantly on
other forces acting on the economy, such as private propensities
to spend, exchange

rates

and foreign output,

Of particular interest at the
impending deficit-cutting measures as
President have

both the Congress and the

The middle

in historical perspective.

1980s and

standards.

early 1990s,
shown in the

Even though the deficit is

ahead, as

the blank line
of Congress's
in the year

labeled

inset to the left,

2002.

red line

"current

absent bold

in the
labeled

law" baseline.

"balanced budget"

recent budget

down

is still large by historical

shown by the

which is based on the CBO's

characterized much of

action, the deficit would tend to widen some
immediately

result

panel puts the deficit scaled by

appreciably from the swollen levels that
the

present time are

embraced proposals that they claim will

a balanced budget.
GDP

and fiscal policy.

fiscal

years
"baseline"
In contrast,

a staff translation

resolution geared to budget

balance

CHART SHOW PRESENTATION

Page 11

July 5, 1995

One way to assess this and other developments
on equilibrium real interest
model like the
panel.
the

staff's.

bearing

rates is through an econometric

Such an exercise is

shown in the bottom

In essence, the experiment performed involves selecting

real federal funds

rate path that results

line with potential and stable inflation.

in output moving in

A word of caution at

this point is that exercises of this sort should be regarded as
illustrative and not read too

literally:

Apart

from all the

uncertainties about behavioral relations in the model, the
particular results depend on various assumptions.
The

red line,

labeled "baseline,"

corresponds to the

baseline deficit shown in the center panel and should not be
confused with baseline
Bluebook.

strategies shown

Under this baseline, the real

remain in the
deficits.

The

3 percent

area, buoyed by

solid black line

federal funds rate

role in this model,

bond rate is

lags,

by about

rate would

continued large fiscal

rate,

which plays

funds

responds primarily to current and
is,

the

process determining

adaptive or backward looking.

circumstances, the

funds

required under the balanced budget scenario,

past levels of short-term rates--that
the

federal

illustrates the path of the

based on the assumption that the bond
critical

in the Greenbook and

In these

rate would need to drop promptly, given

3/4 percentage point or so to avoid a weaker

economy once spending cuts begin to kick in later this year.
This new lower

level would

need to be held for a couple years

before it would have to drift down about another

1/2 percentage

point to counter the mounting drag from ongoing deficit
reduction.

CHART SHOW PRESENTATION

Page

July 5,

Of course, the bond market might be more
looking.

Indeed, it has already built

forward

in some deficit reduction,

a factor that has contributed to the bond market

rally over

This will act to cushion the depressing effects

recent months.

on the economy of impending budget cuts.
illustrates the path that
to take,

The broken black line

the real federal funds

rate would need

in the eyes of this model, if the move to a balanced

budget were

fully credible to market participants

and current

bond rates accurately reflected the future path of the
funds

1995

federal

rate needed to achieve the same outcome as in the other

simulations.
federal

In these circumstances,

two

no reduction in the real

funds rate would be necessary for some time, until

turn of the century, as prompt, forward-looking bond

the

rate

declines provide sufficient stimulus to rate-sensitive sectors to
offset weakness coming from fiscal restraint.
real funds

Eventually, the

rate would need to decline, converging toward the

level in the adaptive expectations case and validating
expectations.
Clearly, both the backward-looking and
looking paths

represent extremes.

In any event,

fully forwardthe somewhat

forward-looking nature of the bond market implies that
rate declines

recent

are, to a degree, reducing the need for aggressive

policy measures

in the

quarters ahead.

Page 13
Lawrence Slifman
July 5, 1995

Your next

chart focuses on the current inventory

To give you the bottom line of our analysis first,

correction.

we do not think inventory overhangs are widespread;

primarily

they are confined to autos and some suppliers such as steel,
housing-related items, and apparel.

Producers in these sectors

have been prompt to cut output, and with demand

showing signs

firming, we think the process pretty much should have run its
course by the end of the third quarter.
Turning to the specifics, the upper left panel shows
the

sharp run-up in dealer inventories year earlier this year.

As you know, automakers responded by slashing production in the
second quarter.

Sales picked up in May--bolstered at least

part by manufacturers'

incentives--

and if.

as we expect, they

climb a bit further during the summer, the current
production should bring stocks close to

level of

the 60-day industry norm

by September.
Outside of motor vehicles,

significant

inventory

overhangs appear to be limited to only a few sectors of the
economy.

I use the phrase "appear to be".

monthly inventory data

are subject to sizable

sometimes can substantially alter
said,

that

the softness

revisions that

stocks are most out

of kilter in areas

in the housing market:

for these market

reports

construction supplies,

groups is

to
and

In addition.

inventories are reported to be excessive.

ratio

That

analytical conclusions.

goods such as appliances and furniture.

apparel
sales

because

the data--shown in the middle panel--and anecdotal

suggest

home

in part,

The

shown by the red

stockline.

CHART SHOW PRESENTATION

Page

July

1995

as shown by the black line, stocks in the aggregate

Elsewhere,

have edged up much less relative to sales.

The lower

left panel

illustrates that manufacturers of construction supplies,
goods,

and apparel

responded promptly to the

recent

home

inventory

accumulation, and have cut production nearly 4 percent since
January.
sectors

We expect that the inventory correction in these
will

completed

combination of some

during the next few months through a

further production adjustments

strengthening of demand.

and a

One tentative sign of that

strengthening was the May rise in new orders received by these
manufacturers--the

lower right panel.

As Mike noted, in our forecast,
containing the

a critical element in

size and scope of the current

inventory adjustment

is a projected firming in consumer demand--the subject of your
next chart.

In making this

projection, we

first had to ask

ourselves why PCE has been so sluggish in recent months.

Among them,

noted in the Greenbook a variety of possibilities.

the exhaustion of pent up demand doubtless has played an
important

role.
As shown in the upper left panel of chart

1992,

93,

indeed,

and 94,

real outlays for consumer

at nearly twice their

probably the case that
half of this year
consumer

least in part. the

often follows a

to above trend levels.

If this analysis

begin to

albeit

For motor vehicles,
auto

fleet,

shown

pace.

It is

the slowing of spending during the first

"breather" that

up,

during

goods grew rapidly:

longer-run average

reflected, at

see a pick

10,

tne upper

limited,

period

typical
rapid spending

is correct,
in

consumer

should

spending.

the average age of the nation's
right

panel has

been trending up

July 5,

Page 15

CHART SHOW PRESENTATION

its highest level since the

and now is at

of the aging of the stock, we expect
continue to boost

late

1940s.

replacement

1995

In light

demand to

sales over the next year and a half.

addition, if housing activity picks up as we are projecting,
consumer

spending for furniture and appliances also should

strengthen.
In the Greenbook we noted that

several of the

fundamental determinants of consumption activity

are still

Among them is unemployment expectations, the

favorable levels.

in the middle panel, which statistically seems

black line

to be a

useful indicator of consumers' willingness to purchase autos and
Given our forecast of sustained growth and

other durable goods.
only a small rise
half, we don't

in the jobless

expect much deterioration in these expectations,

which suggests that
income.

rate over the next year and a

spending

should hold up well

In addition, the recent

stock market

as a share of

rally has

added

several hundred billion dollars to household net worth, the black
line in the

bottom panel,

reversing much of the previous

Over the long run, net worth and
theory would predict,
is much less

tight.

saving are

although in the short

dip.

inversely related,
run the

Nonetheless, last years'

relationship

flat stock market

and declining bond prices may have been a damping influence on
consumption during the

first half of this year, while in the

projection, we see the

recent

the

saving rate a bit

lower than it

Another important
longer the

boom in

chart.

expect

rise in securities

issue

prices

otherwise would

in the

pushing

be.

forecast is how much

equipment spending can be sustained--your next
real

to grow at more than

outlays for producers'

a 5 percent

annual

durable equipment

rate over the next

year

CHART SHOW PRESENTATION
and a half.

Page 16

July 5,

1995

of the double-digit growth rates

Coming on top

for

equipment spending during the past three years, one would think
the current investment

boom should be off the charts compared

with previous cyclical

expansions, and that a major contraction

may be imminent.

as shown in the upper panel,

But,

using a

quantity index that is less distorted by the relative decline in
computer prices over time, the current cycle is well within the
range of previous

long-expansion experience.

One problem with this cyclical
the years,

equipment investment has switched

that depreciate more

Because of the higher depreciation

firms have to "run faster" just to stay in place.

adjust for this,

the middle panels look at

relative to the net capital
the

toward capital goods

rapidly, such as computers and

communications equipment.
rate,

comparison is that, over

net capital stock.

investment

stock--that

net investment

is,

the growth rate of

Because of the dramatically different

rates for computers and other PDE, they are shown

separately.

In both cases, the capital

stock is

growing rapidly,

but not out of bounds by historical standards.
One negative

factor in the

outlook for equipment

spending is our projected decline in capacity utilization--the
lower left

panel.

Clearly, if firms find that

idle equipment, they will

re-think their plans to replace or

upgrade, let alone expand, existing capacity.
keep the

of capital

relative to the

panel--continues to fall
declines

This has

led us to

level of spending for equipment other than computers

essentially flat over the projection period.
cost

they have too much

in computer

cost

In contrast,

of labor--the lower

the

right

rapidly, primarily reflecting further

prices.

On balance, we

expect

investment

July 5.

Page

CHART SHOW PRESENTATION

1995

computing equipment should remain on a rising trend, although
slower than its recent torrid pace, keeping overall PDE growing
at a respectable

rate.

Your next chart
greater detail.

examines our inflation forecast

Basically, the issue is: why, in contrast to

many outside forecasts, do we think inflation is likely to
subside from the 3-1/2 percent rate observed so far this year, to
a shade under 3 percent next year?
consumer prices in the

In part the acceleration of

opening months of this year

has reflected

higher materials costs and rising non-oil import prices--the
middle

Some additional pass-through may

panels.

But we expect those effects

pipeline.

intermediate materials

to wane

still be in the
The PPI for

soon.

excluding food and energy rose only 0.2

percent in May and, with manufacturing activity contracting, spot
prices for many industrial commodities have
fallen recently.

Moreover,

stabilized or even

the dollar is expected to be little

changed during the projection period, and this should keep
price increases

in check, following the recent

Labor cost trends have been quite

import

surge.

favorable recently.

Over the four quarters ending in March, productivity in the
nonfarm business sector increased 2 percent while hourly
compensation was up only 3 percent.
much of the moderation
has come

only 1-1/2

percent

costs.

inflation, actually fell.

costs--much of it

Health insurance premiums

over the past

compensation plans,

contributions

panel,

in compensation over the past two years

from a pronounced slowing in benefit

related to health care

workers'

As shown in the lower

year, while the costs

which are partly

rose

for

related to medical

In addition, employer pension

slowed abruptly in the first

quarter.

Some of

CHART SHOW PRESENTATION
these improvements
savings
next

and we expect

year.

Page

benefit-cost

inflation

some bounce-back

July 5,
reflect
the growth

1995

one-time
of benefits

In addition, with resource utilization rates

expected

to remain fairly high, we are projecting some upward pressure on
the growth of wages and

salaries.

On balance, we are forecasting hourly compensation to
rise at a 3-1/4

percent rate through the end of next year--only a

quarter of a percentage point faster than during the past year.
Karen will now continue our presentation.

Page 19
Karen Johnson
July 5, 1995

As Mike has explained, I will consider issues underlying our thinking on the dollar
and some elements in our outlook for key U.S. trading partners.
Chart 13 shows recent developments in dollar exchange rates. In terms of the
currencies of the other G-10 countries, the dollar has generally been declining during the first
half of this year in both nominal terms, not shown, and price-adjusted terms, the red line in
the top panel--continuing a longer trend of dollar depreciation that began in early 1994.
Economic developments during much of 1995 have worked to lower jointly the real long-term
interest differential, the black line, and the price-adjusted value of the dollar. With respect to
the individual G-10 currencies--the lower left panel--movements of the dollar to date this year
have differed substantially, reflecting the differing factors that lie behind the changes in
bilateral dollar rates. For example, the persistent trade dispute between Japan and the United
States--and their respective trade imbalances--weighed on the yen/dollar rate, and it is against
the yen that the dollar has depreciated most--15 percent--since December. Of the European
G-10 currencies, the dollar has fallen least against the Italian lira and the British pound. The
dollar fluctuated in terms of the Canadian currency during the past half year, often moving in
the opposite direction from its change with respect to the other G-10 currencies, but on
balance, there is now little change from December in the bilateral Canadian dollar rate.
In contrast to its movement against G-10 currencies, the dollar has appreciated
strongly in terms of the Mexican peso, shown in the lower right, since the eruption of the

CHART SHOW PRESENTATION

Page

July 5,

1995

crisis in Mexico last December. At first, the dollar's sharp appreciation in nominal terms,
the black line, resulted in real dollar appreciation, the red line, as well. Subsequently, as
Mexican consumer price inflation rose in response to the exchange rate shock, the real
appreciation in the peso/dollar rate began to retreat. We expect the nominal peso/dollar rate
to move up a bit further over the forecast period, but continued high, though slowing,
Mexican inflation should result in less real appreciation of the dollar in terms of the peso, on
balance, by the end of 1995 than we see now. I shall return to the implications of
developments in Mexico for the U.S. economy shortly.
Chart 14 contains one development common this year to almost all the G-10 countries,
including the United States: lower nominal interest rates, particularly long-term interest rates,
shown on the right. The numbers in the tables in the middle panel show that on average
U.S. short-term rates, on the left, are above foreign rates and have not fallen as much as
those abroad. Just the opposite is the case, however, for long-term rates, on the right.
Japanese long-term rates have come down the most, but the decline in U.S. rates noticeably
exceeds that of foreign rates on average. Our forecast is for long-term rates abroad to
change little from current levels over the rest of this year and next. In that event, the dollar
can be expected to retrace some of its decline, as somewhat higher projected U.S. long-term
rates move the interest differential over the next few months in favor of dollar assets; the
dollar would subsequently remain little changed over the rest of the forecast period.
Of course, other factors can influence exchange rates as well. Two that are

CHART SHOW PRESENTATION

Page 21

July 5,

1995

particularly relevant now are listed in the lower left: U.S. fiscal policy and the long-run
outlook for our current account balance. As market participants associate less risk with the
long-term outlook for fiscal policy, perhaps in response to perceived progress on the budget
in Congress and with the Administration, they may in the near term also have a more
favorable view of the dollar, causing it to rise. Over a somewhat longer perspective,
adjustment within the economy to a sustained lower fiscal deficit is likely to be associated
with lower real interest rates and some decline in the dollar's spot exchange value that would
induce some of the resources no longer consumed in the public sector to move into the traded
goods sector.
Continued current account deficits also pose a risk to the dollar. Our econometric
models based on post-war experience suggest that our external deficit would expand further
over the medium term at current exchange rates. If market participants came to see the
external deficit as implying ever higher U.S. net indebtedness to the rest of the world as a
share of GDP, they would put downward pressure on the dollar. Arguing against widening
deficitis is the fact that U.S. unit labor costs in manufacturing, at current exchange rates, are
well below those of our major industrial trading partners, as can be seen on the right. It may
be that our econometric models do not incorporate sufficiently this competitive edge on the
production side. A more favorable trade outcome would eliminate the hypothesized
downward pressure on the dollar. The exchange markets will bring forward into current
rates the expected outcome of these longer-term developments, but to what extent is difficult

CHART SHOW PRESENTATION

Page 22

July 5,

1995

to anticipate--adding some uncertainty to our outlook for the dollar.
Your next chart presents an overview of the foreign outlook for real growth. As you
can see in the top left, we expect that growth in our trading partners, weighted by U.S. nonagricultural exports, fell sharply during the first half of this year from the robust growth rate
of 1994. Through the end of 1996, we expect to see foreign growth recover somewhat and
continue to outpace growth of U.S. real GDP. The top right box shows the critical role of
the Asian developing countries in sustaining growth of foreign output, particularly in 1995.
We expect that 1996 will see improvement in the industrial and, especially, the Latin
American countries.
The middle left panel provides an insight into the relative importance of these regions
for U.S. exports and output. The industrial countries account for more than half of U.S.
exports, and Canada by itself is particularly important. Latin American and Asian developing
countries each have a significant share. Details of the forecast for the foreign G-7 countries,
Mexico, and the Asian developing countries are shown on the right. For the foreign G-7
countries, the slowdown in the first half of this year is concentrated in Canada and Japan.
For the developing countries, weakness is most pronounced in Mexico.
The lower panels summarize our estimate of the impact of developments in Mexico on
the U.S. economy and our outlook for Mexico and the other Latin American countries. Data
already available confirm an extremely sharp drop in Mexican real output during the first
quarter that accounts for much of the projected 1995 decline shown in the chart on the left.

CHART SHOW PRESENTATION

Page

July 5,

1995

The first-quarter decline in large part results from the policy measures adopted by the
Mexican officials and the impact of the depreciation and rise in peso interest rates on
Mexican consumer and business confidence. We expect that by the end of this year real
output will no longer be falling, and we look for Mexican growth to resume next year. Some
slowing of output growth in other Latin American countries, particularly Argentina, reflects
spillover effects of the Mexican crisis into asset markets and on macroeconomic policies.
On the right, our projection for the U.S. trade balance with Mexico under current
assumptions for Mexican real growth, prices, and the exchange value of the peso is compared
with our projections last December. We expect that the bilateral balance for goods and
services excluding oil will fall from a small surplus last year to a deficit of $15 billion by the
end of this year, a bit larger next year. Data for merchandise trade through April, the line,
suggest that such a substantial turnaround in the trade balance with Mexico is already well
underway.

The severe decline in Mexican output that has occurred largely accounts for the

speed with which U.S. trade with Mexico has adjusted. Looking ahead, real depreciation of
the peso will help maintain a surplus for Mexico as positive real output growth returns in
1996. With the adjustment of our trade balance with Mexico largely behind us, an important
negative influence on the change in U.S. net exports and activity during the first half of the
year will have ended.
Chart 16 addresses in more detail our outlook for the major European industrial
countries and Canada. Recent exchange rate movements are likely to affect the pattern of

CHART SHOW PRESENTATION

Page 24

July 5,

1995

growth in Europe, particularly this year. The top left panel groups Germany and France,
two countries with relatively strong currencies, and compares them with the United Kingdom
and Italy, two countries whose currencies depreciated substantially in 1992 and then fell
somewhat further again this year. For example, the weighted-average value of the mark, on
the right panel, has appreciated during this year to peak values for the floating rate period
while the pound has fallen somewhat from the level it maintained in 1993-94. In both pairs
of countries, growth is expected to slow noticeably this year from the robust pace last year.
We project some boost to growth this year for the United Kingdom and Italy from their
external sectors while in Germany and France net exports will contribute little. However,
despite the near-term slowing, for all these countries growth is expected to average about 3
percent over the rest of the forecast period, moving these economies by the end of 1996 close
to our estimates of their respective levels of potential output.
In contrast, real output growth in Canada fell drastically in the first half of the year
and is expected to revive only to about 2-1/2 percent over the next six quarters--well below
last year's rate. The Canadian outlook in part reflects the slowing to date of output growth in
the United States and the weak projection for the current quarter. In addition, both monetary
and fiscal policy in Canada were tightened in 1994. The panel on the right shows the upward
movement in the Canadian overnight rate of nearly 450 basis points, on balance, since the
beginning of 1994. While the Bank of Canada has begun to ease that rate back down, it
remains quite high. In addition, the Canadian government has injected greater fiscal restraint

CHART SHOW PRESENTATION

Page 25

July 5,

1995

this year and last. The structural budget deficit over this time is estimated to have contracted
by about 1-1/2 percentage points of GDP.

As a consequence of the lags with which these

policy actions have their effects, we expect Canadian real output growth to remain subdued
over the forecast period. We were surprised, however, as were most analysts, by the extent
of slowing that occurred in the first quarter, when real output grew less than 1 percent at an
annual rate. Some of this deceleration may subsequently be revised away or reversed in later
quarters, but there is clearly some risk that such an abrupt drop, which was moderated only
by large inventory accumulation, could be a harbinger--or could precipitate--even weaker
growth than we are forecasting.
Your next chart presents the elements of our thinking about the outlook for the
Japanese economy.

As shown in the upper left, we look for real growth in Japan to begin to

strengthen during the second half of this year but to remain subdued through the forecast
period. The strength of the yen is a major factor restraining expected Japanese growth.
However, for some of the other Asian countries, appreciation of the yen in terms of their
currencies will boost exports so that growth in the Asian developing countries is expected to
continue strong, although it will slow a bit from its very high rate in 1994.
As can be seen in the right panel, Japanese growth of around 2 percent per year is not
sufficient to narrow the gap between actual and potential output, and we project a widening
in that gap through the end of next year. The low level of resource utilization in Japan and
the appreciation of the yen have contributed to deflation in goods prices. The lower left

CHART SHOW PRESENTATION

Page 26

July 5,

1995

panel shows the changes over the preceding twelve months for two major components of the
consumer price index, services less rent and goods less food, and for the producers' price
index. Inflation in the price of services, which are domestically produced and for the most
part do not compete directly with imports, has been between 1 and 2 percent over the past
year. However, prices of goods have actually been falling for some time. This deflation is
not limited to imported final goods, but likely does reflect the influence of competing
imported goods and the falling prices of imported inputs.
The panel on the right shows that critical asset prices--those for stocks and for land-are also falling in Japan--as they have been for some time. The continuing decline in land
prices has added to the woes of the Japanese banking system and risks increasing the already
large burden of nonperforming loans. Lower land prices reduce further the value of
collateral behind real estate loans on the books of the banks, already a much-troubled portion
of banks' portfolios. Further declines in stock prices would lessen the market value of the
hidden reserves of the banks and so reduce the capacity of Japanese banks to finance
additional loan loss from hidden reserves. While these problems have been acknowledged for
some time by Japanese authorities, progress in terms of improving banks' balance sheets has
been limited. Continued declines in these asset prices add to the perceived risk of a banking
crisis in Japan. At the very least, it appears that Japanese banks are not in a position to be
particularly supportive of the recovery of economic activity.

CHART SHOW PRESENTATION

Page

July 5,

1995

Without any foreseeable pressure on resource availability soon and with asset prices
and goods prices falling, easing by the Bank of Japan would seem warranted. In our forecast
we have assumed a small further reduction in the call money rate, but no discrete easing
move, such as a discount rate cut, by the Bank of Japan. While we are forecasting some
recovery in real growth in Japan, without even greater impetus from monetary policy or
additional fiscal stimulus, there is downside risk of a return to recession in Japan in our
outlook. Indeed, Governor Matsushita, in his press conference today following the Bank of
Japan's branch managers' meeting, suggested that a discount rate cut is under consideration.
Mike Prell will now present the committee's forecast.

Page

28
Michael J. Prell
July 5, 1995

To wrap up quickly, let me

just draw your attention for

a moment to the last chart, which summarizes the forecasts you
submitted.

You've lowered your sights considerably for real GDP

growth this year, with the central tendency now bracketing the
staff forecast, at 1-1/2 to 2 percent.
dark cloud is that

the central tendency of your inflation

forecasts is a tad lower now, at
You are
next

The silver lining in that

3 to 3-1/4 percent.

generally looking for some pickup

in growth

year, with the central tendency of forecasts being 2-1/4 to

2-3/4 percent, to the

high side of the staff projection;

your

price forecasts center on 3 percent, close to our prediction.

STRICTLY CONFIDENTIAL (FR) CLASS I-FOMC

Materialfor

Staff Presentation to the
Federal Open Market Committee
July 5, 1995

Chart 1

Second-Quarter Indicators
Hours and Output Growth

Initial Claims
Pe rcent change, saar

Thousands
8

400

Four-week moving average

-6

380

- June 24

4
360

2
340

Q2 proj.

320

-May ave

4,
1994

300

1994

1995

Home Sales and Starts

Real Consumer Spending
Billions of 1987 dollars, saar

Thousands,
3700

e quarterly average

1500

May
Single family starts
1200

3650

SMay
900

3600

New home sales
600

3550

1994

3500

1995

Nondefense Capital Goods
Billions of dollars, saar
550
Excluding aircraft

Orders

300

1994

1995

Nonresidential Construction
Billions of dollars saa
320

e quarterly average
300

1 994May

Shipments

280

260

1995

1994

1995

1994

1995

Chart 2

Monetary and Fiscal Outlook

Federal funds rate assumed to remain at 6 percent into early 1996.
Rate then declines somewhat, given lower inflation and effects of
fiscal restraint on the "natural" rate of interest.

Bond yields rise appreciably by the end of this year and reverse only
a portion of that back-up during 1996.

Lenders become more cautious-but only mildly so.

Dollar little changed through 1996.

Federal Deficit Reduction-Annual Increments
Billions of Dollars of Deficit Reduction
FY1996

FY1997

Budget resolution (before tax cuts)

President's plan (CBO reestimate)

18 (14)

Greenbook assumptions

Transfers, grants, subsidies

Taxes

-4

-8

Purchases

Interest payments

40
6 (4)

Chart 3

Forecast Summary
Real GDP
Four-quarter percent change
-

Q4/Q4 Percent Change
GDP

Final sales

1
\

\ \

1994

1995

Pet cent

3.1

3.0

4.1

3.4

1.7

2.2

8
Q4 Average

,--\

82 -

Manufacturing capacity

utilization
I

Unemp.

C.U.

1993

6.5

81.4

5.6

84.5

6.0

81.9

6.1

81.1

1995

1994

1993

1996

Resource Utilization Rates
Index

Final
Sales

1993

GDP

1996

Consumer Price Indexes
Four-quarter percent change

Q4/Q4 Percent Change
CPI

CPIX

1993

2.7

3.1

2.6

2.8

3.0

3.2

2.9

CPI ex. food and energy
-

'-'N

1993
1993

1994
1994

1995

,
1996

1996

Chart 4

Outlook for Economic Activity
Inventory Investment

Residential Investment

Percent change, saar

Billions of 1987 dollars, saar

S-60

Other

-4

ll.

ifil-mm

Motor vehicles
I

1994

1995

1 1 30

Personal Consumption Expenditures
Percent change, saar
DPI (four-quarter percent change)

1994

1996

1995

Government Purchases

1994

1996

1995

1996

Business Fixed Investment
Percent change, saar

1994

1995

1996

Net Exports
Billions of 1987 dollars
-1000

Percent change, saar

900
Imports
800

700
Exports
600

500
1994

1995

Note: All data are in constant dollars

1996

1994

1995

1996

Chart 5

Credit Availability

•
.....
...
...
iii

Bank Capital-to-Asset Ratio

....ii

. •...
.° .-....

......
. . .
. .

....ii

......

.... °
..-..

.. %....°
. . .

..::::
.9..
....t
Wilinges

Percent

...
::
...
:: :
.....
I ss
.. ..
to.Mke.o. n

1990

1985

1980

1995

Percent
Net percentage of loan officers indicating greater willingness

1970

1975

1990

1985

1980

1995

Bank Loan Rate Spreads
Percent

1980
1970
1975
Auto loan rate less yield on 3-year Treasury note.

1985
. !.F.;-

1990
-te
:

1995

Chart 6

Credit Availability
Market Spreads on Business Debt
Percentage points

:: . I

I I

..I
.1
I

S... I

1970
1975
1980
1985
1990
Rate on Baa bonds less 30-year Treasury bond rate. Rate on 3-month commercial paper less 3-month bill rate

1995

Household Sector Debt-Service Burden and Consumer Loan Delinquency Rate
Percent

Percent
Consumer loan delinquency rate

.:::
..:::....

•..
..:

......

. . . .::

:'..

....

......
:::

Debt--service burden
.

. ,. .

. . . .

. , ..

. . ,. . ,. .

I::

:::!i

:::: :i

. F'.I:: . :: .: : I.I . . . . . . .....
. . . . .
I

1970
1975
1980
1985
1990
Scheduled debt-service to DPI. Consumer loan delinquencies on closed-end loans (ABA series)

1995

Corporate Net Interest Outlays to Cash Flow and Business Loan Delinquencies
Percent

Percent

C&l loan delinquency rate

Net interest to cash flow

1970
1970

::I:

1975
1975

1980

.::::il

I1985II
I

1985

I
I

"1*

1990

1995

Chart 7

Stock Market
S&P 500 Price Index

Percent
40
Six-month percent change
...

- 30

...

0
-10

...:.:II
1960

'%:-

1965

1970

1975

::I
. ..
I" ""
1980

I
I

1985

Il::40
",40

1990

1995

After-tax Economic Profits (NIPA)
Billions of dollars

1960

1965

1970

1975

1980

1985

1990

1995

Earnings-Price and Dividend-Price Ratios (S&P 500)
Percent

1960

1965

1970

1975

1980

1985

1990

1995

Chart 8

Real Interest Rates and Alternative Fiscal Scenarios
Real Federal Funds and Ten-year Treasury Rates
Percent
= 12
Ten-year Treasury**
June

Federal funds*

vII I
I~~~~~~

1960

1965

1970

1975

1980

L I

IJ-

1985

1995

1990

*Real federal funds rate is the nominal rate on federal funds less thechange in the CPI over the previous four quarters.
"Real ten-year Treasury rate is the nominal rate on ten-year notes less the average annual change in the CPI over the
previous five years.

Federal Budget Deficit Relative to GDP

-4

SBaseline

Balanced budget
I i

1996

1998

Pe rcent

2000

2002

\ ^JX
-F
I

1960

1965

11111

III

1970

11111111111

1975

1980

11111

1985

III

1995

1990

Real Federal Funds Rate
Percent

Baseline

Forward-looking bond market

---..

Adaptive bond market

1995

1996

1997

1998

1999

2000

2001

2002

Chart 9

Inventories, Production, and Sales
Days supply

Domestic Autos and Light Trucks
Millions of units

Production

1993

1991

1995

1991

1993

Millions of units

1995

1991

1993

1995

Inventory-Sales Ratio - Manufacturing and Trade Excluding Motor Vehicles
-

I' ^y

Constrnction supplies

Other

1989

1990

1992

1991

IP Index for Construction Supplies,
Home Goods, and Apparel

1987=100

1993

April

1994

1995

New Orders for Construction Supplies,
Home Goods, and Apparel
Billions of dollars

Aay

1989

1991

1993

1995

1989

1993

1995

Chart 10

Consumer Spending
Real PCE Durables and Nondurabl es
Billions of $1987, saar

Median Age of Auto Stock*
Years

- 2000

1800

8
1994

1600
7
1400
6
1200
5

1000
I I I I I I II I I I I I I I I I I I I I I II I I

800
1970

1975

1980

1985

1990

1995

1980
1975
1970
*Year ending July 1.

1985

1990

Unemployment Expectations and Consumer Durables*
Percent of DPI

Index
150

..:.:

::: :

Unerr

130
110

..-

....
..

S...
.

:: :.:

.. ..

30
1975
1970
*Including leased autos.

1980

1985

1990

Household Net Worth and Personal Saving

1995

Percent of DPI
520

490

460

430

1970

1975

1980

1985

1990

1995

Chart 11

Business Equipment
Producers' Durable Equipment, Cyclical Comparison*
Index, trough=100
Chain-weight quantity index

Maximum

Current

Minimum

S I

-2

*Cycles beginning in fiQ1, 75Q1, and 8204

N6umber
of Qarters Pom Trough
m ber of
Qrter

m Trough

I
18

Growth in the Net Stock of Equipment
Percent change, annual rate
[Excluding computers

1970

1975

Percent change, annual rate

1980

1990

1985

1995

Computers

1970

1975

1980

1985

1990

1995

Cost of Capital* Relative to Cost of Labor

Manufacturing Capacity Utilization Rate

Index, 1987=100

Index
1967 -94 Average

1989

1991

1993

1995

III1

III

I I IIIII

1970

1975

1980

111111111'

1985

*Producers' durable equipment

1990

1995

Chart 12

Inflation
CPI, Excluding Food and Energy
Percent change, saar

1990

1991

1992

PPI, Excluding Food and Energy

1996

1995

1994

1993

Non-oil Import Prices

Percent change, saar

-n

Intermediate materials

g-.

fl,1 1
1994

1995

*1/1

1996

IvS

1994

1996

1995

Employment Cost Index
Twelve-month percent change
-

Benefits
^"*'1.

Wage-- an-d 5 a-\

Wages and Salaries

1965198
1985

1987

I199

1989

191I
1991

993199
1993

1995

Chart 13

Dollar Exchange Rates
The Dollar and the Interest Differential
Percent

1990

1991

!ndex 1980 Q4 = 100

1992

1993

1994

1995

* Weighted averages against foreign G-10 countries, adjusted by relative consum.er riceS.
** Difference between rates on long-term U.S. 10-year government bond and a weigted average of foreign G-10 benchmark
government bonds adjusted for expected inflation.

Peso-Dollar Exchange Rates
Price adjusted

Nominal

Percent change
12/94 to 7/3/95

7.50

Deutschemark

6.10

Pound sterling
Italian lira

4.75

Canadian dollar
3.40

G-10 Average
0

N
1994

A
1995

Chart 14

Interest Rates
Three-Month Interest Rates

1992

1993

Percent

1994

Ten-Year Interest Rates

1995

1994

1993

1992

Percent

* Multilateral trade-weighted average for foreign G-10 countries.

Ten-year

Three-month

Germany
Japan
Foreign G-10
United States

Level
7/3/95

Change
12/94 to 7/3/95

4.50

-0.79
-1.17
-0.56
-0.34

1.17

4.76
5.95

Germany
Japan
Foreign G-10
United States

Level
7/3/95

Change
12/94 to 7/3/95

6.94
2.80
6.88
6.22

-0.51
-1.73
-0.82
-1.59

Unit Labor Cost
Index, U.S. level = 100

Influences on the dollar:

* Uncertainty about U.S. fiscal
policy
Germany

* Long-run outlook for U.S.
current account.

1980

1985

1990

1995

Chart 15

Foreign Outlook
Real GDP: U.S. and Foreign
Percent change, saar

1994
1995
1996
* G-6 plus 16 other industrial countries and 12 developing countries. U.S. nonagricultural export weights.

Foreign Real GDP*
Percent change, Q4 to Q4

1994

1995

1996

* U.S. nonagricultural export weights.

Foreign Growth

Share of U.S. Exports: 1992-1994

Industrial Countries

Percent Change, saar
1995
H1

of which

Foreign G-7
Canada

1995
H2

1996

Japan
Canada

Japan
Latin America

European G-7
Mexico

of which

Mexico

Asian LDCs

Asian Developing

U.S. Trade Balance with Mexico*

Real GDP: Latin America
Percent change, Q4 to Q4

1994

1995

1996

Billions of dollars, Q4, ar

1994

1995

* Goods and services, excluding oil.

1996

Chart 16

Europe and Canada
Real GDP: Europe

Exchange Rates - Trade Weighted*
Index, January, 1991 = 100

Percent change, saar
---

France & Germany
United Kingdom & Italy

Sterling

I I'IIIIII I .11IlIIIL ll
IIII
1994
1995
1996
* Weighted by U.S. bilateral non-agricultural exports

1991
1992
1993
* Multilateral trade weights.

1994

Canadian Overnight Interest Rate

Real GDP: Canada
Percent change, saar

1994

1995

1996

Percent

1991

1992

1993

1994

1995

Chart 17

Japan
Output Gap

Real GDP: Japan and Asian LDCs

Percent of potential GDP

Percent change, saar

Asian LDCs*

2
+

. lll
IIIll1 l II,
IU

1994
1995
1996
* Weighted by U.S bilateral non-agricultural exports

Prices
12--month percent change

1990

1992

19S14

1996

Stock Market and Land Prices
Index 1992 = 100C
40000

, -an

30000

20000

1990

1992

1994

1990

10000
1992

1994

Chart 18

ECONOMIC PROJECTIONS FOR 1995
FOMC

Central
Tendency

Range

Staff

Percent change, Q4 to Q4
Nominal GDP
previous estimate

Real GDP
previous estimate

CPI
previous estimate

41/4 to 43/4

4.1

43/4 to 6 / 2

5 to 6

4.8

11/2 to 3

11/2 to 2

1.7

2 to 31/ 4

2 to 3

2.2

3 to 3 1/ 2

3 to 3 1 /4

3.0

23/4 to 33/4

3 to 31/2

2.9

33/4 to 5
1

Average level, Q4, percent
Unemployment rate
previous estimate

51/2 to 61/4
51/4 to 6

53/4

to 6

6.0

5.4

About 5 / 2

ECONOMIC PROJECTIONS FOR 1996
FOMC
Central
Tendency

Range

Staff

Percent change, Q4 to Q4
Nominal GDP

41/2 to 6

43/ 4 to 51/

Real GDP

2 to 3 1 / 4

2 1/ 4 to 2 3/4

2.2

23/4 to 31/4

2.9

2 1/ 2 to 31/ 2

CPI

4.5

Average level, Q4, percentUnemployment rate
NOTE:

51/2 to 61/4

53/4 to 6

6.1

Central tendencies constructed by dropping top and bottom three from distribution, and
rounding to nearest quarter percent.

July 6,

1995

Long-run Ranges
Donald L. Kohn

I will begin with a few points from the long-run scenario
section of the bluebook.

These exercises are, at best, only indica-

tive of the potential outcomes, but they may be useful in illustrating
general tendencies and results as you think about policy alternatives.
First,

judging from the staff projections

and model simula-

tions, the current level of the federal funds rate is slightly restrictive,

and will become more so in coming years as

creases and additional fiscal restraint kicks

in.

inflation de-

This is evident in

the small gap that opens up between potential and actual output this
year in the baseline strategy, and

in the decline in the funds rate in

subsequent years required to keep the gap from getting wider.

By the

in the federal funds rate, the adjustment

standards of past variations

is not that large. Even under the easier strategy, which eliminates
monetary restraint and also offsets fiscal policy, the funds
moves down

rate

only to 4-3/4 percent, remaining well above the lowest

levels reached in the

recent period of sluggish expansion.

fiscal policy were somewhat

less

Even if

restrictive, reductions in the

federal funds

rate probably still would be needed, though when they

might have to

start would depend importantly on the behavior of the

bond market, as Mr.

Simpson illustrated.

Second, with the discussion of price-stability goals
monetary policy again coming to the fore,
the output losses that may be

it may be useful to review

associated with that endeavor.

bluebook simulations, of course, embody the
ist Phillips

curve model,

for

The

conventional acceleration-

and calculations like these probably will be

used in any public debate about changing the goals of the Federal
Reserve.

In sum, the bluebook simulation that gets to the neighbor-

hood of price stability shortly after the year 2000 requires 3 percentage point years of more unemployment than the path of output in
the easier strategy that holds inflation at around its current
To be

level.

sure, the model does not allow for a credibility effect of

announcing and committing publicly to such a goal--that is, the
sacrifice ratio does not depend on the strategy followed.

But it is,

in fact, difficult to find such a credibility effect empirically for
the United States or other countries.
for

The model also does not allow

favorable feedbacks of declining inflation on the level or trend

in productivity.

Using the very generous

estimate of the Rudebusch-

Wilcox paper, and phasing in the productivity gains as the disinnet output losses from

flation occurs, the present value of the
disinflation is
stability is

recovered by only a few years after virtual price

reached in 2000.

Others have found favorable, but less

extreme results for productivity gains;

if the effect is about

it would take about

tenth the Rudebusch-Wilcox result,

now to recoup the cumulative lost output.
course, have been unable to

pinpoint the

Third, the exercises

Some

a predetermined funds

researchers,

subjecting the baseline forecast to
inherent in using a

as the policy instrument.

When holding to

rate path in the face of such shocks,

instabili-

gather increasing force as

changes in

ties begin small, but ultimately

inflation expectations feed back on real
economy and inflation.

19 years from

size of any effect.

supply and demand shocks remind us of the risks
nominal federal funds rate

one-

rates,

which feed back on the

The equilibrium real rate may not change by a

lot in response to a shock;

the two

illustrations in the bluebook

require adjustments of only 1/4 to
less,

1/2 percentage point.

Nonethe-

in the face of such a shock, to get the same inflation outcome

by a given time, the lags in the effects of monetary policy mean that
a much larger funds rate adjustment is needed initially than ultimately.

Moreover, recognizing that the state of the world has changed

will take a while, and the longer the needed adjustment is delayed,
the larger is the required initial rate movement.
from the United States in the

This is the lesson

late-1970s, and apparently from Japan in

the mid-1990s.
At this meeting, you are faced with the task of reconsidering
the annual ranges for money and debt for 1995 and setting provisional
ranges for 1996.

Staff projections and alternative ranges

are given in a table on page 12 of the bluebook.

for 1995

Overall credit flows

have been a little stronger than anticipated early in the year, reflecting importantly the financing of inventory investment.
a remarkably high proportion of credit flows has

gone through depos-

itories, as borrowers continued to favor debt that was
repriced frequently until the recent

range.

range, M3 is

short-term or

sharp decline in bond yields.

As a consequence, although debt growth is
middle of its

Moreover,

only a little above the

appreciably over the upper end of its

With market rates coming down, and yields on M2 assets

sponding sluggishly as
helping to fund the
quence, is

usual,

savers have favored M2

re-intermediation of credit.

re-

assets, in effect

M2, as a conse-

running in the upper portion of its range.

Over the balance of this year, we see credit growth slowing
some--bringing this measure to around the middle of its current range
in longer-term markets.

As a conse-

-- and more

of it being financed

quence, M3

growth should slow substantially, but not enough to put

within its

current range.

M2 growth on average over the

second half

should look much like the first half, leaving this aggregate within
its

range.

We are projecting that the very recent

taper off, partly as

surge in M2 will

rates on money funds and other M2 assets come

more into line with the lower market

rates.

Still, the possibility

that M2 could run above its range, especially if the Committee eases
the stance of policy in coming months, can't be ruled out.
Even so,

only the M3

range would seem to require considera-

tion of a possible adjustment at this meeting.

The Committee could

leave the range unchanged and simply state that a temporary surge in
bank lending was expected to push actual

growth above the

range this

However, the staff believes that the weakness in depository

year.

credit and M3 growth over the previous four years was the outlier.
Until the thrift and bank crises of the late 1980s, M3
grown at least

generally had

fast as M2, and with depository institutions now

healthier, faster M3 growth relative to income and to M2 now seems a
reasonable expectation.

In this case, the Committee

adjusting its M3 range upward;
2 to

an increase

of 2 percentage points--to

6 percent--would seem to represent a reasonable relationship with

the M2

range and to have a reasonable chance of being high enough to

encompass M3

growth for the year.

Such a decision could be explained

as a technical adjustment to take account of the
patterns

return to more normal

of intermediation and M3 velocity, without any

for the thrust

M3 range might

reasons, an increase in the 1995

prove necessary.

Staff projections
given on page

implications

Indeed, the February Humphrey-

of monetary policy.

Hawkins Report warned that for these

nal

should consider

and alternative sets

17 of the bluebook.

Under the

of ranges for

interest rates

income of the Greenbook forecast, we would expect in

1996 are

and nomi-

1996 basi-

cally a continuation of the trends of the second half of this year.

M2 growth would

come in a little higher in 1996 than in

1995, buoyed

in part by a strengthening in nominal income and the assumed drop in
interest

rates next year, while debt

would still remain strong by the

of recent years,

1990s as

standards of earlier in the

to capture a substantial share of total

depositories continue
In Julys

and M3 would slow further;

lending.

the Committee generally has chosen

simply to carryover whatever ranges it has chosen for the current year
as provisional

This has been attractive

ranges for the next year.

because of the uncertainties about evolving money-income relationranges were already low enough that there was

ships, and because the

no scope to lower them further to send a message about the
intent to seek price stability over time.

Given the staff projec-

tions, this strategy would certainly work for 1996,
range higher for

chose to adjust the M3

Committee's

especially if you

1995.

You may have noticed that the staff discussion and forecast
of broad money

and credit

was

a little

most bluebooks over recent years--that is,

straightforward

questions:

Is the

if relying on target ranges

factors.

This

targeting exercise more meaningful?
is

there were fewer mentions

of persistent shifts in asset demands and special
raises two

than

still dubious,

Even

is the behavior of the

aggregates conveying any useful information about the underlying
economic

situation?
To be sure

results

the growth of M2 has

from traditional

specifications

two years as the lure of bond mutual
market

rates last year.

well below that

However,

the

its demand

This latter

in line with

over the last

funds faded with the backup in
level of this aggregate

predicted by these specifications,

the second quarter was appreciably in
standard model.

come much more

remains

and M2 growth in

excess of the prediction of the

miss likely reflects the unusual behavior

of intermediate- and long-term rates; the standard model proxies the
returns on alternative assets with a three-month Treasury bill rate-not a good choice when long-and short-term rates fail to move in their
traditional alignment.

These results suggest that our understanding

of M2 demand is still fragile.

The recent experience may suggest a

greater sensitivity of M2 demand to long-term rates, and associated
changes in its cyclical performance.

In other words, it seems too

early to tell whether we're back on a well-specified and useful demand
curve.

Even if we are, it is well to remember that the monetary ag-

gregates, even in their well-behaved episodes--provided only rough
guideposts for policy, and had to be interpreted in the context of a
broad array of other information in the economy.

It was the Commit-

tee's frustration with trying to make sense out of annual growth
ranges for M2 that led to the P* exercise, which looked to signals
from the longer-term trends in M2.
Nonetheless, the turnaround in broad money and the pickup in
private and total debt growth this year may be indicative of the
substantial easing of financial conditions that have occurred this
year through movements in market interest rates.

Credit is flowing

freely and the liquid assets of the public are rising rapidly.

These

circumstances do not seem to suggest unusual or severe financial
constraints on spending.
The exceptions to this picture of relative strength in flows
are M1, reserves, and the monetary base.

It is true that we're having

to withdraw reserves to keep the funds rate where it is.

In the last

month this has been a result of the bookkeeping of banks, who have
instituted NOW account sweeps to reduce the reserve requirement tax.
But we were draining reserves earlier this year as well.

At the

configuration of interest rates and income flows in the first half,

people don't want to hold as much Ml.

This has been largely a

function of the lagged effects of

rise in interest

We expect these effects to abate;
growth in M1 and

the

rates last year.

without sweeps we would see some

reserves last month and going forward--but very slow.

fundamentally, deregulation and changes in payment

technologies have eroded the differences between transactions and
nontransaction assets, making M1 demand more dependent on interest
rate

relationships.

As a consequence, growth of this aggregate now

swings over a wider range and its velocity varies more than before for
the same changes in short-term interest

rates;

in other words, you

can't judge underlying financial conditions using standards for M1
growth derived from the

1960s and 1970s.

The extraordinarily rapid

expansion of M1 in 1992 and 1993 went along with a decision to go

to,

and stay with, what seemed by other measures a moderately expansionary
policy--less expansionary than in many recessions--that the FOMC
judged appropriate to the circumstances.
of M1

in 1994 and

1995 does appear consistent with the move to modest-

ly restrictive stance of policy.
is

Slow growth and contraction

The question

is whether that stance

appropriate to the current circumstances--but the Chairman will

quickly remind me that that's the subject of another part of the meeting.

July 6,

1995

Short-run Policy
Donald L. Kohn

As noted in the discussion of long-run scenarios, policy may
well be positioned a bit to the
can be seen not only in the
baseline
the

results of the

side at

this point.

This

staff forecast and model

simulation with its downward tilt to inflation, but also in

level of the

real federal

in the read outs

averages,
and

restrictive

funds rate

from various

relative to its historical
"policy rules"

keyed to output

inflation or nominal GDP--which tend to produce federal funds

rates below 6 percent--and

in the behavior of the mone-

even perhaps

Especially if federal

tary aggregates--at least the narrower ones.
deficit

like the

reduction unfolds along anything

staff, a decrease in nominal and real funds

were intent

unless the Committee

on making considerable progress toward price

Implied
is that

rates would seem to be

next few years,

some point over the

needed at

path assumed by the

in the staff forecast

the current

point above its

funds

rate

is about

and the alternative
1/2 to 3/4

natural rate--though this

fine a point on an ambiguous measure.

stability.
scenarios

of a percentage

is undoubtedly putting too

Nonetheless, this estimate does
Those

seem to be consistent with readings from financial markets.
markets have built
magnitude.

Judging from the

seen as sufficient
sociated

in an easing by year-end of something like

to foster the earnings

with continued good

markets do

see

stock market,

a decline

of this

this
size is

growth that would be as-

economic expansion.

As Peter noted,

some possibility of ease at this meeting, and no action

could be associated with a modest edging up in

rates.

Over

a longer

stretch, a failure to ratify the expected decline would cause longerterm rates

to back up more, at least

but by no means

a large portion,

in real terms, reversing some,

of the downward movement registered

since last winter.
But that backing up helps to keep the disinflation process
going in the staff forecast.
at

best difficult to read,

rates

Market expectations for inflation are

but the

overall term structure of interest

retains an appreciable upward tilt,

as well as

and many outside forecasts

survey results seem to suggest widespread expectations

for

flat or even slightly higher inflation over coming years.

An argument

for maintaining the current stance of policy would

in building

be that

in rate declines, the market has misread your intentions for inflation;

keeping the funds

on some

rate unchanged at this time increases the

disinflation and would send another signal

odds

to markets that the

Federal Reserve takes seriously its stated goal of making progress
toward price stability over time.
Keeping policy unchanged might

also be preferred if the Com-

mittee saw appreciable odds on upside risk to the
from the drop

in market interest

decline can be seen as
than-expected economy.

staff forecast, say

rates this year.

largely an endogenous

To be sure,

that

response to to a weaker-

But markets may have over-reacted,

especially

since they may have been encouraged by some exogenous factors,

includ-

ing various testimonies and other public pronouncements from the
Federal Reserve,

as well as by firmer expectations of further

consolidation that

is not yet assured.

spond strongly to an unchanged funds
data perhaps ameliorating concerns

With markets unlikely

rate,

and with the most

about the extent

fiscal
to rerecent

of the downward

impetus to the economy,
tively

the Committee might view the costs as

rela-

small of awaiting additional information to judge the depth and

persistence

of the current slowdown and the response of aggregate

demand to the more accommodative financial market conditions now in
place.
Nonetheless,

although inflation may not be on a downward

track in the eyes of outside observers, it

also is much less likely to

strengthen than it seemed to be when the Committee
this improvement
adjustment
last
ing

last tightened--and

in the inflation outlook may argue for a near-term

in the stance of policy.

February perhaps

can viewed as

In retrospect, the

tightening

an insurance policy against build-

inflation pressures, which is less needed now.

The

slowing in the

economy since then has been considerably more pronounced than anticipated, and the

staff as well as many others have

revised down expected

inflation while also lowering the expected path for the
rate.

federal

funds

Committee members themselves have reduced projected growth for

1995 by almost
employment
the natural

and increased the anticipated un-

a percentage point,

rate at the
rate.

end of the year to somewhere in the vicinity of

With pressures on resources lessened,

the risk of

accelerating inflation would seem to have been greatly reduced, and
the

Committee might be able to decrease the degree of monetary

restraint at least

a little without

actual or expected

inflation.

An inclination in this
extent the Committee did not

regard would be reinforced to the

place

continuing reduction in inflation
number

of you have expressed

risking adverse movements in

a high priority

on fostering a

rates in the immediate future.

a preference over the years

for a

strategy that would attain price stability over time by leaning particularly hard

against upticks in inflation to cap the

levels in each cyclical expansion--that is,
function.

Inherent in this

strategy

rate at

lower

an asymmetrical reaction

is not necessarily

seeking

deliberately to impose a persistent output gap, especially once inflation had stabilized around low levels.
low this strategy, with the
potential,
policy.

If the Committee were to fol-

economy now moving into line with its

it would seem at this

time to call for a more neutral

Such a policy adjustment would better assure that the economy

grew along

its potential in 1996.

Easing at this time, to be sure, would
needing to
tee

increase the odds on

reverse course once again later this year.

saw the chances of this

occurring as

didn't think the federal funds

rate was

If the Commit-

quite large--that is,

if you

fundamentally too high--easing

and then tightening just to react to incoming data would

seem to risk

unnecessarily confusing the markets about your intentions and your
assessment

of the current

situation.

But easing because you thought

rates were

in fact basically too high, and being prepared

later to

reverse should data come in to cause you to revise your assessment,
would seem entirely appropriate and, in the
in the context of that new information.
concerned that
economy, that

the balance of

risks was

event,

readily explainable

In particular,

if you were

tilted toward a weaker

it might take time to recognize developing adverse

shocks, and that

timely adjustments to policy might

stances be difficult,

some easing now might

of holding fixed the nominal
supply or demand.

funds

in these circum-

help to avoid the

rate in the face

pitfalls

of shifts in

If a forward-looking monetary policy is
the

amplitude of cycles in business activity and

successful in damping
in interest

rates,

"mid-course corrections" of relatively small size may become more
common.
tion

But

tended to move in one direc-

far monetary policy has

in relatively long sequences, and, as a consequence, markets are

likely to project further rate reductions
Market

following any easing action.

reactions may be shaped by the words you use to describe and

explain the

action--in today's announcement

and in the HumphreyInstead markets are

Hawkins testimony--but only to a limited extent.
likely to read the action itself quite closely.
basis

point cut

in the

In that regard, a 50

funds rate might be seen as

connoting that the

Federal Reserve saw significant risks to economic expansion and current

short-term rates

resulting significant
sirable if the

as appreciably above appropriate
reduction in real interest

Committee indeed saw the

levels.

rates would be de-

situation in that

A 25 basis point cut would leave also a distinct
that more was coming, perhaps

be smaller than with 50 basis

policy reversal at

light.
impression

even more promptly, promoting specula-

tion almost immediately on when.
well

The

Still,

the market reaction might

points.

Unlike February

1994, a

this meeting would not be occurring in the context

of public statements and analysis that

appreciable further changes

rates were likely to be necessary to achieve the

System's

objectives.

Full text of Federal Open Market Committee Meeting Minutes, Transcripts, and Other Documents : Meeting, July 5-6, 1995 : Presentation Materials

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