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APPENDIX FOMC MEETING JULY 6-7, 1981 Reporting on open market operations, Mr. Meek made the following statement: Open market operations since the last meeting fell into two distinct phases. In the first four weeks, the Desk pursued a nonborrowed reserve path that was adjusted downward to accommodate the weakening of M1B below expectations and the extraordinary bulge in borrowing over the Memorial Day weekend. The discount window borrowing associated with the path remained at $1.9 to $2.1 billion throughout this period. In its June 17 telephone consultation, the Committee accepted the shortfall in M1B that had developed to that point, and reduced discount window borrowing to be used in building the path in the next 3 weeks to $1.8 billion. For the second subperiod, the staff redrew the path on the basis of the M1B growth of 3 1/2 percent then expected from March to June, a growth that compared with the growth of 5 1/2 percent, or somewhat lower, set as an objective at the March 31 meeting. As M1B continued to weaken, the borrowing associated with the new nonborrowed reserve path fell to $1.6 billion in the first two weeks of the subperiod. A second borrowing over- shoot in the first week was also accommodated. In the most recent week further weakness in money and the demand for total reserves suggest that borrowing at the window consistent with the path should be $1.4 billion. The Desk kept nonborrowed reserves close to the adjusted path during the first subperiod and we have been a bit above path during the current three-week interval. Total reserves were also close to path in the first interval, when path itself was lowered by $180 million to accommodate the weakness in M1B. In the second interval, total reserves appear likely to fall short by $165 million, as the demand for reserves has continued to decline without any further downward adjustment in the total reserve path. Achievement of the nonborrowed reserve objective in the past three weeks would normally have produced some decline in the Federal funds rate, but this did not really happen. The Federal funds rate remained close to the 19 percent level prevailing since early May. During June banks evidently anticipated that the Federal funds rate would come down automatically with M1B weakness. In the week ended June 17 in particular, they were willing to accumulate large reserve deficiences through Tuesday hoping that the Federal funds rate would come down from the 18 1/2 percent level prevailing before the weekend. On Wednesday, of course, they had to face up to the gap between their expectations and the reality of nonborrowed reserves being provided by the Desk. Federal funds traded as high as 30 percent and borrowing mushroomed to $6.4 billion. The cold shock of disappointment caused banks to be cautious thereafter, a caution exemplified in the past two weeks by unexpect- edly strong demands for reserves around the statement publishing date and the 4th of July weekend. A reserve shortfall of $2.2 billion last Thursday contributed to keeping the Federal funds rate this week well above the level of 18 percent one would expect from reserve availability near present levels. The securities markets have been rather mystified by the stickiness of the Federal funds rate. A grudging appreciation has gradually developed that the Federal Reserve is trying to rein in excessive growth in the broader aggregates and help reduce inflationary expectations. But market participants were slow to reach that conclusion, in part because the Committee's March 31 directive, the latest published, indicated that M2 growth of 10 1/2 percent was acceptable in the second quarter. As M1B turned weaker in late May and June, participants bet repeatedly on a near-term decline in short-term interest rates. A stream of reports on economic activity and price behavior confirmed that the economy was slowing and that speculative enthusiasms were wilting under the relentless pressure of high interest rates. By mid-June dealers and their customers had pushed rates on the key Treasury bill issues from 180 to 280 basis points below the near-peak levels prevailing just before the last meeting, while long-term bonds had rallied enough to reduce yields by 90 to 110 basis points. Dealers expected the reinvestment of the proceeds of a $13 billion runoff in Treasury cash managea week or so later to reduce repo rates ment bills sharply and ease the financing of dealer positions. The rise in the Federal funds rate above 20 percent on June 17 without Desk intervention to supply reserves dashed the market's near-term hopes. Prices of Treasury notes and bonds dropped sharply as dealers scrambled to prepare for the Treasury's sale of over $12 billion of new issues in the last two weeks. The two-year note sold on June 18 at a yield of 14.72 percent, down a percentage point from the record levels of the month before. But the yields of 14.07 percent established on 7-year notes and of 13.45 percent on the 20-year bond were records, while the 14.02 percent yield on the 4-year note, was not far from the peak for such an issue. Price fluctuations have been substantial during the entire period. Market hopes of lower short-term rates are again on the rise, economy accumulate. as signs of a slowing By last night Treasury bills had retraced a part of their earlier declines, with the 3- and 6-month auction rates down 165 and 100 basis points since May 18. Intermediate Treasury coupon issues -5were generally 25 to 75 basis points lower in yield over the interval, while the 30-year bond was down 40 basis points to 13.15 percent. Rates on 3-month CDs ranged widely over the period, closing 135 basis points lower at 17.45 percent. The prime rate moved in a range of 19 1/2 to 20 1/2 percent, with nearly all banks currently at 20 percent. In other sectors of the securities markets, tax-exempt securities remained the wallflowers of the industry with yields little changed over the interval. Interest remained lackluster from banks and insurance companies, while improving prospects for the Administration's tax-cut proposals raised concerns about their future attractiveness to high-bracket individuals. There was also market talk that Federal spending reductions might affect the creditworthiness of the states and localities. Corporate bond offerings picked up considerably with $4 billion issued during June. A substantial volume remains waiting in the wings, as corporate willingness to finance near current rate levels has grown significantly. One area that deserves special mention is the market for Federally sponsored agency securities. Critical analyses of the Federal National Mortgage Association have led many trust accounts and other investors to take the agency off their approved list or scale back their holdings of its issues. FNMA wisely cut back its monthly offerings in May and June by $850 million, but its recent $600 million four-year issue required a yield about 110 basis points over a comparable Treasury issue, compared with spreads of 30 to 40 basis points about the time of the last meeting. sold well at that spread. The issue There appears to be a good appetite from money market funds and others for the 30to 60-day discount notes being sold at an even wider spread, but there is a certain vulnerability in having so much short paper to roll over. The Federal Home Loan Banks were able to raise about $1.8 billion in the interval, but the spreads of their issues against governments has also widened to 80 basis points or so. The Farm Credit agencies are generally trading at a spread of about 60 basis points. Treasury financing in the third quarter appears likely to be a bit higher than the $9 to $12 billion the Treasury thought likely a few weeks ago. The current Board and New York estimates are at $16 and $18 billion, respectively, while some market as $20 to $21 billion. estimates run as high This would still be a consider- able reduction from the $28 billion sold in last year's third quarter. Notes for FOMC Meeting July 6-7, 1981 Scott E. Pardee Since once again we had no operations for the account of U.S. authorities, and since previous tendencies continued, I can be brief The dollar again advanced across the board, by a net of 6 to 7 percent against the German mark and the other European currencies tied directly or indirectly to the mark. The dollar also rose by 8-1/2 percent against the pound sterling. The dollar advanced somewhat less against the yen and marginally against the Canadian dollar. The factors in the dollar's rise are: --the continued apparent strength of our current account relative to most other industrial countries; --favorable interest rate differentials, with yet another unexpected run-up in our rates recently; --positive sentiment toward the Reagan Administration; --better numbers here on inflation; and --what the Europeans are calling "Euro-pessimism." This last perhaps needs some explanation. It focuses on political divisions within countries, the broader uncertainties generated by the new socialist government in France --which for the first time included communists in the cabinet--and outside concerns such as with Poland. It focuses on the economic dilemmas those countries face, with stagnant economies, unemployment, current account deficits, and declining currencies. There are dangerous elements to this mood, and Europeans are prone to vent their frustrations by criticizing us. The criticism is mainly directed at our high interest rates and the dollar policy. Administration officials as well as many of us from the Federal Reserve have all tried to dispel this criticism. Our central bank counterparts at least understand what we are saying, and may even sympathize with us, but the feeling runs deep. Right now, the market expects the dollar to remain strong for some time to come, but many participants believe that the dollar is unsustainably high. Our counterparts abroad are smarting from the lack of cooperation from the United States on exchange market matters. Should the dollar come under heavy selling pressure for whatever reason, it will have to fall a long way before other central banks would lift a finger to moderate the decline. James L. Kichline July 6, 1981 FOMC CHART SHOW -- INTRODUCTION In our presentations this afternoon we will be refer- ring to the package of chart materials distributed to you. first chart in the package displays the principal tions that underlie the staff forecast. The policy assump- For monetary policy we continue to assume growth of M-1B of 4-3/4 percent this year, adjusted for shifts into NOW accounts, and 4¼ percent next year. This assumption is embodied in long-run Strategy I in the The fiscal Bluebook. policy assumptions include restraint on growth of outlays and tax cuts, both revised somewhat since the last FOMC meeting to reflect our assessment of legislative developments. We now assume the administration will obtain about 4/5 of the expenditure reductions they are seeking in fiscal more than we had been assuming earlier. 1982, a little The personal tax cut has been scaled back to a 5 percent across-the-board reduction on October 1, with an additional 2 percent for selected cuts. A second-stage cut of 10 percent has been included beginning July 1982, a new element in these personal the staff forecast assumptions. tax cuts total about $27 billion Together in fiscal 1982, while depreciation changes are expected to result in about $8 billion of tax reductions to businesses. The next chart provides further federal economic budget. The fiscal information on the assumptions along with the staff's forecast are projected to result in an appreciable increase in the budget deficit next fiscal year, to nearly $80 -2billion. We do not yet have the administration's budget figures to be presented to Congress in the midyear review, but compared to their March program the staff deficit figures are about $5 billion higher in fiscal and nearly $35 billion higher for 1981 next fiscal year. Both outlays and revenues are projected to remain quite high relative to GNP in the forecast period. the bottom left panel The black line in indicates that total outlays as a percent out in fiscal of GNP are expected to only level the sizable program reductions assumed. 1982 even with The underlying economic situation--including rising unemployment and high interest rate levels--acts to hold up outlays relative to GNP; as the red line shows, outlays excluding interest on the debt are projected to decline. panel, Federal receipts as a percent of GNP, the right-hand also are expected to decline somewhat, reflecting the assumed tax cuts. Historically, however, receipts still very high relative to GNP--a remain function largely of the impact of inflation. Mr. Zeisel will continue the presentation with a dis- cussion of recent and prospective developments in nonfinancial economy. * * * * * the domestic Joseph S. Zeisel July 6, 1981 FOMC CHART SHOW 8 The percent quarter--shown in as It was probably in in the the economy the of the year, slowdown 1980, economy experienced In in confluence any event, most from a surge in December and actually began to lose momentum shortly after and there is convincing in a wide range first the next chart--came otherwise disparate factors. January; the part a continuation of spring of the first quarter vigor derived turn GNP growth in left-hand panel of from the collapse with a number of of the top quite a surprise. recovery annual rate of of sectors. It is little or no growth a evidence now of likely that in real GNP in the the second quarter. The bottom left panel shows homebuilding beginning the substantial decline in February which has now carried starts below the a 1.15 million annual rate--25 percent 1980 the upper turned downward in car right-hand April, sales have remained panel shows, led by a drop fourth quarter real terms Excluding autos, retail in autos. Since rate, then, domestic down from 5.7 sales declined in further in May. The generalized weakness of months real retail sales below their pre-rebate pace; sales in June were at a 5.4 million April and May. in to level. As auto in apparently economic is now also being reflected activity in the in recent employment -2figures. Payroll employment adjusted for by 150,000, with declines The next chart shows our view of the outlook of 1981 and for late this year and in mid-1982 in 1982. The should provide some projection period boost to rise in GNP over the entire On balance, and pick up to The about a two percent rate top left role played by panel of in this reflected the from the second important, however, is right-hand panel--which 1982. the next chart indicates the key the first quarter and the sudden loss sales four quarters the last half of consumer demand in both the rebound Some of curbs real GNP growth is projected to average only about one-half percent over the next auto tax cuts remains constrained by monetary policy and on government spending. spring. for real But the weakness of housing will stunt overall growth the near term and generally, the through in June quite pervasive. GNP growth for the balance activity. strikes fell quarter of the economy of momentum in the rebate-associated shifting of into the the cessation of real first. Probably more income accompanied the slackening growth--the of employment gains. As lays will to the real about rise the middle panel shows, we assume in general continue to tax cuts late track disposable this year, and consumer spending will income. Responding again in mid-1982, we anticipate increase over the next six quarters at a 2-3/4 percent annual rate--as compared in 1980. that consumer out- to the half percent -3The saving rate--the bottom panel--is projected remain relatively low by historical standards. reductions should permit some in consumption; into its the 5 we are projecting the percent range recent improvement in But the to tax savings as well as rate to edge up slightly in the latter half of next year from extremely low level--the lowest since the Korean War buying splurge. The decline top panel of the next in housing starts and tighter chart in response financial conditions. indicates the recent to higher interest rates This drop in activity dictates a deterioration in real residential construction expenditures over the balance of the year. Moreover, of demand in real there is evidence of a generalized weakening Sales estate markets. of new homes--shown in the middle panel--in May, were a fifth below their average level last existing homes have also declined. summer; purchases of the bottom panel shows, These figures may in years. since home payments for prices of new homes have continued a substantially slower pace to rise, but at tion, average prices As in than past few price decelera- fact understate the recently have the increasingly incorporated improved financing arrangements. But, as the next chart indicates, housing starts may now well be at, or close it is our view that their bottom. to, Underlying demand pressures associated with population and migration trends deposit remain strong and we are flows looking for improve a bit--partly because of an upturn recent DIDC as S&L actions-- -4and new mortgage market. instruments By the end 200,000 at an annual would still be anemic addresses The next chart spending. the Real fixed rate above the current by historical investment outlays appear data suggest a stagnant situation for growth of top panel indicates, capital goods has to have fallen in surge and the balance of real new orders this year; orders commitments the year. fall; for nondefense for defense equipment, and new contracts for commercial and industrial construction similarly have shown no strength recently. data appear or no growth of real The speculative. spending survey, which suggested little investment outlays to goes on. Liberalized the cost tax is expected and with capacity utilization sectors fundamental factors As as defense and appear remaining capital stock, likely the next chart shows, to remain high; relative to GNP are not demand for expansion of the expanding incentives and investment outlays. of debt capital profit positions is obviously more stimulate increased capital spending as But a number of continue to damp this year. outlook for 1982 investment defense program should These of the most to be generally consistent with results recent Commerce capital time As strongly from mid-1979, have been on a plateau since after rising about last stalled standards. the outlook for business capital second quarter following a first-quarter the the of 1982 we are projecting a 1-1/3 million unit rate of starts, some pace--but this increasingly gain a place in after-tax projected to improve; low, we expect little except in such the energy-related areas. fast growing On balance, we -5are projecting a small decline in capital outlays over the pro- situation does jection period. As not suggest the top result the next any serious panels, of business the weakness stocks 1980 and sales, early and avoiding cates, we assume expect investment relative to sales as reasonable of are not of in the any up and a But half collapse succeed real projection period--raising picks latter the bottom in as balance with generally will increase stocks in spring were projecting As evident few months. last liquidation businesses growth is car in be stock imbalances. the dealers' to distortions We that in As the past a moderate rate through the moment. in inventory year. significant we The inventory sales appear panel. this the some backup in auto overall eliminated by shows, problem at there was sales--the right largely chart panel in in indi- inventory stocks reflecting of the somewhat projected defense buildup. The next spending. rising strongly however, in real they this are year, expected terms by about in 1982 curbs purchases pace. on are addresses defense increase real the Federal chart but at to not quite accelerate rise at last again Excluding about spending, to component projected would be projected government purchases are 7 percent. nondefense the 9-3/4 continue year's 1982, pace; moving compensation, percent. total real slightly in to federal less than of But the given government the 1980 up -6In addition, we are in federal grants by state and anticipating substantial reductions to states and localities. local governments and 1982--shown in projected The curtailed spending for calendar years 1981 the middle panel--reflects this reduction in aid as well as budgetary pressure from continued high interest costs and depressed receipts. As shown in the bottom table, we are now expecting only a fractional rate of ment purchases increase in real through 1982. The next chart The relatively strong reflects largely portrays gain the outlook for increases that have already occurred, however, we expect little employment remainder of this panel, year and in 1982. limited job opportunities Consistent with the experience demand, we anticipate no participation. 8¼ percent by expansion of sation is this labor force labor supply is in the 7¼ percent slack labor markets some easing of wage inflation. trend to continue, sluggish 1982. top panel of some signs of moderation in wages have recently expect periods of from the current still rising rapidly--the second labor force growth. unemployment--shown the end of The prolonged period of dividends in indicated in the increase in the rate of Nevertheless, the in part a growth over the in other recent bottom panel--is projected to rise pay As 1981 In line with projected should depress likely to outpace job creation, and rate to about the labor market. in total employment shown for rebound from the cutbacks early last year. output, total govern- should soon Although compenthe next chart-- emerged and we given the environment of sustained -7high unemployment Reduced consumer improved wage As its percent an price the pressures middle panel Given recent rate through poor in improvement, when combined rate in would result which are the in The moderation of half in price the price performance temporary--in of increases energy in fact prices and on food, there in are wages, and More fundamentally, costs also help. well Overall, at the percent about Mr. international a we is 1982. some in gains the less than a reduction deceleration only of in unit about a in light Nevertheless, expected indicated recently one such wage labor 7 percent food continued dollar slack in by of evident the to a in rebound in energy, improved be some impact reflecting on attitudes. should reduced product the that end of also pressure markets. prices 1982, in feed- international markets are now forecasting rate likely and chart. reflected mainly salutory soon, the next While is should be excluding the has indications a as in sectors. already 7¼ percent rate for particular, improvement position of rising 9 as and forecasting possibly, prices measurable stronger output, the food effects The expect to 1982. back labor also rising at prices--longer-term benefits from contribute a distinct meat showing also are with to be The outlook for be period. in productivity expected latter developments projection we rise performance, we rise costs, should shows, the modest of pressures, the performance. productivity. of anticipated will off should be from recently. Truman will outlook. now continue with a discussion of the E.M. Truman July 6, 1981 FOMC Chart Show Presentation The red line in the top panel of the first international chart shows that, since July 1980, the dollar has appreciated steadily on a weighted-average basis. In June, the dollar's value averaged 25 percent more than a year ago and reached its highest level since 1976. As shown by the black line, the dollar's appreciation on a price-adjusted basis has been about the same, reflecting the fact that over the past year the pace of inflation in the United States has been about equal to the rate on average abroad. The substantial appreciation of the dollar is the principal factor generating the staff's forecast swing of the U.S. current account into deficit in the second half of this year and in 1982. This movement, if realized, is expected eventually to contribute to some decline in the dollar's value. Meanwhile, as Mr. Zeisel mentioned, the appreciation of the dollar since last year should contribute importantly to the expected reduction in the rate of price inflation in the United States. As is shown in the lower panel, although the initial phase of the dollar's appreciation was associated with a widening of the differential between U.S. and foreign interest rates in the latter part of 1980, the dollar's strength so far this year has not been associated with a further widening. Indeed, the differential recently has been smaller than it was at the turn of the year. dollar's strength. Several factors appear to have contributed to the Among them are the unsettled economic and political conditions in Eastern and Western Europe and the continued U.S. currentaccount surplus through the first quarter. But an important factor also -2appears to have been a decline during the past six months in the rate of inflation expected for the United States combined with a rise in the average rate of inflation expected abroad. In the staff's forecast, for example, the net revision in expected consumer price levels is about 5½ percent by the end of the forecast period. This changed outlook has increased the differential between real interest rates. The top panel of the next chart depicts the staff's outlook for consumer prices here and abroad. As can be seen, the gap between U.S. and average foreign inflation is projected to narrow sharply this year and essentially to disappear in 1982. Meanwhile, as is shown in the lower panel, we expect for this year somewhat faster real growth in this country than on average abroad -largely because of the first-quarter results. expected to be reversed. Thus, Next year the pattern is on balance during 1981 and 1982, real economic growth is expected to be generally similar here and abroad. The next chart summarizes our outlook for the international oil market. The apparent glut that has emerged in this market in recent months has caused us to adopt a more optimistic assumption about the outlook for oil prices, which, in turn, has contributed to the staff's somewhat more optimistic outlook for inflation generally. As is shown in the top panel, we expect the unit value of U.S. oil imports to decline very slightly during the rest of 1981, reflecting lower prices on the spot market and a unification of the OPEC price around the current Saudi price of $32 per barrel. the real oil price will rise slightly. In 1982, we are assuming that This scenario implies a price about 12½ percent lower throughout the projection period than we were assuming six months ago. The principal factor contributing to this improved outlook is the reduction in the global demand for oil, reflecting slow real growth and the response of demand to high oil prices. One result, depicted in the middle panel, is that OPEC oil production has declined from almost 31 million barrels per day in 1979 to less than 25 million barrels per day this year and is expected to edge off further next year. Moreover, non-OPEC production has increased somewhat absolutely and, more importantly, relative to OPEC production. With the major exception of Saudi Arabia, many producers need the export revenues generated by their current rates of production and, thus, the scope to scale back output, for an extended period of time, to sustain rising prices is more limited than was the case several years ago. As is illustrated in the bottom panel, U.S. oil imports are now running about 2 million barrels per day less than the rate two years ago, and they are expected to decline further over the forecast period. We now expect that the U.S. oil-import bill in 1982 will be essentially unchanged from the roughly $80 billion projected for 1981. Turning now to the "bad news," as is shown by the red line in the upper panel of the next chart the volume of U.S. non-oil imports is expected to expand rapidly during the forecast period largely as a consequence of the dollar's appreciation. Similarly, as is shown in the lower panel, the volume of U.S. non-agricultural exports is projected to decline quite rapidly in the second half of this year and for the rest of the forecast period. The implications of these shifts for U.S. aggregate demand are shown in the top panel of the next chart. As a consequence of rising real receipts on exports of services, the decline in U.S. exports of goods and services, on a constant-dollar GNP basis, is projected to be moderate and not to start until early 1982. Nevertheless, the contribution of exports to U.S. aggregate demand this year will be substantially less than in 1978, 1979 and early 1980. Next year the contribution is expected to be negative. Returning to current-dollar magnitudes, as is shown in the middle panel, the U.S. trade deficit is projected to increase sharply in the second half of 1981 and in 1982, reaching almost $60 billion at an annual rate in the second half. Meanwhile, in contrast to the pattern in the late 1970s, net surplus on non-trade transactions will show little change. the U.S. current account the Consequently, is expected to swing into deficit, reaching a rate of about $30 billion at an annual rate in the second half of next year. Mr. Kichline will now complete our presentation. James L. Kichline July 6, 1981 FOMC CHART SHOW -- CONCLUSION The staff's economic forecast is associated with an environment of considerable restraint on financial The top panel markets. of the next chart indicates an assumed growth of M-1B this year and next substantially slower than that experienced in the preceding several years and, to achieve the projected nominal GNP, will require sizable increases in velocity. There clearly are many pitfalls in linking a given rate of growth of money to expected GNP and interest rates, but our general is that high will interest rate levels--shown view in the middle panel-- be required on average to restrain strong underlying demands for goods and services money. in the economy and related demands for Such restraint on financial markets likely would be con- sistent with a moderate volume of funds raised by nonfinancial sectors relative to GNP, as displayed in the bottom panel. The household sector, the next chart, is the main area in which total constrained. borrowing demands are expected to be appreciably So far this year, household borrowing has remained close to the sharply reduced volume in 1980. We expect little growth of consumer borrowing next year, consistent with the generally sluggish activity projected for the credit-sensitive housing and durable goods markets. The reduction in borrowing from the rapid pace in the late 1970s has in total led to some decline debt outstanding relative to disposable income, as -2shown in the bottom panel, and further declines are projected. This measure does not take account of the terms of debt taken on or the distribution of debt among households, so one can draw only a small degree of comfort when looking at this aspect of the financial status of households. In the corporate sector, the next chart, financing requirements are likely to continue rising this year and next, as indicated in the top left panel. to be under appreciable financial Businesses generally appear strain and there is reportedly a strong desire to fund some of their short-term debts. While we anticipate a little rise of long-term financing over the course of the projection, the markets seem unlikely to be receptive to much more than rates to be unattractive. probably will term debt will is forecasted and firms may perceive Thus, business borrowing at banks be sizable--the top right-hand panel--and shortcontinue to rise as a proportion of total the bottom left-hand panel. debt-- Pressures on balance sheets arise partly from the sluggish performance of profits, the bottom right-hand panel, and although profits after tax are projected to grow further next year they are weak relative to corporate outlays. Profits as a percent of GNP, a proxy for profit margins, are expected to remain depressed, which is not unusual period of slow economic growth and deceleration of inflation. A key element in the outlook for inflation behavior of wages, shown on the next chart. for a is the The top panel indicates average hourly earnings this year have been diverted from the steep uptrend in 1980. The evidence on slower growth -3of wages is still tentative since it hasn't persisted very long and it is not yet pervasive. But it is encouraging and should be assisted by the recent better price performance through somewhat smaller cost-of-living adjustments and through lower nominal wage demands. We anticipate persistent slack in labor and product markets will contribute to a further moderation of wage growth next year which will help slow increases compensation--the bottom panel. Moreover, legislated changes which add to compensation costs will be small in hourly in 1982 with no minimum wage increase scheduled nor a huge boost in social security payroll taxes as occurred this past January. The top panel of the next chart indicates that unit labor cost increases have slowed recently, as discussed by Mr. Zeisel, and the projected slowing of compensation growth should be showing up in reduced unit labor cost increases over time. And as noted by Mr. Truman, the energy outlook and the behavior of the foreign exchange value of the dollar both will have favorable domestic price implications. Overall, we believe there are now in train a number of forces operating to put the economy on a path of reduced inflation and this continues to be reflected in the staff's forecast. The last chart compares the preliminary administration revised forecast for 1981 and 1982 with the staff forecast. The main difference between the forecasts in 1981 is the pro- jection of the implicit GNP deflator, although both point to -4a considerable year. improvement over the 10 percent increase last In 1982 the price forecasts are similar, but they occur in the context of much different prospects for real a result the administration projection of nominal growth. As GNP expansion remains high historically, having been exceeded only once in the past 30 years. * * * * * CONFIDENTIAL (FR) CLASS II-FOMC Materialfor Staff Presentationto the Federal Open Market Committee July 6, 1981 Principal Assumptions Monetary Policy * Growth of M1-B of 4¾ percent in 1981, abstracting from shifts into NOWs, and 4¼ percent in 1982 Fiscal Policy * Unified budget expenditures of $663 billion in FY 1981 and $725 billion in FY 1982 * Personal and business tax cuts Personal cuts of $27 billion in FY 1982 Business cuts of $8 billion in FY 1982 Federal Budget Fiscal Years, Unified Budget Basis 1980 Billions of Dollars 1981 1982 Percent Change Billions of Dollars Percent Change Billions of Dollars Percent Change Outlays $580 17% $663 14% $725 9% Receipts $520 12 $603 16 $646 7 $79 $60 $60 Deficit Receipts as a Percent of GNP Outlays as a Percent of GNP Percent Percent Fiscal years Fiscal years Total 2 22 ! 20 20 19 Excluding Interest - 18 18 197 1970 1973 1976I 1979I 1982I 197 1973 1976 1979 1982 1970 1973I 1976 1973 1976 1979I I 1982 1979 1982 Economic Activity Real GNP Change from end of previous period, annual rate, percent Real Retail Sales Billions of 1972 dollars 1972 Dollars -48 -46 v - 44 -42 Unit Auto Sales Millions of units 8 1979 1980 1979 1981 1980 1981 Nonfarm Payroll Employment Housing Starts and Permits lillions of workers M Millions of units Strike adjusted - 2.0 -- 92 Total ts - 1.6 -- 90 S1.2 - .8 SManufacturing 1979 1980 1981 1979 1980 1981 Real GNP Change from end of previous period, annual rate, percent 1972 Dollars 6 -4 m 111 111 III IIII m III I III I'll" 1975 1977 1979 1981 1982 Real Personal Consumption Expenditures Change from previous period, annual rate, percent Real Disposable Personal Income Change from previous period, annual rate, percent 6 -3 + 0 3 Real Disposable Personal Income and Consumption Expenditures Change from previous period, annual rate, percent 1972 Dollars, 3-quarter moving average Saving Rate 1975 1977 1979 Housing Starts and Home Mortgage Rate Percent Annual rate, millions of units Mortgage Rate 2.2 1.8 1.4 Starts 1.0 - 1978 1979 1980 1981 New Home Sales Annual rate, millions of units -. 8 .6 -. 4 1978 1979 1980 1981 New Home Prices Change from year earlier, percent Adjusted for changes in quality -15 12 - 1978 1979 1980 1981 9 Housing Starts Annual rate, millions of units Total Single-Family 1.0 - A Multifamily 1978 1979 1980 1981 1982 .5 Real New Orders for Nondefense Capital Goods Billions of 1972 dollars 3-month moving average 13 Total - 11 Machinery 7 1979 1980 1981 Real New Orders for Defense Capital Goods Billions of 1972 dollars 3-month moving average 1979 1980 Business Construction Contracts Millions of square feet -100 - 90 - - 1979 1979 1980 1980 1981 80 70 Corporate Bond Rate Percent Aaa New Issues - 12 9 1978 1979 1980 1981 1982 Corporate Profits Relative to GNP Economic Profits Percent 6 --.---- After Tax ----- 1978 1979 1980 1981 1982 Manufacturing Capacity Utilization Percent 90 1973-Q3 Pre-Recession Peak 87.8 - --- - 85 80 75 1978 1979 1980 1981 1982 Real Business Fixed Investment Billions of 1972 dollars -170 ..... S- - 160 150 1978 1979 1980 1981 1982 Auto Inventories Annual rate, millions of units Manufacturing and Trade Inventories Relative to Sales Ratio 1972 Dollars Days Supply Days Total - 75 60 1979 1980 1981 1979 1980 1981 Change in Business Inventories Annual rate, billions of 1972 d(ollars 1972 Dollars, NIA Basis 30 20 10 . + 0 10 15 1975 1 1977 1979 1 1981 20 Real Federal Government Purchases Change, Q4 to Q4, I Dollars Defense 1978 1979 1980 1981 1982 Real State and Local Purchases Change, Q4 to Q4, percent 4 2 + TTT -- 1978 1979 1980 Real Total Government Purchases 1972 Dollars Change, Q4 to Q4, Percent 1977 1978 1979 1980 1981P 1982P 3.6 1.6 1.9 1.6 0.4 0.6 1981 Im I 1982 - Total Employment Change. Q4 to Q4, millions of persons 4 2 I 79 1975 1981 1979 1977 I+ 1981 Civilian Labor Force Change, Q4 to Q4. millions of persons _ 3 SI 1975 1977 1979 rI 1981 Labor Force Participation Rate Percent I 1975 I I 1977 i 1979 Unemployment Rate Percent 1975 1977 1979 1981 Unit Cost Indicators Nonfarm Business Sector Change from year earlier, percent Compensation per Hour 1975 1977 1979 1981 Change from year earlier, percent 8 - 4 + Output per Hour -4 1975 1977 1979 1981 Change from year earlier, percent -12 Unit Labor Costs -- 8 4 1975 1977 1979 Gross Business Product Prices Change from year earlier, percent Fixed-weighted indexes Total 10 4. Excluding Food and Energy 46 1979 1980 1981 1982 Foreign Exchange Value of the U.S. Dollar March 1973=100 / 105 -95 Weighted Average Dollar * -85 1977 1978 1979 1980 1981 Short-Term Interest Rates Percent per annum 18 U.S. CDs 14 -10 Weighted Average* Foreign Interbank 1977 1978 1979 1980 **Weighted average against or of G-10 countries p!us Switzerlard using total 1972-76 average trade of these countries - 6 Consumer Prices Change, Q4 to Q4, percent * * United States Weighted -12 Average Foreign* i ii I I I I I I I I I I I II II II II II II II Ii II II II 8 i I i I I I I I I i I I I I 1979 I I I 4 + - 0 I I 1980 II it II II : :: I I 1978 I I I I I I I I I I I I I I I I I I I I I I I I I I ii ii ti ii ii ii ii ii II II ii 1981 1982 Real GNP Change, Q4 to Q4. percent -1 4 -- 1 2 *I p ,h* 1978 1979 Weighted average of G 10 counites plus S.vtzerland us 1980 C !otal 1972-76 a.eriag .- 1982 1981 trade cf Ihsc lll I*|** *'i coD.ntfrlS International Oil Market Developments Unit Value of U.S. Oil Imports Dollars per barrel I40 -32 -24 16 1978 1979 1980 1982 1981 World Crude Oil Production* Millions of barrels per day _ OPEC D Non OPEC -50 11 -30 10 1979 I 6tU 1981 1982 U.S. Oil Imports Millions of barrels per day r - 8 - 1978 *Excluding the USSR and China 1979 1980 1981 - S- 1982 610 Non-Oil Imports Billions of 1972 dollars, ratio scale Billions of dollars, ratio scale F I240 200 160 Value 120 80- .. -- / Volume 60- 1975 1977 1979 1981 Nonagricultural Exports Billions of 1972 dollars, ratio scale Billions of dollars, ratio scale - 240 -- 200 160 Value 1 20 80 Volume 6 60 1975 1977 1979 1981 GNP Exports and Imports of Goods and Services Billions of 1972 dollars - ------------- 170 150 S130 110 Current Account Transactions Billions of dollars fl[Non-Trade Current Account Transactions - Trade Balance 1978 1979 1980 H2 H1 1981 Hi H2 1982 Current Account Balance Billions of dollars --- Hi 1978 1979 1980 H2 1981 n H1 H2 1982 Money Change, Q4 to Q4, percent r SM1-B 1975 1977 1979 1981 Interest Rates Percent ,---, - 15 - 3-month Treasury 10 5 1975 1977 1979 1981 Funds Raised by Nonfinancial Sectors Percent As a percent of GNP -- 16 1975 * 1977 1979 Abstracting from shifts into ATS and NOW accounts Households Borrowing Billions Other As a Percent of Total Funds Raised Home Mortgages 1978 1979 1980 41 41 42 1980 1981P 1982P 1977 1977 1978 1979 28 29 27 1981 1982 Total Debt Outstanding Relative to Disposable Personal Income Percent - - 1979 1980 1981 1982 73 - 1978 76 - 1977 79 70 Nonfinancial Corporations Borrowing at Banks Funds Raised Billions of dollars Billions of dollars 50 -40 30 - I 1977 Short-Term Debt Relative to Total Debt Outstanding I I I 20 I 1979 Corporate Profits Percent Billions of dollars Percent After Tax -140 -- 44 - - - - - - - - -- 36 -- As- percen-N - - As a percent of GNP - ( 1977 I 32 3 - I 1979 1981 1977 1979 1981 120 00 Average Hourly Earnings Index Nonfarm Business Sector Change from year earlier, percent moving average Total 10 0 9 8 1978 1979 1980 1981 1982 Hourly Compensation Nonfarm Business Sector - Legislated Changes I .mm 1978 1979 1980 1981 1982 Unit Labor Costs Change from year earlier, percent t Nonfarm Business Sector 1975 1977 1979 1981 Price of Imported Oil er Dollars pc barrel 30 20 10 1975 1977 1979 1981 Foreign Exchange Value of the Dollar Index, March 1973=100 -100 90 1975 1977 1979 1981 Gross Business Product Prices Change from year earlier, percent SFixed-weighted index 9 6 1975 1977 1979 1981 Comparison of Staff and Administration* Economic Forecasts Percent change, Q4 to Q4 1982 1981 Staff Administration Staff Administration 10.8 11.8 8.4 12.9 Real GNP 2.5 2.5 1.2 5.2 Implicit GNP Deflator 8.1 9.1 7.0 7.3 Unemployment Rate 7.8 7.7 8.3 7.0 Nominal GNP Q4 Level *Preliminary and subject to change. FOMC Briefing S. H. Axilrod July 7, 1981 Clearly, the process of setting longer-run money targets is not getting any easier. Assessing the impact of changes in financial regula- tions and technology is a continuing problem. recent DIDC decisions, As a minor point, the for instance, complicate estimates of M2. Of more basic relevance at this time, the public's response to NOW accounts, and also to the sustained high level of short-term rates, has been in many ways unexpected, and leaves considerable uncertainty in its wake. There is uncertainty about when the shift to NOW accounts will be essentially completed. There will also be uncertainty about how to evaluate future behavior of the M1-B aggregate; its composition and presumably in some degree its behavior will differ from previous narrow money measures because it has a sizable component that pays explicit interest, that possibly may behave more like savings accounts, and that gives increased weight in the total to household's demands for transactions balances and liquidity. Then there is some uncertainty about what to make of the sharp rise in velocity of M1-B, particularly shift-adjusted, on average in the first half of this year. Does it indicate that a sustained period of downward shift in public preference for cash is in process? Or should it more be taken as evidence that the short-run relationship between narrow money and GNP is loosening further, given the wide variety of near substitutes for narrow money that has developed. Judgments about these and similar issues affect the Committee's targets for 1981 and 1982. With regard M1-B for 1981, the principal argument to the shift-adjusted range for for lowering it would be a view that -2a sustained downward shift in demand for narrow money relative to GNP is in process than the and one which would produce for this year a shift noticeably larger 2½ percentage points assumed in staff GNP projections at the time this year's target was set in February, and which is also embodied in the staff's current projections. to achieve the present 3 If there were such a larger shift, attempts to 6 percent target range would be more expansionary than the Committee originally bargained for. The absence of a further downward shift of money demand in the staff's projection along with fairly strong continued growth in nominal GNP are why our interest rate projections for the balance of the year call for rather sustained high levels of rates. Unless GNP is considerably weaker than projected, we would expect a rebound in money demand, on the thought that the public has economized on cash this year by about as much as it can, or is willing, given existing financial technology, interest rates, and the learning curves of depositors and institutions. An expectation of such a rebound in money demand would argue for leaving the present shift adjusted M1-B range unchanged for 1981--and would suggest rather strong actual M-1B growth at some point over the next few months. Keeping the present range unchanged does have certain problems. If the midpoint of the current range is attained by year-end, shiftadjusted M1-B will have grown by around a 10 percent annual rate over the next six months--though on a quarterly average basis this would work out as growth at about a 7¼ percent annual rate from the second quarter to the fourth quarter of this year. Such a rapid growth might have an adverse impact on inflationary psychology, of course. On the other hand, aiming at much more moderate growth could place substantial further pressure on interest rates and the fabric of the financial system if staff estimates of money to GNP relationships are correct. One solution is for the Committee to accept or aim at a more moderate growth in M1-B over the next several months that brings growth for the year near the low end of the present target range, especially should that develop in an environment of stable or declining interest rates. If the Committee were to lean toward such an approach, and were at the same time to resist money growth in the 10 percent or higher area, this would not be inconsistent with some little lowering of this year's M1-B target range--or aiming in the low part of the present range. As explained in the blue book, we still anticipate that the broader aggregates for 1981 will come in high relative to the announced ranges for them, particularly so if the midpoint for the M1-B growth range for the year is attained. Thus, the Committee may wish to consider whether or not to raise these ranges for the broader aggregates. However, the credibility of the Committee's will to continue monetary restraint might be called into question if the broader ranges were raised, especially in light of the increased attention given to broader aggregates because of uncertainties surrounding the interpretation of M1-B. With regard to 1982, Mr. Chairman, perhaps in order. just a few words are There seems to be no need for the Committee at this time to declare whether the shift into NOW accounts will or will not be over by next year. If the Committee wishes to continue on the course of gradually reducing its growth ranges, it is probably simplest to consider taking at least another point off the shift-adjusted M1-B range boldly suggests dropping M1-A). (the staff But because of uncertainties surrounding the behavior of M1-B, alluded to earlier, there is good reason to broaden the M1-B range from a 2½ percentage points width to a 3 percentage point width (an even wider range probably lacks credibility). Two logical alternatives if that approach were taken are ranges of 2½ to 5½ percent and 3 to 6 percent--advantages and disadvantages of which were noted in the blue book. A lower range shift in equation, jected for M1-B next year does imply some further downward narrow money demand as measured by our quarterly model money demand given the 8½ percent increase for the year. in nominal GNP that we have pro- In light of this year's experience, and our projection of continued historically high interest rates, which would provide somewhat more incentive than usual to economize on cash, that does not seem implausible. But if nominal GNP were projected, or targeted, to grow much more than 8 percent in 1982, its consistency with a reduced target range money next year might well be called into question. for narrow (I might add-- parenthetically--that if nominal GNP growth were unexpectedly weak next year, including with it a considerable deceleration of price increases and a sharp drop of interest rates, there is likely to be a substantial and probably one-time increase in the demand for narrow money as presently measured that the Committee would need to consider accommodating). Ranges for the broader aggregates next year pose a problem similar to this year in that their projected growth, given M1-B, may be relatively But the problems would appear to be less pronounced than this year. high. The lower nominal GNP growth projected for next year will tend to hold down growth in the broader aggregates; moreover, we are not at this point projecting a substantial drop in market rates that would divert savings flows from market instruments to time deposits. greater Thus, there seem to be adds next year that broader money aggregates will fall within the -5ranges currently in place, though in the upper part. Indeed, on the basis of the projections presented in the blue book, it would not seem implausible to lower the 1982 range at least for M3 by point from this year's range. Finally, Mr. Chairman, I have not mentioned the problem of the ranges for actual N1-A and M1-B growth in 1981. You will recall that the M1-B range for 1981 thought consistent with the 3½ to 6 percent shift adjusted range was 6 to 8½ percent. The question arises whether that should be changed in view of unexpectedly rapid growth in OCDs over the first half of this year. Given the recent slowdown in OCD growth, it would not seem that much more than a point increase in the range for actual M1-B is needed, as explained in the blue book. Indeed, the range could well be left unchanged in the thought that it is wide enough to encompass the likely result for the year, given the increase of only 6¾ percent at an annual rate in actual M1-B experienced over the first half of the year. It would appear more necessary technically to lower the range previously published actual range for M1-A. But all this becomes so com- plicated that the Committee may wish to consider simply abandoning the actual ranges and stick to the shift-adjusted ranges only.
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