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June 24-25, 2003

Appendix 1: Materials used by Mr. Reinhart

163 of 211

June 24-25, 2003

164 of 211

annual average percent

Exhibit 1

18
15
12
9
6
3
0

Federal funds rate

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
Costs associated with a low overnight nominal interest rate
Compressing rates
on those instruments
that typically provide
returns below the overnight
federal funds rate.

Selected interest rates
May 20, 2003
Super NOW
MMDA
Retail MMMF
I/O MMMF
RP
Intended funds
0

Thinning brokering; and
Fostering the misimpression that
monetary policy has become ineffective.

0.2

0.4

0.6
0.8
1
percent
Source: Bank Rate Monitor

1.2

1.4

June 24-25, 2003

165 of 211

Exhibit 2

The Implementation of Monetary Policy
Monetary policy actions are implemented by
altering the Federal Reserve System's balance sheet.
Combined balance sheet of the Federal Reserve System
Billions of U.S. dollars, 6/11/2003
ASSETS
LIABILITIES & CAPITAL
Treasury securities
652 Currency
693
of which:
Deposits
Bills
238 of depositories
21
Notes & bonds
399 of U.S. Treasury
7
Loans to depositories
Other assets

0.06 Other liabilities
89 & capital

20

Changes in the size of the balance sheet
are reflected directly in the overnight
federal funds rate until it is driven to zero
Changes in the composition of the balance sheet
potentially could influence term premiums
Both could influence expectations about the expected path
of policy.

June 24-25, 2003

Exhibit 3

166 of 211

The Transmission of Monetary Policy
The principal channel of transmission of monetary policy
to spending is through the prices and returns of long-lived assets.
Those returns depend on the current and expected
future path of short-term interest rates as well as risk
premiums.
Some economists argue that the quantity of liquidity
has an effect on spending independent of its influence
on the current overnight interest rate.

Three forms of monetary impetus
The Committee can provide impetus to the economy at
an unchanged current short-term interest rate
By encouraging investors to expect short rates to be lower in the future than they currently
anticipate, and
By shifting relative supplies to affect risk premiums.
If the overnight rate is already at zero, the Committee may be able to
provide additional impetus to the economy
By oversupplying reserves at the zero funds rate.

June 24-25, 2003

167 of 211

Exhibit 4

Shaping interest rate expectations
How can the Federal Reserve encourage lower interest rate expectations?
Commitment can take two forms
Unconditional commitment
The Committee pledges to hold short-term rates at a low level for x period of time.
Expected short-term nominal interest rates
implied by swap yields, June 3, 2003

Swap yield curve
June 3, 2003

4.8

percent

percent

3.8
2.8
1.8
0.8
spot

1

2

3

4

5

6

7

8

9

3.8
3.3
2.8
2.3
1.8
1.3
0.8
1

2

3

4

5

6

7

8

years ahead

Conditional commitment
The Committee pledges to hold short-term rates at a low level until y happens.
Caveats
Words ultimately have to be matched by deeds for the public to believe.
The Committee may be concerned about its credibility.

9

10

Exhibit 5

June 24-25, 2003

168 of 211

Altering the composition of the central bank balance sheet

months

Average Maturity of Treasury Debt
80
70
60
50
40
30
20
10
0

Held by the public

Held by the System

1955

1958

1961

1964

1967

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

Acquiring longer-term securities
could lower risk premiums on Treasury securities, and
may convince investors that the Committee intends to keep interest rates low because
lengthening the maturity of the portfolio would impose capital losses in the future
should the Committee put policy on a firmer course than currently anticipated.
The Committee could alter the composition of the System Open Market Account
indirectly, by instructing the Desk to tilt its purchases toward longer-term issues (perhaps by targeting
a longer average maturity of the System Open Market Account), or
directly, by putting a ceiling on one or more points along the structure of interest rates.
Caveats
There is little empirical evidence to suggest that relative supplies influence risk premiums.
Purchases of securities might have to be massive to enforce a ceiling if investors came
to doubt that the FOMC would keep interest rates low.
At that point, there would be a risk that the targeted securities would become
disconnected from the rest of the yield curve and private rates.
Why should a central bank issuing a fiat currency care about capital gains or losses?

June 24-25, 2003

169 of 211

Exhibit 6

Altering the size of a central bank's balance sheet
A central bank usually eases monetary policy
by expanding the stock of reserves.
Currently, most central banks calibrate
their easing in terms of the price
of reserves--i.e., the overnight federal
funds rate.
The Committee could switch its focus from
the price of reserves to the quantity of
reserves (or the growth of reserves).
to drive the funds rate to zero and
possibly provide further monetary
stimulus by oversupplying reserves
at the zero funds rate.

overnight
interest
rate

Supply

Demand
Reserves

overnight
interest
rate

Supply

Demand
Reserves

Oversupplying reserves could affect the economy
by lowering the returns on the assets purchased to supply those extra reserves,
by convincing market participants that the overnight interest rate will be kept low, and
by working through a quantity channel, if it exists.
Caveats
A long-run association does not provide much guidance about the short-run
performance of the economy, implying it would be difficult to calibrate the effects
of policy and risks confusing market participants.
The public has to be convinced that the increase in reserves will stick around, so there still
will be a communications challenge.

Exhibit 7

June 24-25, 2003

170 of 211

Some precedents
The Federal Reserve has always appreciated the importance of correctly aligning market
expectations.
Y2K Options sold by the Desk

1.8
1.6
1.4
1.2
1
0.8

1/6 to 1/12
for week of

5-May

12/30 to 1/5
12/23 to 12/29
0

Sep-04

Jul-04

May-04

Mar-04

Jan-04

Nov-03

Jul-03

Sep-03

6-May
May-03

percent

Expected federal funds rate

50

100

150

200

$billions of notional value

Note: Futures rates less 1 b.p. per month term premium

The Federal Reserve operates in all segments of the Treasury market, and
from 1942 to 1951 enforced a ceiling on the yield curve.
Federal Reserve Holdings of U.S. Treasury Securities
Total

. . . and by maturity
percent, net debt outstanding

100

20
15
10
5
0

75

50

25

Bills
Notes

0

1938 1943 1948 1953 1958 1963 1968 1973 1978 1983 1988 1993 1998

1942

1946

1950

The Federal Reserve targeted nonborrowed reserves from 1979 to 1982.
Monetary Base
20
annual percent change

percent, net debt outstanding

25

15
10
5
0
-5

1960

1963

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

250

June 24-25, 2003

171 of 211

Exhibit 8

Issues regarding sequencing
These forms of monetary policy stimulus could be put in place
Once the overnight rate has already been driven to zero;
As a way of driving the overnight rate to zero; or
Before the overnight rate hits zero (and perhaps as a result
it need never get there).

Other alternatives
The Federal Reserve could
lower the primary credit rate and loosen other discount
window policies;
purchase other assets, perhaps including by seeking legislation
to expand its authority; or
coordinate policy with the Treasury.

June 24-25, 2003

172 of 211

Exhibit 9

Four questions
Are there any alternatives that the Committee particularly
favors for additional study?
Are there any alternatives that should be dropped immediately
from consideration?
How does the Committee assess the costs of very low nominal overnight
interest rates, and are they such that an alternative policy should be put in
place at a funds rate above zero?
How should the Committee’s assessment of these policy alternatives be
conveyed to the public in the months ahead?

June 24-25, 2003

Appendix 2: Materials used by Mr. Kos

173 of 211

June 24-25, 2003

174 of 211

Exhibit 1
The F.R. Balance Sheet & Domestic Financial Portfolio
Combined balance sheet of the Federal Reserve System
Billions of U.S. dollars, 6/11/2003
ASSETS
Treasury securities
of which:
Bills
Notes and bonds
TIIS

LIABILITIES & CAPITAL
659
652 F.R. Notes
Deposits
of depositories
of U.S. Treasury

238
399
14

29
6
0

Loans to depositories
Other Assets
Total Assets

32

32

Capital

RPs

Reverse RPs
in the market
Other liabilities

18

<1
60
Total Liabilities
& Capital
744

The Domestic Financial Portfolio includes
* Outright Holdings of Treasury Securities (domestic SOMA)
* RPs, and Reverse RPs arranged in the market
Working Assumption
* only operate in assets currently authorized to hold

744

June 24-25, 2003

175 of 211

Exhibit 2
Size and Composition of SOMA Holdings of Treasury Securities by Remaining Maturity
Millions of Dollars

Millions of Dollars

700,000

700,000

600,000

600,000

500,000

More Than 10 Years

500,000

400,000

5 to 10 Years

400,000

1 to 5 Years
300,000

300,000
Less Than 1 Year: Coupons

200,000

Bills

200,000

100,000

1941

- 100,000

1946

1951

1956

1961

1966

1971

1976

1981

1986

1991

1996

2001

Percent

Percent

100%

100%
More Than 10 Years

90%

90%

80%

80%

70%

70%

60%

60%

50%

50%

40%

40%

30%

30%

20%

20%

Bills

10%
0%
1941

10%
0%
1946

1951

1956

1961

1966

1971

1976

1981

1986

1991

Data from 1971 to 1978 are at an annual frequency.

1996

2001

June 24-25, 2003

176 of 211

Exhibit 3

Targeting a Positive Federal Funds Rate
1098
7
654321-

plotted values reflect experience with excess
levels and targetfunds rates since 1985

Period-Average Excess Reserves (bil. $)

June 24-25, 2003

177 of 211

Exhibit 4
Alternative Approaches for Conducting Monetary Policy

Change the Composition of the Balance Sheet
- Extend Average Maturity of the domestic SOMA
- Set Ceilings on Treasury Yields
- Use ofDerivative Instruments
* excess reserves stay low and can target a positive funds rate

June 24-25, 2003

178 of 211

Exhibit 5
Issues Associated with Alternative Approaches
* Operating Objectives
* Instruments and Market Intervention Techniques
* Achieving Policy Objectives
* Exit Strategies
* Co-Ordination with Treasury Debt Management
* Potential for Capital Losses

June 24-25, 2003

179 of 211

Exhibit 6
Extend Average Maturity of the Domestic SOMA

* redeem $200 billion of bills over six months (=$8 bn. per week)
* buy 3- to 10-year coupon issues (equal percentage holdings of each issue)
* this extends average maturity of SOMA from 42 to 64 months
* but eliminates most liquidity in the domestic SOMA
SOMA Holdings
Value of Holdings
* Now H After 6 months

350

300

50
Bills

0-3

3-10

10-30

Bills, and Coupons by Years to Maturity

Percent of Outstanding Supply
* Now E After 6 months
50%

40%

30% 20% 10%

-

Bills

0-3

3-10

Bills, and Coupons by Years to Maturity

10-30

June 24-25, 2003

180 of 211

Exhibit 7
Ceilings on Treasury Yields
Structure of Ceilings
3
2.5

2
V 1 .5

0.5

1

0

2

3

5

10
Years to M aturity

Design Issues
* Ceiling structures: step function; smooth function; discrete points, etc.
* Desk Operations: "Hard" versus "Soft" ceilings
* Broader Policy Context
- the primary mechanism for influencing longer term yields
- supports commitment to a path of future short-term rates

June 24-25, 2003

181 of 211

Exhibit 8
Use of Derivative Instruments

Types of Instruments
* Sell options and forwards on term RPs with future settlement dates
* Sell put options on Treasury Securities

=> Best structure determined by other specific operating objectives

June 24-25, 2003

182 of 211

Exhibit 9
Reverse RPs and Higher Requirements

Reverse RPs and higher requirements are additionaltools that:
- blow up the size of the balance sheet
- but can still target a positive funds rate

Expand Level of Reverse RPs
* term operations, regular auction cycle
* financing through primary dealers' balance sheets may be a constraint
* replacing long-term Treasury debt with a short-term nonnegotiable debt
* but it may just recycle Treasury debt

June 24-25, 2003

183 of 211

Exhibit 10
Expanding Excess Reserves

Policies that entail an expansion of excess reserves
- also blow up the size of the balance sheet
- and push the funds rate to near-zero

High Excess as an Explicit Objective: Quantitative Easing
* achieved with an orderly purchase of Treasury securities
* could be paired with an objective to extend the maturity of the SOMA

June 24-25, 2003

184 of 211

Exhibit 11
Summary Observations

June 24-25, 2003

Appendix 3: Materials used by Mr. Kos

185 of 211

June 24-25, 2003

186 of 211
Page 1

Implied Rates on Eurodollar Futures Contracts
Percent

Comparison of May 5, June 16 and June 23, 2003 5-Year Projections

6.00
Source: Bloomberg
5.50
5.00
4.50
4.00
3.50
3.00
May 5, 2003
2.50
2.00
1.50
1.00
0.50
Sep-03 Mar-04 Sep-04

Percent
6.00
5.50
5.00
4.50
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50

June 23, 2003

June 16, 2003

Mar-05

Sep-05

Mar-06

Sep-06

Mar-07

Sep-07

Mar-08

Sep-08

U.S. Treasury Yields
April 1, 2003 - June 23, 2003
2-Year Note

Percent
2.00

5/6 FOMC

Percent
2.00

6/3 Chairman’s
comments to IMC

Percent
4.25

10-Year Note
5/6 FOMC

Percent
4.25

6/3 Chairman’s
comments to IMC

1.75

1.75

4.00

1.50

1.50

3.75

3.75

1.25

1.25

3.50

3.50

1.00

1.00

3.25

3.25

0.75

3.00

Source: Bloomberg

0.75

4/1

4/15

4/29

5/13

5/27

6/10

4.00

Source: Bloomberg

4/1

4/15

4/29

3.00
5/13

5/27

6/10

Option-Adjusted Spreads of U.S. Corporates to 10-Year Treasuries
Basis Points
170

Investment Grade
5/6 FOMC

6/3 Chairman’s
comments to IMC

April 1, 2003 - June 23, 2003
High Yield and EMBI+
Basis Points
Basis Points Basis Points
700
700
170
5/6 FOMC

160

160

150

6/3 Chairman’s
comments to IMC

650

650
EMBI+ Spread

150
600

140

130

550

550

140

130

600

Source: Lehman Brothers

120
4/1

4/15

4/29

120
5/13

5/27

6/10

Source: Merrill Lynch,
JP Morgan Chase

500
4/1

4/15

4/29

High Yield

500
5/13

5/27

6/10

June 24-25, 2003

187 of 211
Page 2

U.S. Equity Indices

Index
4/1/03 = 100

Index
4/1/03 = 100

April 1, 2003 - June 23, 2003

125

125
Source: Bloomberg

5/6 FOMC

6/3 Chairman’s
comments to IMC

120

120
Nasdaq

S&P 500

115

115

110

110

105

105

DJ Industrial Average

6/9 Freddie Mac
management change

100

100
4/1

4/8

4/15

4/22

4/29

5/6

5/13

5/20

5/27

6/3

6/10

Select Global Equity Indices

Index
4/1/2003 = 100

6/17

Index
4/1/2003 = 100

April 1, 2003 - June 23, 2003

140

140
Source: Bloomberg

5/6 FOMC

6/6 ECB rate cut
-50 bp

6/3 Chairman’s
comments to IMC

130

130
DAX

DJ Euro Stoxx

120

120
110

110
FTSE

100

TSE 300
Nikkei

100
90

90
4/1

4/8

4/15

4/22

4/29

5/6

5/13

5/20

5/27

6/3

6/10

Select Emerging Market Equity Indices

Index
4/1/2003 = 100

6/17

Index
4/1/2003 = 100

April 1, 2003 - June 23, 2003

150

150
Source: Bloomberg

5/6 FOMC

Korea Composite

140
Brazil Bovespa

130

Merval

140
130

120

120

110

110
Mexican Bolsa

Hang Seng

100

100
90

90
4/1

4/8

4/15

4/22

4/29

5/6

5/13

5/20

5/27

6/3

6/10

6/17

June 24-25, 2003

188 of 211
Page 3

Euro-Dollar Exchange Rate

U.S. Dollars per Euro
(inverted scale)

U.S. Dollars per Euro
(inverted scale)

April 1, 2003 - June 23, 2003

1.05

1.05
5/6 FOMC

5/12 and 5/19
Treasury Secretary Snow
comments on the USD

5/30 and 6/2
President Bush reiterates
“strong dollar” policy

1.10

1.10

1.15

1.15

Source: Bloomberg

1.20

1.20
4/1

4/8

4/15

4/22

4/29

5/6

5/13

5/20

5/27

6/3

6/10

6/17

Dollar-Yen Exchange Rate
Yen per U.S. Dollar

April 1, 2003 - June 23, 2003

Yen per U.S. Dollar
122

122
5/6 FOMC

5/12 and 5/19
Treasury Secretary Snow
comments on the USD

121

5/30 and 6/2
President Bush reiterates
“strong dollar” policy

121

120

120

119

119
Japanese Intervention
Since May 6:
$36.89b
YTD:
$56.37b

118
117

118
117
116

116
Source: Bloomberg

115

115
4/1

4/8

4/15

4/22

4/29

5/6

5/13

5/20

5/27

6/3

6/10

6/17

Trade Weighted U.S. Dollar
January 1, 1999 - June 23, 2003

Percent

Percent

110

110

105

105

100

100

95

95

90

90
Source: Bloomberg (BoG index)

85
Jan-99

85
Jul-99

Jan-00

Jul-00

Jan-01

Jul-01

Jan-02

Jul-02

Jan-03

June 24-25, 2003

189 of 211
Page 4

Euro-Area 3-Month Deposit Rates and Rates
Implied by Traded Forward Rate Agreements
April 1, 2003 - June 23, 2003
LIBOR Fixing 3M Forward 6M Forward 9M Forward
Percent

Percent

2.75

2.75

5/6 FOMC

6/6 ECB rate cut
-50 bp

2.50

2.50

2.25

2.25

2.00

2.00

1.75

1.75

1.50

1.50
4/1

4/8

4/15

4/22

4/29

5/6

5/13

5/20

5/27

6/3

6/10

6/17

Index of Euro Corporate Spreads to German Government Debt

Basis
Points

Basis
Points

January 1, 2001 - June 23, 2003

300

300
BBB

250

250

200

200

150

150
A

100

100

AA

50

50

0
Jan-01

AAA

0

May-01

Sep-01

Jan-02

May-02

Sep-02

Jan-03

May-03

Japan
BOJ Current
Account Balances

Yen Trillion
35

4/1 Beginning of
new fiscal year

5/16 Resona
Holdings

January 1, 2003 - June 23, 2003
Yen Trillion
35

Percent
1.00

5/16 Resona
Holdings

0.90

30

Percent
1.00

10-Year JGB Yield

0.90

30
0.80

25

25
Shaded band =
target balance

20

0.80

0.70

0.70

0.60

Actual balance

0.60

20
0.50
Source: Bloomberg

15
1/1

2/1

3/1

15
4/1

5/1

6/1

0.40

0.50
Source: Bloomberg

1/1

2/1

3/1

0.40
4/1

5/1

6/1

June 24-25, 2003

190 of 211
Page 5

Freddie Mac and Fannie Mae Equity Prices

Index
1/1/03 = 100

Index
1/1/03 = 100

Jan 1, 2003 - June 23, 2003

120

120
1/22 Freddie Mac announcement of
earnings restatement

115

5/6 FOMC

115
110

110
S&P 500

105

105

Fannie Mae

100

100

95

95

90

90

Freddie Mac

85

85

6/9 Freddie Mac
management change

Source: Bloomberg

80

80
1/1

1/16

1/31

2/15

3/2

3/17

4/1

4/16

5/1

5/16

5/31

6/15

GSE 10-Year Debt Spread to 10-Year Treasury Note
Jan 1, 2003 - June 23, 2003

Basis Points

Basis Points

60

60
5/6 FOMC

Source: Bloomberg

50

6/9 Freddie Mac
management change

50

Fannie Mae

40

40
Freddie Mac

30

30
1/22 Freddie Mac announcement of
earnings restatement

20

20
1/1

1/16

1/31

2/15

3/2

3/17

4/1

4/16

5/1

5/16

5/31

6/15

Freddie Mac vs. Fannie Mae Spreads
April 1, 2003 - June 23, 2003
Basis Points
15

10-Year Debt Yield
5/6 FOMC

6/9 Freddie Mac
management change

Basis Points
15

Basis Points
15

MBS
5/6 FOMC

6/9 Freddie Mac
management change

Basis Points
15

10

10

10

10

5

5

5

5

0

0

0

0

-5

-5

-5

-5

-10

-10

Source: Bloomberg

-10
4/1

4/15

4/29

5/13

5/27

6/10

Source: Bloomberg

4/1

4/15

4/29

-10
5/13

5/27

6/10

June 24-25, 2003

Appendix 4: Materials used by Mr. Oliner, Ms. Johnson, and Mr. Wilcox

191 of 211

June 24-25, 2003

STRICTLY CONFIDENTIAL (FR) CLASS I-FOMC*

Material for

Staff Presentation on the
Economic Outlook
June 24, 2003

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

192 of 211

June 24-25, 2003

193 of 211

June 24-25, 2003

194 of 211

Chart 3

Household Financial Conditions

June 24-25, 2003
Personal Bankruptcy Rate*

195 of 211

Household Delinquency Rates

Filings per 100,000 persons

Percent
600

Quarterly, annual rate

4.5

Q2*
500
3.5
Household loans
at commercial banks*
400
Q1
300

2.5

Apr.
Auto loans at finance companies

200
1991

1993

1995

1997

1999

2001

1991

*Based on data through June 14.

1993

1995

1997

1999

2001

2003

* Consumer and residential real estate loans.

Mortgage Market Indicators
250

1.5

2003

Augmented Debt Service Burden*
Percent of mortgage debt

Basis points

Percent of DPI
6

Monthly

Quarterly

June

200

19

NBER
peak

5
Coupon gap*

150

June

18

4

100
3
50

17
2

0
Refinancing
volume

-50

1

16

0

-100
-150

15
1991

1993

1995

1997

1999

2001

2003

1980

*30-year fixed mortgage rate minus average rate on mortgages
in GSE pools.

1984

1988

1992

1996

2000

2004

*Standard series augmented to include rent payments, auto
lease payments, property taxes, and homeowners’ insurance.

Real House Prices*
Percent
10

NBER
peak

Four-quarter percent change

8
6
4
2
0
-2
-4
-6

1976

1978

1980

1982

1984

1986

1988

1990

1992

*OFHEO repeat sales index deflated by core PCE chain-weight price index.

1994

1996

1998

2000

2002

2004

June 24-25, 2003

196 of 211

Chart 4

Corporate Financial Conditions
Debt Ratios for Nonfinancial Corporations

Components of Net Debt Financing,
Billions of dollars
Nonfinancial Corporations

Percent

Bonds
Commercial paper and C&I loans*

40

35

9

50

Monthly rate

33

30
Q1

8

20

Q2 e

7

2002

2003

29

5

27

-10

2001

31

6

0

2000

Debt to Assets

Q1

10

1999

Percent

10

4

-20

Current Debt to Assets*

Q1

3

25
23

1989

* Seasonally adjusted.
e Staff estimate.

1991

1993

1995

1997

1999

2001

2003

* Current debt equals short-term notes and the portion of
long-term debt due within one year. Source. Compustat.

Debt Service Obligation of Nonfinancial Corporations*

Percent of after-tax cash flow
100

Median firm in each period
90
80

Speculative Grade

70
Q1

60
50

Investment Grade

40
Q1

30
1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

* Ratio of interest expense plus current debt to after-tax cash flow. Source. Compustat.

Market Indicators of Corporate Financial Positions

Defined-Benefit Pension Plans

Percent

Basis Points
300

2.5

Monthly
q

Contributions by S&P 500 firms tripled
in 2002, reaching $45 billion.

250

Ten-Year
BBB Yield
Spread

200
q

Funding gap is concentrated among
investment-grade firms.

1.5
June

150

KMV Expected
Year-Ahead
Defaults*

100
q

Even for these firms, last year’s
contributions amounted to only a small
part of their cash flow.

2.0

May

1.0

0.5

50
0

0.0
1998

1999

2000

2001

2002

2003

* Weighted by firm-level liabilities. Excludes defaulted firms.

June 24-25, 2003

197 of 211

June 24-25, 2003

198 of 211
Chart 6

Financial Developments
Nominal Dollar Indexes

Nominal Exchange Rates
Index, Jan. 30, 2002 = 100

For. cur./U.S.$

110

Index, Jan. 30, 2002 = 100

Weekly

Weekly
100

Broad**

110

100
C$

90

90
Yen

Major currencies*
80

80
Euro

2001

2002

2003

70

2001

2002

2003

70

*Trade-weighted average against major foreign currencies.
**Includes major currencies and other important trading partners.

Long-term Interest Rate Differentials*

EMBI+ Spreads

Percentage points

U.S. minus foreign

5

75

Weekly

Percentage points

Percentage points

25

Weekly
4

65

3

55

2

45

1

35

0

25

-1

15

-2

5

Argentina

20

Japan
15
Germany

Canada
2001

2002

2003

Brazil

2001

2002

10

2003

5

*10-year Treasury yields minus foreign government bond yields.

Stock Prices
Industrial Countries

Stock Prices
Index, July 2, 2001 = 100

160

Weekly

Emerging Markets

Index, July 2, 2001 = 100

160

Weekly
140

140
Korean Kospi

120
100
S&P 500

120
100
Mexican Bolsa

80

TOPIX

H.K. Hang Seng

60

80
60

DJ Euro Stoxx
2001

2002

2003

40

2001

2002

2003

40

June 24-25, 2003

199 of 211
Chart 7

Effects of U.S. Dollar Depreciation
Constant Short-Term Interest Rates
U.S. PCE Inflation and Import Price Inflation

U.S. Real GDP Growth

Percentage point contribution, AR

Percentage point contribution, AR

4.5

1.0

4.0

0.8

3.5

Import price inflation
3.0

0.6

2.5
2.0

0.4

1.5

PCE inflation

1.0

0.2

0.5
0.0

2002

-0.5

2003

2002

0.0

2003

Taylor Rule Case
U.S. PCE Inflation and Import Price Inflation

U.S. Real GDP Growth

Percentage point contribution, AR

Percentage point contribution, AR

4.5

1.0

4.0

0.8

3.5
3.0

Import price inflation

0.6

2.5
2.0

0.4

1.5
1.0

PCE inflation

0.2

0.5
0.0

2002

-0.5

2003

2002

0.0

2003

Effects in Foreign Countries
(Contribution in percentage points, AR)
PCE Inflation
2002

Real GDP Growth
2003

Fixed*

Taylor**

Fixed

Canada

-.1

.4

-2.7

Euro area

-.9

-.7

Japan

-.4

U.K.
Dev. Asia
Mexico

2002
Fixed

Taylor

Fixed

.0

-.3

.0

-.8

.7

-3.6

-1.6

-.5

-.3

-2.8

-1.2

-.4

-.3

.0

-.5

-.4

-.3

.0

-.2

-.2

.3

-.1

-.3

-.3

-.8

-.6

.7

.6

2.0

.8

-.2

-.2

2.7

1.8

2.7

.6

5.4

-.2

2.5

.5

6.4

-.1

*Exchange rates and short-term interest rates at 2002:Q1 values.
**Taylor Rules govern short-term interest rates. Exchange rates react.

Taylor

2003
Taylor

June 24-25, 2003

200 of 211
Chart 8

Monetary Policy Stance Abroad
Euro Area

Canada

Output Gap*

Output Gap*
Percent

Percent

2

2

1

0

-1

-2

2003

0

-1

2002

1

-2

-3

2004

*(Actual GDP - Potential GDP)/Potential GDP.

2002

2003

-3

2004

*(Actual GDP - Potential GDP)/Potential GDP.

Actual and Projected Policy Rates

Actual and Projected Policy Rates
Percent

Percent

5

June 2002 Greenbook

5

June 2002 Greenbook
4

4

3

3

Policy Rate

Policy Rate

2
3-month euribor futures
(week of June 26, 2002)

2

3-month Banker’s Acceptances futures
(week of June 26, 2002)

1

0
Q2

Q3

Q4

2002

Q1
Q2
2003

0
Q2

Q3

Q4

2002

Policy Rates Implied by Taylor Rules*

1

Q1
Q2
2003

Policy Rates Implied by Taylor Rules*
Percent

Percent
8

8

Taylor Rule #1

7

7

6

6
Taylor Rule #2**

5

4

3

Policy Rate

5

4

Taylor Rule #1

3

2
Taylor Rule #2**

1
0

Q2
Q3
Q4
Q1
Q2
2002
2003
*Weights of 1/2 each on output gap and difference of inflation from 2 percent.
**6-quarter ahead staff forecast for headline inflation.

Policy Rate

2
1
0

Q2
Q3
Q4
Q1
Q2
2002
2003
*Weights of 1/2 each on output gap and difference of inflation from 2 percent.
**6-quarter ahead staff forecast for headline inflation.

June 24-25, 2003

201 of 211
Chart 9

U.S. External Outlook
Real GDP Growth: Industrial Countries

Real GDP Growth: Developing Countries

Percent, SAAR*

Percent, SAAR*

2002
2003
2004
H2 H1 H2
1. Total Foreign**

2.1

0.6

2.6

3.4

2. Indust. countries

1.9

1.0

1.8

2.5

3. Euro Area

0.8

0.2

0.7

2.0

4. Japan

2.1

0.2

0.2

1.0

5. Canada

2.2

1.7

2.9

3.2

6. United Kingdom

2.9

0.9

1.8

2002
2003
2004
H2 H1 H2
1. Total Developing** 2.4 -0.0 3.8 4.8
2. Developing Asia
4.4 1.3 4.5 5.7
of which:
3. China
7.1 6.2 7.2 8.1
4. Korea
6.1 0.5 5.7 5.4

2.5

of which:

5. Latin America
of which:
6. Mexico
7. Brazil

0.7 -1.5

3.3

4.4

1.1 -0.7
3.5 0.9

2.8
2.7

5.0
3.0

*Years are Q4/Q4; half years are Q2/Q4 or Q4/Q2.
**Aggregates weighted by shares of U.S. exports.

*Years are Q4/Q4; half years are Q2/Q4 or Q4/Q2.
**Aggregates weighted by shares of U.S. exports.

Real Exchange Rate Outlook

Contribution to U.S. GDP Growth

Index, 2001:Q1 = 100

Percentage points

105
Exports
Imports

Broad Index

Jan. 03 Greenbook

3
2
1

100

0
-1

95

-2

June 03 Greenbook
2001

2002

2003

2004

90

Current Account Balance
Percent
1

-3

Level

-100

-300

Percent of GDP

-500

1996

1998

2000

2004

Billions of dollars, AR
100

-5

-7

2003

Financial Flows
Billions of dollars

-1

2002

2002

2004

-700

2002 2003:Q1
1. Official capital, net
91
2. Private capital, net
437
of which:
3. For. purch. of U.S. sec. 388
4. of which: Equities
55
5. U.S. purch. of for. sec.
16
6. of which: Equities
-18
7. For. D.I. in U.S.
40
8. U.S. D.I. abroad
-138

144
307
258
-13
-103
-133
103
-116

-3

June 24-25, 2003

202 of 211

June 24-25, 2003

203 of 211

June 24-25, 2003

204 of 211

June 24-25, 2003

205 of 211
Chart 13

ECONOMIC PROJECTIONS FOR 2003

FOMC
Range

Central
Tendency

Staff

-------------Percentage change, Q4 to Q4-----------Nominal GDP
February 2003

Real GDP
February 2003

PCE Prices
February 2003

3½ to 4¾

3¾ to 4½

4.1

(4½ to 5½)

(4¾ to 5)

(4.8)

2¼ to 3

2½ to 2¾

2.9

(3 to 3¾)

(3¼ to 3½)

(3.6)

1 to 1¾

1¼ to 1½

1.3

(1¼ to 1¾)

(1¼ to1½)

(1.3)

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

6 to 6¼

6 to 6¼

6.1

February 2003

(5¾ to 6)

(5¾ to 6)

(6.1)

Central tendencies calculated by dropping high and low three from ranges.
ECONOMIC PROJECTIONS FOR 2004

FOMC
Range

Central
Tendency

Staff

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

4¾ to 6½

5¼ to 6¼

6.5

Real GDP

3½ to 5¼

3¾ to 4¾

5.3

¾ to 2

1 to 1½

.8

PCE Prices

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

5½ to 6¼

5½ to 6

5.4

June 24-25, 2003

Appendix 5: Materials used by Mr. Reinhart

206 of 211

June 24-25, 2003

207 of 211

Exhibit 1

Expected Federal Funds Rates*

Percent
- 3.5

Probability of Policy Action Implied by Option
Prices on Federal Funds Futures
May 5

Jun 24

-percent1. Easing

June

I

Oct.
2003

u

Feb.

17

45

50 bp

25

54

4. No Change

June 24, 2003
I I

25 bp

3.

I

99

2.

sIt

42

I
a t

t

June
2004

t

*

Oct.

I

l

Feb.

lI

l

June
2005

Il

Oct.

*Estimates from federal funds and eurodollar futures

Implied Distribution of Federal Funds Rate Derived
from Option Prices on Eurodollar Futures* Percent

I

Sune

Probability the Federal Funds Rate will be at or
Percent
Below 0.50 Percent in Five Months*

I

9A
243

-3
May 5, 2003

0.25 0.50 0.75 1.001.25 1.501.75 2.00 2.25 2.50 2.75 3.00
*Estimates from options on eurodollar futures contracts, adjusted to
estimate expectations for the federal funds rate, five months hence.

Selected Equity Indexes

12/02/02 = 100

Dec.
2002

Jan.

Feb.

Apr.
Mar.
2003

June

May

*Estimates from options on eurodollar futures contracts, adjusted to
estimate expectations for the federal funds rate.

Selected Ten-year Yields

Percent

FOMC

-1

BBB*

k -.

AA*

a..
-

..

N Treasury

Dec.
2002

Jan.

Feb.

Mar.
Apr.
2003

May

June

Dec.
2002

Jan.

Feb.

Apr.
Mar.
2003

May

June

*AA and BBB rates based on yield curves derived from Merrill Lynch data.

June 24-25, 2003

208 of 211

Exhibit 2

The Case for Easing 25 Basis Points

+

Ratify at least a portion of the easing currently built into market prices.

"

Work down resource slack quicker.
View the costs of insurance as low given that inflation expectations
are well contained.

+

Unemployment Rate in the Greenbook

Percent

Inflation Expectations

Percent

-n 6.4
Alternative
1.25 percent
funds rate

16.0
Baseline
1 percent funds rate

I I I II

I

Mar.

June

I I

I

Oct.

Jan.

l

I

Apr.

2003

I

I I I I I

July

Oct.

Jan.

Oct.
2001

June

2004

Feb.

May Aug.
2002

Dec.

Apr.
2003

*Median five to ten-year inflation expectations. **Measured as the inflation rate
at which the price of the indexed security equals the value of a portfolio of
zero-coupon securities that replicates its payments.

Alternative Simulations of the FRB/US Model
PCE Inflation (ex. food and energy)*
Percent

Unemployment Rate

---- -

Pause until 2005
- Pause until 2006
Pause until 2007

-

I

!I

2001

2002

2003

2004

2005

2006

2007

.

2008

I

-

,

,,

2001

Percent

Pause until 2005
- Pause until 2006
Pause until 2007

I

. 1l

,I.I

2002

2003

*Four-quarter percent change.

I..
2004

2005

2006

.1
2007

'3
2008

June 24-25, 2003

209 of 211

Exhibit 3
The Case for Easing 50 Basis Points

Re-establish the degree of monetary policy accommodation of late last year.
Fatten the cushion of inflation protection from the zero bound.
Provide needed stimulus if the Greenbook assessment of aggregate demand is too optimistic.

Actual Real Federal Funds Rate and Range of Estimated Equilibrium Real Rates
[Quarterly

Percent

A

Actual Real Funds Rate

V

TIIS-Based Estimate
Historical Average: 2.68
(1966Q1-2003Q1)

--

---- --- --- ---- --- --- --- ---- --- ---

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

Current Rate
* 25 b.p. Easing
50 b.p. Easing ll
lI

Il

1990

liI
1991

l lI

1992

1993

l

Ilii
1994

i
1995

Intierest Rate Prescription From a
......
....
...
F-orwara-LooKing i aylor- Iype Policy Ruie
Actual funds rate
End of
.
.--Interest rate prescription estimation

I I I I I I I I I I I I I I I I I III
1996

Pe.....t

"'"'"

1997

1998

1999

2000

II IIII I I II I
2001

2002

2003

Private Sector Forecasts
Forecasts
2004

3.80

6.00

2. Bear Steams (6/12/03)

4.21

5.60

3. Morgan Stanley (6/19/03)

4.90

5.50

4. JP Morgan Chase (6/17/03) 2.80

6.00

5. Goldman Sachs (6/18/03)

2.00

6.50

6. Memo: Greenbook
1990

Q4
Unemp. Rate

1. Merrill Lynch (6/6/03)

1988

Q4/Q4
leal GDP

5.30

5.40

period

V.4

1992

1994

1996

1998

2000

2002

June 24-25, 2003

210 of 211

Exhibit 4
The Case for Keeping the Funds Rate Unchanged

*

View easing as unnecessary because
-- Considerable fiscal impetus is in train.
-- The Greenbook is too gloomy about investment.
-- Put some weight on the recent rapid expansion of liquidity.

Fiscal Impetus

Equipment and Software Spending
Relative to Economic Troughs

Percent of GDP

Index, trough=100

Average History
-Current Episode
.......... Greenbook Forecast

*

1961

1967

1973

1979

1985

1991

1997

*80

£

-4
-2
0
2
4
6
8
10
12
Current episode trough is assumed to be 2001:Q4; historical troughs
included are 1970q4, 1975ql, 1982q4, 1991q1.

2003

Real M2 and Real Bank Credit*

1960

1963

1966

1969

Percent

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

*Seasonally adjusted. Real values calculated using the GDP deflator. Shading indicates regions declared by the National Bureau of
Economic Research as recessions.

June 24-25, 2003

211 of 211

Exhibit 5
The Assessment of Risks

On May 6th, the Committee

+

Separated the risk assessment,
-- Risks regarding its objective of sustainable economic growth
-- Risks regarding its objective of price stability
-- Balance of those two risks

+

Voted only on the policy rate

A Proposal

Return to the practice of voting on the assessment of risks
Choose among generic formulations of the three sentences
Allow discretion to the drafters

For Today's Choice

MMS Survey Results
Fraction of Respondents

+

At a funds rate of 3/4, 1, or even
1-1/4 percent,

Target Rate

-- Growth rate risks are balanced

0.75

1.00

Total

Downside

0.29

0.42

0.71

Neutral

0.21

0.08

0.29

Total

0.50

0.50

1.00

-- Inflation risks are to the downside
-- Balance to the downside
+

Arguably, at a funds rate of 3/4 percent,
-- Risks may be seen as balanced

Balance of Risks