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June 29-30, 2005 172 of 234 Appendix 1: Materials used by Messrs. Gallin, Lehnert, Peach, Rudebusch, and Williams June 29-30, 2005 STRICTLY CONFIDENTIAL (FR) CLASS II-FOMC Material for Special Staff Presentations on Housing Valuations and Monetary Policy June 29, 2005 173 of 234 June 29-30, 2005 174 of 234 Is Housing Overvalued? Joshua Gallin Board of Governors of the Federal Reserve System 2 of 33 June 29-30, 2005 175 of 234 Exhibit 1 6-29-05 Is Housing Overvalued? Changes in Real House Prices: The United States Four-quarter percent change 15 10 5 0 -5 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 Note: Real house prices are the repeat-transactions price index relative to the personal consumption expenditures chain-price index. Sources. BEA and OFHEO. Real Price Changes: Western Cities Real Price Changes: Eastern Cities Four-quarter percent change - San Francisco Las Vegas 50 Four-quarter percent change - 40 New York Miami 40 30 30 20 20 Q1 10 1975 1980 1985 1990 1995 2000 2005 50 - - 10 0 0 -10 -10 -20 -20 1975 Anecdotes from the Housing Market 1980 1985 1990 1995 2000 2005 Valuing Housing Is housing affordable for the typical household? " Increased speculation. " Rosy assessments of future appreciation. - Are prices too high relative to incomes? " Increased reliance on novel financing without full recognition of the associated risks. - Are required mortgage payments affordable? * " Are prices too high relative to rents? 3 of 33 June 29-30, 2005 176 of 234 Exhibit 2 A Framework for Valuing Housing 6-29-05 The Data " Rental payments in the housing market are analogous to dividends in the stock market. " Repeat-transactions price indexes from OFHEO and Freddie Mac. " High prices can be justified by high rents or low carrying costs. " Tenants' rent index from the CPI. " Carrying costs include interest payments, net taxes, and depreciation. " Several adjustments address shortcomings of the data. Price-Rent Ratio and Real Carrying Costs Percent 10e- Ratio 27.5 - 25.0 Real carrying cost <left scale> (interest payments, net taxes, depreciation) 22.5 20.0 17.5 Note. The price-rent ratio is the repeat-transactions house-price index divided by CPI tenants' rent, adjusted by Board staff. The real carrying cost includes effective after-tax mortgage rates, local property taxes, and depreciation relative to ten-year inflation expectations from the Philadelphia Fed survey. Price-Rent Ratios and Subsequent Changes in Real Prices Cumulative percent change, real prices, subsequent three years ()o 2002:Q1 C'O Co.S)9 1970:Q3 C0 0 0 00 -10 19.0 1 19.5 I 20.0 1 20.5 I 21.0 I 21.5 I 22.0 Price-rent ratio 4 of 33 I 22.5 1 23.0 I 23.5 I 24.0 224.515 June 29-30, 2005 177 of 234 Exhibit 3 6-29-05 Price-Rent Ratios and Subsequent Changes in Real Prices: Selected Cities 1979:Q2 1989:Q4 2005:Q1 San Francisco Percent deviation from long-run level 80 Chicago Miami 70 60 New York 50 - 40 30 151620 -4 10 0 -10 - Real Price Change, subsequent three years (cumulative) -5 -12 2 -16 -20 1 3 -5 K-- Projection of Real Price Changes Two Models of House Price Changes Four-quarter percent change History and staff forecast Variables in the basic model " Recent house prices " Real income, real carrying costs, and the unemployment rate -- Error-correction model Extra variables in error-correction model " Lagged price-rent ratio " Lagged level of carrying costs 2002 I 2003 I 2004 Il 1 2005 2006 Conclusions " The price-rent ratio isvery high by historical standards, suggesting that housing might be overvalued by as much as 20 percent. " Historical experience suggests that the change in real house prices going forward will be slower than in recent years. " The evidence cannot rule out either further rapid gains in house prices for a time or a rapid correction back toward fundamentals. 5 of 33 June 29-30, 2005 178 of 234 House Prices and Mortgage Finance Andreas Lehnert Board of Governors of the Federal Reserve System 6 of 33 June 29-30, 2005 179 of 234 Exhibit 1 Household Sector Vulnerability to House Price Declines Estimated Loan-to-Value Distribution of Outstanding Mortgages Percent of borrowers Sept. 2003 2005 64March 56 19 1 14 7 Less than 70 70-79 80-89 4 90+ Source. LoanPerformance Corp. (LPC) servicer data, flow of funds accounts (FFA), OFHEO LTV at Origination Against Price Change Sensitivity of Household Sector to Price Declines Percent of borrowers with negative equity Average LTV at origination, 2004 4o 40 L By state K Sept. 2003 March 2005 * * - -TX *. . .* -*IL *.NV * S FL SNY* MA"CA I 2 10 20 Price decline (percent) Mortgage Delinquency Rates I I I * I 4 6 8 10 Annualized price change, 1999-2003 (percent) Conclusions Per cent Quarterly . Average LTV has decreased over the past 18 months All loans Q1 . Most borrowers have substantial equity in their homes " Rapidly rising house prices have kept mortgage delinquencies and losses low Loans at commercial banks - Some households are very highly leveraged Q1 "" 1991 1993 1995 1997 Source. MBA, Call Reports 1999 2001 2003 2005 7 of 33 June 29-30, 2005 180 of 234 Exhibit 2 Characteristics of Interest-Only (10) Mortgages in RMBS Pools Components of Home Mortgage Debt 2003:01 10 Share of RMBS Against Price Change 10 share of RMBS (percent) By state 2005:01 --billions of dollars-1. RMBS pools 2. 10 RMBS pools 591 1,191 54 296 6,491 8,282 r = 0.3 N, CA - * 3. Total home mortgage debt MA Memo: 4. 10 RMBS share of home mortgages (percent) 0.8 -* .* 3.6 2 Source. LPC RMBS data, FFA fIL . * . NY . 4 6 8 10 Annualized price change, 1999-2003 (percent) Note. Data are from purchase originations in 2004 Loan-to-Value Ratios of Interest-Only Mortgages at Origination E FL Percent of interest-only mortgage debt March 2003 March 2004 Feb 2005 Less than 70 70-79 80-89 90+ Note. Data are for lo RMBS pools only; observations are weighted by mc Credit Scores of Interest-Only Mortgages Percent of interest-only mortgage debt FICO Score March 2003 March 2004 Feb 2005 420-659 720-779 660-719 Note. Data are for 10 RMBS pools only; observations are weighted by mortgage size. 8 of 33 780-900 June 29-30, 2005 181 of 234 Exhibit 3 Financial Institution Risk Exposure Housing GSEs Credit Risk Exposure Mortgage Types 1. Average LTV at origination 1. Housing GSEs Conforming, mostly fixed-rate 2. Estimated average current LTV 2. Private Mortgage Insurers High LTV 3. Average credit score (FICO) 3. RMBS Pools Wide variety 4. Percent of guaranteed mortgages with credit enhancement 4. Banks and Thrifts Wide variety Institutions Note. Data are from Freddie Mac only Source. Freddie Mac 2004 Annual Report Private Mortgage Insurers Ratio Risks in RMBS Pools Ratio 0.25 0.20 0.15 03 " RMBS pools contain relatively risky mortgages 0.10 0.05 -- 0.0 03 -0.05 e Pools are structured to allow investors to choose risk exposure e Pools are exceptionally transparent -0.10 -0.15 " Pricing depends on loss modeling -0.20 - -0.25 1988 1991 1994 1997 2000 2003 Source. Mortgage Insurance Companies of America Assets and Capital Ratios Mortgage Share of Assets, Banks and Thrifts Percent of total assets Bottom Second Third Quartile Top Note. Not weighted by assets 9 of 33 Mortgage Share Quartile Average Assets (billions) Average Tier 1 Capital Ratio 1. Bottom 0.9 16.5 2. Second 0.8 10.3 3. Third 1.4 10.1 4. Top 1.4 10.4 June 29-30, 2005 182 of 234 Measuring House Prices Richard Peach Federal Reserve Bank of New York 10 of 33 June 29-30, 2005 183 of 234 The OFHEO Home Price Index - An index of the average price of single-family homes purchased (refinanced) with conforming, conventional mortgages - Excludes cash sales and sales financed with FHA, VA, and jumbo loans. Ww - A "repeat-sales" index - Measures sales prices or appraised values of properties at same address at different points in time. - A transactions-based price index. June 29-30, 2005 184 of 234 The Constant-Quality New Home Price Index - Based on a sample of new homes sold, regardless of how the sale was financed. - Hedonic methods are used to hold physical and locational characteristics constant over time. - Sales prices regressed on numerous characteristics such as lot size, square footage of structure, presence of air conditioning, fire places, etc. June 29-30, 2005 185 of 234 6 Nominal Home Price Appreciation % Change - Year to Year 20 % Change - Year to Year 20 15 15 10 10 OFHEO Index Census Constant Quality New Home Price Index 5 5 0 0 -5 ' 1976 ' 1980 1984 1988 ' 1992 Source: Census Bureau and Office of Federal Housing Enterprise Oversight ' '' 1996 ' 2000 ' -5 2004 Note: Shading represents NBER recessions. June 29-30, 2005 186 of 234 Ratio of Home Price Over Median Family Income Ratio 3.5 Ratio 3.5 3.25 3.25 3 3 0 2.75 2.75 2.5 2.5 2.25 2.2 21 1977 1980 1983 1986 Source:Office of Federal Housing Enterprise Oversight and Bureau of Economic Analysis 1989 1992 1995 1998 2001 2004 *Both indices have been converted to dollars using the median price of existing homes in 1979Q1. Note: Shading represents NBER recessions. June 29-30, 2005 187 of 234 Distribution of Single-Family Homes by Value: 20035 # of Single-Family Units 1200 r 900 600 300 0 90,000 25th 150,000 50th Home Values Source: American Housing Survey et 00 250,000 300,000 75th 80th June 29-30, 2005 188 of 234 Appreciation and Turnover Rates by Percentile (percent per year) Appreciation Rate 25th Percentile 75th 50th 80th 4.5% 5.6% 7.5% 8.7% 5.9% 7.5% 8.6% 7.4% (1997 - 2003) Turnover Rate (average 1997 - 2003) Source: American Housing Survey June 29-30, 2005 189 of 234 OFHEO Index and Home Improvements Index, 1977 = 1 1.5 Index, 1977 = 1 1.5 1.4 1.4 1.3 1.3 1.2 Ratio of Constan-QualiOFHEOI Ine 1.2 to 1.1 1.1 1 1 0.9 1977 1980 1983 1986 1989 1992 1995 1998 0.9 2004 2001 0 2000 Dollars 1100 2000 Dollars 1100 1000 1000 900 900 800 800 700 700 600 600 500 19 89 1983 1986 1977 1980 Source: Census Bureau, Office of Federal Housing Enterprise Oversight, and Bureau of Economic Analysis W 1992 1995 1998 2001 500 2004 Note: Shading represents NBER recessions. June 29-30, 2005 190 of 234 Ratios of Median Home Value to Median Family Income by Percentile* of Home Value Ratio Ratio 4 4 3.5 3.5 3 3 2.5 2.5 2 1.5 1985 2 1987 1989 Source: American Housing Survey 1991 1993 1995 1997 1999 2001 1.5 2003 *Home value percentile groups are defined by 3-percentile ranges centered around the cited percentile point. June 29-30, 2005 191 of 234 Implicit Land Price Increases Derived from Constant-Quality New Home Price Indices* (compound annual rate, 1998-2004) U.S. Northeast Midwest South West 5.5% 7.3% 2.9% 2.8% 10.0% *Based on the assumption that land represents 50 percent of the value of the property. June 29-30, 2005 192 of 234 Single-Family Investment Properties Thousands of Housing Units 16000 (renter-occupied plus vacant for rent) i U Renter-Occupied U Vacant for Rent 14000 12000 12,019 (16.0%) 12,280 12,333 (15.7%) (15.1%) 11,165 11,631 (14.2%) (1.% 10000 S i 54i 8000 6000 4000 2000 0 1997 Source: American Housing Survey 1999 2001 2003 June 29-30, 2005 193 of 234 Monetary Policy Responses to Asset Price Movements Glenn D. Rudebusch Federal Reserve Bank of San Francisco 21 of 33 June 29-30, 2005 194 of 234 Monetary Policy and Asset Prices: The Basics 1. Asset price decomposition: Assume an asset price (APt) consists of a component determined by its fundamentals (Ft) and a bubble component (Bt): APt = Ft + Bt. 2. Two proposals for the appropriate monetary policy reaction to an asset price: Standard Policy (SP): " Widespread agreement that the SP is a minimum appropriate reaction. " Respond to an asset price insofar as it conveys information about the future evolution of output and inflation-the goal variables of monetary policy. " In following the SP, it still may be useful-if possible-to identify Ft and Bt. Bubble Policy (BP): * Respond to relevant information as in the SP and also try to influence the asset price directly in order to contain or reduce the bubble and limit costs associated with movements in Bt. 3. A best-case scenario for Standard and Bubble Policies: Example: Consider the ideal theoretical conditions where the decomposition of an asset price (APt) into its fundamentals (Ft) and a bubble (Br) is known. Time (t) The Standard Policy (SP) would: * Try to offset the effects of APt with higher rates than recommended by the fundamentals before the crash and lower rates afterward. The Bubble Policy (BP) would: * Respond to information as in the SP, but also try to reduce the bubble fluctuations and achieve, ideally, the AP't path. This would likely require higher rates than the SP before the crash and lower rates afterward. -1- 22 of 33 June 29-30, 2005 195 of 234 Should Monetary Policy Try to Reduce an Asset Price Bubble? Decision tree for Standard and Bubble Policies Q1. Can a bubble-or asset price misalignment-be identified? i No The asset price is arguably aligned with fundamentals. Follow Standard Policy Yes Asset price appears misaligned. Q2. Do bubble fluctuations result in large macroeconomic consequences that monetary policy cannot readily offset? : No Yes Fallout may include a severe financial crisis, imbalances, or misallocations that cannot be well offset by monetary policy. Macroeconomic consequences from asset price boom and bust are minor or they occur with a lag, so monetary policy can effectively offset them. Follow Standard Policv Q3. Is monetary policy a good way to deflate the bubble? No Yes Relative to the cost of alternatives the dislocations associated with monetary policy actions are small. Follow Bubble Policy 23 of 33 Interest rate effects on bubble are uncertain or costly, especially relative to alternative deflation strategies. Follow Standard Policy June 29-30, 2005 196 of 234 Two Episodes of Possible Asset Price Bubbles Real-time answers to decision-tree questions 1. Equity prices in 1999-2000: Q1: A bubble could be identified in certain sectors and perhaps in overall market. Q2: Serious capital misallocation appeared likely during boom and severe fallout from financial instability was possible during bust. Both hard to rectify. Q3: It appeared unlikely that any bubble could be deflated by monetary policy. US Stock Market Indexes January 3, 1995 = 100 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2. Bond prices in 1994: Q1: A bubble or bond price misalignment appeared likely. Termed an "inflation scare" or "credibility gap." Q2: Possible fallout from propagation of high-inflation expectations. Q3: It appeared likely monetary policy could guide prices back to fundamentals. 30-Year Treasury Bond Yield percent 1993 1994 1995 24 of 33 1996 June 29-30, 2005 197 of 234 Monetary Policy Implications of a House Price Bubble John C. Williams Federal Reserve Bank of San Francisco 25 of 33 June 29-30, 2005 198 of 234 A Tale of Two Bubbles " House prices today: a 20% decline would o reduce household wealth by $3.6 trillion (30% of current GDP) o raise saving rate by nearly 1-1/2 percentage points in the long-run o lower the long-run equilibrium real funds rate (r*) by 40 basis points. " Stock prices in early 2000: twice as a large a potential problem as house price overvaluation today. o Stock market overvalued by 60% in March 2000; correction implied a $6.7 trillion reduction in wealth (70% of GDP at the time). o In the event, stock market wealth fell by $4.6 trillion from March 2000 to March 2001, and at trough was down $8.5 trillion. " Cautionary note: policy cushion today is noticeably smaller than in early 2000. Monetary Policy Implications of a Bursting Housing Bubble " Three scenarios: 1. 20% decline in house prices relative to path in June Greenbook 2. Scenario 1 + spillover effects on demand 3. Scenario 2 + rise in bond premiums. " Two policies: Optimal policy and Taylor rule o Optimal perfect foresight policy: assumes equal weights on unemployment and inflation deviations from targets of 5 and 1.5 percent, respectively, and small penalty on interest rate changes. o Taylor Rule: coefficient of 1 on output gap and '%on inflation gap; r* adjusts to changes in housing wealth and bond premiums. 26 of 33 June 29-30, 2005 199 of 234 1. Effects of 20 Percent Decline in House Prices Unemployment Rate Core PCE Price Inflation (4-qtr change) 6.25 1 2 2 . 5S 6 2 5.75 1.75 5.5 1.5 E 1.25 5.25 5 1 2004 2005 2006 2007 2008 2004 2005 2006 2007 2008 Federal Funds Rate June GB (optimal policy) Optimal Policy Taylor Rule 2004 2005 2006 2007 2008 " House prices decline 20% relative to June Greenbook path by end of 2007. " Demand shock: no significant tradeoff of goals. " Macroeconomic effects build gradually: Under Taylor Rule, policy can respond to them as they develop. 27 of 33 June 29-30, 2005 200 of 234 2. Scenario 1 + Demand Spillovers Unemployment Rate Core PCE Price Inflation (4-qtr change) 6.25 2.25k 6 2 5.75 1.75 5.5 1.5 5.25 1.25 5 2004 2005 2006 2007 2008 2004 2005 2006 2007 2008 Federal Funds Rate June GB Taylor Rule Optimal Policy 2004 2005 2006 2007 2008 " House price declines rattle consumer confidence and dry up equity extraction from mortgage refinancing, crimping household spending. " Optimal policy: funds rate declines to 2-1/4% by middle of 2006. " Taylor Rule fails to act in anticipation of spillover effects and responds too gradually once they occur. 28 of 33 June 29-30, 2005 201 of 234 3. Scenario 2 + Falling Bond Prices Core PCE Price Inflation (4-qtr change) Unemployment Rate 6.25 2.25 6 1.75 |- 5.75 1.5 5.5 1.25 5.25 1 5 2004 2005 2006 2007 2004 2008 2005 2006 2007 2008 Federal Funds Rate June GB U' 2004 " 2005 2006 2007 2008 House prices decline 20% as before, with demand spillovers. " Term premiums on long-term bonds increase 75 basis points by year-end. " Optimal policy drives funds rate below 1 percent by middle of 2006. " Optimal policy able to forestall significant rise in unemployment rate; under Taylor Rule, unemployment rate reaches 6 percent. 29 of 33 June 29-30, 2005 202 of 234 Using Monetary Policy to Preempt a Worsening House Price Misalignment " Pro: House price misalignment may o contribute to conditions that lead to a sharp contraction in economic activity that is difficult for policy to counteract o misallocate resources toward housing-related activities. " Con: Effectiveness of such policies is open to question o uncertain empirical relationship between housing prices, interest rates, and other factors o difficulties in assessing existence and magnitude of misalignment. 30 of 33 June 29-30, 2005 203 of 234 6-29-05 House Prices and Rents in Selected Metropolitan Areas San Francisco Four-quarter percent change - 4 Real price Real rent Percent deviation from long-run level Price-rent ratio 7 - J '1 I||I1I|Iil|||||||111111111111 i75 1980 1985 1990 1995 2000 If 1lIII1111111111111111111111111 175 1980 1985 1990 1995 2000 20( 201 Chicago Four-quarter percent change - Percent deviation from long-run level - Real price Real rent 7 Price-rent ratio f'>A 1975 1980 1985 1990 1995 2000 1975 1980 - -10 1985 1990 1995 2000 2005 Cleveland Four-quarter percent Real price Real rent - Percent deviation from long-run level 70 Price-rent ratio 60 50 40 30 20 4-e- 10 0 -10 ||75 |98||1Il5 1975 Sources: OFHEO, BEA, and BLS. 31 of 33 1980 1985 190I 1990 l 9 l0l0l I 1995 2000 2005 -20 June 29-30, 2005 204 of 234 6-29-05 House Prices and Rents in Selected Metropolitan Areas Boston Ir-quarter percent change - r/ Real price Real rent - Percent deviation from long-run level Price-rent ratio 7 -\/W II1111111111111111111111111111 1975 1980 1985 1990 1995 2000 201 975 1980 1985 1990 1995 2000 20C New York Four-quarter percent change - Percent deviation from long-run level 40 Real price -- -- Price-rent ratio Real rent ilI111111111111111111111111111 1980 1985 1990 1995 2000 201 175 975 1980 1985 1990 1995 2000 1995 2000 Miami Four-quarter percent change - 40 Real price Real rent -- Price-rent ratio 20 10 0 -10 1975 1980 1985 1990 1995 Sources: OFHEO, BEA, and BLS. 2000 20052 1980 32 of 33 1985 1990 200 June 29-30, 2005 205 of 234 6-29-05 Measures of Prices, Rents, and Costs in the Housing Market Changes in Real House Prices and Rents Four-quarter percent change 8 Repeat-Transactions Price Index (adjusted) - Q1 -- Rent Index (adjusted) 6 4 s- 2 -- -4 6 Levels of Real House Prices and Construction Costs Index (1979 = 10 Repeat-Transactions Price Index (adjusted) --- Construction Costs 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 2002 2004 1994 1996 1998 2000 1992 1988 1990 1980 1982 1984 1986 Sources: OFHEO, Freddie Mac, BLS, Census, BEA, and Engineering News Record. 33 of 33 150 June 29-30, 2005 Appendix 2: Materials used by Mr. Kos 206 of 234 June 29-30, 2005 207 of 234 Class II FOMC -- Restricted FR Page 1 of 4 Current U.S. 3-Month Deposit Rates and Rates Implied by Traded Forward Rate Agreements March 1, 2005 – June 28, 2005 LIBOR Fixing 3M Forward Percent 9M Forward Percent 4.50 4.50 4.00 4.00 3.50 3.50 3.00 3.00 3/22 FOMC +25bps 2.50 3/1 6/1 President Fisher’s Comments 5/3 FOMC +25bps 3/15 3/29 4/12 4/26 5/10 5/24 6/3 May NFP +78K 6/7 6/21 Spread Between 2- and 10-Year Treasury Yields January 1980 – June 2005 Basis Points 300 2.50 Basis Points 300 Average since 1980 200 200 100 100 0 0 -100 -100 -200 -200 -300 Jan-80 -300 Jan-83 Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Dollars per Barrel TIPS Breakevens and Crude Oil Futures Percent January 13, 2005 – June 28, 2005 3.1 3.0 62 60 5-Year TIPS Breakeven Rate Front Month Crude Oil Futures (RHS) 2.9 58 2.8 56 2.7 54 2.6 52 2.5 50 2.4 48 2.3 2.2 Jan-05 10-Year TIPS Breakeven Rate 46 44 Feb-05 Mar-05 Apr-05 May-05 Jun-05 June 29-30, 2005 208 of 234 Page 2 of 4 Class II FOMC -- Restricted FR High Yield and Auto Debt Spreads Basis Points 800 Basis Points 800 January 3, 2005 – June 28, 2005 5/3 FOMC +25 bps 700 700 GM 600 600 Ford 500 500 400 400 300 Source: Merrill Lynch, Bloomberg 200 1/3 1/17 1/31 2/14 300 High Yield Index 5/5 GM Downgrade 200 2/28 3/14 3/28 4/11 4/25 5/9 5/23 6/6 6/20 Dow Jones CDX 5-Year Investment Grade Credit Default Swaps Index Basis Points Basis Points April 1, 2005 – June 28, 2005 80 80 5/5 GM Downgrade 70 70 60 60 50 50 40 40 4/1 4/8 4/15 Percent Return 4/22 4/29 5/6 5/13 5/20 5/27 6/3 6/10 Select Hedge Fund Index Returns December 31, 2004 – June 24, 2005 2% 6/17 6/24 Percent Return 2% 0% 0% Aggregate Hedge Fund Index -2% -2% Convertible Arbitrage Index -4% -4% -6% -6% -8% -8% Source: HFR -10% 12/31 1/10 1/20 1/30 -10% 2/9 2/19 3/1 3/11 3/21 3/31 4/10 4/20 4/30 5/10 5/20 5/30 6/9 6/19 June 29-30, 2005 209 of 234 Class II FOMC -- Restricted FR Page 3 of 4 Euro-Area 3-Month Deposit Rates and Rates Implied by Traded Forward Rate Agreements March 1, 2005 – June 28, 2005 LIBOR Fixing 3M Forward Percent 2.70 9M Forward Percent 2.70 5/29 French Referendum 2.50 2.50 2.30 2.30 2.10 2.10 1.90 1.90 3/1 3/15 3/29 4/12 4/26 5/10 Euro-Dollar Euro/$ 5/24 6/7 6/21 Interest Rate Differentials January 3, 2004 – June 28, 2005 1.36 June 28, 2004 – June 28, 2005 Euro/$ Percent Percent 1.36 4.0 4.0 U.S. 2-Year Treasury Note 1.34 1.34 1.32 1.32 3.5 1.30 1.30 1.28 1.28 3.0 1.26 1.26 1.24 1.24 2.5 1.22 1.22 1.20 1.20 2.0 Jun-04 1/3 2/3 3/3 4/3 5/3 6/3 3.5 3.0 2.5 Euro-Dollar Risk Reversals Percent February 1, 2000 – June 28, 2005 1.5 1-Year 25 Delta Risk Reversal 1.0 0.5 0.0 Premium for Euro Puts -0.5 -1.0 Aug-00 Aug-01 Aug-02 Aug-03 Aug-04 2-Year German Schatz Sep-04 Dec-04 Mar-05 2.0 Jun-05 IMM Net Non-Commercial Euro Thousands of Positions Thousands of 1.5 Contracts Percent Contracts 40 40 5/29 French Referendum 1.0 30 20 0.5 10 30 20 10 0.0 0 0 -10 -0.5 -20 -10 -1.0-30 -30 -20 1/7 2/7 3/7 4/7 5/7 6/7 June 29-30, 2005 210 of 234 Class II FOMC -- Restricted FR Page 4 of 4 Global 10-Year Sovereign Debt Yields March 15, 2005 – June 28, 2005 Percent Percent 6.0 6.0 Australia 5.5 5.5 5.0 5.0 UK 4.5 4.5 US Canada 4.0 4.0 Germany 3.5 3.5 3.0 3.0 3/15 3/22 3/29 4/5 4/12 4/19 4/26 5/3 5/10 5/17 5/24 5/31 6/7 6/14 6/21 6/28 Japanese Government Bond Yield Curve Percent Percent 2.8 2.8 2.4 2.4 2.0 2.0 6/28/04 1.6 1.6 1.2 1.2 0.8 0.8 6/28/05 0.4 0.4 0.0 0.0 3M 6M 1Yr 3Yr 5Yr 7Yr 10Yr 15Yr 20Yr 30Yr Year-To-Date Global Equity Performance Percent 10 8 6 4 2 0 -2 -4 -6 -8 2Yr Local Currency Return USD Return U.S. S&P500 Mexico Bolsa Brazil Bovespa U.K. FTSE French CAC German DAX Italy MIB Index Japan Nikkei June 29-30, 2005 Appendix 3: Materials used by Messrs. Oliner, Wilcox, and Leahy 211 of 234 June 29-30, 2005 STRICTLY CONFIDENTIAL (FR) CLASS I-FOMC* Material for Staff Presentation on the Economic Outlook June 30, 2005 *Downgraded to Class II upon release of the July 2005 Monetary Policy Report. 212 of 234 June 29-30, 2005 213 of 234 June 29-30, 2005 214 of 234 Exhibit 2 Key Background Factors Fiscal Impetus Interest Rates Percent 6 Quarterly average 5 April GB 6 5 Percent of GDP 1.2 1.2 1.0 1.0 0.8 0.8 0.6 0.6 0.4 0.4 0.2 0.2 0.0 0.0 4 4 10-year Treasury rate 3 April GB 3 2 2 1 1 Federal funds rate 0 2001 2002 2003 2004 2005 2006 0 -0.2 2001 Equity Prices Index, ratio scale Quarter-end 14000 13000 13000 12000 12000 2004 2005 2006 -0.2 Index, 1980:Q1=100, ratio scale 400 Wilshire 5000 April GB 360 360 11000 9000 9000 8000 8000 7000 2004 2005 2006 7000 330 330 OFHEO repeattransactions index 10000 10000 2003 400 Quarterly April GB 11000 2002 2003 House Prices 14000 2001 2002 300 300 270 270 240 2001 Crude Oil Prices 2002 2003 2004 2005 2006 240 Broad Real Dollar Dollars per barrel 65 65 Index, 2000=100 112 112 Quarterly average Quarterly average 55 55 April GB 104 104 45 45 35 35 96 96 West Texas Intermediate 25 25 April GB 15 2001 2002 2003 2004 2005 2006 15 88 2001 2002 2003 2004 2005 2006 88 June 29-30, 2005 215 of 234 June 29-30, 2005 216 of 234 Exhibit 4 Does Any Slack Remain In The Labor Market? Unemployment Rate Labor Force Participation Rate Percent 7 6 Percent 7 67.5 67.5 6 67.0 67.0 Trend NAIRU 5 5 66.5 66.5 4 4 66.0 66.0 3 65.5 3 1996 1998 2000 2002 2004 2006 1996 Total Hours Worked 1998 2000 2002 2004 2006 65.5 Jobs Plentiful Versus Hard to Get Billions of hours, annual rate 245 245 Trend Diffusion index 150 150 130 130 Average, 1997:H1 235 235 110 110 Q2 90 90 70 70 225 225 215 1996 1998 2000 2002 2004 2006 215 50 1990 1995 2000 2005 50 Source: Conference Board. Jobs Hard to Fill Persons Working Part-Time for Economic Reasons Percent 40 40 35 35 30 30 Percent of household employment 4.0 4.0 3.5 3.5 Average, 1997:H1 25 Q2 Average, 1997:H1 25 3.0 3.0 20 20 15 15 Q2 2.5 2.5 10 10 5 1990 1995 2000 Note. 2005:Q2 is the April-May average. Source: National Federation of Independent Business. 2005 5 2.0 1994 1996 1998 2000 Note. 2005:Q2 is the April-May average. 2002 2004 2006 2.0 June 29-30, 2005 217 of 234 June 29-30, 2005 218 of 234 June 29-30, 2005 219 of 234 June 29-30, 2005 220 of 234 June 29-30, 2005 221 of 234 June 29-30, 2005 222 of 234 June 29-30, 2005 223 of 234 Exhibit 11 Foreign Outlook and Financial Market Indicators Stock Prices* U.S. and Foreign GDP Percent change, a.r.** Ratio scale, Jan. 3, 2003=100 5 200 Weekly 175 U.S. 4 Emerging markets 150 Total Foreign* 3 125 Industrial countries 2 100 1 2004 2005 2006 0 75 2004 2003 *Weighted by shares of U.S. merchandise exports. **Years are Q4/Q4. Half-years are Q2/Q4 or Q4/Q2. * Source: MSCI. EMBI+ Spreads Ten-Year Government Bond Yields Percentage points Percent 15 Weekly 2005 5.0 Weekly 13 U.S. Treasury 4.5 11 9 4.0 Brazil 7 5 Weighted-average foreign* 3.5 Overall ex-Argentina 3 Mexico 1 2003 2004 2005 3.0 2003 2004 2005 * Average of rates for Australia, Canada, euro area, Japan, Sweden, Switzerland, and United Kingdom, weighted by trade shares. June 29-30, 2005 224 of 234 Exhibit 12 Long-Term Interest Rates and Monetary Policy (Weekly data, percent) Ten-Year Government Bond Yields 6 6 Canada United States 6 United Kingdom 3 Japan 5 5 5 2 4 4 4 1 Germany 2003 2004 3 2005 2003 2004 3 2005 2003 2004 3 2005 2003 2004 0 2005 Long-Term Nominal and Inflation-Indexed Yields 6 Euro 6 Canadian dollar 5 6 Sterling 6 Yen 5 5 5 4 4 3 Nominal 4 4 Nominal 3 3 3 2 2 2 Inflation indexed 2004 1 1 0 2005 0 2005 0 2005 2003 2004 Nominal 2 Inflation indexed 1 Inflation indexed 2003 Nominal 2003 2004 1 Inflation indexed 2003 2004 0 2005 Monetary Policy Indicators 4 5 Canada 3 Euro-area refinance rate 6 United Kingdom 4 Trillions of yen 40 Japan 35 5 30 2 3 4 25 Repo rate 1 Bank rate 2 3 U.S. target federal funds rate 2003 2004 0 2005 Balances at BOJ 2003 2004 1 2005 2003 2004 2 2005 2003 2004 20 15 2005 June 29-30, 2005 225 of 234 Exhibit 13 Euro Area and Japan Earnings per Share* BBB Corporate Bond Spreads Index, 1990=100 Basis points 350 Yearly Weekly 250 300 Euro area Euro 250 200 200 150 150 100 Japan 100 50 Yen 50 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 -50 2002 2003 2004 2005 0 *Operating earnings per share in local currency for MSCI indexes; forecasts are from I/B/E/S surveys in mid-June 2005. Euro-Area Confidence Indicators Real Effective Exchange Rates Index, Jan. 2004=100 Diffusion index* 105 5 Monthly Monthly 0 Euro Industrial 100 -5 -10 Yen 95 -15 Consumer -20 2004 2005 2006 90 2002 2003 2004 2005 -25 *Percent of respondents reporting an increase minus percent of respondents reporting a decrease. Euro-Area Real GDP Japanese Real GDP Percent change, a.r.* 2004 2005 *Half-years are Q2/Q4 or Q4/Q2. 2006 Percent change, a.r.* 6 6 5 5 4 4 3 3 2 2 1 1 0 0 -1 2004 2005 *Half-years are Q2/Q4 or Q4/Q2. 2006 -1 June 29-30, 2005 226 of 234 Exhibit 14 China: Why is Import Growth Slowing? Merchandise Trade Balance Merchandise Trade Billions of dollars Billions of dollars 80 Twelve-month moving sum 70 Monthly Exports 60 60 40 50 Imports 1985 1987 1989 1991 1993 1995 1997 1999 2001 Exports to China 2003 2005 20 40 0 30 -20 2003 2004 2005 20 Real GDP Twelve-month percent change Taiwan Percent change, a.r. 180 15 140 12 100 9 Korea 60 6 Japan 20 3 0 2003 2004 -20 2005 Exports by Category 2004 2005 2006 0 Consumer Prices Billions of dollars Twelve-month percent change 25 6 Twelve-month moving sum 5 20 4 Overall 15 3 2 10 Road vehicles Excluding food Iron and steel 1 5 0 1995 1997 1999 2001 2003 2005 0 2003 2004 2005 -1 June 29-30, 2005 227 of 234 Exhibit 15 Outlook for Commodity Prices and U.S. External Accounts Broad Real Dollar Primary Commodity Prices* Index, Jan. 2002=100 Index, Jan. 2002=100 200 Metals Non-fuel commodities** 2002 105 Monthly Monthly 2003 2004 2005 2006 180 100 160 95 140 90 120 85 100 80 80 2002 2003 2004 2005 75 2006 *IMF indexes. **Weighted by U.S. import shares. WTI Current Account Balance Dollars per barrel Monthly 65 1 55 Billions of dollars, a.r. 100 Quarterly 60 Spot Percent 0 0 50 45 -1 35 Far-dated futures 30 -100 Balance 40 -2 -200 25 20 2002 2003 2004 2005 2006 Balance of Payments Billions of dollars, a.r. Trade Balance 2005 Q1 Q2 Net Invest. Income Current Account H2 -687 -701 -747 21 18 5 -780 -785 -847 2006 H1 Q3 Q4 -776 -783 -800 -20 -42 -58 -907 -934 -960 Change from 2005Q1 to 2006Q4 -113 -79 -180 -3 Share of GDP -300 15 -4 -400 -5 -500 -6 -600 -7 -700 -8 -800 -9 -900 -10 1996 1998 2000 2002 2004 2006 -1000 June 29-30, 2005 228 of 234 Exhibit 16 ECONOMIC PROJECTIONS FOR 2005 FOMC Range Central Tendency Staff -------------Percentage change, Q4 to Q4-----------Nominal GDP February 2005 Real GDP February 2005 Core PCE Prices February 2005 5 to 6¼ 5½ to 5¾ 5.9 (5 to 6) (5½ to 5¾) (5.4) 3 to 3¾ 3½ 3.6 (3½ to 4) (3¾ to 4) (3.9) 1½ to 2¼ 1¾ to 2 2.1 (1½ to 2) (1½ to 1¾) (1.6) --------------Average level, Q4, percent--------------Unemployment rate 5 to 5¼ 5 5.1 February 2005 (5 to 5½) (5¼) (5.3) Central tendencies calculated by dropping high and low three from ranges. ECONOMIC PROJECTIONS FOR 2006 FOMC Range Central Tendency Staff -------------Percentage change, Q4 to Q4-----------Nominal GDP February 2005 Real GDP February 2005 Core PCE Prices February 2005 5 to 6 5¼ to 5½ 5.4 (5 to 5¾) (5 to 5½) (5.3) 3¼ to 3¾ 3¼ to 3½ 3.4 (3¼ to 3¾) (3½) (3.6) 1½ to 2½ 1¾ to 2 1.9 (1½ to 2) (1½ to 1¾) (1.4) --------------Average level, Q4, percent--------------Unemployment rate February 2005 5 5 5.1 (5 to 5¼) (5 to 5¼) (5.1) June 29-30, 2005 Appendix 4: Materials used by Mr. Reinhart 229 of 234 June 29-30, 2005 230 of 234 Exhibit 1 Probability of a Pause at Upcoming FOMC Meetings Expected Federal Funds Rates* --------- Percent Percent June 29, 2005 May 2. 2005 June 29, 2005 (black bars) May 2 2005 (red bars) LII I June Jan. Oct. 2005 Apr. July 2006 Jan. Oct. Apr. 2007 Jun. Sep. Aug. Nov. Dec, 'Estimates from federal funds and eurodollar futures, with an allowance for term premia and other adjustments. Nominal Treasury Yields' FOMC FOMC June 2004 May 2005 - May Percent June -.... July ...... ...... Aug. . ... - Sept. Oct. Two-Year - Nov. Dec. Jan. Feb Mar Apr. May June 2005 2004 'Par yields from an estimated off-the-run Treasury yield curve. Change In Ten-Year Yields Since June 29, 2004 -basis points 1. Nominal Treasury -79 2. TIPS -52 Actual and Expected Treasury One-year Forward Rates' Percent 9 6/29/2005 -.----- Day before FOMC meeting 6/30/2004 - - - 8 Expected for 6/20/2005 as of 6/30/2004 7 3. Inflation Compensation 4. One-Year Forward' 5. AA Corporate 6. Euro Swap Rate -5 -170 4 'f -78 3 -120 'One-year nomina! forward rate maturing ten years ahead 2 1 3 5 7 Years Ahead Forward rates are the one-year nominal rates maturing at the end of the year shown on the horizontal axis that are implied by the smoothed Treasury yield curve. 10 June 29-30, 2005 231 of 234 Exhibit 2 Slope of Yield Curve* basis points 400 300 200 100 0 -100 -200 -300 1953 1957 1961 1965 1969 Ten-year over one-year constant maturity spread. Note. Shaded areas represent NBER contractions. 1973 Factors Encouraging the Demand for Relative to the Supply of Long Duration Securities 1977 1981 1985 1989 1993 1997 2001 2005 Factors Damping Growth Prospects " Reduced macro volatility " Higher oil prices " Increased demand for duration " Potential increase in domestic saving rate " Reduced supply of duration " Large and sustained trade deficits " Increased global saving Term Premium of One-Year Forward Nominal Percent Rate Maturing Ten Years Ahead* Weekly June FOMC June Four-Quarter-Ahead Real GDP Growth Forecast Percent May FOMC Aug. Oct. Dec Feb. Apr, June 2004 2005 Derived from three-factor arbitrage-free term structure model. 1988 1991 1994 1997 2000 2003 Note, Shaded areas represent NBER contractions. June 29-30, 2005 232 of 234 Exhibit 3 Values from Policy Rules and Futures Markets - Actual federal funds rate and Greenbook assumption - Market expectations estimated from futures quotes Percent -12 Range of Estimated Equilibrium Real Rates Range of model-based estimates 10 E] 70 percent confidence band -- Actual real federal funds rate - - 90 percent confidence band 1990 See explanatory note in Chart 8 of the Bluebook. 1992 -6 ... 1994 1996 1998 2000 2002 2004 See explanatory note in Chart 7 of the Bluebook. What can go wrong? " -8 Greenbook-consistent measure 2.I... l. 1 Percent Percent Inflation Compensation Five-to-Ten-Years Ahead - Next Five Years Stop too soon -- Allowing inflation expectations to become unanchored " Stop too late -- Allowing slack to persist Jan. Intended Federal Funds Rate* Percent Apr. July 2004 Oct. Jan. Risk Spreads* 12 10 Apr. 2005 Basis Points 400 Ten-Year BBB (left scale) 350 1150 Five-Year high-yield (right scale) 300 8 250 6 200 950 750 150 4 2 550 100 350 50 -tliami11 1..11mm. lii 1988 1991 1994 1997 2000 2003 *Red shading indicates periods of sustained tightening. Blue shading indicates periods of sustained easing. Jan. Aug. 2002 Mar. IhIPaIp Oct. 2003 III..Ii iam May 2004 a i ma Dec. 2005 *Measured relative to an estimated off-the-run Treasury yield curve. 150 June 29-30, 2005 233 of 234 Exhibit 4 Monetary Policy Alternatives Yield Curve Signal Decline in Term Premium Economic Weakness Policy Risk Stopping Too Soon C Stopping Too Late A Statement Challenges * "...the stance of monetary policy remains accommodative" * "...coupled with robust underlying growth in productivity" * "...with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal." * "...that policy accommodation can be removed at a pace that is likely to be measured." June 29-30, 2005 234 of 234 Table 1: Alternative Language for the June FOMC Announcement May FOMC L Policy Decision 2. The Federal Open Market Conmmittee decided today to raise its target for the federal funds rate by 25 basis points to 3 percent. 'he Committee helievcs that, cen after this action, the stance of monetary policy remains accomimodatixve and, coupled with robust underyitng growth in productivity, is providing ongoing support to economic acvity. Alternative A Alternative B The Federal Open Market Committcc decided today to raise its target for the federal funds rate 22 basis points to 3-1/4 percent. Alternative C 1hc Federal Open Market Committee decided t oday to raise its target for the The Federal Open Market Conittee decided today to raise its target for the ffnrai tunds rate y tb 3-1/4 percent. percent. hI'ieCommittee >elieves that, -:ft-4 th,_ ac,,, . monetary polo. cy ~ Wsit 'he Committee belicvecs that, cvcn after this "a.cc the degree of t.;. action, the stance of monetary policy remains accommodative and, :.11pk itii is ,--m.d accommodation has been substantially reduced. and, federal 50 basis points to 3-1/2 Ino change} eitlped providing ongoing support to economic acaivity. Robust underlying growth in productivity, continues to provide support to economic acttvity. 3. Rationale ia c th: tha Recent data suggest that the solid pace of spending growth has slowedi somewxxhat, partix to resptonse tt thec .L pat f .pedirgx < i, ht: Nonetheless, growth in spending slowedc sotmexwhat Although energy prices have risen further, Recent it.. d gges .h _LtOle di pace .. f spei.d4ng g ch h.mtx; ', earlier tpRationale increases patttcin energy prices. Lpabor market conditions, however, in the spring, partly in response to +h: ltdie- i *re ~ elevated energy tih. apparently continue to improve prices. Lahor market conditions, however, apparently continue to the expansion remains firm and labor market conditions, eho e: improve gradually. xratreitflly continue to improve graduall. PRa .. t are .oca : n The sIll4 underlying pace of spending growthths t, pard; ;, .eith-dier remains solid despite elevated Reemdta-seggenhm+ energy prices. labor market i: conditions, l-h weter, improve gr arpttdtfted4 continue to lt1. gradually. 4. Pressures on inflation have picked up in recent months and pricing 4 ttmwi-es Readings on inflation have power is more evident. I onger-term inflation expectations remain well peked- up been subdued in recent months, and p:mg p r in,, evident. 1 longer-term inflation contained. expectations ,rmaii " ell atned have Pressures on inflation have ceeemmehastm pitis-i memg-powes n-tt Pressures on inflation have picked up further in recent months an i png , i r e ai:. L stayed elevated, but longer-term inflation expectations evidt.-I. although measures of longer remain well contained. contained. term inflation expectations remain well declined. 5. The Committee perceives that, with appropriate nonetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be ke.pt toughlix euai. Assessment of Risk 0. The Committcc percexes that, with appropriate onctan police -, the upsidc and dtivnsic rtsks to tie attaimict if hoth suxtitohic grt ii( tnd prte sttbiity xiiitd be kept rioaghix equal. Wi th utideri(tonfolattioin expec.ted toieilL \\ith underintg intlatitin expcted pertCoittee bita withat to be Liointaied, titc immittnhe Committee cix es that polic accomtimodationti remaining t ppr mnac pmot dattei a he rmoied t npae that is it e. t bc Lctn he removedi at a pa1ce that is litkei to he measured. Nonethceless measuredi. Nonthless, tiie Conmmittee the CotmmitteL wxiii respontd tio xxwill rexpondi toichangex int ecnotitcii changes it econoitc prospects ats nceded ti ifulfill its obigation to maintain prie stathility. prospects as needed to fultillitx ohligatitn to mioti price xttbiit. pretle h . change equpl, _________________________________ \'. ub ikrlto t.tt, Lt.etei ft li , ino cii'ttgc that itih re t ha k The Coi mtmittee will resp ond ttt chatnges to etoomtc priospects ais needed to fuitfillitsx obligaion to foster the attainment of both sustainable economic grotth and t~tintadu stsoilutit
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