The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
Prefatory Note The attached document represents the most complete and accurate version available based on original copies culled from the files of the FOMC Secretariat at the Board of Governors of the Federal Reserve System. This electronic document was created through a comprehensive digitization process which included identifying the bestpreserved paper copies, scanning those copies, 1 and then making the scanned versions text-searchable. 2 Though a stringent quality assurance process was employed, some imperfections may remain. Please note that this document may contain occasional gaps in the text. These gaps are the result of a redaction process that removed information obtained on a confidential basis. All redacted passages are exempt from disclosure under applicable provisions of the Freedom of Information Act. 1 In some cases, original copies needed to be photocopied before being scanned into electronic format. All scanned images were deskewed (to remove the effects of printer- and scanner-introduced tilting) and lightly cleaned (to remove dark spots caused by staple holes, hole punches, and other blemishes caused after initial printing). 2 A two-step process was used. An advanced optimal character recognition computer program (OCR) first created electronic text from the document image. Where the OCR results were inconclusive, staff checked and corrected the text as necessary. Please note that the numbers and text in charts and tables were not reliably recognized by the OCR process and were not checked or corrected by staff. Strictly C onfide ntial (F.R.) Class II – FOMC March 15, 2001 M ONETARY P OLICY A LTERNATIVES Recent D evelopm ents (1) The Committee’s decision on January 31 to reduce the intended level of the federal fund s rate by 50 basis p oints, to 5½ p ercent, and the an nouncem ent that it viewed risks as re maining w eighted tow ard econom ic weakness w ere widely anticipated and had little impact on m arket yields.1 Information becoming available over the intermeeting period–particularly wid espread earnings disappointmen ts, sharp declines in share prices, and a notable drop in consum er confidence–led market participants to mark down further their anticipated path of the federal funds rate. The market is now confident that the Committee will lower the funds rate by at least 50 basis points at the March meeting and has priced in high odds of a 75 basis point action. Looking further ahead, futures contracts point to expectations that the funds rate will mov e down to around 4¼ percent by the fall (chart 1). (2) Against this backdrop, the Treasury yield curve h as shifted lower over the intermeeting period, with short-term interest rates falling 50 basis points and longer-term yields dropping 30 to 50 b asis points. Broad equity indexes have declined about 15 percent, in large part o wing to declines in the prices of techno logy sh ares. Indeed, the technology-heavy Nasdaq has plunged 32 percent, but of late the weakness ha s spread to oth er sectors. Despite th ese substantial cap ital losses, markets have continued to function w ithout significant signs of strain. However, the gloomier 1 Over the intermeeting period, federal funds have traded at rates near the target level. Th e Desk redeem ed $3.2 billion o f Treasu ry securitie s, mostly c oupon issues, to continue bringing SOMA holdings into conformance with the per-issue limits. To offset the resulting reserve drain and meet longer-term reserve needs, the Desk purchased $9.4 billion of Treasury securities in the market and $790 million of Treasury bills from foreign customers. The volume of outstanding long-term RPs remained at $12 billion. Chart 1 Financial Market Indicators Expected Federal Funds Rates Estimated from Percent Financial Futures* January 30, 2001 March 15, 2001 Selected Treasury Yields Percent 5.75 7.00 6.75 6.50 6.25 6.00 5.75 5.50 5.25 5.00 4.75 4.50 4.25 4.00 Daily 5.50 Two-year 5.25 5.00 Ten-year 4.75 4.50 4.25 4.00 Mar May Jul Sep Nov Jan Mar May Jul 2001 2002 Sep Nov Jun Jul Aug Sep 2000 Oct Nov Dec Jan Feb 2001 Mar *Estimates from federal funds and eurodollar futures rates with an allowance for term premia and other adjustments. Selected Equity Indexes Selected Private Long-Term Yields Index(5/31/00) = 100 Percent 140 Daily 14 Percent 12 Daily 13 11 High Yield (left scale) 120 12 10 Wilshire 5000 100 Corporate BBB (right scale) 11 9 DJIA 10 80 9 Nasdaq 8 Ten-year Swap (right scale) 8 60 Jun Jul Aug Sep 2000 Oct Nov Dec Jan Feb 2001 Mar Jun Selected Risk Spreads* Basis Points 800 Daily Jul 7 Thirty-year Mortgage (weekly, right scale) Aug Sep 2000 Oct Nov Dec Spread of Low-Tier CP Rate over High-Tier CP Rate* 6 Jan Feb 2001 Basis Points 200 Daily 2001 1999-2000 1996-1998 700 Mar 150 600 High Yield 500 100 400 300 50 200 BBB 100 Jun Jul Aug Sep 2000 Oct Nov Dec Jan Feb 2001 Mar *These spreads are the difference between the yields on the Merrill Lynch 175 and BBB indexes and that on the Merrill Lynch AAA index. Note: Solid vertical line indicates last FOMC meeting. 0 Dec Jan Feb *30-day nonfinancial, A2/P2 rate less AA rate. Mar 2 profits outlook and unsettled prospects for corpo rate equities have put upward pressure on private debt spreads in recent days, especially for lower-rated corporation s. As a conseq uence, rates on h igh-yield bond s have fallen only 1 0 basis points, while tho se on the bon ds of better-rated c orporation s are off 35 to 45 b asis points. At commercial ban ks, many lending officers report they have again tightened standards and terms on bu siness loans since the beginning of the year, raising the cost and likely signaling the reduced availability of new loan com mitments. (3) Bond yields and stock prices fell in most other indu strial countries over the intermeeting period, albeit generally by less than in the United States. Still, the dollar apprec iated in value on foreign exchan ge markets, gain ing 3¾ pe rcent against a basket of major currencies (chart 2). The dollar strengthened most against the currencies of countries where the potential for economic weakening was seen to be greatest, increasing 3¾ percent vis-a-vis the Canadian dollar and 5½ percent relative to the Japanese yen. Over the intermeeting p eriod, the Bank of Canada eased p olicy by 50 basis points, but market participants apparently harbored considerable concerns that this would be insufficient to absorb the impact on Canada of a slowing U.S. economy. The Ban k of Japan trimmed 10 b asis points from its call money rate, which now stand s at 15 basis poin ts, and some o fficials hinted that m ore easing m ight be in store. But with Japanese equity prices falling 13 percent over the last six weeks and raising doubts about the banking sector, the political coalition in power looking fragile, and forward-looking indicators pointing to very weak domestic spending, the prospects for eco nomic activity in Japan seem poor. Ma rket participants a pparently viewed the economic expansion in Europe as more secure and seemed unfazed by the European Central Bank keeping its policy on hold. Nonetheless, the dollar gained 2¼ percent against the euro. Over the interm eeting period, Chart 2 Financial Flows and Exchange Rates M2 Opportunity Cost* M2 Growth Percent Annualized Percentage Points 14 3.4 Monthly 12 3.2 10 3.0 2.8 8 Feb 6 2.6 2.4 4 2.2 2 2.0 0 1999 2000 H1 2000 Q3 2000 Q4 1999 2001 J F 2000 * Yield on three-month Treasury bill minus average return on M2 assets. Growth of Debt of Domestic Nonfinancial Sectors Business Debt Total Debt Sum of Selected Components* Percent Annualized 14 Percent Annualized 14 12 12 10 10 8 8 6 6 p p p 4 4 2 2 0 1999 2000 2000 2000 H1 Q3 Q4 p - Preliminary. *Bonds, commercial paper, and C&I loans. 0 2001 J F 1999 2000 H1 2000 Q3 2000 Q4 2001 J p - Preliminary. Nominal Trade-Weighted Dollar Exchange Rates Index(5/31/00) = 100 Major Currencies Index Daily 108 FOMC 106 Broad Index Other Important Trading Partners 104 102 100 98 Jun Jul Aug Sep 2000 Oct Nov Dec Jan Feb 2001 Mar Solid vertical line indicates last FOMC meeting. Dashed vertical line indicates January 3 cut in target federal funds rate. MARA:JW 3 U.S. authorities did not intervene. (4) The dollar ro se ¾ percen t over the interm eeting period in terms of a basket of currencies of our other important trading partners. In Turkey, with a weak banking system adding to pressures on government finances and political tensions flaring, the central bank was forced to abandon its crawling peg in late February. The dollar initially appreciated over 50 percent against the Turkish lira but has subsequently fallen back some to end the period up about 30 p ercent. The spillover to other markets was contained, with investors withdrawing for a time from the debt of Argentin a, which has sim ilarly shaky finances a nd political trou bles. On net, spreads on Argentinian debt edged lower over the period, reflecting confidence in the new finance minister. But with the ou tlook for the global economy loo king poorer and investors so mewhat m ore skittish, spreads o n emerging market deb t rose 65 basis points on net. Emerging market equity prices have followed U.S. markets down but have dropped som ewhat less on balance. (5) Falling interest rates have contributed to rapid growth in th e monetary aggregates in recent months. M2 expanded at a 10¾ percent rate in February, down only a little from its J anuary pace, w ith the strength in both mo nths concen trated in its liquid components (see chart 2). In addition to declines in its opportunity cost, the robust growth of M2 this year may reflect the appeal of safe, short-term assets, given volatile equity markets and the yield advantage of m oney funds relative to longer-term investments. M2 also was lifted somewhat last month by a pickup in mortgage loan prepayments, the proceeds of which are temporarily held in bank deposits, and by larger than usual tax refunds. M3 growth, too, remained strong in February, at an 11½ percent rate, supported by a su rge in institutional money market fund s, whose yields lagged the declines in money m arket rates. 4 (6) Businesses have taken advantage of lower long-term interest rates and a receptive bond market since early in the year to issue a huge volume of bonds, a good chunk of which has been earmarked to pay dow n commercial paper. M any lowerrated commercial paper issuers, facing reluctant investors and elevated interest rates, also have turned to comm ercial banks. Bank lending to businesses has been rob ust since the turn of the year, despite the reported further tightening of standards and terms since then. On net, business borrowing appears to be growing about in line with the pace of late last year. Lower interest rates also have buoyed the mortgage market, supporting househo ld borrowing, which w as augmented by robu st consumer debt growth early in the year. State and local governments, too, have moved to take advantage of favorable interest rates by stepping up issuance, only partly for refunding purposes. O verall, growth o f debt of the no nfederal sectors ear ly this year appear s to have edged down from its pace of the last quarter of 2000, while growth of total domestic no nfinancial debt h as been abou t maintained owing to so me mo deration in the contraction of federal debt. 5 MONEY AND CREDIT AGGREGATES (Seasonally adjusted annual percentage rates of growth) Nov 2000 Dec 2000 Jan 2001 Feb 2001 (p) M2 4.2 9.6 12.3 10.8 M3 4.2 13.8 16.0 11.6 Domestic nonfinancial debt Federal Nonfederal 5.4 -9.2 8.8 5.8 -6.6 8.6 3.8 -7.1 6.3 n.a. n.a. n.a. Bank credit Adjusted1 2.9 4.1 14.7 11.4 9.1 6.6 5.3 5.2 3.5 3.8 5.3 5.5 10.9 10.7 3.2 3.4 Money and Credit Aggregates Memo: Monetary base2 Adjusted for sweeps 1. Adjusted to remove the effects of mark-to-market accounting rules (FIN 39 and FASB 115). 2. Adjusted for discontinuities associated with changes in reserve requirements. p -- preliminary 6 Policy Alternatives (7) In the staff forecast, an inventory correction intensifies further in the current quarter, holding output to a very sm all increase. With inventories better aligned with sales by the second half of the year and the effects of policy easings–including another 50 basis points assumed to occur at this meeting–working their way through to spending, output growth gradually picks up. Although consumption gets a lift from the expected d ecline of energy prices and the assumed retroactive tax cut, the deterioration in the net worth of households damps the rebound. In vestment de mand reco vers gradually, sup ported by co ntinued rap id growth in str uctural prod uctivity. The staff assum ption that po licy will be on h old over the rem ainder of the for ecast period im plies a path for th e funds rate that is higher than e xpected by th e financial mark ets, contributing to some back up in nominal lo ng-term inter est rates, a decline in eq uity prices, and a m ore mod erate depreciation in the dollar. Partly as a consequence, the growth of aggregate demand rises slowly over coming quarters and approaches that of aggregate supply only by the end of the forecast period. The extended period of subpar growth results in the unemployment rate rising to about 5½ percent, producing a small drop in core PCE inflation in 2002 from this year’s projected 2 percent pace. (8) The Committee could select a 50 basis point reduction in the funds rate at this meeting if it thought an e asing of at least this size would pr ove necessary to promote a return of economic growth to an acceptable pace over time. The resulting 5 percent federal funds rate would imply a real rate of around 3 percent–assuming that inflation expectatio ns are in line with the staff forecast of core PCE p rices. Even if this places the real rate below its long -run equilibriu m value, an u ndershoot m ay well be needed for a time to counter the effects of the declines in equity wealth, the apparent do wnward revision to exp ected near-term returns on cap ital, a possible 7 overh ang of prod uctive capacity, and lower business and consu mer confidence. Although the cumulative reduction in the funds rate of 1½ percentage points since the start of the year would represent a sharp and substantial change in the stance of policy, aggregate d emand an d attitudes hav e deteriorated q uickly. The relatively r apid lessening of pressures in labor markets now likely in train should counter any tendency for inflation to move higher. If the Committee suspected that additional easing might be needed at some point, it might still prefer to move by no more than 50 basis points a t this meeting so that it could be tter assess the initial respo nse to its previo us actions, the underlying streng th of deman d, and the extent of p rice pressures. In those circumstances, the Committee presumably would want to retain the current statement that the risks are weighted toward econ omic weakness. The C ommittee could also retain that statement if it believed that 50 basis points could well be sufficient to achieve its objectives, but saw the risks to that outlook as skewed to the downside. (9) Market participants evidently expect at least a 50 basis point cut in the target funds rate at this meeting, with federal funds futures rates suggesting high odds that the reduction will be 75 basis points. Participants also reportedly expect the Comm ittee to state that the b alance of risks rem ains weighted toward eco nomic weakness. Th erefore, a 50 basis po int move co mbined w ith such a statem ent likely would cause interest rates to back up. Price declines migh t be larger in equity markets, where investors seem to be hoping for especially aggressive Federal Reserve action. Further easings in the stance of monetary policy over time would continue to be anticipated, and current market expectations that the funds rate could be around 4¼ percen t later th is year m ight not be m aterially affected. (10) The Com mittee could decide to reduce the target federal funds rate even more at this meeting–choosing a 75 basis point decrea se–if it saw the ou tcome in 8 the staff forecast as plau sible and con sistent with its objec tives but subject to excessive downside risks. Sources of risk include the possibility of substantial further decreases in equ ity prices and tigh tening in credit c onditions as p rofits continue to fall, and fragility in consumer and bu siness confidence. In addition, recent profit and sales shortfalls in the technology sector could indicate a considerable overhan g of high-tech capital throug hout the eco nomy or even a slower pace of structur al productivity growth going forward. Either case would weaken investment spending for some time and probably necessitate significant monetary policy ease. Thus, a 75 basis point reduction in the funds rate at this time could be appropriate to provide some protection against the possibility of a prolonged period of econ omic weakness. Even if the Committee does not see inordinate downside risks to the staff forecast, it might view that forecast as involving unacceptably weak output and employment, justifying a greater easing th an assumed by the staff. In the G reenbook, the unemplo yment rate rises no ticeably above the level the staff ju dges to be con sistent with stable in flation . Moreov er, the Com mittee may se e good od ds that the econ omy can su stainably operate at a no ticeably lower lev el of unemp loyment tha n is embed ded in the staff forecast, and want to lean against appreciable increases in unemployment absent clearer eviden ce that such in creases are ne cessary to con tain inflation . (11) A 75 basis point easing, if accompanied by a statement that the risks remain w eighted tow ard econom ic weakness, wo uld generate so me price gain s in both the fixed incom e and equity m arkets. But, given th e skittishness in finan cial markets and the possibility that the stock adjustment process for capital and inventories may have a ways to run, the Committee might still see a preponderance of downside risks to the economy, even after the 75 basis point m ove and the likely reaction in asset markets. 9 (12) In developing its forecast, the staff has placed considerable weight on the recent deterioration in consumer confidence and equity wealth. If, instead, the Committee put more emphasis on the relatively firm indicators on spending and employment of late, it might view the forecast of output in the Greenbook as too pessimistic. In that ca se, it might think th at less easing is called for than assum ed in the staff forecast and much less than is anticipated by the market, inclining it to favor a smaller, 25 basis point reduction in the target funds rate. Moreover, the disquieting readings on consumer prices for January might counsel caution in lowering the funds rate further. Given the sizable easing already undertaken this year, a more gradual app roach to furth er reductions in the funds rate m ay now be a ppropriate, in part to allow time to gauge the effects o f the po licy actions in the pip eline. (13) Market pa rticipants wou ld be surprised by an easing o f only 25 basis points, and de bt and equ ity markets wo uld sell off apprec iably–and ev en more sh arply if this action were combined with a shift to a statement of balanced risks. But if the Comm ittee saw considerably more underlying streng th in the real economy or greater inflation risks than did market participants, it might view as appropriate the resulting reassessment of the trajectory of expected policy and the consequent tightening of financ ial con dition s. (14) Under the staff forecast, including the assumed 50 basis point easing at this meeting, the debt of domestic nonfinancial sectors is projected to grow at a 5½ percent rate over the period from January to June. Sluggish economic growth and declining profits may make lenders somewhat more cautious, but a significant decrease in credit availability is not foreseen, and the debt of borrowers other than the federal government is projected to increase at an 8 percent annual rate over the same interval. This latter growth rate far exceeds the 3½ percent pace of nominal GDP growth foreseen for the first half of this year. For households, the expansion of 10 mortgage debt is expected to be well maintained, reflecting the influence of low mortgage interest rates on housing activity and m ortgage refinancing. Consum er credit growth, by contrast, is seen as moderating significantly, as consumer outlays on durable goods are projected to be weak. Business debt growth should remain hefty as external financin g needs con tinue to be sub stantial, owing in part to the we akness in profits. (15) Under the Greenbook assessment of the likely evolution of nominal income and interest rates, the staff expects M2 growth to moderate to a 7½ percent pace over the February-to-June interval. Falling market interest rates, mortgage prepayment activity, and attractive returns on mon ey funds relative to longer-term instruments are projected to lift M2 growth in the near-term. However, this boost, on balance, is smaller th an in the first two months o f the year, as the decline s in shortterm interest rates are assumed to slow from their pace aro und the turn of the year. M3 grow th, projected at a 7 p ercent pace ov er the Februa ry-to-June interv al, is supported by further strong expansion of institutional money funds following the assumed easing action at this meeting. Alternative Growth Rates for Key Monetary and Credit Aggregates M2 --------------------------Ease Ease Ease 75 bp 50 bp 25 bp --------------------------- M3 --------------------------Ease Ease Ease 75 bp 50 bp 25 bp --------------------------- M2 M3 Debt --------------------------Greenbook Forecast* --------------------------- Monthly Growth Rates Dec-2000 Jan-2001 Feb-2001 Mar-2001 Apr-2001 May-2001 Jun-2001 9.6 12.3 10.8 10.8 9.9 4.8 5.8 9.6 12.3 10.8 10.8 9.5 4.0 5.0 9.6 12.3 10.8 10.8 9.1 3.2 4.2 13.8 16.0 11.6 7.8 9.2 5.6 6.4 13.8 16.0 11.6 7.8 9.0 5.2 6.0 13.8 16.0 11.6 7.8 8.8 4.8 5.6 9.6 12.3 10.8 10.8 9.5 4.0 5.0 13.8 16.0 11.6 7.8 9.0 5.2 6.0 5.8 3.8 5.4 7.6 5.2 3.4 5.7 Quarterly Growth Rates 2000 Q2 2000 Q3 2000 Q4 2001 Q1 2001 Q2 2001 Q3 6.4 5.8 6.6 10.4 8.7 4.9 6.4 5.8 6.6 10.4 8.2 4.3 6.4 5.8 6.6 10.4 7.8 3.6 9.0 8.9 7.0 12.5 8.1 5.6 9.0 8.9 7.0 12.5 7.9 5.3 9.0 8.9 7.0 12.5 7.7 5.0 6.4 5.8 6.6 10.4 8.2 4.3 9.0 8.9 7.0 12.5 7.9 5.3 6.1 4.9 4.6 5.2 5.4 5.1 8.5 7.9 8.1 7.4 7.7 6.9 8.2 7.3 8.0 7.1 7.8 6.8 8.1 7.4 8.0 7.1 5.5 5.5 1999 Q4 2000 Q4 6.3 6.3 6.3 6.3 6.3 6.3 7.7 9.2 7.7 9.2 7.7 9.2 6.3 6.3 7.7 9.2 6.8 5.4 2000 Q4 Jun-2001 9.1 8.8 8.5 9.8 9.7 9.5 8.8 9.7 5.3 Growth Rates From To Jan-2001 Jun-2001 Feb-2001 Jun-2001 1998 Q4 1999 Q4 *This forecast is consistent with nominal GDP and interest rates in the Greenbook forecast. 11 Directive and Balance-of-Risks Language (16) Presented below for the members' consideration is draft wording for (1) the directive and (2) the “balance-of-risks” sentence to be included in the press release issued after the meeting. (1) Directive Wording The Federal Open Market Comm ittee seeks monetary and financial conditions th at will foster price stab ility and prom ote sustainable g rowth in output. To fu rther its long-run objectives, the Co mmittee in th e immed iate future seeks conditions in reserve markets consistent with MAINTAINING/ INCREASING /reducing the federal funds rate AT/to an average of around ___5-1/2 percent. (2) “Balance-of-Risks” Sentence Against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the Committee believes that the risks [ARE BALANCED WITH RESPECT TO PROSPECTS FOR BOTH GOALS] [CONTINUE TO BE WEIGHTED MAINLY TOWARD CO NDITIONS THAT MAY GENERATE HEIGH TENE D INFLA TION P RESSU RES] [are weighted m ainly toward conditions that may generate econo mic weakness] in the foreseeable future.
@FedFRASER