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APPENDIX SHAxilrod Introduction The G-5 foreign exchange market intervention program has given more immediacy to economic and policy issues involved in a drop in the dollar on foreign exchange markets. course necessary and desirable. Some drop in the dollar is of It provides a source of stimulus to the economy that may be needed as other forces work to slow economic expansion, and it is integral to correction over time of sectoral imbalances in the economy and of our unsustainably large deficit on goods and services in the balance of payments. But one cannot rule out the risk that a desirable fall in the dollar could be transformed by an expectational flight from the dollar into a much sharper and faster drop than may be consistent with reasonably orderly economic adjustments. That has not appeared to happen yet, and confidence in the dollar has been rather well maintained. Thus far, it appears to be mainly official holders which have reduced their preference for dollars--with G-5 countries alone selling $8 billion since the inception of the program to date. In this presentation we hope to clarify the economic and monetary policy issues raised by the potential for a weakening dollar, and in particular the nature of the problems and policy options should the dollar drop very sharply. sections. We have divided the presentation into four Mr. Hooper will first outline two contours of exchange rate adjustment--gradual and very rapid--and the associated likely adjustments in our balance of payments and to a degree in foreign countries. Mr. Stockton will then lay out the associated real adjustments that will need to be made in the U.S. economy. Such adjustments will occur over -2time involving interest rate and price changes and Mr. Slifman will analyze the dynamics. Finally, I will attempt to assess the issues involved in some of the policy options. Peter Hooper November 1, 1985 As shown by the red line in the top panel of the first exhibit, the dollar has fallen about 20 percent on average against the major foreign currencies, to a level slightly below where it was in mid-1984 after peaking in February this year. About one third of the 20 percent decline this year has taken place since the G-5 statement in late September. Over much of the period since 1973, changes in the dollar's spot exchange value have been fairly closely associated with movements in the relative real rates of return on financial investments in the United States and abroad. U.S. long-term real interest rates rose sharply relative to foreign rates between 1979 and 1982, as indicated by the black line in the top panel, contributing significantly to the dollar's rise during that period. More recently, the decline in U.S. interest rates relative to foreign rates undoubtedly has contributed to the dollar's weakening since early this year. However, during some periods the dollar has moved independently of the real interest rate differential. Most notably, the dollar's strengthening between 1982 and 1984 was attributed largely to other factors, often referred to as safehaven factors. In the bottom panel of the chart are three hypothetical paths of the dollar for the next five years. In the top dashed line the dollar is unchanged at its October average level. mainly as a point of reference. This path is given The next line shows a gradual depreciation of the dollar (at about a 5 percent annual rate). This path extrapolates through 1990 the staff's near-term projection of the dollar. -2One should also consider the possibility of an abrupt, adverse shift in sentiment concerning dollar-denominated investments. The dollar's declines both since February and after the G-5 statement indicate how much exchange rates can change in a relatively brief period. Moreover, the dollar's rise during 1982-84, relative to an essentially flat real interest differential, suggests at least the potential for large movements in exchange rates resulting from changes in confidence and other developments affecting markets that are not readily identifiable or predictable. Should market forces turn strongly against the dollar, it could fall a long way in a short time, particularly in an environment where the market is wary that the underlying trend may be downward. It could even fall below a level that eventually would be consistent with a zero current account balance before investors became willing to continue to finance the U.S. external deficits that would persist for at least a while. As an example of a rapid depreciation, the lower path shown in the Chart extrapolates over the next year and a half the dollar's rate of depreciation since February. Under this scenario the dollar would fall another 40 percent to a point somewhat below its low point in 1980, and then begin to rise again gradually. Chart 2 shows the implications of these alternative paths of the dollar for the U.S. trade balance and the current account balance. If the dollar remained at its current level and GNP growth at home and abroad remained in the 2-1/2 to 3 percent range, the current account deficit would begin to widen again after the near-term effects of the recent dollar depreciation were played out while the trade deficit would remain about unchanged. However, with a gradual depreciation of the -3dollar, both deficits would narrow steadily through the projection horizon. In the case of the rapid depreciation, the current account could return to zero balance and move slightly into surplus within about three years. If the extrapolated gradual depreciation were carried beyond 1990 (the last point plotted on the chart) the current account would reach zero balance within another four to five years. The next table shows the cumulative effects of the alternative current account paths on the U.S. net international investment position. According to official statistics, the United States became a net debtor earlier this year, for the first time since World War I. If the dollar remains unchanged over the next five years, we estimate that by 1990 the U.S. net debt position would reach something on the order of $700 billion, which is suggestive of an increasingly fragile position for the dollar. By way of comparison, this level of debt would be about seven times as large as Brazil's current net debt, though when expressed as a percentage of GNP, only one-fourth as large as Brazil's. falls, less debt will be accumulated. If the dollar But even so, by 1990, with a moderate depreciation the debt would accumulate to $550 billion, and with a rapid depreciation it would accumulate to $200 billion. A rapid depreciation of the dollar and a sharp reduction of the U.S. current account deficit implies major adjustments in the current account positions of other countries. In the top half of Exhibit 4, the black bars show average current account positions from 1980 to 1982 for major regions of the world, and the red bars show estimates for 1985. While the U.S. position declined from about a zero balance to a large deficit, the position of other industrial countries rose from a sizable deficit to a sizeable surplus. Among developing -4countries, the ten major borrowing countries were forced by external borrowing constraints to reduce their large deficits between these two periods. Other developing countries as a group incurred larger deficits, substantially due to the reduction in surpluses of the oilexporting countries. Developing countries as a group probably would not be able to absorb more than a moderate portion of the U.S. deficit. Countries already heavily in debt would have difficulty financing substantially larger deficits. A sharp drop in the dollar could place significant pressure on some of these countries at least in the near term. To the extent that U.S. interest rates rose, the major borrowing countries would be facing higher net interest payments on their debt -- as shown at the bottom of the exhibit, about $2 1/2 billion per year for every 1 percentage point rise in dollar interest rates. Over time, however, the rise in dollar prices would tend to reduce the real value of their debt. For other developing countries a rapid drop in the dollar would be more manageable. Based on historical experience, a fall in the dollar would tend to raise the dollar prices of developing country exports more than the prices of their imports. The situation would be much more serious, however, if the general level of demand in industrial countries fell, which could significantly depress the export revenues of developing countries. Given the current position of developing countries, most of the global adjustment would have to take place in the current account positions of other industrial countries. In 1985 the surpluses of Japan, Germany and three other European countries, -- shown in Exhibit 5 -5-- will probably sum to about half the projected U.S. deficit. A sharp reduction or elimination of the U.S. deficit would entail moving the current accounts of some of these countries significantly into deficit. Such declines in net exports would have substantial negative impacts on the economies of a number of countries. To achieve this adjustment without a significant reduction in the growth of GNP, these countries would have to respond by lowering interest rates or adopting more expansionary fiscal policies, as we have assumed they would. The implications of a reversal of the U.S. current account deficit for the U.S. domestic economy, to be discussed by Mr. Stockton, would depend in part on its implications for the sectoral composition of U.S. trade flows. The three panels of Exhibit 6 show historical movements in U.S. real net exports of finished manufactured goods, industrial supplies and materials and food and agricultural products. downturn since 1980 is evident in all three sectors. A In absolute terms, the largest drop by far has been in the finished manufactured goods sector, although as a proportion of domestic output, the decline has been even greater in the agricultural sector. A number of factors have contributed to these declines in net exports, but the rise in the dollar over this period appears to have been the most important proximate cause. A reversal of the dollar's appreciation clearly would improve our net export performance in all three areas, with the largest absolute change coming in the manufacturing sector. D. Stockton October 31, 1985 In this section, I will discuss the adjustments required of the domestic economy in response to a drop in the dollar and the approximate magnitudes of these adjustments, both in absolute terms and relative to previous historical experience. Exhibit 7 presents a hypothetical example designed to illustrate the dimensions of the adjustments in the composition of real demands on domestic production that would accompany elimination of the current account deficit. Although the adjustments would be smaller if the deficit were not fully eliminated, any substantial move towards balance would require significant changes in existing patterns of domestic demands. I should note that the table calculates changes in terms of the composition of current real GNP-line 1-in an effort to clarify the the actual adjustment would shifts in resource use involved. However, likely occur over several years. Thus, the percentage change figures shown in the third column should be interpreted as reflecting shifts in the level of domestic demands relative to what otherwise would occur, growing fast or growing slowly. whether economic activity was unchanged, Turning first to the external sector, a depreciation of the dollar stimulates real net exports--line 4 in competitiveness of U.S. producers. the table-by improving the price However, prices of imports and exports In are not likely to change by the full extent of the depreciation. order to calculate the effect on real net exports of eliminating the current account deficit, it experience--that is assumed-consistent with historical foreign exporters absorb roughly half of the drop in the dollar by reducing their profit margins. At the same time, U.S. firms take the opportunity to raise somewhat the profit margins on their foreign although the bulk of the depreciation will likely be reflected in sales, lower foreign currency prices for U.S. in exports. The accompanying decline the volume of imports and rise in the volume of exports is estimated to increase real net exports by about $77 billion. As shown on line 2, such an expansion of real net exports requires an offsetting reduction in gross domestic purchases-the sum of consumption, investment, and government purchases-of about 4-1/2 percent if of GNP is if to be unchanged from what it government purchases are not lowered, the path otherwise would have been. Furthermore, the decline must occur exclusively among private domestic purchases-line 3--which would drop 5-1/2 percent. It is implausible to expect the current account deficit to be eliminated in a single year. of three years, If it is assumed that balance is achieved over a period as Mr. Hooper indicated was possible, then it necessary for real domestic purchases to grow, on average, would be about 1-1/2 percentage points per year less than production. Although the magnitude of this adjustment of domestic demands relative to production is the same whether the economy is capacity or near its potential, operating below full the characteristics of the adjustment process are likely to differ depending on existing economic conditions. substantial excess capacity, With the production of traded goods can expand with substantially less upward wage and price pressures because resources are readily available to meet the increased demand. economy close to potential output, In contrast, for an the redirection of resources towards the traded goods sector may generate much greater pressure on wages and prices, as it employment in will be necessary for resources to be bid away from current the production of nontraded goods. The upper panel of exhibit 8 places the magnitude of a three-year adjustment to current account balance in some historical perspective. Annual growth rates of real GNP-the black line-and real gross domestic purchases--the red line--are plotted in the chart, assuming that GNP growth averages 3 percent at an annual rate over the next three years. Nearly all previous periods during which purchases grew less than production-shown by the red shading--were associated with recessions. An adjustment of the magnitude and duration depicted in this panel, or even one somewhat smaller, would be unprecedented in a period of economic expansion and suggests there may be considerable tensions created in achieving the necessary suppression of domestic demands. Accompanying the expansion of net exports and the decline in domestic purchases will be a shift in the composition of production. A disproportionate share of traded goods are produced in the manufacturing sector. As a consequence, the shift in production towards traded goods and away from nontraded goods will lead to an expansion of foreign demands in the manufacturing sector. This increase will most likely only be partially offset by a reduction of domestic demands on manufacturing, because a large share of the crowding out of domestic demands will occur outside of the manufacturing sector. Assuming growth in manufacturing capacity at about a 3 percent annual rate-the long run trend-the expected shift in the composition of production towards traded goods could be expected to boost the manufacturing capacity utilization rate 4-1/2 percentage points during the adjustment process. As shown by the red line in the lower panel of exhibit 8, starting from where we are now, the manufacturing utilization rate would rise to 84-1/2 percent. -4Of course, capacity growth could be greater or less than the assumed 3 percent annual rate, even with GNP growth unchanged, on the relative importance of two opposing effects. depending Increased relative prices in the manufacturing sector should act to boost profitability and encourage investment in that sector. In opposition, the higher interest rates resulting from the depreciation are likely to damp demands for investment in new capacity. The shaded area in the lower panel represents manufacturing capacity utilization rates that would occur with annual rates of capacity growth between 2-1/2 percent-shown as the upper black line--and 3-1/2 percent--the lower black line. Levels of capacity utilization in the upper half of this range would likely generate persistent upward pressure on prices in the manufacturing sector. Finally, additional risks would arise if domestic demands on the manufacturing sector are not reduced as foreign demands are expanded. rapid expansion of demands from abroad could temporarily lift A the manufacturing capacity utilization rate above 90 percent if domestic demands were unaltered. Capacity utilization at this level would almost certainly imply production bottlenecks in some sectors. Elimination of the current account deficit also has an important influence on the availability of saving needed to finance both private investment and the federal budget deficit. column of exhibit 9 The first presents our current estimate of the sources and uses of saving. In the which it is assumed second column a hypothetical example is developed in that the current account is brought into balance, thus eliminating net foreign investment-line 4-as a source of saving. If the federal government's demands on saving were unchanged-line 2-the decline in investment by foreigners would have to be met by some combination of a reduction in private domestic investment and an expansion of domestic saving. the Based on statistical analysis of historical relationships, higher interest rates generated by a dollar depreciation could depress net private investment-line 1 in line 3--by roughly equal amounts. the table--and boost domestic savingAs a result, percent of disposable income-shown in percent average level in personal saving as a line 5--could rise from its 1985 to about 6-1/2 percent. 4 I should mention that, if the economy were operating substantially below its full potential, sustainable economic growth would constitute an additional source of saving to offset diminished capital inflows from abroad. The chart in the lower panel of exhibit 9 places the projected behavior of saving in some historical perspective. It is again assumed, for purposes of illustration, that the current account is brought into balance over a period of three years. Although the personal saving rate-shown as the red line in the chart--would not be at an historical high, a 2-1/2 percentage point rise would be a significant increase for a period of economic expansion. The black line plots net domestic nonfederal saving, which includes undistributed corporate profits and state and local government surpluses, in addition to personal saving. As a percent of GNP, climb to nearly 9-1/2 percent over the period, it would reaching a postwar high. Of course, historical relationships may not prove to be an accurate guide to future behavior. A failure to generate an increase in saving of the quantity depicted in exhibit 9 would lead to greater pressures on interest -6- rates and thus further crowding out of investment expenditures. be stressed, however, It should that significant progress towards reduction of the federal budget deficit would ease substantially the burden of adjustment on the private sector and lessen the strains attendant in Mr. this process. Slifman will now discuss the process of adjustment that would occur over time. L. Slifman October 31, 1985 In this section we will contrast possible responses in the economy over time to a gradual depreciation and to a rapid depreciation. general, In a rapid fall in the dollar would necessitate the more extreme shifts in resources and patterns of saving and investment that Mr. Stockton indicated. As a benchmark, exhibit 10 lays out an illustrative path for key economic variables on the assumption of a 5 percent annual drop in the dollar beginning next year. Because our purpose is to contrast the economic effects of alternative exchange rate movements, we have assumed at this point a monetary policy that is--so to speak--neutral, with money growth (abstracting from demand shifts) constant from year to year. By setting aside the question of the policy adjustments needed to reduce unemployment or inflation significantly further, this policy assumption allows us to highlight exchange rate impacts. In terms of fiscal policy, we have assumed a narrowing of the structural budget deficit by about $60 billion during the projection period, reflecting the spending objectives of the latest Congressional budget resolution. This assumption differs the one used in Mr. Stockton's tables, where the structural deficit was held constant. Given these policy assumptions, real GNP is assumed to rise about 2-3/4 percent annually; but growth could be faster if our long-term productivity performance were to improve. The critical element, though, is that throughout the five-year horizon growth of domestic purchases would have to be suppressed relative to the growth of real GNP. In effect, a substantial move toward external balance requires that we give up some of the excess growth in the standard of living we enjoyed during - 2 the period of appreciation from 1980 to 1985. At the same time, inflation is projected to pick up as a result of increases in the prices of traded goods. Nominal interest rates begin to rise after 1986; but the rise is quite modest reflecting our assumed narrowing of the structural deficit. If the budget deficit were not reduced, however, interest pressures would be even higher. The effects of a more rapid depreciation--assuming the same monetary and fiscal policies--are illustrated in red in the next exhibit. These alternative projections are based on a judgmental interpretation of the results from the staff's quarterly econometric model of the U.S. economy and our multi-country model. Focusing on the upper panels, the models suggest that a faster drop in the dollar would require an even greater suppression of domestic purchases over the projection period. During 1986, the stimulus to domestic production arising from an increased demand for traded goods would be about offset by reduced growth of domestic purchases, with little net effect on GNP growth, shown in the upper left panel. By 1987, however, the continued rapid improvement in our trade balance would be expected to provide a sizable boost to GNP. However, growth of domestic demand--the upper right panel--would remain depressed. accomplished, as indicated in the lower left panel, This would be at the cost of faster price increases and a sharp rise in interest rates (the lower right panel). The models suggest that over time the contractionary effects of higher inflation and interest rates would begin to play a larger role, and the growth of real GNP would become depressed for a while. The necessary reductions in domestic demand weigh most heavily on the interest-sensitive sectors of the economy. This is illustrated in -3- exhibit 12. Hardest hit would probably be the housing sector--the upper left panel. Business fixed investment--especially for new structures such as office buildings and stores--also would be sensitive to the higher interest rates. In the consumer sector--the lower panels--the initial rise in borrowing costs, and the reduction in the value of household financial assets associated with higher interest rates, would have retarding effects on purchases of durable goods. In addition, because prices tend to be more flexible than wages in the short run, a drop in the exchange rate restrains real wage growth and boosts profits. additional influence depressing consumption. This could act as an All of these factors would tend to boost the saving rate. However, once households have adapted their level of spending to the new lower levels of real income and wealth, the growth of consumption would be expected to pick up. The preceding two exhibits have illustrated the dimensions of the macroeconomic adjustments that would likely occur if the dollar were to depreciate rapidly. These projections are based on average historical relationships, which implicitly assume that the underlying microeconomic adjustments needed to redirect resources could be made relatively smoothly. Even so, as you can see, a sharp depreciation of the dollar entails considerable distortions and disturbances in the behavior of key variables. Clearly, significant risks and uncertainties would arise if the economy were subjected to a large exogenous depreciation shock, and there could well be disruptions at the microeconomic level that would lead to larger and even more volatile macroeconomic adjustments than we have shown on the charts. -4A number of these risks are summarized in the next exhibit. A major problem is whether it would be physically possible to reallocate quickly the resources needed to accommodate the shift in the composition of output toward the traded goods sector. If not, the result could be bottlenecks, constraints and materials shortages in some specific industries, as well as the emergence of labor market shortages for certain skills or in particular geographic locations. In addition, a sharp rise in capacity utilization rates, with associated bottlenecks and constraints, also could occur if less domestic demand were to be crowded out than our models are showing. If such constraints or shortages were to develop, they could have adverse effects on prices and price expectations that would impede the adjustment process. Another major risk is the possibility that developments in credit markets associated with rapid depreciation might generate a recession. if domestic demand is extremely sensitive to the rise in interest rates. The negative effects of rising interest rates could, in fact, be relatively strong under current circumstances because of the particularly sensitive position of many depository institutions. Borrowers--especially households, who have sustained spending recently through a rapid build-up in debt and and a consequent reduction in the personal saving rate--also could be quite sensitive to credit market conditions. As a result, significant interest rate increases may lead to unusually large cutbacks in lending and borrowing Indeed, these negative financial market effects could well be activity. strong enough to offset the positive effects on activity of a decline in the dollar. Mr. Axilrod will now discuss the policy implications of these risks. Concluding remarks The balancing of recessionary and inflationary risks that are involved in the process by which the economy adjusts to a drop in the dollar, particularly to a very sharp and rapid decline, poses difficult judgmental issues for monetary policy. With regard, first, to the risks of recession, under present circumstances given the possibility of unusually adverse institutional and borrower reactions to significant interest rate increases, an accomodative policy that holds rates down and accelerates money growth for a while might be considered for purposes of averting a significant weakening in economic activity. Such an approach would, however, raise the odds that inflationary pressures would be unduly encouraged as the added expansionary effect of a sharp depreciation of the dollar is not offset by an effort to squeeze out purely domestic demands on capacity. Of course one can debate exactly how tight resource availability is at present, and thus how much scope there would be to expand output in face of a falling dollar without undue inflationary risk. An unemployment rate near 7 percent and manufacturing capacity utilization around 80 percent probably leaves some room for real GNP growth above potential without that growth itself triggering a significant rise in inflationary expectations, but as Mr. Stockton's presentation makes clear whatever margin of unused resources there is would be rather quickly eroded by the added resource needs for export and import-competing industries. As that happens wage and price pressures would tend to be generated on top of the inflationary pressures directly related to the exchange rate induced rise in import prices. those circumstances, Under inflationary expectations would be likely to rise, and a return to slower money growth consistent with reasonable price stability over time would then entail very considerable costs in unemployment and financial disruption. Since a policy of initial monetary accommodation to limit the risk of recession in the short run may involve a substantial inflationary potential and the likelihood of a later recession, one might as an alternative consider a restrictive policy approach that takes the risks of weakness in economic activity sooner but minimizes the potential for inflation-on the grounds Such a that such a policy approach would be less costly over the longer run. policy of lowering money growth, at least by a little and for a while, and thereby exerting more upward pressure on interest rates initially could under present circumstances rather promptly weaken the economy. and inflationary expectations would remain subdued. income growth would work to hold down imports. However, inflation In addition, lower Such a rather "classical" method of reducing trade deficits by lowering domestic demand would moderate downward pressures on the exchange value of the dollar. The FOMC of course does not necessarily have to prejudge whether policy should be tilted in one direction or another in light of the various risks. An intermediate approach that keeps monetary policy unchanged (as indexed by money targets no different from what they otherwise would be) in the face of a sharp drop in the dollar can be viewed as weighting equally the risks of recession or inflation and letting the degree of interest rate pressure that emerges from market forces serve as the balance wheel. Policy could be shaded to the more accommodative or restrictive sides as market and economic responses to a sharp drop in the dollar evolve. Basically, however, I suspect that there is little chance of a very satisfactory econonomic outcome to a sharp drop in the dollar under current circumstances, no matter how well tuned is monetary policy. We would be very likely to experience inflation or recession or possibly both. Sub- stantial real adjustments in the balance of domestic saving and investment and in resource reallocation of the magnitude required by a closer balance in our international position probably cannot be accomplished in an orderly fashion in a relatively short period of time, given rigidities in the economy and lags in response rates to changes in relative prices. Attempts to achieve those large real adjustments quickly would probably entail considerable upward wage and price pressures, which would in themselves work to erode the real effect on our international competitiveness of any given nominal decline in the exchange rate, with the potential then for an even larger drop in nominal terms. At the same time, economic activity probably could not be adequately sustained in face of the relatively substantial rise of interest rates that may be needed to squeeze out domestic demand in the process, given the comparative fragility of domestic and world financial conditions, including debt burdens of borrowers and the balance sheet position of financial institutions. Finally, significant cuts in the federal budget deficit are not assured, and those cuts can make a more direct contribution than monetary policy to the real adjustments in the balance of saving and investment and real resource availability that are needed as the current account returns nearer to balance. But even if cuts were assured, they would take place over an extended period, and would be of little immediate help, except possibly through expectational effects. It is, therefore, at least in my view--and absent a miracle of fiscal restraint or a considerably weaker economy than now envisageddesirable to avert a sharp decline in the dollar. On the other hand, it is also desirable to keep the dollar from being excessively high because of the risks involved in postponing the adjustment process. If postponed unduly, the subsequent dollar decline may be extremely large and economic adjustments may occur at a time when domestic resources are even more highly -4utilized than at present, when upward price expectations may be less subdued, and when needed plant capacity and labor skills for internationallycopetitive industries have rusted further from disuse. That leaves a gradual downward adjustment in the dollar, particularly as it is accompanied by increasing fiscal restraint over time, as having the best odds for promoting an orderly process of economic adjustment. STRICTLY CONFIDENTIAL (FR) CLASS I-FOMC Materialsfor Staff Presentation to the Federal Open Market Committee Economic and Policy Implications of Exchange Rate Adjustments November 4, 1985 130 Exhibit 1 Foreign Exchange Value of the U.S. Dollar Quarterly March 1973 =100 -160 Percentage points Weighted Averaige Dollar - 150 9 -140 6 -130 October -120 3 -110 Long-term Real Interest Rate Differential* 0 - 100 - 90 3 - 1973 1973 1975 1975 1977 1977 1979 1979 1981 1981 1987 1983 80 S70 1989 March 1973=100 160 ge Dollar - 150 -140 i Dollar reciation -120 - 110 -. 100 ation 90 ' - 80 70 1973 1975 1977 1979 1981 1983 1985 1987 1989 *Difference between long-term government bond yields of the U.S. and a weighted average of other G-10 countries plus Switzerland, minus the difference between 12-quarter centered U.S. and foreign inflation rates at annual rates. Exhibit 2 U.S. External Balances Quarterly Merchandise Trade Balance Current Account Balance Exhibit 3 U.S. Net International Investment Position End of Year Billions of Dollars Percent of GNP 1950 13 4.5 1960 45 8.9 1970 58 5.8 1980 106 4.0 1984 28 0.1 1985 -63 -1.6 1990: With Unchanged Dollar -700 -13.0 With Gradual Depreciation - 550 -10.0 With Rapid Depreciation - 200 -3.5 Exhibit 4 Global Current Account Balances Billions of dollars U 19 80 -82 U13 1985 Projected (Second bar) 40 Other OECD I- 0 Ten Major Borrowing Countries* 40 40 Other Developing Countries - 80 -120 United States Billions of Dollars Impact of one percentage point higher dollar interest rates on the net interest payments of: All developing countries, of which: Ten major borrowing countries* OPEC * Includes Argentina, Brazil, Chile, Colombia, Korea, Mexico, Nigeria, Peru, Philippines, and Venezuela. Exhibit 5 Current Account Balances of Major Industrial Countries 1985 Projected Japan Germany Netherlands Switzerland U United Kingdom I Canada France Italy -- I 10 -0+ I I 10 20 Billions of dollars I 30 I 40 I Exhibit 6 U.S. Real Net Exports by Sector Finished Manufactures Billions of 1972 dollars -20 10 0 10 20 30 40 1973 1975 1977 1979 1981 1983 1985 Industrial Supplies and Materials Billions of 1972 dollars Im I 1973 1975 1977 1979 1981 F IF 1983 I 1985 Food and Agricultural Products Billions of 1972 dollars 1973 1973 1975 1975 1977 1977 1979 1979 1981 1981 1983 1983 1985 1985 Exhibit 7 Composition of Current Real GNP and Hypothetical Real GNP Scaled to 1985 Magnitudes Billions of 1972 Dollars Staff Estimate¹ 1985 Hypothetical Example Percentage Change (1) (2) (3) 1. Gross national product (C+I+G +X- M) 1679 1679 0 2. Gross domestic purchases (C + I +G) 1711 1634 -41/2 3. Gross private domestic purchases (C + I) 1392 1315 -51/2 4. Net exports (X-M) -33 1. Staff estimate for 1985 in 1972 dollars (October Greenbook). Exhibit 8 Real GNP and Gross Domestic Purchases Percent change from year earlier 1954 1959 1964 1969 1974 1979 1984 1989 Manufacturing Capacity Utilization Rate Percent 1973 Peak / - 85 h 3 Percent Capacity Growth 80 -- 75 -170 I 1970 III 1975 II I 1980 I 1985 1990 Exhibit 9 Demands on and Sources of Net Saving Billions of Current Dollars Staff Estimate¹ 1985 Hypothetical Example (1) (2) Demands on net saving 1. Net private investment 223 169 2. Federal budget deficit 194 194 3. Net domestic nonfederal saving 298 363 4. Net foreign investment 119 0 4 61/2 Sources of net saving Memo: 5. Personal saving rate 1. Staff estimate for 1985 in current dollars (October Greenbook). Personal Saving and Net Domestic Saving Percent of disposable income Percent of GNP Net Domestic* 8 6 S8 - 7 Personal / / / / 'I V I I I I I I I I I I II I 1954 1959 * Net domestic nonfederal saving. 1964 I I 1969 i I II 1974 I I I I I I 1979 -- I I I I 1984 1989 4 Exhibit 10 Assumed Paths of Key Variables with a Gradual Depreciation Percent Change; Fourth Quarter to Fourth Quarter 1985 1986 1987 1988 1989 1990 1. Real GNP 2.0 2.4 2.7 2.7 2.7 2.7 2. Domestic purchases (C + I + G) 3.2 1.9 1.9 2.2 2.3 2.5 3. GNP deflator 3.6 3.7 4.4 4.7 4.8 4.8 4. Treasury bill rate (level in Q4) 7.2 6.5 6.8 7.0 7.0 7.0 Key assumptions Monetary policy: Constant money growth rate (abstracting from shifts in money demand) Fiscal policy: Narrowing of the structural deficit consistent with the objectives of the Congressional budget resolution Exchange rate: 5 percent per year depreciation, 1986- 1990 Exhibit 11 Impact of a Rapid Depreciation Domestic Purchases Real GNP Percent change Percent change I -- 4 Rapid -3 -- 3 -2 -- 2 Gradual I I I 1987 1985 I I I *, l 1985 1989 GNP Deflator I I I 1989 1987 Treasury Bill Rate Percent Percent change -- 6 -111 - 2 I I I 1985 1987 1989 I 1985 I 1987 1989 Exhibit 12 Impact of a Rapid Depreciation on Spending and Saving Housing Expenditures Business Fixed Investment Percent change Percent change r - -1 - 6 Gradual - 3 I 1985 1987 1989 1985 I 1987 1989 Personal Saving Rate Consumption Percent Percent change F Rapid -- 7 -- 3 -- 6 -- 2 Rapid -14 I 1985 I I 1987 I I 1989 I 1985 I1 1987 1I 9 1989 Exhibit 13 Risks to the Adjustment Process * It may not be physically possible to reallocate sufficient resources to the traded goods sector. - Bottlenecks and capacity constraints - Labor market shortages * Sharp increases in capacity utilization rates could occur if domestic demand were not crowded out sufficiently. * Interest rate effects could be relatively strong because of the sensitive position of many depository institutions. * Household borrowers also could be quite sensitive because of high debt burdens and low saving rate. * Negative financial market effects could be strong enough to offset the positive trade effect associated with a decline in the dollar. Notes for FOMC Meeting November 4-5, 1985 Sam Y. Cross Mr. Chairman, perhaps it would give a clearer perspective if I reviewed developments over the entire six-week period since September 22, when the G-5 made its pronouncements about exchange market intervention, although that goes back a week or so before the last FOMC meeting. As a benchmark, during the week before the G-5 meeting, the dollar was trading around 2.90 DM and 2.42 yen. You will recall that on the first day after the G-5 communique there was a sharp decline in the dollar, which closed on Monday at 6 to 7 percent below those benchmark levels. The market noted that the U.S. had taken the lead in forging the G-5 agreement. and took seriously the fact that the Administration had shifted its attitude both with respect to intervention and with respect to the implications of a strong dollar. Thereafter the market became impressed by the willingness of the authorities to intervene, in particular, the Japanese authorities, who on their first business day spent $1.2 billion, accounting for more than 25 percent of the Tokyo market's gross dollar sales, on the day of the market's largest turnover in history. The dollar continued to trend lower through the first week in October. With pressures relatively light, after the Japanese action, U.S. intervention totalled less than $500 million in the first two weeks after the September 27th announcement. In the second two weeks, the dollar came under upward pressures, reflecting strong commercial and investor demand. The demand for dollars was spurred by the passing of the IMF meeting without announcement by any of the countries of any new economic policy initiatives to reinforce the intervention. Also, there were statements by foreign officials that were interpreted as expressing satisfaction with the extent of the dollar's decline, and suggesting that it would not fall much farther. In addition, there were expectations developing of stronger U.S. economic growth. While we felt that some recovery of the dollar was appropriate in the circumstances and should be allowed, we did act to resist sustained upward pressures by selling substantial amounts of dollars, both through agents and directly in our own markets and abroad. As these upward pressures intensified around mid-October, we sold dollars openly and aggressively against both the mark and the yen. On October 16, as the dollar reached its highs for the period, we sold almost $900 million, and on the next day we openly sold an additional $170 million as the dollar was easing back from its highs after a disappointing GNP figure. Others cooperated in resisting the strong upward pressure on the dollar, and we were in frequent, sometimes around-the-clock contact with our colleagues at the Bank of Japan, the Bundesbank, and elsewhere to coordinate intervention operations. During that second two weeks of the six-week period, the U.S. sold more than $2 billion ($2.167 billion) and the other G-5 countries sold almost another $2 billion ($1.898 billion). Over the last two weeks of the six-week period, in response both to the intervention operations and the less optimistic outlook for U.S. economic activity, much of the upward pressure on the dollar relative to the European currencies abated, although the market continued to sense a strong potential demand for dollars by Japanese investors. Consequently, our dollar sales were much more modest and generally concentrated against yen. For the most part, these operations were designed to defuse pressures before they could build, on occasion nudging the exchange rate when a good opportunity presented itself. Toward the end of the period, the Bank of Japan, responding to the continuing underlying investment demand for dollars, acted conspicuously to guide Japanese market rates significantly higher. Many market participants viewed this action as the first of a series of steps to be taken by the G-5 countries to lower interest rate differentials favorable to the dollar. The Bundesbank, when it offset a seasonal overabundance of liquidity from its markets, was viewed as also changing its policy toward the same objective. Although the idea of a G-5 interest rate agreement has been denied by many sources, the dollar has declined further in this environment and now stands at just below 2.66 DM and 2.08 yen. The dollar is now 10-1/2 percent below the pre-September 22 benchmark figure for the DM I mentioned earlier, and 14 percent below the figure for the yen. Dollar sales by the United States in the sixweek period amounted to $3.2 billion. Dollar sales by other members of the G-5 totalled $4.9 billion during the six-week period. Of the $3.2 billion in U.S. sales, a total of $2.8 billion took place since the last FOMC meeting--$1.65 billion against DM and $1.14 billion against yen. All of these sales of dollars by the U.S. were divided equally between the Federal Reserve and Treasury. These increases in Treasury and System holdings of foreign currency have been invested using existing facilities, as always aiming to obtain market related rates of return along with the required high degree of liquidity and safety. In the case of our yen acquisitions, all have been invested through the Bank of Japan in For the German marks we have acquired, the Bundesbank requested that all of the increase has gone into mark deposits held with the BIS. The Bundesbank's request to us is similar to those we understand it has made of other central banks buying large amounts of marks in the last year or so, and stems from As you know, the level of our intervention activity resulted in our approaching our limit on the maximum change in the Federal Reserve's foreign currency balances between FOMC meetings, and the Committee approved a $500 million increase in this limit to $2 billion. As it developed, we did not have to use this additional leeway, and the limit automatically reverts to $1.5 billion. -3Mr. Chairman, at the last meeting, the Committee approved a maximum overall position limit of $10 billion. Within that $10 billion overall limit, there are informal limits on individual currency holdings--at the level of $6 billion equivalent in DM, $3 billion in yen, and $1 billion in other currencies. At present, we have ample room under the overall formal limit of $10 billion--we are about $3 billion below that limit. But we may need to change some of the informal limits, depending on developments in the weeks ahead. Mr. Chairman, I recommend that the Committee ratify the transactions since the October meeting that I have described. My only other recommendation is that the Committee approve renewal of the System's reciprocal foreign currency arrangements with foreign central banks and the BIS, as these come up for renewal in December. We are suggesting no change in any of the agreements. NOTES FOR FOMC MEETING November 5, 1985 Peter D. Sternlight Domestic Desk operations since the October 1 meeting sought to maintain the same degree of reserve pressure intended at the time of that meeting. Narrow money growth halted in October, on average a sharper slowdown than had been anticipated a month ago, but this still left the M1 measure far above the Committee's intended range from the second to fourth quarter. The broader aggregates also slowed in October, reflecting both the stall-out in M1 and some slowing in time deposit components. This brought M2 just back within its annual growth cone in October, after having been above its range in September, while M3 remained near the middle of its annual range. Against this background, the slowdown in October growth was not seen as calling for a change in planned reserve pressures, particularly against the background of continued moderate growth in the economy and for the most part a weakening in the dollar internationally. Accordingly, reserve paths continued essentially to incorporate a $500 million allowance for seasonal and adjustment borrowing, although in the early part of the interval as we proceeded through the maintenance period ending October 9, an allowance was made for relatively high borrowing in the early part of that period traceable to hurricane disruptions and statement date pressures at the end of September. There were also unusual pressures on October 9 itself, when the Treasury, steering its tortuous way between the Scylla of debt limit and Charybdis of zero cash balances, scheduled a cash management bill for auction and payment that same day. Together, those factors boosted borrowing in the October 9 period to about $770 million. In the next full period, borrowing averaged a close-to-path $470 million while so far in the current period it has averaged a below path $385 million (through last weekend). Fed funds have averaged close to the expected eight percent area, looking at full weeks or reserve periods, but there were some significant departures on particular days. Most notable, on October 9, when the Treasury sold its same day cash management bill, there was small-scale late trading at rates of 10 to 40 percent. On the other hand, early in the current reserve period, there was substantial trading in the 7 1/2 to 7 3/4 percent range as excess reserves were temporarily over-abundant. So far in the current reserve period, funds have averaged 8.02 percent. Outright operations were relatively light for the Domestic Desk, including the sale of $265 million of Treasury bills to foreign accounts and purchases of about an equal amount of bills from those accounts late in the period. This would ordinarily be a period of moderate reserve provision, but that was being accomplished through Foreign Desk currency purchases and somewhat lower than normal Treasury balances as the debt limit problem dragged on. We did have a number of occasions to inject reserves temporarily by passing through customer repurchase agreements--eight times-and five occasions when we withdrew reserves for short periods through matched sale purchase transactions. The uncertain timing of action on the debt ceiling remains a complication for reserve management--as well as in other respects--for the period ahead. As you know, there was one day last month, October 8, when the Treasury ran a small inadvertent overdraft which was plugged to zero the next morning through an accounting adjustment. After some unusual use of the Federal Financing Bank and certain trust funds, their balance is probably okay for about the next 10 days, though perhaps with some close calls and occasionally lower than normal balances. The so-called "drop-dead" date now is November 15 when massive new cash is needed for interest payments. Without uncorking still new gimmicks, which the Administration has professed an unwillingness to use, we don't think they can get past November 15 and would have to default at that time unless the Congress has acted. Financial markets responded to diverse and often confusing signals over the period, with uncertainty about the Treasury's financing plans a continuous background factor. For intermediate and longer-term Treasury issues there was a net yield decline of about 20 to 35 basis points. It stemmed essentially from a prevalent view that the economy was expanding only modestly, with inflation in a state of remission, and a fair likelihood that monetary policy could turn more accommodative in coming months--partly in furtherance of the G-5 efforts to strengthen the major nondollar currencies. This view prevailed even though at times there was also a sense that the System was aiming, short-run, for slightly more cautious conditions of reserve availability. With pent-up appetite for long-delayed coupon issues, the market bid vigorously last week for four-and seven-year notes, and pretty well also for twenty-year bonds. The Treasury raised nearly $18 billion through these issues, the bulk of the $19 billion raised through coupon issues during the period. It remains to be seen whether the market appetite will also be good for the three-, ten-, and thirty-year issues that normally make up the Treasury's mid-quarter financing and would be up for auction this week but for the debt limit hang-up. Last week's auctions have filled in a lot of short positions, and fresh demand may depend on the market's finding further cause for optimism that rates will decline in coming months. The bill market turned in a more staid performance over the period, with some short maturities rising in rate and longer ones edging off only slightly. The bill market seemed to be responding more than coupons to the perception that Fed funds would likely vary around 8 percent--perhaps in a "broad" range of 7 3/4 to 8 1/8 percent. Three- and six-month bills were auctioned today at about 7.22 and 7.30 percent compared with 7.07 and 7.24 percent just before the last meeting. The Treasury will have raised $8 billion in the bill market over the period in the form of short-term cash management bills including $5 billion on October 9 and another $3 billion just announced today for auction and payment tomorrow. The Federal agency market attention continued to focus on the beleaguered Farm Credit System. Through most of the period, spreads of Farm Credit paper over Treasuries tended to widen in response to, or anticipation of, adverse news reports, including a GAO report projecting multi-billion dollar losses for the year ending next June, and FCA's own report of a half-billion loss in the latest quarter. By late October, the spreads were largely around 100 basis points or somewhat more. The spreads narrowed temporarily by about 20 basis points last week following press reports that the Administration was leaning toward some sort of back-up plan, and FCA got the benefit of that temporary narrowing in pricing a six-month issue about 85 basis points over Treasuries. The next day, Administration testimony seemed to shy away from any near-term aid plan and also forecast a heavy fourth-quarter loss for the System that sent spreads back to the 100 basis point area. Market participants did not seem excessively disturbed by these events, though, essentially, I think, because there is a persistent underlying belief that the Farm Credit System won't be allowed to fail. Elsewhere, I should just mention the tax-exempt market where rates declined considerably more than for Treasury issues. about 60 basis points. One broad index fell A few months ago, exceptionally heavy issuance in this market caused rates to back up compared with Treasury issues. Much of the heavy issuance was undertaken to get ahead of possible Congressional restrictions on certain types of tax-exempt financing starting next year. More recently, given the development of unusually attractive rates compared with taxable bonds, demand picked up substantially. Some of it has come, reportedly, from investors that don't normally seek tax-exempt income but are attracted to the current spreads as a short-term holding. Also, we hear of some bank buying on the basis that subsequent legal changes may make it more costly on an after tax basis for them to carry tax-exempt investments purchased after year-end. JLKichline November 4-5, 1985 FOMC Briefing The staff's forecast of the economy prepared for this meeting of the Committee is little changed, although we have shaded a few tenths off projected growth of real GNP for this quarter and next year. Economic activity is expected to advance at a 2-1/2 percent annual rate over the forecast period, which is thought to be consistent with an unemployment rate that is stuck at a bit over 7 percent. Information on developments in the current quarter is quite limited; essentially all we have in hand is the October labor market reports, a tentative reading on industrial production, and partial data on October auto sales. The labor market surveys were upbeat in October as payroll employment rose more than 400,000. Employment gains were widespread among sectors, including growth in manufacturing and construction as well as trade and services. Owing to seasonal adjustment problems, it would seem better to average October with the weaker September report and doing that still provides growth of employment somewhat above the experience earlier in the year. Given the labor market information and some physical product data, it appears that industrial production was about unchanged in October, held down in part by the Chrysler strike which came after the employment surveys. Domestic auto sales in the first - 2 20 days of October plunged as expected following the end of most cut-rate financing incentives, and auto inventories are now in the process of being rebuilt. On the whole it seems that moderate growth this quarter is a good bet, but in our thinking some additional caution flags have been raised as we focused on the forecast through next year. In the consumer sector, spending attitudes are reportedly good and outside the auto sector we have been seeing moderate gains in spending in recent months. However, future gains in spending would seem to be constrained by the prospect of limited expansion in real disposable income--a bit over 2 percent in the forecast--high debt burdens and a very low saving rate. I might note that the 4 percent saving rate in the forecast takes off from currently published data, and it appears likely there will be a sizable upward revision to the data but that will still leave us significantly below historical norms. Developments in the investment sectors in the forecast contribute to holding down prospective gains in income. Housing, frankly, has been a puzzle for some time, but clearly housing starts have yet to show a response to the earlier decline in mortgage interest rates; starts edged lower in the spring and declined on average for the third quarter. We have reduced our expectations for this sector a little but continue to forecast some pickup in starts over the course of the - 3 forecast, partly in response to some further drifting down of mortgage interest rates. We have also lowered our expectations somewhat for business fixed investment spending. New orders for nondefense capital equipment rose 5 percent last quarter, but the bulk of the increase was for aircraft and parts which have long lead times; excluding aircraft, nondefense capital goods orders have been about flat this year. Survey evidence on 1986 capital spending plans has become available to us on a confidential basis since the last Committee meeting and both the McGraw Hill survey (down 1 percent in nominal terms) and the Merrill Lynch survey ( up 3 percent) are weak. Even after allowing for their tendency to underpredict, the surveys suggest cautious business planning for next year. Our forecast is somewhat above these surveys, but with ample capacity, moderate growth of final sales, and uncertainty over tax reform, there do not seem to be any particular sources of strength available. On a more positive note, the decline in the foreign exchange value of the dollar that has occurred and assumed to continue at a more moderate rate should produce an improvement in net exports. For 1986, net exports are projected to contribute to growth of real GNP for the first time since 1980. Also positive has been the continuing generally good performance of wages and prices. Although some transitory factors--the ending of cut-rate auto financing and higher meat - 4 - prices, for example--could boost near-term monthly price indicators, inflation this year is expected to be around 3-1/2 percent, the same or better than last year depending on the measure used. Only a small acceleration is expected next year, in response to a weaker dollar.
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