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Notes for FOMC Meeting
November 5, 1986
Sam Y. Cross

The period since the last FOMC meeting was characterized, first, by three to four weeks of dollar weakness,
followed by a period of dollar recovery.

After these moves

the dollar is now on average about 2 percent above the level
of six weeks ago as measured by the Federal Reserve Board
During late September and the first half of October,
pessimism toward the dollar deepened.
seemed to be going nowhere and

The U.S. economy

there was little evidence of

improvement in the current account.

Dealers and investors

saw little risk in maintaining short dollar positions.
International discussions around the time of the IMF Annual
Meeting had failed to produce any broad initiative for dollar
support, and public calls by U.S. officials for more
stimulative policies abroad were publicly rejected.
The deterioration of market sentiment was most
evident in the downward movement of the dollar against the
German mark and other continental currencies.

The dollar

traded as low as DM 1.97-1.98, both before and after public
declarations by officials of BC countries in late September
after the Gleneagles Conference of their intention to resist


a further slide in the dollar.

2 -

Following those declarations,

continental central banks, under the Bundesbank's lead,
purchased on various occasions a total of


than half of this on a single day.
During that period, however, the dollar remained
steady against the yen.

Market participants perceived

growing stagnation in the Japanese economy, and there were

many reports that some export firms were finding it
increasingly difficult to adjust to the yen's appreciation.
These conditions, and disappointment that a Japanese discount
rate cut had not taken place, reportedly led investors,
particularly foreign investors, to sell their shares in
Japanese companies, and to shift into dollar and other
non-Japanese investments.

Adding to the downward pressure on

stock prices also was talk of probable changes in Japan's
capital gains tax.

Prices on the Tokyo equities markets fell

by more than 10 percent in mid-October.
Another source of demand for dollars resulted from
the fact that various large Japanese financial


apparently chose to repay dollar borrowings to offset the
balance sheet losses in their stock portfolios resulting from
the decline in Tokyo share prices.

These Euromarket

borrowings had been initiated when the dollar was at higher
levels, as a hedge against the purchase of dollar-denominated
securities, and the firms realized a profit by repaying them
at prevailing exchange rates.


3 -

These dollar purchases by Japanese firms occurred at
a time when business statistics were beginning to look
somewhat more favorable for a revival of growth in the U.S.

Then, when the September U.S. merchandise trade

figures came in much better than expected, many traders
joined in with dollar purchases.
Against this background, the hints of a discount
rate cut in Japan, subsequently announced last Friday,
offered good support for the dollar.

When Finance Minister

Miyazawa announced the agreement with Secretary Baker, market
participants scrambled to cover some of

the short positions

which had been built up during the earlier weeks of dollar
pessimism, moving the dollar to higher levels.

The dollar

also moved higher against the European currencies, although
the Treasury was at

some pains to make clear that the

agreement with the Japanese did not imply U.S. satisfaction
with the performance of Germany and others.
Miyazawa's suggestions that appreciation of
resisted by joint

the yen would be

intervention were denied by the Treasury,

dealers interpreted the agreement as,

at a minimum, assurance

that Secretary Baker was broadly satisfied with present
exchange rate levels.

- 4 -

With the exchange markets impressed that international cooperation had been renewed, at least between Japan
and the United States, and that officials on all

sides seemed

generally satisfied with present rates, the dollar continued
to firm and by close of business Tuesday had eased slightly
to trade just below DM 206 and Y

164, less than one percent

higher against the mark and 6 1/2 percent higher against the
yen than at your last meeting.

Although traders remain

uncertain about the exact implications of the agreement
between the two ministers, they have for the present assumed
a more relaxed attitude toward the dollar.
On swap operations during the period, the Bank of
Mexico drew on its own reserves to repay $270 million of the
official bridge financing facility extended in August.


this sum, $133.8 million went to repay drawings from the
Federal Reserve ($66.8 million) and the U.S. Treasury
($67 million).

The remaining outstanding drawings on the

official credit facility are scheduled to be paid in two
tranches, with a payment of $270
and $310 million in mid-February.

million due in late November
Of these sums, a total of

$287.3 million is due to the Federal Reserve and U.S.

Efforts are still proceeding within the Bank

Advisory Committee to arrange a "critical mass" of bank
financing so that the Mexican financing package and IMF
program can go forward.

- 5 -

Before closing, Mr. Chairman, I would like to seek
the Committee's approval of the Federal Reserve swap
agreements with other central banks and the BIS that come up
for renewal in December.

Aside from the swap drawings by

Mexico, these facilities have not been drawn on for several
years, either by the Federal Reserve or any of the counterparties and they cannot be drawn except by reciprocal


However, it is important to keep these facilities

in place and available in case of need.

I recommend that the

Committee authorize their extension for a further period of
one year, without change.


Mr. Sternlight made the following statement:
Domestic Desk operations since the last meeting have
been directed at maintaining unchanged conditions of reserve

The broader monetary aggregates, while hovering

around the tops of their annual growth ranges, tracked within
the Committee's preferred pace for August-to-December.
Economic data remained mixed, but left most observers with a
sense of modest growth over-all perhaps verging to the sluggish
Reserve objectives continued to allow for $300 million
of seasonal and adjustment borrowing.

The provision for excess

reserves initially remained at $900 million, though informal
allowance was made for the recent tendency for excess to fall
short of this level.

As the period progressed, the standard

allowance for excess reserves was trimmed to $850 million in
recognition of the recent experience.

Actual borrowing levels

were close to path, averaging about $325 million in the two
full reserve maintenance periods since the last meeting, and
about $220 million in the first 12 days of the current period.
Average Federal funds rates have remained close to the
anticipated 5 7/8 percent area, ranging a little higher around
the end of September when quarter-end pressures came into play,
and a bit lower in early October as Treasury balances at the
Fed came down swiftly and were redistributed to the banking

The rate was a bit firmer again the last couple of

days, possibly because of pressures stemming from payments

for new Treasury issues while reserves moved toward smaller
banks in the wake of monthly social

security payments.

Reserve needs were moderate for
and were met through a combination of
about $1.3

the period as a whole,

outright purchases of

billion of bills from foreign accounts,

and a

succession of System and customer repurchase agreements on most
days of the period.

Incidentally, the outright purchases bring

the total System portfolio to just over $200 billion, including
nearly $100

billion in Treasury bills.

project quite heavy reserve drains
period, with seasonal
major factor.

I should note that we

in the upcoming


increases of currency in circulation the

At this point,

it is not certain whether we will

require an increase in the standard $6

billion leeway for an

intermeeting period, but that should be clarified as the period

and we'll request additional

leeway if we conclude

that it's needed.
Interest rates through most of

the maturity range

moved moderately lower on balance during the past intermeeting
period, essentially retaining the steeper yield curve that

in September.

There was very little net change in

the bill area, however, where key rates were unchanged to down

10 basis points.

In the latest auctions, the 3-


6-month bills were sold at average rates of 5.23 and 5.30
percent, down just

slightly from 5.25 and 5.39 percent just

before the last meeting.

At times, bill supplies were

curtailed because of Treasury debt ceiling constraints, but net

over the period the Treasury raised about $8 billion in the
bill market, about half of it through a $4 billion cash
management bill that just settled yesterday.
Yields on coupon issues of various maturity were down
about 20-40 basis points, responding essentially to a sense
that the economy's expansion remains on the moderate to
sluggish side--even though some specific indicators looked
stronger at times.

Actual and anticipated strengthening of

foreign demand for U.S. securities was also helpful to the
coupon market, based in part on official statements looking
forward to a steadier dollar and a few signs that the trade
deficit might be starting to turn down.

Given the lackluster

view of the economy, and a subsidence of concerns about
near-term inflation and growth in the broader money measures,
there is some sense that monetary policy could turn a notch
more accommodative, including another discount rate cut--but
generally a move is not expected on the immediate horizon.
Also, there is not much conviction that such a move would in

itself bring lower long-term rates, although the anticipated
softness in the economy could well have that effect.

Let me

add as a footnote that early indications suggest no big market
reaction to yesterday's election results.

There was a modest

markdown of prices overseas, but it did not seem to be carrying
The Treasury has been raising substantial sums in the
coupon market--about $13 billion in the intermeeting period not

counting the quarterly refunding issues for which auctions
began yesterday.

These refunding issues which are also being

auctioned today and tomorrow, will raise a further $15 1/2
billion of net new money.

In line with recent Committee

discussion, the System's holdings of maturing issues in this
refunding will be exchanged predominantly for the 3-year issue,
with only quite modest amounts going into the 10- and 30-year

M. J. Prell
November 5, 1986
FOMC Briefing
Economic Situation and Outlook

The forecast we've provided for this meeting is broadly similar to
those presented at previous meetings.

We are looking for the economy to grow

a bit faster in the coming year or so, and for inflation to pick up a little
because of developments in the oil and foreign exchange markets.
cipated policy environment,

In the anti-

the direction of

including the moderate shift in

fiscal policy, growth in domestic demand should be restrained while resources
are shifted at the margin toward the tradeable goods sector.
Unfortunately, there is not yet much evidence with which to confirm
that these trends are indeed emerging in
data now in

hand go beyond September,

the current quarter.

Few of the

and some don't go that far.

Our fore-

cast of 3 percent real GNP for this quarter thus depends on inferences drawn
from a very small pool of information on production, spending, and prices.
On the production side,

three pieces of information stand out.


the employment report for September showed a relatively small increase in

a further decline in manufacturing jobs, and a flat total for pro-

duction worker hours.


coupled with other indicators and anecdotes,


led us to expect a rather moderate increase on average in labor inputs in
the current quarter.




even allowing for a trimming of assembly

appears that auto output in this quarter will exceed that in the

third quarter by enough to give a slight boost to GNP.
indications of a bottoming out in


the rig count suggest that drilling activity,

which has been a considerable drag on GNP thus far this year,
neutral element in

finally, the

the fourth quarter.

should be a

On the expenditure side of the equation, we find ourselves in the midst
of some complicated special stories.

As a consequence, the composition of

spending in the forecast undergoes some rather exotic gyrations.

In the

current quarter, for example, increases in inventories and net exports more
than account for the growth in real GNP.

Two unusual factors are at work

One is the payback in auto sales after the recent promotions.


car sales have averaged only 6-1/4 million units at an annual rate in the
two ten-day selling periods since the incentives were dropped, and although
some pickup is expected before yearend, we anticipate that an appreciable
share of this quarter's higher auto production will end up in dealer inventories.
The other unusual factor is the surge in oil imports that occurred in the
third quarter and that seems likely to reverse at least in part in the current
period, thereby boosting growth in net exports beyond what we believe to be
the emerging favorable trend.
In terms of the underlying trends, we are projecting only a moderate
expansion in consumer spending over the forecast period.

Even if, as

expected, the personal saving rate does bounce back in the current quarter
from the extraordinarily low level reached during the September auto buying
binge, the presumably waning influence of the earlier surge in stock and
bond market wealth and signs of debt servicing difficulties among households
suggest that we shouldn't look for spending to outstrip income growth in
In the business sector, near-term expenditures may be buffeted by the
cross-currents associated with, on the one hand, a small payback after the
recent runup in auto and truck purchases and, on the other, efforts to
acquire capital goods before less generous depreciation rules take effect.

The September jump in orders for nondefense capital goods was, we
think, influenced by such tax considerations.

But we also believe that

there is a hint of a more fundamental firming in the orders for equipment,
and we are looking for moderate gains in producers' durables spending as 1987

Those gains should be sufficient to offset the decreases that we

expect to occur in nonresidential structures outlays.

Construction put-in-place

was unchanged in September, and up slightly in the third quarter as a whole,
but the data on contracts and vacancies point to a strong enough downtrend in
office building, in particular, to pull down total structures outlays substantially
in the months ahead.
In the residential construction sector, we are projecting only minor
variations in the level of activity, in an environment in which financing costs
do not change substantially.

Housing starts have been trending gradually

lower since the first quarter, dropping below the 1.7 million unit annual rate
mark in September.

Recent figures on sales of single-family units indicate

that a rebound may be in store for that segment of the market, but, in
light of still rising vacancy rates and adverse tax law changes, we expect
multifamily building to sag further.
One surprise in the recent data has been the strength of state and local

Public construction outlays have skyrocketed in the past two quar-

ters, as governmental units appear to have stepped up infrastructure outlays
with the grants and borrowed funds they had been accumulating.


in the Commerce Department's preliminary figures, state and local purchases
accounted for more than half of the growth in real GNP over the second and
third quarters combined.

Regional differences obviously are significant,

but our reading of the state and local budgetary situation suggests to us
that increases in this sector's spending are likely to be more moderate in
the future.
As I noted earlier, the external sector remains a key element in the
pattern of activity we have forecast.

Real exports posted a sizable gain in

the third quarter and we are projecting solid gains throughout the forecast

Agricultural exports appear to be moving up now that support price

levels have dropped, and some non-ag industries--led by aircraft--have posted
healthy orders and sales abroad.

On the import side, noticeable price increases

have become somewhat more widespread, and should increasingly damp the flow
of goods into this country.
Finally, on the wage-price front, the recent news has, on the whole,
been quite favorable.

Consumer and producer price index increases have been

enlarged of late by what ought to be some transitory spikes in food prices and
by what may well be more lasting increases in gasoline and fuel oil prices.
Outside of food and energy, the trends of price increase have not changed
materially in recent months.

As we move on into 1987, however, the firming of

energy prices and the rise in import prices are likely to leave a clearer
imprint on overall inflation rates, especially at the consumer level.
On the labor cost side, recent data measuring compensation trends have
been very encouraging.

It is clear that a combination of slack demand in

some sectors of the labor market and the first-half halt in consumer price
inflation have produced an appreciable moderation of compensation growth
from the pace of the preceding year or two.

That moderation is evident across

the full range of private industries, among union and non-union, white and


blue collar workers.

But it appears to us, too, that people are viewing the

benefits of the drop in oil prices as a one-time bonus and are not building
it fully into their inflation expectations.

Moreover, in coming months

the firming of energy and import prices will be feeding into formal
and informal COLAs.

Under the circumstances, while we do not see labor markets

tightening enough to create general pressures on wages, we believe it most
likely that compensation increases will become somewhat bigger as time passes.
Even so, hourly compensation rises only 3-1/4 percent next year, in our
forecast--still considerably below the 4 percent 1985 pace-and unit labor
costs go up only about 2-1/2 percent in the nonfarm business sector.

Donald L. Kohn
November 4, 1986

Developments in

financial markets since the last FOMC meeting

have--for a change--turned out very close to expectations.

as Mr.

Sternlight has reported,

In credit

the federal funds rate remained in

the 5-7/8 percent area prevailing at the time of the last meeting, while
other rates have tended to decline a bit, especially at the long end of the
maturity spectrum.

M2 growth slowed in

September and M3 in October,


both within the short-run 7 to 9 percent paths the Committee specified for
August to December,

and right at the tops of their longer-run ranges.

growth slowed even more substantially in

September relative to its

over the previous several months, and while it



accelerated in October, the

two months combined are well below the extraordinary growth rates over the
One does not want to make too much of the last two months of data,
but it

could be that we are seeing the beginnings of a return toward somewhat

more moderate money numbers,
For M2,

and at least smaller declines in velocity.

after stripping away the RP and Eurodollar components,

which are

driven by bank funding needs, the rest of this aggregate has been slowing
since late spring.

This has occurred despite further declines in short-term

rates in July and August.

It may be that the declines in rates earlier this

year had more of an effect in part because long-term rates were also falling.

probably was not only the lag in the adjustment of M2 rates but also the

flattening of the yield curve earlier in the year that helped attract funds
from outside this aggregate in the second and third quarters.
curve has steepened a little

The yield

since the spring, and, with intermediate-term

-2rates essentially unchanged on balance over recent months, offering yields
on a portion of M2 time deposits have had a chance to come into better
alignment with market rates.

Overall growth of liquid assets has remained

quite high--estimated at 9-1/2 percent in September--but M2 seems to be
capturing a slightly smaller share.
The alternative B path in the bluebook envisions a continuation
of this trend of decelerating M2 growth, assuming unchanged reserve conditions
and about the current level of market interest rates, as depositor portfolios
become more fully adjusted to the previous declines in opportunity costs
and as depository institutions allow offering yields on the more liquid
components of M2 to edge lower.

M3 growth over the balance of the year

also is considered likely to remain at a reduced pace, given expectations
of relatively slow growth of credit at banks and thrifts--and thus of managed
liabilities to fund that growth.
The Ml picture, as usual, is more uncertain.

The recent slowing

has been accounted for primarily by a sharp reduction in demand deposit


is difficult to account for a deceleration of demand deposits

of this dimension, and some strengthening in this component over coming
months seems likely, in part reflecting the effects of declines in shortterm rates over the summer in raising compensating balance requirements for

At the same time, with the spread between rates on NOW accounts

and on other savings vehicles still

extremely narrow, the OCD component of

Ml has continued to expand at close to the pace of the spring and summer,
and is expected to moderate only slowly.

On balance, M1 under alternative

B is not expected to slow much further over the near term, expanding over
November and December at about its average pace of the last two months.

Even with the recent moderation of money growth, expansion of all

the aggregates continues to outstrip increases in income by a wide margin,
but velocities do seem to be dropping in the fourth quarter less rapidly
And, we expect this trend toward smaller decreases in ve-

than in the third.

locity to be extended into the first quarter as well.

Of course the Committee's

decision today will have an important effect in the growth of the aggregates
early next year.

At that time, there will be several conflicting forces

affecting money growth.

On the one hand, should interest rates remain near

current levels, the effects of previous rate declines would continue to
wear off, helping to moderate money growth.

On the other, the expansion of

nominal income and spending is expected to pick up early next year.

balance, and recognizing the precarious nature of money predictions extending
as many as 5 months into the future, there would seem to be reasonable odds

that money growth would slow a little further from the fourth quarter, with
the broad aggregates expanding a little below the upper ends of their tentative 1987 ranges and Ml somewhat more slowly than the 14 percent rate
anticipated for 1986.
These expectations are based on essentially unchanged money market
rates over the balance of the year as in alternative B, and into next year
as well.

This pattern is consistent with the staff GNP forecast, which

assumed that rates would remain near current levels over the forecast

Real interest rates, at least in the shorter maturity range seem

to be around 2 percent, given nominal yields on a one-year bill of around
5-3/4 percent and inflation expectations of around 3-3/4 percent.


level of real rates is not high by historic standards, and is considered to
be consistent with a modest expansion in domestic demand, with, as Mr. Prell


reported, much of the boost to GNP arising from the turnaround in the

foreign sector.
Should the Committee choose the reserve conditions of alternative
A, the chances are greater that money growth could accelrate a bit towards
year end and into the first quarter, possibly bringing the aggregates above
the upper ends of their growth cones early in the year; but even this
alternative would not be expected to induce expansion outside the parallel
bands in the first


The effects of such an easing in

markets on long-term rates is difficult to gauge.


The yield curve retains

a significant upward slope, likely reflecting expectations of an emergence
of more rapid inflation, skepticism about the sustainability of the trend
toward smaller budget deficits, and concern about the implications of possible
weakness in the dollar for inflation, monetary policy, and foreign demands
for dollar assets.

The slight flattening of the yield curve that has

occurred recently seems to have been associated with some reduced anxiety
about the dollar, and perhaps about inflation prospects as well.


term rates could work their way lower without much additional encouragement
from monetary policy if

incoming data and market developments induced

further downward revisions in expectations about the economy and price

In these circumstances,

more substantial declines in

rates would be possible if policy were also eased.


In the absence of signs

of weakness though,

easing actions may have only limited near-term effects

on long-term rates,

especially if

the easing put substantial downward

pressure on the dollar.
The tightening conditions of alternative C probably would have a

substantial impact raising bond yields, at least initially. This alternative
might be considered most appropriate if

the outlook for the economy seemed


favorable and there were concerns about the broad aggregates exceeding
their ranges in late 1986 and early 1987, and the implications of continued
rapid money growth for potential price pressures in 1987 and beyond.
In this regard, especially should the Committee choose to keep
reserve conditions unchanged, it might want to consider how to respond
to the possibility of an overshoot in the ranges for the broad aggregates
over the balance of 1986.

While actions taken over November and early

December are unlikely to affect to any appreciable extent the actual growth
of the aggregates for 1986, the Committee might want to be seen as reacting
to such a development, at least if the overage seemed likely to be appreciable and other factors also appeared to support a firming move.

The draft

directive in the bluebook retained the language adopted at the September
meeting regarding the factors to be weighed in making intermeeting adjustments to reserve conditions; this structure may be interpreted as putting
a little more emphasis on growth of the aggregates in making such adjustments
than did the language used over the previous year.