View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.


Notes for FOMC Meeting

November 7, 1984
Sam Y. Cross

The dollar rose steadily for about two weeks after
the Committee's last meeting.

By mid-October it was

approaching the highs against the German mark it had reached
in mid-September before the Bundesbank's highly publicized
intervention operation.

But since then its trend has been

downward and last week that decline accelerated.
The dollar has fallen in the last few weeks as
exchange-market attention turned to the accelerating drop in
U.S. interest rates.

Market participants think recently

published statistics point to further slowing in the U.S.
economy and credit demands, and thus suggest that the

Federal Reserve will find room to accommodate more interest
rate declines in the near future.

Some have speculated that

additional interest rate cuts may follow the U.S. national
elections--including a cut in the Federal Reserve's discount
rate--and that this may extend the dollar's decline
Central bank intervention has been moderate in
quantity since your last meeting, but the operations since
mid-September appear to have imparted a more cautious
attitude of speculators toward taking on long dollar


On October 17, when the dollar/mark rose above

DM 3.15 for the first time since September, the German
Bundesbank again intervened in a highly visible operation.
This operation was much smaller than the one of September-only $60 million--but it prompted a sharp fall at the time
because the market had not expected it, judging the advance
of the dollar this time to be far more orderly.

The U.S.

authorities followed up later that day when the dollar was
again rising, selling $95 million against marks in New York,
split equally between the Treasury and the Federal Reserve.
The Desk's operations did not get much attention in the

But they were seen in the market and reportedly

influenced the attitude of professionals, who saw them as
evidence that both German and U.S. authorities are prepared
to resist a pronounced rise of the dollar.
Market participants expect most foreign officials
to lag behind the U.S. in cutting their own interest

A sole exception is the Bank of England which has

cut its dealing rates by 1/2 percent.

In part, the central

bank interventions since September have countered the
impression that Continental authorities are willing to
accept continuing currency depreciation.

Dealers believe in

particular that the Bundesbank's concern over imported
inflation may have heightened.

A mid-September hike in

German gasoline prices was followed by publication of a jump
in the monthly rate of consumer price inflation for October,
although the year-on-year rate was still quite low.


fact, short-term interest rates have not dropped at all in

Germany or Japan.

Where declines in major foreign centers

have occurred, they lagged well behind those here, and
interest differentials favoring the dollar have thus
narrowed substantially since early September, in some cases
by more than 2 percentage points.
Other Operations
On October 12 the U.S. Treasury Department
concluded a swap agreement with the Central Bank of the
Philippines to provide $45 million through the Exchange
Stabilization Fund, in support of the economic adjustment
program which the Republic of the Philippines had agreed
upon with the management of the International Monetary

The Treasury joined the Bank of Japan and the Bank of

Korea in arrangements that total $80 million--including

$30 million from the Bank of Japan and $5 million from the
Bank of Korea.

Last Friday the Treasury approved the

Philippines' request to draw the entire $45 million,
following confirmation by the Managing Director of the IMF
that he was formally submitting the new standby arrangement
to the Executive Board.

This drawing, and those on the

Japanese and Korean central banks, is for value today and is
to be repaid when the Philippines draws on its standby
arrangement with the IMF or by November 30, whichever is

Mr. Chairman, all of the Federal Reserve System's
regular swap arrangements with foreign central banks and the
BIS will come up for renewal in December.
all the swap arrangements be renewed.

I recommend that

We propose no change

in the terms of the agreements, except for a technical
change to the swap with the Bank of Japan.

That agreement

stipulates that when the Bank of Japan initiates a drawing
the spot exchange rate prevailing one business day before
the value date of the drawing be applicable to the swap.


the beginning of last April, the Tokyo market began trading
dollars against yen for two days' delivery, the same as is
standard in other world markets, rather than for one day
delivery as had been the Tokyo convention until then.

As a

consequence, the Bank of Japan has proposed that the
applicable spot exchange rate on swaps initiated by the Bank
of Japan be the one prevailing two days before the value of
the drawing.
Maturing swap arrangements:
($ millions)
Austrian National Bank


Bank of England


Bank of Japan


Bank of Mexico

12 months





Bank of Norway
Bank of Sweden




Swiss National Bank




($ millions)



12 months


Bank for International
Settlements-Swiss francs
Other authorized European





National Bank of Belgium


National Bank of Denmark



German Federal Bank



Bank of France





Bank of Canada



Bank of Italy



Netherlands Bank


NOVEMBER 7, 1984

During most of the period since the October 2 Committee
meeting, the Desk's nonborrowed reserve objectives continued to
incorporate the $750 million level of adjustment and seasonal
borrowing that was adopted shortly before that meeting.

In striking

contrast to the previous intermeeting period-mid-August to early
October--when money market conditions softened only slightly and
grudgingly despite successive reductions in

the planned borrowing gap

from $1 billion to $750 million, conditions eased appreciably in
recent period.



the Federal funds rate worked down,

irregularly, from around 11 percent or a little over to the
neighborhood of 10 percent or somewhat under.
irregular move,

the rate spent a week in

In the course of that

the vicinity of 9 1/2

percent, and the last couple of days have seen trading in that area
also--or even lower.
and 9 percent.

In fact, today's trading started out at 8 3/4

In the last few days,

our paths have been drawn to

provide for a slight further reduction in
$700 million--a change made in

the borrowing gap--to

recognition of the continuing weakness

evident in M1 growth.
Why the contrast between the two periods?

Of course, we've

never pretended to have our finger on a close reliable fit

between the

intended borrowing gap and the funds rate--although I persist in the
belief that there is a rough relationship lurking somewhere out

In the late August-September period,

the absence of more

"give" in

the funds rate despite the decline in

intended (and actual)

borrowings appeared to reflect continuing cautious bank reserve

including some reluctance,


to use the discount window.

until the final days of
Approaching quarter-end

pressures also tended to keep the funds rate up then.

In the more

recent period, the greater "give" in the funds rate appeared to
reflect somewhat greater willingness

to borrow at the discount window

perhaps more important, the psychological

impact of seeing a

sustained period of weak growth in money and moderation in the


at times,

the day-to-day conduct of Desk reserve

management contributed to the softening in rates as sizable excesses

the early and middle part of the period were withdrawn in a fairly

gradual way,

and most recently reserve needs have been met rather

Even so,

we ended up below the formal nonborrowed reserve

the October 24 reserve period,

as substantial reserve

were carried into that period and a full meeting of the path

would have produced a misleading overabundance of reserves.

As it

the money market ended that reserve period on a very comfortable

note that carried over into the start of the current reserve period.
So far in this period, which ends today, borrowing has averaged about
$700 million and Federal funds roughly 9.85 percent--not too far from
an expected relationship, although that's with the benefit of some
averaging out over the period.
Over most of the period since the last meeting,

the Desk

withdrew reserves released by declines in Treasury balances and

transactions stemming from the Continental-Illinois aid package.
Outright holdings were trimmed by a net of about $1.4 billion,

through $1.3 billion of redemptions,

sales to foreign accounts,

over $600 million of

and some $500 million of bill

purchases from those accounts in the latter part of the interval.


addition to the daily matched-sale purchase transactions with foreign
accounts, matched-sales were used several times in the market to
absorb abundant reserves in generally comfortable money markets.
reserve needs developed in


the final few days of the period,

repurchase agreements were employed both as pass-throughs of customer
transactions and on behalf of the System.
Most market rates declined substantially during the interval,
especially in

the latter


Early in the interval,

note and bond market wavered uncertainly,

the Treasury

pulled one way by the

growing sense of a more accommodative approach toward reserve
availability but pushed the other way by apprehension about the huge
amount of Treasury debt to be sold and concern that the economy's
summer pause might be followed by renewed acceleration in
months of the year.
began to pervail in

By about mid-October,

the closing

the downward rate pressures

the tug-of-war, bolstered by the continuing

evidence of weakness in the money supply, sluggishness in the economy,
and a sense that policy was in

process of responding to these

Dealers and investors began to plow through the mountain of

Treasury offerings, backed up and compressed in

timing because of debt

limit delays, with a fairly good appetite, even bordering on
enthusiasm at times.

Including the 10- and 30-year note and bond

issues to be auctioned today and tomorrow,

the Treasury will have sold

about $43 billion of coupon issues to the public since the last

raising some $27 billion of new money.
Through Monday, rates on Treasury coupon issues were down

about 105 to 115 basis points for issues due within five years and 75
to 95 basis points for longer maturities.
coupon yields to their lows for this year.

This brought the longer
The tail

end of the rate

decline, it should be noted, seems to rest on a presumption that
Federal funds will settle down soon at something like a 9 1/2 percent
level or lower.

I think that there could be some disappointment in

coming days if funds tended to trade around 10 percent or higher.
While most market participants'

near-term outlook,

say through

year-end, is fairly buoyant, there is a considerable divergence of
view about next year.

Some see further rate declines based on

progress against inflation and expected modest economic expansion.
Many others, though, anticipate upward rate pressures as they look for
a little stronger expansion--partly based on current rate
declines--little progress on the budget deficit, and a possible weaker
Particular market attention in the recent period was focused
on the Treasury's first "foreign-targeted" issue, a $1 billion 4-year
offering sold alongside a like maturity of a $6 billion issue open to
either domestic or foreign buyers.

The foreign targeted issue could

be sold only to foreign entities at auction, and traded offshore for
its first 45 days.

Its special appeal is that it offers a degree of

anonymity to the final investors who purchase the issue from the

foreign institutions that buy it
of vigorous Treasury promotion,


the auction.

With the advantage

the foreign targeted issue was

auctioned at a yield some 32 basis points below that of the companion
domestic issue.


Secondary market trading has been light thus far, and

not clear how much of the issue has been placed with final


The spread by which the secondary market yield on the

foreign-targeted issue falls short of the "domestic" issue yield
shrank just after the auction and then widened out again to near the
auction average--but without much indication of really broad-based
investor demand.

The Treasury plans to come with other such issues

before long and several Federal agencies are eager to tap this market
as well.

In fact, FNMA announced a 7-year,

$300 million

foreign-targeted issue yesterday.
Treasury bill yields also fell substantially over the period,
by about 1 1/4 to 1 1/2 percentage points.
Treasury raised a modest $1
In last Monday's auction,

Over the interval,


billion of new money in the bill market.

3- and 6-month bills were sold at average

rates of 8.82 and 9.07 percent,

compared with 10.23 and 10.35 percent

of October 1.
Rates on commercial paper declined nearly as much as Treasury

while CD rates fell about in

line with bills

over the whole

though with some day-to-day variations that led to modest

fluctuations in the spread of CD yields over bills.


those spreads remained fairly narrow for 3 to 6 month maturities,
apparently reflecting a combination of reasonably subdued concern
about bank vulnerability (though some market participants deny this)

and an absence of pressure on large banks to issue in
national market.

size in


In turn, the lessened cost of funds to banks and the

fairly flat demand for loans paved the way for further declines in
posted prime rate from 12 3/4 to 12 percent.
suggest there is

room for further cuts in


Current relationships

the prime rate.

Corporate yields fell somewhat more moderately than those on
Treasury issues,

perhaps because of a greater impact from speculative

buying in the Treasury sector as sentiment shifted to the buoyant

Tax-exempt yields came down only slightly as that market

continued to digest heavy new supplies.

November 7, 1984


At the time of the last Committee meeting, most of the
recent information available on the economy related to the summer months, a very sluggish period.

Since then information for

September and October points to a pickup in activity.

To be

sure, there are conflicting signs on the course of the economy,
we have relatively little data for October, and a good deal of
uncertainty is attached to near-term developments.

But on

balance the staff believes the most likely path of real GNP is
growth of about 3-1/2 percent this quarter and a bit less during

this view is not significantly different from that

presented a month ago.
The labor market reports for September and October
indicated considerable growth of employment while the unemployment rate in each month was 7.4 percent, about the same rate
that has prevailed since the spring.

Nonfarm employment rose

substantially in October and the average monthly increase for
September and October was more than 300,000, not much below the
sizable gains experienced during the first half of the year.
Employment increases were notably large in the trade and services sectors, while manufacturing employment expanded somewhat
in October, partly offsetting the drop in the preceding month.

- 2 -

Industrial output during October is estimated to have
increased only about 1/4 percent following a 0.6 percent decline
in September.

Motor vehicle production in both months was

depressed owing to strikes, but outside the auto sector weakness
in output appears to have been rather widespread.

To some

extent domestic production is being damped by the pervasive
competition from imported products.

It also seems that firms

generally have been undertaking efforts to bring inventories
into better alignment with sales.

During the third quarter all

of the growth in real GNP was attributable to inventory investment as final sales were flat, and those inventories were beginning to look uncomfortably high in a number of areas.

With the

pickup in demands and output curtailments, however, business
adjustments likely are well along assuming that sales will continue to exhibit moderate growth.

The latest hard data on

inventories is for manufacturers in September, and there inventory growth was half that of the preceding few months.

On bal-

ance, the staff forecast has the pace of inventory investment
declining this quarter and not contributing to growth of real
GNP over 1985 as well.
One key area of uncertainty has been--and continues to
be--that of consumer behavior.

In September personal consump-

tion spending rose strongly after the weakness evident in the
previous two months.

For October we only have fragmentary




chain store sales appeared to be on the sluggish

side but we have not been able to relate these sales in a consistent way to more aggregative measures of consumer spending.
Foreign car sales rose substantially in October while domestic
auto sales declined to a 7-1/4 million unit annual rate as supplies of the popular cars continued to be very tight, partly
because of strike effects.

Production of autos is scheduled for

a healthy rise this month and we anticipate sales will improve
as well, with a strong auto market projected into 1985.


consumer spending is expected to rise at a moderate rate,
reflecting continuing expansion of employment and incomes and
positive spending attitudes.
In the residential construction sector, housing starts
and new home sales rose in September after a poor performance in

The declines in mortgage interest rates in recent

months should be supportive of housing activity, although rates
are expected to remain high enough over the forecast period to
limit growth in this sector.

Housing starts are projected to

hover around 1-3/4 million units throughout the forecast which
is a little above the level in the third quarter.
Business fixed investment spending picked up in September with shipments of equipment and construction spending both

Investment spending slowed considerably during the

third quarter as a whole, however, following exceptional



increases over the preceding year.

Our reading of the forward

looking indicators has induced us to reduce a bit projected
outlays over the forecast period, but at a 7-1/2 percent real
increase next year capital spending provides strong support to
overall economic growth.
For price and wage behavior the news generally remains
quite favorable.

We have incorporated a somewhat lower oil

price in this projection reflecting recent developments, but
have assumed that OPEC will be able to constrain production so
as to avoid a major price break.

Food prices have risen less

over the past few months than we had expected, and the forecast
in the near term has been reduced a little.

The aggregate

forecast of both prices and wages shows an increase that is a
couple of tenths lower than in the last projection, and the GNP
deflator is expected to rise 4-1/4 percent next year, about 1/2
percentage point above the rate anticipated for this year.

FOMC Briefing
S.H. Axilrod
November 7, 1984
The recent substantial and unexpected weakness in M1 naturally
raises the question whether it reflects or presages unexpected and
substantial weakness in GNP.

In part the answers depend on how long the

weakness in M1 has lasted, and whether it reflects primarily changes in the
supply of money or a shift in the demand for money.
In the first place, I would argue that any significant weakness
in M1 is of quite recent vintage.

The failure of money to grow in July

and August seems to me to be best viewed as an offset to the rapid growth
of late spring.

Through August, M1 growth was just about at the midpoint

of the 4 to 8 percent long-run range.

However, the weak performance of

M1 in late summer and early fall has brought this aggregate well into the
lower half of the long-run range.
I would take the late summer-early fall behavior as the more
troublesome to interpret.

It will take a bit more time before one can be

reasonably sure that it is part of a disturbingly weak trend.
most recent data being weak.)


But even if there is a rebound of growth

in November and December to around the dimensions of alternative A or B,
over the last four months of the year growth will have been only about 3
to 4 percent at an annual rate-still a fairly marked phase-down from the
about 6 percent growth over the first eight months of the year.
The counterpart of such a phase-down would be the apparent
substantial rise in velocity of M1 that appears in prospect for the fourth

The rise in velocity is close to what we experienced during the

first half of this year, but at that time interest rates were rising,
money was becoming relatively more expensive to hold, and credit and GNP
growth were very strong.

Now rates are going down and money is becoming


less expensive to hold, so there should be more rather than less demand
for it for that reason alone.

Much of that effect occurs with a lag, but

in any event our quarterly model suggests that M1 should grow some 4
percentage points more than we are expecting at an annual rate in the
fourth quarter, given projected GNP and interest rates.
The model, therefore, suggests that there has been a downward
shift for money, evidenced by the willingness of the public to hold less
cash than the model predicts.

One might then feel some confidence in a

judgment that spending will not be adversely affected by recent money
There is of course something to be said for such an analysis
of money demand.

But it carries most conviction when the model has been

consistently overpredicting money for sizable amounts for some period.
It then becomes clearer that something fundamental affecting attitudes
toward cash may be in train.

We have in fact been running with less M1

growth than our quarterly model predicts for four straight quarters now,
but the amounts have been very small.

This quarter would be, on current

assumptions, by far the largest miss yet.

However, it occurs at a time

when there are very few special factors on the demand side that appear to
explain the weakness in M1.


is possible that MMDAs,

which have again

begun growing relatively rapidly, may have displaced NOW accounts as an
outlet for highly liquid savings funds in an environment of falling
interest rates.

But it is difficult to account for more than a few

percentage points of the recent restraint on M1 from such a factor.
The demand for money, given income and interest rates, may have
weakened, but it

is also plausible that a sharp rise in velocity this quarter,

if it occurs, should be interpreted as instead reflecting mainly curtailment


in the supply of money.

In that case, a contemporaneous increase in velocity

can be expected-both for arithmetic reasons and behaviorally in view of
the lags in the system--but after a period of time GNP growth may also be
expected to weaken so as to bring GNP growth more in line with money.
Still, M1 has not proved to be a very reliable predictor of GNP over the
past few years.

Thus, while it is plausible that GNP could be weaker

than we have projected, such a result does not necessarily follow from
the recent behavior of M1.
in other aggregates.

Moreover, we are not seeing confirming weakness

M2 growth over the past two months has held up

remarkably well, averaging close to 7 percent, about the same as earlier
in the year.

And M3 growth has recently picked up again after a lull in

late summer when banks and thrifts held back on issuance of managed

However, the behavior of M1, particularly if not much more

than a moderate rebound is ahead of us, is certainly not inconsistent
with a weaker GNP.
Interpretation of the significance of recent money behavior depends
in part on assessment of interest rate trends--in particular, whether or
to what extent declines in nominal rates also involve drops in real rates.
Such an assessment is particularly difficult at the present time because we
seem to be passing through a period in which inflationary expectations are
in process of change--in this case lowered-partly in response to OPEC's
well-publicized problems in holding up the oil price.

Three-month Treasury

bill and CD rates have dropped about 1-1/2 percentage points since the last
FOMC meeting, and the funds rate by about the same amount.

As a result the

constellation of short market rates is not far from where it was last

With the short-run outlook for inflation probably little different,

real short-term rates have probably also returned to levels of that
period, and are substantially lower than in summer.
However, the story is somewhat more complicated for longer-term

As with nominal short rates, nominal longer-term market rates are

close to, and some cases a little below, last winter's levels, after falling
substantially from early summer peaks.

But in contrast to the probable

stability of the short-term inflation outlook, longer-term inflationary
expectations have probably improved-according to one poll by 1 to 1-1/4
percentage points since last winter.

Thus, real longer-term rates have not

declined as much as nominal rates; real long-term rates are probably now
below their early summer peaks but they may well still be above levels of
last winter.
Whether nominal rates should be even lower in an effort to press
real rates down further depends obviously on assessment of the strength
of demands for goods and services.

When interest rates fall while money

is weak and bank reserves are dropping, one is tempted to conclude that
underlying demands for goods are weak and interest rates could appropriately
fall further.

This argument is not quite foolproof, however, particularly

if credence is given to M2 and M3 behavior as representing monetary policy
or if there is belief that we are experiencing yet another demand shift for
Of the alternatives before you, A would be most appropriate on
the view that underlying demands for goods and services have weakened
significantly or that inflationary expectations will continue to abate.
In that case, the risk of an unduly sharp re-expansion of M1 early next
year from additional money market ease in the weeks ahead would not be
particularly large.

Alternative B, which initially keeps bank reserve


positions about unchanged from recent levels, would be consistent with a
view that the economy may be moving forward satisfactorily after the
summer lull and given the recent declines in rates.

I should note,

however, that under this alternative at least some of the recent rate
declines are likely to be reversed since the market appears to have
anticipated sane further easing of bank reserve positions.