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Prefatory Note The attached document represents the most complete and accurate version available based on original files from the FOMC Secretariat at the Board of Governors of the Federal Reserve System. Please note that some material may have been redacted from this document if that material was received on a confidential basis. Redacted material is indicated by occasional gaps in the text or by gray boxes around non-text content. All redacted passages are exempt from disclosure under applicable provisions of the Freedom of Information Act. Content last modified 02/09/2012. CLASS I FOMC - RESTRICTED CONTROLLED (FR) OCTOBER 19, 2006 MONETARY POLICY ALTERNATIVES PREPARED FOR THE FEDERAL OPEN MARKET COMMITTEE BY THE STAFF OF THE BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Class I FOMC - Restricted Controlled (FR) October 19, 2006 MONETARY POLICY ALTERNATIVES Recent Developments (1) The FOMC’s decision at its September meeting to leave the federal funds rate target unchanged at 5¼ percent was largely anticipated by financial market participants. Similarly, the wording of the accompanying statement roughly matched the market consensus, leaving the expected path of interest rates little changed in response. 1 Over the intermeeting period, investors remained virtually certain that the federal funds rate target would hold steady for the remainder of this year. Expectations for policy further ahead, though, moved as much as 30 basis points lower early in the period in response to a few data releases with a weakish cast. In recent weeks, however, those declines were rolled back in the wake of speeches by FOMC members and the minutes of the September meeting—which were reportedly read as emphasizing the risks to inflation—as well as stronger-than-expected economic data. The market response to these releases was probably heightened by the monetary policy communications. Futures quotes currently indicate that investors expect about 50 basis points of easing during 2007, about what had been anticipated before the September meeting (Chart 1). Respondents to the Desk’s survey of primary dealers also expect the FOMC to ease policy during 2007, although by somewhat less than implied by futures market quotes. Investors became a bit more confident in their expectations about monetary policy in that the implied probability distribution for the federal funds rate from options on Eurodollar futures contracts maturing in about six months narrowed further, with about 20 percent probability The effective federal funds rate averaged near its intended level over the intermeeting period. The Desk purchased $1½ billion of Treasury coupon securities in the market and redeemed $3¾ billion of coupon securities. The volume of outstanding long-term RPs increased by $2 billion. 1 Class I FOMC - Restricted Controlled (FR) Page 2 of 42 Chart 1 Interest Rate Developments Expected Federal Funds Rates* Percent 6.0 Implied Distribution of Federal Funds Rate about Six Months Ahead* Percent 35 Recent: 10/19/2006 Last FOMC: 09/19/2006 October 19, 2006 September 19, 2006 30 5.5 25 20 5.0 15 10 4.5 5 0 4.0 Oct. 2006 Feb. May Aug. 2007 Dec. Apr. Aug. 2008 *Estimates from options on Eurodollar futures contracts, adjusted to estimate expectations for the federal funds rate. *Estimates from federal funds and Eurodollar futures, with an allowance for term premiums and other adjustments. Implied Volatilities Percent 11 220 FOMC Ten-Year Treasury (left scale) Six-Month Eurodollar (right scale) 9 Nominal Treasury Yields* Basis points Daily 4.00 4.25 4.50 4.75 5.00 5.25 5.50 5.75 6.00 6.25 Percent 7 Daily 200 FOMC Ten-Year Two-Year 180 5 160 7 6 4 140 5 3 120 2 100 3 1 80 1 60 Apr. Aug. 2004 Dec. Apr. Aug. 2005 Dec. Apr. Aug. 2006 0 Apr. Aug. 2004 Dec. Apr. Aug. 2005 Dec. Apr. Aug. 2006 *Par yields from a smoothed nominal off-the-run Treasury yield curve. Inflation Compensation* Oil Prices Percent FOMC Daily Next Five Years Five-Year Forward, Five Years Ahead 4.0 $/barrel FOMC Daily Spot WTI Far-Dated Futures 3.5 80 70 60 3.0 50 2.5 40 2.0 30 1.5 Apr. Aug. 2004 Dec. Apr. Aug. 2005 Dec. Apr. Aug. 2006 20 Apr. Aug. 2004 Dec. *Estimates based on smoothed nominal and inflation-indexed Treasury yield curves and adjusted for the indexation-lag (carry) effect. Note: Vertical lines indicate September 19, 2006. Last daily observations are for October 19, 2006. Apr. Aug. 2005 Dec. Apr. Aug. 2006 Class I FOMC - Restricted Controlled (FR) Page 3 of 42 weight now being placed on tightening and 45 percent being placed on easing by then. Forward-looking implied volatilities derived from longer-term interest rate derivatives also remain near historical lows (see box on following page). (2) Yields on nominal and inflation-indexed Treasury coupon securities rose slightly, on net, over the intermeeting period. Inflation compensation for next year declined modestly, likely reflecting a further fall in spot energy prices, but was largely unchanged at longer maturities. Survey data pointed to a decline in household shortterm inflation expectations. Trading conditions in the Treasury securities market remained healthy despite reports of substantial liquidations of short positions in Treasury issues by some large hedge funds (Chart 2). Similarly, the winding down of Amaranth, a hedge fund that posted losses in excess of $6 billion in energy trading and that had positions in several other markets, left no discernible imprint on the functioning of markets. (3) Broad equity indexes rose 4 to 5 percent over the intermeeting period. Investor optimism was reportedly buoyed by a relative paucity of profit warnings ahead of scheduled third-quarter earnings announcements and, in the event, by aggregate earnings news that has thus far outstripped expectations with about onefifth of the S&P 500 firms having reported; analysts’ estimates now suggest that earnings for the third quarter will come in 15 percent above the levels of a year ago. The drop in oil prices may also have supported share values. Equity implied volatilities remain near historical lows. Spreads of investment-grade corporate bond yields over those on comparable Treasury securities held steady, while those on speculative-grade corporate bonds narrowed a little. Corporate credit quality remained solid, with expected and realized bond default rates staying very low. (4) The trade-weighted index of the dollar versus major foreign currencies rose about 1 percent on balance over the intermeeting period, with the gains spread evenly Class I FOMC - Restricted Controlled (FR) Page 4 of 42 Implied volatility, realized volatility, and turning points in monetary policy Measures of interest rate uncertainty have stayed near historical lows during the past few months. For example, implied volatilities derived from options on two- and tenyear swap contracts, shown by the black lines below, remain near lows observed in the past six years. Implied volatility could reflect both expected volatility over the horizon of the option and a premium for volatility risk. Past volatility likely informs investors’ expectations of future volatility, and realized volatilities on two- and ten-year swap rates are still near sample lows after having edged a bit higher over the intermeeting period. The subdued level of realized volatility notwithstanding, some commentators find currently low implied volatilities particularly puzzling given that monetary policy might be at a “turning point,” denoted by the shaded regions below.* However, reduced-form econometric models that include realized volatility and other variables generally indicate that implied volatility is not greater during the periods between easing and tightening cycles. * Historical turning points refer to periods between the last increase (decrease) in the target of a tightening (easing) cycle and the first decrease (increase) in the target of a subsequent easing (tightening) cycle. For the purposes of this analysis, the period after the June 2006 FOMC meeting is presumed to be a turning point, although the results reported here are insensitive to that assumption. Class I FOMC - Restricted Controlled (FR) Page 5 of 42 Chart 2 Asset Market Developments Daily Total Trading Volume in Two-, Five-, and Ten-year Treasury On-the-Run Notes Billions Stock Prices 300 Index(12/31/03=100) FOMC Daily 140 Wilshire 250 130 200 120 150 110 100 100 50 0 Jan. Mar. May 2006 July 90 Sept. Apr. Sept. 2004 Feb. July 2005 Dec. May Oct. 2006 Source. BrokerTec Interdealer Market Data. Total interdealer market volume estimated from ICAP volume and market share. Corporate Earnings Growth Implied Volatilities Percent Quarterly* Q3p 40 Daily 30 Q2 Percent FOMC S&P 500 Nasdaq 20 30 10 20 0 -10 S&P 500 EPS NIPA, economic profits before tax 10 -20 -30 1989 1992 1995 1998 2001 0 2004 Apr. *Change from four quarters earlier. Source. I/B/E/S for S&P 500 EPS. Corporate Bond Spreads* Basis points Apr. Aug. 2005 Percent of Outstandings 6 Daily FOMC Ten-Year BBB (left scale) Five-Year High-Yield (right scale) 240 Dec. Dec. Apr. Aug. 2006 Corporate Default Rates Basis points 280 Aug. 2004 750 Percent of Liabilities 2.5 Monthly Bond Default Rates(left scale)* Expected Year-Ahead Defaults (right scale)** 5 625 4 1.5 500 200 3 1.0 375 160 2.0 2 0.5 250 1 120 0.0 125 0 80 0 Apr. Sept. 2004 Feb. July 2005 Dec. May Oct. 2006 *Measured relative to an estimated off-the-run Treasury yield curve. 1990 1993 1996 1999 2002 2005 *6-month moving average, from Moody’s Investors Service. **Firm-level estimates of default weighted by firm liabilities as a percent of total liabilities, excluding defaulted firms. Source. Moody’s KMV. Note: Vertical lines indicate September 19, 2006. Last daily observations are for October 19, 2006. Class I FOMC - Restricted Controlled (FR) Page 6 of 42 against most currencies (Chart 3).2 Both nominal and real yields on long-term government bonds in foreign industrial countries moved roughly in tandem with those on comparable U.S. securities. Major foreign stock markets also recorded gains similar to those in the United States. On October 5, the European Central Bank raised its main policy rate 25 basis points, the fifth such increase in the present round of tightening. (5) The dollar was down slightly over the intermeeting period against an index of currencies of our other important trading partners, led by declines of 2 and 1 percent against the Brazilian real and the Mexican peso, respectively. Stock prices in most Latin American and Asian markets recorded solid gains over the period. Prices of Thai financial assets dropped after the September 19th coup, but they ended the period higher on balance. More recently, South Korean equity prices fell somewhat on news of the nuclear test in North Korea and have since only partially recovered. (6) Domestic nonfinancial sector debt is estimated to have expanded at an annual rate of 6½ percent in the third quarter, in line with the second-quarter pace, as a pickup in government debt growth was likely offset by a moderation in business and household debt growth (Chart 4). Consumer credit slowed noticeably over the summer, and mortgage debt growth is anticipated to have dropped further in the third quarter, owing largely to an expected further deceleration in house prices. In the business sector, growth in C&I loans weakened substantially in September but was quite strong for the third quarter as a whole. Bank lending to businesses through commercial real estate loans slowed during August and September, a pattern consistent with results from the October Senior Loan Officer Opinion Survey, which indicated a weakening of demand and a tightening of credit standards for such loans. 2 Class I FOMC - Restricted Controlled (FR) Page 7 of 42 Chart 3 International Financial Indicators Ten-Year Government Bond Yields (Nominal) Nominal Trade-Weighted Dollar Indexes Index(12/31/03=100) Daily Broad Major Currencies Other Important Trading Partners 112 6.0 Percent Daily UK (left scale) Germany (left scale) Japan (right scale) 110 5.5 2.5 108 106 5.0 2.0 104 102 3.0 4.5 1.5 100 4.0 98 96 1.0 3.5 94 0.5 3.0 92 90 Jan. May Sept. 2004 Feb. Stock Price Indexes Industrial Countries June Oct. 2005 Feb. June 2006 Oct. Index(12/31/03=100) Daily 2.5 0.0 Jan. May Sept. 2004 Feb. June Oct. 2005 Stock Price Indexes Emerging Market Economies 175 170 Feb. June 2006 Oct. Index(12/31/03=100) Daily 265 250 165 UK (FTSE-350) Euro Area (DJ Euro) Japan (Topix) 160 235 Brazil (Bovespa) Korea (KOSPI) Mexico (Bolsa) 155 220 150 205 145 190 140 135 175 130 160 125 145 120 115 130 110 115 105 100 100 85 95 90 Jan. May Sept. 2004 Feb. June Oct. 2005 Feb. June 2006 Oct. 70 Jan. May Sept. 2004 Feb. Note: Vertical lines indicate September 20, 2006. Last daily observations are for October 19, 2006. June Oct. 2005 Feb. June 2006 Oct. Class I FOMC - Restricted Controlled (FR) Page 8 of 42 Chart 4 Debt and Money Growth of Nonfinancial Debt Growth of Household Debt Percent Percent, s.a.a.r. 21 Quarterly, s.a.a.r. Total _____ Nonfederal __________ 8.9 8.9 Q1 Q2 Q3 Q4 9.3 8.2 9.7 9.6 8.5 9.9 10.5 10.0 Q1 Q2 Q3 9.5 6.4 6.5 9.1 8.3 7.2 2004 18 Consumer Credit 15 12 2005 2006 p 9 Q3p Home Mortgage Q3p 6 3 0 -3 1991 p Projected. 1993 1995 1997 1999 2001 2003 2005 p Projected. Changes in Selected Components of Nonfinancial Business Debt $Billions Net Percentage of Domestic Respondents Tightening Standards for Business Loans Over the Preivous Three Months Percent 50 40 C&I Loans Commercial Paper Bonds 80 C&I loans to large and medium-sized firms Commercial real estate loans Monthly rate 60 30 40 p Sum 20 20 10 0 0 -20 -10 -20 2004 H1 H2 Q1 Q2 -40 Q3 1990 1993 1996 1999 2005 2006 p Preliminary. Note. Commercial paper and C&I loans are seasonally adjusted, bonds are not. Source: Senior Loan Officer Opinion Survey. Growth of M2 M2 Velocity and Opportunity Cost Percent s.a.a.r. 10 8.00 2002 Percent 2005 Velocity 2.3 Quarterly 8 Opportunity Cost* (left axis) 4.00 2.2 Q3p 6 2.1 2.00 4 2.0 2 0 1.00 Q3p Velocity (right axis) 1.9 0.50 -2 1.8 0.25 -4 2004 H1 H2 2005 Q1 Q2 2006 Q3 1993 1995 1997 *Two-quarter moving average. 1999 2001 2003 2005 2007 Class I FOMC - Restricted Controlled (FR) (7) M2 grew modestly in the third quarter, evidencing the lagged effects of prior increases in opportunity costs and slow growth in nominal spending. Strong advances in small time deposits and retail money funds offset a runoff in liquid deposits. The stock of currency was about flat, owing to continuing weak overseas demand for U.S. banknotes. Page 9 of 42 Class I FOMC - Restricted Controlled (FR) Page 10 of 42 Medium-Term Strategies (8) Over the intermeeting period, incoming data on economic activity and inflation were mostly consistent with the staff’s September projection. Accordingly, the latest Greenbook forecast continues to point to below-trend economic growth and gradually ebbing core inflation. As in September, the forecast is predicated on an assumption that the Committee maintains the current stance of policy through mid2008 and then eases slightly. Long-term Treasury yields follow a path similar to that projected in September, that is, rising marginally as investors come to realize that policy is unlikely to be eased next year. Stock prices once again are anticipated to increase at about a 6½ percent annual rate, but from a level that is about 3½ percent higher than anticipated in the previous forecast. The foreign exchange value of the dollar is again assumed to depreciate gradually. Given recent developments in energy markets, oil prices in the near term are assumed to be about $5 per barrel lower than in the September projection, but that difference largely unwinds over the next two years. Against this backdrop, real GDP growth is expected to slow to around a 1½ percent annual rate in the second half of this year, just a touch softer than in the September Greenbook. Thereafter, economic growth picks up gradually to about a 2½ percent pace in 2008, which brings it up to the staff’s estimate of the expansion of potential GDP. The sluggish performance over the next few quarters pushes the unemployment rate up to a little above 5 percent. The flattening out of energy and other commodity prices, combined with an expected deceleration in import prices and slight cooling in product and labor markets, nudges core PCE inflation down from an annual rate of around 2¼ percent in the second half of 2006 to close to 2 percent by the end of the forecast period. Headline PCE inflation is projected to slow to an annual rate of less than 1 percent in the second half of this year, reflecting the recent sharp declines in consumer energy prices, but to rebound to 2.7 percent in 2007 and 2.1 percent in 2008. Class I FOMC - Restricted Controlled (FR) (9) Page 11 of 42 To shed light on the economic outlook and policy strategies at a longer horizon, the FRB/US model was used to construct an illustrative extension of the Greenbook forecast beyond 2008 based on a set of medium-term assumptions together with some judgmental adjustments. Important influences on the inflation outlook include trend multifactor productivity growth of about 1¾ percent per year, approximately flat energy prices, and a pickup in real dollar depreciation to an average rate of 3 percent per year. Based on these assumptions, the unemployment rate would need to be a bit above the staff’s assumed long-run NAIRU of 5 percent to keep the core PCE inflation rate stable. The illustrative extension also assumes that the unified federal budget deficit rises gradually from just under 2 percent of GDP in 2008 to a little over 2½ percent by 2012 and that the assumed pace of dollar depreciation and steady growth abroad are sufficient to stabilize the current account deficit at just below 8 percent of GDP. Further assuming that both term and risk premiums on bonds gradually move back to their historical norms, the real funds rate would need to decline to around 2 percent to keep output expanding along its potential path. (10) The value of the equilibrium real federal funds rate (r*) is subject to substantial uncertainty, which can be seen in the range of different estimates reported in Chart 5. The Greenbook-consistent measure of short-run r*—the value that would close the output gap over the next twelve quarters—has remained around 2½ to 2¾ percent since the June Bluebook, reflecting the relatively small revisions since the start of the summer in the staff’s assessment of the strength of aggregate demand relative to potential output. This judgmental estimate currently lies just above the range of the three model-based measures of short-run r*. Model-based estimates of the medium-run value of r*—the real rate consistent with output at potential at a horizon of about seven years, on the assumption that monetary policy acts to close Class I FOMC - Restricted Controlled (FR) Page 12 of 42 Chart 5 Equilibrium Real Federal Funds Rate Short-Run Estimates with Confidence Intervals Percent 8 Actual real federal funds rate Range of model-based estimates 70 percent confidence interval 90 percent confidence interval Greenbook-consistent measure 7 6 5 4 3 2 1 0 -1 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Short-Run and Medium-Run Measures Current Estimate Previous Bluebook 2.1 2.1 2.7 2.2 2.1 2.7 Short-Run Measures Single-equation model Small structural model Large model (FRB/US) Confidence intervals for three model-based estimates 70 percent confidence interval 90 percent confidence interval Greenbook-consistent measure (0.8 - 3.8( -0.1 - 4.6( 2.8 2.6 2.2 2.2 2.2 2.2 Medium-Run Measures Single-equation model Small structural model Confidence intervals for two model-based estimates 70 percent confidence interval 90 percent confidence interval TIPS-based factor model (1.3 - 3.1( (0.7 - 3.7( 2.1 2.1 2.9 2.9 Memo Actual real federal funds rate Note: Appendix A provides background information regarding the construction of these measures and confidence intervals. -2 Class I FOMC - Restricted Controlled (FR) Page 13 of 42 the output gap over the next several years and keep it closed thereafter—are also close to the value implicit in the illustrative Greenbook extension. (11) Medium-term implications of alternative monetary policy strategies can be assessed using optimal control simulations of the FRB/US model. In these simulations, policymakers and participants in financial markets are assumed to understand fully the forces shaping the economic outlook (as summarized by the extended Greenbook projection), whereas households and firms form their expectations using more limited information. The optimal path of policy balances three stabilization objectives: keeping core PCE inflation close to a specified goal; keeping unemployment close to the long-run NAIRU; and avoiding sharp changes in the nominal federal funds rate. The optimal policy and associated macroeconomic outcomes depend on the level of the inflation goal and the weights assigned to the stabilization objectives; these paths also reflect both the structure of the FRB/US model and the specific assumptions embedded in the extended Greenbook outlook. (12) The first set of simulations, shown in Chart 6, explores the implications of alternative goals for core PCE inflation, assuming that policymakers place equal weights on the three stabilization objectives. With an inflation goal of 2 percent (denoted by the solid lines), the optimal control simulation prescribes a nominal funds rate of about 5¼ percent through the end of next year followed by a gradual decline to about 4¼ percent by the end of the decade. Unemployment remains a bit above the long-run NAIRU of 5 percent and core inflation remains slightly above the 2 percent goal through 2012, reflecting the balancing of the inflation and employment objectives in an environment in which steady dollar depreciation is generating persistent upward pressure on domestic inflation. With an inflation goal of 1½ percent (the dashed lines), the optimal policy prescribes a funds rate path that rises to nearly 6 percent next year before declining to about 3½ percent by 2012. In this case, the unemployment rate peaks at about 5½ percent later this decade while Class I FOMC - Restricted Controlled (FR) Page 14 of 42 Chart 6 Alternative Long-Run Inflation Objectives Federal Funds Rate 2 Percent Objective 1½ Percent Objective 2006 2007 2008 2009 2010 Five-Year Real Interest Rate Percent 7.0 2011 2012 Percent 5.0 6.5 4.5 6.0 4.0 5.5 3.5 5.0 3.0 4.5 2.5 4.0 2.0 3.5 1.5 3.0 2006 2007 2008 2009 2010 2011 Civilian Unemployment Rate 2012 1.0 Percent 6.5 6.0 5.5 5.0 4.5 2006 2007 2008 2009 2010 2011 2012 Core PCE Inflation Four-quarter average 4.0 Percent 3.0 2.5 2.0 1.5 2006 2007 2008 2009 2010 2011 2012 1.0 Class I FOMC - Restricted Controlled (FR) Page 15 of 42 core inflation declines gradually towards its goal. The slow pace of disinflation is importantly shaped by the high output costs associated with lowering long-run inflation expectations in FRB/US and by the relative weights that policymakers are assumed to place on their inflation and unemployment objectives. (13) Chart 7 depicts two alternative scenarios that illustrate, for an inflation goal of 1½ percent, how policymaker preferences and the costs of disinflation influence the policy path in optimal control simulations. In the first scenario (the dashed lines), policymakers place considerably greater relative weight on achieving the inflation objective, rather than placing equal weight on inflation and unemployment stabilization as in the benchmark scenario (the solid lines). With a greater focus on the inflation objective, the optimal funds rate path continues to rise well into 2008 and remains on a track about 50 basis points higher than in the benchmark scenario for several years thereafter. As a result, the unemployment rate rises to nearly 6 percent, helping push core inflation closer to the 1½ percent goal by the end of the decade. The second scenario maintains the baseline assumption that policymakers place equal weights on the three stabilization objectives, but departs from the model’s standard equation for the evolution of long-run inflation expectations; in particular, this scenario posits that unexpectedly tight monetary policy directly induces wage and price setters to mark down their assessment of the policymakers’ inflation goal, thereby diminishing the amount of economic slack needed to reduce actual and expected inflation in the FRB/US model.3 The optimal policy in this case (the dotted More specifically, the learning mechanism assumes that wage and price setters believe that monetary policy is determined by a Taylor rule for which all the parameters are known except the inflation goal. The level of the nominal funds rates therefore provides a signal of the inflation goal that wage and price setters use to update their expectations of long-run inflation—a channel that is absent from the other model simulations in which wage and price setters use only past inflation to update their assessment of long-run inflation. This change in the learning mechanism lowers the sacrifice ratio—the cumulative amount of excess unemployment needed to lower inflation one percentage point—from over 6 in the 3 Class I FOMC - Restricted Controlled (FR) Page 16 of 42 Chart 7 Optimal Policy with a 1½ Percent Inflation Objective Federal Funds Rate Equal weights More weight on inflation With learning 2006 2007 2008 2009 2010 Five-Year Real Interest Rate Percent 7.0 2011 2012 Percent 5.0 6.5 4.5 6.0 4.0 5.5 3.5 5.0 3.0 4.5 2.5 4.0 2.0 3.5 1.5 3.0 2006 2007 2008 2009 2010 2011 Civilian Unemployment Rate 2012 1.0 Percent 6.5 6.0 5.5 5.0 4.5 2006 2007 2008 2009 2010 2011 2012 Core PCE Inflation Four-quarter average 4.0 Percent 3.0 2.5 2.0 1.5 2006 2007 2008 2009 2010 2011 2012 1.0 Class I FOMC - Restricted Controlled (FR) Page 17 of 42 lines) prescribes a near-term rise in the funds rate to about 6¼ percent by mid-2007, with subsequent policy easing as long-term inflation expectations converge to the inflation goal. The more favorable policy tradeoff is readily apparent in this scenario: Core inflation descends more quickly towards the 1½ percent goal even though the unemployment rate is only modestly higher than the long-run NAIRU. (14) These optimal control policies prescribe broadly similar and relatively stable funds rate paths over the next two years, in part because all of the simulations are premised on the same set of assumptions regarding the medium-term outlook. The upper portion of Chart 8 provides some information on the extent of uncertainty about the future course of monetary policy. The left panel depicts confidence intervals for the range of federal funds rate outcomes implied by stochastic simulations of the FRB/US model, assuming that monetary policy is wellcharacterized by an estimated outcome-based rule and that the shocks hitting the economy are typical of the experience over the past two decades. In the absence of any shocks, the outcome-based rule (denoted by the dashed line) prescribes a funds rate path that remains between 5¼ and 5½ percent through mid-2007 and then declines gradually to about 5 percent. The stochastic simulations indicate a 70 percent probability that the prescriptions of the outcome-based rule will fall in the range of 4 to 6½ percent during 2007. By comparison, confidence intervals implied by options prices on federal funds and Eurodollar futures contracts (right panel) point to noticeably less uncertainty in financial markets regarding the prospective path of policy over the next two years. (15) While optimal control analysis necessitates the use of a macroeconomic model such as FRB/US, simple policy rules based on a limited set of variables can serve as benchmarks for monetary policy strategy, and the near-term prescriptions of baseline case to less than 2, comparable to estimates of the sacrifice ratio for the disinflation of the early 1980s. Class I FOMC - Restricted Controlled (FR) Page 18 of 42 Chart 8 The Policy Outlook in an Uncertain Environment Information from Financial Markets FRB/US Model Simulations Percent 9 Estimated outcome-based rule 70 Percent confidence interval 90 Percent confidence interval Estimated forecast-based rule Q4 2006 Q1 Q2 Q3 Q4 2007 2007 Q1 Q2 Percent 9 Expectations from futures contracts 70 Percent confidence interval 90 Percent confidence interval Actual and Greenbook assumption 8 Q3 Q4 8 7 7 6 6 5 5 4 4 3 3 2 Q4 2008 2008 Q1 2006 Q2 Q3 Q4 Q1 2007 2007 Q2 Q3 Q4 2008 2008 Near-Term Prescriptions of Simple Policy Rules 1½ Percent Inflation Objective 2006Q4 2007Q1 Taylor (1993) rule Taylor (1999) rule Taylor (1999) rule with higher r* First-difference rule 4.7 4.7 5.5 5.5 4.8 4.8 5.5 5.7 2 Percent Inflation Objective 2006Q4 2007Q1 4.4 4.5 5.2 5.2 4.5 4.5 5.3 5.2 Memo 2006Q4 2007Q1 Estimated outcome-based rule Estimated forecast-based rule Greenbook assumption Market expectations 5.4 5.3 5.3 5.2 5.5 5.1 5.3 5.2 Note: Appendix B provides background information regarding the specification of each rule and the methodology used in constructing confidence intervals and near-term prescriptions. 2 Class I FOMC - Restricted Controlled (FR) Page 19 of 42 such rules can be obtained without specifying any particular model. As shown in the lower portion of Chart 8, the rules proposed by Taylor (1993, 1999) prescribe a funds rate of about 4½ to 4¾ percent, depending on the inflation objective (either 2 or 1½ percent). A higher funds rate of 5¼ to 5½ percent is prescribed by a variant of the Taylor (1999) rule—introduced in the August Bluebook—that incorporates a value of r* that is 75 basis points higher than in the original rule. Finally, with an inflation objective of 1½ percent, the first-difference rule—whose prescriptions do not depend on the level of the output gap or any particular value of the equilibrium real interest rate—calls for a distinct upward tilt to the path of policy, with the funds rate rising to 5¾ percent by the first quarter of next year; in contrast, with a 2 percent inflation goal, the first-difference rule is consistent with holding the funds rate at its current level. Class I FOMC - Restricted Controlled (FR) Page 20 of 42 Short-Run Policy Alternatives (16) This Bluebook presents three formal policy alternatives for the Committee’s consideration, associated with the draft statements in Table 1. Under Alternatives A and B, the Committee would again leave the stance of monetary policy unchanged at this meeting; Alternative A would indicate that the Committee has no clear view as to the likely future direction of policy, whereas Alternative B would repeat the statement from September that further policy tightening may prove necessary. Under Alternative C, the Committee would increase the target rate 25 basis points at this meeting and continue to stress upside risks to inflation. In all three, the Committee would acknowledge that economic growth appears to have slowed further in the third quarter, but the characterization of growth going forward varies across the alternatives. (17) If the Committee judges that the news since its decision to hold the funds target unchanged in September has not significantly altered the outlook for inflation and activity, it might be attracted to Alternative B. A combination of below-trend growth and an edging lower in core inflation, as in the staff forecast, may be viewed as the best attainable outcome. With the real federal funds rate around the upper end of the range of model-based estimates of its equilibrium value as noted earlier, the Committee might judge the current stance of policy as broadly consistent with achieving this result. Moreover, from a risk-management perspective, modest policy restraint may be viewed as appropriately weighing the competing risks to inflation and economic growth. The possibility that inflation expectations could begin to drift higher and the tightness of the labor market, as evidenced by data on labor compensation and reports of difficulties in filing certain positions, may both be viewed as pointing to upside risks to costs and prices in the Greenbook projection. Despite those upside inflation risks, the Committee may want to refrain from tightening in light of the downside risks to economic growth, including the possibility Class I FOMC - Restricted Controlled (FR) Page 21 of 42 Table 1: Alternative Language for the October FOMC Announcement September FOMC Policy Decision Rationale Assessment of Risk Alternative A Alternative B 1. The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5¼ percent. 2. The moderation in economic growth appears to be continuing, partly reflecting a cooling of the housing market. The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5¼ percent. The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5¼ percent. Economic growth appears to have slowed further in the third quarter, partly reflecting a cooling of the housing market. Although there is a risk that the slowdown in economic growth may become more pronounced, the economy seems likely to expand at a moderate pace. Economic growth appears to have slowed further in the third quarter, partly reflecting a cooling of the housing market. Going forward, the economy seems likely to expand at a moderate pace. 3. Readings on core inflation have been elevated, and the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures. However, inflation pressures seem likely to moderate over time, reflecting reduced impetus from energy prices, contained inflation expectations, and the cumulative effects of monetary policy actions and other factors restraining aggregate demand. 4. Nonetheless, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. Readings on core inflation have been elevated, and the high level of resource utilization has the potential to sustain inflation pressures. However, inflation pressures seem likely to moderate over time, reflecting reduced impetus from energy prices, contained inflation expectations, and the cumulative effects of monetary policy actions and other factors restraining aggregate demand. In these circumstances, future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. [Unchanged] [Unchanged] Alternative C The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 5½ percent. Economic growth appears to have slowed further in the third quarter, partly reflecting a cooling of the housing market. Going forward, the economy seems likely to expand at a moderate pace. Readings on core inflation have been elevated and the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures. Inflation pressures seem likely to moderate over time, but the extent and speed of that moderation is uncertain. In these circumstances, the Committee believed that an additional firming of policy was appropriate to bolster progress towards achieving price stability. Although the Committee both seeks and expects a gradual reduction in inflation, it continues to view the risks to that outcome as remaining to the upside. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. Class I FOMC - Restricted Controlled (FR) Page 22 of 42 that the housing market could continue to deteriorate. Holding the federal funds rate unchanged would permit additional information bearing on the prospects for growth and inflation to accumulate before making a move in either direction. (18) With little news since the September FOMC meeting, the Committee could essentially repeat its previous statement, but acknowledge softness in the economy in the third quarter. If the Committee wished to include an explicit assessment of the prospects for growth, it could also include an additional sentence in row 2 noting that “Going forward, the economy seems likely to expand at a moderate pace.” (19) Money market futures and options indicate that investors remain confident that the Committee will maintain the federal funds rate at 5¼ percent at this meeting. Moreover, the Desk’s survey of primary dealers indicates that the accompanying statement is expected to replicate broadly the September announcement. The release of a statement along the lines of alternative B, therefore, would not prove a surprise, and the market reaction would likely be limited. (20) In recent statements, the risk assessment has pointed to upside risks to inflation and the possible need to firm policy further. However, market participants appear to attach greater likelihood to policy easing than tightening. To protest that view and to underscore its commitment to reduce inflation, the Committee might choose to modify its words to note that “Although the Committee both seeks and expects a gradual reduction in inflation, it continues to view the risks to that outcome as remaining to the upside.” The variation in wording might also be seen as having the advantage of eliminating repetition, which in the past has led to market participants viewing certain phrases as heavily freighted with meaning. If modifying the statement along these lines was successful in increasing investors’ perception of the upside risks to inflation, near-term policy expectations might back up somewhat and short-term Treasury yields rise. In this case, the value of the dollar on foreign exchange markets would likely edge higher, and stock prices could fall. Class I FOMC - Restricted Controlled (FR) (21) Page 23 of 42 In contrast, the Committee might now be more concerned about the downside risks to growth, perhaps in part as a result of the sharp slowing estimated for the third quarter. If so, Alternative A might find some support. In this alternative, the stance of policy would be maintained at this meeting, and the statement would indicate that the outlook was such that the Committee did not have a clear view as to the likely future direction of policy. The Committee might judge that there is a material probability that growth could prove weaker than in the staff forecast, perhaps reflecting a more pronounced housing market adjustment with more extensive effects on the rest of the economy, along the lines of the “Housing correction with spillovers” scenario described in the Greenbook. Moreover, if the Committee, like the staff, saw only sluggish near-term growth in activity and employment, it might be concerned that any additional adverse shocks to demand could have a disproportionate impact on the economy. Maintaining the federal funds rate at 5¼ percent for some time would be broadly consistent with the Committee’s past behavior as captured in the estimated policy rules presented earlier. Further, as noted in the medium-term policy strategies, the optimal policy path associated with pursuit of a 2 percent inflation objective has the federal funds rate remaining near current levels for the next year or so, before moving gradually lower thereafter. (22) In order to point out the downside risks to growth, the statement accompanying Alternative A could note that “there is a risk that the slowdown in economic growth may become more pronounced.” To simplify the statement, the Committee might want to remove from the discussion of inflation the reference to the high levels “of the prices of energy and other commodities.” Indeed, the Committee might see some merit in this simplification for the other alternatives as well. Given the competing risks to inflation and growth, the risk assessment might simply state that “In these circumstances, future policy adjustments will depend on Class I FOMC - Restricted Controlled (FR) Page 24 of 42 the evolution of the outlook for inflation and economic growth, as implied by incoming information.” (23) Although market participants expect the current target for the federal funds rate to be maintained at this meeting, they do not expect a statement that explicitly identifies risks to growth as well as to inflation and suggests the Committee is no longer predisposed towards policy firming. Market participants are likely to interpret such a statement as implying that the Committee might ease rates sooner than they had previously thought—and perhaps by even more than the half point reduction already built in for 2007. As a result, near-term policy expectations would probably move lower and shorter-term Treasury yields decline. The value of the dollar on foreign exchange markets would likely edge lower and stock prices rally. The implications for long-term yields would depend on whether the statement caused investors to adjust their views about the Committee’s longer-term inflation intentions or the appropriate path for the real interest rate. (24) If the Committee expected higher inflation than the staff, or if it thought the Greenbook forecast was broadly plausible but viewed inflation as remaining unacceptably high, it might wish to raise the target federal funds rate to 5½ percent at this meeting, as in Alternative C. This alternative might be favored if the factors underlying the increase in core inflation in the first half of this year were viewed as likely to be more persistent than envisaged in the staff’s projection, perhaps reflecting an increase in inflation expectations as illustrated in the “Higher expected inflation” simulation presented in the Greenbook. In that regard, the Committee may be concerned that the current level of inflation expectations is already somewhat higher than the objectives cited by a number of policymakers. (The box on the following page discusses various measures of inflation expectations.) Even if the Committee shares the staff’s view that inflation is likely to decline gradually over the forecast, it may view the pace of that decline, in which core PCE inflation is projected to remain Class I FOMC - Restricted Controlled (FR) Page 25 of 42 Estimates of inflation expectations fall The level of inflation expectations is a key factor affecting monetary policy. Estimates of such expectations can potentially be gleaned from surveys and financial asset prices. But given various technical and measurement issues, these indicators do not typically provide a clean read of investors’ expectations of core inflation. The difference between yields on nominal Treasury securities and those on TIPS contains information about investors’ inflation expectations. However, a number of adjustments are necessary to translate the raw spread between nominal and real yields into an estimate of core PCE inflation expectations: • First, the raw spread includes a liquidity premium. Although the liquidity premium in TIPS is estimated to have declined notably over time, and by some recent calculations now stands very close to zero, this issue somewhat complicates any reading of inflation expectations. • Second, TIPS compensate investors for inflation with a two-and-a-half month lag, and hence raw prices partially reflect inflation that has already occurred. Adjustments for these “carry effects” are straightforward but imprecise. • Third, TIPS payments are based on the non-seasonally-adjusted headline CPI, not the core PCE. The staff’s forecasts of these two series can be used to translate between price indexes under the assumption that financial markets have a similar assessment. • Fourth, the raw spread includes an inflation risk premium. To separate inflation risk premiums from expected inflation, Board staff employs a number of methods based on affine term structure models that are necessarily model dependent. After considering these adjustments and based on the most recently observed differences between yields on nominal Treasury securities and TIPS, the staff’s point estimates of expected core PCE inflation from the very near term to ten years ahead vary between about 2.0 and 2.4 percent. However, the caveats associated with these adjustments suggest substantial confidence intervals around these point estimates. The Desk’s recent survey includes primary dealers’ forecasts of quarterly core PCE price inflation from the current quarter through the first quarter of 2008, and the average projection across that horizon also ranged from about 2.0 percent to 2.4 percent. The monthly Michigan Survey does not refer to a specific price index, but regressions can be used to infer anticipated core PCE inflation from the survey responses. The most recent reading of 2.9 percent over the next twelve months implies expected core PCE inflation of approximately 2.6 percent over the same period. Unfortunately, limited data preclude a similar mapping for longer-run expectations. Finally, assuming the staff’s presumed discrepancy between headline CPI and core PCE, inflation expectations for 2007 and over the next ten years from the August Survey of Professional Forecasters are about 2.4 and 2.1 percent, respectively. Class I FOMC - Restricted Controlled (FR) Page 26 of 42 above 2 percent beyond 2008, as unacceptably slow. In the medium-term strategies presented earlier, for example, bringing inflation below 2 percent in the next few years involves raising the federal funds rate to about 6 percent over the next several quarters. (25) In the statement accompanying Alternative C, the discussion of growth could be identical to that proposed for Alternative B. However, in the second half of the inflation paragraph, rather than listing the various factors contributing to the expected moderation in inflation, the Committee could posit that “Inflation pressures seem likely to moderate over time, but the extent and speed of that moderation is uncertain.” The discussion of inflation could conclude by stating that “In these circumstances, the Committee believed that an additional firming of policy was appropriate to bolster progress towards achieving price stability.” If, despite the firming in policy, the Committee continued to be predominantly concerned with inflation risks, it presumably would want to leave the risk assessment tilted as was proposed for Alternative B. However, that sentiment could perhaps be conveyed more strongly to market participants by adopting the language in paragraph 20 earlier in this Bluebook noting that the Committee “both seeks and expects a gradual reduction in inflation.” (26) The tightening of policy envisaged under Alternative C would catch market participants unawares. Investors would revise up sharply their expectations for the path of policy over the next year or so. Short- and medium-term nominal and real rates would rise markedly. Nominal long-term yields would probably decline if market participants concluded that the FOMC was seeking a steeper decline in inflation or had a lower objective for inflation than they previously thought. With real rates higher, the foreign exchange value of the dollar would likely rise, and equity prices would probably decline, perhaps sharply. Class I FOMC - Restricted Controlled (FR) Page 27 of 42 Money and Debt Forecasts (27) Under the Greenbook forecast, M2 is projected to expand at around a 4 percent annual rate in the second half of 2006, reflecting moderate growth in nominal income and the restraining effects of past policy tightening. However, as opportunity costs gradually decline given the assumed path of the federal funds rate, M2 growth picks up to around a 5 percent annual rate in 2007 and 2008. (28) Growth of domestic nonfinancial sector debt is expected to slow to an annual rate of around 6¼ percent on average over the forecast horizon, down from growth of 9½ percent in 2005. The growth of home mortgage debt is expected to step down considerably, reflecting both a deceleration in house prices and declining residential investment. Business debt growth remains moderate over the forecast period, as profits flatten out and firms draw on their accumulated cash to finance growing investment spending. With the budget deficit projected to widen some over the next two years, federal government debt is forecast to expand 6 percent in 2007 and 2008, up from the 4½ percent increase expected in 2006. Class I FOMC - Restricted Controlled (FR) Page 28 of 42 Table 2 M2 Growth Under Alternative Policy Paths No Change 25 bp Tightening Greenbook Forecast* Money Growth Rates Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 5.5 3.5 4.8 10.8 4.0 3.0 3.2 1.0 5.2 3.7 4.2 2.7 6.2 3.7 3.7 4.0 4.3 4.6 5.5 3.5 4.8 10.8 4.0 3.0 3.2 1.0 5.2 3.7 4.2 2.7 6.2 3.3 2.9 3.2 3.6 4.1 5.5 3.5 4.8 10.8 4.0 3.0 3.2 1.0 5.2 3.7 4.2 2.7 6.2 3.7 3.7 4.0 4.3 4.6 Quarterly Growth Rates 2006 Q1 2006 Q2 2006 Q3 2006 Q4 2007 Q1 2007 Q2 6.3 3.0 3.8 4.4 4.0 4.8 6.3 3.0 3.8 4.2 3.3 4.3 6.3 3.0 3.8 4.4 4.0 4.8 Annual Growth Rates 2005 2006 2007 2008 4.0 4.4 4.8 5.1 4.0 4.4 4.5 5.1 4.0 4.4 4.8 5.3 Growth From Oct-06 To Mar-07 4.1 3.4 4.1 2005 Q4 2006 Q3 4.4 4.4 4.4 * This forecast is consistent with nominal GDP and interest rates in the Greenbook forecast. Class I FOMC - Restricted Controlled (FR) Page 29 of 42 Directive and Balance of Risks Statement (29) Draft language for the directive and draft risk assessments identical to those presented in Table 1 are provided below. Directive Wording The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining/INCREASING/REDUCING the federal funds rate at/TO an average of around ________ 5¼ percent. Risk Assessments A. In these circumstances, future policy adjustments will depend on the evolution of the outlook for inflation and economic growth, as implied by incoming information. B. Nonetheless, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. C. Although the Committee both seeks and expects a gradual reduction in inflation, it continues to view the risks to that outcome as remaining to the upside. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. Class I FOMC - Restricted Controlled (FR) Page 30 of 42 Appendix A: Measures of the Equilibrium Real Rate The equilibrium real rate is the real federal funds rate that, if maintained, would be projected to return output to its potential level over time. The short-run equilibrium rate is defined as the rate that would close the output gap in twelve quarters given the corresponding model’s projection of the economy. The medium-run concept is the value of the real federal funds rate projected to keep output at potential in seven years, under the assumption that monetary policy acts to bring actual and potential output into line in the short run and then keeps them equal thereafter. The TIPS-based factor model measure provides an estimate of market expectations for the real federal funds rate seven years ahead. The actual real federal funds rate is constructed as the difference between the nominal rate and realized inflation, where the nominal rate is measured as the quarterly average of the observed federal funds rate, and realized inflation is given by the log difference between the staff’s estimate of the core PCE price index and its lagged value four quarters earlier. For the current quarter, the nominal rate is specified as the target federal funds rate on the Bluebook publication date. Confidence intervals reflect uncertainties about model specification, coefficients, and the level of potential output. The final column of the table indicates the values for the current quarter based on the estimation for the previous Bluebook, except that the TIPS-based measure and the actual real funds rate are the values published in the previous Bluebook. Measure Description Single-equation Model The measure of the equilibrium real rate in the single-equation model is based on an estimated aggregate-demand relationship between the current value of the output gap and its lagged values as well as the lagged values of the real federal funds rate. Small Structural The small-scale model of the economy consists of equations for five variables: the output gap, the equity premium, the federal budget surplus, the trend growth rate of output, and Model the real bond yield. Large Model (FRB/US) Estimates of the equilibrium real rate using FRB/US—the staff’s large-scale econometric model of the U.S. economy—depend on a very broad array of economic factors, some of which take the form of projected values of the model’s exogenous variables. Greenbookconsistent The FRB/US model is used in conjunction with an extended version of the Greenbook forecast to derive a Greenbook-consistent measure. FRB/US is first add-factored so that its simulation matches the extended Greenbook forecast, and then a second simulation is run off this baseline to determine the value of the real federal funds rate that closes the output gap. TIPS-based Factor Model Yields on TIPS (Treasury Inflation-Protected Securities) reflect investors’ expectations of the future path of real interest rates, but also include term and liquidity premiums. The TIPS-based measure of the equilibrium real rate is constructed using the seven-year-ahead instantaneous real forward rate derived from TIPS yields as of the Bluebook publication date. This forward rate is adjusted to remove estimates of the term and liquidity premiums based on a three-factor arbitrage-free term-structure model applied to TIPS yields, nominal yields, and inflation. Because TIPS indexation is based on the total CPI, this measure is also adjusted for the medium-term difference—projected at 40 basis points—between total CPI inflation and core PCE inflation. Class I FOMC - Restricted Controlled (FR) Page 31 of 42 Appendix B: Analysis of Policy Paths and Confidence Intervals Rule Specifications: For the following rules, it denotes the federal funds rate for quarter t, while the explanatory variables include the staff’s projection of trailing four-quarter core PCE inflation (πt), inflation two and three quarters ahead (πt+2|t and πt+3|t), the output gap in the current period and one quarter ahead ( yt − yt* and yt +1|t − yt*+1|t ), and the three-quarter-ahead forecast of annual average GDP growth relative to potential ( Δ 4 yt +3|t − Δ 4 yt*+3|t ), and π * denotes an assumed value of policymakers’ long-run inflation objective. The outcome-based and forecast-based rules were estimated using realtime data over the sample 1988:1-2005:4; each specification was chosen using the Bayesian information criterion. Each rule incorporates a 75 basis point shift in the intercept, specified as a sequence of 25 basis point increments during the first three quarters of 1998. The first two simple rules were proposed by Taylor (1993, 1999), while the third is a variant of the Taylor (1999) rule—introduced in the August Bluebook—with a higher value of r*. The prescriptions of the first-difference rule do not depend on assumptions regarding r* or the level of the output gap; see Orphanides (2003). Outcome-based rule it = 1.17it-1–0.37it-2+0.20[1.04 + 1.76 πt + 3.32( yt − yt* ) – 2.37( yt −1 − yt*−1 )] Forecast-based rule it = 1.16it-1–0.36it-2+0.20[0.89+ 1.74 πt+2|t+2.32( yt +1|t − yt*+1|t )–1.40( yt −1 − yt*−1 )] Taylor (1993) rule it = 2 + πt + 0.5(πt – π * ) + 0.5( yt − yt* ) Taylor (1999) rule it = 2 + πt + 0.5(πt – π * ) + ( yt − yt* ) Taylor (1999) rule with higher r* it = 2.75 + πt + 0.5(πt – π * ) + ( yt − yt* ) First-difference rule it = it-1 + 0.5(πt+3|t – π * ) + 0.5( Δ 4 yt +3|t − Δ 4 yt*+3|t ) FRB/US Model Simulations: Prescriptions from the two empirical rules are computed using dynamic simulations of the FRB/US model, implemented as though the rule is followed starting at this FOMC meeting. This quarter’s prescription is a weighted average of the actual value of the federal funds rate thus far this quarter and the value obtained from the FRB/US model simulations using the timing of this meeting within the quarter to determine the weights. Confidence intervals are based on stochastic simulations of the FRB/US model with shocks drawn from the estimated residuals over 1986-2004. Information from Financial Markets: The expected funds rate path is based on federal funds and Eurodollar futures quotes. The confidence intervals for this path are obtained from prices of at-the-money options contracts that are traded on the Chicago Mercantile Exchange. Near-Term Prescriptions of Simple Policy Rules: These prescriptions are calculated using Greenbook projections for inflation and the output gap. The first-difference rule’s one-quarter-ahead prescription is computed using that rule’s prescription for the current quarter. References: Taylor, John B. (1993) “Discretion versus policy rules in practice,” Carnegie-Rochester Conference Series on Public Policy, vol. 39 (December), pp. 195-214. ————— (1999). “A Historical Analysis of Monetary Policy Rules,” in John B. Taylor, ed., Monetary Policy Rules. The University of Chicago Press, pp. 319-341. Orphanides, Athanasios (2003). “Historical Monetary Policy Analysis and the Taylor Rule,” Journal of Monetary Economics, vol. 50 (July), pp. 983-1022. Appendix C Table 1 Class I FOMC - Restricted Controlled (FR) Page 32 of 42 Selected Interest Rates (Percent) Short-term Treasury bills secondary market Federal funds 1 Long-term CDs secondary market Comm. paper Off-the-run Treasury yields Indexed yields Moody’s Baa Municipal Bond Buyer Conventional home mortgages primary market 4-week 3-month 6-month 3-month 1-month 2-year 5-year 10-year 20-year 5-year 10-year Fixed-rate ARM 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 05 -- High -- Low 4.30 2.19 4.01 1.86 4.08 2.31 4.37 2.63 4.49 2.50 4.30 2.24 4.52 3.11 4.59 3.58 4.79 3.97 5.04 4.28 2.11 0.98 2.22 1.50 6.48 5.64 5.24 4.72 6.37 5.53 5.22 4.10 06 -- High -- Low Monthly Oct 05 Nov 05 Dec 05 5.34 4.22 5.20 3.91 5.13 4.17 5.33 4.37 5.50 4.50 5.30 4.22 5.32 4.34 5.20 4.28 5.32 4.42 5.45 4.59 2.60 1.82 2.68 1.94 6.94 6.17 5.31 4.76 6.80 6.10 5.83 5.15 3.78 4.00 4.16 3.49 3.91 3.67 3.79 3.97 3.98 4.13 4.30 4.33 4.13 4.31 4.45 3.84 4.01 4.23 4.31 4.44 4.43 4.34 4.46 4.39 4.56 4.66 4.57 4.77 4.85 4.76 1.69 1.96 2.07 1.94 2.09 2.15 6.30 6.39 6.32 5.13 5.22 5.18 6.07 6.33 6.27 4.86 5.14 5.17 Jan Feb Mar Apr May Jun Jul Aug Sep Weekly Aug Aug Sep Sep Sep Sep Sep Oct Oct Oct Daily Oct Oct Oct Oct Oct Oct Oct Oct Oct Oct Oct Oct Oct 4.29 4.49 4.59 4.79 4.94 4.99 5.24 5.25 5.25 4.10 4.38 4.55 4.60 4.69 4.71 4.89 5.17 4.76 4.34 4.54 4.63 4.72 4.84 4.92 5.08 5.09 4.93 4.47 4.69 4.79 4.90 5.01 5.18 5.27 5.17 5.08 4.56 4.72 4.88 5.03 5.15 5.35 5.46 5.38 5.34 4.36 4.47 4.61 4.80 4.95 5.12 5.24 5.22 5.21 4.42 4.69 4.77 4.92 5.00 5.15 5.15 4.93 4.78 4.35 4.60 4.72 4.90 4.98 5.04 5.02 4.79 4.64 4.50 4.66 4.82 5.07 5.19 5.18 5.15 4.94 4.80 4.67 4.75 4.93 5.24 5.36 5.30 5.26 5.09 4.94 1.92 1.97 2.08 2.25 2.26 2.41 2.43 2.24 2.35 2.03 2.06 2.21 2.41 2.45 2.54 2.52 2.32 2.35 6.24 6.27 6.41 6.68 6.75 6.78 6.76 6.59 6.43 5.11 5.12 5.10 5.19 5.24 5.24 5.21 4.98 4.82 6.15 6.25 6.32 6.51 6.60 6.68 6.76 6.52 6.40 5.17 5.34 5.42 5.62 5.63 5.71 5.79 5.64 5.56 06 06 06 06 06 06 06 06 06 18 25 1 8 15 22 29 6 13 20 06 06 06 06 06 06 06 06 06 06 5.23 5.25 5.26 5.24 5.24 5.24 5.29 5.28 5.24 -- 5.16 5.17 5.15 4.89 4.78 4.72 4.61 4.73 4.88 5.03 5.10 5.10 5.06 4.97 4.93 4.94 4.88 4.92 5.03 5.09 5.19 5.17 5.14 5.12 5.11 5.07 5.01 5.02 5.11 5.15 5.37 5.36 5.35 5.34 5.35 5.34 5.32 5.32 5.33 5.33 5.22 5.21 5.20 5.21 5.20 5.20 5.22 5.19 5.20 5.21 4.95 4.89 4.84 4.82 4.84 4.78 4.69 4.68 4.87 4.87 4.81 4.73 4.70 4.71 4.71 4.63 4.53 4.54 4.72 4.72 4.97 4.88 4.85 4.88 4.87 4.79 4.68 4.70 4.85 4.85 5.12 5.04 4.99 5.02 5.00 4.92 4.82 4.85 5.00 5.00 2.24 2.23 2.27 2.33 2.39 2.40 2.29 2.35 2.51 2.54 2.33 2.27 2.29 2.36 2.39 2.37 2.29 2.33 2.47 2.48 6.61 6.53 6.50 6.52 6.49 6.40 6.32 6.36 6.50 -- 4.97 4.93 4.91 4.88 4.85 4.79 4.77 4.77 4.76 -- 6.52 6.48 6.44 6.47 6.43 6.40 6.31 6.30 6.37 6.36 5.65 5.60 5.59 5.63 5.60 5.54 5.47 5.46 5.56 5.57 3 4 5 6 9 10 11 12 13 16 17 18 19 06 06 06 06 06 06 06 06 06 06 06 06 06 5.25 5.23 5.23 5.22 5.22 5.28 5.25 5.25 5.21 5.28 5.21 5.23 5.24 p 4.70 4.77 4.80 4.74 -4.78 4.90 4.93 4.92 5.00 5.06 5.05 5.02 4.91 4.93 4.94 4.94 -5.00 5.02 5.06 5.05 5.09 5.09 5.09 5.10 5.02 5.00 5.03 5.05 -5.09 5.10 5.13 5.13 5.15 5.15 5.14 5.16 5.33 5.32 5.31 5.33 -5.32 5.32 5.33 5.33 5.32 5.32 5.33 5.33 5.22 5.21 5.20 5.10 -5.21 5.20 5.19 5.20 5.22 5.19 --- 4.68 4.62 4.67 4.76 -4.83 4.87 4.87 4.89 4.88 4.86 4.86 4.88 4.54 4.48 4.53 4.63 -4.69 4.72 4.72 4.74 4.73 4.71 4.70 4.73 4.69 4.65 4.69 4.78 -4.83 4.86 4.85 4.88 4.86 4.85 4.84 4.86 4.84 4.80 4.85 4.93 -4.97 5.00 5.00 5.03 5.01 5.00 4.98 5.00 2.35 2.32 2.34 2.43 -2.48 2.52 2.51 2.54 2.52 2.53 2.56 2.58 2.32 2.30 2.32 2.39 -2.44 2.48 2.48 2.49 2.47 2.48 2.49 2.52 6.34 6.31 6.35 6.43 -6.47 6.51 6.50 6.53 6.50 6.49 6.47 -- -------------- -------------- -------------- NOTE: Weekly data for columns 1 through 13 are week-ending averages. Columns 2 through 4 are on a coupon equivalent basis. Data in column 6 are interpolated from data on certain commercial paper trades settled by the Depository Trust Company. Column 14 is the Bond Buyer revenue index, which is a 1-day quote for Thursday. Column 15 is the average contract rate on new commitments for fixed-rate mortgages (FRMs) with 80 percent loan-to-value ratios at major institutional lenders. Column 16 is the average initial contract rate on new commitments for 1-year, adjustable-rate mortgages (ARMs) at major institutional lenders offering both FRMs and ARMs with the same number of discount points. MFMA p - preliminary data Class I FOMC - Restricted Controlled (FR) Page 33 of 42 Appendix C Table 2 Money Aggregates Seasonally Adjusted Period M2 1 2 Nontransactions Components in M2 3 Annual growth rates (%): Annually (Q4 to Q4) 2003 2004 2005 7.4 5.4 0.3 5.6 5.3 4.0 5.1 5.3 5.1 Quarterly (average) 2005-Q4 2006-Q1 Q2 Q3 p -0.1 2.2 0.9 -4.7 5.0 6.3 3.0 3.8 6.4 7.4 3.5 5.9 Monthly 2005-Sep. Oct. Nov. Dec. -3.8 1.7 0.7 -5.8 5.5 5.5 3.5 4.8 7.9 6.5 4.2 7.6 10.3 -4.1 7.9 1.8 5.5 -19.6 2.6 -2.8 -10.9 10.8 4.0 3.0 3.2 1.0 5.2 3.7 4.2 2.7 10.9 6.1 1.7 3.6 -0.1 11.6 4.0 5.9 6.2 1393.1 1370.4 1373.4 1370.2 1357.8 6787.8 6817.3 6838.6 6862.3 6878.0 5394.7 5447.0 5465.2 5492.0 5520.2 1388.9 1351.0 1345.3 1360.2 6891.0 6860.0 6881.1 6889.5 5502.1 5509.0 5535.8 5529.3 1367.7 1378.6 6903.2 6934.0 5535.5 5555.4 2006-Jan. Feb. Mar. Apr. May June July Aug. Sep. p Levels ($billions): Monthly 2006-May June July Aug. Sep. p Weekly 2006-Sep. Oct. p M1 preliminar y 4 11 18 25 2p 9p Class I FOMC - Restricted Controlled (FR) Page 34 of 42 Appendix C Table 3 Changes in System Holdings of Securities 1 (Millions of dollars, not seasonally adjusted) October 19, 2006 Treasury Bills Treasury Coupons Net Purchases 3 Net Redemptions Net Purchases 2 (-) Change <1 1-5 5-10 Redemptions (-) Over 10 Net Change Federal Net change Agency total Redemptions (-) outright holdings 4 Net RPs 5 ShortTerm 6 LongTerm 7 Net Change 2003 2004 18,150 18,138 ----- 18,150 18,138 6,565 7,994 7,814 17,249 4,107 5,763 220 1,364 ----- 18,706 32,370 10 --- 36,846 50,507 2,223 -2,522 1,036 -331 3,259 -2,853 2005 8,300 --- 8,300 2,894 11,309 3,626 2,007 2,795 17,041 --- 25,341 -2,415 -192 -2,607 2005 QIII 4,743 --- 4,743 1,298 5,025 1,118 90 757 6,774 --- 11,517 964 1,538 2,502 QIV 1,512 --- 1,512 1,596 2,789 800 902 189 5,897 --- 7,410 -1,202 -1,293 -2,496 2006 QI 4,099 --- 4,099 1,200 7,443 1,704 1,219 1,321 10,245 --- 14,345 793 1,839 2,631 QII QIII --1,649 ----- --1,649 1,375 415 6,063 3,323 1,181 548 --228 1,217 3,931 7,402 583 ----- 7,402 2,232 -627 -3,229 -4,413 -839 -5,040 -4,068 2006 Feb Mar 1,308 1,228 ----- 1,308 1,228 1,200 --- 2,498 2,136 25 174 924 90 ----- 4,647 2,400 ----- 5,955 3,628 -396 393 -3,672 -232 -4,068 162 Apr May ----- ----- ----- --1,375 1,096 2,317 --101 ----- --1,217 1,096 2,576 ----- 1,096 2,576 626 -756 -3,995 2,511 -3,368 1,755 Jun Jul --1,649 ----- --1,649 ----- 2,650 549 1,080 --- ----- --3,931 3,730 -3,382 ----- 3,730 -1,733 -2,633 -909 -2,077 110 -4,710 -800 Aug Sep ----- ----- ----- 415 --- 1,454 1,320 --548 --228 ----- 1,869 2,096 ----- 1,869 2,096 -231 -469 548 -2,291 318 -2,761 ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- -6,472 5,587 3,000 --- -3,472 5,587 Aug 9 Aug 16 ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- -3,477 3,052 -3,000 1,000 -6,477 4,052 Aug 23 Aug 30 ----- ----- ----- --415 --1,454 ----- ----- ----- --1,869 ----- --1,869 -5,503 4,592 5,000 --- -503 4,592 Sep 6 Sep 13 ----- ----- ----- ----- --1,320 --548 --228 ----- --2,096 ----- --2,096 2,681 -6,144 -2,000 -2,000 681 -8,144 Sep 20 Sep 27 ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- 1,770 -1,680 -1,000 -2,000 770 -3,680 Oct 4 Oct 11 ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- 4,465 -2,442 -2,000 4,000 2,465 1,558 Oct 18 --- --- --- --- 1,395 33 --- 3,749 -2,321 --- -2,321 -2,913 2,000 -913 2006 Oct 19 --- --- --- --- --- --- --- --- --- --- --- 3,506 --- 3,506 --- --- --- --- 1,395 33 --- 3,749 -2,321 --- -2,321 5,087 2,000 7,087 277.0 129.1 217.2 61.7 489.6 --- 766.7 -21.6 15.0 -6.6 2006 Jul 26 Aug 2 Intermeeting Period Sep 20-Oct 19 Memo: LEVEL (bil. $) Oct 19 1. Change from end-of-period to end-of-period. Excludes changes in compensation for the effects of inflation on the principal of inflation-indexed securities. 2. Outright purchases less outright sales (in market and with foreign accounts). 3. Outright purchases less outright sales (in market and with foreign accounts). Includes short-term notes acquired in exchange for maturing bills. Excludes maturity shifts and rollovers of maturing issues, except the rollover of inflation compensation. 81.6 4. 5. 6. 7. Includes redemptions (-) of Treasury and agency securities. RPs outstanding less reverse RPs. Original maturity of 13 days or less. Original maturity of 14 to 90 days. MRA:SPS Class I FOMC - Restricted Controlled (FR) Page 35 of 42 Appendix C Chart 1 Treasury Yield Curve Spread Between Ten−Year Treasury Yield and Federal Funds Rate Percentage points 4 Quarterly 2 0 + −2 −4 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 + Denotes most recent weekly value. Note. Blue shaded regions denote NBER−dated recessions. Treasury Yield Curve* Percent 6.0 October 19, 2006 September 19, 2006 5.5 5.0 4.5 4.0 3.5 1 3 5 7 10 20 Maturity in Years *Smoothed yield curve estimated from off−the−run Treasury coupon securities. Yields shown are those on notional par Treasury securities with semi−annual coupons. Class I FOMC - Restricted Controlled (FR) Page 36 of 42 Appendix C Chart 2 Dollar Exchange Rate Indexes Nominal Ratio scale March 1973=100 150 Monthly 140 130 120 Major Currencies 110 100 90 + 80 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 + Denotes most recent weekly value. Ratio scale March 1973=100 Real 140 Monthly 130 120 Other Important 110 100 Broad Major Currencies 90 80 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 Note. The major currencies index is the trade−weighted average of currencies of the euro area, Canada, Japan, the U.K., Switzerland, Australia, and Sweden. The other important trading partners index is the trade−weighted average of currencies of 19 other important trading partners. The Broad index is the trade−weighted average of currencies of all important trading partners. Real indexes have been adjusted for relative changes in U.S. and foreign consumer prices. Blue shaded regions denote NBER−dated recessions. Class I FOMC - Restricted Controlled (FR) Page 37 of 42 Appendix C Chart 3 Stock Indexes Nominal Ratio scale 1941−43=10 Ratio 45 2000 Monthly + 40 S&P 500 1500 1000 35 30 500 25 P/E Ratio* 250 20 + 15 125 10 5 0 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 * Based on trailing four−quarter earnings. + Denotes most recent weekly value. Real Ratio scale 1941−43=10 160 140 Monthly 120 + 100 80 60 S&P 500* 40 20 1960 1964 1968 1972 1976 1980 * Deflated by the CPI. + Denotes most recent weekly value. Note. Blue shaded regions denote NBER−dated recessions. 1984 1988 1992 1996 2000 2004 Class I FOMC - Restricted Controlled (FR) Page 38 of 42 Appendix C Chart 4 One−Year Real Interest Rates One−Year Treasury Constant Maturity Yield Less One−Year Inflation Expectations (Michigan Survey)* Percent 8 Monthly 4 + 0 −4 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 * Mean value of respondents. One−Year Treasury Constant Maturity Yield Less One−Year Inflation Expectations (Philadelphia Fed)* Percent 8 Monthly GDP Deflator 4 + + CPI 0 −4 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 * ASA/NBER quarterly survey until 1990:Q1; Philadelphia Federal Reserve Bank Survey of Professional Forecasters thereafter. Median value of respondents. One−Year Treasury Constant Maturity Yield Less Change in the Core CPI from Three Months Prior Percent 8 Monthly 4 + 0 −4 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 + Denotes most recent weekly Treasury constant maturity yield less most recent inflation expectation. Note. Blue shaded regions denote NBER−dated recessions. 2005 Class I FOMC - Restricted Controlled (FR) Page 39 of 42 Appendix C Chart 5 Long−Term Real Interest Rates* Real Ten−Year Treasury Yields Percent 10 Monthly 8 Real rate using Philadelphia Fed Survey 6 Ten−year TIPS yield 4 + + Real rate using Michigan Survey 2 + 0 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 Nominal and Real Corporate Bond Rates Percent 14 Monthly 12 Nominal rate on Moody’s A−rated corporate bonds 10 Real rate using Philadelphia Fed Survey 8 + + Real rate using Michigan Survey 1985 1987 1989 + 1991 1993 1995 1997 1999 2001 2003 2005 * For real rates, measures using the Philadelphia Fed Survey employ the ten−year inflation expectations from the Blue Chip Survey until April 1991 and the Philadelphia Federal Reserve Bank Survey of Professional Forecasters thereafter (median value of respondents). Measures using the Michigan Survey employ the five− to ten−year inflation expectations from that survey (mean value of respondents). + For TIPS and nominal corporate rate, denotes the most recent weekly value. For other real rate series, denotes the most recent weekly nominal yield less the most recent inflation expectation. Note. Blue shaded regions denote NBER−dated recessions. 6 4 2 Class I FOMC - Restricted Controlled (FR) Page 40 of 42 Appendix C Chart 6 Commodity Price Measures Journal of Commerce Index Ratio scale, index (1980=100) 200 180 Weekly 160 140 120 Metals 100 Total 80 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 CRB Spot Industrials Ratio scale, index (1967=100) 450 Weekly 400 350 300 250 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 CRB Futures Ratio scale, index (1967=100) 450 Weekly 400 350 300 250 200 1985 1987 1989 1991 1993 1995 Note. Blue shaded regions denote NBER−dated recessions. 1997 1999 2001 2003 2005 Class I FOMC - Restricted Controlled (FR) Page 41 of 42 Appendix C Chart 7 Growth of M2 Nominal M2 Percent 14 Quarterly 12 10 8 6 4 2 0 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 Real M2 Percent 10 Quarterly 5 0 −5 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 Note. Four−quarter moving average. Blue shaded regions denote NBER−dated recessions. Gray areas denote projection period. Real M2 is deflated by CPI. Class I FOMC - Restricted Controlled (FR) Page 42 of 42 Appendix C Chart 8 Inflation Indicator Based on M2 Price Level Ratio scale 140 Quarterly 120 100 Implicit GDP price deflator (P) 80 Long-run equilibrium price level (P*) 60 40 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 Inflation 1 2007 Percent 12 Quarterly 10 8 6 4 2 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 1. Change in the implicit GDP price deflator over the previous four quarters. Note: P* is defined to equal M2 times V* divided by potential GDP. V*, or long-run velocity, is estimated using average velocity over the 1959:Q1-to-1989:Q4 period and then, after a break, over the interval from 1993:Q1 to the present. For the forecast period, P* is based on the staff M2 forecast and P is simulated using a short-run dynamic model relating P to P*. Blue areas indicate periods in which P* is notably less than P. Gray areas denote the projection period.
@FedFRASER