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APPENDIX Notes for FOMC Meeting October 5, 1982 Sam Y. Cross Mr. Chairman: The dollar has moved sharply higher against the currencies of Europe and Japan since the Committee's last meeting in an environment of increased anxiety -- anxiety over military conflicts and governmental changes in foreign countries, over the deepening world economic recession, and over the sovereign debt problems and widespread liquidity strains that have disturbed financial markets. The dollar now stands almost 5 percent higher in terms of the German mark and more than 7 percent higher in terms of the Swiss franc and the Japanese yen than on August 24, and against many currencies except the mark is at peak levels not seen for years. Interest-rate incentives to invest in dollar assets increased over the period. Most short-term U.S. interest rates backed up some- what while those in the major European centers dropped as central banks eased domestic credit conditions. Also, present market expecta- tions are that dollar interest rates are not likely to decline while those in Germany and other European countries will. More than interest-rate considerations, continuing concern about credit exposures and potential liquidity strains encouraged investors to prefer dollar-denominated assets and bid up the dollar. With so much of the questionable exposure made up of dollar-denominated claims, dollar-based United States institutions as a group were thought to be in -2a better position than others to deal with a liquidity Moreover, the United States was also preferred shortage. as a safe haven at a time of continuing conflicts in the Middle East and elsewhere. At the same time, the dollar benefited from perceptions that the U.S. economy being international trade than some others more immune from the effects of demand. less dependent on is perhaps slumping worldwide In addition, heightened political divisions in several foreign countries over economic policies and, some cases, difficulties in forming workable coalition governments affected exchange market psychology. in particular was caught up The mark in the crosscurrents of political events leading to the replacement of government in by a more conservative one. the Schmidt At first the prospect of more cautious economic policies and more pro-Western foreign policy buoyed the mark. But then the continuing disagreement about ways to contain Germany's rising budget deficit, and the prospect that a new center-right coalition may face serious difficulties in winning a majority at upcoming federal elections next spring provided a more hesitant tone. The EMS has also been strained at times by bouts of heavy selling pressure against the French and Danish currencies, reflecting market doubts that those countries' governments would be able to keep tneir economies' competitiveness from deteriorating further. These -3- pressures have subsided in the last week or so as traders became more convinced that a realignment in not imminent. However, the Scandinavian currencies -- particularly the Swedish krone in the last few days -- have come on offer at times as the market puzzled over the probable implications of the return to power by Olaf Palme's socialist government. Central bank intervention has been a relatively minor factor in the markets during the last six weeks, with dollar sales totaling about $1.5 billion. Sales of dollars by the Japanese and Swedish central banks been the largest, on the order of have each. Total dollar intervention reported by the Japanese thus far in 1982 is Yesterday, however, up after the dollar had been bid in reaction to publication of larger-than-anticipated money supply figures, the central banks of Japan and Germanyboth intervened in their market in an effort to curb the dollar's rise. $20 Then in New York, million of yen and $30 the Desk bought million of marks. The price of gold, which had surged past $500 early September in response to worries problems and Middle East conflicts, below $400, with firm U.S. of in over LDC debt has now fallen to interest rates and the strength the dollar contributing to the decline. Agreement was reached on August 28 for new temporary credit facilities for the Bank of Mexico -4- totaling $1.85 $325 billion -- the Federal Reserve providing million, the U.S. Treasury $600 million, and the Bank for International Settlements $925 million. Mexican central bank has used $263 So far the million on lines -- $46 million on the Federal Reserve these credit swap and $86 million on the Treasury swap line, and $132 million from the BIS credit line -- leaving nearly $1.6 billion still available in the entire facility. The Bank of Mexico also made one drawing on the combined credit facilities of $250.0 million which was repaid partly the same day and the remainder the following day. The earlier $700 million drawing of the Bank of Mexico under its regular swap arrangement with the Federal Reserve will mature on November 4. Negotiations are in progress between Mexico and the IMF looking toward a Fund program, and if agreement is reached, that would be a centerpiece of a Mexican proposal for a more fundamental restructuring of Mexico's public sector debt to the commercial banks expected later this year. Realistically we should expect that a renewal of the Federal Reserve swap will be requested, and at this time I see no reason not to approve a renewal for the normal three months. NOTES FOR FOMC MEETING OCTOBER 5, 1982 PETER D. STERNLIGHT Desk operations since the last meeting were conducted against a background of above-path growth in monetary aggregates and reserves. While this showed through to some extent in an enlarged demand for borrowing and associated reserve pressures, the System's response was tempered in light of evidence of continued sluggishness in the economy and fragile financial markets. Thus to a considerable degree the stronger-than-path money growth was considered acceptable and was accommodated. For the three months from June to September, M1 growth at an 8 percent rate compared with a path rate of 5 percent, while M2 growth at about a 10 percent rate modestly exceeded the 9 percent path. For the first 3-week subperiod, ending September 15, the over-run in reserve demands was small, exceeding path by about $115 million. Nonborrowed reserves were some $65 million below path and borrowing about $180 million above path. An upward adjustment was made in the initial $350 million level of assumed adjustment borrowing to allow for borrowing situations that reflected limited money market access by certain institutions, rather than general pressures on reserve availability. With borrowing averaging about $800 million for the three weeks, including some "special situation" borrowing, Federal funds moved up to trade on average slightly over 10 percent, compared with about 9 percent in the week of August 25. For the second subperiod--the three weeks ending tomorrow--the stronger money growth produced a greater bulge of demand for reserves above path, roughly on the order of $500 million. In line with discussion at a Committee consulta- tion call on September 24, accommodated, in this bulge in demand was partly order to avoid a sharp rise in borrowing and associated reserve and rate pressures that seemed inappropriate in light of information on the economy and financial markets. Reserve paths were drawn in recent weeks with a view to holding seasonal and adjustment borrowing in of $500-600 million. the neighborhood Actual borrowing slightly exceeded these levels, averaging around $600-700 million. Federal funds continued to hover slightly above 10 percent in last two full weeks of September, over 11 percent so far in the but have averaged a bit the current week, partly reflecting pressures associated with the end of the calendar quarter and temporarily very high Treasury balances at Reserve Banks. Federal funds opened today at 10 1/4 percent. As reserves ebbed and flowed from market factors, Desk operations were handled largely through temporary transactions. $773 million, Outright holdings of securities declined about largely reflecting bill run-offs of $400 million and $792 million of bill sales to foreign accounts early in the period, partly offset by $425 million in bill purchases from such accounts later in the interval. There were numerous day-to-day reserve injections through System repurchase agreements or the passing through to the market of customer account repurchase transactions. On two occasions, reserves were withdrawn temporarily by matched sale purchase arrangements in the market. Interest rates showed relatively moderate and mixed changes over the interval, following the sharp declines of the previous intermeeting period. Short-term rates registered a small net back up, responding to the firmer Federal funds rate compared with late August, and a market sense that renewed money growth seemed to preclude further easing of reserve conditions for the time being. The discount rate cut to 10 percent on August 26 was widely anticipated and quickly came to be regarded as the last reduction for a while. Rates on private short-term instruments such as CDs and commercial paper rose by roughly a percentage point or somewhat more, while bills were up more modestly, partly reflecting the preference for quality. Three- and six-month bills were auctioned yesterday at average rates of about 8.10 and 9.23 percent, compared with 7.75 and 8.99 percent just before the last meeting. Meantime, the Treasury raised about $7 1/2 billion in bills over the period. In the intermediate and longer term markets, rates generally tended lower over the period, though with some backing and filling. Underlying sentiment was affected substantially by the continuing evidence of weakness in the economy and fragility in the financial markets--elements that outweighed concern over budget deficits, strengthened money growth or higher short-term rates. The longer markets were also helped by the extent to which shorter rates had dropped earlier in the summer. The Treasury coupon market readily absorbed some $20 million of new issues including a concentrated bloc of 4, 7 and 20-year issues on September 21-23. Over the interval, rates on Treasury coupon issues from 2 years on out declined by some 15-60 basis points. As part of last summer's tax legislation the Treasury got authority to reenter the long bond market, and they did so quite successfully with a $2 3/4 billion sale of 20-year bonds. Corporate and tax-exempt bond yields also declined over the period--about 3/4 percentage point for corporate and more like 1/4 to 1/2 percentage point for tax-exempts, with fairly sizable new issue flows for both sectors. In the corporate market, there was a revival in offerings of longer term issues which had dropped sharply early this year. In appraising the current rate outlook, market participants are following Fed actions closely, seeking a sense of how we may respond to recently strengthened money growth. My impression is that because of continuing dis- appointment in the performance of the real economy and apprehensions about the sturdiness of the financial system, market observers are prepared to be more tolerant of money growth over-runs than might have been the case a month or two ago. As regards Government securities market surveillance, thankfully I have no new casualties to report. Our strengthened surveillance unit is now getting into operation under Ed Geng's direction. As of yesterday, all the primary dealers are supposed to be including accrued interest in their repo calculations with all customers, to be sure they do this. We still earlier casualties, however. bankruptcy is and we'll be checking have some fall-out from The judge in the Lombard-Wall inclined to view repurchase agreements as secured loans rather than purchases and sales transactions and in at least one case he refused to let the party liquidate the securities acquired from Lombard on repo. This type of interpretation could pose a considerable threat to the liquidity of the repurchase agreement market in Treasury issues, possibly causing a number of participants to withdraw from that market rather than risk having their funds tied up. An effort was made in the closing days of the just-adjourned Congressional 6 session to get some relief from this type of ruling but it did not get through--not because it lacked merit but because the bankruptcy legislation to which it was to be attached was side-lined for the time being. We expect to be watching the repo situation in the market closely. James L. Kichline October 5, 1982 FOMC Economic gish of in recent activity in the aggregate and as yet there months, a recovery. The staff now unchanged in the offset by an accumulation of very small somewhat not altered wage than the and price expected of a the continued real the in progress sales forecasting -- essentially but areas in about quarter recovery these final are next forecast was not in GNP was signs fourth forecast slow We slug- convincing a decline for previous of that remained a -- year. have The changed have bringing been down on the the rate inflation. Since the production, and weaker. In another labor large last meeting sales have labor demands. the our has aren't inventories. developments track of with in activity projection as estimates quarter, component significantly, of third expansion less BRIEFING markets The drop initial claims survey have during the rates for been first reached of in nonfarm average workweek in isn't expected hint of the at insurance same this of September, recession and the about a bit in in showed time that Moreover, since averaging or pickup employment manufacturing declined. three weeks a in August surprisingly high, in any as employment, labor markets unemployment earlier the Committee, performed about there survey of mid-August 660,000 above the 1980 the peak - downturn. In the past, 2 initial - claims have been quite as an indicator of developments in behavior weeks is a source in recent the economy, and of output. is consistent with During August the industrial for production ward, decline. while duction of Output of the only production index fell 0.5 defense and space A portion of efforts designed sales. autos, business persistent source better a least of sectors still hold small rise down- but it seems as in to inventories to such as that is nearing an end, sales final can be traced excess stocks -- machinery -- of of strength has been pro- alignment of inventory correction in the aggregate ing at equipment continued the cutbacks in output primary metals, and one-half equipment. to provide a A number of in some further decline in percent, with auto assemblies accounting for about the total their concern. The limited information now available September generally reliable the assum- the staff projec- tion. The rise in final sales in the near term hinges importantly on the behavior of consumers. ter, consumer spending appears than we had August, projected at retail of nearly last meeting of and tenths while a drop 1 percent third quar- to have been appreciably weaker sales excluding autos rose only a couple of a decline the During the in the Committee. In nonconsumption items in auto total retail sales sales. produced For - averaged of the month; annual 6 million units that rate sales August, helped by various ducers, however, - available are for auto sales, September, the only hard data which 3 rate from July and up considerably is Auto pro- incentive programs. sales 20 days for the first generally remain bearish, having once again cut their production schedules. spending during the expansion of in consumer and the lagged effects of the projected short-run consumer spending Clearly, is debatable and we do not have evidence yet of a behavior upturn decided pickup fourth quarter, associated with continued disposable income tax cut. midyear some forecast entails The staff next month or The economic news coming out in spending. two seems the continue negative, which likely to spending attitudes. carries a risk of damping in But our forecast doesn't call for a dramatic upturn in outlays, and given the income prospects the only a small level last projected spending can be attained with in the downward move saving rate from the higher quarter. In the housing sector, a mild recovery has been underlast winter and we way since in housing this starts in summer remained interest rates have according to the next low, led couple although of quarters. recent declines small rise Home sales in mortgage to a stirring of buyer interest, field reports. capital appreciation are projecting a further But those rates are still high, prospects have been damped, and overall the - forecast retains residential a pattern of fixed ther declines cyclical in real qualitative reports spending. turnaround for sizable contraction risks commercial and experienced of The forecast little sectors with for this decline in cycle, small and near-term weakness of the high exchange value of these sectors and outlook for the to a forecast of of this year and a poor cyclical recovery in throughout next the where silver there substantial vests, and further we have in in dollar, the Taking sectors leads the second half 1983. The rate around the forecast 10 percent year. lining in all of this is on the wage-price continues to be considerable progress. slack in labor and well behaved oil prices, progress a the exports in real GNP in have so far. private domestic consistent with an unemployment 10 percent growth abroad. us little change fixed growth the fur- it still seems for outlays we anticipate sluggish economic side real to Although we especially Mexican situation and The of industrial construction sector where government spending, area pointing a decline of a whole. are on the down side, relatively association 1983 as investment For other seems in improvement prospects are rather gloomy, spending during 1982 entails with little the very weak investment with orders, contracts, and that - construction. Business investment 4 in slowing product the markets, Given abundant har- chances of seeing inflation next year are very good. FOMC Briefing S. H. Axilrod October 5, 1982 Mr. Chairman, it is no longer clear--and it has not been so for some time--that the behavior of the aggregates and the behavior of the economy are consonant with what might have been earlier expected, or hoped, for economic activity. One of the prime virtues of a monetary aggregate targetit has been frequently noted, is that adherence to it would reduce the risk that monetary policy would be pro-cyclical. If money growth were kept from falling off significantly in a recession, conventional analysis tells us that interest rates would tend to fall sharply enough to encourage an early resumption of real economic growth. But under current circumstances, there appear to be difficulties with that simple, straightforward analysis-though the analysis, I hasten to add, has enough historical verification behind it that exceptions which may appear to arise have to be judged with considerable care. The chief problem under current circumstances is illustrated by the fact that maintenance of money growth through the recent period has not led to an early economic recovery, but has been accompanied by consistent downward adjustments to estimates of the strength of recovery and by delays in its expected timing. The sustained strength of money growth is illustrated, I believe, by successive annual growth rates over a 3-month period beginning in the last three months of 1981 and going through the summer of this year for M1 of 9, 6-3/4, 2-3/4, and 8 percent; for M2 of 9 to 10 percent in each period; and for M3 of growth rates that rose from about 9 percent to about 11-1/2 percent in the most recent 3 months. At the same time the weakness of the accompanying economy is seen in the decline in velocity of money. Looking at velocity behavior since the beginning of this year, the decline has been particularly sharp for M2 and -2M3--5½ to 6¼ percent at an annual rate--but even M1 velocity has dropped over the past three quarters by about 1½ percent at an annual rate. Of course, interest rates have declined since the fourth quarter of last year, but the declines did not show any substantial downward momentum until the last couple of months. The funds rate and other short-term rates are now about 2 to 3 percentage points below levels in December of last year (and a little further below fourth quarter '81 averages) and long-term rates are down close to 2 percentage points. Assessment of the meaning of rate declines of this magnitude depends in part on how much of a drop in occurred. inflationary expectations one believes has Obviously if the drop in inflation expectations is on the order of 2 points or so since the end of last year (or say 3 points since the fourth quarter on average) no decline in In that case, little real market rates has occurred. progress may have been made in despite relatively substantial money growth, been made in curbing inflation. even less than expected, it stimulating recovery though progress would have Progress in stimulating recovery could be should be added, essential constancy in if real market rates has been accompanied by declining expectations of real rates of return on investment, as may well have been the case recently, given the deepening gloom in the outlook for business spending on plant and equipment. What could be happening in part is that the demand for liquidity may be increasing relative to GNP--and with it not being fully accommodated, short-term interest rates in real terms have remained high. An increase in liquidity demand seemed to have affected M1 in late '81 and early '82, has probably affected M2 and M3 demand throughout the year. be a factor in the recent strong behavior of M1, It and could also although other alternative explanations certainly should not be quickly or entirely rejected--that is, recent growth may be in lagged response to earlier interest rate declines, as our models would suggest (implying also rapid growth in the months ahead), or growth may reflect temporary increases in deposits in response to the tax cut, with these funds perhaps soon to be spent or invested. Liquidity demands have not been manifested only by declines in the velocity of money measures. tional behavior. They have also been reflected in institu- Thrifts have been building up liquid assets rather than taking an aggressive stance toward the mortgage market. And I would not doubt that banksor at least some key banks, have become more cautious in their approach to lending--and less willing or even able to add to short-term indebtedness--in view of the well-known financial problems that have affected them. It is not really possible to foretell how long unusual liquidity demands will last, but so long as they do and to the degree they are not accommodated, short-term interest rates should remain relatively high and economic activity relatively low. Assessing the interaction of liquidity demands and the behavior of various measures of money which have both liquidity and transactions characteristics is difficult enough under the best of circumstances, but it will be made even more difficult when the public can place funds in the new instrument that DIDC is required to authorize to make depository institutions competitive with money market funds. That instrument or instruments--which must be available in early December at the latest but conceivably earlier--will almost certainly play havoc with M at least for a transition period. Thus, even apart from questions about how strong (or weak) an M1 expansion the Committee may wish to tolerate between now and year-end under existing circumstances, M1 will be subject to large shifts of funds, either in or out, depending on the exact characteristics of the instruments authorized by DIDC and their inclusion or exclusion in the definition of Ml. I would suggest that the Committee today would need to come to some judgment about whether there should be somewhat more flexibility than usual in its specification of growth in next three months. the monetary aggregates over the Prospective regulatory changes cast doubt on the use- fulness of a rigid, if any, M1 specification unless we are prepared with "shift adjustments." In that context, the Committee may also want to consider--for an interim period while regulatory changes, liquidity demands, and financial market problems sort themselves out--whether a relatively wide range of tolerance for behavior of the monetary aggregates, might not be in narrow or broad, order and whether credit market conditions and the economic need to assure a stable flow of funds in financial markets under current circumstances should not be given some added weight in setting the near-term policy course.
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