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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) SEPTEMBER 14, 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) September 14, 2006 MONETARY POLICY ALTERNATIVES Recent Developments (1) On the eve of the August FOMC meeting, market participants were confident—but not completely certain—that the Committee would leave the funds rate at 5¼ percent. As a result, the announcement of the decision to put policy on hold after seventeen consecutive firmings pulled policy expectations a few basis points lower (Chart 1).1 Those expectations subsequently fell further in response to softer-than-expected inflation data for July, declines in oil prices, and the minutes of the August FOMC meeting, which were interpreted as underscoring that Committee members generally saw price pressures as likely to abate amid moderating economic growth. Futures quotes indicate that investors generally believe that the target rate will be left unchanged at the September meeting and over the remainder of the year. Further ahead, futures rates now imply about 50 basis points of easing next year and point to a funds rate of about 4½ percent at the end of 2008. Respondents to the Desk’s survey of primary dealers also expect policy easing next year, albeit somewhat less than that apparent in futures prices. In addition, the dealers anticipate little change in the wording of the September FOMC statement. Implied volatilities derived from options on Eurodollars futures contracts that expire over the coming two years remain near the low end of their historical ranges. (2) Yields on two- and five-year nominal Treasury securities fell about 10 basis points over the intermeeting period. By contrast, yields on similarly dated indexed debt rose, leaving near- and intermediate-term TIPS-based inflation compensation The effective federal funds rate averaged near its intended level over the intermeeting period. During the period, the Desk purchased $4 billion of Treasury coupon securities in the market. The volume of outstanding long-term RPs increased by $1 billion, to $13 billion. 1 Class I FOMC - Restricted Controlled (FR) Page 2 of 36 Chart 1 Interest Rate Developments Federal Funds Futures and Slope of Eurodollar Futures Curve Percent 5.5 Percent FOMC CPI -0.30 FOMC Minutes PPI -0.35 Dec 2006 Federal Funds (left scale) 5.4 -0.40 Payrolls 5.3 -0.45 December 2007 - December 2006 Eurodollar (right scale) 5.2 -0.50 -0.55 5.1 -0.60 5.0 -0.65 Aug. 7 Aug. 9 Aug. 14 Aug. 17 Aug. 22 Aug. 25 Aug. 30 Sept. 4 Sept. 7 Sept. 12 *5-minute intervals. Expected Federal Funds Rates* Implied Volatilities Percent Percent 6.0 11 September 14, 2006 August 7, 2006 5.5 Basis points 220 Daily Ten-Year Treasury (left scale) Six-Month Eurodollar (right scale) 9 FOMC 180 160 7 5.0 140 5 4.5 200 120 100 3 80 4.0 Sept. Jan. 2006 May Aug. 2007 Dec. Apr. Aug. 2008 1 60 Apr. Aug. 2004 Dec. Apr. Aug. 2005 Dec. Apr. Aug. 2006 *Estimates from federal funds and Eurodollar futures, with an allowance for term premiums and other adjustments. Nominal Treasury Yields* Inflation Compensation* Percent 7 Daily FOMC Ten-Year Two-Year Percent FOMC Daily Next Five Years Five-Year Forward, Five Years Ahead 6 4.0 3.5 5 4 3.0 3 2.5 2 2.0 1 0 Apr. Aug. 2004 Dec. Apr. Aug. 2005 Dec. Apr. Aug. 2006 *Par yields from a smoothed nominal off-the-run Treasury yield curve. 1.5 Apr. Aug. 2004 Dec. Apr. Aug. 2005 Dec. Apr. Aug. 2006 *Estimates based on smoothed nominal and inflation-indexed Treasury yield curves and adjusted for the indexation-lag (carry) effect. Note: Vertical lines indicate August 7, 2006. Last daily observations are for September 14, 2006. Class I FOMC - Restricted Controlled (FR) Page 3 of 36 considerably lower. The appreciable decline in energy prices—spot oil prices fell by $13 per barrel, on net—and the shortfall of readings on inflation relative to what markets had anticipated apparently led investors to trim their expectations for nearterm inflation, which is evident in the pronounced decline in short-run inflation compensation (see the box “Short-run Inflation Compensation”). Further out the yield curve, one-year nominal and real forward rates ending in ten years were down a little, implying only small changes in inflation compensation at that horizon.2 (3) Against the backdrop of lower oil prices, broad stock price indexes increased about 3 percent, on net, over the intermeeting period (Chart 2). Implied volatility of the S&P 500 declined, and spreads of yields on investment- and speculative-grade bonds over those on comparable-maturity Treasury securities edged down. Corporate risk spreads are narrow by historical standards, consistent with continued solid credit quality and very low expected defaults for the coming year. (4) The trade-weighted index of the dollar versus major foreign currencies rose about ¾ percent on net over the intermeeting period, as modest increases against the euro and sterling and a larger advance relative to the yen were partially offset by a small decline vis-à-vis the Canadian dollar (Chart 3).3 Nominal yields on long-term government securities in industrial countries moved down 10 to 20 basis points over the period, while yields on indexed debt were little changed. As a result, most of the decline in nominal yields was concentrated in the inflation-compensation component, as market participants appear to have revised inflation expectations down in reaction to the recent drop in oil prices. In Japan, softer data on inflation and activity led investors to trim their expectation of policy tightening by the Bank of Japan, and that A discussion of the historical relationship between the slope of the yield curve and economic growth can be found in the box at the end of this section. 2 3 Class I FOMC - Restricted Controlled (FR) Page 4 of 36 Short-Run Inflation Compensation fall The inaugural TIPS issue, which was sold in 1997, will mature in January 2007. The rich schedule of issuance since then provides numerous points along the indexed-debt yield curve at short and intermediate maturities. The amount of interest and principal that will be paid on the TIPS issue maturing in January 2007 will be determined by the average of the CPIs for October and November, making it relatively straightforward to calculate inflation compensation for the twelve months ending that period. More generally, quotes on indexed debt maturing in January in each of the next three years can be matched up with quotes from the nominal yield curve to generate estimates of annual inflation compensation ending in October-November for the next two years as well. The chart below shows that these measures of short-run inflation compensation shifted lower over the intermeeting period. The implied rate for the one-year period ending this autumn fell about 70 basis points to 2.45 percent,* and the rates for similar intervals ending in 2007 and 2008 fell 5 and 15 basis points, respectively, to 2.80 and 2.45 percent. CPI up to July 2006 has been published, and as a result, most of the inflation compensation from October-November 2005 to October-November 2006 is already known. According to the methodology employed here, the unknown portion for that period—that is, the implied monthly average seasonally adjusted inflation compensation between July and November 2006—is 0.06 percentage point. * Class I FOMC - Restricted Controlled (FR) Stock Prices Oil Prices Index(12/31/03=100) Daily Page 5 of 36 Chart 2 Asset Market Developments 130 FOMC Wilshire Dow Jones Technology $/barrel Daily FOMC Spot WTI Far-Dated Futures 120 80 70 60 110 50 100 40 90 30 20 80 Apr. Aug. 2004 Dec. Apr. Aug. 2005 Dec. Apr. Apr. Aug. 2006 Equity Valuation Dec. Apr. Aug. 2005 Dec. Implied Volatilities Percent 12 Monthly Aug. 2004 Apr. Aug. 2006 Percent 40 Daily FOMC S&P 500 Nasdaq 10 30 8 12-Month Forward (Trend E)/P Ratio + 6 20 4 + Real Long-Term Treasury Yield* 10 2 0 1988 1992 1996 2000 0 2004 Apr. *Perpetuity Treasury yield minus Philadelphia Fed 10-year expected inflation. Note. + Denotes the latest observation using daily interest rates and stock prices and latest earnings data from I/B/E/S. 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. Aug. 2004 Dec. Apr. Aug. 2005 Dec. Apr. Aug. 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 August 7, 2006. Last daily observations are for September 14, 2006. Class I FOMC - Restricted Controlled (FR) Page 6 of 36 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. June 2005 Stock Price Indexes Industrial Countries Oct. Feb. June 2006 Index(12/31/03=100) Daily 2.5 0.0 Jan. Feb. June 2005 Stock Price Indexes Emerging Market Economies 175 170 Oct. Feb. June 2006 Index(12/31/03=100) Daily 160 250 235 Brazil (Bovespa) Korea (KOSPI) Mexico (Bolsa) 165 UK (FTSE-350) Euro Area (DJ Euro) Japan (Topix) May Sept. 2004 220 155 205 150 190 145 140 175 135 160 130 145 125 120 130 115 110 115 105 100 100 85 95 90 Jan. May Sept. 2004 Feb. June 2005 Oct. Feb. June 2006 70 Jan. May Sept. 2004 Feb. Note: Vertical lines indicate August 8, 2006. Last daily observations are for September 14, 2006. June 2005 Oct. Feb. June 2006 Class I FOMC - Restricted Controlled (FR) Page 7 of 36 weighed on the foreign exchange value of the yen. Stock price indexes in most major industrial countries rose between 1 and 5 percent over the period. (5) On balance over the intermeeting period, the dollar was about unchanged against an index of currencies of our other important trading partners. The Mexican peso edged down only slightly versus the dollar, despite lingering uncertainty created by the recent presidential election in that country. The Brazilian real moved up against the dollar. EMBI+ spreads for both Brazil and Mexico remained near record lows. The heavily managed dollar-renminbi exchange rate moved in a wider daily range over the intermeeting period than earlier this year, and the currency appreciated 3⁄10 percent on net. Some analysts interpreted the larger fluctuations as a possible prelude to greater flexibility of the renminbi. The People’s Bank of China increased its benchmark bank lending rate 27 basis points on August 18, pointing to the rapid growth of credit and investment. (6) Domestic nonfinancial sector debt is estimated to be increasing at a 6½ percent rate in the current quarter, about the same pace as in the second quarter, as a projected slowing in household borrowing about offsets a more-rapid expansion of federal debt (Chart 4). C&I loans have picked up briskly in recent months, but net corporate bond issuance has slowed. On balance, growth of nonfinancial business sector debt this quarter is expected to remain near its second-quarter pace. Debt of the household sector expanded at a 9 percent annual rate last quarter, slightly slower than in the first quarter, as mortgage borrowing moderated a bit. The limited indicators for the current quarter, including July and August bank credit data, point to some further slowing of household mortgage borrowing, consistent with the cooling in the housing market. (7) M2 growth, at a 4 percent annual rate, remained slow in August. In recent months, money growth was damped by the moderate expansion in nominal income and the lagged effects of earlier increases in opportunity cost. Liquid deposits, whose Class I FOMC - Restricted Controlled (FR) Page 8 of 36 Chart 4 Debt and Money Growth of Federal Debt Growth of Household Debt Percent Percent 21 s.a.a.r. Quarterly, s.a.a.r. 14 18 Q3p 8 9 Home Mortgage 10 12 Q3p 12 15 Consumer Credit 6 6 4 3 2 0 0 -2 -3 -4 1991 1993 1995 1997 1999 2001 2003 2005 2002 Q1 Q2 Q3p 2006 Note. Treasury debt held by the public at period-end. p Projected. p Projected. 2003 2004 2005 Growth of Nonfinancial Debt Changes in Selected Components of Nonfinancial Business Debt $Billions Percent, s.a.a.r. 50 Total _____ Nonfederal __________ 8.9 Monthly rate 8.9 40 C&I Loans Commercial Paper Bonds p Sum 2004 30 2005 Q1 Q2 Q3 Q4 9.3 8.2 9.7 9.6 8.5 10.0 10.5 10.0 2006 20 Q1 Q2 Q3 9.5 6.4 6.5 9.2 8.3 7.4 10 0 -10 -20 2004 H1 H2 Q1 Q2 2006 JulyAug. p 2005 p Preliminary. Note. Commercial paper and C&I loans are seasonally adjusted, bonds are not. p Projected. Growth of M2 M2 Velocity and Opportunity Cost Percent s.a.a.r. 10 8.00 Percent Velocity 2.3 Quarterly 8 Opportunity Cost* (left axis) 4.00 2.2 Q2 6 e 4 2.1 2.00 2.0 2 0 1.00 Q2 Velocity (right axis) 1.9 0.50 -2 1.8 0.25 -4 2004 e Estimated. H1 H2 2005 Q1 Q2 July Aug. 2006 1993 1995 1997 1999 *Two-quarter moving average. 2001 2003 2005 2007 Class I FOMC - Restricted Controlled (FR) Page 9 of 36 rates of return tend to lag rising market rates, continued to run off. In contrast, small time deposits and retail money funds, whose rates of return tend to adjust more promptly, increased briskly. The currency component continued to expand at a sluggish rate, apparently due to weak overseas demand for U.S. currency. The Term Structure of Interest Rates and Growth Prospects Various econometric models of future real GDP growth that include the shape of the term structure suggest that the expansion will slow somewhat and that the odds of an outright recession have increased, on net, over the course of this year. For example, a model that includes the slope of the yield curve—as measured by the difference between three-month and ten-year Treasury yields—and an estimate of the term premium, estimated with data over almost the past twenty years, now implies fourquarter-ahead expansion of just below 3 percent. This calculation is little changed since the August FOMC meeting and is broadly comparable to private sector forecasts, such as the Blue Chip consensus. Also, a model using the slope of the yield curve and the short rate suggests that the probability that the economy will be in recession within the next four quarters is about 40 percent. In contrast, respondents to the Blue Chip survey this month reported a 25 percent probability of recession. Notably, however, the point estimates derived from these models are highly sensitive to specification and sample selection, and therefore sizable confidence intervals surround implied growth rates as well as recession odds. Class I FOMC - Restricted Controlled (FR) Page 10 of 36 Economic Outlook (8) The staff forecast for real GDP growth has been lowered somewhat, owing to the effects of a more abrupt slowing in housing activity and lower growth in potential output. The stimulus imparted by the recent appreciable decline in energy prices and by rallies in some financial markets provides only a partial offset to these effects. Real GDP is anticipated to expand at about a 1¾ percent annual rate on balance over the remainder of 2006 before accelerating gradually over 2007 and 2008. Resource slack follows the same path as in the August Greenbook, with the unemployment rate edging up to 5¼ percent by the second half of 2008. The staff forecast assumes that the Committee holds the stance of policy steady through mid2008 before easing policy slightly. With that policy backdrop, long-term Treasury yields rise marginally from a level that is about 20 basis points lower than anticipated in the August Greenbook, and stock prices increase at about a 6½ percent annual rate from a starting point that is 2 percent higher than in the last forecast. The foreign exchange value of the dollar depreciates gradually as in previous forecasts, but along a track that is 1 percent above that in August. As suggested by futures quotes, oil prices are forecast to rebound somewhat from their recent declines but to run considerably below the path in the previous forecast. The flattening out of energy prices and other commodity prices helps to nudge core PCE inflation down from about 2½ percent at an annual rate in the second half of 2006 to about 2 percent by the end of the forecast period. Product and labor market slack also exert a small downward influence on the inflation outlook by 2008. Overall PCE inflation runs at 2½ percent in 2007 and 2 percent in 2008. Policy Alternatives (9) This Bluebook presents three formal policy alternatives for the Committee’s consideration, summarized by the draft statements in Table 1. Under Alternatives A Class I FOMC - Restricted Controlled (FR) Page 11 of 36 Table 1: Alternative Language for the September FOMC Announcement August FOMC Policy Decision Rationale Assessment of Risk 1. The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5¼ percent. 2. Economic growth has moderated from its quite strong pace earlier this year, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices. 3. Readings on core inflation have been elevated in recent months, 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 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. Alternative A Alternative B 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. The moderation in economic growth appears to be continuing, in part reflecting a cooling of the housing market. The moderation in economic growth appears to be continuing, in part reflecting a cooling of the housing market. Although core inflation remains elevated, recent readings have been slightly more favorable. While some inflation pressures persist, they 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. Readings on core inflation have been elevated on balance, 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. In recent weeks, the upside risks to inflation appear to have diminished somewhat and downside risks to growth have become more significant. 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] 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 has moderated from its quite strong pace earlier this year, partly reflecting a cooling of the housing market. Readings on core inflation have been elevated on balance, and the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures. In these circumstances, the Committee believed that an additional firming of policy was appropriate to foster a decline in inflation. [Unchanged] Class I FOMC - Restricted Controlled (FR) Page 12 of 36 and B, the Committee would again leave the stance of monetary policy unchanged at this meeting; Alternative A would suggest that the Committee now sees the risks to growth and inflation as balanced, while Alternative B would repeat the indication from August that the Committee is concerned predominantly with inflation risks. Under Alternative C, the Committee would firm policy 25 basis points and, as in Alternative B, would highlight upside inflation risks. A few key data releases are scheduled between the publication of this document and the Committee’s meeting, including consumer prices for August on Friday and housing starts on Tuesday, so the wording of the rationale portions of the various draft statements should be viewed as more tentative than usual. (10) The Committee might want to keep the federal funds rate unchanged at 5¼ percent if it finds the staff forecast to be both plausible and acceptable. While the relatively slow pace of growth and the gradual decline in core inflation from an elevated level in that projection might have little appeal individually, policymakers may feel that circumstances are such that this combination of outcomes is likely the best that can be attained, particularly in light of the downward revision to longer-term growth prospects. Holding the funds rate steady at this meeting would be generally consistent with the Committee’s past behavior as captured in the estimated policy rules shown in Chart 5, as well as with most of the simple policy rules shown in Chart 6. Even if members harbored some reservations about the Greenbook outlook, policy inaction might be favored as balancing the risks of, on the one hand, a more precipitous downturn in housing and, on the other, some uptick in inflation pressures. (11) If the Committee deemed it appropriate to keep the funds rate unchanged at this meeting, its key remaining policy decision would seem to be its assessment of the risks to the economic outlook and the associated implications for future action. Alternative B in Table 1 is designed to signal that policy remains more likely to tighten than ease by repeating the sentiment of the August statement. Such a position Class I FOMC - Restricted Controlled (FR) Page 13 of 36 Chart 5 Information from Estimated Policy Rules and Financial Markets Estimated Policy Rules Market Expectations Percent 9 Actual and Greenbook assumption Outcome-based rule 70 percent confidence interval 90 percent confidence interval Forecast-based rule Percent 9 Actual and Greenbook assumption Market-based expectations 70 percent confidence interval * 90 percent confidence interval * 8 8 6 5 5 4 4 3 2007 7 6 2006 7 3 2 2008 2006 2006 2007 2007 2008 2008 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Outcome-based policy rule 70 percent confidence interval Lower bound Upper bound 90 percent confidence interval Lower bound Upper bound 5.2 5.4 5.4 5.4 5.2 5.1 5.0 4.9 4.9 4.9 5.2 5.3 5.1 5.7 4.9 6.0 4.6 6.2 4.3 6.3 4.1 6.3 3.9 6.3 3.7 6.3 3.6 6.4 3.6 6.5 5.2 5.3 4.9 5.9 4.5 6.3 4.1 6.6 3.7 6.8 3.3 6.9 3.1 7.0 2.9 7.0 2.8 7.2 2.6 7.3 Forecast-based policy rule 5.2 5.2 5.1 4.9 4.8 4.7 4.7 4.7 4.8 4.7 5.2 5.3 5.2 5.1 4.9 4.8 4.7 4.6 4.6 4.6 5.2 5.3 5.2 5.4 4.9 5.5 4.6 5.5 4.4 5.5 4.1 5.5 3.9 5.5 3.8 5.5 NA* NA* NA * NA * 5.2 5.3 5.1 5.4 4.8 5.6 4.4 5.8 4.1 5.9 3.7 6.0 3.5 6.1 3.4 6.1 NA* NA* NA * NA * 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.0 5.0 Estimated Policy Rules Market Expectations Expected funds rate path 70 percent confidence interval Lower bound Upper bound 90 percent confidence interval Lower bound Upper bound Memo Greenbook assumption * The confidence intervals for market expectations are not available after 2008Q2 since there are no options traded beyond that horizon. 2 Class I FOMC - Restricted Controlled (FR) Page 14 of 36 Chart 6 Policy Implications of Simple Rules 1½ Percent Inflation Objective 2 Percent Inflation Objective Percent 9 Actual and Greenbook assumption Taylor (1993) rule Taylor (1999) rule Taylor (1999) rule with higher r* First-difference rule Actual and Greenbook assumption Taylor (1993) rule Taylor (1999) rule Taylor (1999) rule with higher r* First-difference rule 8 7 Percent 9 8 7 6 5 4 3 2007 5 4 2006 6 3 2 2008 2006 2006 2007 2007 2008 2008 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 5.2 5.2 5.0 4.7 5.0 4.8 4.8 4.6 4.8 4.6 4.7 4.5 4.6 4.5 4.6 4.5 4.6 4.5 4.6 4.5 5.3 5.2 5.1 4.8 5.0 4.8 4.7 4.6 4.7 4.6 4.6 4.5 4.6 4.5 4.6 4.5 4.6 4.6 4.7 4.6 5.4 5.3 5.8 5.5 5.6 5.4 5.2 5.0 5.1 4.9 4.9 4.8 4.8 4.8 4.8 4.8 4.8 4.8 4.8 4.7 5.3 5.2 5.5 5.3 5.8 5.4 6.1 5.5 6.3 5.6 6.4 5.7 6.5 5.6 6.6 5.6 6.6 5.6 6.6 5.5 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.0 5.0 Simple Policy Rules Taylor (1993) rule 1½ percent inflation objective 2 percent inflation objective Taylor (1999) rule 1½ percent inflation objective 2 percent inflation objective Taylor (1999) rule with higher r* 1½ percent inflation objective 2 percent inflation objective First-difference rule 1½ percent inflation objective 2 percent inflation objective Memo Greenbook assumption 2 Class I FOMC - Restricted Controlled (FR) Page 15 of 36 Policy Rule Charts: Explanatory Notes For the rules described below, it denotes the federal funds rate for quarter t, while the explanatory variables include the staff’s estimate of trailing four-quarter core PCE inflation (πt), its forecasts of inflation two and three quarters ahead (πt+2|t and πt+3|t), its assessment of the current output gap ( yt − yt* ), its one-quarter-ahead forecast of the output gap ( yt +1|t − yt*+1|t ), its three-quarter-ahead forecast of annual average GDP growth relative to potential ( Δ 4 yt +3|t − Δ 4 yt*+3|t ), and the assumed value of policymakers’ long-run inflation objective ( π * ). Rule prescriptions 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. Except for backward-looking rules, it should be noted that prescriptions near the end of the Greenbook horizon also depend on extended baselines. Estimated Rules: Estimation is performed using real-time data over the sample 1988:1-2005:4, and the specifications are chosen according to the Bayesian information criterion. Each rule incorporates a 75 basis point shift in the intercept, specified as a sequence of 25 basis point increments that occurred during the first three quarters of 1998. Confidence intervals, shown only for the outcome-based rule, are based on stochastic simulations of the FRB/US model. The following table indicates the specification of each rule used for dynamic simulations and its root mean squared error over the sample 1993:1-2005:4. 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 )] .17 .16 Market Expectations: The expected funds rate path is based on quotes from fed funds and Eurodollar futures, and the confidence intervals are obtained from options on those futures. Simple Rules: The following table indicates the specification of each rule. 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 ) Class I FOMC - Restricted Controlled (FR) Page 16 of 36 might be viewed as appropriate by the Committee if it saw high energy and other commodity prices and high levels of resource utilization as implying that the upside risks to inflation remain substantial. Moreover, recent data on labor compensation and productivity, while not fully congruent with other indicators of labor costs, may also be seen as pointing to potentially substantial inflation risks, as in the “greater wage pressure” scenario presented in the Greenbook. (12) The rationale wording for Alternative B could note that the moderation in economic growth appears to be continuing. In view of recent information on the residential construction sector, it could indicate that the housing market is cooling, rather than referring to a “gradual” cooling as in the August statement. The paragraph on inflation could be generally similar to the one in the previous statement. However, to acknowledge that the most recent data on core inflation were lower than those in preceding months—but not to be seen as overly optimistic in that regard— the statement could indicate that core inflation readings have been elevated “on balance” over recent months. The Committee might also wish to explain more explicitly its expectation that inflation pressures seem likely to moderate over time by citing a reduced impetus from energy prices. (13) Money market options indicate that investors are quite sure that the Committee will keep the federal funds rate at 5¼ percent at this meeting. In addition, the Desk’s survey of primary dealers indicates an anticipation that the statement released after this meeting will about replicate the August announcement, apart from some updating of the characterization of the economy and inflation. Accordingly, the market reaction to this alternative should be quite limited. (14) Judging from current financial quotes, market participants do not view maintaining the federal funds rate at 5¼ percent for some time as an approach the FOMC would select to balance competing macroeconomic risks. Even though the Committee identified upside risks as its predominant concern in the August Class I FOMC - Restricted Controlled (FR) Page 17 of 36 statement, money market futures prices suggest the anticipation of ½ percentage point of policy easing next year, an expectation that imparts financial stimulus to the extent that it has been incorporated in other asset values. If that stimulus is seen as excessive, the Committee could use the statement as a means to make plainer its assessment that the policy rate is more likely to rise than to fall. In particular, the Committee could strike the reassuring phrase “on balance” about recent inflation readings in row 2 of Alternative B and add an explicit characterization of the odds of future action in row 4. For example, after explaining that inflation risks remain, the Committee could add that “. . . policy is more likely to firm than ease going forward.” (15) In contrast, with overall economic activity apparently decelerating further in the current quarter, inflation data for July more favorable than in preceding months, and energy and other commodity prices down notably in recent weeks, the Committee may now view the upside risks to inflation as having diminished somewhat and as roughly balanced by the downside risks to economic activity. If so, the Committee may be attracted to Alternative A, under which the stance of policy would be maintained at this meeting and the statement would no longer suggest a predilection to firm policy going forward. While moderate economic growth may be viewed as the modal outcome under an unchanged federal funds rate, the downside risks to growth may seem considerable in light of the most recent data pointing to a more pronounced slowing in housing activity, a possibility that is illustrated by the “housing slump” scenario in the Greenbook. Moreover, the Committee may see the recent decline in the prices of oil and other commodities as potentially signaling a slowdown in global economic growth. In any case, with the real federal funds rate at the upper end of the range of model-based estimates of its equilibrium (Chart 7), policy may now be in a stance that is consistent with below-potential economic growth going forward, so that resource pressures are likely to diminish some. And, if the Committee believes that energy prices probably will not return to their higher levels of Class I FOMC - Restricted Controlled (FR) Page 18 of 36 Chart 7 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 25 b.p. Tightening Current Rate 3 2 1 0 -1 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Short-Run and Medium-Run Measures Current Estimate Previous Bluebook 2.4 2.1 2.7 2.4 2.1 3.1 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 (0.9 - 3.9( (0.1 - 4.7( 2.6 2.7 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 2.85 2.78 Memo Actual real federal funds rate Notes: Confidence intervals reflect uncertainties about model specification, coefficients, and the level of potential output. The final column 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. The differential between the current and previous Bluebook values of the FRB/US estimate mainly reflects the recent reestimation of the model equations. -2 Class I FOMC - Restricted Controlled (FR) Page 19 of 36 Equilibrium Real Rate Chart: Explanatory Notes 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. For the first three measures listed below, 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. For the first two measures, 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. 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. In light of this model’s simple structure, the short-run measure of the equilibrium real rate depends only on the recent position of output relative to potential, and the medium-run measure is virtually constant. 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. Unlike the estimates from the single-equation model, values of the equilibrium real rate also depend directly on conditions associated with output growth, fiscal policy, and capital markets. 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. These projections make use of several simple forecasting rules which are appropriate for the three-year horizon relevant for the short-run concept but are less sensible over longer horizons. Thus, we report only the short-run measure for the FRB/US model. Greenbookconsistent Measures of the equilibrium real rate cannot be directly obtained from the Greenbook forecast, because the Greenbook is not based on a formal model. Rather, we use the FRB/US model 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. The medium-run concept of the equilibrium real rate is not computed because it requires a relatively long extension of the Greenbook forecast. 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 20 of 36 earlier this year, it may view inflation pressures as likely to ebb slowly, such as in the Greenbook forecast. If so, the Committee may not see particularly high odds that policy will need to be tightened further. (16) The rationale for Alternative A could be similar to that for Alternative B, except that the Committee may wish to note explicitly that recent inflation readings have been slightly more favorable than those of previous months. In the risk assessment, the Committee would mention downside risks to growth and indicate that future policy adjustments, implicitly in either direction, will depend on the implications of incoming data for the outlook. (17) While market participants expect no policy action at this meeting, they do not appear to anticipate a policy statement that identifies downside risks to growth and that no longer hints at a possible need for additional firming. Market participants could read such a statement simply as a step in the transition to the policy easing that is already foreseen; in this case, there would probably be only moderate effects on other market prices. But market participants might instead extrapolate from this statement, inferring that the Committee was more likely to ease rates before long. In this latter case, the downward tilt to the market’s expected path for policy could steepen somewhat, and shorter-term Treasury yields could decline a little. The value of the dollar on foreign exchange markets would likely edge lower, and stock prices would rally. The implications for long-term yields could depend in part on what investors read into the announcement about the Committee’s longer-term inflation intentions. (18) If the FOMC expected stronger growth or higher inflation than the staff, or if it saw the Greenbook forecast as credible but was unhappy with the forecast path for inflation, it might wish to take another firming step at this meeting, as in Alternative C. The Committee’s concerns about the inflation outlook may have been exacerbated by recent compensation and productivity data. Moreover, in the Class I FOMC - Restricted Controlled (FR) Page 21 of 36 staff projection, core PCE inflation is projected to remain a bit above 2 percent until late 2008—an outcome that would mark five consecutive years of elevated core inflation relative to the objectives cited by a number of members of the Committee. Overall inflation likewise is forecast to remain relatively high until 2008. Given this forecast, members may believe that acceptable progress toward price stability will likely involve a somewhat firmer stance of monetary policy over coming quarters than assumed by the staff. Even if the Committee found the rate of decline in inflation forecast in the Greenbook to be generally acceptable, it might wish to firm policy another step at this meeting to provide more assurance that inflation was headed down. (19) An announcement associated with Alternative C could, as in the August statement, indicate that growth “has moderated” and, as in the other alternatives, drop the word “gradual” in characterizing the cooling of the housing market. The first sentence in the inflation paragraph could also be similar to the one in the August statement, but it might include the phrase “on balance” to acknowledge implicitly the lower inflation figures published for July. Rather than repeat the expectation that inflation pressures would moderate, the Committee could state that it took the firming action to foster a decline in inflation. The Committee might also want to indicate that, despite the firming step, it continued to be concerned with inflation risks, as it was in August, and again reference the possibility of additional firming. If, by contrast, the Committee saw such a step as a final “insurance” move against inflation, the risk assessment section could take a neutral position and simply indicate that future policy adjustments will depend on the evolution of the economic outlook, thereby suggesting that the Committee no longer had a predisposition to firm policy. (20) The tightening of policy and the statement shown under Alternative C of Table 1 would come as a considerable surprise to market participants. Investors would likely conclude that at least one more policy firming action was in store after Class I FOMC - Restricted Controlled (FR) Page 22 of 36 the action at this meeting. Nominal money market rates and shorter-term coupon yields would rise sharply. Real rates further out the curve could also increase, but nominal long-term yields could decline if market participants concluded that the FOMC was seeking a steeper decline and had a lower ultimate objective for inflation than they had previously perceived. With real rates higher, the foreign exchange value of the dollar would likely rise, and equity prices would probably decline. However, if the Committee instead opted to remove the reference to future firming and to suggest that it saw the risks as balanced after the move, these market responses would likely be muted considerably. Money and Debt Forecasts (21) Under the Greenbook forecast, M2 growth is projected to average about 2½ percent at an annual rate over the remainder of 2006, restrained by damped expansion of nominal income and the lagged effects of past policy tightening on opportunity costs. The velocity of M2 is forecast to rise 1½ percent over 2006, after increasing at an average annual rate of 1¾ percent in the previous two years. Over 2007 and 2008, however, M2 accelerates gradually to about a 5 percent annual growth rate, about in line with nominal income, as opportunity costs level out and then decline slightly in response to the cessation of policy tightening. (22) Household debt is expected to slow noticeably over the next several quarters. The rate of expansion of home mortgage debt declines considerably, reflecting lower residential investment and sharply decelerating home prices. The growth rate of business debt is also projected to decline a little, mainly as a result of much slower commercial mortgage borrowing compared with its torrid pace of recent years. Federal sector debt is forecast to expand at a bit more than a 6 percent annual rate on average over the forecast period. All told, the growth of domestic Class I FOMC - Restricted Controlled (FR) Page 23 of 36 Table 2 M2 Growth Under Alternative Policy Paths No Change 25 bp Tightening Greenbook Forecast* Monthly Growth Rates Aug-05 Sep-05 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 5.7 5.6 5.3 3.5 5.0 11.0 3.4 2.7 4.0 1.2 5.9 4.0 3.9 3.6 2.2 2.0 2.0 5.7 5.6 5.3 3.5 5.0 11.0 3.4 2.7 4.0 1.2 5.9 4.0 3.9 2.7 1.0 0.5 0.5 5.7 5.6 5.3 3.5 5.0 11.0 3.4 2.7 4.0 1.2 5.9 4.0 3.9 3.6 2.2 2.0 2.0 Quarterly Growth Rates 2005 Q3 2005 Q4 2006 Q1 2006 Q2 2006 Q3 2006 Q4 4.5 5.0 6.3 3.2 4.0 2.6 4.5 5.0 6.3 3.2 3.9 1.5 4.5 5.0 6.3 3.2 4.0 2.6 Annual Growth Rates 2005 2006 2007 2008 4.0 4.1 4.4 5.1 4.0 3.8 3.9 5.1 4.0 4.1 4.4 5.0 Growth From Aug-06 Sep-06 To Dec-06 Dec-06 2.5 2.1 1.2 0.7 2.5 2.1 2005 Q4 2005 Q4 2006 Q2 2006 Q3 4.8 4.6 4.8 4.5 4.8 4.6 2005 Q4 2005 Q4 Aug-06 Sep-06 4.6 4.5 4.6 4.4 4.6 4.5 * This forecast is consistent with nominal GDP and interest rates in the Greenbook forecast. Class I FOMC - Restricted Controlled (FR) nonfinancial sector debt is expected to drop from a 6¾ percent pace in the second half of this year to 6½ percent in 2007 and 6 percent in 2008. Page 24 of 36 Class I FOMC - Restricted Controlled (FR) Page 25 of 36 Directive and Balance of Risks Statement (23) 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 further 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 recent weeks, the upside risks to inflation appear to have diminished somewhat and downside risks to growth have become more significant. 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. 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. 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. Appendix Table 1 Class I FOMC - Restricted Controlled (FR) Page 26 of 36 Selected Interest Rates (Percent) Short-term Treasury bills secondary market Federal funds 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 1 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 Sep 05 Oct 05 Nov 05 Dec 05 5.31 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 4.88 6.80 6.10 5.83 5.15 3.62 3.78 4.00 4.16 3.21 3.49 3.91 3.67 3.50 3.79 3.97 3.98 3.80 4.13 4.30 4.33 3.87 4.13 4.31 4.45 3.64 3.84 4.01 4.23 3.96 4.31 4.44 4.43 4.01 4.34 4.46 4.39 4.28 4.56 4.66 4.57 4.55 4.77 4.85 4.76 1.40 1.69 1.96 2.07 1.70 1.94 2.09 2.15 6.03 6.30 6.39 6.32 4.94 5.13 5.22 5.18 5.77 6.07 6.33 6.27 4.51 4.86 5.14 5.17 Jan Feb Mar Apr May Jun Jul Aug Weekly Jul Jul Jul Aug Aug Aug Aug Sep Sep Sep Daily Aug Aug Aug Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep 4.29 4.49 4.59 4.79 4.94 4.99 5.24 5.25 4.10 4.38 4.55 4.60 4.69 4.71 4.89 5.17 4.34 4.54 4.63 4.72 4.84 4.92 5.08 5.09 4.47 4.69 4.79 4.90 5.01 5.18 5.27 5.17 4.56 4.72 4.88 5.03 5.15 5.35 5.46 5.38 4.36 4.47 4.61 4.80 4.95 5.12 5.24 5.22 4.42 4.69 4.77 4.92 5.00 5.15 5.15 4.93 4.35 4.60 4.72 4.90 4.98 5.04 5.02 4.79 4.50 4.66 4.82 5.07 5.19 5.18 5.15 4.94 4.67 4.75 4.93 5.24 5.36 5.30 5.26 5.09 1.92 1.97 2.08 2.25 2.26 2.41 2.43 2.24 2.03 2.06 2.21 2.41 2.45 2.54 2.52 2.32 6.24 6.27 6.41 6.68 6.75 6.78 6.76 6.59 5.11 5.12 5.10 5.19 5.24 5.24 5.21 4.98 6.15 6.25 6.32 6.51 6.60 6.68 6.76 6.52 5.17 5.34 5.42 5.62 5.63 5.71 5.79 5.64 06 06 06 06 06 06 06 06 14 21 28 4 11 18 25 1 8 15 06 06 06 06 06 06 06 06 06 06 5.25 5.25 5.24 5.27 5.25 5.23 5.25 5.26 5.24 -- 4.87 4.89 4.98 5.15 5.16 5.16 5.17 5.15 4.89 4.79 5.06 5.10 5.10 5.10 5.08 5.10 5.10 5.06 4.97 4.93 5.29 5.28 5.22 5.18 5.17 5.19 5.17 5.14 5.12 5.11 5.48 5.48 5.45 5.43 5.38 5.37 5.36 5.35 5.34 5.35 5.22 5.23 5.25 5.26 5.21 5.22 5.21 5.20 5.21 5.21 5.18 5.14 5.09 4.98 4.96 4.95 4.89 4.84 4.82 4.84 5.05 5.01 4.97 4.86 4.84 4.81 4.73 4.70 4.71 4.70 5.16 5.13 5.10 5.01 5.00 4.97 4.88 4.85 4.88 4.86 5.26 5.24 5.23 5.15 5.15 5.12 5.04 4.99 5.02 5.00 2.44 2.42 2.39 2.29 2.21 2.24 2.23 2.27 2.33 2.39 2.54 2.51 2.47 2.39 2.32 2.33 2.27 2.29 2.36 2.40 6.76 6.75 6.72 6.65 6.65 6.61 6.53 6.50 6.52 -- 5.21 5.19 5.13 5.06 5.02 4.97 4.93 4.91 4.88 -- 6.74 6.80 6.72 6.63 6.55 6.52 6.48 6.44 6.47 6.43 5.75 5.80 5.78 5.69 5.69 5.65 5.60 5.59 5.63 5.60 29 30 31 1 4 5 6 7 8 11 12 13 14 06 06 06 06 06 06 06 06 06 06 06 06 06 5.23 5.25 5.31 5.25 5.25 5.26 5.21 5.23 5.23 5.24 5.21 5.26 5.26 p 5.19 5.17 5.12 5.08 -4.96 4.88 4.88 4.83 4.84 4.75 4.77 4.80 5.07 5.05 5.05 5.02 -5.00 4.97 4.97 4.92 4.94 4.91 4.92 4.95 5.16 5.14 5.11 5.10 -5.13 5.12 5.13 5.10 5.13 5.12 5.08 5.11 5.36 5.35 5.35 5.34 -5.34 5.35 5.35 5.33 5.34 5.35 5.34 5.35 5.21 5.19 5.21 5.20 --5.23 5.19 5.22 5.20 5.19 5.23 -- 4.88 4.85 4.81 4.78 -4.82 4.83 4.84 4.81 4.85 4.83 4.82 4.85 4.73 4.70 4.67 4.66 -4.70 4.72 4.71 4.69 4.72 4.69 4.68 4.72 4.87 4.85 4.82 4.82 -4.87 4.89 4.88 4.86 4.89 4.86 4.84 4.87 5.01 4.99 4.96 4.96 -5.02 5.03 5.02 5.00 5.03 4.99 4.98 5.01 2.28 2.28 2.24 2.26 -2.31 2.32 2.35 2.35 2.41 2.39 2.37 2.37 2.31 2.30 2.27 2.28 -2.34 2.36 2.37 2.37 2.42 2.39 2.37 2.38 6.53 6.50 6.47 6.46 -6.51 6.53 6.52 6.50 6.52 6.48 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 27 of 36 Appendix Table 2 Money Aggregates Seasonally Adjusted M1 Annual growth rates (%): Annually (Q4 to Q4) 2003 2004 2005 M2 1 Period 2 Nontransactions Components in M2 3 7.4 5.4 0.3 5.5 5.3 4.0 5.0 5.3 5.1 Quarterly (average) 2005-Q3 Q4 2006-Q1 Q2 0.8 -0.3 2.4 1.1 4.5 5.0 6.3 3.2 5.5 6.4 7.3 3.8 Monthly 2005-Aug. Sep. Oct. Nov. Dec. 6.7 -3.0 0.3 0.6 -5.7 5.7 5.6 5.3 3.5 5.0 5.5 7.9 6.7 4.3 7.8 11.8 -5.5 7.8 4.9 2.6 -20.5 2.2 -3.1 11.0 3.4 2.7 4.0 1.2 5.9 4.0 3.9 10.8 5.7 1.4 3.8 0.8 12.7 4.4 5.6 1390.6 1393.6 1369.8 1372.3 1368.8 6789.8 6796.4 6829.8 6852.3 6874.3 5399.2 5402.8 5460.0 5480.0 5505.5 7 14 21 28p 1358.3 1347.0 1367.6 1377.5 6849.1 6848.1 6882.8 6876.4 5490.8 5501.1 5515.2 5498.9 4p 1386.7 6899.7 5513.0 2006-Jan. Feb. Mar. Apr. May June July Aug. p Levels ($billions): Monthly 2006-Apr. May June July Aug. p Weekly 2006-Aug. Sep. p preliminar y Class I FOMC - Restricted Controlled (FR) Page 28 of 36 Appendix Table 3 Changes in System Holdings of Securities 1 (Millions of dollars, not seasonally adjusted) September 14, 2006 Treasury Bills Treasury Coupons Federal Net Purchases 3 Net Redemptions Net Purchases 2 (-) Change <1 1-5 5-10 Redemptions (-) Over 10 total Redemptions (-) Net Change outright holdings 4 Net RPs 5 Net change Agency 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 QII 2,010 --- 2,010 --- 3,495 1,708 1,015 1,305 4,914 --- 6,923 1,082 1,361 2,443 4,743 1,512 ----- 4,743 1,512 1,298 1,596 5,025 2,789 1,118 800 90 902 757 189 6,774 5,897 ----- 11,517 7,410 964 -1,202 1,538 -1,293 2,502 -2,496 2006 QI QII 4,099 --- ----- 4,099 --- 1,200 1,375 7,443 6,063 1,704 1,181 1,219 --- 1,321 1,217 10,245 7,402 ----- 14,345 7,402 793 -627 1,839 -4,413 2,631 -5,040 2006 Jan Feb 1,563 1,308 ----- 1,563 1,308 --1,200 2,809 2,498 1,505 25 205 924 1,321 --- 3,198 4,647 ----- 4,761 5,955 252 -396 -1,355 -3,672 -1,103 -4,068 Mar Apr 1,228 --- ----- 1,228 --- ----- 2,136 1,096 174 --- 90 --- ----- 2,400 1,096 ----- 3,628 1,096 393 626 -232 -3,995 162 -3,368 May Jun ----- ----- ----- 1,375 --- 2,317 2,650 101 1,080 ----- 1,217 --- 2,576 3,730 ----- 2,576 3,730 -756 -2,633 2,511 -2,077 1,755 -4,710 Jul Aug 1,649 --- ----- 1,649 --- --415 549 1,454 ----- ----- 3,931 --- -3,382 1,869 ----- -1,733 1,869 -909 -231 110 548 -800 318 ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- -2,352 2,334 -1,000 -3,000 -3,352 -666 Jul 5 Jul 12 ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- 3,395 -6,958 5,000 --- 8,395 -6,958 Jul 19 Jul 26 1,649 --- ----- 1,649 --- ----- 549 --- ----- ----- 3,931 --- -3,382 --- ----- -1,733 --- 6,023 -6,472 -4,000 3,000 2,023 -3,472 Aug 2 Aug 9 ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- 5,587 -3,477 ---3,000 5,587 -6,477 Aug 16 Aug 23 ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- 3,052 -5,503 1,000 5,000 4,052 -503 Aug 30 Sep 6 ----- ----- ----- 415 --- 1,454 --- ----- ----- ----- 1,869 --- ----- 1,869 --- 4,592 2,681 ---2,000 4,592 681 Sep 13 --- --- --- --- 1,320 548 228 --- 2,096 --- 2,096 -6,144 -2,000 -8,144 2006 Sep 14 --- --- --- --- --- --- --- --- --- --- --- 7,582 -1,000 6,582 --- --- --- 415 2,774 548 228 --- 3,965 --- 3,965 1,855 1,000 2,855 277.0 135.4 214.6 60.3 491.8 --- 768.9 -17.3 13.0 -4.3 QIII QIV 2006 Jun 21 Jun 28 Intermeeting Period Aug 8-Sep 14 Memo: LEVEL (bil. $) Sep 14 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. 81.5 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:BEW Class I FOMC - Restricted Controlled (FR) Page 29 of 36 Appendix 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 September 14, 2006 August 7, 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 30 of 36 Appendix Chart 2 Dollar Exchange Rate Indexes Nominal Ratio scale March 1973=100 150 Monthly 140 130 120 Major Currencies 110 100 90 + 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 80 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 31 of 36 Appendix 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 32 of 36 Appendix 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 33 of 36 Appendix 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 6 4 + 2 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. Class I FOMC - Restricted Controlled (FR) Page 34 of 36 Appendix Chart 6 Commodity Price Measures Journal of Commerce Index Ratio scale, index (1980=100) 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 35 of 36 Appendix 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 36 of 36 Appendix 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.
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