STRICTLY CONFIDENTIAL (FR) CLASS I-FOMC

Material for

Special Presentation to the
Federal Open Market Committee

December 18,1989

Outline of Presentation The long-run relationship between money and prices Factors influencingthe cost of disinflation

-

Difficulties of reducing inflation expectations Establishing and maintainingthe credibility of the central bank

Econometric model simulations with different degrees of central bank credibility Possible impediments to price stability in live years

- Persistent downward pressureon the foreign exchange
value of the doiiar

- A jump in WOM prices oil

-

A less restrictiveflscai policy

Comparison of alternative strategies for disinflation

Exhhit 2

CPI. ALL KEMS

r

Ratio scale
150 130

I
I

110

19511965

90

I

/

70

50

30

10

1918

1930

1942

1954

1966

1978

1990

CPI. ALL ITEMS

(1) (2)
P'
= M2.(V*/Q')

The P-star Model
P' P M2 V' Q'
= = = = = =

-

equilibrium price level, actualpticelevel. monetary aggregate,
historical average of M2 velocity,
potential real GNP,
inflation rate.

R - n t l = - a ( Pel - P"c,)

n

PRICE LEVEL (1982=1001

Ratlo scale
240 180

120

60

I

GNP IMPLICIT PRICE DEFLATOR

r

4-quaner percent drange 1 1 2

ExhMt 4

P-star Simulations

c

-

- 8
- 7

- 6

- 5 - 4

-

- 3
- 2 - 1

I

I

I

1

I

I

I

1 - 0

P-P', PERCENT DIFFERENCE

Percent

-

- 6

- 5

-

- 4

- 3
- 2 - 1

I

I

I

I

I

I

I

I

0

Exhibd 5

-

Factors lnfluenclng the Costs of Dlslntlatlon Nominal rigidities - Wage and price contracts - Costs of changing prices - Decision lags Failure of inflation expectations to adjust correctly to changes in monetary policy

INFLATION EXPECTATIONS

Percent

1982
* 1 2 - M h p e ~ c­ m h

1983

1984

1985

1986

1987

1988

1989

Altematlve Hypotheses about Inflation Expectattons FOMC announcements have complete credibility. Inflation expectations reflect current actions and announced monetary policy plans. FOMC actlons have credibility. Inflation expectations r e W the observable actions of the FOMC, but not announcements concerning future intentlons. FOMC actions and announcements have no direct effect on Inflation expectations. Inflationexpectations are formed by IooWng at past behavior of prices.

0

A Fomard-Looklng Yodel o the Economy f

Incorporates 'rational expectations"

-

Individualsare forward looking. Individualsunderstandthe structure of the economy well enough to anticipate correctly the consequencesof changes In monetary policy.

Nominal rigidities

- Staggered contracts prevent immediate adjustment to unexpected
changes In monetary policy. Assumptions about central bank credibility

-

"Strong credibility"-After

two years, wage and pdce settlng behavior

Is altered on the bask of current actual and announced Mure changes in monetary policy.

- Weak credibility"-Wage

and price sefflng behavior Incorporates

current actual, but not announced future, changes in monetary policy. Addltional assumptions

-

In the absence of any significant change In real Interest rates from current levels, the real foreign exchange value of the dollar would remaln unchangedIn real terms.

-

Oil prices are constant In real terms. Fulkmployment Federal budget deficit I eliminated by 1996. s

Both simulationsemploy the same monetary policy.

Exhbn7

Simulations of Foward-Looking Model

-

- 5

-

- -.
1 .

- 4

1 %

";--. -. ---

-3

'

1-

\

Weak -- --._credibility

/ '\
Strong credibility

\

--- --- -- -'-+ ---____--------_ - 1
- 0

-----_--1 -- -. . I

- 2

I

I

I

I

I

1

- 3.5
-

-

Strong credibility
------I -\

- 3.25

-

------- --- ..-. .- '-- . ---- Potential Growth
/
d .

- 2.5 Weak credibility J - - - - - - - - - - - - - _______------- 225
I

/

/

/

/

/

\

-z

--

- 3

- 2.75

I

I

I

I

I

2

6.5

Weak credibility

6.25 6 5.75 5.5

I1

-1
1988 1890
1991

525

1992

1893

1994

1995

5

Exhbil8

Zero Inflation Base Case

r

GNP DEFLATOR

Percent change. 04/04

15

-
-
-

,
"Natural rate"

- 9

- 8

- 7

- 6

- 5

1989 1990 1991 1992 1993 1994 1995

.,

I

I

I

I

I

I
Percent

4

REAL GNP

Percent chancre. 04/04

REAL TREASURY BILL RATE
10

8

6

4

2

1989 l9gO 1991 1992 1993 1994 1995

-

0

Sacrifice Ratios
Change in Excess inflation rate' unem loyment.' (percentage points) (percen age points)

P

Sacrifice ratio
W(1)

(1)

(2)

1. 2.
3.

Forward-looking model (1989-95) Strong credibility Weak Credibility Board model (1989-95) Historical experience in U.S. 1957-61 1970-72 1975-77 1981-85

3.9 3.9 3.9

.7 2.4 8.4

.2 .6

2.2

4. 5. 6. 7.

2.6

7.1

.8 3.1 6.7

. 8
6.8 11.8

2.6 1.o 2.2 1.8

Foreign experience (1981-85) 8. Japan Germany 9. France 10. 11. Unked Kingdom 12. Canada

1.2 2.3 7.1 1.8 7.5

2.6 9.5 5.8 6.3 13.5

2.2 4.1

. 8
3.5 1.8

* GNP implicl deflator ** Cumulative differenceover the time periodbetween the actual unemployment rate and the "natural rate" of unemployment.

Exhbit 10

I

Possible Factors Affecting the Reallsm of Model Slmulatlons increased global competition Heightened efficiency and cost consciousness on the part of business Diminished strength of labor unions Financialstrains and financial fragility

-

Our modeis are not equippedto shed much light on this case. A combination of higher real rates and weaker economic growth cwld affect highly leveraged firms or households. It is possible that more defaults could influenceconfidence more generally and have broader systemic effects.

Simulated

i
14

12

10

8

I

I
1979

I
lee0
1981

I
1882

I
1983

I
1984

I
1985

I
1988

I
1987

I
1998

I
1989

0

ExNbic 11

Alternative Exchange Rate Assumptions

1

- 110 -.-.. ---. * .
*. 100

/
Base case

/
Weaker dollar

-..-.

-90

. '.

*.

---- -..
I

-80

--. -. -

70

I

I

I

I

60

-

Weaker Dollar Exchange Rates
1990 1991 1992 1993 1994 1995

-

1. Real Treasury bill rate (%) 2. Base case

4.0
4.5

5.4
5.1

6.3
5.7

6.4
5.3

6.3
4.5

7.0
4.0

3. Real GNP (% change, Q4/Q4) 4. Basecase 5. Unemploymentrate (%) 6. Basecase 7. Current account deficit (% GNP) 0. Base case

.4
. 5

.9
1.0

3.0
3.1

1.6
24

20 .
2.3

2.7
3.2

6.3
6.3

7.3
7.2

7.3
7.2

7.5
72

7.0
7.2

7.7
7.0

2.2
2.2

2.1
2.4

1.a
2.4

1.6
2.3

1.4
2.3

1.3
2.3

Exhibii 12

Alternative Oil Price Assumptions

7

-40

Base case

Higher oil price
*-

I I

.

. .-.. ..
*

\..‘ ,...-=‘

..‘.. .-

*--------___

- 35
- 30

- 25 I
I
20

15

I

I

10

1 989 lee0 1991 US Import Pdce / CPI indexed t 1989-1 .O. o

r

1. Real Treasury bill rate (%) 2. Base case
5. Unemployment rate (“A) 6. Basecase
I

.ligher Oil Prices
1990 1991 1992 1993 1994 1995

4.5
4.5

5.1
5.1

5.6
5.7

5.2
5.3

4.0
4.5

5.0
4.0

3. Real GNP (“Achange, Q4Q4) 4. Basecase

.5
..5

1.O
1.0

2.7
3.1

1.5
2.4

1.6
2.3

2.6
3.2

6.3
6.3

7.2
7.2

7.3
7.2

7.6
7.2

8.0
7.2

0.0
7.0

Exhibit 13

Alternative Fiscal Policy Actions

FULL EMPLOYMENT BUDGET DEFICIT

Percentof GNP

Unchanged deficit

1

4

Unchanged Full-Employment Budget Deficit
1990
1. Real Treasuly bill rate (%) 2. Ease case

1991 6.1
5.1

1992 7.2
5.7

1993 6.7
5.3

1994 6.5
4.5

1995 6.5
4.0

5.1
4.5

3. Real GNP (“Achange, Q4/Q4) 4. Ease case

.8
.5

1.4
1.0

2.6
3.1

1.6
2.4

2.2
2.3

3.0
3.2

5. Unemployment rate (%) 6. Base case
7. Budget deficit (% GNP) 8. Base case

6.2
6.3

6.9
7.2

6.9
7.2

7.1
7.2

7.3
7.2

7.1
7.0

2.9
2.7

3.0
2.4

3.1
2.1

3.8
2.1

4.3
2.1

4.6
1.8

Exhibit 14

Costs of Achleving Zero Inflation Under Alternative Scenarios
Cumulative Losses 1989-95 Shortfallof GNP Excess of unemployment from potential' over naturalrate* (percent) (percent) (1 1 (2) Sacrifice3 ratio (3)

1. Zero inflation base case 2. With weaker dollar
3. With higher oil prices

20

8-112

2.2

24-112

9-112

2.5

25-11 2

10-112

2.7

4. With unchanged full-ernpioyment budget deficit

20

a

2.1

1. Calculated as the cumulativepercentage gap bstween potentialGNP and actual GNP from 1989 to 1995 .

2. Calculatedas the cumulativegap between the actual unemployment rate and the natural
rate (assume to be 5-112 percent) from 1989 to 1995. 3. Calculatedas the cumulativeexcess of unemployment over the naturalrate divided by 3.9 (thereductionin inflationbetween 1989 and 1995).

Exhibn 15

Alternative Policy Strategies
GNP - DEFLATOR -

Percent change, a4104

- 5

Tight money earlier

- 4

Base case

-3

-2

-- -- - - - - - _ _ _ _ _ _ _ _ _ _
1992 1993 1994 1995

- 1

+
0
-

1989

1990

1991

REAL GNP

...,.I
'\

r

Percent change, 041~34

1

Tight money earlier

*I -

__-__-_.-*--

*_______----

Base case

/
I

'
3

I

--..-I

*.--

1
5
2
1
0 -

4

+

I

I

I

- 1

UNEMPLOYMENTRATE

r
Base case

Percent

rl:
/
1989
1990

I1991 1992 1993 1994 1995