Chart 2

KEY FACTORS IN THE STAFF FORECAST

l

Federal funds rate assumed to remain at 4 percent through 1993.

l

Long-term

interest rates projected to fall further.

l

Credit crunch should ease somewhat by 1993.

l

Fiscal policy assumed unchangeddxcept adjustment.

for withholding

l

Dollar projected to be’essentially level.

unchanged

from current

l

Oil prices assumed to rise a little in the next several months and then to stabilize at $18 per barrel for imported crude.

marl

22

ECONOMIC PROJECTIONS FOR 1992

FOMC Range
--_________

Central Tendency
_ -____

Administration

Board Staff

Per~ntchange,Q4toQ4___________

Nominal GDP estimate previous Real GDP
previous estimate

4 to 6
4 to 634

4’ to 531 12 4
S’ ,, to 6’ 4

5.4
7.5

5.1
6.1

1’ to 2V4 12
Zto3’ /z

2 to 2’ 1-2
2’ /4 to 3

2.2
3.6

2.1
2.6

CPI
previous estimate

2’ to 3314 12
2’ to 4’ /2 4 -_ ----_ --_----

3 to 3’ 12
3 to4 --A~erag6~6~e~,Q4,p6r~en*____

3.1
3.9 ______

3.5
3.7 _ ____ ___

Unemployment rate
previous estimate

6’ to 7’ 12 14
Sloe/,

6314to 7
6’ to St/, L,

6.6
6.6

7.2
6.3

February Long-run ranges Donald L. Kohn

5, 1992

The choice associated complicated pectations

of money

and credit

ranges

for this strategy the

year,

with is

implications by a number in 1991

for intermediate-term of factors, money including

for policy,

shortfall

from exabout and the in-

in both

and income, measures

and uncertainties and credit

the relationship final objectives

between

various

of money

of the Committee

for inflation

rates

or nominal

come growth. With book gives the with regard staff to the latter, forecast the table on page 13 of the bluethought nomi-

for growth forecast.

in money

and credit

consistent

the greenbook is given

The 5 percent but will obviously, set the

greenbook

nal GDP projection those faster money

in the table, rates also

we believe for the of the

and credit rates

growth

stage

GDP growth then, money

forecast sizable

for 1993. increases

A notable they

feature

projections, of the broad outcome

is the

embody

for velocities to the rates, was

aggregates. when

For M2, this

would

contrast the

for 1991,

M2 and nominal to be an early

GDP grew indicator

about that

same

and weak money falling short

proved

the economy

of expectations. there were two roughly a downward offsetting shift forces affecting for

In 1991, M2 velocity. money host relative of unusual money

On the

one hand,

in the

demand

to income forces holders

and market

interest

rates

resulted that

from a induced savings money

working

on the financial into other rather interest

system

potential to pay

to shift

assets, than

or to use

down

or avoid On the

going

into debt market

accumulating

balances. costs

other

hand,

rates

and opportunity short-term

measured

in the

standard

way against

alternative

-2investments assets, even fell sharply, and this helped as might that to buoy been demands expected. forces will be relarates for M2

if not by as much we anticipate

have

In 1992, affecting tive

only

one of these shift

M2 velocity--a interest

further rates

downward

in money

demand

to market

and income. under that

Short-term

interest

themselves In normal interest

are not expected times, rates we would

to change anticipate

the greenbook

forecast.

a period would

of flat market of up

following

a sharp

decline reduced

see some widening rates demand to catch

opportunity with the tories could

costs

as depositories of market

offering loan

lower

level

rates. this

With year,

at deposirates

expected

to continue steep,

weak

the drop rise

in deposit

be especially

resulting in capital

in a marked markets This

in opportunity of debt, as

costs--relative well

to returns money

and the cost increase Velocity which

as to short-term would give

substitutes.

in opportunity also would we project portand be to

cost then, boosted

a boost

to M2 velocity.

by the

disruption

resulting

from the RTC, and from time

be at least folio

as active

in 1992

as in 1991, yielding down debt.

continuing deposits the

restructuring

as higher hold

small

mature

as households for money reductions only with

generally

In effect,

staff

outlook

and GDP embodies in interest a greater

a fairly have

conventional initial

pattern, effect

in which and rates The

rates

their

on money,

lag on spending.

Thus

the drop

in interest in 1992.

last year boosted story turing money

M2 primarily however, flows away both

in 1991 and the economy by layering on top

is complicated, of financial relative

of it the restrucwhich depresses

from depositories, years. last year seemed and this

to income

One difference the downward in the demand est rates shift

between

is that

last

year, shift interthe

in money

demand

to presage the need connection

a downward for lower

for goods

and services,

hence the

to rekindle

growth.

In part,

ran through

-3credit money markets, before with restraint on both The supply and demand for 1992 affecting sees similar

it affected in the demand

spending. for money,

forecast

disruptions tions banks level sheet should reducing tightening sheets,

but without

comparable recent

implicareports from

for the demand suggest that

for goods

and services. conditions And, lower

Most have

credit

supply

stabilized, rates

at a high and balance

of stringency restructuring relieve

to be sure. already

interest

undertaken

by households to draw

and businesses back further to the by

some of the pressure relative to income

on them

spending

and wealth.

The halt

of credit with

availability the lower

and the level

improvement

in balance rates to At the

combined

of interest

and exchange sufficient year.

prevailing produce

now than

at mid-1991, economic unlikely

are expected than

to be

a stronger it seems has

performance that

we saw last

same time, balance high

the restructuring The steep yield

of financial curve, relatively re-

sheets

come to an end. activities outside

cost

of debt,

of the RTC, the banking on money

and tendency system all

for the should

covery

to be financed downward These

exert

continuing

pressure

demand,

even

if not on spending. M3 and credit unchanged a bit as in

forces

are expected credit

to be affecting

well.

Total

depository

is projected

to be about

1992 after faster larger velocity than

declining last

sharply but

in 1991, only this

and M3 should 2 percent, year than

increase

year,

still

implying last.

an even debt all of

increase

in its velocity

Although

is expected in debt

to be little growth from

changed

in 1992,

virtually

the pickup Equity

1991 is in the federal cash flow at businesses, to holding of 1991.

component. and general the expansion is

issuance, of debt sector

strengthening finance debt

avoidance of private expected

all contribute the pace

down Ml,

to about

by contrast, last year and

to accelerate to drop

from its robust substantially

rate

of growth

its velocity

further.

This behavior

reflects

-4-

the very marked interest sensitivity of this aggregate.

Despite re-

ductions in NOW account rates, Ml is boosted this year primarily by the lagged effects of the huge declines in interest rates on market instruments and on small time deposits late in 1991 and early 1992. you probably know it already--the Pre-

I should emphasize--though high degree of uncertainty

associated with our M2 projection.

viously reliable relationships have broken down, leaving us without benchmarks for our projections. My sense is that the risks to the

staff forecast of velocity are probably tilted a bit toward the downside; that is, velocity might not increase as much, so that the GDP and interest rates of the greenbook might well be associated with more money growth than we have built in. But, the staff outlook has growth in targeted money and credit variables well down in their provisional July. ranges selected last

Thus, those ranges, listed as alternative I on page 13, would greater growth in money should money demand

allow for considerably

relative to income not shift down further as much as the staff anticipates, or should the Committee wish to accommodate stronger GDP for nominal

than in the staff forecast.

The Committee's expectations

GDP growth, which are stronger than those of the staff, likely would be associated with money growth around the middle of the provisional range. A combination of a smaller shift in M2 demand & higher GDP

therefore would imply money growth in the upper portion of the provisional range. If the Committee wished to retain this range, it

might indicate that growth in the upper half would be acceptable if there were evidence of a return to more normal velocity relationships. Given the staff economic and monetary forecast, the provisional ranges could be thought of as biased toward ease. That is,

with growth expected in the lower half of the range, chances for it falling to the lower end and triggering easing actions are greater

-5than the odds that money would expand near the top of the range and suggest tightening reserve conditions. This bias might be considered

appropriate in light of the results of last year and emphasis at this juncture on ensuring a solid economic upturn. tee wished a more balanced-approach However, if the Commitstrategy, it

to its medium-ten

could consider reducing the ranges by half a point, as in alternative II. This alternative would emphasize the desire to consolidate and

extend gains in reducing inflation; even alternative II implies midpoint M2 growth, at 4 percent, appreciably above the trend likely consistent with price stability, which probably would be closer to 3 percent. considerably A strong surge in money growth, after all, could suggest a stronger economy than anticipated, rather than a rebound In that circumstance, tightening trig-

in the money demand function.

gered by the reduced upper bound of alternative II might be needed to avoid creating monetary conditions that in time could lead to short circuiting the downward tilt to inflation rates now in prospect. If, on the other hand, the concern were more on the side of emphasizing a willingness to take further actions to foster a reason-

ably robust recovery, the Committee could increase the ranges, say by the half point suggested in alternative III. Such a range would sigim-

nal that the Federal Reserve found the monetary growth, and by plication the economic performance, of 1991 unacceptable,

and would

take strong action to counter monetary growth at 3 percent ox below if it persisted. The higher upper end of this alternative might even be

needed if the money demand shift began to reverse in 1992, especially if the Committee wished to foster something stronger than the 5 and 6 percent nominal GDP growth forecast by the staff for 1992 and 1993. there were no velocity shift coming in 1992, M2 growth around 5 perCent might be needed to achieve GDP of 5 or 5-l/2 percent this year and 6 percent in the early part of 1993. If

-6

Growth below If the the level Committee

of this projected wished

sort

in 1992 would

still

leave

nominal last

GDP July. and

by the Committee more explicitly

at its meeting

to make

up for lost money such as the

GDP growth, option" ties

an alternative

targeting

procedure,

"tunnel

discussed

in the bluebook year's ranges

might

be considered.

This technique year, relative

a particular that

to the ranges shortfall

of the previous or overshoot be recouped

implying

some portion of such

of a major

to the midpoint year. AS noted

ranges

one year would this

in the next linked ties to

in the bluebook, to targeting supply

suggestion Such

is usually an approach

a multiyear the level

approach

money.

down

of the money between

over time,

and if there level,

is a reliable it will in that tie down relationon a would not

relationship the price ship,

that

level

and the price require

level

as well. over periods

It does

confidence

not only

of several since

years

but to a degree and overshoots implies

year-to-year be allowed judgments Committee

basis

as well,

shortfalls procedure

to cumulate. each would year about

The current why money

making

fresh the years, is

came out where GDP or inflation these

it did,

where

like to see nominal is needed when to achieve swings

over coming

and what money most level sient. cess appropriate

objectives. rates

This process have altered than

lasting

in market shifts money

the

of velocity, In the

or when money situation, to a more

demand unless normal

may be more demand

tran-

current back use

is in the proand for

of snapping

relationship is likely

to spending a need

opportunity easing comments

costs,

of the tunnels year.

to imply will

actions

early

this

Governor

Lindsey

have

additional

on this

option.

February 5, 1992 Short-run Briefing Donald L. Kahn There has been a great deal of discussion about how much ease might be "in the pipeline", with a critical bearing on your decision about the stance of policy in the period immediately ahead. Some of what is meant by this is difficult to quantify,

since it refers to progress that has been made in redressing financial imbalances and building up capital by both borrowers and lenders. Other measures--especially those involving rates or perhaps

prices in financial markets are easier to quantify--though not to interpret.

The latter are given in the financial indicators It is instructive to

package, along with measures of money growth.

look at these indicators to see what they suggest about how much easing of monetary policy the Committee has done in recent months. TWO base periods suggest themselves for comparison as times when,

in retrospect, policy was probably tighter than was consistent with the kind of economic performance the Committee for in 1992 and 1993. seems to be looking

One is the first half of 1990, before the

Gulf War, when it appears that the economy could well have been in the process of weakening in any case. The other is the spring or

summer of 1991, when policy last thought it was positioned to support an expansion. The results of this comparison are somewhat mixed. important channel for monetary policy is the exchange rate. weighted average value of the dollar is appreciably One The

lower than it It

was in the first half of 1990 or last spring and early summer.

has fallen relative to those base periods in both nominal and real terms--the latter by about 10 percent. The other policy variable giving unambiguous boost to economic activity is short-term real interest signals for a
rate.3.

It

is clear that the Federal Reserve's easings have significantly outpaced the drop in inflation expectations. Short-term real rates

may be 3 to 4 percentage points below their levels in the first half of 1990, and a significant portion of that has occurred in the last few months. Participants developments in capital markets apparently see these Stock prices and price-

as favoring a strong rebound.

earnings ratios are at all-time highs.

Although bond rates are

down from a few months ago, the yield curve is remarkably steep. Concerns about potential fiscal stimulus as well as about looming

SUPPlY, from the federal government and private borrowers, probably are contributing to this configuration, but it seems unlikely that

such a steep yield curve could persist in the face of real pessimism about the economic outlook, or optimism about the prospects for price stability. However, the still-high long-term rates that contribute to the pitch of the yield curve also are one indicator that, perhaps in contradiction to market expectations, less may be in the pipe-

line than is suggested by short-term rates or the exchange rate. Measurement of long-term real rates is probably even more tenuous What measures we have, however,

than for short-term real rates. show some reduction

since the first half of 1990 or summer of 1991, high level when compared to averages over a

but still a moderately

-3-

longer

span.

Both

theory

and empirical measure

work

indicate influences

that

real

long-term than

rates

are a better

of what

spending drop

are real

short-term rates, levels

rates. commodity

Perhaps price

reflecting indexes periods. about half than

the modest

fin real flat,

long-term their

remain

relatively

below

in the two base raising Both

The other ease is the growth 1991 this

indicator of M2.

questions

the degree and in

of

in the first faster

of 1990

spring now.

aggregate

was growing second

it seems

to be

M2 has picked growth

up in the

half

of January, partly

and we see absence average. quarter

4-3/4 percent of year-end But this

for February, that held 3-3/4

elevated

by the monthly

distortions leave

down the January percent above

would

M2 only

its

fourth

1991 base, Part

and staff slowing will

is projecting reflects cause

a slowing that

in M2 growth aggressive

in March. of

of that

our view

lowering away

offering from

rates

a further

redirection

of savings

assets

in this

aggregate. to pick

In addition,

the pace in February

of RTC acand even

tivity were

is expected

up substantially agency attempts

so in March,

as that

to utilize

funding in as

authorized connection primarily spending especially growth about

only through with the

March.

TO be sure,

as was discussed view with this

long-run

ranges, fully

we would

weakness in

a shift forecast

in demand,

consistent But

the pickup expansion

in the greenbook. to drop fourth

sluggish below also

of M2,

if it were from the policy

appreciably quarter,

a 3-l/2 raise

percent questions

track whether

might

was positioned to pass, even with

to promote also could the special

solid

economic as very

expansion, bullish

should

it come

not be seen

for the economy,

explanations.

-4-

Thus, pipeline" down, but

as I noted, real

the picture

of how much

might

be "in the are of

is mixed: real flows

short-term rates

rates

and exchange as other

rates

long-term are

and M2 as well Given

measures of the con-

financial economy

somewhat

ambiguous. pressure

the state

and associated might

downward

on inflation,

this

figuration tional would tions easier effect though ease fall

be seen

from one perspective recovery.

as arguing bond

for addilikely

to better in response, current

assure since

Nominal

yields

any increase probably

in inflation would

expectaand

in the

circumstances should have

be muted, albeit also

monetary on real perhaps

policy long-term

an unambiguous, growth

small, respond, and

rates. since

Money

should

not by much, accelerate other hand,

the yield into

curve

would

steepen

depositors

might On the

shifts

capital that

market

instruments. monetary

the possibility expansionary "watchful

earlier

actions with short

could

exert

considerable
for more

force

on the economy, at least for a to

a lag, might time.

argue

waiting",

Additional its 3 percent a weaker

ease might

be indicated path,

if money

begins

drop below data

December-to-March situation of even

or if incoming than of a seen as than

suggest

underlying or a lack easing

in the economy glimmerings were

previously response skewed those could prompt market

expected, to previous

early

actions. costs than

If the risks of a shortfall anticipated, side,

to the downside, of a bit be made response rate was stronger

or the growth

greater

the directive implying a fairly

asymmetrical

on the easing that

to indicators appropriate.

further

reduction

in money

STRICTLY CONFIDENTIAL

(FR) CLASS II-FOMC

Financial Indicators

February

5, 1992

ma*

1

The Yield Curve
Quarterly Data Percentage Points - -6 ‘ T

jpreac I Betv veen 35year PT

T-Bond

Yield and Federal Funds Rate’
T

%

> 19!

I I I I I I I I
1963 1967 1971 1975 1979

I I I I I I
1983 1967 1991

r

* war to tw,:c)2, Ihe x-year Constantmaturity rate is used. + Denotes most recent weekly value.

Selected Treasury

Yield Curves

Percent -

10

February 4, 1992

December

17, 1991

3-month

1o-year

30-year

The Exchange Value of the Dollar
(Monthly G-10 Index)

Nominal
PT

Index Level,March

1973=100 160

140

120

100

BO

4

60

Index Level (Deflated)

1
I
1966 1970 1972

ii

I

I
1974

I
1976

I

I
,976

I
1980

L

I
1984

I
1966

I

I
1986

I

I
1'

191

+ Denotes ,mos,rece"twe*~y"eJ"e.

Stock Indices
(Monthly) IndexLevel, 1941-43.10 490 PT Standardand Poor's X 5WStocklndex

25

P

T

I , :o : 280

: :: ”

-2210

-

140

-

70

I

I

I

I

I

I

I

I

I

0

eflated1 lndexLevel(D'
400

Standard8 Poor's 500 Stocklndex 350

300

250

zoo

f

\

4
I I I
1979 1991 1983 1995 1987 1999 1975 1977

150

_1 I
1971 1973

100

marl

4

One-Year

Real Interest Rates

One-Year Monthly

T-Bill

Minus OneYear

Inflation Expectations

(Michigan)

PerCWlt 10

I

I

I

I

I

I

I

I

I

I

I

I

I

I

I

I

I

5

One-YearT-Bill Monthly

Minus One-Year

Inflation Expectations

(Philadelphia

Fed)*

Percent IO

GNP

deflator

___--_.cp,

I

n

V

r
Monthly

One-Year

T-Bill

Minus Change in the CPI from Three Months Prior”

oIlan

5

Long-Term
1O-Year Treasury

Real Interest Rates’

bond yield less 1O-year inflation expectation

PeNXllt -8

Nominal and Real Corporate Bond Rates ,” . , 1,’‘ I< %,‘

Percent

Nominal Rate on Moody’ A-rate corporate bonds s

.' :

_....' I ;.'

-

Chart 6

Experimental

Price Index for 21 Commodities

(Weekly)

ALL COMMODITIES

Index, 1966 Q1=100
-

160

-

160
140

-

ALL COMMODITIES 7

EX. CRUDE

OIL

Index, 1966 Ol=iOO -

160
160

-

-

140

-

120

-

100

-

60
60

ALL COMMODITIES

EX. FOOD AND CRUDE

OIL

Index. 196601=100
160

-

160

-

140

Chart 8

Inflation Indicator Based on M2

Current price level (P) - - - - - -. Long-run equilibrium pf given current M2 (P+)

r;“ ’

I I I I J I I I I I

Ll

-

I I I I I

I I I

Inflation ’

1 f

I I I I I I I I I I
,963 1968 1973

u

1976

I I I I I
1983

I I I
198,
1993

1. Change in GNP implicit deflator over the previous four quarters. Note: Vertical lines mark crossing of P and P’ . For 1990:Q4 to 1992:Q4 P’ is based on the staff M2 forecast and P is simulated using a short-run dynamic model relating P to P’ From 1955:Ql . to 195Wl4, P’ is based on preliminary estimates of potential GNP.