APPENDIX

Notes

for FOMC Meeting June 30, 1992 J. McDonouah

William

.There was the Foreign

no intervention desk

in the

foreign

exchange the

markets

by

Exchange since has

on behalf

of either

Federal

Reserve

or the Treasury The factors: I) 2) 3) dollar

the Committee's declined

last meeting. because of four major

steadily

Interest Apparent Questions recovery,

rate

differentials preference strength for a stronger economic yen

G-7 official about and reaction the

of the U.S.

4) Using comparison, favor

Overseas one-month there

to the presidential yields spread of as 594 points the

campaign. standard points of in of

Euro-deposit

is now a positive German marks with is much the and

basis

of holding yen,

88 basis

for holders the

Japanese rate DM,

as compared story that

dollars. more

obviously, in the the

interest of the is also to

differential but I believe These

dramatic with

case yen

differential not only

important. prefer market against officials

differentials holdings, hold

encourage

investors

foreign

currency to

but make dollar

it very expensive positions,

for FX

participants

long

especially German

the DM and other have been quite

European vocal

currencies. in stating

Furthermore, that they

are not

2.

likely suspects be

to

reduce a further

interest

rates

during Federal

1992,

whereas

the

market to

.easing by the case in

Reserve. we believe

This is

seems the

particularly force

the behind

Europe, and

most in

important recent

the strength

of the DM against

the dollar

days. on top of large interest is at least rate rate differentials of further be already

Therefore, existing, Wide market currency there

the possibility can

widening. by the

interest

differentials anticipation rates.

overlooked

if there with

is a general interest are very

of strengthening is not

of the for

lower There

But this bulls at United is the

the case

the dollar. a growing

few dollar based the yen

out there, least in

but rather on the and

bearish from Japan

conviction, officials that in

part

statements especially

States, goal of

Europe G-7

a stronger

policy.

The Bank of Japan to market

has not been but form has of push

leaving been

the strengthening intervening the dollar the the quite down BOJ dollar

of the yen heavily, market to it of

forces, in the

especially forces, intervene down even

pushing it lower is an up.

when

even at

briefly,

Then of

continues to push

increasingly This

levels

further.

unusually

agressive

method

intervention. The decision has been upcoming in favor until yen G-7 summit presents official Japanese an opportunity to support bring for a

of multilateral unilateral

action to

what a

now

action

about such

stronger

and a weaker

dollar.

The market. anticipates

a decision.

3.

Regarding

the

economic

recovery,

the

view

that

FX market

participants seem to hold appears to be very close to that of the Federal Reserve staff, but part of the bullish tone of the dollar earlier this year stronger. This came from a view that the recovery would be of

self-induced

disappointment

and the reality

quite a lot of uncertainty

in U.S. equity markets combine to

stifle capital flows into the U.S. Lastly, and most difficult to either evaluate or measure, but I believe necessary to mention, is widely-shared confusion overseas regarding the presidential campaign. foreigners country,
so

The common starting point for is very popular outside this

is that President

Bush

people abroad can't figure out why

the public opinion All

polls are so negative.

They don't know Governor Clinton well.

they seem to hear about is Mr. Ross Perot, about whom by and large they have no opinion at all. not necessarily because of Perot$s candidacy scares foreigners the man, but because it creates

uncertainty about the political direction, if not stability, of the country that they have looked to for political leadership and

guidance for over half a century.

People in this country may think people abroad know

that our leadership position has evaporated; that there is no substitute. This weights political uncertainty on top of

the

three

economic a very

on the dollar

I have discussed

gives the dollar

heavy feel.

We are back at the levels of early January, but with At that time, the mood was shifting from

a very big difference.

4.

neutral to positive. get more negative. official

Now it is negative, with a definite trend to Then the market thought that any would be to strengthen the dollar; now it

intervention

anticipates official action to weaken it.

Technically, that is the

kind of market in which the dollar could take off if there should be an upside surprise such as very bullish economic news or what would be viewed as positive political developments. On the other

side, any push downward either from market forces or from official action could have a substantial weakening effect on the dollar

exchange rate. At the last meeting, I reported on the large long dollar The

speculative position held by the Central Bank of Malaysia.

Bank Negara has become somewhat more circumspect and, we believe, has reduced its position at least somewhat at a good-sized loss and with an even bigger loss in whatever part of the position may

remain.

There is a new head of the banking department who visited

me in New York and we had a rather polite, but direct, conversation on their activity. experiencing, he Probably inspired mainly by the loss they were seemed very aware of both the dangers and

questionable appropriateness of what they had been doing and we may see less of Bank Negara at least for a while. In fact, market

reports suggest that Negara has become less active than usual in recent weeks. You have all been reading about the effect of the negative Danish vote on the Maastrict agreement, so I will not elaborate on

5.

it, except currencies. the safest

to note

that

it has had

strong

effects

on the European again looks like rate

The DM has haven,and has once the

strengthened exchange become direct currency Kingdom. a huge

as it once in the

risk

high

interest

currencies officials mark been about

again

manifest. in talking system. There fiscal

Senior

Bundesbank of the have

have been highly the and European the United

up the strength Important is growing losers

within Italy

suspicion and a new the

Spain. with

Italy, a very

with small

deficit

government lira outside indicate there band,

Parliamentary

majority, markets, devaluation can stay

now

sees

the ERM limits devaluation.

in the forward If a lira sterling

where

the rates

a fall

is required, the wide

is a question although central

on whether

within

the British bankers but

authorities that are I

will

try to keep

it there. rate

European structure At request sale of

think there

they clear

can hold signs with

the present

together, the from DMlO last the

of strain. the Committee the

meeting, Bundesbank from of given

discussed we

that the

engage

in another of the U.S. time

off-market monetary pressures, or on

billion Because

reserves and view our

authorities. Treasury the

pre-summit us their from when

other

has not yet sale the of

on the transaction currency

ongoing inform

interest

foreign

holdings. reply.

I will

Committee

we receive

Treasury's

Notes

for Joan E. Lovett FOMC Meeting 6/30 - -l/1/92

The Desk throughout Federal borrowing keep pace

sought

to hold

reserve

conditions

unchanged with

the period

since

the May

19th meeting,

consistent The

funds

continuing was

to trade raised

around

3 3/4 percent.

allowance with

by $125 million

to $225 million component.

to

springtime

increases

in the seasonal needs

A seasonal feature was of Desk

buildup

in reserve

was the prominent Much of the need

operations

during purchases

the period.

met with

two outright of bills

in the market, for $3.5 billion

one for
of coupon

$3.2 billion issues. directly

and the other

Another from

$1.4 billion accounts,

of securities bringing Small

was purchased addition of maturing a hair at the to have below to

foreign

the total

the portfolio agency issues

to $8.1 billion. kept the net

redemptions

increase

in the portfolio requested

$8 billion meeting was

so that

the additional Nonetheless, in doing needs

leeway

last for the and

not used. it provided

it was useful market

flexibility in case

the second had been

operation higher. temporary These funds

estimated

reserve

slightly

The balance injections-generally Banks either

of reserve

needs was met with BPS. in the a buildup

System

or customer-related trading anxious conditions to avoid

were market.

timed

to match to appear

continued

of excess

-2-

reserves,

and large banks really seemed more comfortable holding We

reserve deficiencies until late in the maintenance periods.

took account of this preference in shaping reserve operations. Indeed, a small amount of reserves was drained on one occasion when money market ease developed even though reserves were below path. Following the experience with taxes in April, we made arrangements with the Treasury for a higher target Fed balance following major tax dates. These arrangements were put into

effect with the June corporate tax date and will be used going forward as well. The higher balance is a temporary measure to

help cope with the very variable flows into the Treasury's Fed account that accompany large tax dates. In any event, the

balance ended up exceeding forecasts considerably but should be returning to normal this week. On average, Federal funds were close to the expected 3 3/4 percent area, coming in at-3.76 percent for the full period through yesterday. Today's quarter-end is eliciting very muted

rate pressure with early trading at 3 3/4 and 3 7/B percent. Market yields on Treasury issues backed up in the days following the May meeting, first on the absence of an expected easing move and then on news reports that a symmetric directive had been adopted at the meeting. The removal of a policy-tilt

toward ease--for the first time since last summer--caused some choppy trading as participants worked to sort out the implications for the future. Subsequent reports on the economy were

-3-

uneven, however, and money supply data were mostly weak.

These

reports served to revive expectations that a further easing step was possible, though comments by an array of Fed officials suggested that such a move was not imminent. In the bill area, rates ended the period pretty much unchanged on a net basis. Sporadic anticipation of "flight-to-

quality" demand followed bouts of weakness on global equity markets but had little lasting impact. The Treasury raised only

a small amount of net new cash here as regular bill supplies were offset by maturing cash management bills. In yesterday's regular

3- and 6-month bill auction, average issuing rates of 3.59 and 3.66 percent, respectively, compare with rates of 3.61 and

3.71 percent just before the last meeting. Yields on short- and intermediate-term Treasury coupon issues declined a net 15 to 35 basis points while long-term rates were essentially unchanged. The Treasury raised $21 l/2 billion

of new cash through 2- and 5-year note sales during the period. Demand for these maturities was pretty robust and this was the area where the rate declines were most pronounced. Declines in

long-term yields were limited by underlying concerns about future inflation prospects amid continuing budget woes and political uncertainty. As to the current state of market thinking, until very recently most participants felt that the Committee's preference was to keep policy unchanged, and that it probably would be able to do so. Over the last week or so, though, a case for another

25 basis-point ease in the funds rate has been building in the market. Weak spots in economic data, should they continue, are

seen as making an unchanged policy stance harder to defend at a time when persistent weakness in money growth also has to be explained. In light of recent calls for lower rates by the

Administration, many market participants think the Fed may feel constrained not to ease unless the case for such action in the economic and monetary data is very clear. In this regard, the employment report for June due later this week is considered a critical indicator by the market and one that will weigh on the Fed's thinking. A weak report is widely seen as a spur to ease.

The long end of the market probably would not back up if an easing were seen to be justified by the data, but chances for significant yield declines are seen to be limited. Two brief comments about our primary dealer arrangements are in order. Following the last meeting, on

May 20, a civil settlement between the Government and Salomon Brothers was announced arising from the firm's Treasury auction irregularities. The $290 million settlement agreement covers

government fines and private damage claims and settles the case against the firm without criminal charges. As part of the

Salomon resolution, the Federal Reserve Bank of New York announced that it was temporarily suspending its trading relationship with the firm, while retaining the designation as a primary dealer. The two-month trading suspension will end on

-5-

August 3, 1992.

At that time, the Treasury will reinstate the

firm's ability to bid in auctions on behalf of customers, a prerogative suspended at the time of the revelations last August. On another front, the Bank added Eastbridge Capital Inc. to the list of primary dealers on June 18th. a subsidiary of Nippon Credit Bank. Eastbridge is

The addition brings the

number of primary dealers to 39 and the number of Japanese-owned firms to 9.

i.

,_

Michael J. Prell June 30. 1992

FOMC CHART

SHOW

PRESENTATION

-- INTRODUCTION

It has been my habit unveiling I'm going appears There the summary to eliminate of the

to conclude forecasts

chartshoti presentations submitted. with that This summary.

by

you've

time, which

any suspense with

and start

in chart

1. along

the corresponding agreement that

staff

projections. likely outcome

would

appear

to be broad

the most

is sustained decline 3 percent

expansion

at a pace with

sufficient

to produce

a gradual of

in unemployment, next year.

inflation

running

in the neighborhood

I'm sure we'd bunching Nor does

all agree. does that the

though,

that

the

fairly

tight

of the forecasts it likely mean or traveled

not signal

the absence from

of uncertainty.

we've same

all started

the same to this

assumptions common

analytical

road

in getting

destination. The next chart lists the assumptions that have shaped the

staff

projection. For monetary policy, we've assumed that the federal Our analysis in turn with leads some funds of us to in

rate

remains

close to the credit supply

current and rate

3-3/4

percent.

prospective expect that

demand would

conditions be consistent

such a funds we're of l-114 larger

decline

long-term

rates:

thinking percent decline

in terms by early

of a 30-year next year. certainly

Treasury

yield

in the vicinity A still possible--indeed, short-term past. With

in bond yields model proven that

would

seem

an econometric a lag has rate.

says

long rates reliable point

follow in the larger

rates with

remarkably would

a flat funds

that model

to a much

- 2 bond rate decline over the coming year or so. In contrast. however. that the

the markets and private economists appear to be anticipating

current wide spread between long and short rates will be narrowed by a substantial increase in short rates. By implication, the markets are saying that the stable funds

rate assumed in the staff forecast.is potentially quite inflationary. Our long rate forecast in essence says that the bond market is overestimating the underlying strength of aggregate demand. and that

it will rally somewhat as it discovers that the Fed does not have to tighten soon in order to keep aggregate demand under control. said. I would reiterate a point made in the Bluebook, That

namely that the

funds rste currently is lower in real terms than one would expect: to prevail over the longer run. so that some firming of short rates could be necessary by 1994 to hold the ensuing expansion to disinflationary proportions. Another factor conditioning our projections is our that have been If

anticipation that the unusual credit supply constraints

afflicting the economy will diminish, but only gradually.
, mythi?.;, yn_ ’.,rp_ becoms 3

little less sanguine in thi; r~gzrd, ss -6s of the impediments FDICIA may place in the

have become more conscious

path of a revival of more normal depository lending. On the fiscal front, the presidential and congressional elections introduce scme additional uncertainties: assumed no significant as you know. we've

changes in budget policy, partly on the thought

that--if there are any major shifts--they are likely to affect mainly developments very late in, or beyond, the projection horizon. of course, overlooks possible markets.) anticipatory effects in financial (This,

3 -

With we assume that

regard there

to two will

occasionally

troublesome supply

exogenous shocks from

forces. the

be no significant sectors. that

agricultural And against other

or petroleum finally. G-10

we anticipate will

the dollar's

exchange

value

currencies

not change

materially

over the

projection

period. On that point, I'd like to turn the floor sector. over to Ted. to

develop

more

fully

our view

of the external

-4-

E.M. June Chart Show Presentation with the -- International exchange

Truman 30, 1992

DeVelODments of the dollar, (the red line end of So on G-10 and the last

Starting Chart in the 3 illustrates top panel) range year,

foreign

value basis

that

on a price-adjusted has returned

the dollar has

toward

the low

the broad far this balance. average yen, the

that

prevailed value

for the past is essentially

five years. unchanged for the

the dollar's as shown

However, and

in both panel about been

the top panel in terms

in the middle-left has traversed

of the mark range to

dollar These

a 10 percent loosely

since

December. fluctuations black line

movements

have

related

in long-term in the

interest

rate differentials panel.

-- the On

top panel

and the lower-right

balance, movement

as can be seen in the major

in the middle-right interest

panel,

the net December has

long-term

rates

since

been modest. The of the reasons have much projecting recent, Committee has already heard from Bill McDonough and I do not forecast we are from is a its most

for the dollar's Suffice dollar

recent

weakness, for the

to add. that the

it to say that will

be essentially This forecast

unchanged we believe

relatively midpoint or minus a range

low level. in a wide 15 percent would

reasonable say, plus

band

of uncertainty

and ignorance, The low

for the next the dollar

12 months.

end of such possibly

bring

into new terrain,

involving

additional

financial

risks.

-5-

We do not anticipate will be a major Although factor

that movements the dollar

in interest over the

rates forecast

influencing built

period. adjustment

we have

into our forecast soon and

a downward one in German time to be small, rates even

in Japanese European

rates rates

relatively

and associated horizon,

over a somewhat rates are

longer

the adjustments of 50 basis

in short points,

expected in long

on the order smaller.

and those

While we usually activity have abroad

the dollar more and over

is always

a wild

card

in the

outlook,

confidence their

in our forecasts for U.S.

of economic exports. in foreign growth

dmplications year

Unfortunately, have been more

the past than

or so, trends to discern.

difficult

normal

Consequently, detail what

my next now

two

charts

consider

in more foreign

than the usual

appears

to be a mixed 4 provides

outlook. on trends for each in industrial of the major

Chart production foreign

information price inflation

and consumer

industrial In Japan,

countries. upper economic left, industrial production only real has better

declined, than

overall and

activity remain

has been in the

a little

stagnant,

imbalances overall

and financial has been well

sectors. maintained, both

Although

employment

generally

and labor, force to support

participation

continues really

to increase, positive to

helping

consumption, starts,

the only which seem

indicator the over

has been

housing

to be responding rates

substantial the past

decline 12 months.

in long

and short

interest price

in Japan has

Meanwhile,

consumer

inflation

-6-

been relatively calm.

As

you

are

aware,

stimulative fiscal

action is under active discussion in Japan; we have built into our forecast a supplemental budget on the order of yen 5 trillion, as well as an easing in short-term interest rates. While the expansion of the West German economy -- top right panel -- appears to be slowing, consumer price inflation remains a major concern because the economy continues to operate near its potential. Activity in the first quarter was positively

affected, in fact as well as in the statistics, by special factors that have been reversed in the second quarter. In

general, indicators of economic activity do not suggest much near-term strength, but they do not suggest weakness either. Year-over-year inflation rates will decline after mid-year when special tax effects wash out; the issue is by how much. In the rest of continental Europe, represented in the middle panel by France and Italy, a moderate acceleration of economic activity appears to be underway. France has been aided

by its improving competitive position within Europe and the strength of demand from Germany. Italy as usual has its

political and budgetary problems; but consumer confidence and auto sales have picked up in the second quarter. The economies in the bottom panel have been in recession -- the United Kingdom -- or near recession -- Canada. United Kingdom, retail sales, manufacturing output, and construction orders point to an a further acceleration
Upturn in

In the

the second quarter with

in economic activity a possibility in the In Canada, data on employment, orders

second half of the year.

-J-

and shipments occurred expected

suggest

that

an acceleration however,

of activity the overall

may have recovery is

in the second to be moderate The next chart

quarter; at best.

summarizes

our outlook

for economic top panel in the

activity indicates economies trend 1991,

abroad.

The march

of 'the red bars that the pace

in the

our basic

conviction

of growth

of our trading the next

partners

will From

continue

on an upward percent in

over

six quarters. rate

a low of l-3/4 countries

the average above

growth

in foreign

is projected

to move rate

3-l/2

percent

in 1993;

this would

be the highest

since

1988. from the box much at the of the right and in the is This

As can be seen black bars in the middle

panel,

acceleration countries. of monetary stimulus,

expected

to come

from the G-6 major by the

industrial stance fiscal

acceleration policies waning

is propelled countries,

easier

in some

the Japanese

the

of balance-sheet Growth

problems,

and the passage also helps

of time. to pull up the panel.

in the G-6 countries change

countries -- the

other

industrial

red bars

in the middle

We do not as a group

see much

in growth

in the developing

countries Although year and

-- the blue

bars

and the box at the right. in Mexican growth this

we are projecting next,

a small

pickup less

it is significantly authorities rates

than

in our previous to reach about

forecast.

The Mexican inflation economy: tightened

are determined concerned

single-digit in their have been

and are also

bottlenecks policies

as a consequence, somewhat.

monetary

and fiscal

-t?-

As is shown price follow similar contrast fall inflation the

in the

bottom

panel,

we expect

consumer to

in the major

foreign

industrial inflation

countries and

same general

contour

as U.S.

for a However, in to

reason with

-- persistent our U.S.

slack

in most

of them.

outlook,' growth growth

generally

is projected suggesting

short

of estimated downward

in potential on prices

output,

increasing

pressures about the

and costs. of the foreign useful

In thinking outlook for U.S.

implications exports,

nonagricultural

it is sometimes in terms 6 presents second

to consider sources relevant average went going

the destination The

of our exports of Chart

of potential some column, on exports

of demand. information. in 1991,

to-p panel As

can be seen

in the

almost

65 percent of and industrial most

of our nonagricultural countries, with

to the two groups to Latin Japan America but

15 percent

of the rest

going

to Asia, the was last

excluding two columns

including the

the Middle

East.

However, last year

show that Latin

growth

of our exports which

skewed

toward than

America

and Asia,

together This will

accounted

for more

70 percent

of the increase. that

disproportionality sustained spending War. because in Latin

is something it rested, America first edged and

we believe on a surge activity

not be

in part,

in investment after the Gulf to

rebuilding

Indeed,

in the

quarter

of 1992, those

our exports to industrial

developing countries unchanged

countries increased from the

off while to keep

by enough

the total

essentially

fourth-quarter

rate.

-9-

The bottom panel summarizes our outlook for real nonagricultural exports, excluding computers, along side our outlook for foreign growth (the red bars) We

(the black bars).

are projecting that foreign economic growth next year will be above that in the first half of 1990. However, we do not expect

the growth of exports to recover commensurately because of the absence of the special factors, including gains in price competitiveness, that boosted exports in 1990 and 1991. The

widening gap between the two sets of bars in 1993 does reflect, in part, the influence of the low average level for the dollar underlying this forecast. We are projecting : essentially no increase in

agricultural exports over the next six quarters; we will do well to sustain the recent high level of exports that has been partly associated with increased grain shipments to Russia and the other republics of the former Soviet Union. Turning to imports and Chart 7, we think the basic story:, is somewhat simpler. As can be seen in the top panel, after the

gyrations introduced by the recession and swings in inventory behavior last year and the first part of this year, we are projecting that real non-oil imports, excluding computers, (the

red bars) will expand at an annual rate of a bit more than six percent over the next three half years, even as U.S. real GDP (the black bars) accelerates slightly. In this case, the

projected low level of the dollar is expected to contribute to narrowing the gap between the two bars.

-

10 -

Oil prices are an area of perennial uncertainty in our forecast. H,owever, as Mike indicated, we are assuming that we As can be seen in the

will have no surprises on this front.

lower left, after the spurt in oil prices this spring and early summer, we are assuming that the average price of imported oil will drop back to $18 per barrel by early next year: the corresponding spot price of West Texas Intermediate will be about This modest easing in oil prices is largely

$20.50 per barrel.

predicated on an increase in Saudi production during the second half of this year -- why else would they be adding to their capacity -- and on the availability of supply from Iraq next year. Even with this moderate assumption about oil prices, the

value of our oil imports is projected to increase -- the box at the right -- because rising demand and declining domestic production combine to boost the quantity of petroleum imports. My last chart summarizes our outlook for the external sector. Although the message is rather neutral and dull, I hope

I have not conveyed the impression that our forecast is risk free. As can been seen in the top panel and the bottom line of

the table below, we are projecting for the second half of this year a small negative contribution to overall economic activity from real net exports of goods and services, followed by a tiny negative effect during 1993. The underlying current account position -- line (1) in the table -- is estimated to have improved during the first half of this year, to deteriorate somewhat during the second half, and to return to about the 1991 level in 1993. Comparing the columns

! ,I’

-

11 -

for 1991 balance net

and 1993, -- line

a considerable

deterioration offset

in the

goods in

(2) -- is essentially (3) -- and you

by an improvement -- line (4).

services

-- line

investment you have I will

income nothing

Having about back from

convinced of the set

that

to worry oral real baton side

the rest who

world, your

now pass about

the the

to Mike,

will

mind

at ease

of the domestic

economy.

-

12 -

Michael J. Prell June 30. 1992

FOMC

CHART Chart

SHOW PRESENTATION 9 is intended

-- DOMESTIC

EXPENDITURE

FORECAST some of

to bring

you up to date the recent

on what

the key indicators economy. production vehicle story.

are telling left

us about

performance industrial rebound

of the

In the upper turned

corner. after

you can see that with the

up nicely being while

January.

in motor the

production However.

an important

element--but surveys--such

not all--of

manufacturing released

as the Chicago are in

purchasing moderately output

managers' upbeat. May.

report

this morning--still suggests

the available owing in part

evidence

some hesitation

since

to an edging

off in vehicle

assemblies. The insurance. last Thursday evidence. falling right-hand On this panel shows moving initial average claims basis, until for unemployment the jump we have reported more

four-week

is just barely reasonable range thaT that

perceptible--and. to interpret has prevailed in this

it seems the

it as another since April.

observation Recent with only

within

experience sluggish forecast.

suggests growth

claims

range are consistent anticipated

in payrolls.

which

is what we've

in our

Last spending month.

Friday

we received

the May figure left panel.

on real the

consumer that

plotted another

in the middle increase

Given

increase

moderate

in June will yield

a second-quarter in the vehicles we don't in know

gain close Greenbook. the first

to the

1 perCent regard.

(annual the

rate) we projected sales sign, of light though

In that 20 days

stronger

of June

are a promising

the consumer-business

split.

- 13 -

The housing spending this year.
Given

market with

has

followed surge

the same on and

pattern

as cmsumer

a big

early

a drop-back through May (the

thereafter. black line)

the usual a pretty

lags. solid

the starts basis

figures

provide

for our projection current

that quarter. raises that

single-family However.

building

activity very weak

will

be up for the sales

yesterday's about

new.home

number

for May

some questions I'll return

the underlying

strength

of housing

demand

to shortly. sector.
as

In the business trending show. upward. But,

equipment

demand

appears

to be left

the

orders

and shipments Moreover. firms the

at the lower

the pickup

is far from computer falling

spectacular. category. prices

it is highly are taking powerful new equipment

concentrated advantage technology has been

in the

where

of rapidly that only

to acquire for basic

is available. thus far. side

Demand

industrial

so-so

On the structures continued to fluctuate right--the

of business from month

investment, to month.

contracts but--as

have

violently moving

may be

seen at the

average

we use to filter GGP

out the noise S&C" a azzll our

has been moving increase assessment in itself

sideways.

kithough

the revised

&'~a first

in real nonresidential is that being we are still

construction edging toward

in the

quarter.

a bottom

right

now--that plunge.

a notable

improvement a mixed

compared picture

to the previous admits of a GDP

To sum up. we have considerable growth. latest range

that

of plausible still seems

estimates

of second-quarter round than number. upside

Two percent figures

a reasonable mqre

with risk.

the

perhaps

suggesting

downside

But. perhaps Greenbook

more

to the point

is the observation process appears

that

we made

in the

that.

while

the recovery

still

to be intact, certain

the economy

has yet to exhibit

a broad

dynamism

that

makes

- 14 -

even the have

grudging

acceleration quarters

of production ahead. provide a brief

and employment

that

we

forecast

for the

The next highlights Real

few charts

review

of the

sectoral spending.

of the GDP forecast. the top panel,

The first

covers

household

consumption. 1993.

is expected disposable

to increase income.

moderately Spending has of

through been

roughly

in line with

low for some time demand pickup probably

no" for a variety is growing.

of goods.

and the backlog anticipated

deferred is a mild because

HOWeVeL-, we*ve by past

what

in big-ticket it will mood take

expenditures a while longer

standards--partly to break

we think

for consumers

out of their

current

of caution. left panel. the ConferenCe it nor the Behind market people who this Board

As you can see in the middie confidence Michigan continuing conditions. believe their their index index flattened

out in June. anything

and neither ebullience. about

is signaling

like

malaise

undoubtedly

is a concern there

labor

In addition. jobs

though,

probably

are many

are secure. about real

but who feel estate values

less well have been

off because seriously

expectations

disappointed. I'm inclined debt burdens more reluctant to think these factors are more important consumers The than are

per se. but certainly than usual to borrow

there

are signs

that

to make

purchases.

good news debt of debt down.

on this reduction servicing

SCOL-e is that,

through

a combination interest

of installment rates. the ratio

and the effects obligations drop

of lower

to income--shown further expecting.

at the right--has over the coming

turned year

and it should turn

considerably like we are rates

if things

out anything Interest

obviously

are especially earlier

important this year.

for the visible in

housing

market.

The

burst

in activity

- 15 the bottom left panel. owed at least in part to the fact that 30-year mortgages were briefly available at fixed rates in the vicinity of g-1/4 percent. Rates backed up all the way to 9 percent by March--and element in the spring slackening in

this may have been a significant sales.

Now rates are once again approaching the January lows. and to action.

we'll have to see whether this stirs potential homebuyers

As you can see at the right. given our interest rate forecast. our expectations projection of modest increases in nominal home prices. and our income growth. home affordability is going to

of moderate

continue improving in the coming quarters; consequently, while the incentive to invest in the largest possible house may no longer be there. it is our expectation that unit starts will be moving up toward the trend requirements of a growing population. We're forecasting a

Chart 11 looks at business spending.

fairly steady 5 to 6 percent growth rate for real fixed investment over the next six quarters. Outlays for equipment--the black shading--are

projected to pace the advance. but a bottoming out in nonresidential construction is expected, partly on the basis of the trend in

contracts that I noted eariier. The financial backdrop for business spending decisions has improved considerably over the past few quarters. As you can see in corporations have

the middle left panel. the profits of nonfinancial

turned upward smartly. with improved efficiency augmenting the effects of declining interest payments. Moreover. many firms have been able

to exploit favorable market conditions to repair some of the balance sheet damage of the 1980s. As the righthand panel shows, we expect

that debt growth will pick up to moderate proportions later this year and next. as
a

gap emerges between expenditures and internal funds; level and composition of borrowing is such as

however. the projected

- 16 -

to permit liquidity.

an extension

of the

recent

favorable

trends

in corporate

One element tight panel the rein shows businesses

in the weakness have kept

of credit

growth

has been

the left

on their

inventories. this year

The bottom in correcting of 1991. points

that businesses imbalance that

succeeded

early

inventory

emerg'ed in the latter tabulated rate at the

half

Our to a

forecast gradual

of inventory movement toward

investment. a moderate to the

right.

of accumulation--but. stock increases will

as you be in

can see by looking the context of the

back

left.

such

ongoing

efforts

of firms

to reduce

their

inventory-

sales

ratios. That leaves level, the goveFnment sector. the subject of chart i2.

At the federal purchases. panel shows

the story

remains

one of contraction spending. to flatten

in real

reflecting that this

the cutback decline will

of defense only help

The middle out the the picture

unified

deficit more

as a percent favorable that

of GDP over the coming income

year;

is a little the

for the national strips

accounts effect you

concept--

red line--because expenses reiated

out the adverse insurance. while

of RTC and slice it. tax

other

to deposit that. policy

Anyway

though,

the message actions

is still fiscal

in terms mildly

of discretionary restrictive. the

and spending federal

remains

government

will

be issuing

a lot of debt and absorbing

a lot

of saving. In the state surprising the 4 percent. and local annual sector. real purchases posted a on have of

rate.

increase

in the first Some

quarter. analysts because

strength

of a surge this

in construction

spending.

suggested favorable

that

reflected there might

an acceleration be something

of activity to this, but

weather:

in any event

- 17 -

we doubt quarter

that bulge

the higher in purchases the

level

can be sustained. offset

We expect

the firstof

to be largely toward more

over the remainder budget

the year before indicated at the

progress

sustainable upturn

positions next year.

right

permits

a modest demand

in spending briefly.

To sum up the domestic that that a gradual a year acceleration too.

picture demand

we believe We thought Obviously. and

in aggregate

is likely.

ago.

so one might

ask what

has changed.

nominal mortgage were

interest rates

rate.5 are lower ease further. a year

now.

and we expect supply

that bond

will

Credit

conditions

probably

still

tightening

ago but now seem likely gone been

to ease a bit. their results appears some

Households balance of late.

and businesses

have

some way in strengthening experiencing better income

sheets,

and both have from

The drag

declining

nonresidential

construction

to be diminishing, progress obviously upturn. the toward do not but they

and state.s and localities their the budgetary

as a group imbalances.

have made These

correcting guarantee appear

factors

greater

vitality

of the economic in that seems direction. rather At

to us to tip the scales of a run-away

same time, now.

the

danger

expansion

remote

right

and thus

the chances stability will now

of achieving look good.

significant

further

progress

toward Dave

price

Stockton

conclude

the presentation

by

discussing

our inflation

forecast.

-

18

-

David J. Stockton June 30. 1992 FOMC CHART SHOW PRESENTATION -- INFLATION OUTLOOK

The upper panel of your next chart displays the staff projection of consumer price inflation. The overall CPI--the black

line--is expected to pick up to a 3-l/2 percent pace this year, before dropping back to around a 3 percent rate in 1993. This pattern masks

our view that core inflation is headed lower over the forecast period. The CPI excluding food and energy--the red line--is projected to move down from its current pace of a bit below 4 percent to about 3 percent by the end of 1993. As we*ve noted. prices for energy and food are not major stories in our forecast. We expect retail energy prices--the middle

left panel--to be boosted by the recent increase in world oil prices. after the steep declines of last year. accounts for the projected This turnaround more than In

pick-up in the total CPI this year.

1993, we anticipate that these prices will rise at roughly the same rate as overall inflation. panel--slowed Consumer food prices--the middle right

sharply last year from the pace of the preceding five

years and are expected to run a bit below overall inflation throughout the projection period. As has been the case for some time now. a key element in our inflation projection is a further easing of labor cost pressures-displayed in the lower left panel. Trend unit labor costs, which

abstract from cyclical swings in productivity that experience suggests normally have only minor effects on price setting, are expected to slow steadily through next year.

- 19

-

As we projection particularly, panel--shows can the of attribute remainder our lies

have near

noted the

at lower The

previous end of

meetings, the range

the of

staff private in the

inflation forecasts. lower right we

for an to of

1993. upward their my

Blue to

Chip

survey--shown and by

tilt lower

inflation

somewhat rate. detailed the

more

than

expected on and

unemployment a more .some of for the

I will

focus

remarks

pioviding address

explanation that

inflation have raised

projection about in is our the the the

concerns

others

prospects among

further reasons is

disinflation. to expect to a further prevail of your

Foremost. drop in inflation economy is

view. level~of

slack and

that

projected The upper the

in the next rate that

over

next

year

a half. the

panel

chart (the has

a scatter axis)

plot. relating to to an

change.in rate time

inflation axis)

vertical been of line To be

unemployment constant I have two over also

(the horizontal the age-sex a simple

adjusted the labor

hold force.

composition regression

plotted

that sure.

relates this of

these is

variables. simplification it clearly of a more of a

plot

a gross and any

fully rather

articulated wide range the rates

model of

inflation, ar

admits

possibilities

given on have

unempioyment average, been

rate.

Nevertheless. unemployment declining adjusted a bit roughly

regression exceeding and for

suggests
5-3f4

that,

adjusted with the by

percent

associated gap between has results

inflation, unemployment than l/2 to

every

percentage percent. per our year. more to

point

rate

and

5-314 point from

inflation These

slowed are

more

percentage those the derived

similar We

elaborate

models. from end its of

expect of

unemployment percent years. to

rate around

decline

gradually by the

current 1993. the

level In the

7-l/2

6-314 has

percent never Our

past

thirty

inflation in this range.

increased

when shown

unemployment

rate

averaged

projection.

- 20 -

by the boxed experience.

red points.

is in general

accordance

with

this

historical

Questions rate is understating As you know. participation this shortfall. forecast a small left

have

been

raised

about

whether

the unemployment in the labor in labor market. force of to line

the actual surprised

amount

of slack

we were that

by the sharp

declines

occurred

in 1990 and in labor force

1991.

As one indication led our models

weak

conditions

markets

sag in labor panel--but the

participation--the sharp

red dashed that these of poor the

in the lower occurred people

not the actual

decline that

through

end of last year. the labor force

To the extent

were

exiting

because

of perceptions understated to meet

job

opportunities. to which demand.

the unemployment potentially

rate may were

have

degree

resources

available

increased

However. rapidly. Over

since

last December. employment

the

labor

force has

expanded of job to

that

period.

moved

up and perceptions Board survey. appear

availability. have improved

as measured somewhat.

by the Conference Sorting

out underlying 'but with with

trends

from

cyclical

movements rate back

remains

difficult broadly

at present. consistent

the participation relationships.

to levels

historical

the odds have understating are expecting employment.

diminished slack.

that

the unemployment

rate is significantly looking force ahead. we

As you can see at the gains in both the

right. labor

only modest

and

It has are accomplished with enough

sometimes

been

suggested and that.

that

reductions

of inflation is under way

in recessions to reduce The upper point.

once a recovery rate. chart

vigor

the unemployment panel of your next

disinflation presents breaks

will

come to a halt. concerning this

the facts in

It is true that

the sharpest

-

21

inflation areas both

generally panel

have

occurred

in downturns. have

But as the

shaded when

in the

highlight. rate slowed

there

been numerous

occasions

the inflation That said,

and the unemployment that the pece

rate declined. of the expansion.

there

is evidence

as well referred word

as the

level

of slack, effect."

influences While

inflation--sometimes one would hardly associate the

to as a "speed with rates the

"speed"

recovery

that we are projecting. capacity utilization though. tend

declining against not

unemployment disinflation by enough more

and rising

do work

over the next

year

and a half. Speed

in our view. to show

to stall

the process. setting I have

effects

through In rate

clearly

in price

at the plotted

earlier the

stages

of processing.

the middle

left panel,

change

in the inflation rather

for intermediate level.

materials

prices

against

the change. The

than the line

of manufacturing that with increasing

capacity capacity

utilization. utilization

regression

indicates associated shown

rates

are typically materials. moving As

accelerating panel,

prices

for intermediate utilization firming

in the

right

with

capacity

up in our

projection, materials

we are expecting prices.

some modest

of intermediate

The unit the labor

lower

panel

displays

the markup

of prices of aggregate

over

actual and

costs.

The pickup tightening their

in the growth of resource markups

demand

corresponding firms

utilization labor

is one factor costs. now which and the above are

allowing held down

to boost

over unit

by above-trend

growth

in productivity the markup a pronounced environment with

between

end of 1993. its historical profitability

In our prdjection, average. even allowing

increases

to a level in

improvement

in our projected

of disinflation. recovery,

Beyond other reasons

the concerns been cited

associated

an economic little

have

for expecting

or no further

- 22 -

reduction in inflation.

One often mentioned argument suggests that

monetary policy has a weak or nonexistent effect on service prices. As seen in the upper panel of your next chart. this vie" has little empirical basis. To be sur.e. service prices tend to increase more by two percentage points per year. red line--exhibits much the same black line--rising and falling As seen in the

than goods prices--on average.

However. service price inflation--the pattern as goods price inflation--the

in response to the same general macroeconomic forces.

right panel. in the current episode, service prices slowed earlier and by a greater amount than commodities deceleration of rents. prices. mainly reflecting the

By the end of 1993. we project that both from

commodities and service prices will have slowed substantially their recent highs. Questions also might be raised about our compensation projection. Is our forecast

of 3-l/2 percent grovrth in 1993 in fringe benefits--implausibly The truth

nominal compensation per hour--including low, requiring a significant is we jusr don't know.

break from prevailing norms?

But with unemployment remaining relatively we expecr compensation per hour to slow, However.

high and prices decelerating,

much as it did in the mid 1980s under similar circumstances. because medical care benefits

are likely to continue to rise rapidly, I

we ate expecting less slowing in hourly compensation than in "ages. should also point out that we had an extended period in the early 1960s when rates of increase in compensation per hour were about as The experience of that

low as we are projecting to occur in 1993. period offers little evidence

of structural impediments to achieving

or maintaining low rates of wage inflation. A final. and perhaps more serious obstacle to reducing inflation is the adjustment of inflation expectations. One hears

- 23

-

divergent According one-year

views

expressed

about

current

and prospective in the lower averaged

inflation. left panel. over

to the Michigan ahead inflation months. do not

survey.

plotted have

expectations marginally expect

3-314 percent Moreover,

the past three these households

above

our projection. to hold out have

inflation

at its current been running

pace: in the

expectations

for inflation percent

5 to IO years

4-112 to 5-l/2

range. many manufacturers they report that there is no

In sharp inflation either. As seen higher in their And.

contrast. industries

and that cases.

are not expecting

much

indeed,

in many right were

they

are backed for crude

up by the data. are no

in the lower today than

panel.

prices

materials

they

$n early goods have

1988. been

and prices virtually may

of intermediate stable over the some

materials past three downward prices

and manufactured years. But

even here. Given

expectations

require

adjustment. of materials,

the secular prices lower

declines

in the relative

these

may actually consumer

need to fall in an inflation. of

environment

of significantly

price

As we noted years ago. the costs

in a special

presentation in terms

to the FOMC a couple of output loss, are

of disinflation. speed

closely

related

to the

with which makers.

inflation Given the

expectations current

conform on

to the intentions inflation

of the policy there

readings

expectations, will this

are few indications than we have

that future thus far.

disinflation With paths

be less

costly

experienced on alternative

in mind.

some perspective exhibit.

inflation

is offered

in my'final

I have used

our quarterly as to how
I

econometric inflation have case,

models

to lay out three could

alternative

scenarios

and unemployment the first

evolve

over the next five years. scenario. In this

labeled

simulation

a disinflation

the Committee

is assumed

to foster

a recovery

of sufficient

- 24 -

strength to lower the unemployment

rate to 6-l/4 percent by 1994 and Inflation drops to roughly 2-

then hold it at 6 percent through 1997.

1/2 percent in 1994 and, with a small margin of slack. edges lower over the remainder of the period. In the second case, the Committee is assumed to seek approximate uncertainty price stability by 1997. Although considerable

surrounds our estimate. research undertaken by the staff

suggests that measured CPI inflation in the l/2 to l-314 percent range would account for the likely measurement bias in this index. FOI

purposes of the present exercise. I have assumed a target of about 1 percent. According to the model. achieving price stability in this

time frame would require holding the unemployment rate at about 6-314 percent through 1996. In a final simulation that I have labeled "stable inflation." the economy grows rapidly enough for the unemployment rate to fall to about 5-314 percent by 1994. which is roughly our estimate of the natural rate. In these circumstances. the model predicts that GDP

inflation would stabilize at around its current 3 percent pace. Of course. the usuai caveats apply to these simulations. the Committee were to gain credibility over time for its announced intention of reaching price stability. the costs associated with disinflation would be smaller than implied by the model. On the other
if

hand. if--despite the improved price performance that we already have witnessed--workers and firms continue to expect some acceleration of

prices and wages. the cdsts could be larger than we have estimated. On the whole, the simulations probably provide a useful benchmark for of alternative inflation paths.

gauging the output consequences