APPENDIX

Notes

for FOMC

Meeting

October William

6, 1992

J. McDonoueh

The foreign since

exchange

markets

have

been

unusually collapse

turbulent of the

the last meeting, Monetary You will

dominated

by a partial

European

System. recall that at the last meeting we discussed Reserve that

intervention further would

operations

and the view operations likelihood

of the Federal be expected a goal

dollar-support a high

would

by the market, of strengthening that we had opinion.

not have

of achieving

the dollar been

and could seeking

be counterproductive. to convince after

I reported of that

actively

the Treasury

On the Friday wished against to avoid

the meeting,

August

21, the Treasury all-time low

the dollar Despite

passin~g through very strong

the then

the mark.

advice

from me,

representing the desk had only to two as

the views organize choices:

of the Federal a coordinated either to have this

Reserve,

the Treasury

instructed Reserve

intervention. the desk year.

The Federal

intervene

for the Treasury

alone.

we had once

earlier

or to participate we believed that

in the intervention. it would become were be even sooner

If we did not join worse than

the Treasury.

an ill-advised that the American was weak

intervention. monetary

It would

public

or later, when ever

authorities monetary

split

at a time showing by the we

the dollar greater

and the European We made was the

system

was

signs

of stress. choice

decision,

approved

Chairman. bought

that

the wiser

to join marks;

the Treasury. other

Together central

$300 million

against

German

seventeen

-2. banks lift, that bought just over an additional further and set a new After low of DM1.4255 a brief later

the dollar day.

dropped

The following advice desk from the Federal

Monday,

we had a repeat. the Treasury intervention. to keep

Against

very

strong the same

Reserve,

again Faced

instructed with the

to organize

a coordinated Reserve

choice, united against

the Federal and joined marks, We had

chose

the American bought

authorities $200 million

in the intervention. other central banks

The desk bought

while

authorization the dollar the later from

to buy up to $300 million. continued agreement to fall

Even

during

the intervention, intervention, risk further not directed new all-time with

and I stopped

our than has its

of the Treasury, effort.

rather

damage

a counterproductive since that

The Treasury reached

any intervention low of DM1.3865

time. 2.

The dollar

on September during

The dollar EMS, After reaching at least a high

strengthened of DM1.5116 lull

the partial

collapse left

of the the ERM.

the day that in that

sterling

the temporary became

storm,

dollar/DM

interest

rate differentials settled back

the most

important

driver

and the dollar

to a range other the

of about operations

DM1.3950 during

to 1.42. the period took place on

The only September speculative and asked transaction million. market 8. when

Swedish

central

bank.

in the midst

of a strong reserves

run on their the Federal in which In addition

currency,

ran out of Deutsche them by entering

Mark

Reserve we would

to help

an off-market of $400 out of the of

sell them

the DM equivalent this kept

to helping have been

the Swedes,

them

in what

would

a possibly

destabilizing

dumping

-3. dollars. Chairman both On behalf of the Foreign the Currency transaction. in System a single holdings in day of Subcommittee This of of the FOMC. covered $150

Greenspan to

authorized exceed

clearance more than

approval in net

a change Reserve

million currency change the

Federal

a single limit

foreign for the since

and in the

to

accommodate open

this

transaction in foreign

the

overall meeting.

position

currency

holdings

previous

In the details of what of the

interest partial and are

of

time,

I will of on the it.

not EMS,

attempt but

to

describe cover only

the some

fracturing then comment the EMS

will

happened As you

aware,

was in

created which was 13,

in

1979

as

a system parity realignment different Dutch,

of

fixed,

but

adjustable took

exchange

rates

occasional no currency widely

realignments between

place. and

HOWeVer, last

there

January

1987

September

despite

macroeconomic and and French Ireland on on of

performance one the the side and

betweewthe the United

Germans, Kingdom,

Belgians, Italy,

Danes

Spain, after

Portugal the

other. country,

German

economic

performance by large

unification above-target high high interest interest of

characterized growing neighbors maintain made to least

budget and

deficits, very

monetary rates, rates some of

expansion. forced in order its to

inflation to have

resulting

growth-inhibiting The of weak cyclical high had on did the not

parities. the costs

positions interest hoped to

the

countries

maintaining Europeans referendum

rates avoid

increasingly realignment scheduled the of

difficult until for at

bear. the 20, the

The French but

Maastricht permit of a 7%

Treaty, First,

September moved on on

the

market

that.

market lira

Italian 13 and

lira:

a response small

devaluation

the

September

relatively

-4. interest little had to or rate reductions After the by Germany heavy rate Irish, And the the following of day accomplished the British 16.

nothing. out the of

very

losses

reserves. on and

pull by

exchange The

mechanism Spanish French

September Portuguese

followed introduced

Italians.

exchange

controls.

in successful the mark. effort Very Most maintain their to strong maintain the franc remain on whether DM. Perhaps in within within the its the French can, limits EMS. are

a so-far

vis-a-vis

pressures now with is the

attention parity

able

to

they

since French over of franc when Germany the to

macroeconomic over French put the DM. to

performance HOWeVer, keep on the even

comparisons the

fact

favor is

the not those

short-term at levels

fight well

have

call short

money

over

a high

price if

positions. can has be~defended, a very will large there will be trade after serious balance the the U.K. Irish go new

Even problems with float stay to the and tied

franc France

following. United

positive deteriorate

Kingdom, if

which not

surely

effective, to the DM.

formal,

devaluation. one third

Similarly, of their merely

even

though

about to

exports create

the

U.K.

Apparent

solutions

today's

problems

One.9 for

tomorrow. With the French the the finance French market minister reminding went to the of and the world that it was the is

speculators worth not noting only the

during that

Revolution attack on

guillotine. currencies lags and

a cascade of leads

old-fashioned

combination such as

assault from

of market we know

professionals of bank foreign

commercial profits

banks. in the

HOWeVer, third

what

exchange

-5quarter, guillotine soon to be announced. on the Place Monsieur Sapin will no doubt order the

mounted A major

de la Concorde. is that the apparent especially stability of a

additional convinced

factor many

fixed-rate that there

system was

investors. risk

fund managers,

little

or no exchange of months and those especially grew began

in high-interest-rate they invested to the concern in

currencies. high-yield system about

Over EMS

a period

or even years, of other

currencies the ECU. rate

countries

tied When

through exchange

Finland

and Sweden.

stability

as the French to move into

referendum currencies. devaluation investors or

approached, After

these

investors policy

stronger

the inadequate interest toward

response

of the small many

Italian

and the small went roaring

rate moves exit

by Germany. and ordered

of these

the same

their

commercial

investment immediately most

banks

to get them

out of their

foreign

exchange

positions

at virtually factor,

any exchange at least

rate.

We believe

this was the runs on as

important

at the margin,

in the huge

various

currencies

and the inability rate moves, of these into

of traditional to thwart

defenses.

such

intervention

and interest some

them. out of European the yen against reached a new and

As at least assets, both they moved

investors Japan,

moved

a portion

strengthening the dollar Japanese

the dollar

and the mark.

Last week,

all-time their

low against

the yen of 118.60. exporters are them

authorities about an

manufacturing strong

starting

to worry that of

excessively its name moving

yen

giving '80s.

the problem most

gave the the recent

rust belt money move out

in the early Japan

In addition, liquid

into

is in short-term in.

deposits

and could

as quickly

as it moved

-6. Runs Growing economy. confronted interest chartered basis worries have the rates banks against about caused a currency Canada's have not been peculiar future. to Europe. on top of a weak of Canada

constitutional

a run on the Canadian intervention 2 percentage their

dollar.

The Bank in official

run with of almost increased

and increases points.

Last week,

the Canadian

equivalent

of the prime

rate by 200

points. Looking at our own situation, the dollar with has been Europe. about weak But the this

year been

because

of interest weak

rate differentials there has been candidacy

it has strength worry

particularly recovery,

when

concern has made

of the about

and Mr. Perot's future. interest

foreigners

our political Regarding

rate differentials, desk

the market

interpreted that

the lack

of action

by the open market until

last Friday

as meaning

Fed policy

is on hold into

this meeting. rates

It is anticipating point

an ease

and has built funds rate.

the exchange

a 25 basis

cut in the

The market may just be reading concert about with

is also

confused After

about

German

monetary

policy in

and

it wrong.

lowering

interest

rates very its

the Italian questioning I believe

devaluation. of whether that at least

the Bundesbank

was

tender

the wide

it had maintained some

independence. that they

of the key directors to their

feel own

are well that

on their

way

to having rate moves last week at existing points

established will

satisfaction their

any interest Although rates

be deemed

to be of maintained it lowered three the

own free

doing.

the Bundesbank high levels. where

the discount call money

and Lombard rate to 8.9%.

80 basis

below

it was

-7. weeks ago. Schlesinger last Friday. policy. emphasized This One may of this be the development first at his press step towards

conference easier is the that EMS

fair-sized such

monetary the and

the its

reasons goal that of

behind

a possibility to of

Bundesbank lessening as

achieved the

restoring would

flexibility lose control the

likelihood in

they

monetary Bundesbank operations, banking

policy added an

they

did

September. to

During

last

month.

92 billion amount at the equal start

marks to of the the

reserves

through of

intervention the German 25% of the

total month

reserves or

system

approximately the

Bundesbank's than their it would basic

total take four-and has

assets. us because

Sterilization of the

took

Bundesbank

longer of

relatively

inflexible

nature the

eight-week contributed the use of as

monetary to

operations. in

However, operations. operations

experience announced willingness If from

clearly to

a change

Friday, to the use

two-week short to point as

maturity a few and the

and

a

operations

days. yet appear of kinds of the independent the of German people

Bundesbank pressures. improving M-3 as of

wishes it can price is

ease. to

political

weakening and all

economy. explaining inverted is at the

slightly the yield

performance a technical Mind they

rapid curve

growth

result you. are if

their Bundesbank to proceed

justifications. an easing and period.

beginning

likely

with

considerable Regarding

caution the

rather

slowly. growth capital of the kind into envisioned the United Perot's at least early in

U.S. will

economy, not help

the

Greenbook because and

forecast such

flows growth

states, candidacy

flows

require view

a stronger that

pattern. victory is

a growing and would

market probably

a Clinton

a possibility

bring

a fiscal

stimulus

package

-8. next The year worry create has shows would I do event, of to how uncertainty, be that these large could also adversely in flows affecting a world can capital in which out of flows. recent a of plan or, and see the for in are such

pressures, capital be

history country, dollar. such the an best

rapidly

move

trigger not

what

a rather is

rapid

weakening

believe it at

that could all. to

there happen We those

a single in to

contingency of ways, vigilant who

because not

a variety be very

cases,

have

keeping asset

particularly reallocation

close moves

market

participants

early.

RECOMMENDATION:

Mr. operations $150 million

Chairman,

we

need

a motion sale of

to

approve

the

three to buy

I have in

discussed:

the

German August of

mark

reserves $100

the the

intervention sale of the

operation equivalent bank.

21 and

million

on August on

24 and 8 to

$400

million

in marks

September

the

Swedish

central

Notes for FOMC Meeting October 6, 1992 Joan E. Lovett

Domestic Desk operations were at first geared to maintaining the existing.degree of reserve pressure and then to

imparting an easing of those pressures on Geptember 4 in response to weak employment data and sluggish money supply behavior. Thus, Fed funds initially were expected to continue in

the 3 l/4 percent area, moving down to 3 percent in association with the September 4 easing. The borrowing allowance was cut The

twice by $25 million, bringing the level to $200 million.

first was a technical adjustment to seasonal reductions in use, and the second was made in conjunction with the change in policy stance. Borrowing ran above the allowance during the period, This reflected a couple of statement

averaging $273 million.

date bulges when reserves fell short of expectations. The Desk was active throughout the intermeeting period, seeking to meet large reserve needs with a variety of temporary transactions portfolio. as well as with permanent additions to the A large seasonal need for additional reserves was

anticipated at the outset, stemming from increases in currency and required reserves early in the period and rising Treasury balances later in the interval. Against this background, the

Desk purchased $3.7 billion of Treasury coupon issues in the market on September 1 and purchased additional securities

-2-

directly from foreign accounts periodically thereafter. System'sportfolio

The

rose by a total of $6.2 billion, consisting of

$5.6 billion of coupon issues and $0.7 billion of bills. As September progressed, reserve needs exceeded initial expectations considerably: currency growth was somewhat

stronger, and Treasury balances were substantially higher following the mid-month tax date. considerably Although Treasury cut back

on its auctions, Treasury balances at the Fed ended

the quarter at about $25 billion versus estimates of about $13 billion made at mid-month. under $60 billion. General balances came in just

Individual nonwithheld income taxes were

stronger than expected, and RTC receipts were also somewhat above expectations. The higher balances were a surprise to the market

as well and led to reduced estimates of Treasury's 4th quarter borrowing requirements. In meeting reserve needs, the Desk used a mix of RP's ranging from customer-related to multi-day System operations. The multi-day RP's were a combination of withdrawable and fixed term, depending on the outlook, and included one operation that was preannounced. With the money market generally to the firm

side, Desk operations were constrained on only a few occasions by the need to insure market clarity about policy rather than optimal reserve management. For the most part, the Desk was able

to inject the estimated volume of needed reserves--acting on all but four days of the period --but reserve shortfalls tended to keep a firm bias to the money market. The quarter-end also saw a

-3-

firming

trend,

exacerbated

by the confluent settlement. for the

ending

of a reserve

maintena.nce funds rate

period averaged

and auction 3.22 percent

In all, the Federal intermeeting period from

September

4 on. Although Federal funds were among often market above the expected as to over the weakness

level,

there

was no uncertainty level. There were,

participants views

the desired period at the about

however,

shifting

the System's was

next move.

A bout

of dollar

outset

seen as impeding returned reasoned

a Fed ease.

As the dollar state of the exchange the Fed

stabilized, economy. market would

the

focus

to the stagnant that, while

Participants developments

foreign

were

a significant

factor

such that

not

act while remain

the dollar the Fed's

was unsettled, top priority.

the domestic Thus, yields in the

economy dropped August

would quickly

and dramatically report announced would

on the weakness on September feel compelled of a key The

evident

employment that

4 as the market to ease. focus The

anticipated foreign

the System market

exchange

became

even more

over much in

of September that market

given had,

the turmoil

in the ERM. only a limited relative struggling

turbulence

on balance,

impact

on Treasury data

market

yields

given

the dollar's an economy bias

calm.

Meanwhile, and this

continued imparted period. report

to portray a downward In this

to grow,

to yields,

particularly expected

later a weak

in the employment ease.

setting,

participants

on October incoming

2 to be the catalyst information

for further

System

In fact,

was viewed

as so soft that

-4-

additional Fed ease was already built into the rate structure prior to'the employment report. That report was viewed as weak--

not so weak as to trigger a move prior to today's FOMC meeting but weak enough to leave. expectations of an imminent move in place. In the coupon sector, rates on short- and intermediateterm issues ended the period 25 to 55
basis

points lower. The

Rates

on the long bond ended only a few basis points lower.

Treasury raised a net of $22 billion in the coupon sector during the interval including the initial "Dutch11 auctions of two- and five-year notes that will comprise the Treasury's year-long experiment with this format. That experiment was announced on

September 3 and is designed to test whether the single price format will prove beneficial in terms of taxpayer cost and auction participation. Demand for the 2-year note was strong and

only a small percentage was awarded at the stop-out rate, a level that was right on the market. The initial 5-year note auction, Demand

on the other hand, could be considered a disappointment.

was lackluster, and the stop-out was several basis points above 1:00 p.m. market levels. However, this may better be viewed as a

necessary cost to getting the format launched. Rates in the long end of the market declined with the rest of the curve when economic data looked particularly weak. The 30-year bond reached its interperiod low of 7.23 percent s right after the System’ ease on Saptambar 4. Declines in this

sector were subsequently tempered by uncertainty related to the

-5-

upcoming Clinton fiscal looked of size reflected to reverse declines debt the that Fed's

Presidential victory stimulus. likely and were

election. seen as more

Initially, likely

prospects

of a a move package being one to

to generate a fiscal

By the end of the period, who wins,

no matter

the only difference about

timing.

Market that

uneasiness

such prospects States

the belief Government

it is impossible once

in the United

spending

it is initiated. outpouring

Yield of corporate

were was

also tempered issued after

by the huge the Labor

Day holiday

and following during the as

easing

move. time

Some

$36 billion

was marketed Sales

period hedges

and

required

to distribute.

of Treasuries

against

unsold

corporate

inventories

led to some market lo-year note. over the

scarcities,

most Bill

notably were

for the Treasury's

rates

lower by 40 to 45 basis down $7.3 billion yesterday's

points

period. during cash

The Treasury the interval

paid

in the bill

sector

(including

auction) fillip

amid rising periodic were

levels.

The short-end spurts.

got an added New three-

during

but brief sold

quality

and six-month percent,

bills

yesterday with

at rates 3.10 and

of 2.67 and 2.78 3.18 percent short-term

respectively,

compared meeting.

just prior

to the last were lower by

Rates

on private points.

instruments

20 to 30 basis

Michael J. Prell October 6. 1992 FOMC BRIEFING -- DOMESTIC ECONOMIC OUTLOOK

As best we can judge at this point. .real GDP grew at a rate in the third quarter somewhere in the vicinity of the 1.6 percent average pace of the first five quarters of this recovery. Such an

outcome would be in line with our expectations at the time of the last meeting. Even so. as you are aware, we've sliced more than a percentage point off the growth rate projected for the current quarter and sizable fractions off the rates in the first half of next year.
ve MOreOVer. we’

raised the unemployment rate I'd like to

disproportionately

relative to the trimming of GDP.

spend a few minutes reviewing the-,logic underlying these revisions to the forecast. The first point is that the available indicators suggest a weak output trajectory as we begin the fourth quarter. Most

notably. employment has fallen of late. and industrial production appears to have declined another third of a percent last month. Unless things turn around soon, both of these variables are likely to be down on a quarterly average basis in the current period--far below the path anticipated A turnaround in the August Greenbook.

certainly is possible. but--and this is my in the household sector don't make it

second point--developments look likely. appreciably

Although we estimate that real consumer spending rose in the third quarter, that gain largely reflects a spurt Recent

in non-auto retail sales at the beginning of the summer.

data give no hint of sustained strength. and the latest indications of wage and salary income and consumer sentiment don't bode well for

October FOMC Briefing future spending.

-2-

Michael J. Prell

Meanwhile. the housing market indicators have been

a bit confusing of late. but on the whole they suggest that the decline .in mortgage rates has produced only a modest that sector. improvement in

It seems doubtful that the economy is going to build become more inclined to spend.

up much steam until households

This brings me to point three, which is that households probably won't open their wallets wider until they are more confident about their economic prospects. circularity--or. in technical It is here that the the

jargon, the simultaneity--of

problem becomes apparent:

People won't spend much until they feel for

more secure about their jobs and income. but the potential

generating additional purchasing power is limited as long as people hesitate to spend. Moreover--and this is point four--such increases in demand

as we have experienced to date in this recovery have not translated into job growth. Instead. productivity gains have more than To be sure, it is the

accounted for all of the increase in output. norm for labor productivity

to surge in the early part of a cyclical

upswing, because companies typically have hoarded some labor during the recession and are able to operate more efficiently back toward more normal rates of output. as they move

But, in a more typical increments

recovery. demand is strong enough to require significant to employment as well.

My fifth point is that. while the pickup in productivity thus far in the recovery seems to be on track with previous relationships. the extent of restructuring going on in many industries suggests to us that output per hour may rise relatively rapidly for a while longer. thereby damping new hiring. The

October FOMC Briefing

-3.

Michael J. Prell

adjustment we've made to the forecast in this regard accounts for the extra elevation of the unemployment rate that I noted earlier.

So. in sum. the downward adjustment to the near-term GDP forecast reflects not only a recognition of recent weakness in of the

employment and industrial production, but also a reassessment prospects for household

spending in light of the employment-damping gains. A more sluggish

effects of relatively strong productivity path of consumption investment.

in turn diminishes the incentive for business

That said. why have we stuck with the projection significant acceleration

of a One

of activity over the course of 19931 are becoming

senses that a good many consumers and businessmen

skeptical about the predictions that better times are just around the corner, and economic forecasters are becoming increasingly wary But,

about sticking with this story and just changing the dates. while admitting that the pickup and, especially,

its timing are far

from assured. we still believe the analysis makes good sense. The projection of an acceleration of activity next year is

founded in part on the belief that the "headwinds" associated with a number of sectoral problems and financial stresses will be diminishing over time. In addition. though. we are projecting that further by

longer-term interest rates will decline substantially

next spring. with the 30-year Treasury rate falling to around 6-l/2 percent. This should aid the balance sheet restructuring generally--provide impetus to demand.

process and--more

Obviously. an

important question is what funds rate change,

if any. might be necessary to bring about this easing of longer-term yields. As we hinted in the Greenbook. we have anticipated that the

October

FOMC

Briefing

-4-

Michael

J. Prell

funds term

rata might rates

move

a little

lower.

but we would

expect

longerto remain by

to fall

appreciably

even if the funds undoubtedly

rate were

at 3 per.cent. their

Investors' And the

expectations longer the

are influenced remain worry low and that

experience. remains

short-term

rates will

inflation will

subdued.

less investors

rates

be headed

higher

in the

future

and the more

willing

they will that our such

be to accept quarterly

lower

bond

yields.

It is inter,esting many has

to note

econometric of term

model.

which--like behavior.

others--embodies done well

a formulation the shape

structure curve down

in tracking that even more

of the yield should come

to date... and over the next

it would couple

suggest

bond yields than we've

of years

predicted. uttered the word lining "inflation" a few seconds ago. I

Having should high price say that

the silver is that The rate

in our forecast

of distressingly progress at only a joblessness remain trend above drifts still toward

unemployment stability. annual

we seem to be making

solid

CPI is projected at the point. and

to be rising and with could

2 percent

end of 1994. output

in the high potential

6s at that 1995

growth the

through

1996 while range.

inflation

into the 1 to l-1/2

percent

But this may more fact immediate

be getting would

too far ahead

of the

game.

The in

question

seem to be whether

activity a more

will

pick up fairly out than

soon.

or whether

we are facing

serious and if jolt of

stalling

suggested

by the Greenbook. stimulus--or then

If the latter. some autonomous would

a significant animal that

and prompt not

fiscal

spirits--is

in the easing economy.

cards, action

our analysis

suggest few

a sizable

further the

may be needed

in the next

months

to recharge

October FOMC Briefing

-5-

Michael 3. Prell

There is an understandable

tendency to look at the state of

the economy after almost 700 basis points of easing and conclude that more cuts won't do much good. However. I'm more inclined to

think that the 300 basis points left before we get to zero do provide the scope for meaningful action. It may be worth noting, in

this regard. that. even a funds rate in. say, the 1 to 2 percent range would not be unprecedentedly low in real terms. The way the

markets would react to such a drop obviously would depend on the context--but I suspect that. if it occurred as the unemployment rate

was moving up toward 8 percent. any loss of anti-inflationary credibility would be minor. and remediable with a timely tightening once things began to pick up. Obviously. in thinking about the prospects for the economy

and for market responses to policy actions, the external sector is of particular that regard. .*.****.ttttttt*t*** interest at present. and Ted has a few words to say in

October 6, 1992 E. M. Truman FOMC Presentation -- International in this Develooments was to present an

My original insightful and the financial unclear analysis

intention of the deep

briefing

implications exchange

for the U.S. market and

economy

staff

forecast

of the recent However, play

turmoil how these

in Europe. events will

it still

is exceedingly as far as we has happened to

out. economy

Moreover, of what

can tell, date

the effects

on the U.S.

are minimal. While exchange rate relationships from the within Europe have

changed,

the principal States

development has been

economic

perspective

of the United monetary Most

a slight

easing

of European stronger on U.S. effect policy from dollar. real from is the

conditions

accompanied imply

by a somewhat

empirical from

models

only modest type:

effects the

activity stronger generally stronger typically

an episode

of this

income monetary

growth offset dollar.

as a result

of the easier

by the negative The estimated as well. into the

substitution effects

effects

on U.S.

inflation this

are small insight

We have staff

incorporated

conventional One turmoil in turn, dollar; working activity. within

forecast. would be that continued that,

alternative Europe

assumption generate

will

substantial in Europe and price

uncertainty and to bid would

works in that in the

to reduce case, same

investment income

up the be

both

effects

direction

and would

be negative

for U.S.

-2-

Several the external

other

developments

have

affected

our

outlook

for

sector. the positive effects on European we have with the growth down

Notwithstanding associated growth with

ERM developments, industrial The

on balance, countries,

marked important fiscal

in the

foreign

exception package about

of Japan. boosted our

larger-than-expected for 1993, with but

Japanese

outlook

we remain over the

pessimistic second half

the near-term year

situation,

growth

of this rate. activity changes, less next

projected have

at less than down

one percent

at an annual of economic of all these a percent of a percent

We also

marked

our projection The net

in developing using U.S.

countries. weights, this

result

export

is about year and

a half

foreign year.

economic

growth

a quarter

As noted, foreign exchange

we raised

slightly

our projected This morning,

path the

for the dollar

value

of the dollar. emphasize

on average percent

-- and I would its level percent

on average of the

-- is l-1/2 FOMC ago. about in the interest with 5 percent meeting,

above

at the time above

August

and about

5-l/2

its low of a month since last January,

The dollar's in real terms, has

decline

been

accompanied and

by a decline real

differential rates normal dollar's dollar

between

U.S.

foreign This

long-term

of about

50 basis

points.

is broadly interest

consistent rates

statistical value. is boosting

relationships One question recovery channel

between

and the

is whether

the decline economy,

in the that is, Reserve

the

of the U.S. for the

providing

the expected

effects

of Federal

-3-

ease. would

My tentative note, however,

answer that

to this over

question nine

is affirmative. months, terms, during we have

I which

the past

the dollar lowered our

has declined estimate l-3/4

by 5 percent

in real

of foreign percentage growth

economic

activity In the near

for 1992-93 term, such

by a to

a cumulative reduction offset effects price the

points. normally

in foreign lower

would

be expected run,

largely the relative longer

dollar.

However, should

over the longer
predominate the system

of the

lower work

dollar way

because with

effects

their

through

lags.

We have a dollar a barrel.

raised

our assumption factor

about behind

oil prices this

by about is a

The major assumed

adjustment

postponement from early

of the

flow of Iraqi second Iran half

oil to world

markets a bit

in 1993 to the it appears more

of the year.

Gazing

further

out,

that than

is increasing previously

its potential expected, forecast and after

production this Iraqi could

somewhat produce

had been risk

a down-side becomes

to our price

production

available. second quarter that became available

Information since level your

for the

last meeting exports

suggests

a somewhat

weaker

underlying However, trade data

of net

of real

goods

and services.

conditioned for July rise

on the new 42 information, relatively

the merchandise aside from

contained

few surprises, and parts.

a further

in imports larger The net

of computers deficits result and

We continue

to expect

somewhat

in coming

months. factors is that to provide forecast real net a A

of all these

exports very

of goods boost

services real

are projected GDP over the

only period.

slight

to U.S.

-4-

moderate

improvement

in services

is almost

offset

by a small

deterioration That

in goods. completes our report.

October 6. 1992 FOMC Briefing Donald L. Kahn Perhaps in contrast to the tone of much of the nonfinancial data received since the last Committee meeting, some financial market indicators of the thrust of monetary policy have turned more positive in recent months. showing the effects of the easings over the summer. Broad money growth picked up in August and September, with M2 expanding at a 3 percent pace, following declines on balance over the previous four months. signs of life. Credit flows may also be showing a few tentative

Though data are very limited, we are estimating that

debt growth for nonfederal sectors, while still anemic, strengthened a bit over the third quarter. After showing very little change in late

spring and early summer, bank credit picked up to 5-l/2 percent in August and September. including~the first increase in business loans in a year. rates: Moreover, the easings have shown through to real interest

The one-year rates shown in the chart package have moved down

noticeably and are at their lowest levels in a dozen years: long-term real rates at the lo-year maturity used in that package also appear to have declined and are below their levels of most of the 1980s and 1990s. And the dollar's weighted average foreign exchange value

remains close to. though somewhat above. its historical low. These indicators. while somewhat encouraging in their implications for economic expansion ahead, do need to be interpreted cautiously. With regard to credit and money flows. growth rates re-

main quite low--broad money aggregates are below their annual ranges and debt is only a little above the lower bound of its range. over. at tained. More-

least with regard to money. recent strength may not be susThe bluebook has M2 and M3 slowing a little in coming months

-2-

from their recent pace under the unchanged interest rates of alternative B. Expansion of the aggregates should be supported by some mortgage refinancing ana the unwinding

special factors--specifically.

of the First Union reserve avoidance scheme--but underlying growth will be damped by sluggish $ncreases in nominal income, and velocities will continue to be boosted by downward adjustment of deposit rates and the tug of capital market investments and debt repayment. As a

consequence. we are projecting that both M2 and M3 will come in a half percentage point short of their 1992 annual ranges. Moreover, capital

markets are quite skittish, with worries about the strength of expansion and about possible fiscal policy outcomes resulting in both upward pressure on bond yields and downward pressure on stock prices in recent weeks. Against the backdrop of these mixed signals. and of the downward revisions in the greenbook forecast of output and prices to or below the central tendencies of Committee members'forecasts in

July, the decision that would seem to be posed today for the Committee is whether or not to reduce the federal funds rate another notch at this time. I thought I would address three of the issues that might

have a bearing on weighing the costs and benefits of such an action: the monetary policy implications of the possibility of more stimula-

tive fiscal policy next year: the potential effects of policy easing on tender financial markets. especially working through movements in the dollar; and whether and how easing might in fact have a stimulative effect on spending. The uncertain dynamics and outcome of the election process may have widened the range of possible outcomes for fiscal policy. As already noted, concern and uncertainty about the fiscal outlook likely was an important factor behind the failure of bond rates to

-3-

follow short-term rates down over the intermeeting situation presents potential difficulties

period.

This As

for monetary policy.

markets build in the possibility of higher budget defi'cits, the resulting rise in long-term rates damps activity well before the actual. offsetting, fiscal stimulus.arrives. if it ever does. In concept, one

might be able to make monetary policy adjustments in the direction of offsetting the effects on nominal~ spending of the fiscal/financial market adjustments by easing no" and perhaps tightening more later. if the fiscal stimulus turns out to be excessive. However. this degree

of "fine-tuning" implies far more certain knowledge of the strength and timing of policy channels than we have. Short of this, the seem to be a good

possibility of future fiscal stimulus would ti

reason to hold back from policy easing at this time, provided other considerations were seen as pointing in that direction. Important among those considerations would be the effect of an easing on the exchange value of the dollar and on financial markets more generally. In light of the extraordinary volatility in foreign

exchange markets and the sensitivity of stock and bond markets. the concern is that a further decline in interest rates might trigger. not an orderly drop in the dollar. but a generalized run that feeds on itself and shows through adversely to the prices of dollar assets. In writing the bluebook. we considered this possibility under alternative A. Clearly one can not dismiss the risk of substantial further

declines in the dollar, especially were the economy to turn out even weaker than expected and monetary policy acted forcefully to counter that weakness. Indeed, if the U.S. authorities were outspoken in as they have been at times,

their indifference to dollar depreciation,

that drop could be steep and not very orderly, boosting bond yields

for a time.

The key to whether the dollar decline would become out-

sized and have a more lasting effect on bond yields would seem to be the credibility of the System's inflation objectives. 'The danger

is that the easing action would be perceived as signalling such an intense focus on promoting economic activity it raised questions about the Federal Reserve's willingness to lean against inflation pressures. In our view, the risks of this outcome would be fairly well contained if easing was clearly understood to be taken in the context of persisting high levels of slack in the economy and sluggish expansion of money and credit that pointed to considerable further disinflation. Market perceptions that the dollar is already undervalued against many

currencies may help to limit further declines in response to appropriate easing actions. In these circumstances, lower federal funds rates

are more likely to be accompanied by lower bond yields. Having made this case. ~however. it's also important to note that the yield curve continues to suggest considerable skepticism

about the prospects for holding inflation below previous trends once the economy recovers. Further easing is unlikely to contribute to And they might be especially doubtful in

convincing the skeptics.

light of heightened market concerns about outsized budget deficits over coming years. with potential pressures on the Federal Reserve. In light of the possibility of adverse market reactions to a System easing, an assessment of likely benefits in terms of added spending is particularly important. Ted has discussed the exchange

rate channel for policy influence, which remains operative, even if other forces restraining demand abroad are affecting our exports. Questions seem more pointed with regard to the effects of lower interest rates directly on spending. Many have noted the apparent some of

damped response of the economy to declining short-term rates.

-5

this may represent the effects of exogenous factors, unrelated to interest rate levels. that would be depressing spending in any case. Cne such example would be decreases in defense spendirig. And other factors may have reduced the sensitivity of spending to interest rates. One would hope that the excess capacity in nonresidential

structures would sharply limit the usual response of this sector to declining interest rates. In addition, earlier in the current cycle, rates for

the emerging credit crunch also played a role--effective

borrowers were not declining as much as observed rates. and might even have been rising after taking account of tightening standards and rising nonprice terms of credit. This seems less likely to be true

this year: most reports suggest that credit tightening has stopped. at least outside of commercial real estate. so we ought to be moving down borrower demand curves as interest rates decline. Declining interest

rates reduce the rewards for saving, encouraging current consumption and spending. But discomfort with existing balance sheet structures,

particularly in light of concerns about future income prospects and about the future value of real assets, such as houses. probably are encouraging business and household borrowers to use additional cash flow to pay down debt rather than to spend on current consumption or to accumulate real assets. saving to maintain incomes. In these circumstances. the effects of lower interest rates And. creditors may be reacting by raising

on spending itself might be more delayed than usual, but in the interim they would speed the balance-sheet especially for borrowers. Particularly restructuring process.

if lower short-term rates feed

through to long-term rates, refinancing will be encouraged and asset prices-.-including that of equity--supported. As households and busi-

nesses increasingly become more compatible with their financial condition and adequately protected against possible adverse outcomes, they should begin to spend. And intermediaries would be better posiPerhaps what this suggests is an

tioned to meet their credit demands.

interest rate channel for monetary policy that is damped in the short run. but could operate with greater force over time. If the Committee were to ease, it Andy the Board would be faced with the issue of the role of the discount rate in such an action. There is no technical barrier to pushing the funds rate below In the view of my predecessor, Mr. Axilrod. as

the discount rate.

noted in the Greenbook supplement. such a configuration might reduce the risks of excessive pressure on the dollar. The effect would be

through signalling the Federal Reserve's intent that easing wasn't lasting or likely to proceed further for a time--similar nailing effect of intervention.~ to the sig-

But such an action would also raise

questions and speculation as to why the Federal Reserve was changing long-standing practices at this time. perhaps confusing observers and providing grist for newspaper and newsletter mills. If the Committee

wished to ease policy and there appeared to be a good chance that a discount rate cut might be forthcoming. it could acknowledge that

possibility by adding a "taking account of a possible cut in the discount rate" to the first sentence of the directive. guage used in similar situations in the recent past. This is the lan-