February Short-run policy Donald L.

Kohn

4, 1994

The decision to its reserve immediate market

facing

the Committee would occur seem now,

at this meeting to be whether

with

regard of

policy conditions

options should

a firming

or can be safely as Mike Aggregate

and apit is

propriately delayed ing that that

put off. the

In the half

staff

forecast.

discussed, demand

until

second

of the year. or the rise

underly-

forecast

is not so strong the beginning

amount

of slack deflects

so small the core

postponing rate

of the downward rather reduce

in rates

inflation inflation would this

from a slight

trend. than

A willingness it moving

to accept lower. rates at

at its current

rate,

keeping

correspondingly time. The "wait

further

the urgency

for raising

and see" policy assess

of alternative to which

B also would the recent

allow strength a but one and

the Committee in demand number that

to better likely

the extent

seems

to persist important

in the new year--an last Committee effects

evaluation meeting.

of you thought

at the term

is complicated weather.

in the near

by the

of the quake

severe slow

Over the balance and inflation action,

of the year, remain take

the economy damped

may well

considerably Reserve

potential

without

Federal economies houses own: last

as tax increases

effect. stocks

key foreign of durables and on its

founder,

and additions Moreover,

to household

moderate.

the market interest

has done

some tightening rates

the rise

in long-term damp

rates

and exchange ahead.

since these are some

fall should will

demand

in the quarters at least

To be sure. if they Still,

increases

tend

to reverse, point

in real terms, rates.

not validated

at some

by rising

short-term

-2-

delay

is not likely

to have

a major

effect

on the degree Federal

of restraint, to firm.

especially

if markets However,

continue

to expect

the

Reserve

if the than

Committee staff

desired

a more

definite

downward risks on

tilt

to inflation inflation, at this

in the

forecast,

or saw the as tilted

output, firming

and inflation would

expectations

to the up side.

time

seem appropriate. to its potential strength does increase demand

The proximity the danger would that

of the economy

even moderate over time

unexpected

in aggregate increase

feed through In this

to an unacceptable real short-term expressed

in inflation seem these the quite rates

pressures. low, must

situation,

rates

would

and the Committee be raised at some need Both

has already point

its view that Given

to contain fairly

inflation.

lags, in in

tightening

might

to begin

soon to avoid and the staff

difficulties foresee

1995 and beyond. nominal tendency GDP growth might

the Committee

a pickup this

in 1994 relative as consistent

to 1993. with

Leaning

against

be seen

the Committee's

longer-run

objectives. Tightening tions tions could have ahead of any deterioration effects on capital yet. in inflation markets. at least expecta-

salutary picked

Such expectajudging from or in re-

may not have recent

up appreciably in direct

the most outside mained they light

evidence

surveys

of price

expectations has

economists'

forecasts exchange

of inflation, markets. postponed

and the dollar But there is some very

firm in foreign if the

risk that long, in

could

Federal

Reserve

its action prices.

of recent

data

on activity by factors

and commodity unrelated

A sense

that

inaction policy

was motivated

to the conduct

of monetary funds Delay more

would

be especially

damaging.

An increase dating

in the federal

rate is widely risks raising

anticipated--even questions about

if the

is in question.

our priorities

and necessitating

drastic have

action

later.

A modest

rise

in the

federal remind

funds

rate would that

small

effects

on the

economy,

but would

the markets

the Fed is still

on the

job. of money decision. as early last and credit Broad year. is of only growth staff months lower limited remains has and use weak--

As usual. in guiding albeit growth percent not

growth

the Committee's quite as weak

money The

forecast l-1/4 of their hand.

of 2 percent in M3. Both

on average aggregates Borrowing

in M2 over would

coming

be in the

halves

provisional strengthened that

ranges.

by private

sectors. half

on the other

significantly sheet

in the second

of the year, and lenders

suggesting have been

the balance rapidly. pace,

constraints growth

on borrowers in private

ebbing more

We expect

debt

to continue further.

at this

rapid

but not to pick

up significantly

February Long-run Donald Policies L. Kohn

4, 1994

As background policy objectives annual that

for the Committee's might be presented

discussion in the

of longer-run to Congress, presented policy. the projecthat are in

report staff

and of the the bluebook Given tions the the

ranges

for money

and credit, scenarios forecasts too

the

a number

of long-run of economic be taken

for monetary in general,

limitations

obviously

shouldn't may expand

seriously.

But we think in ways

simulations in the The

on the Greenbook consideration gives

forecast

that

useful

context first

of your

of longer-range three possible

strategy. strategies to full on

set of simulations of the Committee's

for policy employment page

in terms or price chart

emphasis

on moving

stability.

The results page.

are found

on the table point is

8 and the from

on the following three

One important start from the

evident that

the chart--all

scenarios need

premise levels interdriving which the

real

short-term prices

interest

rates

to rise from

current long-term

to prevent est rates the

from

accelerating. rates

In the models,

and exchange but

are the key financial rates are the instrument variables. by when

variables through

economy,

short-term influences the

Federal

Reserve with

these

The monetary and how much

policies short-term

associated rates

strategies

vary

are raised. You will note that or the the differences interest this full rates among needed the alternatives--in to get them--are the economy

terms

of the

outcomes

not large. currently

For the most

part,

reflects employment

the fact that and price full

is not far from both strategy makes

stability. and

The baseline price

some progress get to either

toward

employment Full

stability,

but doesn't

objective.

employment

-2-

can be achieved rate at the price same

fairly

promptly,

however,

by keeping longer: the

the

federal

funds

current

level

for only

a little by moving

alternatively, rate up by the In the to

stability amount

can be approached

funds

as in the baseline, policy in the latter

but two

sooner

and less

gradually.

out years, avoid

alternatives direction. quickly

must

be calibrated

overshooting

in one or the other policy could nudge

On one side, the economy

overpast

staying

an accommodative

push

its potential possibility in 1995

and give an upward requires easy two a fairly

to inflation: in short-term in nominal side,

avoiding rates

this beginning that policy the

sharp

rise

in the

strategy--to

a level On the

terms

above

for the other of pushing period with

strategies.

other

an aggressive within

up nominal

rates to approach risks arriving implies

price

stability ultimate

of the

simulation

at this future

objective avoiding in the this

an unemployment dictates strategy. Charts

rate that

deflation:

outcome tighter

a drop

in rates mid-way

through

the period

2 and 3 look These

at the

implications make

of some

potential

risks First, staff

to the they

outlook.

exercises of some they in the

two types

of points. in shaping the

show the importance And second, by lags

key assumptions

projections. policy

illustrate response

the difficulties of policy

for

monetary

caused

to changed to policy that the

circumstances actions. NAIRU

and by lags 2 following

in the response page

of the economy

Chart

10 addresses or lower

the possibility than assumed

is l/2 percentage

point

higher

in the compensaIn by

baseline. tion this data,

If it is higher, the economy

a possibility operating

raised

by recent

is already rapid

beyond

its potential. shown

circumstance, line, can't

even the which

and pronounced a bit until pickup

tightening,

the dashed apparent,

is delayed some small

the problem

becomes

avoid

in inflation

in the near term.

-3-

If the natural line, keeping

rate policy

is lower, on hold

as recently

asserted

by some,

the dotted

for a considerable attainment

period the

has no adverse lower by this favor-

consequences--in unemployment able

fact

it allows inflation

of both

and lower

possibilities

implied

situation. Chart 3 posits stronger and weaker case, aggregate in designing demand the in 1994 scenarios, be from in

than

in the

staff that

forecast.

In this

we assumed easier levels

evidence

of the change

in circumstances continued

would

to detect, assumed

as indicators

of demand Even quickly

to deviate

in the baseline. feeds through

so, the excess to labor

or shortfall

aggregate whereas is only responses more rapid

demand the felt

and product policy rapid

markets. response

influence some

of an alert later.

and prompt Thus, even

monetary fairly

quarters

and robust case or

do not avoid inflation

rising

unemployment demand growth

in the weak case. paths

demand

in the

strong

In constructing took well that account of movements

the money in both

for each

strategy, rates,

we as

short-term

and long-term In addition,

as the behavior

of nominal

spending.

we assumed years would at

some of the unusual that they

intermediation fade

patterns

of recent as loan

persist--but depositories availability relative

would

out over time became

demands

picked

up and as savers funds

better

adjusted inherent

to the riskiness

of mutual

and to their

greater

to deposits. These factors informed on page our projections 13. We expect More of money debt and credit about in

for 1994 and line with

1995,

shown

growth

nominal credit than

GDP again

in 1994. lead

comfortable

balance

sheets by

and greater sectors a drop

availability governments. borrowing,

to a pickup

in borrowing is about

other

In the total, to the

this

offset

by

in federal

owing

effects

of deficit

reduction

-4-

measures

and a stronger

economy.

A greater both

proportion

of this

credit

is financed to lend

at depositories, strengthening

reflecting of private

an increased demands. funds

willingness Moreover, in bond and

and the

credit

depositories stock growth markets,

are assumed given

not to raise already

quite

as much

their

hefty

capitalizations, percent

and thus M3

is projected M2 growth

to pick up to l-1/2 also strengthens--to to long-term

in 1994 and 2 percent this year, slow, and in part

in 1995. 2-l/2

2 percent mutual

percent

next--as

flows yield

funds

reflecting through strong

a flatter of 1993.

curve

and smaller of the

capital

gains

than assets is

much enough

The ebbing the effect

diversion

to non-M2 drop-off

to offset year

of an expected general

in mortgage shortto

refinancing term rates

this

and the more

influence

of higher

assumed

in the forecast.

M2 and M3 velocities 1993. out two

continue

advance,

but by a bit less than Against this ranges background, for money ranges

in 1992 and page

16 lays for

alternative I con-

sets sists

of annual of the 1993

and debt from

1994.

Alternative were

provisional ranges,

last July: were

these reduced

set equal time.

to the With than

which,

as you

recall,

at that higher

growth

in the aggregates the staff

expected forecast, the

to be a little there would assuming

in 1994

in 1993 under rationale

seem to be no that something

pressing

for reducing

ranges,

like the staff able outcome.

forecast

for the economy

is considered

to be an accept-

Of all the provisional at risk, consistent in the sense with

ranges, that the

the one for M2 would staff expectation for

seem to be most that rates aggregate is only

its outlook above

for spending

and interest range. in the I

one percentage increase could hand,

point

the lower rates short

end of the than assumed

A greater forecast range.

or earlier conceivably

in short-term M2 to fall

cause

of its alternative of the aggregate

On the

other

the interest

elasticity

-5-

has not been short-term rates,

very

large

in recent

years,

and, moreover, movement

if rising in long-term could be

rates

are associated for capital than we have

with

some upward alternatives

appetites damped

market

to M2 assets

even more

assumed. II would adjust the M2 range the risk to of it for as more in

Nonetheless, center it better

alternative staff

on the

expectations, reserve

reducing

shortfall would

in response

to tighter

conditions. less might

Because tolerance be seen

seem to allow acceleration with

for such in money

actions, growth,

and implies this range

a major

consistent the next

intentions

to reduce

inflation

appreciably outlined

further earlier.

few years, Alternative

as under II also even

the tighter lowers the

strategy range

for debt,

an action at their

the

Committee provisional percent expand

could

take

if it left of debt

the M2 and M3 ranges in the upper if debt part

levels. seems

Growth high,

of a 4 to 8 tend to nominal also

range

especially have

and GDP again the

together,

as they

in recent

years:

Committee's might

GDP forecast be concerned uberance perhaps lowering attention tight.

centers about

around

5-l/2 debt

percent. growth

The Committee as symptomatic sheet

very markets

rapid

of over-exleveraging, A drawback too much that to

in asset fueled

and a return in inflation might

to balance

by a pickup range

expectations.

the debt to this

alone

be a tendency

to draw

variable,

whose

link to spending

has not been

The downgrading policy, about term for both

of the monetary

aggregates has

as guides raised

to

the Committee are ways

and the public, we might better

questions intermediatereports and

whether policy

there

communicate

objectives have given

and strategies. a sense members'

Humphrey-Hawkins objectives

testimonies mittee, the

of the ultimate projections

of the Comvariables

Committee

for key economic

-6-

for the next Of necessity, toward

year

to year

and a half. has been

and the vague

risks

to the

forecast. trajectories respond to

the discussion objectives projections. ranges

as to desired might were

ultimate from

and to how the Committee When money velocities

deviations predictable, better

reasonably a little and was ad-

target

for the aggregates strategy or weakness

perhaps

gave

sense

of the intermediate-term to unexpected strength

of the Committee in spending that

its reaction reflected vantage force

in growth

of money

relative

to its ranges. targets

A distinct they

of aggregates

for intermediate to specify

was that

did not

the Committee

its notions

of short-run of the have other

output/infla-

tion tradeoffs Members Committee could

or long-run of Congress supplement

characteristics and their ranges

real economy. asked whether the

staffs with

money

methods

of explainof

ing important policy. was with One this

intermediate-term possibility in mind

considerations out the

guiding forecast

the conduct period,

is to stretch

and it

that we asked of projections

for your

1995 projections. out is that extent imposed embedded are probably they prob-

A key aspect ably can be viewed members' starting economy. long that desired point That

two years

as representing within

to an important the constraints

Committee by the in the not so

outcomes, and the

structural

relationships effects

is, the lags Committee still

in policy viewed

if the

the outcomes to take

as not the best to improve some the informa-

available, situation.

it would Seen

have way,

time

actions

in this

the projections

do contain

tion .about the tradeoffs
.

Committee's

preferences

and its view

of the

short-run

Your from

1995 projections, 1994 coupled with

for example, some further

show no deceleration decline in the unsuggests

in inflation employment that,

rate to the neighborhood you share

of 6-l/2 view

percent.

This

on average,

the staff's

of the level

of the

NAIRU, 1996,

and hence, would

absent

a sharp

weakening

on aggregate

demand have

in lower

not anticipate rates staff,

further with

disinflation. roughly the

You also same levels

unemployment tion as the

associated perhaps curve

of inflain the

indicating assumed

a more with

favorable

slope

short-run

Phillips The risk

than

staff

projections. is that Congress such may as

in giving

long-run

projections on the tend

focus

on these

as targets--especially rate. These forecasts

real variables, to highlight

the unemployment tradeoffs exploit stability greater over without these goal pressure

short-run of trying to

focussing

on longer-term

consequences

tradeoffs.

Without

the discipline we could which

of an explicit ourselves

price

for the central

bank,

find

under

on real variables

over

our power

is limited to set obcould be-

a period

of years, was once

and for which an adjunct

we have

no authority ranges

jectives.

What

to the monetary be giving

come the centerpiece; years the in which

indeed,

we would

projections forecasts

for a are used, does the

we had no monetary ought

targets.

If the both

report

and testimony the level

to emphasize of potential

that

the FOMC

not control lowest

of growth

GDP and would with

welcome

possible

unemployment

rate consistent short-term

sustainable can be

growth.

and that

an attempt

to exploit

tradeoffs

counterproductive.