APPENDIX

FOMC Notes -- Peter Fisher July 5, 1994

Mr. Chairman, I will try to address three questions: First, why did the dollar's decline against the mark and the yen accelerate in June? Second, what factors le,dto the decision to intervene on June 24th? And third, what are the likely reactions of the foreign exchange market to possible outcomes of the Committee's meeting? I will be referring to the three charts distributed at the table. The proximate cause of the acceleration of the dollar's

decline in mid-June was a series of discrete events which triggered a sharp appreciation of the German mark and the Swiss franc. These rate movements occurred at a time when there was

beginning to be a shift in the percci_v_ed fundamentals, with German economic prospects appearing less bleak, the Japanese economy appearing to recover, and views of the U.S. growth rate becoming somewhat mixed. mwement The combination of the sudden rate

in mid-June and these changes in perception stimulated

the growth of what had been a festering, negative sentiment about the Administration's policies and Federal Reserve policy, all at the very time that prospects for improvements in the U.S.-Japan trade dialogue appeared to fade once again.

-2

-

Beginning in May, foreign exchange market participant6 began to reexamine the premise that had supported the expectation of dollar appreciation against the mark. Since the autumn of 1993,

and particularly at the start of 1994, the dollar had been expected to rise against the mark as U.S. interest rates rose and ., expectation is reflected in the top German rate6 declined. This left panel on the first page of charts, indicating the course of three-month rates implied by futures contracts before the committee's February 4th meeting. Throughout the winter and

spring of this year, the dominant market sentiment favored long dollar positions against the mark based on this expected trend of interest rates.

At the same time, notwithstanding the trade deficit with Japan and trade policy frictions, many viewed the dollar as undervalued against the yen. Even after the dollar's decline

following February 11th -- and, perhaps because of this decline --many who lost money at that time returned to take long-dollar, short-yen positions during the spring.

From February on, the dollar failed to sustain any upward
.,.

movement following Federal Reserve and Bundesbank actions, as long-dollar positions were quickly sold on the fact of interest rate changes. This can be seen in the middle panel which traces

the spot, dollar-mark exchange rate over the first half of the year, punctuated by the dates on which the Bundesbank reduced

-3official
rates

and on which the

Federal

Reserve increaaed rates.

In particular, in mid-May, the combination of the Bundeabank'e reduction in rates and the Federal ReLICNe'B increaoe
in

the Discount Rate actually m
near
term.

expectation6 for This can be
men

further interest rate changes in the

in the bottom panel which traces the differential implied by the September euro-deposit contracts, which began to reflect a differential in favor of the dollar in the days prior to the Bundesbank's May 11th action, but this quickly unwound over auboequcnt days.

fn late May and early June, dollar-mark traded in a range
while market participant8 reaseeased the dollar's prospects. while expectations that money market rates would move strongly in the dollar's favor by September had waned, the basic mtructure Of expected interest rates continued to indicate U.S. rate6 above German ones over the coming year. On the other hand, the June 7th release of West German 1st quarter 1994 GDP, up 0.5 percent quarter-on-quarterand 2.1 percent year-on-year, combined with the upbeat tone of the Bundesbank's monthly report, gave some the baeis for optimism about the German economy.

On the second page of charts, you can see that from mid-May to early June the dollar traded between 104 and 105 against the Yen. This relative stability in dollar-yea reflected the

-4-

market's optimism that the Administration would work with the Japanese government on trade issues with less rancor, as indicated by.the reopening of the "framework" talks on May 24th. It also reflected the prospect, perceived by some in the exchange market, that the Bank of Japan would follow up on its accommodative stance in May with a reduction in the Official Discount Rate. The middle panel on the second page graphs the

deviation of Japanese bank reserves from required levels, as reported by the,Sank of Japan.

IIIthe foreign exchange market, there is a widespread perception that comments by Mr. Kantor and Secretary Brown on June 7th and 9th, respectively, each indicating an unchanged U.S. Rtoughness" in the trade talks, served to undercut the fragile, optimistic sentiment and triggered a decline in dollar-yen and a

rise in U.S. bond yields.

1 would note, however, that the return to a neutral stance bY the Bank of Japan, and the corresponding rise in Japanese bond yields, were sufficiently obvious by June 7th to undercut any hopes for a reduction in the discount rate. There were also

increasingly positive statements about the economy coming from Bank of Japan officials, which seemed to be SubseWentlY confirmed bY the release of 1 percent gtowth in Japanese GDP, quarter-on-quarter, for the 1st calendar quarter of 1994. However, there is a healthy debate in the exchange market

-

5 -

as to whether a

recovering

Japanese

economy will help or hurt the

dollar, with the dominant view being that it will help the dollar, given the prospects for increased imports to Japan as demand picks up..

Another factor in the dollar's decline against the yen, from early June, was the increasing recognition that the Hata Government was likely to fall once the budget was enacted. Thus,
in

the run-up to the submission of a no-confidence motion on

June 23rd, the foreign exchange market became increasingly skeptical as to whether the Japanese government would be.ahle to deliver its side of promised progress on trade issues before the G-7 summit.

With this background, and many market participants still holding substantial long-dollar positions, on Monday, June lsth, the Swiss franc and the mark began to appreciate sharply against both the yen and the dollar, as can be seen in the chart on the third page.

~ Over the prior weekend, tensions with North Korea increased, causing both anxiety about Japan's proximity to the peninsula in the possible event of hostilities,
Korean

On Sunday the 12th, in Germany,~ Chancellor Kohl's party did surprisinglywell in the elections for the European

-6

-

Parliament, which appeared to promise greater stability in German politics in the upcoming national election6 in the fall. Then on

Monday morning, an official of the Swiss National Bank was quoted a8 saying that further declines in Swiss interest rates should not be expected.

Wfiilethe initial movements in the franc and the mark
appeared to be in quick reaction to these events, the dollar's decline came to be seen a8 vindicating the perceived shift in fundamentals in Germany, the perception of a lack of confidence in the Clinton Administration, and the view that Fedsral Reserve policy is too accommodative. A8 the dollar broke through

technical levels, long position8 were steadily unwound, leading to further downward pressure and an escalation of the negative rhetoric about U.S. policy.

To a great extent, I regard the dollar'8 rapid decline in late June as a-,caseof technical and negative sentiment feeding on one another -- against the background of preliminary change8 in the perception of Japanese and German economic fundamentals and somethitqof the U.S. economy. a lull in the release of economic facts about

On Friday, June 17th, in very thin markets, the dollar was marked down from 1.6370 to 1.6065 against the mark. Most of this

movement occurred in just 30 minutes at mid-day, in reaction to a

-

7

-

headline reporting a Conference Board economist's long-term forecast,of a mark.
IO

percent depreciation of the dollar against the

This rapid price adjustment, without any corresponding

position adjustment, squeezed the holders of long-dollar positions and set up the very negative conditions for the following week.

Why did we intervene on June 24th?

First, Treasury official8 felt under pressure to stop the acceleration of negative views of the Administration's policies, increasingly identified with the dollar, and also to follow their words in support of the dollar with some kind of action.

Second, Treasury officials were aware that the Chairman and Vice Chairman of the Committee would be reluctant to operate the closer we came to this meeting.

Third, we shared a desire to avoid having the bottom drop out from under the dollar, particularly against the yen, with the
-

resulting risk of accelerating the whole downward trend of the dollar and market sentiment.

FinaLly, with the benefit of hindsight, it seems to me that in making the decision to operate we were caught on the horns of dilemma. We did not want to operate unless we thought we "had

- 8 to" -_ that is, unl?ss we could see rate movements that seemed to justify the need ior operating in the form of a risk of a rapid, downward movement. But by choosing the moment, Friday morning, when the pressures did appear to justify that perception, we entered the market at a time when the selling pressures against us were most intense and, thus, at a time when the likelihood of
,

achieving an upward bounce for the dollar was correspondingly low.

The operation, in which we were joined by 16 other central banks, did not generate any appreciation of the dollar but, of course, we will never know with any confidence what would have

happened had we not operated. One positive outcome, in my view, is the relative stability with which dollar-yen has been able to trade just below the 100 level. I doubt that this could have occurred without sotie
of U.S.

substantial effort to reduce the perception

official indifference.

Turning to the Committee's work today, many in the foreign exchange market perceive a necessity for the Committee to effect an increase in rates in order to avoid a further decline in the dollar. InLmy opinion, however, the risks outweigh the benefits of any increase in rates perceived to be in support of the dollar. While the dollar
ie

likely to decline somewhat in the

event that no increase in rates is announced, I think over the wegkend and through this morning the exchange market ha6 pretty

-9-

much adjusted to the expectation

of no action.

Morewer,

given

the series of significant events this week for the market -- this meeting, a Bundesbank council meeting on Thursday, Friday's employment data and the G-7 Summit over the weekend '-- I think that we have somewhat greater,chances of avoiding big movements in exchange rates, particularly early in the week, because market participants will want to wait and see the outcome of the next events before altering their positions.

Finally, given the dollar's behavior over the first half of the year, I would have a hard time giving you assurances,that any rate increases, announced immediately after this meeting, could provide enduring support to the dollar. I am especially

concerned that a rate increase perceived as a failed attempt to support the dollar could trigger a very negative market reaction in the form of the perception that even the big policy tool of interest rate changes could not help the falling dollar.

Mr. Chairman, I would also like to inform the Committee that in the last 3 weeks we have begun a weekly conference call with

the foreign exchange functions of the Bank of Mexico and the Bank of Canada.

We have for some time had daily multilateral calls with the European central banks and a weekly senior call with the same groap.

-

10

-

The purpose outgrowth Secretary on market operations.

of this

"North American" Financial

call, which Group

is an by

of the North American Bensten in April

announced

is to facilitate

an exchange on

of views

conditions

and an exchange

of information

While note

markets

had been relatively

calm in Mexico, and

I

would

that last week pressure

on the peso increased

This morning current outer

the peso

is trading

at 3.3994,

50 pips

from the

band of 3.4044.

This 50 pip buffer

is viewed

as the

edge that the Bank of Mexico

will let it trade.

MZ-. Chairman, during Deutsche the period marks

I will need a motion in which

to approve

the operations worth of

we sold 475 million dollars

dollars

and~305

million

worth of Japanese

yen for

the System's

account

on June 24th.

I would be happy

to answer

any questions.

.-..

CHART 1

Interest Rates Implied by Prices of Series of 3-month Eurodeposit
January 31, 1994
7.50 7.00 6.50 6.00 5.50 5.00 4.50 4.00
Sep94 Dec94 Mar95 Jun95 Sep95 Dec95 Mar96 Jun96

Futures Contracts
June 30, 1994
7.50 7.00 6.50 6.00 5.50 5.00 4.50 4.00
Sep94 Dec94 Ma195 Jun95 Sep95 Dec95 Mar96 Jung6

Dollar/Mark

Interest Rate Differential Implied by Prices of September 1994 3-month Euro $ and Euro DM Futures Contracts
_ I.w.U.S.- .German .,....: I . . . . . . . . . ..~ 1 I. _ ,~oo

Foreign Exchange

Function: FRBNY

Source: Bloomberg

information

Service

I CHART 2

Dollar/Yen

D.eviation of Japanese Bank Reserves from Required Levels

24

Jun

78

23

Government

Bond Yields

I May

24

Jun

78 Source: Bloomberg Information and Bank of Jaoan Service

Foreign Exchange Function: FRBNY

CHART

3

% Change in Selected Currencies
Period: May 2, 1994 to June 30, 1994

4.00

2.00

0.00

-2.00

-6.00

Foreign Exchange

Function: FRBNY

Source: Federal Reserve Bank of NY

Notes

for FOMC Meeting 5-6, 1994

July

Joan E. Lovett

Reserve

management

was relatively

uneventful flows

over

the We on

inter-meeting period, sought to maintain

notwithstanding the firmer funds degree

some huge of reserve to trade by a total rising

in reserves. adopted

pressure

May 17, with The borrowing interval

Federal

expected

around

4-I/4 percent. over the ending

allowance steps Total close

was lifted to reflect borrowing

of $150 million borrowing,

in three

seasonal

at $325 million. and was generally

averaged

$274 million

for the period

to or modestly

above

the allowance.

Sizable growth

reserve

shortages

stemmed

primarily

from seasonal and from higher the June 15 tax

in currency leading balances

up to the July 4th holiday half of June following

Treasury date.

in the second were

Treasury

balances

subject

to the usual

uncertainties through its at the call and

surrounding account were

the tax and quarter-end enormous.

dates when

flows

By way of illustration, followed

balances

peaked

Fed at $9 billion of an unprecedented an assortment day.

on the quarter-end, $31 billion payments

by the Treasury's social

for July estimated

1 to meet at about

security that

of other over

$35 billion

On balance

the interval, exchange reserve

revisions

to market

factors, that ends

including today,

our foreign

intervention shortages.

in the period

tended

to deepen

Both reserve market

outright

and temporary $3-3/4 another

operations billion $l-3/4

were used

to meet bills in the

needs. on June from

We purchased 1 and bought foreign

of Treasury billion

of securities mark, the $16

directly System's billion portfolio

accounts.

At the year's

half-way

portfolio over

stands

at $360 billion, the average

an increase

of nearly

the year,

while

maturity

of the Treasury

is nearly

unchanged

at just over 38 months.

-2-

During slightly

much

of June,

the funds rate often reserve shortages

traded Seen.

with

a

soft cast even when

were

Somewhat leading up to

uncharacteristically, the quarter-end but we have been market desire

this pattern

prevailed

in the days

as well. hearing

We are not sure we have a full explanation of high levels of cash available and RPs, in the

for one-day

Eurodollar

deposits pending

and it may be that the rate view is what through

to stay short rates

and liquid at or below

a clearer

has put those the period.

the funds rate periodically itself, funds firmed

On the quarter-end reserve

up substantially day to

amid the aforementioned more or less normal

flows but returned

the next

levels.

For the period

as a whole,

the effective

rate averaged

4.21 percent.

In the securities and yields 30 basis policy recent sharply

markets, course

conditions several

were again Yields

turbulent, fell 25 to after from Yields that time, the

reversed

times.

points

at most maturities were announced

in the days

immediately declines

changes yield

on May

17, extending

highs their

that had come just ahead

of the meeting. fashion since

have worked

way back up in an irregular close to the levels

and they now stand last meeting,

prevailing

on the eve of the relatively range, small--up daily volume,

leaving

net changes points. large

for the period

a net of 5 to 15 basis swings were sometimes

Within

this overall occurred

and sometimes

on limited

a hallmark

of a nervous

market.

The policy cally, even though

actions

adopted

in May were greeted come as a great the funds

enthusiastiMost

they may not have

surprise.

participants

felt that with consistent might

the May 17 move with neutrality, for a while,

rate had reached took hold the summer

a level roughly that policymakers months. Since

and the view possibly

pause

through

that

time,

however,

the underlying

mood has soured.

The sinking pas_t few weeks. currency's slide,

dollar

has been

disturbing

to the market

over the

A variety as Peter

of explanations has already

are offered

for the

reported.

The weakening

-3-

currency

has prompted speculation

investors

to pare

some of their direct

dollar

exposures

and kindled propping

that the Fed might Perceptions

policy

towards was in

up the currency. faster markets auctions

that economic also

activity

recovering financial security

than expected there, with

in Europe

sparked

some turmoil

the Germans Thus

cancelling

two of their the period, re-allocating in search over the markets was of we

in late May. that

on occasion investors U.S.

during were

were hearing

reports

international towards

their portfolios more value liquid

more heavily

assets,

partly

markets.

But mostly and on many

we were hearing days activity

concerns

of the dollar, linked

in domestic

directly

to its performance.

Economic contributed reports were

statistics

have

offered

a mixed

picture,

which

has

to some of the recent encouraging

volatility.

Most

aggregate

price that price

to the market but severe

by continuing in leading

to suggest commodity

inflation measures commodity about

is contained, have been

swings Most

disconcerting. with

analysts

interpret

short-term

price

movements drift

considerable

skepticism,

but some worry

the upward

in virtually

all of the key commodities component of some surveys were of

indices.

Increases

in the prices to be more

paid

manufacturers, troubling. Consumer

thought

forward-looking,

also a bit

Data spending

on economic has shown

activity

have been no less divided. but other sectors, of

signs of moderating strong

such as housing, analysts have

continue

to register

gains.

A number

remarked

upon

the divergence worked

between

some production data, and

side reports, spending

such as the hours

series

in the payroll

information.

Supply

was not a major

hurdle

for the market $22 billion

this past in coupons while

inter-meeting period. continuing purchases, bank

The Treasury

raised

to pay down modest we bought sizable

amounts amounts

of bills. of bills technical however,

Aside

from our own central

for our foreign condition periodic

customers, Apart

adding

to the strong supply,

in this

sector.

from official

announcements as a

of losses--including

some at a handful

of mutual

funds--serve

-4-

background liquidating holdings, municipal

chiller. a chunk
was

On some days rumors of its portfolio,

that some firm was mortgage-backed steeply. Corporate and

usually down

enough

to send the market

issuance

was generally

restrained.

The international confidence participants exchange especially

immediate

prospects

for policy

have become

clouded

by both

and domestic

developments, direction doubt

and investors for rates.

lack real

about

the near-term

Domestic let foreign policy,

for the most part

that the Fed would factor

considerations to the extent

be an overriding

in setting

that they perceive activity

the weakness

as reflecting of

stronger-than-expected domestic and foreign worries.

economic political

abroad

and a variety

uncertainties

rather

than an indication to achieve the

of inflation desired

Furthermore,

the measures

needed

result

are unclear,

and any misstep

could be counterof a major noted. slide in the

productive. currency

Nonetheless,

the implications as the Chairman

cannot

be ignored,

As for the domestic perhaps the majority--see in rates

economy,

a good number reason

of participants--

no compelling

for a further in good number-either for

adjustment argue

just now, although

others--also

that a move that

is warranted. will

Evidence continue

can be marshaled above

the view forward and both fairly

the economy

to expand to more

trend

going levels, a

or that growth camps have

will

soon moderate

sustainable

their proponents. exists

However,

across

the spectrum

broad

consensus

that price

pressures

are likely

to build

gradually

over

the coming

year.

The prevailing for now, awaiting

sense

is that the Fed would

like to stand pat is responding to

clearer

signs on how the economy remains

past policy towards

actions. rates

But the perception is still in place,

that the trend of an

higher

and the possibility dismissed.

immediate

slight

firming

is not being

entirely

Michael J. Prell July 5. 1994

FOMC

CHART

SHOW

PRESENTATION

-- INTRODUCTION

AND ECONOMIC

OUTLOOK

I thought brief that review just

I'd begin

the presentation economic

of our forecast was

with

a

of where

we think

activity left

in the quarter 1. the firsthuge

ended. worker

As shown hours

in the upper and May

panel

of Chart above

production quarter

in April

soared

well

average

(the last However.

red dot), with

seemingly

indicating we've

another discounted

gain in real GDP. that reading

some uneasiness. than usual

deeply.

giving data data

heavier available

weight

to the side. of the and
~

distinctly

less Some

robust

to date

on the spending panels

of these right.

are exhibited

in the other

chart.

At the

the net decline take

in consumer gain

outlays

in April

May implies revisions) And though are still included

that

it will

a sizable

in June advance

(or some we've

upward

to yield capital rising. in these

even the modest goods shipments.

quarterly plotted

forecast. panel. are not

in the middle of autos

left

the weakness figures)

in fleet will

sales

(which

likely

be reflected

in a deceleration put-in-place

of overall figures, depressed left,

equipment

spending. right.

Friday's

construction

charted winter

at the pace,

show a pickup

from the weatherAt the lower is

but no more

than we anticipated. information

you can see that toward however. would

the fragmentary

on inventories

pointing quarter: Greenbook track

a step-up the appear

in the pace of accumulation in manufacturing only to confirm at the right were that stocks that

in the second reported after the

spurt again

we were

on the

right

in our forecast. of goods

Finally.

you can see that

net the in net

exports

and services we've

in April projected

not too far below the pace

-first-quarter

average:

of decline

Michael

J. Prell

2

July

5, 1994

exports 1992. percent think

in the second In sum.

quarter

was only half

the average to reach

since

late

it still

is a bit of a stretch GDP number

our 3-l/2 side. but we data. a

second-quarter remains

from the expenditure with

this

a reasonable

compromise

the labor year

market

Shifting central putting issue. issue

now to the outlook scope

for the next there

and a half. without

is just how much pressure

is for growth. This

excessive and chart

on productive

capacity.

is a complex points First,

2 highlights

only a few of the of current resource

relevant

pertaining I would

to the evaluation that,

utilization. of the Current

emphasize Survey.

because

of the revamping uncomfortably rate.

Population respect

we are flying

close

to blind

with about

to the

level

of the unemployment by the upper that

The uncertainty The so-called the

the numbers "parallel" unemployment survey higher since

is suggested survey rate

left

panel.

indicated relative using

the new CPS would

raise

to the old survey.

But the

"follow-on" has shown

January.

the old CPS instrument. We've talked

actually with BLS

unemployment

than the new CPS. have only

researchers. Based survey

and they work

a few clues

as to what

is going

on.

on their

and our own. we are now guessing rate than

that we'd

the new assumed you

is adding perhaps

less to the unemployment about a third of a point. on this.

earlier. should Friday.

Obviously, even

though.

stay tuned

for updates

perhaps

as early

as this

There adjustment seasonal

are also

serious

questions

about

the

seasonal that revised rate from put the of our

of the new unemployment factors might eventually

figures. raise

BLS says

the May unemployment that would

6.0 to 6.2 percent. _May

Subtracting

l/3 of a point.

rate on the old basis estimates derived

at 5.9 percent--the

central

tendency

NAIRU

from the old series.

Michael

J. Prell

3 -

July

5, 1994

There there

are. however. more rate.

a number

of arguments slack is that who than there

to the effect suggested

that

is currently jobless

disinflationary One argument workers,

by the

aggregate large

are an unusually would be willing of the of

number

of -employed hours

presumably

to work more wage late

or in higher-level

jobs without right panel

an elevation shows

structure. 1993, before

For example, the time

the upper was

that--as

series

broken they

by the new CPS--the part-time than same for economic in early

proportion reasons.

of workers rather than

reporting by choice.

that

were

was a bit higher last at the

it was level.

1987. when

the unemployment argument,

rate was propounded

Another that

recently

by James ads.

Medoff,

is

job vacancies.

as measured

by help-wanted

are low relative of excess differ '

to unemployment. demand for labor.

so that we are not close The numbers we've plotted

to a condition

in the middle stab

left panel

from Medoff's. wanted

because

made

a crude

at adjusting supply

the helpas an in

data for the increasing to direct hiring.

use of personnel There

agencies divergence in this two

alternative

is an interesting

the two lines. context series

starting you

in 1985: scan

but the key observation across

is that--if are currently

carefully

the chart--The to their

at similar inflation

positions flared

relative up. right.

levels

in

the late Eighties. One more responses perceptions calculated individuals plentiful. -explanations consistent

when story

is depicted Board

at the survey

which

shows

the

to the Conference

question

regarding

consumer it's of

of job availability--or here. The chart that suggests

"unavailability." that

the way

the net percentage to find. rather rate. than Many

reporting is high might

jobs are hard with

compared

the unemployment pattern.

be offered that

for this pressures

but the data wages

are

with the view

for higher

are being

Michael J. Prell

- 4 -

July 5. 1994 and job

muted somewhat by concerns about employment opportunities security.

Still. one must square this. and the other stories I've

noted, with the scant statistical evidence that wages were still decelerating even before unemployment fell to its recent level. and

with anecdotal reports of emerging labor market, pressures. Signs have also emerged of pressure on industrial plant capacity. As the lower left panel shows. utilization rates remain

below the highs of the late 1980s. but the fact is that they ti reached levels prevailing when price acceleration began in the past. The right-hand panel shows vendor performance manufacturing plotted against

utilization. the point simply being that this

alternative measure of pressure on capacity is sending essentially the same signal as our utilization index. If we stipulate at least for the sake of argument that little, if any. anti-inflationary slack is left in the economy. the

next question is how fast activity can grow from here without exceeding capacity. regard. Chart 3 summarizes some key points in this

First. in the top panel. we have depicted the behavior of

labor productivity. which we believe has been consistent with our assumption of an underlying growth trend of 1.4 percent. Over the

forecast period, we expect actual output per hour to move a little closer to the trend line. resulting in the 1994 and '95 increases of around one percent shown in the box at the right. In the middle panel. we've plotted the labor force participation unemployment rate. which has been a frequent source of error in our forecasts over the past several years. We're upturn

anticipating that the rate will rise cover coming months--an -that seems overdue.

If it fails to occur. it not only might lead in but it would

the short run to an unexpected decline in unemployment,

Michael

J. Prell

5

July

5. 1994

call into question growth. more than For now.

our assumption however.

regarding

the trend that

of labor

force

we are assuming

the trend this with

is a little the at

one percent trend Z-112

per annum--and, factors,

combining

productivity just under

and other

we see potential

GDP growth

percent. panel of the chart changes indicates that a simple growth. Okun's yields

The bottom law regression.

relating The

in unemployment GDP growth

to GDP

the same conclusion: this

2.4 percent output

intercept

implies

is the rate of potential Thus.
we

increase. probably must slow

think

that

GDP growth

considerably especially energy, policy

in the

short

run if inflation

is to be contained. upswings in food. what the panel a real shown of monetary

in the face

of prospective

near-term

and import adjustments.

prices.

Our next task

was to gauge ro produce

if any. would

be needed

corresponding the next chart substantial rates--since here--not

deceleration indicates.

of aggregate

demand. There

As the top has been

by our reckoning.

run-up last

in real interest fall. Indeed.
an

rates--especially examination model

long-term

of the history

to mention

of econometric well

simulations--would the past predicted four

suggest slowing to

that the increase in GDP growth 2-l/4 percent But. softening MOreOVer. aggressive credit -monetary

could

be ample percent

to produce pace of the

from the 4-l/4 in 1995. until recently.

quarters

there are &

were

few. hints

if any. at this

hints point. toward

of a

of demand--and we appear bank

there

to be in the midst rather

of a movement

more of of longer-term at

lending, that

than the kind many

of constriction episodes that

availability policy

accompanied Thus,

previous

tightening.

it is our judgment seemingly

rates will

have to remain

at the present

high

levels

Michael J. Prell

6

July 5. 1994 of demand

least for a while longer to bring about the deceleration we've outlined.

And we think that a further rise in short rates will

be needed--not only to make short-term credit more costly. but also to hold long rates near current levels. As we noted in the Greenbook. we

interpret the brief bond rally in May as supportive of our assessment that there is a sizable risk premium in the term structure. which is likely to narrow once traders recover from their shell shock and begin to feel they have a handle on the market's direction. A brief further word about the term structure. As you know,

the slope of the yield curve is often used as either an indicator of financial restraint or of future GDP growth. In the middle panel.

the black line is the spread between the lo-year and 3-month Treasury yields, and the red line is real GDP growth. and you can see some lead-lag relationship. For what it's worth. the flattening of the

yield curve that has occurred since 1992. and that is predicted to continue. seems consistent. at least in broad rrerms. with the expected

deceleration in activity. Finally. the bottom panel shows debt growth and GDP growth. There is no clear-cut lead-lag relationship here. and the main point is simply that debt and income growth have moved into rough alignment recently and are expected to remain there. One of the factors affecting our judgment about the degree of domestic financial restraint needed to slow growth has been recent and prospective developments discuss those. tttt**,**t in the external sector. and Ted will now

E.M.Truman July 5, 1994 FOMC Presentation As Mike important This our -- International external overall
DeVelODmentS

and

Prosuects are

stated,

developments outlook

and prospects economy.

to the staff's

for the U.S.

is because assessment valve,

of the stage of the external

in cycle sector

and because from

of a shift a drag, on

in or

its being

safety prices sources: around economic

on output

to its being This

a source

of pressure from two

and aggregate the lower current

demand. dollar, and

pressure

comes

which

is projected

to be sustained country somewhat. exchange in the top in that the

levels,

the pickup

in industrial to accelerate reviews

activity, The first

which

is expected

international rate

chart

recent

rate

and

interest

developments. markedly comfort

As can be seen from from its peak the fact

panel,

the dollar

has declined take some

February. dollar's with

One might most recent

depreciation

appears between

to have real

been

correlated

a decline rates

in the differential on dollar assets A puzzle 1993, most late despite

long-term in

interest other

and on assets from this

denominated

G-10

currencies.

perspective

is the

dollar's

rise during through since

the narrowing and

of that general

differential failure increase

of the year, last year, interest aside,

the dollar's

to rise in U.S. Leaving

despite

the relative

long-term that puzzle

rates

on balance. some perspective we turned that to the

to provide

on the possible our econometric

implications models. They

of the lower imply,

dollar,

ceteris

paribus,

- 2 -

decline

of the dollar adds almost

from

its peak

in early

February, of real of that

if GDP by boost

sustained, the fourth comes next

one percent

to the level part

quarter year

of 1995

-- the greater adds almost equal

-- and also level

one percent amounts on prices activity.

to the year,

consumer since earlier instead changes way

price

-- in roughly

in each are

the direct than

effects

of depreciation on real economic

felt if to the

the effects

Moreover, in response year,

of depreciating in interest

the dollar here say

had appreciated

rates, models dollar would

and abroad, it should

so far this behaved, higher.

our econometric of the lower level

have

the actual

effects

relative be somewhat

to that

counterfactual

magnified. the dollar's the dollar's Swiss
:

As detailed decline has not been has been

in the middle uniform largest against
against

left panel, all

currencies; and the

depreciation franc, and

the yen

it has appreciated in short-term

against rates

its Canadian have also

cousin. been divergent

Movements --the

interest

middle-right

panel.

However,

on average,

the short-term in the lower

differential left. although rise

has narrowed

substantially, rates have

as is shown risen that

In contrast,

long-term panel

everywhere, the cumulative larger than that

the lower-right rates

illustrates

in dollar

since

a year

ago has been

in foreign

rates

on average. we have countries next year assumed will before expansion that short-term rates on

In our outlook, in the other -average forecast industrial early as the

ease

slightly a bit

further late

through period

rising

in the

foreign

solidifies.

Judging

- 3 -

from EuroDM and Euroyen futures markets, the staff's assumption about the rise in foreign short-term interest rates falls short of the market's expectation by about as much as it does in the case of dollar interest rates (roughly 100 basis points). term rates abroad are assumed in our forecast to back off somewhat from their recent spike -- by about as much as U.S. long rates on average. Turning to the second shift in the staff's thinking about the outlook, the pickup in economic activity in foreign industrial countries, Chart 6 presents data on recent trends in industrial production and consumer price inflation.in the major countries. In general, production has either continued to rise Long-

as in the top panels for Canada and the United Kingdom, has just turned the corner as in the bottom panels for western Germany and Japan, or is in between as in the middle panels for France and Italy. Inflation is either low and declining (Canada, France and (United

Japan), finally on a downtrend Kingdom and Italy).

(Germany), or stable

Thus, recessions appear to be over and

recovery is beginning or expansion continues in the major foreign industrial countries, while inflation appears to be generally under control. This pattern of recent developments is projected to The upper left

be extended as is illustrated in the next chart.

panel shows that foreign growth on average is now projected to exceed growth in the United States this year by a small margin (in contrast with the picture at the time of the January Chart Show) and by a considerably larger margin next year. As shown at

- 4 -

the right, growth

faster

growth

in the G-6 countries

countries and

helps

to push growth panel of

up in the

in other

industrial

to sustain

developing presents countries.

world. details

The box on the for selected can see,

left

in the middle or groupings in growth countries foreign

countries the pickup European

As you major

is concentrated and Mexico. industrial those we we of

in the three

continental settings a bit

Since countries have been are

policy

in the major less work

if anything

stimulative with over a lag

than

assuming,

and policies that

in any

case,

are led to conclude the considerable cases with with more

the effects, in interest fiscal

the past

two years,

reductions stimulative and

rates,

combined

in a few generally

policies,

and more have

the economic than we had

financial

healing

process The

had greater foreign

effect outlook

earlier

anticipated.

overall to our

illustrates

one of the upside demand

risks and

forecast

-- a

risk principally States. As major

to aggregate

inflation

in the United

is shown

in the right

panel,

the output (and also

gap

in the

industrial

countries very

collectively large while

individually) remains low. on in to

is expected However, U.S. these

to remain

inflation

as reported that

in the paper was circulated

on international to the Committee

influences last week,

inflation countries

individually to chances

and as a group in the output

inflation gap than lower

appears to the m panels, to remain

be more

sensitive

of the gap. - inflation

Consequently,

as is shown countries

in the

on average

in these

is projected

- 5 -

fairly

stable

at just below above

2 percent

while

U.S.

inflation

temporarily

moves

3 percent. our forecast year, other quite for exports. our Latin exports American The top-left the

Chart panel United shows

8 presents over

that,

the past Mexico, expanded

to Canada, and

Kingdom,

Japan, have

certain

countries categories computers with have

in Asia that

substantially. increases computers have

The been

have

shown goods

the largest other than

and capital

-- consistent exports

our principal declined

comparative

advantage.

Agricultural

following

our production

shortfalls. panel, real goods the
:

As is illustrated exports faster lower year are projected rate of foreign following in the

in the middle-left more rapidly the

to increase growth

in line

with of the

and under in the

influence quarter The

dollar, and a dip

a surge first

fourth

of last overall line in

quarter

of this

year.

picture

for real panel,

exports

of goods

and

services, grew

the blue faster

the bottom real 1992, again GDP

demonstrates line) kept

that

exports

than U.S. mid-

(the black roughly

during over

the recession the past over

and

through

have will

pace

two years,

and once

be a source

of stimulus

the balance

of the

forecast

period. Imports are the subject (upper been left), widely of the next chart. As is shown over enjoying

in the top panel the past year

the origins dispersed

of our many

imports areas right)

have growth

with

double-digit - experiencing other capital

rates.

The categories again with have

(upper been

the fastest goods

growth

computers pace

and

-- consistent

the strong

of domestic

- 6 -

equipment expenditures.

However, imports of industrial supplies

have also increased markedly in real terms -- a pattern characteristic of the mature phase of U.S. expansions. The middle panels present our projection of imports. Imports of both goods and services are generally expected to slow. The pattern shown for oil imports in the box at the right is distorted by the unusual increase in imports in the fourth quarter of last year that was followed by an unusual dropoff in the first quarter of this year. The basic forces

underlying the outlook for oil imports remain rising domestic consumption against the background of declining domestic production. While imports of computers are projected to increase at a somewhat slower, but still-very-rapid, pace, the rate of increase of imports of other non-oil products should decline markedly as the increase in U.S. demand slows (see panel chart at lower left) and the effects of the lower dollar are felt. The data in the lower-right panel show the disparate recent movements of prices of imports of manufactured goods from different industrial countries. They have risen markedly in the

case of goods coming from Japan, as the yen has appreciated, and declined for goods from the European Union and Canada, under the combined influence of low inflation and declining or stable exchange rates against the dollar. As is shown by the red line,

- the recent very moderate pace of increases in import prices is projected to be interrupted by a rise in the second half of this

-

7

-

year

because

of the recent

more

generalized

decline

in the

dollar. Your international commodity average, month next chart presents data on selected categories that spot on on a 121989. in of

prices.

The top panel dollars rising

illustrates

prices, have

in U.S.

or in G-10 at around increase has been

currencies 10 percent since early

recently the

been

basis,

largest

sustained

However, dollar

the recent terms. Meanwhile,

acceleration

more

pronounced

oil prices index

(middle

left),

which

are not .have rebounded supply stable average period a :

included under

in the overall

of commodity expected

prices,

the influence

of faster

economic and spot

growth,

disruptions OPEC

in the North

Sea and Yemen, that

relatively prices will

production. $18.50

We are assuming

around

per barrel

for the balance This outlook,

of the forecast which is about

as supply dollar

disruptions higher that

ease. than

a barrel

in recent

Greenbooks,

is predicated to resume

on the assumption exporting about panel, in 1995

Iraq will

not be permitted will boost

and Saudi barrels leaves outside assumption.

Arabia day.

its production in the lower left

one million this

per

As is shown slim margin

outlook capacity

a rather of Iraq,

of excess a possible upside

production risk

suggesting

to our price The

two panels

on the right

illustrate

two dimensions manufactures. prices of

of

other

international panel,

influences the gross line)

on domestic impacts of wide

prices

- In the upper manufactures

on domestic swings

(the black

in the dollar's

-

8

-

external dollar's subsequent influence import domestic While will lower the

value

(the blue rise What

line)

are evident half

in connection of the 1980s is the the red the line

with and

the its

substantial decline.

in the first is not quite abroad, in recent but

as evident note that

of low inflation has trended without

line for

for

prices

years

below trend

prices

any discernible prices

in the dollar. inflation of the

influence during will

on domestic

of low foreign the influence

continue dollar

the forecast

period,

be in the other panel presents that

direction. data on the share of domestic through

The bottom demand net

for manufactured

goods

is supplied

externally the two lines

imports

of such goods demand

-- the gap between

showing

domestic

and supply

respectively.
goods

The proportion is supplied from as This rising

of domestic abroad well also

demand tends

for manufactured to be influenced and demand

that

by movements at home helping capacity.

in the dollar and abroad. to divert Over the

as by supply has

conditions recently,

proportion pressure period

increased

again

of domestic ahead,
as

demand

on domestic relative

demand

eases

to capacity, to level

we expect

the

proportion

that The

is supplied

from abroad chart are

off. our outlook in the top for

last

international

summarizes illustrated

the external panels:

sector.

Four points

First, services (black

the balance line)

on real

net

exports

of goods to decline.

and

is projected

to continue

-

9

-

Second, the rate of decline will slow markedly because of faster growth abroad, sloxder U.S. growth, and the lower dollar. Third, the current account deficit (red line) widens in our terms of

more rapidly; this illustrates the deterioration

trade associated with the decline of the dollar and the rise in oil prices as well as the decline in net investment income as our deficits increase and interest rates rise. However, fourth, as noted in the box at the right, this deficit in 1995 would be "only" 2.3 percent of nominal GDP, compared with 3.7 percent in 1987. Nevertheless, at a projected near-record annual rate of $170 billion by the end of 1995, the deficit would be large, and it is reasonable to consider the capital account counterpart. Although it can be very misleading to infer motivation about ex ante demands for assets in the aggregate from ex post data or even the ex ante "guesstimates" presented in the lower panel for 1994, I would make three comments about these data: First, while total net private capital inflows recorded last year were negligible, line 1, inflows from private foreigners were substantial -- $105 billion in securities purchases (line 3), $21 billion in direct investment (line 61,

and a large share of the $51 billion in other net inflows reported by banking offices offices of foreign banks. - U.S. assets. (line 8), many of which involved U.S. Thus, private foreigners did not shun

However, in 1993, U.S. private outflows were also

very large; hence, the small net inflow.

-

10

-

Second, estimates produce year;

as illustrated small

by the data in these

in the large

column

of well

for 1994, a substantial

changes

flows

could

change

in the pattern inflow in the

of net first

flows quarter

for the

indeed, the

the net private total

exceeded

for all of 1993. in response to President inflows from Melzer's (line 10)

Third, earlier were Since

as I noted while more

questions,

net official half came

in 1993

substantial, these can

than even

non-G-10

countries. to the

countries,

if their

currencies assets, more

are pegged it would closely be

dollar,

and do invest to presume investors that than

in non-dollar their behavior

reasonable to private countries.

conforms

to monetary

authorities

in the G-10

Notwithstanding account account may deficits

these

reassuring

points,

large the

current capital and they

inevitably and the

lead

to questions course

about

counterpart investors' Prell

future

of the dollar,

affect

attitudes will

as well

as market

psychology. for the

Mike remaining

now present

the outlook

sectors

of the economy.

Michael J. Prell July 5. 1994

FOMC Chart As you which that

CHART

SHOW

PRESENTATION our projection

-- CONCLUSION for household after spending. a period exceeded small of of in

12 summarizes

can see in the top panel, the pace of consumption there will saving

we are expecting. black

growth--the

line--has

of income.

be a modest rate here.

reversal. at the the

The resultant right. expected declines

rise in the personal considerations the erosion and bond household months. and. as little. at least

is shown including related

A number effects

are involved

of financial as well

net worth

to the

in stock for

prices.

as the expected activity

flarrening

of demand

durables

as housing

slackens growth

somewhat exceeds

in coming income growth

In our forecast. shown

household left

debt

in the middle

panel.

debt-service

burdens

rise a '

But indebtedness at this juncture:

does

not look

to be a constraint rates are down.

on demand.

delinquency shown

bank

willingness willingness survey.

TO lend is up. and--as to borrow is relatively

at the

right--household to the Michigan

high.

according

Housing weather-influenced contribution higher market. until at the

starts

in recent

months decline,

have

retraced

much

of their

first-quarter

but with All

an important are that

from multifamily rates ux expecting

building.

indications

mortgage

putting

a damper

on the

single-family in that sector

and we're

a further

erosion

of demand 1995. point

rates turn down. right, however. rates

as we've even with

forecast.

during

As you can see rise in fixed-

the 2 percentage monthly we're carrying

rate mortgage -low relative

since

October.

costs

are still the level

to income:

consequently,

predicting

that

Michael J. Prell of single-family construction

2 -

July

5.

1994

will remain quite healthy by historical

standards, or in relation to demographic trends. The recent spurt in multifamily surprise. building has taken us by

It may be that we focused too much on national rental

vacancy rates. and did not pay sufficient heed to the reports of improved financing availability housing markets. and of tightening in some local

:' starts after the recent sharp surge, but we've raised the level of the :;::;'~
: ~.Y,. ,...’

We are looking for some back-off in multifamily

forecast path appreciably.

One thing to keep in mind. though, is that .:t $&,~
i :

construction cost per unit is much lower for multis than for singles, and it takes huge movements effects. Turning to the business sector, the top panels of chart 13 portray our forecast for fixed investment. As you can see at the in the series to have substantial GDP

" .:

left. both equipment and structures outlays are expected to remain on solid upward trends. but there is a deceleration on the equipment side

'

that is mirrored in the aggregate BFI growth rates tabulated at the right. Some slackening in the pace of investment is to be expected

when economic activity decelerates. though the rates of increase we're projecting are scarcely weak. Despite the rise in interest rates and the decline in stock prices. the cost of capital is still low--especially for which prices continue to fall. panel. the user-cost for computers.

As depicted in the middle-left

of equipment is expected to continue looking

cheap relative to labor, even before taking account of employer concerns that healthcare costs. And. acquisition or other mandates might add further to worker of new high-tech equipment remains an and

- integral part of many efforts to enhance productivity competitiveness.

On the negative side. though. as shown at the right.

Michael

J. Prell

3

July

5. 1994

firms do not

probably cover

will

find. capital

increasingly. outlays. side.

that

their

internal

cash

flows

their

On the inventory maintain panel. for some toward further the leaner Slower

we anticipate

that

firms by the

will

wish

to

inventory

positions

indicated order firms

lower-left might working projected argue

deliveries

and lengthening ratios. but many operation. interest

lead times are still the

rise in desired

the goal

of just-in-time

Moreover. rates

rise in real short-term to extra graphed stocking.

suggests

some

disincentive investment, second half

Our forecast shows

for inventory fall-off over the of

at the right.

a modest steady

of this year. thereafter.

but a pretty As a result.

and moderate are not

level

accumulation element

inventories

a major

in the dynamics Chart 14 covers

of the projection. the final panels. trending nondefense purchases sector of domestic demand. purchases in the

government. are projected defense panels. after

In the upper to continue but with

you can see that lower--paced also appear

federal

by the decline

sector. state

constrained.

In the middle this year.

and local

to be decelerating With

a surge

in construction areas.

activity

in 1993. pressure

budgetary we are The

strains

in some that

and political will

for tax cuts.

projecting bottom state

purchases

pick up only moderately one point Unlike the

in 1995. the when could

panel

is intended budgetary deficits

to highlight situation. on operating high

regarding 1960s.

current

and local large

relatively attributed attribution recent

and capital

account

be

to exceptionally is not warranted has been the

construction

spending.

a similar story in

currently.

Rather.

the biggest

years

soaring

cost of Medicaid. we've been saying together. with a

Chart summary

15 pulls

all of what Real

of the staff

forecast.

GDP growth.

as noted

earlier-is

Michael

J. Prell

4

July

5. 1994

projected

to slow to 2-l/4 of private

percent

next

year.

the major fostered

factor

being

the damping restraint. is expected May level

domestic

final

purchases

by monetary panel, low Because

The unemployment to rebound

rate.

the black term

line from

in the middle its seemingly 1995.

some in the near over 6-l/4

and to run a shade sector

percent

through

the goods-producing capacity inflation utilization

will

bear

the brunt

of the GDP slowing, Finally. core of in

is expected to move

to moderate

a bit.

is projected

up from May's

year-on-year of significant

change slack

2.8 percent. the economy agricultural

to 3.1 percent, permits

as the absence near-term and from

the expected

impulses

from the depreciation and

and petroleum Reflecting overall at about

Sectors

rrhe dollar's

to show through. energy pace. components, registering

as well

the acceleration picks up more

of its food from 1995.

CPI inflation 3 percent

its recent

in both

1994 and refer

To conclude chart, which lays

the presentation.

I would the GDP

you to the last 1995 forecasts of 3 to 3-l/4

out in the usual

manner

1994 and growth

you submitted. percent

Most

of you are projecting to 2-3/4

this year

and 2-l/2

percent

in 1995. with percent area. CPI and

unemployment inflation

ending

each year projected

in the 6 to 6-l/4 at 2-l/2 There

is mainly

to 3 percent

this year.

2-3/4 to 3-l/2 between your

percent

in 1995.

is no significant last

disparity numbers

forecasts

and the Administration's and those of the

official

or between

your

forecasts

staff.