APPENDIX

FWIC

Notes -- Peter Fisher 20, 1994

DECEMBER Mr. Chairman, I will be briefly addressing

two major

points: the dollar; and,

First, the improved market sentiment toward Second, the pressure on the Mexican peso.

Since

the Committee's the dollar both

75 basis continued

point to gain

increase

in rates rising

at its 1.9

last meeting, percent positive when yen,

in value, with

against market

the mark

and the yen, since highs

increasingly of December, and 100.73

sentiment. reached has

However,

the start

the dollar the dollar

its period sideways

of 1.5835

marks

traded

in narrow

ranges.

Perhaps

the best

reflection

of the dollar's was the initial and 100 yen. through

relative period Over of

strength,

and of the change consolidation just

in sentiment, above

1.57 marks uneventfully three

several of events have the been

days,~ the dollar which, quite had they

traded occurred

a series ago,

or six months These

would

likely

to cause

sharp

declines.

included:

resignation Bankers

of Secretary as well year-end

Bentsen

and the supervisory

action

with

Trust, with

as the oscillations position

of the yield and with

curve Orange

associated County.

adjustments

From

a European these

vantage events

point, implied

the dollar's a degree

quiet,

firm strength

tr_ading through not seen

of dollar

for some

time.

.

- 2 -

In the last week resume any upward

or so, as the dollar market

has been

unable

to to:

momentum,

participants

have pointed

the mark's

strength

within

Europe; that the Bundesbank of any further rate that the Committee will be able to decreases; and, will act to

the decreasing likelihood maintain the plausibility

the diminishing expectations raise rates today,

all as reasons Overall,

for taking

profits

on the dollar's is still

November

rally.

however,

the dollar's

resilience

noteworthy.

The Canadian U.S. dollar over

dollar

declined

by over

two percent

against

the

the period with

f1.3639 to 1.39451,

as their

market

seemed effort point.

to respond to avoid Thus,

disappointment U.S.

to the Bank basis

of Canada's point for basis range

matching

rate increases of Canada points

while

the Bank

has raised over

its target

for overnight three-month

rate by 50 basis Canadian rates have

the last by over

five weeks, points

backed~up

100 basis

Throughout pressure, against

the period, at or near --

the Mexican

peso

has been

under limit

trading the dollar

the Bank of Mexico's

internal

As a result, Bank of Mexico began intervening, for the over first time since

the

July,

and has sold

over

the period,

of which

- 3

were

sold on Friday

and

were

sold yesterday.

The

events

and announcements administration

associated

with

the inauguration effect of

of the Zedillo overshadowing anxiety rising events about U.S. might

have not had the hoped-for tensions in Chiapas, reform,

the increased the prospects Indeed,

the growing and impact of

for political the very to overcome

rates.

expectation these

that the inaugural factors has

be sufficient the market's in thinning, market

negative

accentuated on the peso environment, appetites declining

disappointment, end-of-year

putting

further

pressure

markets. to have

In the current decreasing prospects are

participants investments

appear whose

for Mexican relative

risk-return

to those

of other

countries.

We expect

some

announcement in their

this morning rate

from the Mexican The market what

authorities

of a change We will

exchange

regime.

is full of rumors. of the change in the bands

are not certain be, whether float

at this point

the nature adjustment

it will

be a discrete

or a

of some kind.

Mr.

Chairman, I would

while

we had no intervention the Committee lines

operations

during

the period, completed

like to inform renewal

that we have with our European arrangements

the annual

of the swap (The Canadian in December

and Japanese come

counterparts. renewal

and Mexican 1995.)

up for biannual

I would

be happy

to answer

any questions.

Notes for FOMC Meeting December 20, 1994 Joan E. Lovett Open market operations during the intermeeting period were aimed at implementing and maintaining the increased degree of reserve pressure adopted at your meeting on November 15, consistent with Federal funds trading around 5 l/2 percent. recall that, at the time, the borrowing allowance was left unchanged because the full rise of 75 basis points in the discount rate was allowed to show through to reserve markets. Since then, the allowance has been reduced by $100 million, in two steps, as seasonal borrowing fell. $125 million. It now stands at YOU

Adjustment borrowing was again quite light on most

days but jumped at the end of two maintenance periods when money market conditions tightened up. For the intermeeting period,

adjustment borrowing averaged $65 million. The start of the interval saw fairly large reserve shortages, primarily the consequence of the buildup in currency ahead of the holiday season. These needs were expected to rise

another notch in the period currently underway as a result of continued growth in currency and an elevated Treasury balance following the mid-December corporate tax date.

Actual reserve needs over the interval as a whole were reduced modestly as a result of revisions to operating factors. Individual revisions were sometimes substantial but, on balance, their effects were mostly offsetting.

2 Both outright and temporary operations were used to meet the large reserve deficiencies. We bought about

$4 I/4 billion of Treasury coupon issues in the market at the end of November. This was our sixth market purchase of the year, and We also took in another $1 I/4 billion

the fourth for coupons.

of securities through intermittent purchases from foreign accounts. For the year to date, our holdings of Treasury

securities have now grown by $33 billion, an expansion on a par with each of the preceding three years. Temporary operations were used to fill in remaining gaps. Altogether since your last meeting, we arranged seven

multiday System RPs and five operations lasting one business day. Multiday RPs were arranged ahead of the coupon pass, and again in the current maintenance period with the further deepening of reserve needs. In the middle period, an accumulation of factor

revisions after the coupon pass eventually left us in temporary oversupply. We wound up absorbing reserves on two occasions

towards the end of that period after the surplus became apparent. In the upcoming reserve maintenance period which covers the year-end, reserve shortages are expected to grow further as currency jumps one last time before receding. We anticipate that

a sequence of large multiday RPs will be necessary to meet deep deficiencies and the high demands for excess reserves that often arise around the year-end.

3 Funds traded with a very firm bias on several days during the interval, even when some of the factors that typically generate heavy payment flows were absent. Trading on the Our own

December 7 settlement date was a particular surprise.

estimates pointed to a substantial reserve surplus, even after allowing for the modest-sized draining operation we arranged that day, and this was reflected in a low funds rate in the morning. But the rate soared as high as 20 percent in later trading as the demand for excess reserves apparently was well above even the elevated level we had allowed for. For the interval as a whole,

the effective funds rate averaged 5.56 percent. In securities markets, the yield curve flattened dramatically further over this past--relatively brief-Rates on shorter-term Treasury coupon

intermeeting period.

securities and some bills jumped by over 50 basis points, on balance. These rates were driven upwards by a combination of Longer-term

economic considerations and technical developments.

yields, meanwhile, dropped by as much as 20-25 basis points. Thus, the coupon yield curve was about 75 basis points flatter at about 30 basis points. The momentum behind the flattening

reached a point where it became almost self-reinforcing, but it has eased off in more recent trading sessions. participants While

had anticipated a continued flattening trend, many

were caught off guard by the speed with which the recent move occurred and the level which it ultimately reached.

4 The more aggressive initially 75 basis policy point move hike in reserve market rates was a The

than was generally tentatively The move was

anticipated. and seen seemed as to

market groping

reacted

somewhat levels.

to be

for appropriate that

demonstrating contain proved upward

the Fed was prepared pressures and,

to act decisively this policy behind

price

thus,

action the curve

to be a key component as the period The climb

in the psychology

flattening

unfolded. over the period was that

in shorter-~term rates by a steady robust stream

strongly pointed

supported to continued

of economic Labor markets

indicators showed

growth.

signs

of tightening confidence during quarter momentum general helped noted flash

further,

and buoyant

measures

of consumer about spending fourth

were

reflected season.

in available Most market

information analysts range

the holiday

now place with the the

real GDP growth expected absence to hold

in a 4 to 5 percent into next year. price pressures

to extend of visible

Meanwhile, at the final analysts

level have to

down

longer-~term yields,

although

that many warning The

of the more advance

price

indicators

continue

signals. immediate occurred catalyst during behind many of the often abrupt of of in

rate

moves

that

the period in part

was a restructuring

financial interest equities longer

portfolios, rate early increases

responding

to the accumulation A wave

over the past

year.

of selling into

in the period

was accompanied which were

by some move seen

dated

Treasury

securities,

as offering

5 relatively entities hedging which dated more attractive returns. A number of financial or

reportedly their

restructured

portfolios rise

by liquidating in interest

exposures

to a further selling

rates,

often

involved

heavy

of short-

or intermediatesome of this

securities.

With

the year-end by a desire

approaching, to realize

activity already

was motivated disappointing

losses forward

in an unprofitable

year

rather

than carry

positions. The unraveling investment the fund's liquidation Not long pool was financial of the Orange County California When word of

felt in a variety plight broke,

of markets.

the prospect

of a massive rates higher.

of its holdings dealers

pressured began

shorter-term

afterwards,

selling

the collateral The fund held of

supporting both agency market could

the reverse

RPs extended

to the fund. agency notes,

"plan vanilla" paper

and structured There

and spreads jolt in the

widened.

was also an initial that other

for municipal be facing While

debt on fears similar

municipalities

problems

to Orange

County's. played out, the

this episode appears

has yet

to be fully

fallout

to date

to be relatively from a market

contained. standpoint, involved

The disposal proceeded and some of

of the pool's fairly

assets

has,

smoothly,

despite

the large along

amounts

the legal sales have

questions been

raised

the way.

Of course, and this stabilized, far not

the

initial the

of the more The municipal

marketable market funds

paper

aided and

aistribution. large-scale

quickly have

outflows

from bond

thus

6 materialized. the uneasiness other financial With thinning thinner out, Perhaps the greatest effect has been that to reinforce may be

that exists land mines the year-end

in most markets yet to come coming

there

to light. the markets is making are for even about

into view, it has been there for now

and the kind of year than usual.

conditions will

While

is some seems

caution to be

how things approaching financing range

turn out,

the market calmly.

the year-end have been

Trading

volumes for some funds

for end-of-year over year-end paying

limited,

and quotes with

between

7 and 8 1/2 percent, end. investors

foreign

names

towards

the higher

As for the Fed, clear tightening

see monetary

policy

on a nearof rate as

trajectory.

However,

expectations to decipher on some

about

term policy the many

adjustments that have

are not as easy had an impact analysts expect

because

flows

of the usual to act the

indicators. soon
move

Few market

the Committee to be that

as today. in November hand price

The prevailing

sense

seems

larger may stay

and the shorter for a spell. indices,

period

between round

meetings of favorable volatility

the Fed's aggregate financial most don't

The latest

and some of the

recent this

in while An seen is

markets expect

are seen as supporting a move, few would

view. rule

Still, it out. is also it comes,

completely

interim

rate

adjustment

via

an asymmetric step,

directive whenever

as a real

possibility,

and the next

not expected

to be the last.

E. M. Truman December 20, 1994

FOMC

Presentation together

-- International the Greenbook

Developments projection for this no sector of and

In putting meeting, we were

in the uncomfortable on developments This U.S.

position

of having external

comprehensive

data

in the U.S. with

for the current October services,

quarter.

morning,

the release in goods

data on nominal we received As noted

merchandise hard

trade

our

first

data. report in front was of the $10.1

in the exchange deficit

market

Committee, billion Compared deficit more were

the October

on goods alone

and services was $15.0

and the deficit with

on goods

billion. the overall increased and by

the average somewhat,

of the third while

quarter, deficit

widened

the trade increases

modestly. the same

The percentage -- about l-l/2

in exports

imports with off

percent.

However,

compared edged

September, somewhat,

imports primarily A downward

in October

rose while

exports

as the result revised

of reduced on goods upward

aircraft trade

shipments.

deficit

in September in the as a whole revision to

combined estimated

with

the more

substantial

revision quarter

surplus

on services

for the third suggest

that was released net exports that

last Wednesday and services add about

an upward

of goods

for the quarter. 3/lOths

We estimate of real

the revisions rate.

will

to the growth

GDP at annual

The data essentially

released

this morning the Greenbook

for October forecast

are

in line with

for the fourth

- 2 -

quarter.

They tend to confirm our outlook for continued strong That growth will be sustained by the ongoing

growth in exports.

expansion of economic activity in our major trading partners at an average annual rate of about 4 percent and, to a lesser extent, by the effects of the weakening of the dollar, on balance, this year. A reasonable question is why we are not projecting a further pickup in growth in the major foreign industrial countries next year. One answer is that there are risks to our We are expecting faster growth in

forecast in both directions.

some countries that will be offset by slower growth in'Germany, the United Kingdom, and Canada. In Germany, a major cause is

tighter fiscal policy, in particular the income tax surcharge that takes effect on the first of January. In the United

Kingdom, tighter fiscal policy combines with tighter monetary policy to slow growth. In Canada, policy restraint is also a

factor, but the major influence is the projected slowdown in the U.S. economy. While our forecast contains an upside risk for foreign growth and, therefore, for our projection of exports, one would be hard pressed to argue that the surprise might be of the magnitude that we have experienced this year -- more than a percentage point and a half. Moreover, the magnitude of the

surprise this year has moved actual output much closer to our estimates of potential in most of the foreign industrial countries. The gap is now projected to narrow further over the If foreign authorities share our analysis and

projection period.

- 3 -

believe that the attendant risks to inflation have increased substantially, monetary policies abroad could well turn out to be more restrictive than we have assumed in our forecast. On the import side, we continue to project a substantial slowing in growth after the first quarter of next year particularly in the volume of non-oil imports excluding computers; the expansion of imports of computers should slow but remain at hefty double-digit rates. The principal driving force

in our outlook for imports is the slower growth of U.S. economic activity, although effects of the lower dollar also are expected to play a role. A final word on the dollar, a perennial risk to our forecast. As you know, the dollar has appreciated on average in

terms of other G-10 currencies by about 5 percent from its low point in early November, including a couple of percent since the mid-November FOMC meeting. We are projecting that the dollar

will remain at essentially its current level throughout the forecast period. Over the next couple of quarters, we expect

that the dollar will be sustained by moves by the Federal Reserve to contain inflation. Further along, short-term interest rates

abroad are expected to start rising while dollar rates are unchanged or declining. One question is what will be happening

to nominal and expected real long-term interest rates here and abroad. Real long-term rate differentials could turn against the

dollar, but in our forecast we have assumed that they will be essentially unchanged. Mike Prell will now continue our presentation.

Michael J. Prell December 20. 1994

Unlike report.

Ted.
we

I don't did

have

anything a couple

hot off the of pieces

presses

to

However, after

receive

of information might warrant a

last week. few words. importance.

the Greenbook because

was they

completed. highlight

and they areas

I say that

of considerable

and uncertainty. first piece

in our forecast. related to business outside only inventories auto in

The October. with third the

of news

Stocks pace

were

up substantially. running

of the

sector, of the

of accumulation

a little

below

that

quarter. Forecasting inventory year behavior has is a perilous once activity. But as the there's

experience no way

thus

far this the issue.

illustrated staked their

again. deal

to duck

and we've to build of 1995. once or the

a good stocks

in our clip their A

projection through the

on firms opening fairly

wanting months promptly

at a good

and then show

seeking signs

to curtail

accumulation deviation appreciably quarters. The accumulation ensure price

sales other

of decelerating. pattern could several

in one direction alter

from this

the dynamics

of the

economy

in the next

risks

obviously months

are two-sided. has been stocks

Conceivably, by the

some desire

of the to

in recent holiday

motivated

adequate

season

or by efforts Under quickly ratio the

to beat

expected

increases--for investment

example. might

for steel. off more

circumstances. year. But. low

inventory given in our that

drop

next

the aggregate

stock-to-sales conditions

remains

relatively it is

forecast.

and supply

relatively

tight.

FOMC

Briefing--December

20, 1994

Michael

J. Prell

possible prove might

that

the current than

wave

of desired

inventory

accumulation were

could

more delay

persistent

we're

anticipating. behind half

If that

so. it

one of the key forces in the

our projection of 1995. direct That

of a marked would put even

slowing greater effects effects

in GDP growth weight on the

latter

shoulders

of the more And,

demand-damping signs of such

of higher have been

interest scarce regard, Housing since

rates.

as you

know,

to date. the housing starts last data reported on Friday are reaching was

In that worthy their evenly of note. highest split

jumped

7 percent spike.

in November. The increase starts. restraint

level between

December's

single-family whether

and multifamily there is much

Clearly. in train if

one would the most

have

to question

interest-sensitive Given

component

of expenditure

is still near-term especially

showing

such buoyancy. weakening comforting.

our forecast I don't

of a significant find these data

in final

demand,

HOWeVet-, I'm not willing analysis, key either. First, permits

to throw slipped

in the towel a touch last

on our month in the

single-family

category--and susceptible

that

is a less

volatile

indicator. We thought might with that give that

MOreoVer, the mild us a blip

it is less weather

to weather of the regional

effects.

in some parts and the the

country data

in November are consistent

in building,

interpretation. the December Given data these

Finally,

latest

anecdotal

information--including in activity. starts

Homebuilders considerations. only

survey--points I would

to a weakening

characterize risk

the November

as suggesting Obviously,

a mild

upside

to our forecast. of risks regarding This the is

judging

the distribution policy that

outlook

for demand

is key to your share

decision the

today.

especially

so if you

our view

pressures

on productive

2

FOMC Briefing--December

20, 1994

Michael J. Prell

resources already have reached levels that presage an early upturn in inflation. albeit~a gradual one. As you know, the most recent data on And there is at in prices

'wages and on consumer prices have been favorable. this point no definitive indication

that the acceleration

that has been so evident at the crude and intermediate levels is about to be mirrored in retail prices.

materials

HOWeVer. we believe it would be a mistake to conclude from the recent good numbers that a pickup in inflation is not at hand. Broad pressures on manufacturing And, as capacity or on labor supplies are a I've noted previously, the fact that

quite recent phenomenon.

the economic conditions are such that we would expect only a gradual acceleration a percentage in prices--one that would amount to less than a tenth of point per month of additional increase--means noise. that the

signals could be lost in the month-to-month suggests that these are circumstances

Experience convictions about

in which on&

the basic situation could be severely tested: in the late Eighties. for example, the initial phase of the pickup in inflation was difficult to discern and it misled us--and others--into while that the natural rate of unemployment previously thought. That said, we have. nonetheless, projection somewhat in this forecast recalibrated our inflation thinking for a

might be lower than we had

round.

Despite the higher output the

path and lower unemployment

rates in our current projection,

outlook for the level of inflation is more favorable. predicting a quarter-point

We are still

pickup in core CPI inflation next year, but rather than 3.4 percent. The slightly oil price

it is now only to 3.2 percent,

higher path of the dollar, and a somewhat lower near-term are factors in this change.

But more important is the fact that we

have seen inflation come in lower than expected this year. and we have

3

FOMC Briefing--December made a commensurate
rates.

20, 1994

Michael J. Prell inflation

level adjustment to our forecasted

Mr. Chairman.

I have resisted the temptation Greenbook.

to reiterate

fully the analysis in the the continuing

In a nutshell. we believe that

strength of the economy has pushed resource utilization levels. and it appears likely that action will be needed to prevent the into a

rates beyond sustainable substantial

further tightening

projected near-term

step-up in inflation from evolving

significant upward trend.

Some of you expressed concern at the last This

meeting about the very low growth rates we were projecting. remains a feature of the current forecast.
recession?

Does this imply a risk of

Yes, it probably does.

But, given where the economy is

now and seems to be headed in the short run, we see that ,risk may be unavoidable if the Committee wishes to keep inflation firmly in check.

4

December FOMC Briefing Donald L. Kohn

20, 1994

The would have seem been

situation

facing

the Committee

at this meeting The economic data

to have

an eerie

familiarity: labor and,

surprisingly has risen

strong, further,

and capital

resource the the

utilization staff has

as a consequence, tightening

increased needs

its estimate

of how much pressures from

Committee enough higher. eerie will

to do to reduce the inflation circumstances, and

on resources steadily risks I an

to keep In the

rate

climbing

my briefing

as well

familiarity, be short. The

in the spirit

of holiday

giving.

greenbook

noted was

the

reasons

for thinking

that

additional pressures. structure cast.

policy

firming

needed

to relieve into

inflation the term foreis that for the

In fact, of yields so. the

the market more

has built than

tightening

in the staff forecasters

Even

consensus

of outside than but

inflation last

will

be somewhat only

higher next

it has been over

few years--not After

year. last

the longer-run real interest from

as well. rates may

the Committee's

action,

be slightly experience.

to the restrictive However. a lasting

side,

judging

historical well only

even more uptick

restraint

may

be needed to counter

to avoid

in inflation--not demand of increased

the effects

on aggregate

-2credit lier fects availability, strengthening growth abroad. and the earef-

declines

in the dollar,

but also

to overcome beyond

on inflation innovation liquidity

of operating

for a time

potential. have

Moreover, reduced degree

and deregulation

in credit

markets same

constraints, real rates

and to achieve may have

the

of restraint, than

to be higher before

now 1980. long-

for a time With

in earlier already

decades--especially beyond

the economy

producing

its likely

run potential. in aggregate toward firming. higher

and in the absence demand,

of any signs seem still

of slackening be to tilted

the risks would

inflation

in the absence

of additional

If the Committee ening under were needed, prompt C. would

were

convinced even

that

further

tightas

action,

at today's

meeting cir-

alternative waiting

be appropriate. won't help

In these move

cumstances. toward terms

to tighten

the economy hurt in

the Committee's of risking

objectives,

and could in inflation more

even

a deterioration

expectations generally. A

in financial near-term action taining the

markets would

and in the economy build

move

on the effects

of November's to mainthat

in demonstrating low or declining did not seem

the Committee's inflation,

commitment

and its assessment that would

economy

to be on a path

produce

those

results. But, in some changed respects. from that the situation facing the and

-Committee

has

of the last half

year,

-3these scope changes may give the Committee tightening, For some reasons for, and

to. postpone

further

as under one. after real

alternative the unrates to see

B, at least usually probably more than

for a little firming

while.

large

of November,

and with

at higher

levels.

the Committee data

may want

one month's

additional to bite

to asses

whether action. out, the con-

policy

is beginning In addition,

before Peter

taking

further

as both

and Joan

pointed now that well

financial economy tained.

markets will The slow

seem

to be more

confident

and inflation recovery

will

be fairly

partial curve.

of the dollar.

the flattening commodity

of the yield price that indexes policy some

and the leveling few weeks somewhat

out of some suggest

in the last

expectations Of

will

be at least

successful.

course, cant

of these policy

responses

are predicated but the change

on signifiin attitude rise in the in

further

tightening,

does mean dollar--are attitude tighten

that market reinforcing reduce

reactions--for the thrust

example of policy.

the

This

shift to

may

any urgency though were

to take

further

steps could

immediately,

the new attitudes additional adverse

turn

out

to be fragile bearing on the

if there inflation

information

outlook. in financial along with raise markets concerns about about

Finally, where showing capital clean

nervousness may

losses

reside,

statements

at year-end. over the next

the possibility Somewhat

_of a flight

to quality

few weeks.

-4. wider would working Moreover. abrupt risk premiums and greater adjunct less care in extending policy credit in

be a welcome to foster

to monetary

restraint

ebullience

in borrowing

and spending. an

a further

tightening market

is unlikely adjustment. policy

to precipitate Still,

or destabilizing disruption

the odds

of market smaller

from

tighter

will

be even

after

year-end. saw these factors as arguing for B, it with is

If the Committee a pause might in tightening to consider directive. But

and the adoption whether

of alternative that

want

to accompany

choice meeting

an asymmetric only 6 weeks.

The period

to the next viewed the

if the Committee toward was one side, over

risks' still to

as strongly wait able until

tilted

it might

not want

the period half

if the data continued

becoming

avail-

in the first

of January especially

to suggest accompanied data to

unsustainable by a pickup would convey

strength. in inflation. the Federal

if that were reaction continuing forestall

A prompt Reserve's might

to such resolve

contain

inflation

and hence inflation

any developing

tendencies

to raise

expectations.