APPENDIX

FOMC JANUARY

BRIEFING

- P.R.

FISHER 1, 1995

31 - FEBRUARY

Mr.

Chairman: I will be referring this to the three color charts on the single

page

distributed

morning.

1n describing markets over

domestic

interest

rate

and

foreign

exchange

the period,

I will

try to answer

two questions:

First:

Why have ez?ectations for interest come down so much over the period, Why has the dollar German mark? weakened so much

rate and

increases

Second:

against

the

in response for were interest rate

to the

first

question,

I think,that so much

expectations they

increases

have unwound in part, were

because

exaggerated of those

-- at least, expectations

because

commonly-accepted by a number of

measures factors

distorted

at the end of last

year.

At end of

the end of Novembc~- and into early the yield closed curve backed-up sharply

December,

t!le short-

as a number- of bank paper were :OL- t!l2 of wilat a:ld

portfolios as Orange liquidated. Committee's was seen

out posi~tions in two- and three-year

County":; filiancillg posilliun:.: and portfolio At tile same time , mai-L:ct something expectations

actions

implied

of an extrapolation approach

as the Commit tee 'i; ~morc aggressive these two phenomena were mutually

in November. EVl2!1

bloreover,

reinforcing.

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as market

participants of Orange market by May

began County

to think might

that

concerns

about

the

implications in December, tightening seven yields rapid

prevent

an increase points of

in rates

expectations

for 150 basis 2-and

appeared percent were

to justify and, seen

3-year time,

yields short-end

over

and one half at these increase

at the same

levels

as confirming rate.

expectations

for a

in the Fed funds

Over unwinding

the both

course

of January,

there

has been

a gradual and of the

of expectations curve.

for Committee

action

'I hump 'I in the yield

For example, the release sales. implied curve the

a major

step

in this process

occurred

following retail the rates

on January first

13th of the weaker-than-expected two panels Fed Funds of charts Futures -- depicting contracts

In the

by the monthly -- the impact

and the yield be seen in

of this process

can particularly lines:

shift

from

the green

to the orange

shaving increase increases and, in

expectations more the

for this

meeting

to a 50 basis the pace

point

significantly, future.

lowering

of expected

While either data,

most

people

in the market

remained

skeptical

about sales

the accuracy it did serve likely

or enduring to remind to face

significance

of the retail that

market two-way

participants risk

they were data

increasingly

in upcoming

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3

-

releases. lock much down

This,

in turn,

gave

confidence 5-year

to those yields. finally

wanting

to

in the relatively talk of "heavy

high

Z-to

Thus, began

despite to work

supply,"

the market curve.

the hump

in the yield

The

release

of fourth-quarter component,

GDP last provided

Friday,

particularly occasion: it of

the inventory while the

investment

a similar to revision,

inventory both a hint

estimate

may be subject

provided two-way

of a softening releases.

of demand

and a reminder

risk

in upcoming

Turning progressive actions,

to the dollar, unwinding

in my opinion,

it was precisely

the

of expectations yields, positions

for the Committee's to weigh and on the triggered crisis a was

and of short-end long-dollar initial begun factor

thatbegan

accumulated the dollar's has recently

in late December the Mexican

decline.

While

financial became

to weigh

on the dollar, after

this only

significant already well

in mid-January,

the dollar's

decline

underway.

In December, dollar have in the face

I mentioned of events to cause

the surprising which, dollar earlier weakness.

resilience in the year, (These

of the would the

been

expected

included

resignation curve

of Secretary Orange The

Dentsen, County

the oscillations and the Bankers

of the yield supervisory corporate that

surrounding

Trust

announcement.) and speculative

strong

demand

for dollars-'-both on the numerous

-- was predicated

forecasts

-4-

the dollar forecasts rapidly

would

rise

in 1995. were based curve;

To a great on: the

extent,

these of the of yet

themselves flattening

implications

yield

the extrapolative and the absence

projections of any data

the Committee's indicating

likely

actions;

a slowing

of the economy.

Having early

brought

forward were

much

of the demand seeking

for dollars dollars markets was

into after on

December,

there

few firms

to buy holiday

the Committee's December 28th,

December after

meeting.

In thin, close,

the European to push

the dollar by triggering

subject

to an energetic orders. almost noted, returned it had 75-basis Given

effort the lack

it lower

stop-loss dropped

of interested than that half this

buyers, an hour. initial

the dollar However, drop

3 pfennings and should

in less be noted,

it was

merely where November

the dollar traded point

to the levels,

around

1.55 marks,

for several increase.

days after

the Committee's

The rush

dollar's

second

step

lower

occurred

as a result

of a and major

of demand

for marks European having were The

coming

out of the politicallyIt appears that

fiscally-weak intermediaries, over

currencies. taken

several

long-dollar, wrong-footed way

short-mark by their their

positions customers' positions was

the year-end, for marks. dollar-mark

caught quickest

demand to sell

to adjust 9th, again

and,

on January

in New York

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trading, minutes.

the dollar

fell nearly

two pfennings

in under

45

With momentum,

the dollar and the yen

having

demonstrated becoming

a surprising subject

downward

eventually

to the came to be

uncertainties seen

of the Kobe

earthquake, of choice,

the mark rising basis

quickly

as the reserve high

currency

to within on January

a hair 25th.

of its all-time 1199.40 vs.

on a trade-weighted

200.40

on 10/5/921

Thus,

the dollar's of the

first

two steps

lower

were

caused in

by the

unsustainability December, for rate in the

long-dollar

positions, extent

built-up

face of the decreasing But by mid-January, shifted from

of expectations duration the is

increases. crisis

as the expected

of the Mexican Mexican nothing through

temporary

to indefinite, But

situation especially which

did begin "Mexican"

to weigh about

on the dollar.

there

the specific

mechanisms

the crisis

has affected

the dollar.

First, unwinding assumption matters weakness

the Mexican

crisis

provided

a further actions

reason

for the

of expectations that

for Committee Reserve

-- on the to make and the market

the Federal Indeed,

would

not want

worse.

because financial

of the peso's system, skeptical

weakness,

of the Mexican became

foreign about

exchange

participants

increasingly

the prospects

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6

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for the Committee to raise rates and about the prospects for the dollar to rise even in the event of a Committee action.
._

Second, the Mexican crisis served as a catalyst for the development of an alternative, negative forecast for the dollar in 1995, which goes something like this: If emerging market

economies, and Mexico in particular, are going to be a decreasing source of demand for U.S. goods and services, while the U.S. economy continues to grow strongly, then the U.S. current account deficit is likely to increase. If one combines a forecast for an

increasing current account deficit with a forecast for U.S. interest rates to rise less, and less quickly, than previously assumed, it is hard to see why one would expect the dollar to move higher.

Finally, last week and on Monday, the foreign exchange market has had something of a knee-jerk, negative reaction to the political back-and-forth over the Mexican aid package.

Yesterday, the dollar got an initial bounce-back in early European trading on rumors of concerted central bank dollar support, indicating the nervousness of those who had taken shortdollar positions. Apparently, just as the market was getting

comfortable with the idea that we were unlikely to be intervening, and short-positions were being reestablished, President Clinton's announcement hit the wires that "executive authority" would be used for the Mexican package. The scramble

-

I

-

to cover that

short

positions

again

was made its marks

more

urgent

by the rumors the

the ESF would

be selling

and yen

to fund

package.

Looking repetition, explanation now that

back Mexico of why

over

the month,

it seems part

to me that by dint of the accepted is deserved. of Mexico nature

of

has become the dollar is lower,

a bigger moved

lower

than

But as a

the dollar cause

and the perception the unresolved holding

contributing peso crisis

is widespread, factors

of the

is one of the

the dollar

down.

In addition been high under price

to the peso's during

weakness,

the Canadian

dollar

has a

pressure
from

the past

month.

The markets

exacted

the Bank

of Canada

for its failure 75 basis

to raise points.

rates Their the

in November lagging Canadian rate

in step with increases,

the Committee's combined with

market

anxieties

about

government's brought

fiscal

policy

and the Quebec to a g-year 30-year

separatist low against

referendum, the U.S. interest By last

the Canadian l/201

dollar

dollar rates week,

[1.4269

and pushed points

Canadian December. the Bank

up by over

50 basis

from early increases, that

however,through

repeated

rate

of Canada maintain

seems

to ilave persuaded short-term

the market rates

it will

the higher, their

to defend long-term I would

the currency, rates back down. of

stabilizing

dollar

and bringing rates,

If the Committee Canada to match

wei-e to raise it with

expect

the Bank

a 50 basis

point

increase

of their

own.

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Turning to the Desks' operations, throughout the period, domestic operations were aimed at maintaining the existing degree of reserve pressure, with Fed funds expected to trade around 5 and one half percent, as directed by the Committee. Year-end

pressures in the funds market only reached 7 percent, and by the time traders left their desks for the New Year weekend, the funds rate had touched a low of one-quarter percent.

The first part of the current maintenance period required a draining of reserves as the seasonal increase in required reserves and in currency rapidly reversed themselves. Because of

the expected need to return to adding reserves in upcoming maintenance periods, we met our draining needs with temporary transactions and by the redemption of 600 million dollars in 7-year Treasury notes which matured without replacement. Over

the past few days, we have returned to adding reserves as a rise in the Treasury balance has introduced a temporary need, while security market settlement pressures and expectations for a policy move at the conclusion of this meeting have worked to elevate rates in the money market.

Over the three maintenance periods since your last meeting, the effective Fed funds rate has averaged 5.42, 5.49, and, as of last night, 5.55 percent.

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9

Mr. Chairman, other than the 1.5 billion dollars in swap drawings by the Bank of Mexico, during the period we had no foreign exchange operations on behalf of the System's account.

I would be happy to answer any questions.