APPENDIX

FOMC

BRIEFING JULY
S-6.

- P.R.
1995

FISHER

Mr.

Chairman: Since your last meeting, rates there has been more volatility in than

short-term were

interest

and less volatility months both

in the dollar of the year. to reflect

experienced different risk

during price

the previous movements

These

somewhat decreased of market

appear

appetites,

and increased

uncertainty,

on the part

participants.

Within forth

the continued in June futures

trend

toward

lower

rates,

the back-andrates and of by

movements rate

-- particularly

in short-term

interest data

-- reflected

the shifting interpretations uncertainty course

implications of comments about both

releases

and the alternating With increasing

Committee direction policy, with

members.

the

of the economy market

and the likely have traded

of the Committee's rate markets The market's back-up in

participants anxiety

the interest conviction.

increasing

and decreasing reflected

skittishness rates

was most

recently

in the abrupt sales.

following

the release

of new homes

Because too fine market. dollar

of the market's on what

skittishness,

I am reluctant priced into

to put the

a point While

has or has not been of Fed Funds

current contracts

prices

futures

and Europoint

futures

are consistent

with

a 25 basis

ease

by the end of the month of such a move

and a greater

than

50 percent caution

probability against Indeed, July

at this meeting, estimate

I would

extracting I think

such point

of market

expectations. now in the between

that

the 14 basis contract

points

of easing a clearing

Fed Funds majority an ease

futures

reflects

price

a wide expect

of market

participants

who do not, number

in fact, who have an ease in

at this meeting that

and a small

convinced policy

themselves

the Committee

will

announce

tomorrow.

With conviction concerted

somewhat

different

consequences, markets.

the same Following

lack of the

is present intervention in narrow

in exchange

on May 31st, ranges

the dollar the mark ranges.

traded and the yen,

uneventfully albeit

against

gradually

declining

within

those

Many can find cannot German Japanese state, much

market little

participants to justify will cause

see the dollar decline.

as undervalued, But they also While

and

a further the dollar appear system

see what

to appreciate.

the

and European economy uncertainty and

economies financial

to be slowing,_ and the appear to be in a dismal it hard day-by-day bonds to see market and and

about

the U.S.

economy

makes

upside

for the dollar. see continued dollar selling banks

In the short-run, higher yields

participants persistent European

in European

by Japanese

exporters

and Asian upward

central

as capping

the dollar's

potential

- 3 -

and defining and 86 yen.

the upper

end of the dollar

ranges

around

1.42 marks

Last week toward around

the dollar

experienced

some

choppiness

and closed and

the lower

end of its ranges, yen.

just above

1.38 marks

84 and a half German

As a result

of higher-than-expected saw a decreasing The dollar moved up, and

preliminary likelihood following then moved leave this rates

CPI

for June,

the market

of a Bundesbank the announced down after

rate reduction.

resolution

of the auto-trade announced sales

dispute to

the Bundesbank's and the new homes

decision

unchanged

data.

In my view, reflected on the part

back-and-forth

of the dollar

last week

principally

the thinness of market

of the market

and the lack of conviction

participants.

In foreign 1 billion divided sold

operations, worth

as I mentioned,

the Desk 31st,

sold evenly we

dollars

of marks

and yen on May

between

the System dollars

and the ESF of both

-- so for the System, marks and yen. This

250 million

worth

operation

was undertaken

at the initiative the April

of the Treasury which

for sought With

the purpose an "orderly

of underscoring reversal" and that

G-7 communique rate

of recent

exchange

movements. G-10

our support banks market Halifax agreed

of the Bundesbank, the operation,

the other clearly

central the

to join

which

surprised

and helped
summit.

to stabilize

the dollar

in the run up to the

-

4

-

For value billion brings dollars

today,

the Mexican

authorities Medium-Term

have

drawn

2.5 This

on the Treasury's dollars with

facility.

to 10.5 billion facility,

the total

outstanding also

on the on

Medium-Term both

I billion

dollars

outstanding

the Treasury's

and the System's swaps

short-term

swaps. to

On August

1st, when undertake System's

the short-term the second swap.

next mature,

we expect

of the agreed-three

rollovers

of the

In domestic were quite and

operations, from our

actual

reserve

needs

in the period

different large weaker

initial

forecast

of a consistently turned out higher As a pass in on

growing

reserve than were

need.

Demand

for currency

to be much Treasury result, May

forecast more

and the generally-expected than anticipated. dollar bill

balances after

concentrated

an initial

4 and a half were

billion

31st,

temporary

operations need.

adequate

and effective

meeting

the remaining

Looking demand billion

forward,

the combination and the Treasury's to fund

of the weaker-than-expected monetization~ drawing, of 2.5 puts us in

for currency dollars

of SDRs

the Mexican

the posture July.

of expecting

to be draining

reserves

by the end of

Mr. ratify happy

Chairman,

I will foreign

need

separate

votes

of the Committee and I will be

to

the Desk's to answer

and domestic

operations

any questions.

Michael J. Prell July 5. 1995

CHART We're afternoon. I'll going

SHOW PRESENTATION the tag-team approach this overview Tom some to the submitted

to employ

commence

the presentation

with

a brief

of the staff's Simpson, issues Larry

economic Slifman.

projection. and Karen might

The". my colleagues. Johnson. will address

that we thought
I’ ll wrap

be of particular

interest you

Committee. for inclusion

up

by unveiling

the forecasts

in the Board's 1 starts about

Humphrey-Hawkins

report. some of the recently. among quarter, oneAs

Chart key things we noted analysts

things where

off by summarizing the economy there's has been

we know

in the that

Greenbook.

while

a consensus the second

activity has marked we've

slowed

a lot during down

not everyone half percent

GDP growth

as low as the minus for the period vigorously

estimated. so we could Be that the

The data not argue

are still

far from complete, optimistic view. was

for our less swayed us in

as it may, what ultimately in labor market worker hours

our assessment notably left. right, with

softness

indicators--most May. at the at the

the drop Although have not

in production initial risen claims

through benefits, think

for jobless

shown

to a level that we would in employment, any more

consistent

outright

declines slide

we hesitated heavily highlight

to discount

the reported The expenditure

in hours

than we did. the sectors of

remaining

four panels

for which left,

we have two months

of datt.

As you can see in May.

at the middle HOWeVer. large give"

real consumer start

spending

rose smartly take

the weak

in April. more than

it would

another

gain in June

to produce

a mediocre

quarterly

CHART

SHOW

PRESENTATION And. though well starts

Page 2 the May burst for future

July

5. 1995 sales, the

average shown

increase. right,

of new home

at the

bodes

building

activity.

descent that

of single-family

into the spring

months

guarantees negative for and. and in

residential

construction GDP.

will contribute left panel,

a hefty

second-quarter nondefense while motor

In the lower goods have

new orders of late:

capital

been very choppy other

shipments vehicles

are up substantially. suggest

data on aircraft gain

that the second-quarter

in overall in the

equipment first

spending

may be less than half that at the right.

recorded

quarter.

Finally,

nonresidential and appears rise. likely to we

construction record

fell

off in the spectacular

latest month quarterly

a less than

Unfortunately. inventory of room for
I

have only net export surprise emphasize.

one month's components

full data of GDP.

for the volatile plenty

and

so there's

in the

second-quarter

GDP picture.

Thus.

would

again, Turning

the tentativeness now to the outlook and fiscal

of our current for coming

estimate. Chart As that 1996: point. 2

quarters.

summarizes you know.

the monetary we based funds that

features

of our forecast. assumption into early

our forecast rate will

on the arbitrary

the federal we assumed given the ahead

be held at 6 percent

it would

then

drift down a half percentage we expect to occur

slowing

of inflation

in the period restraint on

and an allowance of the

for effects

of ongoing

fiscal

the trend

"natural"

real rate of interest we've predicted evidence higher

in the economy. that the assumed of a pickup in

In long-term failure activity and that during

markets,

of the Fed to ease and incoming will there push bond will yields

appreciably

by year-endsback-up

be only a partial

reversal

of that

1996.

CHART

SHOW

PRESENTATION We believe that

Page 3 the economy has received

July

5. 1995 over

a boost credit

the past

couple

of years

from a swing toward loan terms: cautious

easier

availability that lenders

and more will so.

lenient more

we are anticipating quarters. but

become

in coming

only mildly

Meanwhile. in response

apart

from a slight

firming

in the near term we anticipate be little

to the projected exchange 1996. factor with that

rise in bond yields, of the dollar will

that the foreign changed through One developments fiscal

value

obviously

could

play a role in shaping rates is

respect

to interest

and exchange budget

policy.

The outlook

for the federal

is highly the did a

uncertain. prospects few months to convert bills that

We share the oft-expressed for deficit ago. the the slashing
we

sentiment

that

seem greater think

now than they

HOWeVer,

don't budget

it will

be at all easy specific such broad that,

congressional President will

resolution

into

sign or that have will In the end. it seems

support if there

as to be veto-proof. is to be a budget.

likely

there

will have to some panel,

serious our assumed are

compromising. fiscal smaller before spelled more '96 and than

As you can see in the bottom '97 deficit contained tacks reductions

of $30 and $25 billion, resolution--at

those

in the budget

least

the Congress out.

on any tax cuts. which hand, our deficit

have yet to be is much We've it

On the other than that that

reduction

sizable

recommended

by President will

Clinton.

anticipated
will

cuts in purchases and grants We've

be modes';. and that the bulk of the

be transfers

that provide

deficit-reduction. credit for children.

included

a tax cut, in the form

of a

CHART

SHOW

PRESENTATION Chart 3 describes, against

Page 4 in broad terms.

July

5. 1995 the

how we think GDP growth,

economy

will

evolve

this backdrop. final

the red as seems to

line in the top panel, inventory investment this

outstripped

sales

last year. pattern

shot up.

As expected,

that

be reversing

year. rates of l-3/4 percent in 1995 and and assumed to be the 2-l/2

The GDP growth 2-l/4 trend percent rate

in 1996 are both below what we've of potential pressures output.

of expansion Consequently, panels

which

is about

percent.

on resources

should

diminish.

As the middle unemployment of factory average

indicate,

we are projecting 6 percent.

that the while the rate

rate will

inch back above

use is expected

to drop to below

its longer-term

of 81.3 percent. With this decline should that in resource utilization. consumer this be

price year. edging

inflation We expect south

ease back

after the bulge

earlier

both the overall

and core CPIs will

of 3 percent 4 sketches of GDP.

again by 1996. out the projected I perhaps should movements of the

Chart major components these

note that we haven't in the firstchanges were that and stocks

updated quarter small.

graphs

to reflect

the revisions

GDP data

released

last Friday.

but those panel.

As you can see in the upper-left investment further probably slowed

we believe quarter summer.

inventory will slow

in rhe

second

in the third. alignment

By the end of the with sales.

should

be in reasonable accumulation fourth This

and the resumption of

of moderate GDP in the

will contribute

to an acceleration

quarter. of course. here on the vitality of final to

all hinges,

demand.

One key ingredient

is the response

of housing

CHART

SHOW PRESENTATION decline that

Page 5 has occurred figure in mortgage sales

July rates.

5, 1995 Even

the large discounting

last week's appear investment With

on new home

considerably, the upturn in

the prospects residential

good

for achieving is graphed

at least

that

at the right. sector. to firm. we would But. as

an improvement for furnishings

in the housing and appliances panel.

expect

demand

you can see in the middle-left income hiring, growth growth is now slowing, looking

the trend

of disposable pace of

in line with

the weaker

and so we're of personal We expect

for only a limited expenditures

rebound

in the

consumption that there

in coming

quarters. of

will be a further

deceleration

business that that

fixed

investment

over the second

half of this year--one red bars--but A moderate year. as firms demand

is most also

marked

for producers' nonresidential spending lags,

durables--the structures.

encompasses

step-up respond,

in equipment with

is forecast

for next

the usual level

to the firming costs.

in product

and the lower

of capital purchases

Government assumptions. federal grants Not

will be sluggish.

under

our fiscal push in to

only will down

the deficit-reduction rare. but the on states

effort

purchases will

at a faster the pressures outlays

reduction

intensify

and localities

trim the growth

of their

for goods and services. of foreign growth should already seen

Finally, combine with

a strengthening

the depreciation rapid

of the dollar of exports sucked

we have

to produce period.

a more

expansion

over the forecast

With

imports

also being

inro the U.S. at a rise only marginally. to GDP than few years.

substantial Still,

clip.

though.

net exports

will

this will

be a far more

favorable

contribution

the sizable

negatives

that we've

seen cover the past

CHART

SHOW

PRESENTATION I've obviously given

Page 6 only a broad-brush admittedly

July

5. 1995 to

treatment

our projection--and

much

of that

repeats

what you've to add out

read in the Greenbook. some value in this

My colleagues

now will

attempt

presentation.

Tom will

start by fleshing

some of our thoughts Larry will focus

on the financial

setting

for the economy; questions

on .some of the more for private some issues

interesting spending

relating and Karen

to the outlook will address

and for inflation: to the prospects of our key trading

pertaining of some

for the dollar partners.

and for the economies

Page

7 Thomas D. Simpson July 5. 1995

In my comments economic forecast, front: I will

on the financial focus on: gains

setting

for the staff on the credit thus far in and the

developments in stock

availability

the healthy represents rates

prices

1995 and whether level fiscal of real

this

formation

of a "bubble;" a period

interest

as we enter

of greater

restraint. Charts 5 and 6 address credit availability. positions The upper quite a

panel

of chart

5 shows

that bank capital of recent

remain

comfortable

by the standards

decades,

having

climbed

good bit from the period 1980s and early banks 1990s. have

of asset

quality

concerns

of the late capital the center

In the context become willing of banks

of stronger

positions. panel shows

lenders.

Indeed,

thar: the margin

more willing sizable

ro make over the first this greater

business half

and co~~sumer loans has remained year. seems standards confirmed Consistent

of this

In the case of business to importantly imposed reflect years

loans.

willingness stringent generally

a relaxarion

of the very

several

ago. an observation

by examiners. with loans. rhe willing represented loans. years. posture of loan officers. Ln the

spreads bottom

on business panel

by the red line have Auto

for small the past

business couple months

been on a mild loan spreads have

downtrend widened

over some

in recent have

but from unusually typical levels fashion

low le.\-els.as lagged rn2.lbet rate

auto loan declines,

rates

in fairly below

and they Spreads

remain

of the early debt,

199Cs. a? the ro?

on open market have

business

shown

of your

next chart.

risen some of late as the bond market:

CHART

SHOW

PRESENTATION larger volumes while

Page 8 the paper market pressures.

July

5. 1995 has though.

has absorbed been they affected remain

perhaps

by some quarter-end fairly tight. the dramatic

On balance.

Meanwhile, in the end. consumer

improvement

in credit

quality

and business

sectors

seems to have shows that

come to a" consumer loan in

The red line

in the middle

panel

delinquencies keeping line. with

appear the

to be turning upturn

up from very

low levels. burdens. that

recent

in debt-service forecast

the black household line, in

Looking

forward,

the staff

implies

debt-service and thus

burdens

rise further.

as shown by the broken further increases

it seems

reasonable

to expect

delinquencies. The bottom nonfinancial panel shows net interest in relation to cash payments flow. of with began

corporations

along

the delinquency rising last year they

rate on business but remain

loans.

Interest low and.

payments

relatively midyear.

in the staff while higher the in

forecast, delinquency coming

edge down after on business the increase these

Accordingly. will move

rate

loans likely should

quarters, 0" net.

prove modest. suggest rhat lenders will

considerations and credit

be turning However, staff

more should

cautious income
any

will become rates unfold will

less available. in line with be mild. the

and interest

forecast, only

such move

to stringency

exerting

a slight

drag on spending. run-up in stock prices about whether this year to eve" a "bubble" might at i

The tremendous higher records has raised

co"cer"

be developing this time illustrates

in this market foster share

and whether speculative

an easing behavior.

of policy Chart

might that

further prices

have rise" about

17 perce":

over

CHART the

SHOW first

PRESENTATION half been that of this year. on

Page a period the upside

9 in which by

July analysts

5.

1995

have

generally Spikes although they shows were have that up of

surprised magnitude typically been

earnings

reports. for long. and panel of late.

typically have not of

have been

not

persisted

they not

reversed

immediately The center out two

harbingers profits,

recession. sane

economic

despite

leveling from

nearly and

25 percent the broken of

in the line

first that

quarter the

years looks

earlier. for

shows growth the that

staff year.

forecast

a resumption In the

profits

later red the

this

bottom and

panel. shows

line

charts

the

S&P yield I will of months, a is

dividend very be low

price

ratio

current bond

dividend which side

historically. shortly, norms. might

MOreOVer, may be

real

rates, high

discussing

a little

on the

historical iactor dividend unusually earnings it was were that

despite call for number for these oi

sizable higher iirms

declines dividend have been have

over

recent

yields. exrremely fa\;ored back

HOWeVer, low, retained shares when as an

pay-outs large to

corporations investment

finance that

fixed the

or to buy on

thought

potential as the

returns black

internal illustrates. on

investments rhe

inadequate.

Indeed, ratio. rising

line

earnings-price basis, has been

using this is,

earnings year, the P-E and

measured its

a trailing is not

level is not

particularly high. On that. in near in the

low--that

ratio

particularly

balance, context are be

there of the

are

no

strong economic

reasons

to

believe recent 7dins

staff

forecast. a' th_ risks

stock term

prices may appear

unsustainable. on the

However. downside, than

111 th:-

greater fo

especially the staff

since abour rhe

analysts

be more

optimistic

I

CHART

SHOW

PRESENTATION and we have

Page 10 interest

July rate.s going

5. 1995

outlook

for profits.

up. which

does not appear

to be built

into the market. rates, the upper panel funds of and the of this

Turning chart 8 plots

to real interest of the note

measures Treasury

real rate on federal 1960.

key ten-year long period,

since

By the standards funds

the current

3 percent

real federal experience.

rate is a

bit on the high real rate has above decade longer

side of historical

The longer-term remains

fallen

a good bit this year but it. too. averages. both By the standards real short whether and long

historical

of the past rates are

and a half.
In any

though.
event.

moderate. restrictive other

judging

real interest

rates are on

or not at any point acting

in time depends

importantly

forces

on the economy. rates and foreign interest measures proposals

such as private output.

propensities policy.

to spend,

exchange

and fiscal time are

Of particular impending President a balanced deficit-cutting have embraced

at the present

as both the Congress that they claim will

and the result scaled in by

budget.

The middle perspective.

panel

puts the deficit

GDP in historical appreciably the 1980s standards. action,

Even though levels

the deficit

is down much of

from the swollen and early As shown 1990s.

that characterized large

it is still

by historical absent bold fiscal

in the inset would

to the left, some

the deficit ahead,

tend to widen

in the years labeled "baseline" In contrast, translation balance

immediately which

as shown

by the red line "currenr

is based line

on the CBO's labeled recent

law" baseline. is a staff

the blank

"balanced

budget"

of Congress's in the year

budget

resolution

geared

to budget

2002.

I

CHART SHOW PRESENTATION

Page 11

July 5. 1995

One way to assess this and other developments bearing on equilibrium real interest rates is through an econometric Such an exercise is shown in the bottom

model like the staff's. panel.

In essence. the experiment performed involves selecting

the real federal funds rate path that results in output moving in line with potential and stable inflation. A word of caution at

this point is that exercises of this sort should be regarded as illustrative and not read too literally: uncertainties Apart from all the

about behavioral relations in the model. the

particular results depend on various assumptions. The red line. labeled "baseline." corresponds to the baseline deficit shown in the center panel and should not be confused with baseline strategies shown in the Greenbook and Bluebook. Under this baseline, the real federal funds rate would

remain in the 3 percent area. buoyed by continued large fiscal deficits. The solid black lirie illustrates the path of the

federal funds rate required under the balanced budget scenario. based on the assumption that the bond rate, which plays a critical role in this model. responds primarily to current and past levels of short-term rates--that is, the process determining the bond rate is adaptive or backward looking. circumstances. In these

the funds rate would need to drop promptly, given

lags. by about 3/4 percentage point or so to avoid a weaker economy once spending cuts begin to kick in larer this year. This new lower level would need to be held for a couple years before it would have to drift down about another 112 percentage point to counter the mounting drag from ongoing deficit reduction.

I

CHART SHOW PRESENTATION Of looking. a factor recent on the cour.se. it the has bond

Page market built the

12 might in bond be more

July

5.

1995

forward reduction. over effects black would line need

Indeed. that months. economy the in were the fully accurately needed
In

already to act to

some deficit market the rally

has

contributed will

This of

cushion cuts. federal if

depressing

impending that of

budget the real model, to market the the

The broken funds rate

illustrates to take,

path eyes

this

the

move to

a balanced and current

budget bond funds

credible

participants future path of

rates rate

reflected achieve

the the in

federal other real the two

to these

same outcome

as in

simulations federal turn of funds the

circumstances. be necessary prompt.

no reduction for some time,

the until rate

rate century,

would as

forward-looking to

bond

declines offset real level

provide weakness

sufficient coming would from need

stimulus fiscal to

rate-sensitive Eventually. toward

sectors the the

to

restraint. converging

funds in

rate the

decline, case

adaptive

expectations

and validating

expec~atlons. Clearly, looking paths both the backward-looking In any market and fully event. implies the need the that for forwardsomewhat recent aggressive

represent nature are, in to the

extremes. of the bond

forward-looking rate policy declines measures

a degree. quarters

reducing ahead.

Page

13 Lawrence Slifman July 5. 1995

Your correction.

next chart

focuses

on the current

inventory first,

To give you the bottom inventory to autos items, overhangs

line of our analysis are widespread:

we do not think they are confined

primarily

and some suppliers Producers

such as steel. in these showing have sectors signs of

housing-related have been prompt
we

and apparel.

to cut output. the process

and with demand should

firming, course

think

pretty much quarter.

run its

by the

end of the third

Turning the sharp run-up

to the specifics, in dealer

the upper year

left panel this

shows year. in the in

inventories

earlier

As you know. second

automakers Sales

responded picked

by slashing

production

quarter.

up in May--bolstered

at least

part by manufacturers' climb

incentives--

and if. as we expecr, the current level

they of norm

a bit fur-ther during should bring

the summer.

production

stocks

close TO the 60~day

industry

by September. Outside overhangs economy. monthly somerimes appear
I use

of motor

vehicles,

significant

inventory of the because that That reports to and

to be limited the phrase data

to only a few sectors to be". in part.

"appear

inventory

are subject alter

to sizable analytical panel--and

revisions

can substantially

conclusions,. anecdotal

said, the dara--shown suggest that stocks

in the middle are most

out of kilter market:

in areas

related

the softness home goods

in rhe housing as appliances are

construction

supplies.

such

and furniture.

In addition. The stockred line.

apparel sales

inventories

reported

to be excessive. is shown by the

ratio

for rhese

marker

groups

CHART

SHOW

PRESENTATION as shown up much that by the black less relative

Page

14

July

5, 1995

Elsewhere, have edged

line. stocks to sales.

in the aggregate lower left panel

The

illustrates goods,

manufacturers responded

of construction promptly

supplies,

home

and apparel

to the recent nearly

inventory since

accumulation, January. sectors

and have

cut production

4 percent

We expect will

that the inventory during

correction

in these through a

be completed

the next few months adjustments

combination strengthening strengthening

of some further of demand. was

production

and a

One tentative

sign of that received by these

the May rise in new orders lower noted. right panel.

manufacturers--the As Mike containing

in our forecast.

a critical inventory

element

in

the size and scope firming In making

of the current demand--the

adjustment of your

is a projected next chart. ourselves noted

in consumer this

subject

projectio".

we first had to ask months. Among an We them,

why PCE has been so siuggisi-!in recent a variety of possibilities. doubrless

in the Greenbook

the exhaustion important role.

of pent up demand

has played

As shown

in the upper

left panel

of chart goods

10. during rapidly: It is the first

1992. 93. and 94. real outlays indeed. probably
at

for consumer

grew pace.

nearly

twice that

their

lcnger-r::!l average of spending

the case year

the slowing

during

half of this consumer to above begin

reflected, that

ai least follows

<n part, the Typical a period of rapid spending

"breather" trend

often If this

levels.

analysis limited.

is correct. in co"sumer

we should spending.

to see a pick up, albeit For motor vehicles.

the average

age of the nation's trending up

auto fleet,

shown

irl tne upper

right ~c::el. hzs been

CHART

SHOW

PRESENTATION level

Page since

15 the late replacement

July 1940s. demand

5. 1995 In light to IIi

and now is at its highest of the aging continue addition, consumer of the stock, sales

we expect

to boost

over the next year picks

and a half.

if housing spending

activity

up as we are projecting. also should

for furniture

and appliances

strengthen. In the Greenbook fundamental favorable black useful other only half. which line determinants levels. Among we noted that several activity of the are still at the to be a and and

of consumption them

is unemployment which

expectations. seems

in the middle

panel,

statistically

indicator durable

of consumers' Given

willingness

to purchase of sustained

autos growth

goods. rise

our forecast

a small

in the jobless much

rate over the next in these

year

and a

we don't suggests

expect that

deterioration should

expectations. as a share of

spending

hold up well

income. several line Over

In addition. hundred

the recent dollars

stock market to household much

rally

has added the black dip. as

billion

net worth,

in the bottom the long would

panel,

reversing

of the previous are inversely run the flat

run, net worth predict,

and saving

related. relationship

theory is much

although

in the short

less tighT. bond during

Nonetheless. prices

last years'

stock market influence in the pushing on

and declining consumption projection. the saving

may have been a damping half of this year. rise in securities

the first

while

we see the recent rate a bit lower Another important in equipment

prices be.

than it otherwise

would

issue in the forecast spending

is how much next

longer chart.

the boom

can be sustained--your durable

We expect

real outlays

for producers' annual

equipment year

to grow at more

than

a 5 percenr

rate over the nexr

I

CHART SHOW PRESENTATION and a half.

Page 16

July 5, 1995

Coming on top of the double-digit growth rates for

equipment spending during the past three years. one would think the current investment boom should be off the charts compared with previous cyclical expansions, and that a major contraction may be imminent. But. as shown in the upper panel, using a

quantity index that is less distorted by the relative decline in computer prices over time, the current cycle is well within the range of previous long-expansion experience. One problem with this cyclical comparison is that, over the years. equipment investment has switched toward capital goods that depreciate more rapidly, such as computers and communications equipment. Because of the higher depreciation To

rate. firms have to "run faster" just to stay in place. adjust for this, the middle panels look at m

ir?vestment

relative fo the net capital stock--that is. the growth rate of the net capital stock. Because of rhe dramatically different

investment rates for computers and other PDE, they are shown separately. In both cases, the capital stock is growing rapidly,

but not out of bounds by historical standards. One negative factor in the outlook for equipment spending is our projected decline in capacity utilization--the lower left panel. Clearly. if firms find that they have too much

idle equipment. they will re-think their plans to replace or upgrade. let alone expand. rxisting capacity. This has led us to

keep the level of spending for equipment other than computers essentially flat over the projection period. In contrast. the

cost of capital relative to the cost of labor-~the lower right panel--continues to fall rapidly, primarily reflecting further On balance, we expect
investment

declines in computer prices.

in

CHART

SHOW

PRESENTATION equipment should remain

Page

17

July trend,

5. 1995

computing slower

on a rising keeping

although PDE growing

than

its recent rate.

torrid

pace,

overall

at a respectable Your greater many detail.

next chart Basically,

examines

our inflation is: why.

forecast in contrast

in to

the issue

outside

forecasts.

do we think percent next

inflation

is likely so far this

to year. of to

subside a shade consumer higher middle

from the 3-l/2 under 3 percent

rate observed

year?

In part the acceleration of this year

prices

in the opening costs

months

has reflected

materials panels.

and rising

non-oil

import

prices--the be in the The PPI for 0.2 spot

Some additional those

pass-through effects

may still soon.

pipeline. intermediate percent prices fallen changed price

But we expect materials

to wane

excluding

food and energy activity have

rose only contracting,

in May for many recently.

and. with industrial

manufacturing commodities the dollar period,

stabilized

OI even

MOreOVer,

is expected and this

to be little keep import

durirlg the projection in check,

should surge.

increases Labor

following have

the recent

cost trends

been quite

favorable

recently. in the

Over

the four

quarters sector

ending

in March.

productivity while

nonfarm

business

increased 3 percent.

2 percent

hourly lower panel,

compensation much

was up only

As shown

in the

of the moderation from

in compensation slowing

over the past rwo_years costs--much premiums of it rose

has come related only

a pronounced

in benefit insurance while

to health percent

care costs. over

Health

l-112

the past year. which

the posts related

for to medical

workers' inflation,

compensation actually slowed

plans. fell.

are partly

In addition,

employer- pension Some of

contributions

abruptly

in the firsr quarrer.

CHART SHOW PRESENTATION these improvements

Page 18

July 5. 1995

in benefit-cost

inflation reflect one-time

savings and we expect some bounce-back in the growth of benefits next year. In addition, with resource utilization rates expected

to remain fairly high, we are projecting some upward pressure on the growth of wages and salaries. On balance, we are forecasting hourly compensation to rise at a 3-l/4 percent rate through the end of next year--only a quarter of a percentage point faster than during the past year.

Karen will now continue our presentation.

Page

19 Karen Johnson July 5. 1995

As Mike has explained,

I will consider issues underlying

our thinking on the dollar

and some elements in our outlook for key U.S. trading partners. Chart 13 shows recent developments currencies of the other G-10 countries, in dollar exchange rates. In terms of the during the first

the dollar has generally been declining

half of this year in both nominal terms, not shown, and price-adjusted the top panel--continuing Economic developments a longer trend of dollar depreciation

terms, the red line in

that began in early 1994.

during much of 1995 have worked to lower jointly the real long-term value of the dollar. With respect to

interest differential, the individual

the black line, and the price-adjusted

G-10 currencies--the

lower left panel--movements

of the dollar to date this year

have differed substantially, bilateral dollar rates. States--and

reflecting

the differing factors that lie behind the changes in the persistent trade dispute between Japan and the United on the yen/dollar December. rate, and it is against Of the European The

For example,

their respective

trade imbalances--weighed most--l5

the yen that the dollar has depreciated G-10 currencies, dollar fluctuated

percent--since

the dollar has fallen least against the Italian lira and the British pound.

in terms of the Canadian currency during the past half year, often moving in from its change with respect to the other G-10 currencies, but on

the opposite direction

balance, there is now little change from December In contrast to its movement

in the bilateral Canadian dollar rate. the dollar has appreciated

against G-10 currencies,

strongly in terms of the Mexican peso, shown in the lower right, since the eruption of the

CHART SHOW PRESENTATION

Page 20

July

5.

1995

crisis in Mexico last December.

At first, the dollar’ sharp appreciation in nominal terms, s

the black line, resulted in real dollar appreciation, the red line, as well. Subsequently, as Mexican consumer price inflation rose in response to the exchange rate shock, the real
appreciation in the peso/dollar rate began to retreat.

We expect the nominal peso/dollar rate
high, though slowing,

to move up a bit further over the forecast period, but continued Mexican inflation should result in less real appreciation balance, by the end of 1995 than we see now. developments in Mexico for the U.S. economy

of the dollar in terms of the peso, on of

I shall return to the implications shortly.

Chart 14 contains one development

common this year to almost all the G-10 countries, long-term interest rates,

including the United States: lower nominal interest rates, particularly shown on the right. U.S. short-term those abroad.

The numbers in the tables in the middle panel show that on average

rates, on the left, are above foreign rates and have not fallen as much as Just the opposite is the case, however, for long-term rates, on the right.

Japanese long-term

rates have come down the most, but the decline in U.S. rates noticeably Our forecast is for long-term rates abroad to

exceeds that of foreign rates on average.

change little from current levels over the rest of this year and next.

In that event, the dollar U.S. long-term

can be expected to retrace some of its decline, as somewhat higher projected rates move the interest differential dollar would subsequently

over the next few months in favor of dollar assets; the

remain little changed over the rest of the forecast period.

Of course, other factors can influence exchange rates as well. Two that are

CHART

SHOW

PRESENTATION

Page 21

July

5, 1995

particularly

relevant now are listed in the lower left: U.S. fiscal policy and the long-run As market participants associate less risk with the progress on the budget

outlook for our current account balance.

long-term outlook for fiscal policy, perhaps in response to perceived in Congress and with the Administration,

they may in the near term also have a more Over a somewhat longer perspective,

favorable view of the dollar, causing it to rise. adjustment within the economy

to a sustained lower fiscal deficit is likely to be associated value that would

with lower real interest rates and some decline in the dollar’ spot exchange s induce some of the resources goods sector. Continued current account deficits also pose a risk to the dollar. no longer consumed

in the public sector to move into the traded

Our econometric

models based on post-war experience over the medium

suggest that our external deficit would expand further If market participants came to see the

term at current exchange rates.

external deficit as implying ever higher U.S. net indebtedness share of GDP, they would put downward

to the rest of the world as a Arguing against widening at current exchange rates, are It may

pressure on the dollar.

deficitis is the fact that U.S. unit labor costs in manufacturing,

well below those of our major industrial trading partners, as can be seen on the right. be that our econometric production downward side. models do not incorporate sufficiently this competitive

edge on the

A more favorable trade outcome would eliminate the hypothesized on the dollar. The exchange markets will bring forward into current developments. but to what extent is difficult

pressure

rates the expected

outcome of these longer-term

CHART

SHOW PRESENTATION

Page 22

July

5.

1995

to anticipate--adding

some uncertainty

to our outlook for the dollar. As you

Your next chart presents an overview of the foreign outlook for real growth. can see in the top left, we expect that growth in our trading partners, agricultural of 1994. exports, Through weighted

by U.S. non-

fell sharply during the first half of this year from the robust growth rate the end of 1996, we expect to see foreign growth recover somewhat and The top right box shows the critical role of in 1995.

continue to outpace growth of U.S. real GDP. the Asian developing countries

in sustaining growth of foreign output, particularly in the industrial and, especially,

We expect that 1996 will see improvement American countries. The middle left panel provides for U.S. exports and output.

the Latin

an insight into the relative importance

of these regions

The industrial countries account for more than half of U.S. important. Latin American and Asian developing

exports, and Canada by itself is particularly countries each have a significant Mexico, and the Asian developing countries, the slowdown share.

Details of the forecast for the foreign G-7 countries, For the foreign G-7 in Canada and Japan.

countries are shown on the right.

in the first half of this year is concentrated weakness is most pronounced

Par the developing

countries,

in Mexico. in Mexico on Data

The lower panels summarize the U.S. economy

our estimate of the impact of developments

and our outlook for Mexico and the other Latin American countries.

already available confirm an extremely quarter that accounts

sharp drop in Mexican real output during the first 1995 decline shown in the chart on the left.

for much of the projected

CHART

SHOW

PRESENTATION

Page 23

July

5. 1995

The first-quarter

decline in large part results from the policy measures

adopted by the

Mexican officials and the impact of the depreciation Mexican consumer and business confidence.

and rise in peso interest rates on

We expect that by the end of this year real Some

output will no longer be falling, and we look for Mexican growth to resume next year. slowing of output growth in other Latin American countries, particularly Argentina,

reflects

spillover effects of the Mexican crisis into asset markets and on macroeconomic On the right, our projection assumptions

policies.

for the U.S. trade balance with Mexico under current

for Mexican real growth, prices, and the exchange value of the peso is compared last December. We expect that the bilateral balance for goods and

with our projections services excluding

oil will fall from a small surplus last year to a deficit of $15 billion by the Data for merchandise trade through April, the line,

end of this year, a bit larger next year. suggest that such a substantial turnaround underway.

in the trade balance with Mexico is already well largely accounts for the of

The severe decline in Mexican output that has occurred

speed with which U.S. trade with Mexico has adjusted.

Looking ahead, real depreciation

the peso will help maintain a surplus for Mexico as positive real output growth returns in 1996. With the adjustment negative influence of our trade balance with Mexico largely behind us, an important

on the change in U.S. net exports and activity during the first half of the

year will have ended. Chart 16 addresses countries and Canada. in more detail our outlook for the major European industrial

Recent exchange

rate movements are likely to affect the pattern of

CHART SHOW PRESENTATION

Page 24

July 5. 1995

growth in Europe, two countries

particularly

this year.

The top left panel groups Germany and compares

and France,

with relatively strong currencies, whose currencies

them with the United Kingdom in 1992 and then fell value of the mark, on

and Italy, two countries somewhat

depreciated

substantially

further again this year.

For example,

the weighted-average

the right panel, has appreciated

during this year to peak values for the floating rate period from the level it maintained in 1993-94. In both pairs

while the pound has fallen somewhat of countries, growth is expected

to slow noticeably this year from the robust pace last year.

We project some boost to growth this year for the United Kingdom and Italy from their external sectors while in Germany and France net exports will contribute despite the near-term slowing, little. However,

for all these countries growth is expected to average about 3 by the end of 1996 close

percent over the rest of the forecast period, moving these economies to our estimates of their respective levels of potential output.

In contrast, and is expected last year’ rate. s

real output growth in Canada fell drastically in the first half of the year below

to revive only to about 2-112 percent over the next six quarters--well

The Canadian outlook in part reflects the slowing to date of output growth in for the current quarter. In addition, both monetary

the United States and the weak projection

and fiscal policy in Canada were tightened in 1994. The panel on the right shows the upward movement in the Canadian overnight rate of nearly 450 basis points, on balance, since the

beginning of 1994. remains quite high.

While the Bank of Canada has begun to ease that rate back down, it In addition, the Canadian government has injected greater fiscal restraint

I

CHART SHOW PRESENTATION

Page 25

July 5. 1995

this year and last.

The structural budget deficit over this time is estimated points of GDP. As a consequence

to have contracted

by about l-1/2 percentage

of the lags with which these

policy actions have their effects, we expect Canadian real output growth to remain subdued over the forecast period. of slowing that occurred annual rate. quarters, We were surprised, however, as were most analysts, by the extent

in the first quarter, when real output grew less than 1 percent at an may subsequently be revised away or reversed in later only

Some of this deceleration

but there is clearly some risk that such an abrupt drop, which was moderated accumulation, could be a harbinger--or could precipitate--even

by large inventory

weaker

growth than we are forecasting. Your next chart presents the elements of our thinking about the outlook for the Japanese economy. strengthen period. However, currencies As shown in the upper left, we look for real growth in Japan to begin to

during the second half of this year but to remain subdued through the forecast The strength of the yen is a major factor restraining expected Japanese growth for some of the other Asian countries, appreciation of the yen in terms of their countries is expected to

will boost exports so that growth in the Asian developing

continue strong, although

it will slow a bit from its very high rate in 1994.

As can be seen in the right panel, Japanese growth of around 2 percent per year is not sufficient to narrow the gap between actual and potential output, and we project a widening in that gap through the end of next year. the appreciation of the yen have contributed The low level of resource utilization to deflation in goods prices. in Japan and

The lower left

CHART

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PRESENTATION

Page 26

July

5. 1995

panel shows the changes over the preceding consumer index.

twelve months for two major components

of the

price index, services less rent and goods less food, and for the producers’ price in the price of services, which are domestically produced and for the most

Inflation

part do not compete year. However,

directly with imports, has been between 1 and 2 percent over the past This deflation is

prices of goods have actually been falling for some time.

not limited to imported

final goods, but likely does reflect the influence of competing

imported goods and the falling prices of imported inputs. The panel on the right shows that critical asset prices--those are also falling in Japan--as they have been for some time. for stocks and for land-decline in land the already

The continuing

prices has added to the woes of the Japanese banking system and risks increasing large burden of nonperforming loans.

Lower land prices reduce further the value of portion

collateral behind real estate loans on the books of the banks, already a much-troubled of banks’ portfolios. Further declines

in stock prices would lessen the market value of the

hidden reserves of the banks and so reduce the capacity of Japanese banks to finance additional loan loss from hidden reserves. progress While these problems have been acknowledged for

some time by Japanese authorities, been limited. crisis in Japan. particularly Continued

in terms of improving banks’ balance sheets has risk of a banking

declines in these asset prices add to the perceived

At the very least, it appears that Japanese banks are not in a position to be of the recovery of economic activity.

supportive

CHART SHOW PRESENTATION

Page 27

July

5.

1995

Without any foreseeable pressure on resource availability soon and with asset prices and goods prices falling, easing by the Bank of Japan would seem warranted. In our forecast

we have assumed a small further reduction in the call money rate, but no discrete easing move, such as a discount rate cut, by the Bank of Japan. While we are forecasting some recovery in real growth in Japan, without even greater impetus from monetary policy or additional fiscal stimulus, there is downside risk of a return to recession in Japan in our outlook. Indeed, Governor Matsushita, in his press conference today following the Bank of

Japan’ branch managers’ meeting, suggested that a discount rate cut is under consideration. s Mike Prell will now present the committee’ forecast. s

Page

28 Michael J. Prell July 5. 1995

To wrap a moment submitted. growth staff dark this to the

up quickly.

let me just draw summarizes

your

attention you

for

last chart. lowered with

which your

the forecasts

You've year,
at

sights

considerably

for real GDP the in that

the central

tendency The

now bracketing silver lining

forecast, cloud

l-l/Z to 2 percenr. central tendency

is that the

of your

inflation

forecasts

is a tad lower

now. at 3 to 3-l/4 looking tendency for some

percent. pickup in growth 2-114 your to

You are generally next year, Z-3/4 price with the central to the high center

of forecasts staff

being

percent. forecasts

side of the

projection;

on 3 percent.

close

to our prediction.