APPENDIX

FOMC BRIEFING NOVEMBER

- P.R.

FISHER

15, 1995

Mr.

Chairman:

Given the number of topics I need to cover this morning, my report will be broken into four parts -- as indicated on the agenda and on the detailed outline of my report which you should find in front of you. I will also answer any questions you may have and request the relevant votes of the Committee after each of the first three agenda items.

A.

Report on foreign operations

exchange

market

developments

and Desk

On balance, the dollar is little changed against the mark and the yen. As you can see on the first page of charts behind my outline, the dollar began to come off against the mark in late October as the mark appreciated within Europe. The dollar then recovered as the mark unwound its gains against other European currencies and as the dollar moved up a bit against the yen. At the end of October, the dollar was bid up against the yen in anticipation of outward investment from Japanese institutional accounts and on a brief surge of demand for dollars from Japanese banks in both the spot and the FX swap market as an alternative vehicle for dollar funding. Sentiment toward the dollar became quite positive at the start of November. But this positive outlook began to dissipate as the widely anticipated outflows from Japan did not appear to materialize, as some began to take profits on the dollar's quick run-up and as the confrontation over U.S. fiscal policy loomed larger. By the end of last week, the dollar traded limply against both the mark and yen, with market participants blaming its condition on both heightened rhetoric over fiscal policy and the weakness of the Mexican peso. On Monday, the dollar got a bit of a boost as short positions were covered following the Treasury's auction announcement, but overnight it has come off again. As you can see on the second page of charts, following the narrow defeat of the Quebec referendum, the Canadian dollar recovered the losses it suffered just prior to the vote, even as the Bank of Canada promptly lowered its target range for call money by 25 basis points to a range of 5 and three quarters to 6 and a quarter percent.

- 2

The Mexican peso has been under consistent pressure since the end of September and has weakened sharply, in volatile trading over the last three weeks. volatile and Last week, Mexican markets became increasingly the peso weakened abruptly as anxiety built up in anticipation of the events of this week, which include: the weekend elections, the presentation of the 1996 budget, the release of 3rd quarter tranche of GDP, and the maturity of the single largest remaining tesobonos. As the perception developed that the authorities would take no direct steps to halt the currency's slide, the peso's jerky, downward movements appeared to reflect both thinning markets, in which many participants were choosing simply pressures. to stand aside, as well as speculative Last Thursday, after the peso had weakened abruptly to around for the first time since May, 8.20, the Bank of Mexico intervened for pesos, bringing the peso to close selling Thursday and Friday at 7.50. Consistent with these operations, the Bank of Mexico left their money market quite short on Thursday and over the weekend, prompting overnight rates to rise from 54 percent last Wednesday to highs of over 80 percent While initially the tightness in their money yesterday morning. market was supportive of the peso, the high rates reached yesterday caused chaotic conditions in the markets, appearing to As the peso weakened threaten the slim prospects for growth. sellina yesterday above 8, the Bank of Mexico agai~n intervened, The Bank of and the peso closed around 7.80. Mexico also acted yesterday to ease pressures in their money Subsequently, in the primary auction for 28.day Cetes market. rates came in at a surprisingly low 60 percent. We received a $350 dollar payment from the Mexican authorities on the System's short-term swap, as did the Treasury $650 on theirs, and on October 30th we rolled over the remaining million outstanding for, what was agreed with the Treasury, will be the last of the go-day extensions of the outstanding amount on our swap with the Bank of Mexico. Mr. Chairman, I would be happy to answer any-questions on I will need the Committee's ratification this part of my report. of the Desk's foreign operations.

B.

Annual

renewal

of reciprocal

currency

arrangements

Mr. Chairman, as you can see on the schedule which is the last page attached to my outline, the System's reciprocal currency arrangements come up for renewal at this time of year, with the one exception of our swap with the Bank of Mexico which is up for renewal at the end of January. I will bring the

- 3

Mexican swap line up for the Committee's discussion at your meeting on December 19th. I need the Committee's authorization at this time to begin the process of communicating with the other central banks about the renewals before year-end. I have no change in the terms and conditions to recommend and I request that the Committee approve their renewal without change.
C.

Report on domestic operations

market

developments

and Desk

open

market

Mr. Chairman, before turning to domestic markets and I would like to give the Committee a bit more operations, background on the Desk's cooperation with the Japanese monetary authorities in managing the liquidity of their portfolio of U.S. government securities, as part of their broader efforts to aid the dollar liquidity of the Japanese banks. had this job, the New Several years ago, when Bill McDonough York Bank began a dialogue with the Bank of Japan aimed at improving the dollar funding practices of the Japanese banks in New York. This resulted in our working together to encourage It also resulted in sounder practices by the Japanese banks. conversations in which we tried to discourage the Bank of Japan from thinking of our Discount Window as the appropriate first step in emergency liquidity support for the Japanese banks. As described in Don's and my note to the Committee of approached October 17th, this past July, Governor Matsushita Chairman Greenspan and Vice Chairman McDonough about possible sources of emergency dollar liquidity support for the Japanese banks during the time of day when Tokyo is closed. As a result of this conversation, the Desk was asked to work with the Japanese authorities to help manage the liquidity of their portfolio and to stand ready, in extremis, to be able to purchase outright a large amount of the Japanese authorities' holdings late in the New York business day and possibly outside our normal operating hours. I have viewed our task as helping the Japanese authorities do what THEY need to do to manage the Japanese banks' liquidity. It was made quite clear to the Japanese authorities that the Desk does not currently have the authority from the Committee to engage in repo transactions with foreign accounts -- that is, we could not LEND them money against their collateral. We also made clear that our outright operations are subject to the intermeeting leeway limit of ~3 billion dollars, but that, in a crisis, additional authority could be sought. To provide an initial liquidity buffer, immediately available with no liquidations costs, we invited the Ministry of Finance to increase its balances invested with us in the overnight RP pool.

- 4 -

In part, as a result of our gentle prodding and, in part, as a result of the increasing pressure on the Japanese banks, the Japanese authorities began to inject dollars into the Japanese banks in September to help them over their fiscal half-year-end. We have helped them by selling of their holdings of Treasury bills into the market, by purchasing of bills from them for the System Account, and by managing the flow of their funds into the RP pool and of more than out of the pool. Throughout, I have viewed this as a workinq arrangement albeit a special one with the Japanese authorities -- in the nature of central bank cooperation. --

While there appears to have been a lull in the dollar funding activities of the Japanese banks in the past 2 weeks and some narrowing of the spreads, I should note that pressures remain and that we are just coming into the period when the Japanese banks must complete their efforts to fund for the turn of the year. for an ease In domestic interest rate markets, expectations in policy by the Committee have been postponed to December, but such expectations are held with increasing conviction. The bill curve -- from 3 months to a year -- began to flatten in late October as market participants came to perceive the economy as softening and as they increasingly came to expect both significant fiscal consolidation and the Committee to respond to At this a Federal budget package with an easing in policy. the point, the bill curve has inverted, perhaps reflecting abundant supply at the very short end. But even so, both oneyear and two-year yields are currently around 30 basis points below the Funds rate. At the end of October, as concern over the debt ceiling grew, we began to hear about portfolio managers and investors interested in swapping out of Treasury issues that paid coupons or principal this week and about dealers reluctant to take these issues from customers. Last Wednesday the bond market rallied, with the long bond closing the day with a yield of 6.24 percent. On Thursday morning, when the PPI came in around expectations, a number of market participants began taking profits on their positions just as the extreme rhetoric from each side of the Correlation became fiscal confrontation began hitting the wires. causation as the market lost all of its previous day's gains and Thursday afternoon as attention shifted squarely to Washington. and Friday, Treasury securities with principal payments on November 15th and 16th began to trade at discernibly cheaper prices than similar issues.

- 5

The bond market was under pressure early Monday morning, but the Treasury's announcement of a definitive auction calendar removed the immediate risk to default and the market rallied back again. Even so, investors now concerned about the possibility of default continue to shy away from Treasury securities maturing in 1995. In domestic operations, reserve needs were mostly in a range around $4 billion. The Funds rate was firm for several days around the end of the third quarter, as well as on most maintenance period settlement days. The effective average rate for the period was 5.78 percent. Required reserves have fallen slightly since your last meeting, as sweep activity continues to depress growth in Ml. Reserve shortages are forecast to deepen substantially beginning with the current maintenance period, as currency grows with the holiday season. However, currency growth appears a bit weaker than expected and already the daily numbers in this maintenance period have brought us to revise our forecasts lower. We addressed most of the reserve needs with temporary operations. Eth, was Our bill pass, of $3.8 billion on November timed to coincide with the deepening of the reserve shortage in the current period. Our purchase of these bills, as well as others from foreign accounts, had the effect of shortening the maturity of the portfolio by a few days, but this will be more than offset when we roll into the new 3- and lo-year issues on November 24th. I would like to inform the Committee of changes that I plan to make in the scope and frequency of our bill and coupon pass operations in order to reduce the time it takes us to complete these operations. The Desk has continued to be frustrated by the takes 40 minutes to an hour for us to respond to the propositions, despite our investment in automation. situation imposes risks on the dealers and cannot be in the prices we receive. fact that it dealers' This helping us

It has become apparent to Sandy and me that the best means of improving our turnaround time is to minimize the number of issues considered on any one occasion. In the recent bill pass, it was relatively easy for us to impose an internal discipline, by looking exclusively at the propositions in a set number of bills in which our holdings were particularly low. This permitted us to get back to the dealers within 20 minutes, less than half the time of other recent, similar operations.

-

6

-

With over 250 coupon issues outstanding, selecting and promptly responding to propositions in a coupon pass poses a much greater challenge, without some pre-selection. To improve the situation, I plan to meet our normal needs for outright purchases of coupons through a short series of smaller operations, each one focused on different parts of the yield curve -- rather than our current practice of trying to digest the entire curve all at one time. For example, instead of a single $5 billion pass on a over the single day, we would carry out 3 or 4 smaller operations course of a week or so. We plan to explain this approach to the dealers in advance, in order to avoid confusion or the mistaken attribution of significance to that portion of the curve selected for any single operation. the faster Over time, as the dealers come to appreciate this change should benefit the portfolio in the turnaround, prices we receive and benefit the market by not forcing it into lull while dealers first price their propositions and then wait for our responses.

a

reserve needs are now projected to grow to Mr. Chairman, about $7 and a half billion by late December, but between the expansion of sweep accounts and the relative weakness of currency to the forecast reserve shortage is demand, the risk of revisions on the downside. Thus, ,it does not appear that, in the normal course of business, we will need an increase in the intermeeting leeway of $8 billion. I would be pleased to answer any questions on this part my report and I request the Committee's ratification of the Desk's domestic operations during the period. of

D.

Report on issues relating to domestic event of a Treasury default

Desk

operations

in the

Over recent weeks, we have given some thought to the issues the Desk might confront in the event of a default by the In such circumstances, Treasury. the Desk's goal -will be to maintain the cost of overnight funds consistent with the Committee's directive, while taking steps, within our power, to help maintain the market mechanism on which the Desk principally relies: the financing market for government securities -- the RP market. Because of our concerns, we have tried to impress our colleagues at the Treasury with the importance of ensuring that securities which had missed either a principal or interest payment would continue to be transferable over the book-entry wire. Assuming this would be the case, it would be helpful if the Desk could make clear to the primary dealers that such

-

7

-

securities would be accepted as collateral in Desk operations. The Desk would also seek to establish a pricing convention for the valuation of collateral which reflected any guidance the could give on the appropriate rate for the continued Treasury accrual of interest. In the absence of guidance from the the Desk would seek to establish a convention with the Treasury, dealers.
In our current operating regime, the allowance for borrowing and our estimates of demand for excess reserves are the two most judgmental factors, but ones which we do seem to be able to work with fairly well. In the event of default, both borrowing and demand for excess would be expected to increase sharply but I would be kidding you if I suggested that we had any idea by how much.

For example, had a default occurred this week and had the decision been made to pend the payment of interest to the holderof record on the night prior to the payment dates ~~ as opposed to having the unpaid coupon trade with the securities and ultimately be paid to the holder at the time that the Treasury cured its default -- the roughly $25 billion worth of anticipated interest payments to the public would, in effect, have been frozen out of the expected payment flows in the market, representing an amount roughly equal to the entire banking system's current operating balances. Clearly, we would aim to be generous in our temporary But given the disruption of normal payment flows, as operations. well as the potential demand for discount window borrowing, we would have to be prepared to be on both sides of the market -adding and draining reserves in short order ~~ to maintain the funds rate. The Bluebook raises the possibility of the Desk buying I think that this defaulted securities outright from the market. is a particularly risky idea and I strongly recommend that the Committee NOT consider such operations BEFORE there is convincing evidence that the other actions undertaken by the Desk and the Reserve Bank discount windows had been demonstrated to be inadequate to deal with a crisis situation. While the initial market reaction might well be positive -in that holders of defaulted securities would likely be only too pleased to swap out into other issues, I think that prompt action on the part of the Desk to buy up these securities, in the initial days of a defatilt, could well have a decidedly negative impact on the market as reflecting official panic and implying a greater duration to the crisis than the market would otherwise first assume. Moreover, by establishing a pricing convention for the accural of post-default interest and by accepting these

-

8

-

securities as collateral in temporary operations, the Desk would have already gone a long way to stabilize the RP market and the prices of these securities. By using the considerable powers of the central bank to immunize the holders of specific Treasury securities against creditors and beneficiaries go empty loss, while other government handed, the Committee would be taking the single most effective step to enhance and perpetuate the image of the Federal Reserve as a bondholders' protection society -- an image which I think is not accurate, not appropriate and certainly not helpful in enhancing the credibility of monetary policy. Having just seen the Congressional response to the Administration's extraordinary use of the Exchange Stabilization Fund to assist Mexico -- in circumstances initially supported by the Congressional leadership, before going any further down this road, the Committee may want to consider the very real risk of subsequent legislation constraining the Committee's discretion in the future. There may be circumstances in which taking these risks would be justified, but as the Bluebook suggests, such a decision should only be considered in relation to the overall judgment of the appropriate response of monetary policy to a prolonged crisis of macro-economic consequence. I would be happy to answer any questions Mr. Chairman, members of the Committee may have on this final part of my report, but then again, I won't mind if you all are tired of listening to my voice.

Outline of Manaser's Rewrt November 15, 1995

A.

Report on foreign Desk operations: -__ _Dollar Canadian

exchange

market

developments

and

little

changed; volatility; and the first intervention by the Bank of

dollar

Mexican peso Mexico since NO U.S.

weakness May;

-_ __

intervention

operations;

Received $350 million payment on swap with Bank of Mexico and on October 30 rolled over remaining $650 million for final go-days.

B.

Annual renewal of reciprocal December 31, 1995

currency

arrangements

expiring

before

C.

Report on domestic market open market operations: _-__ __ Desk's Market Domestic assistance expectations operations

developments

and Desk

to the Japanese of an ease during

monetary

authorities;

in policy;

the period; the timeliness of the Desk's outright

Planned changes operations.

to improve

D.

Report on issues related Treasury default.

to domestic

Desk

operations

in the event

of a

1.45 Spot Exchange Rate

German Marks per U.S. Dollar

1.42 1.41 1.40 1.39

I
Ott 6.00 Nov

1.38 6.00

Selected German Cross Rates

105 Spot Exchange Rate

105

Japanese

Yen per U.S. Dollar
104

103

102

101

100

Ott Foreign Exchange Function: FRBNY

Nov

99

Updated November 13,1995

May
_.
v..

June 8.00

I
_.

Spot Exchange Rate

Mexican

Pesos per U.S. Dollar

7.00 -- -

.

6.50

_

.

6.50

6.00

Foreign Exchange Function: FRBNY

Updated November 13,1995

Reciprocal Currency Arrangements Renewal Schedule

Svstem

reciDroca1

arrangements

for renewal in 1995: Dollar Amount (millions) 5,000 3,000 4,000 300 2,000 1,000 500 6,000 2,000 3,000

G-10 Countries Bank of Japan Bank of England Swiss National Bank Bank of Sweden Bank of Canada National Bank of Belgium Netherlands Bank Deutsche Bundesbank Bank of France Bank of Italy
Non

Exuiration Date December 4, 1995 December 4, 1995 December 4, 1995 December 4, 1995 December 15, 1995 December 18, 1995 December 28, 1995 December 28, 1995 December 28, 1995 December 28, 1995

G-10 Countries Bank 250 250 600 1,250 250 December 4, 1995 December 4, 1995 December 4, 1995 December 4, 1995 December 28, 1995 '

Austrian,National Bank of Norway BIS (Swiss francs) BIS (other)

National Bank of Denmark

System reciprocal arrangements for renewal in 1996: Bank of Mexico 3,000 January 31, 1996

Treasury arranvements: Bank of Mexico Deutsche Bundesbank 3,000 1,000 December 15, 1995 January 4, 1996

Michael J. Prell November 15, 1995 FOMC As you the period you US: nice can know, it's common BRIEFING for key statistics to come out in that for be

between

Greenbook that this

day and the FOMC meeting. is more than a little are

I'm sure

appreciate

discomforting it would of our our

Although to have before level

we know at least we was face even

that

our

forecasts spell

imperfect,

a decent the

of blissful humiliation. because

ignorance

errors anxiety

inevitable

Last week,

higher

than usual

of the exceptional finished our

ambiguity forecast.

of the

indicators

available

to us as we

In any event, the early sales August data and estimates that were September

it's now

time

to face the An important

facts--or

at least

of those released indicate

facts.

set is the retail figures was for than four-

yesterday.

The updated spending quarter,

that consumer for the third
real

stronger

the Commerce tenths hand,

Department

gauged
poi~nt on

by perhaps

of a Dercentaqe the advance

PCE growth. in October

But, on

the other alnd would PCE in the we know

estimate

of sales

was weak,

sluggest the wisdom growth %-L/2 now. Indeed, of upward or strong either somewhat. to 3 percent

of lowering

our forecast 3-l/2

of fourth-quarter percent; something what

The Gr-eenbook showed range might be more

reasonable,

given

even

to get

to that pace, figures

we'd

need

some combination couple of months L:, thollgi:,

revisions gains over

to the sales tlhe remainder is quite
I

for the past

of the year. plausible,

As we see

of these

outcomes

in light

of some solid and grow1~1. of

favorable

fundamentals.

have

in mind

the continuing rigurei,

i~ncorne, suggested

by the October

label- market

t!~,e lhuv>e

inc:r~ca.se in weal~th that

the? house!lold sector

his enjoyed

t~!li:; year

FOMC Briefing - Michael November 15, 1995 Page 2

Prell

For what might

it's worth--and that

that

admittedly and chain

may

not be a great reports

deal--I

note

the department look

store

for the first

two weeks

of November At this point,

strong. Up the surprises in the incoming data

summing

since that

Commerce real final That

published sales estimate trade

its third-quarter not 4-l/4 change

GDP estimate, but perhaps

it appears around 4-3/4

grew

percent when

percent.

could

we receive

the September seems time. carried among that

international demand was

report this

next week;

however,

it certainly at the has

stronger

summer this into

than we appreciated that

Judging greater other owing positive

whether momentum

implies

the economy quarter

the current

requires,

things,

an assessment

of the inventory

picture.

Unfortunately, the

to the shutdown release would

of the government, inventories the last

we didn't

receive

September That

on retail have

that was due

out this morning. of do with it

report

supplied

significant: piece So we must we

information what

on stocks

in the third

quarter.

make

we have, that

and based

on the available investment it implies

infornation, was that

think

likely

overall If that

inventory is true,

ltss t!lan (Commerce the aggregate ratio of

estimated. stocks

to sales Even

declined

in the third that

quarter. investment will slow as

so, we expect term.

inventory

further to stop likely retail than

in the near the economic outcome sales

HOWeVer,

the drag

>;houLrinot be so great We think that

expansion

in its tracks.

the most the

this quarter

is a I-eturn to moderate a GDP growth

(g~~owt11. Given

data,

that means percent

~-ate rcioser tc 2 percent

to the 2-l/2 As you

in the Greenbook. considerably report. ir?fluenced in our GDP that, adjusted folk

know.

we were labor

forecast

by the October

It indicated

FOMC Briefing - Michael November 15, 1995 Page 3

Prell

the Boeing furthermore,

strike, total

payrolls production from

expanded worker

at a quite hours

decent

clip; sector were

in the private average. these The

up a percentage discounting numbers that

point

the third-quarter considerably, a weak

Even

the hours typically

figures signal

are not the kind of same can be said

econonxy.

for the drop

in unemployment the latest

last month. data on industrial upbeat production, tone than we was down 0.2 which we

MOreOVer, published just

this morning, Although

have a more

anticipated. percent,

manufacturing less

output

in October

that was strike there

a shade more were

than we expected

in the Greenbook--and AlSO

the Boeing important, estimates

than upward

accounted revisions

for that decline. to the factory September--enough

production to push the

for August growth

and, rate

especially, up

third-quarter set the These stage

3/4 of a l>oint to 3.3 percent for d !~leall:hier fourth-warter narrowing rates

and also gain.

arithmetically go at least

figures

some way toward second-half

the discomforting of manufacturing

gap between output

the projected

growth

and GDP. But, from a policy over perspective, the higger question is where

the economy concluded our prior some

is headed

the next ye(ir or so. tha!: GDP gvwth logic would

As you continue

know, we to run above simple. we of While

in the Greenhook expectation. in activity reason The

be!iind this

is pretty

bulges

carry to view

the seeds

of their- own reversal, upside surprise

didn't that

see much

?lhc recent

as being

sort--aside we judged plus

from the

third-yudrler domestic

jump> in federal final sales--that

purchases. is, to date this

Rather,

that private fixed

consumption and that

investmen--hA.c!

not decelerated

much

the decline

in inter-est z~it"c anxl ri.se Ian stock

prices

FOMC Briefing - Michael Prell November 15, 1995 Page 4 year will be adding fuel to demand in the coming months. we expect that the decline In addition,

in real net exports has now essentially

come to an end, removing what has been a significant drag on growth over the past few years. restraint Under the circumstances, the fi~scal

that we've assumed will be implemented doesn't appear great

enough to push GDP growth much below trend. If that is so, then resource utilization rates will remain in the recent range. is headed. This brings me to the question of where inflation the October CPI report was published by The total index was up 0.3 percent The twelve-month change in the core

This morning,

essential employees

of the BLS.

and so was the core component.

index rose to 3.0 percent, and our projection calls for a continuation of that pace through 1997. The forecast in the September Greenbook was for a somewhat lower inflation path, but that <was in a noticeably softer economic environment. Indeed, WE would i?ve presented a less favorable price

path this montlh were it not fol- our interpretation of the good inflation news that we've bee11 experiencing unemployment this year. Despite an

rat~e that has remained in the 5-l/2 to 5-3/4 percent per hour--at least as measured by the Employment

range, compensation

Cost Index--has decelerated an es.sentially stable p,lce

furt!ler, alld the core CPI has increased at Furthermore, the anecdotal evidence, such

as that reporteil in the Beige Book, portrays a steady inflation p1ntrrre.
Althollqh some

firms ~SY finding labor in short supply, tlley
In

appdrent Ly are 1Io1: biiiriing up i?ages

light of these patterns,

we've stuck ours necks out and inched iilrther in the optimistic direction, mope
Like

pr-eparlng il forecast that, in effect, takes the NAIRU to he
S-i .‘ 4 ~jczr~i:er~:

FOMC Briefing - Michael November 15, 1995 Page 5

Prell

It

is,

of course,

arguable

that

the

recent lower

data than

suggest 5-3/4

that

the economy percent however, sufficient mention

can operate

with

unemployment of prices. One

even

without

an acceleration this

We would reason

counsel

caution, is to

in accepting short-run

inference.

is that

there

looseness

in the Phillips measures--that on the

curve

relation--not

imprecision don't

in the price show two

the underlying schedule. a role in

tendencies Another holding

always

through

expected

reason down

is that

factors prove

that we think less helpful

have played going forward: by,

inflation medical

could

First, second, and All path,

incremental sustained embolden things

cost

savings

may be harder

to come

and

low unemployment workers to push

may diminish harder

feelings

of insecurity of the pie. output

for a bigger given

share

considered, attending

I believe our

that,

the predicted

the risks

inflation

forecast

are reasonably

balanced.

I

November

15. 1995

FOMC Briefing Donald L. Kohn

I'd like appears

to begin

by discussing "Financial into Not

a new

chart

that

at the end of your as a transition of policy.

Indicators"

package,

and use that current Week"

a discussion

of the by "Business

stance

to be outdone policy,

in our analysis several prescribes up from

of monetary

the new chart Taylor federal the rule. funds real rate, value, from

summarizes That rule

versions a level

of the so-called of the nominal funds

rate built in turn with

a real federal around

rate;

is made

to vary

a presumed

equilibrium of inflation

the variations and output

keyed from

to deviations For

target

potential.

example,

above-target

inflation funds rate

or output

over potential

would

call for the real In Taylor's in the top inflation a 2 per-

to be above

its equilibrium of which as aiming

value. are shown

own formulation, panel, the FOMC

the results is modelled

at 2 percent viewing

as measured cent real

by the implicit funds rate

GDP deflator,

as equilibrium, and inflation a number

and reacting-moderately gaps. for policymakJohn Taylor

and equally The ing, and

to resource rule raises

of issues a few.

I'd like the policy

to highlight

just

formulated monetary

rule

as a normative to be doing:

description it turned

of what out to be a

ought

reasonably Reserve's a central relative

accurate behavior bank

positive since

description The rule

of the Federal does illustrate of output price how

1987.

can pay attention while also

to the level achieving

to potential, any other speed goal with

reasonable

stability--or term. The

inflation which

objective--over bank will

the long approach

the central

its inflation to the price

depends

on the strength

of its reactions

and output

gaps. of the rule. Taylor stresses the

In his benefits bank.

discussions

of rule-like These include private

or systematic disciplining sector

behavior monetary

by the policy

central

and

facilitating bank stand sector is more

planning

because

the central bank may

predictable. chance

A predictable

central

a better that

of fostering

behavior policy

in the private objectives. be noted. output As

helps

to achieve a number depends

monetary

That formulated, and prices, anticipatory gaps determine rule

said,

of caveats on current

should

the rule

and lagged It is

and not forecasts only in the sense price

of the future. that resource The

utilization

future

b~ehavior. of the

characteristics

of the probably

and its

"middle

road"

coefficients "behind the curve" the

would

forestall

getting

too far

or problems performance at forecasts

of instrument of monetary for these

instability. policy might And

Nonetheless, be improved

by looking of equal,

gaps.

its prescription

I

-3

moderate

responses to all

to output

and inflation

gaps

may

not be

appropriate better

circumstances. shocks,

In particular, where the Committee output

it may be

suited

to supply

necessarily stability prompt price

is facing objectives, of the

conflicts than

between

and price where a up a

it is to demand gap will going

shocks,

closing gap.

output that

forestall

opening but deeply

I might

note

from mild resembles

embedded

inflation

to price with shock;

stability

in some ways

an economy choices inflation situation, minimized abrupt open

confronted

the conflicting that is. efforts gap.

intermediate-term to whittle 1n this losses are down

of a supply imply

opening

up an output

the Taylor by a gradual to price

rule advises, transition,

society's as apposed

to a more this an

move

stability;

some may

consider

question. Within the Taylor framework, the prescribed measures funds for

rate

is very

sensitive price

to the specific gaps. This which

chosen in the

the output middle but

and

is illustrated uses the Taylor and

panel

of the

chart,

parameters

several use

alternative of the

measures

of output

inflation.

Taylor's important funds

implicit

GDP deflator

is especially that the current

to the result

in the top panel higher than

rate

is substantially As you can see, rule

the rule would funds other

suggest. rate

the overage

of the current reduced

relative

to the

is considerably

when

measures

are

used.

It's also

true

that

using doesn't

these mimic past

alternatives, Federal Reserve

the resulting behavior

"envelope"

as well. original has been intention. but one use the

It wasn't of these current behavior attempts purpose types stance

Taylor's

of exercises of policy

to see whether with panel the past of the rule

is consistent The bottom

of the Committee. to improve by estimating

chart

on the use a monetary

of the Taylor policy rule. Judd

for this function func-

reaction The

in the framework tion used,

of a Taylor-type on work

specific

building

by John

at the Federal dynamics rate that is credit time was the

Reserve

Bank

of San Francisco, adjustment rule:

allows

for short-run

in the Committee's prescribed shown crunch below by the

to the steady-state steady state

it is this

in the chart. period, the value when

Reflecting the federal

the influence funds rate for

of the some

prescribed imply

from Taylor's that the Federal gap and

specification, Reserve

statistical weight

results

put more on bring-

on closing down the

the

resource

less weight In this

ing inflation formulation, your average

than

the Taylor funds

rule.

current

rate is about 1993.

in line with

behavior

from

1987 through

It is important this period were

to recall with

that your

policies

over

associated right"

a net

decline

in inflation, still mean,

so that

being

"just

by that

guidepost

may

-5-

as implied slightly economic at his

by the upper

two panels.

that

policy

remains of

restrictive, slack estimate

consistent

with

the emergence Taylor real

and further

disinflation. equilibrium

arrived funds rate

of a 2 percent and that

by looking from these

at history exercises

so. not surprisingly. the current funds rate

the notion suggests people The have

monetary drawn

restraint long-run

is similar interest

to the conclusion rate averages. or related rates

using

recent may For

behavior also

of some

other

financial real

indicators side:

be read

as suggesting

to the high have been

example, broad past

industrial and

commodity growth

prices

soft,

and of the

money year.

credit

slow by the standards

In the at their inflation a somewhat historic proxy current rate,

staff

forecast, are seen

real and nominal as consistent this

funds

rates

levels and

with

a steady embodies rule or or

thus,

implicitly,

forecast

higher averages.

equilibrium The host

rate than rate

the Taylor is only

real funds of financial

an index

for a whole spending the

market

conditions Among

that other

influence

and prices relationship

in complex

ways.

difficulties, other, more

of the funds may change forecast

rate-to over

these For

important,

variables

time.

example, behavior fairly

one factor of long-term low. Judging

behind

the staff Real

is the rates are

rates. from

longer-term

other

charts

in the Financial

Indicators over the

package, last

they

are about with

as low as they

have

been

15 years.

the exception rates

of 1993. to buoy

The equity

depressed prices these yield

level

of real bond down the

has helped

and hold rates curve

real value

of the dollar. rate.

And

are low

relative

to the funds than

The nominal since the

is somewhat and with higher

flatter

its average expected

mid-1960s, to somewhat the real

inflation over time,

still it's

to be unchanged the spread of

likely narrow

that

yield A flat

curve yield

is relatively curve.

as well. be seen as in

by itself, But,

might

indicative 1995.

of restrictive has been measured

policy. primarily

the flattening

as in 1993, rates.

a result

of declining terms.

long-term The drop occurred tion

in real as well is noteworthy strong and

as nominal because resource it

in long-term with economic

rates

growth

utiliza-

high.

Given

the usual months

lags,

the pick up in economic is associated higher real with the

activity influence later

in recent

actually

on spending

of the much

rates

of the pre-

half

of 1994 and early

1995 than

are

currently

vailing. To an important has anticipated fiscal a shift extent, the decrease of macro in real policy rates

in the mix

toward

further

consolidation markets build

and monetary in fiscal

ease.

But, when that may

the financial not affect

tightening for

government

or private

spending

some

time,

-7-

considerable monetary basis

temporary easing

stimulus built reflect

can result.

The

expected of 50

policy

in is only in part

on the

order

points,

and may might

expectations and

of what

the Committee statements market

do based

on its Minutes than

the public by economic

of its members,

rather

a conviction to support

participants In any

of the policy case, rates

needed back

activity.

should

up only moderately expectations, reflecting seem to and this

if the Committee the staff has

does

not validate

market

built

into

its forecast economy

a rise

factor expect.

and a bit

stronger

than markets

Finally, supplies have more are

there

are only a few so that

signs real

that

credit

tightening. Bank were

a given

rate would that margins minor stayed fairly this have on

bite. loans

loan

officers further.

reported With

business

squeezed

exceptions, narrow. channel. been

spreads

in securities ample credit

markets

have

suggesting Although loan

availability rates

through

delinquency officers

on household very limited

debt

rising, and Thus

reported

tightening

of terms

conditions the staff a case

for consumer forecast,

credit. at face B, with policy value, little move, However, real would preassumas

taken

seem

to present about lack there

for alternative

sumption ing the noted,

the direction

of the next were

of disinflation are a few straws

acceptable. that

in the wind

rates

-8

might

be on the high surprise than the

side,

suggesting

the possibility to be less

that durable

the positive or smaller stances,

to output staff

may prove

has assumed. of policy

In these really

circumprove to

the

current

stance

could

be restrictive, time. it were If this concerned alert

opening result about

up a margin were not

of economic

slack intent want

over and to be

the Committee's

such an outcome, that a more

it might

especially stance

to evidence

accommodative In addition failure to

could

be appropriately on spending

implemented. and output.

the usual rowing

evidence

of bor-

to pick

up as the staff in broad financial

is forecasting money growth

or further indicate

unexplained less

weakness

might

accommodative While

conditions at current

than

anticipated. slightly

disinflation

or even

lower such

levels

of resource might

utilization special

would

be surprising, for

an outcome

merit

consideration

policy.

In particular, would rate. raise

falling real

inflation short-term any further

and inflation rates at a steady off of economy real

expectations nominal inflation was higher as well would funds

Moreover, that

edging of the

might

suggest

the potential In that event.

than we

thought. funds

a lower

as nominal

rate than the economy were

in the staff

forecast

be needed

to hold

at its potential. the level of real it

If the Committee rates was too high,

worried would

one question

be how strong

would

wish

evidence

to be that directive

policy

was

restrictive

before

acting.

An asymmetric wanted regard

toward

ease would

suggest

the Committee demanding before burden low with

to act promptly

and would

not be

to the decisiveness directive more

of the evidence imply a greater current of

acting. of proof,

A symmetric perhaps

would account

taking

of the

level

of the unemployment outside

rate and the expectations of little further

staff gress

and many toward

forecasters

pro-

price

stability.