Bluebook

Prefatory Note The attached document represents the most complete and accurate version available based on original copies culled from the files of the FOMC Secretariat at the Board of Governors of the Federal Reserve System. This electronic document was created through a comprehensive digitization process which included identifying the bestpreserved paper copies, scanning those copies, 1 and then making the scanned versions text-searchable. 2 Though a stringent quality assurance process was employed, some imperfections may remain. Please note that this document may contain occasional gaps in the text. These gaps are the result of a redaction process that removed information obtained on a confidential basis. All redacted passages are exempt from disclosure under applicable provisions of the Freedom of Information Act. 1 In some cases, original copies needed to be photocopied before being scanned into electronic format. All scanned images were deskewed (to remove the effects of printer- and scanner-introduced tilting) and lightly cleaned (to remove dark spots caused by staple holes, hole punches, and other blemishes caused after initial printing). 2 A two-step process was used. An advanced optimal character recognition computer program (OCR) first created electronic text from the document image. Where the OCR results were inconclusive, staff checked and corrected the text as necessary. Please note that the numbers and text in charts and tables were not reliably recognized by the OCR process and were not checked or corrected by staff. Strictly C onfide ntial (F.R.) Class II – FOMC January 26, 2001 M ONETARY P OLICY A LTERNATIVES Recent D evelopm ents (1) Interest rates backed up slightly and equity markets sold off following the annou ncement th at the FOM C had left the sta nce of policy un changed at its December meeting.1 However, yields generally declined over subsequent days, as the wording o f the Com mittee’s annou ncement an d weaker eco nomic da ta apparently fostered a sense that an easing of monetary policy was imminent. Even so, the timing and size of the FOM C’s 50 basis point cut in the target federal funds rate on January 3 surprised market participants, and many inferred that additional monetary easings would occur sooner than they had expected. Over the entire intermeeting period, interest rates on sh ort-term Tre asury securities an d the highest-g rade private de bt fell substantially, in some cases by nearly a percentage point, with only a small portion of the declines on private debt reflecting an unwinding of year-end premiums. Current futures quotes indicate that investors place high odds on an additional 50 basis point easing at this m eeting and an ticipate that the fede ral funds rate w ill be about 125 basis points below its current level by year-end (chart 1). Howev er, options quotes suggest a relatively high degree of uncertainty about this ex tended outlook. (2) The Committee’s action and the market’s inference about the likelihood 1. Federal funds traded at rates near the FOMC’s targets over the intermeeting period, except on the last business day of the year. On that day, the Desk’s generous reserve provision pushed the effective rate down to 5.41 percent, a fairly typical deviation from target for a year-end. Since the last FOMC meeting, the Desk has redeemed $1.8 billion of Treasury securities, mostly Treasury coupon issues, to continue bringing SOMA holdings into conformance with the per-issue limits. In part to offset the resulting reserve drain, the Desk purchased $3.5 billion of Treasury coupon securities in the market and $670 million of Treasury bills from foreign custom ers. To accom modate the seasonal runo ff in currency, it trimmed the volume of outstanding long-term RPs by $9 billion, to $13 billion. Chart 1 Financial Market Indicators Expected Federal Funds Rates Estimated from Percent Financial Futures* December 18, 2000 January 26, 2001 Selected Treasury Yields Percent 7.00 7.00 Daily 6.75 6.75 6.50 6.50 Two-year 6.25 6.25 6.00 6.00 5.75 5.75 5.50 5.50 Ten-year 5.25 5.25 5.00 5.00 4.75 4.75 4.50 Jan Apr Jul 2001 Oct Jan Apr Jul 2002 4.50 Oct Jun Jul Aug Sep 2000 Oct Nov Dec Jan *Estimates from federal funds and eurodollar futures rates with an allowance for term premia and other adjustments. Selected Equity Indexes Selected Private Long-Term Yields Index(5/31/00) = 100 Daily Wilshire 5000 Percent 130 14 120 13 110 12 100 DJIA 90 10 Corporate BBB (right scale) 11 Sep 2000 Oct Nov 8 7 Ten-year Swap (right scale) Thirty-year Mortgage (weekly, right scale) 70 Dec Jan Jun Selected Risk Spreads* Basis Points 800 Daily 9 10 8 Nasdaq Aug 11 High Yield (left scale) 9 Jul 12 Daily 80 Jun Percent Jul Aug Sep 2000 Oct Spread of Low-Tier CP Rate over High-Tier CP Rate* Nov 6 Dec Jan Basis Points 160 Daily 2000 1998-1999 1995-1997 700 140 600 120 500 100 400 80 300 60 200 40 High Yield BBB 20 100 Jun Jul Aug Sep 2000 Oct Nov Dec Jan *These spreads are the difference between the yields on the Merrill Lynch 175 and BBB indexes and that on the Merrill Lynch AAA index. Oct Nov Dec Jan *30-day nonfinancial, A2/P2 rate less AA rate. Note: Solid vertical line indicates last FOMC meeting. Dashed vertical line indicates January 3 cut in target federal funds rate. 2 of future easings apparently contributed to a sense that the odd s of a prolonged period of economic w eakness had diminished. This revision to sentim ent bolstered equity markets, with broad equity price indexes increasing, on balance, over the intermeeting period despite further substantial dow nward revisions to analysts’ nearterm earnings expectations. Moreover, yields on lower-tier investment-grade bonds and junk b onds fell 35 and 116 basis poin ts, respectively. The ab atement of safe haven demands, along with heightened prospects for a large tax cut and perhaps some increase in inflation compensation, contributed to a sm all rise in longer-term Treasury yields. In some segments of financial markets, however, concern s about risk appeared to escalate. Results fro m the Janu ary Senior L oan Officer O pinion Su rvey indicate that a majority of banks have further tightened their standard s and terms on business loans. Moreover, risk spreads on lower-rated com mercial paper have widened significantly since early January, as the defaults of California utilities, along with the earlier downgrades of other prominent commercial paper issuers, seem to have increased investo r wariness. To d ate, fallout from th e difficulties of the C alifornia utilities has been limited, although rating agencies have announced that the debts of some corporations and municipalities affected by the West Coast electricity situation have been downg raded or are being mon itored for possible downgrade. (3) In December, overall business debt grew at a moderate pace, but the patterns of financing continued to reflect heightened investor concern s about risk (chart 2). Although issuance of investment-grade bonds was brisk, virtually no equities or junk bonds were bro ught to market. Bank bu siness loans grew rapidly, with the adv ance owing partly to lower -rated comm ercial paper issuers temporarily drawing down lines of credit at banks to avoid paying high year-end premiums, and comm ercial paper ou tstanding declin ed. Since the inter meeting po licy move in ea rly January, a substantial volume of corporate bo nds, including a number o f junk bonds, Chart 2 Financial Flows and Exchange Rates S&P 500 Volatility* M2 Growth Percent Annualized Percent 35 14 Daily 12 p 30 10 25 8 6 20 4 15 2 10 0 1999 2000 H1 2000 Q3 O N D 1999 J 2000 *30-day rolling standard deviation of the daily percentage change. p - Preliminary. Growth of Debt of Domestic Nonfinancial Sectors Business Debt Total Debt Sum of Selected Components* Percent Annualized Percent 14 Annualized 14 12 12 10 10 8 8 6 6 p 4 4 2 2 0 1999 2000 H1 2000 Q3 0 O N D 1999 2000 H1 2000 Q3 O N D p - Preliminary. *Bonds, commercial paper, and C&I loans. Nominal Trade-Weighted Dollar Exchange Rates Index(9/1/99) = 100 114 Daily 112 Broad Index 110 Other Important Trading Partners 108 106 Major Currencies Index 104 102 100 98 Sep Oct Nov 1999 Dec Jan Feb Mar Apr May Jun Jul 2000 Aug Sep Oct Nov Dec Jan Solid vertical line indicates last FOMC meeting. Dashed vertical line indicates January 3 cut in target federal funds rate. MARA:SF 3 has been issued in response to lower yields in more receptive markets. Business loans have continued to advance briskly in January, likely boosted by further substitution out of the commercial paper market. With lower-rated borrowers dissuaded by elevated interest rates and unable to issue at maturities beyond a few days, the outstanding amount of commercial paper has continued to run off in January. In the household sector, consum er credit is estimated to have decelera ted sharply in December , and bank loan data sugg est con tinued moderation early this yea r. Mortgage grow th is estimated to have remained relatively strong, however, supp orted by declines in m ortgage rates. Fed eral debt contin ued to contr act late last year and in January. Data for debt growth in recent months are partial and preliminary, but on balance it appears that nonfederal and total debt expanded at a moderate pace, similar to that recorded in the third quarter of last year. (4) M2 growth p icked up sharply in Decem ber and appears to have risen further in January. 2 The strength likely reflects in part investors’ decisions to seek the safety and liquid ity of M2 assets, suc h as retail mon ey funds and liquid depo sits, in response to the rise in equity market volatility in November and December. Also, the recent declines in s hort- and inter mediate-term rates have narro wed the op portunity cost of holding M2. M3 has grown even more rapidly than M2, boosted in part by faster issuance of large time deposits to fund a pickup in bank credit, which accelerated to an 11 percent annual growth rate in December. In addition, institutional m oney funds h ave ballooned as their yields, which adjust to chan ges in market rates with a lag, have become m ore attractive with the fall in short-term market interest rates. (5) While the w eaker econom ic outlook in th e United Sta tes, along with 2. Money stock data incorporate revisions from the annual benchmark and seasonal review and are confidential until their release on February 1. 4 lower interest rates, tended to put downward pressure on the foreign exchange value of the dollar, economic stagnation in Japan exerted a countervailing influence. Since the December FOMC meeting, the dollar was about unchanged, on net, against the currencies of the major industrialized countries. The dollar lost 3 percent of its value relative to the euro , on net, as econom ic growth in E urope cam e to be seen as likely to outpace that in the United States. The dollar also depreciated vis-à-vis the Canadian dollar as the momentum in domestic spending and the prospect of considerable fiscal stimulus in Canada were thought likely to cushion the impact on Canadian exports of softening U.S. aggregate demand. By contrast, incoming economic data for Japan proved disappointing to hopes that economic recovery had gained a foothold, and the dollar appreciated 4½ percent against the yen over the intermeeting period. The bleak Japanese economic picture revived talk that the Bank of Japan may return its official interest rate, now at ¼ percent, to zero, and money market futures rates, as well as longer-term yields, shifted down a touch. The exchange value of the dollar rose about 1 percent against a basket of cur rencies of our other important tradin g partners. General con cerns about th e effects on Latin A merica of a slow ing in U.S. gro wth supported the dollar relative to the Mexican peso and the Brazilian real. The currencies of m any Asian em erging mar ket econom ies that are viewed as especially vulnerable to a slowing in global demand for electronic goods also slipped against the dollar. Still, in most emerging markets, bond spread s narrowed somew hat, and prices rose in equity m arkets. U.S. autho rities did not interv ene in foreign ex change m arkets over the intermeeting period; . 5 MONEY AND CREDIT AGGREGATES (Seasonally adjusted annual percentage rates of growth) Oct. 2000 Nov. 2000 Dec. 2000 Jan. 2001 (p) M2 5.5 4.2 9.6 11.2 M3 4.4 4.2 12.5 15.7 3.1 -10.0 6.2 4.7 -9.2 7.9 4.6 -6.7 7.2 n.a. n.a. n.a. -6.0 -5.1 2.7 4.0 14.4 11.0 7.3 4.0 4.2 4.6 0.4 0.9 5.0 5.2 19.8 18.9 Money and Credit Aggregates Domestic nonfinancial debt Federal Nonfederal Bank credit Adjusted1 Memo: Monetary base2 Adjusted for sweeps 1. Adjusted to remove the effects of mark-to-market accounting rules (FIN 39 and FASB 115). 2. Adjusted for discontinuities associated with changes in reserve requirements. p -- preliminary 6 Longer-Term Strategies (6) This section co nsiders longer -term strategies for m onetary policy a s well as the policy implications of several of the alternative scenarios presented in the Greenbook. 3 All of the charts include a baseline scenario in which the Greenbook forecast is extended through 2005 using the FRB/US model, adjusted to preserve the key characteristics of th e econom y embod ied in the judg mental foreca st. In this extension, poten tial supply is assum ed to expand at the same rate as in 2002, with structural labor productivity growth continu ing at 3 percent per year. The earlier acceleration of structural productivity had helped to hold d own price increases because efficiency gains outpaced the lagging pickup in real wages. But with the leveling out of structural productivity growth, this disinflationary effect wanes, and the degree of labor market slack consistent with steady inflation (the effective NAIRU) edges up from about 4¾ percent currently to about 5¼ percent by 2005.4 Also after 2002, the federal surplus on a NIPA basis remains roughly stable at its current value of about 2 p ercent of GD P. The dollar is p redicted to dep reciate at a 5 percen t rate per year in real terms, and foreign econom ic growth picks up som ewhat. Together, these last two factors roughly stabilize the ratio of the current account deficit to GDP. (7) In the alternative strategies for monetary policy shown in chart 3, the baseline policy keeps the federal funds rate unchanged at 5¾ percent beyond 2002. In contrast to the conditions underlying the long-run scenario section of a number of bluebook s in recent years, pote ntial supply an d aggregate d emand ar e approxim ately in balance at the end of the Greenbook forecast in 2002, and little impetus to raise or lower inflation rates is in the pipeline. Moreover, the real federal funds rate at that 3. See pages I-13 to I-15 of the January 2001 Greenbook. 4. Past 200 5, the effective N AIRU would b e expected to rise somew hat further and settle in at its long -run va lue of 5½ percen t. Chart 3 Alternative Strategies for Monetary Policy Real Federal Funds Rate1 Nominal Federal Funds Rate Percent Percent 7.0 Percent Percent 7.0 5.5 6.5 5.0 6.0 6.0 4.5 4.5 5.5 5.5 4.0 4.0 5.0 5.0 3.5 3.5 4.5 4.5 3.0 3.0 4.0 2.5 Baseline Taylor Rule2 Price Stability 6.5 4.0 2000 2001 2002 2003 2004 2005 5.5 Baseline Taylor Rule Price Stability 2000 2001 2002 2003 2004 2005 5.0 2.5 Civilian Unemployment Rate Percent Percent 7 7 Baseline Taylor Rule Price Stability 6 6 5 5 4 4 3 2000 2001 2002 2003 2004 3 2005 PCE Inflation (ex. food and energy) (Four-quarter percent change) Percent Percent 2.5 2.5 Baseline Taylor Rule Price Stability 2.0 2.0 1.5 1.5 1.0 1.0 0.5 2000 2001 2002 2003 2004 1. The real federal funds rate is calculated as the quarterly nominal funds rate minus the four-quarter percent change in the PCE chain-weight price index excluding food and energy. 2. The Taylor rule uses a concept of potential output corresponding to the effective NAIRU, rather than corresponding to the long-run NAIRU as in the original specification of the Taylor rule. 2005 0.5 7 time is close to its eq uilibrium lev el (recognizing , of course, the cons iderable uncer tainty that surroun ds this and all other aspects of our projection s). Consequently, under this policy, the unemployment rate remains in the vicinity of the effective NAIRU from 2002 to 2005, and core PCE inflation is little changed. The Taylor rule policy sets the federal funds rate in response to core PCE inflation and the gap between actual output and the level of output consistent with the effective NAIRU.5 The equilibrium real interest rate used in the rule is that implicit in the extended Greenboo k baseline (slightly above 4 percent), while targeted inflation is set at 1½ perce nt. As show n by the dot-d ash lines, the path fo r the federal fund s rate given by the Taylor rule follows the baseline assumption reasonably closely, although the nomin al and real federa l funds rates are a b it lower in the n ear term and a bit higher later.6 With the price stability policy, the Co mmittee p laces inflation on a path to virtual price stability–as measured by core PCE inflation at a 1 percent rate. In order to accomplish this objective, policy has to be tighter than the baseline at some point. In the alternative shown, the funds rate is kept at its current 6 percent level for a time so that the required tightness occurs early in the simulation period, and thus inflation is on a perceptible downward track beginning in 2002. (8) Chart 4 presents alternative supply-side scenarios. The 4 percent NAIRU scenario has be en designed to explain the go od perform ance of inflation in recent years in terms of a permanently lower long-run NAIRU, rather than on the basis of transitory effects o f accelerating pro ductivity. Again , monetary po licy is assumed to follow a Taylo r rule, but one th at incorporate s a lower inflation target 5. In the policy rule, coefficients on the contemporan eous output and inflation gaps are equal to ½. 6. In 2005, the Taylor rule has not yet stabilized the economy at targeted inflation and an output gap of zero, but would do so in the longer run. Chart 4 Alternative Supply-Side Scenarios Real Federal Funds Rate1 Nominal Federal Funds Rate Percent Percent 7.0 6.5 Percent 7.0 Baseline (chart 1) 4 Percent NAIRU Productivity Slowdown Percent 5.5 5.5 Baseline (chart 1) 4 Percent NAIRU Productivity Slowdown 6.5 5.0 6.0 6.0 4.5 4.5 5.5 5.5 4.0 4.0 5.0 5.0 3.5 3.5 4.5 4.5 3.0 3.0 4.0 2.5 4.0 2000 2001 2002 2003 2004 2005 2000 2001 2002 2003 5.0 2004 2005 2.5 Civilian Unemployment Rate Percent Percent 7 7 Baseline (chart 1) 4 Percent NAIRU Productivity Slowdown 6 6 5 5 4 4 3 2000 2001 2002 2003 2004 3 2005 PCE Inflation (ex. food and energy) (Four-quarter percent change) Percent Percent 2.5 2.5 Baseline (chart 1) 4 Percent NAIRU Productivity Slowdown 2.0 2.0 1.5 1.5 1.0 1.0 0.5 2000 2001 2002 2003 1. The real federal funds rate is calculated as the quarterly nominal funds rate minus the four-quarter percent change in the PCE chain-weight price index excluding food and energy. 2004 2005 0.5 8 (1 percent) than was used in the baseline’s Taylor rule, as the Com mittee takes advantage of the “opportun ity” of emerging slack to make further pro gress toward price stability.7 As shown by the d ot-dash line, the federal funds rate is eased aggressively over the next two years to limit the rise in the unemployment rate, but the lower NAIRU means that a decline in inflation to 1 percent still can be achieved. The productivity slowdown scenario retains the staff view of the NAIRU and the role of changes in structural productivity growth in the inflation process, but assumes that the rate of structural productivity growth going forward falls permanently to 1½ percent (its 197 3-94 av erage) rather than continuing to run at 3 percent a s in the baselin e. Slower trend growth raises the effective NAIRU sharply, which puts upward pressure on inflation, but it also weakens demand; on balance, demand is restrained more than potential supply relative to the baseline, lowering the equilibrium real interest rate. If policy follows th e Taylor rule, as assu med in this sce nario, the federal fu nds rate drifts down, but by less than the decline in the equ ilibrium real funds rate in order to check the rise in inflation. (9) Chart 5 con siders the imp lications of alternative demand-side scenarios presented in the Greenboo k, but under the assumption th at monetary policy follows the Taylor rule. In the recession scenario (dot-d ash lines), weakne ss in aggregate demand is more pronounced than in the baseline by enough to push the econom y into an outr ight recession. Th e downw ard impetu s to deman d reverses fully during 2002. As show n, the unemploymen t rate rises to 6 percent in 2002 even though the federal funds rate is reduc ed to about 4½ percent by the end of 2001. Even with the unemployment rate rising well above the effective NAIRU, inflation 7. The rule also incorporates a slightly lower equilibrium real interest rate that arises on account of an increase in potential output that is not accompanied by a corresponding increase in government spending or foreign GDP. Chart 5 Alternative Demand-Side Scenarios Real Federal Funds Rate1 Nominal Federal Funds Rate Percent Percent 7.0 Percent Percent 7.0 5.5 6.5 5.0 6.0 6.0 4.5 4.5 5.5 5.5 4.0 4.0 5.0 5.0 3.5 3.5 4.5 4.5 3.0 3.0 4.0 2.5 Baseline (chart 1) Recession Growth Pause 6.5 4.0 2000 2001 2002 2003 2004 2005 5.5 Baseline (chart 1) Recession Growth Pause 2000 2001 2002 2003 5.0 2004 2005 2.5 Civilian Unemployment Rate Percent Percent 7 7 Baseline (chart 1) Recession Growth Pause 6 6 5 5 4 4 3 2000 2001 2002 2003 2004 3 2005 PCE Inflation (ex. food and energy) (Four-quarter percent change) Percent Percent 2.5 2.5 Baseline (chart 1) Recession Growth Pause 2.0 2.0 1.5 1.5 1.0 1.0 0.5 2000 2001 2002 2003 1. The real federal funds rate is calculated as the quarterly nominal funds rate minus the four-quarter percent change in the PCE chain-weight price index excluding food and energy. 2004 2005 0.5 9 increases slightly in 2002 as lower interest rates induce a steeper drop in the exchange value of the dollar than in the baseline, raising import prices. In the growth pause scenario, the near-term weakness in aggregate dem and stems solely from excess business inventories and not als o from a slow ing in final deman d, as in the baseline. After excess inventories are worked off, the greater underlying strength in final demand shows through to aggregate output growth. As shown by the dotted line, the Committee lowers the federal funds rate to 5¾ percent in the current quarter but promptly reverses this action. With final demand persistently stronger than in the baseline scenario, after 2001 both nominal and real interest rates need to rise further. 10 Mediu m-term Projections o f M2 G rowth (10) This section b riefly reviews the gr owth of M 2 last year and pr esents staff projections for the next tw o years that are consistent with the Gr eenbo ok forecast. (See table below.) Since the mid-1990s, in contrast to earlier in that decade, the demand for this aggregate has conformed fairly well on average with historical relationships to opportunity cost and spending (chart 6). In that context, analysis of the deviations of M2 grow th from projections, against the backdrop of oth er developments in financial markets, could be helpful in understanding the evolution of financial conditio ns and their im plications for the e conomic o utlook. Mo reover, in the very long run, trends in M2 an d prices should be related. Growth Rates of M 2 and M 2 Velocity (in percent) Actual (11) Projected 2000 2001 2002 M2 6.1 5½ 5½ V2 0.0 -1½ 0 Memo: Nominal GDP 6.1 3¾ 5½ Even though velocity and opportunity cost have moved together on average over recent years, significant divergences also are apparent that may be related in part to the unusual behavior of the eq uity market. Beginning in 1996, investors apparently be gan to view e quity returns a s quite attractive, and flows into equ ity mutual funds surged at the exp ense of M2, with the result that velocity trended higher through mid-1997. H owever, velocity subsequently moved back down as the further runup of equity prices boosted stock m arket wealth appreciably relative to income, Chart 6 Percentage points Ratio scale M2 Velocity and Opportunity Cost 2.2 8 M2 Velocity (Right scale) 4 2 2.1 Opportunity Cost (Left scale) 2.0 1 1.9 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Note: The scales are set to match the estimation results shown below. Opportunity cost is a two-quarter moving average of the three-month Treasury bill rate less a weighted average of the interest rates on M2 components. M2 Velocity Ratio scale See lower panel 98:Q4 97:Q3 2.1 01:Q1 Fit from 1993:Q1 - 2000:Q3 92:Q4 93:Q4 •• •• • 91:Q4 •• •• • • • •• •• • • •••• • •• • • • •• • • • • • • ••• • 90:Q4 90:Q2 •• • • •• •• ••• • • • •• • • • •• • • • • • ••• • • •••• •• • • • •• • • ••••• • ••• •• • •• •• • • •• • • • • • • • • •• • ••• • • • •• • • • • • • • 1.9 • 1.7 Fit from 1959:Q2 - 1989:Q4 1.5 0.5 1 2 4 6 Opportunity Cost (percentage points, two-quarter moving average) * The two regressions were constrained to have the same slope. M2 Velocity Ratio scale 2.15 97:Q3 97:Q1 2.10 98:Q2 00:Q2 96:Q3 95:Q1 96:Q1 98:Q4 99:Q4 00:Q3 95:Q3 2.05 99:Q2 02:Q2 01:Q1 94:Q3 2.00 2 2.3 2.6 2.9 3.2 Opportunity Cost (percentage points, two-quarter moving average) MARA:RJ 11 and household s seemed to tak e steps to rebalan ce portfolios by r eallocating fund s to assets in M2. M2 velocity has been flat over the past two years. In 2000, the damping effect on money demand of the rise in opportunity cost appeared to be offset by the response of households to equity market volatility and to a flat, and at times inverted, yield curve, which gave investors little incentive to shift funds out of M2 assets and into lo nger-m aturity capital mar ket instruments. (12) M2 growth is expected to moderate somewhat in 2001 as the expansion of nominal income slows. The downshift in M2 growth is tempered, however, by the reduction in short-term interest rates stemming from the assumed 75 basis points of policy easing in the first quarter and by the anticipated flatness of the yield curve. In addition, lower mortgage rates in the forecast spur a wave of mortgage refinancing activity that pushes up M2 g rowth as mortgage servicing agen ts temporarily place the prepayments in transaction accounts before remitting them to holders of mortgagebacked securities. Moreover, households are expected to favor M2 assets in view of the disappoin ting returns in th e equity mar ket anticipated in the staff forecast. W ith M2 grow th slowing co nsiderably less tha n nomin al income, M 2 velocity is projected to fall notably this year. In 2002, the staff assumes that short-term rates hold steady and that savers will have largely completed their adjustments to the flat yield curve and lower expected returns on h olding equ ities. In this environm ent, M2 gro wth is expected to level out, running at about the sam e pace as nominal incom e. Even though inflation persists over the next two years in the staff forecast, M2 growth on average in 2001 and 2002 is only modestly above the 4½ percent average pace that would be associated with price stability because of shortfalls in the growth of real output relative to that of potential. 8 8. The rate of g rowth of M 2 at price stability is deriv ed under th e assumptio n of stable velocity by summing the staff’s estimate of potential real GDP for the next two years (about 4 perce nt) and th e residua l bias in the GDP deflator (½ percen t). 12 Short-run policy alternatives (13) The staff has again revised down its outlook for economic growth in the near term, reflecting weaker expansion in aggregate dem and than previously projected and m ore aggressiv e prod uction cutbacks to a lign inventories better with sales. However, final demands over the forecast horizon are supported by the effects on consumption and investment of continuing elevated structural productivity gains and are augmented by the substantial declines in most interest rates over recent months as well as by projected decreases in energy prices and the foreign exchange value of the dollar. As a result, the inventory correction is completed fairly promptly, and projected econ omic grow th resumes in the spring and picks up therea fter. Despite the economic rebound, the sizable shortfall from potential output growth in the next few quarters quickly pushes up the u nemployment rate to aro und 5¼ percent b y yearend. By then, though, aggregate demand is expanding at a pace just short of potential and the unemploym ent rate edges only a bit higher over the remaind er of the forecast period. With structural productivity growth leveling out, the rise in the unemployment rate is seen as necessary to keep core consumer inflation rates near current levels. A gainst this backd rop, the staff forecast assu mes only a sm all additional c ut in th e federal fund s rate in the near term . (14) If the Com mittee found the staff assessment o f the outlook to be both reasonable and acceptable, it might opt for alternative A, which would lower the federal funds rate 25 basis points to 5¾ percent. In the context of this forecast, such an easing leans against softness in aggregate demand while resisting an eventual pickup of inflation in circumstances of continued pressures on labor resources. In light of the considerable uncertainty about the prosp ects for spending, such a measured step could be seen as striking a balan ce between tw o possible scena rios for aggrega te demand discussed earlier–a recession and a growth pause. To be sure, the market has 13 a more substantial easing at this meeting built into interest rates, but this expectation was shaped in part by the C ommittee’s unexpectedly a ggressive action e arlier this month. Over a som ewhat longer horizon, the structure of interest rates incorporates a drop in the funds rate to 4¾ percent by year-end–more than the Comm ittee may see as likely to be necessary to restore acceptable growth. If so, it may view disappointing markets a little as possibly fostering more sustainable and stabilizing financial conditions. Indeed, the Committee may be concerned that another 50 basis point action hard on the heels of the January 3 m ove risks leading investors to expect even more ease at future meetings than currently. Such a reaction would heighten the possibility that the stimulus emanating from financial markets would give additional impetus to a rebound in spending that might soon be underway in any event. G iven the lags in the effects of monetary policy, any resulting price pressures could be difficult to contain even with a relatively quick turnaround in po licy. (15) If the Com mittee were to choose this altern ative, it might wa nt to retain the current statem ent that the risks are weighted to ward econ omic wea kness, unless it were confident tha t the econom y had stabiliz ed and moderate growth was in prosp ect. With on ly a 25 basis poin t easing, market in terest rates probab ly would b ack up, credit spreads wo uld widen some, and sto ck prices wou ld decline as the p olicy move fell short of mar ket expectations a nd concern s about a pro longed perio d of econom ic weakness re-intensified. (16) If the Committee thought the economy might well be weaker than in the staff forecast, it may wish to take another substantial easing action by cutting the federal funds rate 50 basis points at this meeting, as in alternative AN . As the recession simulation illustrated, a substantial shortfall in demand would req uire prompt and forceful policy action. Even if the Committee thoug ht the staff forecast was the mo st reasonable po int estimate, it might still favor a 50 basis p oint easing if it 14 perceived that the probabilities around that outcom e were skewed toward considerably softer demand than in that forecast. With inflation and inflation expectations likely to remain quiescent for a while, a substantial easing to cushion downside risks to econom ic activity is unlikely to boost materially the risk of greater inflation pressure s. Indeed, a substan tial easing migh t also be viewed as appropria te if the Comm ittee did not see outsized downside risks to dem and but thought price pressures were unlikely to intensify at an unemployment rate near its current level, as in the 4 percent NAIR U simulation earlier in this bluebook. Financial m arket participants currently have built in high odds of a ½ percentage point cut in the funds rate at this meeting. Although conditions in some segments of financial markets have improved in recent weeks, developments in the commercial paper and bank loan markets indicate that suppliers of funds remain q uite wary. Under these circumstances, the effects of surprising the markets with a smaller easing could be especially adverse. (17) The market response to a 50 basis point reduction in the federal funds rate would depend importantly on the wording of the announcement and balance of risks statement that accompanied the action. Retaining a statement of risks weighted toward economic weakness would seem appropriate if, in light of the evident softening in demand and subdued readings on price and wage inflation, the Comm ittee saw the po ssibility of below-tren d growth a s a more serio us problem in the foreseeable futu re than the cha nce of a rise in inflatio n. Market p articipants expect the C ommittee to announ ce continued unbalanced risks toward ec onomic weakness as w ell as to ease policy b y 50 basis points. S till, markets migh t rally some if participants see th is combinatio n as confirm ing that the Fed eral Reserve inte nded to continue to c ounter econ omic wea kness relatively agg ressively. The dollar could weaken on foreign exchan ge markets as m ajor foreign cen tral banks are u nlikely to 15 match the System easing at this time. A statement that risks were balanced would be justified if the Com mittee thoug ht the 100 basis p oints of easing o ver the last mo nth were likely to be sufficient to promote a rapid return to sustainab le growth, which would keep labor m arkets relatively tight. Such a statement would cause market participants to reassess the prospects for future policy actions and roll back much of the expected easing going forward. In consequence, asset prices could give back some of their recent gains while the dollar could even strengthen a bit on foreign exchange markets. (18) The Committee may choose the unchanged federal funds rate of alternative B if it is dissatisfied with recen t rates of core inflation and wants to establish a downward trajectory for inflation, as in the price stability scenario in the second section of this bluebook. The rationale for this policy choice would be strengthened if the Com mittee saw th e recent slowd own in the growth of a ggregate demand as likely to be mo re temporary than does the staff and thus the recen t policy easing as probably sufficient to counter the sluggishness in the econom y that emerged recently. Regard less of the balance o f risks statement, leavin g the funds rate unchange d would c ome as a co nsiderable surp rise to market p articipants and w ould spark a sell-off in asset markets as participants reassessed the economic outlook and the Comm ittee’s posture. The backup in interest rates and drop in equity prices would prom pt still more caution on the part of loan officers and investors. (19) Under the Greenbook forecast, borrowing by the business and household sectors combined over the first half of 2001 is expected to stay around the reduced pa ce of the second half of last year. Con sumer cred it is projected to decelerate further over the first half, largely reflecting weaker outlays on consumer durables and some rising ca ution by ho useholds exp eriencing unc omfortable debtservicing burdens. Recent declines in mortgag e rates are expected to spur continued 16 heavy mortgage refinancing activity, mostly to reduce debt-servicing costs on existing debt but in a number of cases also to extract some equity. Lower bond rates and an improved tone to the corp orate bond market already hav e begun to boost issuance; going forward, overall business borrow ing should run som ewhat above the subdu ed pace of the latter p art of last year, when firms seemed inclined to ho ld off on their borrowing plans. Business borro wing from banks is expected to m oderate, in part reflecting the increased reliance on bond offerings but also the more restrictive posture of loan officers. Debt of no nfederal sectors is p rojected to gro w at about a 6½ percent rate from D ecember to June and total deb t to grow at a 4¼ percent rate, held dow n by paydo wns of federal d ebt. (20) M2 is projected to grow at a 5½ percent annual rate over the January-to- June period under the Greenbook forecast, well above the projected 2¾ percent growth of nominal GDP over the first half of this year. M2 growth should be boosted relative to that of nominal incom e by the decline in short-term market rates following the January policy easings and by a co ntinuation of the heightened preferences of households for the more stable assets that comprise M2. Mortgage refinancing activity also is likely to lift M2 notably over th is period. M3 is expected to grow at a 7 percent annual rate over the January-to-June period. Growth of institutional money funds is projected to be quite brisk as the yields on these funds lag the downward m ove in short-term market interest rates. Alternative Growth Rates for Key Monetary and Credit Aggregates M2 ---------------------------Alt. A’ Alt. A Alt. B ---------------------------Monthly Growth Rates Nov-2000 Dec-2000 Jan-2001 Feb-2001 Mar-2001 Apr-2001 May-2001 Jun-2001 M3 ---------------------------Alt. A’ Alt. A Alt. B ---------------------------- M2 M3 Debt --------------------------Greenbook Forecast* --------------------------- 4.2 9.6 11.2 8.4 7.3 8.1 2.7 3.8 4.2 9.6 11.2 8.0 6.5 7.3 2.0 3.3 4.2 9.6 11.2 7.6 5.7 6.5 1.3 2.8 4.2 12.5 15.7 11.6 8.4 8.0 3.8 4.6 4.2 12.5 15.7 11.4 8.0 7.6 3.5 4.4 4.2 12.5 15.7 11.2 7.6 7.2 3.2 4.2 4.2 9.6 11.2 8.0 6.5 7.3 2.0 3.3 4.2 12.5 15.7 11.4 8.0 7.6 3.5 4.4 4.6 4.6 2.9 5.4 6.2 3.3 3.4 4.3 Quarterly Growth Rates 2000 Q1 2000 Q2 2000 Q3 2000 Q4 2001 Q1 2001 Q2 5.8 6.2 5.6 6.5 9.1 6.3 5.8 6.2 5.6 6.5 8.9 5.6 5.8 6.2 5.6 6.5 8.7 4.9 10.5 8.8 8.8 7.0 12.1 7.2 10.5 8.8 8.8 7.0 12.0 6.9 10.5 8.8 8.8 7.0 11.9 6.5 5.8 6.2 5.6 6.5 8.9 5.6 10.5 8.8 8.8 7.0 12.0 6.9 5.6 6.2 4.7 4.1 4.4 4.3 Growth Rate Ranges From To Dec-1999 Dec-2000 Dec-2000 Jun-2001 Jan-2001 Jun-2001 6.2 7.0 6.1 6.2 6.5 5.5 6.2 5.9 4.8 8.6 8.8 7.4 8.6 8.6 7.1 8.6 8.3 6.8 6.2 6.5 5.5 8.6 8.6 7.1 5.2 4.3 4.6 1999-Q4 2000-Q4 6.3 6.1 6.3 6.1 6.3 6.1 7.7 9.1 7.7 9.1 7.7 9.1 6.3 6.1 7.7 9.1 6.8 5.3 2000-Q4 Jun-2001 7.2 6.7 6.2 9.0 8.8 8.6 6.7 8.8 4.4 1998-Q4 1999-Q4 * This forecast is consistent with nominal GDP and interest rates in the Greenbook forecast. 17 Directive and Balance-of-Risks Language (21) Presented below for the mem bers' consideration is draft wording for (1) the directive and (2) the “balance of risks” sentence to be included in the press release issued after the meeting (no t part of the directiv e). (1) Directive Wording The Federal Open Market Comm ittee seeks monetary and financial conditions th at will foster price stab ility and prom ote sustainable g rowth in output. To fu rther its long-run objectives, the Co mmittee in th e immed iate future seeks conditions in reserve markets consistent with MAINTAINING/ INCREASING /reducing the federal funds rate AT/to an average of around ___ 6 percen t. (2) “Balance-of-Risks” Sentence Against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the Committee believes that the risks [ARE BALANCED WITH RESPECT TO PROSPECTS FOR BOTH GOALS] [CONTINUE TO BE WEIGHTED MAINLY TOWARD CO NDITIONS THAT MAY GENERATE HEIGH TENE D INFLA TION P RESSU RES] [are weighted m ainly toward conditions that m ay generate economic w eakness] in the foreseeable future . 

Federal Reserve (2001, January 30). Bluebook. Bluebooks, Federal Reserve. https://whenthefedspeaks.com/doc/bluebook_20010131

@misc{wtfs_bluebook_20010131,
  author = {Federal Reserve},
  title = {Bluebook},
  year = {2001},
  month = {Jan},
  howpublished = {Bluebooks, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/bluebook_20010131},
  note = {Retrieved via When the Fed Speaks corpus}
}