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 June 22, 2001 M ONETARY P OLICY A LTERNATIVES Recent D evelopm ents 1 (1) Short-term interest rates in the United States moved down somewhat on the announcement of a 50 basis point easing at the May 15 FOMC meeting.2 Market participants evidently were placing some odd s on a 25 basis point move or at least were anticipating an indication that the Com mittee might subsequently slow the pace of easing. Since th e meeting, new s on econom ic activity and corp orate earnings– both in the U nited S tates an d abro ad–has generally b een weaker than m arket expecta tions. As a consequence, the trajectory for the expected fund s rate shifted down further, triggering declines in other money market rates, which ended the intermeeting period 30 to 50 basis points lower. Market prices now embody at least a quarter-point easing at the u pcom ing m eeting and a little more than an e ven ch ance o f a half-point move. Yields on long-term Treasury and investment-grade corporate securities fell about 15 to 35 basis points over the intermeeting period (chart 1). Rates on speculative-grade bonds, however, jumped in response to adverse earnings warnings, particularly in the telecom sector, widening spreads substantially. Earnings warnings also weighed on 1. Interest rates in this Bluebook have been updated through 3:00 p.m. June 22, and exchange rates are updated through noon. 2. Over the intermeeting period, federal funds have traded near the current target level of 4 percent. The Desk redeemed $2.3 billion of Treasury securities, consisting entirely of coupon issues, to continue bringing SOMA h oldings into conformance with the guidelines on per-issue lim its. To offset the resulting reserve drain a nd meet lo nger-term rese rve needs, the Desk purchased outright $9.9 billion of Treasury securities, consisting of $7.2 billion of coupon issu es, $2.1 billion of bills purchased in the mark et, and $0.6 b illion of bills purchased from foreign customers. The amount of outstanding long-term RPs was kept unchanged at $12.0 billion. Chart 1 Financial Market Indicators Expected Federal Funds Rates Estimated from Percent Financial Futures* Selected Treasury Yields Percent 4.75 7.0 Daily 6.5 Two-year 4.50 6.0 4.25 5.5 Ten-year 4.00 May 14, 2001 5.0 4.5 3.75 4.0 June 22, 2001 3.50 3.5 TIPS 3.0 Jun Aug Oct 2001 Dec Feb Apr 2002 Jun Aug May Jul Sep 2000 Nov Jan Mar May 2001 *Estimates from federal funds and eurodollar futures rates with an allowance for term premia and other adjustments. Selected Private Long-Term Yields Percent 14 12 Daily 13 Selected Risk Spreads* Percent 11 High Yield (left scale) 12 Basis Points 800 300 Daily 700 High Yield (left scale) 10 600 Ten-year BBB (right scale) 11 200 9 500 10 8 400 9 7 Ten-year Swap (right scale) 8 6 May Jul Sep 2000 Nov Jan Spread of Low-Tier CP Rate over High-Tier CP Rate* 200 May Mar May 2001 100 Ten-year BBB (right scale) 300 Jul Sep 2000 Nov Jan Mar May 2001 *These spreads are the difference between the yields on the Merrill Lynch 175 and a ten-year BBB index versus rates on ten-year swaps. Selected Equity Indexes Basis Points Index(5/31/00) = 100 160 Daily 140 Daily 140 120 120 Wilshire 5000 100 100 DJIA 80 80 60 Nasdaq 40 60 20 May Jul Sep 2000 Nov Jan Mar May 2001 *30-day nonfinancial, A2/P2 rate less AA rate. Note: Solid vertical line indicates last FOMC meeting. May Jul Sep 2000 Nov Jan Mar May 2001 2 equity prices, which have declined ab out 1½ percen t on ne t since the M ay meeting. These declines in long-term interest rates and equity prices have reversed only part of the increases register ed from late-M arch to mid -May, sugge sting that investor s remain somewhat more optim istic about econom ic prospects than they were in la te Ma rch. The yield curve retains its upward slope, and futures markets still expect an appreciable rise in short-term rates next year. (2) With indicators of economic activity in Japan and Europe also suggesting softening, the exchange value of the dollar in terms of the m ajor currencies index rose slightly on net over the intermeeting period (chart 2). The decline in first-quarter Japanese GDP surprised observers, and Japanese share prices, especially those of high-tech and banking sector com panies, dropped sharply; yields on Japanese government debt with maturities out to two years fell to near zero. In the large Euro pean e conomies, economic prospects dim med b ut infla tion co ncerns mou nted. Long-term interest rates were little changed on net un til late in the period, when they declined 8 to 10 basis points, but broad share price indexes fell 1 to 5 percent. M arket participants apparently interpreted recent upticks in inflation as lowering the odds that the European Central Bank will ease as much as was previously expected and eliminating any chance for further easing by the B ank of England. Althou gh most other industrial-country central banks did not act during the intermeeting period, the Bank of Canada eased by a quarter point near the end of M ay. . Chart 2 Exchange Rates and Financial Flows Nominal Trade-Weighted Dollar Exchange Rates Index(5/31/00) = 100 Daily Growth of M2 110 Percent 16 FOMC Annualized 14 108 Major Currencies Index 12 106 10 Broad Index p 104 8 Other Important Trading Partners 6 102 4 100 2 98 May Jul Sep 2000 Nov Jan Mar May 2001 0 1999 p - Preliminary. 2001 2000 J F M A M J Solid vertical line indicates last FOMC meeting. Growth of Nonfederal Debt Growth of Business Debt Sum of Selected Components* Percent Percent 16 Annualized 16 Annualized 14 14 12 12 10 10 p p 1999 p - Preliminary. 2000 J 2001 F M A M J p 8 8 6 6 4 4 2 2 0 0 2001 1999 2000 p - Preliminary. J F M A M J *Bonds, commercial paper, and C&I loans. MARA:RJ 3 (3) The dollar’s value against the currencies of other important trading partners edged up on net over the intermeeting period. In early June, Argentina swapped shorter-term for longer-term debt to reduce its debt-servicing burden in the near term. Even though this exchange required generous lon ger-term yields to entice a large volume of propositions, spreads on Argentine dollar-denominated debt declined substantially from their levels in mid-May. In mid-June, Argentina introduced an exchange-rate-linked system o f export subsidies and import taxes, which effectively lowered the value of the peso for traded goods but kept the dollar peg for other types of transactions. The implem entation of this program led to fears that it was a prelude to a full devaluation, and financial markets erased som e earlier gains, leaving Argentine bond spreads over comparable U.S. Treasury securities down only about 120 basis points for the intermeeting period as a whole. The Brazilian real was battered o ver the interm eeting period b y spillovers from Argentina , problems in the energy sector arising from drought, and domestic political scandals, but central bank intervention and a tightening of m onetary policy in late June helped the currency to battle back and end th e perio d dow n only about 3½ p ercent versus the dollar. Benefitting from continued fo reign interest in M exican investm ents and high oil prices, Mexico’s currency appreciated about 1½ percent against the dollar, while the yield spread of Mexican sovereign deb t over Treasuries declined about 30 basis points. (4) The debt o f nonfederal secto rs has continu ed to increase at a good clip in recent months, expanding at about a 6½ percent annual rate in April and, based on preliminary d ata, at a somew hat faster pace in M ay. With bo nd marke ts quite receptive and long-term rates viewed as attractive, nonfinancial businesses borrow ed huge amoun ts in the bond market in M ay, and data for early June suggest another strong month. A portion of this issuance was used to repay bank loans and commercial paper, but much of it represented new financing as internal funds have 4 dropped o ff. Although th e growth o f household debt is projected to slow to ab out a 7¼ percent annual rate for the second quarter as a whole, it remains higher than that of disposable income, pushing up debt-servicing burdens despite declines in consum er loan rates. Prob lems servicing d ebt continue d to increase in ce rtain market se gments but restraint on credit supplies h as been quite lim ited. State and loc al governm ents have continued to raise fu nds at a rapid clip, esp ecially for new capital pro jects. Outstanding m arketable debt of the federal government shran k substantially further over the intermeeting period. From the fourth quarter of 2000 through May 2001, total nonfinancial debt is estimated to have expanded at about a 4½ percent annual rate, only slightly faster th an the projected growth of n ominal G DP over th e first half of the year. (5) M2 growth slowed in May, as a large amount of final individual tax payments cleared, but has rebounded smartly in June to an estimated 8¼ percent annual rate (chart 3). On a quarterly average basis, therefore, M2 has hardly slowed at all this quarter. O verall, from the fo urth quarter of last year throug h June, M 2 is estimated to have grown at about a 10 percent pace, bolstered importantly by the reduction in the opportunity costs of hold ing liquid deposits and mon ey market mutual funds engendered by five policy easings in quick succession. Moreover, a drop in mortgage rates, which began about a year ago, had progressed far enough by the end of 2000 to kick off a wave of refinancing that elevated M2 this year, as the proceeds earm arked to pay o ff previously secur itized mortg ages were tem porarily held in escrow in M2 deposit accounts. A further influence supporting M2 growth in the first part of the year may have been the reduced attractiveness and greater volatility of stock marke t returns. M3 growth, wh ich has com e down fro m Apr il’s unusually strong pace, is still quite robust. Institution-only money funds, which expand ed rapidly during the first quarter because of the effects of policy easing and a continued Chart 3 Money and Credit Aggregates (growth in percent saar) 1 Domestic Nonfinancial Debt Total Federal Nonfederal Bank Credit Adjusted2 Monetary Base M2 M3 6.2 9.2 5.3 -6.7 8.5 9.4 1.4 10.5 13.1 4.6 -6.4 7.2 4.7 6.1 Q4 - May 10.3 13.2 4.5 p -7.4 p 7.2 p 4.8 6.0 Q4 - Junep 10.0 13.0 n.a. n.a. n.a. 4.2 6.4 Q1 10.7 12.2 4.8 -5.4 7.2 6.8 6.4 Q2p 10.0 13.5 n.a. n.a. n.a. 2.6 5.7 April 10.4 17.6 3.4 -10.9 6.6 5.0 7.1 May 5.1 13.3 3.2 p -17.6 p 7.8 p 1.7 6.3 Junep 8.2 11.5 n.a. n.a. n.a. 0.3 8.4 2000 2001: H1p 1. Annual growth rates are Q4/Q4. Semi-annual growth rates are Q2/Q4, annualized. Quarterly growth rates are from previous quarter, annualized. Monthly growth rates are from previous month, annualized. Levels underlying growth rates are averages for the quarter or month. 2. Adjusted to remove the effects of mark-to-market accounting rules (FIN 39 and FAS 115). p - preliminary MARA:RJ 5 strong trend toward their use for corporate cash management, have kept growing rapidly in recent months. From the fourth quarter of last year through June, M3 has increased at a 13 percent annual rate. 6 Longer-Term Strategies (6) This section examines some implications of the Greenbook outlook for longer-term strategies for monetary policy and considers the implications for policy of alternative possibilities for productivity growth. The experiments are constructed from a baseline scenario in which the Greenbook forecast is extended through 2006 using the FRB/US model, with certain judgmental adjustments to the model that preserve the cen tral features und erlying the staff outlo ok. Potential ou tput grow th in the baseline is drive n by several key co nsiderations: M ultifactor prod uctivity growth continues at its 2002 pace; overall investment in capital equipment accelerates beyond the Greenbook horizon, buoying the expansion of capital services; and the degree of labor market slack consistent with stable inflation (the effective NAIRU) rises from about 5¼ percent in 200 2 to 5½ percent by 2005. Taking all these factors together, the rate of increase in potential output is a tad above 3½ percent after 2003, a slight rise from this year and next. Growth abroad strengthens to 3¾ percent by 2003, and the dollar is assumed to depreciate at a 3 percent annual rate in real terms, keeping the ratio of the current account deficit to GDP about flat. Lastly, the fiscal assumptions in the extension hold the unified budget surplus at about 2 percent of nominal GDP, modestly higher than the surplus in calendar 2002. (7) The baseline strategy in chart 4 is designed to hold core PCE inflation at 1¾ percen t, a touch below the rate at the en d of the Greenbook horizon . Monetary policy is relatively accommodative at the start of the extension, with a real federal funds rate of about 2¼ percent, mor e than a percen tage point belo w its equilibrium level implied by the baseline at that time. Co nsequently, monetary policy must tighten in this scenario, by raising the nominal funds rate to 5½ percent by middecade and the real rate to abo ut its equilibrium level of 3¾ pe rcent. The pu rple balland-chain line in chart 4 show s a path for po licy that is sufficient to red uce inflation to Chart 4 Alternative Strategies for Monetary Policy 1 Nominal Federal Funds Rate Real Federal Funds Rate Percent Percent Percent Percent 6 Baseline Price Stability 7 7 6 6 5 5 4 4 3 6 Baseline Price Stability 5 5 4 4 3 3 2 2 3 2000 2001 2002 2003 2004 2005 1 2006 2000 2001 2002 2003 2004 2005 2006 1 Civilian Unemployment Rate Percent Percent 6.5 6.5 Baseline Price Stability 6.0 6.0 5.5 5.5 5.0 5.0 4.5 4.5 4.0 4.0 3.5 3.5 3.0 2000 2001 2002 2003 2004 2005 3.0 2006 PCE Inflation (ex. food and energy) (Four-quarter percent change) Percent Percent 3.5 3.5 Baseline Price Stability 3.0 3.0 2.5 2.5 2.0 2.0 1.5 1.5 1.0 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. 2005 2006 1.0 7 near price stability, defined here as 1¼ percent growth in core PCE prices. To achieve this outcome, the real funds rate needs to rise above its long-run equilibrium level to induce sla ck in the econo my. In this exercise , the nomina l rate peaks at 6 percent by the end of 2004, enough to push the unemployment rate above 6 percent and bring in flation down to its target level by 20 06. Policy, which begins to ease in 2005 in anticipation of the completion of the d isinflation, would presumably ease further after 2006 to bring the unemployment rate back to the NAIRU. (8) The 2½ percentage point decline in the funds rate so far this year represents the swiftest monetary policy easing since the autumn of 1984. To provide perspective on this action, chart 5 compares this outcome with those that would have occurred under two monetary policy rules. As in chart 4, the black solid line in the upper left panel shows the nominal federal funds rate for the extended Greenbook baseline. The blue dashed line shows the path predicted by a Taylo r rule. The rule employed here uses standard coefficients on the contemporaneous inflation and output gaps beginning in 2001:Q1, but incorporates the baseline’s time-varying equilibrium real funds rate and its inflation target of 1¾ percent. In the first half of 2001, p olicy eased co nsider ably m ore than this Taylo r rule w ould h ave suggested. One possible explanation for this discrepancy is that policy choice was informed by more than the limited information used in the Taylor rule, especially forecasts of the economy. To provide a perspective on this possibility, the red dotted line presents the federal funds rate that would be chosen by a policymaker with perfect foresight starting at the beginning of this year. Specifically, the policymaker is assumed to be certain that the model accurately described the econo my and that the baseline Chart 5 Policy Easings in 2001 H1: Alternative Views 1 Nominal Federal Funds Rate Real Federal Funds Rate Percent Percent 7 Percent Percent 6 Baseline Taylor Rule Perfect Foresight 7 6 6 5 5 4 4 3 Baseline Taylor Rule Perfect Foresight 6 5 5 4 4 3 3 2 2 3 2000 2001 2002 2003 2004 2005 1 2006 2000 2001 2002 2003 2004 2005 2006 1 Civilian Unemployment Rate Percent Percent 6.5 6.5 Baseline Taylor Rule Perfect Foresight 6.0 6.0 5.5 5.5 5.0 5.0 4.5 4.5 4.0 4.0 3.5 3.5 3.0 2000 2001 2002 2003 2004 2005 3.0 2006 PCE Inflation (ex. food and energy) (Four-quarter percent change) Percent Percent 3.5 3.5 Baseline Taylor Rule Perfect Foresight 3.0 3.0 2.5 2.5 2.0 2.0 1.5 1.5 1.0 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. 2005 2006 1.0 8 correctly described all of the forces impinging on the econo my. 4 The actual path for the funds rate in the first half of this year has been much closer to that of the perfect foresight policy than to that of the Taylor rule. (9) The staff forecast is arguably at odds with the market’s view, which appears to incorporate expectations of both a rapid reversal of the funds rate and stronger corporate earnings. Chart 6 considers the possibility that the market’s outlook can be rationalized by faster growth of potential ou tput than projected by the staff. In these exercises, structural labor productivity accelerates ¾ percentage point to 3¼ percent beginning in 2001:Q3, abou t the same as estimated for 1999-2000. As before, the black solid line plots the extended baseline, shown for reference purposes. The blue dashed line and the red dotted line show the funds rates from the Taylor rule and the perfect foresight policy, respectively, operating in the context of the higher structural productivity growth. Both rules initially hold the federal funds rate around its current value in response to n ear-term econ omic wea kness and ultim ately raise it enough to be consistent with the higher returns to capital provided by faster long-run growth.5 However, because the Taylor rule does not respond to the productivity surge until it becomes manifest in output, imbalances in inflation and output arise. By contrast, the funds rate under the perfect foresight policy increases much m ore rapidly, 4. More precisely, the red dotted line is the outcome of a full-information optimal control exercise. The policymaker is assumed to place equal weight on minimizing squared deviations of core PCE inflation from its target and unemployment from the short-run effective NAIRU and to follow a gradualist strategy that penalizes quarter-to-quarter changes in the funds rate. The penalty was chosen to approximate the gradual changes in the funds rate that have b een observ ed over the p ast fifteen years. 5. This sp ecification does no t allow th e estimate d equilib rium re al rate in th e Taylo r rule to respon d to this pr oductiv ity shock . Instead, th e higher real fed fu nds rate e volves w ith movem ents in the outpu t and inflation ga ps. Chart 6 Implications of Structural Labor Productivity Surge 1 Nominal Federal Funds Rate Real Federal Funds Rate Percent Percent 7 Percent Percent 6 Baseline Taylor Rule Perfect Foresight 7 6 6 5 5 4 4 3 5 5 4 4 3 3 2 2 3 2000 2001 2002 2003 2004 2005 1 2006 2000 2001 Potential Output (four-quarter growth) Percent 4.0 3.0 3.0 2002 2005 2006 1 6.5 Baseline Taylor Rule Perfect Foresight 6.0 5.5 5.5 5.0 5.0 4.5 4.5 4.0 4.0 3.5 3.5 3.5 Baseline 2001 2004 Percent 6.5 6.0 4.0 2000 2003 Percent 4.5 Potential Output with Structural Productivity Surge 3.5 2002 Civilian Unemployment Rate Percent 4.5 2.5 6 Baseline Taylor Rule Perfect Foresight 2003 2004 2005 2006 2.5 3.0 2000 2001 2002 2003 2004 2005 2006 3.0 PCE Inflation (ex. food and energy) (Four-quarter percent change) Percent Percent 3.5 3.5 Baseline Taylor Rule Perfect Foresight 3.0 3.0 2.5 2.5 2.0 2.0 1.5 1.5 1.0 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. 2005 2006 1.0 9 beginning next year in a pattern similar to that seen in financial futures markets, and fosters a smoo ther path for in flation and un employm ent.6 (10) The reduction in corporate earnings of late, should it continue, might be taken as signaling that structural labor productivity growth will continue to slow. To consider the implications of this possibility, we examine simulations in w hich productivity growth steps down to 1¾ percent, about ¾ percentage point below that projected in the Greenbook for this year and next. Chart 7 plots the funds rate in the baseline case for reference and, with this new assumption for productivity growth, the funds rate paths produced by the T aylor rule (the blue dashed line) and the perfect foresight policy (the red dotted line). The productivity deceleration reduces current and expected income an d leads to a m arked weake ning in aggre gate deman d relative to the baseline, while adding to pressures on costs that boost inflation. The effects of the downshift in demand predominate for each of the policy rules, and so both call for sharp declines in the funds rate in early 2002. Un like chart 6, where the Taylor ru le falls behind emerging economic developments, here it does considerably better. The main reason for the Taylor r ule’s more ap pealing perfor mance is that th e productivity deceleration in this simulation exacerbates the economic sluggishness currently in train, which was already prom pting the backward-loo king T aylor rule to p rescrib e easing. Without the need for the kind of near-term reversal in the stance of policy that was required in chart 6, the myopia of the Taylor rule does not turn out to be a serious liability for the conduct of monetary policy. 6. Indeed, a simulation under perfect foresight with less gradualism than observed over the past fifteen years produces a federal funds rate path that fairly closely matches the near-term dip as well as the subsequen t rebound b uilt into financial m arkets. Chart 7 Implications of Structural Labor Productivity Slump 1 Nominal Federal Funds Rate Real Federal Funds Rate Percent Percent 7 Percent Percent 6 Baseline Taylor Rule Perfect Foresight 7 6 6 5 5 4 4 3 5 5 4 4 3 3 2 2 3 2000 2001 2002 2003 2004 2005 1 2006 2000 2001 Potential Output (four-quarter growth) Percent Percent 4.0 4.0 Baseline 3.0 2001 2002 2003 2004 2004 2005 2006 1 Percent 6.5 6.5 6.0 6.0 5.5 5.5 5.0 5.0 4.5 4.5 3.5 Potential Output with Structural Productivity Slump 2000 2003 Percent 4.5 3.5 2002 Civilian Unemployment Rate 4.5 2.5 6 Baseline Taylor Rule Perfect Foresight 2005 2006 4.0 3.0 3.5 2.5 3.0 4.0 Baseline Taylor Rule Perfect Foresight 2000 2001 2002 2003 2004 3.5 2005 2006 3.0 PCE Inflation (ex. food and energy) (Four-quarter percent change) Percent Percent 3.5 3.5 Baseline Taylor Rule Perfect Foresight 3.0 3.0 2.5 2.5 2.0 2.0 1.5 1.5 1.0 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. 2005 2006 1.0 10 Short-Run Policy Alternatives (11) Incoming data have prompted the staff to revise down its outlook for investment spending over the next year and a half, directly restraining the expansion of economic activity. This slower accumu lation of capital also pulls down the estimated growth of stru ctural produ ctivity, and associated reductions in e xpected return s to labor and ca pital work to d amp furthe r the forecast of agg regate dema nd. The effects of these developments on consumption spending are partly offset by greater stimulus from tax cuts th an assumed in the last Green book. On net, econom ic growth is expected to be somewh at slower this year and the unemp loyment rate to rise more sharply than in the last forecast. Although lower pro ductivity growth implies more intense inflation p ressures at any giv en unem ployment r ate, the econom y is sufficiently weak in the forecast to put effective slack in labor markets by late this year. This slack and the indirect effects of lower oil prices cause core consumer inflation to edge down in 2002 from the higher pace experienced this year. In the staff’s assessment, an unchanged federal funds rate over the next year and a half, as assumed in the Greenbook, is mod erately accommodative and helps growth of aggregate dem and rise a little above that of potential output by the second half of next year, halting the climb in the u nemp loyment rate. (12) The chart on the next page shows an update of the range of estimates of the equilibrium real federal funds rate presented in the previous bluebook.7 The range 7. These individual estimates of the intermediate-run eq uilibrium real federal funds rate are derived from the FRB/US model, from a statistical filter separating permanent and temporary changes in the relationship of the real funds rate to the output gap, and from indexed debt yields. One estima te from the FRB/ US mod el and one from the filter are based on h istorical data, while a nother set takes ac count of the staff ’s forecast through 2002. Chart 8 Actual Real Federal Funds Rate and Range of Estimated Equilibrium Real Rates Percent 5 5 Quarterly Actual Real Funds Rate 4 4 Historical Average: 2.81 (1966Q1-2001Q1) 3 3 2 ● Current Rate ● 25 b.p. Easing ● 50 b.p. Easing 2 1 1 0 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Note: The shaded range represents the maximum and the minimum values each quarter of the five estimates of the equilibrium real federal funds rate described in the text. Real federal funds rates employ four-quarter lagged core PCE inflation as a proxy for inflation expectations, with the staff projection used for the second quarter of 2001. 11 for the current equilibrium rate is roughly the sam e as that shown last time. 8 The ½ percentage po int policy easing a t the May m eeting has pu t the estimated re al funds rate noticeably below that range. This gap provides a measure of the stimulus from the current stance of monetary policy, but one that depends on the many assumptions that went into co nstructing the e stimates of the eq uilibrium fu nds rate, impo rtantly including the staff’s estimate of structural productivity growth and the level of the NAIRU.9 The real federal funds rates implied by the policy alternatives discussed below for this meeting–cuts of 25 and 50 basis points as well as an unchanged funds rate–are also plotted. (13) With m uch of the effect o n spending of the 250 basis p oints of easing still to be realized and the real funds rate already seemingly below its equilibrium value, the Comm ittee may wish to keep the federal funds rate unchanged at this meeting, as assumed in the Greenb ook. In the staff ou tlook, with an u nchanged federal funds rate the effective NAIRU rises along with the unemployment rate over the forecast period, and therefore only a moderate amount of slack opens up in labor markets. The Comm ittee may see that slack as needed to lean against the recent updrift in a num ber of measures of inflation, especially if it wishes to make further progress toward price stability over time . In the Green book forecast, th e growth o f real activity would already be drawing close to that of its potential and headed higher by the time an easing at this m eeting would begin to have a noticeable im pact on the economy. 8. The r ange of estimates for past ye ars has b een adju sted dow nward to some extent, largely because of modifica tions to the FR B/US model. 9. The range indicated by the shaded area does not capture all the uncertainties associated with estimating the equilibrium real funds rate; in particular it does not include standard errors around the individual estimates. For example, the standard error of the current estimated equilibrium real rate from the statistical filter is around 1½ percentage points, even before a ccoun ting for u ncertain ty in the staf f’s estimate of poten tial outpu t. 12 Indeed, the C ommittee may be con cerned that the recent behavio r in financial m arkets suggests that inv estors could rev ise up their inflation expectations sh ould grow th revive especially rapidly. In light of the uncertainties about the response of the economy to the steep easing of po licy so far this year, a pause may be considered appropriate a t present to assess b etter whether th e previous po licy actions are likely to induce a suitable rebound in econ omic activity. (14) A decision to hold the funds rate unchanged at this meeting–even with a statement ind icating that the C ommittee still saw risks weigh ted toward econom ic weakness–would take financial market participants by surprise. The extent of the surprise would depend in part on the data on durable goods orders, home sales, and consumer confidence that will be received just before the FOMC meeting, but judging from current futures market quotes, short-term rates would back up sharply, likely by more than ¼ percentage point, as markets became uncertain about whether any additional easing would be forthcoming this year. The resulting upward pressure on long-term yields, though, would likely be offset somew hat by a decline in stock prices, which could be sharp.10 (15) Instead, the Co mmittee m ay deem it ap propriate to ea se policy at this meeting. A ggregate dem and again h as proven w eaker than an ticipated and h as yet to show con crete signs of firmin g, while declines in resource utilizatio n are likely to relieve pressures on prices. In these circumstances, the Committee may view the staff’s assessment of the e conomic o utlook as reaso nably likely and acceptable, but it may see the risk to that forecast as uncomfortably weighted to the downside. With the economy already soft for three quarters, the extent and further d uration of the forces acting to restrain spending still very unclear, and the degree of the countervailing 10. Market reactions to the surprise elements in policy easings have varied widely and somewhat unpredictably this year, as shown in the appendix on page 17. 13 stimulus from the easier monetary and fiscal policies quite uncertain, an additional easing of policy by 25 basis po ints would provide greater assurance o f a satisfactory strengthening of econom ic activity. Moreo ver, a rate cut sma ller than those ea rlier this year would be approp riate if the Com mittee saw p olicy as already reaso nably accommodative and therefore wished to proceed more cautiously on the thought that the easing cycle might need to be brought to a close before long. Braking the pace of easing would likely limit the tendency of market participants, observed after recent policy actions, to extrapolate further easing, which might otherwise lead to financial conditions that th e Com mittee viewed as ex cessively stimulative. (16) With market participants putting a little more than even odds on a 50 basis point move at this meeting, short-term interest rates would move up on an announcement of a 25 basis point easing, even if accompanied by a statement that the risks were still tilted toward weakness. Market participants are unlikely to revise up significantly their forec ast of the low p oint for the targe t funds rate, but th ey probably would push that po int further into the future, implying that intermediate- and longerterm interest rates w ould only ed ge higher. W ith the Federal R eserve still expected to ease again, the neg ative reaction in sto ck markets co uld well be lim ited. Howev er, if the smaller size of the action and the words o f the announcement fostered the b elief that the easing cyc le had com e to an end, a m ore prono unced reactio n in markets would be likely. (17) Alternatively, the Committee may see aggregate demand or inflation pressures as likely to be noticeably weaker than in the staff forecast, arguing for a more forceful easing of 50 basis po ints. The near-term prospects for corporate earnings are bleak, raising the possibility of larger declines in equity prices than are built into the staff forecast. The resu lting hit to hou sehold wealth , along with the more rapid rise in unemployment, could sap consumption spending considerably. Even if the staff has 14 judged the fundamentals of spending correctly, the Committee may view the inflation outlook to be more favora ble than in the Greenboo k. In particular, the Committee may interpret the good inflation perform ance of the past few years as resulting more from lasting changes in underlying labor market conditions and less from the temporary effects of the acceleration of productiv ity than is implicit in the staff forecast. If so, the equilib rium real fun ds rate wou ld also be low er than is imp licit in the Greenbook, and more forceful policy ease could be seen as necessary to achieve the correct co nfiguration of the a ctual and equilibrium real rate s. (18) If the Committee reduces the funds rate 50 basis points while retaining a statement of risks weighted toward econ omic weakness, short-term interest rates would likely fall, especially as markets build in further easing this year and defer some of the policy tightening now expected for 2002. Equity markets would be buoyed by the move, but the rally could prove transitory if subsequent earnings reports prove disappointing as is likely under the staff forecast. Real bond yields would likely fall as a consequence of the policy action, and–un less the initial equity market rally were particularly vigo rous–nom inal yields could decline som e as well. Any in crease in inflatio n expe ctation s wou ld be sh ort-lived if, consisten t with the Comm ittee’s rationale for its action, the markets subsequently receive evidence of persisting weakness in economic activity and damped inflation. (19) Borrowing by nonfederal sectors is expected to moderate slightly in the second half of the year, in line with the slowing in nominal income growth under the Greenbo ok forecast. Cred it supply cond itions for busine sses are likely to contin ue to tighten in coming mo nths amid signs of further deterioration in the qua lity of weaker borrowers and unfavorable news on corporate earnings. Nevertheless, with the econom y strengthenin g later this year and in 2002, a wides pread contra ction in credit availability is not forese en under th e staff forecast. Businesse s are anticipated to 15 maintain a moderate pace of borrowing, despite softness in capital expenditures and a reduced rate of equity retirements, as sluggish cash flow prompts firms to rely more on external funds. Household deb t growth is forecast to drift down, reflecting a slower pace of spending on consumer durables and the paydown of some credit card debt with a portion of the tax rebates. In the mon ths just ahead, the Treasury is projected to become a net borrower to finance tax rebates, but then to resume paying down debt over the final months of the year. Mainly reflecting this pattern, growth of total domestic nonfinancial debt is forecast to pick up some in the next few months and then to mo ve down o ver the rest of the yea r, bringing gro wth for the yea r to 5 percent. (20) With the w aning of the effects o f previous po licy easings on op portunity cost and money demand, M2 is projected to slow to a 5½ percent growth rate over the June-to-December period under the staff forecast. While tax rebates should boost M2 holdings somewhat in the months ahead, a reduced level of mortgage refinancings likely will restrain growth of this aggregate. Given the Greenbo ok forecast of only a small decline in equity prices, the projection does not incorporate a renewal of investor shifts from the stock market to M2 assets. M2 is expected to post growth of 8¼ percent this year, im plying a 4¼ percent decline in its velocity. The ex pansion of M 3 is projected to slo w to a 7½ percent pace o ver the June-to -Decemb er period, as gro wth of institution al money funds slo ws with the s tabiliz ing of short-term interest rates. Over the fo ur quarters o f the year, M3 w ould expan d 11 percent. 16 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 ___4 percent. (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 HEIG HTEN ED IN FLAT ION P RESS URE S] [continue to b e weighted m ainly toward con ditions that m ay generate eco nomic w eakness] in the forese eable future. 17 Appendix The reaction of financial markets to changes in monetary policy this year has varied considerably and proved difficult to predict. The table below indicates how stock prices and Treasury coupon yields have responded to the five easings undertaken earlier in the year. The first column shows the “surprise” com ponent of each adjustment in the target funds rate, which is inferred from th e change in a near-term federal funds futures contract around the time of a policy announcement. In the afternoons following the first three easings this year, equity prices responded rather strongly to the su rprise in policy actio ns, probably b ecause investors w ere quite uncertain and concerned about the near-term outlook for the economy, and the “surprise” affected confidence as well as the outlook for interest rates. The consequen ces for the econo my and for future policy o f the shift in attitudes an d equity market reactions appeared to cause nominal Treasury yields to move in the same direction as stock prices, rather than in the direction o f the policy surpr ises. In April, however, with investors already becom ing more optimistic about the eco nomic future, a traditional response of market interest rates occurred following the u nexpected policy easing–the equity price rise was more moderate relative to the degree of surprise and yields fell. In the wake of the easing at th e May FO MC m eeting, which w as a little greater than the average of market expectations, short-term Treasury yields dropped, as would traditionally be expected, but stock prices and long-term yields were about unchanged. Policy Surprises and the Responses of Equities and Treasuries Date of Policy Move Jan. 3 Policy Surprise (b. p.) Wilshire Index (percent) 2-Year Treasury Yield (b. p.) 10-Year Treasury Yield (b. p.) 10-Year TIPS Yield (b. p.) Memo: Nominal long rates responded primarily to: - 39 5.8 2 21 6 Equity Prices Jan. 31 4 - 1.0 -8 -4 0 Equity Prices Mar. 20 7 - 3.0 -12 -6 0 Equity Prices April 18 - 44 2.2 -34 -17 -9 Policy Surprise May 15 -9 0.1 -9 2 1 ... M2 --------------------------Ease Ease No move 50 b.p. 25 b.p. --------------------------Monthly Growth Rates Feb-2001 10.9 10.9 10.9 Mar-2001 14.4 14.4 14.4 Apr-2001 10.4 10.4 10.4 May-2001 5.1 5.1 5.1 Jun-2001 8.2 8.2 8.2 Jul-2001 6.7 6.3 5.9 Aug-2001 7.5 6.7 5.9 Sep-2001 8.4 7.6 6.8 Oct-2001 6.9 6.2 5.5 Nov-2001 4.7 4.2 3.7 Dec-2001 4.9 4.5 4.1 M3 --------------------------Ease Ease No move 50 b.p. 25 b.p. --------------------------- M2 M3 Debt --------------------------Greenbook Forecast* --------------------------- 9.9 9.5 17.6 13.3 11.5 8.7 8.0 8.0 7.9 7.5 7.2 9.9 9.5 17.6 13.3 11.5 8.5 7.6 7.6 7.5 7.2 7.0 9.9 9.5 17.6 13.3 11.5 8.3 7.2 7.2 7.1 6.9 6.8 10.9 14.4 10.4 5.1 8.2 5.9 5.9 6.8 5.5 3.7 4.1 9.9 9.5 17.6 13.3 11.5 8.3 7.2 7.2 7.1 6.9 6.8 5.0 6.0 3.4 3.2 5.7 5.4 6.2 5.9 3.3 3.6 4.0 Quarterly Averages 2000 Q2 2000 Q3 2000 Q4 2001 Q1 2001 Q2 2001 Q3 2001 Q4 6.4 5.7 6.3 10.7 10.0 7.3 6.6 6.4 5.7 6.3 10.7 10.0 6.9 6.0 6.4 5.7 6.3 10.7 10.0 6.5 5.3 9.0 8.8 7.0 12.2 13.5 9.7 7.8 9.0 8.8 7.0 12.2 13.5 9.5 7.5 9.0 8.8 7.0 12.2 13.5 9.3 7.1 6.4 5.7 6.3 10.7 10.0 6.5 5.3 9.0 8.8 7.0 12.2 13.5 9.3 7.1 6.1 4.6 4.5 4.8 4.4 5.5 4.4 Growth Rate From To Dec-2000 May-2001 Dec-2000 Jun-2001 May-2001 Dec-2001 Jun-2001 Dec-2001 10.8 10.4 6.9 6.6 10.8 10.4 6.3 6.0 10.8 10.4 5.8 5.4 13.5 13.3 8.6 8.0 13.5 13.3 8.3 7.7 13.5 13.3 8.0 7.4 10.8 10.4 5.8 5.4 13.5 13.3 8.0 7.4 4.2 4.5 4.9 4.8 2000 Q4 May-2001 2000 Q4 Jun-2001 2000 Q4 Dec-2001 10.3 10.0 8.6 10.3 10.0 8.3 10.3 10.0 8.0 13.2 13.0 11.0 13.2 13.0 10.8 13.2 13.0 10.7 10.3 10.0 8.0 13.2 13.0 10.7 4.5 4.7 4.8 6.2 8.9 6.2 8.6 6.2 8.3 9.2 11.2 9.2 11.1 9.2 10.9 6.2 8.3 9.2 10.9 5.3 4.9 1999 Q4 2000 Q4 2000 Q4 2001 Q4 * This forecast is consistent with nominal GDP and interest rates in the Greenbook forecast. 

Federal Reserve (2001, June 26). Bluebook. Bluebooks, Federal Reserve. https://whenthefedspeaks.com/doc/bluebook_20010627

@misc{wtfs_bluebook_20010627,
  author = {Federal Reserve},
  title = {Bluebook},
  year = {2001},
  month = {Jun},
  howpublished = {Bluebooks, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/bluebook_20010627},
  note = {Retrieved via When the Fed Speaks corpus}
}