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 December 6, 2001 M ONETARY POLICY ALTERNATIVES Recent Developments (1) In advance o f the Novem ber FOM C meeting , investors were u ncertain whether the Com mittee would choose to ease po licy 25 or 50 basis points, but they seemed sure that the Committee would continue to view the risks to the outlook as weighted to ward econ omic wea kness. In the even t, the announ cement of th e 50 basis point rate cut–along with the expected statem ent of unbalanced risks–led market participants to mark down short- and intermediate-term interest rates and to boost equity prices, while leaving longer-term rates about unchanged.1 Subsequent economic data came in on the high side of expectations on balance, and with military operations in Afghanistan making substantial progress, investors appeared to become more optim istic about econom ic prospects and in creasin gly willing to take on risk. Futures m arket quotes in dicate that investo rs place high o dds on a furth er 25 basis point easing move at this meeting; the federal funds rate is apparen tly expected to rise thereafter, reaching about 4¾ percent by the end of 2003– a level about 10 0 basis points higher than was ex pected at the time of the N ovem ber m eeting (Chart 1). (2) Reflecting these changed economic and policy expectations, as well as the ebbing of flight-to-safety demands, yields on Treasury coupon securities have climbed 65 to 80 basis points, w ith the largest increa ses posted at interm ediate 1 The federal funds rate has averaged very close to its intended level of 2 percent over the intermeeting period. The Desk purchased $8.6 billion of Treasury securities in outright operations over the period, including $3.3 billion of Treasury bills ($1.3 billion of which was from foreign official institutions) and $5.3 billion of coupon securities. To accommodate the seasonal increase in currency demands, the outstanding volume of long-term System RPs was raised $5 billion to $28 b illion. Chart 1 Financial Market Indicators Expected Federal Funds Rates Estimated from Percent Financial Futures* Selected Treasury Yields* Percent 5.0 7.0 Daily 6.5 4.5 6.0 Ten-year 4.0 5.5 3.5 5.0 Two-year 4.5 3.0 4.0 December 6, 2001 Ten-Year TIPS 2.5 3.5 3.0 2.0 November 5, 2001 2.5 1.5 Dec 2001 Mar Jun Sep 2002 Dec Mar Jun 2003 2.0 Sep Sep *Estimates from federal funds and eurodollar futures rates with an allowance for term premia and other adjustments. 15 Mar 13 Daily Jul 2001 Sep Nov Percent 12 Percent 50 Weekly 12 High Yield (left scale) 11 13 11 40 Long-term Treasury Bond (left scale) 10 12 10 9 Ten-year BBB (right scale) 11 May Capital Market Volatility* Percent 14 Jan *Nominal Treasury yields are estimated from a smoothed yield curve based on off-the-run securities. Selected Private Long-Term Yields Percent Nov 2000 8 10 30 9 20 7 9 Ten-year Swap (right scale) 6 8 S&P 500 (right scale) 8 10 5 7 Sep Nov 2000 Jan Mar May Jul 2001 Sep Sep Nov Nov 2000 Jan Mar May Jul 2001 Sep Nov *Implied volatilities calculated from options. Selected Equity Indexes Index(8/31/00) = 100 120 Daily DJIA 100 Nominal Trade-Weighted Dollar Exchange Rates Index(8/31/00) = 100 110 Daily 108 Broad Index Other Important Trading Partners 106 80 Wilshire 5000 104 60 Nasdaq 102 Major Currencies Index 40 Sep Nov 2000 Jan Mar May Jul 2001 Sep Nov Note: Solid vertical line indicates November 6 FOMC meeting. Sep Nov 2000 Jan Mar May 100 Jul 2001 Sep Nov -2- maturities (see the box on “F inancial M arket Cond itions” on the n ext page). 2 Yields on Treasury inflation-indexed securities have mov ed up about 35 to 55 ba sis points, sugge sting th at mu ch of th e increase in n omin al yield s owed to their real comp onents. With concerns about the economic outlook diminishing, yields on investment-grade corporate bo nds have incr eased consider ably less than tho se on com parable Treasuries, while yields on speculative-grade bonds have declined substantially, bringing risk spreads on such bon ds back to the levels of early September. The failure of Enron Corporation, a major wholesale energy trading firm, put some pressure on the securities of firms in similar and related businesses, as well as on those of banks thought to h ave substantial ex posures to E nron. Altho ugh liquidity in energy mar kets was reportedly reduced and price movements were volatile at times, effects in financial markets more generally were m uted. Broad stock price indexes have increased roughly 6 p ercent over the p eriod, while the N asdaq has risen more than 14 percent. (3) The trade-weighted index of the do llar’s exchange value against other major curr encies has risen sligh tly on balance o ver the interm eeting period. A mid indications of flagging activity, the European Central Bank, the Bank of England, and the Bank of Canada lowered their policy rates 50 basis points. Central bank action, along with b etter U.S. data, con tributed to the p erception that a widespread econom ic rebound was in train, pushing up yields on long-term government bonds abroad, although the increases have been less than in the United States. Stock prices have risen about 6½ percent on average in Europe and 7¾ percent in Canada. Once again, Japan was an exception as economic news proved disappointing: Government bond yields have edged higher, and broad stock indexes are flat on net. Comments from 2 The political battle over the size and content of a possible stimulus package did not seem to hav e a significant effect o n the Treasu ry market o ver the period . -3Financial Market Conditions Over th e interm eeting pe riod, inter est rates ha ve been especially volatile an d appe ar to have been unusually sen sitive to econom ic news and statements by o fficials. In part, this may owe to the uncertainty surrounding the current economic outlook as market participants seek out clues as to whether an economic rebound is at hand. In the Treasury market, some of the backup in yields probably represented an unwinding of the abrupt declines that followed the announcement on October 31 of the suspension of issuance of thirty-year bonds. Overall, upward movements in long-term yields may have been am plified to som e extent by inv estors’ attempts to red uce the dura tion of their portfolios as high er rates trimme d the prepay ment risk of m ortgage-back ed securities. Market reports suggest that the Treasury market has been less liquid than typical, perhaps contributing to the volatility in yields. Bid-asked spreads on Treasury securities widened at times, and the amounts bid or offered have been smaller than usual. Some market participants have reportedly closed out positions ahead of year-end and may have been reluctant to assume new positions amid the extensive volatility of asset prices. Some withdrawal from the market associated with year-end positioning also may have contributed to a recent rise in fails-to-deliver Treasury securities, although the elevated level of fails likely also reflects the low lev el of short-term in terest rates. To date, year-end pressures in financing markets have generally been in the range observed in recent years. In the federal funds and eurodollar deposit markets, the rates at which banks c an borr ow fun ds over year-en d have risen on ly slightly re lative to th e rate on Treasury repurchase agreements of similar maturity (Chart 2). Similarly, highly rated firms in the commercial paper market have had to pay only a small premium to borrow funds over year-end. Spreads for lower-rated issuers of commercial paper, which have been elevated since Septem ber, have increased noticeably for instrumen ts spanning yearend. Japanese officials about possible intervention to weaken the yen and reports that the Bank of Japan may consider purchasing foreign currency bonds contributed to a 2½ percent net increase in the yen-dollar exchang e rate. ; U .S. monetary authorities did not intervene. Chart 2 Year-End Pressures Yield Spreads over One-month Treasury RP Rate Basis Points 250 One-month Eurodollar Rate One-month Federal Funds Rate 200 150 100 50 0 -50 Jun Sep 1997 Dec Mar Jun Sep 1998 Dec Mar Jun Sep 1999 Dec Mar Jun Sep 2000 Dec Mar One-month A2/P2 Commercial Paper Rate over One-month Treasury RP Rate Jun Sep 2001 Dec Basis Points 250 200 150 100 50 0 -50 Jun Sep 1997 Dec Mar Jun Sep 1998 Dec Mar Jun Sep 1999 Dec Mar Jun Sep 2000 Dec Note. Vertical lines represent the first day on which the rates shown encompass year-end. Last observation for commercial paper is on December 5, 2001. Mar Jun Sep 2001 Dec -4- (4) Deepening concerns over the Argentine government’s chances of staving off default apparently have had little spillover to other emerging m arket economies, and the dollar’s exchange value against the cu rrencies of our other impo rtant trading partners has declined so mewhat ov er the interm eeting period. Argentine officials began to implement a debt exchange and, faced with mounting pressures on th e nation’s bank s, announced a set of measur es to limit withd rawals from the banking system and to restrict capital outflows. On balance, the yield spread of Argentina’s debt over Treasuries has risen more than 900 basis points over the period. In contrast, in Mexico and Brazil, bond yield spreads over Treasuries have narrowed substantially. The M exican peso has changed little on net against the dollar, but the Brazilian real has appreciated 6½ percent. Stock prices in Asian developing economies with significant technology-based ex port sectors have posted increases between 10 and 30 perce nt. (5) Nonfeder al debt has exp anded at abo ut a 5¾ pe rcent average p ace in recent months (Chart 3). Despite declining investment spending, business debt growth appears to have picked up in October and November. Low yields on investment-grade bonds evidently hav e encouraged many firm s to lock-in longer-term financing, while the recovery of the junk bond m arket from the effects of the terrorist attacks in September ha s allow ed selected sp eculative-gra de borrowers to issue as w ell. Firms appear to have used the proceeds to strengthen their balance sheets by paying down short-term debt and accumulating liquid assets. Household mortgage debt growth has remained fairly strong, as very low mortgage rates have supported ro bust housing and refinancing activity. The heavy volum e of auto sales posted in October and November has likely boosted consumer credit growth some. With the funding of rebate checks co mpleted, federa l debt change d little (on a seasonally adjusted basis) in October a nd Nov ember. Th e cutback in fed eral debt issuanc e restrained gro wth in Chart 3 Growth of Money and Debt Aggregates Growth of M2 Growth of M3 Percent Percent 28 Annualized 28 Annualized 26 26 24 24 22 22 20 20 18 18 p p Q1 Q2 J 2000 A S 2001 O N 16 16 14 14 12 12 10 10 8 8 6 6 4 4 2 2 0 0 -2 -2 -4 Q1 Q2 J 2000 p - Preliminary. -4 A S O N 2001 p - Preliminary. Growth of Total Nonfinancial Debt Growth of Nonfederal Nonfinancial Debt Percent Percent 16 Annualized 16 Annualized 14 14 12 12 10 10 8 8 p 6 6 p 4 4 2 2 0 0 -2 -2 -4 Q1 2000 p - Preliminary. Q2 J A S 2001 -4 O N Q1 2000 Q2 J A S 2001 O N p - Preliminary. MARA:MI -5- total domestic nonfinancial debt to a 4½ percent pace in October from an average of about 6 perc ent in the prior few months. (6) M2 growth, at a 9¼ percent rate in November, remained robust but was below its average pace over Septem ber and October, ow ing in part to some further unwinding of the high level of business demand deposits that accumulated in the aftermath of the September terrorist attacks and that were not completely drawn down until late in October. Growth in M2 money funds slowed appreciably as reduced concerns about the eco nomic outlook and increases in equity values likely led some investors to reallocate balances from money funds back into equities. Indeed, there were inflows into equity mutual funds in November following a sizable outflow in September and little net change in October. For the year, M2 is estimated to have expanded 10¼ percent on a four-quarter basis, compared with projected growth of nominal in come of on ly 1½ percen t. M2 grow th was boo sted largely by de clines in opportunity costs, the heavy pace of mortgage refinancing, and the disenchantment of investors with the stock market. (An appendix contains a discussion of money and credit in 2001.) 6 MONEY AND CREDIT AGGREGATES (Seasonally adjusted annual percentage rates of growth) Aug 2001 Sep 2001 Oct 2001 Nov 2001 (p) M2 8.2 26.7 -1.5 9.2 M3 0.8 25.0 10.6 15.9 Domestic nonfinancial debt Federal Nonfederal 6.7 7.6 6.5 8.0 12.3 7.1 4.4 0.0 5.4 n.a. n.a. n.a. Bank credit Adjusted1 3.2 -0.6 15.3 13.3 -6.0 -7.3 6.6 5.1 15.4 15.1 47.2 44.5 -19.1 -15.7 -1.0 -0.5 Money and Credit Aggregates Memo: Monetary base Adjusted for sweeps 1. Adjusted to remove the effects of mark-to-market accounting rules (FIN 39 and FASB 115). p -- preliminary -7- Short-run Policy Alternatives (7) On balan ce, economic data over the in termeeting p eriod have ten ded to run somewhat firmer than had been expected by the staff at the time of the November meeting, and equity prices have risen. As a consequence, the Greenbook forecast for real activity has been strengthened slightly. Under the assumption that the Committee leaves the target funds rate unchanged through 2002 before firming policy during 2003, the staff projects that long-term interest rates will drift down a little, the foreign exchange value of the dollar will hold near its current level, and stock prices will stay about flat through next year and edge high er thereafter. The forecast again assumes the passage of legislation that will provide substantial additional fiscal stimulus starting in the first half of next y ear. Against this b ackdrop, real G DP is anticipated to flatten out early next year and then rebound to a growth rate somewhat above that of its potential over the remainder of the pro jection period. The near-term decline in output is expected to push the unemployment rate to about 6 percent next year, and unemploym ent then edges lower over 2003. The slack in resou rce utilization, declining energy costs, and reduced inflation expectations lead to some diminutio n of underlyin g inflation, with th e increase in the co re PCE in dex falling to about 1 perc ent in 2003 from its recent peak of ab out 2 percen t. (8) Even though the prospect of further near-term deterioration in the economy is unappea ling, the Committee m ay view this outcome as unavo idable given the lags in mo netary policy. If the C ommittee saw good prospects of a rela tively strong rebound in the economy beginning in the next few quarters, it might leave the stance of monetary policy unchanged. The unexpected strength of several indicators of consum ption and in vestment cou ld be read as su pporting a v iew that econ omic weakness is ab ating and a tu rnaround in spending is in train. Indeed, the rise in equity prices and real in terest rates of late likely pro vides evidence th at market par ticipants -8- have become m ore optimistic on that score. Such a turnarou nd would be sup ported by the monetary stimulus pu t in place–a substantial portion of which has occu rred only recently–that has positioned the real federal funds rate well below the range of estimates of its equilibrium value (see Chart 4 and the tab le on the next page). In these circums tances, the Com mittee may w ish to bide its tim e, awaiting data th at will help it gauge the effects of policy actions to date as well as the resolution of uncertainty on the fiscal policy fron t. (9) Because m arket prices app ear to incorpo rate high odd s on a 25 basis point easing of monetary policy at this meeting, leaving the target federal funds rate at 2 percent wo uld pr ompt an appreciable inc rease in money market interest rates. Longer-term yields could rise somew hat as well; the extent of the backup, however, would probably be lim ited as long as the Comm ittee, as expected by investors, reiterated its assessm ent that the balan ce of risks is weighte d toward e conomic weakness. H owever, long -term yields wo uld likely rise by m ore, and the do llar could firm, if the Com mittee’s annou ncement su ggested som e optimism about econ omic prospects despite its formal assessment of the balance of risks and, especially, if the Committee shifted to a statement that the risks were balanced. Equity prices might drop initially, but, again, any sense conveyed in the announcement of good odds that the economy wo uld begin to recover before long w ould probably limit the decline. (10) The Com mittee might choose to ease policy 25 basis po ints if it viewed the recent positive news on spending as quite tentative and not providing sufficient assurance that a rebound is in store before long. Moreover, the Committee might be worried about th e possibility o f specific shoc ks that could derail the recovery. Consumer sentiment could decline further in the event of additional terrorist actions or if the current military conflict proves more diffic ult and protracted than expecte d. And, equity prices may be seen as embedding unrealistically high expectations for Chart 4 Actual Real Federal Funds Rate and Range of Estimated Equilibrium Real Rates Percent 5 Quarterly Actual Real Funds Rate 4 Historical Average: 2.79 (1966Q1-2001Q3) 3 2 1 ● ● ● 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Current Rate 25 b.p. Easing 50 b.p. Easing 2002 Note: The shaded range represents the maximum and the minimum values each quarter of five estimates of the equilibrium real federal funds rate. Real federal funds rates employ four-quarter lagged core PCE inflation as a proxy for inflation expectations, with the staff projection used for 2001Q4. Percent Equilibrium Funds Rate Estimates ______ Method 2000 ____ 2001H1 ______ 2001Q3 ______ 2001Q4 ______ -Based on historical data* October Greenbook 2.7 2.6 2.4 2.4 2.3 2.3 2.2 2.3 -Based on historical data and the staff forecast October Greenbook 2.5 2.4 1.9 1.9 1.8 1.8 1.7 1.7 -Based on historical data** October Greenbook 3.8 3.8 2.6 2.9 2.0 2.1 1.9 2.1 -Based on historical data and the staff forecast October Greenbook 2.9 2.9 2.4 2.6 2.4 2.5 2.5 2.7 4.2 4.2 3.9 3.9 3.8 3.8 3.8 4.0 Statistical Filter FRB/US Model Treasury Inflation-Indexed Securities October Greenbook * Also employs the staff forecast for 2001Q4 and 2002Q1. ** Also employs the staff forecast for 2001Q4. Backward-looking moving averages, rather than centered moving averages, are used to estimate the persistent and transitory components of shocks to the model. 0 -9- earnings as well as an unusually low equity risk premium. Should investor expectations be disappointed or the equity premium move back toward its historical norm, equ ity prices could re verse their recent g ains, adding to th e drag on h ousehold spending. In addition, the appearance of stalemate in the Congressional debate on a fiscal stimulus package may be seen as raising the odds that agreement will not be forthcoming. An alternative simulation in the Greenbook illustrated that, without additional fiscal stim ulus, the econo mic recovery could be no ticeably more anemic than envisioned in the baseline forecast. While these downside risks may not materialize, the Committee might view the cost of erring on the side of ease as low at this time given the degree of slack at present in resource utilization and the likelihood that inflation will remain subdued or drift down somewhat in the near term. (11) Because inves tors expect the C ommittee to ease 25 basis po ints and to retain its assessment that the risks are weighted toward economic weakness, financial market prices would likely change little in response to such a p olicy decision. Market participants probably would perceive the 25 basis point move, following three larger steps, as an indication that the easing cycle could be drawing to a close. If the Committee wanted to underscore that perception in markets, it could indicate that the risks were now balanced. In that event, market interest rates could rise as investors moved forward their prevailing expectations of policy tightening, but stock prices and the for eign ex chang e value of the d ollar w ould b e supp orted if the Federal Reserve’s less pessimistic outlook led market participants to revise up their expectations for the rebou nd in e conomic ac tivity. (12) The Com mittee might consider reducing th e target federal funds rate 50 basis poin ts at this meeting if it thought an unacceptably large opening of slack in the economy was likely. As discussed in the box “A ‘Perfect Foresight’ Policy” on page 11, a “perfect foresigh t” rule that uses all th e information contained in th e staff - 10 - outlook to determine a path for the funds rate that minimizes squared output and inflation gaps over the entire forecast period calls for considerable additional nearterm policy easing to counter the projected upward pressure on the unemployment rate. A further sizable easing may be justified not only on the grounds of generating better results than in the staff forecast, but also on the view that the forecast itself has overestimated effective policy stimulus or does not give sufficient weight to forces that will continue to hold back the economy. In particular, if inflation expectations are lower than is embedded in the baseline forecast, then the real short-term interest rate is higher and that will keep real long-term rates elevated and redu ce inflation even further than in the staff forecast. Adjusting the nominal funds rate low er in response to the apparen t drop in inflation expectations m ight be viewed as especially desirab le if the Committee believed that substantial restraints to private domestic spending persist or that the d ownturn abroad is likely to be exacerbated by financial strains in certain foreign economies. Moreo ver, as discussed in a box in the Novem ber bluebook, the possibility that conventional monetary policy action ultimately could be constrained by the zero boun d to nominal interest rates might incline the C ommittee to take prompter and more aggressive action now to stimulate economic activity. The Comm ittee might also v iew the 1 perce nt core PC E inflation rate p rojected to prev ail toward the end of the forecast interval as too low to p rovide a comfortable buffer against hitting the zero bound to nominal interest rates in the event of a substantial adverse shock to the econom y in the future. (13) A 50 basis p oint policy easing at this meeting w ould be large r than is embedded in financial market prices. Although short-term rates would decline sharply, the respo nse of long-term yields, stock prices, and the dollar wo uld depend in part on whe ther in vestors saw th e exten t of the move as sug gesting, on th e one h and, - 11 A “Perfect Foresight” Policy Examining the policy dubbed “perfect foresight” in the June bluebook may provide some perspective on the Committee’s decision at this meeting. Under this policy, the policym aker is ass umed to choo se a path for the fe deral fun ds rate w ith com plete knowledge of all the forces shaping the outlook. The experiment extends the Greenbook outlook through 2006 using the FRB /US m odel w ith certain judgm ental adju stments to the model that preserve the central features underlying the staff outlook. In particular, the rate of increase in potential output is a little over 3 percent after 2003, a slight rise from this year and next. The degree of labor market slack consistent with stable inflation (the effective NAIRU) holds at about 5¼ percent. Growth abroad strengthens to 3¾ percent by 2003, and the dollar is assumed to depreciate at a 3 percent annual rate in real terms after 2003, 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 1 percent of nominal GDP, up from about zero in 2003. The sol id line in th e uppe r left pane l of Cha rt 5 show s the path for the fe deral fun ds rate assumed in the Greenbook out to 2003. The dotted line plots the federal funds rate that would be chosen by a policymaker assumed to have perfect foresight starting at the beginning of next year. Effectively, this assumes that the policymaker is certain that the model accurately describes the economy and that the baseline correctly captures all of the forces impinging on the economy. The funds rate path is chosen to minimize the sum of squared deviations of output from its estimated potential and inflation from an assumed long-run target of 1 percent, with a small penalty applied to changing the funds rate. The policymaker is assumed to view both the output and inflation gaps with equal distaste, and the penalty on interest-rate changes was selected to deliver policy predictions that make the funds rate about as volatile as it has been over the past ten years. This rule calls for additional aggressive easing by holding the funds rate lower for longer than either the Greenbook a ssumption or the expectations now implicit in market prices. Howev er, given this ease early in the forecast period, a perfect-foresight policy has to firm earlier and mo re abruptly than the path assum ed in the G reenbook and to run su bstantially tighter for longer in the latter part of the simulation period to achieve the longer-run inflation objective. that the economy was con siderably weaker than they had perceived o r, on the other, that the Com mittee was inte nt on restoring strong grow th more q uickly and w ith more certain ty than previou sly appreciated. In th e first case, bond yield s, equity Chart 5 Perfect Foresight Policy 1 Nominal Federal Funds Rate Real Federal Funds Rate Percent Percent 7 Percent Percent 7 6 6 5 5 5 4 4 4 3 3 3 3 2 2 2 2 1 1 1 1 0 0 0 -1 6 0 Greenbook Perfect Foresight 2000 2001 2002 2003 2004 2005 2006 6 Greenbook Perfect Foresight 2000 2001 2002 2003 2004 2005 2006 5 4 -1 Civilian Unemployment Rate Percent Percent 6.5 6.5 6.0 6.0 5.5 5.5 5.0 5.0 Greenbook Perfect Foresight 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 2.5 2.5 Greenbook Perfect Foresight 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. 2005 2006 0.5 - 12 - prices, and the exchange value of the dollar all could drop significantly, while, in the second, the decline in bond yields would be significantly smaller and stock prices and the do llar could rally. (14) Given the interest rate assumptions and nominal income projection of the Greenbook forecast, M2 growth is forecast to slow somewhat in coming months from its averag e pace over 200 1, as the influence o f previous easing s on oppo rtunity costs and the d emand for M2 begin s to ebb. Still, M2 growth is exp ected to rem ain relatively brisk: The record surge in mortgage refinancing that is now under way should bu oy M2, and continued str ong dem ands for U.S . currency abro ad owing to unsettled conditions in some countries and, perhaps, a temporary surge in demands for U.S. banknotes around the time of the introduction of euro notes early next year could also spur that aggregate. On balance, M2 is expected to expand at a 7¾ percent annual rate over the November-to-March period. With M2 growth staying well above that of nominal income, velocity continues to drop in the first quarter, although the decline is expected to slow to a 6¼ percen t annual rate. (15) Over the period from October to March, the expansion of nonfederal debt is expected to remain near the 6 percen t pace of recent months. In the business sector, borrowing again should be concentrated heavily in the bond market, as firms take advantage of relatively low long-term interest rates. C&I loan growth and comm ercial paper issuan ce probably w ill stay weak, main ly reflecting the shift to longer-term funding, although continued firming of loan terms and standards and investor resistance to relatively low-grade commercial paper cou ld also play a role. In the household sector, the refinancing boom should augment the expansion of mortgage debt over the next few months, while consumer credit is likely to edge higher on net, owing in part to a dro p-off in growth of expenditures on co nsumer - 13 - durables. With federal debt again expanding, total domestic nonfinancial sector debt is projected to rise at a 5 percent annual rate from October through March. Alternative Growth Rates for Key Monetary and Credit Aggregates M2 -----------------------------Alt. B Alt. A Alt. A’ ------------------------------ M2 M3 Debt -----------------------------Greenbook Forecast* ------------------------------ Monthly Growth Rates Apr-2001 May-2001 Jun-2001 Jul-2001 Aug-2001 Sep-2001 Oct-2001 Nov-2001 Dec-2001 Jan-2002 Feb-2002 Mar-2002 10.1 5.3 9.9 9.1 8.2 26.7 -1.5 9.2 8.5 8.3 8.0 6.2 10.1 5.3 9.9 9.1 8.2 26.7 -1.5 9.2 8.7 8.9 8.8 7.0 10.1 5.3 9.9 9.1 8.2 26.7 -1.5 9.2 8.9 9.5 9.6 7.7 10.1 5.3 9.9 9.1 8.2 26.7 -1.5 9.2 8.5 8.3 8.0 6.2 19.1 13.7 13.0 6.9 0.8 25.0 10.6 15.9 10.5 9.5 9.0 7.6 5.2 6.6 6.1 3.8 6.7 8.0 4.4 4.6 5.8 3.2 4.4 6.8 Quarterly Averages 2000 Q2 2000 Q3 2000 Q4 2001 Q1 2001 Q2 2001 Q3 2001 Q4 2002 Q1 6.3 5.6 6.0 9.8 9.7 10.7 9.3 8.2 6.3 5.6 6.0 9.8 9.7 10.7 9.4 8.7 6.3 5.6 6.0 9.8 9.7 10.7 9.4 9.2 6.3 5.6 6.0 9.8 9.7 10.7 9.3 8.2 9.0 9.1 7.3 13.1 14.7 9.7 14.0 10.2 6.1 5.0 4.4 4.8 5.9 5.8 5.7 4.6 Growth Rate From Dec-2000 Dec-2000 Oct-2001 Nov-2001 To Oct-2001 Nov-2001 Mar-2002 Mar-2002 10.6 10.5 8.1 7.8 10.6 10.5 8.6 8.4 10.6 10.5 9.1 9.0 10.6 10.5 8.1 7.8 13.4 13.8 10.7 9.3 5.7 5.6 5.0 5.1 2000 Q4 2000 Q4 2001 Q4 Oct-2001 Nov-2001 Mar-2002 10.3 10.3 7.9 10.3 10.3 8.5 10.3 10.3 9.0 10.3 10.3 7.9 13.3 13.7 9.7 5.7 5.6 5.0 1999 Q4 2000 Q4 2000 Q4 2001 Q4 6.1 10.3 6.1 10.3 6.1 10.3 6.1 10.3 9.4 13.5 5.3 5.6 * This forecast is consistent with nominal GDP and interest rates in the Greenbook forecast. - 14 - Directive and Balance-of-Risks Language (16) Presented below for the members' 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 Committee seeks monetary and financial conditio ns that will foster p rice stability and pr omote sustainable growth in output. To further its long-run objectives, the Comm ittee in the imm ediate future seeks conditions in reserve mark ets consistent with MAINTAININ G/INCRE ASING/reducing the federal funds rate AT/to an average of around ___2 percent. (2) “Balance of Risks” Sentence Against the background of its long-run goals of price stability and sustainable economic grow th and of the information currently available, the Committee believes that the risks [ARE BALANCED WITH RESPECT TO PROSPECTS FOR BOTH GOALS] [ARE WEIGHTED MAINLY TOWARD CONDITIONS THAT MAY GENERATE HE IGHTENED INFLATION PRESSU RES] [continue to be weigh ted mainly to ward con ditions that m ay generate eco nomic weakness] in the foreseeable future. - 15 - Appendix: Review of Deb t and Money Grow th in 2001 The econo mic contractio n and declin e in interest rates this yea r left a noticeable imprint on the comp osition of financial flows. In general, credit flows shifted toward bond s and m ortgages, as b orrow ers too k adva ntage of low er long-term interest rates. A decline in capital expenditures and inventory financing needs led to a sharp slowing in overall busin ess borrowin g, but lower in terest rates helped to keep househ old credit expansion brisk. Federal debt contracted at a much slower pace than in 2000, as the federal government resum ed net borrowing in the secon d half of the year in response to a reemergence of unified budg et deficits. The decline in short-term interest rates resulting from the easing of monetary p olicy, combined with increased safe-haven demand for liquid assets that likely reflected investors’ disenchantment with the stock market, contributed to rapid growth of the broad monetary aggregates in 2001. Domestic Nonfinancial Sector Debt Despite anem ic expansion in nominal in come, the agg regate debt of d omestic nonfinancial sectors expanded 5½ percent in 2001, a bit faster than in the previous year.3 Nonfederal debt grew b riskly over the first half of the year, but slowed somewhat in the second half as the economy contracted. On balance, nonfederal debt decelerated to ab out 7¼ p ercent in 2001 fro m 8½ p ercent last year. By co ntrast, federal debt continued to shrink earlier in the year, but then resumed growing in the second half, a s the budget swun g into deficit owing to a d eterioration in tax receipts. For the year as a whole, the feder al governm ent paid dow n only 1½ percent of its debt, all of it during the first half, compared with 6¾ percent last year. Overall business borrowing slowed substantially from its strong pace of the previous several years. The financing gap contracted considerably as a drop in capital expenditures outpaced a shrinkage in intern al funds that stemmed from weaker profits. The c omposition of bu siness b orrow ing shifted to ward longer-term markets. Nonfinancial firms, especially those rated investment grade, took advantage of attractive longer-term interest rates and issued a large volume of bonds, using the proceeds to strengthen their balance sheets by paying down bank loans and commercial paper and by boosting liquid assets. The comm ercial paper market suffered severe setb acks in 2001, and the level of com mercial pape r outstanding fell sharply over the year. Early on, defaults of two California utilities and downgrades of 3 Annual growth figures are expressed as the change from the fourth quarter of the previous yea r to the fourth qu arter of the curren t year using staff pro jections. - 16 - the debt of other firms caused spreads between lower- and higher-tier issuers to soar for a time. More recently, market disruptions in the wake of the September 11 terrorist attacks, considerable year-end pressures, and concerns stemming from the bankruptcy of En ron C orporation led spr eads fo r lowe r-rated issuers to widen ag ain. In the banking sector, worries about deteriorating credit quality in an environment of declining economic activity led to a further tightening of business lending standards and terms over the course of the year. Bank s reported weaker deman d for C&I loans, mainly owing to reduced business outlays on capital equipment and inventories and a slower pace of merger activity. These factors, along with the shift to financing through the bond market, caused C&I loans at commercial banks to shrink for the first calendar year sin ce 1993. Growth in commercial mortgage debt remained brisk in 2001, even though nonresidential construction spending fell. Issuance of comm ercial mortgage-backed securities, buoyed by low interest r ates, remained fair ly robust thro ughout 20 01. With office vacancies on the rise and delinquency rates on commercial mortgages edging up from their recent historical lows, commercial banks, on net, firmed standards on comm ercial real estate loan s. In the household sector, strength in durable goods expenditures led to an acceleration of consumer credit in the first quarter. Growth in consumption spending slowed over the spring and sum mer, and the increase in consum er credit fell back sharply, resulting in a moderate gain for the year as a whole. By contrast, the low levels of mortg age rates spurred home m ortgage deb t to a rapid 10 p ercent advanc e in 2001. With the expansion of overall household debt continuing to outrun that of disposable pe rsonal incom e, the househo ld debt-service bu rden rose fairly stead ily over the year, edging closer to the previous peak. At the same time, the ratio of household assets to disposable income moved lower through the third quarter of the year, reflecting the decline in equity prices. In this environment, measures of household credit quality deteriorated som ewhat over the year. Delinquency rates rose on credit cards, home mo rtgages, and other consumer loans. Person al bankruptcy filings shot up to a record level early in the year, and remained well abo ve their yearearlier levels; part of the increase, though, reflected a rush to file before the passage of bankruptcy reform legislation. Despite the falling and volatile stock market, households con tinued net purchases of eq uity mutua l funds durin g the first half of the yea r. But when equity - 17 - prices dropped further during the summer, households responded by shifting investments from equities to bond and money fund s, a pattern that became more pronounced wh en equ ity markets re opened following the te rrorist attack s. Encouraged by a reco very in share prices beginning in Octob er, households resumed accumulating equity mu tual funds. State and local government debt expanded fairly rapidly this year, following slow growth in 2000. Gross issuance of municipal bonds accelerated early on, as local governments took advantage of lower yields to refund outstanding debt. Spurred by falling interest rates and declining tax rev enues, issuance o f long-term b onds to financ e new capital projects ma intained a rapid clip over the course of the year. Credit quality in the municipal market appeared to be topping out late in the year, as tax receipts softened owing to the contracting econo my. The federal go vernment c ontinued to pay down sizable amo unts of mar ketable debt over the first half of the year. By the middle of the summer, however, the tax cut, combined with the w eakening in the economy, led to a deterioration in receipts, and the Treasury announced that it planned to resume borrowing over the rest of the year. Emergency spending in the wake of the terrorist attacks further boosted the Treasury’s borrowing needs. Follow ing a 6 percent rate of contraction in the first half, the federal nonfinancial debt grew at a 3¼ percent pace over the second half of 2001. Depository Credit Growth of depository credit this year was well below that of total nonfinancial debt. Bank cre dit decelerated sign ificantly over the co urse of the year as lo an growth slowed sharply, although bank loans bulged temporarily after September 11 as businesses tapp ed backup lines of credit. An emic loan gr owth at do mestic commercial banks for the year as a whole was partially offset by robust acquisition of securities. The expansion of thrift credit is estimated to have slowed slightly from last year’s pace despite th e rapid grow th in hom e mortgag e debt. The deceleration in bank loans in 2001 reflected a drop-off in loan demand from busin esses and consu mers as well as a tightening of b anks’ lending stan dards in response to growing concerns about worsening asset quality. The net percentage of domestic banks that tightened standards and terms on business loans, which had trended up substa ntially in 2000, bega n to de cline o ver the first half of the year. However, in light of dimming economic prospects following the terrorist attacks, the - 18 - proportion of banks tightening business lending policies again increased. Commercial banks reported that the weaker demand for C&I loans over the course of the year owed mainly to a con tinued decline in customers’ need to finance capital expend itures, mergers and acquisitions, and inventories. In the second half of th e year, a mode rate net percentage of banks also started to tighten credit conditions for hou sehold loans. Monetary A ggregates M2 expanded at a rapid 10¼ percent pace this year, significantly above its 6 percent rate of gr owth in 200 0. The fallout from the events of Se ptember 11 is estimated to have directly contributed only a bit to M 2 growth in 2001. Mo re significantly, sharp declines in short-term interest rates, resulting from the easing of monetary policy over the year, lowered the opportunity cost of holding M2 assets and helped induce a record decline in M 2 velocity. In addition, households’ preferences for liquidity and safety apparently intensified in response to elevated stock market volatility and reduced expectations for corporate earnings growth, further boosting M2 growth. The unprecedented level of mortgage refinancing activity and large currency shipments abroad also sp urred this aggregate. Reflecting in part a surge in its M2 component, M3 grew 13½ percent in 2001, far outpacing the 9½ percent rate of increase last year. Institutional money funds experienced exceptional inflows in response to the decline in sho rt-term interest rates in 2001. By con trast, the flattening of b ank credit resulted in a sharp dece leration in the issuance of m anaged liabilities, inclu ding large tim e deposits. W ith growth in nominal income slowing sharply, M3 velocity dropped for the seventh year in the row. GROWTH OF THE CREDIT, MONETARY, AND RESERVE AGGREGATES (in percent)1 1997 1998 1999 2000 2001 (p) Domestic nonfinancial debt Federal Nonfederal 5.4 0.8 7.0 6.9 -1.1 9.5 6.7 -2.5 9.5 5.3 -6.7 8.6 5.6 -1.4 7.3 Depository credit Bank credit2 Thrift credit 6.5 8.5 0.7 8.5 10.2 3.3 6.1 5.4 8.5 8.6 9.4 6.0 3.6 3.2 4.7 M2 M3 Monetary base 5.6 9.1 5.9 8.5 11.0 7.2 6.3 7.7 12.5 6.1 9.4 1.4 10.3 13.5 8.3 Memo: Nominal gross domestic product 6.2 6.0 6.0 5.3 1.6 7.5 4.3 2.4 15.4 22.8 18.7 8.3 8.9 -1.3 23.6 34.6 11.0 11.1 5.9 -0.6 13.7 17.3 7.7 4.2 3.3 9.4 11.8 25.2 13.6 9.0 17.8 -5.1 8.7 50.5 3.0 Components of the Monetary Aggregates Currency Liquid deposits Small time deposits Retail money market mutual funds Institutional money market mutual funds Large time deposits 1. Growth rates are Q4 to Q4 averages based on seasonally adjusted data. Figures for 2001 are staff projections based on partial data. 2. Adjusted for the estimated effects of mark-to-market accounting rules. Ratio Scale Percentage Points M2 Velocity and Opportunity Cost Ratio Scale 2.2 2.1 25 2.0 M2 Velocity (left scale) 10 1.9 M2 Opportunity Cost* (right scale) 4 1.8 2 1.7 1 1.6 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 * Two-quarter moving average. M2 Velocity 97:Q4 2.1 Intercept Fit from 1994:Q3 - 2001:Q4 (slope taken from lower regression line) 98:Q4 00:Q4 • 94:Q2 01:Q2 93:Q4 01:Q4 p 1.9 • • •• 92:Q4 • • 91:Q4 • • • • 99:Q4 90:Q4 • 90:Q2 • • • •• • • • ••• • • •• •• • • •• • • • • •• •• • • • ••• • • • •• •• • • • • •• • • • • • • • • • • • • • • •• • • • • • •• • • ••• • • • •• • •• • • • •• •• •• •• •• • • • • •• • • • •• • • •• • • • 1.7 • •• • • • • • •• Fit from 1959:Q2 - 1989:Q4 1.5 0.5 1 2 4 6 Opportunity Cost (ratio scale) MARA:JW M3 Velocity Ratio scale 1.8 1.7 1.6 1.5 1.4 1.3 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 Domestic Nonfinancial Debt Velocity Ratio scale 0.80 0.75 0.70 0.65 0.60 0.55 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 

Federal Reserve (2001, December 10). Bluebook. Bluebooks, Federal Reserve. https://whenthefedspeaks.com/doc/bluebook_20011211

@misc{wtfs_bluebook_20011211,
  author = {Federal Reserve},
  title = {Bluebook},
  year = {2001},
  month = {Dec},
  howpublished = {Bluebooks, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/bluebook_20011211},
  note = {Retrieved via When the Fed Speaks corpus}
}