Meeting of the Federal Open Market Committee
July 2-3, 1996
A meeting of the Federal Open Market Committee was held in the offices of the Board of Governors of the Federal Reserve System in Washington, D.C., on Tuesday, July 2, 1996, at 1:00 p.m. and continued on Wednesday, July 3, 1996, at 9:00 a.m.
PRESENT: Mr. Greenspan, Chairman
Mr. McDonough, Vice Chairman
Mr. Boehne
Mr. Jordan
Mr. Kelley
Mr. Lindsey
Mr. McTeer
Mr. Meyer
Ms. Phillips
Ms. Rivlin
Mr. Stern
Ms. Yellen
Messrs. Broaddus, Guynn, Moskow, and Parry, Alternate Members of the Federal Open Market Committee
Messrs. Hoenig and Melzer, and Ms. Minehan, Presidents of the Federal Reserve Banks of Kansas City, St. Louis, and Boston respectively
Mr. Kohn, Secretary and Economist
Mr. Bernard, Deputy Secretary
Mr. Coyne, Assistant Secretary
Mr. Gillum, Assistant Secretary
Mr. Mattingly, General Counsel
Mr. Baxter, Deputy General Counsel
Mr. Prell, Economist
Mr. Truman, Economist
Messrs. Lindsey, Mishkin, Promisel, Rolnick, Rosenblum, Siegman, Simpson, Sniderman, and Stockton, Associate Economists
Mr. Fisher, Manager, System Open Market Account
Mr. Winn, Assistant to the Board, Office of Board Members, Board of Governors
Mr. Ettin, Deputy Director, Division of Research and Statistics, Board of Governors
Messrs. Madigan and Slifman, Associate Directors, Divisions of Monetary Affairs and Research and Statistics respectively, Board of Governors
Mr. Brayton, Ms. Johnson, Messrs. Reinhart and Smith, Assistant Directors, Divisions of Research and Statistics, International Finance, Monetary Affairs, and International Finance respectively, Board of Governors
Ms. Kusko and Mr. Wilcox, Senior Economists, Divisions of Research and Statistics and Monetary Affairs respectively, Board of Governors
Ms. Garrett, Economist, Division of Monetary Affairs, Board of Governors
Ms. Low, Open Market Secretariat Assistant, Division of Monetary Affairs, Board of Governors
Ms. Holcomb, First Vice President, Federal Reserve Bank of Dallas
Mr. Beebe, Ms. Browne, Messrs. Davis, Dewald, Eisenbeis, Goodfriend, and Hunter, Senior Vice Presidents, Federal Reserve Banks of San Francisco, Boston, Kansas City, St. Louis, Atlanta, Richmond, and Chicago respectively
Messrs. Kos and Meyer, Vice Presidents, Federal Reserve Banks of New York and Philadelphia respectively
TO BE CONTINUED ...
MINUTES OF JULY 3, 1996 FOMC MEETING
Re: MINUTES OF JULY 3, 1996 FOMC MEETING
Transcript of Federal Open Market Committee Meeting
July 2-3, 1996
July 2, 1996--Afternoon Session
CHAIRMAN GREENSPAN. I would like to welcome Governors Rivlin and Meyer to their first exposure to this Committee.
I also would like to welcome Helen Holcomb, who is First Vice President of the Dallas Bank, to her first meeting.
I hesitate to welcome, but I have no choice after we approve the minutes, our friend over there.
Would someone like to move the minutes?
SEVERAL. So move.
CHAIRMAN GREENSPAN. Without objection. Peter, I was referring to you a moment ago. [Laughter]
You are on.
MR. FISHER. I will be referring to the package of charts that was just distributed.
CHAIRMAN GREENSPAN. These are very interesting charts.
I am a little puzzled by the implicit theoretical construction in the charts showing the relationship between implied volatilities on currency options and exchange rates.
I would not have a problem if you were endeavoring to evaluate a market price for stocks, bonds, tomatoes, or whatever in which there is only a net long position.
But exchange rates are not of that nature, of course, and what appears to be a theoretical basis for arguing that low volatility is a harbinger of a weak dollar--or whatever you were saying--is it a sharply rising volatility that you were saying is a harbinger of a weaker dollar?
MR. FISHER. A change in the dollar.
I tried to be careful.
If you look at those two charts, they tend to suggest a random walk in the relationship between increased volatility and the direction the dollar will go, but in the last few years the direction has been toward a weaker dollar.
CHAIRMAN GREENSPAN. What I have to say has nothing to do with your statement!
[Laughter]
I am a little puzzled in the sense that whatever the theoretical construction there is for the dollar, it has to be exactly the opposite for the deutsche mark.
I am curious as to how you explain the fact that you are getting this type of relationship in one currency and not the reverse in the other.
Are we looking at really random events or is there a theoretical conception that you can impose on these data to explain why you don't get opposite effects for the dollar versus the mark.
MR. FISHER. Well, I am not going to be able to answer that at the theoretical level for the long sweep of history.
The data show that it is in the last couple of years that the market has had a bias in favor of the mark; when volatility pops, it is the dollar that weakens.
The point is that it ought to be a random walk as to which way the exchange rate goes when volatility goes up, and I think that is probably the case in the long sweep of history.
The phenomena that I am looking at and I am concerned about are not a theoretical or principled articulation of the relationship between options and spot prices, but they relate to what I have observed and heard in talking to dealers, namely, that people are writing a very large number of options right now.
So, I am offering you statistical data points in the chart that reflect what we hear in the market about all the options that are being written.
TO BE CONTINUED ...
July 2-3, 1996
July 2, 1996--Afternoon Session
CHAIRMAN GREENSPAN. I would like to welcome Governors Rivlin and Meyer to their first exposure to this Committee.
I also would like to welcome Helen Holcomb, who is First Vice President of the Dallas Bank, to her first meeting.
I hesitate to welcome, but I have no choice after we approve the minutes, our friend over there.
Would someone like to move the minutes?
SEVERAL. So move.
CHAIRMAN GREENSPAN. Without objection. Peter, I was referring to you a moment ago. [Laughter]
You are on.
MR. FISHER. I will be referring to the package of charts that was just distributed.
CHAIRMAN GREENSPAN. These are very interesting charts.
I am a little puzzled by the implicit theoretical construction in the charts showing the relationship between implied volatilities on currency options and exchange rates.
I would not have a problem if you were endeavoring to evaluate a market price for stocks, bonds, tomatoes, or whatever in which there is only a net long position.
But exchange rates are not of that nature, of course, and what appears to be a theoretical basis for arguing that low volatility is a harbinger of a weak dollar--or whatever you were saying--is it a sharply rising volatility that you were saying is a harbinger of a weaker dollar?
MR. FISHER. A change in the dollar.
I tried to be careful.
If you look at those two charts, they tend to suggest a random walk in the relationship between increased volatility and the direction the dollar will go, but in the last few years the direction has been toward a weaker dollar.
CHAIRMAN GREENSPAN. What I have to say has nothing to do with your statement!
[Laughter]
I am a little puzzled in the sense that whatever the theoretical construction there is for the dollar, it has to be exactly the opposite for the deutsche mark.
I am curious as to how you explain the fact that you are getting this type of relationship in one currency and not the reverse in the other.
Are we looking at really random events or is there a theoretical conception that you can impose on these data to explain why you don't get opposite effects for the dollar versus the mark.
MR. FISHER. Well, I am not going to be able to answer that at the theoretical level for the long sweep of history.
The data show that it is in the last couple of years that the market has had a bias in favor of the mark; when volatility pops, it is the dollar that weakens.
The point is that it ought to be a random walk as to which way the exchange rate goes when volatility goes up, and I think that is probably the case in the long sweep of history.
The phenomena that I am looking at and I am concerned about are not a theoretical or principled articulation of the relationship between options and spot prices, but they relate to what I have observed and heard in talking to dealers, namely, that people are writing a very large number of options right now.
So, I am offering you statistical data points in the chart that reflect what we hear in the market about all the options that are being written.
TO BE CONTINUED ...
Re: MINUTES OF JULY 3, 1996 FOMC MEETING
CHAIRMAN GREENSPAN. Theoretically, in exchange transactions all technical factors should be neutral.
To the extent they are not neutral, then we have only net long positions in some particular security, or claim, or something of that nature.
I am really puzzled that we can construct something like this.
I don't deny the relationship, but it is not outside the realm of a random walk.
Clearly, we get noise in any series, and I am just curious whether or not you have come upon something that has little more than curiosity value versus something that may explain certain fundamentals about the market itself.
MR. FISHER. I think I have both a degree of curiosity and, given the history of the last few years, a point of concern about the level of options being written.
CHAIRMAN GREENSPAN. You should think about that.
This is an interesting set of relationships, but I am not sure what to make of it.
As I said, I am curious.
Governor Lindsey.
MR. LINDSEY. I share your concern.
I am a little worried about what we may be seeing.
I had thought about this a little differently.
It would seem that this autumn is going to be an interesting period, particularly among European currencies.
What is motivating banks to write options, to bet on continuing low volatility in the exchange market when, just reading the papers, we are told that volatility is going to be increasing?
It seems to me that there is a lot more risk out there than usual.
MR. FISHER. The incentive that is most evident to me is that they can't make money through normal channels.
MS. MINEHAN. They can't make money the old-fashioned way!
MR. FISHER. They now are subject to a rather disciplined approach to income targets that are set in terms of the level of income they are supposed to achieve month by month.
I am not saying that is a pretty sight.
MR. LINDSEY. So, we are back in the incentive-structure problem?
MR. FISHER. I think in the short run, yes, that is a big part of it.
MR. LINDSEY. It is not the first time.
TO BE CONTINUED ...
To the extent they are not neutral, then we have only net long positions in some particular security, or claim, or something of that nature.
I am really puzzled that we can construct something like this.
I don't deny the relationship, but it is not outside the realm of a random walk.
Clearly, we get noise in any series, and I am just curious whether or not you have come upon something that has little more than curiosity value versus something that may explain certain fundamentals about the market itself.
MR. FISHER. I think I have both a degree of curiosity and, given the history of the last few years, a point of concern about the level of options being written.
CHAIRMAN GREENSPAN. You should think about that.
This is an interesting set of relationships, but I am not sure what to make of it.
As I said, I am curious.
Governor Lindsey.
MR. LINDSEY. I share your concern.
I am a little worried about what we may be seeing.
I had thought about this a little differently.
It would seem that this autumn is going to be an interesting period, particularly among European currencies.
What is motivating banks to write options, to bet on continuing low volatility in the exchange market when, just reading the papers, we are told that volatility is going to be increasing?
It seems to me that there is a lot more risk out there than usual.
MR. FISHER. The incentive that is most evident to me is that they can't make money through normal channels.
MS. MINEHAN. They can't make money the old-fashioned way!
MR. FISHER. They now are subject to a rather disciplined approach to income targets that are set in terms of the level of income they are supposed to achieve month by month.
I am not saying that is a pretty sight.
MR. LINDSEY. So, we are back in the incentive-structure problem?
MR. FISHER. I think in the short run, yes, that is a big part of it.
MR. LINDSEY. It is not the first time.
TO BE CONTINUED ...
Re: MINUTES OF JULY 3, 1996 FOMC MEETING
CHAIRMAN GREENSPAN. President Jordan.
MR. JORDAN. Peter, I have a question about your domestic operations.
When I see something like a 50 percent fed funds rate, it catches my attention.
In your comments you made some reference to the inefficiencies and anomalies in the distribution of reserves yesterday and again today that initially led banks to think that the market for reserves was tighter than was actually the case.
What all that says to me is that there is an inefficiency in the market due to the quality of the information.
Some of that information we have.
It is an infinite regression sort of thing.
We are trying to guess at what bankers' behavior is going to be over the maintenance period.
Their strategy is to run reserve deficiencies until the 14th day of the period and then look to us on settlement day as the reserve supplier of last resort.
We and they guess at what the total supply of reserves is in the market and its distribution, and on the last day of the period they come in to borrow from the Federal Reserve.
Can't we improve on that somewhat either in the quality of the information we give them or the way we operate to smooth out the availability of reserves over the maintenance period?
MR. FISHER. Let me try to take the second leg of that first.
The skewing of the demand for reserves toward the end of the maintenance period is a normal pattern but one that we have seen become more pronounced in the past year.
My initial reaction to that was to try to force banks to smooth their demand for reserves, force them to come to me in a smoother way over the course of the period.
That, though, has the negative feedback consequence of making the funds rate very soft
early in the period.
We just can't fight it.
They want the reserves when they want them and pushing too hard to counter that does not work.
So, in the current environment I have not found it a fruitful course to try to insist that they take reserves when I want to give them.
With regard to the information available to the market, I think there may be some steps we could take.
I am somewhat uncomfortable with the continued use of the customer RP, which is a bit of an historical artifact.
It used to reflect the pass-through of the repo pool when the repo pool was only $2 or $3 billion or some similarly small amount.
Now the repo pool is $10 billion or more, and we really do not pass it through to the market in any sense.
The customer RP also was used by my predecessors as the non-signaling device, which likewise is no longer necessary, but it does have the tradition of having the amount to be done publicly attached to it.
One thought I have, which I intend to propose when I come back to you with an outline of the steps we have to go through to conduct our operations earlier in the day, would be to ask for your guidance on my desire to eliminate the use of the customer RP as we now employ it.
We would do only System Account RPs.
Currently when we do a customer RP, we announce that we might do, say, a total of up to $1.5 billion; however, if we tell the market that we are doing RPs for System Account we never announce how much we are doing.
I think a big step in the right direction would be to limit our operations to System repos and when we finish our review of the propositions we have received in a given operation we could then announce to the market how much was done--whether it was $4.5 billion or whatever the amount.
Interestingly, that would not have helped us all that much yesterday when we had a very anomalous day.
There were more reserves than we thought, and we would have led the market astray in thinking there were fewer reserves.
So, that would not have helped.
A combination of things occurred yesterday.
One major bank making payments on corporate securities delayed the payments until very late in the day, so recipients of very routine dividends did not think they were coming.
Another bank experienced a shortage early in the day but ended the day with much more funds than they had anticipated.
All of that money became available toward the end of the day, and the federal funds rate fell sharply late in the day.
So, our provision of a little more information yesterday might have misled the market.
But in general I think the practice would be useful and I intend to come back to the Committee--perhaps at the August or September meeting--with a little more detail on how we might provide more information to the public.
MR. JORDAN. Will what you come back with address the fundamental issue of the current reserve settlement structure, which as I recall was set up in the early 1980s to improve the control of M1?
That was the motivation, which is no longer relevant, for setting up this kind of settlement procedure.
MR. KOHN. We do have some folks looking at what you are referring to--the notion of contemporaneous reserve accounting versus lagged reserve accounting.
There would be transition costs to going back to lagged accounting and the issue is whether those costs would be outweighed by the benefits of reduced reserve requirement uncertainties.
We have staff both at the Board and at the New York Bank looking at how we could simplify things.
TO BE CONTINUED ...
MR. JORDAN. Peter, I have a question about your domestic operations.
When I see something like a 50 percent fed funds rate, it catches my attention.
In your comments you made some reference to the inefficiencies and anomalies in the distribution of reserves yesterday and again today that initially led banks to think that the market for reserves was tighter than was actually the case.
What all that says to me is that there is an inefficiency in the market due to the quality of the information.
Some of that information we have.
It is an infinite regression sort of thing.
We are trying to guess at what bankers' behavior is going to be over the maintenance period.
Their strategy is to run reserve deficiencies until the 14th day of the period and then look to us on settlement day as the reserve supplier of last resort.
We and they guess at what the total supply of reserves is in the market and its distribution, and on the last day of the period they come in to borrow from the Federal Reserve.
Can't we improve on that somewhat either in the quality of the information we give them or the way we operate to smooth out the availability of reserves over the maintenance period?
MR. FISHER. Let me try to take the second leg of that first.
The skewing of the demand for reserves toward the end of the maintenance period is a normal pattern but one that we have seen become more pronounced in the past year.
My initial reaction to that was to try to force banks to smooth their demand for reserves, force them to come to me in a smoother way over the course of the period.
That, though, has the negative feedback consequence of making the funds rate very soft
early in the period.
We just can't fight it.
They want the reserves when they want them and pushing too hard to counter that does not work.
So, in the current environment I have not found it a fruitful course to try to insist that they take reserves when I want to give them.
With regard to the information available to the market, I think there may be some steps we could take.
I am somewhat uncomfortable with the continued use of the customer RP, which is a bit of an historical artifact.
It used to reflect the pass-through of the repo pool when the repo pool was only $2 or $3 billion or some similarly small amount.
Now the repo pool is $10 billion or more, and we really do not pass it through to the market in any sense.
The customer RP also was used by my predecessors as the non-signaling device, which likewise is no longer necessary, but it does have the tradition of having the amount to be done publicly attached to it.
One thought I have, which I intend to propose when I come back to you with an outline of the steps we have to go through to conduct our operations earlier in the day, would be to ask for your guidance on my desire to eliminate the use of the customer RP as we now employ it.
We would do only System Account RPs.
Currently when we do a customer RP, we announce that we might do, say, a total of up to $1.5 billion; however, if we tell the market that we are doing RPs for System Account we never announce how much we are doing.
I think a big step in the right direction would be to limit our operations to System repos and when we finish our review of the propositions we have received in a given operation we could then announce to the market how much was done--whether it was $4.5 billion or whatever the amount.
Interestingly, that would not have helped us all that much yesterday when we had a very anomalous day.
There were more reserves than we thought, and we would have led the market astray in thinking there were fewer reserves.
So, that would not have helped.
A combination of things occurred yesterday.
One major bank making payments on corporate securities delayed the payments until very late in the day, so recipients of very routine dividends did not think they were coming.
Another bank experienced a shortage early in the day but ended the day with much more funds than they had anticipated.
All of that money became available toward the end of the day, and the federal funds rate fell sharply late in the day.
So, our provision of a little more information yesterday might have misled the market.
But in general I think the practice would be useful and I intend to come back to the Committee--perhaps at the August or September meeting--with a little more detail on how we might provide more information to the public.
MR. JORDAN. Will what you come back with address the fundamental issue of the current reserve settlement structure, which as I recall was set up in the early 1980s to improve the control of M1?
That was the motivation, which is no longer relevant, for setting up this kind of settlement procedure.
MR. KOHN. We do have some folks looking at what you are referring to--the notion of contemporaneous reserve accounting versus lagged reserve accounting.
There would be transition costs to going back to lagged accounting and the issue is whether those costs would be outweighed by the benefits of reduced reserve requirement uncertainties.
We have staff both at the Board and at the New York Bank looking at how we could simplify things.
TO BE CONTINUED ...
Re: MINUTES OF JULY 3, 1996 FOMC MEETING
CHAIRMAN GREENSPAN. Vice Chairman.
VICE CHAIRMAN MCDONOUGH. I would like to state a hypothesis and then ask Peter how he would evaluate it, since he is closer to the foreign exchange market these days than I am.
It seems to me that one of the reasons that people are writing a lot of options--because that is where profitability is available--is driven by developments in the foreign exchange market.
The major players now have such an investment in people and systems that they have very heavy fixed costs.
For example, part of the remuneration that they had deemed to be variable in the past, namely the bonuses, are now becoming more and more sticky.
We have major foreign banks, mainly in the New York market, who are hiring reasonably pedestrian dealers in all kinds of market instruments but especially foreign exchange and giving them fixed-period contracts with assured bonuses.
So, the bonus becomes a fixed cost for two or three years.
When they are in that kind of situation, unless they are willing to absorb operating losses, they have to scramble and look for whatever profit opportunities seem to be available.
That means that they would have a tendency to develop very large positions, whether it is in derivatives or the cash market.
So if there is an unexpected move in the market, the likelihood of people scrambling to cover their positions can lead to greater volatility.
Does that make sense to you, Peter?
MR. FISHER. Yes, I think it does, particularly in the foreign exchange market.
The early to mid-'90s was a period when these firms were building up capacity.
The great successes in income terms in '92, '93 and '94 for many dealing rooms led them to build up their capacity and their fixed costs just as you described, and I think they are all feeling some pain now and, perhaps regrettably, that is driving the expansion in their position-taking.
CHAIRMAN GREENSPAN. How would the implied volatilities and the historical volatilities move with respect to the magnitude of exchange rate movements?
MR. FISHER. The exchange rate movements follow changes in historical volatility but with a lag.
CHAIRMAN GREENSPAN. What is the order of magnitude?
MR. FISHER. I am sorry I can't calculate that off the top of my head.
CHAIRMAN GREENSPAN. One of the issues that raises is that, if you have a structural problem in the supply and demand for options, it would tend to reflect itself in an inefficient options market which in turn would tend to reflect a pattern that differs from the actual volatility in the exchange market.
One way of testing this hypothesis is to look at how these option volatilities relate to actual historical volatility, and that would give us at least some sense as to the structural change in the system.
MR. FISHER. Well, let me try this on you.
I hope this is helpful.
I talked with one person at a firm in this market for whom I have a great deal of respect, and he referred to the current level of options as both too high and too low.
Implied volatility was too high because it was still considerably above the recent historical experience.
It was too low for his taste because he didn't think he was going to get compensated for the risks he would be taking at the current levels.
CHAIRMAN GREENSPAN. I don't know what I am learning, but I am learning something!
VICE CHAIRMAN MCDONOUGH. I think the hypothesis checks out, but we can go back and do some work on that.
MR. FISHER. Yes, we will go back and work on that.
TO BE CONTINUED ...
VICE CHAIRMAN MCDONOUGH. I would like to state a hypothesis and then ask Peter how he would evaluate it, since he is closer to the foreign exchange market these days than I am.
It seems to me that one of the reasons that people are writing a lot of options--because that is where profitability is available--is driven by developments in the foreign exchange market.
The major players now have such an investment in people and systems that they have very heavy fixed costs.
For example, part of the remuneration that they had deemed to be variable in the past, namely the bonuses, are now becoming more and more sticky.
We have major foreign banks, mainly in the New York market, who are hiring reasonably pedestrian dealers in all kinds of market instruments but especially foreign exchange and giving them fixed-period contracts with assured bonuses.
So, the bonus becomes a fixed cost for two or three years.
When they are in that kind of situation, unless they are willing to absorb operating losses, they have to scramble and look for whatever profit opportunities seem to be available.
That means that they would have a tendency to develop very large positions, whether it is in derivatives or the cash market.
So if there is an unexpected move in the market, the likelihood of people scrambling to cover their positions can lead to greater volatility.
Does that make sense to you, Peter?
MR. FISHER. Yes, I think it does, particularly in the foreign exchange market.
The early to mid-'90s was a period when these firms were building up capacity.
The great successes in income terms in '92, '93 and '94 for many dealing rooms led them to build up their capacity and their fixed costs just as you described, and I think they are all feeling some pain now and, perhaps regrettably, that is driving the expansion in their position-taking.
CHAIRMAN GREENSPAN. How would the implied volatilities and the historical volatilities move with respect to the magnitude of exchange rate movements?
MR. FISHER. The exchange rate movements follow changes in historical volatility but with a lag.
CHAIRMAN GREENSPAN. What is the order of magnitude?
MR. FISHER. I am sorry I can't calculate that off the top of my head.
CHAIRMAN GREENSPAN. One of the issues that raises is that, if you have a structural problem in the supply and demand for options, it would tend to reflect itself in an inefficient options market which in turn would tend to reflect a pattern that differs from the actual volatility in the exchange market.
One way of testing this hypothesis is to look at how these option volatilities relate to actual historical volatility, and that would give us at least some sense as to the structural change in the system.
MR. FISHER. Well, let me try this on you.
I hope this is helpful.
I talked with one person at a firm in this market for whom I have a great deal of respect, and he referred to the current level of options as both too high and too low.
Implied volatility was too high because it was still considerably above the recent historical experience.
It was too low for his taste because he didn't think he was going to get compensated for the risks he would be taking at the current levels.
CHAIRMAN GREENSPAN. I don't know what I am learning, but I am learning something!
VICE CHAIRMAN MCDONOUGH. I think the hypothesis checks out, but we can go back and do some work on that.
MR. FISHER. Yes, we will go back and work on that.
TO BE CONTINUED ...
Re: MINUTES OF JULY 3, 1996 FOMC MEETING
CHAIRMAN GREENSPAN. Governor Phillips.
MS. PHILLIPS. Peter, I just wanted to ask what the source of these options data was that you use for your calculations and charts.
MR. KOS. A couple of investment firms gave us the data.
MR. FISHER. The back data were provided by a couple of investment banks.
We have been collecting more recent data routinely off the screens ourselves.
MR. KOS. These are fresh 1-month and 12-month implied volatilities on OTC options that are collected every day; the data are not obtained from the exchanges.
MS. PHILLIPS. So, they are basically over-the-counter.
Do you think they are comparable going back as far as you do?
MR. FISHER. They are the best data we have been able to get.
MS. PHILLIPS. Well, okay.
CHAIRMAN GREENSPAN. Any further questions?
Would somebody like to move approval of Peter's domestic operations?
VICE CHAIRMAN MCDONOUGH. I move approval.
SPEAKER(?) Second.
CHAIRMAN GREENSPAN. Without objection.
We now move on to the Chart Show presented by Messrs. Prell and Truman.
CHAIRMAN GREENSPAN. Going back to your analysis of world oil markets, I notice in Chart 8 that North Sea oil production is still increasing but at a slower pace.
Are these statistics millions of barrels per day?
MR. TRUMAN. They are changes in production in barrels per day.
Production is expected to peak in 1997 and to turn down after that.
CHAIRMAN GREENSPAN. I gather that the Norwegian expansion has been accelerating very recently.
Is that going to peter out?
MR. TRUMAN. Well, as you probably know better than I, every time we have looked at North Sea production over the last 10 years, it was going to diminish in 2 years.
The people who look at this, and they include the experts of the International Energy Agency, expect that Norwegian production will level off at a peak level in 1997 and then decline.
That is, of course, one of the reasons why we don't get the same non-OPEC supply coming on stream as in recent years.
That is the logic.
New discoveries and new techniques obviously could lead to more production than we now assume, but that remains to be seen.
CHAIRMAN GREENSPAN. This table implies that we will reach oil inventory equilibrium at the end of this year.
Is that going to happen considering the extreme shortfalls that we have experienced?
MR. TRUMAN. Well, one issue has to do with the question of Iraqi production coming on stream.
In fact, we had assumed in our forecast that the 800 thousand barrels per day from Iraq in the second half of the year would be enough to plug the hole in stock building that was created over the first half of the year.
If that were not to happen, if the oil flow from Iraq were to start on January 1 instead of August 16, we would have oil prices staying up above the $17 per barrel range through the fourth quarter and then coming down to the $17 per barrel range over the first part of next year.
So, the inventory plug results in some sense from the supply coming from Iraq.
CHAIRMAN GREENSPAN. And the assumption is that there will be no endeavor by other producers as a group to pull back on their oil production?
MR. TRUMAN. Yes.
In fact, we probably will have a little more cheating.
TO BE CONTINUED ...
MS. PHILLIPS. Peter, I just wanted to ask what the source of these options data was that you use for your calculations and charts.
MR. KOS. A couple of investment firms gave us the data.
MR. FISHER. The back data were provided by a couple of investment banks.
We have been collecting more recent data routinely off the screens ourselves.
MR. KOS. These are fresh 1-month and 12-month implied volatilities on OTC options that are collected every day; the data are not obtained from the exchanges.
MS. PHILLIPS. So, they are basically over-the-counter.
Do you think they are comparable going back as far as you do?
MR. FISHER. They are the best data we have been able to get.
MS. PHILLIPS. Well, okay.
CHAIRMAN GREENSPAN. Any further questions?
Would somebody like to move approval of Peter's domestic operations?
VICE CHAIRMAN MCDONOUGH. I move approval.
SPEAKER(?) Second.
CHAIRMAN GREENSPAN. Without objection.
We now move on to the Chart Show presented by Messrs. Prell and Truman.
CHAIRMAN GREENSPAN. Going back to your analysis of world oil markets, I notice in Chart 8 that North Sea oil production is still increasing but at a slower pace.
Are these statistics millions of barrels per day?
MR. TRUMAN. They are changes in production in barrels per day.
Production is expected to peak in 1997 and to turn down after that.
CHAIRMAN GREENSPAN. I gather that the Norwegian expansion has been accelerating very recently.
Is that going to peter out?
MR. TRUMAN. Well, as you probably know better than I, every time we have looked at North Sea production over the last 10 years, it was going to diminish in 2 years.
The people who look at this, and they include the experts of the International Energy Agency, expect that Norwegian production will level off at a peak level in 1997 and then decline.
That is, of course, one of the reasons why we don't get the same non-OPEC supply coming on stream as in recent years.
That is the logic.
New discoveries and new techniques obviously could lead to more production than we now assume, but that remains to be seen.
CHAIRMAN GREENSPAN. This table implies that we will reach oil inventory equilibrium at the end of this year.
Is that going to happen considering the extreme shortfalls that we have experienced?
MR. TRUMAN. Well, one issue has to do with the question of Iraqi production coming on stream.
In fact, we had assumed in our forecast that the 800 thousand barrels per day from Iraq in the second half of the year would be enough to plug the hole in stock building that was created over the first half of the year.
If that were not to happen, if the oil flow from Iraq were to start on January 1 instead of August 16, we would have oil prices staying up above the $17 per barrel range through the fourth quarter and then coming down to the $17 per barrel range over the first part of next year.
So, the inventory plug results in some sense from the supply coming from Iraq.
CHAIRMAN GREENSPAN. And the assumption is that there will be no endeavor by other producers as a group to pull back on their oil production?
MR. TRUMAN. Yes.
In fact, we probably will have a little more cheating.
TO BE CONTINUED ...
Re: MINUTES OF JULY 3, 1996 FOMC MEETING
CHAIRMAN GREENSPAN. President Parry.
MR. PARRY. Mike, when I compare the current forecast to the May forecast, there appears to be virtually no change in the economy-wide measures.
I guess an exception is the CPI in 1996.
Yet, as I read the Greenbook, and the same impression came through in your presentation today, you seem to have shifted your assessment of the risks significantly to the up side.
What is your rationale for shifting the risks without having an impact on the expected values in the forecast?
In fact, I think I have asked this question about risks many times in the past, and as I recall I have gotten only one answer, namely, that the risks were symmetric.
MR. PRELL. I think there have been some occasions when we have indicated that the risks in our outlook were asymmetric.
I would characterize our forecasts over the years as an effort to present a meaningful, modal forecast of the most likely outcome.
When we felt that there was some skewness to the probability distribution, we tried to identify it.
In this instance, as we looked at the recent data, we felt that there was a greater thickness in the area of our probability distribution a little above our modal forecast, particularly for the near term, than there was on the other side of our forecast.
I am very conscious of the fact that we have made some of our biggest mistakes in the past by losing sight of the trends in responding to the run of recent data, and that is part of the reason why I tried to focus some attention on the GDP pattern on a moving-average basis.
We have been getting very erratic movements in GDP data over the past year or two, and we may well be seeing another episode of that kind.
I don't feel uncomfortable at all in saying that we think the highest probability is that we are going to experience some significant slackening of the expansion in the near term.
We can point to some special factors that have lifted growth in the most recent quarter.
Some of these affected just the second quarter and they were offsets to developments in the first quarter.
Some may have lifted activity above what the second-quarter level would have been in the absence of various shocks, thus raising the first-half growth rate.
On balance, we think there is a good case for the slowing scenario, but we also can see an alternative scenario with somewhat faster growth in the near term than we have projected.
MR. PARRY. Thank you.
TO BE CONTINUED ...
MR. PARRY. Mike, when I compare the current forecast to the May forecast, there appears to be virtually no change in the economy-wide measures.
I guess an exception is the CPI in 1996.
Yet, as I read the Greenbook, and the same impression came through in your presentation today, you seem to have shifted your assessment of the risks significantly to the up side.
What is your rationale for shifting the risks without having an impact on the expected values in the forecast?
In fact, I think I have asked this question about risks many times in the past, and as I recall I have gotten only one answer, namely, that the risks were symmetric.
MR. PRELL. I think there have been some occasions when we have indicated that the risks in our outlook were asymmetric.
I would characterize our forecasts over the years as an effort to present a meaningful, modal forecast of the most likely outcome.
When we felt that there was some skewness to the probability distribution, we tried to identify it.
In this instance, as we looked at the recent data, we felt that there was a greater thickness in the area of our probability distribution a little above our modal forecast, particularly for the near term, than there was on the other side of our forecast.
I am very conscious of the fact that we have made some of our biggest mistakes in the past by losing sight of the trends in responding to the run of recent data, and that is part of the reason why I tried to focus some attention on the GDP pattern on a moving-average basis.
We have been getting very erratic movements in GDP data over the past year or two, and we may well be seeing another episode of that kind.
I don't feel uncomfortable at all in saying that we think the highest probability is that we are going to experience some significant slackening of the expansion in the near term.
We can point to some special factors that have lifted growth in the most recent quarter.
Some of these affected just the second quarter and they were offsets to developments in the first quarter.
Some may have lifted activity above what the second-quarter level would have been in the absence of various shocks, thus raising the first-half growth rate.
On balance, we think there is a good case for the slowing scenario, but we also can see an alternative scenario with somewhat faster growth in the near term than we have projected.
MR. PARRY. Thank you.
TO BE CONTINUED ...
Re: MINUTES OF JULY 3, 1996 FOMC MEETING
CHAIRMAN GREENSPAN. Governor Lindsey.
MR. LINDSEY. Ted, in Chart 10, you have given us a nifty tool of analysis.
I had a question about one of your assumptions.
The policy assumption in the chart is that U.S. and foreign monetary authorities target nominal GDP.
To my knowledge the nominal GDP developments in the developing countries, including much of East Asia and Latin America, have not had a big effect on our decisions.
Would there be a need to relax that assumption with regard to developing countries?
MR. TRUMAN. Well, you have uncovered a sleight of hand.
Actually, the formal assumption that we make for the developing countries in the model simulations is that their interest rates follow our interest rates.
So, if we damp our nominal GDP or lean against a surge in nominal GDP by raising our interest rates, their rates go up, too.
Actually, when we ran this simulation, that proved to be insufficient, for perhaps obvious reasons.
We therefore went in and constrained the GDP growth path for those countries.
That took out some of the shock, if you want to put it that way, so that growth in the developing countries did not continue on a higher path.
MR. LINDSEY. But your added constraint certainly isn't --
MR. TRUMAN. We got that result without specifying the policy mechanism by which nominal GDP is held down for those countries, but in terms of trying to control the impetus to the U.S. economy, we have achieved that modest result.
In fact, when we did it another way, we came up with a huge expansion in the developing countries because the rise in U.S. interest rates was insufficient to set off a timely multiplier-accelerator process in reverse.
We therefore went in and essentially damped things down so that we got something close to the same growth path from the developing countries as we did with the developed countries where the real level of economic activity rises through the first two years, then essentially levels off, and subsequently comes down a bit as the interest rate effects take hold.
We have essentially the same income path in both cases for the U.S. economy.
MR. LINDSEY. Why wouldn't an exchange rate peg work in that model?
It would be a somewhat more relaxed assumption than the one you made, but less relaxed than in an unconstrained model.
MR. TRUMAN. Yes, but the model runs off interest rates and the exchange rates of the developing countries do stay pretty much in line with the dollar.
That is one of the reasons, in fact, why we have a different exchange rate in the two scenarios.
In the first case interest rates go up more in the industrial countries than they do in the United States and as they go up that pulls up their currencies.
In the second case, we don't have that effect, so that's why the dollar goes the other way than it does in relation to the currencies of the industrial countries, because we share in some sense the same income growth factors.
TO BE CONTINUED ...
MR. LINDSEY. Ted, in Chart 10, you have given us a nifty tool of analysis.
I had a question about one of your assumptions.
The policy assumption in the chart is that U.S. and foreign monetary authorities target nominal GDP.
To my knowledge the nominal GDP developments in the developing countries, including much of East Asia and Latin America, have not had a big effect on our decisions.
Would there be a need to relax that assumption with regard to developing countries?
MR. TRUMAN. Well, you have uncovered a sleight of hand.
Actually, the formal assumption that we make for the developing countries in the model simulations is that their interest rates follow our interest rates.
So, if we damp our nominal GDP or lean against a surge in nominal GDP by raising our interest rates, their rates go up, too.
Actually, when we ran this simulation, that proved to be insufficient, for perhaps obvious reasons.
We therefore went in and constrained the GDP growth path for those countries.
That took out some of the shock, if you want to put it that way, so that growth in the developing countries did not continue on a higher path.
MR. LINDSEY. But your added constraint certainly isn't --
MR. TRUMAN. We got that result without specifying the policy mechanism by which nominal GDP is held down for those countries, but in terms of trying to control the impetus to the U.S. economy, we have achieved that modest result.
In fact, when we did it another way, we came up with a huge expansion in the developing countries because the rise in U.S. interest rates was insufficient to set off a timely multiplier-accelerator process in reverse.
We therefore went in and essentially damped things down so that we got something close to the same growth path from the developing countries as we did with the developed countries where the real level of economic activity rises through the first two years, then essentially levels off, and subsequently comes down a bit as the interest rate effects take hold.
We have essentially the same income path in both cases for the U.S. economy.
MR. LINDSEY. Why wouldn't an exchange rate peg work in that model?
It would be a somewhat more relaxed assumption than the one you made, but less relaxed than in an unconstrained model.
MR. TRUMAN. Yes, but the model runs off interest rates and the exchange rates of the developing countries do stay pretty much in line with the dollar.
That is one of the reasons, in fact, why we have a different exchange rate in the two scenarios.
In the first case interest rates go up more in the industrial countries than they do in the United States and as they go up that pulls up their currencies.
In the second case, we don't have that effect, so that's why the dollar goes the other way than it does in relation to the currencies of the industrial countries, because we share in some sense the same income growth factors.
TO BE CONTINUED ...
Re: MINUTES OF JULY 3, 1996 FOMC MEETING
CHAIRMAN GREENSPAN. Vice Chairman.
VICE CHAIRMAN MCDONOUGH. I would like to refer to Chart 14 relating to the labor markets.
On labor productivity, which obviously is a key consideration for the forecast, I think the most recent economic data have productivity trailing off even more than this trend line would indicate.
Indeed, you have productivity improvement in 1997 at 1 percent in the forecast.
MR. PRELL. Roughly.
VICE CHAIRMAN MCDONOUGH. Is that something that you are concerned about in terms of the possibility that it might be on the high side or is that something that, within the confidence factors for estimating productivity, you are feeling rather confident about?
MR. PRELL. I would say that is one of the things that we feel the least discomfort about.
We are forecasting fairly steady, moderate growth in productivity.
We don't start off with any major disequilibria that we can see in terms of employers having hired well beyond production levels.
A trend increase in productivity seems entirely reasonable in these circumstances.
I think the question is whether the trend from here will be what it has been over an extended period.
As I said, the trend has been pretty steady since 1973, and obviously we have discussed many times around this table whether recent higher levels of investment or changes in technology and so on might bring about some acceleration in productivity growth.
We have not seen it yet; the most recent figures don't indicate it.
So, we are staying pretty much with a fairly straightforward extrapolation of recent trends.
CHAIRMAN GREENSPAN. Mr. Jordan.
MR. JORDAN. Mike, I want to ask a question to get your response from the standpoint of the forecast, but I also want to get Peter Fisher's response from the standpoint of how the market would react.
You made reference to slight declines in longer-term interest rates; you used the 10-year rate in the chart.
As I think about your forecast for the next six months, I ask myself what is going to happen after real GDP decelerates from an indicated growth rate of around 4 percent in the second quarter to rates in your forecast of 2.3 and 1.9 percent in the third and fourth quarters; the monthly average for the CPI is an increase of .2 percent for the remaining seven months of the year; housing starts drop from the 1.46 - 1.47 million area; motor vehicle sales and production drop from a rate of over 15 million units to something below that; and job growth slows to increases of only 100,000 a month in the final three months of the year.
I wonder what the reaction is going to be in the bond market, if that pattern of economic statistics is seen as unfolding.
Is that consistent with only a slight decline in bond yields?
MR. PRELL. That is a quite reasonable question, and I certainly would not see it as implausible to have the bond market rallying beyond our assumption for some period of time.
In my view, the only thing that would tend to limit such a rally in terms of how far down yields might go permanently is that we don't have a particularly steep yield curve at this point.
And if one hypothesized that a few months down the road the economy is perceived to be on a stable, sustainable, and moderate growth course with inflation perhaps creeping up, I would not expect--with the assumed 5-1/4 percent federal funds rate--to see the bond yield go a lot lower than we anticipate.
Basically, we have the long bond moving down to a range of somewhere around 6-3/4 percent.
It would not be surprising that a run of softer data would induce a bond rally that would bring the yield noticeably below that level.
How far down the yield on the long bond would be expected to go an ongoing basis, I think, is the question.
Clearly, there are some in the market who are talking about 6 percent bond yields and in terms of the variability we have been seeing in the market--the overshooting--that level is well within reach on a run of appealing data.
MR. FISHER. I can't improve on that; I agree with Mike.
CHAIRMAN GREENSPAN. President Stern.
MR. STERN. Mike, we recently had an auto industry consultant drop by the Bank.
He had a couple of things to say that I, at least, found interesting and I want to get your reaction to it.
First, he was quite sanguine about the outlook for light motor vehicle sales extending over a number of years; basically, he saw them continuing to run at 15 million units or so at an annual rate.
It was largely a replacement story that he was telling.
Having provided us with that, he also talked about what he perceives to be a great deal of excess productive capacity worldwide.
Even allowing for further sales growth in Latin America and parts of Asia, his view is that there is a lot of excess capacity around.
I wondered if that was in fact right, because that would have some implications for the labor negotiations coming along later this year.
MR. PRELL. I don't know how much useful excess capacity is left in the United States.
I suspect that when we tote the numbers up it looks as if there is a lot, but when we look at current production problems, we see that, for those categories of cars and trucks that people want to buy, the manufacturers would like to build more than they currently can.
It isn't simply a matter of assembly capacity.
In many cases the capacity limits are in the production of some key components -- engines and so on.
So, effectively there may not be a lot of slack in this country.
I suspect there is some considerable slack in Japan at this point and maybe elsewhere.
When we talk about yearly sales of 15 million units or a little more on an ongoing basis, I guess I can't quarrel with that too much.
I think the foremost authority in the room on replacement demand is the Chairman.
He has done some research on this subject in the last few years.
Looking at the results of that analysis, 15 million would seem to be a little high.
But if you talk about an economy in which incomes are rising and people have a taste for having more motor vehicles per household -- maybe everyone wants to have a sport utility car, a family sedan, and who knows what else -- perhaps there is a potential for higher ongoing demand.
I think the automobile manufacturers are looking at forecasts based on trends that are a little higher than we have in our forecast.
TO BE CONTINUED ...
VICE CHAIRMAN MCDONOUGH. I would like to refer to Chart 14 relating to the labor markets.
On labor productivity, which obviously is a key consideration for the forecast, I think the most recent economic data have productivity trailing off even more than this trend line would indicate.
Indeed, you have productivity improvement in 1997 at 1 percent in the forecast.
MR. PRELL. Roughly.
VICE CHAIRMAN MCDONOUGH. Is that something that you are concerned about in terms of the possibility that it might be on the high side or is that something that, within the confidence factors for estimating productivity, you are feeling rather confident about?
MR. PRELL. I would say that is one of the things that we feel the least discomfort about.
We are forecasting fairly steady, moderate growth in productivity.
We don't start off with any major disequilibria that we can see in terms of employers having hired well beyond production levels.
A trend increase in productivity seems entirely reasonable in these circumstances.
I think the question is whether the trend from here will be what it has been over an extended period.
As I said, the trend has been pretty steady since 1973, and obviously we have discussed many times around this table whether recent higher levels of investment or changes in technology and so on might bring about some acceleration in productivity growth.
We have not seen it yet; the most recent figures don't indicate it.
So, we are staying pretty much with a fairly straightforward extrapolation of recent trends.
CHAIRMAN GREENSPAN. Mr. Jordan.
MR. JORDAN. Mike, I want to ask a question to get your response from the standpoint of the forecast, but I also want to get Peter Fisher's response from the standpoint of how the market would react.
You made reference to slight declines in longer-term interest rates; you used the 10-year rate in the chart.
As I think about your forecast for the next six months, I ask myself what is going to happen after real GDP decelerates from an indicated growth rate of around 4 percent in the second quarter to rates in your forecast of 2.3 and 1.9 percent in the third and fourth quarters; the monthly average for the CPI is an increase of .2 percent for the remaining seven months of the year; housing starts drop from the 1.46 - 1.47 million area; motor vehicle sales and production drop from a rate of over 15 million units to something below that; and job growth slows to increases of only 100,000 a month in the final three months of the year.
I wonder what the reaction is going to be in the bond market, if that pattern of economic statistics is seen as unfolding.
Is that consistent with only a slight decline in bond yields?
MR. PRELL. That is a quite reasonable question, and I certainly would not see it as implausible to have the bond market rallying beyond our assumption for some period of time.
In my view, the only thing that would tend to limit such a rally in terms of how far down yields might go permanently is that we don't have a particularly steep yield curve at this point.
And if one hypothesized that a few months down the road the economy is perceived to be on a stable, sustainable, and moderate growth course with inflation perhaps creeping up, I would not expect--with the assumed 5-1/4 percent federal funds rate--to see the bond yield go a lot lower than we anticipate.
Basically, we have the long bond moving down to a range of somewhere around 6-3/4 percent.
It would not be surprising that a run of softer data would induce a bond rally that would bring the yield noticeably below that level.
How far down the yield on the long bond would be expected to go an ongoing basis, I think, is the question.
Clearly, there are some in the market who are talking about 6 percent bond yields and in terms of the variability we have been seeing in the market--the overshooting--that level is well within reach on a run of appealing data.
MR. FISHER. I can't improve on that; I agree with Mike.
CHAIRMAN GREENSPAN. President Stern.
MR. STERN. Mike, we recently had an auto industry consultant drop by the Bank.
He had a couple of things to say that I, at least, found interesting and I want to get your reaction to it.
First, he was quite sanguine about the outlook for light motor vehicle sales extending over a number of years; basically, he saw them continuing to run at 15 million units or so at an annual rate.
It was largely a replacement story that he was telling.
Having provided us with that, he also talked about what he perceives to be a great deal of excess productive capacity worldwide.
Even allowing for further sales growth in Latin America and parts of Asia, his view is that there is a lot of excess capacity around.
I wondered if that was in fact right, because that would have some implications for the labor negotiations coming along later this year.
MR. PRELL. I don't know how much useful excess capacity is left in the United States.
I suspect that when we tote the numbers up it looks as if there is a lot, but when we look at current production problems, we see that, for those categories of cars and trucks that people want to buy, the manufacturers would like to build more than they currently can.
It isn't simply a matter of assembly capacity.
In many cases the capacity limits are in the production of some key components -- engines and so on.
So, effectively there may not be a lot of slack in this country.
I suspect there is some considerable slack in Japan at this point and maybe elsewhere.
When we talk about yearly sales of 15 million units or a little more on an ongoing basis, I guess I can't quarrel with that too much.
I think the foremost authority in the room on replacement demand is the Chairman.
He has done some research on this subject in the last few years.
Looking at the results of that analysis, 15 million would seem to be a little high.
But if you talk about an economy in which incomes are rising and people have a taste for having more motor vehicles per household -- maybe everyone wants to have a sport utility car, a family sedan, and who knows what else -- perhaps there is a potential for higher ongoing demand.
I think the automobile manufacturers are looking at forecasts based on trends that are a little higher than we have in our forecast.
TO BE CONTINUED ...
Re: MINUTES OF JULY 3, 1996 FOMC MEETING
CHAIRMAN GREENSPAN. President Minehan.
MS. MINEHAN. Just a quick couple of questions, Mike.
In the adjustments on the CPI that are more or less technical adjustments, have you gone back and redone the CPI over time, or perhaps back a couple of years, to see if we still have the same trend that we saw before?
The striking thing about this Greenbook is that, because of those technical adjustments, we see inflation flattening out from where we think it has been.
But it really has not been there because the numbers that we were using before did not have those technical adjustments in them.
MR. PRELL. Well, I will yield to my colleague, who is much more expert on this, but there is, in a sense, a discontinuity here.
Some of the adjustments we are making have to do with the arithmetic that perhaps you can view as fairly predictable.
When it gets to things like changing the way in which costs of medical care are calculated, there are real underlying economic considerations involved and the relationships could shift.
MS. MINEHAN. They may not be the same.
MR. PRELL. We have tried to make a sensible assessment of how movements in the old and new versions would go and that is what led us to make the adjustments that we did, but I think that all this is a little problematic.
MS. MINEHAN. Maybe very minor.
MR. STOCKTON. President Minehan, we have a long history of adjustments to the CPI; it goes back over the entire postwar period.
Improvements are continually being made, but I believe there will be a concentration of them in this 1996, 1997, and 1998 period.
In fact, we could see some discontinuities stemming from the improvements in methodology as well as changes in medical care estimates.
In 1998, another significant change could be an updating of the weighting scheme that could take another couple of tenths off the core CPI.
CHAIRMAN GREENSPAN. You also have to look back historically and ask yourself what was actually going on.
If we combine all the adjustments and go back in time, it does show a different picture.
We have been looking at a picture in which core CPI appears to have flattened out.
MS. MINEHAN. Maybe it really has been declining.
CHAIRMAN GREENSPAN. The mere change of the dubious medical price component in the CPI for the much better medical net output price in the PPI plus a change in the weights in and of itself takes what was a flat trend and turns it down.
MS. MINEHAN. The Greenbook projects the core CPI to decline and then to come back up again.
CHAIRMAN GREENSPAN. Well, it has not come back up if you look through the month of May.
That's the whole point.
In other words, the backup is a forecast.
I will try to document this at some length tomorrow.
It is a very relevant issue and it is very important for us to answer the question of what in fact the inflation rate has been.
The problem that we are running into here is that we are combining changing inflation with changing BLS procedures.
I think that is creating a degree of skewness that we have to cut through.
MS. MINEHAN. For me the question is not even what inflation is in absolute terms.
It is what the trend is and that is hard to understand.
CHAIRMAN GREENSPAN. I'll try to explain it tomorrow on the basis of the data we have put together.
If we look at various broad measures of inflation including the core PCE chain price index, which is the best consumer price index by far as Roberts pointed out in his memo, it really makes a difference.
Even looking at broader measures such as the gross domestic purchases chain price index, which picks up consumer prices plus everything else, that index has been going straight down into the current quarter with no evidence yet of a turn.
Our view of what is happening to inflation is a critical issue here because it says a great deal about what is going on in the economy.
It is very difficult to forecast the outlook for economic activity unless we have some sense of that pattern.
The emphasis that we have been putting on the consumer price index, I think in retrospect, is turning out to have been a mistake.
It has been a mistake in the sense that the CPI is biased not only with respect to the absolute amount of change--the 1/2 to 1-1/2 percentage point bias--but there is also increasing evidence that the bias is increasing.
That suggests that the true measures of inflation are giving us a somewhat different picture, one that in a certain sense is ambiguous but, to the extent that we can observe, one that indicates a slower rate of inflation.
Now, that may be noise but that is the interpretation.
MS. MINEHAN. Thank you very much, Mr. Chairman.
I have one other small question.
Ted, on your Chart 7, Foreign Growth and U.S. Exports, is that merchandise exports alone or merchandise and services?
MR. TRUMAN. The top chart?
MS. MINEHAN. Yes, or any of those charts.
Do they include services as well?
MR. TRUMAN. No, the top chart in the top panel includes just goods.
MS. MINEHAN. Are the rest of these just goods, too?
MR. TRUMAN. These are all goods in nominal terms.
MS. MINEHAN. It doesn't show on the charts on the next page or at least it doesn't show clearly as I understand this, but exports of services are growing more than exports of merchandise, are they not?
MR. TRUMAN. My memory would be that, for example this year, we have exports of merchandise growing 7 percent and exports of goods and services together growing 5 percent.
Next year it is 11 and 9 percent.
MS. MINEHAN. So you have services pulling the overall rate of growth down?
MR. TRUMAN. Yes, services are pulling it down.
Last year services in the GDP accounts grew only 1-1/2 percent over the four quarters.
I hesitate to offer a firm opinion because this calculation may not have been done correctly.
There were revisions and we tried to incorporate them in the historical GDP numbers.
Whether the revisions got incorporated in the right way, I am not 100 percent confident.
There was some double counting of services.
I think that happened more on the import side than on the export side.
MS. MINEHAN. Is there any reason to assume that the growth of services in foreign trade is being skewed by the relative performance of trade with developing countries versus industrial countries?
MR. TRUMAN. Because you come from New England, you probably think that your region is providing a lot of services.
MS. MINEHAN. That don't get measured, yes.
MR. TRUMAN. That don't get measured in.
I have the same bias, but I have not been able to convince anybody that the treatment is wrong.
MS. MINEHAN. We believe that, but maybe like a lot of the other things we believe, it isn't true.
TO BE CONTINUED ...
MS. MINEHAN. Just a quick couple of questions, Mike.
In the adjustments on the CPI that are more or less technical adjustments, have you gone back and redone the CPI over time, or perhaps back a couple of years, to see if we still have the same trend that we saw before?
The striking thing about this Greenbook is that, because of those technical adjustments, we see inflation flattening out from where we think it has been.
But it really has not been there because the numbers that we were using before did not have those technical adjustments in them.
MR. PRELL. Well, I will yield to my colleague, who is much more expert on this, but there is, in a sense, a discontinuity here.
Some of the adjustments we are making have to do with the arithmetic that perhaps you can view as fairly predictable.
When it gets to things like changing the way in which costs of medical care are calculated, there are real underlying economic considerations involved and the relationships could shift.
MS. MINEHAN. They may not be the same.
MR. PRELL. We have tried to make a sensible assessment of how movements in the old and new versions would go and that is what led us to make the adjustments that we did, but I think that all this is a little problematic.
MS. MINEHAN. Maybe very minor.
MR. STOCKTON. President Minehan, we have a long history of adjustments to the CPI; it goes back over the entire postwar period.
Improvements are continually being made, but I believe there will be a concentration of them in this 1996, 1997, and 1998 period.
In fact, we could see some discontinuities stemming from the improvements in methodology as well as changes in medical care estimates.
In 1998, another significant change could be an updating of the weighting scheme that could take another couple of tenths off the core CPI.
CHAIRMAN GREENSPAN. You also have to look back historically and ask yourself what was actually going on.
If we combine all the adjustments and go back in time, it does show a different picture.
We have been looking at a picture in which core CPI appears to have flattened out.
MS. MINEHAN. Maybe it really has been declining.
CHAIRMAN GREENSPAN. The mere change of the dubious medical price component in the CPI for the much better medical net output price in the PPI plus a change in the weights in and of itself takes what was a flat trend and turns it down.
MS. MINEHAN. The Greenbook projects the core CPI to decline and then to come back up again.
CHAIRMAN GREENSPAN. Well, it has not come back up if you look through the month of May.
That's the whole point.
In other words, the backup is a forecast.
I will try to document this at some length tomorrow.
It is a very relevant issue and it is very important for us to answer the question of what in fact the inflation rate has been.
The problem that we are running into here is that we are combining changing inflation with changing BLS procedures.
I think that is creating a degree of skewness that we have to cut through.
MS. MINEHAN. For me the question is not even what inflation is in absolute terms.
It is what the trend is and that is hard to understand.
CHAIRMAN GREENSPAN. I'll try to explain it tomorrow on the basis of the data we have put together.
If we look at various broad measures of inflation including the core PCE chain price index, which is the best consumer price index by far as Roberts pointed out in his memo, it really makes a difference.
Even looking at broader measures such as the gross domestic purchases chain price index, which picks up consumer prices plus everything else, that index has been going straight down into the current quarter with no evidence yet of a turn.
Our view of what is happening to inflation is a critical issue here because it says a great deal about what is going on in the economy.
It is very difficult to forecast the outlook for economic activity unless we have some sense of that pattern.
The emphasis that we have been putting on the consumer price index, I think in retrospect, is turning out to have been a mistake.
It has been a mistake in the sense that the CPI is biased not only with respect to the absolute amount of change--the 1/2 to 1-1/2 percentage point bias--but there is also increasing evidence that the bias is increasing.
That suggests that the true measures of inflation are giving us a somewhat different picture, one that in a certain sense is ambiguous but, to the extent that we can observe, one that indicates a slower rate of inflation.
Now, that may be noise but that is the interpretation.
MS. MINEHAN. Thank you very much, Mr. Chairman.
I have one other small question.
Ted, on your Chart 7, Foreign Growth and U.S. Exports, is that merchandise exports alone or merchandise and services?
MR. TRUMAN. The top chart?
MS. MINEHAN. Yes, or any of those charts.
Do they include services as well?
MR. TRUMAN. No, the top chart in the top panel includes just goods.
MS. MINEHAN. Are the rest of these just goods, too?
MR. TRUMAN. These are all goods in nominal terms.
MS. MINEHAN. It doesn't show on the charts on the next page or at least it doesn't show clearly as I understand this, but exports of services are growing more than exports of merchandise, are they not?
MR. TRUMAN. My memory would be that, for example this year, we have exports of merchandise growing 7 percent and exports of goods and services together growing 5 percent.
Next year it is 11 and 9 percent.
MS. MINEHAN. So you have services pulling the overall rate of growth down?
MR. TRUMAN. Yes, services are pulling it down.
Last year services in the GDP accounts grew only 1-1/2 percent over the four quarters.
I hesitate to offer a firm opinion because this calculation may not have been done correctly.
There were revisions and we tried to incorporate them in the historical GDP numbers.
Whether the revisions got incorporated in the right way, I am not 100 percent confident.
There was some double counting of services.
I think that happened more on the import side than on the export side.
MS. MINEHAN. Is there any reason to assume that the growth of services in foreign trade is being skewed by the relative performance of trade with developing countries versus industrial countries?
MR. TRUMAN. Because you come from New England, you probably think that your region is providing a lot of services.
MS. MINEHAN. That don't get measured, yes.
MR. TRUMAN. That don't get measured in.
I have the same bias, but I have not been able to convince anybody that the treatment is wrong.
MS. MINEHAN. We believe that, but maybe like a lot of the other things we believe, it isn't true.
TO BE CONTINUED ...