Appendix 1: Materials used by Messrs. Wilcox, Elmendorf, and Reinhart

February 1-2, 2005 137 of 177

RESTRICTED CONTROLLED (FR) CLASS I (FOMC) Material for Board Staff Presentation on:

Considerations Pertaining to the Establishment of a Specific, Numerical, Price-Related Objective for Monetary Policy Divisions of Research & Statistics and Monetary Affairs February 1, 2005

February 1-2, 2005 138 of 177

February 1-2, 2005 139 of 177

Exhibit t

A Specific, Numerical, Price-Related Objective for Monetary Policy?

Inflation Rates GDP chain price index peE chain price index CPI (current methods)

Four-quarter percent change

2·1-05

12

10

8

6

4

2

K----1~--~------------------------------------------------------~ 0

Key characteristics of a specific, numerical, price-related objective:

• Numerical rather than qualitative;

• Stated in terms of a particular published index; and

• Either inflation control or price-level control.

A premise of the paper:

• A price objective should be chosen to minimize the costs of deviations from price stability.

• The premise suggests that the objective should be defined with respect to the price index most closely related to such costs.

February 1-2, 2005 140 of 177

Exhibit 2

Potential Benefits and Costs of Adopting a Specific Price-Related Objective

Potential Benefits:

• Could help preserve the present commitment to price stability.

• Could better anchor long-run inflation expectations and thereby reduce the volatility of both inflation and real activity.

• Could improve public understanding of monetary policy.

• Could help focus policy debates within the FOMC.

Potential Costs:

• Could mislead the public into believing that emphasis had shifted toward the price objective.

• Could cause the FOMC inadvertently to place more emphasis on the price objective.

• Could diminish the FOMC's credibility when inflation differed from the stated objective.

• Could constrain future actions of the FOMC in an unhelpful manner.

Empirical Evidence:

• Little to no evidence regarding the likely influence on FOMC decision-making or the quality of communications with the public.

• Some hints from foreign experience that specific price objectives have helped anchor long-term inflation expectations.

• Disputed evidence that the reduced volatility of inflation and real output owes to improved conduct of U.S. monetary policy.

• Simulation-based evidence that better-anchored inflation expectations would reduce the volatility of inflation and real output.

2·1-05

February 1-2, 2005 141 of 177

Exhibil3

Operational Issues Related to Specifying a Numerical Price-Related Objective

A checklist for policymakers:

• Which price index?

• The inflation rate or the price level?

• What average rate?

• Point objective or range?

If an inflation objective, at what rate?

For index, we favor consumer prices on the grounds of:

• Familiarity_

• Quality of measurement

• Empirical result that inflation rates move together in the long run.

• Measurement bias: Nearly 1 percentage point for CPI; about % percentage point for PCE prices.

• Rationales for aiming for zero true inflation: Traditional costs of inflation.

• Rationales for aiming for positive true inflation: Downward nominal wage rigidity; zero lower bound on nominal interest rates.

Effect of zero lower bound under an updated Taylor rule:

Fraction of time with funds rate at zero

Standard deviation of output gap'

Standard deviation of unemployment rate'

'measured in percentage points

Target PCE inflation rate (measured rate, with

bias-adjusted rate in parentheses)

% (0)

.16

2.53

1.40

1 % (1)

.10

2.31

1.27

2 % (2)

.06

2.21

1.22

2-1-05

February 1-2, 2005 142 of 177

Exhibit 4

Accuracy in Achieving an Inflation Objective

Imperfect controllability:

• Inflation is volatile, and monetary policy influences it only indirectly and with a lag.

• The FOMC could not hit a point objective precisely or guarantee a narrow range.

Percent of time that peE inflation averaged over four quarters could be held within ± 1 percentage point of desired rate:

Total Core

Volatility of economic shocks matters:

1. Drawn from 1968 to 2004 experience 59 64

2. Drawn from 1984 to 2004 experience 68 73

Expectations formation matters:

3. VAR-based expectations with imperfect credibility 68 73

4. VAR-based expectations with perfect credibility 80 89

Summary:

• The FOMC could likely keep four-quarter total PCE inflation within a ± l-percentage-point band about to % of the time.

2·1-05

February 1-2, 2005 143 of 177

Exhibit 5 2-t-05

Governance Issues Related to the Specification of Price Stabilty

Is an explicit numerical 1 specification of price stability

helpful? /"-.

~ YES

Continue the status quo_

At the margin, the FOMC could: Should the objective be

2 made public?

• encourage participants to be more specific about preferences;

- use the minutes, testimonies, and the MPR to provide additional YES guidance to the public_

~ \ Agreement on a private Should the objective be decided

objective may facilitate internal by the Congress (by amending

communications, but the Federal Reserve Act) or by 3 the FOMC?

how can the FOMC justify keeping it secret?

~\roNG~ how will the FOMC keep it secret?

~ Is the FOMC:

. comfortable in seeking amendment to the FRA?

How will the FOMC choose an . confident that the Congress would 4 inflation objective? pick an appropriate inflation objective?

/ -----------And will this lead to the creation of a numerical objective for output growth or employment as well?

7 ------------5 As a group decision, similar As individual decisions,

to choosing a range for a summarized by announcing the

monetary aggregate_ range and central tendency of participants' views_

February 1-2, 2005 144 of 177

ExhibitS

Key Questions for Today's Discussion

How do you define price stability?

• Is it known by inference about behavior of by a numerical specification?

• If the latter,

• What price index do you prefer?

• Should the objective be stated in terms of a path for the price level or as the rate of inflation?

• What are the desired point estimates or ranges for the inflation objective?

What role should the price objective play in the Committee's policy process?

• Alternative I: Maintain the status quo

• Perhaps provide more information to the public over time as to your attitudes toward prevailing and prospective inflation

• Alternative II: Vote formally on a numerical inflation goal

• Alternative III: Survey participants as to the appropriate inflation objective

2-1-05

Appendix 2: Materials used by Mr. Kos

February 1-2, 2005 145 of 177

Current U.S. 3-Month Deposit Rates and Rates Implied by Traded Forward Rate Agreements

December 1, 2004 - January 31, 2005 t LIBOR Fixing 3M Forward 6M Forward 9M Forward

I1 NIT 12 14 OM 4 Minmws 7 NFP 112K 25 bps Release 57K

. . -

2 1 1213 12 2-Year Treasury Yield

December 1, 2004 - January 31, 2005It

1

Percen 3.4

3.2 -

2.8 +-

12/1 12/13 12/25 1/6 1/18 1/30

Yield Spread Between 2-and 10-Year Treasury Notes

December 1, 2004 - January 31, 2005 Basis Points Basis Points 140 , ,- 140

12 14 FO1C .25 bps

I 4 finutes Release

12 114 FOMC S25 bps

1 4 Mines Release

25

Percent Percen T 3 .4 4 .5 -1

3.2 4.3

3.0 4.1

1/6 1118 1 10-Year Treasury Yield

December 1, 2004 - January 31, 2005

12 14 FONC 25 ps

I 4 Inuls Reclease

Percent T 4.5

3.9 -- r i 3.9

12/1 12/13 12/25 1/6 1/18 1/30

Yield Spread Between 10- and 30-Year Treasury Notes

December 1, 2004 - January 31, 2005 Basis Points Basis Points 901 141i t 90

120 70

100 50

I16 1118 1/30

2 14FOMC 25 bps

30+- 1 T

12 I 1213 12/25 1/6 1 18 1 30

Page I

Percen

4.00

3.50

3.00

2.50

-9

Percent

4.00

3.50

3.00

2.50

2.00

F T ~

t

(nu es Release

12/1 12 13 12125

February 1-2, 2005 146 of 177

10-Year Swap Spread June 30, 2004 - January 28, 2005

Basis Points Basis Points 52 52

48 - 48

44 44

40 40

36 36

Basis Points 50

45

40

35

20

MBS Spreads June 30, 2004 - January 28, 2005

630 7 30 830 9130 1030 1130 1230

Investment Grade Corporate Debt Spreads June 30, 2004 - January 28, 2005

Basis Poi

7 5 7 30.' ' 9

6,,30 71/30 8/30 9/30 10/30 111/30 12/30

6/30 7/30 8/30 9/30 10/30 1130 1230

High Yield and EMBI+ Spreads June 30, 2004 - January 28, 2005

nts Basis Points Basis Points 105 520 1 r 520

100 480

95 440

90 400

85 360

80 320

75 280 "o""c: nICITII Lx fcir iior

630 7/30 8/30 9'30 10/30 11 30 12/30

Implied Swaption Volatility May 3, 1999 - January 28, 2005

I lonth \ olatility on 10-Year sw' aption

Page 2

Basis Points 50

45

40

35

30

Basis Points

Percent

15

12

9

6

Percent

15

12

9

6

1.33 N Nay'99 Nov ')9 May-00 Nov-00 May-01 Nov-01 Mav-02 Nov-02 MayV03 Nov-03 May-04 Nov-04

February 1-2, 2005 147 of 177

Page 3

Percent

2.60 - 2 3IT' :+112K

2.50

4A:

Euro-Area 3-Month Deposit Rates and Rates Implied by Traded Forward Rate Agreements

December 1, 2004 - January 3 1, 2005 LIBOR Fixing 3M Forward 6M Forward 9M For

12 14 FOM( 1 4 mues 17 NIP 5 bps Release I57K

ward Percent

T 2.60

--'

- 2.50

-2.40

2.30

2.20

2.10

12"1 12 13 12/25 Euro-Dollar Currency Pair

December 1, 2004 - January 31, 2005 S per Euro S per Euro

1.38 ,1 ... . 1., r 1.38

1 6 1118 1130 Dollar-Yen Currency Pair

December 1, 2004 - January 31, 2005 Yen per S Yen per S

106 1 r c r 106

1.36 105

1.34 104

1.32 103

1.30 102

1.28 10112/1 12/13 12 25 1/6 1/18 I30

Dollar-Yuan Exchange Value Implied by the NDF Market

July 1, 2004 - January 31, 2005 Yuan per Dollar Yuan per Dollar

8.4 -1 U , 11-:S n -. .1 r 8.4

Sep-0

12/1 12/13 12/25 1/6 1/18 1/30

Foreign Exchange Reserves of China & Japan December 3 1, 2003 - December 31, 2004

USD Billions 900 -1

800

700

600

500

7.7 40 f

Dec

USD Billions r 900

Japan

800

700

600

500

4r0

-03 Mar-04 Aun-04 Sep-04 Dec-04

7.7 -1 Jul-04 .an-05

%! * y .1

February 1-2, 2005 148 of 177

Current Account Balances (CAB) at the Bank of Japan and the Overnight Call Rate

April 30, 1998 - December 31, 2004 Yen, trillions Basis points

L zIRP oA Source 3oJ 50

Apr- Apr- Apr- Apr- Apr- Apr- Apr98 99 00 01 02 03 04

1-month Rolling Average of the 3-month Bill Auction History

April 30, 2002 - January 19, 2005 trillions Bid-to-Cover Ratio

_700

Oct-02 Apr-03 Oct-03 Apr-04 Oct-04

Bid-to-Cover on BoJ Outright Purchases of FB/TBs

April 8, 2004 - January 13, 2005

0 +

Apr-02

Ven, tri 30

10 5

0 0

Page 4Japanese Call Market

Uncollateralized Amount Outstanding January 4, 1999 - January 28, 2005

llions Yen, trillions 30

Jan- Oct- Jul- Apr- Jan- Oct- Jul99 99 00 01 02 02 03

Apr- Jan04 05

BoJ Securities Holdings July 31, 1996 - December 31, 2004

Yen, trillions 70 T

600 60 50

500 40

400 30

300 20 10

200 0

Yen, trillions 70

60

50 Bills*

Futright 40 30

20 cer

10

0

100 Jul- Jul- Jul- Jul- Jul- Jul- Jul- Jul- Jul96 97 98 99 00 01 02 03 04

0 * Source BoJ * Teiat Bills tr,,m financial misu ins I bill. u luin corp debt obig ton,

urt la sedi t'll n lunci.tl M in ttumlns

Changes in the Japanese Government Bill Curve Since the Start of Quantitative Easing

Bid-to-Cover Ratio 7

6 5 4 \

Bid-to-Cover Ratio 7

0 0 3-nAnth 6-n-nth-

Yen,

Basis points 10 t

Basis points , 10

Apr-04 Jun-04 Aug-04 Oct-04 Dec-04 12-nwnth 2-vear

February 1-2, 2005 149 of 177

Daily Intra-Day Standard Deviations of the Federal Funds Rate 1987 -2004

Annual av erages of dailyx alus_

Annual medians of daily values

-x l r'; -t v. h -4 r

Average Intraday Standard Deviation of Federal Funds Rates (Maintenance Period Averages)

For Maintenance Periods Ending January 21, 2004 - January 19, 2005

FOMC Unch.

FOMC Unch. FOMC

Unch.

- tx - r-~ - Cl ^ Cl f'- - NC- -1 77 ~ 1 1 r r

FOMC +25 bps

FOMC 25 bps

FOMC +25 bps

rr -- t x n

Year End

FOMC FOMC -25 bps 25 bps

I-l -----,-

Page 5

Percent 0.40

0.35 -

0 30

0.25

0.20

0.15

005

0 00

Bai .4

Basis Points

February 1-2, 2005 150 of 177

Appendix 3: Materials used by Messrs. Slifman and Struckmeyer, and Ms. Johnson

February 1-2, 2005 151 of 177

STRICTLY CONFIDENTIAL (FR) CLASS I-FOMC*

Material for

Staff Presentation on the Economic Outlook

February 2, 2005

*Downgraded to Class II upon release of the February 2005 Monetary Policy Report.

February 1-2, 2005 152 of 177

Private Payroll Employment

Average monthly change, thousands

2002 2003 2004

Chart 1

:ent Indicators

Manufacturing Industrial Production

250 Percent change, a.r.

200

150 1972-2003 4 100 average

50

0

-50

-100 2002 2003 2004

Real PCE exc. Motor Vehicles* Sales of Light Vehicles

In this and subsequent charts, NIPA series in 2004:Q4 are from the January Greenbook.

Orders and Shipments of Nondefense Capital Goods*

Billions of dollars 65 3-month moving average Dec.

Orders 62 Dec. percent change

Shipments 2.2 59

Orders 1.8

56

Shipments 53

2003. .0502002

*Excluding aircraft.

Millions of units, a.r.

2002 2003

Real GDP

2004

Percent change, a.r.

2004:Q4

Jan. GB BEA

1. Real GDP 3.5 3.1

Contributions (percentage points)

2. Final sales 2.7 2.7

3. Inventories .8 .4

i . . . I . . . I . . . i

2003 2004

February 1-2, 2005 153 of 177

February 1-2, 2005 154 of 177

February 1-2, 2005 155 of 177

February 1-2, 2005 156 of 177

February 1-2, 2005 157 of 177

February 1-2, 2005 158 of 177

February 1-2, 2005 159 of 177

February 1-2, 2005 160 of 177

February 1-2, 2005 161 of 177

Chart 10

Financial Developments

60

70

80

90

100

110

Nominal Exchange RatesForeign currency/U.S. dollar

Major currencies*

Euro

Yen

2002 2003 2004 2005*Trade-weighted average against major currencies.

(Monthly data)

Index, Jan. 2002 = 100

0

2

4

6

Ten-Year Interest Rates

United States

Japan

Germany

2002 2003 2004 2005

Percent

0

1

2

3

4

Three-Month Interest Rates

Dollar

Yen

Euro

2002 2003 2004 2005

Percent

1

2

3

4

5

Term Structure of Three-Month Euro Futures

February 1, 2005

January 27, 2004

June 29, 2004

2004 2005 2006 2007

Percent

50

70

90

110

130

Broad Stock Price Indexes

S&P 500

TOPIX

DJ Euro Stoxx

2002 2003 2004 2005

Index, Jan. 2002 = 100

-1

0

1

2

3

Term Structure of Three-Month Yen Futures

February 1, 2005

January 27, 2004

June 29, 2004

2004 2005 2006 2007

Percent

February 1-2, 2005 162 of 177

Chart 11

Foreign Outlook

2003 2004-30

-20

-10

0

10

20

UnitedKingdom

EuroArea

Japan

Quarterly

Business ConfidencePercent balance

2003 200430

35

40

45

50

-20

-15

-10

-5

0

UnitedKingdom

EuroArea

Japan

Quarterly

Consumer Confidence Diffusion index Percent balance

2003 200485

95

105

115

125

UnitedKingdom

EuroArea

Japan

Monthly

ExportsIndex, Jan. 2003 = 100

Foreign Real GDP*Percent change, a.r.**

* Aggregates weighted by shares of U.S. exports.** Year is Q4/Q4; half year is Q4/Q2; quarters are percent change from previous quarter.

2004 2005 2006 Q3 Q4 Q1 Q2 H2

1. Total Foreign 2.6 3.1 3.0 3.3 3.4 3.3

2. Industrial Countries 1.9 2.0 2.1 2.4 2.5 2.4 of which: 3. Japan 0.2 1.0 1.2 1.4 1.6 1.8 4. Euro Area 1.1 1.4 1.4 1.5 1.6 1.6 5. United Kingdom 1.8 3.0 2.1 2.6 2.6 2.2 6. Canada 3.2 2.2 2.6 2.9 3.2 3.0

7. Emerging Economies 3.8 4.8 4.4 4.6 4.6 4.5 of which: 8. China 10.1 11.2 7.1 7.1 7.1 7.5 9. Emerging Asia exc. China 3.2 3.9 4.2 4.6 4.4 4.210. Mexico 2.6 4.0 4.0 4.1 4.2 4.311. South America 4.1 3.8 3.8 3.8 3.7 3.6

February 1-2, 2005 163 of 177

Chart 12

Emerging Market Economies

0

500

1000

1500

2000

2500

0

100

200

300

400

500

600

* The series shown are the EMBI+ Brazil sub-index, the EMBIGlobal Thailand sub-index, and the Indonesian Yankee Bond Spread.

2002 2003 2004 2005

Brazil

Thailand

Indonesia

Weekly

Spreads* Basis points Basis points

50

75

100

125

150

175

200

2002 2003 2004 2005

Brazil

Korea

Singapore

Weekly

Stock Price IndexesIndex, Jan. 4, 2002 = 100

95

100

105

110

115

120

125

130

135

2003 2004

China

Korea

Thailand

Monthly

Industrial ProductionIndex, Jan. 2003 = 100

90

110

130

150

170

190

2003 2004

China

Korea

Thailand

Monthly

ExportsIndex, Jan. 2003 = 100

95

100

105

110

115

2003 2004

Mexico

Brazil

Monthly

Industrial ProductionIndex, Jan. 2003 = 100

80

100

120

140

160

180

2003 2004 2005

Mexico

Brazil

Monthly

ExportsIndex, Jan. 2003 = 100

February 1-2, 2005 164 of 177

Chart 13

Trade Developments

* Excludes oil.** Average of October and November data.

Q3 O-N** Change

1. Balance -621 -698 -77

Imports: 2. G & S 1780 1858 78 3. Cons. Gds. 365 386 21 4. Machinery 180 182 2 5. Ind. Sup.* 241 244 3 6. Oil 180 220 40 7. Other 814 826 12

Exports: 8. G & S 1158 1160 2 9. Machinery 169 165 -410. Ind. Sup. 190 195 511. Other 799 800 1

Trade in Goods and ServicesBillions of dollars, a.r.

120

140

160

180

200

220

2002 2004

Canada

W. Europe

Goods Exports By RegionBillions of dollars, s.a.a.r.

20

40

60

80

100

120

2002 2004

Other Latin America

Mexico

0

20

40

60

80

100

2002 2004

Japan

China and Hong Kong

60

80

100

120

140

160

2002 2004

Other Asia

10

20

30

40

50

60

2002 2004 2006

WTI spot price

U.S. import price

Trade Prices Oil Prices

Dollars per barrel

2002 2003 2004 2005 2006-4

-2

0

2

4

6

8Contribution of foreign prices in US$Contribution of commodity pricesCore import price

Core Import PricesPercent change, a.r.

February 1-2, 2005 165 of 177

Chart 14

External Sector

2004 2005 2006-3

-2

-1

0

1

2

3ExportsImports

Contributions to U.S. GDP GrowthPercentage points

65

75

85

95

105

2002 2004 2006

GB baselineAlternative simulation

Broad Real DollarIndex, 2002:Q1 = 100

-900

-800

-700

-600

-500

-400

-300

2002 2004 2006

Trade balanceCurrent account balance

External BalancesBillions of dollars

2004Q4 2006Q4 Change

Trade balance baseline -689 -720 -31 weaker dollar -689 -689 0

Current account balance baseline -774 -881 -107 weaker dollar -774 -863 -89

Simulation ResultsBillions of dollars

Real Export GrowthPercent, Q4/Q4

*Excludes computers and semiconductors.

2003 2004 2005 2006

1. Goods and 6.1 4.9 8.7 7.2 services

Percentage point contribution:2. Services 1.2 1.4 2.0 1.83. Goods 4.9 3.5 6.6 5.4 of which4. Core* 3.0 3.5 5.1 3.9

Real Import GrowthPercent, Q4/Q4

*Excludes computers, semiconductors, and oil.

2003 2004 2005 2006

1. Goods and 4.9 9.3 5.2 7.6 services

Percentage point contribution:2. Services 0.6 0.3 0.6 0.73. Goods 4.2 9.0 4.6 6.9 of which4. Core* 3.3 6.7 4.5 5.6

February 1-2, 2005 166 of 177

Chart 15

ECONOMIC PROJECTIONS FOR 2005

FOMC

Range CentralTendency

Staff

-------------Percentage change, Q4 to Q4------------

Nominal GDP July 2004

Real GDP July 2004

Core PCE Prices July 2004

5 to 6 (4¾ to 6½)

3½ to 4(3½ to 4)

1½ to 2

(1½ to 2½)

5½ to 5¾(5¼ to 6)

3¾ to 4(3½ to 4)

1½ to 1¾(1½ to 2)

5.4(5.0)

3.9(3.6)

1.6(1.6)

--------------Average level, Q4, percent---------------

Unemployment rate July 2004

5 to 5½(5 to 5½)

5¼(5 to 5¼)

5.3(5.3)

Central tendencies calculated by dropping high and low three from ranges.

ECONOMIC PROJECTIONS FOR 2006

FOMC

Range CentralTendency

Staff

-------------Percentage change, Q4 to Q4------------

Nominal GDP Real GDP

Core PCE Prices

5 to 5¾

3¼ to 3¾

1½ to 2

5 to 5½

3½

1½ to 1¾

5.3

3.6

1.4

--------------Average level, Q4, percent---------------

Unemployment rate 5 to 5¼

5 to 5¼

5.1

February 1-2, 2005 167 of 177

Appendix 4: Materials used by Mr. Olson

February 1-2, 2005 168 of 177

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Seasonal Factors Out of 100 percent)

All Insured Commercial Banks Banks L T $1 billion 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q

NPA Ratio 101 .3 100.2 100.6 97.9 NPA Ratio 101 .7 99.9 100.5 97.8 Net Net ICharge-oft Charge-off Ratio 90.2 96.6 96.3 116.7 Ratio 76 .0 92.4 91 .7 139.7

Prev to Prev to Avg Loans 91.9 94.6 98.9 11 4.3 Avg Loans 85.3 92 .5 97.7 124.4

Total Mean S.D. Total Mean S.D.

NPA Ratio 105.94 1.80 1.32 NPARatio 80.55 1.37 0.74 Net Net Charge-off v harge-off Ratio 51 .75 0.88 0.35 Ratio 26 .54 0.45 0.18

Prev to Prov to Avg Loans 54.21 0.92 0.38 Avg Loans 34.19 0.58 0.22

February 1-2, 2005 171 of 177

Seasonal Factors Out of 100 percent)

All Insured Commercial Banks Banks L T $1 billion 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q

NPA Ratio 101 .3 100.2 100.6 97.9 NPA Ratio 101 .7 99.9 100.5 97.8 Net Net ICharge-oft Charge-off Ratio 90.2 96.6 96.3 116.7 Ratio 76 .0 92.4 91 .7 139.7

Prev to Prev to Avg Loans 91.9 94.6 98.9 11 4.3 Avg Loans 85.3 92 .5 97.7 124.4

Total Mean S.D. Total Mean S.D.

NPA Ratio 105.94 1.80 1.32 NPARatio 80.55 1.37 0.74 Net Net Charge-off v harge-off Ratio 51 .75 0.88 0.35 Ratio 26 .54 0.45 0.18

Prev to Prov to Avg Loans 54.21 0.92 0.38 Avg Loans 34.19 0.58 0.22

Appendix 5: Materials used by Mr. Reinhart

February 1-2, 2005 172 of 177

Restricted Controlled (FR) Class I (FOMC)

Material forFOMC Briefing on Monetary Policy Alternatives

Vincent R. ReinhartFebruary 2, 2005

February 1-2, 2005 173 of 177

Exhibit 1The Case for Tightening 25 Basis Points

Expected Federal Funds Rate

F February 1, 2005-------- December 13, 2004- - - Greenbook path

Percent

h/i' 1 1 1 l iI i mll II I I I AFeb. May Aug. Nov. Feb. May Aug. Nov.

2005 2006

Corporate and Sovereign Bond Spreads*Basis points Basis points

5-year High Yield (left scale)------ EMBI (right scale)

I I I I I I I I I I I I I I

Unemployment Rate Percent

3.2 1990 1993 1996 1999 2002 2005

3.0 Core PCE Inflation Percent

1990 1993 1996 1999 2002 2005

Asset Prices and Monetary Policy

* Asset price misalignments are hard toidentify with confidence.

* Appropriate monetary policy is not clear.

* Other instruments may be better suitedto dealing with such problems.

1990 1992 1994 1996 1998 2000 2002 2004

*Spreads over yields on comparable maturity Treasuries.

Values from Policy Rules and Futures MarketsPercent

- Actual federal funds rate and Greenbook assumption.... Market expectations estimated from futures quotes

An explanatory note is provided in Chart 9 of the Bluebook.

1200

1000

800

600

400

2nn200

Monthly

February 1-2, 2005 174 of 177

Exhibit 2When Will You Stop Tightening?

Market Participants Assume:

* Policy will be tightened 25 bps at everymeeting.

* Until this tightening cycle ends.

* They are uncertain as to when tightening willend.

Cumulative Probability of First FOMC MeetingWithout Tightening Probability

3.50

3.25

3.00

2.75

2.50

2.25

Aug Nov Feb May Aug Nov 2007+2006

First FOMC meeting without tightening

Percent

Range ofdates of

finaltightening

After Nov. 06

Aug. 06 - Nov. 06

Feb. 06 - Jun. 06

Aug. 05 - Dec. 05

Feb. 05 -Jun. 05

1.00

0.75

0.50

0.25

0.0

Median Path for Policy Percent

Feb. Mar. May Jun. Aug. Sep. Nov. Feb May A

2005 2005First F

Range of Estimated Equilibrium Real Rates

S Range of model-based estimates - Actual real federal funds rateS70 percent confidence band - - Greenbook-consistent measure

[i 90 percent confidence band

lit I. Ill 111111 .I I.. I III I I Il . 11111. 111 I I II1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

An explanatory note is provided in Chart 8 of the Bluebook.

- "

February 1-2, 2005 175 of 177

Exhibit 3

Assessing the Risk Assessment

From the FOMC Statement released December 14 th

The Committee perceives the upside and downside risks to theattainment of both sustainable growth and price stability for thenext few quarters to be roughly equal. With underlying inflationexpected to be relatively low, the Committee believes that policyaccommodation can be removed at a pace that is likely to bemeasured. Nonetheless, the Committee will respond to changes ineconomic prospects as needed to fulfill its obligation to maintainprice stability.

Three alternatives

1. Get out of the business of hinting-either obliquely ordirectly-about future actions by dropping the entireparagraph.

2. Revive the first sentence assessing risks by basing it on theassumption of an unchanged stance of policy for the next fewquarters and couching it in terms of probabilities, not risks.

3. Rely on the gradual evolution of the latter part of theparagraph to convey a sense of the future path of interestrates.

February 1-2, 2005 176 of 177

Table 1: Alternative Language for the January FOMC Announcement

December FOMC Alternative A Alternative B Alternative C

1. The Federal Open Market Committee The Federal Open Market Committee The Federal Open Market The Federal Open Market Committeedecided today to raise its target for the decided today to keep its target for the Committee decided today to raise its decided today to raise its target for the

Policy federal funds rate by 25 basis points to federal funds rate at 2¼ percent. The target for the federal funds rate by federal funds rate by 50 basis points toDecision 2¼ percent. Committee's policy actions since mid- 25 basis points to 2½ percent. 2¾ percent.

2004 have materaily reduced the degreeof monetary policy accommodation.

2. The Committee believes that, even The Committee believes that the stance The Committee believes that the stanceafter this action, the stance of of monetary policy remains somewhat Unchanged from of monetary policy remainsmonetary policy remains accommodative and, coupled with robust accommodative and, coupled withaccommodative and, coupled with underlying growth in productivity, is [DEL: robust] the underlying growth inrobust underlying growth in providing ongoing support to economic productivity, is providing ongoing

productivity, is providing ongoing activity. support to economic activity.

support to economic activity.

Rationale 3. Output appears to be growing at a Output appears to be growing at a Output appears to be growing at a Output appears to be growing at amoderate pace despite the earlier rise moderate pace despite the [DEL: earlier] rise in moderate pace despite the [DEL: earlier] moderate pace despite the [DEL: earlier] rise inin energy prices, and labor market energy prices, and labor market rise in energy prices, and labor energy prices, and labor marketconditions continue to improve conditons seem to be improving market conditions continue to conditions continue to improvegradually. gradually improve gradually. [DEL: gradually].

4. Inflation and longer-term inflation Unchanged from IUnchanged from Inflation and kiatctIerter inflationexpectations remain well contained. December statement] December statement expectations remain well contained, but

rsing business costs have the potentialto put upward pressure on prices.

5. The C:ommittee perceives the upside

and downside risks to the attainment I[Unchanged from IUInchanged from (U nchanged fromof both sustainable growth and pricestability for the next few quarters tobe December statement December statement] December statement]

roughly equal.

6. W\ith underlying inflation expected to W\ith underlying inflation expected to beAssessment be relatively losw, the Committee relatively low, the Committee believes

of Risk believes that policy accommodation that policy accommodation can becan be removed at a pace that is likely removed at a pace that is likely to be [Unchanged from Noneto be measured. Nonetheless, the measured. Nonetheless, the Committee December statement]

Committee will respond to changes in will respond to changes in economic

economic prospects as needed to fulfill prospects as needed to fulfill its

its obligation to maintain price obligation to promote price stability and

stability. sustainable growth.

February 1-2, 2005 177 of 177