# Meeting of the Federal Open Market CommitteeJanuary 28-29, 2003 Presentation Materials -- Text Version

Presentation Materials (2.79 MB PDF)

Pages 155 to 195 of the Transcript

## Appendix 1: Materials used by Messrs. Sack, Tetlow, Croushore, and Rudebusch

### Exhibit 1The Smoothness of the Federal Funds Rate

This exhibit presents information on the smoothness of changes in the target federal funds rate over time.

#### Top panelIntended Federal Funds Rate

The top panel plots a time-series of the intended federal funds rate over the period from 1987 to present. The chart demonstrates the FOMC has tended to adjust the stance of policy with a series of fairly small consecutive tightenings or easings. In the chart, 88% of policy actions moved in the same direction as policy action at the previous meeting, and 96% of policy actions were 50 basis points or less.

#### Bottom panels

The bottom two panels examine one way of formalizing this idea of smoothness in the federal funds rate target.

##### Bottom-left panelEstimated Monetary Policy Rule
 ff_t = 0.35 \pi_t (5.83) + 0.19 y_t   (7.24) +  0.76 ff_{t-1}  (10.18)
• ff - federal funds rate
• y - output gap
• \pi - one-year GDP inflation

Estimated using real-time data from 1987 to 2000

T-statistics shown in parentheses. Rule also contains a constant term.

##### Bottom-right panelPolicy Easing in 2001

The bottom-right panel demonstrates how well this specification works in explaining the policy easing episode in 2001. The actual path of the funds rate is plotted along with the projected value of the funds rate derived from the estimated equation. The chart indicates that the estimated equation captures much of the observed behavior of the funds rate in 2001, although the actual path of policy easing was somewhat faster than the model would have predicted.

Vertical line between 2000:Q4 and 2001:Q1 denotes end of sample period.

### Exhibit 2Optimal Monetary Policy: A First Pass

#### Top panelDefining "Optimal" Policy

• FOMC desires to limit squared deviations of:
• - inflation from a target level
• - unemployment rate from its equilibrium level
• FRB/US is the correct characterization of the economy.
• The "optimal" policy is conditional on the model and the objectives assumed.

#### Middle-left panel"Optimal" and Estimated Policy Rules

Coefficient on:
Inflation Output Gap Lagged FF Rate
"Optimal" Rule 3.30 2.43 -0.15
Estimated Rule 0.35 0.19 0.76

Rules also contain a constant term.

#### Middle-right panelPrescribed Policy Paths

The middle-right panel illustrates how the prescriptions from the estimated and optimal policy rules differ. The prescription for the funds rate from the estimated policy rule falls gradually from about 1.25 percent at the end of 2002 to about 0.75 percent by the end of 2003 and then gradually increases to about 1 percent by the end of 2004. In contrast, the optimal policy rule incorporates much more aggressive easing, with the funds rate falling from about 1.25 percent to near 0 percent in the first quarter of 2003. Thereafter, the funds rate increases to 3 percent by the middle of 2004 and then falls to about 2 percent by the end of 2004. For reference, the chart also displays the policymaker perfect foresight path from the Bluebook. This path falls gradually to about 50 basis points in the third quarter of 2003 and then gradually increases to about 2 percent by the end of 2004. This path is smoother than the optimal policy path because the objective function used in generating this path assumes that the FOMC has a preference for smooth policy adjustment.

#### Bottom panelWhy Is the "Optimal" Policy So Aggressive?

• This finding hinges on three key assumptions:
1. Expectations formed as if FOMC following historical policy rule.
2. FOMC knows the structure of the economy with certainty.
3. No measurement error in macroeconomic data.
• We evaluate the implications of relaxing each assumption in subsequent exhibits.

### Exhibit 3Forward-Looking Expectations

This exhibit presents information on the way in which forward looking behavior affects the optimal policy rule.

#### Top panelImplications of Forward-Looking Behavior

• Private agents will expect the initial response of the federal funds rate to be followed by additional policy changes.
• Expectations will be incorporated into current asset prices and economic decisions.
• Inertial response can have an immediate and sizable impact on economic variables.

#### Middle panelVarying the Degree of Forward-Looking Behavior

• Degree of forward-looking behavior governed by a single parameter, \phi.
• Expectations = \phi(rational expectations) + (1 - \phi)(VAR-based expectations)
• \phi = 0 : completely backward-looking
\phi = 1 : completely forward-looking

#### Bottom-left panelOptimal Coefficient on Lagged FF Rate

The bottom-left line chart shows how the coefficient on the lagged funds rate in the optimal policy rule varies depending on the degree of forward looking behavior. In general, the coefficient on the lagged funds rate is negative and small in magnitude when expectations are completely forward looking. In contrast, when expectations are completely backward looking, the coefficient on the lagged funds rate is positive and close to 1.

A point on the curve is labeled "Estimated Coefficient (0.76)" and corresponds with \phi equal to approximately 0.95.

#### Bottom-right panelImpact of Forward-Looking Behavior

Coefficient on:
Inflation Output Gap Lagged FF Rate
\phi = 0 3.30 2.43 -0.15
\phi = 0.5 3.51 2.42 0.08
\phi = 1.0 1.01 0.60 0.87
Memo:
Estimated Rule
0.35 0.19 0.76

Rules also contain a constant term.

### Exhibit 4Parameter Uncertainty

This exhibit presents information on the way in which uncertainty about the structure of the economy can affect the optimal policy rule.

#### Top-left panelEffects of Additive Uncertainty

The top-left panel displays an example of additive uncertainty; the chart plots a downward sloping relationship between the real funds rate (r - r^{\ast}) on the vertical axis and the output gap on the horizontal axis. Additive uncertainty in this relationship moves this line up and down in a parallel fashion.

#### Top-right panelImplications of Additive Uncertainty

• Amount of uncertainty is not affected by the policy decision.
• No effect on "optimal" policy setting.

#### Middle-left panelEffects of Parameter Uncertainty

The middle-left panel presents a chart that illustrates the impact of parameter uncertainty. In this case, uncertainty affects the slope of the line describing the relationship between the funds rate (r - r^{\ast}) and the output gap.

#### Middle-right panelImplications of Parameter Uncertainty

• Uncertainty about future economic conditions affected by current policy decisions.
• Shade policy actions toward choices that reduce uncertainty.

#### Bottom-left panelParameter Uncertainty in a VAR

• VAR (vector autoregression) captures dynamics of key macroeconomic variables.
• Parameter uncertainty measured by variance-covariance matrix of coefficients.
• Use VAR to assess effect on "optimal" policy rule.

#### Bottom-right panelImpact of Parameter Uncertainty

Coefficient on:
Inflation Output Gap Lagged FF Rate
"Optimal" Rule ignoring Parameter Uncertainty 1.48 1.93 0.28
"Optimal" Rule allowing for Parameter Uncertainty 1.22 1.62 0.45
Memo:
Estimated Rule
0.35 0.19 0.76

Rules also contain a constant term. "Optimal" rules are approximated as simple policy rules.

### Exhibit 5Measurement Error in Macroeconomic Data

This exhibit presents information on the role of measurement error in macroeconomic data in influencing optimal policy.

#### Top-left panelRevisions to Real Output Growth Rate*

The panel in the top-left presents a histogram of revisions in the quarterly growth of GDP based on the changes from the first publication of data to data published one quarter later. In general, the chart demonstrates that there are often sizable revisions to initial estimates of GDP growth in a given quarter. As a result, policymakers must be aware of the fact that the picture of the economy they see based on initial data may change significantly over time based on revised data.

* Initial to one-quarter revision, one-quarter growth, expressed at an annual rate. Data are from 1965:Q3 to 2002:Q2. Return to text

#### Top-right panelRevisions to Real Output Growth Rate*

Time Since Initial Release Average Absolute Revision (percentage points)
Release to 1 quarter 0.65
1 quarter to 1 year 0.61
1 year to 3 years 0.87
3 years to latest 1.39

#### Middle-left panelUnobserved Variables

• A number of important variables are not directly observed.
• These variables include potential output, expected inflation, and the equilibrium real interest rate.
• Estimates subject to significant error that can be highly persistent.

#### Middle-right panelOutput Gap Measures*

The chart in the middle-right panel demonstrates this effect by comparing measures of the output gap based on data available at the time and data available through the present. The chart shows that the two series diverge substantially over extended periods of time. For example, the output gap measure in real time during much of the 1980s was well below the most recent estimate of the output gap over that period.

 Standard Deviation 1.77 Serial Correlation 0.84

* Staff estimates taken from Greenbooks; unit is percentage points. Return to text

#### Bottom-left panelPolicy Implications

• No effect if real-time estimate uncorrelated with subsequent revisions.
• In practice, large initial estimates often revised to be smaller.
• Under such conditions, attenuate response to output gap.

#### Bottom-right panelImpact of Measurement Error

Coefficient on:
Inflation Output Gap Lagged FF Rate
Optimal Policy with No Measurement Error 3.30 2.43 -0.15
Optimal Policy with Measurement Error 3.50 1.80 -0.16
Memo:
Estimated Rule
0.35 0.19 0.76

Rules also contain a constant term.

### Exhibit 6Summary and Alternative Explanations

#### Top panelSummary of Findings

• A simple analysis indicates that monetary policy should move more forcefully and be less inertial than observed.
• Investigated the sensitivity to three factors -- forward-looking behavior, parameter uncertainty, and data measurement error.
• None of the factors alone seems to fully explain the observed smoothness of the federal funds rate.
• Caveat: These factors likely interact.

#### Bottom-left panelOther Considerations

• Policymakers face uncertainty about structure of model.
• Economy may demonstrate large, discrete responses.
• FOMC may be concerned about financial fragility.

#### Bottom-right panelInstitutional Aspects

• Policy decisions are made by a committee.
• FOMC might seek to avoid reversals.
 Estimated Rule 10% Optimal Rule 51%

* Based on quarterly changes in federal funds rate from FRB/US simulations. Return to table

### Monetary Policy Inertia

Material for a presentation to the FOMC
January 28, 2003

Glenn Rudebusch
Federal Reserve Bank of San Francisco

#### Page 1Two Types of Monetary Policy Inertia

There is a widespread view among academic and central bank economists that monetary policy is slowly adjusted in response to information about the economy. Such behavior is often called "policy inertia," "gradualism," or "interest rate smoothing."

It is important to distinguish types of monetary policy inertia that operate at different horizons:

• Short-term policy inertia:

• A week-to-week partial adjustment of the policy interest rate. For example, cutting the funds rate by two 25-basis-point moves separated by several weeks instead of reducing it all at once by 50 basis points.
• Breaking up a large interest rate movement into smaller changes may help reduce any adverse reactions in financial markets; however, this motive appears to operate at a very short horizon.
• Such short-term partial adjustment is often apparent, but it is essentially unrelated to policy inertia at a quarterly frequency.

• Quarterly policy inertia:

• A quarter-to-quarter partial adjustment of the federal funds rate. For example, if the Fed wanted to increase the funds rate by a percentage point, it would raise the rate by only about 20 basis points per quarter for the next few quarters.
• Quarterly monetary policy inertia is the conventional interpretation of the estimated monetary policy rules that are widespread in the economics literature. For example, Clarida, Gali, and Gertler (2000, pp. 157-158) describe their empirical estimates of Fed behavior as
"…suggesting considerable interest rate inertia: only between 10% and 30% of a change in the [desired interest rate] is reflected in the Funds rate within the quarter of the change." [emphasis added]
• My discussion below refers only to the issue of quarterly gradualism in monetary policy actions.

Although many have argued that quarterly policy inertia is an important empirical result, my analysis, in contrast, suggests that the federal funds rate is not adjusted gradually over several quarters but that the Fed responds promptly to a wide variety of economic developments.

#### Page 2Apparent Evidence for Quarterly Policy Inertia

Policy inertia--the view that the funds rate is adjusted at a very sluggish pace over several quarters--is apparently supported by numerous estimates of monetary policy rules.

• These policy rules take a partial adjustment form, where the current funds rate can be expressed as a weighted average of last quarter's actual rate and the current quarter's desired funds rate. The parameter \rho--which indicates the amount of inertia--is the weight on last quarter's funds rate level:
{funds rate}_{t} = \rho \times {funds rate}_{t-1} + (1-\rho) \times {desired funds rate}_{t}.
• With quarterly data, many estimates put about a ¾ weight on the lagged funds rate (\rho = .75) and a ¼ weight on the desired rate. The usual interpretation of this partial adjustment is that the Fed adjusts the funds rate only 25 percent toward its desired level in each quarter--a very sluggish policy response.

For example, the FOMC Financial Indicators packet contains two estimated monetary policy rules: one with and one without policy inertia.

• Both rules set the desired funds rate on the basis of the Taylor rule, that is, in response to current readings on the output gap and inflation rate:
{desired funds rate}_{t} = \alpha \times {output gap}_{t} + \beta \times {inflation}_{t}.
• The estimated Taylor rule with inertia follows the actual funds rate path much more closely than the estimated rule without inertia, which apparently supports gradualism.
##### Bottom panel

A line chart displays the actual funds rate (solid line), Taylor rule without inertia (dashed line), and Taylor rule with inertia (dotted line). The period covered is from 1988 through 2002. As noted above, the estimated Taylor rule with inertia follows the actual funds rate path much more closely than the estimated rule without inertia, which apparently supports gradualism.

#### Page 3Evidence against Quarterly Policy Inertia from the Yield Curve

A key implication of policy inertia: Future funds rate movements are very predictable.

• With sluggish partial adjustment, if the funds rate typically is adjusted by only 25 percent toward its desired target in a given quarter, then the remaining 75 percent of the adjustment will be expected to occur in future quarters.
• Therefore, a significant amount of policy inertia implies a significant amount of predictive information in financial markets about the future path of the funds rate.

In fact, funds rate predictability is far lower than quarterly policy inertia implies.

• If the Fed slowly adjusted the funds rate (if, for example, \rho = .75), then a regression of actual changes in the funds rate on predicted changes from financial markets (eurodollar or fed funds futures) would yield a good fit (i.e., a moderately high R^2 ).
• Many researchers have examined this regression and found little predictive information about the funds rate in financial markets beyond the next few months. For example, eurodollar futures have essentially no ability to predict the quarterly change in the funds rate three quarters ahead (an R^2 of zero).
• The chart below gives the actual path of the funds rate during the past three years and various expected paths as of the middle of each quarter (based on fed funds futures). Although the funds rate gradually fell in 2001, market participants anticipated few of these declines at a 6- to 9-month horizon, as they would have under policy inertia.
##### Bottom panel

A line chart displays the target federal funds rate (solid line), and the expected funds rate path as of the middle of each quarter (dashed lines). The period covered is from 2000 through 2002. As noted above, although the funds rate gradually fell in 2001, market participants anticipated few of these declines at a 6- to 9-month horizon, as they would have under policy inertia.

#### Page 4The Illusion of Monetary Policy Inertia

How can the estimates of sluggish partial adjustment (specifically \rho = .75) be explained given the low amount of funds rate predictability in financial markets?

Answer: The Fed's reaction to information and events outside the scope of the Taylor rule could be incorrectly interpreted as sluggish policy adjustment.

• The case for gradualism is that the Taylor rule without inertia appears to fit poorly because there are large persistent deviations of the actual funds rate from the rule. The Taylor rule with inertia explains these persistent deviations as a sluggish response to output and inflation.
• However, an alternative explanation is that the Taylor rule is an incomplete description of Fed policymaking and that the Fed responds to other persistent variables besides current output and inflation. Under this interpretation, the Fed does not exhibit quarterly policy inertia.
• These two explanations are difficult to distinguish through direct estimation; however, the low predictability of the funds rate indicates the absence of inertia.

What "other persistent variables" does the Fed react to so that the funds rate deviates from the Taylor rule (and induces the illusion of monetary policy inertia)?

Answer: The Taylor rule takes into account current output and inflation; however, the Fed also responds to other information about the economy including variables that affect the outlook and credit and financial flows.

• During 1992 and 1993, when the funds rate was persistently below the Taylor rule recommendations, Chairman Greenspan stressed the reaction of the Fed to a credit crunch: "In an endeavor to defuse these financial strains, we moved short-term rates lower in a long series of steps that ended in the late summer of 1992, and we held them at unusually low levels through the end of 1993--both absolutely and, importantly, relative to inflation."
• For the period during late 1998, Governor Meyer described policy this way: "There are three developments, each of which, I believe, contributed to this decline in the funds rate relative to Taylor rule prescription. The first event was the dramatic financial market turbulence, following the Russian default and devaluation. The decline in the federal funds rate was, in my view, appropriate to offset the sharp deterioration in financial market conditions, including wider private risk spreads, evidence of tighter underwriting and loan terms at banks, and sharply reduced liquidity in financial markets."

#### Page 5Two Unresolved Questions

1. How should the Fed's monetary policy decision-making process be modeled?

• The Taylor rule is an incomplete description of Fed behavior, and more research is required to characterize other influences and determinants of policy. Adding partial adjustment to the policy rule is not a solution; instead, partial adjustment is a misspecification that substitutes for clearer understanding of the policy process.
• A closely related question is, What kind of loss function should represent Fed behavior? Currently, the policymaker-perfect-foresight (PPF) path in the Bluebook uses a loss function that assumes the Fed would be equally displeased with: (1) an unemployment rate one percentage point above the natural rate, (2) an inflation rate one percentage point above target, and (3) a 100-basis-point decrease in the quarterly average funds rate. These equal weights place an implausibly high penalty on funds rate volatility. However, without a substantial penalty on funds rate volatility, the PPF path does not match the recent historical path of the funds rate, so the high penalty may be another misspecification that is compensating for some unknown flaw in our calculations of optimal policy.
• If policy over the past two decades has been close to optimal, then an important element is missing from the current specifications used by economists to construct optimal monetary policy.

2. Should the Fed deviate from its historical behavior and become more aggressive in changing the funds rate?

• It may be that our economic models--without interest rate smoothing in the loss function--are basically correct in finding that under an optimal policy, the Fed should be more aggressive in reacting to economic news.
• The analysis above suggests that the Fed has not been sluggish in reacting to economic developments: It has likely set the funds rate equal to its desired rate in each quarter. However, there remain questions about whether the desired rate should react more forcefully to economic news, that is, whether the Fed has been too timid.

#### Page 6References

##### Short-term policy inertia:

Dotsey, Michael, and Chris Otrok. 1995. "The Rational Expectations Hypothesis of the Term Structure, Monetary Policy and Time-Varying Term Premia," Economic Quarterly, Federal Reserve Bank of Richmond, pp. 65-81.

Goodfriend, Marvin. 1991. "Interest Rates and the Conduct of Monetary Policy." Carnegie-Rochester Series on Public Policy 34, pp. 7-30.

Rudebusch, Glenn D. 1995. "Federal Reserve Interest Rate Targeting, Rational Expectations, and the Term Structure." Journal of Monetary Economics 35, pp. 245-274.

##### Quarterly policy inertia:

Clarida, Richard, Jordi Gali, and Mark Gertler. 2000. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory." Quarterly Journal of Economics 115, pp. 147-180.

English, William, William Nelson, and Brian Sack. 2002. "Interpreting the Significance of the Lagged Interest Rate in Estimated Monetary Policy Rules," FEDS working paper 2002-24.

Gerlach-Kristen, Petra. 2002. "Interest-Rate Smoothing: Monetary Policy Inertia or Unobserved Variables?" manuscript, University of Basel.

Rudebusch, Glenn D. 2002. "Term Structure Evidence on Monetary Policy Inertia and Interest Rate Smoothing." Journal of Monetary Economics 49, pp. 1161-1187.

##### Optimal monetary policy:

Levin, Andrew, Volker Wieland, and John C. Williams. 1999. "Robustness of Simple Monetary Policy Rules under Model Uncertainty." In Monetary Policy Rules, ed. John B. Taylor, pp. 263-299. Chicago: Chicago University Press.

Rudebusch, Glenn D. 2001. "Is the Fed Too Timid? Monetary Policy in an Uncertain World," Review of Economics and Statistics 83, pp. 203-217.

Rudebusch, Glenn D. 2002. "Assessing Nominal Income Rules for Monetary Policy with Model and Data Uncertainty," Economic Journal 112, pp. 402-432.

Woodford, Michael. 1999. "Optimal Monetary Policy Inertia." The Manchester School Supplement, pp. 1-35.

## Appendix 2: Materials used by Mr. Kos

### Page 1

#### Top panel

Title: Current 3-Month Deposit Rates and Rates Implied by Traded Forward Rate Agreements
Series: U.S. and Euro Area LIBOR fixings, U.S. and Euro Area 3-, 6-, and 9- Month Forward Rate Agreements
Horizon: November 1, 2002 - January 27, 2003
Description: Three-month Libor fixings and rates implied by traded forward rate agreements in the U.S. and euro area declined during the intermeeting period.

#### Bottom panel

Title: 10-Year U.S. Treasury and German Bund Yields
Series: 10-Year U.S. Treasury and German Bund Yields
Horizon: November 1, 2002 - January 27, 2003
Description: Ten-year U.S. Treasury and German Bund yields declined over the intermeeting period.

### Page 2

#### Top panel

Title: Euro-Dollar Exchange Rate
Series: Euro-USD
Horizon: January 1, 2002 - January 27, 2003
Description: The dollar has appreciated against the euro.

#### Middle panel

Title: Dollar-Yen Exchange Rate
Series: USD-Yen
Horizon: January 1, 2002 - January 27, 2003
Description: The dollar has depreciated against the yen over the intermeeting period.

#### Bottom panel

Horizon: January 1, 1995 - January 27, 2003
Description: The trade-weighted dollar has depreciated over the last year.

Percent change in U.S. dollar vs. major components of the index 12/9/02-1/27/03: Canadian dollar -2.31%, yen -4.04%, euro -7.36%, British pound -3.51%, Swiss franc -7.68%, Australian dollar -4.64%, Mexican Peso +6.36%.

### Page 3

#### Top-left panel

Series: Investment Grade U.S. Corporate Bond Index, Weekly Investment Grade U.S. Corporate Issuance
Horizon: November 1, 2002 - January 24, 2003
Description: The investment grade U.S. Corporate Bond Index has decreased over the past few months.

Source: Lehman Brothers and SDC

#### Top-right panel

Title: Corporate Spreads to U.S. Treasuries and Corporate Issuance Data: High Yield
Series: High Yield U.S. Corporate Bond Index, Weekly High Yield U.S. Corporate Issuance
Horizon: November 1, 2002 - January 24, 2003
Description: The high yield U.S. Corporate Bond Index has declined over the past few months.

Source: Merrill Lynch, Reuters and Selected Dealers

#### Middle panel

Title: Monthly Corporate Bond Spreads to U.S. Treasuries
Series: Investment Grade and High Yield U.S. Corporate Bond Indices
Horizon: September 3, 2002 - January 24, 2003
Description: The spreads between investment grade and high yield U.S. corporate bond indices and U.S. Treasury yields have narrowed during the intermeeting period.

Source: Merrill Lynch and Lehman Brothers

#### Bottom panel

Title: Total U.S. Corporate Debt Issuance
Series: Quarterly U.S. Corporate Debt Issuance
Horizon: 2001-2002
Description: Total U.S. corporate debt issuance declined between 2001 and 2002.

#### Middle-right panelFinancial Flows

Financial Flows, Billions of dollars. The table shows data for 2001 in Column 1, for projected 2002 in Column 2, and the change from 2001 to 2002 in Column 3.

Billions of dollars
2001 2002p Chng
1. Current account -393 -499 -104
Selected financial flows:*
2. Foreign official 7 97 90
3. For. purch. U.S. sec. 404 361 -43
4. U.S. purch. for. sec. -95 0 95
5. Net direct investment 3 -74 -77

* Projections for lines 2 through 4 incorporate TIC data through November, and, for line 2, FRBNY data for December. Return to table

#### Bottom panelSimulation Results (Real GDP Growth, Deviation from Baseline; Percent change, Q4/Q4)

##### Bottom-left panelPotential Iraq War*
2003 2004
1. Euro Area -0.3 0.2
2. Japan -0.7 0.4
4. Mexico -0.5 0.1
5. Taiwan -0.1 0.6
6. Korea 0.5 0.9

##### Bottom-right panelGreenbook Alternative*
2003 2004
1. Euro Area -1.3 1.0
2. Japan -2.2 0.8
4. Mexico 0.9 -1.9
5. Taiwan -2.7 2.3
6. Korea -4.5 5.8

### Chart 14

#### Top panelECONOMIC PROJECTIONS FOR 2003

1/28/03

FOMC Staff
Range Central
Tendency
Percentage change, Q4 to Q4
Nominal GDP 4½ to 5½ 4¾ to 5 4.8
(July 2002) (4½ to 6) (5 to 5¾) (5.6)
Real GDP 3 to 3¾ 3¼ to 3½ 3.6
(July 2002) (3¼ to 4¼) (3½ to 4) (4.1)
PCE Prices 1¼ to 1¾ 1¼ to 1½ 1.3
(July 2002) (1 to 2¼) (1½ to 1¾) (1.4)
Average level, Q4, percent
Unemployment rate 5¾ to 6 5¾ to 6 6.1
(July 2002) (5 to 6) (5¼ to 5½) (5.5)

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

## Appendix 4: Materials used by Mr. Reinhart

### Exhibit 1

Exhibit 1 outlines the movements of key asset prices over the intermeeting period, using 6 panels.

#### Top-left panelExpected Federal Funds Rates*

The line graph in the top-left panel shows the expected federal funds rate inferred from future quotes for December 9, 2002 (dotted line) and January 28, 2003 (solid line). The January 28, 2003 line is flat for most of 2003, which indicates that market participants are not expecting a policy change, and then rises steadily to about 3.2 percent in 2005, which indicates expected policy firming starting year-end.

#### Top-right panelMMS Survey

The table in the top-right panel displays market expectations about balance of risks for the next three meetings.

(Percentage of Respondents)
Balance of Risks FOMC Meeting
January March May
Weakness 14 14 16
Neutral 86 83 74
Inflation 0 3 10

#### Middle-left panelTreasury Forward Rates (Change Since Last FOMC Meeting)

The bar chart in the middle-left shows the change in Treasury forward rates since the last FOMC meeting. Forward rates 1 to 3 years ahead declined 15 to 25 basis points, possibly owing to a sense that policy will be on hold for longer than previously expected, while forward rates 5 to 20 years ahead moved down only 7 to 2 basis points.

#### Middle-center and middle-right panelsCommodity Prices and Stock Prices

The middle-center and middle-right panels reveal further evidence of market skittishness with prices of oil and gold rising over the intermeeting period and equity indexes, such as the Nasdaq and Wilshire 5000, decreasing 3 to 5 percent.

Finally, the panel at the bottom shows risk spreads on BBB-rate and high-yield corporate bonds continuing to reverse their recent spike. Even so, the spreads remained elevated relative to their levels of the preceding dozen years. The inset in this graph points out that most of this improvement in the high-yield sector is due to Telecom and Energy firms.

 Telecom/Energy -163 Other -4

### Exhibit 2Policymaker Perfect Foresight Strategy for Monetary Policy

Exhibit 2 is comprised of four panels which focus on the nominal federal funds rate, the real federal funds rate, the unemployment rate, and PCE inflation. Each of these panels contain 3 lines: the Greenbook history and forecast (black solid line), the path under optimal policy based rules based on a policymaker perfect foresight with a 1-percent inflation goal (red dotted line), and the path under optimal policy with a 1-1/2 percent inflation goal (blue dashed line). The Greenbook history and forecast extends from 2001 to 2004 while the paths under the optimal policy assumptions start in 2003, where the historic data ends, and extend to 2008. The optimal policy paths extend key assumptions of staff simulations (other than the path of monetary policy).*

#### Top-left panelNominal Federal Funds Rate

The top-left panel shows nominal federal funds rate. All the forecasts point to near-term policy easing. The Greenbook forecast is for the funds rate to move to 1-1/4 percent and hold there for most of 2003 and 2004 before inching up to 1-3/4 percent at the end of 2004. The optimal path under a 1 percent inflation goal prescribes a decline in the nominal federal funds rate by about 50 basis points to around 1/2 percent by mid-2003 and the optimal path with a 1-1/2 percent inflation goal points to a 100 basis points drop in the funds rate to about zero, also by mid-2003. After this trough, the two optimal policy paths recover steadily, and both hit a value of about 3.75 percent in 2006 after which they remain flat.

#### Top-right panelReal Federal Funds Rate1

The top-right panel shows the path for the real federal funds rate, which exhibits the same pattern, only shifted slightly lower. The Greenbook forecast indicates a flat path at about zero percent before ticking up to about 1/2 percent. The path under a 1 percent inflation goal drops to -1/2 percent while the path under a 1-1/2 percent inflation goal drops to about -1 percent in mid-2003. Both optimal paths recover to about 2.5 percent by early 2006 and then remain flat until the end of 2008.

#### Middle panelCivilian Unemployment Rate

In the middle panel, civilian unemployment rate peaks within a quarter or two of the current meeting before decreasing. The rate of decline varies in the different forecasts. In the Greenbook path, the unemployment rate reaches a maximum of 6-1/4 percent in mid-2003 and then drops gradually to about 5-1/4 percent by the end of 2004. The unemployment rates under the 1 percent inflation goal and the 1-1/2 percent inflation goal peak at about the same level and time as in the Greenbook but show steeper declines; they fall to 5 percent and to 4-3/4 percent, respectively, by the third quarter of 2004 and remain about flat until the end of 2008.

#### Bottom panelPCE Inflation (ex. food and energy)

The final panel shows PCE inflation (excluding food and energy) as a four-quarter percent change. The Greenbook path shows inflation staying flat for a few quarters at 1.3 percent before slipping to 1.2 percent by the end of 2004. Under the 1 percent inflation goal, inflation ticks up slightly in the near term before moving down to 1.1 percent by the end of 2005, after which it holds steady. Under the 1-1/2 percent inflation goal, inflation rises a bit more than in the other cases, to 1.4 percent, after which it fluctuates in a modest range.

* The perfect foresight simulations extend the key assumptions of the staff outlook (other than the path for monetary policy) through 2008:

• potential output grows at about 3-3/4 percent per year
• the relative price of oil stabilizes at its end of 2004 level
• the exchange value of dollar measured in real terms falls at a 3 percent clip
• federal budget deficit relative to GDP declines moderately

1. The real federal funds rate is calculated as the quarterly average nominal funds rate minus the four-quarter lagged core PCE inflation rate as a proxy for inflation expectations. Return to text

### Exhibit 3Actual Real Federal Funds Rate and Range of Estimated Equilibrium Real Rates

Exhibit 3 shows a line graph which provides information on the equilibrium real federal funds rate and long-run inflation expectations.

#### Top panel

The panel depicts the actual real federal funds rate starting in the first quarter of 1990, together with market-based and staff estimates of the equilibrium real funds rate and an historical average calculated over the 1966-2002 period. The historical average is plotted as a horizontal line at 2.70 percent, while the actual real funds rate and the market-based estimate are plotted as declining lines. The staff estimates consist of a shaded region bound by the maximum and minimum values for each quarter. The market-based estimate is currently slightly above 3 percent, while the staff estimates range between roughly 1-1/2 percent and -1/4 percent. Two points correspond to alternative values of the actual real funds rate based on two possible monetary policy decisions--i.e., no change in the target federal funds rate, and a 25 basis point cut.

Note: The shaded range represents the maximum and the minimum values each quarter of four estimates of the equilibrium real federal funds rate based on a statistical filter and the FRB/US model. Real federal funds rates employ four-quarter lagged core PCE inflation as a proxy for inflation expectations, with the staff projection used for 2002Q4 - 2003Q1.

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