FOMC Minutes

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, August 20,

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, 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. Prell, Economist

Messrs. Lang, Lindsey, Mishkin, Promisel, Rolnick, Rosenblum, Siegman, Simpson,

and Stockton, Associate Economists

Mr. Fisher, Manager, System Open Market Account

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

Ms. Johnson, Assistant Director, Division of International Finance, Board of

Governors

Ms. Low, Open Market Secretariat Assistant, Division of Monetary Affairs, Board of

Governors

Mr. Connolly, First Vice President, Federal Reserve Bank of Boston

Mr. Beebe, Ms. Browne, Messrs. Davis, Dewald, Eisenbeis, and Goodfriend, Senior

Vice Presidents, Federal Reserve Banks of San Francisco, Boston, Kansas City, St.

Louis, Atlanta, and Richmond respectively

Ms. Krieger, Vice President, Federal Reserve Bank of New York

Mr. Sullivan, Assistant Vice President, Federal Reserve Bank of Chicago

Mr. Bryan, Consultant, Federal Reserve Bank of Cleveland

By unanimous vote, the minutes of the meeting of the Federal Open Market Committee held

on July 2-3, 1996, were approved.

The Manager of the System Open Market Account reported on recent developments in

foreign exchange markets. There were no open market transactions in foreign currencies for

System account during the period since the meeting on July 2-3, 1996, and thus no vote was

required of the Committee.

The Manager also reported on developments in domestic financial markets and on System

open market transactions in U.S. government securities and federal agency obligations during

the period July 3, 1996, through August 20, 1996. By unanimous vote, the Committee

ratified these transactions.

The Committee then turned to a discussion of the economic and financial outlook and the

implementation of monetary policy over the intermeeting period ahead. A summary of the

economic and financial information available at the time of the meeting and of the

Committee's discussion is provided below, followed by the domestic policy directive that was

approved by the Committee and issued to the Federal Reserve Bank of New York.

The information reviewed at this meeting suggested that the economic expansion had

moderated somewhat recently. Growth in consumer spending appeared to be slowing,

business purchases of equipment and structures were rising less vigorously, and higher

mortgage rates were beginning to exert a restraining effect on housing construction. Business

inventory accumulation had been quite modest, and production and employment were

expanding less rapidly. Increases in labor compensation had been somewhat larger this year,

but consumer price inflation, adjusted for food and energy prices, had remained on a fairly

steady trend.

Private nonfarm payroll employment increased relatively rapidly in July, though at a

considerably slower pace than in the second quarter. Job growth in the services industry

slowed sharply, and manufacturing employment declined appreciably after having risen

somewhat in the second quarter. In contrast, the expansion in employment in wholesale and

retail trade picked up slightly in July, and the number of jobs in construction continued to

increase at about the second-quarter pace. The average workweek for private production or

nonsupervisory workers fell considerably in July, to a level a little below its average for the

second quarter, and the civilian unemployment rate edged up to 5.4 percent.

Industrial production rose slightly further in July after three consecutive months of strong

gains; manufacturing production expanded less rapidly, and electricity generation dropped

sharply as a result of unseasonably cool weather. A substantial increase in the production of

motor vehicles and parts accounted for most of the advance in manufacturing output.

Elsewhere, the manufacture of office and computing equipment continued on its strong

upward trend in July while the production of other business equipment slipped. The output of

consumer goods edged lower after having risen slightly in May and June. The rate of

utilization of total industrial capacity declined a little in July but remained at a relatively high

level.

Retail sales weakened somewhat over June and July following several months of robust

growth. Sales of motor vehicles were down in both months, and spending on other goods

rose sluggishly on balance. Housing starts fell somewhat further in July, reflecting a sizable

decline in single-family starts that more than offset a bounceback in multifamily starts. The

drop in housing starts, coupled with lower sales of new and existing homes in June (latest

data available), suggested that the rise in mortgage rates was exerting a damping effect on

housing demand and homebuilding activity.

Growth in business spending on durable equipment and nonresidential structures had slowed

after a very rapid expansion earlier in the year. Shipments of nondefense capital goods were

little changed in June after a sizable increase in May. Weakness in outlays for aircraft more

than offset persisting strength in spending on office and computing equipment, and purchases

of other types of equipment, notably communications and industrial equipment, continued to

advance briskly. Nonresidential construction activity rebounded in June from an appreciable

decline in May. The pace of office building picked up, and construction of other commercial

and industrial structures posted healthy gains after May declines.

Business inventories increased by a modest amount in June after having contracted in May.

In manufacturing, inventories continued to run off in June, reducing the sector's stock-sales

ratio to near its historical low. Wholesale trade stocks also fell in June, and the

inventory-sales ratio was in the lower portion of its range over recent years. Retail

inventories rose in June; larger stocks at automotive dealers more than accounted for the

increase. The inventory-sales ratio for the sector as a whole edged higher but remained at a

relatively low level.

The nominal deficit on U.S. trade in goods and services narrowed in June, but on a quarterly

average basis the deficit widened in the second quarter from its rate in the first quarter. In

June, the value of exports declined slightly, but the value of imports dropped by a

considerably larger amount from a relatively high rate in May. Available information

suggested that economic activity in the major foreign industrial countries continued to

advance, but at an uneven pace; in Germany, activity rebounded from the contraction in the

first quarter, while in Japan a considerable slowing of growth had occurred in the second

quarter after very rapid expansion in the first quarter.

Price inflation remained moderate on balance in June and July, with declines in energy prices

essentially offsetting increases in food prices. Over a somewhat longer horizon, consumer

prices for nonfood, non-energy items increased slightly less in the twelve months ended in

July than in the previous twelve-month period. Producer prices of finished goods other than

food and energy also increased more slowly in the twelve months ended in July. In contrast,

growth in labor costs had picked up. The employment cost index for private industry workers

advanced at a somewhat faster rate in the second quarter than in the first quarter or in the

second half of 1995. Measured over the year ended in June, the index rose by a slightly larger

amount than in the previous year.

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At its meeting on July 2-3, 1996, the Committee adopted a directive that called for

maintaining the existing degree of pressure on reserve positions but that included a bias

toward the possible firming of reserve conditions during the intermeeting period. The

directive stated that in the context of the Committee's long-run objectives for price stability

and sustainable economic growth, and giving careful consideration to economic, financial,

and monetary developments, somewhat greater reserve restraint would be acceptable and

slightly lesser reserve restraint might be acceptable during the intermeeting period. The

reserve conditions associated with this directive were expected to be consistent with

moderate growth of M2 and M3 over coming months.

With economic growth moderating and inflation quiescent, open market operations were

directed toward maintaining the existing degree of pressure on reserve positions throughout

the intermeeting period. The federal funds rate averaged a little higher than the level

expected with an unchanged policy stance, in part because of unexpectedly high demand for

reserves in late July and early August. On balance, most other short-term market interest

rates declined slightly, and intermediate- and long-term rates fell somewhat more, over the

intermeeting period. In the days immediately following the meeting, rates rose sharply in

response to incoming data, notably the employment report for June that market participants

viewed as indicating increasing pressures on economic resources and labor costs.

Subsequently, however, that rise was more than reversed when further data releases were

interpreted as suggesting that the economic expansion might be slowing and that the upturn

in labor compensation was mild. Equity prices also exhibited considerable volatility over the

period since the Committee meeting on July 2-3, with major indexes of stock prices falling

steeply through late July before recouping part to most of their losses in association with the

bond market rally and favorable earnings reports.

In foreign exchange markets, the trade-weighted value of the dollar in terms of the other

G-10 currencies declined slightly over the intermeeting period. The flow of information

suggesting a slowing in U.S. economic growth and reduced prospects for a near-term

tightening of Federal Reserve policy weighed against the dollar. On the other hand, the yen

was bolstered by incoming data suggesting that the Japanese current account surplus was

again widening, and the German mark benefited from the Bundesbank's inaction at a time

when market participants were expecting a policy easing.

Growth of M2 and M3 moderated in July. Much of the slowdown in the expansion of M2

was associated with an unexpected decline in demand deposits, which had grown rapidly

earlier in the year. With bank credit expanding sluggishly, the funding needs of banks were

modest, and the slower growth of M2 showed through to M3. For the year through July, both

aggregates were estimated to have increased at rates somewhat below the upper bounds of

their respective ranges for the year. Expansion in total domestic nonfinancial debt had been

moderate on balance over recent months and had remained in the middle portion of its range.

The staff forecast prepared for this meeting suggested that the expansion would slow to a rate

around, or perhaps a little above, the economy's estimated growth potential. Consumer

spending was projected to expand at a more moderate pace that would be in line with the

projected increase in disposable income; the favorable effect of the earlier run-up in equity

prices on household wealth and the generally ample availability of credit were expected to

balance continuing consumer concerns about the adequacy of their savings and the

restraining effect of high household debt burdens. Homebuilding was forecast to slow

somewhat in response to the backup in residential mortgage rates but to remain at a relatively

high level in the context of sustained income growth and the still-favorable cash-flow

affordability of home ownership. Business spending on equipment and structures was

projected to grow less rapidly in light of the anticipated moderate growth of sales and profits.

On balance, the external sector was expected to exert a small restraining influence on

economic activity over the projection period. Only modest fiscal restraint was anticipated

over the forecast horizon. Inflation recently had been lifted by adverse developments in

energy markets and was projected to remain above the levels of recent years, given the high

level of resource utilization, the effects of tight grain supplies on food prices, and a

noticeable step-up in labor compensation reinforced by the legislated rise in the federal

minimum wage.

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In the Committee's discussion of current and prospective economic developments, members

commented that on balance the information received since the July meeting, including

anecdotal reports from around the nation, pointed to some slowing in the growth of economic

activity from a very rapid pace during the spring. The extent of the slowing remained

uncertain, and it was unclear at this juncture whether the expansion would slow sufficiently

to contain pressures on labor and other producer resources. Nonetheless, broad measures of

price inflation, adjusted to exclude their volatile food and energy components, did not exhibit

any uptrend despite robust growth in economic activity this year and high levels of resource

use. Indeed, some price measures suggested that inflation had trended lower through the

second quarter. Moreover, there were no early signs of pressures or imbalances in the

industrial sector. In labor markets, however, there were increasing indications of tightness

that might at some point feed through to greater inflation. Upward wage adjustments were

becoming more evident and increases in overall compensation had edged up, suggesting the

possibility of further increases in labor costs at current or higher levels of labor utilization

even before taking account of the effects of the rise in the minimum wage. Although

increases in compensation might be moderated by greater productivity or absorbed for a time

by lower profit margins, the risks seemed tilted toward increases in inflation at some point,

especially if the growth of the economy continued to outstrip its potential and added to

pressures on resources.

In the course of the Committee's discussion, members cited a variety of indications that

economic growth was slowing from a very rapid pace, and they pointed to a number of

factors that in their view should promote continued, though more moderate, expansion in

economic activity. These included generally supportive financial conditions, relatively high

levels of consumer confidence, and the absence of major imbalances in the economy. It was

noted that much of the stimulus for the strong expansion in the first half of the year had been

provided by large increases in spending for consumer durables, housing, and business

equipment; however, growth in such spending could be expected to slow in the context of

increasingly satisfied pent-up demands and the lagged effects of earlier increases in

intermediate- and long-term interest rates on these interest-sensitive sectors of the economy.

A key uncertainty in the outlook was the prospective behavior of inventories. Should the

expansion in final demand fail to moderate to a sustainable pace, business firms would be

likely to intensify their efforts to build their inventories, which currently were widely viewed

as satisfactory or even relatively lean in relation to sales. While some buildup in inventories

appeared to be occurring in the current quarter, developments that might lead to a sharp

increase in inventory investment, such as shortages of various goods and materials and

lengthening delays in securing deliveries, were not in evidence at this time. Accordingly,

aggressive inventory accumulation remained an upside risk to the projected expansion but

not one that was likely to materialize unless final demand were to exceed current forecasts by

a significant margin.

In their discussion of the outlook for inflation, members observed that increases in prices had

remained remarkably subdued for an extended period in relation to measures of resource

utilization, notably the rate of unemployment. Such behavior differed markedly from the

historical experience under similar circumstances. One factor tending to hold down prices

has been highly competitive markets--throughout the nation and internationally as well--that

made it very difficult for business firms to raise prices. Another key factor, though one whose

importance might now be starting to diminish, was the persistence of comparatively small

increases in labor compensation, which remained appreciably below earlier norms in relation

to levels of unemployment. This development appeared to reflect worker concerns about job

security in a period of major business restructuring and downsizing activities as well as

substantially reduced increases in benefit costs, notably those relating to health care.

In assessing whether a relatively favorable inflation performance was likely to continue, the

members focused on a variety of issues. One was whether the expansion would moderate

sufficiently to keep pressures on labor and other resources from intensifying. Another was

whether a rate of unemployment in the vicinity of its current level would foster added wage

pressures. Uncertainty also surrounded the extent to which further increases in labor

compensation costs, should they materialize, would be passed through to higher prices.

Improvements in productivity were likely to offset part of such increases, but how much

remained an open question. In addition, profit margins were high, but the extent to which

they might narrow to absorb increasing labor costs was difficult to predict. With regard to the

outlook for wages, members observed that, though it was too early to reach a firm judgment,

the acceleration of wage increases this year might well augur faster advances that were more

in line with historical experience under essentially full employment conditions. Moreover,

the tendency toward reduced increases in the costs of benefits might tend to dissipate, though

some members commented that further economies in the provision of medical services might

well be achievable for some period. On balance, the inflation risks in the outlook clearly

seemed to be to the upside, with the potential for more inflation stemming from rising labor

compensation costs augmented by a rise in the minimum wage and the prospect of higher

food prices and perhaps energy prices over the next several quarters.

In the Committee's discussion of policy for the intermeeting period ahead, members focused

on indications that the economy already was slowing, perhaps by enough to limit pressures

on resources, and they noted that broad statistical measures of prices and the anecdotal

evidence did not suggest that a pickup in inflation was already under way. Consequently, all

but one of the members supported a proposal to maintain an unchanged policy stance. A

number also commented that real interest rates were not unusually low, suggesting that any

pickup in inflationary pressures, should that occur, would be modest and readily contained.

One concern was that policy tightening at this point might generate an excessive reaction in

financial markets, both because it was not generally expected and because it would represent

a change in policy direction that might well lead to expectations of further policy tightening.

Such a development could have serious adverse consequences for economic activity if the

expansion was in fact already slowing to a more sustainable and less inflationary pace. These

members therefore concluded that the prudent course at this point was to await further

developments that would permit them to assess the possible need for some tightening with a

higher degree of confidence. At the same time, it was emphasized that the Committee

remained committed to a policy that would resist a rise in inflation; such a policy would

entail moving in anticipation of greater price pressures and before they showed through to

actual inflation. Accordingly, they also agreed on the desirability of a directive that remained

biased toward possible tightening in the intermeeting period ahead. Such a directive would

imply that any tightening should be implemented promptly if developments were perceived

as pointing to rising inflation. For now, the Committee should remain particularly vigilant to

incoming information bearing on the outlook for inflation.

A differing view gave more weight to the risks of rising inflation. In this view, while there

were uncertainties, the weight of the evidence suggested that a prompt policy action was

needed to contain inflation and set the stage for further progress toward price stability. The

possibility of an overreaction in financial markets to a tightening move could not be ruled

out, but such a reaction was likely to be short-lived. More importantly, a prompt action would

reduce the risk that inflation would worsen and pose difficult problems for monetary policy

later.

At the conclusion of the Committee's discussion, all but one member indicated that they

supported a directive that called for maintaining the existing degree of pressure on reserve

positions and that included a bias toward the possible firming of reserve conditions during

the intermeeting period. Accordingly, in the context of the Committee's long-run objectives

for price stability and sustainable economic growth, and giving careful consideration to

economic, financial, and monetary developments, the Committee decided that somewhat

greater reserve restraint would be acceptable and slightly lesser reserve restraint might be

acceptable during the intermeeting period. The reserve conditions contemplated at this

meeting were expected to be consistent with moderate growth of M2 and M3 over coming

months.

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At the conclusion of the meeting, the Federal Reserve Bank of New York was authorized and

directed, until instructed otherwise by the Committee, to execute transactions in the System

Account in accordance with the following domestic policy directive:

The information reviewed at this meeting suggests that growth in economic

activity recently has moderated somewhat. Private nonfarm payroll employment

grew less rapidly in July, the average workweek fell sharply, and the civilian

unemployment rate edged up to 5.4 percent. Industrial production increased

slightly in July after three months of strong gains. Real consumer spending

weakened somewhat on balance over June and July following several months of

robust growth. Housing starts fell somewhat further in July. Growth in spending

on business equipment and nonresidential structures has slowed after a very

rapid expansion earlier in the year. The nominal deficit on U.S. trade in goods

and services widened in the second quarter from its rate in the first quarter.

Increases in labor compensation have been somewhat larger this year, but

consumer price inflation, adjusted for food and energy prices, has remained on a

fairly steady trend.

Most short-term market interest rates have declined slightly while intermediateand long-term rates have fallen somewhat more since the Committee meeting on

July 2-3, 1996. In foreign exchange markets, the trade-weighted value of the

dollar in terms of the other G-10 currencies has depreciated slightly over the

intermeeting period.

Growth of M2 and M3 moderated in July. For the year through July, both

aggregates are estimated to have grown at rates somewhat below the upper

bounds of their respective ranges for the year. Expansion in total domestic

nonfinancial debt has been moderate on balance over recent months and has

remained in the middle portion of its range.

The Federal Open Market Committee seeks monetary and financial conditions

that will foster price stability and promote sustainable growth in output. In

furtherance of these objectives, the Committee at its meeting in July reaffirmed

the ranges it had established in January for growth of M2 and M3 of 1 to 5

percent and 2 to 6 percent respectively, measured from the fourth quarter of 1995

to the fourth quarter of 1996. The monitoring range for growth of total domestic

nonfinancial debt was maintained at 3 to 7 percent for the year. For 1997 the

Committee agreed on a tentative basis to set the same ranges as in 1996 for

growth of the monetary aggregages and debt, measured from the fourth quarter

of 1996 to the fourth quarter of 1997. The behavior of the monetary aggregates

will continue to be evaluated in the light of progress toward price level stability,

movements in their velocities, and developments in the economy and financial

markets.

In the implementation of policy for the immediate future, the Committee seeks

to maintain the existing degree of pressure on reserve positions. In the context of

the Committee's long-run objectives for price stability and sustainable economic

growth, and giving careful consideration to economic, financial, and monetary

developments, somewhat greater reserve restraint would or slightly lesser

reserve restraint might be acceptable in the intermeeting period. The

contemplated reserve conditions are expected to be consistent with moderate

growth in M2 and M3 over coming months.

Votes for this action: Messrs. Greenspan, McDonough, Boehne, Jordan, Kelley,

Lindsey, McTeer, Meyer, Mses. Phillips, Rivlin, and Yellen.

Votes against this action: Mr. Stern.

Mr. Stern dissented because he believed that policy should become modestly more restrictive.

He was concerned that, in the absence of a substantial and sustained improvement in

productivity, the prevailing pattern of demand might engender an increase in inflationary

pressures, and that such pressures would ultimately threaten the ongoing economic

expansion. In Mr. Stern's judgment, it was prudent at this point to resist such a development

in order to lay a foundation for the long-term health of the economy.

It was agreed that the next meeting of the Committee would be held on Tuesday, September

24, 1996.

The meeting adjourned at 12:45 p.m.

Donald L. Kohn

Secretary

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