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, September

24, 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. Baxter, Deputy General Counsel

Mr. Prell, Economist

Mr. Truman, Economist

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

Sniderman, 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

Mr. Smith, 1 Assistant Director, Division of International Finance, Board of

Governors

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

Governors

Ms. Pianalto, First Vice President, Federal Reserve Bank of Cleveland

Messrs. Beebe, Davis, Dewald, Eisenbeis, and Hunter, Senior Vice Presidents,

Federal Reserve Banks of San Francisco, Kansas City, St. Louis, Atlanta, and

Chicago respectively

Messrs. Bentley, Hetzel, Ms. Krieger, and Mr. Rosengren, Vice Presidents, Federal

Reserve Banks of New York, Richmond, New York, and Boston respectively

Mr. Weber, Senior Research Officer, Federal Reserve Bank of Minneapolis

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

on August 24, 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 August 20, 1996, and thus no vote

was required of the Committee.

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

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

obligations during the period August 20, 1996, through September 23, 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 expansion of economic activity

had moderated appreciably from an elevated second-quarter pace. Growth in consumer

spending had slowed noticeably, and higher mortgage rates seemed to be exerting some

modest restraint on housing demand. While business demand for durable equipment

remained strong, spending on nonresidential structures had weakened a little. Business

inventory accumulation appeared to have picked up, although the level of inventories

remained modest in relation to sales. Employment and production had continued to post

sizable gains in recent months, but the increases were somewhat below those recorded earlier

in the year. Consumer price inflation, excluding its food and energy components, had edged

lower this year despite somewhat larger increases in labor compensation.

Private nonfarm payroll employment grew less rapidly over July and August than it had in

the second quarter; aggregate hours worked by private production workers also expanded at a

slower pace over the two-month period. Job growth in the services industries was somewhat

lower over the two months compared with that of the second quarter. Manufacturing

employment changed little on balance over the July-August period, and construction hiring

was down considerably in August after a July increase that was a little above the pace of the

second quarter. The civilian unemployment rate declined to 5.1 percent in August.

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Industrial production also advanced somewhat less rapidly on average in July and August

after having recorded strong gains in the previous few months; slower growth was evident in

mining and utilities as well as in manufacturing. Smaller increases in the output of motor

vehicles and parts accounted for part of the slowdown in the expansion of the manufacturing

sector in August; in addition, the output of consumer goods other than motor vehicles

remained sluggish, and the production of construction supplies declined significantly after

having surged in the second quarter. Elsewhere in manufacturing, business equipment,

notably its office and computing component, continued its robust expansion over July and

August, and defense and space equipment extended the upturn that began in the second

quarter. The rate of utilization of total industrial capacity was unchanged on balance from

June to August and remained at a relatively high level.

Total retail sales rose slightly over July and August after having declined substantially in

June. Decreased outlays at food stores, gas stations, and furniture and appliance stores in

August were a little more than offset by a sharp pickup in sales at general merchandisers,

apparel stores, and outlets for durable goods other than furniture and appliances. Housing

starts rebounded in August from a July drop and for the two months were about unchanged

on average from their second-quarter level; however, permits for single- family housing were

unchanged in August and had fallen from their second-quarter level. Sales of existing homes

weakened in June and July.

Demand for business equipment had remained strong in recent months. Shipments of

nondefense capital goods declined in July, retracing part of a substantial second-quarter

advance, but recent data on new orders pointed to further increases in business spending for

durable equipment, notably office and computing equipment, in coming months.

Nonresidential construction activity fell somewhat in July after having decreased a little in

the second quarter.

Business inventory investment picked up sharply in July; most of the increase occurred at

retail establishments. Manufacturing inventories rose somewhat, with the gain concentrated

at manufacturers of producers' durable equipment. The stock-sales ratio for the sector was

around its historical low. In the wholesale sector, inventories edged higher in July despite a

substantial drop in stocks of farm products, and the inventory-sales ratio for the sector fell to

the low end of its range over recent years. Retail stocks expanded considerably at both

automotive dealers and non-auto establishments in July. Inventory-sales ratios edged higher

in most retail categories but they remained at relatively low levels.

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The nominal deficit on U.S. trade in goods and services widened substantially in July from

its June level and also from its average rate for the second quarter. Despite one-time service

payments related to the Olympics and larger inflows of imported oil, imports edged down in

July from the sharply increased rate recorded for the second quarter; the latter largely

reflected the strength of the U.S. economy during the first half of the year. Exports fell

considerably more in July than did imports; in addition to decreased exports in such

categories as consumer goods, aircraft and parts, automotive products, and other industrial

supplies, part of the measured decline may have reflected residual seasonality in the data.

Available information suggested that, on balance, the economies of the major foreign

industrial countries had strengthened in recent months. In Japan, a mild second-quarter pause

after very rapid first-quarter growth had been followed by renewed expansion. Economic

activity in Germany had rebounded sharply in the second quarter from a first- quarter

contraction, and further expansion appeared to be in train. Although economic growth had

been sluggish in Canada and the United Kingdom in the second quarter, recent indicators

suggested a pickup in activity in those countries as well. By contrast, France and Italy had

experienced little, if any, growth since early in the year.

Consumer price inflation remained moderate on balance over July and August; declines in

energy prices offset higher food prices. Excluding food and energy, consumer prices recorded

a somewhat smaller advance over the twelve months ended in August than over the previous

twelve months. Producer prices of finished goods other than food and energy were

unchanged on net over July and August, and this index rose at a significantly slower pace

over the twelve months ended in August than over the preceding twelve months. Average

hourly earnings of production or nonsupervisory workers rebounded in August, more than

offsetting a small July decline. Over the year ended in August, this measure of labor costs

increased considerably more than it had over the previous year.

At its meeting on August 20, 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.

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With incoming information generally confirming that economic growth was moderating and

that price inflation remained subdued, open market operations were directed toward

maintaining the existing degree of pressure on reserve positions throughout the intermeeting

period. The federal funds rate generally remained close to the level expected with an

unchanged policy stance, but most other market interest rates exhibited considerable

volatility and rose somewhat on balance over the intermeeting interval. Despite the rise in

many market interest rates, equity prices rebounded over the period, and most major market

indexes reached record highs.

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

G-10 currencies appreciated slightly over the intermeeting period. The dollar's rise reflected

in part the increase in U.S. long-term interest rates over the period. Declines in market rates

abroad, both short- and long-term, also contributed to the dollar's strengthening. In Japan,

newly released data led market participants to lower their assessments of the strength of that

country's economic expansion and of the prospects of any near-term increase in official

interest rates. In Germany, a reduction by the Bundesbank in its repo rate in late August and

subsequent statements by Bank officials regarding possible additional declines in official

rates appeared to foster market expectations that monetary policy might be eased further.

Growth of M2 and M3 picked up in August from sluggish rates in July but remained below

the average increases over the first half of the year. A continuing, rapid runoff in the liquid

deposit components of these aggregates was offset in part by solid gains in retail money

market funds and small time deposits, whose yields had not declined in step with decreases in

market interest rates in early August. For the year through August, both aggregates grew at

rates in the upper portions of their respective annual ranges. 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, which differed little from that for the previous

meeting, suggested that the expansion would slow to a rate around, or perhaps a little above,

the economy's estimated growth potential. Expansion of consumer spending was forecast to

rebound from the sluggish third-quarter rate in light of strong income trends, the favorable

effect of the rise in the stock market this year on household wealth, and the generally ample

availability of credit. Homebuilding was anticipated to slow somewhat in response to this

year's increase 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. The expansion of business investment in equipment and structures was projected

to slow gradually in response to an easing of pressures on capacity, a prospective slackening

in the growth of corporate cash flows, and the rise in long-term interest rates that had

occurred this year. Only modest fiscal restraint was anticipated over the forecast period.

Inflation, which had been boosted thus far in 1996 by adverse developments in food and

energy markets, was projected to remain somewhat above that of recent years, given high

levels of resource utilization and a noticeable step-up in labor compensation that would be

reinforced by the legislated rise in the federal minimum wage.

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

commented that the incoming information had been mixed since the August meeting but that

on the whole it continued to suggest appreciable slowing in the economic expansion from a

rapid and unsustainable pace in the second quarter. Data for many components of final

demand, notably in the consumer sector, indicated that economic growth had moderated

considerably in recent months. At the same time, supply-side data including employment and

industrial production had remained relatively robust, contributing to uncertainty about

underlying growth and suggesting that inventory accumulation had picked up during the

summer. While the extent of the slowing in the overall expansion remained unclear, there

were no indications of serious imbalances in the economy, and the members generally

viewed further growth at a pace near that of the economy's potential as a likely prospect.

They continued to be concerned, however, about the outlook for inflation, given the high

level of production. In that regard, some commented that labor markets appeared to have

tightened further in recent months and that wages were rising at a somewhat faster pace.

Even so, the rate of price inflation had not picked up and the prospects were good that

inflation would remain contained for some time. Whether the factors that had contributed to

such a price performance would persist remained a key uncertainty in the economic outlook,

and the members generally agreed that the risks continued to be tilted to some extent in the

direction of rising price inflation over the forecast horizon.

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In their discussion of the outlook for spending in key sectors of the economy, members

commented that consumer expenditures were likely to pick up after their summer lull, though

probably to a pace appreciably below that in the first half of this year. Favorable factors in

the outlook for consumer spending included strong gains in employment and income, the

wealth effect stemming from the rise that had occurred in the value of financial assets, and

generally buoyant consumer sentiment. The improvement in the consumer sector would tend

to be restrained, however, by the increase in consumer debt burdens and the probable

satisfaction of much of the pent-up demands for consumer durables during the current

expansion. Business fixed investment likewise was expected to provide considerable further

stimulus to the economy. Expenditures for business equipment, notably for office and

computing equipment, were expected to expand substantially further, and recent weakness in

nonresidential construction might well prove to be temporary, judging in part from anecdotal

reports of considerable strength in commercial real estate markets in many areas. On the

whole, however, the completion of numerous capital spending programs in conjunction with

slower projected growth in overall demand could be expected to temper the expansion of

business investment over coming quarters. In the housing sector, recent developments were

somewhat mixed, but they suggested on balance that housing activity had held up better than

expected in the light of increased mortgage interest rates. It was suggested in this regard that

the retarding effects of higher rates on fixed-rate mortgage contracts were being blunted to

some extent by shifts toward adjustable rate mortgages. Even so, and consistent with the

softening already observed in a number of areas, residential construction was thought likely

to drift lower over time.

The outlook for inventory investment, as is typically the case, was very difficult to assess.

The moderation in the expansion of final demand in recent months, together with still

relatively robust growth in employment and production, suggested that inventory investment

had picked up since the second quarter. The strength in inventories in July tended to confirm

that assessment. However, assuming moderate economic growth in line with current

forecasts, there was no reason to anticipate substantial further strengthening in inventory

investment over coming quarters. Indeed, the recent rebuilding of inventories after little or no

growth earlier in the year made rapid expansion less likely going forward. The members

acknowledged, nonetheless, that inventory developments needed to be monitored with care,

including such indirect signs as rising pressures on the prices of intermediate goods and

tightening delivery schedules that might provide incentives for a rapid buildup. With capacity

utilization already at high levels, relatively rapid growth in inventory investment, if it were

superimposed on stronger-than- projected expansion in final demand, could portend serious

pressures on resources and inflationary consequences for the economy.

In their comments about the outlook for inflation, members observed that the recent behavior

of price inflation was a welcome though highly unusual development, given current pressures

on resources. The statistical and anecdotal information provided evidence of increasingly

tight labor markets that under similar conditions historically had been associated with

considerable upward pressure on nominal labor compensation and, in turn, on prices. While

wages, and probably total labor compensation, were rising more rapidly this year, the

acceleration in the latter still appeared to be held down by worker insecurity and relatively

subdued increases in the cost of benefits. Moreover, for a variety of reasons rising labor costs

were not currently being passed through to prices, which by several key measures adjusted

for their volatile food and energy components exhibited a steady or even a declining trend.

Explanations tended to concentrate on the intense competition in many markets, which

prevented firms from raising prices to absorb cost increases.

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Competitive pressures also were compelling firms to curb cost increases through

improvements in their productivity performance. Widespread reports suggested major gains

in productivity in numerous industries, induced in recent years by business restructuring and

related activities and by large capital investments that had introduced increasingly productive

equipment. Although currently available measures of productivity for the economy as a

whole showed only weak gains, sectoral disaggregation of the data gave reasons to question

the productivity measurements. Productivity had increased fairly sharply in manufacturing,

and the slowdown in overall productivity since 1973 had been concentrated in the service

areas of the economy. Indeed, measured productivity in noncorporate businesses--largely

services--had displayed a negative trend for many years. This result was implausible and

suggested considerable error in estimating output and prices for many services.

Consequently, it was likely that actual productivity growth was higher than the current

measures indicated. By the same token, the rate of price inflation was lower than had been

reported, consistent with the findings of a number of studies of distortions in published price

data.

The implications for the inflation outlook were not clear- cut. The key question was how long

the favorable price behavior would persist. Advances in productivity had boosted profit

margins, and high margins were helpful in that they could absorb some portion of any cost

increases for a time. However, many business contacts indicated that they would resist

squeezes in profit margins, and continued acceleration in costs would eventually feed

through to greater price inflation whatever the rate of productivity growth. The behavior of

costs and the ability of businesses to pass along any greater increases over time would

depend on the extent to which the expansion would slow and how much associated pressure

there would be in labor and product markets. In this connection, some members observed that

even if the expansion were to slow to a sustained pace around the rate of increase of the

economy's potential, price inflation could well trend at least modestly higher at current levels

of resource utilization. Others did not disagree that the odds might be tilted marginally in that

direction, but they continued to believe that a great deal of uncertainty surrounded the

outlook for resource use and, in turn, the relationship between a given degree of pressure on

resources and overall price changes. In sum, assuming economic growth generally in line

with their forecasts, the critical question for some was when and how much inflation would

rise; many others were not persuaded of the inevitability of such an outcome.

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In the Committee's discussion of policy for the intermeeting period ahead, nearly all the

members indicated that they could support an unchanged policy stance and the retention of a

bias toward restraint in the directive. The members generally agreed that while the risks were

greater that price inflation would rise than that it would fall, higher inflation was not a

foregone conclusion and most believed that the uncertainties in the outlook made it prudent

to hold monetary policy on a steady course and await further developments. The expansion

appeared to be slowing substantially and broad measures of prices, adjusted for fluctuations

in their food and energy components, still indicated a steady or even slightly declining

inflation trend. In these circumstances, the Committee could wait for more information on

the momentum of the expansion and the degree of pressure on resources and its implications

for inflation. A delay in adjusting monetary policy was facilitated by its current positioning,

which did not appear to be far from a desirable longer-term stance because any pickup in

inflation was likely to be relatively small and gradual, and was further supported by the

possibility of an excessive reaction in financial markets to a change in the direction of policy.

A few members indicated that they could vote for some slight tightening in policy, although

they did not feel any urgency about such a move. They observed that the decision was a close

one for them, and in light of the uncertainties that were involved, they were willing to join

the majority and wait for further evidence bearing on the outlook for inflation. With regard to

possible intermeeting adjustments to policy, the members agreed that retaining an

asymmetric directive that was biased toward restraint would be consistent with their

assessments of the inflation risks in the economy. Accordingly, information suggesting that

the odds on higher inflation had risen should be met with a prompt policy firming.

A differing view focused on the desirability of a prompt move toward restraint to curb what

were seen as growing inflationary pressures in the economy. Tight labor markets were likely

to exert continuing upward pressure on labor costs, barring unexpected weakness in the

economy, and at some point those costs would begin to be passed through to prices. In the

circumstances, it was important for policy to be forward-looking and to move promptly to

head off intensifying inflationary pressures. Potentially, waiting could require more

disruptive policy tightening actions later and could risk the credibility of the System's

anti-inflation policy.

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

they could accept 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.

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 has moderated appre ciably from an elevated second-quarter pace.

Private nonfarm payroll employment grew less rapidly over July and August

than in the second quarter, while the civilian unemployment rate declined to 5.1

percent in August. Industrial production increased somewhat less rapidly on

average in July and August than in the prior few months. Total retail sales rose

slightly over July and August after having declined substantially in June.

Housing starts in July and August were unchanged on average from their

second-quarter level. Demand for business equipment has remained strong,

while spending on nonresidential structures has changed little on balance in

recent months. The nominal deficit on U.S. trade in goods and services widened

substantially in July from its average in the second quarter. Increases in labor

compensation have been somewhat larger this year, but consumer price inflation,

excluding its food and energy components, has edged lower.

Most market interest rates have risen somewhat on balance since the Committee

meeting on August 20, 1996. In foreign exchange markets, the trade-weighted

value of the dollar in terms of the other G-10 currencies has appreciated slightly

over the intermeeting period.

Growth of M2 and M3 picked up in August, but they continued to expand at

rates below those in the first half of the year. For the year through August, both

aggregates are estimated to have grown at rates in the upper portions 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.

Vote against this action: Mr. Stern.

Mr. Stern dissented because he believed that a modestly more restrictive policy was

appropriate. In his view, historical precedents suggested that prolonged periods of taut labor

markets were eventually associated with rising inflation. Given prevailing pressures on

resources, especially labor, Mr. Stern was concerned about the distinct risk of an acceleration

of inflation. Should this acceleration occur, he believed it would prove disruptive to the

favorable performance of the economy, and he preferred to begin to address this risk

promptly.

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Amendment to Authorization for Foreign Currency Operations

At this meeting the Committee considered a proposal to replace the existing 12-month

maturity limit on the investment of foreign currency balances with an 18-month average

duration limit. The proposal was designed to allow the Manager a wider choice of maturities

and hence somewhat greater operational flexibility in the implementation of the System's

primary portfolio objectives of liquidity with respect to investments in foreign government

securities and limits on overall interest rate and credit risks. At the conclusion of their review,

the Committee members voted unanimously to amend section 5 of the Authorization for

Foreign Currency Operations to read as follows:

5. Foreign currency holdings shall be invested to ensure that adequate liquidity is

maintained to meet anticipated needs and so that each currency portfolio shall

generally have an average duration of no more than 18 months (calculated as

Macaulay duration). When appropriate in connection with arrangements to

provide investment facilities for foreign currency holdings, U.S. Government

securities may be purchased from foreign central banks under agreements for

repurchase of such securities within 30 calendar days.

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Liquidity Management and the Maturity Structure of the SOMA Portfolio

The Committee also reviewed, on a preliminary basis, its current practices with regard to the

maturity structure of the System Open Market Account (SOMA) portfolio of Treasury

obligations. In its last such review, at its meeting on March 31, 1992, the Committee decided

that the enhanced liquidity of the SOMA portfolio that had been achieved should be

maintained but that net additions to System holdings should continue to be spread across all

maturity areas. In the course of their discussion at this meeting, the members agreed that the

primary objective in the management of the SOMA portfolio was to ensure a high degree of

liquidity so that prompt and effective adjustments could be made without unduly affecting

the market for Treasury securities.

It was agreed that the next meeting of the Committee would be held

on Wednesday, November 13, 1996.

The meeting adjourned at 1:40 p.m.

Donald L. Kohn

Secretary

Footnotes

1 Attended portion of meeting relating to proposal to amend the Authorization for Foreign

Currency Operations.

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