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, May 20,

1997, at 9:00 a.m.

Present:

Mr. Greenspan, Chairman

Mr. McDonough, Vice Chairman

Mr. Broaddus

Mr. Guynn

Mr. Kelley

Mr. Meyer

Mr. Moskow

Mr. Parry

Ms. Phillips

Ms. Rivlin

Messrs. Hoenig, Jordan, Melzer, and Ms. Minehan, Alternate Members of the Federal

Open Market Committee

Messrs. Boehne, McTeer, and Stern, Presidents of the Federal Reserve Banks of

Philadelphia, Dallas, and Minneapolis 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. Beebe, Eisenbeis, Goodfriend, Hunter, Lindsey, Mishkin, Promisel, Siegman,

Slifman, 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 Simpson, Associate Directors, Divisions of Monetary Affairs

and Research and Statistics respectively, Board of Governors

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

Governors

Mr. Conrad, First Vice President, Federal Reserve Bank of Chicago

Messrs. Dewald, Hakkio, Ms. Krieger, Messrs. Lang, Rosenblum, and Sniderman,

Senior Vice Presidents, Federal Reserve Banks of St. Louis, Kansas City, New York,

Philadelphia, Dallas, and Cleveland respectively

Messrs. Cox, Rosengren, and Weber, Vice Presidents, Federal Reserve Banks of

Dallas, Boston, and Minneapolis respectively

By unanimous vote, the Federal Open Market Committee approved the minutes of its

meeting on March 25, 1997.

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

foreign exchange markets. The Desk did not conduct any transactions in foreign currencies

for System Account during the period since the latest meeting on March 25, 1997, 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 government securities and federal agency obligations during the

period March 25, 1997 through May 19, 1997. By unanimous vote, the Committee ratified

these transactions.

The Committee then turned to a discussion of the economic 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 slowed after having surged in late 1996 and earlier this year. Consumer spending

appeared to be increasing at a considerably slower pace after the spurt in the first quarter,

while business fixed investment remained on a strong uptrend, and the demand for housing

seemed to be well maintained. Growth of labor demand had moderated somewhat from the

rapid pace at the beginning of the year, but labor markets remained tight and worker

compensation appeared to be accelerating gradually. Despite the upward drift in labor costs,

underlying price inflation was still subdued.

Private nonfarm payroll employment rose at a considerably reduced pace over March and

April, and the average workweek dropped from an unusually high rate in February and

March to a more normal level in April. The services industries recorded further large gains in

employment in March and April, but the number of jobs in manufacturing contracted in April

and construction employment declined in both March and April. The civilian unemployment

rate fell appreciably in April to 4.9 percent, and the labor force participation rate edged down

from the record high reached in March.

Industrial production was unchanged in April after having recorded sizable increases in

March and other recent months; declines in mining and manufacturing were offset by a large

rise in utility output. The drop in manufacturing production reflected a sharp decline in the

output of motor vehicles and parts that was largely related to the lagged effects of strike

activity in recent months. The output of manufactured goods other than motor vehicles and

parts rose moderately in April: the production of business equipment posted another solid

gain while the output of consumer goods and construction supplies was unchanged. The rate

of utilization of manufacturing capacity fell in April, reflecting the decline in motor vehicle

output, but it remained relatively high.

Nominal retail sales were unchanged in March and declined in April after having increased

rapidly in earlier months. Weaker sales of motor vehicles contributed to the overall

sluggishness of retail activity in March and April, but spending on many other categories of

goods, both durable and nondurable, also was down over the two-month period after having

previously grown strongly. Expenditures on services advanced further through March (latest

available data) even though unseasonably mild weather held down outlays for heating. While

retail sales had slowed recently, the latest surveys indicated that consumer sentiment had

risen further from an already markedly high level.

Housing activity in March and April was in line with that in other recent months. Singlefamily housing starts were unchanged in April after declining in March. Starts for the

two-month period were only a little below the average for 1996, and sales of new homes

remained at a very high level in March (latest data). Multifamily starts rose considerably in

April and on average over March and April were a little above the elevated level in the fourth

quarter.

Business fixed investment expanded briskly in the first quarter. Outlays for producers'

durable equipment rebounded after fourth-quarter weakness, and spending for nonresidential

structures posted another substantial advance. Available indicators pointed to further sizable

gains in spending on both equipment and structures. Business inventory investment was up

considerably in the first quarter after increasing by a relatively small amount in the fourth

quarter; however, inventory-sales ratios for most industry and trade groupings remained at

very low levels.

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

over January and February from the temporarily depressed rate in the fourth quarter of last

year and was about the same as the rate in the third quarter. A surge in imports reflected a

rebound in the importation of automotive products from the strike-reduced level of the fourth

quarter, further expansion in purchases of imported computers, and an upturn in imports of

semiconductors after four quarters of declines. By contrast, exports of goods and services

rose only slightly in the January-February period; exports of automotive products were up

sharply, but sizable increases in exports of chemicals, computers, and semiconductors were

largely offset by declines in other non-automotive trade categories. Recent economic

information on the foreign G-7 countries, including some preliminary indicators for the

second quarter, suggested that the growth of output had strengthened somewhat on average in

these countries. Activity in continental Europe, though still weak, was improving, while the

economies of Canada, Japan, and the United Kingdom remained strong. Economic activity

continued to expand rapidly on average in the major developing countries in the first quarter.

Recent data indicated that price inflation remained moderate despite a gradual acceleration of

labor costs. Increases in consumer prices were held down in March and April by sizable

declines in energy prices and a small net reduction in food prices. Consumer prices for items

other than food and energy advanced at a moderate rate over the two months, and over the

twelve months ended in April they increased by the same amount as in the previous twelve

months. Producer prices fell in both March and April, reflecting large declines in energy

prices. Excluding food and energy, producer prices edged lower in April after rising a sizable

amount in March. Core producer prices increased considerably less over the twelve months

ended in April than over the previous twelve months. At earlier stages of production,

producer prices registered declines both in recent months and for the twelve months ended in

April. An upward creep in the growth of labor costs was apparent in data on the hourly

compensation of private industry workers; although the rise in the first three months of 1997

was smaller than the increase in the fourth quarter, the advance over the twelve months ended

in March was larger than that over the previous twelve months. A similar but more

pronounced pattern was evident in data on average hourly earnings for production or

nonsupervisory workers.

At its meeting on March 25, 1997, the Committee issued a directive that called for a slight

increase in the degree of pressure on reserve positions; the firming of policy was taken in

light of continued rapid growth of aggregate demand in the first quarter and the attendant

greater risk of heightened pressures on resources and an upturn in inflation. Although further

policy tightening might be needed at some point, the Committee did not believe that

developments during the intermeeting period were likely to require an adjustment, and thus

the directive did not include a presumption about adjustments to policy during the

intermeeting period. The reserve conditions associated with this directive were expected to

be consistent with some moderation in the expansion of M2 and M3 over coming months.

Open market operations immediately after the meeting on March 25 were directed toward

implementing the slightly firmer reserve conditions desired by the Committee and then

maintaining those conditions over the remainder of the intermeeting period. The federal

funds rate averaged close to the higher intended level of 5-1/2 percent. Open market

operations were complicated during the period by extraordinarily large federal tax payments

in April, which substantially increased the volume of open market purchases needed to offset

the reserve drains associated with those tax payments.

Market interest rates generally posted small mixed changes over the intermeeting period.

Most private short-term rates increased only a little in response to the March policy action,

which had been largely anticipated by market participants. Intermediate- and long-term

yields rose over the early part of the intermeeting period, responding mostly to incoming data

suggesting that growth in aggregate demand and output remained strong; these increases

were subsequently more than reversed, however, as later information indicated that economic

growth was moderating and price inflation remained subdued and on news of an agreement

to balance the federal budget. Major indexes of stock market prices fluctuated substantially

over the period but they rose considerably on balance.

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

G-10 currencies declined on balance over the intermeeting period. The movements of the

dollar during the period roughly corresponded to the fluctuations in intermediate- and

long-term U.S. interest rates; the dollar advanced strongly in April on growing expectations

of a further firming of U.S. monetary policy but more than retraced that gain in May as the

likelihood of further tightening waned. The dollar's weakness in May also seemed to reflect

growing attention to the prospects for official intervention to restrain the dollar's rise, notably

against the Japanese yen and the German mark.

The growth of M2 and M3 remained brisk over March and April. Much of M2's strength

during this period resulted from a temporary buildup by households of balances in savings

accounts and money market mutual funds to cover unusually large tax payments. The rapid

growth of M3 was associated not only with the bulge in M2 but also with stepped-up

issuance of large time deposits to fund the expansion of bank credit. For the year through

April, both aggregates expanded at rates appreciably above the upper bounds of their

respective ranges for the year. The growth of total domestic nonfinancial debt had moderated

over recent months as a result of reductions in federal government borrowing.

The staff forecast prepared for this meeting suggested that the economy would expand in the

second half of the year at a rate a little above that of its estimated potential and then would

increase at a slower and more sustainable rate in 1998. Growth of consumer spending,

supported by high levels of household wealth and further projected gains in employment and

income, was expected to remain fairly brisk over the forecast horizon. Business spending on

equipment and structures was anticipated to continue to outpace the overall expansion of the

economy, though the differential would tend to narrow over time in association with the

gradual diminution of increases in sales and profits that was expected to be associated with

moderating economic growth. Housing construction was projected to drift lower over coming

quarters, partly in conjunction with the rise in mortgage interest rates that already had

occurred but also in response to the smaller increases expected in household income. The

staff continued to anticipate that fiscal policy and the external sector would exert mild

restraint on the expansion of economic activity. With resource utilization high and labor

compensation gradually accelerating, core consumer price inflation was forecast to drift

slightly higher.

In the Committee's discussion, the members agreed that the information for recent months

pointed on balance to a marked slowing in the expansion of economic activity from a very

rapid pace in late 1996 and earlier this year. The extent of the reduced growth in the current

quarter and the prospects for subsequent quarters were subject to substantial uncertainty, but

the members generally felt that the economy retained considerable underlying strength. In the

circumstances and assuming no changes from current financial conditions, the individual

members saw likely prospects for expansion over the forecast horizon at a pace close to, or a

little above, the estimated growth of the economy's long-run potential. Many noted, however,

that high levels of consumer and business confidence and supportive financial conditions

among other factors suggested the possibility that growth could turn out to be even faster.

With the utilization of productive resources, notably labor, already at particularly high levels

in relation to the economy's potential, an outcome no stronger than current forecasts could

well have adverse implications for inflation. Nonetheless, the members also noted that the

rise in compensation increases had been damped and that there continued to be few

indications of accelerating price inflation in the statistical and anecdotal information

available at this time; such developments underlined persisting uncertainties about behavior

in labor markets and the level and growth of the economy's sustainable potential.

In their review of developments in key sectors of the economy, members referred to

favorable underlying factors in the outlook for consumer spending, These included solid

growth in consumer incomes, large increases in financial wealth, and currently high levels of

consumer confidence. While more moderate growth in consumer spending for durable goods

seemed likely after an extended period of robust expansion, these favorable factors suggested

that the risks of a different outcome were tilted in the direction of faster-than-projected

expansion. On the negative side, large consumer debts were still viewed as likely to

constitute an inhibiting influence on consumer expenditures, and many banking institutions

had tightened lending terms and conditions at least for their more marginal consumer

borrowers. On balance, growth in consumer expenditures at a somewhat reduced pace

approximating that of the expected expansion of disposable incomes appeared to be a

reasonable prospect, though one that was subject to considerable uncertainty.

Spending for business fixed investment seemed to have retained a good deal of momentum

even after the large increases in such expenditures in recent years. Clearly, businesses

regarded such investments as highly profitable, and they appeared to be leading to gains in

productivity that in turn were helping to offset rising compensation and to maintain profit

margins in highly competitive markets. In the circumstances, it appeared unlikely that growth

in capital outlays would moderate appreciably for some time. A number of members also

referred to the increasing strength in nonresidential construction, notably that of commercial

structures, in several parts of the nation. Some referred in particular to planned or actual

construction of new office buildings in various locales; such activity was being stimulated by

declining vacancy rates, rising rents, and a ready availability of financing. Likewise, a surge

in tourism in a number of areas had resulted in a scarcity of hotel rooms and was spurring

hotel construction in some major cities. Anecdotal reports of nonresidential building activity

undertaken on a speculative basis had increased, but a building boom reminiscent of the

1980s did not appear to be under way.

Concerning the outlook for housing, members referred to forecasts of a mild downtrend in

residential construction associated with the increases that had occurred in mortgage interest

rates. To date, however, there were few indications of any weakening. Indeed, housing

construction had been relatively robust in the early months of the year, though the strength

probably was largely accounted for by unusually favorable weather conditions and may have

borrowed from building activity later in the year. On balance, as evidenced by anecdotal

reports from some areas, various factors including ongoing growth in employment and

incomes, the availability of financing on still generally favorable terms, and the associated

affordability of housing for many homeowners seemed likely to provide continued support

for this sector of the economy for some period of time.

A surge in nonfarm business inventory investment accounted for a substantial portion of the

acceleration in output in the first quarter, and an anticipated moderation in the accumulation

of inventories was an important element in forecasts of greatly reduced economic growth in

the current quarter. In keeping with business practices aimed at achieving or maintaining lean

inventory-sales ratios, inventory investment was projected to continue at a relatively subdued

pace in coming quarters. A number of members expressed the view, however, that

stockbuilding represented an upside risk in the economic outlook, at least in the nearer term.

While there were some indications of efforts to pare inventories in recent months, generally

optimistic business sentiment and currently trim inventories in most industries might well

foster efforts to accumulate stocks at a relatively rapid pace, especially if more-buoyantthan-anticipated sales were to stimulate a precautionary demand for inventories as had

occurred in 1994.

With regard to the outlook for inflation, members observed that increases in prices had

remained subdued despite the rapid expansion in economic activity in recent quarters and the

associated increase in pressures on already highly utilized resources. The appreciation of the

dollar undoubtedly had helped to damp domestic inflation this year, and reported increases in

consumer prices also had been held down to a marginal extent by an ongoing series of

technical adjustments to the CPI. These were only partial explanations, however, and the

members found it very difficult to account for the surprisingly benign behavior of inflation in

an economy that had been operating at a level approximating full employment--indeed,

possibly somewhat above sustainable full employment in labor markets in the view of a

number of members, especially taking into consideration the recent further decline in the

unemployment rate. On the basis of historical patterns, any overshooting of full employment

would be expected to generate rising inflation over time. Although increases in labor

compensation had been trending higher, these pressures were muted and had not shown

through to prices.

Members focused on the possible role of faster-than-reported increases in productivity as a

key explanation for the benign behavior of inflation in current circumstances. Business firms

had continued to report robust profit margins in a period when competitive pressures

generally prevented them from raising their prices, or raising them sufficiently, to pass on the

increases that they were experiencing in worker compensation. Standard statistical measures

that pointed to relatively limited increases in productivity seemed inconsistent with strong

profits as well as with anecdotal reports of sizable gains associated with widespread business

restructuring activities and large additions of high-technology equipment to an increasingly

efficient capital stock. The ongoing development and spreading adoption of automated

equipment along with the increasing skills and other infrastructure needed to use it

effectively appeared to be creating growing efficiencies or synergies that were markedly

enhancing productivity and enabling firms to hold the line on prices and maintain high profit

margins.

While these were welcome developments, members continued to express concern that,

perhaps sooner rather than later, growing pressures on productive resources would be

reflected in some upturn in overall inflation. Although most measures of labor compensation

had been relatively favorable recently, such measures had been displaying a clear uptrend

over a somewhat longer period, and it seemed likely that, if this trend continued, labor cost

developments would at some point be reflected more fully in core measures of prices.

Members commented that the timing and extent of any upturn in price inflation would

depend on growth of overall demand in the economy, but they also believed that expansion of

demand in line with their current expectations could induce a somewhat less favorable

inflation experience during coming quarters. However, recent developments had underscored

the fact that historical experience was not a fully reliable guide to the prospective behavior of

prices; accordingly, the inflation outlook remained subject to considerable uncertainty.

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

members indicated that they could support a proposal to maintain an unchanged policy

stance, although some also expressed a preference for some tightening at this meeting. Those

who endorsed a steady policy at this time agreed that some tightening might well be needed

later to contain potentially rising inflation. For now, however, economic growth seemed to be

slowing to a more sustainable pace, and the uncertainties surrounding the extent of the

slowing and the outlook for inflation pointed to the desirability of a cautious approach to any

policy tightening, especially given the persisting absence of a rising inflation trend in current

measures of prices. A number of members also observed that real interest rates were not

unusually low. Thus, the present stance of monetary policy probably was not very far out of

alignment with what likely would prove to be a desirable degree of restraint, thereby

lessening any risk of large and persisting imbalances that a delay in implementing further

restraint might incur.

Members who preferred some tightening, at least in the near term if not necessarily at this

meeting, noted that the Committee needed to weigh the risks of having to implement a small

degree of restraint now versus considerably more later if inflation were allowed to build

momentum. Monetary policy exerts its effects with a considerable lag, and a small but

relatively prompt tightening action would provide some further insurance against an

intensification of inflation. Such an outcome could be seen as more likely now, given the

increased tightness in labor markets and the possibility that relatively strong growth would

put added pressures on resources. Some of these members commented that the risk of a

retarding effect on the economy from a small move at this time was quite limited in light of

the apparently solid momentum of the economic expansion. Indeed, the strength of

investment demand, the ready availability of financing, and possible favorable productivity

gains argued that real rates of interest would need to be higher than historical norms to

balance aggregate demand and supply. The risk of slightly lower economic growth needed to

be compared with what they viewed as the greater risk of losing ground to inflation and

thereby inhibiting the Committee's ability to reach its ultimate goal of price stability, a goal

that all the members viewed as necessary to achieve maximum sustainable economic growth

over time. Given the quiescence of inflation and the uncertainties surrounding its outlook,

however, all but one of these members could accept a wait-and-see policy stance for now.

With regard to possible adjustments to policy during the intermeeting period, all the members

supported a shift from the symmetric directive that had been adopted in conjunction with the

policy tightening action at the March meeting to an asymmetric directive tilted toward

tightening. While such a bias did not necessarily imply an intention to tighten policy during

the weeks immediately ahead, it was consistent with the members' view that the risks were in

the direction of a potential need for some tightening in monetary policy to counter rising

inflationary pressures, and that they might be required to make such a decision in the not-toodistant future.

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.

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 slowed after surging in late 1996 and earlier this year. Private

nonfarm payroll employment increased at a considerably reduced pace over

March and April, but the civilian unemployment rate fell appreciably to 4.9

percent in April. Industrial production was flat in April following sizable gains

over previous months. Nominal retail sales were unchanged in March and

declined in April after a considerable advance in earlier months. Housing

activity in March and April was little changed from other recent months.

Available indicators point to further sizable gains in business fixed investment.

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

January-February from its temporarily depressed rate in the fourth quarter.

Underlying price inflation has remained subdued.

Market interest rates generally have posted small mixed changes since the

Committee meeting on March 25, 1997; share prices in equity markets have

risen considerably. In foreign exchange markets, the trade-weighted value of the

dollar in terms of the other G-10 currencies declined on balance over the

intermeeting period.

Growth of M2 and M3 was brisk over March and April, boosted by a buildup in

household balances to cover unusually large tax payments. For the year through

April, both aggregates expanded at rates appreciably above the upper bounds of

their respective ranges for the year. Growth in total domestic nonfinancial debt

has moderated over recent months, reflecting reductions in federal government

borrowing.

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 February

established ranges for growth of M2 and M3 of 1 to 5 percent and 2 to 6 percent

respectively, measured from the fourth quarter of 1996 to the fourth quarter of

1997. The monitoring range for growth of total domestic nonfinancial debt was

set at 3 to 7 percent for the year. 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 some

moderation in the expansion of M2 and M3 over coming months.

Votes for this action: Messrs. Greenspan, McDonough, Guynn, Kelley, Meyer,

Moskow, Parry, Mses. Phillips and Rivlin.

Vote against this action: Mr. Broaddus.

Mr. Broaddus dissented because he believed that the strength of investment demand, due

possibly to an increase in the trend growth rate of productivity, required somewhat higher

real interest rates to prevent inflationary pressures from developing. He was concerned that,

with the economy already operating at a high level and labor markets apparently very tight,

any increase in such pressures might be costly to reverse and might reduce the credibility of

the Committee's longer-run strategy of promoting maximum sustainable growth by fostering

price level stability. He also believed that the risk to the economy of a moderate further

tightening was small given the apparent momentum of aggregate economic activity.

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

July 1-2, 1997.

The meeting adjourned at 12:45 p.m.

Donald L. Kohn

Secretary

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