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, October 2,

2001, at 9:00 a.m.

Present:

Mr. Greenspan, Chairman

Mr. McDonough, Vice Chairman

Mr. Ferguson

Mr. Gramlich

Mr. Hoenig

Mr. Kelley

Mr. Meyer

Ms. Minehan

Mr. Moskow

Mr. Poole

Messrs. Jordan, McTeer, Santomero, and Stern, Alternate Members of the Federal

Open Market Committee

Messrs. Broaddus, Guynn, and Parry, Presidents of the Federal Reserve Banks of

Richmond, Atlanta, and San Francisco respectively

Mr. Kohn, Secretary and Economist

Mr. Bernard, Deputy Secretary

Ms. Fox, Assistant Secretary

Mr. Mattingly, General Counsel

Ms. Johnson, Economist

Mr. Reinhart, Economist

Mr. Stockton, Economist

Ms. Cumming, Messrs. Fuhrer, Hakkio, Howard, Lindsey, Rasche, Slifman, and

Wilcox, Associate Economists

Mr. Kos, Manager, System Open Market Account

Ms. Smith, Assistant to the Board, Office of Board Members, Board of Governors

Messrs. Ettin and Madigan, Deputy Directors, Divisions of Research and Statistics

and Monetary Affairs respectively, Board of Governors

Mr. Simpson, Senior Adviser, Division of Research and Statistics, Board of

Governors

Mr. Connors, Associate Director, Division of International Finance, Board of

Governors

Messrs. Oliner and Struckmeyer, Associate Directors, Division of Research and

Statistics, Board of Governors

Mr. Whitesell, Assistant Director, Division of Monetary Affairs, Board of Governors

Mr. Kumasaka, Assistant Economist, Division of Monetary Affairs, Board of

Governors

Ms. Low, Open Market Secretariat Assistant, Office of Board Members, Board of

Governors

Messrs. Eisenbeis, Goodfriend, Ms. Mester, Messrs. Rolnick, Rosenblum, and

Sniderman, Senior Vice Presidents, Federal Reserve Banks of Atlanta, Richmond,

Philadelphia, Minneapolis, Dallas, and Cleveland respectively

Messrs. Evans, Hilton, and Judd, Vice Presidents, Federal Reserve Banks of Chicago,

New York, and San Francisco respectively

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

on August 21, 2001, and the conference calls held on September 13 and 17, 2001, were

approved.

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

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

the System's account in the period since the previous meeting. The Manager also reported on

developments in domestic financial markets and on System open market transactions in

government securities and securities issued or fully guaranteed by federal agencies during the

period August 21, 2001, through October 1, 2001. By unanimous vote, the Committee

ratified these transactions. The Committee expressed its appreciation of the outstanding

manner in which the Federal Reserve Bank of New York had carried out its open market

operations and other responsibilities under very difficult circumstances after the terrorist

attacks on September 11, 2001.

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.

The information reviewed at this meeting suggested that the attacks of September 11 might

well have induced a mild downturn in economic activity after several months of little

movement in the level of economic activity. While few nonfinancial economic data were

available on developments since the attacks, anecdotal and survey reports suggested that

heightened uncertainty and sharply reduced confidence had curtailed consumer spending and

had intensified the downward trajectory in business capital expenditures. Consumer price

inflation had remained relatively subdued over the summer months.

Data for August portrayed some continued softening in overall labor market conditions.

Private nonfarm payroll employment fell appreciably further, with the decline more than

accounted for by additional job losses in manufacturing. Labor demand remained sluggish in

most other sectors, though some pickup was reported in services. The unemployment rate

rose to 4.9 percent in August, its highest level in four years. A sharp increase in initial claims

for unemployment insurance in recent weeks was suggestive of additional deterioration in

labor markets.

Industrial production fell substantially further in August after posting monthly losses starting

in October of last year. Motor vehicle assemblies were down sharply, reversing a large

advance in July, and production of high-tech equipment continued to register large declines.

Outside of those two industries, production of business equipment, business supplies,

consumer nondurables, and materials also moved appreciably lower. The rate of capacity

utilization in manufacturing continued to fall, reaching its lowest level since mid-1983.

Growth in consumer spending picked up somewhat in July and August from a reduced pace

in the second quarter despite a small drop in sales of new motor vehicles. However, anecdotal

reports from around the nation pointed to a downturn in September, largely reflecting marked

weakness after the terrorist attacks. Indicators of consumer confidence fell further in

September.

Despite low mortgage interest rates, residential building activity softened somewhat in

August and some indicators of housing demand, including mortgage applications for home

purchases, had downshifted a bit further in recent weeks. However, builder backlogs

appeared to be large enough to sustain homebuilding activity at a fairly elevated level for

several months. Sales of new homes edged up in August but were little changed on balance

since April.

Business capital spending contracted substantially further over the summer months, and

anecdotal information after September 11 pointed to even deeper cutbacks by many firms.

The added weakness evidently stemmed from increased concerns about future sales and

earnings, which also was reflected in the sharp declines in stock market prices after the

equity markets reopened on September 17. Available indicators suggested that expenditures

for equipment and software had remained on a sharp downward trajectory into late summer,

though the overall decline in such spending was moderated by sizable outlays for aircraft in

July and August. New orders for nondefense capital goods edged up in August but were still

well below their average for the second quarter. Nonresidential construction activity appeared

to be falling appreciably further after a sharp downturn in the second quarter.

Business inventory liquidation remained substantial in July, extending the sizable declines

since the start of the year. Large drawdowns were recorded in manufacturing and, excluding

motor vehicles, in both wholesale and retail trade. The limited data available for August

indicated some reduction in dealer stocks of motor vehicles and sizable further liquidation of

durable goods by firms in the manufacturing sector. Nonetheless, the aggregate

inventory-sales ratio for producers of durable goods edged up in August, led by a further rise

in the ratio for computers and electronic products. In the days following the terrorist attacks,

anecdotal reports indicated that disruptions in transportation facilities, including the

temporary suspension of air cargo service and lengthy trucking delays at the nation's borders,

caused some backups in inventories at some firms and shortages at others, but these problems

generally seemed to ease within a few days.

The U.S. trade deficit in goods and services was about unchanged in July from its June level,

but both exports and imports dropped sharply as weakness in worldwide economic activity

continued to affect the nation's foreign trade. The reduced value of exports in July was spread

among most trade categories but was especially pronounced in machinery, industrial

supplies, and automotive products. The reduction in imports was led by declines in oil,

semiconductors, other machinery, automotive products, and consumer goods. Data for

foreign industrial economies confirmed earlier indications of little or no growth in those

economies in the second quarter, and more recent information for the period prior to the

terrorist attacks pointed to further weakness, including evidence of declining activity in

Japan. Available information on conditions in major developing countries also suggested

slowing or negative growth in recent months, in part as a consequence of weakness in their

exports to the United States and, notably for some Asian economies, the poor performance of

the global high-tech industry.

Consumer price inflation remained relatively limited in July and August, with core personal

consumption expenditure (PCE) price inflation on an appreciably lower track than core

consumer price index (CPI) inflation. For the twelve months ending in August, core PCE

prices rose a bit less, and core CPI prices a bit more, than over the previous twelve-month

period. Consumer energy prices fell sharply in July and August, but a sizable rebound was

anticipated in September as prices of petroleum products moved higher after midsummer in

response to refinery disruptions and tightening supplies. In electricity markets, upward price

pressures dissipated over the summer, while the sharp run-up of natural gas prices continued

to unwind as inventories rose further in the context of persisting high levels of production

and sluggish demand. At the producer level, core prices declined in August, notably at the

early stages of processing. With regard to labor costs, the rise in average hourly earnings of

production or nonsupervisory workers diminished somewhat over July and August, but the

year-over-year advance was still appreciably above that for the previous twelve-month

period. In addition, large increases in health insurance costs were continuing to add to overall

employment costs.

At its meeting on August 21, 2001, the Committee adopted a directive that called for

implementing conditions in reserve markets consistent with a reduction of 25 basis points in

the intended level of the federal funds rate to a level of about 3-1/2 percent. The Committee

took this action in light of the absence of firm evidence that the deceleration in the economic

expansion had run its course or that a recovery in output was imminent. With increasing

slack in labor and product markets and with inflation expectations contained, the members

agreed that the balance of risks continued to be weighted toward conditions that could

generate economic weakness in the foreseeable future. Subsequently, on September 17, the

Committee reduced its target for the federal funds rate by a further ½ percentage point. This

action was taken against the backdrop of heightened concerns and uncertainty created by the

recent terrorist attacks and their potentially adverse effects on asset prices and the

performance of the economy. In conjunction with this easing move, the Federal Reserve

indicated that it would continue to supply unusually large volumes of liquidity, and the

Committee recognized that the federal funds rate might fall below its new target until the

normal functioning of financial markets was restored.

In the period before the terrorist attacks, federal funds traded at rates near the reduced target

level established at the August meeting. Most market interest rates edged lower over that

period in response to generally downbeat news on the economy, and broad stock market

indexes fell appreciably. For a few days after September 11, with federal funds brokerage

disrupted, banks generally agreed to trade reserves at the 3-1/2 percent federal funds target

rate then prevailing. As more normal functioning resumed in the federal funds market, the

rate fell well below the Committee's formal targets, including the reduced rate set on

September 17. By the latter part of September and early October, however, the effective rate

was fluctuating around the new target level. After the terrorist attacks, rates on short- and

intermediate-term Treasury securities fell appreciably further, as did yields on highly rated

obligations such as federal agency debt. However, the yield declines did not extend to

long-term Treasury bonds, which changed little as investors apparently reacted to the

deteriorating outlook for the federal budget surplus and prospectively larger Treasury bond

supplies. Yields on investment-grade corporate bonds also were little changed, but rates on

high-yield bonds, evidently reflecting increased investor aversion to holding risky securities,

rose sharply in very thin markets. In the stock market, broad equity price measures fell

considerably further in volatile trading after the markets reopened on September 17, but part

of those losses had been recovered by the time of this meeting.

The trade-weighted value of the dollar against the other major foreign currencies was about

unchanged on average over the period since the August meeting, as modest dollar

appreciation early in the period was reversed after September 11. The dollar ended the period

somewhat lower against the yen and the euro but registered an advance against the Canadian

dollar. The dollar rose over the period against the currencies of other important trading

partners.

Growth of M2 remained relatively robust in July and August, though below the average pace

in the first half of the year, while the expansion of M3 weakened markedly over the two

months. More recently, a record surge in M2 components in the week ending September 17,

which was largely reversed in the following week, resulted in very rapid growth in both

aggregates on a monthly average basis in September. In the immediate aftermath of the

terrorist attacks, disruptions to the infrastructure of financial markets, including

communications and transportation facilities, led to massive dislocations in the distribution

of deposits and reserves. At the same time, greatly heightened demand for safe and liquid

assets encouraged shifts from equity markets into deposit assets. These financial disturbances

called for and were accommodated by record infusions of Federal Reserve credit through

open market operations, the discount window, and other sources. In addition, the Federal

Reserve eased its rules for lending securities to dealers and took a number of other steps to

facilitate the operation of financial markets. To a considerable extent, more normal

functioning was restored to those markets by the latter part of September, and the unusual

demand for reserves abated.

In the presentation of its forecast to the Committee, the staff indicated that its downward

revised outlook was subject to a very wide range of uncertainty regarding the ongoing effects

of the tragic events of September 11. A mild downturn in overall economic activity probably

was now under way and business conditions would continue to be depressed for some

uncertain period by the sharp further deterioration in business and consumer confidence

triggered by the terrorist attacks. However, a gradual recovery was anticipated during the first

half of 2002, especially against the backdrop of a very accommodative monetary policy and

an increasingly stimulative fiscal policy. The recovery would gather momentum during 2002

to a pace late in the year near the staff's current estimate of the growth in the economy's

potential. With long-term trends in innovations and business opportunities expected to

remain favorable, business fixed investment after the completion of ongoing adjustments

likely would return to robust rates of growth, with favorable implications for employment,

labor productivity, and consumer spending. The current and prospective slack in resource use

over coming quarters, augmented by the pass-through effects of lower oil prices, would result

in some modest deceleration in core PCE and CPI inflation.

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

members focused on the shock to consumer and business confidence occasioned by the

events of September 11 and the adverse repercussions on an already weak economy. The

economy appeared to have been growing very little, if at all, prior to the terrorist attacks, and

the dislocations arising from the latter seemed to have induced a downturn in overall

economic activity against the backdrop of heightened anxiety and uncertainty about

economic prospects and a sharp drop, at least initially, in stock prices after the equity markets

reopened on September 17. Looking ahead, the members generally saw a relatively mild and

short contraction followed by a gradual recovery next year as a plausible forecast but one that

was subject to an unusually wide range of uncertainty, notably in the direction of a

potentially much weaker outcome in the nearer term. In the short period since the attacks,

anecdotal reports provided indications of a rebound from the sharp cutback in spending that

characterized the immediate aftermath of those tragic events, but on balance business activity

seemed to be in the process of moving lower. It was especially difficult to assess the outlook

for consumer sentiment and spending in the period immediately ahead, which likely would

depend to an important extent on the progress of the war against terrorism and reactions to

any further terrorist activities. One risk bearing on that outlook was the possibility that prices

in equity markets might continue to decline and perhaps even overadjust to lower earnings

expectations. The confluence of worldwide economic weakness added to current

uncertainties and concerns. In these circumstances a substantial further drop in consumer and

business confidence and spending could not be ruled out.

The members nonetheless saw favorable prospects for an upturn in business activity next

year, though the recovery clearly would be more delayed than they had anticipated before

September 11. Major reasons for optimism about the outlook were the substantial easing in

monetary policy, whose lagged effects would be felt increasingly in the year ahead, and the

fiscal stimulus measures that already had been enacted and might well be supplemented over

coming months. Other supportive elements included a likely rebound in business high-tech

investment after its sharp retrenchment and a gradual turnaround in inventory investment as

stocks became better aligned with expected sales. A sound banking system and low inflation

were seen as sources of underlying strength in the economy that would contribute to the

eventual pickup in economic activity. Even with a rebound in activity next year, however,

consumer price inflation appeared likely to remain subdued or perhaps trend a bit lower in

association with reduced pressures on labor and other resources and declining energy prices.

The Committee's review of recent and prospective developments in key sectors of the

economy underscored the uncertainty that surrounded the overall economic outlook. The

major question at this point was the extent to which the recent tragedies would continue to

weigh on consumer spending and business investment. In the consumer sector, spending had

with some exceptions held up well through late summer, but confidence had begun to

deteriorate even before September 11. A factor that seemed to be exerting an increasingly

depressing effect on consumer attitudes was the persisting stream of worker layoffs and

rising unemployment. The adverse wealth effects stemming from the cumulative declines in

stock market prices were a further negative, though one that had been cushioned by

continued increases in the value of real estate. Retail sales along with expenditures associated

with travel-related services had fallen dramatically in the immediate aftermath of the terrorist

attacks. Very recent anecdotal reports suggested some improvement in consumer spending,

though not a total recovery, with mixed indications ranging from a rebound to levels near

pre-attack norms to still relatively depressed activity. Looking ahead, many retailer contacts

anticipated sluggish sales over coming months. There were no historical precedents for

judging the likely effects on consumer confidence and spending of the unique recent events,

though it seemed likely that prospects for added job losses and the decline in equity wealth

already experienced would hold down consumer expenditures over the months ahead. Even

so, the members did not rule out a stronger-than-anticipated pickup later, depending in part

on the size of additional fiscal policy actions.

Housing demand had remained at a relatively elevated level across much of the nation,

though signs of some softening were apparent prior to September 11, especially in the

high-priced segment of the housing market. The near-term outlook suggested some further

waning in housing demand in association with the prospective weakness in employment and

income. Some members noted in this regard that they sensed growing caution among

homebuilders. However, the outlook for housing activity over the intermediate to longer term

remained fairly promising against the backdrop of relatively low mortgage interest rates and

a prospective recovery in overall economic activity that would foster rising employment and

incomes.

The events of September 11 produced a marked increase in uncertainty and anxiety among

contacts in the business sector. Spending for equipment and software and for commercial

structures had been declining sharply through the summer, with only a few tentative signs

that the pace of decline might be about to ebb. According to contacts, intensified concerns

about prospects for sales and profits were depressing investment further by fostering an

increasingly widespread wait-and-see attitude about undertaking new investment

expenditures. While nationwide statistics on expenditures in the period since the terrorist

attacks were not yet available, anecdotal reports pointed to especially large cutbacks in

planned spending for commercial aircraft and rental cars stemming from the sudden and

sharp deterioration of activity in the travel and tourist industries. Reports from banking

contacts also indicated a substantial drop in demand for business loans that was attributed in

part to the diminished willingness of small businesses in particular to undertake new

investments in capital equipment and other production facilities. More generally, the increase

in uncertainty and the decline in business confidence and corporate profits along with the

currently high levels of excess capacity in many industries pointed to the persistence of poor

prospects for capital spending over the short to intermediate term, with declines in outlays for

high-tech products expected to remain especially pronounced. Looking further ahead,

however, a robust upturn in business capital spending was still a probable outcome.

Businesses likely would respond to profit opportunities stemming not only from rising

demand resulting in part from fiscal and monetary stimulus but also from ongoing

technological improvements and the need for new capital equipment as the process of

retrenchment from earlier overinvestments was completed.

With a few short-lived exceptions, production on the whole had not been directly disrupted

by the effects of the terrorist attacks. Consequently, some unintended accumulation of

inventories probably had occurred as a result of sizable and unanticipated declines in the

demand for many products. Even so, the pronounced downtrend in overall inventory

spending appeared to be continuing, and with many business firms evidently still trying to

liquidate what they viewed as excessive stocks, the inventory adjustment process was likely

to persist for some time. Nonetheless, as progress was made in reducing unwanted stocks, the

rate of inventory liquidation would diminish and an eventual turn toward accumulation

would emerge, with positive implications for economic activity. Indeed, this buildup could be

larger than previously anticipated if businesses now felt the need to hold larger stocks against

the contingency of supply-chain slowdowns and disruptions.

The members saw the international sector as contributing to weakness in the domestic

economy, especially over the nearer term. Downshifts in the U.S. economy were reinforcing

more sluggish performance in many foreign economies, which in association with continued

firmness in the dollar was in turn depressing the outlook for U.S. exports to those countries.

In this regard, several members cited anecdotal evidence of flagging foreign markets for a

variety of U.S. products. On the positive side, weakness in world demand for oil was

fostering a significant downtrend in energy prices, albeit with adverse effects on energy

producers in this country and abroad.

Members viewed the outlook for inflation as favorable. Expectations of greater and longerlasting slack in labor and product markets than anticipated earlier had led to downward

revisions to forecasts of wage and price inflation. This outlook was abetted by substantial

declines in oil and other commodity prices. On the negative side, increases in spending on

insurance and security and continued upward pressure on costs in the healthcare industry

likely would impinge on business margins, limiting the downward adjustment of inflation.

In the discussion of policy for the intermeeting period ahead, all the members endorsed a

proposal calling for some further easing of reserve conditions consistent with a 50 basis point

reduction in the federal funds rate to a level of 2-1/2 percent. While monetary policy had

already been eased substantially this year, the increased evidence of a faltering economy and

the decidedly downside risks in the outlook called for a further move at this meeting. Easing

would help limit the extent of the downturn and later provide impetus to the eventual upturn

in economic activity. Further vigorous easing action would tend to support business and

household confidence, which a number of members saw as especially important in the

current circumstances. Even after a 50 basis point reduction, the federal funds rate would not

reflect an unusually accommodative policy stance in that, in real terms, it would still be

positive by many measures and above its typical level in most earlier periods of economic

weakness. Moreover, the decline in stock market prices and the widening of risk spreads had

damped the stimulative financial effects of the Committee's earlier easing actions. The

relatively low level of inflation and well-contained inflationary expectations allowed the

Committee flexibility to focus on countering the downside risks to the economy without

incurring a significant threat of fostering expectations of higher inflation. Monetary policy is

a flexible instrument and, with inflation expectations likely to remain relatively benign,

policy could be reversed in a timely manner later should stimulative policy measures and the

inherent resiliency of the economy begin to foster an unsustainable pace of economic

expansion.

In keeping with their views about the risks to the economy, all the members supported the

retention of the sentence in the press statement indicating that the risks continued to be

weighted toward further weakness in the foreseeable future.

At the conclusion of this discussion, the Committee voted to authorize and direct the Federal

Reserve Bank of New York, until it was instructed otherwise, to execute transactions in the

System Account in accordance with the following domestic policy directive:

The Federal Open Market Committee seeks monetary and financial conditions

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

further its long-run objectives, the Committee in the immediate future seeks

conditions in reserve markets consistent with reducing the federal funds rate to

an average of around 2-1/2 percent.

The vote encompassed approval of the sentence below for inclusion in the press statement to

be released shortly after the meeting.

Against the background of its long-run goals of price stability and sustainable

economic growth and of the information currently available, the Committee

believes that the risks continue to be weighted mainly toward conditions that

may generate economic weakness in the foreseeable future.

Votes for this action: Messrs. Greenspan, McDonough, Ferguson, Gramlich,

Hoenig, Kelley, Meyer, Ms. Minehan, Messrs. Moskow and Poole.

Votes against this action: None.

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

6, 2001.

The meeting adjourned at 12:30 p.m.

Donald L. Kohn

Secretary

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