Transcripts of the monetary policymaking body of the Federal Reserve from 2002–2008.

Thank you, Mr. Chairman. Among market participants, September has a reputation for being difficult on portfolios, for sudden bursts of volatility that lead to risk aversion and wider spreads, and for sometimes spectacular blowups in the speculative community. The ERM crisis in 1992, Long-Term Capital Management in 1998, and the aftermath of the terrorist attacks in 2001 are three of the more notable examples.

Until Monday, this year looked different. Spreads were and they continue to be narrow. Volatility has generally been low, with the notable exception of energy. Yields are benign, and equity prices, if anything, have been rising in recent weeks. The massive loss disclosed on Monday by a large hedge fund has had remarkably, almost suspiciously, little spillover effects thus far. But with political crises suddenly popping up in Hungary and Thailand, it may suggest that risks in some of these smaller, less-liquid market sectors such as emerging markets and commodities have risen. Overnight the Thai baht was slightly weaker, Thai banks and markets were closed, and currencies and equity markets of neighboring countries were, on balance, only marginally weaker. Meanwhile in the G3, markets have generally been calm, though recent moves suggest a more sober outlook for growth than had been priced in earlier this summer.

On page 1 of your handout, the top panel graphs the three-month Eurodollar deposit rate in black and the same rate three, six, and nine months forward in red since the beginning of the year. In recent weeks, forward rates traded through the cash rate as assorted reports—especially housing and inflation data—convinced market participants that (1) the Committee would continue to hold the target funds rate steady for sometime longer and (2) the probability of an ease early next year was far more likely than a resumption of the tightening cycle. That view was seemingly shared by investors in the Treasury market. As shown in the middle panel, two-year and ten-year yields have been gently declining since the June meeting. The ten-year yield currently trades about 50 basis points below the target funds rate—the widest negative spread since March 2001. Meanwhile, various measures of the yield curve have now been mildly inverted for several weeks—perhaps also reflecting the market’s view that a slowdown is in the offing. The bottom panel graphs the straight ten-year breakeven rate and the five-year rate five years forward. Both declined modestly since the last meeting, helped by inflation readings that did not repeat this spring’s elevated numbers and also by the moderation of commodity prices in general and energy prices in particular.

The view that growth may be less robust was reflected in overseas markets as well. On page 2, the top panel graphs the calendar spread for interest rate futures between the December 2007 and the December 2006 contracts for the G5 economies since January 1. In recent weeks that spread has, on balance, been declining slightly as markets have taken out tightenings that had been priced in for coming quarters. Even in Europe, where the ECB has been talking tough, market participants are reassessing what effect a U.S. slowdown would have on the ECB’s trajectory. The middle panel graphs ten-year sovereign yields for the United States, Canada, the United Kingdom, and, as a proxy for the euro area, France. Those yields rose during the first six months of the year and have retreated more recently. While there is a story for each economy, the most recent sets of data have been slightly less favorable, and forecasts for the next few quarters have been trimmed back. Meanwhile, as shown by the middle right panel, U.S. and Canadian breakevens have declined slightly. In contrast, breakeven rates in the United Kingdom and France have risen somewhat. Indeed, the ECB has repeatedly voiced concerns about rising headline inflation and the persistence of that trend.

Japan is a somewhat special case. Through midyear, forecasts for Japanese growth had been rising. Deflation was ebbing, loan growth was rising, and the BoJ opportunistically exited its quantitative easing policy in March and then exited the zero interest rate policy in mid-July. However, as shown in the bottom left panel, yields could not get past 2 percent and then began to decline as data such as machinery orders disappointed investors and led them to question how fast the BoJ would raise interest rates. Then on August 24, Japan released revisions to the CPI, which showed that inflation had been lower than previously reported. Markets quickly pushed back the timing of future call rate increases despite the BoJ’s assertions that the revisions did not change its basic outlook. Japan does have a nascent inflation-linked Japanese government bond market. The bottom right panel graphs the breakeven, which has fallen from about 1 percent to about 60 basis points. As shown in the top panel of page 3, the entire JGB curve has shifted down since the last FOMC meeting. One factor that has continued to work in favor of Japan’s export sector has been the exchange rate. The yen’s nominal value has been falling against most currencies in recent weeks and hit its lowest level against the euro since the single currency’s launch. The middle panel takes a much longer perspective on the yen; it graphs the real effective exchange rate since the beginning of the floating rate era. The real effective rate has been falling steadily since 2000 and is at its lowest level in more than 20 years despite the chronic trade and current account surpluses that Japan has generated in the interim.

The bottom two panels on page 3 reflect the recent volatility in commodity prices, with metal prices on the bottom left and energy prices on the bottom right. Metal prices continue to fluctuate but show some signs of having topped out for the time being. Energy prices, however, have made a round trip from where they were at the beginning of the year. The retracing of prices has fed discussions about whether the so-called speculative premium in energy prices has now been taken out. Certainly there are signs that speculators have been exiting some of these positions. Those signs are most visible for natural gas, which is something of an outlier in the bottom right. Last week’s sharp decline in prices may have been related to the liquidation of positions by the large hedge fund that was closing out positions. If the speculative money is being chased out, for natural gas but also for other products, then perhaps energy prices now better reflect underlying fundamentals.

Finally, I want to come back briefly to a topic I mentioned at the last meeting related to the nascent development of an early-return fed funds market. As background, fed funds contracts do not generally dictate the timing of the return leg. So, not surprisingly, most fed funds are returned to the lender late in the day. The GSEs have been interested in developing an early-return facility to meet the principal and interest payment timetable given the new PSR (payment system risk) rules. The data are sparse, and our conclusions are tentative, but I wanted to give you a brief update. On page 4, the blue bar in the top panel graphs daily volumes of regular overnight fed funds contracts. The smaller green bar represents overnight early- return volumes. The black line shows the percentage of overall volumes represented by early returns. The time series starts on August 8, which is when data first became

available to us. This series does not include term trades with early-return provisions.

In general, early returns make up about 10 percent of overall volumes. The middle

panel graphs the effective rate for those trades with early-return provisions in red.

The blue line is the 9:00 a.m. rate. Early-return trades are transacted in midmorning

and thus show a strong correlation with the 9:00 a.m. rate, generally trading about 2

basis points below regular funds. Finally, as shown in the bottom panel, early-return

trades have far less volatility. The reason for the lower volatility is primarily that

these trades are executed in midmorning rather than during the late afternoon rush,

when the funds rate often can move with large swings. Getting back to the GSEs,

they in fact have not been active users of overnight early-return fed funds. They

have, however, used term fed funds of up to a month maturity with early-return

provisions timed to mature on the date of their large P&I dates. For term rates, unlike

for overnight trades, there is no rate concession.

Mr. Chairman, there were no foreign exchange operations for the period. I will need a vote to approve domestic operations.

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