appendix 1: materials used by messrs. gallin, lehnert ... · pdf filewilliams june 29-30, ......

Appendix 1: Materials used by Messrs. Gallin, Lehnert, Peach, Rudebusch, and Williams

June 29-30, 2005 172 of 234

STRICTLY CONFIDENTIAL (FR) CLASS II-FOMC

Material for

Special Staff Presentations on Housing Valuations and Monetary Policy

June 29, 2005

June 29-30, 2005 173 of 234

Is Housing Overvalued? Joshua Gallin

Board of Governors of the Federal Reserve System

2 of 33

June 29-30, 2005 174 of 234

Exhibit 1 6-29-05

Is Housing Overvalued?

Changes in Real House Prices: The United States Four-quarter percent change 15

10

5

0

-5

1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 Note: Real house prices are the repeat-transactions price index relative to the personal consumption expenditures chain-price index. Sources. BEA and OFHEO.

Real Price Changes: Western Cities Real Price Changes: Eastern Cities Four-quarter percent change 50 Four-quarter percent change 50

- San Francisco - New York - Las Vegas 40 - Miami 40

30 30

20 20 Q1

10 - - 10

0 0

-10 -10

-20 -20

1975 1980 1985 1990 1995 2000 2005 1975 1980 1985 1990 1995 2000 2005

Anecdotes from the Housing Market Valuing Housing

" Increased speculation. * Is housing affordable for the typical household?

" Rosy assessments of future - Are prices too high relative appreciation. to incomes?

" Increased reliance on novel - Are required mortgage financing without full recognition payments affordable? of the associated risks.

" Are prices too high relative to rents?

3 of 33

June 29-30, 2005 175 of 234

Exhibit 2

A Framework for Valuing Housing

" Rental payments in the housing market are analogous to dividends in the stock market.

" High prices can be justified by high rents or low carrying costs.

" Carrying costs include interest payments, net taxes, and depreciation.

Price-Rent Ratio and Real Carrying Costs Percent

10e-

The Data

" Repeat-transactions price indexes from OFHEO and Freddie Mac.

" Tenants' rent index from the CPI.

" Several adjustments address shortcomings of the data.

Real carrying cost <left scale> (interest payments, net taxes, depreciation)

Ratio 27.5

- 25.0

22.5

20.0

17.5

Note. The price-rent ratio is the repeat-transactions house-price index divided by CPI tenants' rent, adjusted by Board staff. The real carrying cost includes effective after-tax mortgage rates, local property taxes, and depreciation relative to ten-year inflation expectations from the Philadelphia Fed survey.

Price-Rent Ratios and Subsequent Changes in Real Prices Cumulative percent change, real prices, subsequent three years

C'O

1970:Q3

2002:Q1

Co.S)9

C0 0

0 00

1 I 1 I I I I 1 I I20.519.0 19.5 20.0 221.0 21.5 22.0 22.5 23.0 23.5 24.0

Price-rent ratio

4 of 33

6-29-05

()o

-10

24.515

June 29-30, 2005 176 of 234

Exhibit 3

Price-Rent Ratios and Subsequent Changes in Real Prices: Selected Cities Percent deviation from long-run level 80

1979:Q2 San Francisco New York Chicago Miami 70 1989:Q4 60 2005:Q1

50 - - 40

30 15 1620

- -4 10 0 -10

Real Price Change, subsequent three years -5 -12 2 -16 -20 1 3 -5 (cumulative)

Two Models of House Price Changes

Variables in the basic model " Recent house prices " Real income, real carrying costs,

and the unemployment rate

Extra variables in error-correction model " Lagged price-rent ratio " Lagged level of carrying costs

Projection of Real Price Changes Four-quarter percent change K-- History and staff forecast

-- Error-correction model

I I Il 1 2002 2003 2004 2005 2006

Conclusions

" The price-rent ratio is very high by historical standards, suggesting that housing might be overvalued by as much as 20 percent.

" Historical experience suggests that the change in real house prices going forward will be slower than in recent years.

" The evidence cannot rule out either further rapid gains in house prices for a time or a rapid correction back toward fundamentals.

5 of 33

6-29-05

June 29-30, 2005 177 of 234

House Prices and Mortgage Finance Andreas Lehnert

Board of Governors of the Federal Reserve System

6 of 33

June 29-30, 2005 178 of 234

Exhibit 1

Household Sector Vulnerability to House Price Declines

Estimated Loan-to-Value Distribution of Outstanding MortgagesPercent of borrowers

Sept. 2003 64March 2005

56

19 1 14

7 4

Less than 70 70-79 80-89 90+ Source. LoanPerformance Corp. (LPC) servicer data, flow of funds accounts (FFA), OFHEO

Sensitivity of Household Sector to Price Declines LTV at Origination Against Price Change Percent of borrowers with negative equity Average LTV at origination, 2004

4o 40 L K By state

Sept. 2003 March 2005

10 20 Price decline (percent)

Mortgage Delinquency Rates

Quarterly

Per

All loans

Q1

Loans at commercial banks

"" Q1

cent

-TX *

* - *. .

.* -*IL

*.NV * S FL

SNY*

MA"CA I I I I * I

2 4 6 8 10 Annualized price change, 1999-2003 (percent)

Conclusions

. Average LTV has decreased over the past 18 months

. Most borrowers have substantial equity in their homes

" Rapidly rising house prices have kept mortgage delinquencies and losses low

- Some households are very highly leveraged

7 of 33

1991 1993 1995 1997 1999 2001 2003 2005 Source. MBA, Call Reports

June 29-30, 2005 179 of 234

Exhibit 2

Characteristics of Interest-Only (10) Mortgages in RMBS Pools

Components of Home Mortgage Debt 10 Share of RMBS Against Price Change 10 share of RMBS (percent)

2003:01 2005:01 By state --billions of dollars-- r = 0.3

1. RMBS pools 591 1,191 N, - CA

2. 10 RMBS pools

3. Total home mortgage debt

Memo:

4. 10 RMBS share of home mortgages (percent)

54

6,491

0.8

296

8,282

3.6

2 Source. LPC RMBS data, FFA No

Loan-to-Value Ratios of Interest-Only Mortgages at Origination

* FL

fIL -* . . .* * .

MA

NY

4 6 8 10 Annualized price change, 1999-2003 (percent)

te. Data are from purchase originations in 2004

Percent of interest-only mortgage debt

March 2003 E March 2004 Feb 2005

Less than 70 70-79

Note. Data are for lo RMBS pools only; observations are weighted by mc

Credit Scores of Interest-Only Mortgages

FICO Score

March 2003 March 2004 Feb 2005

420-659 660-719

Note. Data are for 10 RMBS pools only; observations are weighted by mortgage size.

8 of 33

80-89 90+

Percent of interest-only mortgage debt

720-779 780-900

June 29-30, 2005 180 of 234

Credit Risk Exposure

Exhibit 3

Financial Institution Risk Exposure

Housing GSEs

Mortgage Types

Conforming, mostly fixed-rate

High LTV

Wide variety

Wide variety

Private Mortgage Insurers Ratio Ratio

0.25

0.20

0.15

0.10 03

0.05

-- 0.0

03 -0.05

-0.10

-0.15

-0.20

- -0.251988 1991 1994 1997 2000 2003

Source. Mortgage Insurance Companies of America

Mortgage Share of Assets, Banks and Thrifts Percent of total assets

Bottom Second Third Top Quartile

Note. Not weighted by assets

1. Average LTV at origination

2. Estimated average current LTV

3. Average credit score (FICO)

4. Percent of guaranteed mortgages with credit enhancement

Note. Data are from Freddie Mac only Source. Freddie Mac 2004 Annual Report

Risks in RMBS Pools

" RMBS pools contain relatively risky mortgages

e Pools are structured to allow investors to choose risk exposure

e Pools are exceptionally transparent

" Pricing depends on loss modeling

Assets and Capital Ratios

Mortgage Average Share Assets Quartile (billions)

1. Bottom 0.9

2. Second 0.8

3. Third 1.4

4. Top 1.4

Average Tier 1 Capital Ratio

16.5

10.3

10.1

10.4

9 of 33

Institutions

1. Housing GSEs

2. Private Mortgage Insurers

3. RMBS Pools

4. Banks and Thrifts

June 29-30, 2005 181 of 234

Measuring House Prices Richard Peach

Federal Reserve Bank of New York

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June 29-30, 2005 182 of 234

The OFHEO Home Price Index

- An index of the average price of single-family homes purchased (refinanced) with conforming, conventional mortgages - Excludes cash sales and sales financed with FHA,

Ww VA, and jumbo loans.

- A "repeat-sales" index - Measures sales prices or appraised values of

properties at same address at different points in time.

- A transactions-based price index.

June 29-30, 2005 183 of 234

The Constant-Quality New Home Price Index

- Based on a sample of new homes sold, regardless of how the sale was financed.

- Hedonic methods are used to hold physical and locational characteristics constant over time. - Sales prices regressed on numerous

characteristics such as lot size, square footage of structure, presence of air conditioning, fire places, etc.

June 29-30, 2005 184 of 234

Nominal Home Price Appreciation 6 % Change - Year to Year % Change - Year to Year

20 20

15 15

10 10 OFHEO Index Census Constant

Quality New Home Price Index

5 5

0 0

-5 ' ' ' ' '' ' ' -5

1976 1980 1984 1988 1992 1996 2000 2004

Source: Census Bureau and Office of Federal Housing Enterprise Oversight Note: Shading represents NBER recessions.

June 29-30, 2005 185 of 234

Ratio of Home Price Over Median Family IncomeRatio

3.5

3.25

3

0 2.75

2.5

2.25

Ratio 3.5

3.25

3

2.75

2.5

2 1

1977 1980 1983 1986 1989

Source:Office of Federal Housing Enterprise Oversight and Bureau of Economic Analysis

2.2

1992 1995 1998 2001 2004 *Both indices have been converted to dollars using

the median price of existing homes in 1979Q1. Note: Shading represents NBER recessions.

June 29-30, 2005 186 of 234

Distribution of Single-Family Homes by Value: 20035# of Single-Family Units

1200 r

900

600

300

0300,000 80th

Source: American Housing Survey

90,000 150,000 et 00 250,000 25th 50th 75th

Home Values

June 29-30, 2005 187 of 234

Appreciation and Turnover Rates by Percentile (percent per year)

Percentile

25th 50th 75th 80th

Appreciation Rate 4.5% 5.6% 7.5% 8.7% (1997 - 2003)

Turnover Rate 5.9% 7.5% 8.6% 7.4% (average 1997 - 2003)


June 29-30, 2005 188 of 234

OFHEO Index and Home ImprovementsIndex, 1977 = 1

1.5

1.4

1.3

1.2

1.1

1

0.91977

0

2000 Dollars 1100

1000

900

800

700

600

500

Index, 1977 = 1

1980 1983 1986 1989 1992 1995 1998 2001

1.5

1.4

1.3

1.2

1.1

1

0.92004

2000 Dollars 1100

1000

900

800

700

600

W 500

1977 1980 1983 1986 19 Source: Census Bureau, Office of Federal Housing Enterprise Oversight, and Bureau of Economic Analysis

89 1992 1995 1998 2001 2004

Note: Shading represents NBER recessions.

Ratio of OFHEOI to Constan-Quali- Ine

June 29-30, 2005 189 of 234

Ratios of Median Home Value to Median FamilyIncome by Percentile* of Home Value

1993 1995 1997 1999 2001

Ratio

2003

Source: American Housing Survey*Home value percentile groups are defined by 3-percentile

ranges centered around the cited percentile point.

4

3.5

3

2.5

2

1.5

Ratio 4

3.5

3

2.5

2

1.51985 1987 1989 1991

June 29-30, 2005 190 of 234

Implicit Land Price Increases Derived from Constant-Quality New Home Price Indices*

(compound annual rate, 1998-2004)

Northeast

7.3%

Midwest

2.9%

South

2.8%

West

10.0%

*Based on the assumption that land represents 50 percent of the value of the property.

U.S.

5.5%

June 29-30, 2005 191 of 234

Single-Family Investment Properties Thousands of Housing Units (renter-occupied plus vacant for rent)

16000 i

14000

12000

10000

8000

6000

4000

2000

0

U Renter-Occupied

12,019 (16.0%)

11,165 (1.%

1997

12,280 (15.7%)

1999

U Vacant for Rent

12,333 (15.1%) 11,631

(14.2%)

S i 54i


2001 2003

June 29-30, 2005 192 of 234

Monetary Policy Responses to Asset Price Movements

Glenn D. Rudebusch Federal Reserve Bank of San Francisco

21 of 33

June 29-30, 2005 193 of 234

Monetary Policy and Asset Prices: The Basics

1. Asset price decomposition:

Assume an asset price (APt) consists of a component determined by its fundamentals (Ft) and a bubble component (Bt):

APt = Ft + Bt.

2. Two proposals for the appropriate monetary policy reaction to an asset price:

Standard Policy (SP): " Widespread agreement that the SP is a minimum appropriate reaction. " Respond to an asset price insofar as it conveys information about the future

evolution of output and inflation-the goal variables of monetary policy. " In following the SP, it still may be useful-if possible-to identify Ft and Bt.

Bubble Policy (BP): * Respond to relevant information as in the SP and also try to influence the

asset price directly in order to contain or reduce the bubble and limit costs associated with movements in Bt.

3. A best-case scenario for Standard and Bubble Policies:

Example: Consider the ideal theoretical conditions where the decomposition of an asset price (APt) into its fundamentals (Ft) and a bubble (Br) is known.

Time (t)

The Standard Policy (SP) would: * Try to offset the effects of APt with higher rates than recommended by the

fundamentals before the crash and lower rates afterward.

The Bubble Policy (BP) would: * Respond to information as in the SP, but also try to reduce the bubble

fluctuations and achieve, ideally, the AP't path. This would likely require higher rates than the SP before the crash and lower rates afterward.

-1-

22 of 33

June 29-30, 2005 194 of 234

Should Monetary Policy Try to Reduce an Asset Price Bubble?

Decision tree for Standard and Bubble Policies

Q1. Can a bubble-or asset price misalignment-be identified?

i No

Yes Asset price appears misaligned.

Q2. Do bubble fluctuations result in large macroeconomic consequences that monetary policy cannot readily offset?

: No

Yes Fallout may include a severe financial crisis, imbalances, or misallocations that cannot be well offset by monetary policy.

Q3. Is monetary policy a good way to deflate the bubble?

No

Yes Relative to the cost of alternatives the dislocations associated with monetary policy actions are small.

Follow Bubble Policy

The asset price is arguably aligned with fundamentals.

Follow Standard Policy

Macroeconomic consequences from asset price boom and bust are minor or they occur with a lag, so monetary policy can effectively offset them.

Follow Standard Policv

Interest rate effects on bubble are uncertain or costly, especially relative to alternative deflation strategies.

Follow Standard Policy

23 of 33

June 29-30, 2005 195 of 234

Two Episodes of Possible Asset Price Bubbles

Real-time answers to decision-tree questions

1. Equity prices in 1999-2000:

Q1: A bubble could be identified in certain sectors and perhaps in overall market. Q2: Serious capital misallocation appeared likely during boom and severe fallout

from financial instability was possible during bust. Both hard to rectify. Q3: It appeared unlikely that any bubble could be deflated by monetary policy.

US Stock Market Indexes January 3, 1995 = 100

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

2. Bond prices in 1994: Q1: A bubble or bond price misalignment appeared likely. Termed an "inflation

scare" or "credibility gap." Q2: Possible fallout from propagation of high-inflation expectations. Q3: It appeared likely monetary policy could guide prices back to fundamentals.

30-Year Treasury Bond Yield percent

1993 1994 1995 1996

24 of 33

June 29-30, 2005 196 of 234

Monetary Policy Implications of a House Price Bubble

John C. Williams Federal Reserve Bank of San Francisco

25 of 33

June 29-30, 2005 197 of 234

A Tale of Two Bubbles

Monetary Policy Implications of a Bursting Housing Bubble

26 of 33

" House prices today: a 20% decline would

o reduce household wealth by $3.6 trillion (30% of current GDP)

o raise saving rate by nearly 1-1/2 percentage points in the long-run

o lower the long-run equilibrium real funds rate (r*) by 40 basis points.

" Stock prices in early 2000: twice as a large a potential problem as house price overvaluation today.

o Stock market overvalued by 60% in March 2000; correction implied a $6.7 trillion reduction in wealth (70% of GDP at the time).

o In the event, stock market wealth fell by $4.6 trillion from March 2000 to March 2001, and at trough was down $8.5 trillion.

" Cautionary note: policy cushion today is noticeably smaller than in early 2000.

" Three scenarios:

1. 20% decline in house prices relative to path in June Greenbook

2. Scenario 1 + spillover effects on demand

3. Scenario 2 + rise in bond premiums.

" Two policies: Optimal policy and Taylor rule

o Optimal perfect foresight policy: assumes equal weights on unemployment and inflation deviations from targets of 5 and 1.5 percent, respectively, and small penalty on interest rate changes.

o Taylor Rule: coefficient of 1 on output gap and '% on inflation gap; r* adjusts to changes in housing wealth and bond premiums.

June 29-30, 2005 198 of 234

1. Effects of 20 Percent Decline in House Prices

Unemployment Rate Core PCE Price Inflation (4-qtr change) 1 2 .2 5S

2

1.75

6.25

6

5.75

5.5

5.25

5

1.25

12004 2005 2006 2007 2008 2004 2005 2006 2007 2008

Federal Funds Rate

2006

27 of 33

1.5 E

June GB (optimal policy)

Optimal Policy

Taylor Rule

2004 2005 2007 2008

" House prices decline 20% relative to June Greenbook path by end of 2007.

" Demand shock: no significant tradeoff of goals.

" Macroeconomic effects build gradually: Under Taylor Rule, policy can respond to them as they develop.

June 29-30, 2005 199 of 234

2. Scenario 1 + Demand Spillovers

Unemployment Rate Core PCE Price Inflation (4-qtr change) 2.25k

2

1.75

1.5

1.25

2004 2005 2006 2007 2008 2004 2005 2006 2007 2008

Federal Funds Rate

2004 2005 2006 2007 2008

28 of 33

6.25

6

5.75

5.5

5.25

5

June GB

Taylor RuleOptimal Policy

" House price declines rattle consumer confidence and dry up equity extraction from mortgage refinancing, crimping household spending.

" Optimal policy: funds rate declines to 2-1/4% by middle of 2006.

" Taylor Rule fails to act in anticipation of spillover effects and responds too gradually once they occur.

June 29-30, 2005 200 of 234

3. Scenario 2 + Falling Bond Prices

Unemployment Rate Core PCE Price Inflation (4-qtr change) 2.25

2004 2005 2006 2007 2008

1.75 |-

6.25

6

5.75

5.5

5.25

52004 2005 2006 2007 2008

Federal Funds Rate

U' 2004 2005 2006 2007 2008

" House prices decline 20% as before, with demand spillovers.

" Term premiums on long-term bonds increase 75 basis points by year-end.

" Optimal policy drives funds rate below 1 percent by middle of 2006.

" Optimal policy able to forestall significant rise in unemployment rate; under Taylor Rule, unemployment rate reaches 6 percent.

29 of 33

1.5

1.25

1

June GB

June 29-30, 2005 201 of 234

Using Monetary Policy to Preempt a Worsening House Price Misalignment

" Pro: House price misalignment may

o contribute to conditions that lead to a sharp contraction in economic activity that is difficult for policy to counteract

o misallocate resources toward housing-related activities.

" Con: Effectiveness of such policies is open to question

o uncertain empirical relationship between housing prices, interest rates, and other factors

o difficulties in assessing existence and magnitude of misalignment.

30 of 33

June 29-30, 2005 202 of 234

6-29-05

House Prices and Rents in Selected Metropolitan Areas

San FranciscoFour-quarter percent change 4

- Real price - Real rent

I||I1I|Iil|||||||111111111111 i75 1980 1985 1990 1995 2000 201

Percent deviation from long-run level - Price-rent ratio 7

J '1 If

1lIII1111111111111111111111111 175 1980 1985 1990 1995 2000 20(

Chicago

Four-quarter percent change

- Real price - Real rent

1980 1985 1990 1995 2000

Cleveland

Four-quarter percent

Real price Real rent

Percent deviation from long-run level

- Price-rent ratio 7

f'>A

- - -10

1975 1980 1985 1990 1995 2000 2005

Percent deviation from long-run level 70 - Price-rent ratio

60

50

40

30

20

4-e- 10 0

-10

||75 |98||1Il5 190 9 I l l0l0l I -20 1975 1980 1985 1990 1995 2000 2005

Sources: OFHEO, BEA, and BLS.31 of 33

1975

June 29-30, 2005 203 of 234

6-29-05

House Prices and Rents in Selected Metropolitan Areas

Boston

Ir-quarter percent change- Real price - Real rent

r/ -\/W

1975 1980 1985 1990 1995 2000 201

New YorkFour-quarter percent change 40

- Real price -- Real rent

ilI111111111111111111111111111 175 1980 1985 1990 1995 2000 201

Percent deviation from long-run level - Price-rent ratio 7

975 1980 1985 1990 1995 2000 20C

Percent deviation from long-run level

-- Price-rent ratio

975 1980 1985 1990 1995 2000 200

Miami

Four-quarter percent change 40- Real price - Real rent

20

10

0

-10

1975 1980 1985 1990 1995 2000 20052

-- Price-rent ratio

1980 1985 1990

Sources: OFHEO, BEA, and BLS.32 of 33

1995 2000

II1111111111111111111111111111

June 29-30, 2005 204 of 234

6-29-05

Measures of Prices, Rents, and Costs in the Housing Market

Changes in Real House Prices and Rents Four-quarter percent change 8

- Repeat-Transactions Price Index (adjusted) Q1

-- Rent Index (adjusted) 6

s- 4

-- 2

-4

6

Levels of Real House Prices and Construction Costs

Repeat-Transactions Price Index (adjusted)

--- Construction Costs

Index (1979 = 10 150

I I I I I I I I I I I I I I I I I I I I I I I I I I 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Sources: OFHEO, Freddie Mac, BLS, Census, BEA, and Engineering News Record.

33 of 33

June 29-30, 2005 205 of 234

Appendix 2: Materials used by Mr. Kos

June 29-30, 2005 206 of 234

of 4

-300

-200

-100

0

100

200

300

Jan-80 Jan-83 Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04

Basis Points

-300

-200

-100

0

100

200

300

Basis Points

Average since 1980

Spread Between 2- and 10-Year Treasury YieldsJanuary 1980 – June 2005

2.22.32.42.52.62.72.82.93.03.1

Jan-05 Feb-05 Mar-05 Apr-05 May-05 Jun-0544464850525456586062

5-Year TIPS Breakeven Rate

10-Year TIPS Breakeven Rate

Front Month CrudeOil Futures (RHS)

TIPS Breakevens and Crude Oil FuturesJanuary 13, 2005 – June 28, 2005

Dollars per BarrelPercent

Class II FOMC -- Restricted FR

2.50

3.00

3.50

4.00

4.50

3/1 3/15 3/29 4/12 4/26 5/10 5/24 6/7 6/212.50

3.00

3.50

4.00

4.50

Current U.S. 3-Month Deposit Rates and Rates Implied by Traded Forward Rate Agreements

March 1, 2005 – June 28, 2005LIBOR Fixing 3M Forward 9M Forward PercentPercent

3/22 FOMC+25bps

5/3 FOMC+25bps

6/1 President Fisher’s Comments

6/3 May NFP+78K

June 29-30, 2005 207 of 234

of 4Class II FOMC -- Restricted FR

200

300

400

500

600

700

800

1/3 1/17 1/31 2/14 2/28 3/14 3/28 4/11 4/25 5/9 5/23 6/6 6/20

Basis Points

200

300

400

500

600

700

800Basis Points

High Yield and Auto Debt SpreadsJanuary 3, 2005 – June 28, 2005

High Yield IndexSource: Merrill Lynch, Bloomberg

Ford

GM

5/5 GM Downgrade

5/3 FOMC +25 bps

40

50

60

70

80

4/1 4/8 4/15 4/22 4/29 5/6 5/13 5/20 5/27 6/3 6/10 6/17 6/24

Basis Points

40

50

60

70

80Basis Points

Dow Jones CDX 5-Year Investment Grade Credit Default Swaps IndexApril 1, 2005 – June 28, 2005

5/5 GM Downgrade

-10%

-8%

-6%

-4%

-2%

0%

2%

12/31 1/10 1/20 1/30 2/9 2/19 3/1 3/11 3/21 3/31 4/10 4/20 4/30 5/10 5/20 5/30 6/9 6/19

Percent Return

-10%

-8%

-6%

-4%

-2%

0%

2%Percent ReturnSelect Hedge Fund Index Returns

December 31, 2004 – June 24, 2005

Source: HFR

Aggregate Hedge Fund Index

Convertible ArbitrageIndex

June 29-30, 2005 208 of 234

of 4Class II FOMC -- Restricted FREuro-Area 3-Month Deposit Rates and

Rates Implied by Traded Forward Rate AgreementsMarch 1, 2005 – June 28, 2005

1.90

2.10

2.30

2.50

2.70

3/1 3/15 3/29 4/12 4/26 5/10 5/24 6/7 6/211.90

2.10

2.30

2.50

2.70

LIBOR Fixing 3M Forward 9M Forward PercentPercent

5/29 French Referendum

1.20

1.22

1.24

1.26

1.28

1.30

1.32

1.34

1.36

1/3 2/3 3/3 4/3 5/3 6/31.20

1.22

1.24

1.26

1.28

1.30

1.32

1.34

1.36Euro/$ Euro/$

Euro-DollarJanuary 3, 2004 – June 28, 2005

2.0

2.5

3.0

3.5

4.0

Jun-04 Sep-04 Dec-04 Mar-05 Jun-052.0

2.5

3.0

3.5

4.0U.S. 2-YearTreasury Note

2-Year GermanSchatz

Percent PercentInterest Rate DifferentialsJune 28, 2004 – June 28, 2005

-30

-20

-10

0

10

20

30

40

1/7 2/7 3/7 4/7 5/7 6/7-30

-20

-10

0

10

20

30

40

IMM Net Non-Commercial Euro Positions

-1.0

-0.5

0.0

0.5

1.0

1.5

Aug-00 Aug-01 Aug-02 Aug-03 Aug-04-1.0

-0.5

0.0

0.5

1.0

1.5Percent Percent

Euro-Dollar Risk ReversalsFebruary 1, 2000 – June 28, 2005

Premium for Euro Puts

5/29 French Referendum

Thousands ofContracts

Thousands ofContracts

1-Year 25 DeltaRisk Reversal

June 29-30, 2005 209 of 234

of 4

3.0

3.5

4.0

4.5

5.0

5.5

6.0

3/15 3/22 3/29 4/5 4/12 4/19 4/26 5/3 5/10 5/17 5/24 5/31 6/7 6/14 6/21 6/28

Percent

3.0

3.5

4.0

4.5

5.0

5.5

6.0Percent

UK

Germany

US

Australia

Canada

Global 10-Year Sovereign Debt YieldsMarch 15, 2005 – June 28, 2005

Class II FOMC -- Restricted FR

0.00.40.81.21.62.02.42.8

3M 6M 1Yr 2Yr 3Yr 5Yr 7Yr 10Yr 15Yr 20Yr 30Yr0.00.40.81.21.62.02.42.8

6/28/05

6/28/04

Japanese Government Bond Yield CurvePercentPercent

-8-6-4-202468

10

U.S. S&P500 Mexico Bolsa BrazilBovespa

U.K. FTSE French CAC German DAX Italy MIBIndex

Japan Nikkei

Percent

Local Currency ReturnUSD Return

Year-To-Date Global Equity Performance

June 29-30, 2005 210 of 234

Appendix 3: Materials used by Messrs. Oliner, Wilcox, and Leahy

June 29-30, 2005 211 of 234

STRICTLY CONFIDENTIAL (FR) CLASS I-FOMC*

Material for

Staff Presentation on the Economic Outlook

June 30, 2005

*Downgraded to Class II upon release of the July 2005 Monetary Policy Report.

June 29-30, 2005 212 of 234

June 29-30, 2005 213 of 234

Exhibit 2

Key Background Factors

2001 2002 2003 2004 2005 20060

1

2

3

4

5

6

0

1

2

3

4

5

6Percent

Federal funds rate

April GB

10-yearTreasury rate

April GB

Quarterly average

Interest Rates

2001 2002 2003 2004 2005 2006-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2Percent of GDP

Fiscal Impetus

2001 2002 2003 2004 2005 20067000

8000

9000

10000

11000

12000

13000

14000

7000

8000

9000

10000

11000

12000

13000

14000Index, ratio scale

April GBWilshire 5000

Quarter-end

Equity Prices

2001 2002 2003 2004 2005 2006240

270

300

330

360

400

240

270

300

330

360

400Index, 1980:Q1=100, ratio scale

Quarterly

OFHEO repeat-transactions index

April GB

House Prices

2001 2002 2003 2004 2005 200615

25

35

45

55

65

15

25

35

45

55

65Dollars per barrel

Quarterly average

West TexasIntermediate

April GB

Crude Oil Prices

2001 2002 2003 2004 2005 200688

96

104

112

88

96

104

112Index, 2000=100

April GB

Quarterly average

Broad Real Dollar

June 29-30, 2005 214 of 234

June 29-30, 2005 215 of 234

Exhibit 4

Does Any Slack Remain In The Labor Market?

1996 1998 2000 2002 2004 20063

4

5

6

7

3

4

5

6

7Percent

NAIRU

Unemployment Rate

1996 1998 2000 2002 2004 200665.5

66.0

66.5

67.0

67.5

65.5

66.0

66.5

67.0

67.5Percent

Trend

Labor Force Participation Rate

1996 1998 2000 2002 2004 2006215

225

235

245

215

225

235

245Billions of hours, annual rate

Trend

Total Hours Worked

1990 1995 2000 200550

70

90

110

130

150

50

70

90

110

130

150Diffusion index

Q2

Average, 1997:H1

Source: Conference Board.

Jobs Plentiful Versus Hard to Get

1990 1995 2000 20055

10

15

20

25

30

35

40

5

10

15

20

25

30

35

40Percent

Q2

Average, 1997:H1

Note. 2005:Q2 is the April-May average. Source: National Federation of Independent Business.

Jobs Hard to Fill

1994 1996 1998 2000 2002 2004 20062.0

2.5

3.0

3.5

4.0

2.0

2.5

3.0

3.5

4.0Percent of household employment

Q2

Average, 1997:H1

Note. 2005:Q2 is the April-May average.

Persons Working Part-Time for Economic Reasons

June 29-30, 2005 216 of 234

June 29-30, 2005 217 of 234

June 29-30, 2005 218 of 234

June 29-30, 2005 219 of 234

June 29-30, 2005 220 of 234

June 29-30, 2005 221 of 234

June 29-30, 2005 222 of 234

Exhibit 11

Foreign Outlook and Financial Market Indicators

2004 2005 20060

1

2

3

4

5

*Weighted by shares of U.S. merchandise exports.**Years are Q4/Q4. Half-years are Q2/Q4 or Q4/Q2.

U.S.

TotalForeign*

U.S. and Foreign GDPPercent change, a.r.**

75

100

125

150

175

200

2003 2004 2005

Industrial countries

Emerging markets

* Source: MSCI.

Weekly

Stock Prices*Ratio scale, Jan. 3, 2003=100

3.0

3.5

4.0

4.5

5.0

2003 2004 2005

U.S. Treasury

Weighted-average foreign*

* Average of rates for Australia, Canada, euro area, Japan, Sweden, Switzerland, and United Kingdom, weighted by trade shares.

Weekly

Ten-Year Government Bond YieldsPercent

1

3

5

7

9

11

13

15

Overallex-Argentina

Mexico

Brazil

2003 2004 2005

Weekly

EMBI+ SpreadsPercentage points

June 29-30, 2005 223 of 234

Exhibit 12

Long-Term Interest Rates and Monetary Policy

3

4

5

6

United States

Germany

2003 2004 2005

Ten-Year Government Bond Yields

(Weekly data, percent)

3

4

5

6

2003 2004 2005

United Kingdom

3

4

5

6

2003 2004 2005

Canada

0

1

2

3

Japan

2003 2004 2005

0

1

2

3

4

Monetary Policy Indicators

U.S. target federalfunds rate

Euro-arearefinance rate

2003 2004 20052

3

4

5

6

United Kingdom

Repo rate

2003 2004 20051

2

3

4

5

Canada

Bank rate

2003 2004 200515

20

25

30

35

40

Japan

Balances at BOJ

2003 2004 2005

Trillions of yen

0

1

2

3

4

5

6Euro

Long-Term Nominal and Inflation-Indexed Yields

Nominal

Inflation indexed

2003 2004 20050

1

2

3

4

5

6Sterling

Nominal

Inflation indexed

2003 2004 20050

1

2

3

4

5

6Canadian dollar

Nominal

Inflation indexed

2003 2004 20050

1

2

3

4

5

6Yen

Nominal

Inflation indexed

2003 2004 2005

June 29-30, 2005 224 of 234

Exhibit 13

Euro Area and Japan

-50

0

50

100

150

200

250

300

350

1990 1992 1994 1996 1998 2000 2002 2004 2006*Operating earnings per share in local currency for MSCI indexes;forecasts are from I/B/E/S surveys in mid-June 2005.

Japan

Euro area

Yearly

Earnings per Share*Index, 1990=100

2002 2003 2004 20050

50

100

150

200

250

Euro

Yen

Weekly

BBB Corporate Bond SpreadsBasis points

2004 2005 200690

95

100

105

Euro

Yen

Monthly

Real Effective Exchange RatesIndex, Jan. 2004=100

2002 2003 2004 2005-25

-20

-15

-10

-5

0

5

*Percent of respondents reporting an increase minus percent ofrespondents reporting a decrease.

Industrial

Consumer

Monthly

Euro-Area Confidence IndicatorsDiffusion index*

2004 2005 2006-1

0

1

2

3

4

5

6

*Half-years are Q2/Q4 or Q4/Q2.

Euro-Area Real GDPPercent change, a.r.*

2004 2005 2006-1

0

1

2

3

4

5

6

*Half-years are Q2/Q4 or Q4/Q2.

Japanese Real GDPPercent change, a.r.*

June 29-30, 2005 225 of 234

Exhibit 14

China: Why is Import Growth Slowing?

-20

0

20

40

60

80

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

Twelve-month moving sum

Merchandise Trade BalanceBillions of dollars

20

30

40

50

60

70

2003 2004 2005

Exports

Imports

Monthly

Merchandise TradeBillions of dollars

2003 2004 2005-20

20

60

100

140

180

0

Taiwan

Korea

Japan

Exports to ChinaTwelve-month percent change

2004 2005 20060

3

6

9

12

15

Real GDPPercent change, a.r.

0

5

10

15

20

25

Iron and steel

Road vehicles

1995 1997 1999 2001 2003 2005

Twelve-month moving sum

Exports by CategoryBillions of dollars

2003 2004 2005-1

0

1

2

3

4

5

6

Overall

Excluding food

Consumer PricesTwelve-month percent change

June 29-30, 2005 226 of 234

Exhibit 15

Outlook for Commodity Prices and U.S. External Accounts

2002 2003 2004 2005 200680

100

120

140

160

180

200

*IMF indexes.**Weighted by U.S. import shares.

Non-fuelcommodities**

Metals

Monthly

Primary Commodity Prices*Index, Jan. 2002=100

2002 2003 2004 2005 200675

80

85

90

95

100

105Monthly

Broad Real DollarIndex, Jan. 2002=100

2002 2003 2004 2005 200615

20

25

30

35

40

45

50

55

60

65

Spot

Far-dated futures

Monthly

WTIDollars per barrel

1996 1998 2000 2002 2004 2006-10

-9

-8

-7

-6

-5

-4

-3

-2

-1

0

1

-1000

-900

-800

-700

-600

-500

-400

-300

-200

-100

0

100

Balance

Share of GDP

Quarterly

Current Account Balance Percent Billions of dollars, a.r.

Balance of PaymentsBillions of dollars, a.r.

Net Trade Invest. Current

Balance Income Account

2005 Q1 -687 21 -780

Q2 -701 18 -785

H2 -747 5 -847

2006 H1 -776 -20 -907

Q3 -783 -42 -934

Q4 -800 -58 -960

-113 -79 -180Change from

2005Q1 to 2006Q4

June 29-30, 2005 227 of 234

Exhibit 16

ECONOMIC PROJECTIONS FOR 2005

FOMC

Range CentralTendency

Staff

-------------Percentage change, Q4 to Q4------------

Nominal GDP February 2005

Real GDP February 2005

Core PCE Prices February 2005

5 to 6¼ (5 to 6)

3 to 3¾(3½ to 4)

1½ to 2¼(1½ to 2)

5½ to 5¾(5½ to 5¾)

3½

(3¾ to 4)

1¾ to 2

(1½ to 1¾)

5.9(5.4)

3.6(3.9)

2.1(1.6)

--------------Average level, Q4, percent---------------

Unemployment rate February 2005

5 to 5¼(5 to 5½)

5(5¼)

5.1(5.3)

Central tendencies calculated by dropping high and low three from ranges.

ECONOMIC PROJECTIONS FOR 2006

FOMC

Range CentralTendency

Staff

-------------Percentage change, Q4 to Q4------------

Nominal GDP February 2005

Real GDP February 2005

Core PCE Prices February 2005

5 to 6(5 to 5¾)

3¼ to 3¾(3¼ to 3¾)

1½ to 2½(1½ to 2)

5¼ to 5½(5 to 5½)

3¼ to 3½(3½)

1¾ to 2(1½ to 1¾)

5.4(5.3)

3.4(3.6)

1.9(1.4)

--------------Average level, Q4, percent---------------

Unemployment rate February 2005

5(5 to 5¼)

5(5 to 5¼)

5.1(5.1)

June 29-30, 2005 228 of 234

Appendix 4: Materials used by Mr. Reinhart

June 29-30, 2005 229 of 234

Exhibit 1

Expected Federal Funds Rates* Percent

June 29, 2005 --------- May 2. 2005

June Oct. Jan. Apr. July Oct. Jan. Apr. 2005 2006 2007

'Estimates from federal funds and eurodollar futures, with an allowance for term premia and other adjustments.

Nominal Treasury Yields'

FOMC June 2004

Probability of a Pause at Upcoming FOMC Meetings Percent

June 29, 2005 (black bars) May 2 2005 (red bars)

I LII Jun. Aug. Sep. Nov. Dec,

Percent

FOMC May 2005

- -.... ...... ...... ... . - - Two-Year

Aug. Sept. Oct. 2004

'Par yields from an estimated off-the-run Treasury yield curve.

Change In Ten-Year Yields Since June 29, 2004

-basis points

1. Nominal Treasury -79

2. TIPS -52

3. Inflation Compensation

4. One-Year Forward'

5. AA Corporate

6. Euro Swap Rate

-170

-78

-120

Nov. Dec. Jan. Feb Mar Apr. May June 2005

Actual and Expected Treasury One-year Forward Rates' Percent

9 6/29/2005

-.----- Day before FOMC meeting 6/30/2004 8 - - - Expected for 6/20/2005 as of 6/30/2004

7

-5

'f 4

3

2

1 3 5 7 10 Years Ahead

Forward rates are the one-year nominal rates maturing at the end of the year shown on the horizontal axis that are implied by the

smoothed Treasury yield curve.

May June July

'One-year nomina! forward rate maturing ten years ahead

June 29-30, 2005 230 of 234

Exhibit 2

Slope of Yield Curve*basis points

1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 Ten-year over one-year constant maturity spread.

Note. Shaded areas represent NBER contractions.

Factors Encouraging the Demand for Relative to the Supply of Long Duration Securities

" Reduced macro volatility

" Increased demand for duration

" Reduced supply of duration

" Increased global saving

Term Premium of One-Year Forward Nominal Rate Maturing Ten Years Ahead* Percent Weekly

June FOMC May

FOMC

June Aug. Oct. Dec Feb. Apr, June 2004 2005

Derived from three-factor arbitrage-free term structure model.

Factors Damping Growth Prospects

" Higher oil prices

" Potential increase in domestic saving rate

" Large and sustained trade deficits

Four-Quarter-Ahead Real GDP Growth Forecast Percent

1988 1991 1994 1997 2000 2003 Note, Shaded areas represent NBER contractions.

400

300

200

100

0

-100

-200

-300

June 29-30, 2005 231 of 234

Exhibit 3

Values from Policy Rules and Futures Markets - Actual federal funds rate and Greenbook assumption - Market expectations estimated from futures quotes

See explanatory note in Chart 8 of the Bluebook.

What can go wrong?

" Stop too soon -- Allowing inflation expectations to

become unanchored

" Stop too late -- Allowing slack to persist

Percent Range of Estimated Equilibrium Real Rates -12 Range of model-based estimates

E] 70 percent confidence band 10 90 percent confidence band

-- Actual real federal funds rate - - Greenbook-consistent measure

2.I... l.1990 1992 1994 1996 1998 2000 2002 See explanatory note in Chart 7 of the Bluebook.

Inflation Compensation

Five-to-Ten-Years Ahead - Next Five Years

Jan. Apr. July Oct. Jan. Apr. 2004 2005

Percent 10 -8

-6

2004

Percent

Intended Federal Funds Rate* Percent12 400

350 10

300

8 250

6 200

150 4

100

2 50

Risk Spreads* Basis Points

Ten-Year BBB (left scale) Five-Year high-yield (right scale)

--tliami11 1.. 11mm. lii IhIPaIp III..Ii iam a i maJan. Aug. Mar. Oct. May Dec.

2002 2003 2004 2005 *Measured relative to an estimated off-the-run Treasury yield curve.

1988 1991 1994 1997 2000 2003

*Red shading indicates periods of sustained tightening. Blue shading indicates periods of sustained easing.

1150

950

750

550

350

150

...

June 29-30, 2005 232 of 234

Exhibit 4

Monetary Policy Alternatives

Yield Curve Signal Decline in Economic

Term Premium Weakness Policy Risk

Stopping Too C Soon

Stopping Too A Late

Statement Challenges

* "...the stance of monetary policy remains accommodative"

* "...coupled with robust underlying growth in productivity"

* "...with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal."

* "...that policy accommodation can be removed at a pace that is likely to be measured."

June 29-30, 2005 233 of 234

Table 1: Alternative Language for the June FOMC Announcement

May FOMC Alternative A Alternative B Alternative C

L The Federal Open Market The Federal Open Market Committcc The Federal Open Market Conitte e 1hc Federal Open Market Committee Policy Conmmittee decided today to raise its decided today to raise its target for the decided today to raise its target for the decided t oday to raise its target for the federal

Decision target for the federal funds rate by federal funds rate y 22 basis points to ffnrai tunds rate tb 50 basis points to 3-1/2 25 basis points to 3 percent. 3-1/4 percent. 3-1/4 percent. percent.

2. 'he Committee helievcs that, cen hI'ie Committee >elieves that, -:ft-4 'he Committee belicvecs that, cvcn after this

after this action, the stance of th, ac,,, _ "a.cc . the degree of action, the stance of monetary policy remains

monetary policy remains monetary polo. cy ~ t.;. ,--m.d accommodative and, :.11pk iti i accomimodatixve and, coupled with accommodation has been Ino change} is

robust underyitng growth in substantially reduced. a nd, eitl ped providing ongoing support to economic

productivity, is providing ongoing Wsit Robust underlying growth in acaivity.

support to economic acvity. productivity, continues to provide support to

economic acttvity.

3. Recent data suggest that the solid PRa ia c .. t th: tha .L pat Although energy prices have risen Reemdta-seggenhm+ The sIll4

pace of spending growth has slowed i f .pedirgx < i, ht: Nonetheless, further, Recent it.. d gges .h _Lt Ole underlying pace of spending growth ths

somewxxhat, partix to resptonse tt thec growth in spending slowedc sotmexwhat di pace .. f spei.d4ng g ', ch h.mtx; - t, par d; ;, .-

Rationale patttc tpRationale earlier increases in energy prices. in the spring, partly in response to +h: remains solid despite elevated eith-dier Lpabor market conditions, however, ltdie- i *re ~ elevated energy tih. are .oca : n i: energy prices. labor market

apparently continue to improve prices. Lahor market conditions, the expansion remains firm and - conditions, l-h weter, arpttdtfted4 continue to

graduall. however, apparently continue to labor market conditions, eho e: improve gr lt1. improve gradually. xratreitflly continue to improve

gradually.

4. Pressures on inflation have picked 4 ttmwi-es Readings on inflation have Pressures on inflation have pitis-i n-tt Pressures on inflation have picked up further

up in recent months and pricing peked- up been subdued in recent ceeemmehastm memg-powes in recent months an i png , i

power is more evident. I onger-term months, and p:mg p r in,, - e r a i:. L stayed elevated, but evidt.- I. although measures of longerinflation expectations remain well evident. 1 longer-term inflation longer-term inflation expectations term inflation expectations remain well

contained. expectations ,rmaii " ell atned have remain well contained. contained.

declined.

5. The Committee perceives that, with The Committcc percexes that, with h appropriate nonetary policy action, appropriate onctan police -, the the upside and downside risks to the upsidc and dtivnsic rtsks to tie . attainment of both sustainable attaimict if hoth suxtitohic grt ii( change growth and price stability should be tnd prte sttbiity xiiitd be kept equpl, ke.pt toughl ix euai. rioaghix equal. _________________________________

Assessment 0. \\ith underintg intlatitin expcted Wi th utideri( tonfolattioin expec.ted to ie ilL \'. ub ikrlto t.tt, Lt.etei ft li of Risk to be Liointaied, titc immittnhe Committee pe rtCoittee bita withat ,

cix es that polic accomtimodationti remaining ppr t mnac pmot dattei a

Lctn he removedi at a pa1ce that is he rmoied t n pae that is it t bc ino cii'ttgc that itih e. re t ha k

litkei to he measured. Nonethceless measuredi. Nonthless, tiie Conmmittee The Coi mtmittee will resp ond ttt chatnges to the CotmmitteL wxiii respontd tio xxwill rexpondi to ichangex int ecnotitcii etoomtc priospects ais needed to fuitfillitsx changes it econoitc prospects ats prospects as needed to fultillitx obligaion to foster the attainment of both nceded ti ifulfill its obigation to ohligatitn to mioti price xttbiit. sustainable economic grotth and maintain prie stathility. t~tintadu pretle stsoilutit

June 29-30, 2005 234 of 234

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