Thank you, Mr. Chairman. I’ll be referring to the materials that Carol Low is distributing.
Over the intermeeting period, market participants marked up their expectations of your coming actions, as seen in the drift upward of Eurodollar futures rates in the top panel of the first exhibit. The rate for contracts ending this year, the black line, and next year, the red line, rose 40 and 50 basis points, respectively. Three factors apparently came into play. First, the economic effects of the spate of hurricanes this fall seem less momentous now, at least to market participants, than they did on September 20, the date of your last meeting. Essentially, a portion of the worries about the economy that lowered rates in advance of the September meeting was rolled back. Second, data releases, on net, were read as evidence that the economy had considerable momentum in advance of the landfall of Hurricane Katrina. And third, many of you expressed concerns in public about inflation risks, and those statements were taken as a warning of more tightening than previously anticipated.
The net result was to shift up the path expected for the federal funds rate, plotted as the solid black line in the middle left panel, by ⅜ to ½ percentage point relative to that prevailing before the September meeting, but by only ⅛ to ¼ percentage point relative to the August meeting. The funds rate is now anticipated to peak at about 4½ percent in futures markets, which is a touch below long-run expectations of the funds rate suggested by the Blue Chip survey. As shown in the middle right panel, the surveyed economists see the terminal funds rate at around 4¾ percent. That same survey, however, suggests that economists pitch a pretty big tent, in that about 50 percent of their responses span a range from 4¼ to 5¼ percent.
This ratcheting higher of policy expectations was associated with a tightening of financial conditions more generally, seen in the bottom panels as the rise in longer term Treasury yields, decline in stock prices, and appreciation of the foreign exchange value of the dollar.
If you are worried that this financial market reaction was overdone, thereby imparting too much financial restraint, you might favor holding the intended funds rate at 3¾ percent today—the subject of the left-hand panels of exhibit 2. As noted in the first bullet at the top and in the middle panel, the staff forecast of the growth of real GDP for 2006 has been marked down over the course of the year. You may see reasons why this might happen again—say, because the economic dislocation from the hurricanes could be larger than expected or because household spending could sag as real estate values stop escalating, or even decline, and as consumer confidence, plotted in the bottom left panel, sinks further. If so, the shock in financial markets in reaction to alternative A would certainly realign market expectations lower. Indeed, even if you viewed inaction today as likely to be merely a pause in the process of firming, it might be difficult to convey that to the public, making it likely that the rotation downward in rate expectations could be considerable.
More probably, you’ll find the arguments for tightening ¼ point—in the right hand side of the exhibit—to be more compelling. In particular, as the top bullet point and the middle panel relate, you might view the upward drift in the staff’s inflation forecast for 2006 over the course of the year as signaling that the risks to the price outlook are on the upside. A number of you have noted at previous meetings that inflation was running on the high side of your comfort zone, suggesting that the prospect of any further rise would be especially unwelcome. In that regard, you might consider the pickup in the Michigan Survey responses of near- and longer-term inflation expectations, plotted at the lower right, as evidence of such an unfolding dynamic.
A ¼ point firming might be seen as sufficient at this time to keep inflation contained, as long as it was expected to be followed by at least a few more moves going forward. The difference between alternatives B and C in the Bluebook hinges on how many more tightening moves you see in your future—which could be conveyed by the language of the statement. With the aid of exhibit 3, I’d like to cover some of the same ground as President Yellen, but more colorfully, if I say so myself. [Laughter]
This exhibit takes as a starting point the statement issued in September. Among the pertinent questions are: 1. Is productivity growth still robust (the red text)? 2. If the nominal funds rate moves up to 4 percent, will policy still be accommodative (the green text)? 3. If policy remains accommodative, are you likely to remove that accommodation at a measured pace (the blue text)? 4. Is there an appropriate path of monetary policy that will balance the risks to your dual objectives in the face of a supply shock? (By now, I’ve used up much of my color palette—but I think it’s the purple text.)
I would remind you that, even if you do not want to address some of these questions this afternoon, the passage of time could ultimately force you to do so. An earlier, rather than later, dialogue about these issues would provide the opportunity to use the minutes to forewarn the world of changes in language that has been unchanged for so long that the public might be forgiven for thinking it was carved in stone.
Exhibit 4 provides some perspective on these questions, starting with the table at the upper left listing the four-quarter growth of output per hour over the past few years. The 4 percent growth rate of productivity in the third quarter pulled the four- quarter change to 3 percent. While the FOMC statement refers to underlying, not actual, productivity growth, this performance may well make you comfortable retaining the “robust” characterization. In that regard, as can be seen in the chart at the upper right, the private-sector economists in the Blue Chip panel continue to see output growing at better than a 3 percent pace in the long run, an assessment that has been essentially unchanged over the period the Committee has asserted that underlying productivity growth has been robust.
As for assessing the degree of policy accommodation, the middle panel shows that bringing the nominal funds rate to 4 percent would place the real funds rate at the midpoint of the range of the staff’s estimates of its equilibrium level. There are three reasons, listed in the bottom left panel, why you might think that describing policy as accommodative is nonetheless appropriate, beyond Governor Kohn’s gutting the word of any meaning. [Laughter]
First, you might believe that the staff is underestimating the vigor of aggregate demand, perhaps because we’ve penciled in too big a drag on consumption from higher energy prices and an as-yet-unobserved slowing in home-price appreciation. If so, your personal estimate of the equilibrium real rate of interest would be to the north of that plotted in the chart. Second, you might believe that the real rate should be calculated based on a forward-looking proxy for inflation expectations, not the backward-looking four-quarter actual core inflation rate used in the chart. If you also believe that an inflation scare has pulled expected inflation above its recent pace, then the real rate lies to the south of that plotted here. Third, the gap between estimates of the equilibrium real rate and its actual level may not be an appropriate measure of policy accommodation at all. Mechanically, the staff calculates the equilibrium real rate by determining, within a given model, the level of the real rate that would close the output gap in about three years. You might view the path of the output gap in the transition to its ultimate closure as unlikely to unwind current pressures on inflation or maybe even as consistent with pressures building for a while. That is, if you waited three years’ time to close the output gap, you might not like the inflation rate likely to prevail then.
The chart in the lower right panel showing the recent jump in energy prices is a reminder that you might label the current set of forces impinging on the economy as a supply shock. As the textbooks tell us, a supply shock confronts monetary policymakers with unpleasant alternatives, as it tends to weaken aggregate demand and put upward pressure on inflation. In such circumstances, there might not be an appropriate path of policy that balances the risks to your dual objectives. That is, you might have to accept—and relate to the public in your statement—unbalanced risks.
Exhibit 5 presents four alternatives for the language in the relevant part of the Committee’s statement. As in the top panel, you can limp along at this meeting with the current wording, reassured by the fact that this would likely preserve something close to the current path of expected future tightening, because few market participants anticipate any change.
As in the second panel, you can get out of the business of characterizing the degree of policy accommodation by describing the change, not the level, of the funds rate. Thus, you could say that “. . . policy firming can continue at a pace that is likely to be measured,” which implicitly admits the possibility that you may have to impose policy restraint, on net, to check inflation. This could establish the precedent of providing guidance by writing a fresh characterization of the odds of your likely future action at each meeting, appropriately conditioned on the economic outlook. I know that I discourage easily, but I’d like to point out that this was exactly what you were doing with the addition of the “measured pace” language in May 2004. But if the policy outlook does not change materially from meeting to meeting, fresh language can get hardened pretty quickly.
As in the third panel, you can replace the current risk assessment with a formula based on an unchanged stance of policy, thus providing a coarse signal of your likely future action. My argument for tilting at this windmill one more time is that such a formula both provides some transparency about your intentions and should simplify the process of the Committee coming to closure on the language of the statement at each meeting. In my view, prior efforts to find a satisfactory formula to provide guidance about your future policy intentions ran aground because most proposals were too ambitious by incorporating assessments of levels and changes of the Committee’s dual objectives. A simpler formula—perhaps even couched in terms of interest rates rather than the Committee’s goals—is more likely to last. If it is not specific enough on some occasions, you’ve got the rationale part of the statement and the minutes to provide a more nuanced view.
The fourth panel would be appropriate if you wanted to scrap the risk assessment entirely. However, reflecting on the discussion of the Committee and its succession of subcommittees on this subject over the years, I think those of you who prefer the simplicity of this alternative may be tilting at your own windmill. By my count, enough members seem to believe that there is some role for words in narrowing market uncertainty about your future action to make such guidance a durable feature of the statement for some time to come.
It has been a feature of my briefings for what seems to be a long time to remind the Committee that a discussion of your communications policy is warranted. I now know the wisdom of the maxim from the “Monkey’s Paw,” “Be careful what you ask for, you might get it.” Because you have spent some time discussing the issue, the minutes will have to address the topic.
It is also pretty clear that this conversation will continue in December. To inform that discussion I propose circulating a survey fairly shortly to probe your views on key principles governing the statement of the sort Governor Ferguson discussed. My goal is to get back to the Committee before the December meeting with a summary of the results to make it easier to find the middle ground among the various views that have been expressed.
For your convenience, the last exhibit updates Table 1 from the Bluebook.
Relative to what you saw there, we’ve taken comments from some members that I
think simplify the discussion of the outlook in rows 2 and 3.