Thank you, Mr. Chairman. In brief, the news that we have received since the completion of the November Greenbook five weeks ago has been supportive of the view that the economy has been growing modestly above trend and will likely continue to do so into next year. Indeed, both the incoming data on economic activity and some of the key factors that condition the projection point to a more favorable outlook than was anticipated in our previous projection. A pickup in the pace of hiring and stronger growth of consumption led us to mark up the projected pace of real GDP growth in the second half of this year by ¼ percentage point, to 3¾ percent at an annual rate. Since the publication of last week’s Greenbook, we received stronger-than-expected readings on retail sales and wholesale inventories and weaker-than-expected figures on international trade. On net, these data appear to be about a wash for current-quarter GDP.
Looking beyond the near term, higher equity values, larger gains in house prices, a lower exchange value of the dollar, and a drop in oil prices suggest greater upward impetus to spending and activity over the next two years. In fact, incorporating this more favorable configuration of financial and oil market developments into our projection would have resulted in output overshooting potential. In order to forestall that outcome, we raised the trajectory of the assumed federal funds rate, and we are now just slightly below the path implied by futures prices. I suppose that if I were truly in the holiday spirit I would give you a gift by stopping right here, because that is pretty much the story behind the forecast. But seasonally adjusted, I’m not feeling any more generous than usual.
So let me start with the labor market. The October and November employment reports did not provoke in us the same euphoria followed by disappointment that was apparent in the reactions of financial markets. Taken together, the employment increases in October and November were noticeably stronger than had been incorporated in the previous Greenbook and allayed our concerns that weakness in the labor market might sap the vigor of the expansion. As I noted at the last meeting, our November projection had put underlying gains in private payrolls in the second half of this year at around 100,000 per month. But it now looks as if hiring has been running around 160,000 per month, and we expect it to pick up to around 225,000 per month by the spring. Most other readings on the labor market also point to a gradual improvement. The only discordant note has been the increase in initial claims over the past two weeks. We are not yet inclined to read much into that increase, but it does highlight downside risks to the employment outlook.
Consumer spending also surprised us to the upside. In response to the incoming news, we raised the projected growth of real PCE by ½ percentage point in the second half of this year, and yesterday=s retail sales release suggests a further small upward adjustment of a few tenths to our fourth-quarter consumption forecast. We are now estimating that real PCE advanced at an annual rate of more than 5 percent in the third quarter and will increase at a 3½ percent pace in the current quarter. That slowdown is more than accounted for by a drop-off in motor vehicle sales in October and November. With inventories remaining uncomfortably high, we are expecting that the automakers will be forced in coming months to adopt a combination of some cutback in production from current schedules and sweetened incentives to boost sales. Outside motor vehicles, real PCE is now projected to grow at a 4¼ percent annual rate in the current quarter, a bit faster than in the third quarter. The anecdotes about the holiday selling season have been mixed to downbeat in recent weeks. I don’t think that we have ever been very successful in matching holiday anecdotes to the published data. Still, we’ve assumed a weak December for retail sales, in part on the basis of these stories and the dropback in weekly chain store sales.
In the business sector, outlays for capital equipment have continued to increase steeply, with real E&S up about 17 percent at an annual rate in the third quarter and projected to increase 11 percent in the fourth quarter. Taken together, those gains were close to our earlier expectations. In looking at our E&S forecast, it is clear that we are approaching something akin to a “moment of truth.” A few years back, based on calibrated theoretical models and a healthy dose of judgment, we built into our forecast of equipment spending a noticeable effect from partial expensing. That effect included a boost to spending during the period when partial expensing was permitted, followed by a pothole after its expiration. Gee, it seemed pretty logical at the time. And even now, there is evidence to support our position. Real spending on equipment has exceeded the expectations of our econometric models that make no allowance for partial expensing—and by an amount close to that of our estimate of the expensing effect. Moreover, new orders for capital goods fell off in October and fell a bit more than is necessary to create our first-quarter dip in spending. And while the anecdotes have been underwhelming, we’ve always recognized that only a small fraction of firms would be on a margin where this provision actually influenced their spending decisions.
But all that said, it just doesn’t feel as if the risks are symmetric around this aspect of our projection. The probability that the effect will turn out to have been smaller than that incorporated in our projection seems larger to me than the probability that this effect will exceed our expectations. Part of my discomfort arises from the recognition that, if we had started out our forecast with a null hypothesis that partial expensing would have no effect on spending, I could easily imagine myself sitting here today arguing that the data and anecdotes had not contradicted that hypothesis either. I don’t want to exaggerate the vulnerability of our GDP projection to this assumption. In fact, we have offset about two-thirds of the tax-induced swing in equipment spending in inventories and imports so that domestic production of capital goods is much less affected than spending. Still, if the partial-expensing effect turns out to be smaller than we have estimated and underlying demand for equipment correspondingly stronger, the economy is likely to carry somewhat greater momentum into early next year than is implicit in our forecast. While crossing one’s fingers is not a forecasting methodology typically covered in graduate-level econometrics, that is what we will be doing over the next few months. [Laughter]
Of course, the momentum that the economy carries forward into next year will be affected to a much greater extent by the broader developments in the economic and financial environment than by the effects of partial expensing. And on that score, the key factors conditioning our projection have strengthened noticeably over the past five weeks. As you know, one of the key upside risks we saw to the projection was the possibility that the accommodative stance of monetary policy would be accompanied by sharper movements in asset markets than we were forecasting. Some of those risks may have manifested themselves of late, at least to some degree. The stock market is about 4 percent higher than in our previous projection; house prices are projected to average about 5 percent higher; the price of imported crude oil is about $3 per barrel lower, on average, in 2005 and about $2 per barrel lower in 2006; and although the dollar has retraced some of its earlier declines, by the time we closed the Greenbook last Wednesday, it was still below our previous projection. The increase in household net worth associated with higher prices for equities and houses provides a considerable boost to household spending over the projection period, as does the increase in real income stemming from the lower price of oil. Meanwhile, the weaker dollar is projected to give a lift to exports and to trim the growth of imports.
The only notable factor on the negative side of the ledger was the further downward revision that we made to our forecast of spending on high-tech equipment. While the news was not uniformly downbeat, enough of it was negative to make us take another hard look at our forecast. With relative prices for tech equipment not declining at the pace they had a few years back, with few signs of new applications that would substantially stimulate demand, and with domestic and foreign producers reportedly cautious about the outlook, we lowered our projection of the growth of real high-tech equipment spending. We now project that the growth of spending on this equipment will equal, rather than exceed, its historical average going forward. We believe that this outlook better balances the risks.
On net, the positives for the economic outlook significantly outweighed the negatives and, as I noted earlier, without an adjustment to our policy assumption would have resulted in actual real GDP overshooting potential by the end of the projection period. As a consequence, we raised our path for the funds rate 50 basis points, bringing the assumed level to 2¾ percent by the end of next year and to 3¼ percent by the end of 2006. Our assumed path is now just ¼ percentage point, on average, below that implicit in the fed funds futures market. These adjustments altered the contour of our projection, with faster growth in real GDP now projected for next year, followed by a more noticeable slowing of growth in 2006 as the less accommodative stance of policy shows through.
The inflation picture has changed little over the intermeeting period. Our forecast for core CPI in October was right on the mark, as was our forecast for core PCE. Moreover, there have been only modest changes in the key determinants of inflation. The larger-than-expected drop in the price of oil is partly offset by the higher prices for non-oil imports. In our forecast, total PCE inflation is still expected to recede from 2½ percent this year to about 1¼ percent in 2005 and 2006, while core PCE inflation remains roughly unchanged at 1½ percent over the next two years. As in the previous forecast, that stability in core inflation is brought about by several small offsetting effects. A diminishing margin of slack and some slowing of structural productivity are expected to place slight upward pressure on inflation. But these effects are offset by some reversal of this year’s jump in energy prices and a smaller projected rise in non-oil import prices.
At the last meeting, Vice Chairman Geithner asked, in effect, whether the benign outlook for inflation in our baseline and even in our alternative simulations reflected a lack of imagination on our part or, perhaps the unstated alternative, a lack of intelligence. [Laughter] I was at least grateful to implicitly be offered a choice—you know, cigarette or blindfold. In the end, I’m not certain that we can offer the Vice Chairman much comfort on the intelligence front. But we did attempt to exercise our imaginations better, and it is fair to say that, in surveying the landscape, some upside risks to inflation strike us as potentially more potent than others.
One risk is that economic growth will exceed our expectations, causing resource utilization to tighten more quickly than in the baseline projection. While that outcome certainly cannot be ruled out, we don’t see the implications for inflation as being especially large, at least over the two-year time frame of our projection. As we have highlighted in the past, inflation simply is not very sensitive to the output gap in our models; the effect is not zero, but it is nonetheless small. Moreover, a corollary to this observation is that, if we have mis-estimated the natural rate of unemployment or the output gap, we don=t think the consequences for inflation would be large over the next eight quarters—again because inflation does not appear to be especially sensitive to resource utilization.
Another risk might be that the upward pressure on inflation from rising commodity and materials prices will intensify in the coming year. Oil prices have certainly surprised us and participants in futures markets this year. Moreover, a steeper slide in the dollar or more rapid improvement in industrial activity here or abroad could produce more significant pressures in commodities markets. If sharp increases in materials costs were to continue, an increasing fraction of firms that to date have absorbed these costs may attempt to pass them on to customers. Based on quotes from futures markets, we don’t see a continuation of rapid gains in commodity prices as the most likely outcome, and given the small share of costs accounted for by raw materials, the consequences of an upside surprise do not loom especially large. Nonetheless, it does seem a risk worth closely monitoring.
In our view, a more prominent and sizable upside risk to the projection is that firms will act more aggressively to raise prices in order to limit the damage done to their profit margins by slowing productivity and rising unit labor costs. Those tendencies could be amplified if productivity slows more sharply than we are projecting. As you know, we showed a simulation combining these developments in the Greenbook, and the consequence was an acceleration of core PCE prices to 2¼ percent by 2006, ¾ percentage point above the baseline forecast and at the outer edge of our 70 percent confidence interval. We don’t think that the evidence favors such an outcome, but we see this as an important vulnerability in our otherwise sanguine outlook.
More broadly, we are trying to remain especially alert to developments that would suggest that this year’s price shocks will propagate forward into higher underlying inflation. In addition to the possibility of slower growth of labor productivity, any signs of a significant pickup in nominal wages would have troubling implications for costs and prices. But the broad measures of hourly labor compensation have been running a very steady 4 percent or so over the past year, with little indication of an imminent takeoff. Inflation expectations also deserve close scrutiny. Inflation compensation as measured by the five-year TIPS spread has moved up in recent months, but five- to ten-year inflation compensation has barely budged. Moreover, survey measures—either short-term or long-term—have changed little over the past year. At this juncture, we see still few signs that this year’s upturn in inflation is the beginning of a process of more-pronounced deterioration. Obviously, the size of the confidence intervals surrounding our forecast admits a reasonably wide range of outcomes over the next two years, both to the upside and to the downside of our inflation projection. Although we are comfortable with our outlook for inflation, we leave it to the Committee to decide whether this forecast deserves a holiday turkey or whether it is the holiday turkey! Karen will continue our presentation.