Thank you, Mr. Chairman. In the spirit of the season, I am
tempted to report that I bring you great tidings of comfort and joy. However, this is,
after all, the Federal Reserve, so it is probably more appropriate to simply note that
tidings have improved modestly over the intermeeting period. While not quite in the
miracle category, we have raised our projection for the growth of real GDP over the
next two years and lowered our projection of price inflation.
As you know, we revised up our estimate of the growth in real GDP in the third
quarter by more than a percentage point and left fourth-quarter growth unchanged. As
a consequence, real output is now projected to expand at an annual rate of nearly 4
percent in the second half of this year—about ½ percentage point faster than we were
forecasting in October. The surprising strength in recent months has been widespread.
But clearly, one of the standout areas of strength has been consumer spending. To be
sure, sales of light motor vehicles were a bit softer than we had expected, but that was
more than offset by considerably stronger consumer outlays in other areas.
This morning=s retail sales report for November provided further evidence of the
underlying strength in consumption. Although spending in the retail control category,
which excludes sales at auto dealers and building supply stores, dropped 0.6 percent
last month, that decline was more than accounted for by lower gasoline prices. In real
terms, we estimate that spending was up more than 1 percent for the month. That
figure is somewhat stronger than we had expected and would likely cause us to revise
up the growth of consumption nearly ½ percentage point at an annual rate in the fourth
Business spending also has been strong of late. We are now projecting that growth in real spending on equipment and software will average 6½ percent at an annual rate in the second half of this year, an upward revision of nearly 3 percentage points from the October forecast. The surprise was concentrated in capital spending outside the transportation and tech sectors, where the incoming data on orders and shipments of capital goods suggest that the earlier lull in spending has ended. After being about flat in the first half, we are projecting real outlays in this category to rise 5 percent at an annual rate in the second half of this year. As you know, we had been puzzled by that earlier weakness and had been anticipating a recovery of spending in this category. In the event, that recovery has occurred a bit earlier and with more force than we had reckoned six weeks ago.
In light of the 1 percentage point upward revision that we made to real GDP growth in third quarter, it may appear a bit surprising that we only carried the higher level, and not a higher growth rate, into the fourth quarter. But part of our upward surprise in the third quarter was in non-auto inventory investment. With stocks appearing reasonably well aligned with sales in most sectors, we didn=t see the need to make any further upward adjustment to this aspect of the forecast. Moreover, some of the third-quarter strength in GDP reflected defense spending that seemed likely to have been pulled forward from the fourth quarter. Both of these judgments appear to have been supported, and then some, by incoming data in the past two days. Yesterday=s Monthly Treasury Statement and this morning’s reading on retail inventories suggest that both defense spending and inventory investment are likely to be even weaker in the fourth quarter than we had written down. Balancing these softer readings against the stronger retail sales data would leave our forecast for real GDP growth in the fourth quarter unchanged at about 3½ percent.
In contemplating the forecast for 2006 and 2007, we had to make some assessment of the sources of the strength in activity in the second half of this year. As we had anticipated would be the case back in September, we are now in the position of having to interpret whether the errors in our forecast of aggregate activity reflect misestimates on our part of either the hurricane effects or of the underlying behavior of the economy.
We do believe that some of the surprising strength of activity is probably attributable to smaller negative effects from hurricanes than we had previously penciled in. To be sure, production in the energy sector is coming back a bit more slowly than we had expected, especially production from the off-shore platforms in the Gulf of Mexico. But outside of energy, production appears to be recovering more quickly. Output of chemicals, paper, rubber and plastics, and some areas of food processing improved noticeably in October and November. And we look to be getting a bigger plus from the production of construction supplies. On the spending side, the hits to consumption of housing services, food, and gasoline—areas that we had thought would be affected by hurricane-related disruptions—appear to have been smaller over the past few months than we had incorporated in our previous couple of forecasts. Of course, most of this remains educated guesswork and needs to be taken with a grain of salt. But all in all, we are inclined to attribute a few tenths of the surprising strength in second-half growth to smaller hurricane effects.
We have interpreted the remainder of the surprise as suggesting that underlying aggregate demand has been stronger at prevailing interest rates than we had previously projected and that, all else equal, some of this strength will carry forward into next year. Spending receives a further boost in the projection from the upward revisions that we made to stock market and housing wealth, which totaled about $1 trillion over the forecast period. All in all, it=s a stronger demand picture than we were envisioning at the time of the last meeting.
However, the information that we have received over the past six weeks has not been confined solely to aggregate demand. Developments on the supply-side of the economy also appear to have been more favorable than we had expected. The surge in output growth last quarter was accomplished with almost no increase in hours worked. Consequently, output per hour in the nonfarm business sector rose at a 4½ percent annual rate in the third quarter and is now estimated to have been up more than 3 percent over the past four quarters. As optimistic as we have been, the data have continued to outflank us on the upside in recent quarters.
In response to this continued good news, we revised up our estimates of structural labor productivity. In addition to an upward adjustment to the level this year, we boosted the growth of structural labor productivity about ¼ percentage point to a bit above 3 percent in both 2006 and 2007. Capital deepening is making a slightly larger contribution to this estimate, but most of the upward revision has occurred in multifactor productivity. Despite being nearly a decade into this favorable productivity wave, there are few signs that the efforts or abilities of businesses to implement greater technical and organizational efficiencies are flagging.
On balance, the revisions that we made to aggregate demand were a touch larger than those we made to aggregate supply, and we estimate the output gap to be slightly narrower, on average, over the next two years than in the previous forecast. In response to these developments, we raised our path for the funds rate another 25 basis points, to 4½ percent by early next year.
Despite these modest adjustments, the basic contour of our forecast remains unchanged. After increasing 3¾ percent this year, the rise in real GDP slows to 3½ percent in 2006 and 3 percent in 2007. That pattern reflects several powerful crosscurrents. We expect activity to be boosted early next year by rebuilding efforts in the Gulf Coast region. Moreover, with energy prices projected to level out after increasing sharply over the past two years, the drag on aggregate demand from the earlier run-up in prices should begin to ebb. But these positives are more than offset by fading fiscal stimulus, the lagged effects of tighter monetary policy, and a gradually diminishing impetus to consumer spending from equity and housing wealth.
In sorting through the details of our forecast, it should be pretty obvious that a flattening out of activity in the housing sector is one of the principal sources of slower aggregate growth. After contributing about ½ percentage point to growth in real GDP per annum over the past four years, we are projecting residential investment to be a roughly neutral factor over the next two years. But that is still all forecast. To date, the hard data on housing have remained solid. Housing starts have remained at elevated levels, new home sales hit a record high in October, and house prices as measured by the OFHEO purchase index continued to increase at a double-digit pace through the third quarter.
That said, reports of cooling in the housing markets seem to me to be more frequent and more widespread than was the case six months ago. As we noted in yesterday=s Board briefing, a variety of indicators of housing activity have turned down in recent months. Household attitudes toward home buying have dropped sharply; builder ratings of new home sales have deteriorated; the index of mortgage applications for home purchase has fallen off; and the inventory of unsold homes has moved up. Taken in isolation, none of these measures has an especially reliable statistical relationship to housing activity. But taken together, they could be indicating that we are at the front edge of some cooling in these markets.
I offer one more piece of evidence that I think almost surely suggests that the end is near in this sector. While channel surfing the other night, to the annoyance of my otherwise very patient wife, I came across a new television series on the Discovery Channel entitled “Flip That House.” [Laughter] As far as I could tell, the gist of the show was that with some spackling, a few strategically placed azaleas, and access to a bank, you too could tap into the great real estate wealth machine. It was enough to put even the most ardent believer in market efficiency into existential crisis. [Laughter]
Only time will tell if these indicators are giving us a head fake or are the start of our long-awaited slowdown in this sector. For now, we are sticking with our call that housing activity will level off next year. Moreover, we continue to anticipate that a more visible deceleration in house prices will be in evidence by the middle of next year, and the associated slower growth of household net worth contributes to the projected up-tilt in the personal saving rate. In our view, both of these developments are critical for damping growth by enough to prevent the economy from overheating.
To date, the news on inflation does not suggest that we have overshot the mark on potential, though our ability to make that assertion with any confidence in real time is admittedly very tenuous. To begin, measures of core consumer prices came in a bit below our expectations. We also had a faster unwinding of the earlier hurricane-related increase in retail energy prices. Survey measures of inflation expectations have retraced virtually all of this autumn=s run-up, and TIPS [Treasury inflation-protected securities] -based measures of inflation compensation have retreated as well. On the cost side, lower hourly compensation and faster growth in structural productivity imply less pressure from labor costs, and the markup of prices over unit labor costs has risen further, pointing to a somewhat larger cushion between costs and prices.
These developments led us to reduce our projection of core consumer price inflation for 2006 by ¼ percentage point to about 2 percent and to trim our forecast for 2007 a tenth to 1¾ percent. The contour remains much the same. We still are expecting a slight pickup in core inflation as we enter next year, reflecting the direct and indirect effects of higher energy prices this year. In that regard, the core PPI for intermediate materials increased 1¼ percent in both September and October, with the price increases concentrated among goods that are heavily dependent on petroleum and natural gas. And higher prices for these inputs as well as higher prices for transportation services seem likely to place some mild upward pressure on core inflation in the months immediately ahead. Still, I think this forecast is best characterized as one in which inflation pressures are in the process of topping out rather than continuing to build.
Obviously, there are some very important risks on both sides of our forecasts for real activity and inflation, and we tried to highlight some of the more prominent ones in the Greenbook. I recognize that our baseline forecast, in which the economy=s growth slows to about trend, output settles out at a level very close to potential, and inflation pressures ease a bit, all with just a little more tightening of policy, seems too good to be true. No doubt, events will conspire to force adjustments, both major and minor, on the staff projection. Perhaps I=ve just written the “flexibility and resilience” speech for the Chairman so often over the past few years that I=m suffering from something akin to the Stockholm syndrome—the tendency of hostages over time to sympathize with the views of their keepers. [Laughter] But as I look back over the past year and observe how well the economy performed in the face of some pretty substantial shocks, I don=t think our optimistic outlook is unwarranted.
Karen will continue our presentation.