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

  • Good afternoon, everybody. Let me be the first to welcome Dennis Lockhart sitting in for the Federal Reserve Bank of Atlanta. We’ll start with Bill Dudley.

  • Thank you, Mr. Chairman. Financial markets have become much more turbulent since the last meeting—especially in subprime mortgages and associated securities, in U.S. and global equities, and in foreign exchange markets. The good news is that markets have generally remained liquid and well functioning, with a minor exception on the New York Stock Exchange on February 27. Moreover, there are few signs of significant contagion from the subprime mortgage market into the rest of the mortgage market or from subprime mortgage credit spreads to corporate credit spreads more generally. In general, the debt markets have been mostly unruffled by recent developments.

    I plan to focus my attention on four major market developments. First, the substantial turmoil in the subprime mortgage market—I talked about the risk that this market might unravel at the January FOMC meeting; that certainly occurred more quickly and more forcefully than I anticipated. Second, I want to talk a little about the decline in U.S. equity prices and the accompanying rise in actual and implied price volatility. Third is the sharp correction in the so-called “carry trade” in foreign exchange markets. The low interest rate currencies such as the yen and the Swiss franc have appreciated, with the greatest moves coming against their higher-yielding counterparts. Finally, I’ll talk a bit about the sharp downward shift in market expectations about the path of the federal funds rate target over the next year and a half. Two key questions motivate my comments. First, is the market turbulence driven mainly by fundamental developments, or does it reflect mainly a shift in the risk appetite of investors? Second, what is the ongoing risk of contagion from the market area that has experienced the most stress—the subprime mortgage market—to other markets?

    Regarding the subprime mortgage market, the deterioration appears driven mostly by fundamental developments. As you know, the delinquency rates for subprime adjustable-rate mortgages have risen sharply. In contrast, as shown in exhibit 1 of the handout, there has been little change in delinquency rates for fixed-rate mortgages. Most significantly, delinquency rates for the 2006 vintage of subprime adjustable-rate mortgages have climbed unusually quickly. As shown in exhibit 2, the last vintage that went this bad so fast was the 2001 vintage, and that had a much different economic environment—one characterized by a mild recession and a rising unemployment rate. The deterioration in the quality of subprime mortgage credit has led to a sharp widening in credit spreads for the ABX indexes. The ABX indexes represent the cost of default protection on a basket of collateralized debt obligations that are backstopped mainly by subprime mortgages. As shown in exhibit 3, although this widening has been most pronounced at the bottom end of the credit quality spectrum (BBB-minus and BBB), it has rippled upward to the higher-rated tranches that are better protected. Exhibit 4 shows how the credit deterioration initially registered in the ABX indexes as market participants sought to buy protection. In milder form, this deterioration also registered in the underlying collateralized debt obligations and asset-backed securities. The widening of the credit spread in the ABX indexes was probably exaggerated by the fact that there was an asymmetry between the many that were seeking loss protection and the few that were willing to write protection. This can be seen in two ways. First, as shown in exhibit 4, the spread widening was more pronounced in the ABX index than in either underlying collateralized debt obligations or asset-backed securities. Second, as shown in exhibit 3, the ABX spreads have come down a bit from their peaks even as the underlying market for subprime mortgages, as reflected in the ongoing viability of many mortgage originators, has continued to deteriorate.

    The deterioration in the subprime market has undermined the economics of subprime mortgage origination and securitization. This is especially true for those mortgage originators with poorer underwriting track records. Their loans can no longer be sold at a sufficient premium to par value to cover their origination costs. In addition, the costs that they must incur to replace loans that have defaulted early have increased sharply. In several cases, these difficulties have caused banks to pull their warehouse lines of credit. Several of the large monoline originators are bankrupt, distressed, or up for sale—they are highlighted in red in exhibit 5. Moreover, several of the diversified lenders, such as HSBC, have indicated that they are tightening credit standards and pulling back from this sector. The result is that the volume of subprime mortgage originations is likely to fall sharply this year—perhaps dropping one-third or more from the 2006 rate of slightly more than $600 billion. This tightening of credit availability to subprime borrowers is likely to manifest itself through a number of channels. These channels include (1) a drop in housing demand, as borrowers who would have been able to get credit in 2006 no longer qualify under now toughened underwriting standards; (2) an increase in housing supply, as the rate of housing foreclosures increases (notably, the Mortgage Bankers Association reported last week that the rate of loans entering the foreclosure process in the fourth quarter of 2006 reached a record level of 0.54 percent, the highest level in the history of the thirty-seven-year-old survey); and (3) additional downward pressure on home prices, which in turn threatens to increase the magnitude of credit problems, delinquencies, and foreclosures.

    In considering these channels, it is important to emphasize that the credit strains in the subprime sector are unlikely to have peaked yet. The reset risk on the adjustable-rate portion of the subprime loans originated in 2005 and 2006 will be felt mainly over the remainder of 2007 and 2008. Most of the adjustable-rate loans are fixed for two years at low “teaser” rates. When yields adjust upward once the teaser rate period is over, some borrowers may have insufficient resources to service these debts. The good news—at least to date—is that spillover into the alt-A mortgage and conforming mortgage areas is very mild, both in terms of credit spreads and in terms of loan performance. Although there has been some rise in delinquency and foreclosure rates for higher-quality residential mortgages, these rates are still low both qualitatively and historically. Moreover, there is little evidence that the subprime problems have hurt mortgage loan volumes. For example, the Mortgage Bankers Association index of mortgage applications for purchase has increased in the past three weeks.

    Turning next to the U.S. equity market, it is less clear-cut whether the decline in prices and the rise in volatility are fundamentally based. As several observers have noted, equity valuations do not appear to be excessive. If that is the case, then why have equities been more turbulent than corporate and emerging-market debt, for which spreads remain unusually narrow? Although this point is legitimate, two fundamental developments that make U.S. equity prices less attractive deserve mention. First, equity analysts have been reducing their earnings forecasts for 2007. Although the top-down view of the equity strategists for the S&P 500 index has not changed much, on a bottom-up basis, earnings expectations have dropped sharply. As shown in exhibit 6, the aggregate forecasts of the individual sector analysts now indicate a growth rate in S&P 500 earnings for 2007 of about 6 percent, down from about 9 percent at the beginning of the year. In contrast, S&P 500 earnings have grown at an annual rate of more than 10 percent for four consecutive years. It should be no surprise that falling earnings expectations could weigh on equity prices. Second, uncertainty about the growth outlook has increased. This shows up clearly, for example, in our most recent primary dealer survey. Because greater uncertainty about the growth outlook presumably implies greater risk, the rise in uncertainty should—all else being equal—result in lower share prices. In contrast, it is easier to explain the modest widening of corporate credit spreads. In theory, lower share prices and higher volatility imply a greater risk of default, which should imply wider credit spreads. Corporate credit spreads have behaved in a manner consistent with this. Josh Rosenberg from the research group at the Federal Reserve Bank of New York recently investigated this issue. He found that the spread widening in the high- yield corporate debt sector was consistent with past periods in which the implied volatility for equities rose sharply. Exhibit 7 summarizes one key result. The widening in the BB-rated corporate spreads in the week after the February 27 retrenchment was of a magnitude similar to that of other instances in which implied equity-price volatility as measured by the VIX index rose sharply. In the most recent episode, the VIX index rose 848 basis points, and the BB corporate spread rose 27 basis points. This rise compares with an average rise of 21 basis points in the BB spread in the ten cases in which the VIX rose most sharply. The rise in the most recent episode is well within the range of historical experience.

    In many other areas in which asset prices have moved sharply, risk-reduction efforts appear to have played the biggest role. For example, in the foreign exchange markets, the biggest currency moves were in the currency pairs associated with so- called carry trades, such as the yen and Swiss franc for the low-yielding currencies and the Australian and New Zealand dollar for the high yielders. Exhibit 8 indicates the change in the yen versus the Australian dollar, the New Zealand dollar, the euro, the British pound, and the U.S. dollar during three separate periods—the week before the February 27 stock market selloff, the week of the stock market selloff, and the past two weeks. The high-yielding currencies appreciated the most during the run-up to the February 27 selloff, fell the most during the February 27 week, and have recovered the most against the yen over the past two weeks. The changes in speculative positioning in foreign exchange future markets tell a similar story. Exhibit 9 shows the change in the share of the open interest position held by participants in the noncommercial futures market. Over the past few weeks, net short positions as a percentage of the overall open interest in the yen have dropped, and long positions in the British pound and Australian dollar have dropped.

    An examination of how Treasury yields, stock prices, exchange rates, and credit spreads have moved also indicates that risk-reduction efforts have been important. Exhibit 10 shows the correlation of daily price and yield movements in 2007 before February 27. As one can see, the correlations were quite low. In contrast, the correlation matrix in exhibit 11 shows the correlation of daily price moves for the period beginning on February 27. Most of the correlations have climbed sharply, suggesting that risk positioning is driving price and yield movements.

    Finally, short-term interest rate expectations have shifted substantially since the last FOMC meeting. As shown in exhibit 12, near-term expectations have shifted, with market participants now expecting a modest reduction in the federal funds rate target by late summer. However, the federal funds rate futures curve is still above the curve at the time of the December FOMC meeting. In contrast, longer-term expectations have shifted more sharply, with a larger move toward easing. As shown in exhibit 13, the June 2008/June 2007 Eurodollar calendar spread is now inverted by about 60 basis points. This calendar spread is more inverted than it was at the time of the December 2006 FOMC meeting.

    Compared with the shift in market expectations, the forecasts of primary dealers have not changed much. Exhibits 14 and 15 compare dealer expectations with market expectations before the January FOMC meeting and before this meeting. The horizontal bold lines represent market expectations. The blue circles represent the different dealer forecasts. The green circles represent the average dealer forecast for each period. The two exhibits illustrate several noteworthy points. First, the average dealer forecast has not changed much since the January FOMC meeting—the green circles in the two charts are in virtually the same position. Second, the amount of dispersion among the dealers’ forecasts has not changed much—in fact, the range of the blue circles is slightly narrower currently. Although many dealers now mention that their uncertainty about the growth outlook has increased, that does not appear to have been reflected in their modal forecasts. Third, there is now a substantial gap between the dealers’ average forecast and market expectations—the gap between the horizontal bold lines, which represent market expectations, and the green circles, which represent the average dealer’s view, has increased. Why is there a large gap between the dealers’ forecasts and market expectations? I think there are three major explanations. First, the dealers’ forecasts are modal forecasts and do not reflect the downside risks that many dealers now believe have emerged in the growth outlook. Second, dealer forecasts often lag behind economic and market developments. Only when “downside risks” grow big enough to pass some threshold are dealers likely to alter their modal forecasts. Third, some of the downward shift in market expectations may represent risk-reduction efforts. An investor with speculative risk positions that would be vulnerable to economic weakness might hedge these risks by buying Eurodollar futures contracts. This hedging could push the implied yields on Eurodollar futures contracts lower than what would be consistent with an unbiased forecast of the likely path of the federal funds rate.

    Nevertheless, the potential gap between market expectations and the Committee’s interest rate expectations may pose a bit of a conundrum for the Committee. If the Committee were to shift the bias of its statement in the direction of neutral, market expectations with respect to easing would undoubtedly be pulled forward and might become more pronounced. After all, most dealers expect that the Committee will not change the inflation bias of the January FOMC statement. In contrast, keeping the bias unchanged in order to keep market expectations from shifting further in the easing direction might be inconsistent with the Committee’s assessment of the relative risks regarding growth and inflation. If the Committee were to keep the bias unchanged even when its views had changed, the communication process might be impaired.

    On a housekeeping note, I wish to bring to the Committee’s attention the changes to the “Morning Call” with the Trading Desk. They were discussed in a memo distributed to the Committee last week. Under the new format, which we plan to implement on Thursday, the call will be open to all members of the Committee, and you will have the option of participating in the 9:10 a.m. discussion of reserve management issues, the 9:20 a.m. portion covering recent developments in global markets, or both portions. The March 15 memo outlines the new procedures for joining these calls. Finally, there were no foreign operations during this period. I request a vote to ratify the operations conducted by the System Open Market Account since the January FOMC meeting. Of course, I am very happy to take questions.

  • Thank you. Are there questions for Bill either about the outlook or the housekeeping matter? President Fisher.

  • Bill, you talked about subprime mortgages in some detail but not about alt-A mortgages in great detail. My understanding is, and I just want to check to see whether I’m correct, that 20 percent of the 2006 purchase-dollar originations were alt-A, roughly the same percentage as subprime. It’s my further understanding that 81 percent of the alt-A originations were no- documentation or low-documentation loans. How much confidence do you have—and I can tell by your reaction that there’s a question—that alt-A mortgages are not as perilous as subprimes? If you don’t have confidence or if they are perilous, what consequences might ensue?

  • Well, unfortunately, the information on the alt-A market is not very good. In fact, there is disagreement about exactly what an alt-A mortgage is. If you can’t define it, it’s pretty hard to measure. That is problem number one. A good way of thinking about the mortgage market is as a continuum of loan quality extending from, at the bottom, the worst underwritten subprime mortgages that are adjustable rate up to the conforming mortgages that we always associate with the GSEs, with alt-A somewhere in the middle. Obviously, to the extent that the housing market deteriorates and home prices don’t go up, there will be more strain on the alt-A market; but I don’t get a sense that we will see the kind of underwriting problems that we have seen in the subprime mortgage area. As of this date, we don’t see a lot of evidence of a significant problem in that area; but, again, we don’t have very good information, and we’ll have to wait and see.

  • May I ask of Bill, Mr. Chairman, that we continue the analysis on this front and keep probing?

  • This is a continuation of the same question because I was intrigued by your chart that shows 2006 sixty-day and over delinquencies for subprime ARMs tracking with 2001. I don’t recall the world as we know it coming to an end in the subprime market in 2001, but I also wonder how big the subprime market was and how much it might have been characterized by some of the rather difficult practices that we know went on, particularly from the middle of ’06 through the end of the year.

  • You’re absolutely right. The market was much smaller at that time. I would characterize the deterioration that you saw in 2001 as probably mostly driven by the macroeconomy, and the deterioration that you saw in 2006 as driven mostly by two things: more laxity in the underwriting process and a change in the trajectory of home prices. So I think the causes of the deterioration in the two cases were quite different. The subprime mortgage market in 2006 is several times the size of the originations in 2001; so obviously it will have a bigger consequence.

  • You made a distinction at the beginning between something that was fundamental and something that was about a change in risk perception. Just conceptually, how do you distinguish between those two things? Is the latter something that you can’t attribute to a change in observable economic conditions?

  • The distinction I’d make between fundamentals and risk reduction is that the latter occurs when people adjust their portfolios not because they change their view about the quality of a particular asset but because they are reducing the amount of risk exposure to the market that they want to have. So when you have a big event like February 27, obviously volatility goes up, and so value at risk goes up, and you may decide to reduce your risk. So you’re going to sell all sorts of things, and the prices of those things you sell will go down regardless of whether you’ve actually changed your opinion about them in any meaningful way. Why did corn prices on February 27 fall 2 percent? It was probably because corn prices had been in a big bull market, people had risk positions in corn, and so they wanted to get out of those positions.

  • I guess my question is, How do you know?

  • You don’t know. Thank you.

  • You don’t know with certainty. You make an inference.

  • Mr. Chairman, may I follow up?

  • Bill, one of the factors you said that might account for the gap between the primary dealer expectations about the fed funds rate at different horizons and the average market pricing might be the flight to quality. It’s not quite a flight to quality, but it reflects the demand for safer assets.

  • Or assets that would do well in a bad economic environment as a hedge to the rest of your risk.

  • A flight to liquidity or something like that. Do you think the same story might account for what happened in far forward interest rates in the Treasury market as well? Would you say that perhaps the same kind of phenomenon might account for that?

  • Going out on the curve to ten years, it’s possible. The Eurodollar market is probably the most liquid market in which one could do this very, very quickly. So I guess I would view what happened in the longer-dated Treasuries is probably more reflective of emerging downside risk to the economy, but there’s probably some of the flight to liquidity as well. I think it’s hard to tell.

  • What institutional or quantitative constraints are there on traders who would be positioned to take the other side of the movement into Eurodollar futures for the hedging operation? You paint a picture of everyone knowing that the fed funds rate path is above what’s implied by Eurodollar futures and of no one being able to pan that out of the market.

  • Well, another explanation is that the economists who make the dealer forecasts are not the traders who execute the Eurodollar futures positions. So that’s a possible alternative explanation. Generally, there’s a disequilibrium. A number of people that I’ve talked to in the markets have said that this is what they thought was going on, and they advised me not to take what was going on in the Eurodollar futures markets literally because they felt that some of them were putting on these positions in case of a bad scenario that led to significant reductions in short- term interest rates. So I’m basically taking the explanation somewhat on the advice of market participants who told me that they were doing this.

  • Let me just follow up. I look at Eurodollar futures every day. You’re an experienced, savvy market guy and I want to learn how to understand these markets. My presumption would be that, if that takes place, there’s something limiting the capital of people who could take the offsetting position. How could markets be so out of whack for so long?

  • Let me just say for the record that I don’t think Bill is saying that the market is mispricing the value.

  • I thought that was clearly what he said.

  • I think he is just saying that the primary dealers whom we survey, who are a strange group, [laughter] have a view that’s somewhat different from the view of the markets.

  • No, he said that people told him not to take the Eurodollar price as indicative of the expected value of the Eurodollar rate at that date. Is that what you were saying? You said “disequilibrium.” I’m trying to understand how financial markets work here.

  • When people are in risk-reduction mode, they don’t want to take on more risk. So there may be an imbalance temporarily between those who want to hedge versus those who want to take more risk. To take the other side of that bet, they’re basically increasing their risk. The ABX market is another example of that. Why did the ABX index go to a 2,000 yield spread? Well, it was partly because a lot more people wanted to buy protection in the subprime mortgage market than wanted to sell it. In a perfect economic world, it should be arbitraged away, but I think there are cases where that just doesn’t necessarily happen.

  • I think it’s the other point, President Lacker, about how much confidence you put in the green dots, which are the survey of, to use the Vice Chairman’s words, that strange group that the New York Fed contacts.

  • This isn’t about the green dots. This is about the Eurodollar.

  • No, no, no. Because primary dealers’ economists, quite often, probably are reporting their modal forecast because they’re telling a story about where the Committee was going forward and painting an overall picture of the economy, whereas the Eurodollar contracts reflect averaging across all the states of nature. What we see when we look at options is a growing downside tail. So it could be the emergence of that significant downside tail, which economists will talk about as a risk to their outlook but traders actually have to price, as another reason that those two things are diverging.

  • That’s helpful. But, still, apart from the green dots, he’s telling us there’s some mispricing that’s systematic.

  • It’s a possible explanation. Vince’s explanation, which I made in fact in my prepared remarks, is probably one I would put a greater weight on.

  • I just want to get back to the subprime market for a quick question. There have been a lot of newspaper stories about people who default on the first payment in these mortgages, which is a bit of a puzzle to me, unless it’s just pure fraud. I was just wondering if you had any information about whether there has been an increase in fraud here or whether there are other reasons for people defaulting on the very first payment on their mortgage.

  • First, a simple explanation—I don’t know if this is correct—is that, if home prices are going up and you’re getting 100 percent loan to value, you’re getting basically a free option to see if the home prices will keep going up. If they don’t go up, you decide, okay, thank you very much for your loan, and I’m not going to make any payments. So probably some people are speculating. Certainly, there have been anecdotal reports of investors who were doing this. Second, there probably has been fraud. I mean, there are examples of people who were obtaining mortgages for other people, when they weren’t the true beneficiaries of the loan.

  • Have you seen any data or hard evidence on this?

  • Actually, Michael, the CEO of a large bank that originates mortgages, with whom I had a conversation, commented that this indicator is a bit confusing because it has to do with the fact that the owners of these loans change. By the time the person makes the first payment, it is a struggle to figure out to whom that payment goes. So the mortgage shows up as default with the end owner, but the person did make the payment. The payment just didn’t get to the right place. So the CEO said that we need to be careful about making too much of that number because it’s more of an accounting issue than it is people actually defaulting on their first payment.

  • That is a fair point. In fact, that’s why we like to look at sixty-day-plus delinquencies and try to push people away from looking at thirty days—it takes time for the payment to find the actual loan holder.

  • He mentioned that a number of 3 percent was attached to first payments in default and that number is just way out of whack.

  • I had been puzzled about the quantitative relationship between the subprime problems and the stock market. I think that the actual money at risk is on the order of $50 billion from defaults on subprimes, which is very small compared with the capitalization of the stock market. It looks as though a lot of the problem is coming from bad underwriting as opposed to some fundamentals in the economy. So I guess I’m a bit puzzled about whether it’s a signal about fundamentals or how it’s linked to the stock market.

  • It’s hard to know how connected the subprime market and the stock market have been in the past month or two. Clearly, people are nervous about the positive feedback loops of less mortgage origination leading to less housing demand leading to lower home prices leading to a weaker economy—and then that feeding into corporate earnings and disappointments on the corporate earnings side. I don’t think any of us knows exactly how powerful those linkages are, but that’s probably at least one element that equity investors are worried about.

  • Does anyone have any questions about the call procedure? Are there any other questions? Then we need a vote to ratify domestic operations.

  • So moved.

    SPEAKER. Second.

  • Without objection. Thank you. It’s time for the economic situation. Dave Stockton.

  • Thank you, Mr. Chairman. On the whole, the staff forecast has survived the economic news and financial events of the past seven weeks reasonably well. Although we revised down our projection for the growth of real activity, we don’t really see the fundamentals of the economy as having changed significantly over the intermeeting period. Indeed, our forecast for the growth of real GDP for 2007 has been fluctuating in the 2 to 2¼ percent range since last August, and this latest revision has only returned us to the lower end of that relatively narrow range. Still, I’ll admit that I’ve been experiencing something like the pangs of a nervous flier. For the most part, my anxieties have been held in check by an economic ride that has proceeded relatively smoothly along the anticipated flight path. But each episode of turbulence seems to trigger the panicked thought that economies, like planes, really do crash from time to time. Don’t worry. I will spare you another episode of self-psychoanalysis [laughter], loosen my grip on the armrests, and concentrate this afternoon on a dispassionate analysis of recent events and their implications for the economic outlook.

    I must say, we have had some important developments with which to contend— weaker economic data, higher oil prices, problems in subprime mortgage markets, and a drop in equity valuations. Among the weak reports, one that was not a surprise to us was the downward revision in the BEA’s estimate of fourth-quarter GDP. As you will recall, one of the major differences between our January forecast of a 2½ percent increase in fourth-quarter real GDP and the BEA’s advance estimate of a 3½ percent increase was their much higher figure for inventory investment. While I am certain that it was more luck than skill, the incoming inventory data for the fourth quarter were very close to our expectations and far below the BEA’s figures— accounting for a sizable fraction of their downward revision to real GDP.

    That was important because a central element in our story is that, although some inventory buildups have developed in recent months, production adjustments are occurring promptly enough to prevent the emergence of a full-blown inventory cycle that could cause a period of subpar growth to morph into an economic downturn. Inventory-sales ratios rose noticeably over the second half of last year, as the growth of final demand shifted down. The problems were most apparent in the motor vehicle industry. But aggressive cuts in motor vehicle assemblies in the second half of last year and early this year combined with a reasonably stable pace of sales in the neighborhood of 16½ million units appear to have put this problem largely behind us. Judging by the increases in production scheduled for the second quarter, the automakers seem to share that view. Inventories also backed up in a wide variety of construction-related industries, and substantial cuts in the production of construction supplies occurred in the fourth quarter. But we still see inventory problems lingering here. More recently, some signs of excess stockbuilding have extended beyond motor vehicles and construction supplies, most notably in machinery, electrical equipment, appliances, and furniture. As a consequence, we expect manufacturing output to remain quite tepid in the first half of this year. That forecast seems consistent with the generally lackluster results from national and regional surveys of business activity. Still, we don’t see the current situation as precipitating a cyclical downturn in aggregate activity. I offer that observation with some trepidation. For some reason, I recall past humiliations more vividly than successes, perhaps because they have occurred with much greater frequency. [Laughter] But I recall sitting here in the autumn of 2000 telling President Poole that we did not see a serious inventory overhang in the tech sector. Looking back on that episode, it wasn’t that we weren’t looking carefully enough at the data in hand, rather we were led astray by our failure to anticipate how rapidly final demand for these goods would crumble.

    If you were inclined to worry on that score, the recent data on final demand might not be encouraging, as we have had more surprises to the downside than the upside. In that regard, one of the most noteworthy areas of downside surprise has been equipment spending. The January figures on orders and shipments for nondefense capital goods were weaker than we had expected, and those readings came on the heels of considerable softness late last year. Demand for high-technology goods seems to have been well maintained, and although transportation investment has been weak, that had largely been expected. The principal surprise has been equipment investment outside high-tech and transportation, which now seems poised to fall about 7 percent at an annual rate this quarter after having fallen about 5 percent in the fourth quarter—both figures well below our earlier expectations. To be perfectly honest, we’re not entirely sure what to make of the magnitude and extent of this softness in capital spending. We don’t think that it is entirely a statistical mirage because we have seen a noticeable weakening in our industrial production measures of business equipment, which for the most part are independent observations. To be sure, much of the slowing has occurred for equipment related to the motor vehicle and construction industries. But just like the inventory data, the recent information on capital spending suggests weakness beyond these two areas.

    Our best guess is that businesses may have become a bit more cautious and possibly scaled back or put on hold some capital spending plans while they gauge the extent to which the economic landscape may have shifted over the past six months. If so, it may be a while before those concerns fully abate; accordingly, we have marked down our forecast for the growth in real E&S in 2007, to 2¾ percent, from the 5¼ percent pace we were projecting in January. We do, however, expect spending growth to pick back up to a rate of about 5 percent in 2008, only a bit below our previous forecast. We don’t think a more aggressive adjustment—such as the one we highlighted as the business pessimism scenario in the Greenbook—is yet warranted. Financial conditions remain favorable, corporate balance sheets generally look healthy, capital spending surveys have been upbeat, and business sentiment has softened a bit but not seriously sagged. We just don’t see the preconditions for a serious retrenchment in capital spending in coming quarters.

    In addition to E&S spending, the other major source of downward revision in our projection was housing. Two factors led to the further downward adjustments that we made to our housing forecast. First, the actual data on housing starts and building permits came in below our expectations in January and suggested to us that the pace of activity in coming quarters was likely to be more subdued than we had earlier expected. The data that we received this morning on starts and permits was a mixed bag. Starts of single-family homes rose 10 percent in February, in contrast to the 2 percent increase that we had projected. But adjusted permits, a less noisy indicator of activity, fell 2 percent last month, close to our expectations. Taken together, the February readings have little consequence for our projection. The second factor weighing on our housing forecast was the rapid intensification of problems in the subprime market. In this projection, we made an explicit adjustment to our forecast of sales and starts for what we now expect to be a significant pullback in nonprime originations in the period ahead. As we noted in the Greenbook, we estimate that the easing of lending standards may have elevated nonprime originations by an amount equal to 10 percent of total home sales in 2005 and 7 percent of sales in 2006. We have lowered the level of our forecast of starts and sales a further 3 percent to account for a more abrupt pullback in nonprime originations in the months ahead. This would be roughly consistent with a decline of about 35 percent in nonprime originations this year.

    In revising this aspect of our forecast, we have assumed that the increase in foreclosures associated with subprime difficulties will have only a small negative effect on overall house prices. We take some comfort from the fact that futures prices on the Case-Shiller house price indexes have edged only slightly lower in the past couple of weeks as this issue gained attention. We have also assumed that there is little spillover from subprime difficulties into the prime portion of the market. We have for some time been assuming that, as newly issued loans seasoned and as rates reset on adjustable-rate mortgages, some gradual deterioration would occur in loan performance, and that is still our view. In sum, the combination of the weaker incoming data and the problems in subprime lending led us to mark down our residential investment forecast enough to take about ¼ percentage point off the growth of real GDP this year. Obviously, this area will require continued scrutiny in the period ahead.

    Elsewhere in the household sector, consumer spending has been coming in very close to our expectations. Last week’s retail sales report was read by many as weak, but it was right in line with our forecast. To be sure, sales increases have trailed off in recent months, but that pattern is consistent with the marked slowing in consumption growth that we are forecasting for the second quarter. Although the data have been in line with our expectations, the fundamentals for consumer spending have weakened since the January Greenbook. In particular, the trajectory of oil prices is about $5 per barrel above our previous forecast, and this should take a bite out of purchasing power going forward. In addition, we now have equity prices running about 4 percent below our previous projection, which along with slightly weaker house prices, suggests a bit less impetus to spending from wealth. All told, real PCE is expected to increase at an annual rate of 2½ percent this year and next, down about ¼ percentage point from our previous forecast.

    This might sound like a pretty gloomy report. But there have been some positives, too. Karen will discuss the external sector, which is expected to be a smaller drag on output in this forecast compared with our previous one. Also, fiscal policy, most notably defense spending, seems likely to impart more impetus to growth than we had earlier expected. Moreover, the labor market continues to flash stronger signals than would be expected from an economy in which growth has slowed below the pace of its potential. The unemployment rate fell back to 4.5 percent in February and has been basically trendless since last fall. If payroll employment gains have slowed at all in recent months, they have slowed just a bit. There have been a few developments of late that hint of a slowing in labor demand. Initial claims have averaged a higher level in recent weeks, and insured unemployment has moved up. Moreover, job losers unemployed less than five weeks—a proxy for the layoff rate—have increased, and surveys of hiring plans have turned a bit less positive. We still think a slowdown in labor demand will become more evident in the coming months, but you’ve heard me say that before.

    In the end, there were more minuses than pluses over this intermeeting period, and we marked down our forecast for the growth of real GDP by ¼ percentage point both this year and next, to 2.1 and 2.3 percent, respectively. But we consider these to be incremental adjustments to a story that remains basically unchanged. Housing is currently exerting a considerable drag on aggregate economic activity. That drag should lessen in the second half of this year, and the pace of expansion should pick up somewhat. However, the reacceleration of activity seems likely to be limited. The slowdown in house prices implies a diminishing impetus from household wealth and the normal multiplier-accelerator consequences of the current hit to home construction should restrain the growth of consumption and business investment. With growth projected to remain below potential, the unemployment rate is expected to drift up to 5.1 percent by the end of next year, a bit above our previous projection.

    As for inflation, we have had only minor changes in our forecast of its key determinants. As I noted earlier, the path of oil prices is up about $5 per barrel, and this adds about ¼ percentage point to overall PCE inflation this year, boosting our forecast to 2½ percent for 2007 and leaving 2008 unchanged at about 2 percent. The indirect effects of higher oil prices add a few basis points to our forecast of core PCE inflation, but those effects were roughly offset by the slightly larger GDP gap and the slightly higher unemployment rate in this forecast. After the forecast closed last week, we received the CPI and the PPI for February. The core CPI increased 0.2 percent last month, right in line with our projection. However, a jump in the PPI series on physician services suggests that core PCE prices could be up about 0.3 percent in February, a tenth above our forecast. If this estimate is close to the mark, we will revise up our forecast of core PCE inflation in the first quarter to about 2½ percent. We are not inclined, however, to accord much signal to one monthly reading, and for now, we are sticking with our forecast for core PCE inflation of 2¼ percent this year and 2 percent in 2008. One reason for keeping the inflation forecast unchanged despite this news on prices is that we have had some low readings on labor compensation. The ECI and average hourly earnings have come in below our forecast; after we adjust for the transitory influence of a jump in bonuses and stock options, the growth of nonfarm business hourly compensation looks to be running below our previous forecast. Looking at the big picture, pressures on inflation do not appear to us to be intensifying, but they also don’t seem to be abating much either. For the most part, that is what we had been expecting to see at this juncture. I will now turn the floor over to Karen to sum up developments in the other 190 economies of the world. [Laughter]

  • Constructing our outlook for the rest of the global economy this time entailed assessing the information in and implications of varying indicators of activity from different regions, the somewhat weaker prospects for U.S. output growth, and the backup in global oil prices. In addition, we struggled to understand the likely consequences of the episode of financial market volatility that emerged in global equity and credit markets at the end of February as well as the risks to our forecast that this episode might foreshadow. In the end, our baseline forecast for real GDP growth abroad is just slightly stronger over this year and about the same next year as in the January Greenbook. Our projection for foreign inflation has been revised up just a little in response to the higher level of our path for oil prices. The resulting contribution for U.S. real GDP growth this year from the external sector is about neutral and that for next year is a small negative; we now see exports, relative to the January forecast, as contributing slightly more positively to U.S. GDP growth over the forecast period and are projecting an arithmetic negative contribution from imports that is a bit smaller in magnitude, especially this year.

    The favorable news for activity abroad was mostly from the major foreign industrial countries. We were particularly surprised by Japanese real GDP growth in the fourth quarter, which in the latest data was an annual rate of 5.5 percent, 2 percentage points above our expectation in January. Household consumption showed some signs of strength—a development that has been lacking in Japanese economic activity for a long time. In addition, private investment spending increased at a double-digit rate. Available indicators for activity in January, such as machinery orders and household expenditures, support the view that solid expansion is continuing, and we have revised up our near-term forecast such that our projected growth rate for 2007 is ½ percentage point stronger. The economic expansion in the euro area continues to firm, and we were surprised by the fourth-quarter growth rate there, as well. The 3.6 percent annual rate of growth recorded for last quarter was 1 percentage point higher than we had expected in January. That strength was due particularly to investment and to export demand. We have revised up our outlook for growth over the forecast period about ¼ percentage point as a result.

    Within emerging Asia, real GDP continues to expand vigorously in China and in India, sustaining expansion in the region at an average annual rate of about 6 percent. We see average growth in Latin America this quarter as having been slowed by weakness in Mexico that is related to softness in U.S. manufacturing production. Mexican growth should rebound in line with the projected improvement in U.S. industrial production, resulting in average growth in the region of about 3½ percent over the forecast period. We have revised down slightly our forecasts for growth in Mexico and emerging Asia relative to the January outlook.

    On balance, we do not see the negative implications of the slightly weaker U.S. projection this time as outweighing the indications of robust domestic demand in Europe and Asia. Accordingly, our baseline forecast continues to be for vigorous growth on average abroad. A weaker U.S. outcome than projected is clearly a downside risk for the global economy, however. The rise in oil prices over the intermeeting period erased some of the inflation restraint that the low January level of global crude prices provided. We have added a couple of tenths to our inflation projection as a result, with most of the upward revision projected for the Asian emerging-market economies that are very dependent on imported crude oil.

    The heightened financial market volatility that appeared in late February was a global event, with stock prices in several major foreign countries declining 2 to 6 percent through the date of the Greenbook and then retracing somewhat over the past week. Credit spreads widened for risky credit abroad, including emerging- market sovereign risk spreads, and yields on long-term governments bonds moved down in the euro area, the United Kingdom, and Canada as investors shifted to higher quality securities. But in many instances, these moves just brought the particular price or yield back to its level toward the end of last year. Although the drop in Chinese stock prices on February 27 was seen on that day as a contributing factor, market developments on subsequent days support the view that much of the concern of global investors is directed toward the U.S. expansion and, in particular, the U.S. subprime mortgage market. We do not see the market correction to date as a source of significant restraint on spending abroad. In addition, the evident weakness in the U.S. housing sector has limited potential for spillover to economic activity abroad. Accordingly, we have strengthened a little our forecast for foreign real output growth and reduced the magnitude of the net subtraction from U.S. GDP growth implied by the projections for exports and imports. Clearly, global financial market participants are ready to react strongly to any news suggesting less-favorable outcomes on investments. This poses a negative risk to the global outlook as the financial market response to a negative shock may intensify the consequences of that shock for credit extension, spending, and ultimately global growth. On the upside, we have been surprised by the strength of domestic demand in some foreign industrial countries, and we could be underestimating its momentum. In addition, a more buoyant outcome for China is always a possibility.

    Last week we received data on the U.S. balance of payments for the fourth quarter, completing our picture for the year as whole. Although the annual total for the current account deficit rose in 2006, the balance for the fourth quarter narrowed quite a bit. That narrowing is due to a reduced trade deficit and a swing to positive in the figure for net investment income. A decrease in our nominal oil bill largely accounts for the improvement in the trade deficit, but the non-oil trade balance also narrowed somewhat. The smaller bill for imported oil in the fourth quarter resulted mainly from lower prices, although the quantity imported declined as well. The balance on the portfolio portion of U.S. net investment income was a sizable deficit that widened about $4 billion at an annual rate from the previous quarter. However, the positive balance on direct investment income jumped nearly $40 billion at an annual rate as receipts continued to be robust and payments fell sharply. The decline in payments was widespread across sectors and countries. The net result was a positive figure for total investment income of nearly $19 billion.

    Going forward, we expect that the current account deficit will resume widening from its reduced, fourth-quarter level and will reach about $950 billion, or 6½ percent of GDP, by the end of 2008. We project that a widening of the trade deficit will continue, with the oil and the non-oil components of the merchandise balance both becoming larger deficits. However, a positive change in the balance on services will partially offset the deterioration in the deficit on traded goods. The net investment income balance should account for a larger portion of the current account widening. The positive balance of direct investment income should drop back in the near term but then rise slowly to record a small, positive net change over the forecast period. However, the negative balance for portfolio income is expected to increase in magnitude significantly, as our net international investment position records yet greater net indebtedness. This increasing net indebtedness and wider current account deficit will continue as long as the trade deficit remains sizable. David and I will be happy to answer any questions.

  • Thank you very much. Are there questions? President Poole.

  • Dave, I have a question related to housing. I gather that a good part of the projection that the drag from housing will work off by the end of this year comes from the belief that sales will gradually clean out the inventory of unsold homes and, once that happens, construction can return to the rate of sales. That’s the unsold inventory of recently built new homes that I guess have never been occupied. If you take the housing boom over, say, the three years ending in the middle of last year, was there an accumulation of houses that ran beyond the underlying demographics and income—and the financing costs, too? I’m interested in those longer-run determinants of the equilibrium stock of housing. Did we end up with a stock of housing that outran the underlying long-run determinants and has to be worked off—in the sense that the underlying determinants have to catch up to the stock that has already been constructed?

  • That’s possible. We have not taken that view. Overall housing construction had some unexplained strength over the past year, not from a bottom-up demographic addition but just in terms of what we would have expected given the growth in employment, income, and wealth. Admittedly, the evidence is still very tentative, but we think we see some signs of demand stabilizing around current levels so that, in our starts forecast, we’ll be able to drive the months’ supply of homes back down relative to the low level that it had actually been running from the mid-1990s to the middle of the housing boom. So I don’t think we’re seeing an excess supply of homes that people just won’t want at current prices, or roughly current prices, but that is a considerable risk. Adding up household formations and demolitions—there’s a lot of uncertainty about that, and there’s a lot of cyclical sensitivity as well to the overall household formation rates. So whether the housing stock outran the long-run determinants is kind of hard to nail down. We see that as a risk, but it’s not incorporated in this forecast. If that were the case, there could be a bigger drag on housing activity than we’re anticipating.

  • Recovery in that sector could take much longer.

  • Dave, I have a question about the significant downshift in employment that you have starting around midyear because I notice that output per hour continues to move along quite nicely throughout the period through the end of next year. Is that just a bet that most of the expansion on the supply side will come from productivity, or is something else going on there?

  • It’s a combination of two bets that are probably both risky. One is that in fact productivity will continue and that what we’ve seen more recently is a little more pronounced cyclical sag in productivity growth and not a sign that underlying structural productivity is weaker than we’re estimating. The second bet is that, on the supply side, the growth in the labor force will be relatively weak. Therefore, we will not need to have as much employment growth—

  • The unemployment rate does go up.

  • Those are two elements of the forecast that we’re struggling with. Over the past few months there has been a little evidence perhaps that the participation rate has been a bit higher than our model was forecasting. That might suggest some upside risk on the labor force growth. On the other hand, the productivity figures have probably been running below what our model would have expected, given our estimate of structural productivity.

  • Just for clarification, David, from peak to trough in terms of housing starts, what percent change in construction do you forecast?

  • We’re thinking of a decline something like 35 or 40 percent at this point.

  • So 2.1 million, is that right?

  • In our forecast, we’re not too far from the bottom. We made the bottom a little deeper this time and put it off just a little bit longer. I said before that we saw signs that demand was stabilizing. In some sense, the adjustment that we’ve made for these recent subprime developments suggests to us that there will be another small step-down in demand going forward from where we currently are. That makes the process of working off the inventory, to which President Poole pointed, a little more prolonged. It also puts this housing downturn, in terms of magnitude, very close to the one that occurred in the early 1990s.

  • Are there other questions? If not, we are ready for the economic go-round. President Yellen.

  • Thank you, Mr. Chairman. Recent data on economic activity have been downbeat in many sectors, and I agree with the general tenor of the Greenbook that the near-term outlook is weaker than before. Indeed, we have cut expected growth this year almost ½ percentage point, to 2¼ percent. This pace of growth is substantially below potential, and we expect the unemployment rate to start to edge up fairly quickly. Even relative to this lower baseline, I think the downside risks to the prospects for output growth have sharpened in the intermeeting period. I’m especially concerned about two risks—broader retrenchment in financial markets along the lines that we’re seeing in the subprime mortgage market and a further hesitation and faltering of capital spending.

    As we discussed in detail two years ago, an asset price bubble inevitably leads to unsustainable imbalances in the economy and a misallocation of resources. The extraordinary run-up in house prices in recent years led to construction and sales booms that couldn’t last. So far the adjustments to more-sustainable levels of housing starts and sales have been relatively orderly. However, there is still an overhang of precarious financing from the past relaxed mortgage-lending standards that has to be eliminated. For example, in 2005 and 2006 something like 40 percent of first-time homebuyers put no money down with their purchase. The market is beginning to recognize the size of this overhang and, with the recent deterioration in the performance of subprime mortgages, is dramatically reassessing mortgage risk. Going forward, we will have to closely monitor increases in mortgage-risk compensation and tightening of credit standards. Such changes, especially if they go too fast or too far, could amplify the housing- sector decline as has been recognized, pushing housing prices and activity down, and with spillovers to consumer spending, they could prove to be a substantial drag on the overall economy.

    Despite the recent turmoil in equity and mortgage markets, a reassessment of overall risk has yet to occur. We are still in an environment of low long-term yields, ample liquidity, and what appears to be a generally low level of compensation for risk. For example, I recently talked with the principals of several major private-equity funds, who were not just amazed but also appalled about the amount of money their industry has attracted. [Laughter] One partner said that he would have no difficulty immediately raising $1 billion. Indeed, one of his biggest problems is would-be investors who get angry at him because he is unwilling to take their money. This unwillingness reflects his difficulty in identifying deals that are likely to yield adequate returns even though, for the buyout firms, debt also is available in what they depict as very attractive so-called covenant-lite terms—perhaps too attractive given the vulnerability of some of the highly leveraged yields. My contacts suggest that some private-equity firms with similar assessments of the shortage of profit opportunities are less restrained and do take additional money, partly because of the large upfront fees that are generated by these deals. So just as we have seen in mortgage markets, the bubble in private equity, as my sources characterize it, and the overabundance of liquidity more generally raise the risk of a sharp retrenchment in credit and higher risk spreads with associated risks to economic growth and, conceivably, even financial stability.

    A second, related risk concerns investment spending. It’s surprising that, despite the ample financing available, firms have still been reluctant to ramp up their capital spending. Certainly, any precipitous tightening of financing could curtail investment. However, as noted in one of the Greenbook alternative simulations, greater business pessimism about future returns to new capital is also a significant risk. The recent pullback in orders and shipments for capital goods has persisted and deepened more than any of us had anticipated. Even for high-tech spending, which continues to expand, my contacts on the manufacturing side are not very optimistic. Sales of PCs and related equipment were mildly disappointing in 2006, and our contacts don’t see the introduction of the Microsoft Vista operating system in January as having generated much enthusiasm among businesses.

    Turning to inflation, our outlook for core inflation, like that of the Greenbook, has changed little since January. I continue to anticipate gradually moderating inflation with core PCE price inflation edging down from 2¼ percent in 2006 to 2 percent this year. There are certainly clear upside risks to this forecast, especially given the resumption of increases in energy prices. These risks remain despite some weakening in the outlook for real activity. In principle, the anticipated subpar growth should help relieve inflationary pressures. However, we remain very uncertain about what par is. The continued low unemployment rate, coupled with recent sluggish output growth, suggests via Okun’s law that potential output could be growing in the vicinity of 2¼ percent. If, contrary to our assumption, that were the case, any labor market tightness now boosting inflation might not diminish this year.

    More-favorable news is found in recent survey evidence on inflation expectations. As many of you have commented in past meetings, inflation expectations are perhaps more influential to the inflation outlook than is the unemployment rate. Their relative stability over the past several years has probably been a key factor restraining the rise in inflation over the past two years. However, what has not generally been noted is the importance of near-term inflation expectations, those with a forecast horizon of a year or two. Both economic theory and empirical evidence suggest that these near-term inflation expectations are as important as long-run expectations for determining inflation dynamics. The latest Blue Chip and Professional Forecasters surveys both show expectations of core inflation edging down next year. For example, the SPF shows core PCE inflation dropping to 2 percent next year, exactly in line with our own forecast. I also see the general downward tilt in inflation expectations over the next couple of years as contributing to a favorable inflation prognosis.

  • Thank you. President Moskow.

  • Thank you, Mr. Chairman. Conditions in the Seventh District are similar to what I reported last time. Business activity continues to expand at a modest pace. However, while my contacts expressed some increased uncertainty, most of them maintained a positive view about the outlook for the second half of the year. As we know, the two sectors that generated the most uncertainty this round are housing and business investment, and so I want to concentrate some of my comments on those two areas.

    On the housing front, my contacts continue to be unsure about how soon the turnaround will be. A director from Pulte Homes saw hints of a better tone in the market but acknowledged that signs were still tentative. He did say that the larger builders have reduced their stock of speculative homes. Another director, who is CEO of U.S. Gypsum, thought it would be a couple of months before he had a better idea whether the market had hit bottom. Furthermore, he thought that, even after the market hits bottom, it would be quite a while before building materials recovered to normal sales levels. As we were discussing, the subprime situation could be a serious problem for the macroeconomy in a couple of ways. One would be a major spillover to house prices—it’s too soon to tell about this now, but new spring listings should shed some light by our next meeting. The other would be significant fallout to other credit market segments, and we don’t see this yet either. I contacted both GM and Ford, and they said that the subprime mortgages held by their credit subsidiaries had deteriorated, but they had not seen increased defaults in other portions of their portfolios. Notably, they had not seen any unusual problems in auto loans, and we generally heard this sentiment of a lack of spillover from bankers as well. On the supply side, given the ample liquidity in financial markets, it seems unlikely that the subprime problem will cause major changes in overall credit availability or pricing.

    Turning to business investment, none of my contacts reported any major changes in capital spending plans one way or the other. That said, I did sense that businesses had become a bit more cautious, as David mentioned. A CEO of a major bank thought that some of this caution was due to the news in the subprime market, but he didn’t think that this was impinging on spending in a meaningful way. As noted by the head of a major private-equity firm, who is on our board, the recent volatility in financial markets has not significantly altered the availability or terms for financing, even for riskier projects. Private-equity firms continue to raise large sums, as Janet discussed. So although I’m more concerned about the outlook, I don’t see the forces in play that would generate a major retrenchment in capital spending. Inventories are another factor that has weighed on growth recently. We’ve heard mixed reports from District contacts about how far along they are in the inventory-adjustment process. In steel, the process seems to be taking longer than expected, but in motor vehicles, both GM and Ford now are generally comfortable with their inventory positions and currently are not planning any major changes in their assembly schedules. Finally, some sectors of the economy appear to be on good footing. Healthy labor markets continue to support solid gains in consumer spending, and as Karen discussed, growth abroad continues to support export demand.

    After balancing all the factors, we marked down our near-term forecast for GDP a bit but retained the basic contours of our previous projection. The most important difference between our forecast and the Greenbook is that we do not see as much short-term weakness, but the uncertainty surrounding this forecast has increased. By itself, the change to the growth outlook this round would suggest slightly less inflation risk, but other factors point to continued concern about inflation. The past couple of readings on consumer prices have been disappointing. Oil prices are higher than at our last meeting, and unit labor costs accelerated noticeably over the past year. Furthermore, labor markets remain tight. So while the benefits of some factors, notably the earlier declines in energy costs, will be transitory, pressures from high labor costs are likely to persist. Markups remain high enough to absorb some cost increases, but these margins could evaporate quickly, as they did in the late ’90s.

    In the end, we did not materially change our outlook for inflation. We continue to project that core PCE prices will increase about 2¼ percent both this year and next. This inflation rate is too high for my taste, and I think for many of us, and I’m not confident that inflation will moderate adequately as we move into 2009. One reason for my concern is highlighted in the Bluebook—namely, that the private sector seems to be betting that our inflation objective is 2 percent or higher. So I continue to think that over the forecast period as a whole the risks to price stability exceed the risks to sustainable growth.

  • Thank you. President Plosser.

  • Thank you, Mr. Chairman. The economic picture in our region has changed little since our last meeting. It seems as though I’ve used that phrase almost every meeting for the past three meetings. Economic activity is expanding at a moderate pace in our District. Business contacts expect that pace to continue in the coming months. According to our March survey, manufacturing activity in our region remained flat, and we’ve seen little change in this activity in the last six months. The general activity index actually fell from 0.6 in February to 0.2 in March, which are both essentially the same and very close to zero. But there were some positives to be read from the survey. First, both the new orders and shipment indexes improved this month. Second, the diffusion index of capital expenditures, which reflects firms’ planned spending six months from now, moved up to 25 percent—a level that is considerably above the average level of 18 seen over the past two expansions. Third, other indexes of future activity remain relatively strong. Finally, in response to a special survey question and ignoring merely seasonal changes in activity, twice as many of our firms said that they expect their own production to accelerate rather than to decelerate in the second quarter compared with the first quarter—46 percent, compared with 23 percent. I take these as signs that our manufacturers see the soft patch as temporary rather than more prolonged, and this is consistent with the anecdotal evidence gathered in talking to the business contacts in our region. Thus, business sentiment among our manufacturing firms appears to have changed little since our last meeting.

    There has been little change not only in overall activity but also in the pattern across sectors. Housing continues to weaken. Area homebuilders that we surveyed in February indicate that sales continue to decline, and high inventories continue to hold back construction activity. Nonresidential real estate markets in the region remain firm, but construction has not gained any appreciable strength. One of my contacts in a major bank sees continued strong loan demand, however. Businesses that come to him for loans have strong balance sheets, their profits remain good, and from his perspective that is supportive of continued business investment going forward. This may be suggesting that business investment, which—as many of us have been concerned about—has been weak in the past several months, may be on the verge of rebounding. Labor markets in the region remain tight. Employment in my three states has grown at a pace of 1.3 percent over the past three months ending in January, an acceleration from the 0.8 percent pace over the past twelve months. The unemployment rate has held steady, and employers continue to complain of difficulty finding both skilled and unskilled labor.

    On the inflation front, prices for industrial goods continue to move up, but retail price increases have not been widespread. However, there are signs of increased pressures on wages and salaries. Wages in low-skilled jobs in New Jersey and Pennsylvania have certainly increased because of increases in state minimum wages, yet the acceleration in wages appears to be more widespread. Employers in a number of industries have said they had to raise salaries much more this year than they did last year in order to hire and retain workers in certain professional and managerial occupations as well as high-skilled workers in a variety of jobs.

    In summary, business activity in the region continues to advance at a moderate pace— I’m looking for other words to substitute for “moderate,” which gets old after a while. Our business contacts expect this moderate pace to be maintained in coming months.

    Turning to the national economy, at the time of our last meeting, the data on real activity had come in stronger than expected, and inflation, while still elevated, had moved down a bit. Since then, the data suggest perhaps a somewhat weaker near-term growth outlook and a backsliding in my view in the progress on inflation. If these recent data are indicative of the future, then we are in a much less comfortable position than we thought we were a few weeks ago. I think there is still good reason to believe that the weakness we are seeing on the real side of the economy remains confined to the effects of the housing correction and to a lesser extent of the auto correction, which should moderate over the year, and that the fundamentals underlying the economy remain somewhat strong. I think that labor markets will be considerably firmer than in the Greenbook forecast and that the consumer sector will also hold up in part because of that.

    It’s particularly difficult to infer trends from the data from this past January and February. A sizable swing in temperatures from one of the warmest Januarys on record to one of the coldest Februarys has led to large swings in both seasonal factors and the economic data more broadly. So I think that we need to be a little more cautious than usual in trying to interpret these volatile month-to-month numbers. That said, I must admit that the uncertainty surrounding my own forecast that growth will soon return to trend has increased since our last meeting. The recent decline in new orders over the past several months suggests that the weakness we’ve seen in business investment in the fourth quarter may linger a little longer than expected, despite healthy business balance sheets and positive investment and business sentiment. Although in my view the reassessment of risk in the subprime mortgage market suggests that this market is working as it should, the overall weakening in credit conditions in the mortgage market increases uncertainty as to whether the housing correction will be contained or whether it will spill over into other sectors of the economy. Thus, although I’m not really ready to abandon my forecast, I do think my uncertainty of that forecast has increased somewhat.

    At the same time, I’m less convinced that inflation is moderating and that we’re making sufficient progress toward price stability. Perhaps I really should say that I am more concerned that we are not. The twelve-month change in the core CPI was 2.7 percent, and the three-month change has reaccelerated. I find the upward trend in core inflation over the past year, from 2 to 2¾ percent, troubling. I take some comfort in the fact that inflation expectations have moved down somewhat. Even ten-year expected inflation in our first-quarter Survey of Professional Forecasters moved down to 2.35 percent from 2.5 percent. That’s a seismic event, [laughter] given the stability of that number over the past eight years. However, these expectations continue to lag, not lead, inflation. So I remain concerned with the inflation numbers that we are in fact seeing. Thus, I find myself back to where I was this fall. A slowdown in real economic activity, if sustained, would suggest a lower equilibrium real rate, but inflation remains elevated. At this point, I would allow for some implicit policy firming implied by a constant fed funds rate unless we see stronger evidence of a declining economy. Thank you.

  • Thank you. President Hoenig.

  • Mr. Chairman, I’ll spend a little time on the District. I think you can describe it as almost robust, recognizing that we are a District that exports a lot of raw materials and byproducts of raw materials. We have had solid job gains led by further tightening in our labor markets, and recent revisions suggest that 2006 job growth was stronger than we had previously thought. Mining led the job growth, but we also saw strong gains in professional and business services and in leisure and hospitality. In fact, our ski season this year was a record, as the snow was also a record. Besides shortages of skilled labor, of which we are constantly getting reports, we are seeing also shortages of some lower-skilled workers as well—in the temporary employment area, for example.

    It is also noteworthy that our manufacturing activity has been strengthening. We have received good reports from our directors and advisory council members that it actually strengthened in February. Lower inventories of finished goods led to a surge in order backlogs, and most industries reported robust activity led by machinery and high-tech equipment production. In addition, plant managers expressed greater optimism about the outlook for employment and capital spending as they look forward, not as they’re looking right now.

    Turning to real estate, housing activity may have stabilized. We have suffered like the rest of the country in that area, especially in our Denver market, where we have had record levels of foreclosure. But beyond that—and even there—we have seen some stabilizing in our housing market, and our commercial activity remains really quite solid. Housing permits and the value of new residential construction held steady in February. In addition, the buildup of home inventories has actually slowed, and District contacts expect inventories to decline gradually in the coming months, as they are now seeing things turn. Nonresidential construction remains strong, with absorption of office space increasing in most cities and vacancy rates continuing to decline throughout our region. Commercial real estate contacts expect more new construction in the months ahead. They are actually seeing it come on the drawing board. They also reported that office prices and rents increased further, even though sales were somewhat flat over the last month or so.

    Farm financial conditions have improved overall, with increased crop prices that are being driven by the expanded ethanol production. USDA forecasts that net farm income will rise about 10 percent this year. Strong income prospects have boosted land prices—significantly, I might add, in some parts—and solidified farm balance sheets. One piece of information I would note is that ethanol is a boom industry right now in the region—not in just our region but in the area around Nebraska and Iowa. In that area, 100 plants are producing; there are 50 on the drawing boards, but we are seeing some backing away from that. Three projects have been pulled back in Oklahoma recently, and one more in Kansas. But still, a lot are going forward, and it gives me some pause because it has the tone of too much, too quickly, and the real economy will suffer if it backs away from that development. Anyway, on balance, the regional economy is very strong right now.

    Turning to the national outlook, I would say that, on balance, although I have revised my outlook down somewhat in 2007, I still have it projected as growing on the whole for the year better than 2½ percent. So my outlook is more optimistic than that of the Greenbook. There are some reasons for that, at least that we’re thinking through. Like others, we see housing stabilizing, perhaps taking a little longer to come back, but inventories seem to have stabilized. As those inventories are worked off through the first half of this year, we think housing should improve through the rest of the year, at least given where the fixed interest rates lie. We’re also seeing that the secondary effects of the slowing of the housing market seem contained at the moment, so that slowing is not spilling over, and the containment is being strengthened by the facts that personal incomes are actually continuing to improve and that we have a good labor market. So those factors are important. Also, as we discussed earlier, foreign demand is strong, and the outlook seems to be good. Finally, federal spending—the fact is that we’re fighting a war, and you tend to spend more over the course of a war—is picking up I think. Coffers are strong, and states are spending at a fairly rapid rate. So a lot of factors are affecting demand, and therefore I think that this economy will pick up as the year goes on.

    I recognize very clearly that there are some risks to keep in mind. One is that the housing market could worsen, and there could be further spillovers. I’m very mindful of that. But on the other side, I do share some of the concerns raised by others in terms of the inflation outlook. Inflation has not come down as much as we had hoped, although I’m still projecting that it will so long as we keep the rates at their current levels. But there are some upside risks with the tighter labor market and strong demand, and we could see energy prices putting more pressure on it. So it’s a mixed bag perhaps with, on balance, some upside risk as well as downside risk to this economy. Thank you.

  • Thank you. President Fisher.

  • Mr. Chairman, I was reminded the other day that the original story of Goldilocks was not quite as we later came to learn it. The first version that was drafted was actually called Silver Hair. When the three bears came back to the house, the elderly lady, not the little girl, jumped out the window. That was the beginning of the Goldilocks story, which was later adapted to a more palatable commercial story. [Laughter] I’m not ready to jump out the window yet, but I do have some concerns, and I’d like to talk about three areas—the international side, where the porridge seems to be hot; the domestic economy, where it seems to be cooling; and in my District, where it seems to be just about right.

    So, first, on the international side, just to complement some of Karen’s points, our research and anecdotal findings show that global capacity utilization has moved to the higher end of its range. World unemployment rates have been falling. Capacity expansion seems to be underpaced, even though there is some structural change in utilization, and it seems insufficient to meet demand or quell inflation. Prices for imported U.S. goods have clearly moved away from deflationary trends to neutral or slightly inflationary, as I reported before—and, by the way, across nearly all product categories. The growing tightness in the market for skilled foreign labor may be the contributing factor. A very large foreign retailer operating in China reports that they are seeing wage price inflation for the first time in the stores that they are opening and operating. As one of the high-tech CEOs mentioned to me earlier, even the Indians that they now import, not by bringing them physically across but by fiber optic cable, are being priced much more expensively. If you add turnover, these workers have become increasingly expensive. We see pressure from the shippers, noting that there are continued upward pressures on fleet utilization, spot prices, and port congestion. Airlines are reporting stronger international loads and price traction than in the United States. Express shippers and logistic companies are reporting double-digit growth in the year to date in Europe and still higher rates of growth in Asia. So, on balance, our view from the Dallas Fed from the international perspective is that international data and anecdotal evidence point to some excess demand outside the United States with concomitant increases in price pressures.

    Turning to the domestic scene, we appear to be sailing between the Charybdis of a slowdown in the economy and the Scylla of higher inflation. I want to talk about both. We’re both measuring and hearing of greater fragility in the domestic economy relating to economic growth and the kind of excess that is leading to the financial turbulence that Janet spoke about. I’ll turn to that in a second. Also, we’re not encouraged, despite our wishful thinking, on the inflationary front. Let me just give you some points other than those that have already been mentioned, particularly other than capital spending, which we see slowing across the nation. Express shippers, logistic companies, report 0.2 percent growth year over year for domestic ground operations and weaker-than-expected overall growth, between 0 and 0.5 percent on balance in the year to date—substantially less than they expected. Rail car loadings are flat to down, reflecting the decline in demand for materials for housing and a decline in durable goods orders. Truck tonnage is off, and orders for replacement of fleets seem to be reflecting more than the effect of these new engine regulations that are going into place. I’ll give you one data point mentioned: Peterbilt’s order book is one-third of what it was last year. Airlines report weaker domestic booking and slackening demand relative to last year. With regard to the retailers, I have been urged to be cautious in analyzing the data, first because last year was in essence a fifty-three-week year because of the late holiday or a thirteen-month year due to gift cards. Our contacts report continued strength for high-end retailers, 3 to 6 percent unit growth in the first quarter for middle retailers like Kohl’s and JCPenney, and significantly lower growth rates with companies like Wal-Mart praying that the advancement of daylight savings time will lift them from flat growth to 1 to 2 percent comps. Finally, restaurants report continued movement down the food chain—no pun intended—[laughter] from the middle-income eateries to the McDonald’s of the world. If you notice McDonald’s reports, they are quite stout, whereas the middle-income eateries are suffering. In short, we expect slower top-line growth across the board.

    I want to talk for a minute about housing. One of my contacts at Wal-Mart mentioned that, when they recently surveyed their customers, concerns about housing did not even rank in the top ten of consumers’ concerns. Despite that, a large housebuilder, whom I mentioned in previous conversations around this table, says that they have gone from monsoons to scattered thunderstorms, and another reports a decline in the need to grant concessions. Yet both are concerned about subprime and alt-A “infection,” as one called it. Going back to our previous conversation, one of the builders, whose average home price exceeds $300,000, has through thorough analysis just discovered that 40 percent of last year’s builds were financed by alt-A mortgages. If you look at the security analysis for that particular company, the best guesstimate is 20 percent. So, being from the Clinton Administration, I’m a bit worried; I’m getting to the point where “don’t ask, don’t tell” may be the best approach to interviewing some of these homebuilders. Clearly, they are concerned. They have an overstock of inventory, and they’re beginning to cut back significantly on activity. If you remember, David, originally I did talk about a 25 percent peak-to-trough correction when you were not quite at that number. Now I’ve caught up with you. I’m at 40 percent at a minimum and quite concerned about it.

    I’m also concerned about what President Yellen referred to as a possibility for a retrenchment in the credit markets. I point, as others have done, to the significant oversupply of private-equity capital. To give you a specific example, in the case of Texas Utilities, between a Friday and a Wednesday, the two principal investors lined up $2.5 billion apiece, another billion from five other equity investors, and in the end over $50 billion of committed capital from the banks in a two-day lineup period, only half of which was used. So, Mr. Chairman, in short, in the domestic economy, I’m concerned that the tail in terms of a recession has not become slimmer as I mentioned last time. I would redact those words. I believe it has become fatter, and I believe that financial market turbulence has a potential to become greater.

    As to the Scylla of inflation, I keep telling myself, David, that with the passage of time we’ll see improvement, that one month’s set of numbers such as we had in December does not a trend make. I tell myself that two months’ numbers, like those we saw in December and January, do not a trend make. But the numbers are less than comforting. On a six-month basis through January, both our trimmed mean at the Dallas Federal Reserve Bank and your PCE excluding food and energy are stuck at 2.1 percent. On a twelve-month basis, the trimmed mean was stuck at 2.5 percent, and your PCE excluding food and energy was 2.3 percent. The recent CPI report was hardly encouraging. Sixty-eight percent of the components rose 3 percent or more. To be sure, there are tamer OER readings, but they’re being offset by a pickup in core goods inflation. I continue to worry about the political effect of this kind of inflationary run. I note yesterday’s headline in the Christian Science Monitor stating that “inflation is eating up U.S. wage gains.”

    On the regional side, what I’ve reported above is reflected to some extent in the Eleventh District. Growth has slowed, but housing prices are stable, and housing inventories are thus far healthy. Yet we continue to experience significant wage price pressures. Our dynamics are much stronger than those of the rest of the nation. One of the credit card companies reports that sales using their cards in our region were up 10.5 percent year over year through February, versus 1 to 4 percent on the eastern and western seaboards.

    In short, Mr. Chairman, I see geographic dispersion in the growth patterns—strong growth overseas, relatively strong growth in our District, and a developing worrisome growth scenario for the rest of the United States. We see less abatement of inflation than we had hoped for. With regard to preparing for tomorrow’s discussion about what to do about it, I find myself on the horns of a dilemma. I would say that the risks are more evenly balanced, and yet the tail of less growth and the risk of recession and the other tail of awfully stubborn inflation have fattened and not trimmed. Thank you.

  • Thank you. President Lacker.

  • Thank you, Mr. Chairman. Overall, economic activity in the Fifth District expanded modestly in recent weeks, though performance across sectors remains uneven. Growth is centered in the services sector, where moderately positive readings continue. Real activity has recovered somewhat in recent weeks, and big-ticket sales have posted modest gains after two months of quite weak readings. In manufacturing, our survey respondents continue to report a downward drift in activity. They remain optimistic about their future prospects, however, though many comment on generally weak current demand. Labor markets remain tight in most jurisdictions, with the standard reports of spot shortages of skilled workers, but wage pressures are reported to be moderate. We continue to hear of some reasonably firm housing activity in a number of District localities. Home prices remain generally flat, though builders are offering more incentives to buyers. Inflation pressures appear to have moderated in March according to our latest survey, but manufacturers and service providers expect price pressures to increase modestly over the next six months.

    On the national level, risks seem to have risen lately, but my sense is that prospects are still reasonably sound. Subprime mortgages, obviously, have dominated the financial news in recent weeks. Concerns about the welfare of families suffering foreclosure are quite natural, and anecdotes about outright fraud suggest some criminality. But my overall sense of what’s going on is that an industry of originators and investors simply misjudged subprime mortgage default frequencies. Realization of that risk seems to be playing out in a fairly orderly way so far. Mortgage-backed securities have lost value as risk spreads have widened, and there have been insolvencies among firms that specialized in this sector. The updating of risk estimates in light of recent experience will lead to higher borrowing costs in the affected market segments, and at the margin this increase could shift some households from homeownership to renting. But in my judgment, that isn’t likely to affect the net demand for housing units. Notably, we have not seen broader risks to credit availability in other markets or to the financial safety net. Perhaps the greatest economic risk posed by recent subprime developments is legislation that impedes the availability of credit or that provides financial support ex-post that was unanticipated ex-ante but affects private decisionmaking henceforth, somewhat like ad hoc disaster relief.

    Housing construction continues to contract, of course, and inventories remain elevated. The choppy winter data make it hard to gauge the descent, but overall home sales seem to be holding steady, and we haven’t heard anything locally that suggests a renewed contraction in demand. So the housing outlook hasn’t changed much for me. However, the recent weakness in business investment has been disappointing. One would expect soft patches related to housing, autos, and the new truck regulations, but the broader sluggishness is a bit at odds with the generally favorable fundamentals. I still expect this investment to pick up ultimately, although I have to admit that the recent data have left me a bit less certain, especially about when. The outlook for consumer spending remains fairly healthy, though. Real disposable income growth has been powered by continuing gains in employment and firmer wage growth. So all in all, I still think the current episode of below-trend growth is fundamentally a transitory phenomenon that will most likely be behind us by the end of the year, although the recent weakness in business investment suggests more downside risk than before.

    Core inflation continues to firm, and it now seems clear that the fourth quarter’s energy- induced lull is over. We have yet to see much sign of the long-awaited easing in resource utilization. It’s not obvious that we will be getting any help from labor costs any time soon, and inflation expectations remain centered at or above 2 percent. So to me, the prospects for moderation in inflation remain tenuous. I continue to believe that, by summer, growth concerns are likely to be behind us, and we will want to act to reduce inflation, which we recognize is higher than we want. Thank you.

  • Thank you. President Pianalto.

  • Thank you, Mr. Chairman. Comments from my business contacts confirm the softening in economic activity that is depicted in the Greenbook. Most of the people I talked with during this intermeeting period confirmed the slowing that we are seeing in the national data. But at the same time, they expect that business will improve over this year. My business contacts are still planning to add modestly to staff and to expand output, although their capital spending plans are not particularly ambitious this year. A number of my business contacts told me that the dollar depreciation is finally having an effect. They are getting more orders and are being asked to quote more jobs from foreign customers.

    I have recently had conversations with CEOs of the large banks from my District, who have an interesting perspective on the ongoing turmoil in the subprime mortgage market. They don’t seem to be particularly concerned that the situation in the mortgage markets is going to be substantially worse than is already factored into the admittedly weak housing forecast. But they are concerned, as President Yellen mentioned in her comments earlier, that the subprime mortgage problems are symptomatic of broader issues that could spill over into hedge funds and private-equity funds—both of which have become an increasingly important source of funding for business investment activity. They worry that retrenching among managers of these funds could adversely affect business confidence more generally. Their comments resemble the alternative Greenbook scenario labeled “Business Pessimism with Spillovers.” The difference, however, is that my business contacts are suggesting that the problems could originate in the financial sector and spill over to producers’ expectations.

    Turning to inflation, the volatility in the monthly retail price numbers, even in the so- called core measures, will make it difficult to clearly perceive the very modest progress in the inflation trend that appears in the Greenbook baseline. Given the usual noise in the price data, work by my research department indicates that identifying a break in the inflation trend on the order of about ½ percentage point with a fair amount of certainty can take somewhere between a year and a half and two years after the break has in fact occurred. While I believe we are still on a course that leads to a lower inflation trend, the path we take to get there will not likely be a smooth one, and there will be times that will test our nerve. Indeed, as I look at the data today, I would judge that the downside risk to the real economy has increased somewhat. Still, in my view the primary risk we face is that inflation could remain stuck higher than either I or the Greenbook foresee. Under these conditions, I think two qualities are essential—patience and clarity. We need to be patient so that we don’t become unnecessarily aggressive in trying to foster lower inflation in a softening economic environment, and we need clarity so that the public does not come to see our patience as indifference to the current inflation trend. Thank you, Mr. Chairman.

  • Thank you. President Minehan.

  • Thank you very much, Mr. Chairman. Perhaps unlike in the rest of the country, most of the recent cyclical data point to some reasons for optimism about near-term growth in New England, with the possible exception of the rate of foreclosure initiations related to subprime mortgages. The annual benchmark revisions by the BLS paint a happier picture of the current state of regional job growth, especially in Massachusetts and Connecticut. The overall message is that the region has been growing at a pace that is about at its long-term trend and has been adding jobs consistently in recent months. This picture is a bit different from the one we’ve been seeing for some time.

    The region’s unemployment rate remains about at the nation’s, and demand for skilled labor, as measured by both online and newspaper help-wanted ads and by anecdotal reports, is quite strong. Indeed, many continue to note that hiring the skilled workers they need has been difficult. Both temporary-help service firms and software and IT firms report strong demand for labor, particularly to meet finance and technical positions and to meet a growing backlog in activity in high-tech businesses. This aspect of the region’s labor market may be pulling some discouraged workers back into the labor force, as reflected in the perhaps temporary uptick in unemployment. Reflecting this better news on regional job growth, the Philadelphia Fed’s coincident economic indexes point to economic activity in the region’s two largest states that is on a par with national growth. When we surveyed a wide swath of retail contacts, we saw a bit of gloom on the retail side. But the fact that in New England you have an array of very small companies, sometimes in unique circumstances, may have given a little downbeat sense to the retail climate. The reports from larger retailers in the survey—and we have a couple of them— show solid year-over-year growth. Manufacturing employment continued to decline, but manufactured exports last quarter rose at a pace just a bit slower than the nation’s and were buoyed by airline-related products, fabricated metals, and general machinery. As I’ve noted before, downtown vacancy rates in most of the cities in New England are declining, as are suburban office vacancies; rents are rising; and one or two corridors fanning out from Boston are reportedly hot sites for new biotech firm locations. Business confidence, as measured by local surveys, is up, as is consumer confidence. So, overall, things are not too bad.

    A concern among this mostly brighter news is the rising rate of initiations of real estate foreclosures, especially those related to properties financed with subprime adjustable-rate mortgages. According to data from the Mortgage Bankers Association, whether one looks at the rate of total foreclosures or at the pace of foreclosures among just subprime mortgages, initiations have risen rapidly in New England from a very low base and now outstrip the nation’s. This is not a contest you want to win. Anecdotes abound about individual borrowers lured into what appear to be quite inappropriate mortgages, and the Federal Reserve Bank of Boston has been working with local bankers’ associations and the Massachusetts Banking Department and others on outreach and education. Why New England generally, and Massachusetts specifically, should be outstripping the nation in this area isn’t really clear. The local banking industry does not appear to have played much of a role in subprime lending, nor were we an area of bubble-like real estate growth, though clearly prices rose rapidly in the region over a fairly long time. The detrimental effects to local communities from the rise in foreclosures and the potential for negative political fallout—not unlike what President Lacker mentioned—seem obvious.

    On the national scene, the incoming data on the real economy, with the possible exception of job growth, have been slower than I expected. Inflation data, if anything, have been higher. The picture is not comforting, and it is complicated by questions related both to the housing market and the surprisingly slow pace of business spending. Many people around the table have mentioned both those things. The degree of national fallout from problems in subprime mortgage lending is a question right now, as it bears both on the pace of recovery in residential real estate investment and on the potential for wider spillovers from housing to consumption. At present, we in Boston, like the Greenbook authors, don’t expect that subprime mortgage problems will by themselves have much of an effect on overall growth. But we do have a concern if these problems lead to tighter lending standards, making mortgages and other borrowing more difficult to obtain and thereby exacerbate housing inventory overhangs, extend the current period of sluggish new home starts, and create further downward pressure on home prices. So far, we don’t see much of that happening. Trends in overall market and banking liquidity, mortgage interest rates, and new mortgage issuance are all positive. We think that those trends, combined with positive consumer home-buying attitudes, paint a reassuring picture that some of the downward trends will not be as severe as they otherwise might be. Indeed, I spoke to members of the advisory board of Harvard’s Joint Center for Housing Studies in late February. The group was composed of about fifty major homebuilders and major suppliers to the building industry. They were in a bit of collective shock regarding the rapid deterioration that they saw in their industry from late last year into the current quarter and seemed to be focused on inventory and cost control rather than on profits this year, which they didn’t expect. However, they saw continuing spending on home improvement, growth from commercial construction, and strength in non-U.S. markets as partial offsets. No one in the group mentioned the subprime issue or potential problems in mortgage financing, but that may have just been the fact of the moment. It was actually the day before the market break in late February, so it’s possible that they are not thinking along the same lines today.

    We have also been asking ourselves why business fixed investment has been so slow relative to fundamentals. We had been assuming that this inexplicable trend would right itself and that growth of producers’ durable equipment would show greater signs of health, but that hasn’t happened. We, like the Greenbook, have written down expectations regarding PDE. I’d really like to be wrong on the downside regarding this area, as it worries me a bit more than subprime mortgages or any of the recent financial market ups and downs. If businesses lack the confidence to invest in new equipment as much as they might be expected to given the fundamentals, how much longer will they continue to hire staff? If job growth slows, what will happen to consumption? To date, both hiring and consumption remain pretty solid. But while I saw some upside risks here at our last meeting, now I’m a little worried on the downside. In view of the incoming data, we have written down our forecast, much as the Greenbook has, and we have joined the Greenbook in a lower estimate of potential. We see growth a bit above 2 percent this year, rising to the mid 2s in ’08, with slightly rising unemployment and only slightly slowing core PCE inflation.

    However, as I probably implied before, I think the risks around this forecast on both sides seem to have risen. Will housing trends and the possible effects of diminished business spending affect the resilient consumer more than we now expect? Will the underlying pattern of core inflation continue to surprise on the upside, with the moderation we expect remaining mostly in the forecast? I don’t mean to overreact here. There are positives. External growth is strong. Fiscal spending at both the state and the national levels should be supportive. Financial markets, though certainly a bit more volatile and nervous, remain accommodative. Perhaps the downside risks to growth that I see are simply the ebb and flow of the U.S. economy continuing its transition from an above-trend rate of expansion just a year ago, not unlike the slow patch we saw in the late summer and early fall of last year. All in all, I remain somewhat more concerned about risks on the inflation side than about risks to growth. But it does seem to me as though the balancing act in meeting our two objectives has gotten a bit more difficult.

  • Thank you. President Minehan, could you just say a word about your outreach on the mortgage problems?

  • We have done quite a bit of work with the Banking Department of the State of Massachusetts and with the Massachusetts Bankers Association. We have had meetings with those two groups in many of the affected areas around Massachusetts, basically looking to provide education. We’ve done some materials on the education side. Obviously, once you’re in the midst of a foreclosure, education isn’t all that helpful. The Banking Department has been trying to bring along local lenders to see what they can do to create a refinancing situation for borrowers. We’re not part of that particular conversation, but we have been part of the outreach that the Banking Department has been making.

  • Well, we here in Washington expect to have to answer a few questions about the subprime situation, and we would be very interested in anyone’s experience. If any other Reserve Bank is involved or has any plans, we’d be interested to hear about them.

  • I think we recently forwarded some information to Governor Kroszner about this.

  • I haven’t received it. If you sent it by mail, it could take a while.

  • No, no, no—I know that. [Laughter] I think we did it by e-mail, and someone in your Community Affairs area may be in the process of passing it along.

  • But I have a copy of the e-mail in my Blackberry.

  • They have to check the e-mail for anthrax here. [Laughter]

  • I wondered about that. Don didn’t get one yesterday.

  • On that note, why don’t we take fifteen minutes for coffee and come back around 4:40 or a little after. The coffee is in the anteroom.

  • [Coffee break]

  • If we could reconvene—I see a two-hander from Governor Kroszner.

  • I just wanted to mention with respect to foreclosures and wanted to double-check my facts—a note had been sent out from the Board’s Consumer and Community Affairs Division to your consumer and community affairs groups concerning your activities in mortgage foreclosures, and Jeff Lacker fortunately has invited me to a conference two days from now, at which I will be speaking. Unfortunately, I will be unable to be at the hearing at which Sandy Braunstein will be appearing. Regardless of what you might think of me in this regard, please be sure to get things in to help Sandy out. I think a lot of good activities are being done in all the regional Federal Reserve Banks, and if we could just get a little information to her so that she has a few examples to give, that would be very helpful. Then we will follow up in the longer run because we hope to do a larger program here on some of these issues. Thank you, Mr. Chairman.

  • I’m sorry. What are you looking for examples of—mortgages we foreclosed on? [Laughter]

  • Just the opposite—Sandy could use examples showing that we’ve done some outreach to help deal with some of the challenges of foreclosure. Are there educational efforts or studies that have been done?

  • We want to be the good guys.

  • Thank you, Mr. Chairman. Thank you for the earlier welcome. Over the intermeeting period, aggregate economic activity in the Sixth District showed signs of slowing. Manufacturing activity appeared to soften, with the majority of reports suggesting declining orders. Retail reports pointed to a slowing pace of sales. The BLS employment data revisions for 2006 supported the view that Florida’s economy has decelerated considerably in the wake of the housing downturn. Sales tax data suggest that retail spending in Florida actually declined in late 2006. Recovery on the Gulf Coast of Mississippi and Louisiana continues to proceed more slowly than hoped. The immediate post-hurricane boost to spending has waned, and the problems of housing and insurance availability remain largely unresolved.

    The biggest concern for the Sixth District continues to be in real estate markets. As stated at the last meeting, it appears to be too early to suggest that the region’s housing situation has stabilized or that the housing sector’s drag on the District has ended. Reports indicate that many areas in Florida are experiencing dramatic declines in sales of single-family homes and condos, even while new product continues to come onto the market. As a result of this oversupply, construction plans have been cut back. In January, permit issuance for single-family homes in Florida was 57 percent lower than a year earlier. For the rest of the United States the decline was 25 percent. Permits for multifamily development declined 40 percent versus a 7 percent decline nationally. This situation is most extreme in Florida. Interestingly, we do hear anecdotal reports of improved potential buyer traffic in Florida, but that improvement is not translating into sales. Buyers appear to be expecting lower prices. In the other states in the District, single-family permits were down 19 percent in January, less than the decline nationally.

    Regarding the region’s exposure to nonprime and subprime mortgages, the concern is again mostly in Florida. According to the Mortgage Bankers Association, over 9 percent of mortgages serviced in Florida in the fourth quarter of 2006 were subprime ARM loans; this exposure was second only to Nevada, which was at 13 percent, and compares with 6½ percent nationally. In contrast, the exposures of the other states in the District were all at or below the national level. Reports from banking contacts suggest that delinquency rates on nonprime ARM loans in Florida will continue to trend higher this year. Reduced access to credit for nonprime borrowers will slow the absorption of the current oversupply of housing product and will put downward pressure on house prices. Also, the boom in condo conversions and condo construction in 2005 and 2006 drained the supply of apartments in many areas in the District, and landlords have been able to increase rental prices as a result.

    Turning to our perspective on the country as a whole, much of the slowdown in real activity that occurred in the second half of 2006 reflected weakness in the housing sector. If weakness remains contained within the housing sector, the outlook, although subdued, is acceptable in our view. Much of the recent moderation in real activity is consistent with what we had forecast several months ago. Realization of this moderation does not in itself imply that we should revise our outlook. Some professional forecasters continue to anticipate that real GDP growth will rebound to close to its trend rate of 3 percent for the rest of 2007, in effect discounting any drag from prolonged weakness in residential investment. The Atlanta Fed staff forecasts for real GDP growth are consistent with these optimistic commercial forecasts. The current Greenbook forecast implies a slightly weaker outlook from extended weakness in residential investment and weaker growth of consumer expenditures, perhaps incorporating some signal from the recent financial distress in subprimes. Despite slight differences in these forecasts, the outlooks do not suggest recession at this point. Measured core inflation remains in excess of 2 percent. Our staff consensus forecast sees core inflation continuing in the range of 2 to 2½ percent for all of 2007. This forecast is a bit less favorable than the Greenbook forecast, but we have no sense that the inflation outlook has deteriorated significantly.

    The implications of the outlook for real output and inflation are that current policy is set about where it should be. The U.S. economy has performed about as expected. Financial market turbulence and subprime mortgage distress raise potential concerns that should be monitored, but for now it seems that the outlook has not substantially changed. Thank you, Mr. Chairman.

  • Thank you. President Stern.

  • Thank you, Mr. Chairman. As others have commented, the latest numbers on the performance of the national economy have been mixed, which is to say less positive than I had expected; and I take the Greenbook’s point that growth is subdued this quarter. I don’t view the recent news on inflation as especially favorable, but I don’t find it overly alarming either. The question for me is, Do the latest readings have implications for economic performance beyond the current quarter—that is, say, over the next several quarters or so? At this stage, my answer to that question is “no,” in part because I want to avoid getting whipsawed by marking down the forecast now only to mark it back up in May or June. More fundamentally, I think that continued gains in employment and income, sound fundamentals for business investment, sustained increases in government spending, and generally liquid financial conditions are likely to maintain the expansion. I also think that the trade situation may turn out to be a bit better than that depicted in the Greenbook, assuming that energy prices don’t take off a lot from here. I also take some comfort that, at least until now, I haven’t viewed my forecast as especially ebullient. By the way, I do think that the housing correction still has some way to run, as I’ve commented before, largely because of the overhang of unsold properties.

    To get some additional evidence on the latest developments, we called a number of our contacts in retailing late last week to see if we could detect anything new in consumer spending. The short answer I would say is “no.” A clear trend was not apparent from our contacts. Some reported significant increases in sales recently and were optimistic about prospects. Some experienced sales decreases and were at the least cautious, and some said sales were unfolding more or less as anticipated. Overall, this is probably modestly good news, since at least there was no obvious break in consumer outlays. As for inflation, I would judge that the situation has not changed appreciably, and so I continue to expect modest deceleration over time. I don’t sense that price pressures are building at this point, but you have to look pretty hard to find convincing signs of moderation as well. Thank you.

  • Thank you. President Poole.

  • Thank you, Mr. Chairman. Regarding the small handful of contacts with whom I’ve talked, my trucking industry contact finds things slightly better in February and March, but things had been very, very slow before that. The company has reduced its truck fleet by 300. My contact says that pricing is flat for the first time in six years; there is a tremendous amount of price competition. He says that he’s getting four times the usual number of bids. So the customers are shopping around hard looking for price concessions. He said things were just marginally better. Both the UPS and FedEx contacts had a similar message—that activity is coming in substantially below what they had anticipated. The overnight letter business is declining—it is down about 4 percent; the next-day package business is up about 4 percent. Those are the express products. The net of those is about zero or maybe 1 percent, and they had been expecting something on the order of 3 percent. So they’re revising down their expectations for this year but apparently not changing their underlying capital investment plans. However, my UPS contact, in particular, said that they are really scrambling now to reduce outlays. Essentially, their commitments for expenses are pretty well set in the short run, and so revenue shortfalls go directly to the bottom line. Therefore they are scratching around to reduce expenses. They are not replacing staff when there’s attrition, and they are cutting out unnecessary travel—all the usual kinds of things. They have reduced staff, focusing particularly on management positions, which they have reduced by 1,600.

    I’ve been reflecting on what we make out of the slower-than-expected capital spending, and let me summarize my position this way. I’m just uneasy about the outlook. If the Greenbook GDP outlook is wrong, I’m guessing we’re going to come in below it. I’m mindful, of course, of the standard errors going in both directions and so forth, and we could certainly have upside surprises. I’m just saying that I’m uneasy about that. I’m also uneasy about the inflation forecast—it could be on the high side or could hang higher—and I worry particularly because it’s the one that produces the most difficult policy situation for us, with output coming in below expectations and inflation hanging above target. That’s the toughest. That’s the classic policy dilemma situation. It causes the most pain. So that’s the one I concentrate on.

    It doesn’t seem to me that we’re likely to have a traditional recession. Money growth remains on the high side. In the past six months, M2 has been running about 7 percent, and MZM about 8 percent—that doesn’t look like a recession. If you think about the expansion phase of the cycle, with the exception of housing there were no big imbalances. We didn’t have the sort of dot- com and telecom over-investment that we had in the late 1990s. So what might be going on here? Well, it’s clear that businesses have an intense desire to see increasing profits quarter after quarter after quarter; and when you get a revenue slowdown, they go after costs, even if it might not be perhaps long-run profit maximizing, but they feel an intense pressure. Then you get a Keynesian kind of mechanism in which some people get laid off and some things get delayed and so forth, and that produces some declines in income, and it could lead to a prolonged soft spot in the economy. That’s the kind of process that I think may be under way. If that’s what’s happening, we’re going to have to be patient and let it work out. So that’s where I am right now. Thank you.

  • Thank you. Vice Chairman Geithner.

  • Thank you, Mr. Chairman. Our view of the outlook has changed since our last meeting, but more in the balance of risks and the sources of uncertainty than in our actual forecast for growth. But just to go through the changes quickly, we’ve reduced our forecast for growth in ’07 a bit, to something less than 3 percent, and we see more downside risks to that forecast. We’ve moved up the expected path of core PCE inflation just a bit in light of recent numbers, but we have maintained essentially the same view as before—that inflation will moderate to around 2 percent by the end of this year and a bit below that in ’08. We see the risk to this forecast still to the upside. We face greater uncertainty about the near-term outlook than we have over the past few meetings. Looking to the medium term, although we haven’t yet reduced our estimate of potential growth, we’re a bit more concerned than we’ve been about the strength of underlying structural productivity growth going forward. We have also changed our view of the appropriate path of policy a bit, introducing a gentle move down now in the fed funds rate beginning around the middle of the year. So this puts us a bit below the assumed path in the Greenbook, but we assume a slower, smaller reduction in the nominal fed funds rate than the market does today. Our forecast is quite close to that of the staff’s in the Greenbook, and the basic story is similar. Our differences are the same as they have been for some time—we have slightly more growth and slightly lower inflation. That reflects things we talked about before, different views about information dynamics and about potential growth. Our view of the output gap and its evolution, however, is similar.

    I have just a few points on some issues. On the growth front, the recent numbers suggest both a deeper adjustment in housing and a broader weakness in the economy than we anticipated, notably in capital goods orders. The effect of these developments on our forecast is not that large, however. Their significance is more in the risk to the outlook and the uncertainty, the puzzle that the investment weakness presents for the medium term. On housing and consumption, the probability of the dark scenario is still small, but it is higher than it has been and deserves some attention. The dark scenario is the risk that the reduction in credit to the household sector amplifies the decline in housing demand, which leads to a greater adjustment in prices, with a risk of a more- pronounced, prolonged decline in growth and spending. Monetary policy should not be directed at trying to put a floor on housing demand or on prices, only at limiting the risk that the weakness accumulates substantially or spreads to overall demand. Regarding capital spending, we just don’t have a good explanation for why—with margins that are still pretty good, reasonable earnings growth, solid growth in aggregate demand here and globally, relatively low interest rates, and reasonable levels of business confidence—spending has continued to come in well below our expectations. This series of disappointments, of course, has been going on for some time; it’s not just about the latest numbers for durable goods orders. Perhaps this situation will prove transitory, but it justifies a bit more caution to the outlook. Of these two risks—in housing and in investment—I’d say the latter matters more and is potentially more consequential. But both of these effects are offset, in our basic view, by the expected strength in personal income growth going forward, by what are still fairly favorable overall financial conditions, and by fairly robust external demand.

    Regarding productivity, productivity growth per quarter at an annualized rate has, over the past ten quarters, come in significantly below 2 percent, kind of close to the estimates of the trend rate for the period between ’73 and ’95. Some of the analysts who spend a lot of time thinking about this are starting to lose conviction that trend growth is still in the neighborhood of 2½ percent for the nonfarm business sector. We’re still viewing the recent weakness as transitory or cyclical, but the risk that trend growth is below our estimate is, I think, increasing.

    On inflation, despite the higher recent numbers, not much has really changed in our view. We still expect core PCE to move to below 2 percent over the forecast period, and we still see the risk as not getting quite that moderation. The sources of the recent negative surprises in the core data, which seem concentrated in medical services, probably don’t say much about monetary policy or broader inflation dynamics, and inflation expectations remain stable at reasonable levels. So our view of the growth outlook has changed a bit, but our view of the inflation outlook hasn’t changed much based on these numbers.

    On the markets, as many people have said and as Bill discussed at the beginning, I don’t see much that’s been troubling thus far. Although correlations across asset markets have risen, overall liquidity seems fine. There’s been very limited contagion from mortgages into other credit markets. Debt issuance seems to be continuing. People are able to raise money to finance corporate restructuring investment. There is very little concern, I think, about substantial losses, on the basis of what’s happened to date, in the core of the financial system and very limited evidence of stress among the various funds. But it’s still early in some ways, and the fundamental outlook for growth is a bit weaker and more uncertain. Risk premiums, credit spreads, and volatility still look potentially vulnerable to a more substantial reversal. The weakness in the subprime market will take some time to work through the full range of securities issued against pools of collateral that include mortgages. The complexity in valuing structured mortgage products, the difficulty in designing hedges that actually work against exposure to that risk, and uncertainty about the shape of the adverse tail and that part of the credit spectrum are all conditions that apply to a range of other structured credit markets and credit products. In the debate about the implications of this prolonged yield-curve inversion, we have tended to side with those who have found comfort in the contrary signal you see in lower levels of risk premiums and credit spreads. Yet it’s possible that the forces that may have been holding down forward rates are also holding down credit spreads and holding up the value of other assets and, therefore, may be masking weakness in the economy rather than masking strength.

    On balance, although the outlook still looks fundamentally positive, we see a more complicated and less benign set of risks to the outlook, more downside risks to growth, and some continued concern that we won’t get enough moderation in inflation. To us, this outlook justifies a stance of policy with a path for the fed funds rate somewhat above what is now priced into the markets. This doesn’t mean, in our view, that we need to signal that nominal rates going forward are more likely to rise than to fall from current levels; it means only that we should convey the sense that our view of the most likely evolution of policy still implies a higher path than is now priced into the markets. We can afford to be patient before adjusting policy, as Sandy said, but we need to have as much flexibility as possible going forward. This suggests that we acknowledge that the overall balance of risks has shifted a bit toward neutral, toward a flat stance of policy, but not all the way there. A delicate task for us is to do this without inducing a reaction in the market that pulls forward significantly more easing than has already occurred.

  • Thank you. Governor Kohn.

  • Thank you, Mr. Chairman. Like many others, I view the data over the intermeeting period as not fundamentally undermining the basic contours of our expected forecast. We’re still on track for moderate growth and gradually ebbing inflation. The economy has enough underlying strength, bolstered by financial conditions that remain quite supportive of growth, so that the housing correction should not be enough to knock the economy off the moderate growth track. Growth modestly below potential, along with the unwinding of some special factors like rent increases, should allow further declines in inflation.

    Real-side data reflect the fact that the downshift from above-trend growth for several years to expansion at or a little below trend hasn’t been entirely smooth, and maybe we never should have expected it to be so. Besides the overpricing and overbuilding of housing, businesses apparently built their stocks of inventories and fixed capital in anticipation of continued strong growth, and we’re seeing downshifts in demand for inventories and capital to align them with the slower pace of expected growth. Businesses typically also hoard labor under these circumstances, resulting in weaker productivity growth, and we may just be seeing this adjustment getting under way, judging from the gradual upcreep in initial and continuing claims. The inherently uneven nature of the stock adjustment process and the uncertainty around it help to explain both the overall contours of the recent data and the short-run swings in the data and perceptions of them.

    A number of factors, most of them mentioned by others, do support expectations of moderate growth ahead. Outside the subprime market, financial conditions remain supportive of growth. Intermediate and long-term rates are low in real as well as in nominal terms. The dollar has fallen. The fallout from the recent turbulence has been very limited. Aside from housing, a good portion of the inventory correction is behind us or is being put behind us. So over time production ought to line up better with sales. Both a rise in the national ISM index and increases in industrial commodity prices, especially in metals, support the notion of a coming recovery in manufacturing, though I admit the increase in metals prices may be a factor of the global economic expansion as well. Continued good growth of jobs to date will support increases in personal income, and as many have remarked, growth in the rest of the world has been pretty strong. I was struck by the upward revision in rest-of-world growth in the Greenbook despite weakness in the United States, the rise in oil prices, and the decline in equity values. So as Karen remarked, domestic demand abroad seems to be strengthening, and I think this bodes well for global external adjustment as well as for U.S. exports.

    But the information we have received over the intermeeting period not only shifted expected growth down a little but also highlighted some downside risk to activity. In housing, those downside risks center on the implications of the subprime debacle. Will it affect housing demand? Will lending terms tighten beyond the subprime market and the mortgage market? How much will tightening spill over to other lending markets, such as home equity lines of credit, and perhaps affect consumer demand? The possible answers to these questions seem to me to have downside tails that are fatter than the upside tails. Unexpected weakness in investment spending outside housing and auto-related industries is another risk factor. The question is whether this weakness represents just a short-term adjustment to moderate growth or whether businesses themselves see a downside shift in underlying demand that we don’t see. Financial conditions may not remain as supportive of growth, besides the possibility of the dropping of other shoes, such as private equity, as many have mentioned. I see a distinct downside risk to the staff’s assumption of continued increases in equity prices given the likelihood that, if the economy evolves the way the staff anticipates, long-term interest rates will rise and profits will be very disappointing to market analysts.

    Despite weaker spending, we still face upside risks to the gradual downdrift in inflation. Recent data haven’t been as favorable to deceleration as we would have hoped: Softer investments, slower growth of productivity, and continued strength in labor markets could suggest a slower path of trend productivity growth. If so, we would need to adjust down our expectations for growth, and labor costs would get a boost even at slower growth rates unless increases in nominal wages also downshifted pretty promptly. Good growth in labor demand could suggest a stronger path for demand and less slack than the staff is estimating. Finally, the NAIRU could well be lower than the 5 percent that the staff is estimating, especially in light of the relatively slow updrift in many measures of compensation. But, at 4½ percent, the unemployment rate is low by historical standards, and this suggests to me that the risks from resource utilization remain toward higher inflation. In sum, downside risks to our maximum employment objective have increased, but I do not think they outweigh the continuing upside risk to more-moderate inflation, at least not yet. Thank you, Mr. Chairman.

  • Thank you. Governor Warsh.

  • Thank you, Mr. Chairman. Let me say at the outset that I believe the moderate-growth scenario is the most likely for 2007. But as many of you have already discussed, I had thought that business fixed investment particularly was a very real upside opportunity and now consider it a very real downside risk. The Greenbook marked down BFI over the next couple of quarters, but I think there’s further reason to be concerned about it.

    Let me confine the rest of my remarks to the market tumult of the past several weeks and give you my views on that, which are broadly consistent with what Bill said at the outset. First, my sense of what the markets seem to be telling us is that the real economy is weaker. The first-quarter earnings numbers that Bill showed us very much reflect a trend that we could be seeing more of and that suggests some downside risk in the equity markets that Governor Kohn referred to a moment ago. A markdown of data in the fourth quarter of 2006, disappointing data regarding business fixed investment, the weakness in the subprime market, and so forth suggest to me that perhaps the markets have been reacting to a U.S. domestic economy that is in somewhat weaker shape than we could have expected even a couple of months ago.

    What was the cause of the market tumult of the past several weeks? When markets cannot single out a proximate cause, they have a tendency either to construct one or to be completely dismissive. In my view, some subset of rather sophisticated investors over the past six months or so have been looking for an opportunity, or maybe I should say an excuse, to pull back from certain markets in which credit-risk spreads have been unusually low; and over the past several weeks, they found one. There has been a generalized discomfort with markets priced for perfection and levels of volatility that seem uncorrelated with the real world which we’re all trying to analyze. Many of us have noted in speeches during the past couple of quarters that we have been surprised by the level of certainty implied in market prices, and I think that message is now starting to find its way into the marketplace. So the tumult and volatility that we’ve seen in the past several weeks will, as it continues, make it more difficult for us to gauge what’s going on.

    Might this financial market tumult then actually affect the real economy going forward? Generally, I would have said that these financial market activities are quite distinct from the real economy. But in the case of business fixed investment, I can’t help but believe that the market uncertainty, the talk of recession, the animal spirits that certainly have been negatively affected—all might affect some boards of directors and management teams that are trying to decide about whether to step on the gas on cap-ex or might get them to retreat even further. Given strong balance sheets, incredibly strong operating cash flows, and all of the momentum that they should have, I’m as puzzled as Tim Geithner as to why we haven’t seen that capital investment. The tumult in the markets in recent weeks gives me more reason to be concerned there. Perhaps these management teams are going to find share buybacks to be even more compelling compared with the alternative of capital investment.

    In general, I took the volatility of the markets at first blush as probably being a proper wake- up call to folks who had gotten perhaps a little too complacent about what was going on, particularly in the credit markets. Having spent a lot of time in New York in the past several weeks, I think that, if that was a wake-up call, many market participants seem to have hit the snooze button. [Laughter] Many are reviewing their portfolios and risk positions certainly, and we are seeing a bit more caution. Perhaps that’s justified by real economic fundamentals or by some lemming phenomenon. That is, most of these investment banks and other asset managers have in front of them as they’re making decisions a credit-risk button and a client-risk button. Over the past couple of years, they have always hit the client-risk button—that is, I don’t want to take client risk; I don’t want to lose this business. So they have hit that button, and the credit markets have been so accommodative and the syndicated markets so strong that they’ve been able to make some free money there. For a short, short window after February 27, they seem poised to hit the credit-risk button. One senior credit-risk officer at a major institution told me that he was very popular again. People wanted him in every meeting as they were making underwriting commitments. He called me back a few days later and said, “No one wants to talk to me again.” [Laughter] So I worry whether that wake-up call has actually been felt.

    Now, could this market volatility of recent weeks spread beyond the subprime market and lead to the kind of credit crunch that would have meaningful downside risks to the economy? I tried to imagine the circumstances in which that would come. First, I looked at financial intermediaries, and rather than trying to distinguish between commercial banks and investment banks, hedge funds, and other private equity, I tried to think about them as being creators of credit, distributors of credit, or holders of credit, forgetting all other labels that are associated with them. Typically, before the rather robust capital markets of the past several years, most of these institutions would decide which of those areas they would be in. Do they create products and get them off their books, or do they make big bets by deciding what to hold and not? Many of them have now decided that they could be in all three businesses. All three businesses were profitable. To the extent that a portfolio position no longer fit, they could sell it or syndicate it very quickly. In this new environment, however, with new volatility, these portfolio holdings over time may prove harder to liquidate, and the out-of-the-money options that the creators of structured products have been writing may no longer be free. A couple of weeks ago, Warren Buffett described one of these financial hedge fund phenomena. He described the groups as the “innovators, the imitators, and then the swarming masses of incompetents.” [Laughter] I won’t describe who is in what category in these markets, but many financial institutions seem to be following one particular premier investment bank that has managed to be a creator of products, to be a syndicator, and to be taking very large principal positions.

    What happens if these other financial institutions get uncomfortable as these markets tighten, to the extent that they decide that they no longer want to be in the equity bridge business? To cite one example, which President Fisher raised, in a very large, highly leveraged transaction recently, a couple of the investment banks decided to put up a couple billion dollars of capital, and they were short some equity checks. Typically, they would then go to a series of other banks, bring them into the deal, and then try to syndicate that quickly. But the first investment banks that were involved wanted to make sure that there was no competition in the syndicated market. So three non-U.S. financial institutions wrote $1 billion checks for an extremely small fee and agreed to hold that billion dollars of equity on their own balance sheets for a term of not less than 365 days and to syndicate it later only to those who would be satisfactory to the lead investment banks. To what extent over the next twelve months will they and others feel uncomfortable in this new business environment with that kind of equity exposure? If that process ends up being disorderly, there could be a rapid turn to risk aversion. Of course, I think the more likely case is that this is orderly and supportive of sustainable growth, but that’s the financial situation in which I would get very nervous very quickly.

    I think a second mechanism by which the situation could become worse involves a whole set of legal risks around the subprime markets and uncertainty generally over where liability rests. Through the good intentions of policymakers in the Congress and in state legislatures, some uncertainty could be introduced into the foreclosure market and into the syndication markets. Many enterprising state attorneys general seem poised to do just the same, and that kind of legal risk could be very dangerous for these credit markets.

    Finally, what does that situation mean for us? I suspect that, besides our needing to keep a focus on these financial markets, it is what’s happening in the real economy. As we’ll discuss a bit more tomorrow, our statement should be and will necessarily be read in the context of our reaction to incoming real data as opposed to our reaction to what’s happening in the financial markets. Thank you, Mr. Chairman.

  • Thank you. Governor Kroszner.

  • Thank you very much. I very much agree with President Stern’s characterization that, although some of the incoming data are a bit weaker than we had been seeing, we certainly shouldn’t overreact. Optimally, we should react to what the data tell us about the future, and I’m not sure we’ve learned an enormous amount about the future over the past few months. Actually Dave has kept a very steady hand on the forecast throttle because we have seen a lot of data come in over the past six months, but they haven’t led to much change in the Greenbook forecast, and I think that’s quite reasonable. Given that some of the numbers have come in slightly weaker and given some of the market volatility, I think that uncertainty is a bit up; so the tails are somewhat fatter, and I agree with the number of people who had said that.

    Quickly looking at GDP from the C + I + G + net exports context, I think net exports will be reasonably robust as world growth, at least over the next few quarters, is going to be fairly strong. We also heard a lot of anecdotal support for that. On both the state and federal levels, government spending is likely to continue at a pace that will certainly not reduce demand and may have the potential to add to demand. But when it comes to consumption and investment, that’s where the uncertainties are. I won’t restate the concerns that several of you have raised about the deepening puzzle in investment. I mentioned this at the last meeting—that for many months we’ve been seeing very good balance sheets, good employment numbers, good sentiment, good returns, and so on and so forth, but no pickup in investment. Given that we’ve now gone at least six months without seeing that pickup, I am concerned that, with the greater uncertainty that seems to be in the markets, we may not see that pickup and that somehow our models may be missing something that should be in there but that has not been there in the past.

    The other area of the greatest uncertainty is related to the subprime market. As you know now, we and the other federal regulators put out for comment—actually right at the end of the week of the increased concern about volatility in the subprime market—guidance with respect to subprime mortgages, the so-called 2/28s and 3/27s. That is still out for comment. We’re very mindful of some of the comments that have been raised here about whether that could inappropriately reduce the supply of credit in this market, and in the notice of proposed rulemaking, we have really emphasized questions about what the unintended consequences are. So we want to make sure that we get information in on that. Some loans that were made may have been inappropriate, but there may have been some that were completely appropriate. We want to make sure that, when we put out the guidance, we don’t choke off the appropriate loans.

    The supervision and regulation staff has surveyed five active lenders in the subprime market that represent about 30 percent of that market. We’ve gotten data so far from three of the five. From some of them it’s a bit difficult to get the data quickly because of a fair amount of management turnover, but we are still working on it. But I think it’s a healthy thing that there are some delays. What’s interesting is that one of the main concerns is refinancing: What will happen to these guys because this market seems to be drying up. As we discussed at the beginning, it’s really the variable-rate subprime market. The subprime market is roughly 13 percent of the total mortgages outstanding. The variable-rate subprime is about 7.4 percent of total mortgages outstanding, nearly two-thirds of the subprime market. The fixed-rate part has not had any uptick in delinquencies. Because of the inversion of the yield curve, the people who may be facing increases in their variable rates may be able to refinance into fixed-rate subprimes. Over ’06, the average introductory adjustable-rate subprime mortgages were in the 7 percent to 9 percent area—depending on the loan-to-value ratio, debt-to-income ratio, and so forth—if income was stated. Right now, to refinance into fixed rate, the range is about 7½ percent to 9½ percent. It’s fairly similar, so many of these people may be able to move into this area.

    One thing that we want to know is what happens after people get these loans. What do they do with them next? In the survey, about 25 percent of the loans were retained by the individual banks, and so we could follow through what happened to the borrowers when they refinanced; but we see only 25 percent. Obviously this share could be heavily selective, but it still may be somewhat interesting to know that about 40 percent of those on whom we have some information actually moved into a prime product. About 34 percent went into a fixed subprime; and the rest, about 25 percent, refinanced to another type of variable subprime. So a fair number of these are able to move either into prime or into fixed subprime. Although this sample is obviously selective, it says something about the likely effects going forward. The benefits, at least in the short run, of the inverted yield curve are that many of these individuals will have a lot of opportunities to refinance into a fixed product that will have payments similar to the ones that they’re paying now rather than ones that would be much higher.

    That said, the situation suggests that the concerns about what will happen to the market may not be as strong as some people have said. We still don’t know, as President Fisher said, a lot about the alt-A market. That market almost by definition is low documentation or no documentation. The FICO scores tend to be higher. From the survey, a lot of these people appear to be self-employed, so it becomes more difficult to independently verify the income that they have. That’s a large part of the market, but obviously potentially a very risky part of the market. Fortunately, it’s not an enormous part of the market, and so it doesn’t seem to be a major challenge going forward. Certainly there are some potential challenges, but I think some of the data from the survey are interesting.

    With respect to inflation pressures, I think very much like Dave (now that he’s a much more balanced person than he was earlier in 2006), that we see neither intensifying nor abating inflationary pressures. You know, some of the numbers more recently have not been as favorable as they could be, but they are certainly by no means out of control. Expectations continue to appear well anchored and well contained. We don’t know a lot about what’s driving short-term to intermediate-term inflation dynamics. It’s hard to see lots of correlations with unemployment rates, economic activity, resource utilization, energy prices, and other things. I have been hoping to see and we have been seeing a gradual downtrend that seems to be flattening out to neither intensifying nor abating, which leaves us with some concerns going forward about the upside potential to inflation.

  • Thank you. Governor Mishkin.

  • Thank you, Mr. Chairman. One way I think about the situation is to compare what’s happening now, not to the last meeting, but to two meetings before. From December to January we had positive news. Now we have gone from January to March, and we’ve had negative news. When you look at the overall picture, we’re not in a very different place from where we were in December, although I do think that there’s actually more uncertainty around the forecast. So let me go into a little more detail on this. I’m much less worried about the housing market as a serious downside risk. First of all, I do see signs of stabilization of demand, and I really agree very much with what Randy just discussed. First of all, this market is a fairly small part of the overall mortgage market. Also, there are ways for people to work out their situations. So the subprime market has really been overplayed in the media, and I do not see it as that big a downside risk. I am comfortable with the fact that we have lowered our forecast on housing a bit, but the numbers that just came in recently were actually ones that indicate some stabilization there—in terms of housing demand, in particular.

    When I worry about the risk to the forecast, I’m really much more worried about capital expenditure in terms of investment. The problem here is that the fundamentals look fairly strong and yet we haven’t seen strong business fixed investment. I ask myself, “Well, what’s going on?” One possibility is that, in fact, there will be a bounceback—that these strong fundamentals in terms of balance sheets and so forth will produce actually stronger investment in the future, and I think that is a significant possibility. However, I’m really a bit more worried that the weak capital expenditures may indicate that something deeper is wrong in terms of the fundamentals. In particular, I’m a bit worried about the issue of what could be happening to productivity in the future. We’ve seen some weaker numbers in terms of productivity, and we think that is just sort of cyclical and not a change in structural productivity. But maybe the business sector is seeing something that we’re not seeing, and in that context, businesses may not be investing as much because they don’t see that productivity will be that strong in the future. They don’t see the returns in the future, and so they’re not investing as much. That’s actually bad news in several dimensions. One dimension would be that it would actually indicate a serious downside risk in terms of aggregate demand. Also if productivity is lower, that’s not a good thing for inflation. So the situation here is one about which I’m not super worried; but the environment is more complicated, and it makes our jobs more interesting. [Laughter] There is, of course, the Chinese curse that you should live through interesting times, but we’ll have more-interesting FOMC meetings.

    On the inflation front, I am comfortable with the view that the Greenbook and others have expressed that we should expect some moderate decrease in inflation. In fact, the latest data don’t really get me that nervous on this. However, we must recognize that, when we have more-anchored inflation expectations, it’s actually harder to forecast the little blips in inflation because what’s really going on is what’s left—it is no longer the trend but just the transitory movements, and those are particularly hard to forecast. So there is a bad side to the overall better news, but I think the key is that inflation expectations seem to be very solidly grounded. It’s hard to know exactly what the numbers are, but they seem to be around 2 percent. So it’s realistic to think that, in fact, inflation is going to move toward the 2 percent level, although there may be some blips up and down. However, it is also important to recognize that I don’t see any reason for its dropping much below that. Thank you, Mr. Chairman.

  • Thank you. Thank you very much for the comments. I’m going to offer, as I always do, a brief summary and invite any comments and corrections, and then I’d like to add a few comments of my own. Most participants today agree that growth looks as though it’s going to be slower, but there is some diversity of opinion about how persistent the slowdown would be. Many people have marked down growth expectations for the remainder of the year, and there was a general sense that the uncertainty about growth prospects and downside risk have increased. However, some people saw the current slowdown as only a soft patch that would be reversed soon. Housing remains weak, and some participants noted the risk that problems in mortgage and credit markets and increased foreclosure rates might contribute to further weakness. However, others felt that the housing situation has not changed materially since the last meeting. The slowdown in capital investment drew more concern, in part because it has proved difficult to explain. An inventory correction continues, but automobile inventories have been brought into line. Some factors that will support growth include a booming global economy and stronger government spending at both the federal and the state and local levels. The labor market continues to be tight, with some noting increases in wages. Developments in the labor, housing, and credit markets will be important in determining the future course of consumption.

    Several participants pointed to potential financial risks, including possible knock-on effects of the subprime mortgage problems and the possibility of the drying up of currently abundant liquidity and financial markets. Corporate earnings are also likely to slow. If these risks materialize, they could add to downside pressures on output. However, some thought that financial conditions will remain supportive. Some, but not all, think that inflation will continue to moderate, albeit very slowly. There is general disappointment with recent inflation readings, and some were skeptical that any meaningful progress against inflation is being made. In particular, resource utilization pressures, particularly tight labor markets, pose a longer-term inflation threat. Import prices and slower productivity growth also add to inflation risk. The views of most participants were that upside inflation risks still outweigh downside risks to output, that uncertainty has increased, and that the tails of the distribution have become fatter.

    Are there comments? If not, let me just add a few thoughts. It’s very difficult to speak last—all the good ideas have already been presented. So I’ll say just a few things.

    I think the growth outlook is slightly worse. The housing market is, of course, central to near-term developments. The central scenario that housing will stabilize sometime during the middle of the year remains intact, but there have been a few negative innovations. We’ve noted the subprime issues and the possibility of foreclosures, reduced confidence, and tightened credit terms, and I’ve also noted that reports from builders about the spring selling season have not been particularly upbeat, in general. At the same time, we continue to see rough stability in sales, starts, and permits. The effects of the decline in subprime lending may have already been mostly seen, since that has slowed from last fall. Mortgage rates, of course, remain quite low, and the labor market is a key determinant of housing demand and of mortgage delinquencies, particularly cross- sectionally. Across the country, there’s a very close correlation between foreclosure rates and state unemployment rates. So long as the labor market remains strong, I would think that the general health of the housing market would be improving. The housing market, I think, will follow the same scenario, but there are a few negative innovations.

    There was a lot of discussion about capital investments, and I share the puzzlement about why that’s happening. Like Governor Mishkin, I am concerned that it might signal something about productivity. Another possibility in the current environment goes back to my Ph.D. thesis on the effects of uncertainty on investment, which found that greater uncertainty can make people delay their commitments. In our last meeting, we discussed the possible upside risk to consumption. I think that risk is much diminished now. Our retail sales have been quite flat, and the strong growth of consumption in the first quarter is almost entirely due to the December blip, which will carry through to the quarterly arithmetic. But consumption is very likely to slow. Gas prices are another reason that consumption is likely to slow. The labor market, again, remains strong. I agree with the Greenbook that there is some likelihood of softening going forward. In particular, I think Governor Kohn mentioned that the slowing productivity growth we’re seeing could be consistent with some labor hoarding in this late stage of the cycle.

    Again, I’ve marked down my growth expectations only a bit, but if we were handicapping recessions, I’m afraid that risk has probably gone up a bit. I would cite at least three reasons. First, there seems to be a pretty good chance that potential output growth is lower than in the past; and almost by definition, if growth is lower, then the chance of negative quarters is greater. Second, the Greenbook has a 60 basis point increase in unemployment occurring stably over the next two years. If that happens, it will be the first time it has ever happened. [Laughter] Generally speaking, increases in unemployment tend either not to occur or to be bigger than 60 basis points. Finally, we’ve discussed the financial market sensitivities, which are having an effect, so that changes in the outlook could have pretty substantial feedback effects onto the economy through the stock market, other financial markets, and credit markets. So I think, as President Fisher does, that the tail in that direction is unfortunately somewhat fatter.

    Likewise with inflation, the news was disappointing. We knew that there would be—and we have seen—month-to-month volatility. It is difficult, as President Pianalto noted, to make a firm conclusion based on the recent data about whether or not inflation is moderating. I would just note that rents and owners’ equivalent rent are still pretty important here. They have not yet slowed much, which may have to do with the nature of the uncertainties about the housing market. That possibility will be helpful going forward. At an earlier meeting I indicated that medical costs were a risk; and they have, indeed, proved to be a risk.

    Speaking about inflation makes me reflect on the difficulties of measuring aggregate supply in general. As we think about the economy going forward, we face two countervailing possibilities. One, which I and several others have already mentioned, is that potential output growth may well be lower than many outsiders and maybe even the Greenbook think. Obviously that will make it difficult to get economic slack and will make this situation much more challenging. At the same time, the lack of wage acceleration at least raises the possibility that the NAIRU might be somewhat lower than 5 percent, which would be helpful in the other direction. With respect to inflation, again, as I said, I’m disappointed by the recent numbers. I don’t get a sense from business people or from surveys and so on that the general public’s worry about inflation has increased very much, except insofar as they perceive that inflation is constraining the Fed from acting. So, again, I don’t think we’ve seen an adverse breakout by any means, but obviously we’re going to have to remain very vigilant and make sure that we maintain our credibility on the inflation front.

    As the last item, I would like Vincent to distribute table 1. We made a couple of changes in the description of the economy. He can make a few comments, and then everyone will have an opportunity to look at it overnight, and we can discuss the communication issues tomorrow.

  • I have the unenviable position of being the last speed bump between you and the open bar across the street. [Laughter] In the interest of time, I’d like to draw your attention to the latest version of table 1 and then deliver the rest of my remarks tomorrow. That way you’ll get a chance to cogitate over the changes to the table overnight, and I will get to showcase an outfit that I anticipate will be just as fetching as this one tomorrow. [Laughter] The latest version of table 1, which was just distributed, introduces modified wording in the rationale portion of alternative B. In section 2, the factors supporting growth are made a little more explicit, including some of the things that you’ve spoken about today—favorable financial conditions and the recent mixed indicators. As for section 3, the CPI release was a touch to the high side of expectations, and the medical services component of the PPI even more so. This situation makes it likely that the core PCE price index will be disappointing and argues for substituting material similar to the bracketed material in the Bluebook. As for the risk assessment, this draft continues to characterize inflation as the Committee’s “principal” concern, although some of you would prefer to identify it as your “predominant” concern, partly because of the precedential use of that word in the Chairman’s monetary policy testimony. I hope for your sake that your hotel rooms have both a Gideons Bible and an unabridged dictionary. [Laughter] That concludes my prepared remarks.

  • Thank you. I hope you’ll join me now in bidding farewell to Governor Bies. We will reconvene tomorrow at 9:00 a.m.

  • [Meeting recessed]