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

  • Good morning, everyone. Steve Oliner, would you start us off?

  • Thank you, Mr. Chairman. Earlier this morning we received new data on orders and shipments of durable goods, and we’ve distributed a single page chart that I’ll refer to in a moment as I review those data. I should also note at the outset that this single-page chart replaces one of the panels on page 5 of your chart show package, which was produced before we had the data. The top-line figure in this morning’s data release showed that new orders for total durable goods edged down 0.3 percent in May. As you know, within this aggregate we focus on the series for nondefense capital goods excluding aircraft to get a read on business equipment spending. Orders for this grouping of goods declined about ½ percent in May, and shipments were off a tad more. Although these numbers sound weak, they were actually a little better than we had expected and would cause us to nudge up our forecast for equipment and software purchases in the current quarter. In addition, as you can see from the chart we handed out, orders (the solid line) have moved above the level of shipments (the dashed line), providing some support for the moderate near-term increase in capital goods outlays that we have assumed for this projection.

    Turning to your regular package of charts, the data I just reviewed plus the stronger defense spending that we reported last Friday lift our estimate of real GDP growth this quarter to 1¾ percent at an annual rate from the 1½ percent figure shown on line 1 of the table. We are projecting a marked step-up from this pace during the second half of the year, largely on the basis of the policy stimulus—both monetary and fiscal—now in train. This acceleration continues into 2004, when we expect real GDP to advance more than 5 percent. As you can see by comparing lines 1 and 2, the first half of this year turned out to be weaker than we had expected in January, and we now project a sharper acceleration going forward. We anticipate that much of this pickup initially will take the form of stronger household expenditures. As shown on line 3, the growth contribution from consumer outlays is projected to start moving up next quarter, as lower withholding rates and rebate checks begin showing through to spending. With household demand firming, the caution that has pervaded the business sector should gradually recede, boosting outlays on equipment and software (line 4) in 2004. We also expect a sizable growth contribution next year from inventory investment (line 5), as firms build stocks to accommodate the advance in final sales. The faster growth in 2004 reduces the unemployment rate (line 6) to 5.4 percent by year-end, the same level we had projected in January

    The incoming data provide some faint signs of the anticipated transition to faster growth. As shown in the middle left panel, private payrolls were essentially flat in April and May, suggesting that labor demand may be turning a corner after declining for two years. Industrial production, not shown, edged up in May after recording   sizable declines in March and April, and we are looking for a modest rise in June. This outlook is consistent with the indexes for new orders from the various purchasing managers’ surveys, which—as shown to the right—have moved up since April. Among the recent indicators of spending, real consumer outlays on goods other than motor vehicles bounced back in May, as indicated in the lower left panel, and appear on track to post a moderate gain for the quarter as a whole. As shown by the barbell in the lower right panel, the automakers’ forecasts of light motor vehicle sales in June are centered near the sales pace of recent months.

    Although these data are still too mixed to conclude that activity is firming, we believe that the foundation is in place for a substantial pickup, as discussed in your next chart. An important part of that foundation is a heavy dose of fiscal stimulus, including the newly enacted tax law. As noted in the top panel, we had anticipated many provisions of the new law, including the pull-forward of cuts in marginal tax rates, marriage-penalty relief, and the boost in the child tax credit. But the law also contained provisions we hadn’t anticipated in the April Greenbook—notably, the dividend and capital gains tax cuts, an increase in the partial-expensing allowance for equipment investment, and some grants to state governments. Moreover, the personal tax reductions are occurring sooner than we had expected. Taking account of the new tax law plus the continuing effects of earlier tax cuts and the large increase in defense spending, we estimate that fiscal impetus at the federal level (shown by the black line in the middle left panel) will be very large this year and next. Indeed, the cumulative amount of stimulus now in train well exceeds that provided by the tax cuts and the defense buildup during the Reagan Administration. Only a small part of this stimulus is expected to be offset by restraint at the state and local level, shown by the red line.

    Financial conditions are also conductive to growth—and have become more so since the last forecast round. Given the rally in stock and bond markets, we have revised up our assumed path for the Wilshire 5000 (the middle right panel) about 10 percent. We have also taken on board the substantial decline in a wide array of long-term interest rates, including the mortgage rate displayed in the bottom left panel. As shown to the right, we have incorporated the further depreciation of the dollar since the last Greenbook.

    Your next chart takes a look at financial conditions in the household sector. On the whole, we think households are in good financial shape, though there are pockets of stress. As shown in the top left panel, the household bankruptcy rate has continued to rise, no doubt boosted by the still soft conditions in the labor market. However, the bankruptcy rate focuses on the worst tail of the distribution and does not tell us much about typical households. Broader measures of loan performance have been sending a more positive signal. As shown by the red line in the panel to the right, the delinquency rate on all household loans at commercial banks continued to trend down in the first quarter. At the same time, the delinquency rate on auto loans at finance companies (the black line) has ticked up but remains near the bottom of its range over the past decade.

    Households have been restructuring the liability side of their balance sheets through another wave of mortgage refinancing. As shown by the red line in the middle left panel, the “coupon gap,” which measures the difference between current mortgage rates and the average rate on the stock of existing loans, is currently very wide, providing a strong impetus to refinancing activity. We estimate that “refi” volume (the black line) hit yet another record this month, with households extracting a sizable amount of cash through these transactions. Even though mortgage debt has been growing rapidly, the household debt service burden (shown to the right) has been edging down in recent quarters, owing to the decline in interest rates and the lengthening of loan maturities. Going forward, we expect debt burdens to lighten further, as income growth picks up and as households continue to refinance higher- cost debt.

    Turning to the asset side of the household balance sheet, some observers have continued to raise concerns about the emergence of a housing price bubble. The lower panel shows that house prices, as measured by the repeat sales index for existing homes, indeed have been growing rapidly in real terms. While we would not entirely dismiss concerns about a bubble, we believe the price increases in recent years largely reflect solid fundamentals—most notably, the sharp reduction in mortgage interest rates. The rate of house-price appreciation has tapered off from its peak in 2001, and looking ahead, we expect the gains to slow quite a bit further. However, outright declines appear unlikely under our forecast of above-trend economic growth and only small increases in mortgage rates.

    As shown in the top left panel of your next chart, businesses also have been taking advantage of the drop in long-term interest rates to improve their balance sheets. The corporate sector has been relying heavily on bond financing (the red bars) while paying down bank loans and commercial paper (the hollow bars). This substitution toward longer-maturity debt is now in its third year, and the cumulative effect can be seen in the panel to the right. The red line plots the aggregate ratio of current debt to assets for nonfinancial corporations, where current debt consists of short-term obligations plus the portion of long-term debt due within one year. As you can see, this ratio has fallen to the lowest level in more than a decade, even though the ratio of total debt to assets (the black line) has not changed much on net in recent years.

    The combination of lower interest rates and the shift toward longer-maturity debt has reduced the debt service obligation for corporations, as indicated in the middle panel. We have defined this obligation as interest expense plus debt due within one year, expressed as a percent of after-tax cash flow. The debt service obligation for the median investment-grade firm (the black line) has now reversed its entire run-up between 1997 and 2000. For the median speculative-grade firm (the red line), the decline has been less pronounced but this series still has fallen to the lower part of its historical range. These trends are obviously good news about corporate financial positions.

    At the same time, many companies are having to cover funding shortfalls in their defined-benefit pension plans. As noted in the bottom left panel, pension contributions by S&P 500 firms tripled in 2002, reaching $45 billion. Although this is a sizable figure, we doubt that the pension situation poses a major threat to the health of the corporate sector. For one thing, the funding gap is highly concentrated among investment-grade firms, which accounted for roughly 90 percent of all contributions last year. Moreover, even for these firms, last year’s pension contributions amounted to only a small part of their total cash flow—about 5 percent by our calculations. Overall, we believe that corporate financial positions have improved a fair bit, and financial markets evidently agree. As shown by the red line to the right, the spread between the yield on ten-year BBB-rated bonds and comparable maturity Treasuries has dropped sharply from its peak recorded last fall. In addition, as shown by the black line, a market-based measure of expected defaults over the coming year has moved lower as well.

    Against this backdrop of stronger financial conditions, a key element of our projection is the outlook for business investment, addressed in your next chart. As I noted earlier, the data on nondefense capital goods through May painted a mildly encouraging picture about the demand for business equipment. In contrast, as the top right panel shows, nonresidential construction activity remained quite sluggish through April, our latest reading.

    To gather more timely information about the investment outlook, we asked the Reserve Banks to query their business contacts on this topic. As noted in the middle panel, about 35 percent of the respondents plan to increase their capital spending over the next six to twelve months, somewhat outweighing the 20 percent that intend to reduce spending; the rest plan to leave their outlays about unchanged. These responses seem roughly consistent with our forecast of a moderate uptrend in nominal investment spending in coming quarters. Among the firms planning to boost their spending, about two-thirds said that they had already started to place the orders to achieve this increase. We also asked about the major factors driving the reported plans. Few respondents mentioned the cost or availability of external finance, and an equally small fraction cited the partial-expensing provisions as a reason to increase spending over the relatively short horizon on which we focused. Rather, the outlook for sales growth was the factor cited most often—both by firms that plan to increase outlays and by those that don’t. This focus on sales growth accords nicely with a standard accelerator model of investment.

    The bottom panel characterizes our outlook for equipment and software spending, using the accelerator framework. This panel shows the historical relationship between the growth in real E&S spending (on the vertical axis) and the acceleration in business output (on the horizontal axis). As you can see from the red dots, spending in both 2001 and 2002 was below the regression line, and we expect 2003 to end up as another weak year. However, our projection for 2004 is considerably brighter. We expect the degree of business caution to fade, which should provide a substantial direct lift to spending and also make firms more willing to take advantage of the tax incentives and low financing costs now available. Karen will now continue our presentation.

  • Your first international chart presents an overview of developments in selected international financial markets. As can be seen in the top left panel, both the narrow index of the foreign exchange value of the dollar in terms of the currencies of the major foreign industrial countries (in black) and the broad index that also includes the currencies of our other important trading partners (in red) have fallen further and at a faster rate since the January chart show than during the six preceding months. On balance, the index for major currencies has fallen 6 percent since the end of January this year and nearly 20 percent from its peak value at the end of January 2002. As can be seen in the panel on the right, the dollar has depreciated particularly sharply in terms of the euro, moving down about 25 percent from its recent peak in January of last year. The dollar has fallen significantly against both the Canadian dollar and the yen as well, with the stepdown against the yen coming during the first half of 2002; the yen–dollar rate has fluctuated narrowly and changed little on balance since then.

    The depreciation of the dollar has been broadly consistent with changes in corresponding long-term interest differentials, shown in the middle left panel. Although dollar rates are above yen rates, they are below rates in Germany and Canada. Since the January chart show, ten-year government bond yields have decreased in these markets, but U.S. dollar rates have dropped more than German and Japanese rates.

    Borrowing costs have diminished for emerging-market economies as well in recent weeks. EMBI+ spreads for Argentina and Brazil, shown on the right, have fallen to levels not recorded since the spring of last year. Apparent increased market willingness to invest in riskier assets and to seek return as yields have fallen in the industrial countries partly accounts for the declines in spreads. The absence of any major unfavorable developments within these emerging-market economies likely contributed as well.

    As can be seen in the bottom panels, stock prices are generally up in recent weeks in the foreign industrial countries (on the left), and major emerging-market economies (on the right). But since the January chart show, stock prices in continental Europe and Japan are up somewhat less than the S&P 500.

    Your next chart reports the results of our efforts to use the staff’s econometric models of the United States and the rest of the world to address the question, “What have been the effects of the dollar depreciation to date?” Clearly our answer depends on the properties of our particular models. But even for a given model, there is no single answer to that question because, in order to design the exercise for the model, the analyst must give a reason why, in the counterfactual scenario, the dollar would not depreciate as it had in fact done in real time.

    For our first counterfactual scenario, we posited that each bilateral dollar exchange rate in the model remained at its value in the first quarter of 2002, when the dollar on average peaked. We also held short-term monetary policy interest rates constant at their values in 2002:Q1 because the exchange rate is importantly affected by monetary policy and we wanted to begin with no exchange rate effects coming from changes in policy rates. This scenario treats the constant paths of exchange rates as resulting from shocks to risk premium terms in the equations that relate exchange rates to long-term interest differentials and the counterfactual short-term interest rates. As can be seen in the top left panel of the chart, the effect of the dollar depreciation since early last year as structured in our simulation has been to increase import price inflation (the bars) above what it otherwise would have been by an amount that rises to more than 4 percentage points for the first half of this year and then diminishes somewhat. Such an increase in import prices is large enough to make a difference for PCE inflation (the black line). The staff’s FRB/Global model calculates that the increase in PCE inflation owing to the dollar as modeled in this case rises to ½ percentage point in the second half of this year. As can be seen in the right panel, the weaker dollar is also a net stimulus for real GDP growth. In this scenario, that stimulus is calculated to have been negligible in 2002 but to have added about ½ percentage point to real GDP growth in the first half of this year and is projected to add 1 percentage point in the second half. Other models might not estimate effects quite this large.

    The answers provided by the first scenario reflect the imposed condition that short-term interest rates remain unchanged. In general, monetary officials could be expected to respond to the consequences of strong exchange rate pressures. Accordingly, the middle row of panels provides a second set of estimates in which we retained the shocks to the exchange rate risk premiums calculated in the first case but allowed the model to adjust monetary policy both here and abroad in response to these developments and their effects on output and prices according to Taylor rules. As a consequence, both interest rates and exchange rates do not remain unchanged at their 2002:Q1 level. This counterfactual allows for some feedback on exchange rates from the monetary policy response to the pressure on the dollar and its consequences. When monetary policy is allowed to respond, the calculated implications for U.S. import prices, consumer prices, and real GDP growth of the dollar depreciation since early last year are damped. In this estimate, the effects on import price inflation rise only to around 2¾ percentage points, so PCE inflation is boosted only ¼ percentage point. The estimated stimulus to real GDP growth is reduced to less than ¼ percentage point in the second half of this year. As is evident from the range defined by these two estimates, there is no single answer to this question. But we see this range as a reasonable bound for the extent to which dollar depreciation to date has raised U.S. inflation—and so countered deflation—and helped to support real output growth.

    The effects on other countries are reported in the bottom panels as “fixed” for unchanged policy rates and “Taylor” for policy rates governed by Taylor rules. The euro area experiences a substantial reduction in price inflation and GDP growth even in the case in which monetary policy reacts to the exchange rate pressure, suggesting that the appreciation of the euro is important in explaining current euro-area sluggishness. By contrast, the effects are much smaller on the other industrial countries. The currencies of developing Asia were fairly stable against the dollar over the past six quarters, so they too have experienced depreciation on a weighted average basis since 2002:Q1. Thus our model estimates that they have experienced higher inflation and stronger output growth as a result of currency depreciation to date.

    Your next chart presents some evidence on the stance of monetary policy that is currently in place in two of the major foreign industrial economies—the euro area and Canada. The top panels show our calculations for each of these regions of the output gaps currently implied by our baseline forecast. For the euro area (on the left), the gap will widen over the forecast period, as growth remains below potential until near the end of the forecast period. In contrast, we project that actual output will remain slightly above potential in Canada over the same period. This projection assumes another easing of 50 basis points by the ECB by year’s end and no change in the Canadian policy rate.

    The middle left panel compares the actual path of the ECB’s policy rate (the black line) with the expectation for that rate that we incorporated into the Greenbook at the time of your chart show one year ago (the red line) and to the market’s expectation at that time (the dashed blue line). Since mid-2002, the ECB has implemented a somewhat easier policy than we and the markets were expecting a year ago, as economic performance has been disappointing. The bottom panel compares the ECB’s policy rate to two variants of a Taylor rule prescription. The first, the red line labeled “Taylor Rule #1,” utilizes imposed coefficients that equally weight deviations of inflation and growth. By that standard, the ECB has been a bit more expansionary than the Taylor rule indicates, as the rule implies continued effort to move inflation below the 2 percent target.

    The standard Taylor rule can be criticized as incorporating insufficient forward- looking information. The recent declines in oil prices and the appreciation of the euro can be expected to lower inflation in the euro area over coming quarters. In the spirit of including these factors into the assessment of the current policy stance, we calculated “Taylor Rule #2,” the dotted blue line, retaining the same coefficients but substituting for observed inflation the staff forecast for inflation six quarters ahead. By that standard, ECB policy has been and continues to be tighter than the rule would prescribe, even given the recent cut of 50 basis points.

    Similar comparisons are presented for the Bank of Canada policy rate on the right. A year ago, we and the market were expecting the Bank of Canada to tighten by more than in fact has been the case to date. Although Canadian economic growth has remained above potential, the slowing of the U.S. economy and the appreciation of the Canadian dollar stayed the hand of the Bank in raising rates. Compared with Taylor rule calculations, in the bottom right panel, the Canadians appear to have been somewhat expansionary. The move up in rule #1 reflects the rise in headline inflation, which in turn owes importantly to oil prices.

    On balance, the success of the Bank of Canada in keeping that economy close to potential suggests that they have adjusted policy sufficiently in response to economic developments over the past year. For the ECB, the picture is more clouded. Since 2002 Q1, the ECB has lowered rates a total of 125 basis points. We cannot replicate for certain with our models exactly what the shocks have been that have struck that economy since early 2002. But our attempts to quantify the effect of the exchange rate change over that interval suggest that the ECB would need to lower rates significantly more, perhaps as much as a total of 300 basis points, to offset the contractionary effect on euro-area GDP of the exchange rate change they have experienced.

    Our outlook this time for the U.S. external sector is summarized on the next chart. Total foreign real GDP growth, line 1 in the top left panel, is projected to grow at an annual rate of about 2½ percent during the second half of the year—a substantial acceleration of real GDP from the first half. Next year, we look for growth abroad to rise further. Among the industrial countries, activity is likely to remain lackluster in Japan and improve only gradually in the euro area, whereas Canada should continue to outperform the other foreign industrial countries. Growth in developing Asia (the right panel) is projected to rebound over the second half of this year, but to a lesser extent than we previously thought, as incoming data have surprised us on the low side. We are also expecting a pickup in expansion in Latin America, with Mexican real growth recovering in line with U.S. growth.

    Our forecast for the real exchange value of the dollar in terms of all of our trading partners (the middle left panel) reflects the downward shift in the market value of the dollar that has occurred since your January chart show. We still see likely factors that will put upward pressure on the dollar—as the U.S. recovers more vigorously than elsewhere—and factors that will put downward pressure on the dollar, as the financing needs of the widening external deficit grow over the period ahead. With no way to judge just how these will balance over time, we have put into the forecast a very gradual downward trend in the dollar, reflecting the inevitable need for external adjustment to occur some day.

    The implications for real exports and imports of a lower path for the dollar, a slightly stronger outlook for the U.S. economy, and a somewhat weaker foreign outlook, especially in the near term, are shown to the right. Exports (in red) are projected to rebound and to make a significant positive contribution to GDP growth through 2004. Imports (in blue) should expand some during the rest of this year and then accelerate strongly, resulting in a negative contribution of more than 1 percentage point in 2004. On balance, real net exports should make a small positive contribution over the remainder of this year and a moderate negative one during next year.

    Our near-term projection for the current account, the bottom left panel, is for the deficit to reach $600 billion by the end of next year. The widening of the projected trade deficit explains all of the change in our outlook for the current account balance. The table on the right reports the data just released for the balance of payments in the first quarter. Whereas net official inflows (line 1) rose in the first quarter from their average last year, net private financial inflows (line 2) slowed. Within private flows, foreign purchases of U.S. securities (line 3) diminished, and foreigners were net sellers of U.S. equity (line 4). The resumption of U.S. purchases of foreign securities (line 5), particularly equity, contributed to the U.S. external financing need. Foreign direct investment into the United States (line 7) recovered to a pace about equal to U.S. direct investment abroad. Going forward, we expect that more-robust U.S. growth will continue to attract foreign private financial inflows, but the financing need will be growing as well. Accordingly, some additional net inflows of official capital and some downward nominal adjustment of the dollar are likely. David Wilcox will now continue our presentation.

  • Chart 10, your next chart, shifts the focus back to domestic considerations and outlines the major factors conditioning our outlook for inflation. As shown in the top left panel, we expect that a significant, though narrowing, margin of slack will persist over the forecast period—enough to take a couple of tenths off core inflation both this year and next. Although consumer energy prices (the top right panel) have begun to soften, for the year as a whole we still expect them to contribute about a tenth to core PCE inflation. Next year, we expect them to be a neutral influence. Likewise, we expect core non-oil import prices (the middle left panel) to add about a tenth to core inflation this year and to have no net influence next year. All in all, as shown by the red line in the middle right panel and on line 5 in the table at the bottom of the page, we believe that core PCE price inflation is in the process of stepping down fairly noticeably this year, and we expect it to edge down further next year. As can be seen by comparing lines 5 and 6 in the table, we have revised down our forecast for core PCE price inflation both this year and next by about 0.3 percentage point since the January Greenbook.

    The deceleration in core consumer prices over the past year, together with the likelihood that an appreciable amount of economic slack will persist for several more quarters, has—as you know—generated intense interest in and speculation about the possibility that the U.S. economy will begin to experience deflation. The next two charts touch on some aspects of the report on this topic that I wrote with Doug Elmendorf and Dave Reifschneider and that was distributed to you earlier this month.

    The first of these charts summarizes and updates our efforts to assess the probability of deflation and related events. As noted in the top panel, we computed these probabilities using stochastic simulations of FRB/US, the Board staff’s large- scale econometric model of the U.S. economy. For the purpose of these simulations, and consistent with the analysis in the rest of the paper, we defined “deflation” as occurring whenever the Q4/Q4 change in the core PCE price index is less than the estimated measurement bias in that index, ½ percent. Importantly, our definition is meant to encompass a much broader range of circumstances than many observers have in mind when they describe deflation as inevitably generating a downward spiral in economic activity. Also in the realm of definition, we treated the zero bound as having been hit whenever the annual average of the funds rate is less than 25 basis points. We assumed that monetary policy follows a version of the Taylor rule, but with the zero bound enforced. We drew the shocks for the simulations from the model’s residuals over the period 1970-2002. In the paper we circulated to you earlier, we took the April Greenbook forecast as defining the baseline, but the results we show here take the June Greenbook as defining the baseline. However, you will note if you refer back to the original paper that the differences attributable to this change are small.

    The middle panel uses FRB/US to calculate confidence intervals around the staff’s baseline inflation forecast. In particular, the darkest region gives the 50 percent confidence region; the intermediate shading shows the extent of the 75 percent confidence region, and the lightest shading shows the 90 percent confidence region. Thus, for example, in the fourth quarter of 2004, roughly half of the probability mass is estimated to fall between zero and 2 percent. Put slightly differently, about 25 percent of the outcomes show the measured rate of change in core PCE prices over the four quarters of 2004 falling below zero, thus corresponding to true deflation of ½ percent or more; and another 25 percent show the measured rate of change coming in above 2 percent.

    The bottom left panel reports the probabilities of some specific events. As shown on the first row of the table, taking the June Greenbook projection as the baseline, we put the probability of deflation at about 15 percent for this year, just short of 40 percent for 2004, and about 40 percent for 2005. As shown on the second row, we estimate that the risk of hitting the zero bound is lower because, in many of the stochastic simulations, deflation is induced by favorable productivity shocks. As shown on the third row, the probability of both experiencing deflation and hitting the zero bound is smaller still, but nonetheless represents about a 1-in-6 event for 2004 and a 1-in-7 outcome for 2005.

    The bottom right panel provides a model-based perspective on one element of the potential cost of deflation. According to FRB/US, a number of aspects of macroeconomic performance deteriorate when a central bank pursues a very low average rate of inflation; the one we have highlighted here is that the central bank’s ability to stabilize real activity is somewhat impaired. As shown on the first row, at an average CPI inflation rate of 2 percent (the right-hand column), the central bank is able to limit the standard deviation of the unemployment rate to 1.5 percentage points. But at an average CPI inflation rate of zero—corresponding to bias-adjusted deflation of nearly 1 percent per year—the estimated standard deviation of the unemployment rate is 1.8 percentage points. Similarly, as shown in the second row, deep recessions are somewhat more frequent when the average inflation rate is very low, according to the model. While these effects are modest, they nonetheless suggest that your choice of an average inflation objective is a matter of some consequence for the performance of the macroeconomy.

    Your next chart poses a series of questions about the conduct of monetary policy raised by this analysis. First, there is the question as to whether you should aim to put an additional cushion between zero and the long-run average inflation rate beyond any allowance you might make to take account of measurement bias. The asymmetric nature of the zero lower bound and the downward rigidity of nominal wages might incline you toward the view that you should but would leave open the question of how large the additional cushion should be. As noted in the left-hand column, you might lean toward a larger cushion the more concerned you are about the adverse effects of the zero bound and nominal wage rigidity; you might also build in a larger cushion the greater you see the underlying volatility of the economy as being. On the other hand, as shown in the right-hand column, you might be inclined toward a smaller cushion the greater your confidence in the efficacy of the alternative approaches to the conduct of monetary policy that were discussed yesterday afternoon. You might be so inclined as well if you are concerned about the efficiency loss even from low positive inflation—for example, from the impairment of the effectiveness of the price system, the greater scope for losses from nominal illusion, and so forth.

    A second question has to do with how aggressive you should be in moving to head off any incipient deflationary pressures. As shown on the left, a first motivation for aggressive and preemptive cuts in the federal funds rate might arise from concerns that nontraditional policy actions will not be effective. A second motivation could center on second-moment considerations; thus, while you might think that nontraditional approaches would be effective, you might be concerned about the uncertainty surrounding any estimate of the effectiveness of nontraditional monetary policy. Under a conventional analysis of policymaking under uncertainty, that lack of assurance would justify moving aggressively to reduce the odds of your being put in that unfamiliar circumstance. On the other hand, as noted on the right, a less aggressive approach would be warranted the more you are concerned that markets would interpret an easing in that circumstance as signaling a downbeat assessment of the state of the economy or if you believe that the public would become unnerved if and when they see that you have no more scope for traditional actions.

    Finally, a third question has to do with whether your best course would be to counteract a deflation already in process even if real activity is currently at a satisfactory level. You could be justified in combating deflation in these circumstances if you were concerned about the efficiency cost of deflation, just as you have been concerned about the efficiency cost of inflation. The costs imposed by nominal illusion, partial indexation of the tax system, impairment of the price system, and heightened uncertainty about the future course of the macroeconomy would be reasons for moving to counteract deflation. In addition, you might be concerned that deflation—even in this relatively gentle form—could limit your ability to move policy aggressively to counteract a deterioration in real activity should one emerge down the road. On the other hand, as indicated to the right, you might take a very cautious approach in addressing the deflation if you believed that the factors giving rise to it would prove only temporary. A cautious approach might also be warranted if you believed that the deflation would ultimately prove self-correcting, as it might, for example, if it was induced by a favorable shock to productivity growth that so stimulated aggregate demand as to lay the groundwork for an eventual acceleration of prices.

    Your final chart displays your projections for 2003 and 2004. As shown in the top panel, the central tendency for the growth of real GDP is ¾ percentage point lower than at the time of the January meeting, and the central tendency projection for the unemployment rate is ¼ percentage point higher. The projection for PCE price inflation is unrevised. As shown in the bottom panel, you anticipate a pickup in the growth of real GDP next year, little change in the inflation rate, and a somewhat lower unemployment rate by the end of the year. We would now be pleased to take any questions you may have.

  • Steve, could you just repeat the statement you made with respect to corporate funding of pension funds? Did you say that, for investment-grade firms, 5 percent of cash flow was contributed to pension funds? Is that what you said?

  • In 2002. That’s right.

  • Thank you, Mr. Chairman. I have a question about the Greenbook baseline and also about the alternative simulations. First, after reading the text in the Greenbook, it seemed somewhat surprising to me that you had the real growth numbers for the second half of this year as low as they are. I’d be interested in what the results might have been had you allowed the model just to run. That’s one question. Second, as always, the alternatives are very interesting and certainly cover a very wide range of potential experience. But I’m rather amazed—I think that’s the right word—that the lowest rate of growth for 2004 under any of the alternatives is about 4¾ percent. If I went through this exercise, maybe I’d have a similar problem. But I would say that, if one used a VAR model that is affected very much by what has happened to the economy in the last three quarters, it would be pretty easy to get numbers that are a lot lower than these. I just wondered whether you think real growth rates of 4¾ percent and above really are where one would expect the reasonable alternatives to lie.

  • Let me address first the question of what we did to our forecast for the second half of the year. We marked it up by less than one might have done simply on the basis of taking on board the changes in conditioning factors such as fiscal policy and financial conditions. We did that, I think, on the basis of two main considerations. First, in the current climate of business caution that we see, it seemed plausible to us that there would be a smaller reaction—especially by businesses but also perhaps by consumers—than one might expect in ordinary macroeconomic times to the additional fiscal stimulus that has been put in the pipeline. Second, we think that part of the additional demand in the second half will be met out of inventories as businesses will be reluctant to step up production until they become more assured of the solidity of the economic expansion.

    I’m not quite sure how to answer the question about what would have happened if we had just let the model run, given that our model is thirty or forty judgmental analysts. [Laughter] If we had tossed the question to FRB/US, I think we might have gotten something on the order of another ½ percentage point or so of growth in the second half of the year. In part, I think that is spoken to in one of the alternative simulations where we show a weaker-yet response to the fiscal stimulus, which results in ½ percentage point or so less real growth than in the baseline. As to how reasonable it is to show a set of alternative simulations almost all of which have growth rates with a leading digit of 4—

  • Even the second-half result of 3.5 percent growth with the “weaker response to fiscal policy” alternative is impressive.

  • I agree with you that it’s impressive. Another impressive feature of the current situation is the amount of stimulus that is in the pipeline from various sources. They were enumerated by Steve: an unprecedented amount of federal fiscal stimulus, a significant depreciation in the dollar, a 20 percent rebound in the stock market from its low, and a very marked reduction in long-term interest rates. With all that, it certainly looks to us as if the odds are very heavily tilted toward a significant acceleration in economic growth. I do think there are risks to the downside, but there are even risks to the upside of our quite robust baseline projection.

  • Obviously, we can always weave together a series of very plausible outcomes. For example, let’s say we started with weaker productivity growth than we are currently forecasting. If that were to come as a substantial disappointment to financial market participants, one could imagine that, as we pushed out yet again the diminishment of this unusual restraint on investment spending until the middle of next year, we’d have the resource utilization gap remaining. Suppose the gap did not diminish at all over the forecast period. I think the combination of those developments and maybe a little less impetus to spending from the fiscal policy that has been enacted could quite easily get the GDP growth forecast into a range of something that started with a 3 and not a 4. We certainly did not intend the alternative scenarios to suggest that it would be unreasonable to imagine a forecast that was running in the 3½ to 4 percent range next year; I think that would be quite reasonable. David indicated his confidence intervals on the inflation side; the confidence intervals on the real GDP side are quite wide, too, as you know; and a forecast as low as you were suggesting would fit within them quite comfortably.

  • Picking up on President Parry’s comment and looking at the central tendency of the FOMC projections shown in chart 13, we more sage and conservative people also are predicting something above 4 percent for real GDP next year and about 1 percent inflation, which historically is a highly unlikely configuration. In a speech a few months ago I suggested that a relatively easy way to improve the transparency of the FOMC would be to detach these projections from the Chairman’s testimony and release them in a more timely way, perhaps with the minutes of the previous meeting. It occurs to me that the numbers that we see here would be quite useful to release to the public in two senses. One, this combination of unusually high growth and low inflation would make very clear on what we base our balanced risks for growth going forward combined with our downward risks to inflation. Second, I think it would support the financial market configuration that we’re looking for, which is a strong stock market and a strong bond market. So I think these FOMC member projections, which are somewhat more muted but nevertheless quite strong, would be quite supportive of our objectives. I’m wondering, is it on the table that we might let those be released a tad earlier?

  • This is an issue on which I think we really ought to come to a conclusion. We’ve procrastinated on it. The problem that occurs is that if we wait until my testimony to release these forecasts, they are usually obsolescent by then, and I find myself struggling to reconcile those old forecasts with the latest data. I don’t know what to suggest at this stage. You’re raising an important question, but I don’t think we have the time to discuss it at this point. Dave, do you have a suggestion on this?

  • Well, obviously you want to think through the full implications of this. With an earlier release of the FOMC central tendency forecasts, one difficulty you might face in your testimony would be that, with the added three weeks of data, people will be asking you to provide an update on it. You may or may not be in a position to do that. But other than that, I’m not sure that I see any substantial downside risk.

  • Well, I always have the obvious answer to the problem you mentioned. I can say that I have not spoken to more than a fraction of my nineteen colleagues on the FOMC since our meeting, and I can arrange for that to be the case! [Laughter]

  • It probably would be a wise thing to do!

  • We’re going to have to make a judgment on this issue. An obvious alternative is to put this information in the announcement today, which I would frankly recommend against largely because these numbers don’t seem to square exactly with what we’re saying in the statement, though technically they do. These are fairly large numbers and very benevolent ones if I may say so. The trouble is that they’re always benevolent. I don’t recall in recent history a projection coming from the Committee that was as negative as suggested by the discussion that we tend to have around the table. In fact, I would say that if somebody actually sat down and tried to square the individual Presidents’ remarks with what is submitted in these forecasts, there would be some dissonance. I haven’t done it, but I’ve been around long enough to be aware of that phenomenon. If you want to find out, after each one of you discusses what is going on in your regional economy, announce the number you submitted. Nevertheless, I think we do have to address the issue. It shouldn’t be today. But when would be the appropriate time to release our FOMC forecasts is an interesting question. One possibility is to attach them to the minutes for the May meeting when we release them—is it Thursday?

  • On Thursday, yes, Mr. Chairman. I put a cover memo on the materials on communication policy that we circulated yesterday asking for the Committee’s guidance as to when it would be appropriate to discuss general issues about transparency— whether it should be at a lunch, at a one-day meeting, or not until January. This is one topic that I can put on the agenda whenever you’d like.

  • Yes, I would think so. I assume nobody would object to that. We probably can’t resolve this issue prior to my upcoming testimony, but we ought to discuss what we want our policy position to be on it. It shouldn’t be decided ad hoc largely because I think it’s a more important issue than we may have realized in the past.

  • Just on this point, Mr. Chairman. I agree that it should be done in the context of a larger discussion of transparency because there may be some other things we want to announce at the same time. Also on this particular point, you do give the Reserve Bank Presidents and Board members a chance to change their forecasts after hearing the discussion at the FOMC meeting.

  • So we’d have to change that policy, too.

  • Yes, and I don’t think we want to change that policy. That’s a good point, and I had forgotten about that.

  • Just one other intervention. We’re asked to do our individual forecasts in the context of what we consider to be the appropriate monetary policy, and we might not all have the same conclusion about what that is.

  • No, that has always been a problem, and we’ve scrupulously avoided resolving that question.

  • David, I found chart 12, “Implications for Monetary Policy,” very helpful in trying to think through some of the issues we will get to later in the meeting. In the middle panel there, you make the point that one argument for being more aggressive would be a concern that nontraditional approaches would not be effective. On the other hand, suppose one were confident that such approaches would be effective and had a sense that the public shared at least some of that confidence. Could it not also be said that having that confidence would support being more aggressive because we wouldn’t be afraid of getting close to the zero bound and the possibility that we might have to use those approaches? Could you make that argument?

  • I may not have understood your question, but in general on this chart one could take everything in column A and say its opposite would apply in column B. So indeed, the greater one’s certainty about the effectiveness of nontraditional approaches, the more complacent one could be in taking preemptive action against a forecast of deflation.

  • I had a quick question about the survey on capital spending plans. Obviously, capital spending is the key to the forecast for the near-term future. I was wondering if we had ever done this type of survey before. If so, what level of confidence do we have in it, and has it helped us in the past to predict future actual spending by business firms?

  • In January we also had a set of special questions on capital spending plans. I think what might have been a little different this time around—and others can correct me if I’m wrong—is that we tried to structure the questions to get quantitative responses that we could tabulate as opposed to a more qualitative sense of what respondents’ views were. But yes, we’ve done something like this before.

  • So we haven’t done it quantitatively before. I’m just wondering about the percentages you cited—that 35 percent are going to increase spending and 20 percent plan to reduce spending. You also said that two-thirds of those who plan to increase spending indicated that they actually have started to place the orders. Our District went the other way on that, which is rather interesting.

  • I’d have to say that we have no track record to assess the accuracy of this survey as a predictive tool.

  • Did you ask for specific percentage changes?

  • No, it was directional.

  • So there could be a significant dispersion among those who say they’re increasing capital expenditures in terms of how much they’re increasing them by.

  • Yes, that’s absolutely right. Across the Banks there was a fairly close correspondence in the answers to the top line question about increase, decrease, or no change. But as President Moskow noted, there were some discrepancies across the Banks with regard to the other questions—the more supportive questions about whether that was already happening or when the orders would be placed.

  • I’ll pass. I was going to talk about the disclosure issue, but I’ll pass at this point.

  • I have a very brief question on chart 12. You mentioned the concept that deflation could be self-correcting. The example you gave obviously was productivity improvements and so forth. Are there broader examples of self-correcting deflation? I could imagine perhaps a change in exchange rates and a pretty big pass-through of that. But what else would one put in the category of self-correcting deflation?

  • I think the major instance that we had in mind was a favorable productivity growth shock, which in our analysis—as we outlined in the paper—shifts aggregate demand up faster than it does aggregate supply.

  • All right, thank you.

  • You could also get self-correcting deflation if you had a monetary standard like a gold standard, which we don’t have, of course. An increase in the production of gold—

  • If there are no further questions, would somebody like to start the Committee discussion? First Vice President Stewart.

  • Thank you, Mr. Chairman. The New York regional economy has shown some signs of improving in the second quarter. Employment has recovered moderately in the past two months, housing markets appear to have retained good momentum, and there are signs of a revival in both New York City’s office market and in the region’s manufacturing sector, though the latter is still characterized as weak. New York City, which was hit by some of the steepest job losses in the District, has shown recent signs of a pickup, driven in large part by the financial sector. Though large corporations on Wall Street are still not hiring, smaller financial firms as well as legal and business service companies are reported to be adding staff. While New York City jobs data show only a slight recovery from the recent lows, the suburbs— where job losses were milder—have seen more of a rebound in jobs this year. Office vacancy rates have declined in the past two months, most notably in lower Manhattan. The midtown office market appears to have steadied but lower Manhattan’s market has firmed markedly, with vacancy rates dropping from 15 percent to 12 percent in just two months. Wall Street firms are reported to be seeing good growth in profits and revenues. Debt issuance has been strong, while equity and merger-related business remains at quite low levels despite a recent pickup in that high margin activity.

    New York City’s and New York State’s fiscal problems have been addressed largely through a combination of tax hikes and budget cuts. Widely publicized hikes in mass transit fares, tolls, sales tax rates, and regulated rents should have only a modest effect on the overall cost of living in the New York City area. In upstate New York, there are fewer signs of a pickup. Albany, usually one of the state’s star performers, recently saw a sizable downturn in employment. Rochester’s hard-hit manufacturing economy, dominated by firms facing intense foreign competition, remains weak. While Buffalo has sustained fairly mild job losses recently, the troubled finances of the city of Buffalo are being taken over by a state board.

    Our early June Empire State manufacturing survey indicated an improvement in business conditions, but commentary from respondents still characterized the sector as weak. The home purchase market has shown remarkable resilience, with inventories remaining tight across most of the District. In contrast, Manhattan’s rental market remains slack, with nonstabilized rents off about 20 percent from their 2001 peaks. Multifamily construction is remarkably brisk—mainly in New York City, which no doubt reflects the very long lead time for project approval.

    On the national scene we have seen substantial improvements in financial markets, in surveys of consumer attitudes, and in a number of business indexes. Given current levels of interest rates, the tax cut, increases in federal spending, and the drop in the dollar, a forecast of improved growth is certainly reasonable. However, we have yet to see any strong evidence of an actual pickup in spending, employment, or production. There has been a rebound in a few sectors—particularly in travel and recreation, which were heavily affected by the war—but as yet the forecast of overall improved growth remains just a forecast.

    Our business contacts have become less gloomy recently, but the tenor of their remarks is not yet optimistic. Firms seem to be quite hesitant to make capital spending commitments or to increase employment. In many instances they have substantial margins of excess capacity, some of it related to the technology and stock market boom of the 1990s. There is great concern about foreign competition and the lack of pricing power. Our middle market company contacts express growing anxiety about competition from China due to the latter’s significant pricing advantage and constantly improving quality. Many of these contacts expect capacity expansion to occur outside the United States for that reason. Businesses have become very disciplined about continually looking for ways to increase output with fewer workers, and they expect to continue that practice even as sales pick up later this year. For that reason we expect employment to significantly lag economic recovery—even more than was the case in the early 1990s.

    Our large company contacts tell us that management and boards are spending much of their time on governance and accounting issues, which is the cause of a more conservative risk attitude. It does seem quite likely that household spending will remain on track and could gain momentum with the tax cut. Certainly federal spending will be strong. Housing will continue to be quite robust as consumers take advantage of once-in-a-lifetime low mortgage rates. While state and local governments are raising taxes and trimming spending, this negative effect will be small compared with the fiscal stimulus from the federal government.

    The expected strength in household and government spending notwithstanding, some skepticism about a very positive outlook seems warranted. For example, the Greenbook forecast calls for 4½ million jobs to be created over 2004. We believe that the traditional relationship between economic recovery and employment is now much weaker because of new management practices and structural shifts in manufacturing that will continue despite the recovery. On balance, a forecast of improvement in growth looks logical. But we should be cautious about accepting it as a basis for decisionmaking until we see business activity pick up decisively. Housing and deficit spending are not a strong enough foundation for a sustained recovery. We still need clear signs that capital spending and employment are improving. Thank you.

  • Thank you, Mr. Chairman. Economic activity in the Seventh District remains sluggish. Our contacts are still cautious, but the pessimism that was so pervasive earlier in the year has eased. Much of the improvement in attitudes came on the business side. For example, in response to the Board’s special survey on capital spending, substantially more of our District contacts reported plans to increase outlays than to scale them back, and this is a significant improvement over what we were hearing earlier in the year. However, as I mentioned before, in our District the increases we hear about for the most part are still plans; the outlays haven’t started yet, and the CEOs I speak with remain cautious about spending.

    Several of our commercial real estate contacts said that they had seen a pickup in inquiries and property showings but that this had not yet led to an increase in actual leasing. More generally, we hear reports of increasing merger-and-acquisition activity from lawyers and from investment bankers and other intermediaries. Business travel continues to recover, leading at least one major air carrier to restore some previously canceled flights. Moreover, we’ve heard reports that many firms are easing travel restrictions, as concerns surrounding the war in Iraq and the SARS epidemic wane. Despite the modest improvement in business attitudes, firms remain reluctant to hire. Although the BLS in its last survey reported an increase in temporary help, both Manpower and Kelly Services said that orders remained flat through May. Kelly indicated, however, that orders edged up in each of the first two weeks in June. On the household side, sales of both new and existing homes remain robust. But retailers continue to tell us that their sales are disappointing, especially given that they’re offering steeper discounts and more promotions.

    In terms of autos, our contacts report little if any improvement in sales so far in June. At our recent auto outlook symposium held in Detroit, the consensus forecast called for light vehicle sales to average about 16.5 million units for the remainder of this year and 16.7 million units for next year. That pace will not be sufficient to reduce inventories. Some of these stocks are likely a buffer for the upcoming UAW negotiations and will be drawn down if there is a strike. Otherwise, automakers will have to cut back production later unless sales increase to a pace significantly above their forecasts. Weaker prices for used cars also point to overcapacity in the industry. Automakers are beginning to express concern that these weak prices are pushing their dealers’ profit margins to very low levels.

    Outside of autos, District manufacturing generally remains sluggish. “Bouncing along the bottom” is a phrase that we continue to hear quite often. However, there have been some pieces of good news. A few manufacturers reported that a weaker dollar had helped boost orders in May. A major national distributor of computer hardware and software reported that the past three and a half weeks have been the strongest since last October. The Chicago Purchasing Managers’ survey for June will again be above 50; the index will be 52.5, up slightly from 52.2 in May. These survey results are confidential until they’re released next Monday.

    Turning to the national outlook, the data indicate a slight pickup in growth as we moved through the spring. In real terms, the national retail sales numbers show some strength outside of autos. Housing markets are still robust, and financial indicators are positive. Still, the increase in activity appears to be fairly modest. The lack of hiring is very troublesome, and CEO caution—perhaps due to corporate governance concerns—continues to restrain the recovery in capital spending. While our contacts certainly have become less concerned that another downturn is imminent, few are optimistic that a significant step-up in activity is just around the corner.

    In terms of our forecast, a number of factors point to more-solid increases in economic growth. We’ve talked about many of them: accommodative monetary policy, improved equity markets, fiscal stimulus, a lower dollar, and the capital replacement cycle. To date, however, we haven’t seen enough improvement in the numbers or in our contacts’ attitudes to convince us that a pickup is in train. Of course, the longer we remain in this slow growth spot, the more questions are raised about the strength of the underlying fundamentals. For now, we’re still betting that the fundamentals are strong. We project that real GDP growth will average somewhat above potential in the second half of this year and that output will rise more substantially in 2004, but we’re roughly a percentage point below the Greenbook projection of 5.3 percent for 2004. Under either forecast, resource gaps will not close much until we move into next year. Persistent resource gaps and the possibility of hitting the zero bound are legitimate concerns. It’s unlikely that the overall price level will actually fall, but inflation could nevertheless head to levels that would be uncomfortably low in the current economic environment. So, the cost of taking out insurance in the form of reducing rates is low.

  • Thank you, Mr. Chairman. The Twelfth District economy has shown little sign of ending its lull. Consumer spending did not pick up much as the conflict in Iraq subsided, and it even weakened a bit in some areas. Many retailers have been struggling with thin margins, especially in Washington State and Oregon, which have had the highest unemployment rates in the nation. In Washington, Boeing’s production of commercial aircraft has dropped to its lowest levels since the mid-1990s, and the state has offered Boeing substantial financial incentives to produce its newest commercial aircraft there rather than in one of the numerous competing states. The District manufacturing sector more generally has been struggling as well. For many IT products, demand has been especially weak of late, due in part to the restraining effect of SARS on retail purchases of IT products by consumers in mainland China. Few District manufacturers have plans to expand their capital investment spending this year, although firms in other sectors are more upbeat.

    We also see some upbeat news in data for a few key sectors. New home sales and construction have maintained a torrid pace, with only the slightest hint of slowing reflected in a moderated pace of price appreciation in some areas. Increased federal government outlays for defense hardware have provided substantial stimulus to local economies, with southern California and especially Arizona ranked among the primary recipients of the new contracts. As yet, however, the District has shown little or no sign of an improved employment outlook overall. The depth of the job losses in some areas is startling. In the San Jose MSA, which contains Silicon Valley, employment has fallen 18 percent since its peak in late 2000; and the overall job losses in the San Francisco Bay area rival southern California’s losses during its economic doldrums in the first half of the 1990s.

    The persistent economic weakness means that there has been little relief for most states facing large revenue shortfalls in the upcoming fiscal year. In California, budget negotiations are deadlocked; and with the campaign to recall Governor Davis now emerging as a significant distraction, the state is unlikely to approve a new budget until several months have elapsed in the new fiscal year. In the meantime, the state expects to sustain adequate cash flow through September largely through the recent sale of $11 billion in warrants backed by future revenues. After that, additional and more costly short-term borrowing will be required unless a workable budget is in place. California is also grappling with severe problems in its workmen’s compensation system. Last year the typical Californian employer saw a 40 percent increase in workers’ comp costs, and the trend has continued this year. This is large enough to noticeably increase growth in total compensation costs, causing some current and potential employers to reevaluate the desirability of operating in California.

    Let me turn to the national economy. Taken as a whole, the data on the current quarter have been weaker than we expected, continuing the pattern of disappointing news that we’ve seen for several quarters in a row. As a result, we’ve once again revised down our estimate of growth, this time by a full percentage point. That said, there have been a few signs of improvement in activity very recently, although they by no means constitute evidence of the long-anticipated rebound.

    Going forward, financial developments and the recent fiscal package have caused us to revise up our forecast for the next year and a half, although we are far less optimistic than the Greenbook. Assuming a funds rate of 1 percent, our forecast shows growth of 3¾ percent in the second half of this year and 4½ percent in 2004. Although a rebound in activity seems likely, this scenario remains all forecast and little actual data. We have yet to see clear signs of the acceleration in equipment and software spending that appears to be a key to a stronger economy. Nor have we seen a convincing rebound in confidence that would support investment spending following the end of the Iraq war. Moreover, even with the acceleration in our forecast, substantial excess capacity would remain in the economy through the end of next year. As a result, we expect to see inflation remain low for some time, with core PCE prices expected to increase about 1 percent both this year and next.

    Overall, we face considerable uncertainty about the future strength of the economy. There’s a strong likelihood of excess capacity continuing through next year even if the economy does pick up steam. And we have low inflation. We believe this combination of considerations makes a strong case for an easing of policy at this meeting. Thank you.

  • Thank you, Mr. Chairman. We have observed only marginal changes and subdued economic conditions in the Sixth District since the time of the last meeting. In fact at our board meeting one director suggested that the economy reminded him of the movie “Ground Hog Day.” The same scene seems to be repeated over and over again. But here’s an abbreviated version of our regional story.

    Retail sales have been growing at a modest pace and are still being driven primarily by promotional activity. Our tourism and hospitality industries have improved in some areas, and room rates are actually up somewhat in some locations. Low mortgage rates have continued to sustain single-family housing markets, but multifamily construction and nonresidential construction are still hobbled by excess capacity and weak demand. Structural adjustments continue in our manufacturing sector, which remains sluggish except for auto-related activity. Similarly, activity in petrochemicals is declining because of high natural gas prices and burdensome environmental rules. As requested, we also made some special inquiries with regard to investment prospects, but we were unable to find any significant sentiment on the part of businesses to invest except to replace depreciated equipment or to cut costs. Such cost-cutting investments continue to have considerable attraction. A couple of company contacts reported that such investments were expected to cut labor costs as much as 30 or 35 percent. To me this suggests that the outlook for continued productivity gains is indeed real.

    There’s little sign of improvement on the labor market front except in Florida, where the bulk of our District’s economic growth is occurring. District employers generally remain reluctant to hire full-time employees. State governments are adjusting to lower revenues by seeking new revenue sources or by making deep cuts in spending. Certainly that restraint will damp somewhat the stimulative effect of the recent federal tax cuts.

    Finally at the regional level, prices observed in our area have been essentially stable as increases in prices for services have been offset by continued softness in goods prices. Another positive development since our last meeting in this “Ground Hog Day” scenario I just painted is that District measures of consumer confidence are rising and we’re seeing indications that business expectations have improved. The whispered conversations suggesting that things just feel better, which I reported at our last meeting, have continued.

    On the national front, I see a number of marginally positive developments. Housing remains stable at a high level; industrial production edged up last month; manufacturing seems to have stabilized; and durable goods orders are positive. Consumer spending is holding its own, and retail sales, excluding autos, seem to be coming back. Financial market developments have also been positive, with stock market indexes up significantly. Interest rates have actually come down across the curve by more than 50 basis points. Business credit terms have eased; business profitability is up; and credit quality is acceptable and not deteriorating. Finally, energy prices are still down from the highs we saw earlier.

    While my forecast is a bit less exuberant than the Greenbook’s—and my own numbers would be on the low side of those we submitted—it seems to me that the economy has turned the corner and is poised to gain momentum. At the same time, I recognize that the outlook for investment spending and significant job growth over the near term is not as encouraging as we might like. And markets have built in expectations of further easing.

    Looking ahead just a bit to the policy discussion, I would suggest that what we say in our press statement today may be more important than our action. The material presented by David Wilcox emphasized the importance of aligning expectations to achieve the desired response to our decisions. Our statement about disinflation after the May meeting clearly was responsible for the significant decline in rates across the yield curve despite the fact that we did not change the funds rate. Because of expectations, I believe it is important today to link directly any policy move that we might decide to make to concerns about the fundamentals in the real economy.

    I argued for patience last time, and I believe we are seeing a turnaround. Not changing rates today, coupled with a positive statement about the recovery prospects and not saying anything to fuel greater concern about further disinflation, would seem to be a reasonable policy alternative. I would be uncomfortable if we justified a further rate cut by citing concerns about further disinflation or deflation rather than its causes. I would not cut rates because of a desire to avoid operational problems of the zero bound in the future or as an effort to get ahead of the curve in anticipation of further adverse shocks to the real economy. I’m convinced that a prompt response to actual shocks is very appropriate, as was the case with the September 11 terrorist attacks. Since shocks by definition cannot be anticipated, to act in anticipation of an unknown shock would in my view simply waste whatever powder we have left. As for the disinflation argument, I believe it remains a low probability event for the reasons I discussed earlier. The kind of disinflation I think we should be concerned about in terms of specific policy action is the kind associated with a depression, not problems of the zero bound or wage rigidity.

    I’d like to make one additional observation about expectations, though. I think we need to leave a sense that any downward move in rates is viewed by us as temporary. If we lower nominal rates to near zero and state publicly that we intend to keep them down until the economy recovers, then there’s a nontrivial risk—especially if the economy weakens further—that the public’s expectations for deflation will be heightened. That clearly happened in Japan. In other words, trying to avoid the Japan-type of liquidity trap could only increase the likelihood that it will occur because of the effect on expectations. Thank you, Mr. Chairman.

  • Mr. Chairman, as others have said about their Districts, the Tenth District economy has remained sluggish since our last meeting but there are some signs of a turnaround and a little more optimism. Labor markets continue to be soft, manufacturing activity has not picked up noticeably, and commercial real estate remains in a slump. State and local governments are also cutting back, and in some cases they are trying to raise taxes or have raised taxes in order to balance their budgets.

    On a more positive note, indicators of future activity have shown some improvement. While District firms are still cautious about new hiring, they announced far fewer job cuts in the last month than in other recent months. Also, manufacturers’ plans for future capital spending are higher than they were earlier this year. Commercial realtors are now expecting conditions to improve somewhat in the coming months instead of continually getting worse. In other positive signs, retail sales are holding up, housing activity is still strong, and energy activity continues to expand. I’ll say a little more on those sectors in a moment.

    On the inflation front, goods prices have been basically flat since our last meeting. But manufacturers have mentioned to us that they are seeing a bit of increase in the cost of goods. Let me say just a little more about the manufacturing sector. In our survey on capital spending, of those firms that plan to increase capital spending over the next six months about half said that they had already placed the orders. That reflected some improvement from prior surveys. I would also note that several of our directors indicated that optimism was considerably higher among small and medium-sized manufacturers than in some of our larger firms.

    As I noted, consumer spending has continued to rebound after the dip associated with the Iraq war, and housing activity has remained strong. The energy sector is showing improvement but interestingly hasn’t improved as much as one might have expected. Some individuals in our region have told us that an important reason is that they’ve seen prices go up before, have invested to produce more, and then had prices fall on them. They’re not anxious to go through that experience again. The farm economy is showing improvement, as you’ve read elsewhere, so I don’t see any need to comment further on that.

    Let me turn to the national outlook. I agree that economic forces are in place for a more robust recovery, making a rebound to trend growth this year and to above-trend growth next year more likely now than it seemed at our last meeting. Businesses remain cautious, however, in their plans for capital spending and for new hires. That, of course, is a concern for the outlook, and I would suggest that the Greenbook’s forecast probably is a bit optimistic, especially compared with our own forecast. But the point is that our recent surveys of capital spending and other factors are considerably more positive in terms of expectations. So I expect to see growth pick up to about 3½ percent in the second half of this year. While below the Greenbook forecast, that is still, I think, a very positive outcome.

    As for policy, I won’t talk about numbers, but I believe that the probabilities of improvement going forward are much better than they were just a short time ago, at our previous meeting. So I look at the possibility of taking an easing action today as insurance. I think it can be presented in that way—in a very positive light, consistent with an improving economy and economic outlook. In my view that’s a good way to think about it and to present it. Thank you.

  • Thank you, Mr. Chairman. While gathering our regional information this time we were trying to find, as was everybody else, some sign that economic activity was beginning to pick up and turn around. In sum, for our District at least, solid evidence of an actual acceleration in economic activity is very hard to find. Our various surveys, directors’ comments, and contacts with business people all suggest that the District economy is still quite sluggish. I think it’s very likely that some of the sluggishness in our region is due to the extraordinary rainfall we’ve had this spring, which almost certainly has restrained consumer spending and tourism. (I’ll refrain from saying “damped.”) [Laughter] The rain may also be the reason private housing permits in the first four months of this year were a bit weaker than in the same period last year. That’s not to say that the weather is the reason for all the apparent softness in the District. Factory output, for example, which presumably is less affected by the weather, is still contracting as indexed by both shipments and new orders. Unemployment rates have been rising in all but one of our District states. We don’t see any significant signs of capital spending beyond ordinary replacement spending and routine upgrades of computer equipment. So again, there’s little evidence of an actual pickup in activity in our region yet.

    Beyond these reports on actual developments to date and in concert with a number of the other comments we’ve heard already, I do think that on balance business attitudes about the outlook have improved. Sentiment is a bit mixed, but in general people seem more optimistic. At our board meeting a couple of weeks ago, for example, one of our directors said that he thought we were now at an inflection point in the recovery. I think that’s an increasingly prevalent attitude across the District, at least for now.

    That’s a good segue to the comments I would offer on the national economy. Like others, we agree with the staff that the prospects for GDP growth through 2004 have improved to some extent in recent weeks. That’s partly because of the greater fiscal stimulus now in place than expected earlier but also because of the stock market rally and what seems to me to be a growing recognition that overall financial conditions are really quite conducive to increased business investment at this stage of the game. I thought one of your charts in the chart show made that point very nicely, Steve. So the projections we submitted, like the Greenbook, call for an acceleration of growth going forward though our forecast is not as robust as the Greenbook forecast. We expect a smaller boost from the additional fiscal stimulus than the staff projects. Also, with respect to prices, even if the growth of GDP moves moderately above potential growth as projected, it will still take time to work off the overhang of excess labor that has been building up now for about two and a half years. That will continue to be what I would view as a disinflation impulse at work in the economy.

    Moreover, while we think a moderate acceleration in growth is the most likely outcome, we would not attach an especially high probability to it. We also believe there’s a relatively high probability of a weaker outcome. After all, even with the Iraq war about two and a half months behind us, we still have not seen really solid evidence of a pickup, as many people have said. Jamie emphasized that a couple of times, and I think that’s right.

    Most important, while there are a few signs that labor market conditions may be firming, they are far from conclusive at this point, as the Greenbook indicates. Strong productivity growth still appears to be restraining job growth, and if this pattern continues, at some point it’s going to undermine consumer confidence and consumer spending. In that event, core inflation could easily fall below the approximately 1 percent rate that is now projected in the Greenbook baseline through the end of 2004. Allowing for an upward bias in the index of, say, ½ percentage point, that would imply an inflation rate that’s very close to zero; and that, obviously, is pretty close to incipient deflation.

    Ten years ago when I would make a comment in a speech or conversation advocating price stability and somebody would ask me how low I wanted inflation to go, I would always say without hesitation “zero.” I take it back! [Laughter] To borrow a phrase, I think a sustained rate of inflation below the current rate would be “unwelcome.” In my view, there’s a moderately high probability of that outcome going forward.

  • Thank you, Mr. Chairman. My sense of the District economy is that an improvement is under way and that it is broad but not deep. By that I mean that the improvement is broad in that a number of different sectors or different components of aggregate demand are participating in it. But it’s not deep because for every positive reading or every two positive anecdotes we get on the District economy we can find a negative one. So to that extent the situation is still mixed.

    Homebuilding, home sales, and home improvement spending remain the foundation of growth. There’s no question about that. Those numbers not only have held up but have continued to surprise participants in that industry on the upside. Consumer spending overall has been expanding, but slowly. One gets that same sense of the situation on average whether one talks to major retailers and hears their year-over-year comparisons or to managers of large malls in the District. Of course, it’s not universally true.

    Our survey of capital spending suggested, as did many others, that there is some improvement in train and that some of the orders have already been placed. That’s clearly positive. Anecdotes from bankers, which I think reflect the attitudes of their customers and particularly their business customers, are clearly more upbeat than they were six or twelve months ago. That’s also true for the most part of activity in the energy and agricultural sectors of the economy. Putting all that together, I think things are improving

    As for the national economy, I’ll be very brief. I think the trajectory of real growth as reflected in the Greenbook is a reasonable representation of what may happen, although I personally couldn’t bring myself to write down numbers as strong as those in the Greenbook. Nevertheless, to me the general Greenbook profile is a reasonable picture. Our VAR model shows much weaker growth; but because it puts a good deal of weight on the last nine or ten quarters, it’s not surprising that we get something weaker out of the VAR. To me, though, the really distinguishing characteristic of the forecast is low inflation. Not only are domestic conditions right for a continuation of low inflation, but if we look beyond our borders and consider the global situation—what is happening in places like China and India and so forth—it seems to me that an environment of continued low inflation is a very good bet. I have a very difficult time constructing a credible story that has any appreciable acceleration of inflation in the next year or two. Thank you.

  • Thank you, Mr. Chairman. My contacts in the transportation industry—at UPS, FedEx, and a very large trucking company, J.P. Hunt—all report that current volumes are essentially flat. They don’t see any improvement as yet. The way my FedEx contact put it, there’s no increase in the number of packages on the belt at this point.

    Looking ahead, my UPS contact said that, in talking to their customers, he didn’t see any signs of an increase—nothing more than the usual seasonal increase—during the busy fall season. My FedEx contact was a bit more positive. In fact, I wrote down what he said, which was that he was “pretty bullish” on the fall and beyond. I pressed him on what that really meant. He said “pretty bullish” means that he’s a bit more optimistic about modestly improved activity, up from flat. [Laughter] I also talked to him about capital spending plans, and I want to make a point here that I view as quite important, and I think it bears on the interpretation of the survey evidence as well. The capital spending plans for UPS and FedEx are both essentially flat, year over year. Aircraft purchases are an important part of their spending plans, but they’re not buying any new aircraft; all of their purchases are used aircraft from passenger airlines. They put those expenditures into their capital spending plans, and that’s what they report to us. It does not involve new production. Now, it’s true that we need to absorb some of the excess capacity in industrial buildings and transportation equipment and so forth before we see a pickup in production. But we want to be careful that we don’t interpret these reports as meaning that the planned spending is going to feed directly into new production because some of it will simply involve the absorption of excess capacity that already exists in a number of areas.

    I talked twice to my Wal-Mart contact, first on June 12, when he was particularly interested in what was going to happen over the weekend; and I talked to him again the following Monday. What he said on June 12 was that it doesn’t look pretty. That’s the way he started off his remarks. Wal-Mart is seeing signs of what they interpret as liquidity pressures on the household sector. People are buying more from need than from want is the way my contact put it. As I’ve said a number of times in the past, Wal-Mart looks carefully at the way in which spending is related to the receipt of paychecks. There’s a midmonth paycheck cycle, and Wal-Mart is seeing more spending around the time when paychecks arrive. My contact also mentioned that their new smaller grocery stores—I think they’re called New Market stores and they’re much easier to get into and out of than the big Wal-Mart stores—are getting more traffic. While they don’t have many of these New Market stores, there is an increasing frequency of shopping at these smaller facilities and a declining frequency of shopping at their large super centers. Wal-Mart’s interpretation is that customers want to get in and out of the stores quickly to get the items they have to have, like toilet paper and diapers, and are not so interested in shopping for more discretionary items.

    My contact said that Wal-Mart is not optimistic that the tax bill will have a measurable effect on their sales because most of the benefits are going to higher income people and not to those who do the bulk of their spending at Wal-Mart. That was Wal-Mart’s expectation anyway. He also indicated concern about an inventory overhang because orders were placed some months ago and the goods to be delivered will exceed what Wal-Mart views as the likely demand over coming months. So he thought they were going to end up with more inventory than desired.

    Let me make just a couple of comments on deflation. I think several different aspects of this issue need to be sorted out. On the demand side, to the buyers of goods, what is important, of course, is not the price now relative to the price last month or last quarter but the expected price in the future. That is how price is tied in with whether one is speeding up or delaying outlays. I’m talking about the interaction between the prices and the quantities purchased. If you think the goods are on sale, you may purchase them earlier than you would otherwise. If you think the goods are going to be priced even lower next month or next quarter, you may delay your purchase. This applies only to goods that are storable, not to perishable goods or services. You can’t really store tomatoes. Maybe you can store tomato consumption utility, but you can’t store the tomatoes themselves. So in terms of the behavior of buyers, what matters is the durability and the rate of obsolescence. I went back and looked at the behavior of the durable goods price index and the consumption of durable goods. What is interesting is that durable goods prices have fallen in every quarter since the second quarter of 1996. They’ve been declining for a long time. Of course, some of that involves high-tech goods, such as computers, but part of it is automobiles. So it’s not that declining prices per se reduce purchases. If prices are declining in a way that doesn’t lead to expectations of dramatic future declines, it may not cause people to delay purchases. Prices of high-tech goods have been declining for a long time, and people continue to buy them.

    On the producers’ side of the market, the issue applies not just to goods but also to services because no producer wants to put in place expanded operations to produce services or anything else if he doesn’t think he can recover the cost. So the expectations of future prices relative to current prices apply across the entire range of goods on the producer side. There the productivity part is critical—productivity and, of course, future production costs in general, including wage costs and all other costs. If a producer believes that he can recover those costs, even though the product prices are declining, then there’s no reason to pull back from the market. So the price story clearly interacts with the productivity story and the expected productivity story. It is possible to have a perfectly reasonable equilibrium at high levels of employment and production and with ongoing price declines, provided that the expectations of productivity growth are adequate to support the continued investment in productive facilities. I wanted to make that comment about deflation. I think the deflation story is not the total story with respect to the current demand and production outlook. Thank you.

  • In the Eleventh District, particularly Texas, we share in the national mood shift for the better. Maybe it’s because we’re eating more ketchup, which is a way to store tomatoes! [Laughter] In terms of employment growth, we seem to have regained our rightful place as leading the national average; we were not leading it for a while. The mood in our region may have been helped by the San Antonio Spurs winning the NBA Championship, after knocking out the Dallas Mavericks of all teams in the divisional finals. And two days ago the Rice Owls of Houston won the National Collegiate Baseball Championship. So we have our three major metropolitan areas covered there, San Antonio, Dallas, and Houston.

    At the recent meeting of the Conference of Chairmen we got an unscientific reading on the relative mood in Federal Reserve Districts. Our chairman and deputy chairman both thought they were gloomy, but they reported back that they seemed downright upbeat compared with many of their counterparts from other Districts. Maybe it’s a lesson captured by the song “I’ve Been Down So Long, It Seems Like Up to Me.” But on a more quantitative measure, our employment growth has been positive so far this year. Through April, employment grew about ½ percent, compared with being negative before that, and in May it grew 1.6 percent. So employment seems to be picking up.

    We have a new “Texometer” that classifies economic indicators in Texas in a range from hot to cold. We don’t have any that are actually hot; but almost hot are energy, education, health, government spending generally, temporary jobs, and construction. To give a little detail, in energy the rig count is at its highest level in one and a half years; and we’ve had employment growth in that sector now for three consecutive months, which may be leading a bit the developments that Jack talked about that were occurring primarily in Louisiana. In education, spending is up, and employment is up 6.7 percent this year. Health employment is up 4 percent this year, and government jobs are up about 2 percent. Moreover—and I believe it’s contrary to the national experience—our temporary employment agencies have experienced 8 percent employment growth so far this year. Going down the scale a bit, under the tepid category are manufacturing hours, single-family housing, exports, job growth in our border area, reports from Beige Book contacts, and the Texas leading index. Below that in the thawing-out category are high-tech and initial claims. Still cold are Mexico, commercial real estate, multifamily real estate, and manufacturing more generally. To sum up, our District economy has moved from down to neutral with an upward bias.

    For a longer-term perspective I might mention our spaghetti charts, which show employment growth by Federal Reserve District from different base periods. The oldest base period is the beginning of 1990, and in that chart Dallas still leads in employment, with Kansas City and Atlanta coming in second and third. Since the beginning of 1998, San Francisco leads, with Dallas second and Atlanta third. And since the beginning of 2000, the line-up is the same— San Francisco, Dallas, and Atlanta. In recent years the midwestern Industrial Belt states have trailed in that measure, ranking toward the bottom of the twelve Districts—remember that this is just a measure of employment—and going back to 1990, the northeastern Districts trailed.

    Turning to the current national economy, a rebound in the economy is just around the corner, as it has been for some time now. [Laughter] It’s a familiar story. Consumer spending is following a steady upward track while most other hard indicators of real activity are rather stagnant. Our hopes and hunches for an early pickup in the economy come from a number of developments: a rebound in financial asset prices, including both stocks and long-term bonds; a narrowing of risk spreads, reflecting less perceived risks in the economy; a prolonged policy of easy money and low interest rates, with a recent implicit promise of more to come and for longer than previously thought; progressively easier fiscal policy recently augmented substantially with a significant tax cut; and a considerable weakening of the dollar, especially against the euro. I understand that Herb Stein is known for saying that if something is unsustainable, it won’t be sustained. I hope it’s equally true that if something is inevitable, it will happen! [Laughter] I suppose it will sooner or later, but the question is whether it will be sooner or later. It bothers me that the more optimistic outlook reflected in financial markets and in surveys includes an expectation of further easing by the Fed. We may be looking in the mirror in that regard.

    For a long time the Greenbook projections underestimated real growth and overestimated inflation. That has been corrected, thankfully, but we may have overshot a bit. I haven’t looked it up, but my impression is that we have overestimated both growth and inflation lately. In any case, we’ve made better progress in reducing inflation than we had expected to make. I think we should have celebrated for a year or so and taken a few victory laps before replacing our fear of inflation with a fear of deflation. The public and the Congress have no idea what a good job the Greenspan Fed has done.

    I tend to be optimistic when there is reason to be, which I believe is the case now. I also tend to be optimistic when I don’t have a clue, which may be the case now. But I am hopeful about the outlook on the grounds that in this economy over the long run the odds favor optimism over pessimism. Even so, I was a bit taken aback by the strong rebound in real growth that the Greenbook projects will begin next week. [Laughter] I hope it’s right.

  • Thank you, Mr. Chairman. Economic conditions in the Fourth District have not changed very much during the intermeeting period. Many manufacturers continue to report significant amounts of excess capacity and declining prices for the products they are producing. For the most part they’re not planning to acquire new capital equipment beyond the amounts that they had scheduled early in the year. More and more manufacturers with whom I talk indicate that their firms are undergoing a fundamental restructuring. More of the components that they use in the production process are being produced overseas or purchased from overseas, and only the assembly, testing, and value-added components are remaining in the United States for now.

    Bankers consistently tell me that, although their residential mortgage loan origination volumes remain very large, they are hungry for qualified commercial and industrial borrowers. Bankers also tell me that their loan-to-deposit ratios are quite low and their liquidity ratios are quite high. When I talk to business people I find that they’ve become as impatient about the economy’s sluggishness as we have. They are unsettled about their inability to generate sales or to have any pricing traction, and in the meantime their medical costs and pension costs continue to rise.

    Increasingly, my directors and other business contacts report that they are planning additional rounds of cost cutting and personnel downsizing in order to generate respectable profits. Apparently some organizations had decided to wait until midyear—forecasters were projecting that the economy was going to pick up by then—before implementing these plans for additional downsizing, and reluctantly some of the CEOs are now feeling the need to pull the trigger. My business contacts do not see the current price and availability of credit as impediments to capital spending. Perhaps they don’t appreciate the various other channels through which lower interest rates might help the economy, such as through the influence on exchange rates and balance sheets.

    Turning to the national economy, from my perspective the Greenbook outlook is on the high side. What accounts for the difference is that the Greenbook is more optimistic than I am about capital spending, and the numbers that I submitted are consistent with my view on capital spending. The Greenbook does characterize the economy as operating far below potential in terms of both levels and growth rates. Suppose, however, that the economy is not operating quite as far below potential as assumed in the Greenbook. That is, even at somewhat higher capacity utilization levels certain firms would still not be economically viable. I’m hearing from my business contacts that some industries may still need to shed more capacity than they have so far and that the process is going to take some time.

    There are possible reasons why at this time—after a stock market crash, terrorist attacks, accounting scandals, and industrial restructuring—we might prudently lower our estimates of potential output and its growth rate, at least for a few years. To the extent that these various forces are at work, easier monetary policy may not lead to appreciably faster economic growth. I am concerned that we may be too focused on stimulating aggregate demand and not appreciative enough of the supply-side constraints that may be at work and that we just have to work through. Thank you, Mr. Chairman.

  • Why don’t we take a break now for coffee and adjourn for ten or fifteen minutes.

  • [Coffee break]

  • Thank you, Mr. Chairman. Economic conditions in the Third District remain mixed. There are some signs of improvement, but weakness lingers in certain sectors. While the outlook is marginally positive, many of our business contacts continue to express caution about prospects for the rest of the year. Manufacturing in our District appears to have stabilized this month. Our business outlook survey index of general activity increased to plus 4 in June, its first positive reading since February. The indexes of new orders and shipments also improved, but they have yet to move into positive territory.

    Capital spending in our region has not shown evidence of any significant strengthening. About 12 percent more manufacturers said they plan to increase capital spending over the next six months than plan to decrease it. But that is a low level of the index compared with what we saw in the 1990s, and it’s even lower than the average for last year. The special survey on capital spending plans at manufacturing and nonmanufacturing firms in our District suggests that we will see a modest increase in investment over the next year. Similar to the nation, about a third of our firms plan increases in capital expenditures, but it appears that in our region those increases might be more delayed compared with elsewhere in the nation. For the nation, about two-thirds of the firms said they already had started placing orders to achieve the investment increase, whereas in our region fewer than half have begun ordering.

    Our labor market, however, appears to be doing marginally better than the national experience. Employment in all three states rose in March, April, and May, after declining in January and February. And the unemployment rate in our states fell to 5.6 percent from 5.8 percent in the first quarter. Most of the retailers in our area are being cautious in inventory planning as they expect only sluggish growth in sales this year. Although auto dealers reported an increase in sales in May compared with April, inventories are well above desired levels except in the import category. Retailers of general merchandise report that sales rose in May but remained below year-ago levels. In their view, consumers appear to be limiting their purchases because of concerns about job and income security—a point that echoes some of the comments of President Poole.

    The strongest sector in our region continues to be residential real estate. At our last meeting I reported that we had seen some easing in the residential market in recent months. That has now been reversed. Builders contacted in May said that demand for new homes picked up in late April and has continued. In contrast, commercial real estate remains soft, with little change in recent months. Philadelphia vacancy rates have been stable at about 11 percent in the city and 15 percent in the suburbs. Quoted rents have been fairly stable, but effective rental rates continue to fall. Large amounts of space available for subleasing remain on the market.

    Last time I reported that I sensed some renewed optimism and a definite change in tone in our region since the end of the war. I still sense that people want to be optimistic, but it may be getting harder for them to be optimistic as the weakness continues. Many of our contacts say that they’re starting to feel a lack of certainty about the recovery during the rest of the year.

    Turning to the national economy, the improvement in the financial market indicators that began after the conclusion of the war has continued since our last meeting. But in my view the data on the real sector of the economy remain weak. While certain sectors have stabilized, we have not yet seen signs that the recovery has picked up the necessary momentum to move to the next step. The financial market indicators signal that this will occur. The question is when and then how fast an equilibrium will be reached.

    The Philadelphia Fed’s forecast agrees with the Greenbook forecast that GDP will pick up, but we expect a more gradual increase than the Board staff suggests. We see GDP growth rates being in a range slightly below potential in the second half of the year and then accelerating to somewhat above potential in 2004. I might note that our forecast is close to that of the median respondent of the most recent Survey of Professional Forecasters. The combination of both stronger productivity growth and weaker GDP growth in our forecast compared with the Greenbook means that we have slower job growth. While the Greenbook sees nonfarm payroll employment growth at 375,000 jobs per month in 2004, we project it at only 200,000 jobs per month. We see inflation remaining low over the forecast period but slightly higher than in the Greenbook.

    The main reason our growth forecast differs from the Greenbook is that we expect a smaller effect of the tax package. The Board staff assumes that the provisions of the tax law that expire next year will be extended and that households will treat those provisions as permanent. This implies a sizable positive effect of the tax law on consumer spending. In contrast, given the size of the projected budget deficits and the intense publicity surrounding this issue, we think the tax cut is likely to be perceived as more temporary, which will limit its effect. We also note that households spent a relatively small percentage of the 2001 tax cuts, and we believe there’s little reason to think it will be different this time around, especially since a smaller fraction of the new tax cuts go to credit-constrained households than in 2001. Also, in our view about half of the tax cuts at the federal level will be offset by state and local tax increases. The Board staff projects a smaller effect there.

    When we last met I said that it was difficult to assess post–Iraq war economic conditions. The signals from the financial markets were positive. The data on the real sector were weak, but they still largely reflected the influence of the war. I argued that we needed to wait until more data came in before deciding how to respond to the slow growth exhibited in the data and the concern over the prospects of general deflation. Those data have arrived. Postwar conditions show continued sluggishness and little sense of upward momentum. Concern about the risk of deflation has grown.

    In my view, conditions suggest that it’s time for us to consider further monetary policy action, but I think we must be particularly careful how we explain such a move. The wording of the statement becomes even more important this time than usual. If markets were not already expecting a move, I would be concerned that a cut might be misinterpreted and perhaps even counterproductive. If we decide to move rates lower as insurance against the risks of deflation, to use President Hoenig’s word, we should be more explicit in reiterating our goal of price stability on the upside and downside. I believe this will give us more flexibility to begin moving rates back up in the future once we believe the risks have abated and economic conditions warrant it, which is likely to be before unemployment rates move down very much.

    Long-run inflation expectations have remained stable, suggesting that market participants believe that the Fed can fight the risk of deflation in the short run by lowering short-term interest rates without changing its commitment to price stability in the medium and long term. I think our statement should emphasize our commitment to this goal so as to prevent even the slightest depreciation of the Fed’s hard-won credibility capital. Thank you, Mr. Chairman.

  • Thank you, Mr. Chairman. Let me start with a confession. I’m an outlier. I know this is true in many respects, [laughter] but I’m referring to my forecast for growth next year, which is above the Committee’s central tendency and close to that of the staff. I base this bit of exuberance, which I believe to be rational, on the following factors. First, we’ve seen tentative and preliminary signs over the intermeeting period that the economy is indeed beginning to strengthen. It appears to be responding to the gradual waning of the hangover in financial markets and the real economy from the excesses of the late 1990s and to the moderation of geopolitical risks that have been associated with the war in Iraq. Retail sales and industrial production picked up in May. Labor markets have stabilized. Capital goods orders and shipments, while no great shakes, are still at least consistent with a rebound from the exceptionally weak first quarter. And purchasing managers’ surveys have turned up. These signs, including the May orders data, for the most part reflect actual transactions and decisions taken before the May meeting and its consequences.

    Second, there’s now a lot more stimulus coming than we had thought at the time of the May meeting to add to the already gathering momentum. Some of this is fiscal policy, as a number of people have discussed, and some of it is our own doing. The perception that monetary policy will be easier for longer has helped to lower interest rates, increase equity prices, and depreciate the dollar, all without raising inflation expectations. Easier financial conditions are not just occurring in the United States. Equity markets are up, and long-term rates are down all over the globe, though other countries obviously are getting the other side of dollar depreciation. This improvement clearly reflects developments in the United States, but it also probably builds on a perception—reinforced by a significant easing by the ECB over the intermeeting period—that monetary policy abroad will be easier for longer.

    Third, although outcomes like my forecast or the Greenbook’s seem pretty ebullient, in fact they assume that the restraint on business spending lifts slowly and that the economy does not exhibit all that much resilience. These forecasts do not assume that the economy exhibits a reversion to mean behavior once the huge amount of stimulus being applied is taken into account. In effect, the equilibrium real interest rate, although rising a bit over the forecast period, remains unusually low and well below what one might think of as the long-term natural rate, especially taking account of the assumed rise in productivity. In that regard the forecast is somewhat conservative.

    Still, until we see an actual and appreciable strengthening of growth, I consider the risks around such a forecast to be weighted decidedly toward the downside. In fact, the economy has not rebounded sharply from pre-war weakness. Growth in the second quarter is a little slower in this country than anticipated and much weaker abroad. Such downside risk is reinforced for me by the fact that I really don’t understand entirely what is holding the economy back. Perhaps, as we’ve speculated, the slow business spending results from a lack of confidence after the real and financial turmoil of the boom-and-bust period. That caution no doubt has been accentuated by concerns about risk-taking by CEOs and boards, given the severity of potential legal and market punishments for getting it wrong. These restraints should erode under pressure from rising sales and favorable financing terms as they do slowly in the staff forecast. But they haven’t eroded yet. They could persist and be even stronger than in the Greenbook if businesses continue not to see much in the way of profitable opportunities for investment. Businesses already are realizing huge gains in efficiency by utilizing existing capital much better; rapid productivity growth is boosting profits and income and economic potential, but it’s not increasing the incentives to invest, at least so far. The net is that, in marked contrast with the late 1990s, sizable and continuing monetary and fiscal stimulus has been required to have even the hope of eating into underutilized margins of resources. We can’t be sure this configuration will improve until we begin to see convincing evidence of a marked firming in business spending. Until then I think we also can’t rule out the possibility that we may need to reduce interest rates substantially further and hold them there for a time.

    Intermeeting developments have helped to alleviate some of my concerns about the pace of disinflation. The rise in core consumer prices in May along with the drop in the dollar and elevated energy prices suggest to me a lower risk that inflation expectations will decrease substantially in the near term. Stronger demand should limit the longer-term disinflationary trend. Still, inflation is declining at a time when it is already near the low end of a range that’s probably consistent with nominal interest rates that allow us sufficient flexibility to respond to added downward shocks. If inflation expectations are falling along with inflation, real funds rates may actually be edging higher. Moreover, the improvement in financial conditions after the last meeting was built on the expectation that, if the economy remained soft and inflation threatened to go substantially lower, we would respond—not only by keeping rates low but by reducing them further. My forecast, like that of the staff, assumes that the easier financial conditions of the past few weeks will persist. With strengthening demand still a forecast rather than an actuality and inflation still moving down, it seems to me that the economy needs the extra stimulus from highly accommodative policy and the more stimulative financial conditions. And we need to find ways in the policy portion of our meeting to preserve the financial gains of the intermeeting period. Thank you, Mr. Chairman.

  • I’d like to re-emphasize a couple of data points, especially some mentioned earlier in the chart show. The first involves the new tax law. You may remember that Steve Oliner pointed out some provisions of the law that the staff had anticipated and some that were unanticipated. I would remind you that all of the provisions were crammed into a tax bill that met the Senate’s budget constraints. To do that required an artful amount of posturing in order to bring a lot of stimulus into a very short period of time. One of the wags writing about the tax package suggested that it has so many sunrises and sunsets that it could be called the “Fiddler on the Roof tax bill.” [Laughter] My point is that very heavy bets have been made that this tax package will be stimulative in the third quarter, which starts next Tuesday. I have to say that, whatever else may or may not happen, the tax changes will provide a significant amount of additional discretionary spending capability starting right away. Additional incentives for business fixed investment begin at that time also.

    The second point I would mention is the coupon gap. We moved over this issue fairly quickly, but because of the increase in the coupon gap that occurred just recently this month, that rate gap is now at a decade-high level. There is still a tremendous amount of capacity for refinancing and an enormous amount of home equity available to be tapped. So unless mortgage holders have finally reached the point at which they are no longer responding to those low rates, we will continue to see refinancings. As a result, one of two things is going to happen. People will have more spending power either from the cash taken out or from reduced mortgage payments, which will increase their discretionary spending capabilities. So I am optimistic about the prospects for the third and fourth quarters and the possibility that the second half of the year will be as positive as in the staff forecast. That said, the data to this point certainly do not indicate that there has been a turnaround, so it does seem to me an appropriate time for easing.

    I would like to make one more point, just to follow up briefly on a comment that I made yesterday regarding the effect of lower interest rates on the banking industry. As I noted, the banking industry in the first quarter had record profits in spite of the fact that banks had a significant reduction in their interest rate margin. But that was only because the provision for chargeoffs was reduced significantly—and appropriately so, given the improved credit quality of their loan portfolios. The coverage of loan-loss reserves is appropriate by any measure of delinquency or chargeoffs on accrual loans. However, another contributor to the profit picture was the realized gains on securities, which were as high as they have been for the past ten years. So we’re starting to see managers in the banking industry make some strategic decisions based on a new interest rate environment. What this suggests to me is that increasingly we’re going to be hearing from a number of sectors about the impact of low interest rates on their business. I think all of us are going to have an opportunity in the next few weeks to remind people that we set monetary policy not aimed at advantaging one sector or another but on the basis of its likely effect on the overall economy.

  • Thank you, Mr. Chairman. I think Al Broaddus stole my thunder, but I must say that really awful weather continues to damp spirits in New England, literally and figuratively. Most of the contacts we talk to seem to be—excuse the phrase—muddling through, [laughter] but there are as yet few truly bright signs. State and local governments in the region all are engrossed in the process of passing budgets that try to deal with large structural deficits. The long, slow workout from the demise of the high-tech and telecom industries in the bubble period continues. But a number of our contacts say that many jobs, even high-end jobs, have moved to India and China and won’t come back even when activity picks up. There are worsening problems in Medicare and Medicaid reimbursement and other issues in health care, which is one of the region’s largest industries. Even the almost done “big dig”—and it’s a good thing that it’s almost done—has started to affect construction employment. So I guess it’s no wonder that many contacts think the regional economy has more or less stalled.

    Business confidence moved down in May, though we have had some reports of life in the venture capital investment banking industry. Consumer confidence has risen, but mostly about the future, and confidence readings about the present are currently considerably lower than their immediate post–September 11 lows. There has been some job growth in the region, and the unemployment rate remains steady. But the size of the region’s labor force has begun to erode after growing through the recession and its slow aftermath. The length of the slowdown and the high cost of housing and other living expenses in the region may be discouraging potential workers from coming into the area or perhaps causing some current workers to move out. Commercial vacancy rates remain high, though some contacts indicate that the pace of the increase in vacancies is moderating. Declining rents and available space may well be a godsend to some new emerging businesses, as one source reported, but we haven’t seen many actual or potential takers as yet.

    Finally, an index of leading economic indicators for Massachusetts moved into positive territory once again in March and April. This was based on a rise in the equity values of Massachusetts companies, an increase in demand for high-tech products, increased orders for computers and electronic products, and rising merchandise exports. But this index gave positive signals in earlier months that subsequently were taken away. Moreover, that index actually has more to say about what the economy may look like six months from now than in the third or the fourth quarters of 2003. In sum, it hasn’t been a great spring or early summer in New England. We’re hopeful that things will get better. The question is when.

    On the national scene, I see some hints that a faster recovery is in the offing. People have talked about all of these hints before. They include confidence readings, retail sales, equity markets, credit markets, low mortgage rates, a stabilization in industrial production readings, some optimism on the part of purchasing managers, an uptick in orders, a slowly falling dollar, and increased fiscal stimulus. Taking all these developments together, it seems clear that there’s some possibility that economic activity will pick up in the second half of 2003, and it could pick up substantially.

    But when I think about that, my hope that the rebound in activity will occur is mixed with some concerns. Labor markets remain weak, and businesses continue to be extremely cautious, focusing hard on cost control. This works well for profit margins, and it has kept productivity growth strong, but it has been hard on employment. The pace of layoffs may be easing, but they haven’t stopped, and the translation of consumer confidence into spending in this environment seems, to me anyway, to be vulnerable. It may be that the new tax legislation will come to the rescue here. But the analyses I’ve seen suggest that it is focused on wealthy consumers, which leads one to wonder whether its effect on spending, at least in the near term, will be significant. State and local government spending squeezes and the potential for local taxes and fees to go up immediately could drain some portion of the federal stimulus; and consumers may well react to their concerns about the present by saving more rather than spending.

    With this kind of perspective—on the one hand, hope and, on the other, concern—I was a little surprised by the Greenbook forecast. With only a 25 basis point cut in the funds rate, GDP growth in the next two quarters doubles from that of the first two quarters, and GDP growth in 2004 starts with a 5. As far as we can tell, this forecast would put the Greenbook in second place among the fifty-one Blue Chip forecasters, with 2004 growth only slightly behind the projection of the forecaster that’s in first place, which is an organization called Genetski.com. The Greenbook forecast for growth is also 1.2 percentage points faster than the next most optimistic forecast—or maybe Don’s. [Laughter] True, the unemployment rate drops only to the mid-5s, and inflation is low; but with a pickup of that magnitude, the risks of the kind of deflation that we’re wringing our hands about seem rather small to me.

    It may be that the tax cut, the low interest rates, and a rise in equity wealth and confidence will cause consumption to take off in 2003 and the saving rate to stabilize at a level below its historical average. But I wonder about the likelihood of that, at least in 2003, if employment doesn’t grow by much. And will the jump in consumption in 2003 along with the expanded investment incentives in the tax package really spur business investment to grow at a 17 percent pace in 2004? Business investment levels dropped during the recession, to be sure, but they remained at the levels of 1997 or 1998. Given the caution expressed by many businesses, I wonder whether the current process of making do and continuing to restructure in the context of growing demand will continue. Using the same numbers in the fiscal package and similar estimates of potential and monetary policy ease, the Boston Fed’s forecast is much less optimistic than the Greenbook on overall growth and business investment specifically. We see 2004 GDP in the mid 3s with unemployment remaining around 6 percent, inflation trending down, though very slowly, and investment growing at about 10 percent. This is more of a mainstream forecast. It’s likely not right, of course, but I take it and the similar forecast of the Blue Chip panel to be an indication of some considerable downside risk to the Greenbook projection.

    When we finally begin to see solid signs of a pickup—if those signs suggest a pace of growth, especially for 2004, along the lines of the Greenbook forecast—I would start to think about when and how we might get policy to a more neutral stance, recognizing that it will take some time to close the output gap. But for now, in my view the Greenbook is a forecast with more than the normal range of downside uncertainty about it, given the unusual nature of the recovery we’re seeing. Even a more restrained perspective, like ours in Boston or the Blue Chip forecast, has asymmetric downside risks, at least in my estimation. Thus I lean, as I have for some time, toward taking out a bit more insurance in the form of an easing move, with the hope that it, in combination with the added fiscal stimulus, will really get this recovery going.

    In that regard, and recognizing that the specifics of the policy decision will be discussed a little later, I do want to indicate a bit of concern about using all of our remaining ammunition too fast. If activity doesn’t pick up or if some new shock like a terrorist attack or a sudden fall in the dollar were to occur, I’d like to have some room for conventional policy to work. Deflation is a concern to be sure, but I continue to believe that the type of corrosive downward spiral that we witnessed in the 1930s or that Japan may be experiencing today has a very low probability, lower than the probabilities we were talking about this morning. The growing output gap is an important and related concern. But some straws of a stronger recovery are in the wind, and time may be on our side here.

    I’d move cautiously. And I would agree with President Guynn and others who have suggested that what we say now is very important. We’ve raised the issue of deflation, and we’ve qualified that definition—at least in Chairman Greenspan’s talk about corrosive deflation. If we could tilt our comments about whatever we do toward indicating that it’s a relatively normal response to a slower-than-desirable pace of economic growth rather than the imminence of deflation, I think that would be helpful in the current circumstances. Thank you.

  • Thank you, Mr. Chairman. At our last meeting there was a feeling that both the real output term and the inflation term in our policy objective function were pointing downward. The forecast envisioned persistent output gaps, and inflation appeared to be dropping below our desired target range—not necessarily to deflation, just to an inflation rate below our target range.

    Over the intermeeting period there has been improvement on both sides. Consumption has picked up and is now forecast to be stronger than before. Housing is maintaining its strength. Equipment and software investment is picking up. Nonresidential investment has finally stopped sliding, as has employment. Industrial production and all the measures of new orders have turned around. Many of these turnarounds and pickups would be considered still early returns, but turnarounds and pickups are better than the alternative. On the inflation side, too, the evidence is less worrisome than before. The core CPI and the ECI both turned up a bit in the latest data, and all measures of inflation expectations are in positive territory, perhaps off a bit but not careening toward deflation. It now looks as if inflation will settle in at a rate within our target range, not pierce through the lower bound. There is still a persistent output gap in the forecast, so inflation could continue to decline; but again, the situation doesn’t look quite as bad as it did last time. As Steve Oliner pointed out earlier, many policy-related variables have also become more expansionary lately. Steve mentioned rate spreads, the dollar, the tax bill, and the stock market—the usual list.

    As for the policy action we might take today, I actually think there’s a bit of a problem. There’s a difference between what I will call the level approach and the change approach. These roughly map to the more and the less aggressive policy stances that Dave Wilcox mentioned earlier. As argued yesterday by the Washington Times, one can still make a good case for an aggressive monetary policy. Output gaps are large, and it would take a healthy expansion of aggregate demand for a reasonable length of time before they return to anything like preferred levels. As long as output gaps persist, there should be minimal positive inflationary pressures, and indeed, inflation rates should continue to be stable or declining. I would remind everybody that the staff also pointed out that to ward off these disinflationary pressures, to deal with uncertainty in the rate of inflation itself, and to deal with uncertainty about the nontraditional measures that we spoke about yesterday, an aggressive policy, not a gradual policy, is suggested. From this level perspective, a fairly aggressive policy still makes very good sense.

    But from a change perspective, as argued yesterday by the New York Times, the situation looks different. In this view, it is hard to justify an aggressive policy now when we are seeing more signs of strength and when other policy-related influences have become so much more positive. An aggressive policy action today would either be or be seen as adding more fuel to a fire that has finally started burning. From this change perspective one might argue for a less aggressive policy or even for no change in the policy stance. I suppose if pressed I personally might be inclined to split the difference between these two views—I don’t know if Dover has a Times [laughter]—and argue for a middle-of-the-road approach here.

    Let me just mention one other factor, which is that we do have an opportunity now that we don’t always have because the Chairman’s testimony on the semiannual monetary policy report comes up in a few weeks. So we have the luxury of being able to do something today that is more or less a holding action. Then, if we see information on one side or the other that changes our minds in the next couple of weeks, we have a chance to put some words about our views in the Chairman’s testimony. And we know now that our words have enormous effect. Thank you.

  • When I came into this meeting, I had feelings similar to those that President Guynn expressed. In getting ready for today’s meeting, I looked back at my notes on the last couple of meetings and found that we were always on the verge of a rebound in economic activity. Obviously the war erupted and created another discontinuity in this expansion. I’ll use President Guynn’s “Ground Hog Day” movie analogy to say that what is missing is obviously business capital expenditures. I hope, like the hero in “Ground Hog Day,” that CEOs will begin to get the message and start focusing externally instead of internally. If we can make that happen, maybe we will have a happy ending as the movie did.

    I’ve been spending a lot of time looking at the data on the business sector. While I’m not going to go through the points that Steve made earlier, I thought his analysis was excellent in terms of describing the status of the business expansion. The new numbers on nondefense durable goods orders this morning may be a sign that we are at the point where there’s a glimmer of hope that we are past the discontinuity associated with the war. On the other hand, we’re not really seeing evidence of a robust movement ahead, and that does concern me. The European Central Bank has just lowered its forecast of growth in the euro area. And as Karen pointed out, our staff has reduced its expectations for growth internationally over the rest of this year. This suggests that we’re not going to get a lot of support from the foreign sector. I am starting to see some glimmers of hope in the employment statistics. Employment is still very weak, but private payrolls look as if they are beginning to stabilize. At least they’re not falling off as they were earlier in the year.

    I’m not as optimistic as the staff regarding the outlook for 2004. My forecast is at the bottom of the range of those that we on the FOMC submitted. It concerns me, when I look further out on the forecast horizon, that the output gap is sustained to 2005. Given where we are on inflation measures, I’m not so worried about deflation. I am concerned about persistent disinflation because it’s still not clear to me how our banking sector and other sectors that have moved more toward risk-based pricing of credits are going to work through this. So I’m worried about being in a consistently low inflation environment and what that might do to our financial sector. Remember, the last time we were in this type of situation we had Regulation Q, which prohibited the payment of interest on a lot of the deposits in the banking sector. Because of the persistent output gap and these other considerations, I don’t see much downside risk to trying to encourage this expansion that may be getting under way and kick it up another notch. So, I’m leaning toward the view that we ought to go ahead and take out a little insurance at this meeting.

  • Thank you, Mr. Chairman. You closed our last meeting by using a legal term, the concept of the burden of proof. You suggested that the burden of proof at this meeting should fall on those who thought they saw sufficient growth either in the data or in the outlook that we should stand pat. If I were the judge on the case, I’d say that at this stage the case is unproven, as the British would say.

  • As the Scottish would say, not the British.

  • Well no, sir. The British include England, Scotland, and Wales. [Laughter]

  • Well, you have a law degree and I don’t.

  • We’ll split the difference and call it what an island magistrate would say. Let me proceed with the evidence, if I might. First, on the evidence supporting a sense that things are looking better, I’d have to say that there are a number of straws in the wind in support of that assessment. They’ve been talked about here today. Retail sales grew respectably in May, the labor markets appear to be stabilizing, and the data we’ve just received on new and existing home sales are certainly a sign of continued robustness in that sector. It’s not surprising that the household sector seems reasonably strong because the underlying fundamentals for that sector look strong. Real disposable income has improved for a number of reasons; the stock market obviously has contributed positively to household balance sheets; and as was mentioned earlier, there are ongoing opportunities for refinancing. And consumer confidence seems, on balance, to be firming somewhat. If one moves from the household sector to look at the industrial side of the economy, again there are straws in the wind. IP has stabilized, as a number of people have said, and the survey data from both the Reserve Bank regional surveys and the ISM give a sense of perhaps some firming in the manufacturing sector. Finally and most important, as we’ve already noted, the financial conditions are quite consistent with a turning. Equity prices are up; risk spreads are down; and as Vincent and Dino indicated yesterday, some of the forward- looking indicators of risk also suggest some improvement. So there are a number of reasons for a bit of cautious optimism. But I would put the emphasis on “cautious.” What doesn’t seem to be there yet is the type of self-reinforcing improvement that we’d need to see before we decide not to take out some insurance today.

    Let me also go through the bits of evidence that perhaps disprove the case. First, I would say that it’s not really clear what the financial markets are telling us. Normally we could look to them to be forward-looking and to tell us something about the real economy. As I listened to the discussion yesterday and thought about it myself, there seemed to be some question about the markets’ assessment of the real economy. As someone said yesterday, in part what seems to be driving the fixed-income markets are a search for yield and an expectation that interest rates will remain low. Neither necessarily indicates that the market sees the real economy as improving. If one looks at the equity markets, what we heard yesterday—which is consistent with what I’ve heard and what I’m thinking in general—is that we are seeing data from the corporate sector that are not getting worse and may be stabilizing. But the recent data certainly are not consistent with a rapid turnaround. So I have a bit of a question as to whether or not, as someone said earlier, we may be looking in the mirror. At least there is a question as to whether the financial conditions are really supportive or indicative of growth. I would say that they are clearly supportive; I’m not sure they’re yet indicative of growth.

    The second reason I’d be somewhat cautious relates to the fact that I spent a lot of time in the company of CEOs over the past intermeeting period. In my view, they still harbor a fair amount of pessimism, a judgment that is shared by others who have already commented. I say that because of both what the CEOs themselves talked about and what they said about the issues on which their boards of directors are focused. I believe the boards continue to be more heavily focused on corporate governance issues and leeriness about accounting issues as opposed to trying to find places to make investments for expansion. Also, I think order books are not yet sufficiently full for CEOs to have a great deal of confidence in moving forward. I would argue that the data we’ve seen, which Steve described as mildly encouraging, are no more than mildly encouraging. That’s not bad, but obviously they do not suggest that activity is really robust. So I’d put a question mark on the outlook for the corporate sector and particularly for the investment side of that.

    The third area of concern I’d have is the consumer sector. While many of the fundamentals look good, the fact that the unemployment rate is staying relatively high and job creation is relatively muted has at least the risk of weighing more on the household sector than it has in the past. I’m not sure that it will, but it might.

    If one puts the two sides together and adds to it the stimulus in the pipeline from monetary and fiscal policy, I can see how the staff came up with the baseline forecast, and I’m not going to quibble strongly with that. But I do believe that the risks to that forecast are primarily to the downside.

    Nevertheless, even if we take the forecast as given and look out past the next few quarters, we see a number of things happening. One is that the output gap still closes relatively slowly. Second, the unemployment rate hangs up above the NAIRU through next year. Third, core PCE even before the adjustment stays at what I would consider to be the very low end of an acceptable range. Add to that the fact that, even in the context of what some view as a relatively strong forecast, the staff has lowered its expectations for core PCE over the next eighteen months or so from the estimate they had in January.

    The other point I would add is that, in its forecast, the staff normally does not in any sense lead us in terms of implying a change in rates. This time they chose to put in a 25 basis point cut and still got to this longer-term outlook that I would call only moderately acceptable if one thinks about the disinflation picture in particular. On top of that I’d note the information provided in chart 11 of the chart show about the probability of deflation, given the current low rate of inflation. I would describe that chart as really quite sobering. I would then pick up from where Ned Gramlich was—which is that, when we get to the policy session, the choice is between a more aggressive or a less aggressive approach. I think there are legitimate arguments on both sides. I certainly think we need to take out at least some insurance, and I’ll wait until the policy round to talk about what I think that should be. Thank you very much, Mr. Justice.

  • Is that a demotion? [Laughter]

  • If you went to law school, it’s not so bad!

  • Thank you, Mr. Chairman. The economy seems poised for recovery in that policy is accommodative and the financial markets are supportive. But on the ground where it counts we have not yet seen clear evidence of a turnaround in investment or hiring. Moreover, we have more than the usual degree of uncertainty about the amount of slack in the economy, which implies that we face highly uncertain downward risks to the already low rate of inflation. For these reasons, it’s extremely important that we do what we can to maintain the supportive configuration in financial markets. That means continuing our easy monetary policy and, even more important, using our statement to signal our willingness to keep policy easy so long as there is a risk of further disinflation and continuing economic weakness.

    If you will indulge me, I’d like to take my time to add a few words on communication policy in general. Our discussion yesterday and our experience of the past year have shown that effective communication is a big part of successful monetary policymaking. It’s becoming increasingly more important as the inflation risks move from one-sided to symmetric and as the range in which we can move the funds rate narrows. We can communicate to financial markets how we expect to manage short-term interest rates in the future. If we then follow through on our commitments, the power of our interest rate instrument is multiplied many times over. Contrast the effects on financial markets of our 50 basis point easing of last November with our no change policy of May 6. The difference lay entirely in the accompanying statements and not in the decisions themselves. The May 6 statement proves that purely qualitative statements can be effective when policy intentions are conveyed to the markets. Nevertheless, communication that is entirely qualitative in nature also risks misunderstanding. For example, I think the May 6 statement left the mistaken impression with some that the Fed was concerned about the threat of imminent deflation as opposed to what really concerned us—namely, the possibility of a decline in inflation to a level that, while below the desirable range, would still be greater than zero. This misperception may have led to unnecessary anxiety among the less sophisticated and to skepticism about the Fed’s seriousness among the more sophisticated. This misconception can be cleared up; but as we go forward, the subtleties will multiply, particularly as the recovery picks up and as we make the inevitable but very tricky transition from deflation-fighting to inflation-fighting.

    I expect that the need to make our public statements more precise and less ad hoc will ultimately lead to the introduction of some elements of quantification. There are different ways to do that. One approach would be to provide guidance to the markets by issuing a working definition of price stability expressed as a range of measured core inflation that takes into account measurement bias and the need for a buffer zone against deflation. In issuing such guidance, the FOMC would not need to make any explicit commitment, only indicate that this working definition of price stability would be used as a guidepost in its pursuit of its dual mandate relating to price stability and sustainable growth.

    This is not the place to get into details about any specific proposal. I do think, however, that this measure or similar ones would help us enlist the financial markets, particularly the bond markets, in stabilizing the economy. The reason is that any tendency of inflation to move out of range—either up or down—would tend to move longer-term bond yields in a stabilizing direction in anticipation of the forthcoming policy response. Ambiguity has its uses but mostly in noncooperative games like poker. Monetary policy is a cooperative game. The whole point is to get financial markets on our side and for them to do some of our work for us. In an environment of low inflation and low interest rates, we need to seek ever greater clarity of communication to the markets and to the public. Thank you.

  • Thank you very much. Mr. Reinhart.

  • Thank you, Mr. Chairman. I’ll be referring to the materials that Carol Low distributed during the coffee break. The financial market backdrop for the Committee’s decision is provided in exhibit 1. Your announcement on May 6 set in motion a significant downward realignment in market expectations, as can be seen in the movement from the dotted to the dashed line in the top left panel. After all the dust from testimony, speeches, and newspaper articles settled, investors have come to place considerable weight—as seen in the solid line—on a funds rate trading below 1 percent for the remainder of this year and into the next. Options on federal funds futures indicate, as seen in the last column in the table at the right, that the odds slightly favor a 50 basis point move at this meeting. Moreover, as the red bars plotted in the middle left panel suggest, options on Eurodollar futures are consistent with a significantly greater likelihood that the funds rate will be below 1 percent five months hence than was foreseen at the time of the May FOMC meeting (the black line). Indeed, the upward climb of the blue line plotted at the right shows that a notable mass is now being put on the probability that the funds rate will trade at or below 50 basis points in five months. The sense that the Committee intended to keep the funds rate lower and for longer than previously expected supported equity prices, with the major indexes plotted at the bottom left gaining about 10 percent over the intermeeting period. This was also so for bond prices, with the yields plotted at the lower right shedding 60 basis points.

    To repeat, the recent financial market rally was importantly underpinned by the expectation that the Committee would ease. As discussed in the top panel of exhibit 2, one pillar in the case for moving the fund rate 25 basis points lower would be to ratify at least a portion of the easing currently built into market prices. Extending the rally in financial markets would bolster wealth and keep funding available to businesses on easy terms, thereby providing encouragement to spending. Such a configuration of financial market conditions would, as reported in the second bullet, work down resource slack more quickly. The solid line in the middle left   panel plots the Greenbook baseline path for the unemployment rate that is expected to prevail if the Committee lowers the funds rate to 1 percent and holds it there, whereas the dotted line shows the consequences for unemployment, according to the FRB/US model, if the funds rate is held at 1¼ percent. While the spread between the two lines is small, the difference does cumulate over time to lessen the pressures on disinflation.

    In the benefit–cost calculus in current circumstances, the Committee might be reassured that, as shown in the middle right panel, inflation expectations gauged from financial markets (the red and blue lines) or gleaned from a survey (the dotted line) remain subdued. Indeed, the alternative FRB/US simulations presented in the Bluebook give evidence of how little risk there is, given the staff’s assessment of the economy, that inflation pressures may flare. Those simulations, which assume that the nominal funds rate moves down to 1 percent today, all envision the real funds rate being moved up to its long-run equilibrium level of about 2¾ percent over the course of one year. They differ as to whether that adjustment takes place in 2005, 2006, or 2007. The punch line is given in the two bottom panels: The Committee could move the funds rate ¼ percentage point lower from its current level and not have to reverse that action for 1½ years while still keeping inflation on a gentle downward trajectory toward ¾ percent, as close to price stability as one might imagine. Perhaps too close for some, in light of the renewed importance of a cushion of inflation to protect against the zero bound to nominal interest rates. One way to fatten that cushion is to ease 25 basis points today on the expectation that any reversal would be delayed for some time. Another way to fatten the cushion, as listed at the top of exhibit 3, is to ease 50 basis points today. In one sense, such a policy move would merely reestablish the degree of monetary policy accommodation of late last year. As seen by the thick solid line in the middle panel, the ex post real funds rate has moved up from the level prevailing in the second half of 2002, mirroring the decline in inflation, while its equilibrium value—at least as gauged by staff models—has been a moving target that fell over the same period.

    While the staff anticipates that a quickening of aggregate demand is imminent, its assessment of aggregate supply is such that an ease of 50 basis points would seem to position policy better to support a more rapid rundown of slack. Moreover, the Committee might harbor some reservation about the staff projections that spending will show such vigor. Given the lags in the effect of monetary policy, action today will mostly shape economic conditions next year. As shown in the bottom left panel, in the list of the projections for GDP growth and the unemployment rate next year made recently by major investment banks, the staff forecast of vigorous economic expansion (the memo item at the bottom) is squarely at the upper end of the range of projections.

    A projection that you may put even more stock in is your own. As David Wilcox reported earlier this morning, the central tendencies of your economic projections for 2004, not shown, are that real GDP grows at 3¾ to 4¾ percent, the unemployment remains around 5½ to 6 percent, and PCE inflation clocks in at 1 to 1½ percent. Dave Lindsey reports in his opus distributed to the Committee yesterday that the setting of the federal funds rate since the late 1980s can be described well by a Taylor-style rule using those forward-looking forecasts and a lagged dependent variable to capture gradualism. By that standard, as plotted in the red dotted line at the bottom right compared with the actual funds rate in black, your current economic forecast would call for putting the policy rate at nearly ¾ percentage point if you were to operate as you had over the prior ten years.

    Alternatively, it is possible that the Committee views the risks to its forecast of economic growth as especially susceptible to upside surprises, perhaps to the point of arguing for keeping the funds rate unchanged, the subject of exhibit 4. Easing might be viewed as unnecessary because considerable fiscal stimulus is in train. As shown in the middle left panel, the staff estimates that fiscal impetus will to rise to an eye- popping 1¼ percent of nominal GDP this year, moving it into a range rarely seen in the past forty years. Given the complexities of the recent legislation, there’s a large amount of judgment in forecasting how much kick there will be to household and, especially, business spending. If the staff has shaded its estimate of the effects too much, there would be an even more marked pickup in growth than in the Greenbook.

    A muted response to investment incentives and a slow dissipation of the gloom that has damped capital spending over the past few years help to explain why, as in the middle right panel, the staff forecast places the expansion of equipment and software spending during this business cycle (the solid blue line) below the range of postwar experience (the shaded area). If you think we are about to see a rebound in investment more in keeping with its typical cyclical amplitude—that is, the Greenbook is too pessimistic—the corresponding need for monetary policy stimulus would be lessened. You may also have the sense that economic expansion had already gained sufficient traction from the ongoing rapid growth of liquidity. The four-quarter growth of real M2 (the red line in the bottom panel) and real bank credit (the black line) remains robust and in a range typically associated with contemporaneous growth in activity.

    Likely, though, the question is not if but by how much to ease policy. After all, the Committee left its May meeting with a strong presumption that it would ease policy today, leaving the burden of proof to those who believed the economy had picked up enough to make such an action unnecessary. Although the tone of recent readings has brightened, at best the Scottish—and perhaps English—verdict of “not proven” is in order. Your last exhibit examines the Committee’s assessment of the risks to the outlook by first bringing up a procedural question. On May 6, the Committee separated the risk assessment into statements about the risks regarding its objective of sustainable economic growth, risks regarding its objective of price stability, and an overall balance of those two risks. However, as was the case in March, but not the previous three years, the Committee voted only on the policy rate and not on the risk assessment. I assumed in the Bluebook that you wanted to return to the practice of voting on the assessment of risks so that it had the full force of the Committee’s imprimatur. But given the numerous times in the past that members have indicated that it would be unworkable for the statement to have nineteen editors, I also assumed that you would not want to review it routinely before the vote, except, as in May, when substantive changes to the format seemed to be called for. To solve this governance puzzle, I suggested in the Bluebook that the Committee choose among generic formulations of the parts of the risks assessment to allow some discretion to the drafters. That is, when the time comes, the Deputy Secretary would read a single proposal put on the table by the Chairman that wraps together a decision of the intended funds rate and directions for each of the three parts of the assessment of risk.

    As for today’s choice, as considered in the bottom left panel, almost regardless of your decision on rates, growth rate risks would seem to be balanced. Similarly, with inflation edging down from an already low level in most forecasts, risks to the Committee’s goal of price stability would seem to be to the downside. As a result, the overall balance would presumably be to the downside. Conceivably, the Committee might view a 50 basis point ease as sufficient to balance the risks, similar to the action it took last November. There’s some sentiment in the market for this, in that in the latest Money Market Services Survey (the bottom right panel), almost half the respondents who thought the funds rate would be 75 basis points this afternoon also thought the Committee would opt for balanced risks. But it does seem a stretch, in that fostering a sense in the market that the Committee wanted to draw this easing cycle to a close would undercut some of the stimulus of a 50 basis point move. That concludes my prepared remarks, Mr. Chairman.

  • Thank you. Questions for Vincent?

  • Yesterday a number of people raised the question, “If zero isn’t really the lower bound, what is?” I think there was a general feeling that we don’t know what the lower bound is but that it’s below 75 basis points. If we went to a funds rate of 75 basis points with a balanced risk statement, would we build in a market impression that that’s as low as we’re going to go?

  • I think there is a risk that moving to balance in the current circumstances would be interpreted as having the funds rate as low as the Committee really wanted it to go. Given that there is a misperception that 75 basis points might be the bottom end of your comfort zone, I think it may very well turn out that way.

  • I have two questions, Vincent. First, if we look at the middle chart in exhibit 3, which shows the actual real federal funds rate, the current real rate has moved up since the last meeting. How is an easing of 25 basis points an insurance policy?

  • It is the case that 25 basis points would not get you to as easy a policy as, say, in the first half of last year.

  • Or about six weeks ago.

  • But it’s also the case that your sense of the forecast going forward is probably more positive than it was a year ago or even in May.

  • Okay. Second, I just want to raise an issue, and if this is the wrong time, I can come back to it. In exhibit 5 in the bottom left-hand corner, the panel entitled “For today’s choice” says that the growth rate risks are balanced. The issue I want to raise at some point relates to the word “sustainable” that shows up as an adjective in our statement. I really think the way we used it the last time was wrong. I checked how we’ve used it in the past, and I think it was different. It seems to me that the problem could be fixed very easily by using the word “acceptable.” I may be focused on a point that seems narrow to some, but I just don’t think “sustainable” was the right word the last time, and I can’t see how it would be right this time. I don’t know if you’ve given any thought to that or come to any conclusion about it, so I wanted to mention it. Or should we talk about that later?

  • One thing I have learned is that people read different things into the word “sustainable.” I think some members would view the words “sustainable growth” as saying the growth rate of potential.

  • Before May that is exactly what it meant.

  • Whereas I think others have felt that the word “sustainable” also includes a level concept to it. That is, if the economy is well below its level of potential, the growth rate that it could sustain for the next several quarters is actually higher than that of potential.

  • Well, it seems to me it’s a little problematic to view it one way one month and a different way another month.

  • I think the word is ambiguous. And that’s one reason I would like at some point to put on the Committee’s agenda a discussion of its communication policy.

  • Maybe this is going to have to wait until your discussion of communication. One of the other things I struggled with as I read the Bluebook wording— and I see it again in exhibit 5 in the bottom left box—is the part about inflation risks being on the downside. As worried as I am about disinflation, which I see as a significant risk, I am not worried about inflation down the road. If inflation were around 3 percent, we’d be worried about the risk of a rise in inflation. Risk to me always implies something about what could be the worst outcome rather than direction. Given where we are now with regard to inflation, I’m wondering if we should imply concern about inflation’s moving in one direction only rather than the risk of its going up or down. Getting back to Governor Bernanke’s comments, how we communicate our views on inflation is important. Because we’re in such an unusual situation, I think directional words might be better than the word “risk.”

  • In my proposal and in the proposal in the Bluebook I was trying to come up with words that were as generic as possible with regard to inflation. I think the May 6 statement served the Committee well by indicating a direction—the unwelcome risk of a substantial further fall in inflation from an already low level. I’m not proposing this wording as part of the press statement for today’s meeting but rather as a way for you to convey your views about the direction in the statement.

  • Could I just interject one point because it follows directly?

  • This may be just my own deficiency, but when we talked at the end of the last meeting about separating the two parts of the statement, we were basically doing so on a wait-and-see basis. We voted on the policy action, and then we waited to see the wording of the draft statement. I did not say to myself at that point, “Aha, we are not voting on the risks.” Making an issue out of that in the minutes struck me as a little odd. I don’t know if anyone else shares that same impression. Maybe my memory or my understanding of what we were doing is deficient. I thought we were focusing on a new way of talking about where we were, but I certainly thought that we had a shared understanding of the risks.

  • It was implied that you were voting on the risks, but when it came to the actual vote and what Normand read to you before the roll call, you voted only on the interest rate decision.

  • Okay. I thought that was more or less because we hadn’t seen the formulation of what the statement was going to say about the risks. I didn’t view it as a substance issue. Maybe I’m making too much out of it. At the time we had the vote, had we seen the statement? Did we see it before the vote?

  • Yes, we handed out the draft statement before the vote.

  • Then I must be out to lunch.

  • All I really wanted to do was to get the formal process back to the point where the Committee actually does formally vote on the two aspects of its decision.

  • I want to follow up on Governor Bies’s question, just so I understand this. In the Bluebook, the risk assessment language indicates that we’re going to say one of three things about inflation: The risks to the outlook for inflation over the next several quarters are weighted to the downside, are balanced, or are weighted to the upside. So will that be in the statement that comes out?

  • Not necessarily in those exact words, but that sense would be in the statement. There will be a declarative sentence about inflation, and it will follow the direction that the Committee indicates.

  • So the risk assessment paragraph will not be in the statement?

  • But it will be in the transcript?

  • It will be in the transcript, yes, and it will be in the minutes.

  • Further questions? Let me then start. Within a matter of days we should begin to experience a rare test of an economic theory and approach to economic policy. We currently are observing a sluggish economy that seems to be stabilizing but is scarcely exhibiting any robust dynamics. Over the course of July and August, some $20 billion of Treasury receipts will be transferred to households. Our general view of the way the economic world works, essentially going back to Keynes’s General Theory, is that this shift of funds will have a prompt and significant impact on consumption expenditures and economic growth. Secondarily, working through the accelerator effects on capital investment, the pickup in spending should foster, in the classic case, an economic rebound consistent with the forecast in the Greenbook.

    The recent legislation clearly requires that $20 billion or so be shifted to households over the next several weeks. That’s not an expectation. It will happen. The reason we all expect personal consumption expenditures to rise, of course, is that the presumed marginal propensity to consume is greater than zero. If one postulates that the marginal propensity to consume is literally zero and that all we’re seeing is a transfer from the government’s savings account to household savings accounts, then the only result will be a shift in savings from one sector of the economy to another, with national savings unchanged and economic activity not directly affected by that transfer. No econometric model of which I am aware has a zero marginal propensity to spend. But even if our model were to have that property, there would be an increase in household wealth and an increase in the ratio of wealth to income. Although in this model expenditures would not occur out of income, they would occur in much smaller dimension from the increased wealth effects. So there would still be some effect.

    The reason that this is such an interesting and critical test is that we are not in the middle of either a vigorously expanding economy, in which it would be very difficult after the fact to isolate the effect of the tax cut, nor are we in a significantly weakened economy, in which it would be difficult to extract the momentum stemming from the infusion of Treasury cash. As a consequence, we are in a very rare period in which we will have the opportunity to observe a fundamental test of the significance of fiscal policy in the economy. We will probably know a lot, I would suspect, by mid-August. We may even learn something prior to my monetary policy report to the Congress, which is currently scheduled for July 15, although I would not count on that. The test on the effectiveness of fiscal policy will involve a process that will be reported on in a very detailed manner by the press, and I suspect we’re also going to learn a great deal anecdotally about what is going on.

    If it turns out that there is very little impetus to consumption or capital investment, that is going to alter our view of the effectiveness of fiscal policy quite materially. It’s hard to accept the view that there will be little or no effect on PCE on the grounds that a large portion of the tax cuts benefits upper-income groups, which is certainly the case. To be sure, the conventional wisdom is that the marginal propensity to consume is very significantly lower for upper-income groups. But I must tell you that in some of the studies we have carried out using data systems that combine our flow-of-funds data and our survey of consumer finances, we have picked up marginal propensities to consume for the upper-income groups that, while lower than for the middle and lower-income groups, are not that much lower. So one can’t argue that we are going to get little or no effect, at least on the basis of the data I’ve been looking at, merely because of the income distribution of the tax cut.

    Of course, there’s a more interesting and in a sense more important issue as to whether capital expenditures will revive in this context. To an important extent, the evidence will be anecdotal, and I hope we will get greater insight from that source over the next month or two. I sense from conversations with various business people that the restraint on capital investment is really a restraint on any form of aggressive risk-taking. That seems to be in part a reflection of the corporate governance scandals, which have induced a considerable amount of fear on the part of corporate executives. A few years ago, a CEO would present a capital investment project to a board of directors, go through the details, and typically get agreement and approval fairly quickly. The boards of directors were essentially passive in that process because there is no way that their state of knowledge could possibly match that of the CEO backed up by the CFO and a whole panoply of charts and detailed data on the internal workings of the firm. In fact, it really isn’t the job of boards of directors to look too deeply into the details; it’s more a process issue. Indeed, that’s the way it has worked.

    Today it is quite different. The legal risks, which both the boards of directors and the CEOs perceive, have led both to exercise a high degree of caution. Directors, and I say this only half facetiously, who really know nothing, now aggressively question proposed capital investments without a clue as to what is going on. It is true, if one looks very closely at the details of the Sarbanes-Oxley legislation, that the criminal statutes in that law are quite appropriate in the sense that they stipulate willful, aggressive action for perpetration of deception or fraud. By any characterization I know of, people in the business community who are guilty of such theft ought to be in jail. There is no way around that conclusion. Regrettably, the interpretation on the part of a significant portion of the corporate community is that the dividing line between criminal and permissible activities is not clear, so they are leaning over backwards and exercising exceptional caution. That has created, as best I can judge, a degree of risk aversion well beyond anything that one could observe previously in the business community. Indeed, the financial data clearly suggest that risk aversion as perceived by investors is very significantly less than that perceived by corporate directors and executives.

    So it strikes me that we are in an interesting test period for our forecasting capability and hence policymaking. Fortunately, I suspect that we’re going to learn a great deal over the next two months, but it’s very difficult to judge the outcome in advance. So far as today’s policy decision is concerned, as has already been mentioned, we concluded at the end of the May 6 meeting that the burden of proof would essentially ride on whether sufficient information had emerged during the intermeeting period to persuade us not to reduce the federal funds rate target at this meeting. As Judge Ferguson very sensibly ruled, by any measure the threshold of the evidence needed to forestall a cut in the federal funds rate at this meeting has not been reached. I agree that an easing action is the right thing to do.

    We have been considering reductions of 25 or 50 basis points. I’m uncomfortable with 50 basis points for several reasons. As has been mentioned, if we were to approve 50 basis points and then adopt some kind of balanced risks assessment, I believe we would generate the expectation that we are no longer contemplating a lower rate structure for an extended period of time. As a result, I think we would begin to get very significant upward movements in long-term rates. That outcome would be quite counterproductive at this stage unless the Greenbook baseline forecast turns out to be right. But that forecast has a very low probability as far as I’m concerned. It points to an outcome that would be delightful if it were to materialize, but it is not a prospect on which we should focus our policy at this point. So the issue is whether, if we were to reduce the funds rate by 50 basis points, we’d have to do it with a presumption that we would reduce it still further. I’m fearful, as many have suggested, that that would create a view that we are far more concerned about the economy than is in fact the case and that we know something that the markets don’t know. That could result in a quite counterproductive reaction.

    The reaction to the May 6 statement should tell us that the credibility of this institution has increased very materially in the past six months to a year. Even though surveys of economists show them to be far from prepared to address the deflation concerns that we have publicly expressed recently—and hence a very substantial proportion of them do not perceive that a lower rate is the right choice at this stage—half or more are forecasting that we will lower it. But that’s not their recommendation. Basically they are forecasting what they think we will do rather than what they think is right. That leaves us with a sense that, because we have a credible position that people respect, if we were to decide on a 50 basis point rate cut and suggest that we remain concerned about having to lower the rate still more, it would lead to results that I don’t think we would particularly like.

    That leads me to the conclusion that the reduction should be 25 basis points and that we should use wording in our press statement similar to the wording we adopted at the May meeting. We need to convey the notion that we may not have completed our easing and that we are still watching ongoing developments in that regard. I believe, however, that we have to acknowledge that economic conditions have improved, as indeed they have, and that the probabilities of significantly more-positive developments starting soon are clearly better than 50–50.

    So what I want to put on the table at this stage, and I hope it’s acceptable, is to move the funds rate down 25 basis points, maintain the assessment that the risks to sustainable economic growth are balanced, but continue to imply that the risks of igniting inflation are very low. The latter clearly implies that policy easing insurance is exceptionally low priced and that we foresee low inflation as the likely environment in which we are going to function for the period ahead. I don’t know how the markets will respond to all of that, but if our purpose is to maintain the extraordinary communication success of our May 6 announcement, in my judgment this statement is as close as we can get. That, therefore, is what I would put on the table. President Hoenig.

  • Mr. Chairman, I support the recommendation, and let me explain my reasons in the following way. I am scheduled to give a speech next week; and as I think about it, the policy stance you’ve just described makes me comfortable that I will be able to give that speech. In other words, I do think that the outlook is positive. I don’t know if it’s as positive as the Greenbook or as positive as we hope, but I think it’s positive. However, I believe that the cost of insurance is fairly low and a ¼ point cut in the funds rate target is to me a reasonable insurance policy. If we went more than ¼ point, selling the idea that the economy is picking up and that the outlook is favorable would be much harder; that would be very difficult to communicate. So I support your recommendation strongly.

  • First Vice President Stewart.

  • Mr. Chairman, I support your recommendation. I agree that there is no clear sign of a recovery, and it seems to me that we need to back up our antideflation reputation. I would not go to a ½ point cut in the funds rate objective because it seems appropriate—to recall some of my nautical training of years ago—to go slowly in uncharted waters. At these levels of rates we don’t know what the impact on the financial industry will be, and I like the idea of giving the banks, money market funds, and consumers time to adjust to these low rates.

  • Mr. Chairman, I agree with your recommendation and I also very much like the way you got there. I think we do want to reestablish an accommodative policy, which means the choice is between 50 and 25 basis points. Given the fiscal stimulus in the pipeline and given some of the incoming data that suggest a pickup in economic activity, 50 basis points may be a bit too much. As I’ve listened to the discussion today and thought about it, I must say that I would like to have a bit more of a cushion. But if things unfold in a negative way, I think we will have time to provide more of a cushion. I strongly endorse what we’re trying to do overall, which is to send a very clear signal that we’re prepared to be accommodative now and prepared to be accommodative for some time if we have to be. Working with the risk assessment the way you’ve outlined seems quite consistent with that last statement; I think it might send that signal. There is some risk that we’ll disappoint the market to some degree, but I don’t think this action will backfire on us. So I’m very comfortable with your recommendation and the way you got there.

  • Mr. Chairman, I really have a preference for a cut of 50 basis points, in part because of the arguments that were made by Governor Gramlich. In addition to that, it seems to me that 50 basis points would actually more than offset the decline in expected inflation and, therefore, the increase in the real funds rate that has occurred since the last meeting. To me a 25 basis point cut merely undoes an inadvertent tightening brought about by declining inflation expectations. And if that’s the case, it’s hard for me to conceive of a cut of 25 basis points as taking out an insurance policy. It just gets us back to where we were.

  • Mr. Chairman, I support the 25 basis point reduction, and I think your discussion about the statement is right on the mark. It does leave open, of course, a possibility of another 25 basis point cut in the future. That’s part of the purpose of doing it this way. That being the case, we will get questions about where this easing process might end—whether there’s a possibility of another 25 beyond that. In addressing those questions we could punt and say that we’ll cross that bridge when we get to it. I don’t believe that would be the wise thing to say. I think we need to be talking in much more definite terms about what it would mean to move to a so-called nontraditional policy. It’s not that we expect to get there, and we should emphasize that. I certainly don’t anticipate that we will get there. But I think we need to have a coherent view of what it would mean if we did. That’s because such a policy regime is not over the horizon as a remote possibility from the perspective of the marketplace but it’s actually out there on the horizon as a genuine possibility. In my view the market understanding of what it would mean is very, very weak. I don’t think people know what it would mean. If we do get to that point, it will be important for us to make sure that money growth remains substantial, and I would want to emphasize that we will pump funds into the system to be certain that happens. That’s essentially what it means if the funds rate actually goes to zero from time to time. I think we need to talk about that because people will be asking us about it.

  • Well, I think we have a problem in the sense that the markets don’t know very much about it and I’m not sure we do either. That is, we know what the nontraditional activities are, but we don’t know how the market will respond to a whole new set of monetary policy procedures. We do know that uncertainty of this nature will increase risk premiums. It has to. Anything new, good or bad, increases risk. One reason that I’m reluctant to move the funds rate target down 50 basis points is that it gets us closer to the point where we will have to address the issue very immediately. I say that because I agree with you. I don’t think that the markets have a clue, really, about what nontraditional types of policies would mean. We could handle it in the upcoming monetary policy report if we knew much about it. I frankly would prefer to avoid that in the hopes that this economy will start to pick up, which would make that conversation moot. I’m not sure that we could convey to the markets a sense of confidence that the transition from the traditional to the nontraditional would not raise risk premiums. Unless we can do that, we are in a very difficult position. I would hope that Keynes prevails, which is something I rarely say, [laughter] and that this economy picks up and takes that issue off the table. Governor Kohn.

  • Thank you, Mr. Chairman. I support both parts of your recommendation. I do think we need to follow our talk with action. As for the size, 25 versus 50 basis points, I recognize as President Parry said that one could make a case for 50 on the grounds of being aggressive and getting ahead of the problem. But I think 25 is appropriately sized for the situation, given that we do see signs of some improvement and there’s a lot of stimulus in the pipeline. I believe that the 25 basis point cut taken together with a sense of downside risk to inflation should limit any upward ratcheting of interest rates from what little disappointment there will be in the market. Like President Poole, I presume that if we don’t get the rebound that we’re looking for in the third quarter, we’re going to have another serious conversation in August about whether we need to move further.

    Let me make a couple more comments on some of the things that have been said. I do have a little concern about the sense that we might shy away from a rate cut that we think is needed because of the signal that such a move would send to the markets. If I thought 50 basis points were the appropriate action, I would argue in favor of that, and I would have confidence in our ability to explain it, though it would be very difficult to shape our message so that we weren’t sending the wrong signal. I would worry if I thought that concern about the message being sent kept us from doing the right thing. In my view it’s the combination of our words and actions that will shape market expectations and confidence. I think we can put the two together in a way that we get out the message we want to send.

    Let me touch on a few more things that were mentioned. The word “sustainable” in my mind is growth at potential. The way I see the three sentences in the balance of risks statement is that the first sentence is about the output gap, the second sentence is about the inflation gap, and the third sentence adds it up. So if I think the first sentence is about the output gap, sustainable to me means growth at potential. Interestingly, relative to what Governor Bernanke said earlier today, the forecasts that we’ll be putting out are for growth above potential and are not entirely consistent with the statement that we’re likely to put out. How we’re going to handle the balance of risks language may be more of a problem going forward if growth actually does pick up. I don’t think it’s a problem for today.

    Finally, Vincent’s chart in the top left-hand panel of chart 1 brought home to me that actually it wasn’t so much the release of the words in our press statement that resulted in the change in financial conditions; it was all the things that followed, including our own statements. It involved the interaction of what we said later and the data that came out relative to what we had said earlier. Many of us, myself included, were a little surprised by the reactions to some of the things we said. To the extent that some of us have expressed concern that there’s too much talk of deflation—that people don’t understand that it’s disinflation we’re talking about—I think we all, present speaker included, need to be very cautious about what we say. We need to be careful that we’re not confusing the situation and fanning concerns that are not appropriate. Thank you.

  • Thank you, Mr. Chairman. I find today’s decision a very hard call because, in addition to the spending uncertainty issues that you mentioned, we have all the uncertainties—I’ll call them the uncharted waters uncertainties—that we talked about yesterday and how to deal with those. So this time it has been difficult for me to figure out what I think we ought to do. Therefore, I support what I’ll term your middle-of-the-road holding action. It doesn’t go too far wrong in any dimension and it might even be just right. In addition, I would like to support Don in what he just said. I’ve always been uneasy about this argument that if we move 50 basis points we send a message of fear. I would question that, partly for the reasons that Don mentioned. If the economy is really that shaky, maybe we should go 50.

  • Well, that’s what we did in January 2001. The market did not expect us to go 50, but we chose to do that, and we were fully cognizant of what was involved. So I don’t think there’s really a disagreement on how to proceed if a larger move is necessary and that’s what we want to do. I’m referring only to the types of actions when the market misreads what we do because their interpretation involves a combination of what we said previously and what we are in fact trying to do. If we have to move, market reactions to the move cannot be a consideration. President Broaddus.

  • Mr. Chairman, like Ned, I think it’s a very tough call this morning. Clearly the choice for me is between the ¼ point and the ½ point reduction. As I see it, we have a significant risk of further disinflation. We’ve said that publicly. Also, as I said in my comments about the economy, I do believe that an acceleration in economic growth is the most likely outcome, but I don’t think that has a particularly high probability in relation to other possible outcomes. In my view there’s a strong probability of a weaker outcome than that, and I think we need to move forcefully and decisively against those downside risks at this meeting. Moreover, I really don’t see much risk in doing that. To put the issue in a longer-term context, I’ve been attending these meetings for a long time, and it seems to me that often we’ve gotten into trouble when we have not moved quickly in situations where we’ve seen a significant risk in one direction or the other. We haven’t been willing to move as forcefully as we should have. So, like Bob Parry, I have a strong preference for a ½ point reduction.

    I have just a couple of additional comments. I’m worried, looking forward, about how this situation might play out if these downside risks remain in the picture. If we move ¼ point now and then by the August meeting or the meeting after that we don’t see much progress, we may be faced with having to take stronger action at that time. I don’t know exactly how that would go, but we could end up with an even lower funds rate than otherwise and that prospect bothers me a little. On the issue of the signal and whether people would view a 50 basis point cut as suggesting that we see something the public doesn’t see, that to me would be an advantage of what I understood Governor Bernanke to be recommending. If we communicate clearly to the public all of this information—what our real concerns are and their relative importance—I think that would deal with the issue. Another thing that bothers me about a ¼ point reduction is that some people may conclude that the reason we decided on ¼ point rather than ½ point is because we’re worried about the zero bound. We had a wide-ranging discussion of that yesterday, with a lot of views expressed. One thing I took away from it was at least a reasonable degree of confidence that somehow or other we’ll deal with that problem if we have to. I’m a little worried that a cut of only ¼ point today might suggest to some people that we’re not confident of our ability to do that. I’m going to support the recommendation, but I must say it’s a tough call for me.

  • Mr. Chairman, I support your recommendation. I have to admit to being still a bit uneasy, until we see the draft press statement in a few minutes, because how we talk about the disinflation risks concerns me. When I look at the tabulation of our individual forecasts for inflation next year, I don’t see any statistically significant further decline in our inflation expectations. So I find it hard to read into the conversations I’ve listened to and these forecasts a great concern among us about inflation falling rapidly over the period ahead. Therefore, I hope that we won’t create the mis-impression in the statement that we see a bigger risk than our forecasts seem to suggest. That’s not what I see when I look at our forecasts. Nevertheless, I’m supportive of your recommendation, and I will vote for it.

  • I support your recommendation for lowering the fed funds rate at this meeting, Mr. Chairman. I would have preferred a bit more decisive action. My concern is that for the next two months we’ll be talking about this among ourselves and the press will be asking what we’re going to do next and whether we plan to stop at 1 percent—wondering if perhaps there’s a little fear associated with breaking 1 percent. But it’s clearly the case that a reduction in the funds rate is in order to get the economy back to an acceptable growth rate, so I support your recommendation.

  • I, too, support your recommendation, Mr. Chairman. It seems to me that this additional stimulus is very low cost at this point, so I think it’s the right thing to do. I also support the idea of reinforcing the signal that we sent to the market the last time about our views on interest rate levels and so forth. I’m not sure about the best way to do it. Maybe when the draft statement is available, that will clarify it, at least for me. I have one other, perhaps somewhat gratuitous, comment. It seems to me that when inflation is running at 1 percent plus or minus—and it may be more minus than plus—there’s not much of a distinction between being concerned about further disinflation or about deflation. We’re just not very far from deflation. So I’m not sure that trying to make that distinction in our public comments is going to turn out to be very productive.

  • Thank you, Mr. Chairman. I agree with the way that Roger Ferguson phrased the issue—that the threshold of evidence provided by the data since our last meeting was not sufficient for us not to change rates today. So I do agree with the 25 basis point cut and the way you phrased the balance of risks. But of course the data we talk about are always looking backward, and the key is the forecast going forward. As we’ve often said in these meetings, sometimes the last cut or the last increase in the funds rate target is the one that’s not needed because we didn’t have perfect information at the time we made that cut or increase. I certainly hope that’s true this time, and I hope we won’t have to move forward with any nontraditional forms of monetary policy.

    I do want to say a word about the risks statement, though. In my view Vincent has done an admirable job in trying to take the wording of our statement from the last meeting and to put it into this old framework that we had for the balance of risks. On an interim basis, I think that’s fine. But I believe—and I’m going to sound like a broken record here because I recommended this at the last meeting—that a subcommittee of this Committee should be appointed to look at this in more detail, as was done in past. The most recent such subcommittee was the one that Roger chaired, and there were several presidents and several members of the Board on it. This is a very tricky area. A couple of points have been mentioned here today. Governor Bies has concerns about the phrase “downside risks” with regard to inflation, and Bob Parry is worried about the word “sustainable.” Don Kohn made a very good point that down the road, when we’re looking for sustainable economic growth, we may not want to say that the risk is weighted toward the upside. So I think a group of us should look at this in more detail and come back with a recommendation to this Committee regarding how to deal with this on a longer-term basis.

  • Why don’t you survey the members and rather than get into a discussion right now, because obviously we don’t need to do that today—

  • No, I’m talking about the longer term.

  • I understand. It’s a very critical question of how we ought to proceed to get our communication issues straightened out. We’ve moved forward since the last meeting, and apparently effectively, but that’s not the end of the game. Governor Bies.

  • Mr. Chairman, I can support your recommendation. Like several others, I was torn between 25 and 50 basis points. But as you put it very well, we have a huge stimulus coming with the tax package that’s about to take effect, and in accordance with traditional economic theory, that should provide the impetus to get the economic growth that is projected in the Greenbook. For that reason I’m more comfortable with a cut of 25 rather than 50 basis points right now.

    I do support President Moskow’s direction of thinking regarding how we talk about things. At this moment, in a world where CEOs and everybody else are worried about risks, even to imply that the opportunity for growth of 4 or 5 percent is seen as a risk seems not to be the best choice of words. We might want to find better words to convey our message in a way that will encourage what we see as the growth necessary to get economic performance up to potential and to use all of our excess capacity and human resources. I think it’s time that we look at this and try to address some of the comments that Governor Bernanke made.

  • Mr. Chairman, I also support your recommendation for a 25 basis point cut. The reason I support it is the need to address the disinflation risk. In the statement we issued at the last meeting we did tell the public for the first time that we had concerns about that risk, and over the intermeeting period we validated those concerns in such a way as to strengthen the public’s conviction that we would act today. Having called attention to the risk, I think we are obligated to follow our rhetoric with action. As others have said, uncharted territories contain risks that we would be wise to avoid, and I think this action will help us avoid those risks.

  • I also support both parts of the recommendation. It seems to me that, in accordance with what we signaled in May, an easing is appropriate. And consistent with what is in the pipeline, particularly the fiscal stimulus, a ¼ point move seems appropriate. I think we’ve also set a very high threshold for ourselves in terms of our responsibility to communicate, and in my view we ought to look at that question very carefully. Before I joined the Fed and the FOMC, I thought as an outsider looking in that there was a lot of room for improvement in communication. Since joining this group I have come around almost 180 degrees on that. Because of the intense focus on every word from the Fed, I have become an incrementalist in terms of how we change the manner in which we communicate. So I believe we ought to think very carefully about how we do that.

  • Mr. Chairman, I support your recommendation as well as your reasoning. I’d like to follow up briefly on your answer to President Poole. I wonder if you might give some thought to whether or not it would make sense tactically to say publicly that we are willing to lower the federal funds rate to zero if necessary. I realize there is some cost to doing that, but I see two advantages. First, it might allow us to defer gracefully for a longer period the issue of what we might do if we run out of room. That is, if the question comes up, we could say, well, we’re still 100 basis points away from that. Second, I think it would have a beneficial effect on expectations in that there would no longer be a feeling in the market that we had reached the end of our rope. Obviously, we’re going to have to put some thought into that.

  • I agree that the longer we can forestall the threshold of having to move to nontraditional means, the better off we are. As I indicated yesterday, while I think there are serious problems as we move rates down, money market mutual funds are not a big issue. These are ephemeral short-term financial intermediaries that can come and go very rapidly. There are trickier questions, and those questions were raised in some of the papers underlying the proposals and discussions of yesterday. But I think they, too, are minor relative to the risk we would take in altering our basic procedures. Yes, the notion that we have no more room to move rates down may be one of the issues we can address in the Humphrey-Hawkins testimony without necessarily going too far. At least we can knock down the presumption of a 75 basis point limit that a lot of people have brought up. I think we could do that without breaking too much crockery, if I may put it that way. President McTeer.

  • I agree with your recommendation and with Governor Bernanke’s suggestion just now.

  • I support your recommendation, too. Along with Bob Parry and Al Broaddus, I certainly can see the theory behind getting ahead of lower rates of inflation and a high output gap and trying to stem the tide before the economy actually falls into deflation. But I personally think a reduction of 25 basis points has some advantages. I think it’s a more normal way to operate in an environment where there are some signs of growth. Granted, to a large degree that’s only a forecast, but things are looking up more than they were the last time we met. So in view of that environment, I’m very much in favor of the 25 basis points. A 25 basis point move would also tend to moderate a bit the degree to which people might believe that we are going to be constrained in future actions if we need to take them. I believe it is also more consistent with looking at disinflation rather than deflation as a concern right now.

    I would agree with Governor Bernanke that a communication that we’re operating as normal and that we still have 100 basis points to go is appropriate. We need to indicate that there’s a lot of stimulus in this environment and that there are signs of a pickup in economic activity. That is the way to handle the situation at this stage, both in terms of our actions and how we communicate our actions.

    Finally, the task force approach to communication may be a good way of proceeding. But I also thought, given the papers we received yesterday, that we were going to have an opportunity as a group to discuss communication issues—and maybe even before January. I find them extraordinarily complex. A discussion somewhat like the one we had yesterday would be helpful to me in setting a basis for how to think about these issues. Then if we want, we could follow that with a task force to look at this in more detail and to come up with some recommendations. I don’t think we have an immediate, crying need for decisions here—at least I hope we don’t. I believe there’s some time to look at this thoughtfully and to move forward in a measured way.

  • That certainly should be on the agenda for a future meeting. The majority is clearly in favor of a 25 basis point reduction and retaining, not exactly but in similar words, the balance of risk assessment that we put into the May 6 statement. Would you read the appropriate words?

  • The wording is on page 13 of the Bluebook: “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with reducing the federal funds rate to an average of around 1 percent.” With regard to the three sentences for the press statement: “The risks to the Committee’s outlook for sustainable economic growth over the next several quarters are balanced. The risks to its outlook for inflation over the next several quarters are weighted toward the downside. And, taken together, the balance of risks to its objectives are weighted toward the downside in the foreseeable future.”

  • Would you call the roll?

  • Chairman Greenspan Yes
    Governor Bernanke Yes
    Governor Bies Yes
    President Broaddus Yes
    Governor Ferguson Yes
    Governor Gramlich Yes
    President Guynn Yes
    Governor Kohn Yes
    President Moskow Yes
    Governor Olson Yes
    President Parry No
    First Vice President Stewart Yes

  • The members of the Federal Reserve Board will have to discuss the issue of the discount rate. Please distribute the draft statement to the Reserve Bank presidents, and they can look at it while we adjourn temporarily. We will reconvene shortly.

  • The Board of Governors has accepted the recommendation of a number of Federal Reserve Banks to reduce the discount rate to 2 percent. We accepted the requests of the Boston, New York, St. Louis, Kansas City, and San Francisco Banks. At this point I think we need to give the Board members some time to read the draft press release.

  • Isn’t it called the primary credit rate as opposed to the discount rate?

  • Yes, it’s the primary credit rate.

  • We had a request from the folks in our Public Affairs office to continue referring to it as the discount rate because some reporters have expressed confusion about the new terminology. So we’ve indicated that we would call it the discount rate.

  • Well, okay. What about the letter that is being sent to our Banks? Will that call it something different?

  • We send the Banks a legal sheet of paper and in that we need to get it right.

  • If the Committee has a different view, the terminology in the press statement can be changed. In the previous system we had multiple discount rates; we had the adjustment program, the seasonal program, and the extended program. But the actions taken were adjustments to what we termed colloquially “the discount rate.”

  • It’s the same situation now except that it’s the primary credit rate that we refer to as the discount rate.

  • I assume everyone has had a chance at this stage to read the statement. Is it acceptable?

  • Would you accept one little suggestion?

  • I don’t know! [Laughter]

  • I would suggest changing the word “sustainable” to “sufficient.”

  • “Acceptable.”

  • Or “acceptable.”

  • You want to take out “sustainable” and put in “acceptable”?

  • I would argue against that on the ground that it will raise a lot of questions about what that means in these circumstances. I’d leave it alone.

  • Yes, I think it’s a word of art in this type of statement. We’ve used it before; and in the context of what we’ve done, it becomes clear.

  • I always thought we used “sustainable” to mean low enough, and we’re talking here about growth not being high enough.

  • No, “sustainable” means any rate of growth for which the internal dynamic of that growth has the capability of continuing. Now, there are disagreements as to where that rate is. But for the purposes of this statement, we’re saying that all of the signs plus the additional stimulus would suggest a significant acceleration in economic activity. At the moment, however, we’d be hard pressed to argue that the data we have seen thus far could be characterized as self-perpetuating.

  • Mr. Chairman?

    CHARIMAN GREENSPAN. Yes.

  • I know you’re trying to strike a balance between a number of different views, but when I read the words “unwelcome substantial fall in inflation” they sound more menacing, more troubling, and indicative of greater concern than I think most of us have. I wonder if there’s a way to take the edge off of that wording a bit.

  • I agree with that.

  • Are those the same words we used last time?

  • You want to take the word “substantial” out? Is that what you’re arguing?

  • Yes, we have a different projection now, a much stronger projection.

  • Well, it is a projection.

  • Let me put it this way. These are the words we’ve used in the past; and in this environment, the fewer words we change, the better. In August we can change the wording. It is perfectly conceivable to me that, by the time we get to our August meeting, we will be looking at an economy that is comparable to that in the Greenbook forecast. It’s conceivable that a lot of things will change. But I would hope that we could stay with this language for today. Yes, President Parry.

  • In the first sentence of the second paragraph you list the reasons that there is strength. When we talked about it earlier in the meeting, we were citing three reasons: monetary policy, productivity, and the stimulus from fiscal policy. The last one is missing from the statement.

  • That’s because the fiscal policy hasn’t kicked in yet. We’re saying that recent signs point to a firming in spending. In other words, it hasn’t happened yet. We’re trying to indicate that, as we look at what is going on, we see an economy that is soft and whose growth hasn’t taken on the condition of cumulative sustainability. But I would certainly think that by August we’re going to have to address that question. Why don’t we go with this as is, fill in the appropriate names of the Reserve Banks, and show the dissent.

    The next meeting is August 12. Let me remind you before we close that Dave Stockton would appreciate receiving any changes in your forecasts by close of business on July 3. Let’s go to lunch.