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

  • Good afternoon. Let me start by welcoming Pat Barron, First Vice President of the Federal Reserve Bank of Atlanta, who will be here in Jack Guynn’s seat for today.

  • Thanks. It’s good to be here.

  • Welcome. I have a bit of business to start with before we go to Dino. Last month the Congress passed, and the President signed, the Financial Services Regulatory Relief Act, which had a number of measures in it. Included among them were provisions that allow the Federal Reserve to pay interest on reserves and to reduce reserve requirements at our discretion. The act potentially has a lot of very important implications for the conduct of monetary policy, for payment systems, for contractual clearing balances, for data collection, and so on. Because of budget-scoring rules, the provisions of this act will not take place until October 2011. So I feel that, if we hurry, we can possibly be prepared in time. [Laughter] So if the group is amenable, I’d like to ask Vincent Reinhart to form a committee of senior staff around the System to begin talking about these issues. I assume at various intervals we’ll have reports and some discussions at the FOMC meeting about these issues. Do I hear any second?

  • Thank you, Mr. Chairman. I will be referring to the charts that were distributed, and I will divide my comments into two parts. First, a slimmed-down report on market developments in the intermeeting period, and then I’ll touch on the highlights of the memo I circulated last week regarding management of the System Open Market Account.

    The short intermeeting period was relatively calm. Hence, volatility remains low and credit spreads tight, while some equity indexes rose to multiyear highs. Occasional rumors that a large hedge fund lost significant amounts of money betting that yields would rise did not dent the underlying sense of confidence or relative tranquility. On the first page of the handout, the top panel graphs the three-month deposit rate and the same rate three, nine, and fifteen months forward. The longer-dated forwards—as reflected by the solid red line—have declined more than 75 basis points from early summer to early October as market participants priced in an easing of policy for early 2007. Those expectations were heightened as GDP forecasts for the third quarter were consistently trimmed downward. But having pushed forward rates too far, market participants were poorly positioned for the reversal in past few weeks after a surprising Philadelphia Fed survey and comments by Governor Kohn and other Committee members were interpreted as suggesting that policy would not likely be eased on the trajectory that markets had built in. Longer-dated forward rates still anticipate an ease late next year, but the magnitude of that easing has been scaled back. Longer-term Treasury yields show a similar pattern, as indicated in the middle panel. The yield curve remains inverted, though less than it was a month ago. With credit spreads remaining tight and credit quality favorable, there has been less agitation in markets that the inverted curve is sending a recessionary signal. Meanwhile, breakeven inflation rates from TIPS paint a favorable picture, especially at short maturities given the fall in energy prices. As shown in the bottom panel, the five-year breakeven continued to narrow, to about 2.10 percent, and has now contracted more than 50 basis points in less than three months. Longer-term maturities, which are less affected by short-run energy price moves, had less of a decline, as shown by the ten-year maturity. Meanwhile the five-year rate five years forward—the red line—is little changed from the last FOMC meeting.

    The prospect that policy rates may have peaked plus falling oil prices supported equity prices and trumped adverse factors such as evidence that economic growth had slowed. As shown in the top left panel on page 2, the Dow Jones Industrial Average finally pierced the 12,000 level to a new record high. Other major indexes, such as the S&P 500 and the Nasdaq—as shown in the top right panel—also rose, though they remain some distance from their record highs. One feature of the equity markets since the tightening cycle began has been the outperformance of so-called value stocks, as shown in the middle left panel. When economic growth is strong, value stocks—represented by the larger cyclical companies—tend to do better because their earnings are stimulated by the strong economy. But since early August, coincident with the pause in policy tightening, the growth stocks have begun to outperform. One interpretation is that, with economic growth slowing, the effect is biggest on cyclical companies, whose margins compress, whereas growth stocks are better able to maintain margins. Another interpretation is that the equity markets are also pricing in a peak in the tightening cycle on the theory that the Committee will not tighten into a slowing economy.

    Finally, this generally benign picture is also reflected in the foreign exchange market. The bottom panel graphs the dollar against a range of currencies since the last FOMC meeting. None of these currencies moved more than 2 percent in either direction, and most are clustered within a band of 1 percent. For what it’s worth, the currencies that appreciated tended to be higher-yielding currencies. This pattern tends to support anecdotal reports that, in the absence of directional opportunities, carry trades continue to attract speculative flows.

    Switching gears somewhat, I want to summarize the main points of the memo that I sent to the Committee last week about the domestic portfolio guidelines. The last time that we systematically looked at the portfolio was in 1996. We looked at it again in 2000 and 2001 in the context of considering alternative assets given that the Treasury market was shrinking and the Committee was faced with the prospect of acquiring private-sector assets. The table on the right side of page 3 provides a recent snapshot of the System Open Market Account. Given the amount of time that has elapsed and the changed environment, we thought it would be timely to refresh our analysis and assess whether the principles we had been using to manage the SOMA portfolio still made sense. Indeed, we concluded that the four principles identified previously—safety, liquidity, market neutrality, and return—remain appropriate given the objectives for SOMA.

    Safety is the bedrock of a central bank balance sheet, and its importance is uncontroversial. The Committee has achieved the goals embedded in this principle by maintaining a portfolio of Treasury securities with no credit risk. For years SOMA also held smaller amounts of agency and GSE (government-sponsored enterprise) securities, but these were allowed to roll off. The last GSE security in SOMA matured in 2003.

    Somewhat more complicated is liquidity. The Committee has discussed liquidity at various times in the past two decades. In practical terms, the issue is how fast the Desk can offset a reserve-adding event, such as a large discount window loan or a large foreign exchange intervention. Our view is that the critical period for such operations is the short run. Longer-term sterilizations will likely be slow and can be managed in the normal course of reserve management operations. As the memo describes—so I will not go into detail—our conclusion is that it is prudent to add a second limit or guideline of $80 billion of liquid assets over a three-month period while keeping the current $208 billion limit over a twelve-month period. In practice, as shown in the bottom chart on page 3, SOMA maintains liquidity from maturing bills, coupons, and repos far beyond these minimums—a feature we will continue. Additionally, the Desk has other tools if needed in extremis, as shown on the left side. These include the ability to conduct reverse repos and, as a last resort, outright sales.

    The third principle is market neutrality, if you would turn to the next page. This is also somewhat complicated. This issue is, in many ways, simpler now than it was six years ago, when the stock of Treasuries was declining. At that time, we adopted a per issue limit structure, which is summarized in the top right panel of page 4. In short, per issue limits of 35 percent were adopted for bills, which gradually declined to 15 percent for bonds. The blue bars represent SOMA’s holdings for each specific security. This response was reasonable given the environment in 2000. However, the limit structure has, in recent years, created situations in which we have had forced redemptions to stay within these limits, which in turn forces us to make additional outright purchases to offset those maturing assets. We are therefore proposing to revert to an informal flat limit structure of 35 percent for all maturities. I should note that this change would, in reality, have a very limited effect on the portfolio given other restrictions that we have, and which I’ll get to later. At the margin it might allow us to reduce our huge reliance on holdings at the short end of the curve. We are somewhat underrepresented in the middle of the curve.

    An associated issue I wanted to raise is SOMA’s auction participation. Our participation can be highly variable. There are two factors that we cannot control. First, the Treasury’s auction calendar is itself variable and dependent on fiscal needs. Second, the Desk cannot participate in auctions unless it has securities maturing that very day. The middle right panel shows this variability. The yellow box highlights SOMA’s anticipated participation for the three-year note in the next three refundings. We anticipate taking down $6.1 billion in November, $1.5 billion in February, and then $6.0 billion in May. Why is this important given that we are an add-on in the auctions? The Fed’s holdings are part of the floating supply, which can influence the way an issue trades in the repo market. This can, I hope, be seen in the bottom panel. Our participation in the five-year note went from quarterly participation to monthly when the Treasury shifted from a mid-month settlement to a month-end settlement. SOMA’s participation is the green bar. The change allowed us to smooth out our participation because we had large amounts of two-year notes maturing at month end. The black line represents the specialness spread in the repo market for each issue. Note that this spread has been much smaller in recent months, when SOMA’s holdings have been both steady and available to be lent. Our preference for steady and consistent auction participation is, however, constrained by restrictions on how we invest maturing proceeds and, of course, by changes the Treasury makes to the auction calendar. In short, we are likely to continue to wrestle with this principle for some time.

    The last principle very briefly is return. In our view, this principle should not drive the way SOMA is managed, given that our profits are derived from interest on our Treasury holdings and in turn flow back to the Treasury.

    Mr. Chairman, there were no foreign operations during this period, and I will need a vote to approve domestic operations. Helen and I would be happy to answer any questions.

  • Are there questions? I see none. Do I have a motion?

    GOVERNOR KOHN. So moved.

  • The motion is passed without objection. Thank you very much. We’ll turn now to the economic situation. Dave Stockton.

  • Thank you, Mr. Chairman. About a week ago, as we were closing the forecast, I was marveling at how little it had changed over the intermeeting period—both the broad strokes and the details. But the warm glow of accomplishment had barely been kindled when a glance at my desk calendar revealed the source of our success. The last FOMC meeting had been only five weeks ago, so we simply had not had time to accumulate our usual backlog of forecasting errors. [Laughter]

    I recognize that even this assertion is open to some challenge. Because of the incoming data, we have revised down our estimate of third-quarter growth of real GDP about ¾ percentage point, to an annual pace of just 1 percent. However, we don’t think this downward revision carries with it much, if any, macroeconomic signal about greater weakness going forward. Importantly, consumption, housing, and business fixed investment all came in very close to our September forecast. The downside surprises that we experienced last quarter were concentrated in motor vehicle production, defense spending, and net exports. In each case, we believe some good reasons exist for anticipating that these sources of restraint will abate or reverse in the fourth quarter. With regard to motor vehicles, the production cuts needed to deal with the inventory overhang that developed last spring have been larger and have come more quickly than we had expected. As a consequence, the drop in motor vehicle output took a bigger bite out of growth in the third quarter and is now expected to be a roughly neutral factor for growth in the current quarter, rather than being a small drag on growth in both quarters. Defense spending also fell far short of our expectations last quarter, but we expect these outlays to rebound in the fourth quarter to a level more in line with defense appropriations. Finally, imports are estimated to have surged in the third quarter more than seems warranted by the fundamentals and, as best we can tell, without a full offset in other components of spending. Karen and her team expect some of that import surprise to be unwound in the fourth quarter, providing a small plus to estimated growth. All told, we are projecting the growth of real GDP to rebound to a pace of 2¼ percent in the fourth quarter. For the second half, output is anticipated to grow at an annual rate of 1½ percent, a forecast not much different from the one in September.

    We also have made only minor adjustments to our longer-term GDP forecast. By our assessment, lower oil prices and a stronger stock market more than offset the effects of a slightly higher dollar and a bit weaker trajectory for house prices. All told, we revised up our forecast for the growth of real GDP 0.1 percent in both 2007 and 2008, to 2.2 and 2.5 percent respectively. Basically, the general contour of the forecast is the same as in September. As before, the very subdued pace of the expansion that is projected for the second half of this year results principally from a sharp contraction in residential investment that directly subtracts more than 1¼ percentage points from the growth of real GDP. Residential investment continues to contract next year, though that contraction gradually diminishes. In addition, the drag on spending and activity from the run-up in energy prices that has occurred, on net, over the past three years is expected to lessen considerably from this year to the next. The attenuation of the drags from housing and energy alone would result in a prompter return of growth to potential. However, we expect the housing slump to restrain the growth of real output this year and next through wealth effects and multiplier-accelerator influences. Most notably, house prices are projected to about flatten out; and as the impetus from past house appreciation wanes, consumption growth should slow, and the saving rate should begin to edge up. With its usual lag, the overall deceleration in output, income, and sales further damps consumption and business investment. As a consequence, growth remains slightly below potential in 2007, and the output gap edges up to roughly ½ percent of GDP by the end of the year. With the bulk of the direct and indirect effects of the housing slump expected to have largely played out by then, real GDP growth is expected to expand in line with its potential in 2008. Meanwhile, core PCE price inflation, which is currently running a bit less than 2½ percent, edges down to about 2 percent in 2008. The opening up of a small output gap helps to head off an intensification of inflation pressures. But by far the most potent influences are the diminishing upward pressures from prices for energy, non-energy imports, and other commodities.

    Because this basic story is virtually unchanged from the September Greenbook and because we had relatively few surprises to deal with in the forecast, I thought that I would dispense with a further explication of the contours of the forecast. Instead, I=ll offer you a scorecard of sorts to help you audit the plausibility of the forecast story in light of data that we will be receiving in coming months.

    Let me start with housing, because as I noted a moment ago, the recent and projected contraction in residential investment is the principal source of the below-trend growth that we are projecting over the next year. For that story to be on track, housing starts will need to drop sharply further by the end of the year. Single-family starts averaged about 1.4 million units in the third quarter, and in our forecast, we are anticipating a further 12 percent decline, to a pace of 1¼ million units this quarter. We read the incoming data as being consistent with that outlook. Although starts bounced up in September, permits—a less noisy indicator of housing activity—continued to plunge. Moreover, inventories of unsold homes remain at a very high level, and sales cancellations have continued to increase. But after a long period of what seemed to be unrelentingly bad news, the housing data received over the intermeeting period could be fairly characterized as more mixed. Sales of new and existing homes firmed a bit in late summer, the index of pending home sales moved up in August, and homebuying attitudes as measured in the Michigan survey jumped up in September and October. Although it is far too early to conclude that these indicators are pointing to stabilization in housing markets, they provide at least some encouragement to the view that the bottom may now be closer than the top. We will also be scrutinizing the information on house prices. Another reading on the OFHEO (Office of Federal Housing Enterprise Oversight) price index will become available in early December before the next meeting. Here we will be looking for another noticeable step-down in the rate of house-price appreciation, from the 5 percent pace posted in the second quarter to a projected 1¾ percent pace in the third. That forecast is roughly consistent with our near-term forecasting models that make use of the information in the Case-Shiller price indexes and other high-frequency measures of home prices. As you know, we are not forecasting the national average of house prices to drop, but our very low projected rate of house-price appreciation implies that a substantial fraction of households will be experiencing outright declines.

    Consumption will be the second major area that should be monitored, in part because we are expecting the slowing in house prices to show through here. In brief, we will be looking for a continuation in coming months of the moderate increases in consumer spending that we have observed since the spring. Over the past half year, consumer spending excluding motor vehicles has been increasing at a pace of roughly 2¾ to 3 percent, and we are expecting more of the same in coming months. That relatively steady expected growth reflects some crosscurrents that seem likely to be at work. Real income gains should be bolstered by the recent fall in energy prices and continuing, albeit modest, gains in employment. But the lagged effects of higher borrowing costs and an ebbing of positive wealth effects from housing are expected to hold spending below the gains in income and result in a slight upward tilt to the saving rate. Obviously, given the importance of consumption in overall aggregate demand, developments here will have a critical bearing on the probability of achieving our projected soft landing. A snap-back in consumer spending in coming months—an outcome that seems to underlie some of the outside forecasts that are stronger than ours—might lead to no landing rather than a soft landing. In contrast, any serious faltering of consumer spending is “buckle the seat belts and assume the crash position.”

    The third major development that we will be looking for is another sustained step- down in the pace of employment growth. Slower employment growth is a key link in the multiplier mechanism through which the housing-induced slowdown in aggregate output and spending propagates forward into below-trend growth next year. We correctly anticipated the first leg of that slowing earlier this year, when average gains in nonfarm payrolls dropped from the 200,000 per month pace of the preceding several years to the roughly 120,000 per month pace observed since the spring. But our projection anticipates a further slowing in the fourth quarter to an average pace of about 75,000 per month. To be sure, the increase in September was just 51,000, but that came on the heels of a gain in August of 188,000, so we wouldn’t want to lean too heavily on the September observation for support. Moreover, if asked to present just one piece of evidence that casts the greatest doubt on the staff projection at present, I would point to initial claims for unemployment insurance. Claims have basically been moving sideways in recent months and provide no indication that a further softening in labor markets is under way. Given the looseness of the relationship, our forecast of payroll employment is not inconsistent with the current level of initial claims, but right now this important piece of our forecast seems to have more upside risk than downside risk.

    The fourth element of our forecast that we will be looking for in coming months is some signs of slowing in business fixed investment. Of course, the accelerator consequences for equipment spending of the slowing we now think is under way in aggregate demand is really a story for 2007, and given the volatility in the data, it will take some time to detect that slowing when, or if, it occurs. But more immediately, we are expecting to see some slowing in nonresidential construction from the 20 percent pace that we’ve experienced over the past half year to something closer to a 10 percent pace in coming quarters, thus providing less offset to the weakness in residential construction than has been the case thus far this year. With energy prices leveling out, the upward impetus from drilling and mining activity seems likely to gradually abate. Outside drilling and mining, smaller employment gains, slower growth of manufacturing output, and still-high vacancy rates suggest to us that this sector will cool somewhat going forward.

    The final item on the scorecard is inflation. We are going to be looking for core PCE prices to continue to increase an average of about 0.2 percent per month for the remainder of the year, with core CPI running between 0.2 and 0.3 percent per month. Those increases would be higher than in most recent years but lower than the pace observed last spring. Moreover, some of the key factors that underlie our projection of a gradual slowing of core inflation over the projection period now seem to be falling into place. After nearly three years of persistent upside surprise, oil and other energy prices have dropped noticeably from the levels of late summer. If these recent developments hold, the cost pressures from rising energy prices should ease over time. Moreover, the sharp increases in residential rent that occurred in the spring appear to have simmered down of late, and we are expecting that pattern to continue in coming months. Meanwhile, most of the major measures of inflation expectations that we monitor have continued to fluctuate in a reasonably narrow range, and we expect that to remain the case going forward.

    I am tempted to say that, armed with this scorecard, you will arrive at the December meeting with a clear idea of how the staff forecast has stood up to the incoming data. But of course, we all know how the story goes. Much like the cliffhanger serial movies of the 1930s, the promise appears to be that, if you come back next time, all the current problems will be resolved. However, given rational expectations, you know that, to the extent any problems are resolved over the intermeeting period, they will simply be replaced by a new set of puzzles and perils. Karen will continue our presentation.

  • Once again I find myself reporting to you that movements in global oil prices are among the developments during the intermeeting period that were factors in our deliberations about the external sector. Global crude oil spot and futures prices fell further following our September projection but by differing amounts over the maturity spectrum. When we finalized the current baseline forecast, spot prices and very near term futures prices had moved down more than $4 per barrel; futures contracts that mature at the end of 2007 had recorded price declines of about $2; those maturing at the end of 2008 had price declines of about 50 cents. Indeed, for contracts maturing beyond 2009, prices actually rose such that the far-dated contract for December 2012 had moved up about $1 per barrel in price. We adjusted our projection for U.S. oil import prices by amounts similar to these changes in futures prices. The differential movement in prices implies that, even though prices have moved down all along the path through the forecast period, this path now slopes up more steeply than it previously did. So our outlook is for oil prices to rise rather sharply over the forecast period, although from a lower starting point than in the September Greenbook. The reasons for the additional decline in prices during September and October include the return of production to near previous rates at Prudhoe Bay, the absence of any sign of late-season hurricanes in the Gulf of Mexico, and awareness of current high inventory levels. These inventories are by their very nature transitory; hence, market participants seem to believe that some of the current abundant supply will diminish over time, leaving limited spare production capacity and chronic risks to production in Nigeria, Iran, Iraq, and elsewhere. Late last week, OPEC announced production cuts of 1.2 million barrels per day as of November 1. Although the size of actual cuts by individual OPEC suppliers remains to be seen, we judge that significant cuts, albeit not as large as those announced, are needed for prospective demand to be consistent with prices in the futures curve. Those prices remain elevated—around the levels expected at the start of this year.

    We again asked ourselves how the substantial drop in oil prices since their August peak matters for the U.S. economy. As Dave mentioned, some of the near-term variance in U.S. real GDP growth reflects the path of real imports, including oil imports. The nominal trade deficit is clearly narrowed as a consequence of lower oil prices. We expect that the average oil bill in the fourth quarter will show an improvement from the third quarter of $60 billion at an annual rate. The net trade balance on nominal goods and services will improve by just about the same amount as other trade components experience small, offsetting changes. As oil prices rise going forward, the nominal value of oil imports should move back up; but for 2007 as a whole, we expect that the total figure will be about the same as the total for this year, followed by a moderate increase in 2008.

    With respect to our forecast for exports, we again expect that real exports of goods and services will expand at an annual rate of about 4½ percent through early 2008 and then will accelerate slightly, to about 5 percent, over the second half of 2008. We see this pace of export growth as reflecting moderately strong growth of trade in both services and merchandise. These components in turn reflect solid average growth of around 3¼ percent in foreign real GDP. The projected acceleration in real exports in 2008 reflects a boost from relative prices as U.S. export price inflation moderates. This projected pace of export growth is somewhat below that observed in recent years, particularly in the first half of this year. To some extent, the double-digit growth of U.S. real exports early this year reflected rapid real GDP growth abroad at that time. But our models cannot explain all the strong growth, and a sizable positive residual has emerged in our model. During the first quarter, exceptionally rapid growth of real GDP was widespread abroad as most industrial countries and many emerging-market economies in both Asia and Latin America recorded particularly robust real expansion.

    The rapid growth moved many foreign economies closer to potential and was not sustainable over the long run. We read recent indicators of activity abroad as generally confirming our expectation that slowing from those very rapid rates would occur through the year. According to the data, among the industrial countries, Canada and Japan have GDP already decelerating in the second quarter. In contrast, the pace of expansion strengthened in the euro area; but with further tightening of monetary policy and an increase in the value-added tax in Germany to take effect at the start of next year, our outlook calls for a slowdown in growth there as well. For the emerging-market economies, the most important news is Chinese third-quarter real GDP growth, announced just after the Greenbook was distributed. Based on the data and our best estimate of a seasonally adjusted series for the level of Chinese GDP, real growth in China was at an annual rate of about 5½ percent in the third quarter from the second quarter, following two quarters of growth above 12 percent. These data are only approximate as they are inferred from the annual growth rates published by the Chinese authorities. However, it does seem clear that the measures implemented by Chinese officials to cool the economy have had some effect. We are projecting that growth going forward will return to rates between 8 and 8½ percent. Of course, the band of uncertainty around this forecast is significant. We judge growth at that pace to be consistent with Chinese potential and acceptable to Chinese officials. This picture of real output growth abroad is a benign soft landing. We are projecting slowing that does not overshoot in many foreign economies, including importantly the euro area, Japan, and China. We believe that domestic demand growth in Canada, Japan, the euro area, and Mexico will continue to sustain their domestic expansions and growth in the global economy and will underlie ongoing moderate strength in U.S. exports.

    With respect to the current quarter, trade data for August surprised us with the strength of exports and led us to revise up by more than 2½ percentage points our estimate of the annual rate of growth of real exports in the third quarter. The surprise was widespread across categories of merchandise trade other than computers and semiconductors and included strong exports to most of our trading partners, with the important exceptions of Canada and Mexico. With no special stories or specific components of interest, we have projected that real export growth will revert to its historical relationship with foreign output and relative prices. However, the positive surprise in August reminds us that there is upside risk to our forecast for real exports as well as downside risk should foreign growth slow more than expected. Real merchandise imports in August came in above our expectation as well. We have accommodated that surprise in part by reducing real imports projected for the fourth quarter, particularly real oil imports.

    All in all, our baseline forecast for the combined contribution of imports and exports to U.S. GDP growth over the forecast period is for a small negative effect during the second half of this year that becomes slightly more negative through the second half of 2008, reaching about 0.4 percentage point as strengthening U.S. real GDP growth boosts import growth above that for exports. David and I will be happy to answer any questions.

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

  • Thank you, Mr. Chairman. I have a question for David, and it concerns the Greenbook alternative scenarios and the morals we should draw from them concerning the Committee’s ability to affect inflation. The Greenbook this time had two scenarios showing how the forecast would be affected by shocks to aggregate demand. One was a stronger demand scenario; the other a housing correction with spillovers. Demand, of course, is much weaker in that second scenario. In both of them, unemployment by the end of 2008 deviates markedly from baseline, but even so there is virtually no effect on core inflation. It falls just 0.1 percent by the end of 2008 in the negative housing shock scenario, even though unemployment rises to 6 percent. When I actually took a magnifying glass to the panel on page I-21 to look at the core inflation paths, the shocks appeared actually to have a perverse effect on core inflation. The housing correction shock has a perverse effect on core inflation in mid-2007, with inflation actually up in the weak demand scenario and down a bit in the case where demand strengthens.

    Now, I scratched my head and asked myself if I could I invent a reason that this might occur. My thoughts went to possible repercussions on the exchange rate that might have an inflationary effect. But my trusty staff told me that it might be something else entirely—namely, the way inflation expectations are modeled in FRB/US. They told me that inflation expectations in these simulations aren’t much affected by any movement in unemployment with shocks like this because implicitly those forming inflation expectations take the shock to be transitory. But expectations are perturbed, and perversely so, by the reaction of the Fed to the shocks. In other words, the Taylor rule type response that’s embodied in the scenarios has the Fed lowering the fed funds rate to address economic weakness following a downside housing shock. My staff tells me that the Fed’s cut to address the weakness then raises expected inflation, which passes through into inflation in these scenarios, and that’s why we get a stronger housing correction perversely raising inflation.

    Would you comment generally on this? Do I have the correct understanding of how it works? If I do, do these simulations give an unduly pessimistic assessment of the effect of aggregate demand shocks both on inflation and on our Committee’s ability to affect inflation through policy? Is it plausible to assume in your view that easier monetary policy has this direct effect on inflation expectations, even when all it’s doing is offsetting a demand shock?

  • I think, actually, your first story was the more potent one in offsetting these effects—that we’d have an exchange rate response to the monetary policy effect. Now, there is a small change in inflation expectations in response to your doing something the markets don’t expect you to do given the macroeconomic outcomes. The markets lean in a direction in terms of inflation expectations, and if they see you easing significantly, they’re confused as to whether that might say something about your inflation objective being higher.

  • Even when there are negative demand shocks and even though unemployment is rising?

  • That is part of it—yes. Obviously, the question is whether they see those shocks as well.

  • They would see unemployment rising.

  • Well, they don’t see that. The unemployment effects do take a while to begin to develop. All these things happen very slowly. If something is perverse here, it is that we’re showing too short a time frame for the effects to actually play out. With an output gap opening up, we would obviously expect in this model that eventually there would be downward pressure on inflation in the housing scenario and upward pressure in the stronger demand scenario. So there’s nothing unstable about the model or something that works in the wrong direction over the longer haul.

    But as you know, inflation is so inertial in the basic structure of the model that those effects don’t really show through and, because these shocks typically are relatively slow, they tend to get offset in the near term by exchange rate movements in particular but by some movement in inflation expectations as well. So I don’t think that’s necessarily a flaw of the model, but I do think it’s probably a flaw in the short time frame that we show for these alternative scenarios, where most of the interesting effects on inflation, if you think it takes as long as the model does, are typically happening beyond the horizon that we’re showing here. That gets back to an issue that Governor Mishkin raised last time about wanting to look a little further down the road to actually see the response of inflation. Now, that doesn’t mean that the model has got it right in terms of how persistent or inertial inflation is. I think reasonable men and women could come to different views about that. But I don’t think there’s something perverse in the underlying structure of the model.

  • Thank you, Mr. Chairman. Dave, I want to ask you a question about residential housing markets and the effect of this slowdown that we’ve seen on the prices of housing. As you mentioned in your comments, we’ve seen the rate of increase slow. In one of the alternative simulations, you actually plugged in a major reduction in housing prices. Are you aware of any empirical work that has been done, or have you done any work to show us what the time lags would be here that we could expect to see from the drop in housing to some effect on housing prices going forward?

  • A little work has been done in this area, but it’s a bit like modeling the stock market. You wouldn’t take it very seriously in the sense that these are asset markets and they’re sometimes moving in ways that are very difficult to model on the basis of, for example, fundamentals—especially in a period when, by our assessment, prices have moved up significantly above what we think can be justified in terms of interest rates and rents. So now we have a situation in which that asset price misalignment is projected in our forecast to just barely begin to unwind but we’re really uncertain about what the timing of that process is going to be. One of the reasons we wanted to show the alternative simulation is that we’ve taken a fairly conservative approach here. Our slowdown in the growth rate of house prices, to roughly 1½ to 1¾ percentage points over the next two years, doesn’t make a big dent—if you remember from the briefing that we did one and a half years ago—in the price-to-rent ratio, which we plotted there and showed that that had increased very significantly.

    So our best guess is that, as in the past, those nominal prices will flatten out rather than actually decline. But the run-up was so large that we couldn’t rule out this time around that the adjustment of house prices could be more significant and more rapid than in the past. But I don’t know of any reliable empirical model or evidence. We’ve certainly done our share of work in modeling those house prices, and I know our colleagues at the New York Fed have as well. There’s a lot of controversy about whether there even is an asset price misalignment, much less, if there is, how it will unwind. So I don’t have a lot to offer you there, except that we’re going to try to present you with the range of possible outcomes in the sensitivity of our forecast to the baseline assumption that we’ve made. In that regard, I still see more downside risk there than upside risk to our house-price forecast.

  • Thank you. President Fisher.

  • I have just an informational question, David and Karen. If my memory is correct, the September CPI numbers excluding food and energy were not substantially different from those in August. What I’m curious about, if you could just quickly comment, are the dynamics of owners’ equivalent rent (OER). That was you, Dave.

  • As you know, those increases were very substantial in the spring. We had projected them to slow some. They have slowed some. Whether that is noise in the data or an actual response to developments on the ground in housing such as—as I think Governor Bies has mentioned—the possibility that some of this flow of excess housing may turn back into the rental market, and that could help put a lid on rents. We’re expecting a little further slowing going forward. As I noted in my remarks, I see some upside risk, so we’re taking comfort from the fact that those 0.4 and 0.5 percent increases that we saw in the spring have now been running more like 0.3 and 0.4 percent increases. But it’s too soon to conclude that that whole process is over—that it’s all worked out and that things are going to slow down. There’s enough volatility in those rents that we could experience a return to the increases that we saw in the spring. We’re not forecasting that, but I don’t think that outcome should be out of your probability distribution.

    Obviously, our reason for expecting some slowdown is that, in fact, there will be some adjustments in the housing market and especially that people’s expectations for price appreciation on owner-occupied dwellings have shifted down significantly. That downshift is going to make homeownership look less attractive and the rental market look stronger. That’s why we get some slowing but not so much as to go back to the rates that we had a year or two ago, when they were increasing more like 2 and 2½ percent.

  • So, in summary, we are looking at high threes, upward.

  • High threes in the near term on rents, going down, we think, to more like threes by next year.

  • Karen, the most arresting figure, as you pointed out, is reported Chinese growth in the third quarter. What does that stem from? Is it their faux monetary policy or moral suasion or what we call, negotiating with the Chinese, “immoral suasion?” Or do you sense that some capacity constraints are at work here?

  • Well, I don’t know that we have enough detailed information to speak definitively to the question of whether some capacity constraints were reached. We do see the slowdown occurring, importantly, in the sector of fixed investment. That is, the GDP numbers themselves do not give us real component information, but other measures of investment did turn down in the third quarter in a way that’s consistent with seeing GDP slow. The timing of the latest round of administrative measures suggests to us that we are seeing some effect from those. I don’t know that I would call it monetary policy exactly, but I think the bundle of moral suasion and, to some degree, real actions that, in and of themselves, have some bite contributed to this. After two quarters of what we infer from manipulating the numbers as very strong growth, is it possible that in some particular places capacity constraints are reached? It certainly could have been the case.

    From our attempt to turn the series into quarter-to-quarter changes rather than the data that are announced, we certainly had higher numbers for the first half of this year than were generally talked about. The released numbers were tens and so forth, and we had twelves. Similarly, as a consequence we had a much greater slowdown than the released numbers, and we could be exaggerating both. Possibly it wasn’t really quite as strong as we thought in the first half, and it may not have slowed quite as much as we saw in the third quarter. But it would be a real gamble on our part to conclude that it wasn’t, at least in some important sense, due to the administrative measures that they took. I don’t think the officials are so unable to have a consequence with their policy tools, such as they are, if they are really determined—and they certainly seemed to be determined. Thus I would attribute much of the figure to the administrative measures, but we can’t rule out some capacity constraints here and there.

  • Thank you, Mr. Chairman.

  • Thank you. As you suggested, labor force participation plays an important role going forward in how you think about your forecast of the longer-term growth rate and how it evolves. So I have two questions about labor force participation in trying to understand where it comes from and what’s going on. One is the distinction between what’s going on cyclically versus what’s going on in your trend demographics of the labor force participation rate. That distinction is part of it, as is whether the way you estimate the cyclical component of employment and so forth affects the forecast and whether it adjusts very quickly or very slowly in shaping the picture going forward, particularly into 2007 and 2008.

    The second question has to do with the secular decline in general that you’re predicting from demographics. Is there any mechanism in the way you come up with those forecasts that has feedback from the economy? For example, through a certain period, labor participation rates for the 60-year-old cohort were falling rapidly. From more-recent data, that cohort appears to be back in the labor force more aggressively than it was. I’m not exactly sure why that is. Maybe it’s uncertainties about pensions, Social Security, and what have you and whether real wages and adjustments in the labor market affect the secular decline. So I’d like a little discussion about what’s going on in the model that might help me understand where those pieces fit.

  • I’ll turn your question around and address the trend aspect first and then discuss a bit how the cycle gets overlaid on this. Our forecast is based on some research that we’ve been doing in the past several years that was recently presented at the Brookings Panel on Economic Activity. It’s based on a very detailed decomposition of the labor force by cohort, gender, and age. The downward tilt in our projected trend in labor force participation is driven principally by two factors. One is the end of the large uptilt in the participation of women in the labor force. For a long time, women’s participation had been driving the upward trend; that continued rise offset the downward trend in the men’s participation in the labor force, which actually has been a long, ongoing trend that we expect to continue. Now the labor force participation of the entering cohort of women looks a lot like women exiting. We’re not getting any further upward press there, but we are seeing some continued downward press from men. Second, the labor force is aging, and it’s aging within this forecast frame. In 2008, we’re at the front edge of the baby boomers who are eligible at age 62 to collect Social Security payments. Bill Wascher is here if you want him to add anything about the details of his research—but when we run that model, it projects a pretty steep trend in labor force participation.

    Now I will get to your question about all the dynamic feedbacks. I think we would admit that this work does not have all the general equilibrium effects, the potential ways in which employers and employees might respond going forward over the longer haul to the big demographic changes that are at hand. So, any substantial changes in the incentives that employers are providing for older workers to stay in the labor force longer, if they occur, are really not built in here in any significant way. I feel pretty darn comfortable with this forecast over the time frame for which we’re doing it, which is through 2008. I think that these demographic factors will, in fact, be felt and that the labor market institutions will probably not adjust quickly enough to overwhelm the downward demographic tilt. But if we go out a lot further, we have more thinking to do about how those adjustments might occur and whether the steep downward trend that we are currently projecting would continue. As you are probably aware, in trying to model labor force participation, real wages and various other things that make a lot of sense to economists don’t always show up strongly in those models. So in this forecast we’re letting the demographics drive the trend in labor force participation.

    On top of the demographics is the cyclical behavior of labor force participation. We now think the labor force participation rate is probably a bit above its trend. Given the cyclical behavior of participation, we think that is not unreasonable to think that labor force participation has probably already overshot its trend—admittedly, just a bit—when the unemployment rate is below the NAIRU. So the employment dynamics and the labor force dynamics that we have going forward are driven both by the labor force participation rate returning to its trend and that trend continuing to decline. As we discussed at the last meeting, those things together produce a very small increase in overall employment growth. Also, as I think we mentioned last time, we recognize that we’re out of the consensus on this piece of the forecast. Again, I haven’t seen anything over the past year or two to make me more uncomfortable. If anything, I’ve become more comfortable with that view, given the behavior of the labor force participation rate and the unemployment rate in this period as labor markets have tightened up.

    As I said last time, however, if we changed this aspect of our forecast going forward and went back to a forecast of just a flat labor force participation rate, we’d obviously raise employment growth and the growth of potential output. But we’d also raise the growth of projected actual output, and thus this change wouldn’t affect our forecast of the output gap much at all going forward. So this has a big effect on the top-line GDP but not on the GDP gap. Thus if we make a mistake here, it will not have significant policy consequences because with demand and supply revised up by similar amounts, you don’t have to have a higher interest rate to choke off that demand.

  • Thank you. President Pianalto.

  • Thank you. Dave, I have a question on the less-persistent inflation scenario. The description indicates that the scenario allows for inflation to be less persistent in the baseline perhaps for structural reasons. Could you give me a couple of examples of how the structure might change and what the data might tell us or what data would be telling us that such a change is occurring?

  • Clearly, if you have managed to achieve a significant degree of credibility and that credibility has anchored inflation expectations at a rate of 1½ percent going forward and if, therefore, agents expect whatever inflation shock you’ve had to be temporary and for inflation to revert to its average over the past ten years relatively quickly, then inflation could quickly fall back to 1½ percent as suggested by the scenario. We would be looking for evidence that the level of inflation expectations had remained exactly where it was previously and had remained unchanged, at a range of roughly 1½ to 1¾ percent. Now, we don’t think that’s the case, so that scenario does not underlie our baseline forecast. In fact, we think inflation expectations are probably higher than that, more like the 2 percent level that I think implicitly underlies this forecast. But work by our colleague John Williams at the San Francisco Fed, estimating over a very short time span, does produce an estimate that suggests that it might be reasonable to expect—as a good forecast—that inflation reverts reasonably quickly to its recent average. We’re not persuaded by that, but we don’t think it’s entirely unreasonable.

  • Any other questions? Dave and Karen, thank you, as always, for a very good report. We’re ready now for the economic go-round. We haven’t made much use of the two-handed intervention lately, but it’s an option. If you want to make a comment or ask a question, please raise two hands instead of one. We’ll start with President Moskow.

  • Thank you, Mr. Chairman. Conditions in the Seventh District appear to be quite similar to what I reported last time. Except for housing and autos, activity remains on a solid footing, and most of our contacts are relatively optimistic about the outlook. For instance, the two large temp firms we talk to regularly both reported that, although billable hours were roughly flat, their clients were upbeat about the outlook. Furthermore, demand for workers in light industry—the segment most closely tied to the national business cycle—continued to grow. In terms of wages, both temp firms noted that compensation increases have been running much higher than last year at this time. The difficulties of the Big Three automakers continue to be a problem for our region and are showing through in the national numbers for the third quarter. These difficulties don’t stem from an overall lack of demand. Light vehicle sales continue to run at a pretty healthy pace, as the Greenbook notes. To some extent, the Big Three’s difficulties are a consequence of the energy price shock. Demand has shifted away from pickups and big SUVs, which have been their bread and butter. Despite the recent gas price declines, Ford and GM told us that they do not expect a reversal of this shift anytime soon. Otherwise, the District is doing reasonably well. I heard a lot of optimism. Indeed, a few contacts explicitly described the current slowdown as similar to the brief pause in the mid-1990s, which was followed by sustained expansion.

    Turning to the national outlook, clearly economic activity was soft during the third quarter, but the fairly solid growth in consumption and business fixed investment indicates that at least to date we have not seen a spillover of the weakness in housing to other sectors of the economy. This is consistent with the anecdotes that I’m hearing. Looking ahead, we expect several quarters of weak residential investment, but activity in other sectors should increase roughly in line with longer-run sustainable rates. Assuming market expectations for interest rates, we see GDP growth averaging modestly below potential over the next year and a half. We think growth will be a bit above potential in ’08. In our view, the underlying fundamentals— wealth, income, interest rates, and the current level of liquidity in the economy—should support a higher level of spending than what’s in the Greenbook baseline.

    Of course, a major risk for our outlook is that there could be more-substantial spillovers from the housing sector. As has been noted around this table, it could take some time for the weakness in housing demand to show through to house prices. I was hoping we could get more information, but it sounds as though the research isn’t there yet. If prices do fall substantially, a reduction in wealth could have serious ramifications for consumption and spending overall. It’s hard to say when we’ll have a clearer picture as to how events are unfolding. At some point, probably before the decline in the broad measures of housing prices, we’ll likely see early evidence in either anecdotes or risk spreads. Or if the risk is overstated, we may hear of improvements from our contacts.

    Turning to inflation, the projections from our models have not changed much with the incoming data. They still show core PCE inflation in ’08 coming in between 2.3 and 2.6 percent, depending on the period used to estimate the models. So I continue to have the same questions I had last time regarding the interplay between such inflation rates, inflation expectations, and Fed credibility: Will continued high levels of core inflation eventually make the public doubt our resolve to maintain low and stable inflation? Even if inflation is less persistent, as some have suggested, will it settle out at rates like those in the past few years—namely, 2 percent—rather than the 1.6 percent in the Greenbook’s less-persistent inflation scenario? Are the current long-run core PCE inflation expectations, which are likely above 2 percent, just simply too high? I’m quite concerned that the answers to these questions might be “yes.” If so, and the housing spillover risks fade, then we may have to act more forcefully than the Greenbook baseline policy assumption in order to ensure that inflation is more clearly headed into the range consistent with price stability.

  • I wondered, President Moskow, if you had a sense of whether Ford was in a kind of death spiral—I might be influenced by the headlines of today and yesterday—at risk of losing the confidence of customers, so it won’t be able to sell cars, and of creditors. I’m wondering whether that would have any effect on the macroeconomy, or whether we just take down the Ford signs, put up Toyota signs, and continue to produce.

  • My general assessment has been that this is a market share story. It’s not a story of aggregate demand for automobiles or light vehicles in that it is a shift from the domestic, what we used to call the Big Three, to foreign manufacturers, whether they’re producing here in the United States or exporting more to the United States. Obviously, we know there has been a big ramp-up in transplants here, but the import share of light vehicles is going up, too. So I generally think it’s a market share story and, as you said, there will be a lot of dislocations if, God forbid, Ford goes out of business. But I think it would just be a shift.

    Now, in terms of whether what’s happening at Ford is, as you said, a death spiral, I really wouldn’t know. A new CEO is coming in, and there is the old adage, “When a new CEO comes in, he’s going to write off as much as he possibly can and get it behind him.” So some of that may be occurring as well. But the problem with the U.S. firms is both the product they have and the perception of that product. I think their product has gotten better. I don’t, personally, think it’s as good as the foreign firms’ product, but I think the perception of it is much worse than the perception of the foreign firms’ product.

  • President Moskow, didn’t you say that you saw output growing below potential in ’07? Did I hear correctly?

  • So with energy prices down and so forth, why do you see core inflation rising from near-term levels?

  • No, I saw it coming down—oh, you mean in the outer years. Well, I think several things are going on. There is still the spillover of energy price increases flowing through the economy, but also there are more resource constraints than are built into the baseline forecast.

  • Thank you, Mr. Chairman. The New England District economy continues to grow at a moderate pace, pretty much as it was growing the last time we met, with job counts slowly increasing and business and consumer confidence relatively good about both current and future conditions. As I’ve noted before, income growth has been robust in the District, with regional income growing better than 7 percent from second quarter ’05 to second quarter ’06. Indeed, incomes in Massachusetts and Connecticut both rose about 9 percent. Reflecting this rise, the fiscal condition of the states in the region, while varied, remains positive. Regional corporate health is solid, and readings of regional stock indexes follow the positive pace of the nation’s financial markets. Contacts from a wide range of manufacturing industries reported positive trends; fewer cost pressures from commodity, energy, and interest rates; and a continuation of competitive pressures to restrain costs and keep prices stable. We regard this pressure as a return to business as usual.

    On the negative side, the slowdown in the housing sector becomes more apparent with each passing month. According to the overall OFHEO house-price indexes, year-over-year appreciation in the second quarter of ’06 for New England was about half of that for the nation. The change from the first to the second quarter in ’06 was virtually zero. The region now has the lowest rate of annual housing appreciation of any area of the country except the Midwest. This situation is not entirely unwelcome, as housing price levels in the region remain quite high relative to the nation, and there has been much hand-wringing locally about the effect high housing costs have on attracting skilled labor to the region. Of course, the cyclical effect of a sharp residential investment slowdown is of concern. Existing home sales volumes are down 12 percent from their 2005 peaks. New home construction is weakening significantly, and construction employment has declined in both Connecticut and Massachusetts since year-end 2005. Indeed, negative commentary from area business contacts revolved mostly around markets for products aimed at the residential housing industry. While there may be some light at the end of this tunnel, with recent lower mortgage interest rates and some sense of bottoming out, the usual seasonal slowdown in the real estate industry as winter approaches may make this improvement difficult to appreciate for some time.

    The effect of slowing residential investment remains one of the key uncertainties on the national scene as well. Combined with the negative effect of trade, housing trends have caused us to mark down our estimate of third-quarter GDP growth to about the level of the Greenbook. However, positive incoming data on employment, consumer spending, and corporate profits, spurred as they have been by favorable trends in energy prices, financial markets, and worldwide growth, support a modest rebound in overall activity in the fourth quarter and a forecast for 2007 and 2008 of just slightly less than potential. Indeed, I was pleased to see the upward revision to the Greenbook forecast for the fourth quarter of this year, as I had worried whether the earlier trajectory had increased the risk of a spiral downward into a recession. I don’t think that’s likely, and I realize that overall the second-half GDP projection remains about the same. But the upward revision to the fourth quarter in the Greenbook, which brings it closer to our Boston forecast, makes me somewhat more comfortable about the underlying trajectory of economic activity.

    We, like the Greenbook authors, have revised down slightly our estimate of potential, so our sense of any gap in resource usage remains about the same as it was at the last meeting. Thus, unemployment rises very slowly, to just about 5 percent in 2008, and inflation falls slowly as well, along the lines of the forecast at the last meeting. All in all, that is not a lot of change. I must admit, however, to some small amount of hope that we may be seeing the bottoming out of the housing market decline because of the mixture of the data that Dave referred to earlier. Moreover, other aspects of the current situation seem quite positive as well—in particular, the very accommodative nature of financial markets and the continuing profitability of the nation’s corporations. Thus, the risks to what continues to be in many ways a rather benign forecast seem to me to be a bit less on the downside than they seemed at our last meeting. Energy-driven inflation may be lower as well, but I remain concerned about the underlying pressures on resource utilization if the economy does not slow as much as we now expect. Corporate-driven productivity growth, though we haven’t seen it escalate recently, could come to the rescue here, but I think it’s hard to bet on that. Thus, I do see some continuing uncertainty as to whether inflation will be as well behaved as in either the Boston or the Greenbook forecast.

  • Thank you, Mr. Chairman. Our regional economic story is similar to that of the national economy. Regional activity has slowed in the third quarter, mainly because of the housing sector. In general, our business contacts expect the regional economy to continue to expand, albeit at a modest pace. Price pressures remain elevated in the Third District but have not strengthened over the intermeeting period.

    Turning to the individual sectors, manufacturing activity in our region has softened over the past two months. The index of general economic activity in our business outlook survey, which turned slightly negative last month, remains slightly negative this month, indicating basically not much change since September. However, there were some positives in the October survey that were not in the September report. In particular, there was a rebound in the indexes of new orders and shipments, suggesting slightly positive growth in our respondents’ firms. Also, manufacturing executives were much more optimistic this month about future activity, with most indicators rebounding from their September low readings. This optimism is consistent with President Moskow’s comment about the optimism of some executives that he has observed. Now, consistent with the slowdown in activity, payroll employment growth in our three states slowed in the third quarter to an annual rate of about 0.7 percent, compared with 1.1 percent in the nation. The unemployment rate, which had been running under the national rate for the past three years, has now moved up to that rate. Still, our business contacts as well as respondents to our manufacturing survey continue to cite difficulty in finding qualified workers as one of their major business concerns.

    As in the nation, the housing sector in our region continues to decline. We’ve seen some slowing in the value of nonresidential contracts as well over the past three months. But these data are quite noisy, and I think it’s too early to read much of a turning point into the nonresidential construction sector for our region at this point. Office vacancy rates continue to edge down, and the net absorption of office space continues to be positive.

    Consumer spending continues to hold up well in our region. We saw a pickup in retail sales in September, except for autos. Area retailers told us that their sales had increased in recent weeks, and their back-to-school sales exceeded their expectations. Their view is that continued growth at that pace depended on consumer confidence, which for the mid-Atlantic region increased in September, no doubt because of the decline in oil prices.

    The Fed’s current economic activity indexes indicate a slowing in activity in our region over the past three months, especially in New Jersey, which has shown the sharpest deceleration. As of August, year-to-date average growth in these indexes (weighted by gross state product) for our three states has been about 1.8 percent, compared with 3 percent for the United States. Over the past three months, regional growth has slowed to about 0.6 percent. The leading indicators for our three states also have moved down this year, suggesting only modest growth over the coming six to nine months.

    On the inflation front, consumer prices in the Philadelphia region continue to rise at a pace faster than that of the nation. The faster pace is due mainly to the larger increases in shelter prices in the Philadelphia metro area compared with those in the United States. On a more positive note, while area manufacturers continue to report higher production costs, these cost increases have been less widespread in recent surveys than earlier in the year. The index of prices paid in our manufacturing survey has declined for the past three months, and the index of prices received was down significantly in October. So while the levels of these indexes remain high, indicating continued inflationary pressures, some solace may be found in the less elevated levels of these indicators, at least in recent months.

    For the national economy, my outlook is not much different from what it was at the last meeting. Real GDP growth in the second quarter was revised down to 2.6 percent, as has been noted, and the data received to date suggest that growth in the third quarter was even weaker, perhaps 1 to 1½ percent. I expect some rebound in the fourth quarter and, like President Minehan, was pleased to see the upward revision in the fourth-quarter forecast in the Greenbook. The main source of the slowdown, of course, is the fall in the demand for housing. Manufacturing also softened in the third quarter compared with its robust pace earlier in the year. About half of that slowdown was due to autos, and I expect some rebound there, too, in the fourth quarter. Trade subtracted from growth in the third quarter relative to the second quarter, but again, as has been pointed out, I expect that to be less of a drag in the fourth quarter than it was in the third.

    So aside from housing, most other sectors of the economy, including consumer spending and business investment, are holding up, even in the Philadelphia region in the Third District. They aren’t growing as rapidly as they were in the first part of this year, but they are growing somewhat below trend, and they continue to expand. If the slowdown in housing continues to be an orderly one, without large spillovers as has been frequently mentioned, I would not characterize that correction as unwelcome. Housing activity has been at an unsustainably high pace in recent years. Of course, at this point we cannot rule out the possibility that the correction in housing from the unsustainably high pace of activity that we’ve seen over the past few years will derail the expansion. But so far, we have not seen spillovers of housing into other sectors. In particular, we have not seen any retrenchment by the consumer for the most part. The moderation we’ve seen in consumer spending after the strong first quarter is largely in line with expectations. Real disposable income growth remains healthy, and we have been lucky with two positives—the decline in gasoline prices and the rise in the stock market.

    We’ve had some hopeful news on the inflation front over the intermeeting period, but the level of inflation continues to concern me. As we anticipated at the time of our last meeting, the drop in energy prices led to a significant deceleration in headline inflation for September. Although the twelve-month change in core CPI actually edged up to 2.9 percent, a rate that I consider well above price stability, it may be beginning to stabilize. But, frankly, a lot of uncertainty remains, and it is dangerous, to my mind, to rely too heavily on one month’s numbers. Some of the acceleration of core inflation over the past year was likely due to the pass-through from energy prices, as we discussed before. So if oil prices fall or continue to stabilize, then acceleration of core inflation from this source will likely dissipate. However, we’ve seen energy prices retreat only to move back up again, so I don’t think we should become too sanguine. Indeed, the inflation picture remains uncertain. I’ll be more comfortable when we begin to see twelve-month core inflation begin to decelerate. To the extent that some of the acceleration in inflation was fueled by very accommodative monetary policy over the past five years, we still need to consider whether monetary policy has firmed enough to remove the cumulative effects of the past policy accommodation to get inflation back down to a level consistent with price stability in a reasonable time so that our credibility is not at risk. The longer we allow that deviation from price stability to persist, the higher the risk to our credibility and the higher the risk that recent high inflation readings will raise longer-term inflationary expectations. So far, long-run expectations have been stable, and shorter-run expectations have fallen with oil prices. Nevertheless, I think the Fed’s commitment to price stability deserves our protection. One thing to note going forward, though, is that if economic growth remains below trend for a while, then there’s an implicit firming of monetary policy, even without changing the nominal interest rate. Given our economic outlook and the risks to that outlook, at this point that may be actually the most desirable path. Thank you, Mr. Chairman.

  • Thank you. President Pianalto.

  • Thank you, Mr. Chairman. For a while now, I’ve been somewhat more pessimistic than most of the Committee about the downside risk to the real economy. I was beginning to get worried that this might be the perpetual disposition of someone from Ohio. [Laughter] As a prominent member of our business community said to me not too long ago, it’s not the weather, it’s the climate. [Laughter]

    Since our last meeting, I’ve become more comfortable with the idea that substantially weaker-than-forecast growth is less probable—partly because we’re now a little further down the road without any signs that the worst-case scenarios are materializing and partly because my directors and my business contacts seem more positive about the economic outlook. Specifically, as I listened to some of my business contacts in construction, retail, and even real estate, the expectations that things will get substantially worse just aren’t there. Also, the demand for labor seems to be growing at a moderate pace.

    On the price side, my contacts are not indicating much of an impetus for higher final goods prices. Although projected compensation growth seems to be firming just a bit, my contacts are telling me that they think productivity gains will keep costs in check. With the declining energy and material costs, I don’t hear much about the potential for accelerating pressures on prices.

    When I combine what I’m hearing from my District contacts with the aggregate data that have come in since our last meeting, I sense that we have weathered the worst in softness on the real side for now. In September I noted that my biggest concern was the possibility that the inflation trend would worsen. It does not appear that this is happening at this point. However, we have yet to see lower rates of core inflation, and I’m sensitive to the fact that core measures of inflation are being held up by the contribution to owners’ equivalent rent from the rising rents and falling utility bills. Although more-stable energy prices will make the latter effect go away, it’s not clear that the rent part of the picture will quickly fade, as rents continue to converge toward still high housing prices. When we look at the distribution of prices in the CPI, excluding energy, food, and owners’ equivalent rent, prices seem to be either rising rapidly or falling. There isn’t much in the middle, and that makes the underlying movements in the inflation trend hard to interpret.

    It seems to me that the key risk on the real side of the economy has been that the housing market would decline much faster and more deeply than we had forecast and that the effect on consumption spending would be greater than we anticipated. So far, as others have commented, the collateral effect on consumption appears to have been contained. Furthermore, we expected that other forms of spending would hold up as the housing sector slumped, and those expectations appear to be on track for now. I recognize that we’re not out of the woods yet, but the downside risks to the real economy appear somewhat more benign than they did at both the August and the September meetings. In regard to the inflation risks, the probability of accelerating inflation has decreased, in my opinion, but the risk that inflation will remain higher than I personally desire hasn’t really changed. Thank you, Mr. Chairman.

  • Thank you. President Hoenig.

  • Mr. Chairman, I’ll start with the District this time, and I will tell you that conditions in the District remain generally good. Energy activity remains strong, both in the traditional sectors, such as gas, oil, and coal, and in our new sector called ethanol. [Laughter] They are booming, I’m afraid. Despite the recent decline in energy prices, we are not yet hearing, in talking to different producers in the region, about any significant pullback in energy production. In part, this situation reflects a prevailing view right now among those producers that the weakness in energy prices is likely to be temporary. However, if energy prices remain at current levels or move lower at a sustained rate, I think we will then see some pullback in retail activity and so forth—more than we’ve seen so far.

    In other areas of the District economy, we saw some softening in manufacturing activity in the third quarter, but our manufacturing survey shows that businesses remain mostly optimistic about future hiring and capital expenditure plans. Housing activity has certainly slowed across the District. However, we have received few reports of unusual weakness in our recent meetings with directors and economic advisory council members. So it is slowing but shows no sign of collapse, at this point anyway. We have also seen, with the decline in energy prices, strengthening in District retail sales activity and a sharp rebound in expectations for retail activity in the fourth quarter—except for domestic auto sales. Labor markets remain firm across the District. Unemployment rates are low, and our directors and other contacts continue to report shortages of skilled labor across the District. District agricultural conditions remain rather mixed. Drought continues to affect much of the western part of our region. However, livestock and crop prices have been supported by strong world demand and lower supply, so those farmers who are able to bring in a crop are doing quite well.

    Turning to the national economy, I think that the recent decline in energy prices will provide important support to the near-term outlook. Currently, I see second-half growth of around 2 percent, rebounding to between 2½ and 3 percent as we get into next year. Generally speaking, I am more optimistic than the Greenbook, both in the near term and for the next year. Indeed, with the current financial conditions that others have talked about, I don’t envision the pullback in consumer spending and business investment spending that the Greenbook has projected at this point.

    One area that is worth discussion—and Dave talked about it a bit in responding to a question—is the employment outlook, an area for which the Greenbook continues to have, as Dave said, a different perspective. Although demographic forces will clearly work in the direction of slower labor force growth in the coming years, I’m not as convinced that the slowdown will be as sharp or as sudden as the Greenbook suggests right now. I say that because I want to be cautious about viewing the recent slowing in monthly employment growth as being driven by these demographic factors. I believe the recent slowing in employment largely reflects some employer caution about the economic outlook, combined with the effects of weakness in housing and retail sales. Support for this view can be found in the recent slowing of growth in temporary help that has been reported to us. Should the economic growth pick up, as I anticipate, we should begin to see some stronger employment numbers as we get into next year. As to the effects of demographics—again, I think they are going to play a very important part, but another significant factor to keep in mind is the educational composition of the labor force and the skills composition as we move forward in terms of labor demand, because that’s the shortage we’re always hearing about.

    Now, returning to the near-term outlook, the recent decline in energy prices has helped to counter the effects of housing weaknesses. Consequently, the downside risk to the outlook has diminished somewhat. However, because we have not necessarily seen the bottom of the housing market, I do believe that that is an important downside risk to the economy.

    Finally, let me share some of my perspective on the inflation outlook. My overall views on inflation have not changed materially since the last meeting. I continue to expect core CPI inflation to moderate from about 2.8 percent to about 2.5 percent next year and, similarly, core PCE inflation to moderate from about 2.3 percent to 2.1 percent. A significant fall in prices for oil and gasoline and natural gas in recent weeks has already begun to show through to overall inflation. I believe this is a positive development in helping to ensure that inflation expectations remain anchored and perhaps in helping to moderate core inflation next year. Although the decline in energy prices has reduced the upside risk to inflation somewhat, I agree with others that core inflation does remain too high, and I think we have to keep that in mind as we consider our policy options. Thank you.

  • Thank you. First Vice President Barron.

  • Thank you, Mr. Chairman. Data releases and reports we have gathered over the intermeeting period do not indicate much change since the Committee last met, so far as the Sixth District is concerned. Overall growth has been moderate, with the index of District economic activity showing a year-over-year increase of about 2.7 percent, and reports of activity varied considerably among sectors of the District economy. Retail sales have been mixed, and the outlook for tourism is reasonably optimistic. Auto sales remain sluggish, and the housing market—even beyond Florida, where both prices and sales have declined significantly— continues to show additional signs of some slowing. On the positive side, construction is shifting somewhat from residential to commercial. However, the lack of availability and the high cost of home and business insurance in Florida and along the Gulf Coast is a serious concern for our region. Manufacturing activity appears stable. Prices of some commodities are reported lower. Although gasoline prices are lower, fuel surcharges remain in place. As in the national economy, the slowdown in housing and moderation in overall activity have shown little signs of spilling over into the labor market.

    Employment gains through September softened somewhat. However, all states in the District, except Georgia, added jobs, and together accounted for 20,000 of the nation’s 51,000 jobs added during the month. The overall unemployment rate in the District, accordingly, moved down to 3.9 percent. Shortages of skilled labor continue to be reported in some areas, and overall labor quality, as Tom Hoenig noted, continues to be a problem, both of which I interpret as indicating a relatively firm labor market. We had a meeting this past week of our Advisory Council on Small Business, Agriculture, and Labor. Nearly to a person, participants reported things were good—not great but good—and the common problem was finding qualified workers willing to work. Most council members were willing to hire if they found the right people, but at the same time, they would forgo expanding their businesses if it meant hiring individuals who were less than qualified. One member from the construction sector noted that an individual walking around a job site with a piece of pipe, without doing anything else, would fully meet the requirements for continued employment—that is, they were carrying something, and they were moving. [Laughter]

    Concerning the national economy, opinions differ as to how much of a slowdown we will see this quarter and how long it will last. Most professional forecasters, as well as our own in-house models, suggest that growth will slow in the third quarter and then gradually accelerate thereafter. On the positive side, the labor market is very healthy. Corporate earnings continue to be healthy, business investment is supportive, and equity markets not only are at record highs but show no signs of letting up. At the same time, our headline inflation has come down, in the most part because of the decline in energy prices. Core inflation, especially in the service price component, continues to drift upward. Further, it’s not clear that the energy price increases have played a major role in explaining the increase in core inflation, so it may be problematic to assume that the recent decline will provide a significant downward impetus to core inflation, at least in the near term. Federal funds futures prices, the TIPS spread, and inflation expectations seem to be saying that the Fed’s credibility remains intact and are consistent with the belief that the Committee will get policy right, rather than signaling that slower growth is ahead in the foreseeable future. Thank you.

  • That reminds me of the Navy saying: “If it stands still, paint it. If it moves, salute it.” [Laughter] President Fisher.

  • Mr. Chairman, at our last meeting I engaged in a little Texas brag. I mentioned that the employment growth rate in our District was twice that of the national average. Then I read in the pre-briefing for the Board last night the penultimate sentence, which had a wonderful three-word phrase—“Humility is required.” So let me report that economic growth in our District has slowed somewhat, and I want to put the “somewhat” in perspective. We redid the numbers of our first-quarter real GDP growth. Growth of the state real gross product for the first quarter was 9 percent for the Eleventh District. So it’s not a great wonder that it is slowing—it is slowing down from too torrid a pace. But our housing sector is still sweet—perhaps the only spot left in the country—particularly in the Houston area. We actually are building a new auto plant, President Moskow, a Toyota plant in San Antonio, which is getting an inordinate amount of attention. The exports from our state are growing at a monthly rate annualized at 45 percent, and Texas is now the largest exporting state in the nation. So from the standpoint of economic growth, even as I am trying to be humble, the District is doing exceedingly well.

    The only consistently sour note that we hear is what you have heard around this table—and just now from First Vice President Barron—that we have continued reports of shortages of skilled and unskilled labor, from chemical engineers to school teachers to bank tellers and even to hotel housekeeping staff. So we have a significant problem in terms of labor shortages—skilled, semi- skilled, and now, increasingly, unskilled. To put some numbers on this, we have a contact who has surveyed fifty plants on the Gulf Coast for the price of welders. In eight months, the price for a welder has gone from $19 an hour to $25 an hour. You have to pay them a bonus of $100 when they show up, and you have to pay them a completion bonus as well. The bottom line is that in the Eleventh District we’re behaving as though we were a full-employment economy.

    In the rest of my comments, I’d like to emphasize not my District but our views on the U.S. and the global economies, particularly the U.S. economy. I want to go back to your concluding remarks, Mr. Chairman, at the last meeting, when you reminded us that, if we believe we need to have output below potential to help address inflation pressures, it’s a delicate operation, and we may have a very narrow channel to navigate as we go forward—just to keep with your naval analogy of a few seconds ago. This summer I sailed the Corinth Canal, which is so narrow that at times you feel you can reach out and touch both sides. Even though I was on vacation, I was actually thinking of one side as the shoals of slow economic growth—almost recessionary growth, which seems to be what the Greenbook is forecasting at least for the third quarter, and the risk that seems to be out there—and of the other side as the shoals of inflation.

    From the 27 or 28 CEOs and CFOs to whom I spoke in preparing for this meeting, as I always do, I do hear reports of a slowdown. I talked to two of the Big Five housebuilders this time. They are cutting back significantly. Let me give you some numbers. For example, Centex owns 109,000 lots outright and has 54,000 lots under hard option and 80,000 lots under soft option, as they call it. They’ve canceled 25 percent of their hard options. That is $85 million worth of properties. Hovnanian is walking away from $100 million worth of hard option properties. The effort there is to cut back so that what was a two-month leading supply has now become a three- month leading supply. You can see how the dynamics are beginning to work. They’re moving on price, but they are also trying to shut down their inventory and are taking very quick action. That is a depressing factor. One of the truck dealers I talked with, Rush Enterprises, has about $2.7 billion a year in sales. I believe they are the largest in the country; they are nationwide. They are reporting that Christmas retail activity seems to be backing up; in other words, it is slower than it was in previous years. This is an operator with 41 years of experience. They are also building their inventory, particularly in the coastal areas, with the heavy trucks that are going to be used for home construction. The book-to-bill ratio for Texas Instruments has fallen below 1; it is the lowest since 2000. And if you read the newspapers, you will see that the airlines are offering very deep discounts and for longer periods than before. So there seems to be a slowdown in activity.

    With that said, when you talk to the rails, there is a diminution of growth, perhaps 1 percent third quarter over second quarter, and if you talk to UPS, as I reported last time, you’re still seeing some rather robust reports of economic growth of 2 to 3 percent. I think the best way to summarize the economy is, as President Moskow said earlier, that although there are weak signs, the economy is still robust. The chairman and CEO of Cadbury-Schweppes said, “I keep looking and listening, but I’m just not seeing what everybody tells me is going to happen.” Again, as I reported last time, the CEO of EDS, who is an experienced businessman, said, “It’s a funny period. Everybody is prepared to be bearish, but it’s simply not materializing.” So, David, from an economic standpoint, both from the anecdotal evidence and our own economic modeling, we don’t quite accept the Greenbook’s forecast of the kind of slowdown that you’re expecting for the third quarter or for the second half.

    There are positive benefits, and the benefits are, of course, with price pressure abatement. My favorite anecdotal example, by the way, comes from globalization at work, Karen. Interestingly, the CEO of Fluor, who is one of my contacts, reports that when they bid for the Bay Bridge construction, their bid on U.S. steel prices was rejected as being too expensive. They went back and bid based on what they could buy steel from China for, and the bid was accepted. Canadian steel now sells for 25 percent less than U.S. steel, and Chinese steel is being dumped into this market at a price 40 percent lower than Canadian steel. From the standpoint of raw materials and energy, you have seen price pressure abatement. But from businessperson after businessperson, we still hear the same reports, Mr. Chairman, that we hear in our District and that you’ve heard around this table, which is of significant price pressures stemming from labor. As I mentioned earlier, it is not just skilled labor; it is now semi-skilled labor such as truck drivers and welders. Increasingly shortages are being reported, throughout our District and the rest of the country.

    So I would summarize by agreeing with President Moskow in that we in the Eleventh District find the Greenbook’s projection of economic growth to be too pessimistic. Although price pressures have abated somewhat, we know by our measure—the trimmed-mean PCE, off of which we key our view of the economy—that the three-month rate is still running at 2.9 percent and the twelve-month rate is running at 2.7 percent. I would argue as we navigate this narrow channel, Mr. Chairman, whether it’s the channel you describe or the Corinth Canal, that I would be more careful of the inflationary shoals than of the risk of excessive slowdown of growth. Thank you.

  • Richard, clarify for me. You said that some of your national contacts were seeing a slowdown in the book of business. Is that the minority of the contacts? I’m not quite sure I know what you were conveying.

  • The question that I put to each contact was to compare the third quarter with the second quarter. I was trying to get a feel because I’m quite concerned about our staff analysis and the Greenbook’s analysis of the dramatic slowdown to 1 percent in third-quarter growth. So the answer is, yes, there is a slowdown, but it is not now of the severity that our staff projection seems to indicate. But I do want to note that there is some slowdown taking place.

  • As to your reference to the trucking company—one of our trucking company contacts indicated that business is still good. Their bookings out have been reduced from three weeks to about four or five days. So they’ve seen a slowdown, but they’re still busy. They still have business coming in.

  • Part of that, by the way, is in the average fleet of, say, Class A trucks, which are the big ones. The average fleet age is now fourteen months; the normal fleet age is twenty-two months. Part of that has to do with all of these Environmental Protection Agency changes that keep being mandated. So you have to sort out that distortion from economic activity. But the point I was reporting is that the utilization of those trucks in terms of carrying Christmas inventory appears to have slowed and is not running at the pace that it was in previous years.

  • I agree. Thank you.

  • President Minehan, did you have something?

  • Yes. I just wanted to add something that I forgot to mention earlier. President Fisher’s comments reminded me of it. Whether you look at the KMV data on expected- default frequencies for the five major homebuilders or at the Dow Jones home construction index and the stock prices for the top five homebuilders, none of them seems to be indicating a major problem. Now, the expected-default frequency, which again is driven from stock prices, may certainly be above the rest of U.S. industry, but by no means is it even at any kind of historically medium position, let alone high position, and there has been a recent uptrend in the Dow Jones home construction index overall. So that’s another bit of the data that I was using, and others may be using as well, to suggest that maybe things won’t get as bad as the worst of our projections in terms of homebuilding.

  • Mr. Chairman, very quickly—I asked two of the big homebuilders to whom I spoke about that very phenomenon. Their answer was very interesting. They have strong balance sheets. One of them said, “I can feel the private equity shark swimming around my feet.” In fact, there is rumor of one sizable deal that has been proposed—I haven’t been able to figure out what it is—to take one of them entirely private. So some of the buttressing, President Minehan, is coming from significant amounts of liquidity in the system.

  • Private equity interest, yes. But not all five of them, and they all point in the same direction.

  • Thank you, Mr. Chairman. We had a meeting at the Bank last week with representatives from the housing industry in the Twin Cities, including builders, brokers, and lenders, and most of these participants operate nationally. In fact, one of the first you mentioned, Richard, was there. Some of these firms are in nonresidential development and construction as well. The bottom line of the meeting, I would say, was that the comments overall track pretty well with the Greenbook forecast of housing activity—that is, both a further and a prolonged slump in housing. Let me just give you a few of the specifics. They reported, as we know, that sales of new homes have declined dramatically and prices of new homes are going down with sales, also dramatically. Retail brokerages are starting to contract in terms of both number of offices and number of brokers. It was reported that so-called investors have disappeared entirely from many markets and that inventories of unsold homes are rising and the extent of the increase may be understated by the published data. There was little expectation among this group of improvement in housing in the next several months at least, and I would say not a whole heck of a lot of confidence that there was improvement in store even out beyond that, maybe as you get later into ’07. In contrast, and on a somewhat more positive note, the people who are also in nonresidential construction—in particular, office and retail development—thought that the outlook was promising, indeed positive, and are seeing a lot of activity in that business.

    The housing situation notwithstanding, I remain somewhat more optimistic about our prospects for real growth both in ’07 and in ’08 than the Greenbook. Apparently my assessment of the implications of the sustained increase in income, of the run-up in equity values, and of the decline in energy prices is just more positive than the Greenbook’s, and that’s how I arrive at a somewhat more optimistic assessment. I continue to think that core inflation will diminish modestly over this period. So my overall view of the outlook really has changed very little since the last meeting.

  • Thank you. President Poole.

  • Thank you, Mr. Chairman. Let me start by saying that I think the Greenbook outlook is a very good central tendency outlook. I am going to make some comments that are more on the downside of that, which come from hunches and gut instinct. I want to emphasize that I don’t want to make policy on the basis of gut instinct, but I think it helps to keep an open mind about some of the things that might be going on.

    First, on the positive side, my UPS contact says that he is expecting a peak season with a glut of volume and not enough lift. They’re going to have to move express business over to trucks. So if you’re counting on getting a last minute present at Christmastime, I urge you to order a little earlier than you might otherwise. That’s his expectation. On the labor side, UPS has some fairly big increases coming next year as a consequence of recent contracts they signed. They had a long negotiation with pilots, but on the ground side, obviously the less skilled workers, they’re expecting about 3½ percent compensation, very much in line with a normal situation.

    My Wal-Mart contact said that they have not experienced the pickup in sales that they would have anticipated from the decline in energy prices. They had expected an increase of about 65 basis points. They always measure their sales as same-store, year over year. They haven’t seen that. They’re going to be lucky to get 2 percent year-over-year in October. My contact says that weekly information suggests that October is slowing down week by week as we go through the month. Wal-Mart received a lot of attention recently in the press about their slowdown in building new stores next year. They probably had a lot more press than the actual size of the slowdown warrants. They are expecting to increase their square footage 7.6 percent in ’07 compared with 8.4 percent in ’06—so the slowdown is hardly gigantic. Construction costs this year are rising 17 percent; next year they’re anticipating 11 to 12 percent. So there is a slowdown in the increase, but 11 to 12 percent is still a pretty big increase in construction costs.

    My contact in the trucking industry says—and this may make a little more explicit what Richard Fisher was saying—that things in the industry are continuing to slow down. He says it’s the first time in his experience—and he’s been with the company twenty years or more—that the seasonal peak has not yet started. Ordinarily the seasonal peak in shipping for the holiday shopping season would have started. It just hasn’t started, and I think he said they’re running—I forget exactly what the number was—8 percent below a year ago. (Incidentally, one thing that I was thinking when Richard was talking was that sometimes the business people have a hard time doing the seasonal adjustment, so when you compare the third quarter with the second quarter, they may not be seeing a seasonally adjusted slowdown because the volume is bigger in the third than in the second.) My trucking industry contact says that the slower business seems pretty evenly distributed geographically—perhaps a greater softness in the Southeast than in other parts of the country. It is more concentrated in home improvement—I think Home Depot is one of the big customers—and probably autos, but the softness is spread fairly generally across commodity categories.

    We’ve also spent a lot of time talking recently with contacts in the housing industry. The word that we’re getting is that some of the smaller and even regional builders have perhaps six months, and if they don’t see a pickup, they’re going to be filing for bankruptcy. They are very, very hard pressed. A lot of them overbuilt. They are stuck with a big inventory. They have the carrying costs of that inventory, and laying off workers doesn’t solve that problem. They may bring the new construction down very low, but it doesn’t solve the problem of what to do with the unsold inventory. So without a pickup in housing, I think we can anticipate some bankruptcy filings in that area.

    People around the table here and, I think, generally have been treating oil price declines as an unambiguous positive, and I would like to raise a caution flag on that. I remember from my first year in graduate school Milton Friedman pounding into me that a price never declines without a shift in either the supply curve or the demand curve. Over and over again, that’s what Friedman would say. Now, on the supply side in oil, as far as I know, there have been no gigantic new supplies that have come on the market, and the optimistic view on oil is that last winter and spring or starting in the fall perhaps a year ago, there was maybe a $10 to $20 premium built into crude on the basis of geopolitical and weather uncertainties. So a possibility is that prices in the mid to upper seventies were above what was clearing current supply and demand. Inventories accumulated—we know that there has been a big inventory accumulation in the United States for sure—and eventually, with nothing really bad happening on the geopolitical front and with no hurricanes hitting, the prices dropped back down. It seems to me that is the optimistic way of looking at what’s happened to oil prices. But I think we should not rule out the possibility that some fundamental weakness in world demand is showing up in the demand for energy and that might have something to do with the softness. I take that as a hunch, not by any means as a certainty; but I think we ought to be open to that possibility.

    Clearly, the yield curve has been inverted for quite a few months. The market seems to be quite persistent in believing that some time next year there are going to be some declines in short-term interest rates, presumably because of some combination of slower real growth and more-benign inflation. Possibly it’s not all expectations related. It may simply be that the underlying demand for funds is softening—that’s surely true in the mortgage and housing industry—and that is what’s driving yields down. So I think that it’s important to keep an open mind to the possibility that a more fundamental slowing than we see in the current numbers is taking place and to make sure that we don’t dismiss incoming data and say it can’t really be happening. Thank you.

  • Thank you. President Yellen.

  • Thank you, Mr. Chairman. Five weeks have passed since our last FOMC meeting, and not surprisingly the outlook does not appear to have changed in any fundamental way. Recent data bearing on the near-term situation point to noticeably slower growth in the third quarter than we anticipated at our last meeting. However, the Greenbook has revised up its projection for growth during the current and next few quarters so that the overall effect on slack next year is roughly neutral. This forecast strikes me as plausible, but there are few data thus far to bear it out. Meanwhile, measures of consumer price inflation remain uncomfortably high, although the latest readings have been very slightly better.

    With regard to the pace of economic activity, there’s uncertainty in all directions. In fact, we seem to have a bimodal economy with a couple of weak sectors, and the rest of the economy doing just fine. Those two weak sectors are, of course, housing and domestic auto production. Autos seem likely to have only a short-lived effect. In the case of housing, we agree with the Greenbook assessment of housing activity and find it quite consistent with the reports of our contacts in this sector. Besides the falloff in activity, house-price increases have also slowed markedly. The Case-Shiller house-price index has been flat in recent months, and futures on this index show outright declines next year. However, equity valuations for homebuilders, as Cathy mentioned, have risen moderately in the past couple of months, following large declines over the previous year, and we interpret that as providing some indication that the expected future path of home prices has at least stopped deteriorating. Of course, housing is a relatively small sector of the economy, and its decline should be self-correcting. So the bigger danger is that weakness in house prices could spread to overall consumption through wealth effects. This development would deepen and extend economic weakness, potentially touching off a nonlinear type of downward dynamic that could trigger a recession. But so far at least, there are no signs of such spillovers. Consumption spending seems on track for healthy growth.

    Nonetheless, the growth estimate for the third quarter begins with a 1 and just barely. Any time a forecast is that low, it’s reasonable to consider the possibility that the economy could enter recession. So for this reason, we, like the Board’s staff, took a careful look at various approaches to assess this issue, including yield-curve-based models, past forecast errors, leading indicator models, and surveys. Our bottom line is that we agree with the basic results reported in Monday’s nonfinancial briefing. The highest probability of recession that we found, around 40 percent, was obtained from a model developed by a Board staff member. The model includes the slope of the yield curve and the level of the funds rate. An issue with this result is that long-term rates may currently be low, hence the yield curve inverted, for unusual and not very well understood reasons having to do with the risk premium. Estimates from the other approaches came in with lower probabilities. Finally, other financial developments that could presage future economic performance, like stock market movements and risk spreads, suggest some optimism on the part of financial market participants.

    So our sense is that, except for housing and autos, the economy appears to be doing quite well. Indeed, the recent rather sharp drop in energy prices could boost consumption spending even more than assumed in the Greenbook. While this is a possibility, it seems more likely to me that households ran down their savings to fill their gas tanks when gas prices rose and are, therefore, likely to use their recent savings at the pump to bolster their finances, at least partly.

    Overall, under the assumption of an unchanged funds rate, our forecast shows a beautiful soft landing, with real GDP growing at a moderately below-trend pace for a few more quarters and homing in near trend thereafter. But I must admit that we got this forecast essentially by averaging the strong and weak sides of the economy. I think that way of proceeding is reasonable, and I hope the landing happens that way. But I acknowledge there is plenty of risk. We may end up instead with either the strong or the weak side dominating the outcome. For example, if the housing market decline does not spread significantly to consumption, we could end up with a strong economy in fairly short order. However, if it does spread, the slowdown could last quite a while. Scenarios like this are nicely spelled out in the alternative simulations in the Greenbook.

    Which way things go is a key issue, given that we’re in the vicinity of full employment. The desired soft landing depends on growth remaining below trend long enough to offset the moderate amount of excess demand that appears to be in the economy so that inflation can trend gradually lower. The slight drop in unemployment, to 4.6 percent, in September did not help in that regard, and I should note that recent comments by our head office directors almost uniformly supported the idea that labor markets, especially for skilled workers, are tight. However, we do expect the unemployment rate to edge higher over the next year in response to sluggish growth.

    Our forecast for core consumer inflation comes down a bit faster than foreseen by the Greenbook. We have core PCE price inflation edging down from just under 2½ percent this year to just over 2 percent in 2007 and see a good chance that it may fall a bit below 2 percent in the following year. We see the relief on energy prices as helpful, although we keep trying to resist any temptation to overestimate the extent to which past energy price pass-through has been boosting core inflation. Inflation also may benefit from an unwinding of the earlier strong pressures on rents. Finally, as in the discussion we had earlier about the alternative Greenbook scenario, we think inflation may have become less persistent over the past decade, and this is one reason that we’re a bit more optimistic than the Greenbook about the possible degree of disinflation over the next couple of years. But on balance, I have to admit we don’t have a perfect understanding of why inflation has been so high over the past few years, and so I try to remain humble, as always, in my predictions.

    My bottom line is this. I see a non-negligible chance that the downside risks to the economy, emanating especially from housing, could produce a recession in coming quarters, but there’s a very good chance that the spillovers will be sufficiently modest that the economy will avoid a recession. I also see a significant chance that growth could modestly exceed potential. In that sense, the overall risks to the outlook for real GDP growth could be characterized as balanced. In addition, I see quite a bit of uncertainty about inflation going forward with the risks to my forecast probably being a bit to the high side.

  • Thank you. It’s just a little after 4:00. Why don’t we take a coffee break and come back at 4:20?

  • [Coffee break]

  • It’s amazing how great my answers are to your questions at 3 o’clock in the morning after an FOMC meeting. [Laughter] I want to address just a couple of things that came up during the question-and-answer session.

    First, on the issue that President Yellen raised about the expectational channel. That’s a pretty small piece of the story in the way that these model simulations work, so I don’t think you should worry too much that it is being a significant factor. It is a small factor slowing the pace of disinflation. The model guys tell me that the dollar channel is probably the more important factor there.

    Second, in response to President Moskow’s question about house-price modeling, I should have said we do have several models of house-price determination, none of which we think are very good. [Laughter] One is an error-correction model that takes seriously the notion that, when house prices are very high relative to rents, there’s a correction that will bring the price-rent ratio back to the historical average, and we estimate the speed of that correction. That model taken seriously would suggest outright house-price declines in 2007 and 2008. We also have a simpler model based on momentum. That model suggests a bit of deceleration but nowhere near the amount of deceleration suggested by the error-correction model. Our forecast cuts between those two simply as an indication of our ignorance about which of those models might be best at capturing the current situation.

    Third, in response to President Pianalto’s question, besides the notion that the less-persistence scenario could reflect greater credibility anchoring monetary policy, some structural changes could be taking place in the economy in terms of greater flexibility of labor markets and maybe greater price flexibility as well. I don’t think that’s an unreasonable hypothesis. One could think about and be surprised at the extent to which workers have taken a significant hit to their real wage this time without trying to recoup any of it through higher nominal wages. That may indicate that labor markets and maybe product markets are changing in a way that will make the overall inflation adjustment more rapid than the inertia models that underlie our staff projections. I hope those responses are a little clearer. I’ll sleep better tonight. [Laughter] Thank you.

  • Thank you. President Lacker.

  • Thank you, Mr. Chairman. The Fifth District survey for October just released today shows manufacturing flattening out after a run-up last month, though expectations remain upbeat. Services firms note solid increases in revenues, and overall District job growth remains strong. Among retailers, big-ticket sales were softer, and housing-related sales slowed further; but with other retailers, the picture brightened, with sales and traffic notably stronger. The housing sector continues to slow, with sales weakening further in the D.C. area and modest price reductions occurring in other large markets. Some cities in the Carolinas, however, continue to report modest increases in home sales prices and even permits, and in many locations, activity varies significantly across different price ranges. District labor markets remain tight, and our surveys indicate that expectations are for some additional wage pressures in the next six months. This commentary includes the now-usual reports of shortages of particular skills. Our price measures moderated some, but they remain elevated.

    The national outlook has changed only marginally in the past five weeks. At our last few meetings, we have seen the staff mark down their forecast for second-half growth as the pace of the contraction in housing activity has become clear. The information that has come in over the past several weeks does not suggest any steepening in the rate of decline, and if anything, there are scattered signs suggesting that we might be getting close to the bottom. Except for housing, the economy still appears to be in good shape. Consumer spending is holding up well. Employment is tracking labor force growth. Commercial construction is fairly robust, and business investment spending continues to grow. So we’re still not seeing any major spillovers from the housing market to other economic sectors. Housing is certainly going to subtract from headline growth over the next couple of quarters, but I expect GDP growth to return to close to potential at some point next year, and I remain more optimistic than the staff about when that will occur. There is a risk that output growth will come in lower than I anticipate because of a more severe deterioration of the housing markets or more substantial spillover effects on other spending categories. Although it’s certainly too early to rule this out, I think the probability of such an outcome has receded in recent weeks. So my outlook for real growth is about the same as it was in September with, if anything, a tad less downside risk.

    The inflation outlook has not improved since our last meeting. The September core CPI reading was 2.9 at an annual rate, identical to the August reading, and core PCE inflation for September is estimated at an annual rate of about 2.1 percent, I think. I grant that three-month core PCE inflation has come down off its May peak of close to 3 percent. I do take some comfort in the fact that core inflation did not remain so high, but that measure of inflation has been right about 2¼ percent for three straight months. The Greenbook forecast has it stepping up to 2.4 percent for the next six months and falling below 2.2 percent only in the second quarter of 2008. So three-month core PCE inflation is now as low as it gets for the next year and a half in the Greenbook forecast, and at the end of 2008, core inflation will have been above 2 percent for five straight years.

    I have my doubts about the prospects for even the modest decline described in the Greenbook. The notion that slowing real growth will bring inflation down much has already been heavily discounted around this table—and rightly so, in my view, given the tenuous status of the relationship between real gaps and inflation. The recent fall in energy prices may help, but relying on tame energy prices is problematic, I think. It would encourage the public to believe that we will allow core inflation to rise whenever energy prices surge. That belief is, for me, the leading hypothesis explaining the run-ups in core inflation that we saw last fall and earlier this year. We are likely to see some significant swings in energy prices in the years ahead. So help from this direction is by no means certain. More broadly, I believe we should be leery of letting a relative price move core inflation around.

    There was a lot of discussion at our last meeting about the state of inflation expectations, and a number of people pointed to evidence that market participants did not seem to believe we intend to bring inflation down to the center of the 1 to 2 percent range. This is confirmed by the Bluebook, which provides a very useful compilation this time from various sources of market expectations for core PCE inflation, and they are all clustered around 2¼ percent. If the Greenbook forecast is realized and core inflation gradually comes down to 2.1 percent over the next two years, it’s hard to believe these expectations would fall much. So with core inflation running around 2¼ percent and not likely to come down much soon and with expectations apparently settled at about the same rate, I’m deeply concerned about inflation. Thank you.

  • Thank you. Vice Chairman Geithner.

  • Thank you, Mr. Chairman. Our view of the national outlook hasn’t changed much since September. If monetary policy follows the path that’s laid out in the Greenbook, and it’s flat for the next few quarters, then we expect growth to return to a level close to 3 percent in ’07 and for inflation to moderate gradually from current levels. However, we still face the basic tension in the forecast—the combination of relatively high core inflation today and an economy that has slowed significantly below trend—and we still face the same basic questions: Will inflation moderate enough and soon enough to keep inflation expectations reasonably stable at reasonably low levels? Will weakness spread beyond housing and cumulate? Relative to September, we see somewhat less downside risk to growth and somewhat less upside risk to inflation, but as in September, I think inflation risks should remain our predominant concern.

    Relative to the Greenbook, we expect somewhat faster growth in ’07, but we have a higher estimate of potential. The difference is really mostly about hours and trend labor force growth. We expect more moderation in core PCE and expect it to fall just below 2 percent in ’07, but this difference is mostly the result of different assumptions about persistence. With these exceptions, our basic story about the contour of the expansion is fairly close to the Greenbook, and the implications for monetary policy are similar.

    The markets do seem relatively positive, a little more optimistic about the near-term outlook. Equity prices, credit spreads, and market interest rates all reflect somewhat less concern about both recession and inflation risks. Some of this, however, is probably the result of the exceptional factors supporting what the markets call liquidity. What is liquidity, and what’s behind it? I don’t know that we have a good answer to that. Most people would cite a combination of the facts that real interest rates are fairly low in much of the world still, that reserve accumulation by the countries that shadow the dollar is still quite large, that a big energy-price windfall is producing demand for financial assets, particularly in dollars, and that there is confidence in the willingness and ability of the central bank, particularly this central bank, to save the world from any significant risk of a recession. I don’t think all of this, therefore, is the result simply of confidence about fundamentals, so we shouldn’t take too much reassurance. But it still is a somewhat more positive constellation of asset prices, of market views about the outlook.

    Someone wrote this week that the fog over the outlook has lifted. I don’t think that’s quite right. It’s true that the economy still looks pretty good except for housing, and I do think it’s fair to say that core inflation is moderating and that expectations are behaving in ways that should be pretty reassuring to us. But it is too soon to be confident that inflation is going to moderate sufficiently soon enough with the path of monetary policy priced into markets today, and it is too soon to be confident also that the weakness we see in housing, in particular, won’t spread and won’t cumulate. So I think that overall the balance of risks hasn’t changed dramatically, and as in September, I still view the inflation risk as the predominant concern of the Committee.

  • Thank you. Governor Kohn

  • Thank you, Mr. Chairman. The Committee’s focus has been on encouraging a gradual abatement of core inflation, and I think the limited evidence we’ve gotten since the last meeting is consistent with this outcome. The price data themselves show some signs of deceleration of core inflation on a three-month basis from the very high levels of last spring and summer, though the rates are still elevated. A further decline in energy prices should help to keep inflation expectations down and will take a little pressure off business costs and core inflation even if pass-throughs are fairly small. As expected, the rent-of-shelter component has been increasing less rapidly, supporting the projection that, in a soft housing market with overhangs of unsold housing units, this component will not be boosting measured inflation rates very much. Inflation expectations as derived from financial market quotes remain at the lower levels reached earlier this fall. As the Bluebook notes, the exact level of these expectations is really impossible to tease out of the data; and although they may be a bit higher than we would like, they do look lower than the recent twelve-month inflation rates and, at these levels, should exert some downward gravitational pull on realized inflation.

    The economy appears to be running modestly below the rate of growth of its potential, and this should relieve pressure on labor and product markets. How far the economy is running below potential in an underlying sense is uncertain. I suspect it is not as weak as the estimated third-quarter GDP number but is somewhat softer than the labor market indicators, which show no slackening in the pace of demand or decline in resource utilization. I base this conclusion in part on the data and projections of final domestic and total demand, which the Greenbook has averaging in the neighborhood of 2 percent in the second half of the year. Industrial production was weak in August and September, pulled down by the ongoing inventory corrections in housing and autos, and this reinforced my sense that, at least for a time, the economy is growing a bit below the rate of growth of its potential. Going forward, I think a projection of economic growth gradually recovering next year as the drag from housing abates is reasonable, with growth supported by favorable financial conditions and lower energy prices. How quickly it returns to potential is an open question. Though other forms of spending have proven resilient to date, I agree with the staff analysis that some spillovers on consumption and investment from the weakness in housing and in housing wealth are likely to restrain growth at least a little next year. I also see that the spending risk is still pointed somewhat to the downside, although less so than at the last meeting. To be sure, the recent signs are somewhat reassuring that the housing market isn’t weakening faster than expected. Still, in the staff forecast the housing market is left with a relatively high level of inventory at the end of 2008, and prices are still elevated relative to rents, suggesting the possibility of greater declines in activity and prices. In addition, equity prices are vulnerable to disappointing earnings as labor costs rise even gradually.

    The economy is most likely to grow a little below its potential for a while and inflation to trend gradually lower. All in all, this is a pretty good outcome following the earlier oil price shock and rise in core inflation and housing market correction. With demand outside of housing as resilient as it has been and inflation as high as it has persisted, the extent and trajectory of the expected inflation trend is uncertain and should remain our focus. A failure of inflation to reverse the uptick of earlier this year before it becomes embedded in higher inflation expectations continues to be the main risk to good, sustained economic performance over time. Thank you, Mr. Chairman.

  • Thank you. Governor Bies.

  • Thank you, Mr. Chairman. Well, again, as some of you have said, in five weeks we don’t have a whole lot of new information. But I’m coming back and starting with housing again. As you know, that continues to be something I watch. Let me just make a few comments and give you recent feedback from some exams and dialogues with brokers that I’d like to share with you. Looking at both starts and permits, we all know that housing is continuing to soften in terms of construction, and we have also identified the increasing number of contract cancellations for new housing. Someone mentioned earlier the noise that we may be having around housing data, and I get this through some of the anecdotal conversations that I’ve had with folks. One topic was the inventory of existing housing for sale. I’m hearing from a couple of real estate brokers that people who may have wanted to sell their homes or may have put them up for sale are withdrawing them from the market. They don’t need to move, and it isn’t worthwhile for them to move if they don’t get the price they want. I think the supply was possibly bigger than what we’re really measuring, and so we’re seeing some understating of what desired house sales would be in terms of inventory. That’s continuing; it is just beginning at this stage, at least in a couple of regions, according to folks with whom I’ve talked.

    One of the challenges that we’re faced with here is that—again, I try to look for the good news—in the housing purchase process, people file applications for mortgages very often before they qualify to buy the house. When you look at the Mortgage Bankers Association data on purchase mortgage applications, as I mentioned before, they dropped 20 percent from their peak of last summer, but in the past few months they have been leveling off. So if applications are a leading indicator, we may begin to see some moderation in housing purchases. However, the 20 percent drop in purchase mortgage applications means that mortgage brokers are earning a lot less income. If they don’t close a transaction, most of them get no paycheck because three out of four mortgages are originated not in financial institutions but by independent brokers. We’re beginning to see increasing evidence of this in terms of the quality of mortgages that are out there. We continue to track the mortgages that have vintages—in other words, that were originated—in 2005, and we are continuing to see that, as these mortgages age, the early delinquencies for these are greater than early delinquencies for similar-aged mortgages of earlier vintages, which implies a loosening of underwriting standards and more stress on the borrowers.

    We are also seeing in a small way increased predatory activity with loans. Certain practices have been described to me lately with new products, such as the 2-28 mortgage, which is fixed for two years and then escalates and becomes an ARM tied to LIBOR in the third year. But don’t worry—you can refinance it with the broker and bring your payment down and do it all over again. We’re seeing those kinds of things—mortgages for which people are being qualified by brokers with no escrow account; all of a sudden taxes are due, and borrowers don’t have the money for them. So predatory lending is rearing its head at the lower end of the scale, and it’s something we have to continue to watch for. However, before I leave housing, let me just say that the bottom line is that overall mortgage credit quality is still very, very strong. We’re seeing predatory lending only in pockets of the market.

    I continue to believe that the rest of the economy—except for autos, I should add—is still very strong. Consumer spending is good, and business fixed investment is very sound. The moderation in energy prices and the growth in consumer income will continue to add support to the economy going forward. Jobless claims have been low and moving in a very narrow range the past few months. As several of you have mentioned, I’m hearing more concern by corporate executives about the inability to hire the talent they need to meet their business plans, and so I’m seeing more indication of tightness in labor markets.

    Turning to inflation, as many of you have said, core inflation has moderated from the pace in the third quarter. But going forward in the Greenbook forecast, it is still showing significant persistence even though we think we will be growing, at least for a period, below potential. That concerns me because that level is higher than I’m comfortable with in the long run. We might have had some spillover effects from rising commodity and energy prices earlier on, but I was hoping at this point that, with the reversing, we would see more-positive spillover effects that would mitigate inflation. So I am very worried about inflation. At the same time, I know that negative spillover effects on growth due to the rapid decline in housing construction and the moderating house-price appreciation are risks, which we cannot dismiss, to growth; but on net I am still much more concerned about the persistence of inflation. Thank you, Mr. Chairman.

  • Thank you. Governor Warsh.

  • Thank you, Mr. Chairman. My own views are quite consistent with what I expressed five weeks ago and with the central tendency of many of the speakers today—that is, a greater concern about inflation prospects than growth prospects. So I thought what I’d do is just give you maybe three or four perspectives on market activity in the intermeeting period and suggest to you what conclusions we can draw from them and what conclusions I’d hesitate to draw.

    First, as we noted at the last meeting, the growth in the equity markets is all about earnings and not about multiples. As the markets record the eighteenth double-digit quarterly growth rate, with quarterly growth in the third quarter likely to exceed, on an annualized basis, the second quarter, on one level you would see reasons for earnings momentum and for more robustness than the Greenbook shows in the prospect for business fixed investment. Despite those headlines, I think the Greenbook probably has the general slowdown in business fixed investment and the general slowdown in manufacturing about right. Again, at some superficial level you would think that these stock prices would be juicing business activity—that animal spirits would be as high as they’ve ever been. But in fact, what we can say with some confidence is that historical models of cash and profits have done a poor job of indicating what the strength of business demand would be here. Although business demand has certainly picked up over this cycle, it appears not to have picked up as dramatically as a lot of the data might suggest.

    So what does that mean? I think it means that there is generally still conservatism in board rooms, conservatism by CFOs. Although they have plenty of ammunition in terms of their access to capital markets and their cash balances, we’ll likely see them use that only when it’s clear that the economy has turned. If this soft landing followed by a gradual acceleration does appear to be the most likely path, I would expect to see these companies put their feet on the accelerator a bit more and make sure that growth gets back to trend relatively quickly. But the idea that businesses are going to turbo-charge their way through this without hesitation appears to be less likely than the data would suggest.

    Second, let me turn to the debt markets. There is a discussion among pundits about a tug of war going on between growth risks and inflation risks. As I look at the data in the debt markets, I must say that I don’t see that tug of war. The only tug of war is really between a soft landing and a harder landing, under the view that inflation is almost assuredly going to be solved by the central bank or by exogenous factors. Again, a superficial conclusion would be, boy, the markets are not worried about inflation, and we should take great comfort in it. Rather, the thing that gives me the greatest pause is that, just as inflation is nowhere on the table in the capital markets now, it could quickly emerge; and it would not take much data, which all of us would consider to be relatively noisy and perhaps not overly valid, for inflation to become part of the discussion in the debt markets. That’s something I think we have to prepare for. I suspect, as I think about the balance of this year, that another round of discussions in the capital markets about an inflation scare is quite possible.

    The third issue is really one of short-term volatility, which I tend not to overreact to, but I do think this particular case is telling. Typically, several weeks after a quarter, the markets’ assessment of that quarter’s GDP ends up trending toward truth and ends up without a huge disparity as they get closer to and smarter about the underlying information. I have no reason to doubt our own staff’s view that third-quarter GDP is likely to come in around 1 percent. Nonetheless, the markets’ estimates are quite far away from that. Market estimates have, in fact, trended down, but I’d say the median estimate in the market is still in the high ones, maybe even 2 percent. So the question really is, come Friday, if the headline number posts the way that the staff suggests it will, what the market will say about that. My own view is that there will then be an immediate rush to judgment probably amplified to the downside in a political season like this. They will say, “Boy, the economy is really on the wrong track, and the economic landing is a very hard one.” Whether that judgment dissipates as markets look forward and start to understand the reasons for the shortfall is a bit of a concern. Also, some in the marketplace may have the view that, if that landing is relatively hard and fast, the pace of economic growth will do our work for us on the inflation front. Obviously I don’t think that view is shared by many of us around the table; in fact, there might be more work for us to do. It wouldn’t surprise me if the markets didn’t, at the end of this period, expect there to be a couple of rate cuts built into the first half of 2007, and I suspect we’ll need to send Don back out there to give them another speech. [Laughter]

  • I second the motion. [Laughter]

  • What does all of this mean for the real economy? Again, I’d break it up into two pieces. First, in terms of a consumer reaction function, I think consumers are going to be very stubborn and very strong and are not going to be overly scared by a third-quarter GDP number that they don’t really pay that much attention to. On a very fundamental level they are feeling much better about their prospects now than they have felt in some time, this is a function of some of the wage growth that we’ve seen and a function of oil prices and the unemployment rate. So I don’t really worry that there will be any short or intermediate effect on the consumer. I think the Greenbook has consumer spending continuing in the fourth quarter at something like 3 percent. That’s probably a very conservative estimate given the strength of some of those underlying fundamentals. Second, what’s the effect of this on the real economy for businesses? I’m more concerned about their reaction function. Despite the rather robust discussion in the business sector that I mentioned at the outset, I would expect them to be concerned. As they’re thinking about their capital expenditures plans for 2007 and as they’re doing their fiscal year-end meetings, on balance the concern and the discussion of a hard landing may well affect their ability to bet big and make big projects. So, again, I share the rather conservative view that the staff expressed in the Greenbook in terms of where business investment is going to be.

    Finally, let me just talk for a moment about inflation—again in the context of these market perspectives. I tried to be as witty as David is in this discussion, and during the break it occurred to me that I should call this section “Inflation: Are Objects in Mirror Larger than They Appear?” [Laughter] That’s my half-hearted effort at humor. I’ve probably talked about the TIPS markets at least as much as other folks around this table in the past six or seven months, and I do find some comfort in them. But I find myself increasingly viewing them as being a bit divorced from some of the data. My view is that expectations of inflation relevant for price setting may have deteriorated much more substantially than the TIPS markets and the survey measures suggest. I think the Greenbook has an alternative simulation that hits this case well, and its conclusion has to be that expectations may account for more of this year’s rise in core inflation than either we or the markets estimate. Inflation is likely going to be particularly sticky in the labor markets, given my discussion a moment ago. Very low unemployment insurance claims, very low unemployment, and strong wage and job growth make me believe that the labor market may actually be tightening at the same time that everything else we’ve talked about is happening in the housing markets. The revision from BLS suggested that they found 810,000 jobs through March. When all is said and done about the subsequent six-month period, they may have found more jobs as well, bolstering the case that the labor markets may, in fact, be quite tight. Total compensation is up about 8.3 percent, the fastest rate since the third quarter of 2000. Average hourly earnings have accelerated now to 4 percent. At the end of the day, we should take some comfort from the TIPS spreads, but not reliance. As we think about the measure of TIPS spreads as an indication of inflation expectations, I am troubled, probably increasingly, that the TIPS markets appear to be following our forecast rather than the actual data, and we have to continue to address that problem proactively with the markets. Thank you, Mr. Chairman.

  • Thank you. Governor Kroszner.

  • Thank you, Mr. Chairman. I’d actually like to start with a plea based on something that President Fisher said. I’d like to be treated like a welder. Can I get a show-up bonus? [Laughter]

  • Then we’ll be waiting for a completion bonus. [Laughter]

  • As everyone has said, there has been relatively little information to change people’s outlook fundamentally. We have the same sort of tension that we’ve had before—slowing growth but persistent inflation. Although we see some signs that inflation is coming down, it is still persisting at a higher level than many people, including me, would like it to be. Despite the slowing housing market, private domestic final purchases continue to be reasonably robust. The low third-quarter numbers in the Greenbook are really due to some volatile areas, some special factors: inventories reflecting the weakness in the auto sector, some changes in the auto sector, and timing of defense purchases. Net exports also tend to be fairly volatile.

    The suggestion is that maybe this low is just temporary, as the Greenbook has said. Also, virtually everyone around the table has suggested that the labor markets are really quite robust. Exactly as Governor Warsh said, some of the recent numbers suggest that compensation is on the rise, although the ECI is still not quite as robust as some of the other measures. Certainly we could have a benign scenario in which the continuing high profit margins absorb some of these higher labor costs without necessarily leading to higher price pressures down the line. But the high equity markets may also be supporting high demand, or the recent increases in the equity markets could be to some extent offsetting the decreasing wealth effects from the housing market. Obviously, there could be a tension if the markets start to come down and profits aren’t quite as robust as people have been projecting. We also may have other temporary factors that seem to be boosting domestic final purchases—the decline in prices for oil, natural gas, and gasoline. I hope that the lower prices will persist, but certainly the energy sector is extremely volatile with prices moving around enormously; and as a number of people mentioned, there are a lot of potential problems down the line that could lead to higher energy prices. One thing that didn’t lead to higher energy prices this year was a very benign climate. We had unusually good weather this year. Last year and the previous year, we had unusually bad weather. So I don’t know whether a number of factors are just making us have a bit of luck right now and are perhaps temporarily boosting demand.

    What does this mean for inflation? As we always say, there are transitory factors, and there are more likely to be permanent factors. We’ve talked about some measurement issues with respect to owners’ equivalent rent—probably that’s something transitory. We’re certainly not certain about that. As for energy shocks, we have very little evidence that there has been a lot of feed-through from energy shocks to core inflation, and as a number of people mentioned, I don’t think we can rely too much on the decline in energy to say, “Well, it didn’t get there on the way up, but it will help us on the way down.” I don’t see a good basis for relying on that asymmetry. There is the standard output gap story, but from discussions around the table and certainly from the Greenbook, I think there is not an enormous output gap to rely on to bring inflation down, even if one believed that that gap has an important effect—and there is vanishing evidence that it has an important effect.

    Then there’s the role of expectations in the economic models—the multiple equilibriums story. Just our markets’ belief that inflation will be relatively low going forward affects price-setting behavior, which affects the willingness of consumers to pay more for goods and services. That leaves us with a benign but very fragile scenario. As we know, with any so-called multiple equilibriums situation, it’s not clear exactly what is driving expectations. Obviously, part is their belief in the people around this table, which is something that is incredibly important; it’s something that we really need to maintain, but something that we don’t understand very well. In these five weeks, we haven’t had much change in the fundamentals, but I am left just as uncomfortable about really understanding the inflation situation, the short-run inflation dynamics, because we have an output gap approach, an energy shocks approach, an expectations approach, and sort of a measurement approach with owners’ equivalent rent.

    I take a bit of each of these, and there has been a lot of discussion of the different ones around the table; but I don’t think we have a good, overarching view of what is driving inflation, what the key inflation factors are. For me, that’s one of the most worrisome things going forward because I find it hard to put all of them into a consistent framework. It would be valuable for us to think a great deal about that. Certainly, it may come up in the discussion of the communication strategy, but it’s something that I’m trying to face more and have found it more difficult to understand.

    We’re going to get an enormous amount of information. We have holiday retail sales coming up, so we’re going to find out a lot about consumption. We have two employment reports coming up. We have two rounds of ISM, preliminary revised GDP, ECI, and a lot of information on the housing market. We’ll probably find out a lot more, because in the colder areas the housing market tends to slow down naturally. The seasonal is very strong there. So we should know from some of the data in December whether the numbers from permits, which suggest that the housing market is continuing to go down, or the starts numbers, which seem to be flattening out, show where we are likely to be at the beginning of next year. There’s a lot of uncertainty with respect to both the economy and inflation. In particular, my inflation concerns come from not having an overarching way of understanding whether the factors that we talk about as temporary are really going to be temporary. Thank you.

  • Thank you, Mr. Chairman. As I see it, the data have actually been coming in very much along the lines of where we were at the last meeting in terms of the outlook. The only way that I would change my view slightly is actually good news, in that I see somewhat less downside potential than I saw at the last meeting. In particular, I think that the housing market, although it has retrenched a lot, which I actually consider a rebalancing of the economy, does not look as though it’s going to collapse in a nonlinear way. For example, we see that the market has some expectations along those lines—for example, the stock prices of builders have actually come back a substantial amount. We also see that consumers seem to be holding up very well. The real danger that we were worried about in terms of a housing market retrenchment is that it would spill over in a nonlinear way to the household sector. We don’t see any evidence of that either. Consumer confidence is staying strong. The stock market is up— again, an indication that these spillover effects are not occurring over and above those that we think would be normal in terms of wealth effects and so forth. So, for me, there is actually some good news here in that the possibility of a soft landing has actually increased. My view of where the economy is heading has not undergone a major change, but I have a bit less in the downside tails than I had before.

    The characterization of a deceleration of core PCE inflation also seems to be a very reasonable one. I think the evidence is moving in that direction. But I do want to emphasize that I see no reason that core PCE inflation will fall below 2 percent. We see that inflation expectations are solidly grounded. The good news in that has been that we had an increase in energy prices and we did not see an acceleration of inflation expectations. However, the numbers there are around 2½ percent on the CPI, and that’s consistent with a 2 percent PCE deflator inflation. When we think about going out past the two years, I do see deceleration along the lines of the Greenbook. I don’t see anything more encouraging after that. Talking about the issue of potentially less persistence does not tell us, in fact, that inflation should fall below what inflation expectations are anchored at. So thank you very much.

  • Thank you. Let me summarize what I heard, and then I would like to make a few comments of my own.

    There were several themes around the table. Many people noted the bimodal economy. Housing is still quite weak, although a number of people noted that they thought the lower tail had been trimmed somewhat. Autos are undergoing inventory adjustment, and some people noted slowing in a few other sectors. However, the general view was that spillovers from housing to the rest of the economy had not yet occurred. Most people noted that the labor market is quite healthy, with widespread shortages of labor, particularly of skilled workers. It was further noted that consumption spending would be supported by the job market, by income growth, and by the fall in energy prices. Overall, the assessments of growth, as I heard them, were that it would be moderate going forward, either around potential or perhaps slightly below potential, and some saw a bit of upside risk to that projection.

    With respect to inflation, costs of raw materials and energy are rising more slowly or are declining, and headline inflation has fallen with energy costs. Some felt that core inflation would moderate gradually, but others were less confident about that. The behavior of rents and the behavior of productivity are two important unknowns going forward, and wage growth probably presents the biggest upside risk to inflation. Most members expressed concerns that the high level of inflation could raise inflation expectations and undermine Fed credibility. So the general view, which I think essentially everyone shares, was that the upside risks to inflation exceed the downside risks to growth at this juncture.

    I hope that summary was okay; let me just make a few comments of my own. As a number of people noted, the intermeeting data were actually fairly limited. The employment report did indicate a fairly strong labor market. There is still, to my mind, some disconnect between the anecdotes and the data; in particular, the wage data do not yet reflect what I’m hearing around the table about wage premiums. For example, average hourly earnings actually grew more slowly in the third quarter than in the second quarter. I think the ECI next week will be a very important check for our anecdotes. On the positive side, as Kevin and others noted, the tone was generally stronger in financial markets. The stock market is up. I note the ten-year real rate was up about 15 basis points since the last meeting, which I take to be a positive indication of growth.

    Oil prices continue to decline, which obviously is good for both growth and inflation. I thought you might be interested in thinking about the quantity effects of the decline in oil prices. We’ve had a decline in oil prices of about $15, which back-of-the-envelope calculations or FRB/US analysis can tell us should add about 0.45 percent to the level of real consumption or about 0.35 percent to the level of real GDP. Dave Reifschneider was very helpful in finding those numbers. That’s a change to the level, so the oil price declines could add 0.3 to 0.4 percentage point to growth, say, over the next six quarters. Another way to look at that is to think about the relationship between oil prices and house prices. A rule of thumb that might be useful is that a $3 decline in oil prices offsets approximately a 1 percentage point decline in house prices in terms of overall consumption effects. So oil price declines are essentially the negative equivalent of a 5 percent decline in house prices. An interesting question that we may have to address at some point is, what is the policy implication of oil price declines? I think it’s clear that oil price declines will lower both total and core inflation, but will also increase growth. Therefore, our policy response to the lower oil prices could depend on our preferences about growth versus inflation and also our assessments of the risks to both of those variables.

    On the housing correction, I agree that there is perhaps some reduction in the lower tail. But it’s important to point out that, even if we see some stabilization in starts and permits, a lot of inventory is still out there, and there’s going to be an inventory correction process that could be quite significant. The current months’ supply of homes for sale is greater than 6 now, excluding cancellations; the number over the past eight years has been very stable around 4, although before 1997 it was higher and more variable, which is a source of uncertainty. To get a sense of the magnitudes of the potential housing correction, I asked Josh Gallin to do the following simple simulation. Single-family housing sales were about 1.0 million at an annual rate in July, about 1.05 million in August. So I asked Josh to consider a case in which sales flatten out at the level of 1.1 million and continue at that level indefinitely; in addition, homebuilders respond to three-fourths of the increase in sales by extra building and allow the other fourth to go into reducing inventory. When you do that calculation, you find that you actually work off the inventory. By the end of 2008, the months’ supply is down to 4.1. Part of that decrease occurs because the sales level is higher, and so the denominator is bigger as well. Thus that particular scenario is a sensible one in terms of getting the inventories down. However, the effects on GDP, because the correction is still significant, are not trivial, but they are also not that large. The effect of this scenario on GDP growth from the fourth quarter of this year to the second quarter of next year is about 0.2 on growth and about 0.1 in the third and fourth quarters. So a very substantial part of the housing correction is still in place because of the need to work off inventories over the next few quarters.

    Those are a few comments on the real side. I think that some of the tail risk has been reduced. I agree with the Greenbook that growth should be slow, at least through the first quarter of next year, because of housing corrections, but consumption will probably pick up and lead to a stronger growth path after that.

    Let me say a few words about inflation. I think I need to push back a little on the view that there has been no improvement in core inflation or total inflation. In fact, inflation is very slow to respond to its determinants, and the fact that we actually have seen some improvement in some sense is a positive surprise, not a negative surprise. The attention that’s paid to the twelve-month lagging inflation measure is a problem in this context, because we had four months of 0.3 percent readings from March to June, and they’re going to stay in that twelve- month lagging measure until next March. I can predict with great confidence that next March through next June the twelve-month lagging inflation measure will decline. So I think it’s more useful, President Lacker, to look, a bit at least, at the higher-frequency measures to see what the trend of movement is. Although, like President Lacker and others, I’m not happy with the level, I think the direction is actually very good. For example, the core CPI three-month went from 3.79 in May to 2.75 in September, so it’s a decline of 104 basis points. The core PCE three- month inflation measure went from 2.95 in May to 2.20 in September, using the staff estimate for the core PCE deflator for September. So it’s certainly moving in the right direction.

    The other comment I would make about this subject is that we must keep in mind how much is tied to the owners’ equivalent rent component. I would say, in fact, that once you exclude that, if you do, just for comparison, that 2006 is roughly equivalent to 2005 in terms of core PCE inflation. To look at the high frequency numbers, excluding OER, which I’m doing now for illustrative purposes, core CPI fell from 3.01 in May to 2.23 in September, and core PCE inflation fell from 2.52 in May to 1.93 in September at an annual rate. This is saying that a significant part of the speedup and now the decline in the rate is related to this owners’ equivalent rent phenomenon—not all of it, but a significant part. It’s important to know that because, as we’ve discussed around the table, the OER may have its own dynamic. It may respond in different ways to monetary policy than some other components do. It is an imputed price, which people do not actually observe, and so it may have a different effect on expectations than, say, gasoline prices or other easily observed prices. The other important aspect of the OER is that, to the extent that it is a major source of the inflation problem, it makes clear that inflation probably has not been a wage-push problem so far because owners’ equivalent rent is obviously the cost of buildings, not the cost of labor. So if you look at inflation over the past few months, there has been slow improvement, and so far I don’t think that we have seen a great deal of feedthrough of wage pressures into inflation. I’ve looked through all the various categories of goods and services whose prices have increased, and I can find no particular relationship to labor market factors.

    Another comment along this line: It’s also true that inflation of even 2.20 percent, which was the core PCE three-month inflation rate in September, is too high in the long run. I agree it should be lower than that. We do have to ask ourselves, given that inflation has been high and that, as people pointed out, it has been high for a number of years now, how quickly we should bring it down. Most optimal monetary policy models will suggest that a slow reduction is what you would try to achieve if you start off far away from the target and if the real economy is relatively weak. Now, the question arises whether we are going in the right direction. I think so far we are, but I would certainly agree that we have to ensure that we continue to go in the right direction. The Greenbook forecast is predicated on a constant federal funds rate from the current level; actually the rate declines in 2008. But what it leaves out is the notion that we are gathering information and trying to resolve uncertainty, depending on how things develop. Obviously, policy can respond in one direction or another and could, if inflation does not continue to decline, be more aggressive to achieve that. I felt I needed to talk a bit about the fact that we do have some improvement in inflation, and so the situation cannot really be said to be deteriorating.

    Having said all of that, now let me come back and agree with what I’ve heard, which is that, although we have not yet seen much wage-push inflation, clearly the risk is there. Anecdotally, and to some extent statistically, we have very tight labor markets. It is surprising how little wage push there has been so far, and if labor markets continue to stay at this level of tightness, then one would expect that you would get an inflation effect that would be uncomfortably persistent. That is a real concern, which I share with everyone around the table. If the Phillips curve language doesn’t appeal to you, another way of thinking about it is that, if the labor market stays this tight, which means that growth is at potential or better, then the real interest rate that is consistent with that growth rate needs to be higher than it is now. I agree with that point as well. So my bottom line is that I do agree that inflation is the greater risk, certainly. I think that the downside risk from output has been slightly reduced. I also think the upside risk to inflation has been slightly reduced. Thus we’re not in all that different a position than we were at our last meeting. We can discuss the implications of that tomorrow. I think I’ll stop there. Yes, President Poole.

  • Mr. Chairman, I was going to make a suggestion. I don’t know whether there is general assent to this. It seems to me it would be helpful, before our December meeting, to have a better read on the vulnerability of the housing firms to bankruptcy. I can imagine a lot of defaults there, causing us some concern or a lot of public concern. Presumably, with all our banking and housing contacts, we ought to be able to get a better read. All I know is the very informal kind of feedback that I received over recent weeks, and a lot of people brought up that all these builders have only six months or so and some of them are going to go under. So a suggestion is that, as part of the Beige Book process, we try to get a better read on that situation.

  • I would ask the people around the table, in their conversations in their Districts in particular, to talk to medium-sized homebuilders. We’ve had the large homebuilders at the Board, and we have considerable contact with them; but what we don’t have is contact with the medium-sized homebuilders.

  • Right. My understanding is that the large ones are in pretty good shape.

  • Okay. Let me ask the Committee’s preference here. The reception tonight starts at 5:45, followed by dinner half an hour later. We can adjourn now, or Vince is prepared to give his opening remarks on the policy session, which would allow us to finish earlier tomorrow. We’ll do the go-round tomorrow, of course. Jeff?

  • Let’s adjourn now.

  • Okay. How many people would like to adjourn now?

  • Half the class. [Laughter]

  • Is President Lacker allowed to dissent on that? [Laughter]

  • Nothing personal, Vince.

  • We’ll probably remember it between tonight and tomorrow, Vince.

  • All right. Do I take it, then, that we would like to hear Vincent’s presentation?

    SEVERAL. Yes.

  • All right. Vincent, whenever you’re ready.

  • Thank you, Mr. Chairman. The pulse of the market regarding your policy action today is the flat line in the top panel of your first exhibit. [Laughter] Not weakish data releases early in the period, nor stronger ones later, nor speeches by some of you interpreted as hawkish shook the belief that the intended federal funds rate would remain at 5¼ percent after this meeting. Expectations about the policy rate at the end of next year, proxied by the December 2007 Eurodollar futures rate—the dotted line—showed more life, falling about 20 basis points by the middle of the period but ending up 5 basis points higher, on net. As can be seen in the middle left panel, market participants still anticipate almost ½ percentage point of policy easing next year. Once again, as denoted by the green shaded area, the 70 percent confidence interval derived from options prices is quite narrow. We routinely track the economic forecasts of a subset of nine of the primary dealers, and their average path for the federal funds rate through 2007 is plotted as the dashed line in the middle right panel. Those dealers and the forecast from market quotes—but not the Greenbook assumption plotted as the horizontal line—call for policy easing next year. The primary dealers’ policy call occurs against the backdrop of forecasts for the unemployment rate (the bottom left panel) and core CPI inflation (the bottom middle panel) that about match the Greenbook’s. What is different is plotted at the bottom right: These dealers expect real GDP growth to track about ½ percentage point higher than does the staff. One possibility is that these market participants, compared with the staff, foresee both more drag on domestic spending and faster-expanding potential output. If so, dealers would correspondingly view policy ease as necessary to generate economic growth that will be acceptable to you.

    Your own view as to the economy’s potential to produce no doubt influences your views on policy, as do your interpretations of the three factors described in exhibit 2. The top left panel plots existing and new home sales as the solid and dotted lines, respectively. You might see in that chart that house sales have declined sharply and view the resulting weakness as a risk to the outlook, as has been the case at the past few meetings. Alternatively, you might see that home sales appear to be bottoming out amid generally strong fundamentals. As one newsletter put it—and I think that the author meant it to be good news about the prospects for spending—that “the point of maximum deterioration in housing activity has probably passed.” The middle panel plots the real federal funds rate, which some of you may emphasize has risen considerably and take its level now to be restrictive. Others, however, might stress that the real federal funds rate remains below its average of the late 1990s. A third potential source of alternative interpretations might be the measures of inflation compensation plotted in the bottom left panel. For some, the chart shows that inflation compensation remains contained and has declined of late at shorter horizons. Others may find only cold comfort in this because inflation compensation nevertheless remains above the range consistent with their price stability objective.

    The policy choice today depends on your assessments both of the economy in the near term and of the appropriate path of inflation over a longer time frame—the subject of exhibit 3, which repeats some material from the “Medium-Term Strategies” section of the Bluebook. The solid line in the top left panel plots the setting of the nominal funds rate that, in the FRB/US model, best achieves the objective of minimizing deviations of the unemployment rate from the NAIRU and of core PCE inflation from a goal of 1½ percent, while avoiding jarring adjustments in the nominal funds rate. The forces shaping the outlook are the same as in the extended Greenbook baseline, and investors are assumed to understand the entire path of policy—which they deem credible when determining asset values. Wage and price setters, in contrast, base their expectations on less information and alter their views on long-run inflation only sluggishly in response to actual inflation. As is familiar from such exercises in previous Bluebooks, it thus takes a long time to work down inflation when the goal is below prevailing inflation expectations at the start of the simulation. With the Phillips curve as flat and inflation expectations as inertial as in the FRB/US model and with equal weights placed on the objectives, policymakers find it optimal to trade off a persistent miss of the inflation goal (the bottom left panel) for smaller cumulative labor market slack (the middle left panel). In this simulation, progress may seem especially glacial because the steady dollar depreciation that is required to rein in the deterioration of the current account generates persistent upward pressure on domestic inflation. But even the modest progress that is made on inflation under this scenario requires about ¾ percentage point of firming over the next year.

    We explored two modifications of the standard framework to help speed disinflation. In the first, and as plotted as the dashed red lines on the left, policymakers are assumed to put much more weight on the inflation goal relative to maximum employment. Indeed, progress in reducing inflation is notable, but the unemployment rate is also notably elevated. The simulation underlying the dotted green lines maintains the assumption of equal weights in the objective function but changes the assumption about the information that wage and price setters use so as to create a more favorable inflation-unemployment rate tradeoff in the short run. This variant assumes that the level of the nominal funds rate conveys a noisy signal to wage and price setters about policymakers’ inflation goal. It is optimal, then, to impose policy restraint early on so as to send inflation expectations down and accomplish a quicker and less costly disinflation. The credibility you attach to such a channel may play some role in your willingness to firm policy in the near term. But you may not see any need to do so if you are drawn to the dashed blue lines in the right-hand column of charts. Those lines summarize macroeconomic outcomes for policymakers with an inflation goal of 2 percent. Because current inflation expectations about comport with that goal, policymakers can keep the nominal funds rate at 5¼ percent for some time and still observe declines in inflation given the other forces of disinflation in the baseline.

    Exhibit 4 considers some aspects of the wording of your statement to be released after this meeting, starting with the rationale portion in the boxes at the top. As noted at the left, in drafting the Bluebook, we proposed including in row 2 of all the draft statements that “economic growth appears to have slowed further in the third quarter.” This wording seemed to have the advantage of acknowledging the upcoming release of the initial third-quarter estimate of real GDP on Friday, which by the staff’s reckoning is likely to be weak. Some of you may be concerned, however, that this mention might heighten market scrutiny of that data point or potentially set up the Committee for failure if the release proves surprisingly strong. As noted in the top right box, we simplified the language about inflation pressures in row 3 of alternative A, partly in response to earlier criticism that the Committee could be interpreted as having slipped a derivative. The statement has been pointing to the levels of the prices of energy and other commodities as having “the potential to sustain inflation pressures.” Even if you are not drawn to the phrasing of the rest of the alternative, you might see some merit in this simplification for row 3. Or you might not, [laughter] given the focus in markets of changes in the wording of the statement.

    The Bluebook effectively offered four alternatives this time, the three in the table and a possible middle ground between B and C mentioned in the text. These are laid out in the remainder of the exhibit. In recent statements, the risk assessment has pointed to upside risks to inflation and the possible need to firm policy further. Market participants nevertheless appear to attach greater likelihood to policy easing than tightening. To protest that view and to underscore its commitment to reduce inflation, the Committee might choose to modify its words to note, as in alternative B+, that “although the Committee both seeks and expects a gradual reduction in inflation, it continues to view the risks to that outcome as remaining to the upside.” Some of you, however, may view this as change for the sake of change that unnecessarily risks confusing market participants as to the Committee’s intent.

    For the sake of reference, the last exhibit repeats, with no change, table 1 from the Bluebook. That concludes my prepared remarks.

  • Thank you. Are there any questions for Vince? President Moskow.

  • Vince, I want to ask you about charts 5 and 6 in the Bluebook. Also, I want to make a comment and then ask a question. Chart 5, the equilibrium real federal funds rate chart, shows that the current fed funds rate is slightly above the range of models that close the output gap within twelve quarters. It doesn’t really speak to inflation tensions in monetary policy. However, chart 6 deals directly with inflation and monetary policy, and you have the 2 percent target and the 1½ percent target. Neither scenario achieves the target by 2012, though you do get closer to the 2 percent target if that were, in fact, our target. Both of the charts are helpful to us as policymakers. My comment is that I recommend that in future Bluebooks you include them both, as you have done this time and as you have done sometimes but not consistently in the past. I think they give us a fuller picture of the total outlook, and it’s more helpful for policymaking. The question is whether chart 5 and chart 6 can be integrated more closely so that we can understand the implications in chart 5 of the output gap for inflation.

  • You’re exactly right, and that’s why we tried to put them closer together in this Bluebook. [Laughter]

  • So we’re making progress.

  • We’re making progress—incremental, as all progress at the Federal Reserve is. [Laughter] The notion of the equilibrium real rate is: if you held the real rate constant for the next twelve quarters, the output gap would close at the end of that period. That doesn’t, however, mean that you would like the inflation rate you get at the end, twelve quarters from now. It’s not a policy rule. It’s just a way of summarizing the forces at work in the model. The optimum policy exercises explicitly take into account your preferences about inflation as well; hence, you can get different results. In the future we do want to try talking more about the equilibrium real interest rate in terms of the full model simulations rather than the reduction presented in chart 5. Actually, my intention was to include a medium-term scenario in the Bluebook four times a year. They don’t change all that much, and if your calendar is such that you’re going to have four two-day meetings next year, it seemed appropriate to line those up.

  • Well, I know they don’t change very much, but I still think it’s helpful to have them side by side as we look at them.

  • Vice Chairman Geithner.

  • I think I’m echoing Michael, but I want to compliment the staff on the evolution of the Bluebook. I think that seeing that complement of prisms on different policy choices or different paths is useful, and we should see them all the time and more of them. I sort of missed the inclusion of the range of ones we saw in June. But having said that, may I ask a broader question? I want to come back to the debate we didn’t really have about whether what we see in TIPS about long-term inflation expectations should be encouraging or discouraging about the prospects for achieving sufficient moderation in inflation. Would Vince or David or anybody else like to speak to the question of whether, if TIPS five-year inflation compensation five years forward stayed at its current level of between 2 and 2½, that would be holding up underlying inflation going forward? Or would that be consistent with moderation? Now, you’ve given us a bunch of charts that express a view on that, I think. I don’t know much about the assumptions underpinning those about the path of expectations going forward.

  • Let me make two points, Mr. Vice Chairman. First, a good measure of the compliment should be directed to Dave and his staff as well because these model simulations really do take a lot of effort on the part of the folks in the MAQS Section in Research and Statistics. Second, in the box in the Bluebook we tried to take our best guess of that. Actually, President Lacker mentioned it. The basic problem is that those are measures of inflation compensation, not inflation expectations. There are both an inflation risk premium and a differential liquidity premium between nominal and indexed debt that pollute the measure of inflation compensation. Not only could they change, which potentially changes the level relative to inflation expectations, but also they could very well be time varying. We’ve seen big swings in our estimated term premium in the nominal yield curve. We could just as well also be seeing swings in the inflation risk premium. When we go to those factor models of the term structure and try to back out those estimates of the inflation risk premium and also try to take account of the adjustment between CPI and what most of you talked about in terms of core PCE inflation, we see inflation expectations, at least coming from the Treasury market, in the neighborhood of 2 to 2.4 percent across the term structure. That’s a higher number than what many of you have identified as your comfort zone, and it’s not inconsistent with what we see from survey measures as well.

  • If you think about the extension of the staff forecast—basically, if you look at beyond the 2008 period—it’s easy to see how you get back to 2 percent. Beyond that, I guess our underlying assumption would be that you will have to get inflation expectations down if you want to have inflation below 2 percent over that longer term. Now, given the way that we typically run these simulations, you have to create an output gap. There could be other channels that the model can’t capture—perhaps talk or communications or something could shift that. As we have indicated, we don’t know the evidence that we would be able to present to you to assure you that that would be the case. But it looks as though, to get below 2 percent, more work would have to be done to get at those expectations.

  • Other questions? President Minehan.

  • Just to follow up on that, when we were experiencing rates of PCE and CPI core inflation below 2 percent and there was considerable concern about the level of disinflation, what were market expectations saying about inflation at that time? What were measures of inflation expectations saying? My sense is that the professional forecasts have been 2½ percent since time began. But were any other measures suggesting at that time that they expected inflation that low going forward?

  • Basically, it looks as though the five-year inflation compensation five years ahead was running around 2 percent and even then fluctuating. It’s a little harder the further you reach back, so I don’t know about the liquidity premiums and all the various ways in which you would extract that. It has fluctuated but doesn’t really look as though it has had much trend up or down. There would be more noise in the TIPS than there is in the professional survey, but they all seem to be sort of consistent with 2 percent.

  • It kind of begs the question then, doesn’t it, about what level of low, stable inflation is the right level of low, stable inflation? [Laughter]

  • That comes tomorrow. [Laughter]

  • That’s why I pose the question right now.

  • I mean, we don’t have to answer it. I don’t think anybody has an answer to it, but we’ve been through a whole cycle here, and inflation expectations are not telling a totally different story, even through the whole cycle.

  • The ten-year TIPS came down quite a bit during the deflation scare.

  • You do see fluctuations over the past five or six years. It looks relatively trendless after that.

  • Are there other questions for Vince? We’ll reassemble tomorrow at 9:00 a.m.

  • [Meeting recessed]