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.