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

  • Good afternoon, everyone. Today begins Cathy Minehan’s last FOMC meeting. Cathy has been a regular participant since August 1994. We will have an opportunity later in the fall to say goodbye to Cathy more officially, but I think this will be a good opportunity to thank you for your collegiality and for thirteen years of tremendous contributions to the FOMC. Thank you very much. [Applause]

  • It has been truly an honor and an incredible experience, something I never expected to happen and a joy through the ups and downs and ins and outs of every meeting. So I thank everybody around the table who has been here and made it that way.

  • Thank you, and now it is time for the report on desk operations.

  • It is hard to follow that. Thank you, Mr. Chairman. Today, I want to focus on the significant rise in long-dated Treasury yields that has occurred since the last FOMC meeting. As you can see in exhibit 1, Treasury yields have moved sharply higher over the past six weeks, although they have recovered a bit in the past few days. At two-year and longer maturities, the shift in the yield curve has been nearly parallel, with yields roughly 50 basis points higher over this period. As can be seen in exhibit 2, the rise in nominal ten-year Treasury yields has been accompanied by a rise in ten-year TIPS yields. Because the rise in nominal yields has been slightly larger than the rise in real yields, forward breakeven inflation rates have risen a bit since the last FOMC meeting. For example, exhibit 3 shows the trajectory of the breakeven inflation rate five to ten years in the future estimated using nominal Treasury and TIPS yields. This measure has risen more than 20 basis points from its trough in May. So how does one explain the rise in nominal and real Treasury yields and the increase in breakeven inflation? In my opinion, there is one very compelling explanation—market participants generally believe that the downside risks to growth have diminished, and this has led to (1) a sharp shift in monetary policy expectations and (2) a modest change in investors’ assessment of inflation risk. But other factors also played a role, including mortgage convexity hedging and, perhaps, the gradual shift in the appetite of foreign central banks away from U.S. Treasury securities toward other assets.

    As shown in exhibit 4, monetary policy expectations as embodied in the Eurodollar futures market have shifted sharply since the last FOMC meeting. In May, a drop of more than 50 basis points in Eurodollar rates was anticipated to occur by the end of 2008. In contrast, currently the Eurodollar futures strip is virtually flat—indicating that market expectations are close to neutral through 2008. This shift in expectations is also evident in responses to our survey of primary dealers. Using exhibits 5 and 6, we can compare the dealers’ forecasts before the May 9 meeting with their forecasts before our meeting today. The green circles represent the average forecast of the dealers; the size of the blue circles indicates the frequency of different forecasts; and the horizontal dark lines represent market rates. As can be seen in these exhibits, over the intermeeting period the dealer forecasts have moved upward, but much less than market expectations. This presumably reflects the fact that the market rate represents the mean of potential outcomes whereas the dealer forecasts are modal forecasts. Also, the smaller shift evident in the dealer forecasts may reflect the fact that dealer forecasts tend to lag changes in market expectations when expectations are changing rapidly. As can be seen in these two exhibits, much of the dispersion evident in the forecasts toward lower rates has vanished since the May 9 FOMC meeting, and the skew to the downside has disappeared. Dealers who had forecasted a flat or higher federal funds rate path generally did not alter their forecasts. In contrast, dealers who had earlier anticipated easing have eliminated or dramatically scaled back those expectations. For example, the blue circles evident in exhibit 5 at rates of 3.5 percent and 4.0 percent are not present in exhibit 6.

    The dealer forecasts support the notion that expectations are changing mainly because market participants are less worried about downside risks to growth rather than because they think that the growth rate of real GDP will likely be stronger. With the exception of the current quarter, in which GDP forecasts have been revised upward sharply following a very weak first quarter, the real GDP forecasts of dealers have generally not changed materially through 2008. This is illustrated in exhibit 7. Instead, as shown in exhibit 8, dealers are now, collectively, more certain about the growth outlook—in other words, the downside risks to growth have diminished. The reduction in the downside risks to growth may also be important in explaining the modest rise in breakeven inflation measures. If the downside risks to growth have diminished, then a corollary may be that the upside risks to inflation have increased. In that case, investors should show more interest in purchasing inflation protection. The breakeven inflation measure calculated from nominal Treasury and TIPS yields has several components, including expected inflation and the premium paid by investors for inflation protection. In assessing the rise in these breakeven inflation measures due to diminished downside risks to growth, it is unclear how to apportion the rise in the overall breakeven inflation measures between a higher premium for inflation protection and higher expected inflation. In theory at least, reduced downside risks to growth might reasonably be expected to push both components a bit higher.

    Three other factors behind the backup in Treasury yields bear mentioning. First, the shift in monetary policy expectations and the rise in longer-dated yields have been a global phenomenon. When yields are rising elsewhere, that shift should put some upward pressure on U.S. long-term rates. Second, mortgage-related convexity hedging may have exacerbated the speed and magnitude of the rise in yields. A rise in yields causes expected rates of prepayment on lower-coupon fixed-rate mortgages to fall, which lengthens the average duration of mortgage portfolios. Mortgage servicers, the housing-related GSEs, and other mortgage holders respond by selling long-dated Treasury securities and long-dated interest rate swaps to reduce the average duration of their holdings. Exhibit 9 shows that most conventional fixed-rate mortgages are below current mortgage rates. As rates rise, these mortgages get further “out of the money.” This lowers expected prepayment rates and lengthens duration, and people react by hedging. As long-term rates keep rising, the effect of higher interest rates on duration gradually lessens as the rates on most outstanding mortgages fall further below current market rates. The effect of mortgage convexity hedging is evident in the relative underperformance of ten-year Treasuries, which is one of the preferred hedging vehicles versus mortgages, relative to other Treasury maturities. The week ending on June 13 had the biggest rise in longer-term Treasury yields. As shown in exhibit 10, this was also the week in which ten-year Treasury yields rose the most compared with five-year and thirty-year Treasury rates. To the extent that mortgage convexity hedging pushes up nominal ten-year Treasury yields more than other yields, then it may also temporarily distort breakeven inflation measures. Third, diminished appetite among central banks for Treasury securities may have also been a factor behind the rise in longer-dated yields. Central bank buying was often a featured part of the story when bond term premiums were unusually narrow. Foreign central banks may have played a role in the recent rise in bond term premiums. As shown in exhibit 11, the growth rate of Treasury custody holdings at the Federal Reserve Bank of New York has slowed sharply since April. But it is important not to push this point too strongly. Although foreign central banks with the largest foreign exchange reserve holdings are diversifying their portfolios away from Treasuries, they still appear to be extending the average maturity of those Treasuries that they hold, which implies a continued bid for longer-dated Treasuries from this source.

    Turning now to other market developments, the most striking aspect of this period of rising Treasury yields has been the limited effect that this rise has had on the risk appetite of investors in most other markets. This is in sharp contrast to the reduction in risk appetites that occurred in a broad array of asset classes in late February and the first half of March. For example, as shown in exhibit 12, the rise in long-term yields has not caused the U.S. equity market to retrench. As shown in exhibit 13, until the past week or so, corporate debt spreads have been relatively stable. Also, in the foreign exchange markets, the carry trade remains alive and well. One way to see this is in exhibit 14, which illustrates the change in the value of the yen against high- yielding currencies such as the Australian dollar and New Zealand dollar as well as against the U.S. dollar and the euro. As can be seen, in the late February selloff, the yen rallied, and the high-yielding currencies sold off sharply. In contrast, during the recent rise in interest rates, the yen weakened and the high-yielding currencies appreciated. Similarly, as illustrated in exhibit 15, although volatility in the U.S. Treasury market moved up sharply (shown by the rise in the MOVE index), volatility in the equity and foreign exchange markets remained quite low.

    In the foreign exchange markets, movements between the major currencies continue to be driven mainly by changes in expected interest rate differentials. Exhibit 16 shows the movement in the spreads between the September 2008 Eurodollar futures yield versus Euribor futures for Europe and Euroyen futures for Japan. As can be seen here, interest rate expectations shifted more sharply upward in the United States relative to Japan than relative to Europe. Not surprisingly, as shown in exhibit 17, the dollar appreciated more sharply against the yen than against the euro over this period. The yen’s weakness, which has been persistent but stealthy, may begin to receive more attention. After all, as shown in exhibit 18, while the nominal yen/dollar exchange rate has fluctuated in a relatively narrow range in recent years, the real effective yen exchange rate has declined sharply over this period—a rate of decline that may be intensifying. For example, in May the real effective exchange rate of the yen—as estimated by the BIS—had fallen to its lowest point since the early 1980s and had declined nearly to half of its early 1995 peak. Although the June BIS data are not yet available, the rate of depreciation has likely increased over the past month.

    Although calm generally pervades U.S. financial markets, there is one important exception worthy of note. The subprime mortgage space is still very unsettled—hurt both by poor housing market fundamentals and by the problems of two hedge funds sponsored by Bear Stearns. Exhibit 19 shows the behavior of the spread on the ABX 06-2 index, which is an index based on a basket of credit default swaps on underlying cash securities. As can be seen, the spread has increased to a new high, and underlying CDS spreads have also increased. There is a danger that forced liquidation of illiquid subprime-based securities could exacerbate the pressure on this market. However, it should be noted that the Bear Stearns-sponsored hedge funds that are in trouble are not particular large; the problems of these hedge funds appear to be mostly exceptional rather than the norm; and the counterparty exposures generated by these hedge funds are broadly distributed and have already shrunk sharply in size. That said, there still are risks that forced selling could drive market prices down sharply, leading to lower marks for other portfolios of assets related to subprime mortgages. This, in turn, could lead to margin calls, investor redemptions, and further selling pressure in this market.

    In terms of lessons learned, three points come to mind. First, high credit ratings don’t fully capture measures of risk. The ratings are based on the risk of default, not the market risks associated with illiquidity. As a result, highly leveraged portfolios of highly rated but illiquid assets are subject to significant market risk that the ratings may obscure. Second, the performance of some of these complex securities is very sensitive to the correlation of returns. As correlations move higher, the subordination protection offered to senior tranches in complex securities such as CDOs, and CDO- squared products—CDOs of CDOs—can evaporate quickly. Because the ratings for the tranches within such products are typically established on the basis of historical correlations, the default risk for some of these tranches may be understated. Third, marked-to-model asset valuation may artificially smooth returns and obscure risk— both to portfolio managers and to investors.

    The health of the broader CDO and CLO (collateralized loan obligation) markets may rest on this same fragile set of assumptions—that credit ratings fairly capture risk and that historical correlation relationships will continue to apply. This implies the potential for problems: If investors questioned these assumptions in the subprime area, they could also rethink their assumptions about these risks in the broader markets. Such a development might lead to considerably less buoyant conditions in the corporate debt and loan markets. It could be noteworthy that some of the indexes that reference credit default swaps in the corporate debt and loan markets have shown some deterioration in the past week.

    Finally, there were no foreign operations during this period. I request a vote to ratify the operations conducted by the System Open Market Account since the May FOMC meeting. Of course, I am very happy to take questions.

  • On the breakeven inflation rates, the five-by-five rose more, I believe, than either the five or the ten arithmetically because the ten rose more than the five and it’s in the spread. It seems odd that a change in the near-term growth outlook would have significant implications for five-to-ten-year inflation expectations. Are there technical issues there as well as in mortgage hedging, or is it just the way you calculate these spreads with the differences in liquidity and so on?

  • Well, I think there is an issue. You have to wait for the market to settle down. To the extent that you are taking a snapshot at a time that more convexity hedging is influencing the ten-year and the five-year has not caught up, that can be a phenomenon. Also, people in the marketplace say that people in the nominal Treasury markets are different from the people who invest in TIPS, and so the behavior of the two can diverge for short periods. I would be more confident if a month from now we saw the same uptick in five to ten years of forward inflation as we do today. I am not convinced it will necessarily persist. It may be that real yields and nominal yields will eventually equilibrate as these two markets come back into balance. So my own view would be that it bears watching, but I wouldn’t reach strong conclusions about it at this stage.

  • Thank you. Are there other questions for Bill? President Minehan.

  • My memory of the Long-Term Capital Management situation was that the dollar amount that went into the original program that the investment banks put together when they started to manage the situation wasn’t that much bigger than the money that Bear Stearns is throwing at its hedge funds, yet the effect on the market seems to be very, very different. Having been around during the Long-Term Capital episode, I know that there were real concerns that the domino effect was going to be enormous because of the market uncertainty and the lack of liquidity and so forth across a wide range of instruments. Is it the range or the nature of the instruments? How would you see the two situations and compare them because clearly this one, for all you can read and understand and even in your own presentation, doesn’t seem to be that much of a systemic issue.

  • Well, I think there’s a difference in terms of people’s assessment of how much risk Bear Stearns is actually taking on in terms of their hedge fund. My understanding is that they are extending credit, and they are basically taking out the credit that was extended by the counterparties for the less highly leveraged of the two funds. They still have equity. They are hoping that they still have equity—that the assets of the hedge fund are essentially going to exceed the value of the loan that they are making. So they’re feeling that, if all goes well, they are not going to be out any money. My memory of Long- Term Capital Management, and somebody can correct me if I’m wrong, is that the people who came into that pool were putting up equity. So it is quite different in terms of what was actually being contributed in these two cases. Bear Stearns is just replacing the counterparty borrowings with its own line of credit.

  • But then they managed it so that they did come out ahead over a period of time—at least that’s my memory.

  • I’m sorry. Is this two-handed?

  • I was going to follow up on Cathy’s point, but I think Don is, too.

  • I was going to do the same.

  • I was just going to remark that the situation was quite different. LTCM followed the Russian debt default. The markets were already in considerable disarray. All those correlations had already begun to turn, and then on top of that you had the fire sale effects of LTCM. You can see some of that in the subprime market, where this thing is concentrated. It is just not spread out now, and the whole market situation was very different at that time.

  • I think there is a presumption in the Long-Term Capital Management case that a lot of people had similar positions in place. In the Bear Stearns case, we certainly don’t have all the information at this point, but the general thought at this time is that there are not a lot of other people with the same positions in place.

  • Vice Chairman, did you have a comment?

  • I agree with all of that, but the relative size is much smaller—much narrower in the type of positions to which they’re exposed. The state of the world is dramatically different. Direct exposure of the counterparties to Bear Stearns is very, very small compared with other things. Bill is exactly right. These guys are making a loan against a set of positions—a right to those positions—not equity, and what they realize in the value of those positions over time will be determined. They think there is positive value in that. So the situation is dramatically different. It does not mean that you should view it as particularly reassuring. You know, these people were exceptionally experienced in the mortgage credit business, and there were smart people in LTCM, too. [Laughter]

  • That was the general opinion.

  • But these guys were regarded as very smart people, who knew the business well, and this is just a good example of how little one can know in some sense and what leverage does to your exposure to liquidity risk. In this case, people were just not willing to give them the time to realize whatever value might be in these positions, and this is just a natural consequence of leverage. People think they had substantially less leverage than LTCM had in some sense, but that is hard to measure.

  • Mr. Chairman, I would argue that there are similarities in that, with Long-Term Capital, most of the stress-testing had been just computer-model driven. Then when actual market prices began to be quoted, you saw the deterioration. That is clearly the case here. The ABX is a technical index. For a lot of the CDO-squared market, nobody knows what the values, as opposed to the prices, really are. There is a difference between price and value. Price is what you pay; value is what you get. I suppose one charitable interpretation of this, Bill, would be that the good thing about this situation is that we actually may be creating a real market to determine value on these things or at least price relative to value. But I think the phenomena are similar, and I would argue—having been in the business, although the business wasn’t as sophisticated when I used to be in it—that this has broader dimensions than those we had before. If you look at the growth rate of these instruments—again, without any underlying sense of what you ultimately can cash in if you’re pressed—it has been a straight upcurve. The numbers are quite huge.

    Again, I was once a hedge fund manager—I know all the tricks that are played there, including, by the way, the valuation of underlying securities—in a day when the business was less sophisticated than it is now. I don’t feel I understand this issue. I don’t know about my other colleagues around the table, but you did kindly send someone down to brief our staff on this. They came out with more questions than they did answers, but it was very helpful. I am worried that we will be asked publicly at different intervals and perhaps starting now what our opinions and perspectives are. I’m also worried about giving the wrong answer. I wonder if there is not a way—not during this meeting but at some point— that all the principals at this table can be briefed so that we can understand and have a common approach to this issue. I don’t think the issue is contained. I do think there is enormous risk. I hope that something good comes out of this, but speaking personally, I would like to understand this better, and I hope that we all understand it very well in case a negative scenario obtains. That’s just a request.

  • We can monitor the situation here and in New York. I don’t know, Vincent, if we have any reports or materials that we can share with President Fisher.

  • Well, Bill and I can get together.

  • Maybe we could just have a common briefing. I think it would be very helpful, Mr. Chairman.

  • I don’t think, Richard, you need to be in a position to offer an opinion on what happened in Bear Stearns in particular. I don’t think you need to or want to be in the business of doing that in that particular case. Regarding a broader understanding about the implications of what we see in these markets, Bear Stearns is relevant also in some broader sense. There is obviously value in trying to make sure that people have as much understanding as they can. My suspicion is that you are going to find yourself where most people are on this, which is with some differing mix of unease and reassurance that you’re not going to resolve fundamentally until we get through the next period of excitement.

  • Well, again, Tim, I would suggest that we not comment on this. None of us should comment on it. But (1) it would be good to have an understanding, and (2) if it gets worse, more intense, or troublesome, the Committee will have to respond in some way, and it would be nice to at least have a common understanding as we go down this path. That’s my suggestion or request.

  • There are a couple of themes. One is that the subprime problems are still being worked through the financial markets. The second is that subprime is an example of a broader class of structured products that are difficult to value, and that creates some uncertainty in the markets in periods of stress. President Lacker.

  • I am always in favor of more understanding, but for this Committee, what I know about this now suggests that there isn’t any reason for us to be involved. I compliment Vice Chairman Geithner on not serving sandwiches in this case. [Laughter] I agree with Vice Chairman Geithner—there’s a certain danger of our commenting on stuff like this and leading people to believe that we feel some responsibility for damping or otherwise minimizing the effects of changes in market prices on the changes in other market prices.

  • Thank you. We are happy to share all the information we have about the specific case and its broad implications with everybody—in confidence, of course.

  • Other questions for Bill? If not, I need a motion to ratify domestic operations.

  • So moved.

    PARTICIPANT. Second.

  • Without objection. We will turn now to the economic situation, and we call on David Wilcox.

  • Thank you, Mr. Chairman. My colleagues and I will be referring to the packet entitled “Staff Presentation on the Economic Outlook.” Your first exhibit summarizes our economic forecast. As shown in the top panels, we have edged up our forecast for the growth of real GDP this year and next. Taken by itself, the increase in interest rates that Bill Dudley mentioned was a negative for our growth outlook, but it was outweighed by a variety of other factors, including the higher stock market, the upward revision to wages and salaries, and the more favorable composition of real growth during the first half of this year. As shown in the middle pair of panels, we have trimmed our forecast of the unemployment rate—partly in response to the latest readings on this series and partly in light of the slightly stronger outlook for real output—and we now have it ending 2008 just below 5 percent, our estimate of the natural rate. As shown in the bottom right panel, core PCE inflation in the current quarter appears to be running at an annual rate of 1.4 percent, considerably less than the 2.2 percent we expected as of the May Greenbook. However, as I will discuss later in more detail, we have interpreted most of that good news as likely to prove transitory and so have taken down our forecast for core inflation over the projection period only 0.1 percentage point.

    Exhibit 2 turns to the market for single-family housing. The yellow stripes in the top left panel mark major downturns in single-family housing starts since 1970. As can be seen in the box to the right, the current contraction now ranks among these major episodes in terms of magnitude. It differs importantly from previous ones, however, in terms of its origins because this one did not result from a round of monetary tightening aimed at taking economic activity down to bring inflation under control. That difference has important implications for the likely contour of the recovery. In earlier episodes, once the desired reduction in inflation appeared to be in train, the policy rate was brought back down and longer-term interest rates often came down as well. But this time, as shown in the middle left panel, with policy assumed to hold at its current position, we are not banking on any reduction in mortgage interest rates from here forward, suggesting that the housing recovery may be more subdued than it often has been in the past. One factor that poses some downside risk is the overhang of unsold homes, shown in the middle right panel. Months’ supply remains at a very high level. As we illustrated in one of the alternative simulations in the Greenbook, the contraction in the housing sector could be a good deal deeper than the one in our baseline if builders decide to bring inventories down more quickly. Another factor that will be important in shaping the recovery is the pace of sales, shown in the bottom left panel. In light of the tighter conditions in the subprime loan market and the recent backup in rates, we have sales moving a little lower over the next few months but then stabilizing and beginning to edge up around the turn of the year. The data on both new and existing home sales that were released earlier this week were consistent with our Greenbook forecast. I should also note the situation with regard to the price of single- family housing. As you know, home prices have decelerated greatly, and over the projection period, we have them remaining close to their current levels on a national-average basis. But our ability to judge the alignment of prices with fundamentals is limited, to say the least, and a substantial move downward is certainly possible. The bottom right panel illustrates that risk by presenting the estimated valuation error according to the very simple model that we showed you two years ago in our special presentation on housing. To be sure, other models deliver different answers, but this one judges the misalignment of the price-rent ratio to be historically large. If prices break more sharply because builders decide to clear out inventories more quickly, construction activity might well recover faster, even as other consumer spending is crimped by the damage to household balance sheets. Which effect would predominate in terms of overall aggregate demand is not entirely clear.

    Exhibit 3 focuses on business fixed investment. As shown in the top left panel, sales of medium and heavy trucks have more or less fallen off a cliff thus far this year, reflecting the influence of new EPA regulations that took effect on January 1, and this has been an important factor holding down overall equipment spending. We think that this dynamic should be coming to a close over the next few months and are looking for truck purchases to begin trending up sometime during the second half of this year. As shown in the top right panel, orders and shipments of nondefense capital goods hit an air pocket around the turn of the year, apparently driven down in part by the trials of the motor vehicle and construction industries. However, the orders and shipments data for March and April—the latest that were available to us when we were putting together the Greenbook, encouraged us to think that a rebound of at least modest proportions is in train, and this morning’s release came in close to our Greenbook expectations. Moreover, surveys of business conditions, including the two orders-based indexes shown in the middle left panel, suggest that businesses concur that the situation has brightened somewhat in the past few months. As shown in the first line of the middle right panel, we are projecting that, over the next six quarters, equipment investment will post respectable—if unspectacular—increases. Two of the variables conditioning that view appear at the bottom of the page. As shown on the left, we expect real business output to grow a little more slowly over the forecast period than in the preceding few years, suggesting—all else being equal—somewhat more modest growth in investment than in earlier years. Similarly, as shown on the right, we expect the user cost of capital for high-tech equipment, the red line, to continue to decline at about the average pace of the past few years, and we expect the user cost for non-high-tech equipment, the black line, to be about unchanged, much as it has been over the past year and a half. All in all, these factors point to a steady outlook for business investment.

    Exhibit 4 takes a slightly longer term perspective on the inflation outlook by comparing our current projection to the one that we had in the January Greenbook—the last time you submitted projections for a Monetary Policy Report. As shown in the top left panel, since January we have revised up our near-term forecast for overall PCE price inflation but not our longer-term outlook. Part of the near-term revision is due to faster food price inflation— the top right panel—which in turn reflects, among other things, the greater pressure that ethanol production has placed not only on the price of corn but also the prices of other foods that are produced using corn as an input, such as beef, dairy, and poultry. By the end of this year, though, we assume that the livestock and poultry sectors have adjusted to the higher level of corn prices, so we have food prices coming back in line with core inflation. Another part of the upward surprise in overall PCE inflation is due to a steeper climb in consumer energy prices—the middle left panel—reflecting crude oil prices that have been running about $10 per barrel above our January assumption and refinery outages that have kept utilization below typical levels. But as with food, we have energy price increases moderating greatly over the projection period.

    Excluding food and energy—the middle right panel—core PCE price inflation has looked a little tamer thus far this year than we expected in January. Nonetheless, our projection for core inflation next year is unrevised, on net, relative to the January Greenbook. The absence of any net revision since January reflects a mix of considerations. For one thing, not all the news related to inflation has been good; both import and—as I just noted—energy prices have been running higher than we expected and thus have been generating more upward pressure on inflation than we had foreseen. For another, some of the recent good news seems likely to prove relatively short- lived. For example, as shown in the bottom left panel, nonmarket-based prices, which account for about 20 percent of the core index, have been rising less quickly thus far this year than we expected in January. Historically, however, fluctuations in nonmarket prices have not conveyed much information about the future behavior of this series, so we have trimmed our projection for the increase in this component of prices over the second half of this year by only a tenth. As shown to the right, both tenants’ rent—the black line—and owners’ equivalent rent, or OER—the red line—have decelerated lately but, as shown by the bars at the bottom of the panel, OER has slowed by noticeably more. Historically, differences of this magnitude have not persisted long—see, for example, the bulge that emerged and then disappeared in 2003; moreover, these divergences have tended to be resolved in favor of tenants’ rent. Accordingly, we expect the increases in OER over the projection period to look more like the recent increases in tenants’ rent rather than the other way around. In the end, these influences happen to roughly offset one another, leaving our core inflation projection for next year unchanged from January.

    Exhibit 5 focuses on the recent behavior of inflation expectations and, as noted in the top left panel, asks whether those expectations have moved above levels that were typical from mid-1996 through mid-2004—a period when actual core PCE inflation was mostly between 1 percent and 2 percent. As noted in the last bullet in the box, the answer varies by series. In the next three panels, I use shaded bands to indicate levels of each series that were typical during the eight-year reference period—the darker bands marking the middle 50 percent of the series’ observations and the lighter bands marking the middle 80 percent of the observations. As shown in the top right panel, the short-term expectations measure from the Michigan survey of households has indeed been tending to run above the levels that were typical of the earlier period. Roughly, those higher readings seem to reflect the steep climb in energy prices over the past few years. In contrast, as shown in the middle left panel, longer-term inflation expectations from that survey have remained remarkably stable. They have drifted slightly higher relative to the levels that were typical during the reference period, but even so the latest reading sits just at the edge of its 50 percent band. The middle right panel shows a measure of short-term inflation expectations from the Philadelphia Fed’s Survey of Professional Forecasters; the most recent reading on this series is near the center of its 50 percent band. As you know, the measure of ten-year expectations from the SPF, not shown, has mostly been stuck at 2.5 percent since 1998 and was slightly below that in both the first and the second quarters of this year. Unfortunately, the TIPS market is too young to allow an apples-to-apples comparison on the basis used here. On the whole, however, we interpret the evidence as suggesting that inflation expectations have been quite stable recently. We assume that they will remain so over the projection period and thus will not be an important influence on the inflation contour this year and next. The bottom left panel plots our projection of the unemployment rate and our estimate of the NAIRU. We expect the small amount of upward pressure currently being generated from this source to be relieved over the projection period as the unemployment rate drifts up and resource utilization eases. The bottom right panel summarizes our inflation outlook. Relative to the May Greenbook, our forecast for core PCE inflation in 2007 as a whole is down 0.3 percentage point; as I noted earlier, our forecast for the second half of this year and for next year is down only a tenth. Nellie will continue our presentation.

  • The next four exhibits focus on financial conditions in the corporate and household sectors. As shown by the black line in the top left panel of exhibit 6, operating earnings per share for S&P 500 firms for the second quarter are currently forecasted by analysts to be up about 5 percent from a year ago, a deceleration from the 9 percent pace in the first quarter. However, in view of the sparseness of earnings warnings thus far, we expect second-quarter earnings to top analysts’ forecasts by a few percentage points. As noted to the right, for the year as a whole, analysts are forecasting 8 percent growth in earnings per share (EPS), not very different from the Blue Chip Consensus and the staff’s forecast. For 2008, however, analysts appear to anticipate that EPS growth will pick up to 11 percent, whereas we project that profits will flatten as margins get squeezed by rising unit labor costs. Even adjusting for a typical bias in analysts’ views, our outlook is a little more guarded.

    The middle panels use analysts’ forecasts to assess equity valuations. As shown by the blue line in the left panel, the trend-forward earnings-to-price ratio for S&P 500 firms has stayed near its level of the past several years, and the gap between it and the real Treasury perpetuity yield—the equity premium shown by the shaded area—narrowed a touch in the past few months as yields rose. But the premium remains close to its average of the past twenty years, suggesting perhaps that investors still are mindful of the risks of investing in equities. However, this caution seems to be less the case for smaller stocks. As shown to the right, a simple metric of valuation—the forward price- earnings ratio—shows that valuations of smaller companies, the red line, are on the high side of their range of the past two decades. Relative to valuations of larger firms, shown by the blue line, small-cap valuations also appear on the high side. As shown by the red line in the bottom left panel, risk spreads for high-yield bonds have fallen on net in recent quarters and currently stand near record lows. To assess the risk premium on high-yield bonds, we subtract from this spread the compensation for expected losses from defaults that would be required by risk-neutral investors. As shown by the black line, expected losses have been low for the past few years, and the risk premium, the gray shaded area, is narrow at about 120 basis points. Low risk spreads and risk premiums may be supported by the exceptional quality of corporate balance sheets. As shown to the right, the ratio of debt to assets for publicly traded speculative-grade firms, the red line, is just off its twenty-year low. The ratio for investment-grade firms, the black line, continues to edge down.

    Exhibit 7 examines corporate leverage. Some analysts have expressed concern that low risk spreads are encouraging firms to ramp up debt, which will lead to a sharp deterioration in corporate credit quality in the future. As shown by the green bars in the top left panel, share repurchases have risen sharply since 2003, far outpacing the rise in dividend payments, the blue bars. Cash-financed acquisitions, including leveraged buyouts (LBOs), the yellow bars, have also risen. The table to the right characterizes the effects of large repurchases on leverage in 2005 and 2006. Firms with large repurchases, defined as more than 5 percent of assets, had earnings that equaled 9 percent of assets, row 1, higher than earnings of 6 percent at firms with limited or no repurchases. Row 2 shows that high-repurchase firms boosted their debt ratios 2 percentage points, in contrast to the decrease of 1 percentage point at other firms. Even so, the increase raised the debt ratio to only 22 percent at large-repurchase firms, below the average for other firms. Thus, repurchases to date do not suggest material damage to credit quality and would seem likely to do so going forward only if firms were pressured to continue to pay out cash despite weaker profits.

    LBOs tend to involve much more debt than share repurchases, as firms typically have debt-to-asset ratios of more than 65 percent right after an LBO. As shown in the middle left panel, the issuance of speculative-grade bonds for mergers and acquisitions, including LBOs, the dark portion of the bars, has risen notably, and originations of speculative-grade loans for M&A, shown to the right, have shot up. The sharp rise in loans reflects in part greater demand, particularly for collateralized loan obligations (CLOs), by institutional investors, who are estimated to have purchased more than half of these loans last year. One reason for the greater demand could be the relatively attractive risk-return tradeoff of loans relative to bonds, illustrated in the bottom left panel. Returns on leveraged loans in recent years, the black line, are only modestly lower than returns on high-yield bonds, the red line, but are significantly less volatile. Thus, as noted in the inset box, Sharpe ratios— defined as mean excess returns to standard deviation—are higher for loans than for bonds. We expect that institutional investors will continue to pursue loans until expected returns decline, perhaps through tighter spreads or lower recovery rates on loans. Financial data generally are not available for firms taken private; views of examiners and rating agencies can be used to gauge the effect of LBOs on credit quality. As shown by the black line in the right panel, the most current, and still preliminary, reading on the share of syndicated loans outstanding that were adversely rated shows almost no change from the previous year and remains low. For corporate bonds, the share rated B minus and below, the red line, stayed in its recent range at the end of the first quarter. Although these measures provide a bit of comfort, it may take some years to fully assess whether the operating efficiencies attained through LBOs will be sufficient to cover the higher debt obligations.

    Exhibit 8 focuses on household financial conditions. As shown in the top left panel, the ratio of net worth to income is estimated to be up on net through the current quarter, largely on stock market gains. While we expect this ratio to decline in coming quarters as house prices flatten and stock prices advance more slowly, it remains high by historical standards. Moving to the right panel, delinquency rates on consumer loans at banks, auto loans at finance companies, and most mortgages have edged up in recent months but do not suggest signs of stress. Overall, most households appear to be in good financial shape. However, there are strains among some subprime mortgage borrowers. As can be seen in the middle left panel, delinquency rates on subprime adjustable-rate mortgages, the solid red line, have climbed sharply and in April moved up again, while those on other mortgages have remained low. As shown to the right, early-payment delinquency rates—at least three missed payments within six months of origination—on adjustable-rate loans rose further in April, though they remain modest for prime and near-prime types, the blue line. As shown in the bottom left panel, we estimate that new foreclosures were started at an annual rate of 1.3 million in the first quarter. Subprime mortgages, the red bars, accounted for more than half of the starts. As noted to the right, foreclosure starts in states with high unemployment, like Ohio, Michigan, and Indiana, continued at a high rate but were little changed from the fourth quarter. The sharpest increases were in four states— California, Florida, Nevada, and Arizona—accounting for more than the nationwide increase, as house prices in those states decelerated. To predict foreclosure starts, we have developed a model of national rates that regresses state-level rates on house price growth, unemployment, the share of loans that are subprime, interest rates, and other variables. This model predicts that foreclosures will continue to rise and reach a bit more than 1.4 million for 2007 as a whole and 1.5 million in 2008, under the Greenbook assumption that national house prices will be roughly flat this year and next.

    There is unusual uncertainty right now about a forecast given the unprecedented reach of the subprime market in recent years. Some sources of that uncertainty are discussed in exhibit 9. The top four panels present information on interest rate resets on subprime adjustable-rate mortgages, based on a very recently acquired dataset of more than 2 million 2/28 and 3/27 loans that were outstanding as of March of this year. As shown in the top left panel, we estimate that as of the end of the first half of this year, 36 percent of the loans have already had their first interest rate reset. Another 25 percent will face their first reset in the second half of this year, and 21 percent will do so in the first half of 2008. Characteristics of interest rate resets for this snapshot of mortgages are noted in the right panel. The data indicate that, for mortgages close to their first reset date, the initial rate averages about 7.35 percent. Most contracts specified the “fully indexed” rate as the six- month LIBOR plus a margin, which averages 6 percent, and most had caps on the size of each adjustment.

    The diagram at the middle left presents a progression of interest rates that borrowers about to reset likely will face, based on mortgages that were reset in the past year. As shown by the red line (a slightly stylized version of the actual data, the gray line), the jump in the rate at the first reset date is sizable, almost 2½ percentage points, resulting in a new rate of 9¾ percent. The first reset rate almost never jumps to the fully indexed rate, the blue horizontal line, because of the various caps on increases. But rates are subsequently reset every six months, and as shown on the second reset date, the rate rises another 1 percentage point. Our data suggest that a borrower would not reach the fully indexed rate in the original mortgage until twenty-four months after the first reset (not shown). As noted to the right, however, many borrowers historically have refinanced their mortgages before the first reset date or shortly thereafter. In our sample, 25 percent of mortgages had one reset, and only 12 percent had a second reset.

    The expected resets in coming months highlight a risk to the outlook for subprime credit quality. Fewer borrowers currently have the ability to refinance because of less home equity accumulation, higher interest rates, and tighter credit conditions. However, many lenders are working with borrowers to modify their loans. In addition, our most recent data indicate that, while credit conditions have tightened, financing remains available. As shown in the bottom left panel, spreads on new subprime MBS issues have eased from their peaks in April, although they have moved up in recent weeks, triggered by concerns related to losses at Bear Stearns’s hedge funds. Subprime mortgage originations, the full height of the bars in the right panel, while down substantially from record highs in late 2005, are not inconsiderable. Moreover, funds appear to have been available both for refinancings, the blue bars, and for home purchases, the green bars. My colleague Mike Leahy will continue.

  • As you know from the Greenbook, recent news on foreign economic activity has been generally upbeat, supporting our view that growth abroad will continue at a solid pace. The top panel of exhibit 10 shows our weighted average of total foreign GDP growth and our outlook. If our forecast is borne out, foreign growth will soften slightly over the forecast period, to about 3½ percent, which is also our current best guess of the rate of foreign potential growth. As you can see from the chart, rates of growth of 3½ percent (the thin horizontal line) or better are not unprecedented, but a stretch of five consecutive years, like that from 2004 to 2008, would be unusual. The chart also shows foreign growth maintaining most of the momentum it developed over the past couple of years even as U.S. growth has taken a more substantial step down. This is also a bit unusual. However, as shown in the middle left panel, foreign domestic demand gained strength throughout the current expansion, leaving foreign economies less dependent on demand from the United States. Foreign investment spending, in particular, has been picking up. As shown to the right, fixed investment spending as a share of GDP has moved up a couple of percentage points since 2003.

    With foreign activity expanding slightly faster than potential, it is not surprising that we are seeing signs in some foreign economies that labor market slack is dwindling. The unemployment rate in Japan, shown in the bottom left panel, is at a nine-year low; in Canada, the rate is at a thirty-year low; and the euro-area rate is also at a multiyear low. Tight labor market conditions are less apparent in emerging- market economies, although we are hearing stories of labor shortages in certain sectors in China, where growth has been extremely rapid.

    What is more apparent is that in markets for oil and other primary commodities, shown in the bottom right panel, demand has outstripped available supply, driving prices higher. Supply capacity is expanding, however, and we are projecting, consistent with futures markets, that commodity prices will flatten out by the end of the forecast period. Before they do, our forecast calls for oil prices to rise a bit further over the remainder of 2007 and 2008. Food commodity prices are projected to move slightly higher on average as well, in part as energy-related demand for grains remains strong. If this forecast is realized, oil and energy prices should impart in coming quarters noticeable but only moderate upward pressure on headline consumer price inflation abroad. In part this is because the projected increase in oil prices is relatively modest, at least compared with what we’ve seen in recent years. In addition, the direct effect of oil prices on consumer prices in many cases is damped by tax structures or more-active government intervention in energy markets.

    The top panels of exhibit 11, which examine the pass-through of crude oil prices to gasoline prices, provide some evidence of how such pass-through varies across countries. These panels present local-currency prices of unleaded gasoline and imported crude oil over the past couple of years or so, plotted on a ratio scale so that vertical distances correspond to percent changes in prices. Looking across the panels, you can see that the price of imported crude oil in local currency—the black line at the bottom of each panel—moves similarly across countries. In contrast, the prices that consumers pay at the pump—the red lines—are less volatile in the foreign economies shown than in the United States and have moved up more slowly. In part, this reflects some differing movements in refinery and distribution margins, which are represented by the gap between imported crude oil prices and retail gasoline prices excluding taxes (the blue lines). This is most noticeable for Japan, where margins are proportionally higher and more of the increase in crude oil prices was absorbed than in the United States and the other countries. In addition, higher gasoline taxes abroad have inserted a greater wedge between the pre-tax price and the retail price of gasoline—the difference between the blue and the red lines. Accordingly, increased crude oil prices have pushed up retail gasoline prices proportionally less abroad than in the United States.

    The middle left panel presents some calculations of the rates at which the changes in crude oil prices were passed through to the retail gasoline prices between September 2004 and March of this year, the most recent observation I have for these countries. During this period, rates of pass-through were lower abroad, particularly for Japan and Germany, the countries with relatively high taxes. The smaller pass- through of oil prices to retail gasoline prices abroad has also shown through to broader measures of consumer energy prices. As shown to the right, consumer energy prices in Canada, Germany, and Japan have increased less than those in the United States over the past four years. An extra factor holding down energy price inflation in Canada over this period was the substantial appreciation of the Canadian dollar, which made imported energy relatively cheaper. Overall, this suggests that the effects of past increases in global energy prices on headline inflation, as well as on consumer sentiment and inflation expectations, were likely smaller abroad than in the United States.

    In many emerging market economies, gasoline and other retail energy prices are controlled or subsidized, so that energy-related fluctuations in consumer prices, if they occur at all, tend to be gradual. For this group of economies, what has left a bigger imprint on headline consumer price inflation in recent months is the global rise in food prices. The black line in the bottom left panel shows that food price inflation in Mexico has been heavily influenced in recent years by enormous, weather-induced swings in domestic tomato price inflation, shown in red (of course). [Laughter] This year, however, food price inflation has not followed tomato price inflation down. Rather, it has been sustained in part by a sharp acceleration in prices of tortillas and other corn products, shown by the green line, which are responding to the fuel-related surge in the global price of corn. Food price inflation in China, shown to the right in black, has also been boosted by higher grain prices, as higher feed costs, along with an outbreak of swine flu, have driven up meat and poultry prices. Prices for corn and other grains are forecast to level out by the end of 2008, after they have increased enough to align supply and demand growth. A risk, of course, is that further rapid expansion of demand might continue to outstrip that of supply, making food price inflation more persistent and more likely to spur inflation in other sectors. The Bank of Mexico cited such a risk following its policy tightening in April, and China’s authorities have raised concerns that food prices may exert upward pressure on wages.

    Evidence for emerging market economies that inflation pressures might already be spreading outside the food and energy sectors is limited so far, however. The top left panel of exhibit 12 shows core inflation rates in four of our largest emerging market trading partners. China’s core rate (in blue), which excludes only food, shows no sign of wider inflation pressures. In Brazil, inflation has declined substantially over the past few years, despite a slight uptick recently. Core inflation in Korea has been trending upward, but it is still low. Mexico’s core inflation rate has edged up toward 4 percent, a rate that concerns Mexican authorities, but this upward trend may merely reflect the fact that core inflation in Mexico does not exclude processed food such as corn tortillas. The advanced foreign economies appear to be exhibiting more broadly based inflation pressures. As shown on the right, in Canada, the euro area, and the United Kingdom, core inflation has been on a rising trend since the middle of 2006 or earlier. In response, the central banks in all three economies, as well as the Bank of Japan, are expected to tighten policy in the near term. Core inflation is still in generally acceptable ranges, however, except perhaps for the Bank of Japan, for which it might be too low, and market sentiment does not indicate concern that inflation pressures are going to rise substantially. As you can see from the middle left panel, ten-year government bond yields in the major markets have all risen since the beginning of the year. Except for Japan, most of the increases in nominal yields (the first column) can be attributed to higher real yields, shown in the second, which is consistent with stronger prospects for growth. The table to the right shows that survey measures of inflation expectations for the year 2007 rose moderately for Canada between December and June and a bit less for the United Kingdom, whereas the measures fell off some for the euro area and Japan. Longer-run inflation expectations as of the most recent survey date in April were still locked in at rates consistent with inflation targets in Canada, the euro area, and the United Kingdom. Our outlook for headline inflation abroad, shown in the bottom panels, reflects a diminishing inflationary impulse from oil and other primary commodity prices as they flatten out over the forecast period. It also incorporates the view that some further monetary policy tightening will be needed to restrain domestic demand and guide inflation in each economy toward its price stability objective by the end of the forecast period.

    Your last two international exhibits focus on the extent to which external adjustment is under way. A little more than a year ago, in May, was the last time we forecast that the U.S. current account deficit in 2007 would exceed $1 trillion. Since then, as shown in the top left panel of exhibit 13, our outlook for the current account has improved substantially, so much so that currently we don’t see the deficit reaching $1 trillion within our forecast period. As shown to the right, much of the improvement has come through an improved outlook for the trade balance. What surprised us? Two likely suspects fail to provide the answer. Given the recent strength of foreign growth, one might have thought that a year ago we were perhaps too pessimistic on foreign activity and consequently undershot on U.S. export performance. However, as shown in the middle left panel, our outlook today for foreign economic activity is very similar to what we had in mind a year ago. Similarly, the decline over the past year in the broad real dollar, shown to the right, which has helped curb the deterioration in the trade balance, has turned out to be not much different from our forecast a year ago. Part of the answer, it turns out, is that, even though the assumptions we fed our model for exports have not proved much off the mark, our model forecast for core exports, shown at the bottom left, failed to catch the unusually strong growth of exports in 2006. We attribute this miss to the composition of foreign demand rather than its overall magnitude. As shown in the table to the right, the largest contributors to growth of U.S. core exports in 2006 were in the categories of capital goods (line 2) and industrial supplies (line 3). With capital goods making up a large fraction of core exports, the rise in foreign investment as a share of GDP (mentioned earlier) likely provided a boost to core exports above that indicated by our aggregate measure of foreign GDP. Similarly, the global commodity boom likely favored U.S. exports of industrial supplies.

    Additional factors behind the improved outlook for the U.S. current account are described in exhibit 14. One is the lower path of U.S. real GDP, shown in the top left panel, which prompted real imports of core goods, shown to the right, to expand along a shallower trajectory than we had predicted last year. A third factor, illustrated in the middle left panel, is that we did not forecast the dip in the price of oil in the second half of 2006, which reduced the value of oil imports substantially. These three factors explain the bulk of the upward adjustment in our forecast for the trade balance in 2007. In addition, the improved outlook for the current account reflects an upward revision to net investment income, shown in the middle right. This adjustment results from a number of factors, including new data on U.S. holdings of direct investment abroad, new procedures for determining interest payments to foreign holders of U.S. Treasuries, and a change in the methodology used to record interest flows on cross-border holdings of other fixed-income securities. As a result of these surprises, the external accounts have clearly improved. Going forward, we expect the current account deficit to resume widening nonetheless as interest payments on the net external debt mount. But the combination of solid, demand- driven foreign growth and weaker U.S. growth has led the external accounts to make a more positive contribution to U.S. GDP growth in the near term, as shown in the table. In our current forecast, shown in the rightmost column, we project that the arithmetic contribution of real net exports to GDP growth should be roughly neutral starting in the second half of this year, as strong foreign growth helps sustain real export gains that match those of real imports.

  • Thank you. That was an excellent report. We have time now for some questions for our colleagues. Any questions? President Lockhart.

  • Aircraft constitute what share of capital goods exports, and might they have something to do with the competitive situation, particularly between Boeing and Airbus?

  • Aircraft are an important factor in this. In the fourth quarter of last year, Boeing was essentially exporting all the aircraft it could produce; so coming into the first quarter, we didn’t get much more because there weren’t any more to sell. But that issue has been important. I don’t know to what extent Boeing has benefited from the fact that Airbus has had some hard times, but I suspect it has gotten some benefit from that.

  • Aircraft are roughly 5 percent of exports.

  • Five percent of capital goods or of total exports?

  • More like 20 percent of capital goods and 5 percent of exports.

  • I want to take David back to exhibit 5 and try to pin him down, although I am not very hopeful. [Laughter] You took us back to the period from 1996 to mid-2004, in which inflation, by the core PCE measure, was between 1 and 2 almost all the time—I think the only exception was basically the last few months of 2001. Core inflation averaged something like 1.6 percent. You take these three survey measures there and look at them. What I took away from your assessment was that you view these as roughly consistent with that period. Is that fair?

  • I would say that the answer differs by series, so that if you tend to favor the short-term Michigan series shown in the top right, you might get a more alarming picture. But, for example, the Survey of Professional Forecasters’ ten-year- ahead series is all the way at the other end of the spectrum, having been essentially rock solid at 2.5 percent, and these other series fall somewhere in between. Obviously, this analysis is extraordinarily simple and doesn’t take into account other factors that may have been at work over that eight-year reference period that are not operating now. But the hope was that, on a very rough and ready basis, this might be broadly indicative and that an eight-year period might capture some variation in other factors that were influencing inflation.

  • I am wholly on board with you there. What I was most curious about was what you took away from this for your core inflation outlook, which you have going to 2.0 real soon and staying there, and whether you view current expectations as broadly similar to this period and your forecast as consistent with that period? Or do you view expectations and your forecast as potentially at variance with that period, or some combination of the two?

  • I think we view the current constellation of expectations measures as not providing much impetus either upward or downward on inflation—it is just not going to be an important factor shaping the contour of inflation in our view.

  • Okay. A question I had—and maybe Vince can help with this— is that the TIPS measures obviously don’t go back that far; and going back only as far as they go, my sense is that most analysts don’t view them in the earliest period in which we have quotations as representing prices and markets liquid enough to give us a sense. I guess 2003 is around the borderline of the reliability period. In 2003, those TIPS spreads for the next five years were down well into the 1 to 2 percent range, very close to 1½ percent. Do you folks view the TIPS spreads in the year or two leading to 2003 as something out of which we should take any information about inflation expectations?

  • Well, there is a picture in the lower right panel of chart 1 in the Bluebook.

  • It goes back only to ’04, doesn’t it?

  • Yes, that is right.

  • Well, I was looking at Greenbook Part 2, page II-35, and it goes back to ’01.

  • In my conversations with some of the TIPS analysts on our staff, they suggested, as consistent with your statement, that 2003 was, roughly speaking, the period in their view in which the TIPS market emerged into the modern era with some tighter pricing.

  • So there is some informational content there. Are you giving me some comfort in that regard?

  • I think the thing to note, President Lacker, is that, if you look at the term structure of TIPS compensation, the five-year, five-year-forward in that has been a whole lot more stable. The quotes you are looking at are very much influenced by the first five years. In fact, at the end of 2001, again in 2002, and in the middle of 2003, the first five years’ inflation compensation fell below 1½ percent.

  • The TIPS spread measure?

  • Yes, the TIPS inflation-compensation measure. During the same period, however, the five-year, five-year-forward basically bounced up and down around 2½ percent.

  • Right. So the longer-run expectations maybe weren’t so anchored or weren’t tied to the middle of this period. But we had a period in which there was an indication that expectations over the near term were around 1½. I guess the thing I would be curious about, and maybe Vince’s presentation is a more appropriate time to address this question—I would be happy to defer it until then—is that viewing 1996 to 2003 as sort of a distinct period in which we nailed things between 1 and 2 for a while suggests thinking about the transition from ’03 forward a couple of years as a transition out of price stability defined that way and whether we can take any lessons from that for the potential costs of a transition back to a period like that.

  • Mr. Chairman. I just wanted to thank Mike, in particular, for that excellent presentation on the international dimension of this. It was sterling, or euro, or whatever the expression would be in terms of its excellence. I have a tutorial question about the export figures. I assume services are not included in core exports. Is that correct?

  • No, that is just goods.

  • Are our service exports increasing more rapidly than our non- service exports? Do you know? Would they be a possible source of explanation for the improved trade balance?

  • They are a possible source. They were my fourth factor, if I had gone on longer. [Laughter] They were neck and neck with the oil imports in terms of their contribution to the improved outlook for trade.

  • Well, thank you. That was an excellent presentation.

  • Just a question about scale—regarding exhibit 8, serious mortgage delinquency rates—when you refer to adjustable rates going to almost 12 percent of loans, is that of adjustable-rate loans? What is the total dollar value the 10 percent is against?

  • The serious delinquency rate is for the pool of adjustable-rate subprime loans, and they represent about 9 percent of the outstanding mortgages.

  • Okay—and the total outstanding mortgages are what dollar amount?

  • There is $10 trillion in mortgages outstanding.

  • That is what I thought. I just wanted to make sure. Thank you.

  • But to make sure that is right, the red lines are subprime?

  • The red lines are subprime.

  • Subprime adjustable-rate loans are about 9 percent of outstandings, and subprime fixed loans are another 5 percent of outstandings. That would be 9 percent of the $10 trillion in total mortgages.

  • Although the percentages are by number of mortgages rather than by value, I think.

  • By dollar it is very similar.

  • Are there other questions? President Moskow.

  • Also, on exhibit 8, the net worth chart in the top left-hand corner—I thought I heard you say that this was high by historical standards. So there are two things here—the stock market has been strong, and then housing prices have been very weak. I assume if you run this out into another year, the line is going to keep going down as well. I was just wondering if you could expand on this. Is this higher than you expected it to be at this particular time?

  • If we had started this series in the early ’90s, this would be the high. We have the stock market bubble of 2000 in here, and it has come off, but it is 5½. Even at the end of the projection period, it is 5½ times disposable income. That is historically high. Before ’96, it would have been about 3½ or 4.

  • We do indeed forecast it to continue to decline over the next year or so, in large measure because, as David shows in his chart, we still think this house price adjustment has to proceed further before we get into a better equilibrium. Our assumption on the stock price, of course, is pretty neutral because we have it going up pretty close to the overall rate of nominal income, so I think the downward tilt is being driven mostly by the house price story.

  • On a longer-term trend basis, where would you expect it to stabilize or to level out?

  • Take this for what it is worth, which isn’t a whole lot. [Laughter] Thank you. It drops just a bit; it is between 5½ and 5¼ over the longer haul and just gradually declines back in that direction.

  • President Hoenig, I think I interrupted you. I’m sorry.

  • This is the number of loans—then do you have any idea what the percentage of the dollar amount of loans is in delinquency?

  • We think there is probably $900 billion to $1 trillion in adjustable- rate subprime mortgages outstanding.

  • So about the same. Okay.

  • I wasn’t sure I heard correctly. What was the average ratio of wealth to disposable income over the ’90s roughly?

  • The number I recall is 4.6 as the long-run average since the ’80s. President Stern.

  • I want to go back to the surprise in net exports once again. I don’t quite remember the argument, but it seems to me we used to worry a lot about small foreign elasticities of demand for U.S. goods and services when the dollar declined or when income growth differentials changed. Has what we have seen lately affected your view about that?

  • I would say it hasn’t affected our view in the sense that we haven’t changed the elasticities that we are using on the basis of this one year’s observation, but it points in the right direction. I mean, we are getting a little bit more “umph” from foreign growth than we thought before. Whether it is going to be a one-time miss related to aircraft—there was some temporary investment surge in foreign economies, and we are a capital goods exporter, and we are just taking advantage of that, and it is going to go back—or whether it persists is a little too early to tell. But it is possible.

  • We have updated the elasticities since ten years ago. When you first heard us nattering on about the unsustainability of the U.S. current account situation, we had perhaps a more extreme view of those elasticities. If you drop out the 1970s and you restrict your estimates to a more recent period, you tend to get elasticities that move toward each other a little. But the basic asymmetry is still there, and we haven’t responded to 2006 in some specific way. We’re letting a little more time go by to see what happens going forward.

  • In exhibit 9, the average initial rate on the stock of mortgages that you are looking at for resetting over the next couple of years is about 7⅓ percent. What is roughly the current rate for subprime fixed-rate loans?

  • It is around 9 percent. If you get on the Internet and try to find a subprime fixed-rate loan, it would be about that. We can’t find an official series, but roughly 9.

  • So they are facing a 2½ percent payment shock if they stick with the mortgage. But if they were able to switch to a fixed-rate product, it is about 1½ percent.

  • That’s right, right now.

  • If there are no other questions, Vincent, could I call on you to talk about the economic projections?

  • Sure. Thank you, Mr. Chairman. As was evident in the survey responses summarized in the memo of June 15 on your attitudes toward the economic projections, there seems to be broad agreement among you on the key features of the process. Where there was not, including about sharing forecasts, the specification of the monetary policy assumption, and the characterization of uncertainty, the Subcommittee on Communications tried to find common ground. The result was reflected in the survey on the economic outlook for this meeting, which I will discuss with the aid of the material distributed with the cover “Economic Projections of FOMC Participants.”

    As can be seen by comparing the bolded with the italicized numbers in the first exhibit, there were only minor changes in your projections of real GDP growth, the unemployment rate, and core PCE inflation over the next two and one-half years from those you submitted in May. Given the favorable data over the intermeeting period, you raised your real growth forecasts a notch and lowered the core PCE inflation forecasts for 2007. Still, as plotted in the top panel of exhibit 2, the red bars showing the central tendency of your forecasts indicate that most of you anticipate that GDP growth will be somewhat soft this year but will pick up a bit over 2008 and 2009. Although the submissions were not specific about potential output growth—and not all of you would agree that it is even a useful concept—this expansion of real output would seem initially to be slower than that of capacity in that the central tendency for the unemployment rate (the second panel) edges higher. With resource markets less taut and perhaps some transitory factors ebbing, core PCE inflation (the third panel) drifts down. In this experiment, you were asked for inflation readings coming from two measurement systems. The historical wedge between inflation measured by the core PCE price index and the total consumer price index is about ½ percentage point. The central tendency projections for those two series in 2008 and 2009 are about that far apart, leading to the inference that you are not forecasting significant changes to the relative prices of energy and food. The subcommittee suggested forecasting these two inflation series in the spirit of experimentation. Sometime in the next two days, you might want to express how useful you found that part of the experiment.

    Another notable feature of your projections is that the differences among them widen, rather than narrow, the further into the future you forecast. This suggests a diversity of views as to key attributes of the economy as well as where you believe inflation should be headed in the long run. As for the assumption about monetary policy underlying these outcomes, about two-thirds of you indicated general agreement with the path laid out in the Greenbook. As for the others, there were explanations advanced for being on either side of the staff assumption.

    You were also asked to provide a qualitative characterization of your uncertainty about your outlook. The results for real GDP growth are given in the top panel of exhibit 3. Somewhat surprisingly, there was no Lake Wobegon effect, and the preponderance of responses viewed the real GDP growth outlook as just about as uncertain as has been the case on average over the past twenty years. As shown in the bottom panel, a majority of the submissions indicated that the risks around the projections for GDP growth are judged to be broadly balanced. This contrasts with the indication in the May minutes that, although the risks to economic activity had “diminished slightly,” they were still “weighted to the downside.” For some, the incoming news may have led to a reassessment of the risks to economic growth. For others, it may reflect a view that the main downside risks to activity are concentrated in the near term and those risks further ahead are broadly symmetric. To shed light on this issue, participants might want to address the main risks to economic growth and whether they are still judged to be weighted to the downside as had been the case in your May discussion.

    Some more detail about your forecasts of the unemployment rate is provided in exhibit 4. A majority of the projections embody a more muted rise in the unemployment rate than in the Greenbook forecast, the dashed vertical lines. This smaller expected increase may partly reflect the stronger outlook for GDP growth suggested by many of your projections. But then again, it may not: [laughter] From the comments in the narratives about the likely strength of trend growth, it is not clear that the projected growth in output relative to trend is expected to be materially more robust than that suggested by the staff’s forecast. Does the more modest projected rise in unemployment reflect a difference in views from the staff’s about the rate of growth of potential output, the unemployment rate associated with no change in the inflation rate, cyclical movements in productivity, or other factors?

    Exhibit 5 provides a tally of the year-by-year inflation outlook. A majority of the projections have a more benign medium-term outlook for core inflation than that suggested by the staff’s forecast. But the responses to the question about the appropriate path of interest rates indicate that for a majority of projections this does not stem from a significantly tighter stance of monetary policy than assumed by the staff. Likewise, the projections for GDP growth and unemployment do not appear to imply greater economic slack than expected by the staff. For some, this more marked moderation in inflation may reflect a judgment that more of the rise in core inflation reflects the effect of temporary influences, such as the rise in energy prices and owners’ equivalent rent, that are likely to abate over the forecast period. For others, it may reflect an assessment that the NAIRU is lower than that assumed by the staff or that inflation expectations may edge lower over the forecast period, perhaps pulled down by Federal Reserve communications. You might wish to exchange views about the main factors contributing to the expected moderation in inflation in your forecasts.

    As to where inflation is headed in the longer run, many of you indicated that the third-year projections (the bottom panel) reflect to a considerable degree your policy goal rather than initial conditions. If that is the case, the central tendency reveals that most of you individually define the inflation rate that best fosters the dual mandate to be 1½ to 2 percent when measured by the core PCE inflation rate. Given your apparent beliefs about future movements in the relative prices of food and energy, discussed earlier, you would also seem to think that total PCE inflation should place within a range of 1½ to 2 percent.

    As for the process from here on, if you would like to change your forecast in light of the discussion at this meeting or data received since you prepared your projection, we ask that you submit your revision to the Secretariat by close of business Friday. Unless we are instructed differently as a result of the discussion tomorrow, the staff will draft a minutes-style narrative description of the economic projections. This will be a standalone document that will circulate with the draft minutes on the regular schedule as was the case in May.

    One last point: Your final exhibit gives the traditional presentation of your economic projections that will be made public in the Monetary Policy Report and included in the published minutes. If you want to change your submission, please let us know by Friday. How you judge the usefulness of this exhibit compared with the forecasts compiled for the experiment presumably will be one topic for discussion tomorrow. That concludes my prepared remarks.

  • Thank you, Vincent. Thanks for reminding us that this projection counts in some sense, right? [Laughter] Also, I think it is very useful for us to have the discipline of thinking about how our projections fit together. Are there questions for Vincent? If not, then we can begin our economic go-round. Who would like to go first? President Yellen.

  • Thank you, Mr. Chairman. Data relating to both economic activity and inflation during the intermeeting period have been encouraging. Economic indicators have strengthened considerably, and recent readings on core inflation have been quite tame. Although a portion of the recent deceleration of core prices likely reflects transitory influences, the underlying trend in core inflation is still quite favorable. I view the conditions for growth going forward as being reasonably solid. The main negative factors are tied to housing. The latest data don’t point to an imminent recovery in this sector, and I fear that the recent run-up in mortgage rates will only make matters worse. In addition, housing prices are unlikely to rise over the next few years and, indeed, may well fall, and the absence of the housing wealth gains realized in the past should damp consumption spending. I agree with the Greenbook that the recent run-up in bond and mortgage rates reflects primarily a shift in market expectations for the path of policy and, therefore, implies only a small subtraction to my forecast for growth in 2008.

    In my view, the stance of monetary policy over the next few years should be chosen to help move labor and product markets from being somewhat tight today to exhibiting a modest degree of slack in order to help bring about a further gradual reduction in inflation toward a level consistent with price stability. The stance of monetary policy will need to remain modestly restrictive, along the lines assumed in the Greenbook and by markets, in order to achieve that goal. My forecast is for growth to be around 2½ percent in the second half of this year and in 2008, slightly below my estimate of potential growth, and for the unemployment rate to edge up gradually, reaching nearly 5 percent by the end of next year.

    Under these conditions, core inflation should continue to recede gradually, with the core PCE price index increasing 2 percent this year and 1.9 percent in 2008. This forecast is predicated on continued well-anchored inflation expectations and the eventual appearance of a small amount of labor market slack. In addition, special factors such as rising energy prices and the sustained run-up in owners’ equivalent rent that have boosted inflation should ebb over time, contributing a bit to the expected decline in core inflation.

    In terms of risks to the outlook for growth, I still feel the presence of a 600-pound gorilla in the room, and that is the housing sector. The risk for further significant deterioration in the housing market, with house prices falling and mortgage delinquencies rising further, causes me appreciable angst. Indeed, the repercussions of falling house prices are already playing out in some areas where past price rises were especially rapid and subprime lending soared. For example, in the Sacramento metropolitan area east of San Francisco, house prices shot up at an annual rate of more than 20 percent from 2002 to 2005. Since then, however, they have been falling at an annual rate of 3½ percent. Delinquencies on subprime mortgages rose sharply last year, putting Sacramento at the top of the list of MSAs in terms of the changes in the rate of subprime delinquencies.

    Research by my staff examining metropolitan areas across the country indicates that the experience of Sacramento reflects a more general pattern. They found that low rates of house price appreciation, and especially house price decelerations, are associated with increases in delinquency rates even after controlling for local economic conditions such as employment growth and the unemployment rate. One possible explanation for these findings is that subprime borrowers, especially those with very low equity stakes, have less incentive to keep their mortgages current when housing no longer seems an attractive investment, either because prices have decelerated sharply or interest rates have risen. These results highlight the potential risks that rising defaults in subprime could spread to other sectors of the mortgage market and could trigger a vicious cycle in which a further deceleration in house prices increases foreclosures, in turn exacerbating downside price movements.

    The risks to inflation are also significant. In addition to the upside risks associated with continued tight labor markets, a slowdown in productivity growth could add to cost pressures. Although recent productivity data have been disappointing, I expressed some optimism at the last meeting about productivity growth on the grounds that at least some of the slowdown appeared to reflect labor hoarding and lags in the adjustment of employment to output, especially in the construction industry. Data since that meeting have reinforced my optimism concerning trend productivity growth. In particular, new data in the recently released Business Employment Dynamics report suggest that productivity growth may have been stronger than we have been thinking. This report, which includes data that will be used in the rebenchmarking of the payroll survey in January, shows a much smaller increase in employment in the third quarter of 2006 than is reported in the payroll survey; it, therefore, implies a larger increase in output per worker.

    A second risk to inflation is slippage in the market’s perceptions of our inflation objective. Although inflation compensation over the next five years is essentially unchanged since our last meeting, long-run breakeven inflation rates implied by the difference between nominal and indexed Treasury securities are up about 20 basis points. However, our analysis suggests that this increase reflects in good part an elevation in risk premiums or the influence of various—let me call them “idiosyncratic”—factors of the type that Bill Dudley mentioned, such as a possible shift in the demand by foreign central banks for Treasuries or special factors affecting the demand for inflation-indexed securities and not an increase in long-run inflation expectations. We base this conclusion on the fact that long-run breakeven inflation rates have also climbed in the United Kingdom—a country where inflation expectations have been remarkably well anchored over the past decade and where inflation has been trending downward. The fact that breakeven inflation rates rose in both countries, despite their different monetary policy regimes, suggests that a common explanation is needed rather than one specific to the United States. I think this conclusion is supported by the Board staff model that attributes about half of the movement in breakeven inflation to risk premiums. That said, our understanding and estimates of risk premiums are imprecise, so we must continue to monitor inflation expectations very carefully—of course, along with everything else. [Laughter]

  • Thank you. President Moskow.

  • Thank you, Mr. Chairman. Conditions in the Seventh District have changed little since my last report. Overall activity in the District is lagging the nation, mainly because of the continued difficulties of what we now call the Detroit Three, formerly known as the Big Three, [laughter] and their suppliers. But other sectors of our region are doing better—notably, a number of manufacturers outside autos—and consumer spending is moving forward at a moderate rate.

    Looking at the outlook for the national economy, the Greenbook baseline forecast has growth recovering to potential and core inflation stabilizing at 2 percent. Our outlook is not much different. We see growth returning close to potential. Assuming that monetary policy maintains its slightly restrictive stance, we think inflation will edge a shade below 2 percent by 2009. That would be a good outcome, and I sure hope we get it.

    The biggest news since the May FOMC meeting is the adjustment in financial conditions. The change in fed funds futures brings market expectations into better alignment with what I think will be the appropriate path for monetary policy. I’m not sure, however, how much restraint we can expect from the increase in long-term interest rates. As the Chairman heard from our directors last week, the effects can be muted by ample liquidity in the financial markets. One of our directors, who heads a large private equity firm, says that he does not see much of a change in the lending environment. Financing for even high-risk projects continues to be readily available at quite favorable rates and terms. Notably, such loans are being made with few covenants and no automatic default triggers.

    Of course, the housing market remains a risk. Like the Greenbook, we continue to expect large declines in residential investment through the end of this year, and I remain concerned that builders may need to cut back even more to reduce the high inventory of unsold homes. Our Detroit Branch director, who is CFO of Pulte Homes, noted that two-thirds of their sales usually occur between the Super Bowl and Memorial Day. Sales this year in that period were sluggish and relatively unresponsive to price discounting. Accordingly, he is not looking for a turnaround in housing markets before ’08. Another director, the head of U.S. Gypsum, agreed that it would be ’08 before we could expect a pickup in housing.

    With regard to consumer spending more generally, some contacts noted the impact of higher gasoline prices. A developer of malls and shopping centers downgraded his expectations for the rest of 2007, but he is not overly pessimistic and is expecting retail sales in the second half to remain near their first-half pace. Both GM and Ford believe that the higher gasoline prices are holding down the overall level of motor vehicle sales in addition to moving the mix of sales away from SUVs and toward cars. At this point, they believe that higher interest rates are having only a marginal effect on demand. Both are predicting that total light vehicle sales will be about 16.5 million units in 2007. That is the same as the pace predicted by the participants in our annual outlook symposium that we held in Detroit earlier this month.

    But the rest of the manufacturing is doing better than autos. Producers of heavy machinery and agricultural equipment continue to report strong demand. The Chicago purchasing managers’ report, which is confidential until its release this Friday, was 60.2 in June; that reading is down only a bit from its very high one of 61.7 in May. Some of this strength reflects strong growth abroad, which is fueling the demand for U.S. products, as we talked about during the chart show. Indeed, I think that there may be some upside risks to the GDP forecast from faster-than-expected export growth. Labor markets continue to be strong, and we heard the usual stories about selected labor shortages and associated increases in wages. One exception is the soft demand for temporary workers, but this could be normal for a mature business cycle.

    Turning to prices, our contacts seem to be a bit more pessimistic about the prospects for inflation. We heard concerns that higher energy prices would boost transportation costs and that the demand for food stuffs from abroad and the booming domestic ethanol market are pushing up food prices. In contrast to the anecdotes, the incoming data on core inflation were better than expected. Our indicator models revised down a tenth or two from the last round; they now have core PCE inflation being about 2 percent this year and next and then edging down to 1.8 or 1.9 in 2009. Without any meaningful resource slack, this improvement would require a comparable adjustment in inflation expectations, which may be difficult given a prolonged period of core inflation at or above 2 percent. So I continue to think that the predominant risk remains that inflation will not moderate as expected.

  • Thank you. President Lacker.

  • Thank you, Mr. Chairman. The Fifth District’s economy has picked up since the last meeting. Retail sales rose briskly in June following several months of flatness, and shopper traffic increased more broadly as well. Of particular interest, building supply and furniture retailers report better sales. Big-ticket sales remain generally weak, however, with domestic brand automobile dealers continuing to note soft sales. Activity at District services firms added to an already healthy pace of growth, with revenues and employment expanding somewhat faster in June. In May, our manufacturing sector finally joined in the general manufacturing pickup that began a few months back in other regions. Our indexes for shipments and new orders swung well into positive territory after having spent the entire year well down in the negative region. This rebound appears to be broadly based, with most industries posting stronger readings. Housing sales and construction remain weak in most parts of the District, though home prices have been more resilient, with very modest gains reported in most areas and lower prices in only a few. In contrast, the commercial real estate sector appears to be fairly strong, with both leasing and construction looking solid.

    Regarding inflation, our survey measures suggest that price trends in the services sector remain moderate. Our manufacturing numbers, however, consistent with President Moskow’s report of anecdotal information, indicate significant price acceleration, on both the product and the input sides.

    At the national level, the new information on the real economy we have received since the last meeting has been fairly positive. In particular, I’m heartened by the recent reports on business investment and manufacturing, which appear to confirm our expectations that the softness we were seeing a few months ago would prove to be transitory. Consumer spending also continues to expand, although not as rapidly as earlier in the year. Housing, of course, continues to be the main drag on spending, and the most prominent source of uncertainty about the real outlook. My sense is that the uncertainty is receding, however. Construction numbers have more or less moved sideways since the beginning of the year, in contrast to the sharp fall we saw in the first three quarters of last year. So it looks to me as though we’re nearing a bottom in housing activity, albeit a bottom that may slope gently away from the steep cliff we descended last year. At this point, I think the risk of encountering another cliff has become relatively small.

    We have also received favorable readings on core inflation for the past three months. This has brought the twelve-month core PCE number down to 2.0 percent. While this news is good, we should react cautiously, of course. We have seen several months of favorable data before only to see several months of unfavorable numbers. Moreover, the Greenbook points to a number of special factors suggesting that the second quarter’s better inflation performance is likely to be transitory. I am inclined to agree with that assessment, and so I think we could well see core inflation rise again.

    Measures of near-term inflation expectations have not moved much in recent months. They all still point to PCE inflation expectations of 2 percent or so. Moreover, five-year, five-year-ahead inflation compensation has moved up ¼ percentage point, for whatever reason, since just before our last meeting. All this makes it hard to be confident that we are going to see a sustained decline of inflation below 2 percent anytime soon. The good news on the real side, however, suggests that we are making progress toward seeing downside risks diminish enough for us to do something about inflation. Thank you.

  • Thank you. President Fisher.

  • Mr. Chairman, for the sake of consistency, I will refer to my report at the last two meetings on what I call the Goldilocks porridge classification system. I reported last that the international economy was hot, and it remains so as we saw in the excellent slide presentation. I reported that the domestic economy was cold. I believe it remains so, in contrast I think to the previous two interventions, at least from a growth perspective. I also reported that the Eleventh District, home of the NBA champions, vanquishers of the—shall I say “more cavalier”?—Fourth District, [laughter] was just right. It remained so in relative terms. I would say that it has weakened somewhat and cooled somewhat in absolute terms.

    I just want to comment quickly on the international side of the domestic economy, with the hopes of adding on the margin to the staff’s excellent work in the Greenbook, the Bluebook, and the presentations we had earlier. On the international side, I was pleased that for the first time, at least since I have been a member of this august body, the last minutes reported that the participants expressed “some concern that the strength of global demand could contribute to price pressures at home” and noted “heightened levels of capacity utilization in those countries.” We didn’t talk about capacity utilization in your excellent report. I just wanted to add that our work in Dallas and my CEO contacts continue to validate the phenomenon that we are getting closer to capacity constraints abroad. Research by the Dallas staff, imperfect as it is, confirmed continued growth overseas, resulting in a tightening of capacity around the world, as does the work of JPMorgan, one of the few places in the private sector that we find has spent a good deal of time contemplating this issue.

    Anecdotal reports from CEOs and CFOs confirm this trend. The rest of the world is reported to be offering more fertile soil for growth and investment, as I think President Moskow pointed out. Shippers tell me that tonnage demand for dry bulk is running at a rate significantly higher than last year, driven by underlying demand outside the United States and despite slower rates of growth of shipments to the United States. You also see this in ship charter rates remaining high. Freight rates, which don’t have a spot market and are much more difficult to measure, appear to be rising in terms of their volume expansion and in shipments to Europe from the Pacific—certainly at a faster rate than those shipments from the Pacific to the United States.

    One of the largest engineering logistics firms in the world reports that, with the exception of downstream oil and gas investments, power, and an as yet unannounced nuclear power plant that will be built in the United States, their bookings and substantial backlog are “all driven by non-U.S. demand, with cost escalation not only of commodity inputs but of the building blocks and their materials, such as compressors and pumps, and so on, despite the leveling-off of the price of steel.” On the cost side, the head of the United States’ largest importer of consumer goods—without mentioning the name of the retail company—[laughter] reports that cost pressures, as you indicated before in your presentation, coming from China are leading them to “aggressively seek to shift imports to other country sources; in certain sectors, China is becoming too pricey.”

    At home, business operators to whom I talked are more equivocal about growth prospects for the economy, Mr. Chairman, than I expected. The CEO of one of the largest rails describes the economy as “lethargic.” The CEO of one of the largest IT firms “doesn’t see much sequential growth.” The CEO of an airline, which is not Southwest Airlines, says that “domestically, the seasonally adjusted revenue for the industry line is flat.” A usually ebullient CEO of one of the nation’s largest broadcasters said that “while Q2 is always the slowest quarter, this one is slower than normal.” The CFO of one of the flagship express shippers reports that B2C is growing at 3 to 4 percent rates of volume expansion after several years of 7 to 8 percent rates of growth. But there has been no pickup in the second quarter over the first quarter seasonally adjusted, and “it just seems to be as flat as it can be across the board in all segments.” A leading restaurateur with thirty years in the business notes that he is experiencing a combination of soft top line and rising costs for the first time in his history of operating. For added measure, the CEO of a very large retailer describes demand as “flatter than a pancake.” He and retailers at the higher price points report that shoppers are moving away from the malls to closer-to-home retailers because of transportation costs and financial insecurity. They make fewer trips, and they buy larger volumes per trip.

    President Yellen, I won’t depress you with the soundings from the two largest public homebuilders. I only half jokingly recommended that they take all sharp objects off their desks and seal their windows. [Laughter] Their situation is reported to have gone from bad to worse. One of the interesting data points is that they represent 27 percent of the homebuilders. The remainder is in private developers’ hands. They suggest that the rapidity with which those private developers report their stress is certainly much less than the publicly held companies, in part because they are afraid of their lenders. Therefore, those shoes have yet to drop, which is not an encouraging sign.

    On the price front, I hear two common complaints across the board. First, labor remains tight and pricey except in the homebuilding sector, where there has been some relief for obvious reasons. Second—and I think very importantly—food prices driven by corn oil are creating significant cost pressures for all crops, including substitute crops. One of the most astute contacts I have—a leading banker, not a restaurateur or a food person—says that adding ethanol to what he called a tectonic shift in demand for corn, wheat, and other food stuffs stemming from the addition of two billion people—new consumers moving up the food chain (no pun intended)—may place corn at the center of the inflation paradigm in the new century.

    One commonly voiced concern might influence business investment in capital expenditures. I keep hearing from each CEO, “What are we going to do with our capital?” Reports are increasing of competition from rates on the longer end of the yield curve, above 5 percent. Boards of directors are reluctant to embrace the concept that eighteen months out the U.S. economy’s sun will shine more brightly than it is shining currently, and concerns linger about the costs and the availability of labor for domestic cap-ex purposes.

    In summary, Mr. Chairman, statistically we may have a second-quarter snapback driven by inventory adjustment as predicted by the Board staff and by my own staff. But my soundings with business leaders—again, no doubt imperfect—provide some cognitive dissonance. I didn’t hear a single one of twenty-six interlocutors who would agree with the baseline case as stated in the Greenbook. Most would agree with the alternative cases that were presented, which were quite thoughtful. I used the term “dyspeptic” in describing the mood of corporate leaders the last time we met. I would say the mood, Mr. Chairman, remains sour, and perhaps it has become more sour. I remain relatively pessimistic on growth and skeptical about inflation and the utility of reliance on the core measurement in guiding our deliberations. Thank you, Mr. Chairman.

  • Thank you. President Stern.

  • Thank you, Mr. Chairman. Regarding the national economy and real growth, it seems to me that recent developments are unfolding to a considerable extent largely as anticipated. Growth was positive but subdued over the four quarters ending in the first quarter of this year. It apparently snapped back discernibly in the current quarter, and my forecast is for sustained growth around trend going forward. In examining the twelve-month period spanning the last three quarters of last year and the first quarter of this year, it is apparent that the slowing of aggregate demand went beyond the housing sector and, in fact, was fairly broadly based. To be sure, residential construction activity contracted persistently and substantially over those four quarters. In addition, spending on equipment and software barely advanced, federal government outlays were soft in real terms, and there was a significant inventory correction. In most cases, with the likely and perhaps obvious exception of residential construction, there are reasons to believe, based on some of the indicators that David Wilcox covered this afternoon as well as materials distributed before the meeting, that these components of demand—that is, spending on equipment and software, federal government outlays, and inventories—will strengthen going forward. I thought it was particularly heartening, as noted in Part 2 of the Greenbook, that apparently the inventory overhang in construction supplies and in autos has been worked off, which suggests that we should see improvement in those sectors going forward. As I have commented before at recent meetings, I think the outlook for nonresidential construction, for net exports, and for consumer spending remains positive, although not unduly exuberant. All of this fits reasonably well with my view of what we should expect from productivity gains going forward, as well as increases in employment and hours worked. So, overall, I think the outlook for the real economy is promising and favorable.

    As to inflation, there has been, as everybody has noted, some moderation in the core measures recently. I expect this performance to continue, not necessarily on a month-by-month basis but over time. Overall, my reading of monetary policy is that it is moderately restrictive. As a consequence, that should feed into a further, gradual diminution of inflation along with ebbing of some of the transitory factors that pushed it up for a time. I would add that anecdotes from our business contacts don’t suggest any changes in pricing power or acceleration of inflation at this point.

    Now, of course, risks to the outlook abound, as they always do, and many have already been mentioned. Several relate, of course, to housing—construction activity, home prices, mortgage-related paper, and so forth. Then, you can add uncertainty associated with energy prices, the run-up in long-term interest rates that has already occurred, and I am sure a few things that I haven’t enumerated. I wouldn’t want to sound overly complacent or sanguine, but I would observe that many of these risks are not new. Many of them are already built into the Greenbook or other forecasts. In any event, if one of them were to occur in isolation, I would doubt that it would have a profound effect on the outlook that I have described. Thank you.

  • Thank you. President Minehan.

  • Thank you, Mr. Chairman. The pace of growth in New England, at least as measured by employment, remains below that of the nation. Indeed, since the trough of the last recession, New England’s jobs have grown at less than half the pace of the nation as a whole. Some of this is the traditionally slower pace of job formation in the region, and some is undoubtedly the result of the kind of industries— telecommunications and technology more generally—that were hardest hit in the 2001 recession and have yet to recover fully. But some of it also revolves around issues of supply. Almost every firm, large or small, comments on the difficulty of finding skilled labor. There is also reason to believe that, at least relative to the rest of the nation, the supply versus demand imbalance may be a particular issue in the region. This comes from the Conference Board’s online job-posting measure, which for some time has shown New England as having the highest number of advertised job openings relative to the size of the labor force. Contacts report that they are willing to offer—and do offer— higher pay to get the skills they need, but finding the workers is harder to do and takes longer than earlier in the cycle.

    Another issue that came up again in our round of contacts is the pervasive rise in the cost of almost any metal, but especially copper and aluminum. Contacts at one very large diversified company speculated about China’s stockpiling valuable metals. Whatever the cause, worldwide demand is strong, and prices are rising for all types of metal inputs. Some firms report progress in passing on those price increases. Indeed, larger manufacturing companies appear to be buoyed, if not driven, by strength in foreign markets. One firm reported that their booming aircraft business required such long hours and continued stress on skilled workers to figure out ways to meet demand that employee turnover had tripled. Not surprisingly, year-over-year manufactured exports for the region rose in the first quarter.

    Elsewhere, news in the region has been fairly positive, with business confidence rising and commercial real estate markets good and improving throughout. Residential real estate markets remain slow. Regardless of what measure is used, the region’s home prices appear to have slowed more than the nation’s. However, although we had led the nation—this is not something in which you want to lead the nation—in the rate of rising foreclosure initiations, especially for those related to subprime mortgages, the pace of this growth has subsided. Indeed, initiations of subprime foreclosures went down in the region most recently. Moreover, in the most recent data on home sales, the Northeast was a bright spot. I have speculated before that the New England residential real estate market could be bottoming out. Such thoughts may remain in the category more of a hope than a certainty, but perhaps the pace of decline is slowing. Finally, while consumer confidence has been bouncy recently, probably from concerns about gasoline prices, demand seems reasonably strong as gauged by local retailers. Software and IT firms are showing considerable strength, and at least in our region, so is temporary help. Coincident indicators of regional health also show solid growth for all six states. In sum, the region appears to be doing fairly well; and except for residential real estate, there are perhaps growing signs of price and resource pressures, in that regard not unlike the nation as a whole.

    Turning to the nation, I was pleased to see that incoming data validated the substantial pickup in second-quarter growth that we, along with the Greenbook, had forecasted. Indeed, outside of residential investment, incoming data have depicted an economy that is growing at a relatively healthy pace. Data on shipments and orders of capital goods have improved, consumer demand seems relatively well maintained despite high gas and soft home prices, and payroll data show little sign of dwindling labor demand. Markets have at last decided to adopt the Committee’s more positive outlook on economic prospects, and credit was repriced as a result. I view this event as healthy. It has tempered our GDP forecast slightly, but the continued ebullience of equity markets is an important offset. As I noted at our last meeting, we find ourselves a bit more optimistic than the Greenbook about trends in residential real estate, based on new housing starts and data on new home sales most recently, and we have moderated the pace of decline of residential investment for the second quarter just a bit relative to our May forecast. The April value of nonresidential construction put in place was a clear positive as well. The health of the rest of the world continues to surprise, and we, like the Greenbook, expect little drag from net exports over the forecast period.

    Turning to projections for 2008 and 2009, the factors shaping our outlook haven’t changed much. We continue to see output accelerating mildly as the housing situation moderates and more of the underlying strength of the economy shows through. This is tempered a bit both by rising long-term interest rates and by our expectations that consumers will mend their ways a bit—consume less and save more. This hasn’t shown signs of happening yet. By the end of 2009, GDP is about at potential, unemployment has ticked up a bit but remains below 5 percent, and core inflation moves down gradually to 2 percent—again, not much change and certainly within the central tendency of members’ forecasts. One obvious risk to this forecast lies in housing, as everybody has said. But as I noted at our last meeting, the longer there are no obvious spinoffs from the subprime problem to the wider economy, the more that particular risk seems to ebb. Indeed, as we have yet to see the saving rate pick up with the moderation in consumption over what would be expected by the fundamentals, there may be some upside to growth. Pressures from abroad—worldwide expansion of somewhat larger size than we expected—do raise some upside issues, both for growth and for inflation.

    On the inflation side, it is true that the April and May core data were encouraging. However, those numbers were dominated by temporary rather than permanent effects, at least in our view. So we haven’t moderated our forecast of core inflation, as have the Greenbook authors, albeit they moderated it only in a very minor way, and I remain concerned about upside risks. Headline CPI inflation has been strong. The unemployment rate and widening concerns about input costs suggest that pressures to raise prices might have grown, and strong growth worldwide affects not only input prices but the value of the dollar as well. If anything, since our last meeting, I think that risks related to growth have abated and have become more balanced and risks regarding inflation have grown. Thus, as we look over the next two and a half years, our forecast sees policy staying somewhat restrictive given the inflation risks and then easing a bit in late 2008 or 2009 to a level closer to its equilibrium rate.

    Finally, continuing some thoughts I began to articulate at our last meeting, as we think about policy, we also need to be concerned about financial stability. This is particularly true given what we’ve seen in the markets for credit derivatives. We’ve talked before about how high levels of liquidity and low interest rates worldwide cause much reaching for risk, much reaching for return, and related risk-taking. While the Bear Stearns hedge fund issue may well not have legs, the concerns regarding valuation of the underlying instruments do give one pause. Can markets adequately arrive at prices for some of the more exotic CDO tranches? What happens when the bottom falls out and positions thought to be at least somewhat liquid become illiquid? Is there a potential for this to spread and become a systemic problem? Maybe not, and I am not advocating our taking any action as a central bank. But I do think the size of the credit derivatives market, its lack of transparency, and its activities related to subprime debt could be a gathering cloud in the background of policy. Thank you.

  • Thank you. President Hoenig.

  • Thank you. I will spend just a couple of minutes extra on the District this time because, generally speaking, our District economy continues to perform very well despite the weakness in the housing sector. Energy and agriculture remain very strong, and manufacturing remains generally strong although we have seen some leveling-off of that in the past month. The strength in these three sectors has helped spur broad-based job growth throughout the District and a significant tightening of our labor markets and their conditions. Many of our contacts report labor shortages and higher wage pressures. Demand for skilled labor remains very strong, and some firms have limited hiring plans because of the unavailability of qualified workers. To bolster recruiting, a few companies have partnered with vocational schools to offer industry- specific training programs to try to fill the gap. Since our last meeting, hiring announcements, which we try to track, have outpaced layoff announcements by a margin of 6 to 1. One anecdotal piece of information—we have some fairly large engineering firms in Kansas City that build power plants globally, including in China, and also ethanol plants. Last year, one CEO told me that they hired 2,100 engineers and were unable to fill 900 positions on a global basis. So there is a lot of activity going on out there.

    Construction activity remains mixed, with weakness in residential construction balanced by strength in commercial construction. On the residential side, we have seen some pickup in sales, but high inventories have limited new construction. For us, problems with subprime loans are concentrated in Colorado and in a few other areas. But because of the strength in energy and agriculture, some parts of the region are actually experiencing a housing boom, with strong home-price appreciation. Relative to the total market, that is small, but it is a rather sharp contrast. Conditions in agriculture are the best in recent years. Spring rains have alleviated drought conditions in much of our region. Strong demand and limited supplies continue to boost farm commodity prices and farm incomes. However, we are also beginning to see the effects of higher livestock and crop prices on retail food prices themselves. An additional concern is the sharp rise in land prices throughout much of our District. First-quarter cropland values in the District rose roughly 12 percent above year-ago levels, and ranchland values have strengthened as well, that much or perhaps a little more. Our contacts in the real estate industry indicate that some of the recent surge in land prices is speculative in nature, and some District bankers have expressed concern about the bubble in farmland values driven in part by the ethanol boom that we have heard about. In recent examination reports, our supervision staff have begun to see some increases in nonperforming real estate loans, and that includes some pickup in other real estate owned as well. These developments are very preliminary, but they are reminiscent of an earlier time, and we are trying to pay a little more attention to that.

    On the national outlook, data released since the last meeting support the view that growth will pick up over the year. I have been encouraged by the recent pickup in retail sales and by positive news on employment and personal income. At the same time, the recent increase in longer-term interest rates, if sustained, is likely to damp growth somewhat in the period ahead. In particular, the rise in the thirty-year fixed mortgage rate may deepen and prolong the ongoing housing slump. The combined effects of weaker growth in the first quarter and the rise of long-term rates have led me to lower my estimate of growth in 2007 to about 2.3 percent. I expect growth of 2.7 in ’08 and 2.8 in ’09. I now think the risks, perhaps, are roughly balanced. While the downside risk from housing remains, the outlook for other sectors, as others have reported, has appeared to improve. Markets seem to have adopted this view as well, as removal of the expected policy easing has contributed to the flattening of the yield curve at this point.

    In terms of the inflation outlook, recent data have been favorable, with core CPI on a twelve-month basis down to 2¼ percent. I expect continued moderation over the year. In particular, if owners’ equivalent rent continues at the slower pace of the past three months, it will help bring down the twelve-month core inflation number over time. Despite these recent improvements, I continue to believe that upside risks to inflation remain. The possible pass-through of recent energy and food price inflation to core inflation may slow progress toward lower inflation. In addition, pressures from resource utilization and slow productivity growth, if that happens to be the case, could affect that outlook as well. Finally, I am somewhat concerned with the recent uptick in longer-term inflation expectations. We have talked about the TIPS five-year, five-year-ahead breakeven inflation rate; as mentioned in the earlier briefing, it has increased about 20 basis points over the past month. So in light of these factors, I believe it is important that we continue to signal to the markets that current inflation rates are not acceptable over the longer term. Thank you.

  • Thank you. It is about 4:20. Why don’t we take a twenty-minute coffee break and then resume.

  • [Coffee break]

  • If we could resume. President Pianalto.

  • Thank you, Mr. Chairman. News from the Fourth District is little changed from my last report. The District economy continues to be weighed down by weakness in the housing market, and there is general consensus among my contacts that the housing sector has not yet seen bottom. To date, adverse spillovers from housing to other sectors of the economy have not been observed, although this remains a significant risk to the outlook.

    While I have heard some reports from my business contacts that the labor market is strengthening, the official data still do not show net employment growth in the region. My projections for the national economy still call for growth to resume to a more typical expansionary pace as we move beyond 2007. My projection for GDP is slightly stronger than what is seen in the latest Greenbook because of my assumption for slightly stronger growth in potential. Obviously, I don’t make that judgment with great confidence. However, the business leaders I talk with tell me that their plans to expand capital are consistent with a pickup in productivity growth from its recent cyclical low. This includes the Cleveland Cavaliers—[laughter]—a franchise which, as many of you know, experienced a substantial productivity shortfall against the San Antonio Spurs a couple of weeks ago. [Laughter] Here, too, we are projecting a good rebound, so to speak, in 2008. In the meantime, I would like the record to show that I am making good on my wager with President Fisher. I brought with me a selection of Cleveland’s finest, and I will present those to Richard after this meeting with my heartfelt congratulations. I am putting this back, because it feels funny having a beer bottle in my hand. [Laughter]

  • If this were the Australian Reserve Bank, it would be okay. [Laughter]

  • I also extend my heartfelt congratulations to the Spurs on their fourth and final NBA championship. [Laughter] Now, turning to inflation, I am hearing reports of upward price pressures across a handful of industrial commodities, and notably for metals. But wage pressures remain modest. Nevertheless, for the first time in more than a year, I am hearing from my business contacts that they are concerned about inflation. They are bringing inflation concerns up with me, and they are telling me that they concur with the Committee’s assessment that inflation remains a risk. To be sure, there were many positive signs in the May CPI report. The traditional core CPI beat expectations, and while the trimmed mean estimators that we produce in Cleveland were a little higher than the measure excluding food and energy, even those indicators were consistent with the moderation and the longer-term inflation trend we expect to see. Looking at the core measures enables me to be encouraged by the May CPI report. But that view is a rather hard sell to a public that saw headline CPI inflation rise 8½ percent at an annualized rate last month. Indeed, our readings of the underlying inflation trend and what people are feeling in their wallets have been at odds for many years now.

    I understand that our policies are not well advised or even equipped to address transitory price movements. But at some point, large and persistent price disturbances, such as we have seen in energy markets, warrant our attention. If these isolated price pressures become more generalized and enter into consumer and business decisionmaking, we could easily find ourselves living in the Greenbook’s “drifting inflation expectations” scenario.

    In summary, I think the housing market still presents a risk that the economy may not resume a more typical growth trajectory over the forecast period. Nonetheless, that concern is trumped by the risk that we may yet lose the public’s confidence that we are making sustainable progress against inflation. Therefore, I continue to believe that the predominant risk going forward is that inflation will fail to moderate as expected. Thank you, Mr. Chairman.

  • Thank you. President Poole.

  • Thank you, Mr. Chairman. Let me talk first about some of the anecdotal reports. A contact with a large software company suggested that the IT industry is doing fine. Labor is very tight because technical people are in such scarce supply. This company is expanding development facilities in China and India. They are not allowed to import the labor they need, and so they will send the operations abroad. My contacts with transportation industry people get the same information that Richard Fisher is emphasizing. Movement of goods is just really, really flat. The over-the-road trucking industry is actually taking down capacity, selling off the older, less efficient trucks. In the express business, UPS is taking down capacity. FedEx is more optimistic, probably taking market share. A contact with the fast food industry says that their business volume is down. The whole industry is down. Sales revenues are up a bit, but it is because of price increases. The casual dining industry is down even more.

    There is sort of a disconnect here between the overall view of the economy, I think, and the anecdotal reports that come from the movement of goods. Of course, the most cyclical part of the economy is always the goods part. The services part is much more stable. Perhaps what is going on here is simply what is also in the Greenbook’s second-quarter numbers, because the goods part of the economy—consumption—is pretty flat. I think consumption is only—I forget the exact number—1.6 or something. That is an annual rate. You have to divide that by 4 to tell you what is actually going on in the quarter itself. Of course, the housing industry continues to decline. So maybe these anecdotal reports really are consistent with what is going on and what is in the Greenbook picture. The Greenbook picture makes a lot of sense to me.

    Let me talk a little more about housing. The staff presentation had a point that I want to underscore—that the housing downturn is unlike any other that we have had. I think the chart went back to 1972, but you could go back before that. If you look at the housing downturns and the recessions of the 1950s, they were all related to a very standard cyclical pattern. Interest rates would rise, housing—starts, permits, construction—would start to turn down well before the cycle peak, and then housing would start to recover after the cycle peak as interest rates came down. The current situation is completely different from that standard pattern. Here we had a housing boom driven by a period of very low interest rates. The period really got started when we were holding the fed funds rate at 1 percent. Then you had a lot of these financial innovations and subprime mortgages that added a sector to the market that hadn’t traditionally been there. Interest rates came up, housing prices are flattening out, and my concern is that there is a lot more to go. This is an asset market that does not work anything like securities markets. It is completely different from the stock market and the bond market. Housing starts and permits peaked in the early part of last year, and the adjustment really got under way. But if you think about how much of the adjustment is complete—well, there is not much sign that much is complete because the inventory of unsold new houses is close to its peak. There is no convincing evidence that it is really starting to come down. We have seen some bankruptcies of builders, but not very many. A lot of banks—I know from our contacts—are putting pressure on their builders to sell out their houses and pay off the loans. The same thing is true of “the ground,” as the real estate people like to put it. Builders are stopping their development of new land for housing developments because they don’t have the financing to support it anymore. The banks are starting to turn off the credit spigot because these companies are getting pretty close to the edge. They have laid off a large number of workers, but they have to sell out their inventory. Still, the number of months’ supply that they are sitting on is abnormally high; it really hasn’t come down. We also know that prices in this market respond with a very substantial lag to the underlying determinants of prices. So prices of existing homes are only gradually adjusting, and I think there is probably more of that to go.

    We know that there will be a lot more resets of these adjustable-rate mortgages. The projections are that a lot more defaults than we have yet seen will occur in that area. So I think that we have a long adjustment to go here. Whether that will spread into the rest of the economy, I don’t know. I share the Greenbook estimate that probably there won’t be major fallout, but it seems to me that the risk there is significant. I just wanted to underscore that point because I think this risk is by far the biggest that we face at this time. Thank you.

  • Thank you. President Lockhart.

  • Thank you, Mr. Chairman. I would like to speak earlier next time, so I don’t have to give credit to so many of the previous speakers—[laughter] including President Poole, who really said a lot of what I have to say. There wasn’t much change in the Sixth District economic picture during the intermeeting period, particularly regarding things that are relevant to the national outlook. So I am not going to devote a lot of time to discussing across-the-board conditions in the District. My staff’s outlook— and my outlook—for the national economy doesn’t differ much from the Greenbook analysis and forecast, so I also won’t detail small differences between those two forecasts. The Greenbook outlook reflects the baseline expectation of a diminishing drag on real growth from residential investment. Since our forecast largely agrees with the Greenbook, we obviously see the most likely playout of the housing correction similarly. However, as suggested in the Greenbook’s first alternative simulation, we may be too sanguine. I think this is really President Poole’s message about a recovery in the housing sector. That is to say, the downturn in residential investment will be deeper and more prolonged and possibly involve spillovers. So I would like to devote my comments, in a cautionary tone, to this particular concern.

    Credit available for residential real estate purchases is contracting, and the credit contraction, specifically in the subprime mortgage market, has the potential to lengthen the transition period required to reduce housing inventories to normal levels. This tightening of credit availability, along with higher rates, may affect the timeline of the recovery. One market of concern is the starter home market. The subprime mortgage market has been a major credit source for first-time homebuyers—although, as has been mentioned earlier, subprime mortgages are a small portion of the aggregate stock of mortgages. Subprimes were 20 percent of originations in 2005 and 2006, and if you added alt-A nonprime mortgages, you would get 33 percent of originations in the past two years. In many suburban areas, like those around Atlanta and Nashville in my District, much home construction was targeted at first-time buyers. We have heard anecdotal reports from banking and real estate contacts in our region that tighter credit conditions have aggravated the already sluggish demand for homes. The country’s largest homebuilder—there may be a debate with President Fisher—[laughter] so one of the country’s largest homebuilders, headquartered in Miami, reported on Tuesday a 29 percent drop in homes delivered and a 7.5 percent drop in average prices. But that is combined with a 77 percent increase in sales incentives. They attribute their negative sales experience to rising defaults among subprime borrowers and higher rates. That company’s CEO said that he sees no sign of a recovery, and he provided guidance of a loss position in the third quarter.

    Because of the major role that homebuilding—and, I might add, construction materials, particularly in forest products—plays in the Sixth District economy and because of some tentative signs of spillover, we will continue to monitor these developments in our District very carefully. As I stated at the outset, we share the basic outlook described in the Greenbook, but observation of the housing sector dynamics in the Sixth District has raised our level of concern that the national housing correction process may cause greater-than-forecasted weakness in real activity. If that is the case and inflation gains prove transitory, as suggested in the Greenbook commentary, we may be dealing with a far more challenging policy tradeoff than we are today. Thank you, Mr. Chairman.

  • Thank you. President Plosser.

  • Thank you, Mr. Chairman. Since our last meeting, the news in the Third District economy has been mixed but, on balance, slightly more positive than the previous report. The District continues to grow at a moderate pace, and we expect that pace to continue. The bright spot since our last meeting is a rebound in regional manufacturing activity, which had been flat for the past six months. In June, the Philadelphia Business Outlook Survey index of current activity rose sharply—18 percentage points—from a level of 4.2. This is the highest level it has obtained since April 2005. The index of new orders also showed a sizable jump, and capital spending plans firmed in the survey. Respondents also expected further improvement in manufacturing activity over the coming months.

    Job growth in the region, however, was somewhat slower over the past two months compared with earlier in the year, but we really didn’t expect much since payrolls seemed to rise much more rapidly than expected during the first quarter. Year-to-date payroll growth is running about 0.6 percent at an annual rate. That rate is slower than the national average but is fairly typical of our region, where population growth is rather flat. Labor force participation is rather flat as well. Unemployment rates, however, remain low in our three states, and firms still report having difficulty finding both skilled and unskilled workers.

    It is no surprise, as everyone has said, that residential construction in our region continues to decline and remains weak. The value of contracts for residential buildings has fallen more than 30 percent in the region during the first five months of this year compared with last year at this time—but that, we have to remember, was near the peak. Real estate agents and homebuilders generally report slowing of sales in May. While the number of existing homes for sale on the market has increased, average selling prices have not changed much. I would characterize the nonresidential real estate market in the region as fairly firm, although construction is not as strong as last year. Office vacancy rates continue to fall, and in Center City Philadelphia, they dropped to 10 percent. They were about 17 percent just around eighteen months ago. Real estate firms report that overall demand for industrial space continues to be robust and that vacancy rates for this type of space are near record lows in some markets. Rental rates continue to rise, particularly for warehouse space, and rents are at a record high in those areas. I take these reports as indications of continued expansion in economic activity going forward.

    Interestingly enough regarding building, I had two observations from CEOs. One is CEO of a building supply company that manufactures throughout the United States and has sales of almost $10 billion. He said that, remarkably, even with what is going on with homebuilding, his sales are holding up very, very strongly and they are doing very, very well this year. Another CEO, whose company produces products mostly for residential cabinetry and other types of things, one of the largest in the country, says that, while new home sales for his work are way down, they have largely been offset by remodeling activity—people have substituted remodeling for buying a new home.

    As long as I’m reporting anecdotes here, I will pass on one other anecdote, for what it is worth, about trucking. I listened to President Fisher and President Poole talk about volumes in trucking. Just as an observation, an executive who runs a trucking company throughout the country told me that one thing that has happened in trucking is that, rather than shipping boom boxes, they are shipping iPods. [Laughter] That is true of a lot of consumer goods. Instead of shipping large CRT screens, they now ship flat panel displays. So even while the volume of goods is being reduced, gasoline prices are high, and they are laying off truckers and downsizing the volume, the value of what they are shipping has been maintained pretty well. So he was noting a dynamic of value versus volume here, which I thought was very interesting.

    On the inflation front in the District, prices for industrial goods continue to increase, but retail price increases have not been widespread. However, many of our business contacts continue to express concern over rising energy costs and food prices and the effect on their businesses and the consumers. I interpret this to mean that they continue to be puzzled by our focus on core inflation when they see that overall inflation is what affects the consumer and their businesses, and they seem to doubt core inflation’s value as a policy objective or a measure of underlying inflation. They may be wrong in that, but it tells me that, if they continue to be confused by how we view core inflation and what we use it for, we might need to improve our communication to the public about how we think about it and why we focus on it.

    On the national level, I have become more comfortable with the economic situation as the year has progressed. At our meeting in May, we were beginning to see some positive signs regarding both real economic activity and inflation. Durable good orders were up, allaying some concerns about the first quarter’s weakness in business investment. Improved ISM numbers were signaling that the slowdown in manufacturing might be ending; and although housing markets remained weak, there were limited signs of any significant spillovers to other sectors. Labor markets remained firm. At that time there were signs that core inflation might be moderating. As a consequence, I expressed hope that in the coming months those data would be reinforced.

    Fortunately, from my perspective, those hopes have been largely realized. Coming into this meeting, we have received more positive news on the economy, and I have become somewhat more confident that the economy is on track to return to near-trend growth later this year as the effect of the housing correction moderates, albeit very slowly. Indeed, data received to date suggest that we will see a substantial rebound in real GDP growth this quarter, as the Greenbook has noted. After several months of stagnation, manufacturing activity seems to have picked up, and business fixed investment is moderately strengthened. Labor markets remain firm, and yet in recent quarters we have noted a seeming disconnect between strong labor markets and weaker GDP growth. However, we now may be getting some hints that this puzzle is more apparent than real, and I want to reinforce the point that President Yellen made earlier in that I think two factors suggest this. First, from December to May the household survey showed almost no employment growth whatsoever, whereas the establishment survey showed 1.2 percent annual growth during that period. Second— and again as President Yellen noted—the Business Employment Dynamics report came out. It was only for the third quarter of last year, but it showed about 155,000 fewer jobs created in the third quarter than we thought. What is important about that report is that it arguably does a better job of tracking the birth and death of firms in the data, and so there is some reason to believe that, while this is suggestive, the payroll employment that we have been seeing may not be as strong as perhaps we thought, and that may make some of this puzzle less of a concern. Moreover, as President Yellen pointed out, it is also relevant for the longer term because, if employment wasn’t as strong as we thought, productivity is going to end up being higher than we thought, and it will help resolve some of that slowdown in productivity. So I think there are various hints that that may be the direction that we are headed.

    In my own forecast, I see slightly more underlying strength and so a somewhat faster return to trend growth than the Greenbook does. The current stance of monetary policy is maintained. I see strength in personal income, a strong balance sheet (as we saw earlier today), strong equity markets, and a resiliency already shown by consumers despite the lower home equity values and higher gasoline prices, suggesting that there is probably slightly more momentum in consumer spending than suggested in the Greenbook. I am modestly more optimistic about the labor market than the Greenbook—modestly, as I anticipate less of a downturn in labor force participation rates than is built into that forecast. The rise in long-term interest rates reflects the market’s upgrading of its assessment of the economy’s strength going forward. Indeed, as has been noted a couple of times, that uptick in long-term interest rates has been, I won’t say a worldwide phenomenon, but certainly widely spread in many countries around the world, which may be saying that global growth is more stable, predictable, and positive than perhaps we thought.

    Now, this is not to say that I do not see risks around this growth forecast. Of course, as everyone else does, I see housing as the biggest downside risk that we face. There is still considerable uncertainty out there, and I do not want to underestimate the risk. Housing inventories remain high, and I do not see any strong evidence of pickup in demand. Despite the problems in subprime lending markets, however, I think the financial sector remains healthy—healthier now than it was perhaps in the early ’90s with the previous housing boom. I am more comfortable with the notion that there will be no spillovers into other parts of the economy, and thus I have become more comfortable with forecasts of return-to- trend growth in the second half of this year and into ’08.

    On the inflation front, higher energy prices have led to an acceleration of headline inflation, but there has been some improvement in core inflation measures in recent months. The three-month growth rates in the core CPI and the core PCE have been decelerating since February. Although these developments in inflation are encouraging, I remain cautious about extrapolating too much from recent data. During this cycle we have seen periods of deceleration reversed a couple of months later. Indeed, the Greenbook expects that much of the favorable readings on core PCE inflation will prove transitory. So I remain concerned that our core inflation rates may not continue their recent drift down. I would also caution that headline inflation, as I noted earlier, has remained stubbornly high. Thus, in approaching my forecast, I have assumed that the appropriate policy path was one that would return the economy to steady-state growth and to my inflation target by the end of the forecast period.

    Given my outlook on the underlying strength of the economy and an inflation goal of 1.5 percent for the PCE, it should not be surprising that my forecast incorporates a slightly tighter policy path than the Greenbook does. In particular, in my forecast the federal funds rate rises 50 basis points, to 5.75 percent, by early ’08. As progress is made on bringing down inflation starting in the second half of ’08, the fed funds rate moves down, ending at about 5 percent by the end of 2009. This policy path reflects my view that, unless we take further action by additional firming or an announcement or both that commits us to an inflation goal that is lower than the market currently expects, which seems to be about 2.5 percent, I believe it will be difficult to sustain an inflation rate that is in keeping with my view of price stability. I believe this can be accomplished with relatively little effect on real growth in 2008. My assumption in the model with which I’m working is that, once we begin to raise rates, the markets will quickly recognize our commitment to lower inflation and expectations will move down accordingly, mitigating the real output effects of this modest tightening. The movement down in expectations could be expedited by the Committee’s explicitly announcing the target. This view of expectations formation is more heavily weighted to forward-looking elements than to distributed-lag elements of past inflation. By the way, I want to applaud the staff for their work on inflation dynamics. I thought it was an excellent piece of work. I found the discussion very helpful and a step in the right direction, both conceptually and empirically.

    In any event, the bottom line for my forecast is that I anticipate that the economy will grow just below trend of 3 percent in 2008 and at trend of 3 percent in 2009, and we achieve an inflation goal of 1.5 percent by the end of the period. Of course, this forecast is based on my desired inflation objective, which may not be representative of other members of the Committee. If there were a common objective that differed from my own view, then my presumed appropriate policy path might be different. Given this observation and the lack of an agreed-upon goal, I think we need to be concerned about how the public will interpret these forecasts, but I will save my thoughts on that for the next go-round.

  • Thank you. Vice Chairman Geithner.

  • Thank you, Mr. Chairman. The outlook looks a little better, I think. The United States looks okay, and the world looks very strong. Housing here seems as though it will get worse before it gets better, but the rest of the economy seems to be doing reasonably well—with output and investment spending perhaps a bit firmer than we thought they would be and employment growth and income growth looking reasonably good.

    We have not significantly changed our central projection. We still see an economy growing around 3 percent over the forecast period, about our estimate of potential, with core PCE inflation falling just below 2. This assumes a path for the nominal fed funds rate that is flat for several more quarters, essentially the same as in the Greenbook and in the market now. The risks to this outlook, though, have changed. We see less downside risk to growth but still believe the risks to our growth forecast are weighted toward the weaker outcomes. Although the recent inflation numbers have been good, they probably exaggerate the moderation of underlying inflation, and we see, therefore, continued upside risk to our inflation forecast. I still think this latter risk should remain our more consequential concern. Relative to the Greenbook, we have a bit more growth because of our higher estimate of growth in the labor force and a bit less inflation, but these differences are small, smaller than they have been, and they do not have significant implications for our views on monetary policy. The markets’ perceptions of fundamentals have in some respects moved in our direction in the past few weeks. I say “in some respects” because we need to be attentive to the rise in implied inflation that you see in TIPS. Our view and the markets’ view of the expansion, the risk to the outlook, and implications for monetary policy have converged. This means that the effective stance of monetary policy is a little tighter than it was.

    A few important issues going forward: On the growth front, I still think that the probability of weakness exceeds that of strength. There is still a significant risk that we will see a more substantial adjustment of house prices, perhaps drawn out over a sustained period of time with greater adverse effects on confidence and spending. Of course, if employment and income growth stay reasonably strong, the effects of that potential scenario should be manageable. If not, we will have more to worry about. I note that some major financial institutions are now starting to report signs of rising delinquencies in consumer credit products outside mortgages such as automobile loans and leases. This is the first time that I have heard that report in a significant sense, and maybe it is a sign of some vulnerability ahead. The strength of demand growth outside the United States has been helpful, and we agree with the Greenbook that it looks likely to continue for some time. But things could be kind of bumpy out there, particularly in places like China, and monetary policy in much of the world is only now starting to move short-term real rates higher into positive territory.

    On the inflation front, it seems early to declare satisfaction or victory, not particularly because of the recent reacceleration in headline inflation but just because of the role of transitory factors in the recent moderation in core and the rise in breakevens in TIPS. We cannot be fully confident yet that a constant nominal fed funds rate at current levels will deliver an acceptable inflation forecast. We do not, in my view, need to try to induce right now a further tightening of financial conditions to push core inflation down further and faster. But we need more time before we can justify shifting to a more balanced risk assessment of inflation or something equivalent, something that would have the effect, for example, of indicating satisfaction with current levels or of suggesting that the risks are balanced around the path of inflation that we see in our central tendency projections.

    With financial markets, we are at a delicate moment. The losses in subprime are still working their way through the system. Rating agencies are likely to downgrade a larger share of past issues, more than they have already. The marks that people show indicate that both hedge funds and dealers in a lot of this stuff may still have a way to go to catch up with the movement in market prices. This dynamic itself could induce a further reduction in willingness to finance new mortgages. You could see pockets of losses in the system, liquidity pressures in hedge funds and their counterparties, and further forced liquidations. It is possible that we will still have a bunch of that effect ahead of us, even if no big negative shock to demand occurs and induces a broader distress in consumer credit. We could also see it spread to commercial real estate. We could see a broader pullback from CDOs and CLOs as well, either from a general erosion of faith in the rating models—as Bill said, it is a possibility—or from just concerns about liquidity in those instruments. We could see a sharp, substantial widening of credit spreads provoked by an unanticipated default or two or just a general reassessment of risk at current prices. A very large amount of LBO financing that is yet to be closed, distributed, and placed is still working its way through the system. As in the past, we could see a deal or two get hung, the music stop, and that force some broader repricing. People get stuck with stuff they don’t want to hold or did not expect to hold. I think we now see more sensitivity in markets about the prospect of a diminished appetite among the world’s savers and central banks to increase their exposure to the United States, or at least we see more sensitivity to the perception out there that the dynamic might be unfolding. You can see a bit of all this in some spreads, in some reports of resistance to further erosion in covenants, in some reduced appetite for new bridge book exposure to leveraged lending. You can see it in some changes in margin terms in some instruments vis- à-vis some counterparties. For now I think it is a relatively healthy, still pretty modest, and quite contained shift toward a more cautious assessment of risk, but these things generally don’t tend to unfold gradually. On balance, though, I think we are in a pretty good place in terms of policy, in terms of the market’s expectations about policy now, and in terms of how we have been framing the balance of risks to the outlook.

  • Thank you. Governor Kohn.

  • Thank you, Mr. Chairman. My projection was closely in line with that of the Greenbook, modestly below-trend growth for a few quarters, held down by a prolonged weakness in housing. As that drag abates, the economy picks up to potential and is held back from overshooting that potential by various factors, including the rise in the saving rate and slightly lower growth of government spending.

    Under these circumstances, core PCE inflation holds in the neighborhood of 2 percent. I do not really see much to push it one way or another at this point. The economy is producing very near its potential, as close as we can figure. Inflation expectations have been moving in a narrow range. Some of the transitory factors, such as owners’ equivalent rent, that we’re expecting to come down to reduce inflation have already done that to a considerable extent. So I don’t see them, moving forward, as having a big effect. Given the limited pass-through of energy and commodity prices into core prices, I would not expect much downward pressure on inflation from a leveling-out of those prices. I think that we are around 2 percent and that we will probably stay there, at least for a little while.

    In terms of risks, the recent data on capital goods, orders and shipments, and manufacturing activity suggest, as many have remarked, some reduced downside risk from business attitudes on spending. They do not suggest a great deal of strength in business capital spending, however. The fundamentals are less favorable than they were a couple of years ago, and the most recent data, which we received today, suggest a pretty flat or a modest upward tilt to capital spending in the second quarter. The data weren’t that strong, but they do suggest that what I feared in May—that we were in the midst of a cyclical adjustment that was going to make capital spending much weaker—has certainly abated.

    I agree with many others around the table that housing is a significant downside risk to the forecast, given the high level of inventories despite a major reduction in starts over the past year and the price-to-rent ratio being as high as it is. The further slide in housing may be gentle, as President Lacker said, but I do not think we’ve seen the bottom yet. You can go a long way at a gentle slope. [Laughter] We also have not yet really seen the full effects of the tightening in subprime credit terms or, obviously, of the recent increase in mortgage rates.

    I also see a big downside risk from consumption. The Greenbook has the growth of consumption sustained despite an increase in saving rates as the growth in disposable income exceeds the growth in GDP—and that is with the labor share recovering and the business profit share declining. I see two downside risks to that. One is that the saving rate will rise faster as the housing weakness feeds through both in terms of wealth effects and in terms of reduced availability of credit as terms tighten and there is less equity to borrow against, particularly for liquidity-constrained households. I also continue to see a downside risk to equity prices, although I have certainly been wrong so far. Nellie’s table presenting the difference between the staff’s forecast of profits and the market’s forecast of profits showed a huge difference for next year. So though I think the basic outlook is fine, I still see some downside risk on that side.

    On the inflation front, I, like others, see the better-than-expected core inflation as a hopeful sign; but it is recent and may be affected by temporary factors, and I do not think we need to get too enthusiastic about it. I do see several upside risks to inflation: the high level of total headline inflation, which could erode inflation expectations; business resistance to any erosion of profit margins as unit labor costs pick up; the high levels of resource utilization in the United States; and the tighter global conditions of demand on potential supply that others of you have mentioned.

    Let me say a word or two about my year-three projections. I projected output growth at 2½ percent, the unemployment rate at 4¾ percent, and core PCE inflation at 1.9 percent. I certainly saw my output and employment projections as a sense of what the steady state was. On the unemployment rate, I do think the odds are better that the NAIRU is lower than that it is higher than the staff’s 5 percent assumption. This judgment is partly based on the very moderate pickup in the employment cost index, and average hourly earnings growth has actually been coming off recently. On the behavior of core inflation, I don’t see much evidence that we are significantly beyond potential now, although I recognize that, with a very flat Phillips curve, it could be a long time before one figures that out. But I had growth of potential at 2½ percent, which is below what I infer to be the central tendency of the Committee.

    Regarding my reading of the decline in productivity growth, productivity over the past five quarters has been growing significantly below the staff’s estimate of 2½ percent. Some of it is cyclical. There could be a revision, as Presidents Plosser and Yellen have suggested. I confess to having asked David Wilcox about this at the break, and he said that the data are kind of ambiguous here and that it is much too early to predict a significant downward revision to employment. But I hope you are right. Now, some of the recent slowdown certainly must be cyclical, though I would have thought that labor hoarding and things like that would be much less in today’s flexible labor markets, with so much more use of temporary workers than there has been in the past. I would think that the cyclical effects on productivity would be muted, that businesses would move pretty promptly to adjust their labor forces to output. So I wonder how much cyclicality there is. The big uncertainty is in the construction industry and in the fact that construction employment hasn’t come down. We don’t quite understand why it hasn’t come down more. So perhaps productivity will pick up.

    But I still would look at the staff’s 2½ percent as having even just a little more downside than upside risk to it, given the fact that we have had more like 1 to 1½ percent in the past four or five quarters. So I stuck with the staff’s forecast of 2½ percent potential GDP.

    In some sense, our view of what the potential growth rate is isn’t all that important for monetary policy. We ought to be looking at the gap. We ought to be looking at the pressure of the level of production on the level of potential GDP. But I don’t think it’s quite that easy. We don’t know what that gap is. We have seen that the surprises over the past year or two have been in the behavior of the unemployment rate and capacity utilization relative to growth. So we do tend to look at our estimates of potential growth and the actuals coming in relative to those estimates and pass judgment on what’s happening to the output gap even when the unemployment rate doesn’t move. We just need to remember that potential growth is an entirely estimated number that we will never observe, and we need to be aware that it might not be quite as high as the central tendency indicates that my colleagues on the Committee apparently think it is. Thank you, Mr. Chairman.

  • Thank you. Governor Warsh.

  • Thank you, Mr. Chairman. Regarding overall economic growth, my own macroeconomic views are not inconsistent with the central tendency of the projections that were pulled together for this meeting. I think the staff and the participants around the table deserve significant credit for being stubborn about the moderate-growth hypothesis while markets have been on all sides of it. The markets appear ready to look through the second-quarter GDP growth number, which appears to be a bit above trend. I’d say that we have gotten some credit from the markets for being stubborn and stubbornly right on our economic forecast, but they certainly haven’t given us their proxy, and I would not expect them to do so. They happen to share our views for now is what I would say, and I wouldn’t expect that situation to remain over the forecast period. Again, neither should our intention be to somehow get these curves to match over the coming several quarters.

    On the inflation picture, though it has improved a bit—and I am trying not to disregard very good news—I must say that it strikes me as thoroughly unconvincing. To me, inflation, in our old statement language, remains the predominant risk. I am less certain that core will continue the recent trend. I do believe that headline inflation may be telling us something in terms of secular trends around energy and food that we can’t dismiss, and the warnings from some of the other signals that we would see as rough proxies for inflation are still very real.

    Regarding what the financial conditions are telling us about growth, it strikes me that, from all the data we have received between our last meeting and this, financial conditions might be as different as any other sets of data that we received. My view is that financial conditions are still supportive of growth, but somewhat less so. It is hard to determine at this point how much, but let me take a stab at doing just that. Since we last met, as Bill said at the outset, we witnessed ten-year Treasury yields increase on the order of between 30 and 50 basis points. I am not uncomfortable with that incremental tightening of policy in the financial markets, but we have to be careful of what we wish for. I think the explanation from our staff here in Washington and Bill and the staff in New York is right, which is that markets have not come to a rosier view of the future. All they have really done is to take out the downside risk that came out of the first quarter. As the data came in a bit above expectations, that insurance bet that they had—that we were wrong and would have to cut rates—really lost credibility. I think their central view of the economy now is not one that roars back but one that is quite consistent with the moderate growth story. The financial markets have indeed tightened policy somewhat. Even since the time that the Bluebook was produced last week, spreads have apparently widened in addition to the risk-free rate being somewhat higher. But this is all happening in very real time, and my report a week ago would have sounded quite a bit different from the one today.

    We have witnessed increased term premiums and greater volatility across many, if not all, financial markets. Both the MOVE index for Treasuries and the VIX for equities are high relative to the averages of the past year but are still fairly reasonable over a somewhat broader period—say, the last five years. Term premiums I would characterize as returning to more-normal levels—but, again, not out of line with history.

    We have seen in the Bluebook that credit default swap (CDS) spreads and other spreads had widened, but that yet hadn’t happened in the high-yield market, where apparently there was some narrowing of spreads. That has changed rather dramatically in the past four or five trading days. I’m sure Vince will share more information on this tomorrow. But the CDS spreads really occurred first; then there was a lag to high-yield spreads. In the past two weeks, investment-grade CDS spreads have widened about 7 basis points, high-yield CDS spreads have widened about 20; a relatively new index of loan CDS spreads has widened about 65 basis points; and most, if not all, structured products, even assets wholly unrelated to the housing markets, have been undergoing some spread widening. As I mentioned, high-yield spreads appear to be catching up to CDS spreads, and with the incredible flow of deals in the market, I would guess that the trend continues. We’re seeing higher financing costs and slightly tougher terms for LBOs; the latter is a remarkable new development. M&A prices, probably for the first time since I have been sitting at this table, appear in the markets to be coming off their levels. So when auctions for properties of publicly traded companies are occurring, the price between initial indications of interest and final bids for the first time may actually be coming down.

    Why is that? Interest coverage ratios cannot go much below where they have been in this cycle. It is 1.2 or 1.3 times, but again, as the risk-free rate has gone up, as spreads have widened, you can buy just a little less debt for that. As a result, equity players that do not want to compromise their equity returns can pay a little less for these properties. Whether this phenomenon is very short term, like the phenomena we heard about after the tumult in late February and we returned to in the heady days of the capital markets, I do not know. This may just be a temporary preference shift toward quality and toward higher volatility and a return to the “glory” days, but I tend to think not. It is a tough call, and I reserve the right to change my judgment.

    I think that the new supply that’s coming into the markets, most of which needs to get priced before the markets slow down in August, will test the markets’ resilience, will test prices, and will test terms. Up to this point we have seen very little reduction in liquidity, but we are seeing a few deals being pulled from the market. Pricing power appears to be coming back to investors, and negotiations around prices and terms seem significantly more balanced than they have been in a very long time. Some of the instruments that we have sort of giggled about around this table—the pay-in-kind notes with optional cash payment— seem to have lost some traction in the market in the past week. I do not know whether they will return, but I take this new discipline in the markets as an encouraging sign. So what is going to be the resulting effect on prices, terms, and conditions? That is something we will have to judge; but financial conditions, as I said at the outset, are perhaps somewhat more restrictive than they were, but they should still be quite supportive of growth.

    At the outset I talked about the risk on the inflation front. Let me build on a couple of remarks that Vice Chairman Geithner made about risks now in the financial markets. If the problems that we have seen around structured products that have come out of the Bear Stearns scenario are really about the subprime markets and subprime collateral and housing, there’s not much to worry about. But to the extent that the story is really about structured products—products that have not been significantly stress-tested—then there is a risk that the financial markets may react and overreact. That scenario will bring up reputational risk issues. Even financial intermediaries that are in the agency business are relearning the lesson that agency business is not free—that there are, in fact, dissynergies from being in the principal investment business and the agency business under one marketing name. We are learning a lot about what the markets believe about the transparency of prices, particularly in times of financial distress. Of course, in times of distress, the correlations among all these assets do not look as they do in models, and that is something that will play itself out. I think that Tim rightly referenced the role of gatekeepers in the credit agencies, who I suspect are going to have a fairly rude awakening over the next six to nine months. As I also said, regarding this financial innovation, which on net is of great benefit to us, we will really see some of the products tested. Along with the products, moreover, the market participants’ behavior will be tested, perhaps in this upcoming period, as never before. So the financial markets are a friend on this, but there is greater risk than there was when we last met. Thank you, Mr. Chairman.

  • Thank you. Governor Kroszner.

  • Thank you very much. The last time we met, there seemed to be a bit of increased uncertainty about a potential downdraft on economic growth, and now some of that concern about that downturn seems to be no longer there. Some intermeeting data have come in a little more on the upside, and obviously the markets have changed their expectations and seem to agree with that. I think the strength in the labor market and in consumption, although facing some challenges, is still at a reasonable level. It does seem that we are getting some signs that investment is coming back.

    Recent durable goods numbers, which came out today, perhaps raise some questions of that. We have had a couple of good months and now a bit more of a challenge. But when you smooth through, I think, exactly as Governor Kohn suggested, that we’ll have moderate growth going forward, a forecast that I think is consistent with the Greenbook forecast. Strength in nonresidential construction, as we have heard around the table, has also provided us with a bit more optimism for investment in general. But investment is obviously closely tied to where productivity is going because, if we don’t have investment, particularly in the high-tech areas rather than just in the construction sectors, it is going to be hard to sustain high productivity growth. When we get the revised numbers on July 27 and we also get advance GDP, we’re going to get a lot of information about that, and I think there is still a lot of uncertainty as to exactly where productivity is going. So I will defer my comments until the next meeting because we will have those numbers by then.

    Regarding consumption, we have been having the offsetting wealth effects of the recently robust equity asset market and much less robust housing asset market, continuing strength in the labor market, and as the Greenbook points out, increasing disposable income because we’re having incomes grow faster than productivity growth, at least right now. That suggests that we might maintain a reasonable support for consumption growth, but again, as Governor Kohn said, there are potentially some challenges here.

    But now I want to discuss the big challenge that everyone keeps talking about, which is the housing market. It has become obvious that the transition is going to be quite a long one and potentially a painful one, perhaps more in individual pockets and for individual families than for the macroeconomy. It will not just disappear after the third quarter of the year or even the fourth quarter of the year. I would think in four different ways about how housing can have a broader effect on the economy.

    First is obviously the direct effect on prices. The Case-Shiller ten-city index suggests that the prices will fall about 3 percent over the next year. Now, that’s roughly where the market was just before the issues in subprime arose at the end of February, and it is actually better than it was last fall. So the markets don’t think that there will be an enormous challenge with respect to prices, at least in these ten markets. But as President Poole mentioned, sometimes the prices even in these improved indexes, like the Case- Shiller index, may lag what’s going on and may not accurately reflect the underlying actual values that people can realize. So there still may be more challenges even though the index suggests that house prices are down only 3 percent. It is also interesting to look at the delta, the change in the index. We haven’t really seen much from that, which I think is heartening, but it is still something that we have to watch out for.

    Second are the indirect effects, the wealth effects. As I mentioned, there have been offsetting wealth effects from the equity markets and the housing market. More broadly, there can be confidence effects on spending and on saving behavior. So far we haven’t seen a lot of evidence of that. As Vice Chairman Geithner mentioned, there have been anecdotal reports of challenges in other areas of consumer credit, although so far no real systematic data suggest that. Even if there is a little movement up, in almost all the typical indexes we use, many of which were mentioned in the briefing, we are at lows or are much lower than usual historically. So even with the small movement up, there are not necessarily enormous challenges; but these effects also have to be watched.

    A third very important potential effect of this long transition is a response by us or by lawmakers that could make the transition even longer and more difficult. As a number of you know—and all of you have been facing pressure on some of these things—we will be putting out the subprime adjustable-rate mortgage guidance that we put out for comment just at the end of February. Our timing couldn’t have been better for getting that out—we did it just as the problems were becoming more of an issue publicly. I hope the guidance will be out by the end of this week. We are proposing guidance that subprime adjustable-rate mortgages have underwriting at the fully indexed rate. I do not think that’s going to be much of a shock to the markets. The markets have largely moved there already. This was true from some early statements by Freddie Mac and Fannie Mae. Also, some of the major players who were not underwriting at the fully indexed rate are simply not there anymore— they are bankrupt—and some of the other players who were not doing it have changed their standards. As we know from the survey of senior loan officers, standards have been rising. That is not to say that it won’t have some effect, but relative to where the market has already moved, the effect is not going to be significant.

    The other major guidance is for giving a prepayment penalty grace period of sixty days so that people will have at least sixty days before the reset to refinance their mortgage. It’s unclear from the studies we have done at the Board and from looking around how much of an effect that will have on the initial rate or the so-called teaser rate. It seems that changing their ability to do that from zero to thirty to sixty days is unlikely to have an enormous effect on the teaser rate, but that is something that is uncertain. There are some states that already outlaw prepayment penalties or have restrictions on them. There is not a lot of evidence suggesting that it is more difficult to get financing in those states. Again, these guidelines are untested, but I don’t think they will have an enormous effect on the market, but they are obviously something to watch.

    As you well know, we have put out an interagency letter suggesting that servicers and lenders work very closely with distressed borrowers to try to work things out and keep people in their homes. Doing so is in the interest of the people in the homes; it is virtually always in the fiduciary interest of the loan servicer and of the lender. I think we have been making progress on accounting issues that have been making it difficult for some servicers to do this, and we are working very closely with the SEC and with FASB on some of these things. We may be making progress in giving comfort to the servicers who want to do some restructurings that would help keep people in their houses and would ultimately be better for the individuals and for the owners of the securities. We have also had the HOEPA hearings here in which we talked about the potential for rule writing in several areas, such as requiring escrow for taxes and insurance, some regulation or restriction of prepayment penalties, and various other things. That would be down the line, but again, we are thinking that this is unlikely to have a major effect relative to where the markets have already moved.

    Fourth and finally, there has been a lot of interest in the effect of subprimes in the housing market not only on the mortgage market but also more generally on the financial markets, as Governor Warsh and Vice Chairman Geithner pointed out. Fortunately it seems that liquidity is largely being maintained in the mortgage origination market. There are still fairly robust amounts of subprime and alt-A originations occurring. They obviously are going to be declining over time because there are fewer being made; but they were at an unusually high level in 2006, and so it’s a natural part of the transition process that they would go down. There has been a very significant increase in spreads, as has been mentioned by the previous speakers, and there’s much more tiering of risk. It is not just that the Bs are all the same; it is where they originate. The markets are looking through the packages to see what’s in them, which is very, very valuable. Increased volatility and higher pricing in these markets and the higher long-term interest rate will be a bit more of a challenge for people doing refinancing, although we’re now down to about 5.08 for the ten- year, off 20 to 25 basis points from the high of the other week, and so it may not be quite as much of a challenge. But there is also a legal risk in this market because, if some problems become larger, there could be concern about what the new instrument really means and what you have actually purchased. If legal risk is there, the markets will start to run away from these things. Then you may have some severe liquidity problems. I do not think that we see those challenges yet, but it is one indirect effect on the financial market of some of these issues.

    Just quickly on inflation—most people have said that we’ve seen some moderation. It is a little too soon to declare victory. As we said in the initial briefing, when we drill down into the components and look at owners’ equivalent rent, we may get some nasty surprises going forward. Some numbers have gone down, but owners’ equivalent rent may come back up a bit. So I don’t think we can say that the temporary elevation in that area has passed and that we can move on. I think some challenges are still there. Fortunately, expectations still seem reasonably well contained. But I think that there may be some challenges going forward as the economy continues to grow at least at a moderate pace, and some of the temporary factors are not necessarily completely behind us. We still have to look for potential price pressures going forward. Thank you.

  • Thank you. Governor Mishkin.

  • Thank you. My view of what has been happening in the economy is that we have been basically going through a rebalancing. We had a sector that was clearly bubble-like with excessive spending, and now we are getting the retrenchment, which is taking a bit longer than we expected. But the good news is that we are going through a rebalancing in which we are just moving resources to other sectors and that is actually going much along the lines that we want to see. The problem in a rebalancing episode is that you are always worried about the risk that is possible because these transitions don’t always occur smoothly. I think that we were much more worried about that—at least I was more worried—at the previous meeting. But we have been seeing that the rebalancing is actually going along pretty well. In particular, although the housing market is very weak, very much along the lines of the Greenbook forecast, it hasn’t surprised us this particular period. It’s just that it is pretty bad. But the risks are actually fairly balanced on housing because we do not see it as very strong and that is part of the process of undoing the previous excesses. Another very important thing is that we have not seen any surprising spillovers from the housing market. As time goes on and nothing really bad happens, we become more confident that, in fact, the downside risk isn’t there either. We have also seen that the investment sector has been looking a little stronger. Again, that really did concern me at the last FOMC meeting. Yet we have had some reasonable numbers; they are not spectacular, but I think the downside risks have dissipated.

    So the bottom line is that I see the economy as rebalancing and doing it in a fairly good way. In fact, from a long-run perspective, this is a good thing and not a bad thing. The downside risk has dissipated, and the risks are now quite balanced. So I am quite comfortable with the Greenbook forecast on this, which is that we have growth somewhat below trend but moving back toward trend, and I see that there has been a shift in a positive direction and the risks are not excessively on the downside but are much more balanced.

    When I look at the inflation picture, I am in a way pleased with the recent numbers because there is no strong indication that we are far from potential output and, in particular, there is a little indication that the tightness in the economy certainly will be unraveled. According to our forecast, not much is going on in that area, so what’s going on in inflation expectations will be dominant. I mean, given that inflation expectations have been pretty well anchored around 2 percent, although there is some uncertainty, I thought that we would have a return to 2 percent numbers a bit more quickly than the original Greenbook forecast showed. I was really pleased because the Greenbook has basically moved closer to the picture that I had all along; so now I’m very comfortable with the Greenbook forecast.

    In contrast to some other people, I think the risks are pretty balanced. Now, maybe that is not really different because of the people who have inflation going below 2 percent, and I don’t see that. So I believe it’s going to be 2 now and it’s going to be 2 for a while unless we make a concerted effort to change inflation expectations. Then there is the whole issue of how we might go about doing that. But given the current environment, my view is that risks are fairly balanced. Other people are saying that there is risk on the upside, but I think that’s because they just have slightly lower numbers regarding where they think inflation will be. But probably when we look at it from that perspective, it is about the same. So right now I think the economy is evolving in a pretty reasonable way, and I’m sure we will be surprised in one direction or another in the future. Thank you very much.

  • Thank you, and thanks to everyone. Let me try to give a quick summary, and if I misrepresent you, please let me know. Participants’ expectations for growth were varied, but most people expect to see strengthening over the remainder of this year and into 2008 and 2009. The principal source of downside risk is housing, which remains weak, perhaps in part because of problems in mortgage markets. However, significant spillovers have yet to emerge from the housing situation, and other components of demand appear to be strengthening and thereby offsetting the drag from residential construction. A number of participants referred to the strength of the global economy, which is stimulating U.S. exports but also leading to increases in costs of energy and metals. Investment has picked up from a bit of a pothole and is growing now at a moderate pace with particular strength on the commercial real estate side. Inventories are mostly aligned with sales and manufacturing seems to be strengthening overall. Consumption seems likely to grow at a steady but not exuberant level, with factors such as gasoline prices and slower house appreciation creating some drag but strong employment and incomes acting as supports. Indeed, the labor market continues to be strong, although there are some measurement issues that were noted, with unfilled demands for highly skilled workers and with some signs of wage pressures. Overall, the risks to output seem roughly balanced around the path of a gradual increase in growth.

    Participants did note the increase in long-term interest rates, which tended to align market policy expectations with those of the Committee. Higher long-term interest rates and some other changes in financial markets may be slightly restrictive but probably not substantially so. Some also noted risks in financial markets, including the aforementioned risks associated with the subprime sector, but also more-general concerns about structured credit products and the possible effects of a decline in liquidity. However, I would note also, as some others did, that a bit of cooling in the financial markets might not be an entirely bad thing.

    Recent core inflation numbers have been favorable, and most of you see continued moderation in inflation resulting from mildly restrictive policy, the ending of some temporary influences, and slower increases in shelter costs. However, a few of you have suggested that some of the recent improvement in core inflation is transitory, and they noted upside risks, including resource utilization, possible pass-through from energy and commodity costs, slower productivity growth, and the possible effect of high headline inflation on inflation expectations. High capacity utilization—and “globally,” President Fisher—is also a source of possible inflation pressure.

    GOVERNOR KROSZNER. Is President Fisher a source of inflation? [Laughter]

  • Only rhetorical inflation.

  • All in all, there still seems to be general agreement that the risks to inflation remain to the upside and remain the predominant concern. Is that a reasonable summary? Are there any comments?

    Let me present just a few essentially random thoughts at this point. First of all, from my perspective, the biggest puzzle about what’s happening is the behavior of the labor market, which is continuing. We’ve had slow growth. Unemployment is at least not falling anymore, but it remains stable at a fairly low level. My scenario for the soft landing plus some moderation of inflation involves some cooling of the labor market from here. I still think it will happen, but admittedly, there is only the slightest suggestion so far that it is happening. In particular, we have not yet seen the decline of construction employment, which I have continually referred to and continue to expect. There have been a number of discussions about why we haven’t seen that response yet. Some have noted the possibility that a lot of the workers are undocumented and, therefore, are not being counted by the usual measures. However, they seem to have been counted when the market was expanding. So it is a little puzzling why suddenly they are not being counted. Thus I still think there will be some moderate softening in the labor market over the next year. If that does not happen, then we will be at some risk of higher upside growth than we anticipate and higher inflation pressures than we anticipate. So for me that is a central thing to look at. I think in talking about this, it is important to note how uncertain we are about what the natural rate of unemployment is and that entire concept. Judging from the FOMC’s 2009 projections, most of us think that the natural rate may be a bit below 5 percent, and I would note that the unemployment rate was in the mid to low 4s for four years in the late 1990s and has been in that range now for about two and one-half years. So it is not entirely evident where the natural rate is, and it does make some difference obviously. Again, I expect to see some moderation in the labor markets, and I believe that is critical to our scenario.

    Like everyone else, I think the housing situation continues to involve downside risks. I would reiterate what President Poole said—that this is an asset market; that therefore price changes are inherently, at least to some extent, unpredictable; that a lot is going to depend on confidence, which is going to depend on results, which is going to depend on confidence; and therefore, that we need to be very careful, just the same as with inflation, about declaring victory too soon on the housing front. In particular, there is an interaction between the mortgage market and financial markets. There has been discussion of that already today, but there is the potential for some trigger to lead to what would amount to an effective tightening in financial markets, which would affect not only housing but also potentially, for example, corporate credits. Although that remains just a risk, I think it’s one we need to keep in mind.

    I agree with the general view around the table that, except for housing, the economy looks to be healthy. Capital spending is not going gangbusters, but it does seem to have come back to some modest trend. I also agree with what a number of people said about the strength of the world economy. We shouldn’t get too carried away with the export sector. What we’re hoping for here is that net exports will not be a net drag on growth. [Laughter] Nevertheless, that is an improvement over the past, and the strong world economy should on net be helpful to our economy.

    Like everyone else, I’m encouraged about the incoming inflation data. I agree that some of these good numbers may be partially transitory. However, when you analyze this, there has been a decided step-down in the past three or four months in the shelter component. I would make two observations. One is that, excluding shelter, core PCE inflation is now at the lowest number since the end of 2003; if the shelter numbers of the past three months were to persist, then that would automatically arithmetically give us some additional progress on inflation. Now, that may not happen. Clearly we have month-to- month variations, as we have mentioned many times; but I think some slack could combine with some more moderation in rents. On the inflation expectations issue, I thought David Wilcox’s graphs were very instructive. I do very much believe that inflation expectations influence actual inflation and that the anchoring of inflation expectations is very important. But I don’t think they’re anchored at 2.000; I think that they’re anchored at a general range somewhere around 2 percent. What David’s graph showed was that the level of expectations that we observe seems also to be consistent with 1.8 or 1.7. So I don’t think that’s an absolute barrier, though I concede that expectations play an important role. Two, I would also just comment about the statistical issue. I was among a number of people who talked about the statistical significance of the change in inflation that we have seen and noted that these month-to-month changes are subject to a lot of variable shocks. But let me just say that I think it’s probably worth noting that, in the classical statistical significance tests and everything we’re doing here, we’re Bayesian decisionmakers, and we’re trying to make a decision based on our best estimate of where we are at a given moment. Even if we concluded that inflation’s decline is not statistically significant in a classical sense, we still ought to act as if there has been some decline in inflation. As a thought experiment, I would ask what we would be saying now if we had gone up 0.6 percentage point from where we were in May. I think that would have led to a somewhat different tone around the table. So while acknowledging the statistical variability and the transitory nature, I think that there has been some improvement and that it is showing through into our thinking about the economy.

    One last thought—a number of people have mentioned the distinction between core and total inflation. I agree that our communication on this issue really needs some work. I was just in Chicago, and several people, including directors and employees, asked me, “Don’t you guys drive? Don’t you eat?” [Laughter] Clearly, we understand why we do this, but I think we need to improve our communication on that particular front. That’s a little segue into what we’ll be talking about tomorrow. So if you will bear with me—I know it is six o’clock, but I’d like to ask Vincent just to give us a brief introduction to the monetary policy discussion we’ll be having tomorrow. That will save us some time tomorrow and give us a chance to think overnight about the subject.

  • Thank you, Mr. Chairman. Two personal notes to start: First, I am the last person between you and British food, which means that I’m not sure whether it is in your interest for me to speak quickly or slowly. [Laughter] Second, this week marks the first anniversary of the Committee’s last policy action—the quarter-point firming that brought the federal funds rate to 5¼ percent. Paper is the traditional present, and my gift to you is the material labeled “FOMC Briefing on Monetary Policy Alternatives.”

    The intermeeting period saw considerable upward revision to investors’ expectations for the setting of monetary policy. As the shift from the dotted to the solid line shows in the top left panel of the first exhibit, the path of the expected federal funds rate rotated up, posting increases of 15 basis points at the end of this year and about 50 basis points by the end of next year. The starting point for both the May 8 and the June 26 lines, though, is the same: Market participants continue to believe that you will keep the federal funds rate at 5¼ percent at this meeting. Judging by the Desk’s survey of primary dealers, you are also expected to keep the wording of the statement mostly intact.

    Not much of this rise in market yields occurred in narrow windows surrounding the release of economic data and speeches by monetary policy makers. Rather, the economic data, which ran somewhat stronger than anticipated, and Federal Reserve communications, with the steady repetition of the assessment that upside risks to inflation remained, seemed to induce a rethinking of the economy’s prospects and the attendant need for monetary policy support. This rethinking is most evident in the middle left panel, which shows that the latest primary dealer forecasts of the federal funds rate at year-end (the blue bars) have shifted notably compared with the survey forecasts just before the May meeting (the dashed line).

    The revision to investors’ views was associated with the increase of 20 to 50 basis points in the nominal Treasury yields plotted in the right panel (and seen as the shift from the top dotted black line to the solid black line). The pricing-out of near- term policy ease probably explains the now-shallow portion at the front part of the yield curve. The rise in nominal yields can mostly be attributed to an increase in real yields of 30 to 50 basis points, shown in the lower portion of the same panel. Our term-structure models suggest that virtually all the rise in real yields is due to fatter compensation for bearing risk. Because the shifts in the two sets of yield curves did not match, the spread between the nominal and the indexed yields, which measures inflation compensation, widened somewhat at longer maturities. Here, too, the models suggest that some of that larger gap reflects a higher risk premium—this time for bearing inflation risk—leaving their estimates of inflation expectations only modestly higher.

    In recent days, concern about risk-taking, brought into the spotlight by the problems of two hedge funds managed by Bear Stearns, reversed some of the upward tug of yields imparted by the revision to the outlook for the economy and policy. As can be seen in the bottom left panel, the cost of credit protection for subprime mortgage pools packaged over the past 1½ years has risen over the past few weeks as the fear of a fire sale of the collateral seized by lenders to the Bear Stearns funds depressed prices and raised concerns about a more general spillover to other entities and markets. These fears also seem to have set off flight-to-safety flows that pulled Treasury yields lower in recent days. As noted in the table at the bottom right, the ten-year Treasury yield had risen about 50 basis points from the May meeting to when we put the Bluebook to bed (the first column). The outbreak of skittishness in recent days trimmed several basis points off that run-up (the second column) and put equity prices into the red. I wonder if the recentness of these events, which unfolded after much of the staff briefing work was wrapped up and your own interventions were mostly written, means that they have not been completely incorporated into your outlook. If so, this nervousness in financial markets probably adds to the list of reasons for keeping a low profile in your policy action at this meeting by ratifying prevailing expectations—that is, to choose the unchanged policy stance of alternative B in the Bluebook.

    Some of the other reasons are the subject of exhibit 2. In the staff forecast, summarized in the top left panel, output growth runs a bit below that of its potential in the near term, and inflation settles in at 2 percent. If you find that both a plausible and an acceptable outcome, you might also align yourself with the policy assumption of an unchanged federal funds rate upon which that forecast is based. Moreover, you were satisfied with keeping the funds rate at 5¼ percent at your May meeting. If you have filtered the incoming economic information in a manner similar to the staff— seen in the Greenbook as a slight upward revision to the growth of real GDP and a slight downward revision to core PCE inflation—you probably also believe that circumstances have not changed enough to warrant a recalibration of policy. It is true that financial market restraint has ratcheted up somewhat as investors’ forecast of the federal funds rate path has risen—proxied in the top right panel by the year-end expected federal funds rate in futures markets—but the staff expected this to happen over the next year or so, which has been a sentiment shared by some of you at the past few meetings. The adjustment in financial markets over the intermeeting period now brings market pricing into better alignment with the Greenbook assumption— shown by the black dots—and that this adjustment took place on a more compressed schedule than expected should probably not make for a material change to the outlook. As seen in the middle panel, the current real federal funds rate, at 3¼ percent, matches the Greenbook-consistent estimate of its equilibrium level. That is, if maintained, the current real rate would be consistent with the output gap closing within three years, at least in the Greenbook outlook. An unchanged nominal funds rate at this meeting is also consistent with many policy rules, including an estimated one that captures your practice over the past twenty years and that is plotted as the solid line in the bottom left panel. Of course, if you take into account forecast uncertainty, as is done by the light and dark green regions, you can pitch a pretty large tent with such policy rules. There is less doubt about the course of monetary policy in financial markets. As shown by the red bars at the bottom right, options on Eurodollar futures imply a distribution for the federal funds rate six months from now that is tightly clustered around the current setting. Here might be another reason for keeping the fed funds rate unchanged today: For all this year you have been hinting that prevailing market expectations for the fed funds rate were too low. Now that market participants have adjusted in your desired direction, you might not want to surprise them.

    Many of you noted that problem with the version of table 1 that circulated in the Bluebook, a subject discussed in exhibit 3. In the May statement, inflation was characterized as “somewhat elevated,” as in row 3 of the left column. But favorable data since then have put the twelve-month change in core PCE inflation at 2 percent, a level that some of you might find tolerable. As yet the Committee has not spoken with one voice on the subject. We dropped that contentious phrase in the Bluebook and softened the balance-of-risks language as well. As a result, the release of the wording in the Bluebook version of alternative B would likely trigger a decline in money market yields. The new version of alternative B in the right column turns the heat back up somewhat by inserting in row 3 words to the effect that the Committee is not convinced that the present step-down in inflation will persist. This draft also makes clear in row 2 that the characterization of recent economic growth is based on the first half of this year and returns the language in row 4 to that used in the May statement.

    Even if you are willing to keep the funds rate at 5¼ percent for now, you might foresee policy action sometime soon, in which case the changes to the statement probably do not represent your views. In particular, as shown in the top left panel of exhibit 4, the unemployment rate (the red line) has bounced around 4½ percent for almost a year. If you believe that this represents a taut labor market, you may be concerned about inflation pressures, particularly given that the manufacturing sector seems to have gone into a higher gear, as shown by recent readings on the ISM’s new orders index, the black line. You might not be alone in being concerned about inflation prospects. As plotted in the middle left panel, five-year, five-year-forward inflation compensation has risen 30 basis points from its recent low. It might be noise, it might be a wider risk premium, or it might be increased inflation expectations. If it is the last, you may want to position yourself now for policy firming sometime soon on the theory that an early demonstration of your displeasure with a rise in inflation expectations will effectuate a less costly decline. Some suggestions for doing so were offered in alternative C in the Bluebook, a few highlights of which are given in the bottom left panel. In particular, the alternative C draft reverses the order of the description of economic activity in row 2 to downplay the qualification “despite the ongoing adjustment in the housing sector.” More important, it retains the judgment that “core inflation remains somewhat elevated” and gives more reasons that inflation many come under pressure. If you have a frame of mind favorable to finer shades of meaning, you can always try dialing down the modifier of elevated inflation from “somewhat” to “slightly.”

    More substantial changes might be required if you are inclined toward alternative A, arguments for which are shown in the right-hand column. Regardless of the reason behind the run-up in market yields, households borrowing to buy a house now face higher mortgage rates (as shown in the top panel). This may both dissuade potential new purchasers of homes and disappoint those households that were hoping to refinance on more-favorable terms as the lock-in periods on their extant ARMs end. Both will act as a drag on spending and perhaps more substantially so than in the staff forecast. Months’ supply of new homes, plotted in the middle right panel, has edged higher. The staff projection has the feature that the efforts of builders to bring inventories back into line will be a drag on production for some time but that residential investment will begin to turn up by the second half of next year. However, this is a projection, and if you are more pessimistic on that score or want to give greater weight to downside possibilities from a risk-management standpoint, you might want to show some leaning toward policy ease in the statement. The language of the draft statement in alternative A may do so. As summarized in the bottom right panel, that draft pointed to “ongoing weakness in the housing sector” in row 2, excises the reference to “somewhat elevated” inflation in row 3, and moves the risk assessment to balance in row 4.

    The pieces of what I have just been talking about have been put together in your last exhibit, which represents an ever-so-slightly revised version of table 1 that circulated on Monday. In particular, in row 3 of alternative B, the word “sustained” has been inserted in the middle sentence to raise the bar as to what it takes for the Committee to be convinced that inflation has moderated. That concludes my prepared remarks.

  • Are there any questions for Vincent? All right. If there are no questions, then we’ll adjourn. We’ll see you at the dinner, and we will begin at 9:00 a.m.

  • [Meeting recessed]