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

  • Good morning, everyone. We’ll begin today’s session with the chart show presentation.

  • Before we start the chart show itself, I want to give you an update on the data released yesterday on orders, shipments, and inventories. These are on the separate sheet inserted in the chart show package. As shown on line 1, new orders for nondefense capital goods rose 2.8 percent last month—about in line with our expectation. In addition, the November number was revised up reflecting, in part, a whopping revision to aircraft orders. The shipments numbers, lines 6 through 10, were weaker than expected and, all else being equal, would shave 0.1 percentage point off fourth-quarter GDP and put us on a slightly lower trajectory going into the first quarter. However, inventories at manufacturers of durable goods, line 11, are reported to have soared at an annual rate of nearly $30 billion last month, with almost all of the accumulation in the aircraft industry (line 12). Given what we know from Boeing about their production and deliveries last month, we’re puzzled by the size of this number. Nevertheless, taking the figure at face value, it would add about 0.4 percentage point to fourth-quarter GDP.

    Let me turn now to the chart show. In putting together the Greenbook, two of the questions we asked ourselves were, “What the heck happened to the economy in the fourth quarter?” and “How do we get from an economy that appeared to be dead in the water late last year to one that’s growing at a 4½ percent rate in the second half of this year?” Many of you may well have asked yourselves the same questions.

    So, what happened in the latter part of 2002? Two different factors seemed to have been at work. First was the return of the production of motor vehicles to a more sustainable pace in the fourth quarter (the red dot in the top left panel) from the elevated third-quarter rate. We estimate that the drop in assemblies deducted about 1 percentage point from fourth-quarter GDP growth. But as shown by the open dot, we expect this sector to be essentially neutral for GDP growth in the first quarter. As shown in the top right panel, the other factor helping to explain the pause of GDP growth during the fourth quarter was a resumption of inventory liquidation outside the motor vehicle sector following the modest accumulation in the preceding quarter.

    The remaining panels of this exhibit trace out the main elements of the production, demand, and inventory story in the second half of last year. The high- frequency data in these panels and the anecdotal reports in the Beige Book and from our business contacts highlight a feature of last year’s economic performance that is obscured by the arithmetic of quarterly averaging—namely, the abrupt halt in the growth of non-auto factory output that occurred in middle of last year (the middle left panel). The retrenchment doubtless was related in part, as one contact put it, to a “complete loss of business confidence in the wake of the corporate governance scandals.” Despite some retrenchment of production, final sales excluding motor vehicles continued to expand. As shown in the middle right panel, consumer spending (line 1) and housing activity (lines 2 and 3) were both well maintained through the end of the year, although business spending (line 4) remained sluggish. The shortfall of production from demand outside the auto sector had as its tautological counterpart a reduction in inventories, especially for consumer goods and business equipment. As we noted in the Greenbook, because final sales have continued to increase, we are not viewing last quarter’s liquidation as signaling a major problem with unwanted stocks that could cumulate into even deeper production cuts. The days’ supply of inventories, illustrated in the bottom left panel, does not suggest any serious imbalances, nor do the reports from purchasing managers on their customers’ inventories (the bottom right panel). In GDP terms, we expect non-auto inventories to be a neutral factor in the current quarter after subtracting a percentage point from growth last quarter.

    Your next exhibit begins to lay out our answer to the second question I raised initially: “How do we get from here to there?” In the first half of 2003, when GDP is projected to rise at a 2¾ percent rate, the answer is essentially the mirror image of the one for the fourth quarter of this year—an absence of drag from motor vehicles and inventories coupled with continued gains in final demand. Indeed, we already may be seeing the start of this outcome: Factory production excluding motor vehicles ticked up in December, and most reports from purchasing managers have been upbeat of late. In our projection, activity steps up sharply after midyear and remains well above the growth rate of potential through the end of the forecast period. With output increasing faster than potential, the unemployment rate begins to fall later this year. Even so, enough slack remains in the economy to result in a further deceleration in consumer prices. The acceleration of GDP after midyear reflects several factors, some of which are highlighted in the middle panel. As shown in the first bullet, we assume that the cloud of uncertainty and pessimism hanging over the business sector will begin to lift as we go through the year. In addition, strong gains in structural productivity boost real incomes and spending. As regards monetary policy, the stimulus associated with past easings, as well as an assumed accommodative policy in the projection period, provides significant forward momentum. Finally, we expect new doses of fiscal stimulus to be injected into the economy in mid-2003 and the beginning of next year.

    The fiscal package we’ve assumed involves bringing forward in time several tax cuts that currently are scheduled to be phased in between 2004 and 2010— specifically, an increase in the child tax credit, an expansion of the 10 percent tax bracket, marginal rate reductions, and marriage penalty relief. We have not included the Administration’s dividend exclusion proposal in our baseline assumptions. The bottom left panel shows our fiscal impetus indicator, which is a measure of the initial impulse to aggregate demand arising from discretionary changes in federal spending and taxes. The red line shows the amount of fiscal stimulus in the pipeline under current tax law. The shaded area illustrates the extra stimulus that results from our assumption that future tax cuts will be accelerated. The panel on the bottom right uses simulations of the FRB/US model to estimate the direct and indirect effects of our fiscal assumption on the growth rate of GDP as well as the effects of adding in the dividend exclusion proposal. The solid gray portion of the bars indicates our estimate of what GDP growth would be if the Congress made no changes to current tax law. This corresponds to the “political gridlock” scenario shown in the Greenbook. As you can see, even in the absence of another shot of fiscal stimulus, we would still expect the economy to grow smartly in 2003 and 2004. The red shaded area highlights the effects of our assumed acceleration of future tax cuts, while the yellow portion adds in an estimate of the effects of adopting the dividend exclusion proposal. As discussed in the memo sent to the Committee last Friday, there are a number of very thorny issues related to the economic effects of cutting the tax on dividends that are not settled in the economics literature. Accordingly, the simulation results have a very wide confidence band.

    Much of the stimulus from monetary and fiscal policy manifests itself in the household sector, the subject of your next exhibit. Consumer spending (the blue bars in the top left panel) was well maintained last year, spurred in part by low interest rates and the tax-cut-related jump in real disposable income (the yellow bars). Looking forward, we expect that the strong gains in structural productivity and the tax cuts assumed to come on line this year and next will support DPI growth through the projection period. In addition, we assume that there will be no further deterioration in net worth relative to income over the projection period, as shown in the panel to the right. The middle left table provides a parsing of these effects on the growth rate of real PCE. A step-up in the growth of structural productivity boosts the contribution from potential GDP (line 2); this is augmented by the stimulative influence of the tax cuts (line 3) and some waning of the negative wealth effects (line 4). One risk to the outlook for consumer spending that has been raised by some analysts is the possibility that households are overextended and are unusually vulnerable to unanticipated disruptions to income. As shown in the insert in the middle right panel, household debt growth is projected to step down from the rapid pace in 2002, reflecting a moderation in the pace of mortgage borrowing (the yellow bars).

    Nonetheless, the growth of household debt continues to exceed the rise in nominal income, continuing the upward trend in the overall debt–income ratio (line 1 in the bottom left table). However, we don’t see this increase in debt burden as likely to impose serious restraint on consumer spending. In part this is because the rise in debt burdens is heavily concentrated at the upper decile of the income distribution— households with incomes above $108,000 in 2001, according to the Survey of Consumer Finances. As shown on line 2, the staff estimates that between 1995 and 2002 the debt–income ratio for the lower 90 percent rose 9 points, compared with the 30 point increase for the top decile (line 3). Thus the bulk of the rise in debt ratios has been concentrated among households with the means to service these obligations. Moreover, as shown in the bottom right panel, low interest rates have helped keep required consumer payments broadly defined—that is, mortgage debt service as well as required household payments for property taxes, home insurance, tenant rent, motor vehicle leases and consumer credit—below previous peaks.

    Your next exhibit focuses on the business sector. As shown in the top left panel, we expect real investment in high-tech equipment and software to accelerate over the projection period, with an increase of more than 20 percent during 2004—about in line with the gains observed during the last half of the 1990s. The recovery in spending for other equipment, excluding transportation, shown in the top right panel, is more drawn out; but we think that eventually it, too, will begin posting robust gains, boosted in part by the partial-expensing provision enacted last spring. More generally, the pickups for both high-tech and other equipment reflect our assumed lifting of business gloom as well as the direct and indirect effects of monetary and fiscal policy.

    In light of the dismal performance of the equipment sector in recent years, you would be justified in being somewhat skeptical that such a strong recovery will occur any time soon—even with the favorable cost of capital and tax incentives. The middle two panels will, I hope, go some way toward persuading you of the reasonableness of our forecast. The charts translate the level of real gross investment into the growth rate of the net capital stock using the same depreciation rates that the BEA uses in constructing the national accounts. You can see that, even though gross investment is rising rapidly, projected capital stock growth is rather conservative by historical standards. Not only do we think that the investment forecast in reasonable, we also think that, in the current financial environment, it is achievable. As shown in the bottom left panel, firms have taken advantage of low interest rates to restructure their balance sheets away from short-term debt, lightening their current repayment obligations. Moreover, as was discussed yesterday, corporate bond spreads have come in recently (the bottom right panel), and bank financing (not shown) appears to be readily available for creditworthy firms.

    As I said near the beginning of my remarks, a key element in helping the economy get from here to there is the strong growth of structural productivity that we continue to assume, which Sandy will now discuss.

  • One of the defining characteristics of the economy over the past two years has been the lack of any net employment gains despite a recovery in economic activity. As shown in the top left panel of chart 5, nonfarm payrolls in the fourth quarter of last year (the T+4 observation) were lower than at the time of the apparent business cycle trough in the fourth quarter of 2001. Indeed, payrolls have followed pretty closely the pattern of 1990-91—the so-called jobless recovery. As shown in the top right panel, the obvious flip side of this record is that labor productivity has been quite strong in the current episode, with output per hour rising an estimated 3¾ percent over the four quarters of last year.

    These developments have once again led us to raise our estimates of structural multifactor productivity growth. As shown in the middle left panel, we now estimate that structural MFP increased 1.8 percent last year. In our view, a good part of this acceleration reflected corporate actions to restructure operations and eliminate inefficiencies. Such actions boosted the level of structural MFP and hence had only a transitory influence on the growth rate; we anticipate some further gains of this sort in 2003. But we also have inched up our estimate of the permanent component of structural MFP growth to 1½ percent. Technology has continued to improve in recent years, aided by rising real expenditures on research and development (shown in the middle right panel). Although the growth of real R&D spending is down from the pace early in the decade, lagged effects of past increases arguably should still be boosting structural MFP growth. As you can see in the table at the bottom, these adjustments, together with a few refinements to our projection of capital deepening, raised the growth rate of structural productivity to 2¼ percent in 2002 and 2003 and to almost 2½ percent in 2004; these revisions carried through to our forecast of potential output growth as well.

    Chart 6 presents the implications of these assumptions for the expected performance of the labor market. As we have noted before, we believe that the gains in labor productivity over the past year have stretched work forces beyond levels that are sustainable in the long run and that hiring will pick up as the prospects for sales and profits improve. Although we expect nonfarm payrolls to be about flat over the next few months, hiring averages about 100,000 per month in the first half of this year, 225,000 per month in the second half, and about 300,000 per month in 2004. As a result, actual labor productivity grows 1¾ percent, on average, over the next two years—about ½ percentage point below its structural pace. We expect this near-term weakness in the labor market to result in a rise in unemployment, and we are forecasting the unemployment rate to peak at 6.2 percent in the first half of this year. The unemployment rate then is projected to drop back to 5.4 percent by the end of the projection period as economic activity accelerates. As indicated in the middle left panel, this projection closely follows the predictions of the staff model of Okun’s law when allowance is made for the TEUC program, which we estimate raises the unemployment rate by 0.2 percentage point.

    Of course, we could be wrong about our structural productivity assumptions, and in the Greenbook we explored two alternative structural productivity scenarios. It is possible that the gains in productivity last year were entirely cyclical and that there has been no recent acceleration in structural productivity growth (the blue line in the middle right panel). As shown in the table, if this “slower” MFP hypothesis were correct, real GDP growth would run below the baseline forecast, and the inflation rate would turn out higher. Alternatively, if all of the acceleration in structural MFP last year represented a permanent change in MFP growth (the red line), we would be understating the long-run potential growth rate of the economy. Under the assumption of “faster” MFP growth, real GDP growth expands at a faster pace than in the baseline forecast, and inflation is lower.

    Our compensation projection is the subject of chart 7. Although our main measures of hourly compensation have painted somewhat different pictures of compensation growth in recent years—mainly reflecting the movement of stock option realizations that are included only in P&C compensation per hour—we expect both measures to trend downward over the forecast period. This downtrend is most evident in the wages and salaries component of the employment cost index (the middle left panel) where the combination of falling inflation expectations (the bottom left panel) and slack in labor markets—as measured by the unemployment gap shown at the bottom right—continue to temper workers’ wage demands. In contrast, we expect the rising costs of employer-provided benefits (shown in the middle right panel) to offset some of the deceleration in wages. Rising contributions for health insurance premiums and a step-up in employer payments to defined benefit pension plans—as the result of the decline in the stock market in the past two years—are the principal reasons for the acceleration.

    Similarly, as shown in chart 8, consumer price inflation is projected to slow in 2003 and 2004. The PCE chain price index (shown in the top left panel) is forecast to rise at a 1¼ percent pace over the next two years, down about ½ percentage point from the pace last year. After peaking in the current quarter, crude oil prices are expected to decline over the projection period, resulting in falling prices for consumer energy products (the blue bars in the right panel). In contrast, food prices (the red bars) are expected to rise moderately in the next two years. Core PCE inflation (the red line in the middle panel) is forecast to move lower over the next two years. As you can see in the two bottom panels, a continued wide margin of slack in product markets puts downward pressure on prices, and this is only partially offset by the expected updrift in non-oil import prices.

    Chart 9 reviews the analysis that was sent to the Committee last November on the macroeconomic consequences of a potential war with Iraq. As you will recall, we went to great lengths to emphasize that what we don’t know about the economic effects of such a conflict far exceeds the little that we do know. Our analysis was and is intended to serve as a framework for thinking about this issue, and it should definitely not be construed as a forecast of the conduct of the war or its quantitative effects. We examined two potential military scenarios: a successful one-month conflict that entailed an incremental budgetary cost of $20 billion and a successful six-month war that bore a $50 billion incremental price tag. In our analysis, we did not make any special allowance for exogenous confidence effects, swings in risk premiums, or the consequences of retaliatory terrorist attacks. Clearly, such responses could be the key elements in the macroeconomic response to a war with Iraq, but lacking a convincing means of quantifying such events, we decided not to include them.

    The FRB/US model was used to simulate four war and oil price combinations under the assumption that monetary policy follows a Taylor rule. In the “quick victory” scenario, the war lasts one month, no oil production is lost, and as shown by the red line in the middle panel, oil prices drop $4 per barrel below baseline immediately after the conflict. Oil prices continue to fall gradually over time as additional oil production comes on line, eventually reaching a level of $17 per barrel by 2010. As you can see in the bottom panel, such a scenario gives a boost to economic growth in the near term and reduces the inflation rate. In the “six-month war” scenario, Iraqi oil exports cease, and oil prices rise $10 per barrel above baseline (shown as the black line in the middle panel) in the first half of this year; prices then drop back below the baseline path when the war is successfully concluded. There are two offsetting effects on real GDP growth this year: The increase in defense spending tends to push up output, while higher oil prices have a depressing effect. Thereafter, the stimulative consequences of lower oil prices dominate. In the third scenario, a six-month war causes a shutdown of oil production in Iraq and Kuwait and induces several radical states to impose a temporary oil embargo. With the more significant loss of supply, oil prices rise $30 per barrel above baseline in the first half of this year (the blue line in the middle panel) before dropping back later in 2003. Under these assumptions, real GDP declines ¼ percentage point below the baseline path this year, and inflation rises sharply. Lower oil prices and interest rates eventually push real GDP growth above baseline in 2004 and 2005. In the final scenario, a six-month war is accompanied by the loss of 4 million barrels per day from the world oil market for a period of three years, raising oil prices $20 per barrel above baseline (the green line in the middle panel). Rising non-OPEC production eventually causes oil prices to fall but only to a long-run price of $25 per barrel.

  • Are these in real terms?

  • No, these are nominal terms. In this scenario, real GDP falls this year and next, whereas inflation is higher in both years. Real GDP regains some of the shortfall relative to baseline in 2005, largely in response to easier monetary policy. These model simulations suggest two tentative conclusions about the macroeconomic consequences of a potential war with Iraq. First, to the extent that any war is short, successful, and results in a lasting increase in world oil production, the direct economic consequences are, on net, positive for the United States. Second, if the war produces adverse geopolitical developments that result in a persistent reduction in the supply of oil sold on world markets, the direct economic consequences are negative. Karen Johnson will now continue with our presentation.

  • Chart 10 presents recent developments in selected global financial markets. The decline in the exchange value of the dollar in terms of the major foreign currencies has been a feature of these markets since early 2002. The top left panel shows the movements of the dollar in terms of its index of other major currencies (the black line) and in terms of the yen (the red line) and the euro (the blue line). The data are plotted so that the lines coincide at the point about one year ago when the major currencies index reached its peak. The depreciation of the dollar against the euro has exceeded that against most other currencies in the index, with a significant further move down coming since your previous chart show in mid-2002. At its peak last year, this index of the dollar was 40 percent above its low point in April 1995. Currently, it is a little more than 20 percent above that low. Recent market commentary has pointed to the heightened tensions concerning Iraq as a factor in the latest downward pressure on the dollar. These political risks are apparently affecting the terms on which market participants are willing to finance the large and growing U.S. net international indebtedness.

    Yields on ten-year sovereign bonds, shown in the panel to the right, have moved down since the spring of last year. On balance, German and U.S. rates have moved about the same amount, but a small differential unfavorable to the dollar opened during the second half of last year, and some differential remains. Despite their low absolute level, Japanese rates have moved down as well. The ten-year rate crossed below 1 percent late in 2002 and has since moved down further as demand for JGBs continues to be strong. The middle panels show the change in market expectations over the past year for euro (on the left) and yen (on the right) three-month rates as captured in futures contracts. Disappointing macroeconomic performances during 2002 in these two economies and more generally globally contributed to shifts down in futures rates. For euro rates, almost all of that shifting has occurred since the June chart show as real output growth slowed in the second half of the year and expectations of monetary easing became established. The ECB did lower its minimum repo rate 50 basis points, to 2.75 percent, in December; and markets now appear to be pricing in additional easing by mid-2003. Futures rates in Japan have shifted down as well; and the curve has become noticeably flatter, suggesting that markets have postponed further any expected move back up in rates. Stock indexes are shown in the bottom left panel, with the lines scaled to coincide at the time of your last chart show. Stock prices are generally down over the full period shown, falling further since mid-2002. U.S. stock prices have compared favorably with European and Japanese stock prices since the June chart show.

    Overall, these financial developments reflect the generally weaker tone to economic activity that has emerged, especially during the second half of last year. Interest rates have moved lower, partly in response to some additional monetary easing. But stock prices have fallen, reflecting investor caution. Market conditions are generally supportive of a recovery in economic activity and, for the most part, do not by themselves pose additional risks. There are some exceptions, however. For example, the United Kingdom appears to be experiencing a housing price bubble, illustrated in the bottom right panel, with prices up 40 percent over the past two years. The circumstances under which this rise will come to an end and the consequences for the U.K. economy are a source of uncertainty to the foreign outlook, which is the subject of your next chart.

    The top left panel of chart 11 illustrates the deceleration of real GDP in the second half of last year both here and abroad. U.S. and average foreign growth have been roughly comparable and are expected to remain so through midyear. Over the remainder of the forecast period, activity abroad is expected to accelerate but less vigorously than is U.S. output. Past and some prospective monetary easing should boost growth abroad, but there is very limited scope for fiscal stimulus. Recovery of the U.S. economy, along with resolution of some of the geopolitical uncertainties currently impeding growth everywhere, should also support the return to higher growth abroad.

    Consumption spending has been a key factor in maintaining output growth in many industrial countries. However, employment growth (shown in the top right panel) has been strong only in Canada, raising questions about the prospects for future consumption elsewhere. We look for household spending in most industrial countries to continue to expand, but we do not see consumption as sparking a rise in output growth in the euro area or Japan. Rather, we think improvement in investment spending is essential if growth in those countries is to rebound. Orders data (shown in the middle left panel) appear consistent with our view that, at least in the near term, activity in Japan will remain sluggish, with investment spending falling further. German manufacturing orders picked up in November, but that move was entirely because of stronger foreign, rather than domestic, orders. We remain fairly pessimistic about the prospects for investment in Germany but expect that, for the euro area as a whole, investment spending will switch from contributing negatively to growth to being a small net positive. Such an outcome is far from certain, however. As can be seen to the right, survey responses gathered by I/B/E/S imply that expectations of long-term earnings growth of companies in the euro area have come down sharply since early 2001, with the second half of 2002 showing a particularly steep drop. These reduced expectations likely reflect not just changes in the circumstances of individual firms but also market perceptions of greater uncertainty and heightened downside risk that are a consequence of global tensions.

    As can be seen in the bottom left panel, for this year we anticipate that growth in the euro area and in Canada will result entirely from expansion of total domestic demand. Exports from both regions should expand but will be offset by rising imports. Robust domestic demand should underpin output growth at near its potential rate in Canada, whereas weak growth of domestic demand in the euro area will leave that region with a lackluster performance for the year. In Japan, we look for net exports to be the major positive component of very weak growth. The table to the right presents our real output forecast through 2004. We do expect some further strengthening in 2004, with Canada and the United Kingdom continuing to outperform the other foreign industrial countries.

    The economic performance of the emerging-market countries, the subject of chart 12, has continued to be uneven. The emerging Asian economies led the global economy into recovery and continued to outperform in 2002 but cooled somewhat in the second half as global demand, particularly for high-tech products, slipped. The value of the dollar in terms of the Korean won (the black line in the top left panel) moved down in mid-2002 and, on balance, has remained about unchanged since then. The Singapore dollar also gained somewhat against the U.S. dollar during the second half of 2002. Its limited move reflects the fact that high-tech industries were particularly hard hit by the slowdown during the second half of the year. Stock prices, in the right panel, rose in Korea and, to a lesser extent, in Singapore during the first half of last year, as these economies grew vigorously, but then retreated as the global slowdown made itself felt.

    Despite relatively strong economic performance in the region, price inflation in the Asian developing economies has been low. Attention has focused on the potential for persistent deflation in some of these countries, in addition to the ongoing issue of deflation in Japan. The middle left panel reports consumer price inflation for selected emerging-market Asian economies. Deflation was the case during 2002 in China and Taiwan; in Singapore, deflation early in the year became very low inflation in the second half. In Taiwan and Singapore, prices decelerated in response to exchange rate appreciation as well as to the weakening of activity during the second half of the year. These economies are relatively small and very open and sensitive to the fluctuations in high-tech industries. We expect that the rebound in activity projected for this year will lift inflation in these countries, including China, to a low, positive number. These economies show no signs of being caught in a debt deflation process as a consequence of the deflation to date.

    The panel on the right gives the staff growth outlook over the forecast period for developing Asia. We see no signs that growth in China will flag from the 7½ to 8 percent pace that has been reported for recent years. Continued government spending and strength in exports should support output growth. For the remainder of emerging Asia, the projected rebound in U.S. growth and the return to healthy expansion in the global high-tech sector are essential to the return of growth to the 5 to 6 percent range that we have forecast for these countries.

    In Argentina and Brazil, financial market developments are both a barometer of how the economy is currently faring and the channel by which stress is propagated through the economy. Spreads on international debt, shown in the bottom left panel, have stabilized and even retraced somewhat their previous spikes, albeit much more in Brazil than in Argentina. Similarly, exchange rates and stock prices in these two countries, not shown, have come back off their extremes. The situation in Argentina is in a kind of suspended animation, awaiting the outcome of the election now planned for April. While the observed stabilization in markets is welcome and we have written down low, positive growth as can be seen to the right, none of the really hard work of fixing the problems in Argentina has been done. Prospects remain very uncertain. In Brazil, markets have been giving President Lula the benefit of the doubt since the election. But the most recent moves on financial markets have been to take back some of the good news of lower spreads and stronger currency. Much depends on whether the politics of his program can succeed in an environment of fiscal and monetary restraint, and uncertainty remains very great. Only in Mexico do we see grounds for optimism. Our outlook for acceleration in Mexican output is closely tied to the projected recovery in U.S. manufacturing production.

    Your final international chart (chart 13) addresses the external sector of the U.S. economy. The real exchange value of the dollar as measured by our broad index has depreciated on balance since its peak in early 2002, as the staff projected at the time of the June chart show. The most recent move down reflects significant nominal depreciation in terms of the other major currencies. With the real dollar already substantially lower than one year ago, we project only modest further depreciation through the end of the forecast period. We judge that the ever-present need to attract growing amounts of net financial inflows to finance the widening current account deficit will weigh on the dollar. We estimate that real imports (shown to the right) grew 9 percent last year, with extremely rapid expansion in the first half. Real exports grew 5 percent, held back by past appreciation of the dollar and only moderate growth abroad. For this year and next, we project that real exports and imports will rise at comparable rates. Depreciation of the dollar should boost exports as foreign output growth remains moderate and should restrain imports some as U.S. GDP accelerates more strongly. With imports already substantially greater than exports, similar growth rates over the forecast period imply a small negative contribution to U.S. real GDP growth from the external sector.

    Our projection for a widening trade balance largely explains the increase expected in the current account balance, shown in the middle left panel. That deficit should reach about $625 billion by the end of next year, 5¼ percent of GDP. The most recent data available on the financial flows that are the counterpart to that deficit, shown to the right, give some clues as to the factors moving exchange rates in recent months. Our estimate for the fourth quarter implies that, during 2002, the current account balance (line 1 of the table) widened a little more than $100 billion. Increased foreign official holdings of dollars in the United States (line 2) were nearly as large. Private foreign investors (line 3) purchased substantial quantities of U.S. securities, but at a rate slightly below that observed in 2001. Private U.S. investors (line 4) greatly scaled back their acquisition of foreign securities, lessening the total financial inflow needed to achieve balance. With mergers and acquisitions very much reduced, net foreign direct investment into the United States (line 5) is estimated to have been negative last year.

    The final two panels present some foreign detail for two of the alternative simulations that we have recently provided to you. The panel on the left reports the change in foreign real GDP growth that our model projects in the case of a six-month war with a limited embargo, one of the four scenarios that Sandy discussed. For these countries, there are no positive impulses from enlarged government spending, only the effects of higher oil prices and the spillovers that occur across countries. For 2003, the consequences for foreign output growth range from negligible to about minus ¾ percentage point. In 2004, as in the United States, the assumption that the oil price falls below baseline by mid-2003 results in a boost to output growth, and our model calls for growth above baseline for these foreign economies. The panel to the right gives detail for the Greenbook scenario of a $20 rise in the price of oil that lasts four quarters and that includes an additional shock to confidence. In this case, the oil price rise is a bit less than assumed for the limited embargo, but it lasts twice as long. As a consequence, the oil-producing countries of Mexico and Canada experience this as a positive shock to output in 2003. For the other countries, the added confidence factors significantly increase the contractionary effect of the higher oil prices. With oil prices back to baseline in 2004 and the effects of the shock to confidence waning, output growth rebounds to varying degrees in most of these countries. Larry will now complete our presentation.

  • The final chart presents your forecasts for 2003. You have revised down your projection for the growth of real GDP and raised your forecast of the unemployment rate. Your projection for PCE prices this year has been lowered a touch. That concludes our prepared remarks, Mr. Chairman. We’d be happy to take any questions.

  • I don’t have any difficulty with the underlying U.S. forecast. I am bedazzled by the Canadian forecast. It used to be a forecast proxied by the U.S. outlook; it clearly isn’t today. The projections for the two countries are diverging considerably. It’s scarcely a manufacturing industrial commodity type of issue. The strength appears to be in domestic demand, not exports. So it’s not the currency. What is it?

  • You know, I’ve asked every Canadian economist I’ve run into over the past nine months why Canada is doing so well when other countries are not. Partly it may be a fortuitous mix in what their economy produces. Canada is not as heavily high-tech oriented as we are, Nortel notwithstanding, and it did not experience the excesses of the high-tech bubble to the extent that we did. So the capital overhang in that sector as a proportion of their total GDP structure—

  • Is the wealth effect significantly less? I ask because Toronto’s stock prices look about like ours.

  • They do, but Nortel itself is a huge share of the Toronto stock index. Off the top of my head I can’t answer specifically how large the Canadian wealth effects are. We do have estimates of that. I didn’t bring them with me so I can’t tell you, but I can certainly find out. Another issue is the exchange rate. The Canadian dollar, all things considered, has been somewhat weak on a fairly consistent basis.

  • Shouldn’t that be showing up in export demand?

  • It should be showing up in exports, but it could also show up to some degree in the willingness of domestic producers to invest. It’s not that exports haven’t been reasonably strong. It’s just that Canada has been importing as well, so the net export effect is not all that much. But exports have been doing their share. To some extent the performance of the auto industry is a factor. The auto industry has been a big part of the strength in the United States, and Canada shares in that strength in a very direct way. Canada also has been experiencing a phenomenon in the housing sector that is similar to ours. That sector is very strong, and it is supporting consumption demand.

  • Has the corporate governance problem in Canada mirrored what has happened here, or is it significantly less?

  • I don’t know of any specifically Canadian firms that have been making headlines whereas I could name some European firms, for example. That leads me to conclude, merely on the face of it, that it may be a bit less in Canada.

  • The reason I raise the issue is not just for the sake of entertainment or interest regarding what is going on in Canada but because I think their economic performance is telling us something. It would be very interesting to figure it out. Let me give you a hypothesis. The American economy was moving up reasonably quickly until the WorldCom news hit. I’m not saying that that was the cause of the slowdown in our economy; I’m talking about the time frame.

  • The effects of the corporate governance scandals have diffused since then. There are some—Wrightson, for one, among the Wall Street analysts—who claim that that was the turning point or a very significant impact point, and indeed the data are not inconsistent with that. The divergence in Canada emerged from that time on. Now, it’s hardly conceivable that corporate governance uncertainties are of an order of magnitude that one can explain the extent of the second-half weakness in the United States and, even more important, the differential between economic growth in Canada and the United States. My interest in Canada, aside from being a good neighbor, is that I think it’s telling us something about the United States, but I don’t know what it is.

  • Well, I might mention another issue that we are constantly looking into. I can’t claim it as a fact, but I still maintain it as a hypothesis. Canada was always a place where we were looking for an acceleration in productivity growth comparable to the U.S. acceleration because of their links to us and their similarities to us. It didn’t happen in the 1997-2000 period. It is possible that some of the strength in Canada in 2001 and 2002 is due a bit to the fact that their productivity improvement is happening a little behind ours in real time, so that it’s supporting their economy now. But I don’t have actual facts to back up that hypothesis.

  • Am I correct that their productivity growth in 2002 was not greater than ours?

  • It was not, in part because their employment growth has been so strong. If one had a crystal ball and could discern the changes in structural productivity from the adjustment components and so forth, one could draw some conclusions. We on the staff remain equally interested in and to some degree puzzled by the Canadian performance. We will look into these specific issues and everything else we can think of to try to learn more about what is going on in Canada.

  • Second, in the productivity analysis for the United States we always used to factor out capital composition, for example. We’ve ceased doing that in the last year or two. Is there any particular reason why?

  • The capital composition?

  • In other words, there was a shift toward higher valuated capital stock as differentiated from the constant dollar value.

  • I believe that’s in there.

  • It’s in there through the way we calculate the capital services part of the capital deepening.

  • I understand that. What I’m saying is that you used to split it out either as a separate category or a memo item. You tend not to do that anymore.

  • Well, I think that was many years ago, and that’s because we used capital stock growth rather than capital services and we would then make the adjustment for changes in composition. But when we shifted over to using capital services, which incorporates that effect, we no longer showed that separately.

  • But you still do show the constant dollar capital stock from which one can in fact infer the differential. What is it that you forecast? Do you have it by chance?

  • I’m not sure I have it with me.

  • Don’t worry about it now.

  • Yes, we may have to send something to you on that later.

  • When you get it, just send it on. I think I have it somewhere, but I can’t find it. I noticed in the last several weeks that the implicit CPI forecast, which is on the Treasury inflation-adjusted securities, jumped significantly. Is that a technical—

  • We’ve found over the last couple of years that inflation compensation inferred from the indexed debt is very sensitive to oil prices—a little oversensitive. So we can explain part of that by the run-up in oil prices.

  • Thank you. President Broaddus.

  • I have two questions, Mr. Chairman. One quick detail question: On the middle left panel of chart 5, what is the difference between the trend and the transitory components of structural productivity?

  • The trend component was the part that we thought would persist; the transitory part reflected the level effects that we saw going on. So if a business restructures—makes some one-time efficiency gains that we think are going to last in terms of the level of its productivity—we call that the transitory effect. We saw that type of restructuring effect a lot last year as opposed to an ongoing introduction of new technologies that would revolutionize the way businesses operate—as we saw in the late 1990s. So we were trying to distinguish one effect from the other.

  • Thanks. The second question I have is for Karen; it has to do with the dollar. I’ve been on the call for the last month, and one day we had a brief discussion about the unusual nature of the current situation. In the past, in times of great uncertainty and geopolitical risks the dollar often has been considered a safe haven. Money from around the world flowed into dollar assets. That’s not happening this time; in fact, the opposite seems to be happening. At one level the reason is obvious. The United States is now a terrorist target, so we are not nearly as safe a haven, just in a physical sense, as we were. Maybe some other things are going on. We speculated a bit in Richmond that perhaps there’s a concern on the part of some international money managers that, if we get into a crisis, the United States might freeze some accounts. There is that risk. In any event, it seems to me that there’s some possibility that the dollar could decline even more substantially than you’re now projecting. So I would ask what sort of adjustments that would induce in the U.S. economy. I know that’s a broad question, Karen; but if you could speculate on that a little, it would help me.

  • Well, the staff members who deal with the domestic side of the economy might be better able to answer that question. As a preliminary comment on your question, I would have to say that we’ve thought about this a fair amount, and we really don’t have any answers. But one of the things that we think helps the thought process is the realization that, to the extent people are less interested in taking on cross-border exposures, it has an impact on the current account deficit. That is how that long-term structural problem in the United States interacts with the geopolitical situation. The euro area and the rest of the world—Japan, in particular—are running a surplus vis-à-vis the United States. So, let’s say investors in those areas wish to take on fewer new cross-border commitments. Given that their countries are running a current account surplus—and conversely we are the deficit country—that sets up a need for asset prices and exchange rates to change in a way that will induce those investors to take on enough foreign commitments to enable the balance of payments to balance. To the extent that U.S. investors seek to keep their funds at home, that helps a bit.

    I think the box on chart 13 in the chart show illustrates this point. Buried in column 3 of that chart are both fixed-income and equity transactions. Foreign investors are still willing to purchase claims on the United States. They’re investing a substantial amount in the United States—mostly in fixed-income assets, not so much in equities. The figure was $361 billion last year, based on not quite complete data. The problem is that our current account deficit is bigger than that. So a $361 billion inflow from investors seeking to take on assets in the United States just isn’t sufficient to do the job any longer. There’s a willingness among foreigners to acquire dollar assets, but a slightly smaller willingness than earlier. U.S. investors are helping by not wishing, in a gross flow sense, to put assets overseas. But the rest of the world relative to us is in imbalance. That would be the case even if we pulled the flow of dollar investments overseas back to zero. Of course, we can make that number positive by not selling our claims in the rest of the world, so zero is not a bound in any sense. Nevertheless, the order of magnitude is such that it was a fairly important factor, if you will, in financing our current account deficit last year. Could it become a whole lot higher? Absolutely. There is no real benchmark for how big these numbers might become in the various categories if the dollar were to fall sharply.

    We can look back at the episode from 1985 to 1987 and ask ourselves, How bad was that? The United States did rather well, actually. The capacity of the U.S. economy to absorb relative price changes and to make the shifts necessary is remarkable, I think. The U.S. economy can probably adjust to a sharply declining dollar just fine. It would help the export sectors and manufacturers and others who need the help right now and, in some respects, might be just what the doctor ordered. My concern is that the rest of the world might not be as able to make the counterpart adjustment. So when they get what is in essence a deflationary shock coming from the exchange rate, they probably are not going to adjust policy as quickly as we would to maintain total demand as we did in 1995 to 2002. Nor are their economies inherently as able to adjust to a change in the mix of manufacturing versus services or the export sector versus the domestic sector. So global demand may not be invariant to a change in exchange rates that shifts demand from production abroad to production in the United States. Therefore, for the global economy, a sharply falling dollar may have more-adverse consequences than it will have for the U.S. economy.

  • Karen, that’s a very important issue that you’ve just pointed out. Would you have somebody write a short memorandum encompassing the thesis and the evidence supporting it? In other words, there’s a differential here in terms of the flexibility of adjustment in the United States and the rest of the world. It would be useful to get a sense of whether that differential has been changing in any significant way.

  • We will look into it and do what we can.

  • Your decomposition of multifactor productivity into permanent and temporary components is, I guess, largely statistical. I wanted to push you a bit more as to whether you had direct evidence on the permanence of MFP growth and on technological dynamism in the U.S. economy more generally. You do have that graph on R&D spending, but what information do you have, for example, on the stock of R&D investment, patents, and the diffusion of innovation across industries or from surveys on types of innovation? I note the negative impact of venture capital drying up and those sorts of factors. I’m concerned about this for a couple of reasons. One is the related issue of the extent to which innovation is capital embodied. To the extent that we want to have an investment-led recovery, we’ll want to see a lot of these innovations being translated into new investments. So that’s an important question.

    Another issue—besides, of course, the basic issue of the sustainability of productivity growth—involves one of the leading alternative hypotheses to the geopolitical risk hypothesis, which is what I call the real business-cycle theory. That theory says that perhaps the technological hype of the new economy was overstated and we might have a less exciting period now in terms of technological opportunity, which might lead to a slower growth phase in the near future. These are very important issues. Again, my question is, To what extent do we have more-direct evidence on the technological development of the economy?

  • We don’t have a ton of direct evidence. Basically that R&D graph was an attempt to get at the idea that technology has continued to advance in recent years but perhaps not as rapidly as the rate of advance in the late ’90s. If one digs a little deeper into the statistics, it is apparent that the growth in R&D over the last couple of years has been financed mainly by the federal government—not by private companies. By way of comparison, in 1999 and 2000 those numbers for private companies were in the 6 percent growth rate range. So as we’ve watched these developments and judgmentally done the parsing here, the reason we’ve gravitated more toward the transitory as opposed to a major ratcheting up in the longer- term growth rate was the fact that those trends don’t look quite as favorable as before. In addition, if we throw in the embodiment hypothesis, clearly the lack of an investment boom comparable to what we had in the late 1990s should be taking something off structural productivity growth. That doesn’t necessarily reduce the level, but it doesn’t produce the added impetus that it was providing. So our attempt here has been to be cautious in saying how much is permanent. The 1.5 percent multifactor productivity growth is still quite strong. It’s just not as strong as what we saw last year. In part we think there were a lot of adjustments going on— some related to the aftermath of September 11 that were unique to 2002 and others that are more likely to be one-time or occasional events than to be repeated consistently over our forecast period. That’s the thought process that we’ve gone through.

  • Could I make a two-handed intervention here? I’m rather surprised, Sandy, that in response to Governor Bernanke’s important question you didn’t talk a little about developments in the world of semiconductors. If one listens to folks in that industry, they cite a number of, I think, reasonably credible but yet-to-be-proven stories about their ability to build larger and larger semiconductors and to etch more capabilities into these semiconductors. They go on to talk about nanotechnology and other things. These stories are not dramatically different from the kinds of stories they were starting to tell in 1995 and 1996 that proved to be true. So while I think the question is a quite legitimate one and, as you say, very important, there are some indications out there about the basic building blocks of this IT boom that suggest that there still is some room—

  • There are obvious cases like that in biotechnology also. What strikes us is that today these tend to be more evolutionary in the structure of technology than revolutionary the way they were perhaps in the 1990s, when a whole new industry and way of doing business came into being.

  • That’s fair, but there are still some in the industry—and this will be my last comment—who would argue that there’s still further to go.

  • I’m not saying that there isn’t further to go. That will happen. But over our forecast period, given the other conditioning assumptions, this is what we view as the most likely scenario.

  • Do you do any kind of sectoral breakdown of your MFP projections?

  • Thank you, Mr. Chairman. Let me shift to the international arena. I think two very important events occurred yesterday that affect which of the likely Iraq scenarios will play out. One was obviously the State of the Union speech by the President. The other, which may be equally important, was that President Putin of Russia gave a clear signal that the Russians are shifting their view. If they do shift, the European powers that have been giving us a bad time in the United Nations will be faced with becoming irrelevant, which usually gets their attention. Therefore, I think it is very likely that we will have the one- month successful war scenario sooner rather than later. As laid out, and I have no dispute with that, I think that is very good news economically. In my view what this Committee will be thinking about next year, the year after, and five years from now is what the longer-term effect of that will be on the Islamic/Arab world. You will recall that in the sixteenth century [laughter]—

    SPEAKER(?). We’re getting on a bit from that period!

  • The West, after being subservient to a predominantly and powerful Islamic world, began to modernize. The Islamic world had a choice of either competing or of retreating into religion and an unwillingness to modernize. That has continued ever since. Iraq is the seat of civilization as we know it, never mind Islamic civilization. It is the great intellectual leader of Arab and Islamic thought. A successful war in Iraq, if it were to bring about a change in Iraq that looks anything like a modern regime, would have a great shock effect of the rest of the Arab/Islamic world. What we don’t know, first of all, is whether the change would just involve Saddam being replaced by a more benevolent general, in which case there would be very little effect.

  • The Saudi’s Abdullah last week started to raise the question of Arab reform.

  • Indeed. That’s exactly where I’m going. If there is a successful modern regime and there is reform, that would be wonderful. The question is, Will the reform be benign? Will it take place over an orderly period of time, therefore allowing that part of the world to modernize and become a seat of stability and of growth for the world? Or will we see regimes that simply are not capable of changing and thus will be toppled, in which case we could have year after year in this Committee a question of what is going to happen in the oil-producing areas? I think we have to remember that. That’s not going to affect us for the rest of this year or maybe next year, but it will be a challenge to the Committee over time.

    Let me shift to another area, following up on the exchange rate discussion. One of the things that the dollar’s strength depends on—against the background of a huge, and in my view unsupportable over time, current account deficit—is whether the people of the world have confidence in world leadership, which is not completely but very largely American leadership. For whatever reason, our leadership is not providing a very clear view of the way we would like to see the world economy functioning. Sometimes when that happens, people do some very unfortunate things.

    So, my question is to Karen, and it relates to what is going on in South America at the moment. The International Monetary Fund has decided—their staff was pushed by the member nations to do something that the staff thinks is unwise, and I agree with them—to reward Argentina for a violation of the most basic rule of law, which is that one is supposed to pay one’s debts. Argentina has been rewarded by a rollover of its obligations so it can pretend to be current with the IMF and other international institutions. At the same time, across the river Plata, the Uruguayans have been trying very hard to do the right thing—not quite making it but certainly putting forth a very good effort. But the IMF has decided that Uruguay may not be able to pay its debts in a couple of years, so why not have Uruguay declare default now. I might just add that the econometric models used by the Fund in this analysis have conditions that probably would make the United States look potentially bankrupt. Put those two cases together. One country does everything wrong and is rewarded by the IMF saying we’ll roll over your debt. The other poor little country tries to do everything right—and like the rest of us isn’t perfect—and the IMF decides that it will not allow them to pay their debts but, in effect, requires them to default. Let’s move slightly north into Lula da Silva’s Brazil. When the international community is saying to one nation that it’s okay if you don’t pay your debts—and to another that if you try like the devil to pay your debts and aren’t quite perfect, you should default—why should Brazil jump through hoops and pay its debts? They can figure that out. My question is this: Is anybody in this capital at the International Monetary Fund or anywhere else realizing what I’m convinced is a signal to all the emerging-market countries that the rules have changed?

  • You’ve painted the picture in its extreme form, shall we say, for the sake of the discussion.

  • It sounded factual to me! [Laughter]

  • The sad part is that it’s exaggerated but factual.

  • Yes. Let me put one additional fact on the table and then try to give some kind of answer. Brazil’s biggest debt problems are the debts that the Brazilians owe to other Brazilians. So the consequences for Wall Street or the industrial countries of default by Brazil vis-à-vis Uruguay differ. Default by Brazil doesn’t really translate into a direct answer as to how within Brazil to reconcile the pressure for meaningful change in income distribution, in opportunities, in government policies, and a host of other regional and structural kinds of problems. Given the obligations of one Brazilian to another that exist on paper now, how can that whole situation be worked out and not break down into other problems? The situation could lead to violence, unilateral default on some pieces of debt, or behavior on the part of the government that throws into question the stability of other facets of the social structure. That really is a much bigger problem than what Brazil owes the rest of the world, and that’s the problem I think they’re really grappling with.

    Setting aside Brazil, however, there is this issue of why other countries—Ecuador, to pick a country almost at random—won’t somehow think the rules have changed. I don’t minimize this problem that you have posed, but I guess I would use slightly different words to describe what was done for Argentina. Argentina was not going to pay its debts on January 17, January 24, December 31, or any other date one could name. In no meaningful sense was Argentina going to pay the IMF or anybody else. So the question for the IMF was, How do we recognize that fact and try to get ourselves in a position where what happens subsequently in 2003 will have the best chance of being constructive? Rightly or wrongly, the G-7 governments felt it was more likely that the new government in Argentina could be worked with to foster constructive developments with respect to the country’s long-term problems if the fiction were maintained for a little while longer that Argentina was not in default to the IMF. It was not entirely the United States pushing this view, although this country was certainly on that side, but it was the Italians, the Spanish, and others. So that was done. On the surface of it, I wouldn’t really disagree with that. I don’t know that forcing the crisis into January, given that we still haven’t seen the sorting-out in the political parties in Argentina as to who is going to run in the election for president—and we certainly haven’t had the election—would have made for a better outcome. But as you mentioned, there are spillover effects in terms of how it was done, and in some respects those have created very real problems.

    It is certainly true, and it is symptomatic of why Argentina is where it is today, that the picture painted in the Argentine press was that it had looked the IMF in the eye and the IMF had blinked. As far as I know, the Argentine politicians drew that conclusion, too. So until somebody is prepared to hit those people over the head with a brick and tell them that this isn’t the way the world works, this is going to continue. If you have any bricks handy, [laughter] I invite you to do it because that’s why—a year and a half into the crisis—the Argentines still haven’t figured out who’s going to pay even a piece of the bill, whereas at this point in time the Asians are busy growing again. The problem is largely within Argentina; it’s a political problem, and people are still dancing around it. The United States is obviously in a very difficult situation because it’s hard to do the brick throwing without looking like a heavy to somebody, particularly to the people hit on the head with a brick. The chances of it somehow all coming out favorably don’t look good.

  • We can have an amendment to the Sarbanes-Oxley bill to the effect that the accounting is to apply to the IMF as well as everybody else!

  • Well, it’s a tough situation.

  • Just as a footnote, I think Karen’s answer is what one would have to say; it’s the right answer. In these countries when you forbear, you appease the worst of their politicians, and you discourage the ones—they may be somewhere—who are sensible enough to do the right thing. So the likely next president of Argentina probably is going to be weaker as a result of this action than he or she would have been if the action had been tougher. That’s I think the ultimate tragedy.

  • You know, an actual default changes nothing. A good part of the issue involves the internal politics of the IMF and the need to replenish capital in the event of loss, which gets to the taxpayers of the G-7, and that is not an insignificant element in their decision. I am correct that the staff at the IMF was not enthusiastic about this decision?

  • The staff at the IMF wanted a real program. If it was going to be called a program, they wanted it to have teeth. Indeed, the managing director had been told originally, when he first took office, that the IMF was going to have smaller programs and that it was going to be more realistic and firmer in conducting these types of negotiations. Then he is confronted with the situation in Turkey and after that Argentina, and it’s very clear that consistency is not exactly at a high point.

  • Thank you. Circling back from those lofty questions, I have a relatively mundane one on the risks to your forecast and the outlook. It has to do with the consumer, who has been very important to our economy’s ability to maintain itself through this difficult time. If one looks on chart 3 at what I’ll call the debt burden ratio of consumer payments, it is nearly at a record high—with interest rates at a record low. Looking ahead, if in fact our economy begins to pick up, the expectation is for interest rates to increase, and there will be a migration into a heavier debt burden—depending on other circumstances, of course, including income growth and so forth. Since the consumer’s role has been so important and since it will be a factor going forward, how do you assess the downside risks there, given that debt burden, which as you noted in your opening remarks people are concerned about?

  • Well, the simplest answer is that empirically we’ve never actually been able to find a relationship between debt burdens and consumer spending at the aggregate level. We attempt to look at some of these data at a more disaggregated level, and the bottom left panel is one way of trying to do that. As I pointed out earlier, the debt burden levels are far higher for the upper-income consumer; much of the action has occurred in the upper decile, where we think there’s a large cushion to protect against income disruptions.

    We also looked at the Survey of Consumer Finances to see, for example, if there had been any changes between the 1998 survey and the 2001 survey in the data on the households that are late making their payments. At the aggregate level we didn’t see any real change in payment problems. We did see an increase, however—and this perhaps goes to your question— in difficulties in making payments for the lower-income, low-wealth, younger households. I think the category was those under the age of 35, which to me is quite young. So, there are clearly households for which this is a problem, but we don’t have the sense that it is going to be a widespread problem. As I said, empirically we don’t see evidence—in the aggregate anyway— that debt burden matters for PCE. It may well be that it does. We just can’t find a relationship.

  • Obviously, from a broader perspective, one can say that there are some downside risks associated with the consumer sector. We are expecting a very weak labor market over the first part of the year. There are already some signs of concern in the household sector, and those concerns could be compounded by a continuing rise in the unemployment rate and lack of any perceptible growth in payroll employment. On top of that is the fact that we think households are still in the process of adjusting to the hit that their balance sheet has taken. On our forecast of a relatively benign stock market going forward, we see some stabilization of wealth to income, so we’re expecting the effects of that hit to wane. But it still would have to constitute a downside risk.

    Apropos of our discussion yesterday regarding model uncertainty in policy, it’s clear that if we get into a situation where the economy is beginning to improve and interest rates are rising, some of the ameliorative effects of low interest rates on consumer debt burdens will begin to wane. But that might just mean that we’ll need less of an increase in interest rates to produce the kind of restraint ultimately desired and not necessarily that it would trigger a contraction in the household sector. That suggests that you may be confronted with not knowing exactly how big a reaction you will get in terms of aggregate demand from the rise in interest rates that ultimately may be necessary. That will be a question you’ll have to face in determining your policy response.

  • Thank you, Mr. Chairman. After these very large issues I have a rather mundane one. I’ve been struck in recent weeks and months by the movements in commodity prices, and I noted particularly the chart on commodity prices on page 36 in Part 2 of the Greenbook. It looks as if the commodity price increases really took hold perhaps a little before the exchange rate started to move. To what extent are these dollar increases in commodity prices outrunning what can be explained by the exchange rate per se? That is, is a worldwide increase in commodity prices, as measured in euros and other currencies, taking place; and what are the implications, if any, if that observation is correct?

  • Well, it’s certainly true that commodity prices are up a bit in some categories. I don’t have them corrected in an SDR basket or the like, although I could do that at some point just to see what it shows. But we would suggest that the increases are occurring selectively in certain categories where for the most part we think we can explain it on the basis of special factors. We don’t see it as a leading indicator of a global recovery or something of that sort. In a few of the agricultural commodities—cotton and some others that are probably spelled out in the Greenbook, but I don’t have them memorized—supply-side disappointments or crop failures or the like have caused prices to go up. Those categories—in contrast to the metals, say—are the ones in which we’ve seen prices rising. That suggests to us that this chart reflects more or less a weighted average of a number of market-specific, idiosyncratic developments.

  • Steel scrap is a major one—its spot prices have risen dramatically—in the metals components of the general Commerce index.

  • President Poole, we also think that it’s probably an indication that the very modest improvement we believe is occurring in industrial production is in fact happening. In some sense, I think it reflects more than just the dollar effect. Our sense is that it’s also signaling that the softness we saw in industrial production earlier in the fall has probably abated some and that these prices have become relatively firm. They are reasonably well correlated with industrial activity.

  • I have some mundane issues as well. First, I guess I’m struck by how much stronger the second half of this year and 2004 are in the Greenbook forecast than in the majority of other forecasts, such as that of DRI. Particularly for 2004 the staff’s numbers are way out there. Second, each of the factors in chart 2 that Larry went through—the forces shaping the outlook—seems to me to have a fair amount of downside risk. It’s hard for me to see the upside risks on any of them. We were talking earlier about consumer spending. I think housing wealth is even more of a factor in people’s spending—if wealth is a factor in spending— than equity markets. Now, given the sales data that have come out in the last couple of days, maybe these charts need to be redone, but I’ve seen some work that suggests that the value of housing wealth may be leveling off. That raises the question of whether the boost to spending we’ve seen from refinancings, at least the part that stems from increases in housing wealth, will continue. That’s one element of concern I have.

    Another issue is the stimulus associated with past changes to monetary policy. How much is still there, and how much will be there, particularly as we get to 2004? As for expansionary fiscal policy, the fiscal impetus that the staff shows in the chart in the bottom left- hand panel is stronger in 2002 than is projected for 2003, even with the tax cuts. Moreover, I thought the attitude in the Greenbook with regard to the agony that state and local governments are going through was quite dismissive. Yes, they still have some reserves that they can spend, but they are all going to have to cut back expenditures sharply unless this economy picks up the way you say it’s going to pick up and their revenues really start to grow. I’m just wondering how these four factors are weighted in your assessment of the outlook and where you see some upside risks on them.

  • I’ll start, and others can join in. First, let me make a brief comment on our forecast versus those of many outsiders. It’s hard to know exactly, but I think one of the main differences between our forecast and many of the outside forecasts—especially when we’re talking about 2004—is our productivity assumption. We clearly have a stronger assumption and that feeds through in a variety of ways.

  • Let me go through a couple of the other issues you raised and try to address some of them. The main question you asked was, in effect, where are the upside risks in this forecast. If I were to go through the upside risks, an important one would be capital spending. The point of chart 4 on capital spending was to show that it would actually by itself be considered fairly conservative in terms of what we have the growth of capital stock doing. There is a lot of potential there on the upside if businesses really were to become convinced that a strong recovery was in place and they felt comfortable about the outlook going forward. The rates of return on investment seem to be high; certainly that’s consistent with our productivity forecast being very high. They’re related, but my point is that it doesn’t require just that productivity assumption to get the possibility of a strong upside on capital spending if this pessimism lifts.

  • Compared with other forecasts of P&E, the staff forecast already has a strong number.

  • Granted. But you’re asking for the upside risks, and I’m just saying that I think there is some upside risk there.

  • So you think it could be even stronger.

  • It certainly could be stronger, and that would be an important risk I would point to. Is there a possibility that we’ve been low-balling productivity growth? Perhaps. I wouldn’t put a lot of weight on that one. As for the stimulus associated with past changes in monetary policy, we still have some stimulus in train. I forget the exact numbers, but I think it’s in the range of something like ½ percentage point increments going forward for a while before it finally peters out. As you know, our fiscal policy assumption is just that—an assumption. I don’t know what more to say about that in terms of upside or downside risks.

    Now, let me briefly comment on the state and local government situation, if I may. That clearly is a possible source of restraint in the forecast, and we have built fiscal restraint into this forecast from the state and local sector. We’ve built it in both by lowering the growth of state and local government spending to the levels we were seeing in the 1990s—the last time they went through difficulties—and by making adjustments on the tax side as well in their revenue streams. So we’ve actually put in a dose of fiscal restraint from that sector, recognizing exactly the problems that you’ve highlighted. I think Dave Stockton has some comments that he wanted to make as well.

  • Actually, on the fiscal policy side, I see the risks as more to the upside than the downside. We’ve built in less stimulus than the Democrats have proposed and less than the Administration has proposed. If our forecast is correct, we will have an economy in which the unemployment rate is going to be rising. In that circumstance, I believe there’s a considerable possibility that we could get a significant further dose of fiscal stimulus. So I think there are upside risks associated with that.

    On the structural productivity issue, I would just mention—as exotic as this might look— that our statistical filtering models actually would want to put in even more growth than we did, based on the course of productivity over the past year. Now, those models were fooled in the early 1990s when the growth of productivity picked up, a development they interpreted as a bigger step-up in structural productivity than in fact turned out to be the case. Indeed, much of that step-up proved to be cyclical. So we feel quite comfortable that we have discounted that evidence. But I think there are risks on both sides of that.

    I’d say one other thing, too, which is that looking at the forecast and the risks associated with it simply in terms of the GDP growth rate is not the only way to look at it. We revised up both the supply side and the demand side in this forecast. In fact, this is a projection in which the GDP gap is larger than before. There is more slack implicit in the economy over the next two years than we had in the forecast last time; we show a higher unemployment rate and a larger GDP gap. So it would be wrong to think about this as just a story of strength. One could look at it the other way around and say that this is a story of some additional slack, in part because we think there will be productivity gains in the short run that will lead to this higher unemployment rate. So in that regard there are risks on both sides of this.

    Again, as I think we tried to make clear in the Greenbook, we recognize that in this outlook there’s a lot of tension between the near-term weakness that we can actually measure and the strength that we’re showing in the second half of the year. That pickup requires a lot of things to happen in the same direction in the second half of this year—dissipation of the pessimism, a big dose of fiscal stimulus, and a reduction in the wealth effects that we think currently are exerting a drag on the economy. It would be hard for us to know whether all those things would be concentrated in the beginning of the second half, around midyear, or whether some would occur later. Some could be accelerated and others stretched out to produce a forecast that may have as much growth over the next two years on net, but it may be distributed differently—either significantly delayed or pulled forward. There’s not a lot of evidence to go on, in part because we’re so unsure about the lifting of the uncertainty and gloom. We’re talking here about when and to what extent a residual—that is, what we don’t know about in the investment area over the last couple of years—goes away. We face considerable risks there in both timing and magnitude.

  • We just don’t have a lot of science that we can bring to bear here.

  • Okay, any further questions? If not, who would like to start our roundtable? President Parry.

  • Thank you, Mr. Chairman. The Twelfth District economy continued to expand in recent weeks but at a very modest pace. Consumers turned in a disappointing performance during the holidays, and early numbers for January suggest that they remain hesitant and price conscious. One retail consultant characterized the current environment as a “race to the bottom,” with consumers willing to hold out until they get goods at cost. Retailers have responded—offering nearly continuous sales, rebates, financing incentives, and price guarantees. District businesses also are looking for bargains, especially in real estate and IT support services. One commercial landlord said he fields daily calls from tenants threatening to move if their lease rates are not lowered. A contract manager at SUN Microsystems reported increased pressures to lower prices for long-term service contracts and one-time technical support.

    Now, let me say a few words about the state budget crises. The genesis of these crises, not only in the West but elsewhere as well, appears to be overly optimistic revenue expectations and, to a lesser extent, cost overruns. Revenues are running well below expectations, with especially large shortfalls in states dependent on capital gains revenues. On the cost side, Medicaid seems to be the main culprit due to rapid increases in prescription drug prices and provider fees. Although a recent survey of state governors found that twenty-four believed their fiscal crisis is the worst in the nation, it appears that things are especially bad in the Twelfth District. [Laughter] District states account for approximately 21 percent of gross state product, but they account for about one-half of the estimated total state budget shortfall in the United States. Of course, California’s gap is the largest—$26 billion or $35 billion depending on whom you talk to—and that’s for both this and the next fiscal year.

    While these budget shortfalls pose significant challenges for state lawmakers, their economic impact is less clear. For one thing, estimated budget shortfalls represent the difference between desired spending and current revenues. They do not represent budget deficits. Therefore, they typically overstate the tax increases and cuts in spending that are required to balance the budget. For example, California has a projected shortfall, at least as projected by the governor, of $35 billion. But it actually faces a deficit of $15 billion. For another, states usually spread the pain of budget deficits over several years, tempering the immediate impact on state spending and employment growth. That being said, there are real costs to such large budget shortfalls. California’s bond rating was downgraded in part because of the announcement of a $35 billion budget shortfall. With the recent downgrade, rating agencies now score California’s current fiscal crisis as equivalent to that faced during the state’s severe recession in the early 1990s. Moreover, the state faces severe cash flow problems, so it probably will need to take on more debt to meet current payment obligations. On the brighter side, exporters and importers breathed a sigh of relief last week on word that a new West Coast port contract had been signed.

    Turning to the national economy, obviously recent data have been mixed, with employment and industrial activity on the weak side and consumer spending doing fairly well. On balance, though, the data have been somewhat disappointing. Our forecast for this year looks a lot like the one in the Greenbook. We’ve revised down our estimates of real GDP growth in the fourth and current quarters about ¼ percentage point, to ½ percent and 2½ percent respectively. Assuming a constant funds rate this year, the most likely scenario for the third and fourth quarters is that real GDP growth will rise above the potential rate by ½ to 1 percent, depending on what happens with fiscal policy. The excess capacity in the economy brings consumer inflation down at a gradual pace, and inflation in the core PCE price index falls to about 1¼ percent in 2004.

    I have some concerns about this outlook. First, of course, the long-anticipated pickup in growth has yet to materialize. This pickup seems to depend importantly on an acceleration in business fixed investment occurring before consumer spending falters. The longer the growth has to depend on the auto and housing sectors, the riskier the situation becomes especially in the context of geopolitical uncertainties. Second, even the projected expansion is modest at best, and it still would leave the economy with excess capacity through the end of next year. This brings me to my third concern. Our forecast also would leave us with an inflation rate next year that’s below 1 percent after taking out the estimated bias. In my view, that inflation rate is slightly on the low side.

    To see how these concerns play out in the longer-run forecast, we ran a number of perfect foresight simulations as in the Bluebook. We used a couple of different models, including FRB/US, and some alternative assumptions about FOMC policy preferences, including different assumptions about interest rate smoothing and also the degree of responsiveness to the output gap. In all cases where we assumed a target for measured core PCE inflation of 1½ percent, the optimal policy involved significant near-term funds rate decreases. These simulations nicely capture the implications of our current situation. We have excess capacity, prospects for only a modest increase in real GDP growth, and a fairly low inflation rate. Adding any downside risks for economic activity to this picture would only strengthen the argument that perhaps a further easing of policy might be appropriate before too much more time passes. Thank you.

  • Thank you, Mr. Chairman. Our District economy has been fairly sluggish overall since the last meeting, and I have a sense that there probably has been some deterioration in both household and business confidence. The cold weather may be part of it. It was colder in Myrtle Beach the other day than in Anchorage, if I’m not mistaken. [Laughter] I think concern about Iraq is restraining household and business spending in our region as elsewhere in the country. Consumer spending in our District seems to have followed what I understand to be the same pattern that has been reported for other parts of the country—generally weak holiday sales but a revival of automobile sales in December as some of the incentive programs were reintroduced. We have a director in Charlotte who runs a huge car dealership in North Carolina. He said that December was a spectacular month. He’s a pretty sharp guy, and he speculated—I guess based on conversations he’s had with some of his customers—that people are deferring or even forgoing purchases of other major items in order to take advantage of the car deals before they go away again.

    Labor markets, in keeping with what I’ve already said, appear to have softened further in our area. We hear more reports of layoffs. Unemployment rates are rising in all of our District states. The majority of the layoffs are at factories, and general manufacturing remains rather weak in our region. In such an environment, not surprisingly, the information we have on business investment suggests that it’s still quite soft. We have heard a few reports of increased spending on computers for upgrading and that sort of thing, but nothing much beyond that. The only vigorous and bright spot in the District is housing.

    On the national economy, maybe in some contrast to Bob Parry, I think the staff has made a good case—both in the Greenbook and also in response to Cathy’s question a minute ago—for its projection. The Greenbook forecast as a point forecast is as plausible as any I can think of. It basically says that the recovery will gradually, or maybe a bit more than gradually, strengthen over the projection period. As I see it, the two principal underlying fundamentals that support the forecast are the same two main factors that have been supporting the recovery, such as it is, up to this point—an accommodative monetary policy and strong productivity growth. We have eased monetary policy substantially over the last two years as a whole, including the most recent move in November. I think, as the Greenbook says, there’s a good chance that we haven’t seen the full impact of that yet. With respect to productivity growth, as has already been suggested here today, obviously there’s no guarantee that the elevated structural productivity growth of recent years will continue this year and next year. On the other hand, I don’t see any strongly compelling or obvious reason to think that it won’t continue. I believe there’s a good chance that it will continue for reasons that you mentioned, Mr. Chairman, in your speech on productivity to the AEI in October of last year. If it does, that would support continued strong growth of disposable household income and spending and presumably at some point would stimulate, or at least help to stimulate, business investment. Another source of support is the fiscal stimulus. I wouldn’t give as much weight to that as I think the staff does, but certainly it’s in the right direction.

    Nevertheless, I consider the Greenbook’s point forecast plausible. I also think that the confidence interval around it is symmetrical but exceedingly wide, mainly because of Iraq. We’ve had some discussion of this already. It’s rare, at least in my memory, that the near-term economic outlook has been so heavily dependent on the prospect and timing of one contingent event. If we invade in the next few weeks and the war is short, successful, and decisive, both business investment and the overall recovery could strengthen quickly and markedly. I enjoyed very much the part of the chart show that dealt with that. Also, we could get the same result if somehow this impasse is resolved without an invasion. There is still some small possibility of that, though it doesn’t seem very likely now. But in either of those situations I think our current policy stance would be much too accommodative.

    However, if we do invade and the war triggers some other crisis like another terrorist attack somewhere, then confidence could be eroded further, businesses could continue to restrain investment, and the recovery then would become even more vulnerable to some of the downside risks that have been mentioned here today. In such a situation, we might need to ease further, and we might need to do so aggressively—or preemptively if I may use that word—even taking account of some of the tradeoffs and tough choices we’d have to make, as we discussed yesterday. In any case, given the unusual degree of uncertainty in the outlook and the wide range of possibilities, the key point for policy—particularly against the background of our discussion yesterday and with all due respect to prudence—is that we may have to adjust policy substantially and promptly in one direction or the other in the months ahead. In my view we need to be prepared for that possibility.

  • Mr. Chairman, my comments are going to sound fairly familiar. The situation hasn’t changed much since the last time we met. The District economy has been and continues to be sluggish. There aren’t a lot of signs of improvement since our last meeting. Manufacturing activity, from what we’ve observed in the region, actually weakened somewhat in December, disappointing us given the growth that we had seen in October and November. Production and new orders both moved back below year-ago levels after firming in October. Consumer spending has been sluggish since the last meeting, and in most areas holiday retail sales were flat compared with a year ago despite some heavy discounting. I had a conversation with an owner of major shopping malls in the Midwest—in Kansas City, Denver, and elsewhere—and I found his comments about the post-Christmas season interesting. He said that he thought sales were pretty robust in the first week of January. But since then, in the last two weeks, they’ve dropped off dramatically. Retail activity is just dead, and he hasn’t been able to figure out why. It is a concern because that pattern is not unique to one city. It has occurred throughout the Midwest, though Denver in particular has been very hard-hit in terms of a slowdown.

    Our commercial real estate sector is depressed, with a number of vacancies as well as a lot of space that is being leased but not used. We have some real issues there. Housing activity, as elsewhere, continues to be the bright spot in the District except in Colorado, where a slowdown has developed even though prices haven’t adjusted yet to that slowdown. I don’t know whether that’s coming, but I suspect it is. Energy activity in the District actually has been flat despite the oil price increases, and that’s because no one knows exactly where that price is going to go. Many feel it could easily plummet, and if it does, no one wants to be in the position of having made that kind of capital investment. So activity in that sector has remained relatively slow. Wage and price pressures are largely subdued; there’s nothing unique on that front.

    On the national scene, I really can’t quibble with the Greenbook, given the levels of uncertainty. As we’ve noted, the fact is that monetary policy is stimulative, and fiscal policy is likely to be. Another positive is that financial market conditions, given the economic situation we are witnessing, are relatively strong compared with what they’ve been in the past. So the markets are in a position to foster strengthening economic activity. I, too, see the issue as the fact that the risks on both the upside and downside are bound to be so much larger than usual. We could have a very good takeoff or a real slowdown. That is the situation we’re faced with. Whether the outcome is to the upside or the downside, I think perhaps the new phrase for policy that may come from all of this is “prudently bold.” But for the time being we’re looking at possibilities on both sides, and I think we’re in a position to wait and see. Thank you.

  • Thank you, Mr. Chairman. Economic activity remained sluggish in our Southeastern region through December and early January this year. Many of our regular contacts in those sectors that are still seeing little or no rebound are saying, “What recovery?” Someone I talked with recently dusted off an old Southern country boy expression when he said that he just hopes the economic situation doesn’t deteriorate into a hog wallow. I’ll translate that into city boy language during the break, but I think you get the idea.

    Our regional bright spots and soft spots reflect the national picture in most respects. Our contact at the corporate headquarters of UPS in Atlanta was helpful in piecing together the picture of Christmas holiday sales. As we all know and have talked about at various times, there have been significant changes in where people shop. The traditional mall retailers are losing market share to discounters and the Internet. UPS’s chief financial officer told us that their Internet-related deliveries were up some 24 percent from year-ago levels. Despite those big gains, and I guess they were on a small base, everything we know suggests that holiday sales in our region were about flat compared with a year ago, with late-in-the-season spending helping to save the day. The pattern of later shopping surely has multiple explanations, but we would suggest that it may be additional evidence of the broader pattern of uncertainty and postponed commitments that we’re seeing elsewhere in the economy.

    Job growth in our region has been stubbornly absent. In our District, the manufacturing sector, which is still a bit larger as a proportion of total employment than is the case nationally, the extent of job losses and the significance of those losses are very different between durable and nondurable manufacturing. Durable goods manufacturing employment declined by a somewhat smaller percentage than for the nation, mainly because our District’s durable goods firms are less concentrated in industrial and electronic equipment. In contrast, though, nondurable goods manufacturing employment fared somewhat worse than in the nation; much of the employment losses there were from plant closings rather than reduced hours and shifts. So the job recovery in that sector does not look very promising.

    Not surprisingly, the other major problem we’re seeing—and others have already highlighted it—is the condition of state and local finances. Deficits and budget problems abound because ramped up spending during the late 1990s was not curtailed quickly enough as conditions deteriorated. It’s our sense that the hurt at the state and local level, and consequently implications for economic drag, may be even greater than portrayed in the Greenbook. Although our states may be small and Bob Parry’s explanation may be what is most important, at least in our six states the very real tax increases and spending reductions look to be quite significant.

    There are the continuing bright spots. Residential construction remains healthy and strong, with no early signs of slowdown. Current mortgage rates should sustain the high level of activity, although the potential for a further pickup in that activity is questionable in my view. Commercial construction is another story. With the current high vacancy rates, at the present rental rates it’s hard to see a meaningful bounceback anytime this year. Our tourism industry continues to see a slow, steady recovery, although tourism is still not back to the levels in 2000. Business travel and convention business have not recovered at a commensurate rate. So our regional picture is very mixed. As I’ve said before, our region is not getting the special early recovery bounce that has often led the nation at this point in past cycles.

    At the national level I keep looking for the expected signs that help is on the way—that those sectors that have yet to get some traction are beginning to come back. I’ve been trying to practice my own advice of being patient. All things considered, I do share the broad view that the economy will continue to improve and that the recovery will become more broad-based as we move through 2003 and beyond. At the same time, my staff and I are a bit less convinced than the Greenbook authors that we’ll see such strong a recovery as early as later this year. While we do see some pickup beyond the early part of the year, there may be some good reasons—already pointed out by others—to be somewhat cautious about expecting a quick and large bounce. Fourth-quarter profit numbers are just coming in and so far seem to be showing modest improvement compared with year-ago levels and are up significantly in some sectors. However, I’m less certain about the assumed strength of productivity growth and the further growth in housing activity and business investment in the near term that is embedded in the Greenbook forecast for the second half of the year.

    The initial leveling out in labor markets last year is beginning to seem extended. Lots of business people I talked with still seem to be very, very focused on further cost reductions, with more job cuts and delayed hiring a big part of that focus. While certainly there must now be considerable pent-up demand for additional staff to relieve some of the “do more with less” mode that businesses have been in, it may be awhile longer before the unemployment rate moves down and the economy gets a positive kick from sustained employment growth.

    Despite the political pressures to do something on the fiscal side—and despite Dave Stockton’s assertion that the fiscal assumptions embedded in the staff forecast are quite modest—it’s not clear to me that the fiscal stimulus we’ll get will be targeted and timed to affect the near-term slack in the economy. In fact, I’m actually a little encouraged that there seems to be some debate about the longer-term negative consequences of certain specific fiscal actions. Finally, as has been noted repeatedly, how the war worries will play out is still not completely clear. At least for awhile longer, that overhang and the related short-term run-up in oil prices are not helpful and are masking what might otherwise be developing in the real economy.

    For all those reasons, we see growth in 2003 as more modest than in the staff forecast, with less of a sharp pickup toward the end of the year. Still, with monetary stimulus already in place and at least some additional fiscal stimulus probably coming, with more and more imbalances and excesses having been worked off, and with the prospect that geopolitical drags will eventually become less worrisome, we think we’re on a reasonable path at the moment. Thank you, Mr. Chairman.

  • Thank you, Mr. Chairman. Economic activity in the Seventh District generally appears to have remained soft in December and January. Our contacts’ expectations for 2003 are mixed, although perhaps a little better than a month ago. So let me start with the good news.

    The automobile industry ended another very strong sales year with a flurry of activity in December. While light vehicle sales apparently slowed in January, our contacts at each of the Big Three have told us that the decline has been in line with their expectations, reflecting the expiration of incentives and sales pulled ahead into December. The major issue for 2003 is the contract negotiations with the UAW. Key issues of contention are likely to be capacity reductions and health care costs.

    In the Chicago purchasing managers’ report for January, which won’t be released to the public until Friday, the overall index moved up from 51.7 to 56, which is above the consensus estimate of 53. Orders and production in particular increased. The employment component, however, still remained very weak. In heavy-equipment industries, some of our contacts are expecting a pickup in production in the near term. They believe that final users will want new equipment soon—at a minimum for replacement purposes—and they know their distributors’ inventories are very lean. We’ve also heard from producers of machine tools and heavy trucks that they are receiving more requests for price quotes. Still, apart from the new Chicago PMI that I mentioned, we’ve seen few tangible signs of a broad-based sustainable recovery in our manufacturing sector.

    In terms of the not-so-good news, most retailers were disappointed with holiday sales, and it appears that little has changed so far this year. Retailers remain cautious about ordering and continue to be aggressive in discounting merchandise. In addition, both of the major temporary-help firms headquartered in our District, Kelley and Manpower, were less optimistic than a month ago. One, who last month saw a few signs of strengthening labor demand in manufacturing, is now characterizing his business as “inching forward.” The other, who last month was already pessimistic, thinks the recovery actually has stalled. Neither thought they were close to seeing the robust growth their industry experienced following the 1990-91 recession. With regard to the overall employment picture, Manpower’s national index of hiring intentions for the second quarter will be somewhat lower than for the first quarter. That index figure is preliminary at this point and won’t be released for quite some time—not until February 24.

    Turning to the national outlook, as we all know, the news since our last meeting has been mixed. We’ve been in a slow period, and it’s always difficult to be upbeat when we’re receiving negative employment reports and the like. Nevertheless, as I just noted, the anecdotes from most of our manufacturing contacts—while still not rosy—are not as full of doom and gloom as they were last fall. I hope that this is a sign that businesses are working through some of the uncertainties they faced over the past year and that this process will soon show through as increases in payrolls or solid gains in investment. Such a turnaround by the business sector is important because the recent labor market weakness certainly increases one’s concerns about the ability of the household sector to continue leading the expansion, which we discussed earlier.

    As was noted, further declines in employment can make households more cautious about spending. To be sure, the ongoing strength in motor vehicle sales and housing activity indicates that, at least for now, households feel confident enough about job security to take on commitments associated with the big ticket purchases. But I wonder how long this confidence and spending will be maintained if job growth doesn’t resume soon. Still, like the Greenbook, I see the retrenchment of the household sector as more of a risk to the forecast than a factor to build into our baseline assumptions. Importantly, the expansion continues to be supported by the things we’ve talked about—our accommodative monetary policy and productivity gains, which provide the underpinning for profits and real income. And, of course, although the legislative debate has a long way to go, I think it is likely that we will get a boost to aggregate demand from fiscal policy.

    Taking all these factors into consideration, our forecast for 2003 is that real GDP growth will be in the range of 3 to 3½ percent, somewhat lower than in the Greenbook, and that inflation will edge down.

  • Thank you, Mr. Chairman. Not a lot has changed in the New England region. Labor markets remain relatively weak with continuing job losses mostly in Massachusetts. Such losses continue to be most severe in manufacturing, with other industries showing marginal gains and losses. Unemployment did trend down slightly in November, and it remains well below the national level. This recent change, however, apparently was due to a decline in the size of the labor force, which we and other analysts presume was a result of discouragement about job prospects.

    Residential real estate markets continue to hold up surprisingly well, with 2002 seen as likely to have been the strongest year for single-family home sales in recorded Massachusetts state history. Commercial real estate remains moribund, however, with the Boston market particularly affected. Regional consumer confidence fell sharply in December—both current and future expectations were affected—and is now below the level reached in the aftermath of September 11. Business confidence rose a bit, however, and may be one indicator of a glimmer of a hope that there is light at the end of the tunnel. Local manufacturers reported little change in demand over the past few months. Nonetheless, they seemed more confident about the potential for future growth, and some believed that they might be able to beat current expectations. Similarly, a leading indicator index for the region pointed to positive growth over the next six months—not large but enough to suggest that we might be approaching a turning point.

    Meetings of the Bank’s Academic Advisory Council and a group of investment managers that I see regularly echoed similar downbeat messages about the current state of the economy and the markets. Both groups emphasized the many uncertainties both of a geopolitical nature and about the nature of this slow recovery. The academics saw a need to ease policy, even with the fiscal stimulus proposed by the Administration, to deal with what they saw as a widening output gap in the context of declining inflation. The investment managers saw similar weakness and market unease, with dimming prospects for profit growth in 2003, but they thought that further monetary ease would do nothing to increase business investment or decrease uncertainty. In fact, they felt it might increase uncertainty.

    As I look at the national scene, I find myself a bit torn between the perspectives of these two groups. At the last meeting I believed that uncertainty was easing a bit, that credit and equity market conditions had become more hospitable, and that the beginning of some optimism about business spending might be in the works. The incoming data, however, have definitely been on the soft side in my view, with equity markets hitting low points, job losses mounting, and business spending apparently flat. Only the consumer with his seemingly insatiable demand for housing and cars seems to be keeping up his end of the bargain, though confidence readings and the slide in equity markets suggest some concern about future softness in consumer spending as well.

    Our near-term forecast is not unlike the Greenbook’s—almost no growth in Q4 and a pickup to modest rates of growth in the first half of this year. But then we differ, in part because the assumed path of fiscal policy in the Greenbook is more stimulative, taking into account as it does the likely effect of the Administration’s proposals. Even when that is added back in, however, we don’t get quite the bounceback evident in the Greenbook forecast of the second half of 2003 and certainly not as much as in 2004. This reflects, we think, the degree to which reduced uncertainty seems to affect the Greenbook forecast. This reduction occurs in the first half of this year and its positive effects are felt in the second half. Clearly, uncertainty is a major factor in the economic outlook. What will cause that uncertainty to subside, however, is difficult to determine. Will the go/no go decision about war make businesses more confident about the future? Or will the economy’s current soft patch have to show real signs of firming to achieve that end? Or, as Dave Stockton suggested yesterday, are these two sources of uncertainty so intertwined that it’s hard to tell one from the other? I wish I could answer that question, as I think it is critical to assessing the risks in the Greenbook forecast. As you’ve probably inferred from my questions earlier, I do see the risks mostly on the downside. I don’t see a wide error band on the upside.

    That takes me to the quandary posed by the differing perspectives of my Academic Council on one hand and the investment group on the other. The academics were urging pro- active further ease, using logic not unlike that which we discussed yesterday in the interest rate smoothing presentation. Obviously their concerns focus primarily on the slowdown and the need to shore up the economy to face the possibility of other shocks. The investment group saw the uncertainty largely in the context of the war and thought monetary policy really wouldn’t be a useful tool and that easing might even be counterproductive. When I look at the Greenbook forecast—even if one takes it at face value as the most likely outcome—it still projects, as President Parry remarked, considerable slack in the form of unemployment by year-end 2004 and dropping inflation. That might suggest that further easing would be the right direction for policy, to address more clearly the risks that are there. But I find myself attracted to the advantages of inertia, at least for now. Things are uneasy, an unknown amount of fiscal stimulus is in the works, and markets don’t expect the Fed to move. Perhaps we need to be one of the more certain aspects of the situation at this very uncertain time.

  • Thank you, Mr. Chairman. The economy remains suspended between ongoing weakness in the here and now and prospects for future strength, and we’ve seen a bit more evidence supporting each of these sides over the intermeeting period. There’s a long list of factors pointing to a strengthening trend for economic growth over the intermediate to longer run, and a number of these have become more compelling over the intermeeting period. Real interest rates for businesses have declined further—substantially for below-investment-grade businesses—partly reflecting reduced perceptions of risks on the part of lenders. These reduced perceptions were fed by the continued absence of new revelations of corporate wrongdoing and some sense that the credit problems accumulated during the boom period are beginning to top out. Fiscal policy is poised to be more expansionary than previously anticipated and perhaps even more so than in the staff forecast if the unemployment rate edges higher as seems likely. Estimates of underlying productivity growth have been revised up. Rapid increases in productivity should support business and household incomes. The household response to low interest rates and continued growth in incomes has been even greater than expected, supporting ongoing strength in housing and consumer durables spending. The resulting upward revision to private final sales in the fourth quarter leaves a more convincing upward trend in final demand from the first to the second halves of 2002. This should eventually underpin a pickup in investment. The favorable fundamentals of accelerating sales, high cash flow, and a low cost of capital should lead to much stronger investment demand over time. Stocks of inventories and capital have been reduced considerably relative to the putative level of final sales at the economy’s potential, and capital is wearing out rapidly. Replacement cycles have already been stretched out, and unless they are further extended, replacement should begin to show through to spending. This is a trend we can already see in computers. Credit markets seem pretty well convinced that stronger growth is coming. Not only have we seen a decline in risk spreads, but also the yield curve remains unusually steeply upward sloped, as steep as in the past when recessions were about to be over.

    But these positive factors have yet to show through convincingly in the data. Importantly, business investment continues to disappoint, not yet showing signs of a sustained upturn, and largely as a consequence, the economy remains weak. Undoubtedly war jitters and other geopolitical risks are playing a key role in this, but we can’t be sure how big a role. As several people remarked yesterday, “geopolitical risk” is an all-purpose label we’re putting on forecast errors and equation residuals. [Laughter]

    My sense is that the risks to the intermediate-term to longer-term outlook are skewed toward even greater acceleration in output, but these risks are balanced by a skew toward economic underperformance in the near term that could have important consequences for the economy. Most prominently among the longer-term upside risks, business spending could snap back sharply—even more sharply than in the staff forecast—as international uncertainties abate, as financial markets’ skittishness continues to wane with fewer problems of governance and credit, and as the ongoing rise in final sales bolsters confidence about the future. In the current environment, as I already noted, considerably more fiscal stimulus is a distinct possibility and that stimulus might well take effect just as the economy was recovering in any event.

    In terms of the downside risks to the near term, I think genuine geopolitical risks could continue to damp demand to a considerable degree—either because the Iraq situation takes longer to resolve or because situations arise that create new uncertainties in the manner of the Korean and Venezuelan developments of recent months. Or we could find that factors other than geopolitical risks are really restraining demand. This business-investment-led cycle is a new experience for most of us. Recently the Chairman and a visiting economist engaged in a dialogue about the recession of 1846 as a comparable episode, [laughter] but that was a little before my time. Protracted near-term weakness for whatever reason, despite forecasts of strong future growth, could present a difficult challenge for the Committee at a future meeting. Inflation is already low and poised to decline further, perhaps by more than the staff has projected, given the much steeper declines that we’ve seen in recent years in price indexes other than core PCE. That by itself is probably not a problem. It shouldn’t feed back much on demand provided that inflation expectations don’t ratchet down substantially, which would raise the real funds rate and lower asset prices. In the “low NAIRU” simulation in the Greenbook, the expansion continues as projected. But it does leave the economy more exposed to downward shocks in the sense that, with inflation expectations likely to be at least a little lower, the zero bound is a greater constraint on our ability to reduce real interest rates. If that situation threatens, we may need to recall the lesson I was drawing yesterday afternoon—that mistakes of overly aggressive policy are more easily reversed than those of a policy that gets behind the curve. Thank you, Mr. Chairman.

  • Thank you, Mr. Chairman. I’m an avid reader of the “news clips,” and I had seen reports about several of your talks mentioning lights at the end of the tunnel, the economy being well positioned for recovery, and that sort of thing. I was going to add some moderately downbeat comments today. Now that I have actually heard many of your reports, I’m afraid that, instead of being a crotchety outlier, I’m going to be a lemming! [Laughter] Let me proceed anyway.

    The first point to note is that the near-term economic weakness does persist. There are still plenty of positive signs—many of them just cited by Don. But the general property of the forecasting exercise seems to be that the near-term data that can be seen pretty well remain weak while it takes the longer term, not so clearly visible, for the forecasters to become more positive. The Greenbook, for example, made positive changes in the out quarters, but these are based partly on more-aggressive and exogenous assumptions about fiscal policy, partly on the link between higher productivity and spending demands and, I suppose, partly on the belief that business cycles can’t last forever. They can’t, but perhaps we should still pay attention to the data we can see rather clearly and worry more about persisting weakness.

    The financial press seems confident that the cause of all economic weakness now is the possibility of and uncertainties surrounding potential military action against Iraq. Of course, it may be; but we don’t observe this uncertainty directly. What we observe is that investment is slow to turn around, the stock market is weak, the dollar is falling, oil prices are high, consumer confidence is falling, and deficits are rising. We tend to look for a unifying explanation that could explain all of these negative events, and Iraq certainly could do that. But perhaps Iraq doesn’t explain all the sources of weakness, and perhaps the geopolitical uncertainties are now generating further indirect sources of weakness. The key question, as we asked yesterday, is whether everything will turn around once the geopolitical uncertainties are resolved. I, for one, am not so sure that they will.

    On Iraq itself there is little that a mere economist can contribute to knowing how to deal with these uncertainties. But there may be something a football coach can contribute. The coach at the University of Michigan, Bo Schembechler, never passed much. When asked why, he said that when you pass three things can happen, and two of them are bad. [Laughter] If I could adapt Schembechler’s comment to the issue of geopolitical uncertainties, one of the possible outcomes is the potential for further delay. Especially in the last few days, it does not appear that events are speeding up. There are still several forces that could lead to delay. It will be a month or so before we have enough troops in the Middle East. There will be continuing uncertainty about whether weapons inspectors can find the missing weapons, or whether Iraq is or is not in material breach. There’s uncertainty, too, about whether the likely outcomes improve if more allies are brought into the coalition and what it might take to bring these allies into the coalition. Another possible outcome is that the war is prosecuted but does not turn out well. There doesn’t seem to be much doubt that the United States would prevail in a conflict with Iraq, but prevailing in a war such as this could entail many difficult after-effects. There could be serious damage to the oil fields or other unimaginable types of ugliness. The ultimate cost, ramifications, and economic uncertainties of any war, no matter how successful, could be quite serious and could be very much in doubt for a long period of time.

    None of this says that the optimistic talk is wrong, and none of this argues that the economy is not well positioned for recovery. As for policy, there’s probably very little we could do now at this time of maximum uncertainty, and it is not costly to wait a bit for the situation to clarify. But forgive me if I don’t join the optimistic crowd.

  • Thank you, Mr. Chairman. Let me begin with a quick rundown of what has been happening in terms of the readings on the District economy. All in all the reports remain mixed, but I would say that on balance they may be a bit better. A couple of sectors aren’t better. One is agriculture, where the combination of unfavorable weather conditions and lower prices for some commodities probably has worsened the situation, so attitudes among many producers are quite negative at this point. Another sector that isn’t better is tourism. Again, weather seems to be the principal problem there, especially the lack of snow.

    Moving beyond those two sectors, for the most part commercial construction is soft, but retail space in the Twin Cities is quite tight, so there is a substantial amount of new retail construction under way. Labor market conditions appear to have stabilized; the changes in employment and unemployment in recent months have been trivial. And the manufacturing sector appears to be improving. The improvement is small, but we’ve had better anecdotal reports and better readings out of that sector for the last several months now. Consumer spending, as most people have commented, is mixed, depending on the region and depending on the retailer. As the retail space additions in Minneapolis suggest, some people are optimistic in that arena. Of course, optimism certainly pertains to virtually all measures of housing activity— single-family construction, multifamily construction, and sales across the board without regard to price levels. Finally, let me say a word about credit quality. The bankers I’ve spoken with certainly seem comfortable with the credit quality of households but less so with that of businesses today.

    As far as the national situation is concerned, I wrote down numbers very similar to those in the Greenbook. I don’t know if this will make anybody feel better or not, but I went and looked back at last January’s Greenbook to see what the Board staff had forecast for 2002, and they got it just about exactly right. It’s really remarkable. So I hope that between the staff and myself we’re right again, at least as far as 2003 is concerned. I do believe that there are some fundamental reasons that the Greenbook forecast is not a bad one. These reasons aren’t meant to be additive because the phenomena are interrelated. One is the fundamental resilience and flexibility of the U.S. economy, a point that somebody touched on a little earlier. I don’t think we want to lose sight of that. I would add that monetary policy is, of course, accommodative. We are anticipating further fiscal stimulus, and some of that will lead to sustained growth in disposable income. Finally, there’s the favorable productivity outlook. If I ask myself where I might be missing something that would jeopardize that forecast, one area is the state and local government budget situation, for which the consequences may turn out to be more severe than I expect. Another is the labor market. I’m not sure that labor is as stretched as some people seem to think and that employment will pick up rapidly any time soon. So that weakness may be extended. Another possibility is that we may be a little optimistic about productivity. But in the end, I think this is one of those situations in which all of that is probably dwarfed by how the geopolitical developments play out, and I don’t have any special expertise there.

  • Okay. Let’s take a relatively short break

  • [Coffee break]

  • Governor Gramlich and I had a fascinating discussion over coffee about the Revolutionary War. I will spare you that conversation.

    SPEAKER(?) Which revolution?

  • I couldn’t go back to the sixteenth century! [Laughter]

  • The Second District economy has been mixed but generally weaker since the last report. The labor market has softened noticeably. Housing activity has retreated, but manufacturing conditions have improved a bit. Retailers report that holiday season sales were generally sluggish, marked by very steep discounting but decent unit sales. Consumer confidence fell to a cyclical low in December. While unemployment rates in the District were mixed in December, private-sector employment retreated sharply, mainly reflecting reductions in retail holiday staffing.

    Sales of both single-family homes and apartments slowed noticeably in the latter part of the year, but selling prices remained well ahead of a year earlier. In part what I think is going on is that people are unwilling to accept real prices and therefore are slow to sell. That will have to change. New home construction also retreated in October and November but remains at a fairly high level. Office markets in downstate New York were relatively stable in the fourth quarter but office vacancy rates in New Jersey and Connecticut continued to escalate. Manufacturers and purchasing managers report mixed but generally improving conditions in the last few weeks. The state and local governments in the area are considering ways to close sizable budget gaps projected for the upcoming fiscal year, and they are doing it at this stage with varying degrees of realism. I mentioned at the last meeting the possibility of a very crippling transit strike. That fortunately did not take place. Bankers are reporting increased loan demand from commercial borrowers as well as tighter lending standards on that segment of their business. They also note a widespread retreat in consumer delinquency rates.

    On the national picture and the international picture, I am by nature an optimist, and therefore I am very inclined to think that the Greenbook forecast, with which we largely agree, is a quite reasonable one and is likely to take place. But we do have an enormous amount of uncertainty. So the question is, What does the prudent central banker do in an atmosphere of enormous uncertainty? It seems to me that one should think very hard, do nothing, and stay extremely alert. Now, if fortune is kind and the large degree of uncertainty is dissipated, I share the view that when we begin a policy move it is likely that boldness will be appropriate—more along the model of January 3, 2001, than the 1994 example. But that is a decision that we will make appropriately at that time. Thank you.

  • The economy in the Eleventh District has continued its lackluster expansion. If we use employment as our measure, Texas is having a jobless recovery in which output grows while employment slows. As best we can tell, given the lags in regional data, income and output have been growing—assuming our productivity growth mirrors the rest of the nation. Overall, the District economy probably is growing, but there’s not a lot of forward momentum. Businesses and households are in a hunker-down mode. Whether it’s driven primarily by the impending war and other bad news is a matter of conjecture. Nonetheless, the mood is quiet and cautious. Those two words also summarize the tone at the December and January meetings of the Dallas Fed’s board of directors.

    Like the rest of the nation, single-family home construction and sales are doing well, but the market may be getting saturated, and sales of new homes are expected to slow this year. One real estate analyst in the Dallas area, where new homes sales are predicted to decline 6 percent in 2003, commented that while this might sound dismal it would still be the third best year in history. All other categories of construction have been declining, and that is expected to continue throughout this year. One segment that has stopped sliding is the oil and gas sector. In spite of high energy prices, that sector had been shedding jobs for over a year. That seems to have ended. While oil companies do not expect today’s prices to last, drilling budgets have loosened a bit. Natural gas prices are expected to remain above the average of the last few years, and activity in that sector is gaining some momentum. One of my directors has noted the slowdown in the building of new electricity-generating facilities over the last couple of years and anticipates some shortage of gas as the demand for electricity expands in response to a resumption of higher economic growth. Defense contracting is another segment of growth in the Dallas District’s economy. The Dallas–Fort Worth area will benefit from the Defense Department’s decision to continue production of several aircraft and from Poland’s choice to purchase the F-16 instead of one of its European competitors.

    Looking at the national picture, it seems to me that the reductions in the staff’s estimate of fourth-quarter GDP reflect a catching-up of the forecast to the last several Beige Books. One has to worry that, like a bicycle, the economy has to maintain some speed to stay upright and we’re rapidly losing that speed. Having said that, I must confess that our projections for 2003 show no discernible differences from the staff forecast. But my sense of uncertainty and lack of conviction about our projections are as great as they’ve ever been. The risk as I see it—and this is reinforced by the nature and tone of the questions I’ve received from people throughout the District—is primarily on the downside. I’m not alone in this. That’s the view out there, and I think it calls into question the continued credibility of our neutral bias.

  • Thank you, Mr. Chairman. Unlike Ned Gramlich, who used a football metaphor, I’m going to use a boating metaphor. I think the economy is like a high-powered speedboat moving forward; however, we don’t know how far forward the throttle is. There’s a rope over the stern—this is the war anchor—but we don’t know how big that anchor is and to what extent it is holding the boat back. The boat’s speed will change when and if the war anchor is lifted. We don’t know exactly how this is going to play out, but it’s possible to imagine the rope being severed and the speedboat shooting ahead. However, what we observe in the data is the forward speed of the boat. We don’t know to what extent that speed is being held down by that anchor—it might be a really little anchor—or how much of the speed is due to the fundamentals of the economic situation. I do think that, at some point, we’re going to find ourselves scrambling in an environment that could be very different from the current one.

    I think the staff did a spectacular job, by the way, in describing the outlook and presenting a very thought-provoking and cogent exposition of the considerations and the risks. Nonetheless—if I could switch the analogy here a bit—if you’re skiing on a mountain that may experience an avalanche, you may think you’re safe, and in fact you may be safe. But when that mountain starts to rumble and that avalanche comes down, you’re going to have to stop and take stock and try to figure out where you are. We don’t know how the markets are going to respond if and when the bombs start to fall. I can think of a wide range of possibilities there. What seems to me to be most clear is that the situation is extremely fluid and we really don’t know how all this is going to play out. So while I think the staff did a great job of looking at the fundamentals, we actually don’t know how the situation is going to unfold. What will be critical for us is to form a sound policy response which, of course, may be not to do anything until we have some resolution or a greater amount of information on the situation.

    From people I talk with I hear phrases like “flat loan demand” or descriptions of the situation as “spotty” or “mixed.” Those are the types of comments one hears over and over again. I think that’s the tone of the reports around the table today; it’s what all of us are hearing. I talked to my Wal-Mart contact yesterday, and he said that some very peculiar features have emerged in the retail business. One is that consumer behavior is tilting toward chicken away from steak. By that he means that there’s a widespread phenomenon of people buying more goods at lower value price points. We see this also in the reports we get from FedEx and UPS. There’s a substitution of ground for express services, for example, as people look very hard for ways to economize. I think it’s a very generalized phenomenon.

    But strangely enough, at the same time that Wal-Mart notes this movement toward chicken and away from steak—a behavior that is true across almost all lines of their business— consumer electronics, which are viewed as involving highly discretionary types of purchases, are also strong. My Wal-Mart contact says that his firm just doesn’t understand what’s going on there. I was amazed when he told me that Wal-Mart has computerized every single one of its sales tickets for the last nine years. It’s a mind-boggling database. They analyze the data to try to understand what they can about consumer behavior, for example, in terms of the mix of goods people buy. He says this recent pattern is a mystery; they don’t have an explanation for it.

    I’ve been pressing my contacts on their capital expenditure plans. Wal-Mart takes a long view. They have a business strategy with a fairly long time horizon, and they’re not changing that strategy one iota in terms of the investments they make in new stores and warehouse facilities and so forth. I asked my contact at FedEx particularly whether they are expecting to move ahead some of their capital expenditures to beat the expiration of the incentives in—what is it—September or so of 2004. He said that their planned expenditures are essentially flat this year over last year though there are a lot of expenditures they would really like to make. He’s on the edge of springing for $250 million to $300 million of outlays, primarily in the technology area. In particular, they’re studying the prospects for bringing some outlays forward into 2004 that would otherwise have come in 2005. I think that’s something we would want to continue to follow closely to try to understand what these numbers mean as we go through coming quarters.

  • President-presumptive Pianalto.

  • Thank you, Mr. Chairman. I’ll begin my remarks with a report from La Paz, Mexico, where Jerry Jordan is taking possession of his new sailboat. He sent me an e-mail a few days ago saying that he had found a dollar store there—sort of. [Laughter] It is called “Uno Precio,” and everything in the store is priced at 10 pesos. So at just over 10 pesos to the dollar, he notes that it’s a bit more expensive than the dollar store he found in Canada. But the Mexicans who are packing this place still find it a great bargain. Jerry’s final comment to me was “price stability reigns.” I noted in reading the transcript of the December meeting that many of you commented that you’re going to miss Jerry’s anecdotes and vignettes. So I’ll do my best to bring interesting but, more important, entertaining anecdotes from the Fourth District.

    Economic conditions in our District have been moving sideways for the past six months, and this intermeeting period was no different. Manufacturers in the District continue to express their disappointment about the current state of economic affairs more vocally than just about any other group. Automobile manufacturers are doing a bit better than most, but even in that sector there are differences depending on which plant and what model one is looking at. Home sales and new home construction continue strong, as many others have mentioned about their Districts. One director who last week attended a national convention for homebuilders indicated that there was a great deal of optimism in that group. Her company is a supplier to homebuilders and they as well as other suppliers are seeing strong orders. So, that area of the economy continues to be optimistic. Auto sales in our District have continued to be brisk, although they are backing off a bit from the record levels of last year. Consumer spending is flat to down over the past two months compared with a year ago.

    We made a point of asking our advisory council members about the poor state of capital spending. Specifically, we asked them how the geopolitical situation might be affecting their capital spending plans. Although the sample is not really representative of anything, what we heard was interesting. They told us that they don’t put a great deal of weight on the view that terrorist activity or the pending war with Iraq is holding back a lot of capital spending. Businesses are spending. But they’re spending on higher health care costs, increased insurance premiums, and the higher costs of maintaining their old plant and equipment. So if this view has any merit, the easing of geopolitical tensions may not lead to the immediate surge in capital spending that some analysts are predicting.

    Regarding the national outlook, my view is consistent with the Greenbook; the economy does appear capable of continued growth. However, using Larry Slifman’s term from this morning, I am “somewhat skeptical” about the timing of the snapback in business fixed investment, which many forecasters believe is necessary to propel the economy by the summer back to the higher growth trend. Given the reported figures on excess capacity in the economy, it may be that capital services can expand without a substantial snapback in investment expenditure, at least in the short run. My guess is that it depends on whether the excess capacity represents past investments that are simply not likely to become productive in the short run— those that were highly speculative in the high-tech industry—or whether the excess capacity represents a more traditional weakness in demand. At least some of the individuals I have spoken with in the Fourth District suggest that it is the weakness in demand. They have the capacity to meet increased demand but seem to be saying that they’re not going to be in a hurry to invest in new capital equipment when business picks up again. I know that would break from the historical patterns we’ve seen, so maybe this attitude will prove to be just pessimism and not reality.

    I believe that we’re seeing in our region the same phenomena many of you have mentioned in the labor markets. Firms are looking at ways to produce more with their existing workforce. I agree with Sandy’s comment this morning that the relatively tepid employment growth we’re seeing is mirroring the pattern of the 1990-91 recovery more closely than other postwar recoveries. If that pattern continues, we may face a second year of very little employment growth while GDP again is growing. Thank you, Mr. Chairman.

  • Thank you, Mr. Chairman. One of the things I’ve observed in various committees I’ve been on and in other decisionmaking situations is the difficulty of knowing what you know and knowing what you don’t know. This meeting strikes me as one of those cases where understanding that difference is key. Just to review what we know, it is primarily what has happened in the recent past and, as many of you already described, the data have been quite mixed. What we don’t know is whether or not that recent past is a precursor to a further slowing going forward or indeed, as is consistent with the Greenbook forecast, a precursor to some growth. It strikes me that the risk of renewed slowing is not sufficient at this stage to warrant any action by the Committee today. To put it another way, although the dichotomy between the recent past and the forecast for the future is quite palpable, at this time I would place some reasonable odds on something along the lines of the baseline forecast as being generally correct.

    There are a number of reasons for that judgment. One is that monetary policy continues to be, I think, reasonably accommodative. I believe fiscal stimulus is in the pipeline or soon will be. Inventories–sales ratios are quite low. We see some anecdotal evidence to suggest that demand for replacement investment is emanating from various businesses and may actually show through. That’s the fundamental sense of what we know from the recent past. What we don’t know is what the future is going to look like. But in that regard I’d say that the staff forecast is not unreasonable. Obviously, the other thing we don’t know is the impact of the geopolitical uncertainties. I think the effort the staff has made in the work put forward by Sandy Struckmeyer is very useful and quite instructive. But we really are confronting a great deal of uncertainty there.

    So, given the configuration of monetary and fiscal policy, financial conditions that have changed, leading and lagging indicators, and other issues, the key question is what we should do today. Ned Gramlich quoted a football coach; I’m going to quote the cartoon character, Dilbert, who says that 85 percent of the time doing nothing is the right response. I will leave it at that.

  • I’d like to add two points to the discussion. One is based on having talked with a number of bankers—in this case, representatives of some of the largest lenders of the thrift industry—who reaffirm what we have learned from other sources about the residential mortgage market. Their figures on applications and closings track the Mortgage Bankers Association data, which is to say that they, too, are strong. I’d also mention a couple of variations on the asset quality issue. The lenders tended to support what we’ve heard around the room that the asset quality of the consumer portfolios is strong. But my contacts were quick to say that they have adjusted their lending standards. One said that they have raised the minimum FICO score for borrowers about 5 percent, which I think is significant. The other noted that they have developed a more-sophisticated internal scoring model—it’s FICO-based—and they attribute a great deal of the current strong quality of their portfolio to having changed their standards. That can be done very quickly on the consumer side.

    On the residential mortgage side, the largest lender that I talked to indicated that in very recent months they have seen a noticeable uptick in their nonperforming first-mortgage residential real estate loans. They attribute that to the long lag between a downturn in the economy and the effect on home mortgage loans. People will sacrifice a great deal before they let their individual residences go into foreclosure or become a loan that is in a nonaccrual status. One of the lenders also maintains a segment of his loan portfolio in commercial real estate based loans, and those typically are to franchises. He said that the performance of that portion of the portfolio is strong, with the notable exception of convenience stores. He attributes that to the impact of the increase in oil prices both on the cost side—they’re not able to pass on their increased costs—and on the demand side because there is some downturn in demand. So, that was the notable exception to high credit quality across the board.

    Moving to the broad subject of fiscal policy, as you probably noticed, this week the Congress had to pass another continuing resolution, either the third or fourth such resolution. We still don’t quite have a budget. The Senate produced an omnibus budget bill, but it will take probably until the end of next year before it is reconciled with the House! As for the tax bill, two pressures are threatening the tax bill as it stands now. The first, and perhaps the most obvious, is the concern about the dividend exclusion. That is getting a lot of attention, and much of it is focused on the anecdotal examples of the effect on the richest people in the country. But the other pressure, which I think will be very persistent and will have a real impact on the debate, comes from the status of the state economies. A number of you have talked about the budget difficulties faced by state governments. I think there are as many as twenty new governors who currently are meeting with state legislatures and are dealing with very serious budget issues. From the federal government side, among the issues that they’re dealing with are the mandated but unfunded costs related to homeland security. If a dividend exclusion is added to that, for states that use federal government taxable income as the basis for the calculation of state income, that means a reduction in income that is taxable. But the dividend exclusion, if enacted, will become law after the state legislatures will have met for the most part. It may well take a special session of the state legislatures to address the issue. So the two effects on the states are both negative at perhaps the most critical time in their fiscal situations in many, many years. The anticipation, therefore, is that the pressures on the Congress from the states will build.

    How will this play out? I think in one of three ways. One, we could get a bill very similar to what we have now if it is perceived that it is indeed stimulative to the extent that we’ve described it. Another is that we could get a scaled-down version of the bill that includes only the most obviously stimulative features. That’s not impossible. You may remember that a year ago the Congress did in fact adopt the top two priorities identified by our own economists as the two priorities they’d like to see enacted, and they were indeed passed in a single bill. The other possibility is that the Congress could move away from the stimulus issue and simply passing some bill will become the goal, in which case we might see a combination of some reduction in the dividend exclusion and direct grants to the states. In terms of the economic impact of a bill like that, I think all bets are off. We’ve seen that kind of thing recently; that essentially is what happened with the ag bill last year, as you may recall. The bipartisan goal ultimately became producing a bill, the economic consequences notwithstanding. For those reasons I would say that the segment of the forecast that presumes an economic stimulus package is not certain, and I think it bears watching very closely

  • Thank you, Mr. Chairman. I continue to believe that structurally the U.S. economy is reasonably healthy, both financially and in real terms. So why is the economy struggling? A few stories have circulated. In my view, the various analyses we’ve been hearing comparing the United States economy to the post-bubble Japanese economy are overwrought to say the least. There’s little evidence of important remaining capital overhang except in a few sectors. Moreover, as I’ve said before, I don’t think it’s meaningful to talk about a generalized capital overhang. To my mind “generalized capital overhang” is just another name for insufficient aggregate demand or low general capital utilization. In any case, the main post- bubble problems in Japan were financial, and there is certainly no comparable set of problems here. As my earlier question suggested, another possible explanation for the slow recovery is that there’s a lull in the technological opportunity for growth, a real business cycle. This also seems somewhat implausible to me, but we’ll have to wait and see. If that is the case, then there’s not much that monetary policy can do about it.

    At this juncture the leading hypothesis must still be the geopolitical uncertainty and its damping effects on hiring and investment decisions. I feel some déjà vu here. My PhD thesis twenty-five years ago considered the problem of a firm contemplating an irreversible physical investment in the face of uncertainty. As it happened, the example I used in my paper was uncertainty about the long-term price of oil. I showed in my dissertation that the firm’s optimal hurdle rate for investment not only increases with the degree of uncertainty, as might be expected, but also was higher the nearer the expected resolution of the uncertainty. Intuitively, uncertainty that is expected to be resolved relatively soon is a strong incentive to delay commitment.

    Currently the geopolitical situation is not only one of high uncertainty but also one in which the uncertainty may be resolved at least partially in a matter of weeks or a few months. The damping forces of uncertainty on the economy are therefore currently at their maximum level. A reasonably likely scenario, one that we all hope for, is that the geopolitical situation will be speedily and favorably resolved and that a significant economic recovery will therefore follow. Frankly, therefore, I don’t think there is much we can do about this now. We’re just going to have to wait and see what happens.

    There is, of course, also the possibility that the economy will continue to move sideways into the spring either because the geopolitical uncertainties drag on or because the new investment and hiring that we’re expecting now simply are not forthcoming, perhaps because of continuing business pessimism. Given the ongoing slack in utilization of labor and capital and our projection that core PCE inflation may slip to 1 percent or lower, I would hope that in such a circumstance we would be prepared to ease aggressively earlier rather than later on the grounds that the risk of inaction at that point would be greater than the risk of action. Thank you.

  • Thank you, Mr. Chairman. Since our last meeting there has been very little change in economic activity in the Third District. The recovery continues at a slow pace. While the fourth quarter ended on a weak note, this wasn’t a surprise. Data suggest that consumers in the region pulled back on spending on nondurables, and that story is consistent with the points that were made by President Broaddus. Most of our retail contacts, including two national chains and one large regional department store chain, reported that holiday sales generally did not meet expectations. The one exception was auto sales, which showed a strong pickup at the end of December, fueled by incentives.

    Manufacturing activity in the District paused from August to October but has shown some improvement since then. Our business outlook survey’s general activity index has been positive in the last three months, and the index for new orders has increased steadily since August. Still, signs of a pickup in business investment are mostly in terms of expectations. In the manufacturing sector, low capacity utilization is restraining capital expenditures. According to a special question in our January survey, which seemed to have been developed expressly for our new president, almost half of our respondents indicated that they were operating at below 70 percent of capacity. We asked our respondents how much of an increase in production would be necessary for them to increase capital expenditures; nearly three-fourths indicated that they would need an increase in production of at least 15 percent before they would respond by increasing plant and equipment spending.

    Labor markets in the District, particularly in manufacturing, remain weak. Manufacturing jobs are still declining on a monthly basis, although the pace of losses has abated somewhat. According to another special survey question, it will take less output growth for firms to begin hiring workers again than to start investing in plant and equipment. This suggests that respondents are beginning to be stretched in terms of productivity gains expected from the current workforce. Still, 70 percent of the respondents said they would not add employees unless output in their firms increased more than 10 percent, and they didn’t expect to be hiring in any sizable number until later this year. Nonmanufacturing firms in the District are more optimistic. Nearly two-thirds of the respondents to our South Jersey survey, which includes retailers, service-sector firms, and manufacturers, plan to increase employment this year, and half of those plan to do so in the first quarter.

    Continued weakness is having a detrimental effect on state budgets, as nearly everyone has mentioned. So far in fiscal year 2003, revenues are falling 1 to 2 percent below projections in each of our three states. Pennsylvania and New Jersey have already exhausted the surpluses they accumulated over the decade of the 1990s and will be less able to mitigate the negative effects of economic weakness going forward. I’d summarize by saying that the situation is little changed from last year. The fourth quarter was weak but was expected to be weak. The recovery continues at a languid pace.

    My view of the national economy is similar. The recovery continues at a sluggish pace. There are few tangible signs of an imminent pickup in investment spending, capacity utilization remains at a low level, and factory orders remain weak once month-to-month swings are smoothed out. Employment and manufacturing are also weak. On the positive side, the housing market remains healthy, and consumer spending has held up.

    The Philadelphia staff forecast is similar to the Greenbook forecast in that they both expect the economic recovery to gain momentum in 2003, with faster growth in the second half than in the first. They also both acknowledge that there are significant risks to the forecast, especially regarding the timing and duration of a war in Iraq. Our work suggests somewhat weaker growth over the next two years, partly because our forecast incorporates a smaller impact from the fiscal stimulus and partly because of differing assumptions about rate movements in 2004. Both forecasts expect growth in consumer spending to continue at a moderate pace, buoyed by reasonable underlying growth of real incomes and the expected tax cuts. We are less optimistic about business fixed investment than the Greenbook. Philadelphia’s analysis suggests that low capacity utilization will have a stronger drag on business fixed investment this year. This view is supported by the business outlook survey results I just discussed. While the Greenbook sees double-digit growth in business investment by the end of the year, we don’t see it picking up such strength until the second quarter of next year. The Board staff is also more optimistic about residential investment. We believe the single-family housing sector will remain strong but won’t be the driver of growth because we expect refinancings and cashouts to slow. In both forecasts, businesses don’t begin to add to their payrolls until later this year. Again, the Greenbook is somewhat more optimistic than our staff. This time I hope that the Board staff is correct and we are not.

    I think it’s important to restate what others have said: There are significant risks. This time the risks are on the upside and the downside. The largest downside risk is geopolitical, and I’ll spend no more time on that. But there are also upside risks. The most obvious is dissipation of the geopolitical uncertainty, as has already been mentioned. In addition, there may be significantly more stimulus in the tax package. Frankly, I’m not convinced of that for some of the reasons that Governor Olson indicated. That is in fact a very uncertain event. On balance, I see little reason to change our policy stance at this meeting. I do have some concern, though, that when the fourth-quarter GDP numbers are released and activity is shown to be relatively weak, the public reaction may not be all that favorable. Perhaps we should be prepared to address this in our statement or at least be cognizant of it when those numbers come out. Thank you.

  • The factors underlying the momentum in the economy continue to be split, as we’ve been saying around the table. Households continue to show optimism, and businesses continue to find ways not to expand. Consumers bought cars for Christmas and housing starts reached sixteen-year highs. Mortgage refinancings supplied additional cash flow for spending and to help pay down consumer debt, which declined for the first time in years. Core consumer price inflation is running well below 2 percent, and people are shopping for bargains. While jobs are declining, personal income continues to grow at a modest pace. Yet business activity continues to show signs of weakness: Industrial production has fallen in four of the last five months; employment and production hours worked are below August levels; and inventories have fallen in the last couple of months after expanding in the summer and early fall. There are also long-term structural problems that are becoming more prominent given the slow expansion that we’re going though—namely that several key industries in this economy are struggling with excess capacity. As we look at companies’ announcements of restructuring plans, we know that the weakness in these sectors is going to continue for quite a long time into the future.

    The concerns about imminent war and the unknown repercussions, such as terrorism, are affecting financial markets, and those concerns provide another excuse for businesses not to expand. On the other side, as others have mentioned, we know there are potential tax reductions. But even if the Congress acts, that probably won’t happen for several months, and the impact won’t be felt until late in the year. The staff forecast is for very modest expansion in final sales even with the expected stimulus from tax reforms. That leaves the output gap very wide. We know when the economy is soft that it’s more vulnerable to outside shocks. Because of that I think we need to be more vigilant in the coming weeks regarding what the uncertainties about war could do to the economy so that we will be able and willing to respond appropriately as events transpire.

  • Thank you, Mr. Chairman. I’ll be referring to the materials that are being handed out. One of the more difficult aspects of putting together the materials supporting your policy discussion was reconciling the divergent movements of key financial asset prices over the intermeeting period. The first exhibit reviews those tensions, not because I’m fishing for sympathy but because it bears on today’s deliberations. The financial developments I am most confident in explaining are plotted in the top portion of the exhibit. As evidenced by the most recent path of the expected federal funds rate inferred from futures quotes (the black line), market participants do not expect a policy change to be announced this afternoon. Mixed economic data, a pall cast by gloomy corporate earnings guidance, and concerns about a conflict with Iraq led investors to push back the anticipated start of policy firming until year-end. Surveys suggest that, as noted in the middle row in the table at the right, market participants are mostly of the view that you will assess the risks to your goals as still balanced. The sense that policy will be on hold for longer than previously expected pulled Treasury yields lower, with most of the decline, as shown in the middle left panel, attributable to lower forward rates at the front end of the yield curve. In addition to a downward revision to the near-term outlook associated with worries about global tensions, Treasury yields may have benefited from flight- to-quality demands, in that other indicators of skittishness, such as gold and oil prices, rose as well (the middle portion of the chart). Such relative shifts might help to explain why major equity indexes, at the far right, shed 3 to 5 percent over the intermeeting period, with those losses mounting in recent days.

    The chief puzzle is that corporate bond risk spreads have narrowed considerably, particularly for the riskiest credits (the black line in the bottom left panel). Even so, as President Minehan noted yesterday, a longer perspective shows that spreads remain on the high side of the experience of the past dozen years. Moreover, to an important extent compositional effects matter, shown in the inset by the fact that excluding the telecom and energy sectors spreads have narrowed by far less. This increase in the relative price of risky debt instruments, even as investors otherwise moved to safety and liquidity, may be evidence that an unusual and overdone pessimism about default and recovery rates on corporate debt, inflamed by revelations of corporate wrongdoing, is in the process of unwinding. Associated improvements in the liquidity of the markets where those securities trade have probably also whetted investors’ risk appetites.

    With markets more receptive to corporate debt, firms should be able to fund new capital projects—when they shake their reluctance to spend. That hesitancy appears to be due to elevated worries about the world situation, but implicit in the configuration of market prices must be the average expectation that these tensions will abate starting sometime soon. If not, it is hard to understand why futures market quotes have oil prices moving lower and the Committee beginning to tighten, albeit not by much, by year-end. This is one of the observations made in the box in the Bluebook on geopolitical tensions and monetary policy. Namely, your outlook, to the extent that it anticipates some reversion nearer to normalcy in interest rate spreads, oil prices, and business hiring and spending decisions, implicitly must incorporate at a least a partial unwinding of global tensions. Moreover, you’ve adjusted policy already to offset at least some of the restraint imposed on spending by those tensions in the interim—by lowering the federal funds rate to 1¼ percent.

    I’d like to repeat two more observations from the Bluebook but recast them in light of yesterday’s discussion. For one, restraint on spending, as households and businesses view deferring purchases as a more attractive option at a time of elevated volatility, would seem to be an adverse additive shock to aggregate demand. All of our modeling efforts thus far advise that you should take your best guess as to the net restraining effect on aggregate demand of such influences and try to offset them. For another, though, some aspects of geopolitical tensions would seem—by making investors more skittish and potentially complicating market dynamics—to make the consequences for financial prices of your actions more unpredictable. If so, this multiplier uncertainty would suggest that you should scale back the size of any desired action in light of the wide range of potential outcomes.

    Committee members might be less optimistic than is implicit in markets about the timing and the extent to which restraints on spending associated with geopolitical tensions will lift. That would provide a reason to doubt the staff projection that the economy will transit from about-unchanged real GDP last quarter to growth above that of potential by the second half of this year. Such a position might incline you to ease policy at this meeting. To be sure, it would come as a complete surprise to market participants, but that very surprise would imply a more forceful transmission of that policy impetus to the financial markets. The case for easing does not solely rely on doubting the staff forecast.

    The policymaker perfect foresight simulations—shown on your next page, which duplicates chart 4 from the Bluebook—take the staff assessment of the economy completely on board, including both the structure of the FRB/US model and projections of the forces impinging on the economy in the extended Greenbook baseline. As President Parry already noted, the simulations suggest that there is some scope to work down unused resources a bit faster in the near term by easing policy, with virtually no risk to the attainment of what you may view to be a reasonable inflation goal. Indeed, even a long-run target for core PCE inflation of 1 percent would allow some scope for modest additional policy stimulus according to the simulation. You might find that argument particularly persuasive if you saw inflation of 1 percent at the low end of the range that you’d consider a working definition of price stability.

    As the Committee devoted a considerable portion of yesterday discussing policy gradualism, it is worth noting some of the limitations involved in this optimal planning exercise, beyond the obvious one that FRB/US is only a rough approximation of reality. In particular, in this simulation the reaction of economic agents to your policy action is estimated from history—that is, the exercise uses the version of the model with expectations following a vector autoregression. While the funds rate is assumed to be as smooth as observed in the past, it is also varied more aggressively in response to perceived resource slack than observed in the past. This systematic difference between the way that investors mechanically anticipate how you will conduct policy and how you actually do it may give a false impression of the extent to which policy easing influences the economy—a point President Santomero raised yesterday. The bottom line is that, among other problems with this exercise, you might not get as tidy a financial market response as in the figure. Speaking outside the model, this raises the issue of how market participants will react should they read the action and the accompanying words as an implicit acknowledgment on your part that economic prospects are darker than previously thought.

    Even given a strong desire to make more inroads in reducing resource slack, you might not think it is within your ability to do much about the unemployment rate edging up to 6¼ percent in the near term, given the lags in monetary policy and the uncertainty attendant to how markets would react. Indeed, the staff has revised up considerably its projection of economic growth in the second half of 2003 and all of 2004, the window in which your action today would mostly be felt. Moreover, the Committee might believe sufficient monetary stimulus is in the pipeline to push growth even beyond that pace as the forces currently impairing business confidence abate and additional fiscal stimulus kicks in. You might be influenced in that judgment by the fact—as shown in your next exhibit, which repeats chart 3 from the Bluebook—that the real federal funds rate has run considerably below its equilibrium value over the past year.

    The outlook in the Greenbook and in the central tendency of your own projections retains the contrast that has marked the previous few meetings. Decidedly subpar economic performance is seen as giving way to a robust expansion in just a few quarters. This suggests two ways of assessing the balance of risks surrounding your current policy setting. First, are you satisfied with the temporal dimension of the economic outcomes that your policy is projected to help foster? That is, does your distaste of the slow performance in the near term about balance your concern that the expansion may pick up too much steam later this year and next? This is the balance that Governor Kohn was weighing in his remarks. Second, within the period of time when you think the bulk of any action today would be felt, does the risk of some further slippage in inflation—perhaps into an undesirable region—about match the chance of growth running significantly faster than that of potential output?

    As I’ve noted, market participants mostly believe that you will assess the risks to your dual objectives to be about balanced, probably because they believe you are answering the second question and balancing potential outcomes at some point in the foreseeable future. For most forecasts, economic performance at that later date looks a little more robust than seen previously, which would support retaining the assessment that the risks are balanced. The minority of participants who are calling for a switch back to risks unbalanced toward economic weakness probably think that you’re answering the first question and comparing economic performance in the near term with that in the longer term. They see the “soft spot” as a little softer and the rebound to above-trend growth as a bit further removed in time. If the path were graded solely by the measure of resource slack, you might judge that they had a case. Even though the staff has revised up its projection of the future growth of aggregate demand, slack persists at a higher level for a while because aggregate supply also has been revised up. Inclining you against changing the risk assessment, however, would be a concern that the announcement of that shift would impair confidence and make the outcomes you fear a little more likely.

  • Questions for Vincent? If not, let me see if I can review what has been said around this table.

    I think there is a general consensus that the evolution of geopolitical risks, the rise in oil prices, and the increased probability and nearer time frame of a war in Iraq have essentially masked what the underlying structure of the economy is doing. We know a number of facts, notably that the business community has been holding down its expenditures to a very substantial extent. That is, capital appropriations are at levels that seem to reflect only those perceived as necessary to carry on essential activities. Most interesting is the behavior of inventories. Limiting inventory stocks has generally been the case across the board, and indeed the consensus of purchasing managers as expressed in their recent report is that inventories are getting to levels that are subnormal. We often see contractions in inventories when they generally are viewed as excessive irrespective of their levels. This is one of those rare cases in which inventories are perceived to be very low but are being held down to a considerable extent.

    All this raises the interesting issue as to what will happen if and presumably when the geopolitical risks are removed. Will we be looking at a bounceback as this particular risk is removed, or will we be shocked to find that the sluggishness is still there? I don’t know any way to judge analytically the relative probability of those two potential outcomes. We can guess. We may say that history suggests such and such, but we really can’t assess with confidence the probability of the two events.

    In a way it probably doesn’t matter insofar as monetary policy is concerned. The reason it doesn’t matter is that, unless I misread the military tea leaves, we’re going to get a resolution of this Iraqi issue reasonably quickly. If we look at the pattern of the logistical moves of our military forces, it’s evident they’re all focused on a near-term military campaign. In this regard one can look at the movement of our aircraft carriers; the relatively delayed deployment of personnel, which can be accelerated as needed; and the recently begun movement of heavy equipment, which requires a relatively protracted period to be transported from the United States and other U.S military equipment depots around the world. All are indicative of our positioning for a substantial U.S military presence in the Persian Gulf area.

    This is a very large and a very expensive operation. The military cannot realistically undertake these preparations and then sit tight, especially with summer beginning to emerge on the desert. There is also the fear that the potential for chemical and biological warfare is by no means negligible. It would be a rather sad event if this “smoking gun” were to materialize in the midst of battle. The difficulty that the UN inspectors are having and indeed our own intelligence is having is that Iraq has 180,000 square miles of territory, the size of California, and the Iraqis have had four years in which to bury or otherwise hide such materials. The most recent hypothesis is that they have put all of these materials on trucks that can be moved around indistinguishably so that the inspectors cannot find them.

    Over the past ten years it’s pretty evident that the Iraqi military has not been able to regain the stature it had before the Gulf War, whereas the technology that the United States military has obtained over the past decade is close to awesome. We are going to find that both the relative number and the capabilities of the so-called smart bombs that were used in the Persian Gulf War have been dramatically increased so that the vast proportion will now be guided missiles with accuracies far greater than those available in the Gulf War. So what we can envisage is a fairly quick resolution of the military phase of this confrontation, with a probability of somewhere between, say, .9 and .95. The problem is that the .05 to .10 residual is really scary. The reason that markets are behaving as they are is that, if a residual with a very small probability has a very large outcome associated with it, the discounted risk is a very major issue. It’s not that the Iraqi military has somehow been strengthened and can give us fairly significant opposition in battle. They can’t. The problem basically is that the Iraqis have relatively high- tech chemical and biological warfare capability, and they are likely to spring it on us, perhaps even in advance of our attack. The one big uncertainty here is that they may force us to move a lot faster than we are planning, largely because we cannot anticipate what Saddam might do under these conditions.

    Even if the initial situation is wholly in our court, it’s not likely—in contrast to what happened during the Gulf War—that the air war by itself will turn the probabilities around. There is no question that we will prevail in the air war. We can do huge damage. The question is whether chemical and biological agents will be used in this war. We probably will not know that until after the ground war begins and is well under way. So the impact on our economy may well differ from that related to the Gulf War—when the probabilities of success became very evident shortly after the air war began, with the result that risk premiums in financial markets came down sharply from their highs and the price of oil plummeted. Everything effectively was in place for a strengthening economy, with consumer confidence popping—as I recall, some 22 points in the Conference Board numbers. It was quite an extraordinary swing. That is not likely to happen with an air war under present circumstances or at least not anywhere near the extent to which it happened in the past unless it becomes acutely evident that our military superiority has been greatly underestimated. But until we have contained Saddam and his operatives on the ground in a manner that eliminates the risks of chemical or other types of mass destruction warfare, we are not apt to get any significant reduction of the uncertainty.

    Then there is the risk of secondary reactions in the form of potential uprisings in the Middle East or just further concerns about terrorist actions in the United States. Accordingly, I would not anticipate a jump in confidence. It will take a while, though perhaps not a great deal of time, for us to know whether there is a coiled spring under this economy ready to take off once the geopolitical risks have been contained or whether in fact there is no spring at all. In my judgment we should have enough in the way of an answer to that question by the time of our next meeting on March 18. There are a lot of things that can go differently. Saddam could go off to a South Sea island with some of his loot, but even that might not be the ideal solution because we’re not quite sure what’s left of the Baath party. There could also be concerns about reduced supplies of oil.

    The bottom line to all of this is that the military uncertainty is so overwhelming with respect to the question of potential monetary policy actions that the less we do, even in how we phrase our post-meeting statement, the better off we are. The problem, as the Vice Chair of the Board said, is that we do not know what will happen, and like him I think that it’s important for us to hedge our judgment at this stage. Those of you who are arguing for potentially aggressive action are in a way saying that something is currently suppressing a vigorous economic expansion or that the hope for such an expansion will turn out to be false when the war is over. It is conceivable that we may want to take more than just a modest incremental monetary policy action in the near-term future, but it’s not clear in which direction, and that does create some degree of inhibition.

    I would propose that we stay where we are and retain a balanced risks statement. Strangely, the one problem none of us has really discussed, which is not irrelevant and is not related to the possible war, is the Venezuelan oil problem. Our country does not have enough crude oil capacity. If we lose access to both Iraqi and Venezuelan oil, we will almost surely have to tap into the strategic petroleum reserves. It’s not that crude oil inventories are inadequate worldwide, but they are very badly distributed. The huge oil distribution structure that moves oil from Venezuela through Curaçao and through the Caribbean into the United States has essentially been shut down. Venezuelan production has come back a little from a low point of 200,000 to 300,000 barrels a day to well above one million barrels, but that is still substantially below normal output, and it is not clear how long the recent level of production is going to last. Moreover, that could create a shortage because, even if there’s a military action in Iraq that is very effective and short, there is a probability of damage to the Iraqi oil fields. The resulting loss of production could be very readily handled if Venezuela were fully productive. However, even if the Venezuelan crisis gets resolved fairly quickly, the shutdowns have been quite damaging, and it’s going to take a while to get that production system back to full operation.

    By March 18 we should have an answer to the major question of whether the economy is buoyant or not. I’m not sure that the Venezuelan crisis will be completely resolved by then, and I’m not sure what the state of production of Iraqi crude will be because some disruption is inevitably going to occur in the event of an invasion. We may well have an inordinately high oil price, which would be a restrictive force, even though the forward market might be somewhat benign. So we will not have an altogether clear picture by March 18, but it is very likely that the major questions confronting us will be resolved at that point. So my recommendation is essentially that we stay with a 1¼ percent federal funds rate and leave the risks balanced as they are. Vice Chair.

  • Mr. Chairman, I think in an atmosphere of enormous uncertainty it’s the easiest call in the world to agree with your recommendation, which I support fully.

  • I also support your recommendation.

  • Yes, I support your recommendation.

  • I support your recommendation, Mr. Chairman.

  • I support your recommendation, Mr. Chairman.

  • I support your recommendation, Mr. Chairman.

  • I support your recommendation.

  • I support your recommendation.

  • I support it as well.

  • I support your recommendation.

  • I support your recommendation.

  • I support both parts of your recommendation, Mr. Chairman.

  • I support both, Mr. Chairman.

  • I support it as well.

  • Anybody left? Well, let me put it the other way around. If we were to call a vote, would anybody object? Okay, let’s go with it.

  • The draft language is in the Bluebook. The page is not numbered, but I guess if it were, it would be page 14: “The Federal Open Market seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 1¼ percent.” For the balance of risk sentence for the press release: “Against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the Committee believes that the risks are balanced with respect to prospects for both goals in the foreseeable future.”

  • Chairman Greenspan Yes
    Vice Chairman McDonough Yes
    Governor Bernanke Yes
    Governor Bies Yes
    President Broaddus Yes
    Governor Ferguson Yes
    Governor Gramlich Yes
    President Guynn Yes
    Governor Kohn Yes
    President Moskow Yes
    Governor Olson Yes
    President Parry Yes

  • The press statement that we scribbled out is perhaps slightly more optimistic than was the tone of the Committee’s discussion, but it fits pretty well the forecasts that the individual Bank presidents and Board members have submitted. I think what we’re confronted with is what we were discussing yesterday. There is a sense of risk aversion here. That is, if we have a risk neutral evaluation in this type of environment, we tend to be more concerned about the downside. Anyway, take a look at the draft of the press statement. I think we’ve got it as close as we can get. My preference would have been to issue no statement, but we can’t retreat from our practice.

  • Not issuing a statement would attract a lot of attention.

  • A lot more attention than the statement would.

  • As a bear, let me say that this middle paragraph is vague enough that it’s fine.

  • Any questions? If not, we will go with it. I forgot to mention earlier that for those of you who’d like to change your forecasts, please give the revised forecasts to Dave Stockton by the close of business this Friday. The meeting is adjourned. We will reconvene on March 18, if not before.