Thank you, Mr. Chairman. As can be seen in the top panel of your first exhibit, market participants marked up their expectations of policy action at this and subsequent FOMC meetings, on net, over the intermeeting period. Apparently, the upward impetus of stronger-than-anticipated releases on inflation and statements by Federal Reserve officials more than offset the drag of readings on economic activity that had a soft cast. The expected path for the federal funds rate over the next two years, the middle left panel, had shifted 25 to 35 basis points by the time of the publication of the Bluebook. In the week since, those expectations edged higher still, with investors sure of a ¼ point hike today and expecting more of the same by autumn. As has been true for a while, the funds rate is apparently seen by investors as trailing off subsequently—with your last ¼ point rise rolling off in 2007.
Three explanations have been offered for this inversion of the money market futures curve, as noted in the middle right panel. The first, which is probably more popular inside this building than outside it, is that it may well be optimal to raise the nominal funds rate in response to a temporary bulge in inflation so as to keep the real interest rate from falling. As inflation recedes, the nominal funds rate can be reduced so as to prevent the real funds rate from rising. Such a path has been a common feature of the Bluebook exercises we’ve shown you when the Committee is assumed to desire an inflation goal below the prevailing rate of inflation.
The second explanation is based on an assumed nonlinearity in the housing market. Housing demand, some analysts claim, has been importantly buoyed by outsized expectations of capital gains, expectations that for a time have been impervious to the level of the policy rate. In such a circumstance, the FOMC has to tighten to the point that it gets the attention of those investors. But when it does get their attention and housing demand softens suddenly, the Committee will have to change gears quickly.
The third explanation relates to a hardy perennial in FOMC transcripts. Over the years, many of you or your former colleagues have said that your last action in any phase of a policy cycle is always a mistake. And you can’t look at the current configuration of futures rates without wondering whether it is happening again. The Committee might, however, be willing to accept tilted odds of over-tightening if that were judged to be the least unattractive alternative. That is, a funds rate a little higher than that consistent with full resource utilization for a time may be seen as the necessary cost of countering inflation that has risen above your comfort zone. Note also that the extent to which markets view you as rolling back some portion of your anticipated 50 basis points of additional firming will lessen the consequences of that near-term policy path for the prices of longer-lived assets and, presumably, aggregate demand.
As can be seen in the second column of the table at the bottom left, the upward revision to near-term policy expectations flattened the yield curve somewhat, with rates on two-year Treasury notes rising 30 basis points compared with the 13 basis point gain in their ten-year counterparts. As the bars at the right show, the rise in nominal rates was more than accounted for by an increase in their real components, especially at short maturities, and inflation compensation edged lower.
This rise in real rates, along with the decline in equity values shown in the bottom two rows of the table, implies that financial market conditions tightened over the intermeeting period. As shown in the top panel of exhibit 2, such a tightening, against the backdrop of weakish data on spending, might incline you to keep the funds rate unchanged at 5 percent today. Such concerns would be particularly acute if you interpreted the anecdotes and survey measures of participants in the housing market (as in the middle left panel, for instance) as suggesting a more pronounced housing slump than embedded in the staff forecast.
But you might see some reason to pause now even if you bought into the basic contours of the Greenbook outlook. Estimated policy rules explaining the Committee’s behavior over the past eighteen years that are fed outcomes for inflation and the output gap as in the staff forecast (plotted as the dashed lines in the middle right panel) predict that you will be lowering the policy rate. Similarly, the simulations shown in the Bluebook and repeated in the remaining panel suggest that, with a 2 percent inflation goal and specific assumptions about your preferences, you’d also be satisfied with a funds rate no higher than 5 percent. In that scenario, however, you’d be willing to accept core PCE inflation (the bottom right figure) running at 2⅜ percent for almost one year. Market participants, in part learning from your public comments, evidently view you as unwilling to accept such an outcome. And if your own assessment of the economy has evolved in the same direction as that of the staff, then your near-term policy choices have probably gotten more unpalatable.
As can be seen in the top panel of exhibit 3, the Greenbook outlook for unemployment (at the left) and for core PCE inflation (at the right) has worsened over the course of this year. We tried in the Bluebook to summarize the net consequence of the changes over the past six months in the forces shaping the economy using the FRB/US model. In those simulations, repeated in the middle panel, the policy that best accomplishes the assumed objectives and the resulting macroeconomic outcomes given by the current outlook (the solid lines) are compared with those implied by the extended outlook at the time of the January Bluebook (the dashed lines). In each of these simulations, policymakers are assumed to have a long-run inflation goal of 1½ percent and to place equal weights on the three stabilization objectives: output, inflation, and policy stability. The current outlook implies a funds rate path that peaks a bit above 5½ percent in mid-2007 and then declines gradually to about 4½ percent by 2010, noticeably above the rate call in January.
Another aspect of the changed outlook, this time seen from the perspective of financial markets, is the rise in far-ahead inflation compensation, the red-dotted line in the bottom panel, over the past year. True, you may be heartened that inflation compensation has moved lower since the outbreak of jitters in late April and that, as noted in the inset box, changes in policy expectations prompted by official statements appear to have been associated with a decline in far-ahead inflation compensation. But concerns about investors’ confidence in your commitment to price stability, witnessed by the positive correlation of data surprises and inflation compensation over the same period, are probably at the root of a decision to tighten at least 25 basis points today and signal that more may come, the subject of exhibit 4.
As can be seen in the top panel, a ¼ point move today would position the real funds rate more assuredly above the center of staff estimates of its neutral level. And putting some weight on the simulations presented in the Bluebook, if your inflation goal is 1½ percent, as in the middle panel, you may see the need to move the nominal funds rate up from 5 percent sometime soon. Indeed, if you put a particularly high priority of the attainment of that goal—as in the dashed lines—even more tightening is in store.
As shown in the bottom panel, the prevailing market sentiment is toward a ¼ point firming today, which has been a compelling, but not conclusive, argument for action in the past. The key question for each of you is, What probability do you place on another ¼ point firming in August? The solid line in the bottom left figure plots the implied probability currently in financial markets of tightening at both the June and the August FOMC meetings. When drafting the statement, we thought an 80 percent market probability of such a dual action was on the high side of what you would prefer. So, in table 1, which is updated as your last exhibit, we put a few markers to rein in expectations of action in August. Note that the rationale paragraph asserts that growth is moderating and repeats reasons that inflation might be held in check. More important, the assessment of risk is also couched in terms of your goals rather than just the policy instrument. My bet is that, with the release of the statement, the odds would go to 50-50 on action in August, but you should probably view that as no more informative than the flip of a coin.