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

  • Good afternoon, everybody. Today is the last meeting for our friend and colleague, Bill Poole. Bill has been here for 81 meetings, 80 as a Reserve Bank president and one as an adviser to the Federal Reserve Bank of Boston. I thought I would read to you the transcript from March 31, 1998, when Bill first joined the table.

    “Chairman Greenspan. I especially want to welcome back an old colleague, Bill Poole. I didn’t realize the last time he sat in this room was 25 years ago.

    Mr. Poole. I was sitting back there along the wall.

    Chairman Greenspan. It has taken you 25 years to move from there to here? [Laughter]

    Mr. Poole. Baby steps.” [Laughter] We’ll have a chance to honor Bill at our farewell luncheon on March 18, at our next meeting, but let’s take this opportunity to thank you for 10 years of service and collegiality.

  • Thanks, Mr. Chairman. I came here 10 years ago with a boom. I’m going out with a pause. [Laughter]

  • We’ll let Bill have the last word on that. [Laughter] Okay. Today is the first regular meeting of the year. This is our organizational meeting, so we have some housekeeping things. Item one, nomination of the Chairman. Governor Kohn.

  • It’s an honor and a privilege to nominate Ben Bernanke to be the Chairman of this Committee.

  • Thank you. Second?

    SEVERAL. Second.

  • A pregnant pause.

  • Other nominations? Without objection, thank you very much. We need a nomination for Vice Chairman.

  • I can do that, too. It’s another honor and a privilege to nominate Tim Geithner to be the Vice Chairman of this Committee.

  • Other nominations? Without objection. Thank you. Ms. Danker will read the nominated staff officers for the Committee.

  • Secretary and Economist, Brian Madigan; Deputy Secretary, Deborah Danker; Assistant Secretaries, David Skidmore and Michelle Smith; General Counsel, Scott Alvarez; Deputy General Counsel, Thomas Baxter; Assistant General Counsel, Richard Ashton; Economists, Nathan Sheets and David Stockton; Associate Economists from the Board, Thomas Connors, William English, Steven Kamin, Lawrence Slifman, and David Wilcox; Associate Economists from the Banks, Loretta Mester, Arthur Rolnick, Harvey Rosenblum, Mark Sniderman, and Joseph Tracy.

  • Any questions? We’ll need a vote. All in favor? [Chorus of ayes] Opposed? [No response] Thank you.

    Item two on the agenda: There are some cosmetic changes to the Committee rules. Scott Alvarez and Debbie Danker circulated a memorandum. Are there any questions? If not, I’ll need a vote in favor. [Chorus of ayes] Opposed? [No response] Thank you.

    Item three: We need to select a Federal Reserve Bank to execute transactions for the System Open Market Account. I have been informed that New York is again willing to serve. [Laughter] All in favor? [Chorus of ayes] Opposed? [No response] Thank you.

    We need to select a manager for the System Open Market Account. Bill Dudley is the incumbent. Are there other nominations? Well, if not, in favor? [Chorus of ayes] Opposed? [No response] Thank you. All right.

    We turn now to annual authorizations for Desk operations. Bill circulated a memo that had one revision to the authorization for foreign currency operations. Are there any questions about that change? If not, all in favor? [Chorus of ayes] Opposed? [No response] Thank you. There are no changes proposed for the authorization for domestic open market operations, the foreign currency directive, or the procedural instructions with respect to foreign currency operations. All in favor? [Chorus of ayes] Opposed? [No response] Thank you.

    All right. We turn now to the business of the meeting. Let me call on Bill Dudley to give us the Desk report.

  • Thank you, Mr. Chairman. I’ll be referring to the handout that you should have in front of you. Over the past month, term funding pressures for banks have generally subsided. But the bigger story remains the continued pressure on bank balance sheets, the tightening of credit availability, and the impact of this tightening on the outlook for economic activity. The travails of the monoline financial guarantors—some of which have already been downgraded by one or more of the rating agencies—have exacerbated the worries about the potential for further bank writedowns and have created risks that some financial instruments that rely on monoline guarantees might no longer be viable. At this juncture, whether the major monoline guarantors will receive the new capital needed to keep or restore their AAA ratings remains uncertain.

    I’ll start today by noting that U.S. and global equity and fixed-income markets have behaved in a way consistent with a darker economic outlook. As shown in exhibit 1, the major U.S. indexes have fallen sharply since the December 11 FOMC meeting. These declines in the stock markets have been mostly matched abroad, as shown in exhibit 2. At the same time, corporate credit spreads have risen in tandem with the equity markets’ decline. As shown in exhibit 3, high-yield corporate bond spreads are up more than 100 basis points since the December FOMC meeting, pulling the interest rates on high-yield debt significantly higher. Investment-grade spreads have also widened. But for investment-grade debt, the decline in Treasury yields has been larger than the rise in spreads, lowering somewhat the absolute level of yields. Global credit default swap spreads have also increased sharply, as shown in exhibit 4. Market price risk has increased. This is most visible in the rise of most market measures of implied volatility. For example, the VIX, which measures implied volatility on the S&P 500 index, recently climbed back to the peak level reached in August (exhibit 5) and the MOVE index, which measures volatility in the Treasury coupon market, has climbed to its highest level since 1998.

    The problems of the financial guarantors have been an important part of the story. In recent years, the major financial guarantors have diversified into insuring structured-finance products, including collateralized debt obligations (CDOs). Currently, their exposure to all structured-finance products is about $780 billion. Exhibit 6 shows the distribution of exposure across three buckets: U.S. public finance, U.S. ABS and structured finance, and the total non-U.S. exposure for the six major monoline guarantors. Because the structured-finance guarantees have typically been issued against the highest rated tranches at the very top of the capital structure, until recently the rating agencies did not think that these guarantees would result in meaningful losses. However, as the housing outlook has continued to deteriorate and the rating agencies have increased their loss estimates on subprime and other types of residential mortgage loan products, the risk of significant losses has increased sharply. This is particularly the case with respect to these firms’ collateralized debt obligation exposures—a portion of their total structured-finance exposure. As I discussed in an earlier briefing, given the highly nonlinear payoffs built into these products, modest changes in the loss assumptions on the underlying collateral can lead to a sharp rise in expected losses on super senior AAA-rated collateralized debt obligations. Unfortunately, the CDO exposures of several of these financial guarantors are quite large relative to their claims-paying resources. As shown in exhibit 7, statutory capital for even the biggest firm is less than $7 billion; the total capital for the entire group is slightly more than $20 billion; and total claims-paying resources for this group from all sources is about $50 billion. Exhibit 8 compares these claims-paying resources with the subset of CDO exposures that contain some subprime mortgage-related collateral. For four of the six major guarantors, these CDO exposures represent more than 200 percent of their total claims-paying resources. These exposures and the uncertainty about how these exposures will actually translate into losses are the proximate cause for the collapse in the financial guarantor share prices and the widening in their credit default swap spreads. This is why new sources of capital have been either prohibitively expensive or dilutive or both to existing shareholders.

    As I noted in last week’s briefing, credit rating downgrades of the financial guarantors would likely lead to significant mark-to-market losses for those financial institutions that had purchased protection. For example, in its fourth-quarter earnings release, Merrill Lynch wrote down by $3.1 billion its valuation related to its hedges with the financial guarantors; $2.6 billion of this reflected writedowns related to super senior ABS CDO exposures. Unfortunately, there is not much transparency as to the counterparty exposures of the guarantors on a firm-by-firm, asset-class-by-asset-class, or security-by-security basis. However, major broker-dealers have considerable non- ABS CDO exposures to the financial guarantors. For example, they are thought to have hedged an even larger amount of the super senior tranches of synthetic corporate CDOs with the financial guarantors. This suggests the potential for significant additional mark-to-market losses for commercial and investment bank counterparties should the financial guarantor credit ratings get further downgraded. In addition, such downgrades would increase market anxiety about counterparty risk because there would be considerable uncertainty about the magnitude and incidence of the prospective losses such downgrades might trigger. Financial institutions are also exposed to the monoline guarantors via the wraps these guarantors have issued on certain money market securities, including auction rate securities, tender option bonds, and variable rate demand notes. The amount of these securities outstanding is significant. The total market size for these three types of securities is estimated to be about $900 billion. The major risk here is that the loss of the AAA-rated guarantee from the financial guarantor could undercut the demand for these securities. In the case of tender option bonds and variable rate demand notes, this could trigger the liquidity backstops provided by major commercial banks and dealers, leading to further demands on their balance sheets.

    In the case of the auction rate securities market, the dealers would be faced with a difficult Hobson’s choice. They could either allow the auction to fail or take the securities onto their books to prevent a failed auction. In the case of a failed auction, the investor receives a higher interest rate but has to wait until the next auction to try to redeem the securities. If failed auctions were to persist, as would be likely, then the securities would essentially become long-term rather than short-term obligations. Failed auctions would undoubtedly distress clients that had purchased the securities on the assumption that they would be liquid and could be redeemed easily. Failed auctions would also likely lead to broader distress in the associated municipal and student loan securities markets. We have already experienced a number of failed auctions for auction rate securities. Moreover, the recent downgrades of Ambac and FSA have led to significant market differentiation among tender option bonds and some upward pressure on municipal bonds wrapped by weaker monoline financial guarantors. If the monoline guarantors are unable to find additional equity or other forms of support, these pressures are likely to intensify in coming weeks.

    The travails of the financial guarantors have added to the pressure on major commercial and investment banks. As shown in exhibits 9 and 10, commercial and investment bank equity prices and credit default swap spreads have generally continued to widen. The cumulative writedowns reported for a selected group of large banks has now reached $100 billion over the past two quarters (exhibit 11). Coupled with balance sheet growth and other factors, such as acquisitions, these writedowns have put significant downward pressure on bank capital ratios. For example, although all of the top five U.S. commercial banks can still be characterized as “well capitalized,” there has been significant erosion of their capital ratios over the past two quarters (exhibit 12). This balance sheet pressure helps to explain why commercial bank counterparties continue to complain about their access to credit, the tightening in lending standards, and the wider spreads for assets such as jumbo residential mortgages, commercial mortgages, and leveraged loans that can no longer be readily securitized and distributed into the capital markets.

    Shifting now to what market participants expect from us from this meeting: Monetary policy expectations continue to shift in the direction of more cuts that are delivered more quickly. As shown in exhibit 13, the federal funds rate futures market currently implies that market participants now expect additional rate cuts totaling about 100 basis points by midyear. Further out, as shown in exhibit 14, the Eurodollar futures curves indicate that about another 25 basis points is anticipated during the second half of the year. But these expectations are volatile and have been shifting considerably day to day. The primary dealer survey tells a similar story. The modal forecast of the primary dealers shows a federal funds rate trough slightly below 2.5 percent (exhibit 15). Compared with the previous dealers’ survey conducted for the December FOMC meeting (exhibit 16), the trough has moved down about 75 basis points. As of last Friday, seventeen of the twenty primary dealers expected a 50 basis point rate cut at this meeting. This sentiment appears to be generally shared by market participants. As shown in exhibit 17, as of last Friday, options on federal funds rate futures implied a rate cut at today’s meeting, with the highest probability on a 50 basis point rate cut to 3 percent. However, it is important to recognize that the probabilities shown in exhibit 17 put a zero weight on the notion of another intermeeting cut in February—so they should not be taken literally as to the outcome at today’s meeting. The distribution of yields on Eurodollar futures 300 days ahead suggests that there has been a regime shift since the December FOMC meeting. As shown in exhibit 18, not only have expectations shifted down sharply, but the skew has reversed direction. The mode of the distribution is at 1.75 percent, and the skew of the distribution around that mode is toward less extreme rate outcomes. This could be viewed as market participants now pricing in considerable risk of a severe recession but maintaining some hope that a milder downturn might occur or that a recession could possibly be averted altogether.

    As shown in exhibit 19, the intermeeting rate cut was accompanied by a rise in inflation compensation at the five-year to ten-year time horizon. However, it is unclear that this represents a genuine deterioration in inflation expectations for several reasons. First, the rise occurred, in part, because breakeven inflation at the five-year horizon has fallen as nominal five-year Treasury yields have dropped sharply. It is this decline that has lifted the five-year, five-year-forward measure. I would agree with the memo by Board staff that was distributed to the FOMC yesterday on this issue: The rise in five-year, five-year-forward inflation compensation likely reflects a greater liquidity premium for nominal Treasuries. The rise in interest rate volatility is also a factor. According to TIPS traders, the rise in five-year, five-year-forward inflation reflects technical factors such as a temporary increase in the demand for shorter-dated Treasuries, month-end index extension flows, and a greater liquidity premium for nominal, on-the-run Treasuries. The general rise in interest rate volatility is probably also a factor. Second, the rise in five-year, five-year-forward expectations has not been accompanied by a broad set of other signals consistent with deteriorating long-term inflation expectations. For example, the four- to five-year-forward breakeven inflation measure shows a much smaller rise, the dollar has been relatively stable, and estimates of bond term risk premiums remain low. On the other side, gold prices have increased sharply in the past week. Third, in our primary dealers’ survey, there was very little change in long- term inflation expectations. Finally, it is worth noting that following the 50 basis point rate cut in September, which was more aggressive than expected, the five-year, five-year-forward rate also rose, but the rise proved temporary.

    I would also like to briefly discuss the state of play in bank term funding markets—some good news. As shown in exhibit 20, the spreads between the one- month LIBOR and the one-month OIS rate and the three-month LIBOR and the three- month OIS rate have fallen sharply since year-end. However, over the past week, there has been considerable volatility in these spreads. This could be due to a variety of factors—including a temporary increase in the demand by Societé Générale for term funds and the sharp shift in expectations about the near-term federal funds rate path. Currently, these spreads are close to the narrowest we have seen since the market turmoil began last August. Although the passage of year-end was the predominant factor behind the decline in term funding spreads, the term auction facility (TAF) also appears to have been helpful. Exhibit 21 shows the results for the first three U.S. auctions. Completing the exhibit, the results for the fourth auction, which was conducted yesterday, were minimum bid rate, 3.10 percent; stop-out rate, 3.12 percent; propositions, $37.5 billion; bid-to-cover ratio, 1.25; and number of bidders, 52. In general, the pattern is one of declining bid-to-cover ratios and a declining spread between the stop-out rate and the overnight index swap rate. The results for the ECB and Swiss National Bank auctions show a similar pattern. At the latest auction, the ECB had $12.4 billion of bids, a bid-to-cover ratio of 1.24, and their number of bidders fell to 19 from 22 at the previous auction. The Board of Governors has said that on February 1 it will announce plans for the TAF in February. The staff has recommended to the Chairman that the auctions continue on a biweekly basis, that the size be maintained at $30 billion per auction, and that the minimum bid size be cut to $5 million from $10 million to make it easier for smaller institutions to participate.

    Finally, there was no foreign currency intervention activity during this period. I request a vote to ratify the operations conducted by the System Open Market Account since the December 11 FOMC meeting. Of course, as always, I am happy to take any questions.

  • Thank you, Bill. Are there questions? President Poole.

  • Bill, could you talk about the role of foreign banking organizations? What fraction roughly are they responsible for?

  • We have been very cautious about talking about the role of the foreign banks, but they’re definitely a significant factor. The best way to look at it is just to look at the New York District, which is taking an overwhelming share of not all but most of these auctions, and most of that is foreign. Regarding the participation in terms of number of bidders, the split is more even between domestic and foreign; in terms of the actual takedown of dollars, it does skew a bit to the foreign side, but it has been variable. It is not the same in each auction.

  • If I may make a comment about that—I think everyone is aware of my view that the TAF does not change the marginal conditions. It’s entirely an inframarginal operation. What it does is to save banks the spread between what their cost of funds otherwise would be and what they get at the TAF. So it increases bank earnings by that amount. It seems to me that there is potentially some reputational risk to the Federal Reserve in the long run if a significant share of the benefit is going to foreign banking organizations. I guess one question that I would pose is, If we think that this information would be terribly sensitive to release, shouldn’t we be careful about whether we continue if the foreign banking organizations are taking a very large fraction?

  • Yes, I have a couple of questions. I want to start with the issue about foreign banks, though. Why are we sensitive about talking about foreign banks—I mean, is this a public stance, or is this in the Committee? The information about the identity of the winning bidders was sent to every Reserve Bank.

  • I don’t think we’re particularly sensitive, but I think other central banks would be very sensitive.

  • Well, these are confidential proceedings—this is a consequential policy matter.

  • Mr. Chairman, if I could. I think, President Lacker, just one point is that the detailed information on the bidders was sent only to those Reserve Bank presidents and Board members who specifically asked for it, so it was not distributed unilaterally.

  • Just the winning bidders?

  • Yes. Well, the spreadsheet of bidders.

  • I thought that every Bank, all the discount officers, received the identity of the winning bidders, and the other information about all the bids went only to those who requested it.

  • That is correct, yes. The second point I would make is that I do not think there is particular sensitivity about foreign banks but instead sensitivity about taking any chance of identifying who the bidders are at all because of the great concern about avoiding stigma from the TAF.

  • I wanted to ask a couple of questions about the term auction facility. First, I’d like to hear more from you about what your understanding is of the effects the term auction facility had on the funding market. The first question under that would be, To your knowledge, were these completely sterilized or just partially sterilized? Another question would be, For the recipients, were these additional funds that they wouldn’t have otherwise borrowed, or did they displace some other borrowing? The next question would be, This crowded out something, and if it didn’t change materially the total amount of reserves in the system, some lending ought to be shifted from the recipients to someone else—so what do we know about other spillover effects in the markets? The focus of our attention probably for data reasons was the LIBOR market, but there was also discussion in December of the term fed funds market. What do we know about the behavior of that since then? I’d be interested in your sense of whether bidders were riskier than nonbidders and whether riskier institutions bid more than nonrisky institutions. We’ve done a bit of empirical analysis—it’s preliminary—but I’d be interested in your folks’ sense of that. About the foreign institutions, I’m interested in learning about what the advantage was of our lending dollar balances via this mechanism to foreign banks versus the alternative of having them borrow dollar balances from their central bank, perhaps funded by a swap or out of the foreign central bank’s own dollar balances. Finally—and this is sort of the most important question—how should we evaluate whether this has been a success or not? To what sort of objective evidence should we look to decide whether we achieved our objectives? Related to that, can a case be made for ending this facility soon in light of the fact that the LIBOR–OIS spread is now half of what it was in September, when we decided that it had come down enough to shelve the plan?

  • Those are a lot of questions. [Laughter] Okay, I’ll take the easy one first. The TAF is completely sterilized. For every dollar that goes into the TAF we drain reserves, and we’ve been doing that mainly by redeeming maturing Treasury bills. Regarding whether these are additional funds to those entities, it is hard to know what they would have done if the TAF facilities hadn’t been available. This may have funded some assets on their balance sheets that they otherwise would have decided not to fund. I think it is very difficult to know what that counterfactual is. It is hard to believe that in the system as a whole it led to a lot of additional funding. I would be surprised by that, especially given that we did sterilize reserves and didn’t allow expansion of the balance sheet. In terms of the issue of crowding out, the way I think about the TAF is changing the composition of our balance sheet and changing the composition of the banking system’s balance sheet. It’s not crowding out. We are basically supplying Treasury securities by redeeming bills, and then the Treasury issues more bills that the markets want, and we are essentially absorbing collateral from the marketplace that’s hard for them to finance elsewhere. So it is a change in the composition of the balance sheet. That’s how I would think of the way it works.

    In terms of how we should evaluate the success, we don’t know how much was the year- end. We don’t know how much was monetary policy easing. But market participants view the TAF as very positive. I think that, if we were to discontinue it abruptly, they would be unhappy. There’s no evidence to suggest that the TAF has caused any great harm. It looks as though the benefits, to my mind, are likely to significantly exceed the costs even though we can’t measure those benefits very accurately. Regarding the foreign institutions issue—the choice between dollar balances from us versus dollar balances from foreign central banks—I think it was a little more complicated than that because, if I remember how we got to the foreign exchange swaps, they were essentially more or less conditional on our doing the TAF. They were willing to do the swaps if they could get the auctions in tandem with our term auction facilities. So my judgment would be that we probably didn’t really have a choice of getting the dollars to those foreign banks through the ECB if we hadn’t done the term auction facility.

  • If I could just follow up.

  • Well, on the last point, that’s a matter of the ECB’s willingness to lend to those institutions. You’re saying that they would be willing to lend themselves to those institutions only if we did this. It’s not about the economics of their borrowing from their central bank versus borrowing from us—nothing about the market functioning.

  • I wouldn’t say it’s about their willingness to lend to their institutions. It’s their sense of what their responsibility is in terms of providing dollar liquidity to their institutions. To the extent that they could just passively take the dollars and funnel them through this auction process in which their auction was very passive—their auction was essentially a noncompetitive auction that was based off ours—they were willing to do that. They were less willing to do something in which they were taking responsibility for the problem and saying that they were going to get the dollars and supply them to those banks.

  • Do market participants view foreign banking organizations as broadly riskier than comparable-sized institutions based in the United States?

  • Well, it’s difficult to say. If you look at credit default swaps, that would say not. But as President Rosengren and I were talking before the meeting, those credit default swaps may also contain different appetites to recapitalize banks when they get in trouble in the United States versus abroad. So the one thing that we can probably say with confidence for the period is that there’s more anxiety that things are hidden in certain foreign banks that are probably not as likely to be hidden in U.S. banks. There’s better disclosure in the United States on a faster and more real-time basis. The market sense is that there isn’t really the same kind of quarterly disclosure process abroad that happens for U.S. institutions.

  • May I add one factual comment to that?

  • During the height of the dislocations in December, the fed funds rate overnight was regularly trading substantially higher early in the morning—this happened also in August for a while—either early in the U.S. trading session or before that. Our understanding from market participants was that the reason for those higher rates in the morning was excess demand from European-based institutions to borrow in the funds market, and when the U.S. institutions became more active later in the day, the funds rate would then go back down to the target.

  • Thanks. Going back to the LIBOR–OIS spread—that was what motivated this. It has fallen a lot. The bid-to-cover ratio is falling. If we try to lend $30 billion three more times, we could get to a point at which we satiate the market in term funds.

  • Well, first of all, continuing that $30 billion is not supplying any additional dollars, so we’re just going to be rolling over maturing auctions.

  • Yes, but the bid-to-cover ratio keeps falling.

  • Right. But, second, I would caution you that this last auction was right before an FOMC meeting and that may have diminished the appetite. We don’t know with certainty, but our supposition is that the demand would have been higher if the auction had been a week later, if that’s how the schedule had fallen. Third, February might be fine, but March is a quarter-end. Lastly, the fact is that, while the term funding pressures seem to be better, a lot of other things seem to be worse, and clearly the pressure on bank balance sheets has not diminished at all. If anything, it has grown more intense. So to remove this prematurely would be a risk, especially when market participants view this as helpful and it gives them a sense of confidence that the Fed is there.

  • The questions that President Lacker asked covered one of the questions I wanted to ask. But as we go down in terms of the number of bidders as we proceed, is the portion that is foreign increasing, relatively speaking? Do we know?

  • I don’t remember any strong sense of that.

  • It’s decreasing.

  • What has happened, as the auction has proceeded, is that people have bid more tightly around where they think it’s going to come, except for a few institutions who just say, “I want the money,” and they bid at very high rates because it’s a single price auction. You usually see some behavior like that.

  • Foreign banks were $19 billion out of $20 billion at the first auction; $18 billion out of $20 billion at the second auction; and a declining fraction thereafter, President Fisher.

  • Thank you, President Lacker.

  • Bill, in your remarks, you devoted quite a bit of time to the deteriorating situation in the monolines, the implication being that the risks they may have affect the whole system. In the normal course, do we have direct contact with them to get any insight beyond what we get through analysts and rating agencies? I think you said that they are not terribly transparent in terms of asset class and individual securities as to what they really hold. Have we had any direct dialogue just to inform ourselves as to what the real situation is?

  • I haven’t had much contact with them. I don’t know if Tim has.

  • We have not been in touch with them directly to get a sense about their risk profile and so forth. We have had extensive conversations with the New York State Insurance Commissioner, who is the lead supervisor of many of them, but not all of them. It turns out that office also has very little information, particularly on the stuff that is on the leading edge of concern, which is to whom they sold credit protection and on what. But it is in the process of trying to remedy that, and we have been giving them a little help in trying to figure out what they need to ask for.

  • Another thing that is not very well known is what their assets consist of. We have rating buckets, but we don’t know what those ratings actually apply to. We don’t know who they have reinsurance with. Some people think that they’re reinsuring each other to an extent or they have reinsurance with subsidiaries that they own so that the insurance is not at arm’s length. So there’s quite a bit of cloudiness about what their true condition is.

  • We have better information on the protection that banks purchased from the monolines—by monoline and by underlying asset—and it is important, of course, to have that.

  • Yes. I would just note with the TAF experience, going back just for a minute, that the Boston financial community has been overwhelmingly supportive. I don’t know whether you have gotten the same sense when you talk to the financial community in New York, but whether people were bidding or not, they actually thought that it was quite a fruitful exercise. In terms of the credit default swaps, just looking at some of the institutions that were involved, it seemed as if the U.S. institutions, if you look at individual organizations, may have had much higher credit default swap rates than many of the foreign institutions. As you noted, many of the foreign institutions were substantially lower than at least a couple of the U.S. ones that were involved, and we obviously thought the U.S. ones were sound, or we wouldn’t have been willing to have them participate. We should look at the LIBOR rate, but I think we should also look at the Treasury securities market because you don’t have to do as much in open market operations if you’re doing some of it in the TAF, and we’ve had the interest rate on Treasury securities quite low. So I’m wondering whether, when we think about the analysis, we look not only at things like LIBOR but also at the functioning of the Treasury market, and whether that was actually helped out by this process. I don’t know if you’ve done any work on that, but it would be of interest to know if that had helped with the better functioning of the Treasury market.

  • Well, I think the presumption is very much that it went in the right direction in terms of the Treasury market because basically the Treasury has auctioned off larger weekly one-month, three-month, and six-month bills to replace those that we were redeeming. So the floating public supply of bills went up.

  • Very quickly, we should not be surprised that banks like the TAF. It increases the bank’s profits because of the difference between the funding costs. The issue is whether the TAF improves the way the markets are functioning, not whether it’s feeding profits into the banks and whether they happen to like it.

  • I think it’s clear in Bill’s presentation that there’s a very strong case that the TAF, the associated measures by other central banks, and, as important, the commitment and the signal that we would continue the TAF longer than was necessary have been very important to the improvement of market functioning and very important to the improvement and confidence in liquidity and markets going forward. It is very hard to know how important it has been to that, but I think it has absolutely been very important, and I think it is very important for us to continue it until we can comfortably say it is no longer necessary in this context. I think we are far from the point that we can claim that. It was 24 basis points in October, President Lacker, and there are a lot of reasons that we should be expecting to be living with a long period of fragility in markets going forward. We all debated the merits of this going forward. There’s a set of good, principled objections to this kind of stuff, and I didn’t expect that those objections would change on the basis of the experience with this thing, and I don’t think we’ve learned anything new about the merits of those objections, except that there’s a very good basis of evidence for suggesting it has been important to the improvement in confidence and market functioning. One of our jobs is—and I think we’ve been pretty successful in doing it—trying to give some confidence to people that we as the central bank have provided a quality of liquidity insurance more powerful than we can through our classic instruments. I think it has been very successful in this context. To take it back prematurely would be damaging to the improvements we’ve achieved.

  • Are there any other questions for Bill? If not, I need a vote to ratify domestic operations.

  • I move that we ratify the operations.

  • Objections? Without objection. Thank you. We turn now to the economic situation. We begin with Dave Reifschneider, whenever you’re ready.

  • Give me one second. On balance, the news we have received since the December Greenbook has been disappointing. The top panel of your first exhibit sorts some of the main indicators into two categories—those that were surprisingly weak and those that came in to the upside of our expectations. As you can see, the list to the left is long. Private payrolls fell in December, and the unemployment rate jumped to 5 percent. Manufacturing output has declined since the summer. Single-family housing starts, new permits, and home sales have fallen further. New orders and shipments of capital goods were disappointing, although a little less so after today’s release of December data. Business sentiment deteriorated, joining already unusually low readings on consumer confidence. Finally, stock prices have tumbled, and credit conditions have tightened. Not all the news was bad. Nonresidential construction activity has continued to be surprisingly robust, and defense spending looks to have been higher last quarter than we anticipated. Moreover, retail sales in November came in stronger than we predicted, and the figures for September and October were revised up. Overall, we read the incoming data as implying an increased risk of recession. The middle left panel provides some evidence for this assessment. As was discussed at yesterday’s Board briefing, based on the signal provided by 85 nonfinancial indicators (the black line), the estimated probability of being in recession now or over the next six months stood at 45 percent in December, up from 19 percent in June. A similar exercise carried out using 20 financial indicators, the red line, yields an even bigger jump in the estimated likelihood of recession, from 14 percent at midyear to 63 percent this month.

    As you know, we are not forecasting a recession. While the model estimates of the probability of recession have moved up, they are not uniform in their assessment that a recession is at hand. Another argument against forecasting recession is that, with the notable exception of housing, we see few signs of a significant inventory overhang. In addition, the recent weakness in the labor market and spending indicators is still limited; for example, initial claims have drifted down in recent weeks rather than surging as they typically do in a major downturn. Finally, a good deal of monetary and fiscal stimulus is now in process that should help support real activity. That said, it was a close call for us. Even without a recession, our assessment of the underlying strength of aggregate demand has revised down markedly since the summer. This is illustrated in the bottom panel by the recent decline in the Greenbook-consistent estimate of short-run r*, the value of the real funds rate that would close the output gap in 12 quarters. By our estimate, short-run r* has fallen more than 2 percentage points since the middle of last year and 1¼ percentage points since December. A jump in the equity premium accounts for most of the downward revision since the last Greenbook, although a further deterioration in the outlook for residential investment is also a factor.

    Your next exhibit summarizes the current forecast. So, how did we respond to all this bad news? As shown in the panel at the top, we boosted real GDP growth a little from 2007 through 2009. In 2008 and 2009, however, this faster growth is not demand driven but instead reflects upward revisions to the supply side of our forecast that I will discuss in a moment. For 2007, the upward revision to real GDP in the fourth quarter—noted in the panel to the right—reflects the stronger data on nonresidential construction, defense spending, and retail sales that I just mentioned. However, because the incoming data point to a weaker trajectory for real activity in the near term, we have trimmed our forecast of GDP growth for the first half of 2008, and we have marked down final sales growth (not shown) quite a bit. Beyond the middle of the year, we project real output to expand at a rate close to its potential. Under these conditions, we project greater labor market slack than in December, with the unemployment rate—shown in the middle left panel—now expected to edge up to 5¼ percent by next year. And as shown in the bottom two panels, we continue to expect both core and total PCE prices to decelerate noticeably by 2009, although inflation this year is likely to run a little higher than we previously projected.

    Your next exhibit provides an overview of some of the key factors influencing the outlook. As shown in the upper left panel, we conditioned our forecast on an additional 50 basis point cut in the funds rate at this meeting and then held it flat at 3 percent. We made this revision in response to the weaker underlying level of demand in this projection but with an eye to keeping inflation on a long-run path to 1¾ percent—the midpoint of the range of 2010 inflation projections that you provided in October. Another key element in the outlook is our assumption that concerns over financial stability and a possible recession will begin to abate once the economy gets through a rough patch in the first half of this year. As Nellie will discuss in more detail, this assumption implies that risk premiums on bonds and corporate equity should drift down over time. As a result, we project that equity prices, shown to the right, will stage a partial recovery over the second half of 2008 and in 2009. These and other financial market developments, coupled with an improvement in business and consumer sentiment, should help to support consumption and investment over time.

    As regards fiscal policy, odds now seem high for the passage of a fiscal stimulus package, although the details are still up in the air. As a placeholder, we built a $125 billion package into the baseline, with two components—$75 billion in tax rebates that households will receive in the third quarter and a 30 percent one-year bonus depreciation allowance that should cost the Treasury about $50 billion in 2008. Our judgment is that the rebate component will provide a significant, albeit temporary, boost to the level of consumer spending during the second half of this year and in early 2009, the period over which we expect most households to spend their checks. In contrast, we think that bonus depreciation will have only a small effect on equipment and software outlays. As indicated by the blue bars in the panel to the right, these assumptions imply a large fiscal-driven contribution from PCE and E&S to real GDP growth in the second half of this year, followed by a similar-sized negative contribution in the first half of 2009. As a result, the long-run contribution to real GDP growth from these two factors is essentially zero. We have assumed that inventories and imports in the short run will offset a substantial fraction of the swings in domestic demand, thereby muting the overall effect of the fiscal package on real GDP growth (the green bars).

    As I noted earlier, we also have reassessed our supply-side assumptions—shown in the bottom left panel. Specifically, we have raised our estimate of potential output growth from 2005 to 2009 about ¼ percentage point per year, partly in response to the solid gains in output per hour recorded last year. These revised estimates have two important implications. First, the upward revision to potential output translates roughly one for one into faster growth in actual output during the projection period because of its implications for permanent income and hence consumption and investment. Second, the revisions to potential output in history imply that the output gap—shown to the right—currently is lower than we previously thought, and we expect it to remain lower.

    Your next exhibit provides some details on the real-side outlook. As shown in the top left panel, we have once again revised down the projection for new home sales in light of weak incoming data, including those received after we put the Greenbook to bed. However, we continue to expect that sales will reach bottom in the first half of this year and then begin to edge up as mortgage credit availability improves. This stabilization in demand should allow single-family housing starts (shown to the right) to level out at about 660,000 units by midyear, well below our December projection. Thereafter, we anticipate a slow pickup in starts. As shown in the middle left panel, builders still have a long way to go to bring the backlog of unsold homes down to a more comfortable level, and this overhang should restrain construction activity into next year. We have also revised down the near-term outlook for real business fixed investment—the middle right panel—in response to slowing sales, tighter credit conditions, and some deterioration of business sentiment, but we now expect a greater cyclical rebound starting in the second half of this year as overall conditions start to improve. The bottom left panel shows our projection for consumption, the blue bars, together with the profile for spending excluding the effects of fiscal stimulus, the green bars. Absent the stimulus package, we would expect consumer spending to increase only 1 percent this year but then to pick up around 2¼ percent in 2009 as confidence recovers and credit conditions ease. However, the tax rebates will likely obscure this cyclical pattern by inducing saw-tooth swings in spending, with actual growth realigning with longer-run fundamentals only in the second half of next year. As shown to the right, some of these fundamentals are less favorable than before; we estimate that wealth effects will hold down PCE spending growth by ½ percentage point this year and almost ¾ percentage point in 2009.

    Your next exhibit reviews the inflation outlook. As indicated by the blue line in the upper left panel, monthly readings on core PCE inflation have moved up since the summer. We are inclined to take only a small signal from this movement, much as we did early last year when price increases were unusually subdued. In part, this is because a portion of the recent pickup was attributable to the erratic nonmarket component and quarter-to-quarter fluctuations in this category tend to fade away quickly. In addition, while market-based prices also came in higher than expected, we are interpreting some of that surprise as a reversal of some earlier low readings in particular categories. That said, we also think that a portion represents somewhat more persistent inflation pressure coming into 2008. We project both core and total PCE inflation to moderate over time because of several factors. To begin with, futures prices for crude oil imply the sharp deceleration in energy prices shown to the right. We also expect food prices (the middle left panel) to decelerate into 2009, partly as result of the increased production of beef and poultry that is now under way. In addition, the impetus to inflation from core import prices (the middle right panel) should diminish over time, although by less than projected in December because we now anticipate a faster rate of dollar depreciation. These developments, coupled with the additional economic slack built into this projection, should help to keep inflation expectations anchored, allowing actual inflation to fall below 2 percent in the longer run. Indeed, survey measures of long-run inflation expectations (the blue and red lines of the bottom left panel) remain stable. TIPS inflation compensation (the black line) jumped following the intermeeting fed funds rate cut, as Bill pointed out. But as was discussed in the memo by Jonathan Wright and Jennifer Roush that was circulated to the Committee, we are inclined to attribute most of this increase to changes in inflation risk and liquidity premiums, not to a rise in inflation expectations per se. Putting all this together, we project core inflation—the first column of the panel to the right—to remain at 2.1 percent this year but then to drop down to 1.9 percent next year, the same as in December. Similarly, we continue to expect that headline inflation will slow to 2¼ percent this year and slide to 1¾ percent in 2009 as energy prices moderate. I will now turn the floor over to Nellie.

  • As discussed earlier, Treasury yields and stock prices are down sharply since the December FOMC meeting on news that indicated greater odds of a recession and large writedowns at financial institutions. As shown by the blue line in the top left panel of exhibit 6, the fall in stock prices pushed up the ratio of trend forward earnings to price. The difference between this ratio and the real Treasury perpetuity yield, shown by the shaded area and plotted to the right, is a rough measure of the equity premium. As you can see, this measure jumped in the past few months and is now at the high end of its range of the past twenty years. In the corporate bond market, the spread on high-yield corporates, the black line in the middle panel, widened sharply, and investment-grade spreads, the red and blue lines, also rose. Forward spreads (not shown) rose especially in the near-term, suggesting particular concern about credit risk in the next few years. In the forecast, we assume that the equity premium and bond spreads will recede some from their recent peaks as the risk of recession recedes and activity picks up, but they will remain on the wide side of their historical averages. As shown in the bottom left panel, our most recent indicators suggest that the OFHEO national purchase-only house-price index, the black line, fell 2¾ percent in the fourth quarter; we project further declines of about 3¼ percent in both 2008 and 2009. In some states with many subprime mortgages— such as California, Arizona, Nevada, and Florida—house prices, the red line, began to fall earlier and have declined by more. Reports of spectacular writedowns from some financial firms may also have caused investors to assign greater odds of tighter financial conditions. As noted in the bottom right panel, financial firms took writedowns and loan-loss provisions of more than $80 billion in the fourth quarter. Most of the reported losses were from subprime mortgages and related CDO exposures, but many banks also increased loss provisions for other types of loans. In response, financial firms raised substantial outside capital and cut dividends and share repurchases. Still, the risk remains that writedowns and provisioning will grow larger if house prices or economic activity will slow more than currently anticipated or if financial guarantors are downgraded further. Moreover, many of the largest firms are still at risk of further unplanned asset expansion from previous commitments for leveraged loans and their continued inability to securitize non-agency mortgages. Consequently, these firms are likely to be cautious in managing asset growth.

    Your next exhibit focuses on business financial conditions. As shown by the black line in the top left panel, top-line operating earnings per share for S&P 500 firms for the fourth quarter are now estimated to be about 23 percent below their year-ago level, dragged down by losses at financial firms. For nonfinancial firms, the green line, earnings per share are estimated to be up 10 percent from a year ago. Analysts’ estimates of Q1 earnings for nonfinancial firms were trimmed a bit last week but suggest continued growth. Robust profits since 2002 have put most businesses in strong financial shape. As shown in the right panel, loss rates on high- yield corporate bonds, the black line, have been near zero for more than a year as very few bonds defaulted and recovery rates were high. However, we project that bond losses will rise gradually in the next two years as the nonfinancial profit share slips from its currently high level. In commercial real estate, the middle left panel, the net charge-off rate at banks, the black line, was low in the third quarter of last year despite a slight tilt up mostly from troubled loans related to residential land acquisition and construction. We project that this rate will rise fairly steeply, reflecting weakness in housing and expected softening in rents for commercial properties.

    A similar outlook may lie behind the tighter standards for business loans reported in the January Senior Loan Officer Opinion Survey. As shown by the orange line in the middle right panel, the net percentage of domestic banks reporting having tightened standards on commercial real estate loans in the past three months reached 80 percent, a notable increase from the October survey. In addition, one-third of domestic banks tightened lending standards on C&I loans in the past three months. Large majorities of the respondents that tightened standards pointed to a less favorable or more uncertain outlook or a reduced tolerance for risk. Despite wider spreads, borrowing rates for investment-grade firms are lower than before the December FOMC meeting. As shown by the red line in the lower left panel, yields on ten-year BBB-rated bonds, the red line, fell about 25 basis points, and rates on thirty-day A2/P2 nonfinancial commercial paper, the blue line, have plummeted about 200 basis points since just before year-end. In contrast, yields on ten-year high-yield bonds, the black line, are up and now are close to 10 percent. Net borrowing by nonfinancial businesses, shown in the right panel, is on track in January to stay near the pace of recent months. Net bond issuance, the green bars, has been sizable in recent weeks with most of that issuance by investment-grade firms. Unsecured commercial paper, the yellow bars, rebounded after substantial paydowns ahead of year-end.

    Your next exhibit focuses on the household sector. As shown in the top left panel, delinquency rates at commercial banks for credit cards, the blue line, and nonrevolving consumer loans, the black line, edged up in the third quarter, as did rates for auto loans at finance companies through November. Some of the recent rise in delinquency rates for credit cards is in states with the largest house-price declines, and could represent spillovers from weak housing markets. As shown to the right, delinquency rates on subprime adjustable-rate mortgages, the solid red line, continued to climb and topped 20 percent in November, and delinquency rates on fixed-rate subprime and on prime and near-prime mortgages also rose. Looking ahead, we expect delinquency rates on consumer loans to rise a bit from below-average levels as household resources are strained by higher unemployment and lower house prices. These developments have spurred lenders to tighten standards on consumer loans. As noted in the middle left panel, responses to the January Senior Loan Officer Opinion Survey indicate a further increase in the net percentage of banks tightening standards on credit cards and other consumer loans in the past three months. Banks also reported substantial net tightening of standards for subprime and prime mortgages, with the latter up considerably from the October survey. In addition, spreads on lower-rated tranches of consumer auto and credit card ABS jumped in January amid news that lenders were increasing loan-loss provisions. That said, interest rates on auto loans and credit cards, not shown, are not up, and most households still appear to have access to these forms of credit. As shown to the right, issuance of securities backed by these loans was robust through January. Securitization of nonconforming mortgages, the grey bars in the lower left panel, was weak in the fourth quarter of last year, and there has been little, if any, this month. But agency-backed securitization, the red bars, was quite strong in the fourth quarter and appears to be again in January. Moreover, as shown to the right, interest rates have fallen appreciably. Rates on conforming thirty-year fixed-rate mortgages, the blue line, and one-year ARMs, the red line, fell, and offer rates on prime fixed-rate jumbo mortgages, the black line, are also down. The six-month LIBOR, the rate to which most subprime ARMs reset, plunged in January, although, even at this level, the first payment reset will still be substantial for many households.

    The next exhibit presents our outlook for mortgage defaults. The top left panel shows cumulative default rates for subprime 2/28 ARMs by year of origination. A default here is defined as a loan termination that is not from a refinancing or sale. The default rates for mortgages originated in 2006 and 2007, the red and orange lines, respectively, have shot up, and for mortgages originated in 2006, about 18 percent will have defaulted by the loan age of eighteen months. This rate is higher at every comparable age than for mortgages made in 2005, the blue line, and the average rate for loans made in 2001 to 2004, shown by the black line, with the shaded area denoting the range across years. Softer house prices likely played an important role in defaults on 2006 and 2007 loans because borrowers had little home equity to tap when they lost their jobs or became ill, or they walked away when their mortgages turned upside-down. These mortgages have not yet faced their first interest rate reset. As shown to the right, we expect a sizable number of borrowers to reset to higher payments, about 375,000 each quarter this year, if these mortgages are not prepaid or rates are not reduced. While many borrowers still have time to refinance or sell before the first rate reset, lower house prices and tighter credit conditions are likely to damp this activity. As noted in the middle left panel, to project defaults on subprime ARMs, we use a loan-level model that jointly estimates prepayments and defaults. The model considers loan and borrower characteristics at origination, subsequent MSA- or state-level house prices and employment fluctuations, interest rates, and “vintage” effects. As shown to the right, with data for the first three quarters in hand, we estimate that defaults in 2007 about doubled from 2006 and predict that they will climb further in 2008 and stay elevated in 2009. These estimates imply that 40 percent of the current stock of subprime ARMs will default over the next two years.

    An important source of uncertainty around our projections is how borrowers will behave if falling house prices push their loan-to-value ratios above 100 percent. As shown in the first line of the bottom left panel, we estimate that 20 percent of subprime borrowers had a combined loan-to-value ratio of more than 100 percent in the third quarter of last year. If we assume that national house prices fall about 7 percent over the forecast period, as in the Greenbook, an estimated 44 percent of subprime mortgages would have combined LTVs above 100 percent. A similar calculation for prime and near-prime mortgages, shown in the second line, indicates that a not-inconsequential share, 15 percent, of these would also be upside-down by the end of 2009. While prime borrowers likely have other financial assets upon which to draw in the case of job loss or sickness, such high LTVs pose an upside risk to our baseline projection of defaults. Another source of uncertainty—this one on the positive side of the ledger—is how loan modifications can reduce defaults or loss of a home. We have limited information, but recent surveys indicate that loan workouts and modifications were modest through the third quarter of last year but likely accelerated in the fourth quarter. Servicers are strained working on the large number of loans that are delinquent before the first reset. One survey indicated that servicers assisted about 150,000 subprime borrowers in the third quarter, which would represent about 15 percent of those with past-due accounts, but were not addressing current accounts with an imminent reset.

    As highlighted in the top panel of your next exhibit, we summarize our projections for credit losses in the next two years for major categories of business and household debt. These projections rely on the paths for house prices, unemployment, interest rates, and other factors from the Greenbook baseline. We also present projections based on the Greenbook recession alternative with the additional assumption that national house prices fall 20 percent. In this alternative scenario, real GDP growth turns negative in 2008, and the unemployment rate rises above 6 percent in 2009. As shown in the first column of the bottom panel, if we use the loss rates over the past decade or two as a guide to approximate losses under average economic conditions, total losses, line 6, would be projected to be $440 billion over the next two years. Such losses could be considered what might be expected by lenders of risky debt in the normal conduct of business. But conditions over the next two years are not expected to be normal, even under the baseline scenario. As shown in the second column, losses under the Greenbook baseline are expected to be considerably higher than average and total $727 billion, given our outlook for only modest growth. These losses might not greatly exceed the amounts that investors already have come to expect given signs of slowing activity. The above-average losses are especially large for residential mortgages, line 1, including those for nonprime mortgages, line 2. In contrast, losses for consumer credit, line 3, and business debt, line 4, are only a touch higher than normal. In the alternative scenario, in which business and household conditions worsen further, losses are projected to rise even more, not only for mortgages but also for other debt. Losses of this dimension would place considerable strains on both households and financial institutions, creating the potential for more-serious negative feedback on aggregate demand and activity than is captured by our standard macroeconomic models. Nathan will continue our presentation.

  • Your first international exhibits focus on the recent strength of the U.S. external sector. As shown in the top panel of exhibit 11, U.S. exports are now seen to have expanded at a moderate 4½ percent pace in the fourth quarter, following the 19 percent surge in the third quarter. With import growth in the fourth quarter stepping down to 2 percent, net exports are estimated—as shown on line 3— to have made a positive arithmetic contribution to real GDP growth of 0.2 percentage point. Going forward, we see the external sector contributing 0.5 percentage point to GDP growth in 2008 and 0.3 percentage point in 2009. Exports are expected to expand at a crisp 7¼ percent pace in both years, supported by stimulus from the weaker dollar. The pace of import growth, after stepping down on average in the first half of this year, should pick up some through the forecast period, broadly mirroring the contour of U.S. growth. As shown in the bottom left panel, some additional impetus to import growth should come from a projected decline in core import price inflation, due to moderation in both exchange-rate-adjusted foreign prices (the red bars) and commodity price increases (the blue bars). Returning to line 4 of the upper panel, we estimate that the current account deficit increased to 5½ percent of GDP during the fourth quarter, driven up by a surge in the oil import bill. We see the deficit declining to 4¾ percent of GDP in 2009, as the non-oil trade deficit narrows to just 1½ percent of GDP. As shown on the bottom right, the oil import bill—which has increased from around 1 percent of GDP early this decade to about 3 percent of GDP at present—looms as an increasingly important factor influencing the evolution of the current account balance.

    Your next exhibit examines U.S. external performance from a longer-term perspective. As shown in the top panel, the arithmetic contribution from net exports was persistently negative from 1997 to 2005, subtracting ¾ percentage point on average from the growth of U.S. real GDP. The contribution from net exports, however, has swung into positive territory over the past two years, adding about ½ percentage point to growth, and we expect net exports to continue to make a positive contribution over the next two years. As shown in the middle left panel, this upswing in the net export contribution has reflected—in roughly equal measure—an acceleration in exports and a slowing of import growth. Over the past two years, export growth has stepped up to 8½ percent, more than twice its average 1997-2005 pace, and it is projected to moderate only slightly in 2008 and 2009. In contrast, import growth over the past couple of years has fallen off to less than half its 1997- 2005 average and is expected to remain soft through the forecast period. The individual contributions of exports and imports to U.S. GDP growth have both risen about ½ percentage point in recent years. This swing in U.S. external performance has been driven in large measure by the cumulative effects of the decline in the dollar (shown on the middle right). Since its peak in early 2002, the dollar is down more than 20 percent in broad real terms, including a 30 percent fall against the major currencies. We project that going forward the broad real dollar will depreciate at a pace of a little less than 3 percent a year, with this decline coming disproportionately against many of the emerging market currencies (including the Chinese renminbi), which have moved less since the dollar’s peak in early 2002. The bottom panel highlights another factor that has supported the shift in U.S. external performance. From 1997 to 2005, U.S. growth was on average just ¼ percentage point below that of our trading partners. In recent years, U.S. growth has slowed relative to foreign growth, and this gap has widened substantially, reaching 1½ percentage points on average in 2006 and 2007. This has, consequently, restrained imports relative to exports. Our forecast calls for this gap to narrow only slightly through the forecast period. But this projection depends crucially on the resilience of growth abroad—an issue that is examined in your next exhibit.

    Recent data have confirmed our expectation that foreign activity slowed markedly in the fourth quarter. As shown in the top left panel of exhibit 13, economic sentiment in the euro area fell in December for the seventh consecutive month, and the ECB’s survey of bank lending pointed to further tightening of credit standards for both households and firms. In addition, euro-area retail sales volumes and industrial production (not shown) have moved down in recent months. In the United Kingdom, the preliminary reading on fourth-quarter GDP growth was surprisingly strong, but other indicators seem to point to some softness going forward. As shown on the right, the Bank of England’s new survey of credit conditions indicates a further decline in the availability of credit to corporations during the fourth quarter, and the level of new mortgage lending has plunged. Other indicators, including consumer confidence, have also slid of late. The Japanese economy may be weakening as well. As shown in the middle left panel, the December Tankan survey showed a further retreat in business confidence, including a softening of sentiment among both large manufacturers and large nonmanufacturers. Housing starts have declined dramatically lately, as the construction sector adjusts to new, tighter building standards. We also see signs that labor market conditions may be weakening. As shown in the bottom panel, our assessment is that total foreign GDP growth slowed to about 2¾ percent during the fourth quarter, distinctly down from the 4 to 4½ percent pace recorded through 2006 and the first three quarters of 2007. Notably, the fourth- quarter slowdown was broadly based. We estimate that growth in Mexico (line 8) declined sharply, in line with a contraction in U.S. manufacturing output. Chinese GDP data, which were reported after the Greenbook went to press, indicate that growth in the fourth quarter remained below its double-digit pace in the first half of the year, with exports posting a contraction.

    The middle right panel summarizes what we see as the key sources of this near- term slowing. First, a number of countries have experienced headwinds from the ongoing financial turmoil; this is particularly the case for the euro area, the United Kingdom, and Canada. In addition, sharp recent declines in equity markets have occurred in a much broader set of countries. The softening of U.S. growth is a second factor weighing on activity abroad, especially for countries like Canada and Mexico and many in emerging Asia that have sizable trade linkages with the United States. Third, through 2006 and 2007, many of the foreign economies enjoyed exceptionally rapid cyclical expansions, so some eventual moderation in the pace of growth seemed inevitable, and we have been projecting a deceleration for some time. Returning to the bottom panel, we see these factors as continuing to weigh on foreign activity through the first half of the year. Thereafter, growth should gradually strengthen, to 3 percent in the second half and to 3.4 percent in 2009, as financial turmoil subsides and as the U.S. economy rebounds. Nevertheless, we expect that growth will remain well below the heady pace recorded over the past two years.

    As shown in the top left panel of exhibit 14, our foreign outlook is also supported by projected easing of monetary policy abroad. Given mounting evidence of economic weakness and continued financial stress, we see the ECB and the Bank of Canada cutting policy rates 50 basis points by the middle of the year, and the Bank of England easing 75 basis points. Given the persisting inflation risks, this is admittedly an aggressive call. But we see the case for monetary action as compelling and believe that these central banks will be persuaded, notwithstanding their recent hawkish rhetoric. The futures markets also appear to be pricing in some easing, albeit at a more gradual pace than we envision. Finally, we now expect the BoJ to remain on hold until the end of 2009. To be sure, there are a number of risks surrounding our forecast, most of which are on the downside. First, the prevailing financial headwinds or the slowing of U.S. growth may be larger or more protracted than we currently project. Second, we do not yet have a good sense of the extent to which many foreign financial institutions have been affected by the recent turmoil, and the release of year-end financial statements over the next six weeks or so could bring some bad news. A third risk is that overly optimistic expectations of decoupling may lead to policy mistakes. Specifically, to the extent that foreign authorities are convinced that they have decoupled from the United States—or that they are immune from spillovers due to the financial turmoil—they may be too slow to ease policy to address weakening demand. Policy abroad may also be restrained by too narrow a focus on the recent rise in inflation, a topic to which I will return momentarily. Finally, housing markets in some countries may be vulnerable. As shown in the bottom left panel, many countries have experienced run-ups in house prices in recent years that are similar to or even exceed those recorded in the United States, and house prices are now decelerating sharply in a number of these countries. Further weakening of house prices poses the risk of adverse wealth effects. Notably, of the major economies shown in the right panel, only the United States has yet seen a marked downward swing in the contributions from residential investment to GDP growth.

    Your final international exhibit discusses our projections for foreign inflation. As shown in the top panel of exhibit 15, average foreign inflation jumped up to an annual rate of 4½ percent in the fourth quarter, with marked increases in both the advanced foreign economies (line 2) and the emerging markets (line 7). The sources of this rise in inflation—including rapid increases in the prices of food and oil—have been well documented. Going forward, we see average foreign inflation moving back down to an annual rate of 2½ percent in the second half of this year and continuing at that pace in 2009. Despite the run-up in realized inflation rates, readings on long-term inflation expectations have remained well anchored. As shown in the middle left panel, breakeven inflation rates for the advanced foreign economies have continued to hover around 2.3 percent on average, and long-term inflation forecasts have stayed near 2 percent. For the emerging markets, average long-term inflation forecasts (shown on the middle right) have remained between 3 and 3½ percent in recent years. The bottom panels show four-quarter percent changes for the prices of oil, food, and metals. Given the marked slowing of global activity, the stage seems set for some deceleration in commodity prices; indeed, metals prices are already on a downward trajectory. Thus, in line with quotes from futures markets, we see the pace of increases in oil prices and food prices as declining significantly over the next few quarters. Nevertheless, we have been wrong on this score before and freely acknowledge that there are upside risks to this projection. Brian Madigan will now continue our presentation.

  • I will be referring to the separate package labeled “Material for FOMC Briefing on Economic Projections.” Table 1 shows the central tendencies and ranges of your current forecasts for 2008, 2009, and 2010. Central tendencies and ranges of the projections made by the Committee last October are shown in italics. As for conditioning assumptions, most of you see the appropriate near-term path of the federal funds rate as at or below that assumed in the Greenbook. Eight policymakers explicitly assumed somewhat more near-term easing than in the Greenbook. However, several of you assumed that policy would need to begin firming no later than 2009. Many of you also projected that the funds rate would exceed the level forecasted in the Greenbook by the end of the forecast period.

    As shown in the first row, first column, of table 1, the central tendency of your forecasts of real growth for 2008 has been marked down about ½ percentage point since last October. Most of you remarked that a range of factors had prompted you to lower your growth expectations for the current year, including the continued turmoil in financial markets and the resulting tightening of credit conditions, the persistent deterioration in the housing market, incoming data suggesting slower consumption expenditures and business investment growth, and higher oil prices. A few of you suggested that stronger export demand as well as fiscal stimulus would provide some offset to weakness in private domestic demand, particularly beginning later this year. Your half-yearly projections, not shown, suggest that you all think that, more likely than not, the economy will skirt recession. On average, you see real GDP growing at an annual rate of about ¾ percentage point over the first half before picking up to a 2½ percent pace in the second half. As shown in the second row, in view of the weak growth forecast for this year, most of you revised up your expectations for the unemployment rate in the fourth quarter about 0.4 percentage point, to around 5¼ percent. Most of you project slightly brisker growth this year than the Greenbook does—perhaps partly reflecting the assumption that a number of you made that there would be more near-term monetary ease than the staff assumed. As shown in the third and fourth sets of rows, with incoming inflation data a bit higher than previously expected and despite projected weaker real activity, the central tendencies of your projections for total and core PCE inflation this year have increased about 0.3 percentage point. That upward revision is a bit larger than the 0.2 percentage point upward revision to the Greenbook inflation forecasts but leaves the level of your projections close to those in the Greenbook: Most of you see total and core inflation this year at a little above 2 percent. But as shown in the bottom section, the upper limit of the range of your overall inflation projections for this year has moved up to 2.8 percent. Your forecasts for total PCE inflation this year remain a bit higher than for core inflation, reflecting the expectation of higher energy, food, and in some cases, import price inflation.

    Looking ahead to next year, your forecasts indicate that you expect economic growth to pick up as the drag from the housing sector dissipates and credit conditions improve. The midpoint of the central tendency of your forecasts for real GDP growth is 2.4 percent. Your growth forecasts for next year are mostly above the staff’s forecast of 2.2 percent, perhaps again because a number of you assumed more- aggressive policy easing in the near term and perhaps because at least some of you appear to see potential output growth as a bit brisker than the staff does. With most of you evidently seeing growth a bit above trend next year, the unemployment rate begins to edge lower, but the central tendency of your unemployment projections still remains distinctly above that in October. Although you are generally optimistic about improving conditions next year, your views have become considerably more dispersed: As shown in the lower section, the width of the range of the growth projections for 2009 has nearly doubled, as has the width of the range of the unemployment projections. The third and fourth sets of rows in the upper panel indicate that most of you see overall and core inflation as moving below 2 percent next year. Some of you said that those declines reflect less pressure from energy prices and, with the unemployment rate above the NAIRU, the emergence of some slack in the labor market. It is worth noting, however, that despite the easing of pressure on resources during 2008 and 2009, the central tendencies of your inflation projections for next year are essentially unchanged from October. This development presumably reflects your perception of some deterioration in the near-term inflation- output tradeoff, perhaps prompted in part by the publication of surprisingly high inflation data for the fourth quarter of 2007 and an expectation that those effects will linger in 2009.

    Turning to 2010, the interpretation of your longer-term projections is a bit less straightforward than it was in October. It was noted during the trial-run phase that a time may come when the economy is seen as unlikely to be in a steady state by the third year of the projection. To some extent, that time seems to have already arrived. In particular, a comparison of the central tendencies for unemployment in 2010 from your January and October projections suggests that you now see a bit of slack persisting that year. The central tendencies and ranges of your total and core inflation projections for 2010 have changed just a bit from those in October, but those changes might be viewed by outside analysts as significant. In particular, the central tendency for total inflation in 2010 has inched up 0.1 percentage point, and the lower limit of the central tendency for core inflation has increased the same amount. Absent guidance to the contrary, some analysts might now conclude that your “comfort zone” has edged up to 1¾ to 2 percent from 1½ to 2 percent. To counter this impression, presumably the published “Summary of Economic Projections” should suggest that, because a bit of economic slack is expected to persist at the end of 2010, inflation could continue to edge lower beyond the projection period. This discussion, however, raises not only a presentational point but also a substantive one, and that is, Why should your inflation projections for 2010 have revised up at all? True, the inflation-output tradeoff appears to have deteriorated a little recently, but as Dave Reifschneider noted, some of that deterioration is likely to be temporary. Also, higher inflation than otherwise might in principle be a consequence of taking out some insurance now against especially weak economic outcomes. But given the significant negative shock to aggregate demand embedded in your modal forecasts and the associated upward revision to slack across all three years of your projections, as well as the absence of any upward revision to your inflation projections for 2009, even the small upward revision to your inflation projections in 2010 seems somewhat surprising.

    Turning to the uncertainties in the outlook, the upper panel of exhibit 2 shows that even more of you than in October judge that uncertainty regarding prospects for economic activity is higher than its historical level. Even with the significant reductions in the target funds rate already in place and, for many of you, an assumption of more easing to come, the lower panel illustrates that most of you still see the risks to growth as tilted to the downside. As reasons, you again cited tighter credit conditions for households and businesses emanating from further disruptions in financial markets as well as the persistently deteriorating housing outlook. As shown in the upper panel of exhibit 3, more of you than in October see the uncertainty around your total inflation forecasts as close to that of the past two decades, while a smaller minority viewed uncertainty as greater than in the past. As shown in the lower panel, fewer of you now see the inflation risks as predominantly to the upside. On balance, as in October, downside risks to growth were more frequently cited than upside risks to inflation, which seems broadly consistent with each of the alternative policy statements that were in Bluebook table 1. Thank you.

  • Thank you. That’s quite a bit of information to digest. Does anyone have questions for our colleagues? President Evans.

  • Thank you, Mr. Chairman. I have a couple of questions that are somewhat different. On the labor front, I’m curious if you could offer some thoughts on how deterioration in the labor market might be coming about—whether or not it would be from the hiring front or the job-destruction front. As the research literature has evolved over a long time, I think it has moved a bit away from job destruction playing the key role and more toward reductions in hiring. I wonder how this informs the way you look at the data. Any insights you have into that would be quite helpful. Then I wonder if you could just talk a bit more about the interesting memo that was distributed on inflation compensation and the implications for expectations. As I read it, it seemed to indicate that inflation expectations, if anything, were coming down from the five-year forward but that inflation compensation was higher. So does that mean that the variance of inflation is higher? Are people talking about the possibility of disinflation during this period? I would expect it to come with that type of compensation. Your thoughts on that would be great.

  • Do you want me to take that last question, or do you want to?

  • Well, I could start if you would like.

  • I think the points we are trying to make in that memo regarding inflation compensation were that, first of all, it’s very difficult to make these judgments about what is going on with inflation expectations, inflation risk premiums, and so on; but our best reading of the evidence was that probably inflation expectations have not moved up significantly recently. We base that on a variety of indicators. I won’t go through all of them now, but to me the most compelling evidence to support that point is that inflation compensation over the next five years has actually come down over the intermeeting period, and it is a little hard to rationalize why inflation expectations would have risen so far out, whereas in the near term they seem, if anything, to be declining. Of course, various factors can affect inflation compensation, including relative liquidity and inflation risk premiums, and we certainly don’t want to exaggerate our ability to decompose these changes into these various factors. It is possible that inflation risk premiums, in particular, have moved up, and some evidence does suggest that.

  • I neglected to say how interesting that memo was. The analysis is really very good. I look forward to seeing more of it.

  • The only thing I would add to Brian’s statement is that I think uncertainty about inflation in the long run could be moving up noticeably without really bringing into play disinflation or something like that. In other words, you could be more worried about going down to 1½ or 1¼ than you were before—I don’t know—it could be more just as it was in the forecast.

  • May I have a two-hander on this?

  • When you think about what’s going on, it is plausible that it is both up and down. That’s the key point here. Because if you also look at the projections, there is a lot more uncertainty about what’s going on in the real side of the economy. That could mean that inflation could drift down and longer-run inflation expectations could drift down if, in fact, there’s some uncertainty about what the objectives of this Committee are. On the other hand, we actually did take a very sharp interest rate cut, and that could indicate that the Committee might tolerate somewhat higher inflation. So even though the action that was related to the big jump in inflation compensation was a cut in interest rates, I think there is a plausible argument that it could be symmetric in terms of increasing uncertainty on both sides.

  • That’s what I was focusing on—the mean-preserving nature of that.

  • I think it is consistent with your view, but I just wanted to clarify.

  • On job destruction versus a slower pace of new job creation, it’s hard to answer that one. Some of those patterns have changed over time; and in monitoring labor market developments, we’re trying to keep track of those two elements and that sort of thing. Whether that would materially change the way we would look at, say, just what payroll employment growth was doing, it would still be one of our main reads coming in. As to exactly how that worked out behind it, I’m not sure it would make too much of a difference. I don’t know whether Dave might want to add something to that.

  • Obviously, we would be monitoring those developments. We are monitoring the gross flows in the labor market, and I think to a large extent the slowing that we have seen thus far in employment growth has come more from a slower pace of hiring than it has from an increase in layoffs. More recently, in the JOLTS data as of November, there has been a significant increase in layoffs and discharges, and there has been some further slowing in hiring. If we were to truly move into a recession, you would still see a lot of layoffs, and there would be a fair amount of job destruction, so the cyclical aspect would still likely show through pretty strongly.

  • I guess I was thinking that, if you talk to people, you hear more about the job destruction aspect, but you don’t hear quite the same information about hiring, except you might hear more nervousness. That’s all.

  • Hiring plans have come off a bit in most of the surveys that we follow, but just a bit—not a lot yet.

  • President Lockhart, did you have an interjection?

  • Yes. My staff is suspicious that the employment numbers have actually been weaker than the data have shown. They have been focusing on the birth-death model and the payroll survey is based upon assumptions related to the birth of construction firms, which logically would not be creating jobs in this environment. Do you have a take on that issue?

  • Well, if Bill Wascher, who is our expert in this area, wanted to say something, I would certainly let him go ahead and say something.

  • Sure. The birth-death model basically assumes that the cyclical properties of births and deaths are the same as for continuing establishments. The BLS has only about five years of experience with the birth-death model, so I think it is pretty difficult to judge whether they need to make any additional adjustments in births and deaths, other than the same pattern that occurs in terms of net employment changes in continuing firms. But without much to go on, they don’t take a very strong stand on whether they do a very good job of picking up the turning points because they don’t have any history on which to base their analysis. So I think there are reasons to suspect that that is possibly the case, but I don’t think there is any strong evidence that it is, and it is important to note that they do assume some cyclicality in births and deaths in their procedures.

  • Thank you, Mr. Chairman. Brian, I want to ask you about the projections. Well, it is more than an exercise now—the projections that we are offering are for real. What is the message that comes out of the projections—that is, if I am talking to the press or to others and they say, “What do I make of all of this?” My question to you is, What do you make of all of this? What is the message for the implications for policy or the implications for anything? You know, the data don’t really speak for themselves. We are throwing out a lot of stuff here to the market, and what is the market supposed to make of it?

  • Well, that is a hard question, actually. You know, obviously in some sense the numbers at some level do speak for themselves.

  • Okay. What are they telling us? [Laughter]

  • I think they say that the Committee is expecting relatively slow growth in the period immediately ahead but that the economy avoids a recession. There is some recovery over the subsequent years. It is not extraordinarily brisk. It is a fairly gradual recovery in terms of growth. The unemployment rate moves up a little, as you would expect with a period of growth below trend, but does not get extraordinarily high; and inflation, after coming under some upward pressure of late, gradually edges back down to levels below 2 percent. I am not sure that I am saying anything terribly enlightening here. Of course, one point that I should emphasize is that the full summary of economic projections, we hope, gives more texture than I was just able to give to the Committee’s views about the modal outcome and to the Committee’s concerns about the risks to both growth and inflation.

  • The reason I raise the question is that it seems to me very important that we have some interpretation as to what we make of all this and what we want the market to make of all this. In particular, let’s say the observation that the projections or the risks are weighted to the downside. You might get some people saying, “Well, if we get some employment reports or others that in fact come in weaker than anticipated, that means that the Committee is on the edge of pulling the trigger to respond to it.” That might be a possible message that people would take from this. If that is not the message that we want to convey, then we had better be very careful how we talk about these.

  • President Poole, I would just point out that when these are released it will be simultaneous with my testimony to the Congress, and so I will have opportunities to put some context on it at that time.

  • I guess my question is directed as much to the Chairman as it is to Brian, which you will answer in the testimony.

  • I will answer in the testimony. [Laughter] President Fisher.

  • First, I, too, wanted to thank you all for the paper on forward inflation compensation. I agree with the conclusion that it is difficult. Especially in times of strained trading conditions, I think that is the conclusion—whether you interpret the outcome the way it was interpreted in the paper or the way I do it more cynically, I think that is the key underlying point. I thought that was a very valuable, useful paper, and I want to thank you, Governor Mishkin, for commissioning it.

    My question is to Nathan on your inflation projections. Reading through the Greenbook—even though the section on the international side is very thin—with the exception of China, where I think we can sell a lot of “Whip Inflation Now” buttons, and of Argentina, where the numbers are rigged, but even in those countries, what I took home was that everybody was surprised on the upside in every country ranging from the advanced countries, as we call them, to Turkey. Then, if you look at the exhibit 15 that you just presented to us, those numbers are confirmed in the fourth quarter, and then there is a sharp falloff proceeding from there. You gave us a good analysis of the risk to the foreign outlook in growth, and then you concluded your comment on inflation by saying that we have been wrong before, that there is some upside risk. So my question is, What are the risks on the inflation side? Could you elaborate on them, just as you elaborated on the risks to growth in the foreign outlook?

  • We are happy to hear that there is demand for a bigger international section. [Laughter] You had better be careful what you wish for.

  • But I am very serious about this. Suddenly there is a falloff. Would you give us a sense of the risk? It can’t be all one-sided.

  • Right. Just a word of background. The rationale for the falloff is the expected decline in these commodity prices and the expected slowing of global demand. Now, thinking about the risks, I am reasonably convinced that global demand is going to slow, which I believe will translate into reduced demand for many of these commodities that have driven up inflation. However, that says something only about the demand side of these commodity markets. There is also a lot going on on the supply side. At the last FOMC meeting, we talked about ethanol and the fact that many of these emerging-market countries are wealthier, that they want to eat better than they used to, that the relative price of energy has risen, and that it takes a lot of energy to raise these crops. So there are supply factors as well as demand factors at work in driving up these commodity prices. It is very hard for us to forecast the supply side of these markets. It is driven by things like weather and geopolitical developments and so on and so forth. On the commodities, my sense is that demand is going to shift in to some extent. As long as the supply doesn’t shift in as well, we should be able to see a decline, or at least a slower rate of increase, in these prices. A very important point here is that, in order to get less of an impetus coming from commodity prices and inflation in these countries, we don’t necessarily need oil prices to come down in level terms. We just need them to stop going up at such rapid rates. If we get slower rates of price increases, that will be disinflationary relative to where we have been. That is how I would characterize the risks around this forecast, mainly on the supply side of these commodity markets.

  • Thank you, Mr. Chairman. Nellie, I have two questions for you. One is on exhibit 9, where you forecast in the middle right panel the rate of increase in defaults on subprime ARMs. If you compare that with your reset rate estimate and your house-price assumption or the house-price assumption in the market, I wonder whether that looks a little optimistic. Can you just say a little more about why, under the baseline scenario, given what has happened to house prices already and what is ahead, you wouldn’t think that would be substantially greater?

  • We have revised this forecast up quite a bit since the first time we looked at this maybe in June or August, in part because of lower house prices and tighter credit conditions. The model requires as inputs defaults and prepayments, and the prepayment rates have been fairly slow but not zero. The 2006 vintage, as it approaches its first reset, has been that 20 to 25 percent are able to prepay. They are able to find something. So we don’t want to assume that none of them will be able to. The model would approach both of those, so that is the positive side. The downside is that our forecast, with the national house-price assumption of roughly minus 7 over the forecast period, does imply house-price declines on the order of minus 20 percent a year or more in California, Florida, and some other places. That does leave the loan-to-value ratio, as I mentioned, pretty high for many borrowers. We have never had this kind of episode, so we have to make a judgment about the point at which subprime borrowers walk away from their houses. The current assumption is that at about 140 percent we just say you are out; but it has to be almost an assumption that, if by then you hadn’t defaulted, we would push you out. So there is an upside. On the other hand, saying 40 percent of the outstanding stock will default over two years sounds like a big projection as well. So we tried to balance. There are risks on both sides, for sure.

  • Thank you. My second question is about your projected credit loss, and I apologize if you said this in your introduction. Are these losses across all holders of that credit risk?

  • Yes. We have not distinguished between who is holding the securities— banks or investors—so mortgages would include the 20 percent or so that are commercial banks, and it would also include those held by investors in the primary form.

  • We, being the Fed, know a fair amount about what banks hold. Do you have a crude estimate of what share of this banks hold, or what share of this would end up being eaten by banks?

  • In mortgages, 20 percent is actually probably a pretty good estimate.

  • They have that much of the business sector and that much of the mortgages, so that pretty much covers it.

  • I am just trying to get at how you interpret this. So 20 percent of the additional $600 billion relative to normal or relative to bank capital cushions now, is what? Is it a lot or not so much?

  • One issue here is whether you want to do it relative to current capital cushions. Banks can raise capital. If they anticipate that they will need to raise capital, they can cut dividends further. I haven’t done that sort of exercise. One way to think about this is that the average long-run rate is about 60 basis points on debt; in the Greenbook baseline it runs to about 1 percent, and in the alternative, it gets close to about 1½ percent of debt. So, it is not outside the realm of history. It is on the high side.

  • We have had some bad points in history. I am not trying to force you to give a prediction, but were you reassured by this or troubled by it, fundamentally, in terms of the capacity of the financial system to absorb it?

  • No, I understand. I think the third alternative gets beyond what most are expecting at this point.

  • Yes, I would agree with that.

  • In that sense, it does represent a risk that you are going to get dynamic feedback between losses and household spending and lending—it is a high risk. So I wouldn’t say “comforted.” I think we were saying that this is beyond probably what our models could respond to in our typical way or it would be another dynamic feedback loop of some sort that we don’t typically adjust for.

  • President Plosser. Oh, I am sorry—a two-hander.

  • Just a quick followup, this doesn’t include losses from securities. It is only the loans, right?

  • The loans could be packaged in securities. This is debt. It includes all debt. Now, whether it is repackaged into an MBS, it would be there. It wouldn’t be if it got in a CDO or something.

  • Just in corporate bonds, for example.

  • Yes. It includes corporate bonds.

  • Thank you, Mr. Chairman. I have three questions. Let me go to Brian first. This is more of a comment. In your description of the forecast, you referred several times to the notion that there might be slack in the economy in 2010 based on these numbers. I guess my reaction to that, while I was kind of skeptical, I am not sure exactly how you infer that from what was reported. Certainly, that seems to be true in the Greenbook forecast, but trend growth seems to be as good as or better than it was in the last projection. In 2010, inflation—true—is a little higher. The unemployment rate may be a 0.1 or 0.2 percentage point higher. But unless you infer something about what people thought the NAIRU might be, I don’t know how you would necessarily infer that the reason inflation went up in these forecasts was that there was slack in the economy in these projections. So I just wanted to caution about the language we use in how we describe what we see here without necessarily inferring something about whether, in any individual person’s forecast, there may or may not have been slack. In mine, there wasn’t in 2010, but I don’t see that necessarily follows from what these numbers look like. That was my only observation here.

  • Maybe I can respond to that. It is very inferential, and it is based partly on the two-tenths’ difference from the October exercise when it was actually clear—I think clearer at that time—from participants’ forecasts that many participants characterized their NAIRU as being in the vicinity of 4¾ percent. Unfortunately, the writeups this time were not all that explicit on this point, but it is the comparison with October that I was leaning on fairly heavily.

  • I have two other questions that I would like to pose. One is the change in the Greenbook’s assumption about the increase in potential GDP. In particular, I am curious because what it essentially does, it seems, is to build in a significant amount of slack or output gap in 2009 and 2010 that didn’t exist in the last Greenbook. I am inferring that part of the reason the more-aggressive easing in the policy assumption does not have any effect on inflation to speak of is that it is offset by the increased gap that you have built in. So I would like a little more explanation about the justification for building in a greater gap or a higher potential. But I am also curious to know, if you hadn’t done that, what your forecast for growth and inflation would look like in, let’s say, 2009 and 2010. Could you give some guesstimate of how that might have affected it?

  • In terms of the rationale for increasing potential going back over history, some of that, as I think I mentioned, was just that actual productivity performance has been better than the last time we reviewed this in the summer, and we are taking that on board. That is part of the motivation. Another part of the motivation is what we perceive is a somewhat growing tension between the way we saw labor market slack developing and the way we were looking at slack in terms of the product side through the output gap. We had arrived at a point this round where those tensions had increased over time, and this revision mitigates some of that tension, so those two things are in better alignment with each other. We also were taking the opportunity, when we opened up, to look at some other technical factors we used that get involved in going from, say, the nonfarm business sector to GDP, that sort of thing, and those also pushed us in the direction of being a bit more optimistic on growth going back. So we did view it, if you look at it in terms of product markets, as that there was more slack now than we had previously been thinking and that there was also more slack in the labor market—but that was from the actual data that came in. Going forward, we have more slack. We have more slack just in the labor market because we have revised up the unemployment rate. With that, and taking on board these assumptions of potential output, we have more slack on the output side.

    Now, one question would be, to address your second question, how would things have changed if we hadn’t taken that on board? Well, going forward, we would have written down a lower GDP forecast because what we are really saying here is that it is not that households and firms have changed their perceptions; this is just us, the poor econometricians, trying to infer what is out there in the real world. So the poor econometricians have inferred that potential output is growing stronger. We have to look at it and say, “Well, so the prospects going forward for permanent incomes, corporate earnings, and that sort of thing, will be stronger, and that implies basically a one-for-one ratcheting up.” If we had said, “Well, no, potential output growth going forward won’t be stronger,” we would have revised down the GDP growth rate with it, so there wouldn’t have been any change in the output gap from that. That would have been shifting one for one. It wouldn’t have changed our sense of what resource utilization would be going forward.

  • So are you saying that your path of the gap would have been unchanged?

  • The path of the gap would have been to a first approximation unchanged going forward. Some of the greater resource utilization now and going forward is a combination of the fact that we haven’t really changed our view on the labor market, aside from once we took on board the new unemployment rate data, but that we did change on the product market. Going forward, the way it evolves further on, we see the labor market gap opening up a little more and the output gap opening up a little more—that is driven primarily by our sense that the economy in an underlying sense is weaker—and we have made an adjustment for that with the monetary policy assumption. But it is not quite enough. We haven’t lowered the funds rate as much as we would have needed to do to totally wipe out that fact and keep resource utilization constant going forward on the product side. This is a difficult question. It was a difficult one for us, definitely, going through it because we had many moving parts.

  • Well, it does really change the character of the forecast substantially, I think.

  • If you think about the forecast as resource utilization and inflation, then it has an effect on resource utilization that is bigger now going forward in the product market. We also see a bigger effect in the labor market, and if that were the only thing, it would have put more downward pressure—but not a lot—on inflation. But as I mentioned, we are coming into this forecast with somewhat worse inflation performance lately, and we think that has some persistence. So that is helping balance it out.

  • My last question is also related to some adjustments that struck me in the panel you talked about where you constructed the revised estimates of r*. The first item on your list that you talk about was that the equity premium had gone up, and that was a big factor. So I have a couple of questions. That was an adjustment factor. Now, the way I would think about the stock market declining would be primarily having a wealth effect that works its way through consumption—that would be the normal channel. Yet the Greenbook and this discussion seem to suggest that somehow there was an additional adjustment made because of the rise in the equity premium. Is that correct or not, or is it just the wealth effect that you are talking about? Are these separate?

  • No, it is not separate; the equity premium is a large reason that we had the big drop in stock values.

  • But is the mechanism through a wealth effect on consumption growth?

  • Mostly, but not totally.

  • Well, what does that mean?

  • I would say a couple of things. One, you can think of the cost of raising capital through equity as having some small influence on business investment. That is pretty small. The big effect would be primarily on consumption, as you mentioned. Wealth effects to a smaller extent would affect housing as well. But I think of that as a wealth channel. But there is a bit of a cost-of-capital effect through raising funds through equity that you might think of as well. Another thing I would say is that the difficulty here is distinguishing the equity premium from general risk concerns, risk premiums in general, or increased compensation for higher risk or default risk in a number of these credit spreads we are talking about; those are sort of related. It is hard to keep these things separate in any kind of an accounting. Also, these things tend to be correlated with consumer and business sentiment. Again, that is another thing that is hard to keep separate.

  • So are these “extra channels”— if you want to call them that—typically part of the forecast change and how you evaluate? That is to say, in the fall, when the stock market booms 10 percent, are we going to get another kicker upward in r* due to these same factors?

  • It might not happen. I mean, you could have a situation in which business sentiment would not take a hit, for example, simultaneously with the stock market tumbling, and you would not see some risk premiums on bonds going up. That would be very unusual.

  • I am just reacting to this very large change in your estimate of r* and attributing it to equity premiums, and I was just trying to figure out both.

  • We just had a really big drop in the stock market, and that is the biggest piece of what is going on. But we have also marked down considerably our housing forecast. That is in an exogenous shift in aggregate demand, the IS curve. That is another chunk of what is going on here. We have had some increase in risk spreads, not just in the equity premium. Despite the fact that Treasury rates have fallen, corporate bond yields have not as much, and we don’t have as much there, so there is in general a widening of risk premiums.

  • Well, I am just trying to sort out how much of this is really due to the stock market moving around.

  • A big chunk of this is due to the stock market, so I don’t know what we can do other than to take that on board in our forecast. As Dave noted, there are a few other, small wrinkles, and we didn’t just invent those extra wrinkles this time around. They have always been there. But most of this is working through the wealth effect on the consumer spending side. So it is a weaker stock market and much weaker consumption. That is the aggregate demand channel. The other piece is housing, which I don’t want to minimize because, in fact, that is another nontrivial factor holding down demand and, we think, depressing our estimate of the equilibrium funds rate here over the intermediate term.

  • I didn’t understand that this was just primarily the wealth effect or whether you were referring to something different.

  • No, nothing different. Again, the way the stock market and other elements of spending operate is a little more complicated than just a consumer spending channel, but it really is wealth effect.

  • I wonder if I could entice anybody for a cup of coffee. [Laughter] Why don’t we take a fifteen-minute break, and then we’ll commence with the go- round. Thank you.

  • [Coffee break]

  • If it is okay with everybody, we can start the economic go- round at this point. President Poole, you are up.

  • Thank you, Mr. Chairman. I am not sure how I got to be first here, but I guess I was being unusually agreeable when Debbie asked me. [Laughter] The general tenor of comments that I hear from our directors and people around the Eighth Federal Reserve District— these are the community bankers and smaller firms—is that things are slow but not disastrously slow. The comments that I hear from a series of phone calls to much larger national companies are decidedly more pessimistic, with one exception that I will talk about in a moment. My contact at a large national trucking firm says that they are in a 20-month recession in transportation. They are cutting their capacity, cutting the number of trucks, and I think the numbers on their cap-ex illustrate the situation: for 2006, $410 million; for 2007, $336 million; and their plan for 2008 is $200 million. That is down a little more than 50 percent in two years, so they are really cutting back. I also called friends at UPS and FedEx, and generally things are not a whole lot different but a little weaker than they have been. Neither firm has any particular issues with labor supply. Domestic express business is flat, and customers are switching to the lower-priced services instead of overnight delivery at the end of the afternoon, shifting to ground services, and that sort of thing. On international business, U.S.-outbound volume for FedEx is up 6 percent. That would be consistent with the export increases that we have seen. Reports are that Asia is a bit slower but is still growing very rapidly. Asia to the United States is up 80 percent, 20 percent to Europe and Latin America. The freight market is dead—that is the way my contact put it—down 5 percent year over year. That is consistent with my trucking industry contact—and pretty much the same with UPS. My contact with the fast food industry—the quick-serve restaurant, or QSR, business—says the demand there is definitely weak. They are coming in roughly flat, I guess, or actually down so far this year. Prices are up because of the increase in food costs. The casual dining industry is in worse shape than the fast food industry. My contact also follows retail in general pretty closely and finds that retail business in general is weak. That is consistent with a lot of the reports that we have been receiving.

    A major exception is in the IT area—software. I have contact with a large software company, and the contact noted that, as announced, Microsoft had a fantastic quarter. The earnings were up sharply. PC hardware sales are growing at a rate of 11 to 13 percent expected in the first half of this year, so we see strong growth in the PC market. Consumer demand is stronger than business demand. Both, however, are pretty strong. The international business is doing better, in part because the industry is having some success in reducing the amount of software piracy. The biggest problem is finding software engineers. This particular company is running 8 percent behind its hiring forecast and cannot find software engineers. Positive for us old guys; some of the retirees are coming back to write code. [Laughter] Thank you. That is all I have.

  • Thank you. President Yellen.

  • Thank you, Mr. Chairman. I broadly agree with the Greenbook forecast for economic growth this year and with the assessment that the downside risks to that forecast are considerable. The severe and prolonged housing downturn and financial shock have put the economy at, if not beyond, the brink of recession. My forecast incorporates fiscal stimulus of the same magnitude as the Greenbook and monetary stimulus that is somewhat larger. I have assumed a 50 basis point cut at this meeting and an additional 25 basis point cut during the first half. My forecast shows growth of 1½ percent in 2008, like the Greenbook, but it has a more pronounced acceleration in 2009 as the monetary and fiscal stimulus kickstarts the economy. The unemployment rate edges up this year to 5¼ percent before dropping gradually next year toward the natural rate of 4¾. I am especially concerned about the outlook for consumer spending. The combined hits to equity and housing wealth will extract a considerable toll, and consumer spending will be further depressed by slower growth in disposable income due to weaker employment growth. Delinquencies and charge-offs on most forms of consumer debt have already risen, and slower job growth seems likely to exacerbate this trend, prompting financial institutions to further tighten credit standards and terms. In my forecast, such developments reverberate back negatively onto economic activity.

    Like the Greenbook, I downgraded my economic outlook substantially since our last in- person meeting. The December employment report was probably the single most shocking piece of real side news prompting this revision. But knowing that it is unwise to put too much weight on any single piece of data, I have been examining the question of whether that report was more signal or noise. The drop in initial UI claims to relatively low levels in recent weeks makes such an assessment important. Because the behavior of both series may have been affected by seasonal factors near year-end, it seems worthwhile to examine a broad range of data bearing on the labor market. My conclusion is that the labor market has indeed been weakening since mid-2007, and the extent of weakening, while relatively modest thus far, is quite typical of patterns seen when the economy is tipping into recession.

    Independent evidence of a weakening in the labor market comes from the household survey. Even when adjusted for definitional and measurement differences from the payroll survey, the household survey shows a fairly smooth trend of declining employment growth during 2007. The drop in payroll employment in December helped bring the establishment data into closer alignment with the household employment data. In the payroll survey, the slowdown is concentrated in construction and finance. In the household series, higher unemployment is actually widespread across sectors. The household survey also contains other signs of a weakening job market: a 25 percent increase in the unemployment rate for job losers, which accounts for the lion’s share of the overall increase in aggregate unemployment; an increase in the number of newly unemployed job losers, which can be thought of as a broader measure than UI claims of inflows into unemployment; and an increase of 5 to 10 percent in the estimated expected completed duration of an unemployment spell, suggesting a reduced pace of outflows from unemployment. The labor force participation rate of men and women of age 16 to 24 years has also fallen notably in recent months. Labor force participation rates for this group have been edging down since the last recession, but the decline accelerated in 2007, and historically this group is among the first to respond to weakening labor market conditions.

    Data from the JOLTS survey, which we discussed in the Q&A round, confirm the weakness revealed elsewhere. The job openings, or vacancy, rate is down, consistent with the reduced pace of outflows from unemployment, as reflected in continuing UI claims and unemployment durations, and layoffs and discharges are up sharply. Other data cited in the Greenbook, Part 2, such as net hiring plans for Manpower, and NFIB and survey measures of job availability and unemployment expectations further corroborate a slowdown. With the aggregate unemployment rate now up only 0.6 percentage point off its low, I would describe the deterioration in the labor market thus far as modest, but it is noteworthy that an increase in unemployment of this magnitude, in the space of 12 months, has occurred only twice since 1948 outside of recessions.

    While my modal scenario contains a near-term slowdown rather than a contraction, it is actually pretty rosy compared with what I fear might happen. My contacts have turned decidedly negative in the past six to eight weeks, and further financial turmoil may still ensue. On consumer spending, two large retailers report very subdued expectations going forward following the weak holiday season, which involved a lot of discounting. On hiring and capital spending, my contacts have emphasized restraint in their plans due to fears that the economy will continue to slow. A serious issue is whether the tightening of credit standards that is under way will deepen into a full-blown credit crunch. The new Senior Loan Officer Opinion Survey shows a noticeable tightening in lending standards, and this is confirmed by my contacts. For example, senior officers of a large bank in my District recently described a variety of new steps they are taking to protect against credit losses. They are tightening underwriting practices across the entire consumer lending and small business loan portfolio. A recent strategy has involved classifying MSAs according to whether their real estate markets are stable, soft, distressed, or severely distressed, using both historical and prospective views of property values. Based on these designations, the company has reduced permissible combined loan-to-value ratios in their home equity portfolio, and going forward they intend to apply them across the entire consumer portfolio. On the positive side, though, they note that lower interest rates have spurred a surge in applications for mortgage refinancing, and a recent analysis shows that the reduction in the prime rate is having a significant impact on ARM reset expectations, shifting a large number from increases to reductions at reset. In fact, an analysis conducted before our most recent rate cut that assumed a 7 percent prime rate in February 2008—and it is now at 6½—estimates that two-thirds of the subprime ARM portfolio would now experience a decrease in their monthly payments at reset. This is a sharp contrast from an analysis in June 2007 with a prime rate of 8 percent.

    Now let me turn briefly to inflation and inflation expectations. I project that inflation will decline over the forecast period to around 1¾ percent, and I see the risks around that forecast as balanced. Admittedly, though, the recent data on inflation have been worrisome, and they raise the issue of whether or not we can afford to cut rates as much as needed to fight a recession without seriously risking a persistently higher rate of inflation and inflation expectations. I tend to think this risk is manageable, largely because of the credibility we have built. It appears to me that this credibility has reduced the response of inflation to all the factors thought to influence it, including energy prices, the exchange rate, and business cycle conditions. Thus I consider it less likely that rising energy prices are going to push up core inflation very much or that the pass- through that does occur will easily get built into inflation expectations. So I view inflation as less persistent now than it once was, tending to revert fairly quickly to the public’s view of our inflation objective. I do hope that our long-run inflation forecast will help people identify what that objective is. But even if inflation expectations turn out to be less well anchored than I think, I still see the inflation risk going forward as roughly balanced. With less well anchored inflation expectations, there is greater risk that higher energy and import prices will pass through into core inflation and inflation expectations. By the same token, there is also a greater likelihood that inflation will decline should a recession occur. We looked at the behavior of core and total inflation in the first three years following recessions from 1960 to the last one in 2001, and inflation declined in most of these episodes. The exception is 2001, when core inflation remained essentially unchanged—which seems consistent with my view that inflation has become less responsive to the business cycle over the past decade or so as we have acquired more credibility.

  • Thank you. President Lacker.

  • President Yellen, I think you answered this, but could you say a bit more about your monetary policy assumption in your forecast. How did you get to an additional 75?

  • We assumed 50 at this meeting.

  • We assumed an additional 25, which would be held in place through 2009:Q1, and then a gradual rise.

  • I mean the “why,” not the “what.” Sorry.

  • Yes. Why that much rather than—

  • A larger amount? I wouldn’t attach too much significance to the precise figure—it’s somewhat more.

  • Thank you, Mr. Chairman. The Fifth District economy has shown additional signs of softness in recent weeks. According to our surveys, manufacturing activity drifted lower in the past few months, although we also heard reports of stronger overseas demand for U.S. goods. Revenue growth in the District’s services firms also weakened in January, and our index for that sector dipped into negative territory for only the second time in the past four years. Our retail index, which in December had blipped up to neutral after three negative months, dived again in January. Our retail respondents say that the holiday sale season finished up weaker than expected and that big ticket categories continue to slump, especially furniture and appliances. Business spending seems to have softened as well in recent weeks, as an increasing number of firms reported that they were delaying capital spending projects such as IT upgrades.

    At our December meeting, I reported on a former director who headed a firm that owned a large portfolio of retail properties and said that he described the sector as in the best shape he had ever seen in his life. Well, he is singing a different tune. Although his portfolio is in good shape so far, he is hearing a lot about cancelled projects as a result of financial constraints from lenders or equity interests, and he says that the environment that he is operating in is completely different from what it was when he talked to me sixty days ago. We are hearing very similar comments from a wide range of contacts in commercial real estate and community bankers. Residential real estate markets in the District remain generally weak. Home sales and construction remain dormant in many markets. Several Realtors reported seeing more prospective buyers, but they seem interested only in kicking the tires, in part because of difficulties in selling their current homes.

    Turning to prices, concerns about rising input costs were more widespread among our contacts in recent weeks. Our survey measure of manufacturing raw material prices was up sharply in January at 4.3 percent, the second highest reading in the fourteen-year history of the survey. The prices-paid measure in manufacturing was a touch lower but still in an elevated range. Expected price trends in manufacturing were off sharply, however, perhaps reflecting the softening in demand that many respondents said they expected. In the service sector, both current and future price trends picked up outside of retail. Labor market conditions in the Fifth District have deteriorated in the last month. In a noticeable shift from previous surveys, numerous contacts told us they had begun to trim payrolls. The job cuts were concentrated in machinery and building material manufacturers, financial services firms, and general contractors. In some regions, however—Northern Virginia, for example—some labor markets remain tight, and we continue to hear of difficulty finding highly skilled workers.

    I spent a bit more time than usual on our regional picture because right now I am placing a bit more weight than usual on our District reports and what I read in the Beige Book. One can be skeptical about the incremental value of anecdotal reports in typical times, but at times like these, I believe they can and do provide a more timely read on what is going on. These regional reports have shaded my outlook to the downside relative to the picture painted by the national data, which is itself a somewhat discouraging picture. Home construction has continued to decline, and the fall in permits last month suggests that further declines are in store. Consumer spending appears to have slowed somewhat at the end of last year and seems to be carrying less momentum into this quarter, as the Greenbook likes to put it. The December employment report certainly was weak and has added considerably to fears of a recession. The Greenbook forecast just skirts the border of an outright recession. My own projection is fairly similar but a bit weaker in the first half and with the weakness stretching out a bit longer this year. I am inclined to see the bottom in housing as occurring later than in the Greenbook, which has housing starts flattening out relatively soon, and I am a bit less hopeful about business investment, particularly structures. I agree with the Greenbook that the main effect of a stimulus package will be to shift consumption growth from ’09 to late ’08 but that the effects are uncertain. I think the risks are on the side of a smaller boost to spending, though. But there is a chance that many rule-of- thumb consumers will find that their rule is telling them to pay down debt. In sum, I expect very weak growth in the first half of this year with only gradual recovery to trend. While I think weak growth is the most likely scenario, similar to President Yellen, I do think that a recession is a quite distinct possibility this year. If that happens, I think it will be due to a more sizable pullback in nonresidential construction than we are expecting right now.

    Turning to inflation, it is hard to put a good face on the recent numbers. The Greenbook describes the recent upside surprise as transitory and expects inflation to diminish this year. Indeed, we have been getting some relief on retail gasoline prices in recent weeks. But I don’t think our problems with inflation are transitory, and I don’t want to lose sight of them in the midst of the current weakness. If you look back over the past four years, the overall PCE price index has averaged 2¾ percent. On a 12-month basis, the index has been below 2 percent only four months in that span. Now, one could interpret this as a regime of 2 percent inflation with a series of misses that happen to be virtually all on the plus side. Alternatively, you could view this as a regime in which inflation fluctuates around a mean of 2¾ percent. Market measures of inflation expectations seem more consistent with the former right now. But the longer that inflation averages well above 2 percent, the more risk we run of seeing expectations rising to match actual inflation rather than the other way around. Another way to see this is that the fragility we need to focus on now is our credibility. I mention all of this because it is why, in my economic projections this round, I wrote down a relatively sluggish recovery after the first half of this year. I am skeptical that we have seen nothing but positive inflation misses around a 2 percent trend for four years because of chance alone, and I am not optimistic about inflation coming down in a sustained way on its own. As a result, I believe that, in order to keep expectations from drifting up and to bring inflation down, we will need to raise rates later this year, even if that means a longer and slower recovery. Thank you, Mr. Chairman.

  • Thank you. President Plosser.

  • Thank you, Mr. Chairman. You know, listening to the staff discussion I have certainly come to understand why everyone continues to believe that economics is a dismal science. [Laughter] It is quite a dismal picture. But more seriously, recent economic data have certainly helped feed that view, and the Third District is no exception. Economic activity has weakened in our District since December, and to double the fun, firms continue to face increasing price pressures—not a very comfortable position for monetary policymakers. The Philadelphia staff’s state coincident indicators indicate that overall economic activity has been moderate in New Jersey, flat in Pennsylvania, and declining in Delaware over the past three months. Our Business Outlook Survey of manufacturers fell sharply in January. The index fell to minus 20.9 from minus 1.6 in December. Now, some of that we have to remember is sentiment, in the sense that the question has to do with general activity and doesn’t necessarily reflect just their firm. But it is a sentiment of pessimism that certainly is more prevalent than it once was. A reading that low, of minus 20, indicates declining manufacturing activity in the region and is usually associated with very low GDP growth or perhaps even negative GDP growth at the national level. More related to the firms’ own performance, though, the survey’s indexes of new orders and shipments also declined in January, and both are now in negative territory, although much less so than the general activity index.

    On the other hand, while expectations of activity six months from now have moved down somewhat this month, they remain firmly in positive territory, and firms’ capital spending plans over the next six months remain relatively strong. District bankers are reporting weaker consumer loan demand, but business lending continues to advance at a moderate pace from their perspective. Loan quality has shown slight deterioration, mainly in residential real estate and auto loans, to a lesser extent in credit cards, and to an even lesser extent on the business loan side. This downtick in quality follows a period of extraordinarily low delinquencies and default rates and thus is well within historical norms, so it has not greatly alarmed our banking community. Thus far, our District banks apparently have largely escaped the credit problems plaguing the larger money center banks and investment banks. While there has been some tightening in credit conditions and standards around the District, most non-real-estate-related firms I spoke with are not finding it difficult to obtain credit for any reasonable project they want to do, and so they have not identified largely with the credit crunch scenario.

    Despite the softness in the activity, firms in our District report higher prices in their inputs and outputs. As President Lacker said, inflation seems to be alive and well. The current prices-paid and prices-received indexes in our Business Outlook Survey accelerated sharply in January and are at very high levels, almost record levels, of the past twenty years. Firms also expect prices to rise over the next six months. These forward-looking price indexes, too, are at very elevated levels relative to their twenty-year history. I am hearing from business contacts and from one of my directors, for example, that they are planning to implement price increases to pass along costs they are experiencing. Thus, even though they are pessimistic about growth in the future, they are not pessimistic about price increases. This adds to my skepticism about arguments that link inflation too closely with resource utilization.

    The national near-term economic outlook is also deteriorating, as we have been hearing, and I have revised down my growth forecast for 2008 compared with my October submission. It is hard to find much positive news in the data released since our last meeting, and the Board staff has summarized that quite eloquently, and so I won’t repeat them. Nevertheless, in general, my forecast is probably slightly less pessimistic than the Board’s forecast. However, I must add that, at the same time that growth has slowed, inflation has trended up. Both the core CPI and the core PCE accelerated in the second half of ’07, compared with the first half. The core CPI advanced at a 2.6 percent rate in the second half of ’07, compared with a 2.3 percent rate in the first half, and the core PCE was up at a 2.4 percent rate in the second half compared with 1.9 in the first half.

    As we know, the PCE price index gets revised. Recent research by Dean Croushore, one of our visiting scholars, has shown that between 1995 and 2005 the average revision from initial release until the August release the following year was positive on average for both the core PCE and the total PCE. This suggests that inflation is likely to be even higher in the second half of ’07 than the current estimates indicate. I am also concerned that, over the past 10 year period, core and headline inflation for both the PCE and the CPI have diverged on average about 50 basis points. Headline rates have exceeded core rates in 8 of the last 10 years for the CPI and 9 out of the last 10 years for the PCE. While I would like to believe that these two rates should be converging on average, I am concerned that core rates may not be as indicative of underlying trend inflation as we might have thought. This line of thinking also leads me to question estimates of ex post real funds rates calculated by the staff and presented in the Bluebook, which are based on subtracting core PCE from the nominal funds rate. I am not convinced that the core PCE is the right measure of inflation in this context. Even if you thought it was, then the reported real rates are likely to be overstated for recent quarters given the apparent systematic bias in the preliminary estimates of the PCE that I have noted before. Moreover, some measures of inflation expectations are not encouraging: In particular, the Michigan survey one-year-ahead measures and five-year-ahead measures are up. We have already discussed a bit the acceleration in some of the TIPS measures. I will return to that in a minute. The Livingston survey participants have also raised their forecast for CPI inflation in 2008 from 2.3 percent to 3 percent.

    My forecast overall is similar to the Greenbook’s, and I expect a weak first half and a return toward trend growth later this year and into ’09 and inflation at the 1.7 to 2 percent range. But the policy assumptions that I make to achieve the forecasted outcomes for the intermediate term are different from the Greenbook’s. The ongoing housing correction and poor credit market conditions are a significant drag in the near term on the economy, and I expect growth in the first half of the year to be quite weak, probably around 1 percent. As conditions in the housing and financial markets begin to stabilize, I expect economic growth to improve in the second half of the year and move back toward trend, which I estimate to be about 2¾ percent, about 50 basis points higher than the Greenbook, I think, in 2009.

    The slowdown in real activity suggests a lower equilibrium real rate. How much lower is difficult to measure with any precision. Ten-year TIPS have fallen about 100 basis points since the beginning of September. In such an environment, optimal policy calls for the FOMC to allow the funds rate to fall as well. And we have; the funds rate is down 175 basis points since September—or more if we cut today. But we also must remain committed to delivering on our goal of price stability in this environment of rising prices. To my mind, that means we must continue to communicate that commitment to the markets and to act in a manner that is consistent with that commitment. I want to stress that while many of us, myself included, have argued that inflation expectations remain well anchored, we cannot wait to act until we see contrary evidence to such a claim because by then it will be too late and we will have already lost some credibility. I also might add that the staff memo on inflation compensation, which I thought was very good, suggests that one reason for the increase in forward inflation compensation might be a greater inflation risk premium rather than a rise in expected inflation. That may, in fact, be true, and I think the memo was very well done. But if that is the case, if the rise is in the inflation risk premium, then I think it might be worth asking ourselves if the increase in inflation uncertainty might be an early warning sign of our waning credibility.

    This perspective leads me to a different policy assumption from the Greenbook’s. In particular, once the real economy is stabilized, the FOMC must act aggressively to take back the significant easing it has put in place in order to ensure that inflation is stabilized in 2010. Employment is a lagging indicator, so we will likely have to act before employment growth returns to trend, should output growth pick up in the second half of the year as forecasted. Thus, I expect we will need to begin raising rates by the fourth quarter of this year and perhaps aggressively so. In contrast, the Greenbook assumes a flat funds rate at 3 percent throughout the forecast period. Despite the real funds rate remaining below 1 percent—and well after the economy has returned to trend growth—inflation expectations remain anchored in the Greenbook. In my view, this seems somewhat implausible or, at best, a very risky bet. It appears that the Greenbook achieves this result through an output gap—related to the question I was asking earlier this afternoon. I think all of us understand the very real concerns that many researchers have with our ability to accurately estimate the level of potential GDP. Furthermore, in the recent research on inflation dynamics that we have discussed—and President Yellen was referring to this—inflation becomes less persistent and appears to be less related to other macroeconomic variables as well. We do not know whether these changes are an outcome of a more aggressive and credible stance of monetary policy against inflation or are due to some fundamental changes in the world economy. If the lower persistence is due to enhanced policy credibility, then it is incumbent upon this Committee to maintain that credibility. Otherwise, we cannot expect inflation persistence to remain low.

    Thus, if the economy performs as forecasted on the growth side, with a return toward trend growth in the second half, I would be very uncomfortable leaving a real funds rate below 1 percent. The Bluebook scenarios involving risk management indicate that the inflation outcome is poor when there is a gradual reversal of policy. Better outcomes are achieved under a prompt reversal strategy. Given that forecast, I believe we must begin thinking now about what our exit strategy from this insurance we have put in place is going to be. How we communicate our monetary policy strategy will also be crucially important because of the effects such communications will have on expectations. We need to better understand in our own minds, I think, what our reaction function looks like so that we can be more systematic and articulate in our implementation of policy. Thank you.

  • Thank you. President Lockhart.

  • Thank you, Mr. Chairman. In my view, the decision we took on January 21 reflected a broad consensus that economic fundamentals were weakening at a rapid pace in an environment of continuing, even heightened, concern about financial market stress and fragility. My contacts over this last week in the business and financial markets may add a little texture to the picture on which we based our January 21 policy action. Conversations with these contacts in various industries provide information generally consistent with a downward revision of the outlook. Forward-looking sentiment of the directors of the Federal Reserve Bank of Atlanta turned decidedly pessimistic in January. Retail contacts noted quite disappointing results through mid-January and are taking a conservative approach to 2008 in terms of hiring and inventory. Regarding the residential construction industry, regional weakness continues and is spreading from coastal markets to interior markets. In addition, I had a conversation with the CEO of a large public homebuilder of national scope. He cited historically high contract cancellation rates, especially on the West Coast and the D.C. area, because of the buyers’ difficulty selling existing homes and getting financing. This limits their market to first-time buyers. His judgment is that a change in market atmosphere will require inventories falling to around six months. He pointed out that the spring is traditionally the key season for sales, so the next several months will be particularly telling.

    Weakness in the region’s commercial real estate market appears to be spreading. The retail segment is continuing to experience declining leasing activity, and weakness is now emerging in the warehouse and office markets as well. In partial contrast, reports from the manufacturing sector are more mixed. Activity remains very weak in housing-related industries. One CEO, reflecting the concern of others, predicted business failures in lumberyards and construction supply firms because of excess capacity and the slow response to a lower building environment. The trucking sector continues to slump. However, industries related to oil and gas production; import-substituting industries, such as steel, aerospace, and defense; and the foreign brand auto sector are all performing quite well. Atlanta’s national forecast is largely consistent with the Greenbook in direction, and our differences with the Greenbook in magnitude and timing are not material. Like the Greenbook, we premise our forecast on a lower funds rate at the level of 3 percent.

    So the principal risk to the forecast in my view is the fragility of the financial markets. Uncertainty and fear continue to loom large. I made a number of calls to financial market players, and my counterparts cited a variety of concerns relevant to overall financial stability. For instance, one of the recent concerns, as Bill Dudley depicted, has been the situation of the monoline credit insurers. Several of my contacts had comments, but I spoke to the newly appointed interim CEO of one of the two monoline insurance firms most prominent in the news, and he characterized the firm’s solvency and liquidity fundamentals as in question only toward the far end of current independent forecasts of subprime losses. Perhaps predictably, he contrasted his assessment with what he views as alarmist atmospherics resulting from press coverage, quixotic rating agency actions, and state regulator political positioning. A regional bank’s CFO cautioned that more data on actual mortgage performance in 2007 will soon be available, and that could force restatements in 2007 bank earnings. Commenting on market illiquidity, one source said that in some fixed-income markets, where many on the buy side currently depend on moderate leverage to achieve the required rates of return, banks have greatly reduced their lending. He also indicated that, even though there are real money investors—as he called them—interested in return to the structured-finance securities markets but currently on the sidelines, they are reluctant to expose themselves to volatility that arises under mark-to-market accounting using prices set in such illiquid markets. These anecdotal inputs simply point to the continuing uncertainty and risk to financial stability with some potential, I think, for self-feeding hysteria.

    I share with my colleagues on the Committee worries about the heightened levels of inflation and uncertainties around my working forecast that inflation will moderate in 2008. The assumptions about energy prices are the most precarious. Nevertheless, I am prepared to take the position that the economy, with its apparently rapid deceleration compounded by continuing financial volatility, is a greater concern than inflation at this juncture. Thank you, Mr. Chairman.

  • Thank you. President Hoenig.

  • Thank you, Mr. Chairman. Let me talk a bit about the region. The Tenth District is generally moving forward at a fairly steady pace, but there are some mixed data. The obvious wide variances are in real estate. Housing is weak—not as weak as some parts of the country but still weak. Also, it is interesting that commercial real estate in each of our major cities right now continues to do well. I recently talked with several developers. They are all doing well but are very concerned, and they are beginning to cut back on their plans and move away from them. So you can see the worry carrying forward in terms of what actions they are taking. In the agricultural area and in the energy area, real estate is a different story. It is booming. Land values have gone up in the ag part—non-irrigated land, something like 20 percent over the past year. If you are near an ethanol plant, it has gone up 25 to 30 percent. It is also interesting that the ag credit system is helping to fund that. Their increase in lending was about 12 percent this past year. That is up from about 9 percent the year before, so they are providing that. They are also now involved in lending to these ethanol plants in a very significant way, helping to carry that boom forward. That gives me some pause in terms of what is going on in some of the rural areas. Related to that, the energy and lease values are also accelerating at a fairly high rate. I found it reminiscent and somewhat disturbing in talking to a couple of individuals when they noted that the land values have about doubled over the past two or three years in some areas, and they said that I should relax because on current ag prices they should have tripled. [Laughter] Where have I seen that before?

    On the other side, actually, manufacturing in our region has held steady. We have a lot of aircraft manufacturing, which is really strong, and some other smaller manufacturers providing support in both ag and energy, and they seem to be doing well. Technology is also doing well in the region, especially in the mountain areas—the Colorado and Denver areas. Engineering firms are still very strong—the strong demand for engineers and the unfilled positions continue. They are supplying that service across the globe and see continued demand there. So it is mixed, but overall probably our region is doing better than average relative to the rest of the nation.

    On the national level, my projections suggest that we are going to grow below our potential growth rate. I am not as pessimistic as the Greenbook. I also have inflation coming down, but that is on the assumption that we are able to reverse our monetary policy at a fairly quick pace as we move through this year and into 2009. I will leave it there. Thank you.

  • Thank you. President Stern.

  • Thank you, Mr. Chairman. Let me talk about the economic outlook. My initial comments are organized kind of along the lines of Dave Reifschneider’s exhibit 1. There are certainly still some positive things going on: growth in exports, and I think that is likely to continue; strength in the agricultural sector and in natural resources in general, outside of lumber and wood products; state and local construction spending—there seem to be a lot of schools, hospitals, sports stadiums, et cetera, being built now; and the labor market may be a bit better than the December household and payroll surveys depicted, given the low level of initial claims.

    But I think those considerations are really overwhelmed by several factors on the negative side, and let me summarize those quickly. First is the breadth of the negative news on the national economy that we have received recently. The vast bulk of the news has been negative. It doesn’t suggest to me that there is a lot of positive momentum or latent strength left in the economy. The second factor I would cite—and this is not new—is the persistence of a large volume of unsold, unoccupied houses, with implications for activity in that sector, for prices, for wealth, and for foreclosures. Of course, as somebody already noted, many recessions turn out to be inventory recessions. If we have one, this will be an inventory recession, too; and the inventory in question is housing. Third, maybe even more important, are the financial conditions themselves—prominently but not exclusively, the impaired capital positions of large banks and likely prospects for growing credit quality problems in auto loans, in credit cards, in commercial real estate, and perhaps in other areas as well. Adding up those considerations, I think what we confront resembles the aftermath of the 1990-91 recession, when so-called headwinds restrained growth in real GDP, and my forecast anticipates something similar going forward, something like the persistent weakness scenario in the latest Greenbook. So I expect subpar growth both this year and next year before better growth resumes in 2010. I further expect lots of inertia in both core and overall measures of inflation this year and next before some diminution below 2 percent in 2010. Thank you.

  • Thank you. President Fisher.

  • First, Mr. Chairman, I want to say a good word about President Poole. I have sat next to him since I got here. I would give him hyperbolic praise if he hadn’t handed me the IT Oversight Committee; otherwise, I think he is a wonderful human being. [Laughter] Much of what I was going to say has been said. I think President Plosser, President Lacker, and others have summarized what I would have said about my own District. We continue to grow, but at a decelerated pace, and our current forecast is for employment growth of 2 percent for our District for 2008. That is relatively healthy, and I really am not going to take more time on that subject.

    I am delighted to hear all this anecdotal evidence. We were talking, Governor Mishkin and I, about Woody Allen earlier. If I remember correctly, he had a wonderful quip—that he cheated on his metaphysics exam by looking into another boy’s soul. [Laughter] Basically, what we are doing at this time of transition is almost cheating on the data by looking at the anecdotal evidence. My broader CEO soundings indicate pretty much the same as what we are seeing in our District and what others have mentioned—shipping, rail, express delivery, manufacturing, and other activities are much slower. Retail sales are soft. As President Poole and others pointed out, truckers are suffering. Receivables are being stretched out. Delinquencies are rising. I could bore you with specifics company by company, as I am tempted to do, but I will not unless you wish me to. The point is that, while there are tales of woe, none of the 30 CEOs to whom I talked, outside of housing, see the economy trending into negative territory. They see slower growth. Some of them see much slower growth. None of them at this juncture—the cover of Newsweek notwithstanding, a great contra-indicator, which by the way shows “the road to recession” on the issue that is about to come out—see us going into recession. I will just give you two indicators there. If you look at MasterCard and dig into their data, their December retail sales ex-auto, ex-gas, were up 5 percent and in January to date were up 4 percent. President Poole mentioned UPS, and President Lockhart has the incoming CEO of UPS on his board. Year over year to January, they are up 2 percent. So it is anemic. It is not negative. The expectation is not to be negative. My CEO soundings indicate pretty much what we have forecast as a group—much slower growth, not necessarily a recession.

    Where the difference comes, Mr. Chairman, is on the inflation front. Others have spoken eloquently about inflation. I just want to make a couple of comments here. It is uncanny in the charts that we show in exhibit 5, for example, that we have food PCE prices and energy PCE prices peaking almost as we speak. That may be true in the spot markets. That is not the way it works in reality. AT&T has 100,000 trucks. Southwest Airlines has I don’t know how many airplanes. They contract and hedge out forward their energy costs, and the kick-in of any turndown does not occur immediately but rather is stretched out over a time period. I would ask our staff, as we go forward, to try to get a better feeling for that. We are certainly struggling with that in Dallas. As far as food prices are concerned, which again I remind you are twice the weight of energy prices in the headline PCE and the CPI, I heard some very disturbing news. Frito-Lay, for example, which when we last met I reported was going to increase prices 3 percent, has inched them up another 3 percent, to 6 percent, and that is their planning for the year. This is the first time in memory, according to my contacts, that grocery prices are rising faster than restaurant food. Yet it is not simply food where we are seeing this kind of pressure, and I want to come back to the lag effect that occurs. This morning the CEO of Burlington Northern told me that the so-called rail adjustment factor, which captures fuel, labor, supply, and other costs from the previous quarter and is contractually input into contracts for the coming quarter, rose at the highest rate in history—11 percent. That means that even if you are shipping lumber, even if you are shipping whatever goes into housing, by contract—of course, that can be negotiated, I am sure—for the coming quarter the price rise from the shippers, the railers, will be 11 percent. Finally, going back to food and other items bought by consumers—when you drill down deep into Wal-Mart, which has 127 million customers, and you talk about the specifics of their sales, their expansion is not coming from unit sales, it is coming from price inflation. A senior official there tells me that they are budgeting a 2 to 3 percent increase for nonfood items for ’08, 6 to 7 percent for food items. It is the first time in his fifteen-year history at the company that they are going to use their price leadership strategy on the plus side of the inflation ledger. So I do worry about inflation expectations, Mr. Chairman. I will summarize with the statement that was in today’s New York Times by the CEO of Tyson Foods, who said, “Because of the unanticipated high corn and soybean meal costs, we have no choice but to raise prices substantially.” That is my major concern besides the additional weakness we are seeing in the economy. Thank you, Mr. Chairman.

  • Thank you. President Evans.

  • Thank you, Mr. Chairman. My assessment of the national economy is that we are in the midst of a period of very weak growth and that there is a significant chance of a serious downturn. The three-month average of our Chicago Fed National Activity Index in December was minus 0.67. Historically, by my calculation, such a value has been associated with a recession about 70 percent of the time. Now, in the Board briefings yesterday and again today, I noticed that Thomas Laubach’s estimate is 45 percent based on the same data, and that is certainly large enough for concern.

    Reports from my business contacts seem broadly consistent with this slow but positive growth scenario. The most positive news I received was from firms whose international businesses were strong. As one would expect, the most dire reports were from those in residential construction and related industries. While I was surprised to hear from the CEO of a national specialty retail chain that its business over the past 60 days was the worst he has seen in 45 years, much of his business is in housewares and furniture; but he indicated that many other segments of the retail sector were also struggling. I also spoke with the CEO of General Motors. His outlook was a lot like what President Fisher was just mentioning from other CEOs. They are looking for slow economic growth overall, and they are concerned about the risk of a serious downturn. That is not what they are planning on. The industry is clearly facing softer demand, but his expectation for 2008 as a whole is for only a moderate decline in light motor vehicle sales, down to a pace of about 15¾ million units. GM’s current production plans are not premised on recession-level sales, but they are prepared to cut production quickly if they see the economy turning down. He also reported that, while the performance of GMAC’s auto loans currently was okay, the credit quality of prospective buyers—people coming into showrooms— has declined and that lenders have tightened underwriting standards for those loans. In addition, if auto loans became more difficult to securitize, it would be a big additional problem. Apparently, so far they are robust, though.

    Turning to the forecast details, my modal outlook for 2008 is close to that in the Greenbook. I expect that we will eke out positive growth in the first half of 2008. This expectation largely reflects the judgment that businesses have not begun to ratchet down spending plans in the nonlinear fashion that characterizes a recession. My assessment also has been influenced by some positive developments that we have seen. The most notable ones in my mind are that UI claims have moved down, that major banks are having some success raising capital from a variety of sources, and that the orders data today were better. For the second half of 2008, I see growth increasing toward potential by year-end. This assessment depends importantly on accommodative monetary policy and expansionary fiscal policy. Our cumulative actions following this meeting should provide noticeable stimulus to the economy by midyear. Tax rebates should also help somewhat this year. In addition, the financial system should continue to sort through its difficulties, making further headway in price discovery and repairing capital positions. So in the absence of further negative developments, growth should improve in the second half of this year. I then see real GDP rising at a pace a bit above potential in 2009.

    Although this seems like a plausible projection, it has the feel of threading the needle, which brings to mind nimbleness, and Governor Kohn is our expert at nimbleness, so I start thinking about how his nimble fingers will be critical for threading this needle. The downside risks are large, and the recession scenarios are quite possible. Any of the factors currently holding back growth could intensify. For example, a reduction in bank lending capacity could make financial conditions much more restrictive. This, along with increased business pessimism and caution, could cause a more pronounced cutback in investment and hiring. Even a moderately weaker job market would add to the factors already weighing on consumer spending.

    Now, unfortunately, even while we are dealing with concerns on the growth front, the inflation picture is difficult and quite uncertain. The inflation outlook will likely be affected by more crosscurrents than usual. Headline inflation has been quite high, driven largely by increasingly high energy, food, and commodity prices. Although our best assessment is that these pressures will come off later this year, these influences have lasted longer than typical and could well continue to do so. I had calculated the same type of statistics that President Plosser calculated, but only since 1999. Headline PCE inflation has been running about 0.4 percentage point higher than core PCE since that time. This is a source of some concern and cautions us against relying too heavily on core inflation measures. I don’t think that is a big issue today, but we need to be thinking about that in our inflation strategy. In addition, core inflation has not improved as much as I expected. As the Greenbook discusses, the decline during the second quarter of last year may have reflected technical quirks in the indexes rather than true improvements in underlying inflation as I had hoped. The weakening U.S. economy is likely to diminish inflation pressures somewhat in 2008, but it is unclear how big a factor this will be or, given our projection that growth improves, how long it will last. So I think that inflation risk will be rising next year. Consequently, recalibration of short-term interest rates will be an important element of monetary policy in 2009. Looking at the write-up, it seemed to me as though 10 out of 17 participants had that viewpoint—different timing. Our inflation projection has core PCE running 2.1 percent in 2008 and edging off to 2 percent by 2010. In the context of what Brian was talking about in terms of slack, we have a higher inflation path and inflation coming down with a bit of slack. Much of the Committee’s discussion today has suggested that 2 percent is slightly higher than most participants’ benchmarks. For me, the trajectory of my outlook is satisfactory as long as I see inflation prospects continuing to improve as we move beyond the end of our current forecast period. Thank you, Mr. Chairman.

  • Thank you. President Pianalto.

  • Thank you, Mr. Chairman. In my view, economic conditions have deteriorated significantly since our December meeting. Taken as a whole, the stories that have been relayed to me by my Fourth District business contacts have been downbeat, and several of the contacts are concerned that we may be slipping into a recession. I’m hearing that consumer spending has declined appreciably since the soft December retail sales numbers were reported. The CFO of one of the nation’s major department store chains told me last week that her company’s January sales are shaping up to be the worst that they have seen in the past twenty years. She said that they had already cut back some of their buying plans because of the weak holiday sales, but after seeing the numbers for the first three weeks of January, she is concerned that they have not cut back buying plans enough. In December I had heard some upbeat assessments about the demand for capital goods and exports, but in January the incoming numbers are softer, and expectations for the coming year are less optimistic than they were just a month ago.

    I’m also concerned that I’m now detecting the first signals of a credit crunch. Bankers in my District tell me that they’re finding it much more difficult to issue debt and that they are safeguarding their capital. I’ve heard several motivations for this, depending on the institution. Some bankers are simply preparing for further losses. Some are expecting to have to bring some downgraded assets back onto their balance sheets. Even those bankers who have adequate capital say that they have become much more disciplined about how they’re going to allocate that capital. Collectively, the concerns that bankers have expressed to me about capital have convinced me that credit will be less available and more expensive than it has been in quite a while. Deals that bankers would have done for creditworthy borrowers not long ago are simply not being done today. Of course, it’s possible that nonbank financial companies will step in and fill the gap, but it is not clear to me that they have the capital and the risk appetites to do so.

    These developments have had a significant influence on the economic projection that I submitted for today’s meeting. Like many around the table, I continue to mark down my outlook for residential and nonresidential investment in response to the incoming data and also in response to greater business pessimism about the economic prospects. In addition, I’ve built in a sharper and more protracted slowing in consumer spending stemming from greater deterioration in the household balance sheet and tighter credit market conditions. These adjustments have caused me to cut my 2008 GDP growth projection about 1 percentage point since the December meeting, and some of that weakness spills over to the out years. If credit conditions deteriorate further than I have expected, then my projection would more closely resemble the persistent weakness alternative scenario described in the Greenbook. But that isn’t my projection for the economy. Rather, my projection is roughly in line with the Greenbook baseline.

    My inflation outlook hasn’t changed much from where it was in December—or October, for that matter. Like the Greenbook, I still project inflation to moderate as commodity prices level off and business activity wanes, but the risks to my inflation outlook have shifted to being weighted to the upside. The December CPI report was not much improved from the troubling November data, and my business contacts continue to report that commodity prices are being passed downstream. So I have less conviction in the inflation moderation than I did a month ago. That said, the downside risks to the economy still dominate my thinking about the outlook today. I do believe, however, that our policy response to date combined with an additional rate cut tomorrow will allow the economy to regain some momentum as we move into the second half of 2008. Thank you, Mr. Chairman.

  • Thank you. President Rosengren.

  • Thank you, Mr. Chairman. The contours of our forecast are broadly in line with the Greenbook: Growth well below potential for the first half of this year results in additional slack in labor markets with a consequent reduction in the core rate of inflation over time. Our forecast returns to full employment by 2010 only if we reduce interest rates more than they are in the Greenbook. Thus, our baseline forecast assumes that we reduce rates 50 basis points at this meeting followed by additional easing in 2008, which eventually results in core inflation below 2 percent and the unemployment rate settling at our estimate of the NAIRU, somewhat below 5 percent. But even with this easing, there are significant downside risks to this forecast. Historically, increases in unemployment in excess of 0.6 percent and forecasts of two or more quarters of real GDP growth below 2 percent have almost always been followed by a recession. In fact, a variety of probit models looking at the probability of recession in 2008 indicate an uncomfortably high probability of recession, in most cases above 50 percent.

    Several factors make me concerned that the outlook could be worse than our baseline forecast. First, we have consistently underestimated weakness in residential investment. While our forecast assumes a gradual decline in real estate prices, it does not have a substantial feedback between rising unemployment rates causing further downward pressure on real estate prices and the health of financial institutions. Were we to reach a tipping point of higher unemployment, higher home foreclosures, increased financial duress, and falling housing prices, we would likely have to ease far more than if we were to act preemptively to insure against this risk. Second, our weak consumption is driven by negative wealth effects induced by weakness in equity markets and modest declines in real estate prices. However, the heightened discussion of a potential recession could easily result in a larger pullback by consumers. This would be consistent with the behavior of rates on credit default swaps of major retailers, which have risen significantly since the middle of December. Third, banks are seeing increasing problems with credit card debt. Capital One, one of the few concentrated credit card lenders, has had their credit default swap rate rise from less than 100 basis points to more than 400 basis points as investors have become increasingly concerned about the retail sector. While liquidity concerns have abated, credit risk for financial institutions has grown. Rates on credit default swaps for our largest banks have been rising since December, despite the announcement of additional equity investments. In addition, the greatest concern I hear raised by the financial community in Boston is a risk posed by the monoline guarantors. The movement in equity prices last week as a result of highly speculative statements on resolving the monoline problem indicates a sensitivity of the markets to significant further deterioration in the financial position of the monolines. Fourth, our model does not capture potential credit crunch problems, although supplementary empirical analysis conducted by the Boston staff suggests that such problems pose additional downside risks to our outlook. Bank balance sheets continue to expand as banks act in their traditional role of providing liquidity during economic slowdowns. While the balance sheet constraints are likely to be most acute at our largest institutions, further deterioration in real estate markets is likely to crimp smaller and midsize banks that have significant real estate exposures.

    Given my concerns that we could soon be or may already be in a recession, I believe the risks around our forecast of core inflation settling below 2 percent are well balanced. Inflation rates have fallen in previous recessions, and I expect that historical regularity to be maintained if growth is as slow as I expect. Thank you, Mr. Chairman.

  • Thank you. Vice Chairman.

  • Thank you, Mr. Chairman. Let me just start by saying it’s not all dark. [Laughter]

  • Don’t worry; be happy?

  • I’m going to end dark, but it’s not all dark. The world still seems likely to be a source of strength. You know, we have the implausible kind of Goldilocks view of the world, which is it’s going to be a little slower, taking some of the edge off inflation risk, without being so slow that it’s going to amplify downside risks to growth in the United States. That may be too optimistic, but the world still is looking pretty good. Central banks in a lot of places are starting to soften their link to the dollar so that they can get more freedom to direct monetary policy to respond to inflation pressure. That’s a good thing. U.S. external imbalances are adjusting at a pace well ahead of expectations. That’s all good, I think. As many people pointed out, the fact that we don’t have a lot of imbalances outside of housing coming into this slowdown is helpful. There’s a little sign of incipient optimism on the productivity outlook or maybe a little less pessimism that we’re in a much slower structural productivity growth outlook than before. The market is building an expectation for housing prices that is very, very steep. That could be a source of darkness or strength, but some people are starting to call the bottom ahead, and that’s the first time. It has been a long time since we’ve seen any sense that maybe the turn is ahead. It seems unlikely, but maybe they’re right.

    In the financial markets, I think it is true that there is some sign that the process of repair is starting. We have seen very, very substantial adjustment by the major financial institutions; very, very substantial de-leveraging ahead as the institutions adjust to this much, much greater increase in macroeconomic uncertainty and downside risk; very, very substantial early equity raising by major firms; pretty substantial improvement in market functioning; and easing of liquidity pressure. Those are useful, encouraging things. There is a huge amount of uncertainty about the size and the location of remaining credit losses across the system. But based on what we know, I think it’s still true that the capital positions of the major U.S. institutions coming into this look pretty good relative to how they did in the early 1990s. Of course, as many people have said many times, there’s a fair amount of money in the world willing and able to come in when investors see prices at sufficiently distressed levels. One more encouraging sign, of course, is that the timing, content, and design of the stimulus package look as though the package will be a modest positive. It could have been a worse balance of lateness and poor design, but I think it looks to be above expectations on both timing and design, and it will help a little on the downside and take out some of the downside risk.

    Having said that, though, I think it is quite dark still out there. Like everyone else, we have revised down our growth forecast. We expect very little growth, if any, in the first half of the year before policy starts to bring growth back up to potential. The main risk, as has been true since August, is the dangerous self-reinforcing cycle, in which tighter financial conditions hurt confidence and raise recession probability, causing people to behave on the expectation that recession probably is higher, reinforcing the financial headwinds, et cetera. The dominant challenge to policy is still to arrest that dynamic and reduce the probability of the very adverse outcome on the growth side. Of course, we have to do that without risking too much damage to our inflation credibility and too much damage to future incentives and future resource allocation.

    Like many of you, I think the inflation outlook for the reasons laid out in the Greenbook is better than it was. It’s not terrific, but it’s better. The risks are probably balanced around the inflation outlook. Our inflation forecast still has core PCE coming down below 2 percent over the forecast period. There’s obviously a lot of uncertainty around that, but I really think that you can look at inflation expectations in the markets as somewhat reassuring on the credibility front to date. So again, I think the key question for policy is how low we should get real short-term rates relative to equilibrium, and our best judgment is that we’re going to have to get them lower even with another 50 basis points tomorrow. We’re still going to need to try to reinforce the signal that we’re going to provide an adequate degree of accommodation or insurance against this very dangerous risk of a self-reinforcing cycle in which financial weakness headwinds reinforce the risk of a much deeper and prolonged decline in economic activity.

  • Thank you. Thank you, Vice Chairman Geithner, for a little less gloom here. I didn’t expect the bright side from that source. [Laughter] Like everyone else around the table, I have revised down my forecast, which looks very much like the Greenbook: a couple of quarters of very slow growth before a pickup in the second half of the year spurred by monetary and fiscal stimulus. The collapse of the housing market has been at the center of the slowdown, and most recent information was weaker than expected. There is no sign in the data anyhow that a bottoming out is in sight. Sales of new homes have dropped substantially, and that must reflect reduced availability of credit, especially for nonprime and prime nonconforming loans, and perhaps buyers’ expectations of further price declines. As a consequence, a steep drop in housing construction has made only a small dent in inventories, and those will continue to weigh on activity and prices. Indeed, house-price declines in the Case-Shiller index picked up late last year. I think we just got November.

    It looks increasingly as though other sectors are being affected as well, slowing from the earlier pace of expansion and slowing a little more than expected. You can see this in broad measures of activity, as President Stern pointed out: industrial production, purchasing manager surveys, and the employment report. I think it is also evident in some measures of demand. Retail sales data suggest a deceleration in consumer spending late in the fourth quarter. Orders and shipments for capital equipment excluding aircraft picked up in December, but that followed a couple of months of flat or declining data. A slowdown in consumption and nonhousing investment probably reflects multiplier-accelerator effects of the drop in housing, a decline in housing wealth, and additional caution by both businesses and households given the highly uncertain and possibly weakening economic outlook. Certainly the anecdotes we’ve heard around the table reinforce the sense of business caution.

    But like other people, I see the softening outlook and the spread beyond the housing sector as importantly a function of what’s going on in the financial sector and of the potential interaction of that over time with spending. We have seen improvements in short-term funding markets, in spreads, and in the leveling out of the ABCP (asset-backed commercial paper) outstandings, but investors and lenders seem increasingly concerned about the broader economic weakness and spreading repayment problems, and they are demanding much greater compensation for taking risk in nearly every sector. To me one of the defining characteristics of the period since, say, mid- November is the spreading out from the housing sector of lending caution to other sectors in the economy. Nonfinancial corporations have experienced declines in equity prices. Credit spreads on both investment-grade and junk bonds have increased. A substantial portion of banks reported tightening terms and standards for C&I loans. Commercial real estate sector lenders are very concerned about credit. Spreads on CMBS have risen substantially, and most banks—like 80 percent—tightened up on commercial real estate credit, and that has to affect spending in that sector over time. Banks tell us that they are being more cautious about extending consumer credit, as President Yellen noted. A number of large banks noted a pullback in this area and deterioration in actual and expected loan performance when they announced their earnings over the past few weeks. There have also been increasing doubts about how robust foreign economies will remain, and this was evident in equity markets around the globe and in rising risk spreads on emerging- market debt. The staff has marked down its forecast of foreign GDP growth again this round. The total decrease in projected foreign growth in 2008 since last August has been around ½ percentage point, and this is at a time when we are counting on exports to support economic activity.

    The extraordinary volatility in markets is, I think, indicative of underlying uncertainty, and that underlying uncertainty itself will discourage risk-taking. The uncertainty and the caution are partly feeding off the continued decline in housing, the still-unknown extent of the losses that will need to be absorbed, and the extent to which those losses are eroding the capital of key institutions like the monolines. The monoline issue raises questions about who will bear the losses and provides another channel for problems spreading through the credit markets, through losses being felt or credit being taken back on bank balance sheets, making them more cautious, and even more directly, into the muni market through the monolines. Despite these developments, my forecast for 2008 was revised down only a few tenths from October. But that is because of the considerable easing of monetary policy undertaken and assumed in my forecast. I assumed 50 at this meeting, and unlike that piker, President Yellen, I assumed another 50 over the second quarter.

  • I’ll see you and up you. [Laughter]

  • This is a bad dynamic.

  • I thought we needed some insurance, and I also assumed some fiscal stimulus as in the Greenbook. I still see, despite these policy responses, risks around my outlook for activity as skewed to the downside, and it’s because of the potential further increases in required compensation for risk and tightening standards for extending credit and the feedback on demand.

    Although inflation has been running higher than expected of late, and that is troubling, I expect it to ease back even with my more accommodative policy. The combination we’ve seen of slower income growth and higher inflation suggests elements of a supply shock, and that’s obviously coming from the energy sector and its spillover into food. It is true, as President Fisher pointed out, that some of those increases in food and energy prices are coming from demand from emerging-market economies, but to the extent that such demand is putting upward pressure on our prices and it’s not really sucking exports from the United States at any great rate, I think that it acts more like a supply shock on the U.S. economy than a demand shock. Energy and other commodity prices should level off in an environment of slower global growth, and they’ve started to do that. They have at least showed signs of leveling off recently. Greater slack in resource utilization and product markets should discipline increases in costs and prices. At least some of the reports about airlines suggest that they have tried to pass through fuel surcharges and have been unable to do so, and I think that’s an encouraging sign from the inflation perspective. Any easing of inflation pressure does require that inflation expectations not begin to ratchet higher. I agree with everyone else. I’m persuaded that the balance of evidence is that they have not, despite the rise in five-year- forward inflation compensation and despite the persistently higher rate of increases of total headline than of core inflation. But this is something we will need to monitor very carefully. I interviewed Paul Volcker yesterday afternoon for our oral history project. The discussion with him reminded me again of the high cost of reversing a rise in inflation once higher inflation expectations become entrenched. Thank you, Mr. Chairman.

  • Thank you. Governor Warsh.

  • Thank you, Mr. Chairman. I will endeavor to stay out of the growing, creeping pessimism caucus. [Laughter] You can judge for yourselves whether I’ve been successful doing so. Let me talk briefly about two economies that are in a tug-of-war, and rather than reference the housing and nonhousing economies, let me try to talk about it in the context of the economy of financial services versus the real economy. On one level, of course, financial services are not so large a share of GDP that they could threaten the macroeconomy. But the transmission mechanism between credit markets and the real economy, whether it be through the credit channel or other channels, while imperfectly understood, is having very negative effects on the cost and availability of credit for real businesses and households, with the risks there to the downside. Financial institutions, as many of you said, are open for business, but I would say somewhat less so than when we met in December. As we approach the credit line renewal season, that is happening amid a period of depleted credit availability and significantly tighter lending standards. In addition, financial institutions as a group are, in my view, undercapitalized, even with the recent capital infusions. Finally, the dynamism that I would be hoping to see among financial institutions is clearly lacking; and while I think, as President Pianalto referenced, that there are new market entrants like hedge funds that are pretty keen to provide mezzanine financing, it’s a pretty slow process to match providers and users of capital. So at least for the near-term forecast, I wouldn’t expect that to come much to our rescue.

    If the U.S. financial institutions were an economy all to themselves, they would probably already be in a recession. While that doesn’t necessarily equate to a recession for the broader economy, it sure doesn’t help. The repair process that President Geithner referenced among financial institutions strikes me as very fragile and quite incomplete. Income statement shortfalls due to falling profits, poor visibility, weaker pipelines, and the need to reduce headcounts very meaningfully strike me in some ways as a more urgent and troublesome issue for large financial institutions than their balance sheet weakness. On the balance sheet front, however, I’m also concerned that more impairments are to come for large financial institutions and more dilution is expected for current shareholders. Although the window for foreign investment is open now, I wouldn’t expect that window to stay open throughout 2008. So even though I’d say that income statement concerns should be more pressing for them, these balance sheet issues are very real. In some way these institutions have been built, or I should say rebuilt, over the past six years to prepare themselves for a low volatility, high liquidity world, and what they found is the exact opposite. They are at different levels of understanding the new world, and it will take them quite some time to rebuild their businesses to be profitable in it.

    Rolling capital calls across financial institutions are continuing. Many are hoping to play for time, but I think there’s a risk that time will run away from them as new events find their way into the front pages. Virtually no financial institution strikes me as immune to these pressures, and while we see that new problems and new acronyms are emerging daily, they strike me as having the same underlying problems affecting different asset classes. Regional banks have begun to fund their balance sheets successfully—certainly a good sign—but I suspect that they are also in the early stages of needing to raise considerably more capital.

    As Governor Kohn said, there is a hope and an expectation that global institutions would be a source of strength, at least in financial services. Again, in financial services, my sense is that non- U.S. financial institutions, especially those in the United Kingdom and Europe, are in the midst of playing catch-up to their U.S. counterparts. I expect the year-end reporting process for them, which really begins now but will be at full speed by mid-February through early March, will find many of the Landesbanks needing to be recapitalized. I think we’re going to find that both large and small institutions are having a hard time getting through the bank reporting season in Europe. Equity prices in Europe and CDS spreads are already giving us some indication of what’s on the horizon. It’s not just about subprime in Europe, contrary to some of the indications we received. Perhaps even more than U.S. institutions, many European financial institutions have incorrectly believed that high credit ratings across asset classes would in and of themselves serve as protection. The overreliance on credit ratings that we see in the United States strikes me as even more pronounced in Europe. The shocks caused by these financial institutions could have a dramatic impact on their economies, probably more so than the effect of U.S. financial institutions here in the United States. That obviously has a consequence in terms of a further shock and also a consequence on the real side in terms of U.S. exports.

    Let me turn to the other side of that, that is, the real economy itself, excluding financials. I think many of you referred to the labor market data, which strike me as mixed. I’m perhaps a touch more optimistic that we’re going to see some improvement at least in the short term there, but I can’t have the conviction that I’d like. The real economy is doing its best to resist these financial shocks. We can see that fight playing out around E&S spending, around business fixed investment, and around cap-ex more generally. You have nonfinancials with strong corporate balance sheets, excess cash, and high profit levels that are debating in corporate boards about the uncertainty posed by the macroeconomy. It’s hard to say which side is going to prevail in that battle. The backdrop, as many of you mentioned, has weakened, with risk premiums widening across the board. Real PCE for January is not showing much of a snapback from a weak December but also, I would say, not much more deterioration from December levels according to the credit card companies that I spoke to. The bottom line on the real economy—the trends in the real economy may be a bit more positive coming into the first quarter from the fourth quarter than the Greenbook projections, but I would say I am a little less optimistic that the fiscal stimulus package is as likely to be as constructive as the Greenbook would have us believe.

    The forecast, as a result, overall depends on the ability of nonfinancial corporations to hire and invest despite this macroeconomic uncertainty. I have some confidence that the Fortune 500 will be willing to continue to push along this path of moderate growth; but small companies, particularly those that are really the source of job creation, may be more negatively affected while the credit channel is impaired, and this is happening at a critical time. The Greenbook base case or the “faster recovery” pace depends to a degree on improvement in credit intermediation or at least not another shock, and it’s that other shock that worries me. If deterioration among credit intermediaries continues, the real economy will suffer. Of course, the correlation is hard to pin down.

    Finally, on the inflation front, I share the concerns expressed by several of you that the persistence of recent inflation information coming into this period is a cause for concern. I’m less sanguine than the Greenbook that we’re going to see the power of that inflation fade in the event that the economy softens some. The backdrop of stubbornly high commodity prices, despite lower global demand in recent weeks, and a lower exchange value of the dollar are likely to put pressure on the inflation front. The data, as we have all talked about, on core and total inflation are not promising, so I would consider that also to be an upside risk. Thank you, Mr. Chairman.

  • Thank you. Governor Kroszner.

  • Thank you very much. Well, if that’s the optimistic scenario, I think we had all better pray. But I think it’s a relatively balanced scenario that accurately reflects the risks that are there. The Greenbook has done a very good job of trying to thread the needle, and I think making a close call for contraction but not actually calling it seems to be very reasonable. The kinds of insurance discussions in both the Greenbook and the Bluebook and that we’ve had preliminarily here make a lot of sense. Our models have never been successful at assessing turning points, and that is true whether they are the typical linear models, nonlinear models, probit models, Markov switching models, or other things like that. We sort of know once we’ve switched, but it’s hard to get that transition. As many people have suggested, there are an awful lot of indicators that would go into those kinds of models that would flash for contraction being likely. I think that is correct, but that makes it very difficult for us to assess what will happen. So I think—as well reflected in the projections—a lot of downside risk is there.

    I do share some of the optimism about improvements that we’ve seen in the financial markets, but I had that feeling in October and November, and it is hard for me to really understand exactly what drove the subsequent deterioration. Certainly there were some issues around year-end, but it seems that more issues than just the year-end were driving the fairly significant reversal of improvement that occurred during October through mid-November and the fairly sudden backing up. So I’m concerned that, since I don’t really understand what happened there, I don’t want to take too much comfort from what has happened so far. But I also don’t want to dismiss what has happened so far because it’s certainly conceivable that things will move in a more linear way forward for improvement.

    One issue that I raised both at the last FOMC and in our various conference calls related to some discussions I’ve had with the major credit card companies, which in some sense have a very good feeling for real-time consumption. I’ve talked with two major credit card companies, and they both had very negative views of what had happened in the very sharp transition consistent with a switch into a contractionary state from the discussions before the October FOMC versus before the December FOMC. But in the most recent discussions, basically it flattened out. It’s certainly not recovering, but it is not a continuing downward trend, which at least in my view provides a great deal of comfort because I was very concerned about the nonlinear break to a very low consumption state, and I think there’s less evidence of that. I won’t go through the specifics of what they said, but basically we’re still seeing challenges and increases in personal bankruptcies, slower repayment rates, more people slipping from 30 days overdue to 60 days overdue, et cetera, et cetera. But it’s not as dramatic a change, and it’s sort of within the range that they have been anticipating given the data from December. Also as someone mentioned, and I have forgotten who, these numbers are still at relatively low levels. Now, the change is in a very bad direction and certainly could move very quickly, and we’ve seen that in other recession scenarios. But fortunately it seems, at least from this anecdotal evidence, that it isn’t a significant change to the downside, and it’s possible that it could just be re-flattening out. My concern is still that sort of “slow burn” scenario that I’ve talked about and that Nellie and others have fleshed out on the pressures on banks’ balance sheets. I liked Nellie’s very politically correct phrase “unplanned asset expansions.” That’s a very nice way of putting like “oh, my goodness, something is suddenly on the balance sheet that we didn’t expect”—SIVs, asset-backed commercial paper, and so forth. I think people are still waiting for the other shoe to drop, and the other shoe certainly could drop. There may be things that we haven’t fully anticipated, but we know that there are still leveraged loans that they can’t get off their books, a pipeline that’s still coming on. We know that many banks are still making mortgage loans and cannot get those off their books—at least the jumbo ones. It’s conceivable that raising the limits at Freddie Mac and Fannie Mae may help in the short run even if there may be costs in the longer run.

    A number of other things could suddenly come on the balance sheets. The example of what happened at SocGen is just another uncertainty that could be out there. So even at a major financial institution that was generally quite well respected, something like this could happen. A lot of finger pointing and a lot of uncertainty can come from that, and that’s broadly reflected in the CDS spreads. About the point that Bill Dudley made in conversation with President Rosengren about being careful to say, well, CDS spreads are lower in Europe and that suggests there’s less risk in Europe—you have to take into account the reaction function by the governments, by the regulators, in terms of recapitalization, as Governor Warsh made reference to. There are very real challenges, but overall we have seen these CDS spreads go up quite a bit. So I think that concern about the negative dynamic scenario that people talked about is real, and that’s why it is very important to be thinking about buying insurance.

    With respect to inflation, certainly some of the numbers have been worrisome. It is clear that inflation uncertainty is up. We can disagree as to exactly what that means either about credibility or whether it is just uncertainty or whether it’s upside or downside scenarios, but I think it is up and that is something we should be concerned about. We should carefully craft our message to take that into account because uncertainty can lead to unanchoring of inflation expectations, and that is something that we certainly don’t want to see. I don’t see evidence of unanchoring yet, but I do see a potential first step in that direction, which does concern me. The simple fact that a memo had to be written about what was going on with respect to some of these sharp movements suggests that it’s not clear. Although the memo was excellent, I think there are elements in it that suggest we don’t fully understand and we need to be very careful about that. Thank you.

  • Thank you. Governor Mishkin.

  • Thank you, Mr. Chairman. I think we’re all trying to be cheery here. It reminds me a little of one of my favorite scenes in a movie, which is Monty Python’s “Life with Brian.” I remember the scene with them there all on the cross, and they start singing “Look on the Bright Side of Life.” [Laughter] So let me talk a bit about my views on this. My personality does do that, but it is really that I’m strapped a bit to the cross. My view on the economy is that we are going to have quite a weak first part of 2008, in which we’re going to skirt recession. This is my modal forecast. I do think that the economy will be stronger in 2009 and 2010, but that’s because I decided to be even less of a piker than Governor Kohn. He accused President Yellen, but I was going to accuse him because I did actually assume a 75 basis point cut at this meeting and then another 50 basis point cut at the meeting following. Then I hoped that afterward we would be able to reverse. Of course, this is something to discuss tomorrow, but it has to do with my views on how you deal with financial disruptions and risk management. So I’ll talk about that tomorrow.

    Even though I have a scenario that looks okay, I do want to point out that four very significant downside risks really worry me. We all talked about them. Of course, the first is housing. But I worry about a particular dynamic, which is that the negative price movements that we currently see could be getting worse. People could be expecting that they’re getting worse, and therefore, they want to hold off from buying a house because the effective cost of capital is higher. As somebody who stupidly is just going to contract on a new house because I have to please my wife, I actually thought exactly along these lines and was thinking about pulling out but then decided that my marriage was more important.

  • It was close. [Laughter]

  • By the way, if you know my wife, no it wasn’t close. The second issue is that the potential for weaker house prices, which really is a significant possibility, not only could lead to lower household wealth but, more important, also could reduce the value of collateral for households and as a result mean that the relaxation of credit constraints that collateral affords is no longer there. That could have major implications in terms of household spending, so it is also a very substantial downside risk to PCE. The third issue is that we also see that the financial disruption has already gotten worse. The good news is that there has been improvement on the liquidity front, and I give a lot of credit to the TAF, which was superbly thought out by our staff and has been quite helpful. However, credit conditions have worsened. Particularly worrisome—and something that hasn’t been discussed much—is that the Senior Loan Officer Opinion Survey had substantial tightening. Usually when you see this kind of tightening, it could indicate that we could have serious negative economic consequences. Again, that actually makes me very nervous. Finally, to get even more depressed, there really is potential for a negative feedback loop that has not yet set in. The financial disruption that we’re seeing right now could then mean a more substantial worsening of the aggregate economy, and that could make the financial markets have even more strain, and you have a problem. So I really worry about the downside risks and think that they are very substantial and that we should be very concerned about them in thinking about what the appropriate policy stance is.

    On the issue of inflation, I’m more sanguine. I see inflation going down to 2 percent by 2009. The key here is that I think that inflation expectations are grounded—in fact, are grounded at a level that is consistent with my inflation objective, around 2 percent on PCE, which might be different from others’ views, but that’s where I am right now. In that context, given that inflation expectations plus expectations about future slack in the economy are the primary drivers of inflation dynamics, I actually think that inflation will come down. It is true that the recent inflation numbers have been very bad; but in thinking about the overall risks, I’m a bit different from the average person on this Committee because I think the risks are balanced and actually somewhat to the downside. The reason I say this is that I think that inflation expectations are grounded. At the same time, there is a substantial downside risk in the economy that could really widen slack in the economy, and that would mean that inflation would come down.

    I don’t want to be too sanguine on the issue of inflation expectations being grounded. In fact, one thing that I think we have to monitor very closely is what’s happening in terms of inflation expectations, particularly financial markets’ views of inflation expectations. In a sense, I think of that as the canary in the coal mine. We are also going to want to look at expectations spreading to professional forecasters and to households, but I think information would come in first in terms of the financial markets for the reason that they put their money on the table and react quickly. That’s one reason I think it’s very important to look at things like inflation compensation. But we do need to look at this and do the analysis. My reading of the analysis that the staff gave and my thinking about the issue is that there is just no evidence that inflation expectations have gone up. The story is extremely hard to tell to go in that direction. However, it is very easy to tell a story that inflation uncertainty has gone up a lot, and this is something that President Evans talked about and we talked about at the very beginning of a long day. In this context, that does concern me, and it really tells me that we have to think about whether we can better anchor inflation expectations. So I think that this is something that we have to be concerned about, but I do not think that what has happened in inflation compensation is that the canary is dropping dead at this stage. But we do have to monitor this very, very closely, and again, it’s part of the risk-management strategy that I think we have to pursue. Thank you, Mr. Chairman.

  • Thank you, and thank you all for succinct and very insightful comments. [Laughter] I’m going to try as usual to summarize what I’ve heard; but even more so than usual, no warranty is expressed or implied. Again, trying to bring together some of the comments, we noted that incoming data since the last meeting have been broadly weaker than expected, and anecdotes generally suggest slower growth, in some cases significantly slower growth. Housing demand, construction, and prices have continued to weaken, and inventories of unsold homes are little changed. Housing weakness has implications for employment, consumer spending, and credit conditions.

    With respect to households, consumption growth has slowed, reflecting falling house and equity prices and other factors, including generally greater pessimism about the labor market and economic prospects. The labor market has softened by a range of measures, with unemployment jumping in December. However, workers in some occupations remain in short supply. Together with financial indicators, weaker labor and consumption data suggest that the economy is at a risk of recession; in any case, it is likely to grow slowly for the first half of the year. The second half of the year may be better, the result of easier monetary policy, fiscal stimulus, and possible improvement in housing and credit markets. However, there are significant downside risks to growth, including the possibility of an adverse feedback loop between the economy and credit markets.

    Reports by firms are mixed. Investment may have slowed, reflecting uncertainty and slower growth in demand. Commercial real estate activity may be constrained by tighter credit conditions. Manufacturing is slow to mixed, though IT, energy, and some other sectors continue to be strong. Financial markets remain stressed. Credit conditions more generally appear to be worsening, and the problems may be spreading beyond housing. Additional risks are posed by the problems of the monoline insurers. Credit losses have induced tighter lending standards, and a key question is how severe those may become and how persistent they may be. One offset is the ability of banks to raise capital.

    Core inflation and headline inflation have remained stubbornly high and are a concern. One risk is the ability of some firms to pass through higher input costs. Inflation compensation has risen at long horizons, reflecting some combination of higher inflation expectations and inflation risk premiums. Going forward, a slowing economy, anchored inflation expectations, and possibly stabilizing food and energy prices should lead to more moderate core and total inflation. However, some see upside risks, especially the possibility that higher headline inflation might affect inflation expectations. So that’s my attempt to summarize. There’s a great deal more detail and a great deal more color in the conversations around the table.

    Let me try to add a few points. Again, much of what I’ll say has been said. I do think that there has been a significant deterioration in the outlook for economic growth and an increase in the downside risks to growth. It was sufficiently severe as to prompt me to call the January 9 videoconference that we had, and I think that since then we have had further deterioration. A number of things have happened and are going on. Very important, perhaps most important, is the continued further deterioration in the prospects for the housing market. Housing, of course, feeds directly into the real economy through employment, income, and wealth, and I think there are some indications that spillover from the housing sector to the rest of the economy is increasing. However, the critical aspect of the housing outlook is the relationship to the financial system, which I’ll come back to.

    Consumer spending has slowed. I think there’s little doubt about that at this point. There are a lot of factors now that are acting as headwinds in the consumer sector. Let me just point out the basic fact that most households in the United States have very little in the way of liquid financial assets. Therefore, when they, on the one hand, are denied access to home equity if they see tighter credit conditions on cards, autos, and so on, and if at the same time they see greater uncertainty in the economy and the labor market, then their natural tendency would be to be much more conservative in their spending. I do note that fiscal action may be of some help, particularly for people in that kind of situation. Like President Yellen, I think the indicators of a weakening labor market are broader than just the payroll report. There are a number of other things as well. We may get a better report this week. The UI claims are a little encouraging, but I do think that the weakening economy is going to drag down the labor market to some extent. Certainly the financial markets have deteriorated, reflecting greater concern about recession. We see it in the equity markets but also in short-term interest rates and a variety of credit measures as well. Finally, just going through this list of items, we continue to see problems—credit issues, banks concerned about additional losses not just in mortgages but perhaps in other areas as well—with the potential implication of a further tightening of credit conditions.

    Those are some of the developments that we’ve seen since the last meeting. On our January 9 call, I talked about the regime-switch model and those ways of thinking about the business cycle. Others have talked about that today. I think many of those models would suggest that the probability of recession at this point is quite high, at least 50 percent or more. I don’t think any of us would be happy to see a garden variety NBER recession; but if we had that, there would probably be a few benefits, including correction of some imbalances that we’re seeing in the economy and perhaps some reduction at the edge in the inflation picture. But, like others, I am most concerned about what has been called the adverse feedback loop—the interaction between a slowing economy and the credit markets. A phrase you might have heard, which is getting great currency among bankers, is “jingle mail.” Jingle mail is what happens when otherwise prime borrowers decide that the value of their house is worth so much less than the principal of their mortgage that they just mail their keys to the bank. (I wonder if that 140 percent is the right loan-to- value number. Maybe it’s less than that.) Even if prime mortgages hold up—and I think in some regions of the country there will be significant problems with prime mortgages—there is a lot of other potential trouble. We’re just beginning to enter the period of maximum subprime ARM resets. Second lien piggybacks and home equity loans are all questionable at this point. We haven’t begun to address the option ARM issue, which is about the same size as the subprime ARM category, and of course, we have the issues with the monolines and private mortgage insurers. Outside of mortgages, expectations for credit performance are worsening in a range of areas, including commercial real estate and corporate credit. So I think that even under the relatively benign scenario that the Greenbook foresees, we’re going to see a lot of pressure in the credit markets and perhaps a long period of balance sheet repair, tight credit, and a drag on the economy. Again, our experience with financial drag or headwinds has been that it can be quite powerful and deceptively so, and I think that’s a significant concern.

    Now, the central issue here, though, ultimately comes back to the housing market. Certainly by this point there must be some pent-up demand for housing. We’ve had obviously very low sales for a period. House prices are soft. Mortgage rates are low. Affordability is better. What’s keeping people from buying houses is the fact that other people aren’t buying houses. If there were some sense that a bottom was forming in the market or in house prices, we probably could actually see a pretty quick snap-back, an increase in housing demand, and that in turn would feed back into the credit markets, I think, in a very beneficial way. So there’s the possibility that, if the housing market can get restarted, we could get a relatively benign outcome.

  • However, there appears to be a law of nature that the turnaround in the housing market is always six months from the present date. We simply don’t have any evidence whatsoever that the housing market is bottoming out. We have guesses and estimates about how far prices will fall and how far demand and construction will fall. The key issue is prices, and we are far from seeing the worst case scenario that you could imagine in prices. So long as we don’t see any stabilization in the housing market or stabilization in house prices, then I don’t think we can say that the downside risks to the economy or to the credit system have been contained. Until that point, I think we need to be very, very alert to those risks.

    Everyone has talked about inflation, as should be the case. I am also concerned. The pickup in core inflation is disappointing. There are some mitigating factors, such as the role of nonmarket prices, which tend not to be serially correlated. We haven’t discussed owners’ equivalent rent in this meeting for the first time in a while, but we know that it can behave in rather odd ways during periods of housing slowdowns. The hope is that energy and food prices will moderate; in fact, if oil prices do rise by less than the two-thirds increase of last year, it would obviously be helpful. Nominal wages don’t seem to be reflecting high inflation expectations at this point. So I think there are some reasons for optimism; but as many people pointed out, there are upward pressures, including the point that President Fisher made that the lagged effects of the previous increases in energy, food, and other commodity prices have probably not been fully realized in core inflation. Furthermore, as we’ll talk about more tomorrow, to the extent that we decide at this meeting to take out some insurance against downside risks, then implicit in that insurance premium might be a greater risk of inflation six months or a year from now. So we have to take that into account as we think about policy and about our communications, as President Plosser and others have pointed out. In particular, as Governor Mishkin and others have noted, we need to think about a policy strategy that will involve not only providing adequate insurance against what I consider to be serious downside risks but also a policy strategy that involves removing the accommodation in a timely way when those risks have moderated sufficiently.

    So my reading of the situation is that it’s exceptionally fluid and that the financial risks, in particular—as we saw, for example, after the October meeting—can be very hard to predict. There are a lot of interactions between the financial markets and the real economy that are potentially destabilizing, and so we are going to have to be proactive in trying to stabilize the situation, recognizing that we have a confluence of circumstances that is extraordinarily difficult and that no policy approach will deliver the optimal outcome in the short term. We’re just going to have to try to choose a path that will give us the best that we can get, given the circumstances that we’re facing.

    All right. Any further comments or questions? We will reconvene tomorrow at nine o’clock. There is a reception and dinner, optional, available in the Martin Building. Thank you.

  • [Meeting recessed]