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

  • Good afternoon, everyone. Let me be the first to welcome Bill Dudley to the table.

  • Thank you. [Applause]

  • Today is our annual organizational meeting, so we have a few items to take care of.

  • I’ll start, if that’s okay with you.

  • Go ahead, Governor Kohn.

  • Before we get illegal here, I am honored and pleased to nominate Ben Bernanke to be Chairman of the Committee.

  • Thank you. Objections? [Laughter]

  • I need to interrupt again.

  • I am as pleased and as honored to nominate Tim Geithner to be Vice Chair.

  • Are there any objections? Thank you very much. Ms. Danker, will you read the list of staff officers of the FOMC.

  • Secretary and Economist, Vincent Reinhart; Deputy Secretary, Debbie Danker; Assistant Secretary, Michelle Smith; Assistant Secretary, Dave Skidmore; General Counsel, Scott Alvarez; Deputy General Counsel, Tom Baxter; Economists, Karen Johnson and Dave Stockton; Associate Economists from the Board, Tom Connors, Steve Kamin, Brian Madigan, Larry Slifman, and David Wilcox; Associate Economists from the Banks, Charlie Evans, Jeff Fuhrer, Bob Rasche, Gordon Sellon, and Joe Tracy.

  • Thank you. Are there any questions or comments? Approved without objection. Next on the agenda is a proposed change to Committee rules. We received a memo from Scott Alvarez and Debbie Danker, which concerns how a backup would be appointed in case the Desk Manager was unable to serve. Are there any questions for our colleagues on that memo?

  • I have a question. It has nothing to do with the changes, but something struck me this morning as I was reviewing this material again. Let me refer you to the FOMC’s Rules of Organization, page 1: “If a member or alternate ceases to be a president or first vice president of a Reserve Bank, a successor may be chosen in a special election by the boards of directors of the appropriate Reserve Bank or Banks and such successor serves until the next annual election.” Now, if Jack Guynn, for example, had retired last year in March, Atlanta had filled the position, and a president had been in place as of September, let’s say, would he have come back? This says “no” because it says “until the next annual election.” Am I reading that wrong? I’m not sure that has been even the practice in the past.

  • Our General Counsel can probably comment on that, but I can try.

  • There’s a little lawyer in all of us. [Laughter]

  • I believe the election that statement refers to is if a new president is appointed and that person is then elected as a member by the boards of directors of the three Reserve Banks, he or she would serve until the next annual election at this time of year, at which point the successor would be elected from one of the other Banks.

  • Then I was not reading it correctly; but you understand where my confusion came from.

  • That’s exactly right.

  • Okay. So the alternate would serve until the next president was in office. That has certainly been the practice; my question was about the wording. Thank you.

  • Are there other questions about the memo? I need a vote. In favor? Opposed? Thank you. Third, we need to select a Federal Reserve Bank to execute transactions for the System Open Market Account. Governor Kohn, would you like to make a proposal? [Laughter]

  • I nominate the Federal Reserve Bank of New York, once again.

  • Comments? Objections? Without objection. The fourth item is that we need to select the Manager of the System Open Market Account. Governor Kohn.

  • I’d be very pleased to nominate Bill Dudley as the Manager of the System Open Market Account.

  • You have to put your head down, Bill. [Laughter]

  • Thank you. Without objection. Thank you.

  • I think we should rule out humor. [Laughter] This is an important annual process, and New York plays an important role.

  • So it will not say “laughter” in the margins. [Laughter]

  • I think we’ve started on the wrong tone here. [Laughter] Item 5, we need authorization for the Desk operations. We have two items to vote on separately. On the domestic side, we have a memo from Bill Dudley proposing to change the accounting of repurchase agreements so they will be booked on the SOMA rather than on the books of the FRBNY. Are there any questions for Bill? If not, without objection. Thank you. On the foreign side, Mr. Dudley is proposing no change to the authorization, directive, or procedural instructions. Any questions? Without objection. Thank you. Bill, you’re up.

  • Thank you. In terms of market developments, I would like to focus on three major topics. First is the sharp adjustment in market expectations concerning monetary policy since the last FOMC meeting. Second, I will talk about the persistence of high risk appetites in credit markets, with a focus on what may be the most vulnerable market in the United States—the subprime mortgage sector. Third, I want to discuss the possible factors behind some of the sharp shifts we have seen in commodity prices since the last FOMC meeting, in particular whether these price movements reflect a shift in risk appetite among noncommercial investors or fundamental developments in supply and demand.

    First, there has been a sharp shift in market expectations with respect to interest rates since the last meeting. At the time of the December meeting, the consensus view among market participants was that the FOMC would begin to lower its federal funds rate target this spring and that this easing process would continue into 2008, with cumulative rate cuts of about 75 basis points. As you can see in chart 1, which looks at the federal funds futures market, and chart 2, which looks at the yield spreads between the March 2008 and the March 2007 Eurodollar futures contracts, expectations have shifted very sharply over the past month. There is now no easing priced in through midyear 2007 and a residual of only about 25 basis points of easing priced in beyond that. This shift in expectations can also be seen across the Treasury yield curve. As chart 3 shows, the Treasury yield curve is now slightly above where it was at the time of October FOMC meeting. Since the December FOMC meeting, there has been a rise of about 35 to 40 basis points in yields from two-year to thirty- year maturities. The shift in expectations is reflected predominately in real interest rates. As can be seen in chart 4, breakeven inflation rates have not changed much since the last FOMC meeting—the decline in breakeven rates that occurred early in the intermeeting period has been reversed more recently, and so we are at or slightly above where we were at the December meeting. This upward shift in real rates appears to reflect a reassessment by market participants not only about the near-term path of short-term rates but also about what level of real short-term rates is likely to prove sustainable over the medium and longer term. The buoyancy of the recent activity data may have caused some market participants to reassess what level of the real federal funds rate is likely to prove “neutral” over the longer term.

    Regarding the issue of risk appetite, there appears to be no significant change since the last FOMC meeting. Risk appetite remains very strong. Corporate credit spreads remain very tight—especially in the high-yield sector (as shown in chart 5)— and implied volatilities across the broad market categories—equities and interest rates (see chart 6) and foreign exchange rates (see chart 7)—remain unusually low. Moreover, the turbulence in some emerging debt and equity markets experienced early this month was mostly transient and has subsided as well. So things appear calm. But what are the areas of greatest risk?

    In the United States, the subprime mortgage market appears to be a particularly vulnerable sector. The vulnerability stems from four factors. First, this market is relatively new and untested. Chart 8 shows the overall trend of first residential mortgage originations and the share of these mortgages by type—conforming, jumbo, subprime, and alt-A, which is a quality category that sits above subprime but is not quite as good as conforming. As can be seen in this chart, subprime mortgage originations have climbed in recent years, even as overall originations have fallen. In 2006, subprime mortgages were 24 percent of total originations, up from a share of about 10 percent in 2003. The second factor is that credit standards in this market appear to have loosened in 2006, with the proportion of interest-only loans and low- documentation loans climbing as a share of the total. As a result, there are some signs that strains in this market are increasing. As chart 9 shows, delinquency rates have moved somewhat higher. In contrast, charge-offs remain low, held down by the rapid house price appreciation that we saw in recent years. Most noteworthy, as shown in chart 10, the most recent 2006 vintage of subprime mortgages is showing a much more rapid rise in delinquencies than earlier vintages showed. The third factor is that most outstanding subprime mortgage loans have adjustable rates. There is significant reset risk given the rise in short-term rates in 2005 and the first half of 2006 and the fact that many of these loans started with low “teaser” rates. Fourth, housing prices are under some pressure, and this could contribute to further credit strains. I see some risk of a vicious cycle. If credit spreads in the securitized market spike because loan performance is poor, a sharp downturn in lending could result as the capital market for securitized subprime mortgage products closes. This constriction of credit could put downward pressure on prices and lead to more credit problems among borrowers. The result would be additional credit quality problems, wider credit spreads, and a further contraction of credit. Fortunately, to date the news is still fairly favorable. The strong demand for the credit derivatives obligations created from subprime mortgage products has restrained the rise in credit spreads. As can be seen in chart 11, spreads are still well below the peaks reached in late 2002 and early 2003. Thus, the economics of making such loans and securitizing them into the capital markets still work. But this situation could change very quickly, especially if the labor markets were to become less buoyant and the performance of the underlying loans were to deteriorate, leading to a surge in delinquencies and charge-offs.

    Let me now turn to the commodity markets. The issue I wish to examine here is whether some of the sharp movements in commodity prices that we have observed since the last FOMC meeting represent shifts in the risk appetite among noncommercial investors who have put funds into commodities as a new asset class versus the contrasting view that these price movements predominantly represent changes in the underlying supply and demand fundamentals. To get a sense of this, let’s look briefly at three commodities that have moved the most and are representative of their classes—copper, corn, and crude oil. As chart 12 shows, the sharp decline in copper prices appears linked to the large rise in copper inventories at the London Metal Exchange. If anything, the price decline appears overdue. For corn, the rise in prices also appears consistent with declining stocks both in the United States and globally (see chart 13) as well as the growing demand anticipated for corn in the production of ethanol. For crude oil, the decline in prices is more difficult to tie back to inventories. Although U.S. inventories remain high relative to the five-year historical average (as shown in chart 14), this situation has persisted for some time without having a big effect on prices. Instead, the shift in oil prices appears to be driven mostly by longer-term forces. This can be seen in two ways. First, as shown in chart 15, the change in oil prices has occurred in both spot and forward prices. The oil curve has shifted downward in mostly a parallel fashion, which also calls into question the role of unseasonably warm weather as the primary driver. If weather were the primary factor, then the decline in prices should have been reflected much more strongly in the spot and very short-end of the oil price curve. Second, as shown in chart 16, OPEC spare production capacity has been increasing and is expected to continue increasing in 2007. This growing safety margin reflects both slower growth in global demand and the expansion of non-OPEC output. The improved safety margin may be an important factor behind recent developments in the energy sector.

    Finally, there were no foreign operations during this period. I request a vote to ratify the operations conducted by the System Open Market Account since the December FOMC meeting.

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

  • I was astonished when I saw the note—I think it was in the Wall Street Journal a couple of weeks ago—that oil consumption actually fell worldwide in ’06 relative to ’05, which really surprised me. I don’t know quite how to explain that because the economies around the world are pretty strong. I’m assuming that the longer-run price elasticities are taking hold and that a lot of the traders probably believe the elasticity is zero and they pushed prices up pretty high. Does that make sense?

  • I think that is definitely part of the story. Another part of the story is that in some countries, especially emerging market countries, the oil was heavily subsidized, and some of those subsidies are now coming off because continuing to subsidize as the oil price climbs entails a rather heavy budgetary burden. So you’re also seeing a sort of normalization of oil prices in a lot of places. Think about the oil that Russia used to sell to Eastern Europe or some of the surrounding countries at preferential prices. They are no longer getting those preferential prices, so there is a demand response. I think it is happening on both sides. There has been a demand response to higher oil prices, and there has been a supply response coming out of places like Africa.

  • If I may add a footnote—I think you also need to watch the pattern of how inventories have behaved. When prices were being pushed up in the process from, say, the end of 2003 to their various local peaks, the incentive to hold inventories rose. At some point in 2006, inventories were very high—we had basically filled every bucket we could find with crude oil—and inventories feed back. It’s a dynamic. Price changes create the demand for inventories. The real-time value of inventories feeds back on the price. So I think you saw some of that going on as well in 2006 in terms of driving the price versus driving usage. Purchase for inventory is not well measured. We have inventories only for the OECD, so separating production from consumption is not perfect because we can’t always capture the inventories and they are measured as consumption in some cases.

  • Bill, if you talk to the producers and the refiners—you’ll find out that I like to do that kind of thing—there has been some concern, although one can’t measure it with any precision, that the so-called city refiners in London or on Wall Street, meaning the speculators, do affect prices. We have had some discussions with your predecessor, but I’m curious as to what your views on that phenomenon are.

  • As you know, this topic is undergoing a lot of further research. The academic literature that I’ve surveyed has yet to uncover a strong causal relationship between a climb in speculative open interest and the effect on price. One reason that is hard to imagine happening to a powerful degree in the end is that the speculators really don’t want to take actual delivery of the physical commodity, and so the price really should clear in the spot market on what’s happening to underlying supply and demand. But this topic certainly remains under investigation by a number of researchers. I don’t think we have the definitive answer to the question at this point.

  • But we’re still working on it.

  • Vice Chairman Geithner.

  • Bill, could you or Dave remind us what share of the total outstanding stock of mortgages consists of subprimes or what share of the housing stock do we think is financed at the subprime level? My recollection is that the share is still small even though it has been a large part of the recent flows.

  • It’s quite a bit smaller share of total outstanding because the average life of the subprime mortgage loan, I’m told, is only two or three years. In other words, if your credit quality improves, you will refinance out of your subprime mortgage into a higher quality mortgage. So originations are 24 percent, but the actual number of subprimes that are actually outstanding is much lower.

  • We reported in yesterday’s briefing that subprime borrowers constituted only about 13 percent of all mortgages outstanding.

  • Ex post subprime mortgage-backed securities seem to have been overvalued in the sense that they underestimated default risk for some market segments. So the presumption would be that such information gets taken on board and reflected in the prices of new mortgage-backed securities and that it would translate into higher credit spreads at the retail level. In your remarks you seemed to suggest that there is a chance that this process of adjustment might cause markets not to work. I’m wondering what you meant by that.

  • It’s not that markets won’t work. It’s just the economics of originating subprime loans and selling them into the market would no longer work. In other words, at some point, if the actual capital markets are not willing to accept those subprime mortgages at the right price, then the ability of the person to originate the mortgages and sell them into the market goes away. Now, would this wreck the market? Well, it depends, because some subprime originators can carry these loans on their own books. But the industry is quite fragmented, with a lot of these issuers not having the ability to carry these subprime loans on their books. So that part of the subprime origination market would go away. Some of the monoline subprime originators would be unable to exist if there weren’t a securitized demand for those assets.

  • So quantities would go down.

  • You could think of the situation as credit availability to that sector diminishing, which could have feedback effects on price. That’s the risk.

  • Are there other questions? We need a vote to ratify domestic operations.

  • Without objection. We turn now to the economic situation. Mr. Slifman.

  • Thank you, Mr. Chairman. I’ll wait for my colleagues to come to the table. We’ll be using the chart package that you all should have on the economic outlook. Separating the signal from the noise in the recent economic data has not been easy—what with the motor vehicle anomaly, the defense spending pull- forward, and the transitory swings in oil imports. We tried to cut through the clutter by highlighting in the Greenbook real private domestic final purchases, or PDFP— that is, the sum of consumption, residential investment, and business fixed investment. We think this aggregation, which is shown on line 3 of the table in exhibit 1, currently is giving a fair representation of the thrust of aggregate demand. The data that we have received since the December meeting have been stronger than expected. As a result, we have revised up our estimates of the growth of PDFP in both the fourth and the first quarters to annual rates of about 2 percent—roughly the same rates as those in the middle two quarters of 2006.

    The remaining panels of exhibit 1 highlight some of the indicators that have informed our judgment about the current pace of activity. Starting with the labor market, the middle left panel, increases in private payroll employment averaged 119,000 in the fourth quarter, close to the average pace in the preceding two quarters. As you may remember, at the last FOMC meeting we commented on the stronger signal for activity coming from the labor market compared with the spending data. That tension seems to have been largely resolved, not because of weaker employment but because of stronger spending—especially consumption. Retail sales increased briskly in November and December; accordingly, in this Greenbook, we boosted our estimate of fourth-quarter real PCE growth, the middle right panel, to an annual rate of about 4½ percent. The fundamentals for consumption remain quite solid: steady employment gains, recent declines in energy prices that have raised real income, well- maintained consumer sentiment, and further increases in stock market wealth. That said, at least according to some of our models, the fourth-quarter pace of consumer spending was stronger than would have been consistent with those fundamentals. Our forecast for the growth of real PCE in the first quarter, at 3.6 percent, reflects a bet that some of the surprising fourth-quarter strength will carry forward for a while. Turning to housing, sales of new and existing homes—which are not shown in the exhibit—appear to have stabilized in recent months, and the ratio of new home inventories to sales has moved down a bit. As shown in the bottom left panel, the apparent stabilization of housing demand may now be starting to show through to permits and starts for single-family homes. Of course, the unusually warm weather in December makes a definitive assessment at this time particularly difficult. In the business sector, investment spending slowed appreciably in the fourth quarter. In particular, shipments of nondefense capital goods, the red line in the panel to the right, have been unexpectedly soft recently, including the December figure that we received after publishing the Greenbook. Part of the recent weakness in this category appears to be for purchases of equipment related to construction and motor vehicle manufacturing. With orders remaining above shipments, we expect real equipment spending to rise modestly in the first quarter.

    Exhibit 2 takes a closer look at some recent developments, starting with an examination of the effects on the industrial sector coming from the recent sharp declines in the production of light motor vehicles and residential investment. By our reckoning, production of light motor vehicles, the top left panel, tumbled nearly 20 percent at an annual rate in the third quarter of 2006 and dropped further in the fourth quarter. Meanwhile, we estimate that residential investment, shown to the right, plunged at an annual rate of about 20 percent in both the third and the fourth quarters. In thinking about the effects of these developments on industrial production, we need to keep in mind the upstream effects. As noted in the bulleted items in the middle left panel, the drop in production of light motor vehicles affects IP not only through its direct effect on light motor vehicle manufacturing but also indirectly through its influence on production in upstream industries such as primary metals, tires, and, nowadays, semiconductors. In the case of construction, of course, all the IP effect comes through the influence on upstream industries—lumber, concrete, plumbing fixtures, and so forth. The table to the right shows the estimated effects on IP growth, including upstream effects, associated with the declines in the production of light motor vehicles and residential construction illustrated in the top panels. We have used input-output relationships to estimate the direct and upstream effects and then translated these effects into their IP contributions. Lines 2 and 3 show that, after we account for upstream influences, motor vehicles and residential construction were sizable drags on IP in the third and fourth quarters. Yet, as shown in line 4, the drag from those two sectors was not the whole story. Even so, we think the more likely track from here forward involves modest growth rather than a cumulative weakening of industrial activity, in part because we think that most producers have been moving reasonably promptly to address any emerging inventory problems.

    The bottom panels widen the scope from the industrial sector to the economy as a whole and address the question of whether developments in less-cyclical industries have been helping support economic activity. My colleague Stephanie Aaronson divided the establishment survey employment data into three categories—highly cyclical industries, moderately cyclical industries, and acyclical industries—based on the correlation of individual industry employment changes with the GDP gap. The bottom left panel presents some history, with the highly cyclical grouping plotted by the black line and the moderately cyclical plotted in red. To keep the chart easier to read, the acyclical group is not plotted. The chart shows what you might have expected ex ante: Fluctuations in both series are highly correlated, but the amplitude of swings in the moderately cyclical is more damped. The panel to the right puts a microscope on the past few years—note the change in scale. As you can see, despite the step-down of employment gains in the highly cyclical industries, employment in the moderately cyclical industries has continued to grow apace. This suggests that the softness we’ve seen lately in residential construction and some parts of manufacturing has not spilled over to other parts of the economy.

    That conclusion is an important factor that has shaped our view about the longer- run outlook for the economy—the subject of exhibit 3. As shown in line 1 of the table in the top panel, later this year the growth rate of real GDP is expected to move back up toward our estimate of the growth rate of potential, and it stays there in 2008. This basic pattern is unchanged from the last Greenbook. The bullets in the middle panel highlight some of the major forces shaping this projection. The most important is our forecast that the restraint from housing will diminish this year and that its contribution to GDP growth will turn slightly positive next year. Second, the recent declines in oil prices, plotted in the bottom left panel, have raised real income; we believe that the drag from the earlier increases in oil prices should dissipate in the near term, and over time the stimulus from the recent price declines should begin to predominate. Third, federal fiscal policy, the bottom right panel, also is a bit stimulative, although the impetus is projected to ebb over the next two years. Finally, given our conditioning factors, the assumed path of the nominal federal funds rate is consistent with a real funds rate that closes the output gap over time.

    Exhibit 4 focuses on the components of PDFP. As I noted earlier, the leveling-off of home sales, the uptrend in mortgage applications, and the improvement in homebuying attitudes suggest that housing demand may be leveling off. The top panel shows the historical relationship between housing demand, as measured here by sales of new homes (the red line), and housing construction, shown here by single- family housing starts (the black line). The shaded areas highlight previous housing downturns as well as the current situation. As you can see, cyclical recoveries in sales and starts have generally been fairly coincident historically. You’ll have to take my word for it, but this has been the case even when the inventory of unsold homes has been high. Accordingly, we think that the recent stabilization of sales should be accompanied soon by a stabilization of starts. Then, as sales move up, so should starts. The middle panels focus on the consumption forecast. We expect real PCE, the red bars in the left panel, to increase 2¾ percent this year and next. The forecast reflects two main crosscurrents. On the one hand, real income growth, the blue bars, is projected to be robust, reflecting, in part, continued increases in real wages as well as further employment gains. On the other hand, the wealth-income ratio, plotted by the black line in the panel to the right, falls in our forecast as house prices appreciate only about 1 percent per year. With slower gains in wealth, and spending gradually coming back into line with fundamentals after the current period of unexplained strength, the saving rate should rise.

    The bottom panels present some details on the outlook for business fixed investment. As illustrated in the bottom left panel, total real outlays for equipment and software, excluding the volatile transportation equipment component, are projected to increase about 6 percent both this year and next. You can see from the red portion of the bars that the bulk of the support comes from spending for high-tech equipment as telecommunications service providers further expand their fiber optic networks and as businesses continue to invest in information technology equipment and software. We expect the contribution from the other equipment category (the blue portion) to narrow this year and then to edge up in 2008, largely reflecting the pattern of changes in the growth of business output. The bottom right panel shows our forecast for nonresidential structures excluding drilling and mining. The incoming information on construction outlays for nonresidential buildings and the forward-looking indicators that we monitor suggest that spending growth has downshifted. Accordingly, after rising 12¾ percent in 2006, real outlays for this component of nonresidential structures are expected to decelerate to a pace of 5½ percent this year. Our projection for 2008 brings growth in this component of nonresidential structures down to its long-run average. Bill will now continue our presentation.

  • The top panel of exhibit 5 summarizes our assumptions about the supply side of the economy. As indicated in line 1, we assume that potential output growth will edge down over the forecast period, from 2.7 percent in 2006 to 2.5 percent in 2008. This slowing primarily reflects our assumptions about trend hours growth (line 2), which steps down from about ¾ percent last year to ½ percent in 2008 because of a steepening downward trend in the labor force participation rate and a gradual slowing of population growth. Although we are comfortable with these assumptions—and, indeed, have not made any changes to them in this projection— we do see risks on both sides of our point estimates. For example, as shown in the middle left panel, many outside forecasters are basing their projections on a significantly higher estimate of potential output—in some cases above 3 percent per year. We suspect that these differences, at least in part, reflect different views about the underlying trend in the labor force participation rate.

    The participation rate and our estimate of its trend are shown in the middle right panel. As indicated by the black line, labor force participation has risen about ½ percentage point since its trough in early 2005. Some forecasters appear to have taken this increase as a signal of faster labor force growth going forward. However, we see it as largely a cyclical response to steady employment growth and a tighter labor market, and we expect it to be reversed in the near future as the pace of hiring slows and the underlying demographic forces show through. In part, our view reflects the fact that the participation rate tends to rise above its trend when the unemployment rate is low. Periods in which the unemployment rate was below the staff’s estimate of the NAIRU are denoted by the yellow shaded areas in the chart, and the current gap between the actual participation rate and our estimate of the trend does not appear to be outsized relative to historical norms. In addition, as shown in the bottom left panel, the increase in the participation rate over the past couple of years has been fueled by a rise in the percentage of individuals who moved directly from out of the labor force to a job; this flow also exhibits noticeable sensitivity to labor market tightness. That said, some groups have behaved differently than our models would have predicted. On the one hand, the participation rate of older individuals, shown by the red line in the bottom right panel, has risen steadily for some time, presenting an upside risk to our forecast. On the other hand, participation among teenagers (the black line) has remained surprisingly low, and there are undoubtedly downside risks to our forecast of an upturn for this segment of the population.

    Exhibit 6 describes another source of tension in the recent data that may have implications for our estimate of potential output. As shown in the top left panel, our standard Okun’s law simulation (the red line) suggests that the unemployment rate (the black line) fell more last year than would have been expected given our current estimate of real GDP growth in 2006. In the baseline forecast, we assume that an increase in the unemployment rate causes that gap to disappear gradually, an assumption that does not seem unreasonable given that the error in Okun’s law at the end of last year was within the bounds of historical experience. However, other interpretations are possible as well. One possibility is that current estimates of real GDP understate economic growth last year. One piece of evidence in support of this hypothesis is shown in the top right panel. We currently estimate that real gross domestic income rose 4 percent in 2006, about ¾ percentage point more than real GDP. As shown by the green line in the top left panel, if we replace real GDP growth with our estimate of real GDI growth over the past year and re-run the Okun’s law simulation, the actual unemployment rate in the fourth quarter lines up very closely with its simulated value.

    An alternative interpretation of the recent error in Okun’s law is that potential output growth was weaker last year than we have assumed—perhaps because of a downshift in structural productivity growth. The middle and bottom panels address this possibility. As shown by the difference between actual productivity growth (the black line in the middle left panel) and a simulation from our standard model (the red line), labor productivity decelerated much more last year than the model would have expected. As shown in the panel to the right, a purely statistical model based on a Kalman filter would have responded to the incoming data since March of last year by cutting its estimate of structural productivity growth by a full percentage point. In contrast, because we place less weight on the recent data that have not yet been through an annual revision, we have reduced our own estimate by only 0.6 percentage point. The bottom panels provide a couple of reasons for our reluctance to lower our estimate of structural productivity growth as much as the statistical model would have lowered it. First, as shown on the left, labor productivity in the nonfinancial corporate sector was quite strong last year. In part, the better performance of productivity in this sector reflects the fact that its output is measured from the income side of the accounts and thus incorporates the difference between GDI and GDP noted above. In addition, this component omits some sectors that are notoriously difficult to measure. Second, as shown on the right, a measure of productivity that excludes the residential construction industry also held up fairly well last year, suggesting that much of the deceleration in nonfarm business productivity may be cyclical. As shown in the middle panel, all told we expect actual labor productivity growth to step back up to an annual rate of about 2½ percent by the middle of this year as businesses reduce the pace of hiring in lagged response to the slower rate of output growth in recent quarters.

    The implications of this forecast for the labor market are shown in the top panels of exhibit 7. In particular, gains in nonfarm payroll employment—shown by the black line in the top left panel—are projected to slow to about 60,000 per month by the second half of this year. This pace is somewhat below our estimate of trend employment growth—the red line. As a result, the unemployment rate—shown in the top right panel—drifts up to just under 5 percent, our estimate of the current level of the NAIRU. To help gauge whether the estimated gap between the unemployment rate and the NAIRU is sending an appropriate signal about the degree of tightness in the labor market, I have included some other measures of slack in the remaining panels of this exhibit. As shown in the middle left panel, the job openings rate from the BLS’s JOLTS (Job Openings and Labor Turnover Survey) rose over the second half of last year to its highest level since early 2001. Because the job openings rate has such a short history, its equilibrium level is difficult to estimate. However, we can learn something by combining the openings rate and the unemployment rate to form the Beveridge curve shown to the right. The curve is estimated using data from the first quarter of 2001 through the fourth quarter of 2006, with the openings rate on the vertical axis and the unemployment rate on the horizontal axis. The relationship between job openings and unemployment appears to have been fairly stable in recent years, which suggests that the NAIRU has not changed materially over that period. Moreover, the latest data point is in the far upper left portion of the graph—the segment of the curve indicative of a tight labor market. Two other margins of slack are shown in the lower two panels. The bottom left shows the percentage of employed persons working part time because of slack work at their firm or because they couldn’t find a full-time job. This measure has moved down over the past couple of years and is currently below its average level in the second half of 1996— an earlier period when we thought that labor markets were roughly in equilibrium. Also, as shown to the right, the capacity utilization rate in manufacturing remains a little above its long-run average level.

    Exhibit 8 presents the inflation outlook. Despite our view that labor and product markets are tight, other influences on our inflation projection have been more favorable than we were expecting at the time of the last Greenbook. Perhaps most notably, the recent data on core consumer prices—shown in the top left panel—have been lower than expected. Core PCE prices were about unchanged in November and, based on the latest CPI reading, we expect an increase of only 0.2 percent in December. As a result, as shown in the second column of the table, we have marked down our estimate of core PCE inflation in the fourth quarter by ½ percentage point, to an annual rate of 2.1 percent. As shown in the top right panel, the lower path of oil prices led us to revise down our projection of consumer energy prices. These lower prices directly pull down our forecast for total PCE prices; they also imply somewhat smaller indirect effects from energy costs on core prices over the forecast period. As shown in the middle left panel, a higher exchange value of the dollar in this forecast led us to reduce the projected path of core nonfuel import prices. The combination of these various influences led us to shave our projection for core PCE prices—line 4 of the middle right panel—by 0.1 percentage point in both 2007 and 2008, to 2.2 percent and 2.0 percent respectively. As before, the slight downward trajectory to core inflation reflects our projections of waning indirect effects of the earlier increases in energy and other commodity prices, declining relative import prices, and a deceleration in shelter costs.

    In light of my earlier discussion of the risks to our assumptions about potential output growth, the bottom panels present one alternative simulation from the Greenbook, in which we assume both a higher trend for the labor force participation rate and slower growth in structural productivity. Specifically, we calibrated the simulation so that overall potential output growth was essentially the same as in the baseline forecast, but with structural productivity growth ½ percentage point weaker and trend hours growth ½ percentage point stronger. As shown in the bottom left panel, this change to the composition of potential output growth has little effect on aggregate activity and the unemployment rate. However, the implications for inflation—the middle panel—are noticeable, with core PCE inflation moving up toward 2½ percent next year because of the effects of lower structural productivity growth on trend unit labor costs. Joe will now continue our presentation.

  • Your first international exhibit (exhibit 9) covers recent market developments. As shown by the green line in the top left panel, oil prices dropped further this month, bringing the West Texas intermediate spot price back to pre- Katrina levels. The IMF index of nonfuel commodity prices (the red line) was little changed this month after a year of remarkable increases. Readings from futures markets imply a flattening out of nonfuel commodity prices and only a moderate increase in oil prices going forward. The top right panel shows that our real trade- weighted dollar indexes declined on balance last year. In recent weeks the dollar rebounded modestly against the major industrial-country currencies (the red line), but we estimate that it continued to decline in real terms against the currencies of our other important trading partners (the green line). As usual, our forecast calls for a small downward trend from current levels, reflecting our belief that the risk of significant depreciation is slightly greater than the risk of significant appreciation, owing to the unsustainably large U.S. trade deficit. The bottom panels report equity market indexes, with industrial countries shown on the left. The lines are set to equal 100 in March 2000, the previous peak month for the Wilshire 5000. Equity prices have risen broadly across the industrial countries over the past two years and are now just above their March 2000 levels in the United States, the United Kingdom, and Japan, but not in the euro area (the red line). For major emerging markets, on the right, equity indexes are well above March 2000 levels. In Mexico (the blue line), equity prices have more than tripled over this period. In Thailand (the green line), the government’s recent attempts to slow capital inflows and relieve upward pressure on the currency have taken their toll on equity prices, but contagion to other emerging equity markets has been minimal. Overall, commodity and financial market developments are consistent with expectations of strong global growth.

    Exhibit 10 focuses on financial flows between emerging markets and industrial countries. As shown in the top left panel, the major developing regions have continued the downward trend in their reliance on external borrowing. Fiscal deficits have declined in most countries, and many governments have turned increasingly to local, rather than external, borrowing. The panel to the right shows that yield spreads on dollar-denominated sovereign debt of emerging market countries have dropped to historically low levels.

    But emerging markets, in the aggregate, have gone much further than just reducing their borrowing. In recent years, emerging markets have experienced record outflows of official capital (the gold bars in the middle panel). These official outflows are composed of the accumulation of foreign exchange reserves, the servicing and paying down of sovereign debt, and the purchase of foreign assets by government-run investment funds such as the Kuwait Investment Authority. In all the emerging market regions, official capital outflows have recently exceeded current account surpluses (the blue bars), which are themselves at record levels. For example, the IMF estimates that in 2006, governments in emerging Asia invested on balance $270 billion outside their borders, a sum that greatly exceeds their combined current account surplus of $185 billion. Most of these official flows have taken the form of additions to foreign exchange reserves, as governments have built up war chests against future financial crises and sought to counter upward pressures on their currencies.

    The bottom panel looks at these flows from the point of view of the industrial countries, plotting aggregate emerging market net official flows (the gold bars) relative to industrial-country GDP, with negative values denoting net flows into the industrial countries. The statistical accounts do not report the destinations of all these flows, but the available evidence suggests that the overwhelming majority is destined for the industrial countries. Before 2003, net official inflows or outflows from the emerging markets had never exceeded 1 percent of industrial-country GDP. But since 2003, things have changed. Net official outflows from emerging markets are now estimated to equal 2½ percent of the combined GDP of the industrial countries. As shown in the panel, the timing of this unprecedented increase in net official flows corresponds well with the puzzling decline in real short-term interest rates in the industrial countries (the green line) that persisted long after industrial-country GDP growth (the purple line) rebounded from the slowdown early in this decade. The evidence suggests that aggregate policy-driven capital flows from the emerging markets may be an important factor behind low real interest rates in the industrial countries. Moreover, low real rates are not limited to short-maturity instruments.

    The top panels of exhibit 11 show that ten-year indexed bond yields are also low and have been for several years in the major industrial countries. These rates have ticked up over the past month or two, but only by a small amount. Long-term inflation compensation (shown in the middle row of panels) remains contained. Indeed, in Japan and Canada (the two panels on the right) inflation compensation has moved down in recent months. In the euro area and the United Kingdom (the two panels on the left), where inflation compensation lingers above policymakers’ targets, we project modest additional policy tightening early this year, shown in the bottom row of panels.

    Despite recent and expected future inflation rates close to zero, the Bank of Japan seems poised to tighten gradually over the next two years. In Canada, policy is expected to remain on hold. If these projections prove to be the peak policy rates for this cycle, they will be the lowest cyclical peaks for short-term interest rates in these countries for at least forty years. Nevertheless, we judge that these policy stances are likely to be consistent with low and stable inflation this year and next. The large capital inflows and low real interest rates in the industrial countries have contributed to rising housing prices in many of these countries. Higher home prices in turn have stimulated housing construction. The top panel of exhibit 12 shows that the extent and timing of the house-price boom differs markedly across countries. The Netherlands (the blue line) was one of the leaders of the global housing boom, with prices rising continuously since the early 1990s, though at much slower rates in recent years. Japan (the green line), on the other hand, is a notable exception to the trend of rising house prices in recent years, reflecting the lingering effects of the bursting of the 1980s asset bubble and Japan’s extended economic slump. The middle panels focus on two countries that experienced strong house-price increases (the purple lines) early in this decade but where house-price increases subsequently halted, at least temporarily. In both Australia and the United Kingdom, as in the United States, residential investment (the green lines) responded positively to higher house prices. In Australia, on the left, real house prices have been flat for the past three years, and residential investment has declined gradually about 1 percentage point of GDP, though it remains above its historical average. In the United Kingdom, on the right, house prices stabilized in 2005 and picked up again modestly last year. Despite lower house-price inflation, residential investment has continued to rise toward historically high levels. The relevance of these foreign experiences for the United States is difficult to gauge, but they provide some support for Larry’s forecast that the downturn in U.S. housing is nearly over.

    In light of the signals from financial and commodity markets, as well as other real-side indicators, we project continued solid growth in the foreign economies at rates that are not likely to strain resources or to put upward pressure on inflation. As shown in the bottom panel, total foreign growth (line 1) is estimated to have stepped down last year from 4½ percent in the first half to about 3½ percent in the second half, and it is projected to remain around 3½ percent over the forecast period. This projection is about 1 percentage point stronger than the staff’s projection for U.S. growth, shown at the bottom of the panel. The foreign industrial economies (line 2) overall are projected to grow at about the same rate as the United States, Japan a bit slower (line 4), and Canada a bit faster (line 5). The emerging market economies (line 6) are projected to grow at nearly twice the pace of the industrial economies over the forecast period. We expect that emerging Asia (line 7) will continue to grow very rapidly and that Latin America (line 8) will grow at a solid, though not exceptional, rate. Our forecast assumes that the Chinese government will take additional measures if necessary to reduce the growth rate of investment, and we project that Chinese GDP growth will be slower this year than last. But the risks to our growth forecast for China are probably greater on the upside.

    Exhibit 13 provides an assessment of what all these foreign influences mean for the U.S. economy. Overall import prices, the black line in the top left panel, fell sharply last quarter and are projected to continue to fall in the current quarter, primarily owing to the drop in the price of imported oil. As oil prices stop falling and begin to move gradually back up, overall import price inflation should turn positive. Prices of imported core goods (the red line), which exclude oil, gas, computers, and semiconductors, rose at a rate of nearly 4 percent in the middle of last year, primarily owing to sharply higher prices of nonfuel commodities. With commodity prices projected to stabilize and with only a small depreciation of the dollar in our forecast, prices of imported core goods should increase at a subdued pace over the next two years.

    The contributions of exports and imports to U.S. GDP growth are shown in the lower panel. We now estimate that the external sector made a positive arithmetic contribution to growth last year, the first positive annual contribution since 1995. Import growth stepped down from previous years as U.S. GDP grew more slowly. Export growth benefited from robust foreign economic activity, but exports turned out even stronger than our models project. Line 1 in the top right panel shows that, for the first eleven months of last year at an annual rate, exports of goods grew 10½ percent from the previous year in real terms. Lines 2 through 4 show that three categories of capital goods—aircraft, machinery, and semiconductors—contributed nearly half of total export growth. Although it is possible that blistering growth rates in exports of these goods may continue, we base our forecast on a return of export growth to a rate more consistent with historical relationships. With the vast majority of aircraft production being exported in recent months and with aircraft factories running at high utilization rates, further large increases in exports from this sector, at least, do not seem likely.

    Returning to the bottom panel, we project that the negative arithmetic contribution of imports (the red bars) to GDP growth will outweigh the export contribution (the blue bars) in 2007 and 2008 by about ¼ percentage point (the black line). This projection is driven by the historical tendency of U.S. imports to grow at a much faster rate than U.S. GDP. In addition, the larger value of imports relative to exports means that, even if imports and exports were to grow at the same rate, the negative contribution of imports would be greater than the positive contribution of exports. The projected strong growth rates of foreign GDP, discussed in your previous exhibit, are not large enough to outweigh these factors over the next two years. On balance, relative prices have little effect on net exports over the forecast period, as the real trade-weighted dollar has moved in a relatively narrow range over the past couple years and is not projected to move substantially over the forecast period. And now Larry will complete our presentation.

  • The final exhibit presents your forecasts for 2007 and 2008. I’ll be mercifully brief. The central tendency shows real GDP increasing 2½ to 3 percent this year and roughly the same next year, with the unemployment rate holding in the range of 4½ to 4¾ percent during both years. The central tendency of your projections sees the core inflation rate falling ¼ percentage point over the next two years. That concludes our prepared remarks, Mr. Chairman. I’ll be happy to take your questions.

  • Thank you. That was very interesting. I have a couple of questions about your counterfactuals. In exhibit 6, you look at the simulated rate of unemployment, assuming that gross domestic income is the true measure of output, and you find that unemployment fits Okun’s law. But then below you also use GDI to measure productivity. You’re not doing the same thing in both simulations, right? If you assume that GDI measures output and use it to calculate both Okun’s law and productivity, I think the puzzle comes back. I think you just increased potential output, and you’re back to where you started.

  • That’s right. The potential output measures are based on a GDP concept, and productivity in the nonfarm business sector is the measure of structural productivity that we’re using for potential GDP. The upper panel is just to illustrate what might happen if, for example, the real GDP numbers for last year were revised up to show the same growth rate that GDI shows now.

  • Okay. The other question is about exhibit 8, where you consider a simulation with a decline in productivity and an increase in labor participation and you get a higher rate of core inflation. In that simulation, the decrease in productivity and the increase in participation offset each other, on both the aggregate demand side and the aggregate supply side, and the result is, of course, that the unemployment rate doesn’t change so that demand-supply balance is unchanged. I assume the reason you get inflation is that nominal wages are sticky, and therefore, as productivity slows, labor costs go up and firms can push them through. I guess I would question whether that’s realistic, for two reasons. One is that this increase in unit labor costs is clearly temporary, and I think we tend to believe that longer increases are needed to affect pricing. The other reason is that with the demand-supply balance unchanged, why would firms be able to pass through those costs in this scenario when they couldn’t raise prices absent that increase in unit labor costs?

  • Well, real wages wouldn’t be different, but the adjustment could come either through flexible nominal wages or faster increases in prices. In the FRB/US model, which is used to generate these simulations, trend unit labor costs do cause an increase in the rate of price inflation, which is what you see here, and that helps equilibrate the labor market.

  • For a given level of resource utilization, you’re getting more cost pressures, and you’re getting more upward pressure on prices. So it’s not a matter of their absorbing all of it in their profit margins when they’ve got that increase in costs. You’re absolutely right. In our basic framework, we don’t think that actual year-to-year unit labor costs influence overall price setting. It is in some sense a trend unit labor cost measure, and that actually was incorporated in FRB/US through a moving average or a set of lags. So there is still some upward pressure on trend unit labor costs coming about through the slower productivity growth, some of which in essence would be perceived to be lower trend productivity.

  • You also have to assume that the Fed accommodates with increased nominal GDP growth as well.

  • Thank you. Are there other questions for our colleagues? President Fisher.

  • Just to follow up on your point and go to exhibit 12, about foreign GDP growth rates, which Joe talked about. In terms of any pressures on unit labor costs that you see developing, I didn’t quite catch your statement, or I may have misinterpreted it, but basically I thought I heard that these growth rates are not likely to lead the inflationary pressures.

  • That’s correct.

  • So I would be curious as to what your observation is in terms of trend unit labor costs in our important trading partners.

  • Actually, I’m not sure of the answer about unit labor costs per se, but these growth rates are close to what we think these countries can sustain without exceeding their capacity limit.

  • So it’s a gap analysis.

  • They are close to what we think their potential rates are, and they don’t seem to be above or below their potential rates by very much in the aggregate. There are a few exceptions, of course—Argentina, perhaps, and Venezuela.

  • I want to see if I understood something you said that pertained to exhibit 13. I think you said that U.S. exports were stronger than expected—stronger than the models would have predicted in ’06—even though growth abroad turned out to be quite strong. Is that right?

  • By about what order of magnitude? I’m just trying to determine whether this was really significant or we’re talking about a tenth or two.

  • Well, the export contribution to GDP growth last year was about ⅓ percent, and I would have to check, but I’m guessing that it might have still been zero if we hadn’t had this surprise. It would have been close to zero. I can check on that.

  • Well, you can let me know later.

  • May I follow up on that?

  • On the same chart, Joe, I was wondering whether there is any evidence that the foreign demand for our exports, that elasticity, is coming into closer alignment with our demand for imports. That difference has really been driving the trade imbalance, and I was looking for little clues that this wasn’t all special factors, that maybe they’re catching up to us in their appetites for imports.

  • This topic is actually close to my heart in terms of research, and I wish I could say it was so and maybe it will be so. [Laughter] I thought it was so around 2000, when we had really strong exports we couldn’t explain, and then it all went away with the recession of 2001-02, and it’s only now coming back. But I looked at a lot of other countries, and it does seem that you can explain these differences between export and import elasticities based on potential growth rates. The one country that seems to fit the worst is the United States, and I have never understood why the most important country is the one that doesn’t fit. I won’t go into details, but there are theoretical reasons to believe that, indeed, you shouldn’t expect such elasticities to be structurally different.

  • Vice Chairman Geithner.

  • I have two questions. The first is about our inflation forecast. We’ve discussed several times the basic question about whether the now-prevailing level of long-term inflation expectations in markets is likely to provide support for forecasts of further moderation or likely to constrain the prospects for further moderation in core inflation. My recollection of that discussion, although a little hazy, is that expectations might be a bit of a constraint. Am I right in my recollection? Has your view on that changed?

  • Well, your recollection is correct, I think. That was probably just a hazy answer, not a hazy memory on your part. In some sense our basic view is that getting to 2 percent is the gravitational constant that we currently see. We haven’t really seen any evidence to suggest any significant shift in that view in recent months. Something below that number, on a sustained basis, is harder for us to see. In some sense, implicit in this forecast is that, at the end of 2008 and into an extended Greenbook forecast, we get 2 percent without creating an output gap that would actually drag things down further. Then the question is how quick the dynamics might be to take you to 2 percent. The view in our forecast is that the movement would be slow over the next two years. But one could imagine a faster adjustment, especially if it were aided by a stronger dollar and by weaker oil prices. So there are reasons for thinking that the adjustment would be faster, but it’s also possible that some of the recent incoming data have given us a bit of a head fake. Maybe we’re not quite as far along in the process of getting back to 2 percent, and maybe we’re too optimistic in that regard.

  • This is a different question for Joe. Your exhibit 10 describes broad trends in net official capital flows from emerging markets to the United States and global real interest rates. Has your view about the relationship between them changed? I thought we had sort of the conventional view. The accepted view within the System was a little skeptical that there was much of an effect, and I didn’t think the research that looked at the relationship between these two things suggested that the effect was that large. Has your view about that changed, or is this exhibit consistent with it?

  • The relationship between the official flows and the current account surpluses?

  • No, between official flows and global—really industrial- country—real interest rates.

  • People often talk about China’s reserve accumulation affecting U.S. interest rates, but they are only two countries in a big world and you may think that the United States, Europe, and Japan have relatively open financial markets with a lot of mobility. If you look at all the industrial countries together and the flows to all of them together, however, maybe there’s less mobility between the industrial countries as a group and the emerging markets as a group. That might be more believable. That—along with the fact that these flows are big, even when you distribute them over all the industrial countries—is what makes me think that there may be an effect. That may raise a doubt in your mind. It’s not just to the United States or just to Europe; it is in the aggregate.

    To answer President Stern, it looks to me—and I’ll double check with our experts—as though, according to our forecast, our model would have predicted negative real net exports last year. So all the growth is a surprise.

  • Just to clarify the response—overpredicted what?

  • The positive contribution from net exports last year, about ⅓ percentage point, is entirely a surprise. In fact, it would have been negative, if I am reading our model correctly.

  • So it was an upward surprise in terms of what your model would have predicted.

  • I’m interested in the risks you see around the GDP growth rate in your forecast. I note a couple of things. First, some of the growth rate depends upon consumers getting the message that they really ought to be saving for the future instead of spending as they have been. I wonder why they’d do that this year if they didn’t do it last year. Second, I notice that, if you compare the Greenbook GDP forecast with the central tendency of the members of the Committee, growth is a good deal slower—0.3 or 0.4 slower, which in this realm is a lot. I’m interested in how you see the upside risk to this, particularly given that, even with your slower growth rate, you get to zero output gap relatively quickly.

  • Let me first comment specifically on our consumption forecast and the larger question that we raised. Dave may want to add some comments. With regard to our consumption forecast, as I had mentioned and as we suggested by the alternative simulation that we showed in Part 1 of the Greenbook, clearly the unexplained strength that we’ve been seeing in consumption spending in the second, third, and fourth quarters is an upside risk to the forecast. We’ve carried some of that through into 2007, as we noted in the Greenbook and I noted in my briefing, and we think that it will eventually correct. We base that forecast just on the historical patterns in the data. In the past when spending had gotten out of line with what we think of as being the fundamentals for consumption, it eventually corrected over time. There are a couple of possibilities. One is that we’ve got the timing wrong and that the correction is going to take longer, in which case there would be more consumption. Another possibility—and this goes back to the point Bill made—is that we could be wrong with regard to income growth. That might be revised up, and we will find that a lot more income growth is out there. Now, taking our forecast rather than the alternative simulations at face value—yes, we are slower than the FOMC. I suspect that part of the reason may be that the staff has a lower estimate of potential output growth than most members of the Committee probably have in their minds; we can’t know for sure, but I suspect that it probably goes a good way toward explaining the difference.

  • You’ve got seven alternative scenarios there, if I recall correctly

  • Yes, you were. All kudos to you guys. Four of the simulations have slower GDP, higher unemployment, and a lower fed funds rate. In a couple of cases you had, even in the context of slower growth and higher unemployment, somewhat higher inflation. Then you have three or so that show stronger paths. I’m wondering, do you weight these alternative scenarios equally? You know how DRI (DRI is the wrong name now, but I mean the successor company) does it: They give their baseline forecast a certain rate of probability, and then they give alternative rates of probability to the various scenarios. Do you have a sense of that? Would you weight the stronger consumption scenario somewhat higher than the rest or no?

  • I don’t think so. Personally, I could think of equally plausible reasons that we could get stronger aggregate demand growth or somewhat weaker aggregate demand growth over the next year. We highlighted one possibility in the Greenbook with regard to the weaker investment scenario. Another could be the housing forecast: Housing could turn out to be weaker than we’re forecasting. So, on the aggregate demand side, I’d give them equal weighting. With regard to the aggregate supply side, I suspect there, too, the weighting probably is equal. It’s a little harder for me to judge. I don’t know whether Bill wants to add something.

  • I think that’s probably right.

  • At the time of the last FOMC meeting, we were feeling as though the incoming spending data were coming in pretty darn close to our expectations and were pretty consistent with our story about entering a period of below-trend growth. As we noted, and President Moskow quizzed us about, the big fly in the ointment with respect to our story was the labor market and its ongoing strength. Since then, as Larry noted, the spending data have moved toward the labor market data rather than the labor market data moving toward the spending data. The developments have certainly brought into sharper focus the upside risk associated with buoyant consumer spending. If we made an important policy-magnitude type error, it might be that the third quarter was just a period of low measured GDP growth but basically we haven’t moved much below trend. I think that you would need to take that risk very seriously as you thought about the current setting of policy.

    There are some critical reasons for remaining patient about whether, in fact, we have or have not moved below trend. I think that we still haven’t seen the full effects of the housing shock that we had in the second half of 2006. I suspect that we are going to see more of the employment effects associated with that going forward. I don’t think that we’ve seen the full multiplier accelerator effects of that, and we certainly haven’t seen, if our estimated econometric models are anywhere close to right, the lagged effects of the slowing house prices and consumer wealth that we think will be part of the reason for motivating a higher saving rate. So we’ve raised the forecast, and we’ve raised it significantly, but I don’t think we’re yet surrendering the notion that this current setting of policy can produce a period of modestly below trend growth. Now, I think that the upside risk continues to be the labor market strength.

    As Larry said, even given the overall dimensions of the housing shock, we’ve been encouraged about our story of stabilization. But I remember that, as we went into the investment shock earlier in this decade, we just didn’t have enough imagination about how bad things could get, and we kept thinking that we were seeing signs of slowing or stabilization, that the new technology was still great, and that there should be reasons or underlying motivation for investment. Perhaps what we’ve seen recently as stabilization are the beneficial effects of the drop in long-term interest rates that occurred from last summer into the fall and pulled some people forward, but really we may not have fully made the adjustment yet. The overhang of unsold homes out there is very large, and we could be underestimating the size and duration of that. So even given the recent stronger data on spending, I still don’t see all the risks on that side of things. I still think there are some significant downside risks that you ought to be at least concerned about.

  • Thank you, Mr. Chairman. I just want to follow up on Vice Chairman Geithner’s first question—on inflation. It seems to me that most of the factors that are leading to lower inflation in this forecast period are temporary—energy prices, owners’ equivalent rent, and import prices. The longer-term factors are the pressures in the labor market that we’ve talked about and maybe some follow-through from the earlier accommodative financial conditions that we’ve had. As you said, chart 6 of the Bluebook, when you look past the forecast period, doesn’t show inflation coming down. Inflation actually goes up a bit with both the 1½ percent target and the 2 percent target. Doesn’t this mean that expectations have moved up a bit when you see inflation go up in ’09 and beyond?

  • Many of the factors that you’re citing as temporary on the downside regarding inflation we see as having been temporary on the upside regarding inflation as well. The higher energy prices and the pickup in import commodity prices were some factors explaining how we got above 2 percent, and their dissipation is principally the reason that we go back to 2. Now, for the extended Greenbook scenario that we show in the Bluebook, one reason for the upward pressure on inflation beyond the near term is that part of the construction of that forecast is an assumed 3 percent depreciation of the dollar that has to go on almost forever. So we have built in some upward pressure on inflation. We have to do that in the model simply to begin making some progress on the external balance. Whether that happens in 2009, in 2015, or tomorrow would be hard to say, but it is one reason that the pickup is not principally the dissipation of the temporarily good factors. It’s really more of that built-in dollar-depreciation effect.

  • So that’s a key variable.

  • To go back to what I said to the Vice Chairman, implicit in that long- run scenario is a 2 percent inflation expectation that is sort of pegging inflation. Obviously we could be seriously wrong about that. We could also be seriously wrong about the degree of resource utilization in the economy right now. That 2 percent comes about because we don’t have a big positive or negative output gap either now or going forward. If the NAIRU is more like 4½ percent, then you might, in fact, make some progress in long-run inflation expectations. If the economy slows, you push the unemployment rate to 5 percent, and you get a bit of output gap, then you might get some good behavior there. Another issue with which I know you’ve been grappling is that headline inflation has been high in recent years. If that condition were to persist, it could lead to some deterioration in inflation expectations that might raise us from 2 to something above 2 going forward. We haven’t seen the evidence of that in measures of inflation expectations either from surveys or from financial markets, but that’s something we’re watching to see whether or not our story is right.

  • Thank you. I have a question that is related to this issue, but it comes out of the Bluebook. I think I understand how this model is working, but then I get a surprise, and I realize I really don’t understand how it works. I noticed in the Bluebook that there was a jump of 50 basis points in the Greenbook-consistent estimate of the real funds rate. At the same time in the model and the simulations, you keep the fed funds rate constant, which would be slightly below what that Greenbook real rate might suggest. The unemployment rate remains somewhat below your NAIRU estimate, and yet you still have inflation modestly declining. I’m trying to figure out how that works. Is there something that I’m not understanding, or can you clarify the mechanism by which those things fit together?

  • Well, I can speak to the Greenbook-consistent measure, and perhaps Vincent will want to talk a bit about the simulations of the Bluebook. One thing that you have to keep in mind is that the Greenbook-consistent measure of R* is the level of a real interest rate that would be required for the output gap to return to zero in twelve quarters. In some sense, given that is what’s built into the Greenbook forecast, the current level of the real interest rate is delivering that particular outcome. It’s not that we have those longer-run estimates of R*, which are, in essence, the monetary policy that is assumed to return the economy to equilibrium over the next three years and then beyond that to stabilize the economy. That’s a different construction. The Greenbook- consistent R* is answering a very specific question that is of limited value. Those longer-run simulations give you a clearer picture of where we think real interest rates would have to be to equilibrate the economy over the longer haul, not just over the short run.

  • The 0.5 percentage point increase in the Greenbook-consistent R* is really due to a collection of factors. In the model, the estimated bond premiums come down a little, and the equity premium came down over the intermeeting period. That just means you need a higher real interest rate to get the same level of policy restraint. Also, they take the model and force in the errors to get the Greenbook simulation. Effectively the model is less enthusiastic about the economy than the Greenbook, and so the model errors tend to raise R*. As to why inflation is coming down, we do have the lagged effects of the drop in energy prices, inflation expectations are contained, and the output gap is closing.

  • Other questions? President Lacker.

  • I’ll follow up on the question of Vice Chairman Geithner and President Moskow about the gravitational point of 2.0 percent. I remember asking you about the NAIRU and getting a response that suggested I should think of a cloud of probabilities surrounding that estimate. I’m essentially asking you for your characterization of the cloud you have in your mind around the idea that 2 percent is the number to which core inflation is going to have some gravitational pull. What comes to mind here is that Vince told us several meetings ago that 2 to 2½ on core PCE inflation was the range that he thought expectations were lying in, and TIPS numbers and survey numbers haven’t come down much since then as I recall. I am also interested in your commentary on the kind of technical adjustment factor that traverses the CPI, which the TIPS are based on, and the core. When you plot that, it moves around a lot. So I’m wondering whether you have sharp views about that going forward or how you’d characterize your uncertainty about that factor in helping us understand what the TIPS spreads imply about gravitational points.

  • I’m not sure I have an empirically based response. We can actually estimate from the model a confidence interval around a parameter estimate of the NAIRU, which as I indicated, is wide; but I don’t have a similar thing for inflation expectations. However, I would argue that, if you just look at the confidence intervals around inflation forecasts over the longer haul, they are pretty wide. Obviously you control inflation over the longer haul. If you would tell me what your tolerance is for five years from now, given our ability on a year-to-year basis to forecast inflation, plus or minus 1 percentage point, actual inflation would fall plus or minus 1 percentage point around whatever you tell me your longer-run inflation objective would be. In terms of the measures that we look at—and I think those probably have not changed much since Vincent presented them in the Bluebook a while back—0.5 percentage point is just on the difference in the measures alone; it is not actually a measure of uncertainty around any individual measure. So it’s wide. I don’t know if you would want to add a confidence interval around that.

  • The intervals are, no doubt, wide. In the materials we sent to you in October, when you were talking about your inflation goal, a staff memorandum looked at the gap between the CPI and the PCE price index. From 1994 to 2004, the minimum is minus 0.2, and the maximum is 1.2. They do move around. We found in the regressions that we reported in the Bluebook box that they’re not very precise at all. The standard errors were quite large. So I think the answer is that we don’t have a measure of inflation expectations that we could put much confidence in.

  • Seeing that there are no further questions, I propose that we start the economic go-round. Remember, we do have the two-handed option if anyone cares to exercise it. President Yellen.

  • Thank you, Mr. Chairman. Recent data on economic activity have been loaded with upside surprises for most spending categories and also for labor markets. Our response, like the Greenbook, has been to boost our estimate of growth last quarter and our forecast for growth this quarter. For 2007 as a whole, we have revised up our projection for real GDP growth about ¼ percentage point, to about 2¾ percent, which is just a bit below our estimate of the trend, which is a bit higher than the Greenbook. This performance continues to reflect the so-called bimodal economy with weakness in housing and autos coupled with strength almost everywhere else.

    Looking beyond the first quarter, we interpret recent data as suggesting that the drag from both weak sectors is likely to diminish, providing impetus for an acceleration of activity later this year. Even so, the Greenbook forecasts, and we agree, that other factors will likely offset this acceleration so that GDP will grow slightly below trend in 2007. In particular, the Greenbook hypothesizes that the growth of consumer spending will slow, with the saving rate rising from minus ¾ percent at the end of last year to plus 1 percent at the end of next year. This forecast strikes us as quite reasonable. House-price appreciation has slowed dramatically, and the impetus it has given consumption should diminish over time. In addition, the Greenbook notes, and Larry emphasized, that consumer spending has grown more rapidly than fundamentals can explain, and it’s sensible to predict some unwinding of this pattern. Such an outcome, however, would represent a noticeable change in the trend of the saving rate. So to me the possibility that the saving rate will not, in fact, rebound to the extent anticipated in the Greenbook constitutes a serious upside risk to the outlook. Of course, the staff has emphasized this.

    An alternative simulation in the Greenbook illustrates that if spending instead advances in line with income, the unemployment rate would decline noticeably further from a level that is already low. It is precisely because we are starting from a situation in which labor markets are already arguably tight that the upward revisions to growth during the intermeeting period particularly concern me. Some period of below-trend growth may ultimately be necessary to address inflationary pressures emanating from the labor market.

    In December, I emphasized the puzzle presented by the combination of an apparently sluggish economy and a robust job market. Upward revisions to estimated growth in the fourth and first quarters resolve a portion of that discrepancy. Even so, Okun’s law still suggests that the excess demand in labor markets as reflected in the low unemployment rate is abnormally large relative to that in goods markets as reflected in estimates of the output gap. The current low unemployment rate may turn out to have benign implications for inflation. For example, labor market tightness may well diminish somewhat over time, given that the lags between output growth and labor market adjustments can be quite variable. Another benign possibility is that the unemployment rate may be overstating the tightness of labor markets. For example, some indicators of labor market conditions, like the Conference Board index for job market perceptions, suggest a bit of softening. Indeed, available indexes of labor compensation do not provide compelling evidence of cost pressures emanating from the labor market. However, compensation data are mixed, and I must admit that the signal from them is somewhat confusing.

    While I remain concerned about the risk that labor market pressures could boost inflation over time, I’m still fairly optimistic about the outlook for inflation overall. Core inflation has come down in recent months, which is welcome, although we must be careful not to overreact. Recent favorable data could reflect the dissipation of pressures from energy prices and owners’ equivalent rent; these sources of disinflation are inherently transitory, and once they are fully worked through the system, we will be left with the influence of more-enduring factors, such as the extent of excess demand or supply in labor and product markets. If these markets are, in fact, unduly tight, we could eventually see rising inflation. Inflation expectations also matter for the inflation outlook, and I see the stability of inflation expectations as contributing to a favorable inflation prognosis. As I previously mentioned, my staff and other researchers find some evidence that inflation has become less persistent over the past decade, a period during which inflation and inflation expectations have been low and stable. Both survey and market-based estimates suggest that longer-term inflation expectations remain stable and well anchored.

    So to sum up, I continue to view a soft landing with moderating inflation as my best-guess forecast, conditional on maintaining the current stance of policy. We expect core PCE price inflation to edge down from 2¼ percent last year to about 2 percent in 2007. While there are risks on both sides of the outlook for growth, I’m a little more focused on the upside risks after the recent spate of strong data. It’s encouraging that the recent inflation news has been good. However, there’s a great deal of uncertainty about inflation going forward, and to me these risks remain biased to the high side.

  • Thank you. President Moskow.

  • Thank you. Mr. Chairman, some of my colleagues have told me they expected me to brag today because both teams in the Super Bowl are from the Seventh Federal Reserve District, but I assured them I would not do that. [Laughter]

  • I notice that they’re not playing in the Seventh Federal Reserve District, though. [Laughter]

  • Some day we’ll have the Super Bowl at the Seventh Federal Reserve District. But turning to the business at hand, business activity in our District continues to expand at a somewhat modest pace, but the tone of my business contacts was more positive than at our last meeting. Manufacturing activity in the District is currently a bit soft. The Chicago purchasing managers’ index fell from 51.6 in December to 48.8 in January, and this number will be released tomorrow morning.

    Many of my contacts are expecting a significant pickup in activity in the second half of the year. We heard this from manufacturers of building materials, agricultural equipment, construction machinery, autos and steel, temporary-help firms, and even from several retailers. Though a number of manufacturers thought that the recent softness was temporary and reflected the need to work off some modest inventory buildups, they said the final demand for their products remains solid. The steel industry is a good example of this kind of dynamic. Industry production has fallen sharply since the summer; but when I recently talked to the head of a major steel company, he noted that demand from end users had remained quite stable, and he expected it to stay that way. The production cutbacks were mainly the result of inventory fluctuations at the service centers, which buy bulk quantities of steel to process and distribute to final customers. The analysts in the industry are divided on when this inventory correction will be complete, but even the pessimists think that it will be done by late spring. With the steady demand from end-use customers, my contact thought that production and prices would definitely be rising by the second half of the year. There was an article in the paper today that mentioned that Nucor is trying to raise prices by $20 a ton in March. My auto contacts had mixed views about 2007. Last year was especially tough for the Big Three. High gas prices shifted sales from SUVs to cars, and then the mix of sales shifted from retail toward fleet sales, where their margins are lower. GM thought that gas prices probably have fallen enough to stabilize the market share of light trucks and that retail sales were now down near their long-term trend levels. Ford was not as sanguine about either of these developments. Finally, the strength of foreign demand and the weaker dollar seem to be showing through to increased export demand for a number of our District’s manufacturers, and this situation supports the comments in the chart show.

    The national economy is clearly showing more underlying strength than we thought in December. Moreover, the downside-risk scenarios now seem less likely. The housing markets look to be nearing the bottom, and the spillover to other sectors now seems likely to be minor or is being offset by other positive factors. Importantly, tight labor markets and lower energy prices are boosting consumer spending. We continue to expect that growth will be modestly below potential in the first half of the year, but like my business contacts, we expect activity to pick up in the second half and growth to be a touch above potential by 2008. Unlike the Greenbook, this projection is conditioned on market expectations for interest rates, which impart some degree of accommodation next year. So currently I see the risks to the growth forecast as being fairly well balanced. On the downside, we could be wrong about the stabilization in housing, and on the upside, consumer spending could remain robust or demand from abroad could accelerate.

    Overall, the recent data on inflation have been positive. As a result, the forecasts from our inflation models are lower by a tenth or two. The models estimated using data only since 1984 predict that core PCE inflation will be flat at 2.3 percent through 2008. So I’m less optimistic about inflation than the Greenbook. In my mind, there are two key questions concerning the inflation outlook. First, what happens in 2009 and beyond? As we were discussing before, in chart 6 in the Bluebook, for whatever reason, inflation is moving up, and I think that’s a concern. Second, there’s the issue of longer-run inflation expectations. In the Greenbook forecast, by the end of ’07, inflation would have been at or above 2¼ percent for a year and a half with no change in the fed funds rate and a reasonably strong economic environment. I think markets might interpret this inaction as a signal that we’re satisfied with 2¼ percent inflation, not the 1 percent to 2 percent comfort zone that many of us have said we prefer. This view was shared by the participants at our recent gathering of academic and business economists—we have an advisory committee that meets a few times a year. Indeed, several academics thought we were already at this point. In their minds, the current policy stance and inflation picture revealed that we were satisfied with inflation stabilizing at or a bit above 2 percent. The business economists also were predicting that we would find ourselves in the position of needing to increase rates some time this year in order to put inflation on a pronounced downward path.

  • Thank you. President Stern.

  • Thank you, Mr. Chairman. Trends evident in the District economy for some time fundamentally are continuing. Specifically, employment is increasing moderately and steadily. Most components of aggregate demand are expanding, and I would note, in particular, strength in nonresidential construction. There has been no significant acceleration of inflationary pressures or of wage pressures. The housing sector is subdued, but the District data on sales and starts suggest stabilization, as do the national data. The data on the inventory of unsold homes perhaps are contradictory to that statement because there are still a lot of unsold properties; at least those data suggest that it will be some time before there is any pickup in housing activity. In any event, as Bill Dudley mentioned, mortgage delinquencies and foreclosures are rising, albeit starting from a fairly low level, and though that probably won’t have a significant effect on economic performance, it could be a political issue in Minnesota and elsewhere in the District.

    As far as the national economy is concerned, it seems to me that the incoming data over the past several months underscore a couple of things. First, the data demonstrate, again, the underlying resilience of the economy. Second, they bolster the case for sustained growth over the next year or more, accompanied by steady to diminishing core inflation. Let me elaborate briefly on those observations. The economy apparently grew better than 3 percent in real terms again last year, despite the significant run-up in energy prices, the appreciable decline in housing activity, and problems in the domestic auto industry. As I think about the prospects for ’07, I see little in the broad scheme of things to suggest that overall real growth over the next year will be much different from that over the past year or, for that matter, much different from that experience from ’03 through ’05. It also seems to me that our earlier concerns about the possibility of a further acceleration of core inflation have diminished, largely on the basis of the incoming information on inflation, thereby through the process of elimination heightening the outlook for steady to declining core inflation. I actually think that case is pretty good, partly because some of the factors that boosted core inflation were transitory and partly because inflation expectations, as best I can judge, have remained well anchored. That’s the message I get, at least from financial markets, from labor markets, and from conversations with our directors, other business people, and so forth. So for me, overall the near-term to medium-term outlook both for real growth and for inflation is constructive. I’ll stop there.

  • Thank you. President Minehan.

  • Thank you very much, Mr. Chairman. The New England regional economy continues to grow at a moderate pace with relatively slow job growth, low unemployment, and moderating measured price trends. Consumer and business confidence is solid, and while retail contacts reported an uneven holiday season, manufacturers were generally upbeat about business prospects. Skilled labor continues to be in short supply and expensive. In every one of the New England states, there is concern over the long-run prospects for labor force growth, given their mutual low rates of natural increase, out-migration of 25 to 34 year olds, and dependence on immigration for labor force growth. New England is an expensive place in which to live, and concerns abound about how to attract and retain the highly skilled workers that are needed for its high preponderance of high value added industries. Obviously, there’s nothing new or particularly cyclical about the foregoing comments. But I’ve been to quite a few beginning of the year “let’s take stock of things” conferences in all the states recently, so perhaps I’ve become more impressed than usual by the medium-term to long-term challenges facing the region. In the short run, however, the positive overall trend of the regional economy does seem to be a powerful offset to the continuing decline in real estate markets. At our last meeting it seemed as though New England’s real estate problem was more significant than that in the rest of the country. But now it appears that both are similarly affected whether one looks at prices, sale volumes, inventory growth, or declining construction. As with the nation as a whole, there are signs of stabilization; but at least in New England, making any judgment about the imminent revival of real estate markets in midwinter is foolhardy at best.

    On the national scene, the data have been more upbeat since our last meeting. Apparently the holiday season was a bright one, with consumption likely growing at a pace of more than 4 percent in the last quarter. That’s remarkably strong given the continuing decline in residential real estate and proof—to reiterate what President Stern said—that the U.S. economy continues to be unusually resilient. Supporting consumption are tight labor markets, lower energy prices, tighter though still reasonably accommodative financial conditions, strong corporate profits and some signs of revival in business spending after declines related to housing and motor vehicle expenditures, and continuing strong foreign growth. Even inflation has moderated a bit, with three-month core price increases in both the PCE and the CPI trending down. Our forecast in Boston and that of the Greenbook are virtually indistinguishable. The last quarter of ’06 was stronger than expected. The first quarter of this year will be slightly better as well, but after that, the trajectory remains the same as it has been for the past two or three meetings. An increasing pace of growth in ’07 and ’08 as the housing and motor vehicle situations unwind, a slight rise in unemployment, and a fall in core PCE inflation to nearly 2 percent by the end of the forecast period. In many ways, this is the definition of perfection, a forecast that is seemingly getting better each time we make it, with growth a bit higher, unemployment a bit lower, and inflation ebbing slightly more. The underlying mechanics that produce this outcome are relatively straightforward, but I wonder whether we should have a heightened sense of skepticism about such a halcyon outlook. Let me focus on two reasons for such skepticism.

    First, all other things being equal, inflation could be less than well behaved. One reason that inflation ebbed in earlier forecasts was that slower growth brought about a small output gap and rising unemployment. Now, the output gap is virtually eliminated, and unemployment remains below 5 percent. Ebbing inflation is solely the product of recent favorable inflation readings, which are assumed to persist: lower energy prices, declining import prices, and falling shelter prices. It’s hard to tell at this point whether the recent readings on core inflation are the result of fundamentally lower inflation pressures or just luck or maybe a combination of the two. I think a similar range of uncertainty applies to oil prices and the strength of the dollar. With virtually no output gap, it seems to me that, while the baseline best guess might be lower inflation, for all of the reasons discussed in the Greenbook one should approach that analysis with some caution.

    Second, demand could well be stronger. The baseline forecast assumes that consumers somehow get the message some of us have been trying to deliver about the need for an increase in private saving. The saving rate moves from a negative 1 percent to a positive 1 percent, the highest saving rate in several years. As I noted before, I have to ask myself why this is likely to happen over the next coming months when it hasn’t in the wake of the housing situation in 2006. Clearly, the downturn in residential real estate, an important political issue in all our Districts and certainly devastating for subprime borrowers in particular, hasn’t affected consumer spending in general. In fact, household net worth as a share of disposable income remains quite high, buoyed in part by a likely overestimate of real housing values but also by rising equity markets. The timing of the needed increase in the personal saving rate could well be further out in the future, creating some version of the buoyant consumer alternative scenario instead of the baseline. Again, with no output gap, the potential for increased inflationary pressure is obvious.

    In sum, the Greenbook forecast remains in my view the most likely baseline. There are downside risks, as I mentioned before, for the seven alternative scenarios do anticipate some downside risks; but if the housing situation is beginning to stabilize, I find it hard to believe that broader anxiety about it will affect business spending or the consumer as some of these scenarios contemplate. The bigger risk may well be that business spending picks up in light of consumer strength, unemployment stays low, growth exceeds our current projections, and resource pressures become more intense. I am concerned that risks to inflation have grown somewhat since our last meeting. I think I’m still in a “wait and see” mode, as I do believe there are downside risks to the evolution of housing markets. But if the Greenbook growth forecast is right, the best risk management on our part may have to be to seek tighter policy sooner rather than later.

  • Thank you. President Minehan, just to clarify, I think that the forecast of consumption is not based on the idea that the saving rate has to rise. Rather, consumption is modeled using underlying determinants, like income and wealth, and an endogenous indication of that is that saving rises.

  • Anyway, you gave the impression that higher saving was itself something that was going to happen naturally.

  • As I look at the forecast in the Greenbook, the higher saving rate—money out of income that’s expected to be there going into savings—is one element that makes consumption lower than it would otherwise be.

  • But the saving rate is not driving the consumption forecast. Rather, the consumption forecast is driving the saving rate.

  • In the forecast, yes.

  • Well, Mr. Chairman, first on our cheaper, more affordable, and perhaps luckier Eleventh District economy, we estimate that employment growth ran at a rate slightly greater than 3.2 percent last year and our output growth exceeded 4 percent. We do see some possible slowing, but there is still very strong momentum in the Texas economy and to an extent in the New Mexican economy, despite a lower rig count.

    What I’m about to talk about is not based on the buoyancy of the Eleventh District economy but on my talking with CEOs as well as the economic projections of our own staff. I’ve talked with twenty-five CEOs for today’s discussion. I’ve added two, and just for the record they are the CEO of Disney and the CEO of MasterCard.

    First, my retail contacts, with one exception, report a pickup in dollar volume and foot traffic that began with the second half of December and has continued. As a result, the Wal-Mart CEO for the United States is much more optimistic and is now forecasting volume expansion of about 2 to 3 percent. My contact from JCPenney, which is in an income range that is double that of Wal-Mart, reports a similar pattern of behavior that started the Friday before Christmas and has carried forward and says that the consumers “feel good about the economy.” The one exception, incidentally, is 7-Eleven, and I would be upset, too. Tobacco constitutes 30 percent of their sales, and Texas just levied a $10 tax on a $30 carton of cigarettes. Otherwise, the retailers seem to be much more optimistic than they were when I last reported. A not unimportant factor in this report has to do with the phenomenon of gift cards. In the public release of Safeway is an interesting piece of data: Their gift card business, which is called Blackhawk, grew 100 percent last year and dropped $100 million to the pretax bottom line. Wal-Mart reports—and this is not yet public information—a peak gift-card balance for this season of $1.2 billion. Now, mind you, 70 percent of the card use occurs before February 1. So this business has extended the retail season, and it may well have affected the buoyancy that I’m hearing from retailers in terms of their current activity. MasterCard confirms the pickup in consumer activity, particularly that it began late in the Christmas season, and its CEO reports from his contacts certainly much less “noise” about a possible recession and sees that risk abating. Just to jump forward, we forecast, based on economic research, economic growth in our District of 2.7 percent for 2007, which is what MasterCard happens to be projecting—so I found that CEO to be instantly credible. Disney reports extremely strong advertising growth. They expect the year-over-year growth to be 20 percent in terms of their first- quarter network advertising, with strength in every sector except for autos, according to the CEO. They also report record foot traffic at their parks over the holidays. In contrast, UPS reports a weak start to December but a strong finish in the last seven days of the year, with year-over-year numbers for January not as robust as expected—running around 1 percent. The rails also report a bit slower volume, as the CEO of one of the large rail companies said. There are clearly shifts taking place. For example, lumber shipments of Union Pacific and Burlington Northern are down 25 percent year over year, reflecting the falloff in the construction of homes. Both CEOs caution that company year-over-year numbers are like comparing apples and oranges, given the robust growth in the first quarter of 2006. I did talk to two of the top five housing CEOs and a third one, a smaller company. They seem to confirm the sense of the staff in that they feel that the housing situation is bottoming out, but they continue to caution that any reading of the housing industry between Thanksgiving and the Super Bowl is of questionable value.

  • The one with two teams from the Seventh District. [Laughter]

  • Yes. But here are some data to put this statement in perspective. The contact from the largest company reports that cancellation rates, which were running at 50 percent in their most stressed markets, particularly in California and Florida, have come back to 20 to 25 percent—relatively good news. One aspect worth noting is that they are getting relief from their subcontractors—they estimate, on average across the industry, about 10 percent cost relief. Another predictable behavior pattern becoming manifest is that the large contractors with very strong balance sheets are looking to buy the distressed smaller contractors. David, I agree with you that we haven’t seen all the downturn in housing yet in terms of its effect on the economy, but we may well come out of it with an even more tightly consolidated industry. The bottom line on growth from the Eleventh District perspective is a Wagnerian summation—that is, the economy’s growth dynamic is not as bad as we thought it was sounding when we last read the score. I would summarize it by saying that the tail in terms of the risk of recession has become much slimmer.

    However, my conclusion is the opposite with regard to inflation—that is, on reflection and working with our staff and listening to CEOs, I think the tail in terms of risk of higher inflation has fattened, and this is reflected in several reports. Just very quickly—because of my Australian DNA—Anheuser-Busch decided to raise beer prices 2 to 3 percent at year-end. That doesn’t bother me. What bothers me is the price of skilled workers who drink that good beer in terms of what’s happening for wages and total compensation of skilled and unskilled labor. You know that I have talked about the massive projects that Texas Utility plans for coal to gas conversion and whether they get the so-called Dirty Dozen that they’re planning or just a handful. I did go over with the CEO the studies that McKinsey, BCG, and Bechtel have provided for them, and some interesting data points came out that I want to summarize. In the summer of ’05, they estimated that all-in labor costs for these plants, which they estimated per plant, would take 4.6 million worker hours at $36.25 an hour. Today they don’t believe they can get the job done for less than $44 an hour; and because of worker quality issues, they now believe it will take 5.2 million worker hours for each plant. So if you have a 21 percent per hour increase and a 13 percent increase in hours, one wonders about the ability to see a short-term reduction in skilled and unskilled labor costs. These numbers, by the way, take into account the recent slippage in oil rig activity, which is down for the fifth straight week, and also the slowdown in housing and some initial slowdown in commercial construction. It dovetails with reports like that of BP’s to us that they decided to pay all their salaried operators, to whom only two years ago they were offering incentive packages to leave, $25,000 bonuses per year for the next two years to stay. Fluor’s CEO reports that they are having the largest year in their history of hiring college graduates, and the 900 mechanics who work for a large truck dealer with which I regularly talk are now fetching $35 an hour.

    Another piece of data comes from a study by McKinsey and BCG, and I want to talk about it very briefly in terms of the intermodal transportation system of our country. The shippers tell me that port congestion is very high. The fleet utilization rate is running at about 95 percent. You know that I like to talk about Panamax ship rates because of their size and liquidity. Prices have not eased since we last met, and the interesting factoid is that the ten-year-old fleet is available for purchase at the same price as the fleet expected to be delivered two and a half years from now. These ships run $39 million apiece before their add-ons, which tells you that there’s a short-term tightness. If you talk to the rails and the effective two operators—there’s really a duopoly in this country between Burlington Northern and Union Pacific—their pricing is based on opportunity costs because they do not foresee the ability to expand their networks. This may well facilitate an upward price spiral as all the infrastructure projects currently on the drawing boards begin, whether TXU’s or some other liquefied natural gas companies’ projects that we have heard about.

    A couple of other points with regard to inflation that I think bear watching: These inputs are anecdotal, but I think we have a pretty good survey in terms of the oil and gas operators. Most of the major oil and gas operators would not be surprised to see $40 oil and to see a range between $40 and $60 oil—that fits with the Brown-Yücel model that we developed in Dallas—and for natural gas prices to ease to a level of about $5 in the spring. That’s the good news.

    I want to mention two other negative news items. One was referred to earlier, and that regards corn prices. The price for corn was $2.30 a bushel last year, if you looked on the graph that Bill, I think, presented earlier. Corn is now running $4.00 a bushel, and the food production companies we talked to project the price to be $5.00 by the end of the year. Now, this is good for farmers. It’s good for John Deere. It’s not good if you raise a chicken, a cow, or a pig, and it’s certainly not good if you’re a human who eats at Whataburger, one of my other new contacts. I won’t use the language that the CEO used, but he reports that his margins are coming under pressure.

    The second development may be a bit more disturbing; it concerns the cost of imported goods from China into Wal-Mart’s network. According to Wal-Mart’s CEO for international operations and their vice chairman, Chinese import prices into Wal-Mart’s network were depreciating at an annual rate of between 2 and 5 percent. Recently, however, the rise in China’s labor costs for their suppliers net of the increase in productivity is leading to import price costs that are increasing at a rate of approximately 1 percent. To me this development raises an issue that I think President Moskow touched on regarding our views on inflation and perhaps rates going forward, which we’ll talk about tomorrow. At home, we’re seeing unacceptably high and sustained wage developments for certain critical components of labor, which I mentioned earlier. Abroad from Germany to China, we’re seeing economic growth rates that are well above sustainable trends, which is why I asked the question about your gap analysis earlier. My own staff calculates that, if you do a gap analysis—that is, if you compare current growth to what they estimate trend growth to be—there is no significant inflationary pressure. However, if you analyze capacity utilization rates in the G7 countries and in the BRICs, we are getting closer, given the economic growth that has been experienced, to more heavily used capacity and to igniting inflationary pressures. The bottom line for inflation from our perspective is that what was once a tailwind generated by globalization may be closer to becoming a headwind than our models indicate and our limited understanding of the effect of globalization otherwise leads us to understand. Thank you, Mr. Chairman.

  • President Fisher, just a quick question. I couldn’t quite gather whether you were saying that commercial construction is overall slowing. You mentioned that once, but then you talked about a variety of projects.

  • It appears to be slowing in certain areas and in our District but is nonetheless running at a stout rate. It seems to have come off somewhat but, given the large projects that are planned, the numbers work out to show increasing pressure on the labor that’s available to construct those projects.

  • Thank you. President Pianalto.

  • Thank you, Mr. Chairman. I have the sense that since our last meeting we’ve received a wealth of data but not necessarily a wealth of information. Between the data that have come in and the conversations that I’ve had with my District contacts in the past six weeks, I’m a little more confident about the outlook for real growth, and I view the inflation outlook as unchanged. Housing is an example of having more data, but not necessarily more information. Though some aspects of the residential housing data have been encouraging, neither futures on housing prices nor reports that I have received from people in the business suggest that the slowdown in that sector will end any time soon. Despite that, it still looks as though the spillovers to consumer spending and financial markets have been limited. At our last meeting, there was also some uncertainty regarding the health of the manufacturing sector. For the most part, the intermeeting data have been favorable for the manufacturing sector. The industrial production numbers, for example, have been strong, but manufacturing employment remains flat.

    The usual story that makes sense of these disparate trends is the continuing strength in manufacturing productivity. But I’d like to mention another element in the picture—others have mentioned it this morning—and that’s the skills mismatches. My directors and business contacts in the manufacturing sector tell me that they have jobs available but that they face great difficulty in filling those jobs because they can’t find people with the right skills. Interestingly, as was mentioned in the staff presentation earlier, the JOLTS data show openings as rising, and that’s also true in the manufacturing sector. Openings have been rising over the past two years. This news really isn’t so good per se, but it does suggest that at least some of the sluggishness in manufacturing job growth is coming out of the structural elements in the labor markets and is not purely a cyclical decline in aggregate demand. In a somewhat related vein, according to the National Association of Colleges and Employers, college placements are up 17 percent this year, the strongest showing since 2001. The story is that relatively high profits and good business prospects are driving up demand. We also understand from the Ohio governor’s office that last year, although sales tax receipts were lower, income tax receipts were stronger than expected.

    These bits and pieces combined with some of the positive news in the aggregate data reports in the past couple of months make me somewhat less worried about the downside risks to economic growth than I was at the last meeting. I don’t want to go overboard on this. I had that feeling several times last year only to be subsequently moved in the other direction. It is hard to tell whether some of this good news has been related to weather—that is, some spring activity might have shifted into the fourth quarter.

    On the inflation front, both the official data and the anecdotal stories from my contacts continue to provide some encouragement that core inflation will moderate over the next year, but the data are not yet entirely convincing. My staff has noted that for most of 2006, especially in the later half of the year, the growth rates of individual CPI components exhibited a bimodal distribution. On an expenditure-weighted basis, most components were either falling in price or rising at a troubling rate. Very few CPI components were rising at a pace that the CPI tells us is about average. This pattern is highly unusual, and I don’t know what to make of it, except to say that it does make it more difficult to tell which way the inflation trend is leaning.

    My only material difference of opinion with the staff baseline projection concerns the assumption about labor supply. Economywide, there is some reason to think that aggregate labor supply is more abundant than the Greenbook baseline contemplates. Labor force participation rates for most demographic groups have been running stronger than the staff has been expecting, indicating that the growth of potential output could lie somewhat above the Greenbook estimate. That’s what I am assuming, and therefore I get a slightly better combination of output and inflation .

    In the end, my outlook for the economy hasn’t changed. The general contours of the forecast for a modest slowdown in growth coupled with a very gradual decline in core inflation make sense to me. However, I have lowered just slightly my assessment of the risk that real growth will fall short of my projection, and I have not changed my risk assessment of inflation. There’s still a notable risk that year-over-year changes in inflation might remain stuck where they are today as opposed to drifting down half a point or so over time as I would prefer. Thank you, Mr. Chairman.

  • Thank you. President Lacker.

  • Thank you, Mr. Chairman. Economic activity in our District lost a bit of momentum in January. Retail sales contracted in recent weeks as automobile dealers noted waning interest and buyers of big-ticket electronic goods stayed home, perhaps to watch the big screens they purchased during the holidays. [Laughter] Another source of slowing was a further pullback in the factory sector. I should mention new orders in our District slipped in recent weeks, on top of December’s modest contraction, and factory hiring edged lower for the second straight month. On the plus side, services firms continued to report moderate growth in revenues and employment. Despite this mixed picture, however, a wide variety of firms remained optimistic about their prospects six months out. District labor market conditions remained tight, and skilled workers continued to be in strong demand in large metropolitan areas. Businesses tell us that they are pushing up wages as a result.

    Real estate activity is, on balance, hanging in there. Anecdotal reports indicate fairly firm home sales across many areas in December, and we’re hearing more reports of pockets of strength in some suburban housing markets around D.C., though assessments from other areas continue to be somewhat downbeat. We have also heard that homebuilding activity rose somewhat in a number of District metropolitan areas in recent weeks. Commercial real estate prospects remained relatively bright, with leasing activity firm and a solid number of projects on the books for ’07. Price pressures at District firms seem to have moderated somewhat, confirming the national trends.

    The national data flow since our last meeting has been encouraging. The Greenbook now predicts a higher trajectory for real GDP. I agree with the Greenbook’s short-term outlook. Declining housing construction is still depressing the real growth rate now, but demand has stabilized, I think, and inventories may be topping out. Each batch of housing data has bolstered my confidence in the trajectory we sketched out last fall—namely, that the drag from housing will mostly disappear by midyear with spillover having been relatively limited.

    Consumer spending has been quite resilient. Evidently, favorable income prospects have trumped weakening housing prices. The fundamentals for business investment remain favorable with the cost of capital low and profitability high; and the latest news—that unfilled orders for capital goods are continuing to increase—fits in well with the view that equipment investment is likely to be a source of strength going forward. The Greenbook has real growth later this year and into next year returning to trend, driven by strength in business investment and solid consumer spending. I agree with that outlook with the caveat that my estimate of trend growth is higher than the Greenbook’s.

    The inflation news since the last meeting has been encouraging as well. Core CPI inflation was 1.8 in the fourth quarter, and core PCE inflation was estimated to have been 2.1 percent. It’s tempting to extrapolate this favorable news forward as the Greenbook does and forecast a gradual downward drift without further overt action by the Committee. That outcome is certainly plausible, especially if oil prices cooperate and remain contained within recent trading ranges. But I remain apprehensive. First, core inflation has exhibited fairly substantial high-frequency swings over the past couple of years. So it will take many more months for me to be very confident that inflation is trending down. Second, and related, over the past three years large swings in energy prices have been followed by swings in core inflation with a short lag. Indeed, the cross-correlation between core and energy components of the PCE price index seems to have increased in the past few years. The recent dip in core inflation may therefore be the transitory effect of last summer’s decline in energy prices, and the December uptick in core CPI may signal that it’s behind us now. A downward drift in inflation thus is likely to depend critically on the absence of upward movements in energy prices. Note that the staff follows the futures market in assuming, as I calculated it, a 13 percent rise in oil prices by the end of 2008, which suggests continuing upward pressure on core inflation. Third, expectations could well exert a gravitational pull in an upward direction rather than the downward direction as claimed recently in a popular newsletter and also as the staff indicated underlies their forecast. Personally, I place the center of gravity a little higher, above 2 percent. The twelve-month change in core PCE inflation has been above 2 percent, as we all know, since March 2004, and none of the usual measures of expectations either from surveys or TIPS markets are much below 2½ percent for the CPI. So even though the recent inflation news has been comforting, I think there’s a good reason to continue to worry about it.

  • Thank you. President Plosser.

  • Thank you, Mr. Chairman. Conditions in the Third District have continued to evolve much as they have for most of the past several months. Economic activity is still expanding. I think I can use the word “moderate”—I don’t think anybody else has used that yet, and our contacts expect the pace to be maintained in the coming months. There has been little change in the pattern of activity over the sectors. Retailers in our region indicated that their holiday sales were about as they expected or somewhat better. Housing continues to weaken at a somewhat orderly pace, but there are signs of stabilization of demand. Inventory has remained elevated, and construction continues to decline. However, the weakness in residential construction is being offset by continued strength in nonresidential construction. Office vacancy rates continue to decline in Philadelphia and in the near suburbs as well. The net absorption of office space has increased for the past twelve quarters. Manufacturing activity in the region hit a soft spot in the fall, as I indicated in previous meetings, but our most recent Business Outlook Survey, in January, presented somewhat positive but also somewhat mixed signals. The general activity index returned to positive territory with a reading of plus 8, indicating a slight increase in manufacturing activity, and there was a significant rebound in shipments. New orders, however, remained close to zero. That’s somewhat of an aberration because new orders and shipments tend to move very much together, and so there are some inconsistencies there, which is why I said the situation is a bit mixed. According to our survey, however, the firms expect a rebound of general manufacturing activity and orders over the coming six months. Indeed, most of our business contacts see moderate growth in the region continuing for the foreseeable future. Their positive attitudes are consistent with the recent positive news we’ve had about conditions in the nation. Firms remain concerned about their ability to hire both skilled and unskilled labor. Labor markets are tight for many of the reasons that President Minehan described in New England; we have some of the same things going on in the Third District.

    Regarding national conditions, the unusually warm weather in December may have temporarily buoyed some of our numbers; but based on incoming information, I’ve become increasingly confident that the national economy has a positive underlying momentum. At the time of our last meeting, there was a contrast between the mixed data on consumption and production and the relatively strong indications from the labor market. The picture that appears to be emerging from the latest economic information is one of stronger underlying growth that has been temporarily weakened by housing and autos. There is little, if any, evidence that the housing and auto corrections are spilling over into the other sectors of the economy. We’ve been looking for those spillovers for the past six months and have yet to see any significant evidence that they are occurring or are about to occur. Of course, spillovers may yet materialize with a long lag, but that likelihood to my mind is diminishing as we have begun to see some hopeful signs of stabilization in housing. Labor market conditions remain firm, and manufacturing indicators improved in December as did capital goods orders. Although I didn’t talk to the chairman of Disney, I did talk to a small manufacturing firm with total revenues that come to $2 million. He has been very positive about the outlook. His sales depend a lot on construction, and he said that, after the most miserable August and September he had ever seen in his twenty years of running the business, the pickup began in late November, continued through December, and has continued into January as well. Other contacts from banks, particularly credit card issuers to whom I’ve talked, suggest that banks are seeing numbers coming across their books on credit card purchases continuing to be strong even after Christmas. So that also is good news.

    All of this suggests that the downside risks to growth have receded since our last meeting. I believe this is the market’s assessment as well, as expectations of future policy firm. My outlook is that the economy will return to trend growth, which I put at about 3 percent this year, and will continue at that pace into 2008. Of course, as everybody has indicated, that’s a little stronger than the Greenbook’s outlook, and it is, again, based on my view that potential growth or trend growth is somewhat higher than the Greenbook has stated. I expect the unemployment rate to rise slightly, maybe to 4.8 percent by the fourth quarter of this year, and then to stabilize into next year. I think this is going to be accompanied by employment growth of nearly 1 percent, and again, that’s what accounts for the difference in the trend growth.

    I anticipate a decline in core PCE inflation of about 0.4 percent by 2008. I would like to underscore that this forecast is not driven by a lower pass-through of oil prices, which have declined. My reading of the empirical evidence, including work done by some people on the Philadelphia staff, is that it’s very difficult to attribute movements in core inflation of six months to twelve months or longer periods to changes in oil prices. In fact, there’s growing empirical evidence that neither movements in oil prices nor Phillips curve type factors significantly improve our root mean square error forecasts of core inflation two or more quarters ahead. I note that this refers to forecasts of six months or longer and not to short-run high-frequency movements. This suggests that we should be careful in the language we use describing the reasons for our projections of future inflation to avoid perpetuating views of inflation processes that we can’t empirically substantiate.

    In my view, core inflation will not come back down until monetary conditions, which I believe have been very accommodative over the past few years, have tightened sufficiently. The Greenbook forecast has a slightly smaller decline in core PCE inflation to about 2 percent in 2008, but incorporates a less restrictive monetary policy than I believe is likely to be appropriate given my view of the strength of the underlying economy and of the fundamentals that we are seeing. Indeed, over the past two meetings, my feeling was that the slowdown in economic activity that we might be seeing, combined with a constant fed funds rate, might have been enough to bring inflation back to a more acceptable level. Now I’m less convinced that price stability will be achieved without further action on our part some time later this year. But I will leave that discussion to the policy go- round. Thank you.

  • Charlie, I’m not sure I understand your thinking. You said that you expect what sounded like a pretty significant moderation in core PCE, but that’s on a monetary policy assumption that implies further tightening.

  • That’s right, somewhat tighter, somewhat more aggressive than what’s in the Greenbook.

  • Though I don’t want to pin you down, that sounds sort of modest. You are saying that with another 25 basis points you’d get what core PCE inflation over the forecast period?

  • The path I was thinking about as I was doing the forecast and trying to determine the appropriate policy here—my desire is to get inflation down lower, and that’s reflected in my forecast—is one in which the fed funds rate goes up somewhat from where it is today, perhaps to 5½ or 5¾ percent. But then by the end of ’07 and into ’08, it’s coming back down again to more of a steady-state level, and then we can talk about what the real neutral rate is.

  • Just in orders of magnitude—if we did another 25 or 50 basis points and there were some sort of associated changes in overall financial conditions so that that was reinforced, you’d get a core PCE inflation forecast that would go how far down? Would it go to 1.5?

  • Well, there’s some uncertainty about that. I think it would get to between 1.5 and 2 percent.

  • Thank you. It’s 4:30. Why don’t we take a fifteen-minute coffee break?

  • [Coffee break]

  • Would you come to order, please? Thank you. We are ready to recommence with the go-round. President Hoenig.

  • Thank you, Mr. Chairman, now that I have everyone’s attention, [laughter] I’m going to start with some information on the District and then talk briefly about the national economy from my perspective. Let me begin by saying that the District’s activity did slow over the second half of 2006 in line with the national economy itself. The slowdown was most apparent in housing and manufacturing. However, the most recent data that we have from November and December indicate a pickup in some of the activity. Moreover, reports from our directors and our business contacts suggest a considerable degree of optimism among them going forward, more than we expected actually. One area in which we are seeing signs of improvement is housing itself. While new construction activity does remain subdued in our region, sales activity has picked up, and the inventory situation appears to be improving in our major markets. Nonresidential construction remains strong and is offsetting some of the weakness on the residential side. District employment growth has risen in recent months, and labor markets remain tight for us. In addition to continuing shortages of skilled workers in a large number of technical and professional areas, we have recently received reports that the hospitality and recreational sectors are experiencing difficulty in finding lower-skilled workers as well. We have also received numerous reports from directors in District businesses indicating higher year-end wage and salary increases.

    The situation in agriculture is somewhat mixed. The sharp increases in crop prices, especially corn, driven by exports of ethanol and exports of corn itself, have caused the USDA to boost estimates of 2007 farm income rather significantly. However, higher crop prices are also eroding profitability of livestock producers and processors in our region, which is a fairly important sector.

    One important sector in which activity appears likely to slow in 2007 is energy. The District economy has benefited tremendously over the past few years from the rise in energy prices, which has spurred increased production of traditional products—and that includes oil, gas, and coal—as well as alternative fuels like ethanol and biodiesel. According to reports from a couple of our directors, however, the recent decline in energy prices has already led to a reduction in drilling activity and is likely to cause some cutbacks in new investment in alternative fuels as well.

    Turning to the national outlook, I, like others, have noted the recent strength in the economy and have raised my estimates of growth for the fourth quarter and somewhat raised them for the first quarter. I continue to expect growth to rise over 2007 modestly toward what I think is potential, in the neighborhood of 3 percent. However, now I expect it to occur a little more quickly than I did at the December meeting. Accordingly, recent economic information has led me to reassess the balance of risks to the outlook. I believe the downside risks from the further slowing of housing have diminished somewhat. Moreover, I share the view that the recent weakness in manufacturing activity reflects a better balancing of production and inventories rather than a fundamental weakness. Going forward, the improved outlook for energy prices should support consumer spending by improving consumers’ disposable income, and we may see additional fiscal stimulus resulting from the more-favorable budget positions of the state and local governments.

    Finally, in terms of the inflation outlook, my views have not changed materially since the last meeting. I’ve been encouraged by the recent inflation data, and I continue to expect inflation to decline over the forecast period. I expect the core CPI to be in the 2.3 percent range and core PCE inflation to be about 2 percent for 2007. However, as others have noted, core inflation is too high, and considerable uncertainty remains about whether the recent progress will be sustained. Particularly, it is not clear how the opposing trends of lower energy prices and greater resource pressures may play out over the next few quarters. Consequently, it seems to me that there is upside risk to the inflation outlook. Thank you.

  • Thank you. President Barron.

  • Thank you, Mr. Chairman. I thought I’d focus a little more today in my comments on the State of Florida as it relates to the housing sector. We’ve heard a lot more positive comments in just the past few minutes about housing. So let me offer a contrarian view, if you will. Florida accounts for about 41 percent of our District employment and 6 percent of overall U.S. employment. As for housing, Florida represented 8 percent of U.S. home sales in 2005 and 6 percent in 2006 as sales and construction continued to decline. To put these numbers in perspective, single-family existing home sales in Florida have dropped 40 percent since January 2005 versus an 11 percent decline in the United States as a whole. Anecdotal reports are that builders are continuing to work down existing inventory and are not starting new projects. In most areas of the state, starts have fallen even more than sales, which should lessen the run-up in housing inventory over the immediate future. Permit issuance for single-family homes is down 54 percent in Florida since January 2005 compared with 28 percent in the nation as a whole. There are certain encouraging signs from reports noting, as mentioned earlier, that buyer traffic is better in some areas, and several of the building contacts that we spoke with expect or, perhaps I would note more accurately, are hopeful that new home sales will improve by the second quarter of 2007.

    Home prices have declined modestly but remain well above the levels implied by the pre- 2003 trends in most areas. This places housing affordability at a relatively low level by historical standards. As I noted at previous meetings, the demand in coastal markets is being constrained by the steep rise in homeownership insurance that has caused monthly housing costs to rise sharply, even as house prices moderate. We’ve heard reports that in markets where prices accelerated the most in recent years, such as south Florida, employers are struggling to recruit staff because of the high housing costs, with some firms electing to leave south Florida and others beginning to convert corporate owned land to corporate housing just so that they can recruit employees. As I reported at our last meeting, the decline in housing activity continues to have a negative effect on housing- related sectors specifically in the South because of our concentration in the carpet and other related industries. Housing-related employment is no longer a net contributor to year-over-year employment growth in the United States, even though overall job growth has remained very firm.

    District banks reported that credit quality has softened but remains at very strong levels. However, banks are beginning to be a bit more vocal in expressing concern with regard to the possibility that builders will face financial problems in the coming months. In addition, banks express concern about the number of speculative condominium projects in south Florida. District banks have lower earnings targets for 2007, and the expectation is that bank merger and acquisition activity and layoffs will increase in the coming year. Some banks are even putting out the “for sale” sign in the hope of cashing out now, noting that things could get ugly over the next two years in some areas.

    Outside the housing sector, indicators of economic performance in the District were mixed. Reports on holiday-related sales were on the positive side, whereas tourism remains relatively mixed across the District. Reports from the manufacturing sector were also mixed, with a weakness in the housing-related industries offset to some extent by the expanding activity in industries related to defense and energy.

    For the U.S. economy as a whole, the drag from housing that we experienced over the second half of 2006 does not appear at this time to pose a serious threat to the overall economy, although some forecasters anticipate below-trend real GDP growth for the end of 2006 and the first quarter of 2007. Most would say that this situation is temporary and would anticipate that real GDP growth will rebound and be close to the trend rate of 3 percent for the rest of 2007. Our staff projections of real GDP growth have had about the same tone as those of the external forecasters. Our staff believes real GDP growth will be sustained in 2007 by job creation that should match the experience that we’ve seen in 2006.

    Measured core inflation was well in excess of 2 percent at the end of 2006. The staff forecast is that core inflation will continue to hover just above 2 percent for all of 2007. The expectation is that price growth in services will continue to dominate core inflation going forward. In my comments I’ve focused a bit more on housing. I would just close by noting that my continued concern would be the lack of impetus to drive down inflation over the long term. Thank you.

  • Thank you, Mr. Chairman. I have to start by saying that it’s hard to compete with my colleague Richard Fisher, with his stable of contacts. I have perhaps just a slight amendment on Wal-Mart. My contact there said that he has observed in recent years a changing pattern of holiday shopping, with shoppers procrastinating and putting their shopping closer to Christmas, and that might have moved some sales from November to December; also the growth of the gift card business moved some of those sales into January. Those circumstances might explain a bit of what we’re seeing. He said that it looks as though the January same-store sales growth will come in at 2½ to 2¾ percent. I’m sure that’s consistent with Richard’s information. My contact points out that, although those numbers are a little better than what they had anticipated a month or two ago, they are still 200 basis points below the original plan, which was set about a year ago. For February their plan is 4½ percent, but he believes that anything north of 3 would be good performance. His view is that he doesn’t see a lot of momentum one way or another, that things are pretty steady, and that there’s been no particularly significant change in the situation.

    My FedEx contact sees business as very steady. There was a very strong peak season, pretty much on projection. The one negative he sees is in the less-than-truckload business, and that confirms information coming directly from a trucking industry source as well. Basically, the outlook is good, steady, and very confident. As for capital expenditures, FedEx is expecting to have 15 percent above this fiscal year in the next fiscal year, which starts June 1. My contact does not see any particular labor market pressures. My UPS contact said that the company is cutting its cap-ex, and they are actually cutting capacity. He said that they are cutting out twelve flights, I think it was, that they had just added in June. The cuts are basically a consequence of a careful analysis of their express business, which showed that a lot of it is just unprofitable, particularly the shipping of packages to individual homes. They are renegotiating contracts with online retailers and mail order retailers, and they’re trying to shed some of that business.

    My trucking industry contact says that things just don’t look very sound. Freight volume, which would be full truckloads, is actually off 4 percent year over year in January. Shipping rates are flat, but there are intense pressures from their clients to cut rates. Driver turnover is up because the drivers are not getting enough business to eat well, and so they are shopping around for other companies. So they are losing some drivers, but they’re not too worried because they have plenty of drivers at the moment. The intermodal business is holding up well, my contact said.

    I’d like to just make one brief comment on the national outlook. I think it’s pretty clear, and it’s reflected around the table, that the outlook for real GDP is a bit stronger than it was at our December meeting, and depending on your perspective in reading the data, maybe the inflation picture is a bit better, too. But I would emphasize that, compared with past revisions of the outlook, these are really marginal and not material revisions. There hasn’t been any really big news here. We don’t want to get carried away with a flow of data that is only slightly stronger.

    Let me also comment, along the same lines, about what has been going on with longer- term interest rates. At the time of our December meeting, the constant-maturity ten-year rate was 4.49. At least that’s what I have in my spreadsheet. On Friday, it was 4.88. There has been a lot of comment to that effect. I think that change is due partly to the string of marginally stronger news and partly to a change in the market’s assessment about our likely future behavior. The market has simply taken out the expectation of a rate cut in the near term. The market has looked again at where we are to a much greater extent than we ourselves have. Thank you.

  • Do you think that’s because they have changed their minds about our reaction function or about how the shocks are likely to come in between now and then?

  • I suspect that it’s a combination. But I also think that a number of us in our speeches have been saying things such as that we think policy is at about the right place. If we repeat that often enough, the markets begin to think that we’re not about to cut rates.

  • So what about our statement in October? Did they miss that?

  • I guess that it’s a consequence of the interaction between what we’ve been saying and the flow of data. You have to be careful about double-counting here, but the flow of data has perhaps convinced the market that what we were saying is right because the market, I think, had developed a somewhat different sense of where the economy was going than they had thought that we held.

  • Does Mr. Lacker have an alternative explanation?

  • I think he’s right. He is suggesting that his belief is that the reaction function they hold to hasn’t changed much in the past month or two but that the shocks have come in more consistent with our assessment of how they were going to come in. Is that fair?

  • Thank you. Vice Chairman Geithner.

  • Thank you, Mr. Chairman. Just a few quick points. We feel somewhat better about the outlook for growth and inflation, but we haven’t really changed our forecasts for ’07 and ’08. So just as we expected over the past few cycles, we currently expect GDP to grow roughly at the rate of potential over the forecast period, which we believe is still around 3 percent, and we expect the rate of increase in the core PCE to moderate a bit more to just below 2 percent over the forecast period. We see somewhat less downside risk to growth and somewhat less upside risk to inflation than we did, but the overall balance of risks in our view is still weighted toward inflation—the risk that it fails to moderate enough or soon enough. The basic nature of the risks to both those elements of our forecast hasn’t really changed.

    As this implies, our forecast still has somewhat stronger growth and somewhat less inflation than the Greenbook does. The differences, however, are smaller than they have been. We see the same basic story that the Greenbook does in support of continuing expansion going forward. We have similar assumptions for the appropriate path of monetary policy—at least two, perhaps several, quarters of a nominal fed funds rate at current levels. The main differences between our view about the economy and the Greenbook’s relate first, as they have for some time, to the likely growth in hours; we’re still not inclined to build in a substantial reduction in trend labor force growth. Second, our view is that inflation has less inertia, less persistence, than it has exhibited over the past half-century. Third, we tend to think that changes in wealth have less effect on consumer behavior than does the staff.

    We have seen a general convergence in views in the market, as we just discussed, toward a forecast close to this view, close to the center of gravity in this room, and a very significant change in policy expectations as well. We can take some comfort from this, but I don’t think we should take too much. Markets still seem to display less uncertainty about monetary policy and asset prices and quite low probabilities to even modest increases in risk premiums than I think is probably justified.

    Let me just go through the principal questions briefly. Is the worst behind us in both housing and autos? Probably, but we can’t be sure yet. If we get some negative shock to income—to demand growth—we’re still vulnerable to a more adverse adjustment in housing prices with potentially substantially negative effects on growth, in part because of the greater leverage now on household balance sheets. How strong does the economy look outside autos and housing? Pretty strong, it seems. We see no troubling signs of weakness, despite the disappointment on some aspects of investment spending. What does the labor market strength tell us about the risk to the forecast? It seems obvious that on balance it justifies some caution about upside risk to growth and more than the usual humility about what we know about slack and trend labor force growth. But I don’t think it fundamentally offers a compelling case on its own for a substantial change to the inflation forecast or the risks to that forecast.

    Is there any new information on structural productivity growth? Not in our view. We’re still fairly comfortable with the staff view of around 2 percent or 2½ percent for the nonfarm business sector. I’m not a great fan of the anecdote, but I’ll cite just one. If you ask people who make stuff for a living on a substantial scale, it’s hard to find any concern that they are seeing diminished capacity to extract greater productivity growth in their core businesses. That’s not a general observation, just a small one.

    Have the inflation risks changed meaningfully in either direction? I think the recent behavior of the core numbers and of expectations is reassuring. The market doesn’t seem particularly concerned about inflation, and the market is therefore vulnerable to a negative surprise, to a series of higher numbers. Can we be confident we’ll get enough moderation with the current level of long-term expectations prevailing in markets, with the expected path of slack in the economy, and with the range of potential forces that might operate on relative prices— energy, import, and other prices? Again, I think this forecast still seems reasonable, but we can’t be that confident, and we need to be concerned still about the range of sources of vulnerability of that forecast. Another way to frame this question is, Is the inflation forecast consistent with the current expectations for the path of monetary policy acceptable to the Committee? We haven’t fully confronted that issue because we don’t get much moderation with a monetary policy assumption that’s close to what’s in the markets. But I don’t think there’s a compelling case to act at this stage in a way that forces convergence on that. In other words, how tight is monetary policy, and how tight are overall financial conditions today? I don’t think there’s a very strong case for us to induce more tightness or more accommodation than now prevails. There’s a good case for patience and for giving ourselves a fair amount of flexibility going forward, within the context of an asymmetric signal about the balance of risks and a basic judgment that we view the costs of a more adverse inflation outcome as the predominant concern of the Committee.

  • Thank you. Governor Kohn.

  • Thank you, Mr. Chairman. In preparation for submitting my forecast, I looked at my previous forecasts—a humbling but instructive experience usually. [Laughter] Going back a year, I found that, based on the staff’s estimate for 2006, inflation and growth had each turned out within a quarter point of my projections. I’m quite certain that this is not a consequence of any particular expertise on my part. Rather, it is indicative that, in a broad sense, the economy is performing remarkably close to our expectations. President Poole was making this point. Even going back a few years to when we started to remove accommodation, despite large fluctuations in energy prices in recent years, huge geopolitical uncertainties, and a housing boom and bust the dimensions of which we really didn’t anticipate three years ago, the economy is in the neighborhood of full employment, and core inflation is at a fairly low rate by historical standards.

    Now, the surprises last year were the surge of inflation in the spring and early summer. That has not been entirely reversed. The extent of the slowdown in productivity growth, both in terms of trend and of actual relative to the lower estimated trend, and the related decline in the unemployment rate suggest that we are entering 2007 with a higher risk of inflation than I had anticipated a year ago. Given this risk, it is especially important that economic growth be no greater and perhaps a little less than the growth rate of potential, and that is my forecast—a small uptrend in the unemployment rate. The issue I wrestled with was how fast the economy will be growing when the drag from housing abates. In early December, the debate might have been about whether demand would be sufficient to support growth as high as potential. But given the stabilization of housing demand, the strength of consumption, and ongoing increases in employment, I asked myself whether we might not find the economy growing faster than its potential beginning in the second half of 2007 and in 2008, thereby adding to inflation pressures.

    A couple of forces, however, gave me a little comfort in supporting my projection of only moderate growth. One is the modest restraint on demand from the recent rise in interest rates, especially the restraint on the housing market, and the dollar exchange rate. Another is the likelihood that consumption will grow more slowly relative to income and will lag the response to housing as housing prices level out and as energy prices begin to edge higher. Consumption late last year was probably still being boosted substantially by the past increases in housing wealth and by the declines in energy prices, which combined with warm weather to give a considerable lift to disposable income. On the housing wealth factor, I think our model suggests that it takes several quarters for a leveling out in housing wealth to build into consumption. In fact, the data through the third quarter suggest that prices were really just about leveling out in the third quarter. So it may be a little early to conclude that, just because we’re not seeing a spillover from the housing market to consumption, there isn’t going to be any. I expect some, though modest, spillover. Moreover, some of the impulse in the fourth quarter was from net exports. These were spurred in part by a temporary decline in petroleum imports and an unexpected strength in exports. Those conditions are unlikely to be sustained. In addition, business investment spending has been weaker than we anticipated. Now, I suspect this is, like the inventory situation, just an aspect of adapting to a slower pace of growth, and investment will strengthen going forward. But it does suggest that businesses are cautious. They are not anticipating ebullient demand and a pressing need to expand facilities to meet increases in sales, and their sense of their market seems worth factoring into our calculations. Finally, the fact that I would have been asking just the opposite question seven weeks ago suggests that we’re also putting a lot of weight on a few observations, [laughter] whether regarding the weakness then or the strength more recently.

    I do continue to believe that growth close to the growth rate of potential will be consistent with gradually ebbing inflation. For this I would round up the usual suspects, reflecting the ebbing of some temporary factors that increased inflation in 2006. One factor is energy prices. Empirical evidence since the early 1980s to the contrary notwithstanding, the coincidence that President Lacker remarked between the rise and fall in energy prices in 2006 and the rise and fall in core inflation suggests some cause and effect. The increase in energy prices into the summer has probably not yet been completely reversed in twelve-month core inflation rates, so I expect some of that to be dying out as we go into the future. Increases in rents are likely to moderate as units are shifted from ownership to rental markets. The slowdown in growth relative to earlier last year seems to have made businesses more aware of competitive pressures, restraining pricing power. When we met last spring, we had a lot of discussion about businesses feeling that they had pricing power—that they could pass through increases in costs. I haven’t heard any of that discussion around the table today.

    The recent slowdown in inflation is encouraging but not definitive evidence that the moderation is in train. The slowdown could have been helped by the decline in energy prices, and that decline won’t be repeated. Goods prices might have been held back by efforts to run off inventories, and that phenomenon, too, would be temporary. As I already noted, the initial conditions—the recent behavior of productivity and the relatively low level of the unemployment rate—suggest upward inflation risks relative to this gentle downward tilt. To an extent, the staff has placed a relatively favorable interpretation on these developments. They haven’t revised trend productivity down any further. They expect a pickup in realized productivity growth over this year. They see a portion of the strength in labor markets as simply lagging the slowdown in growth—a little more labor hoarding than usual as the economy cools, along with some statistical anomalies. Thus, in the Greenbook, the unemployment rate rises, and inflation pressures remain contained as activity expands at close to the growth rate of potential.

    President Yellen at the last meeting and Bill Wascher today pointed out two less benign possibilities. One is that demand really has been stronger, as indicated by the income-side data, and that the labor and product markets really are as tight as the unemployment rate suggests. In this case, the unemployment rate wouldn’t drift higher with moderate growth. Businesses might find themselves facing higher labor costs and being able to pass them on unless we take steps to firm financial conditions. The second possibility is that trend productivity is lower. In this case, actual productivity growth might not recover much this year. Unit labor costs would rise more quickly. Given the apparent momentum in demand, we might be looking at an even further decline in the unemployment rate in the near term. Now, my outlook is predicated on something like the staff interpretation, but I think these other possibilities underline the inflation risks in an economy in which growth has been well maintained. Thank you, Mr. Chairman.

  • Thank you. Governor Bies.

  • Thank you, Mr. Chairman. Like several of you, I’m going to focus on housing and what we’re seeing in the banking sector and in mortgage performance. Since the last meeting, I am feeling better about the housing market in the aggregate. It looks as though home sales are stabilizing for the fourth quarter. On the whole, home sales actually did go up a bit. The inventory of new homes for sale has now fallen for five months through December, and mortgage applications for home purchases continue to move above the levels of last summer, when they hit bottom. The National Association of Realtors is estimating that existing home sales have already bottomed out, and homebuilder sentiment improved in three of the four past months. But even if sales really have stabilized, the inventory of homes for sale still must be worked down before construction and growth resume in this market. Given that some existing homes have likely been pulled off the market in light of slower sales and moderating housing prices, this inventory correction period will probably continue into 2008. I think this is particularly true in markets such as Florida, as First Vice President Barron mentioned, where a large amount of speculative investment occurred during the boom period—with three to five years of excess construction from the investor side. So those homes still have to be worked through.

    Asset quality in the consumer sector as a whole is very good. We have come through one of the most benign periods. The exception, as Bill mentioned in his presentation earlier today, is the subprime market. When you dissect it, you see that prime mortgage delinquencies are flat and subprime mortgages at a fixed rate are flat. The whole problem is in subprime ARMs, which are running into difficulties. The four federal regulatory agencies are looking harder at some of these subprime products. We started reviewing 2/28 mortgages, and now we’re looking at and testing some other products. We’re finding that the issues are getting more troublesome the further we dig into these products. To put the situation in perspective, subprime ARMs are a very small part of the whole mortgage market. As Vincent mentioned, subprime is about 13 percent, and the ARM piece of the subprime is about half to two-thirds, so we’re talking perhaps around 8 percent of the aggregate mortgages outstanding. We’re seeing that the borrowers who got into these during the teaser periods now are seeing tremendous payment shocks. For example, 2/28s that are going from the fixed two-year period to the adjustment period basically had their interest rates double, so they’re going from a 5 percent handle to a 10 percent handle, and the borrowers don’t have the discretionary income to absorb that. This type of mortgage was sold to a lot of subprime borrowers on the idea that they are lending vehicles to repair credit scores. You will show that you are going to pay during the early period, and then you can refinance and get a lower long-term rate, so you’ll never pay the jump. But we’re finding that some of these mortgages have significant prepayment penalties, and so to refinance and get the better terms, some borrowers are getting into difficulty. Because of the moderation in housing prices, these borrowers haven’t built up enough equity to absorb the prepayment penalty. So the problem stems from a combination of factors. There are a lot of spins on these products, but we’re trying to take an approach based on principles in looking at what’s really happening.

    I also want to mention that, although the ownership of the mortgages is very diffuse and so we’re not seeing any real concentrated risk, particularly in banking, we do need to pay more attention to where the mortgage-servicing exposures are. The servicing of these mortgages that are securitized is concentrated in certain institutions. Clearly, when you have such a high level of delinquencies and potential defaults, all profitability in servicing is gone. So there could be some charge-offs in these securitized mortgages. Also, I think all of you have noticed the number of mortgage brokers that have closed up shop in the past six months because they couldn’t get enough liquidity or capital to repurchase the early defaults of these recent pools. That is really shrinking the origination pocket. I should also say that, with the exception of the subprime ARM mortgages, we feel very good about overall credit quality.

    When I look at the economy as a whole, I also see that except for housing construction and autos, the rest of the economy is sound. The recent growth in employment and the strong wage growth give me comfort that the income growth of consumers is there to mitigate some of the wealth effects that we may have with moderating housing prices. But I also share the concerns that some of you mentioned here, and that President Yellen spoke of in a speech, about the issue regarding productivity trends and wage growth, and determining how fast the economy is growing. Productivity is going to have to grow faster to absorb the higher wage growth, particularly as employment growth continues strong, and I think the slack in the skilled labor force is getting very, very limited.

    When I think, in aggregate, about the data since our last meeting, I feel a little better about inflation because it appears to be moderating, but I’m not jumping for joy because we need a few more months. However, the growth information has been, instead of mixed as at the last meeting, generally stronger, and that does make me feel better. In net, then, based on the recent information, I’m even a bit further along on the side that the risks have moved higher for inflation than on the side of the risk of a slowdown in the economy. Thank you, Mr. Chairman.

  • Thank you. Governor Warsh.

  • Thank you, Mr. Chairman. I thought I’d provide just a couple of perspectives, first on the 2006 economy and then, by extrapolation, on the trends in ’07. With respect to 2006, I think the economy outperformed market expectations and Greenbook expectations, for probably at least four reasons. The first is the underlying strength of the employment market, which has been much discussed today. Second, the strength and durability of household finance, which, as Vice Chairman Geithner said, turned out to be far more determined by W-2 income than some of the household balance sheet items like home equity and stock market effects. But we need to take another look at that trend in 2007. Third, the economic outperformance in ’06 had much to do with the resilience of the U.S. capital markets as evidenced in credit spreads and other financial instruments, particularly in the face of some rather seismic events—one-time, potentially systemic events like the Amaranth Advisors collapse; cyclical price spikes with respect to commodity prices that may well have been somewhat demand-driven; a series of supply shocks driven by oil; and a seeming transition to slower growth in the middle of the year. Fourth were the continued powerful sources of liquidity that smoothed the transition over the several bumps in the road.

    I also looked at what the most reliable and the least reliable indicators of the state of the economy in ’06 were to see whether those signposts might hold for ’07. I think the tax receipt information that we saw in ’06 was telling us that incomes were likely ahead of trend—tax receipts for ’06 were up a total of 11.6 percent. Corporate profits, which were up 92 percent in the past four years, had another remarkable year, up in the mid-teens. Stock prices, obviously closely related to corporate profits, were up 84 percent in the past four years and up about 15 percent in 2006. Credit spreads continued to trend tighter; high-yield spreads were down about 100 basis points from September. Another couple of reasonably reliable indicators for ’06 were the household survey of employment, which suggested early and often that employment growth was likely to be ahead of expectations, and merger and acquisition pipelines, which suggested a degree of confidence in the markets by business leaders and other folks involved in finance.

    A less reliable indicator for 2006 growth was the shape of the yield curve, and the suggestion from most of us around the table to the markets was that the yield curve wasn’t predicting much by way of recession in the short term. Another less reliable indicator was the consumer confidence and business confidence surveys, which seemed to snap all over the place, perhaps more because of geopolitical events and some short-term data than any really driving profile. With respect to inflation, it is hard to find any indicators that were very good at telling us its path, but I do think that the TIPS spread, even when there was much talk in the spring and the summer about rising inflation, seemed to stay relatively well anchored and not to move too much based on some of that noise in the data. So that indicator seems to have been reasonably good. As was mentioned earlier, monthly CPI and PCE core measures seemed to be moving around rather significantly, so it was hard for us to determine too much from them as 2006 went forward.

    Taking all of that into account, as I think about 2007, I find that analyzing those indicators is not without significant peril, but let me attempt doing so. The trends appeared supportive of strong, balanced economic growth for 2007, and although inflation expectations are well anchored and recent high-frequency data appear promising, I remain much more concerned about inflation prospects than about growth. Having said that, I do think that as an institution we go into 2007 with probably even heightened credibility on the inflation front and in terms of our perspectives on the economy, which should help us over the next twelve months.

    Two key themes summarize my views on 2007. First, strong employment trends should continue to support consumer spending. Second, strong corporate balance sheets and balanced global growth should support capital expenditures. Now, of those two themes, I would note that I have considerably more confidence in the former than in the latter. I’ll spend another moment on that shortly. The tone of the markets appears to be exceptionally strong. Spreads have tightened, even as yields have trended back to 5 percent. Over November and December, we had three weeks, each with more than $11 billion being priced in the high-yield market. Just to give some perspective on that fact, for the year 2000 there was a total of $50 billion in the high-yield market. But what has happened in the past six weeks that might be able to inform our judgments? Double B spreads have tightened about 25 basis points, single Bs have tightened 50 basis points, and triple C spreads have tightened 70 basis points in the past six weeks, all of which continues to signal to me that the economy maintains a relative strength and that investors feel confident about the bets that they’re making. In summary, I would say there are significant tails on both sides of this rather strong base case for the economy, but the economy is more likely to track above the expectations of the Greenbook.

    Let me spend a couple of moments on the consumer. Contacts from two large credit card companies to whom I spoke last week expect and have seen in January the same kind of strength that they saw in December. The first three weeks of January look to be a continuation of the late but positive trend in the fourth quarter. For what it’s worth, the contacts’ own projections are that the first quarter will be rather strong, much like the fourth quarter ended up being. Today, we’ve all tried to wrestle with what the Greenbook referred to as the “unexplained strength” of household spending during 2006 to determine its effect on ’07. Let me spend a couple of moments on a hypothesis that the contacts proffered regarding that strength, which the Greenbook references in its “buoyant consumer” simulation.

    What that strength may well prove is that employees worked more, earned more, and had more savings from their household balance sheets to fund consumption than the data to this point are suggesting. I think that could turn out to be the case in 2007. First, people worked more. The benchmark payroll survey on total job creation may well be revised upward again significantly, like the revision of last year. Gains in service jobs may well be less counted than some of the losses in other kinds of jobs—another bias for upward revisions. The JOLTS data to which President Pianalto referred continue to be very positive, suggesting a real dynamism in the economy that may well be accelerating. Participation rates may continue their recent spike as new workers selectively choose to enter this marketplace. Average hours worked moved up in the fourth quarter to an annual rate of 2.2 percent, and that trend could continue. So monthly employment gains have not proved much harder to achieve as we approach what we thought was full employment, and the NAIRU may be lower than estimated. Second, people certainly may well have earned more. Average hourly earnings were up 4.2 percent for ’06, an acceleration that was rather widespread from ’05 measures. Though the data on compensation continue to be mixed, they do seem to be trending in that direction. The divergence between profits and compensation suggests to me at least that there is large upside potential for unemployment to stay low and for wages to accelerate, perhaps in a catch-up for wage gains that we didn’t see earlier in the cycle. Third, as a result of working more and earning more, I suspect that workers may continue to spend more, particularly with the gift of what seems to be relatively low oil prices, in the mid-fifties. The oil price seems to me to have less of a risk premium and now appears to reflect some elevated supply and at least modestly lower demand. In sum, with respect to the consumer side, I am reasonably well confident.

    I’ll spend just a moment on the business side of the equation. Fourth-quarter profits appear to be quite good, with two-thirds of companies beating estimates. As many of these companies are challenged to have double-digit earnings in 2007, they may look for other avenues in which to buy those earnings—in the M&A world—or increase cash outlays through share repurchases from their excess cash on the balance sheet to maintain earnings per share growth in the double digits. Another alternative is that they might choose to increase cap-ex as many of us, including myself, would have expected them to do earlier in this cycle. Doing so could have a negative effect on short-term earnings but would show some real confidence in their long-term investment and growth plans. As already mentioned, shipments and orders fell in the fourth quarter, and our working explanation is that much of that fall is really an inventory adjustment. We’ve had that discussion for a while. I would expect business investment and industrial production to pick up. If it doesn’t do so in the first quarter, my confidence about this side of the economy, about this leg of the stool, will be significantly reduced. Between now and the next time we meet, we will have a better sense of whether that turn on the business side of the economy is real or whether we just saw a false start in December. So I think we’ll be able to come to a much firmer view when we meet in six weeks. All in all, I remain reasonably confident and optimistic about the forecast. Thank you, Mr. Chairman.

  • Thank you. Governor Kroszner.

  • Thank you very much. Well, the data have come in so far according to plan, and you can thank Chairman Bernanke for doing that. I think he has some special relations with the BEA and others. [Laughter] Exactly as we had hoped they would and said they would, the data show moderation in growth with a prospect for accelerating growth through 2007 and moderation in inflation—again, according to plan. I think my views are similar to those that President Stern put forward: The economy has shown an enormous amount of resilience.

    I want to talk about a few possible puzzles in the way the data have evolved and could perhaps deviate from plan as we go forward. One puzzle is the great strength of the consumer. The consumer has been very, very strong for the past five years, and it seems that no matter what has happened—whether a housing downturn, an equity-market downturn, or a September 11— the consumer has come through rather strongly and continues to be strong. We certainly have had a slowdown in the housing market, and maybe we’re waiting to see its effect on the consumer, as Don Kohn mentioned. But it may just be that some special factors have come in; for example, we have had very strong international economic growth, and perhaps that will persist. When you talk to officials and business people outside the United States, whether in emerging market economies, in the Gulf region, or in industrial economies, they are extremely optimistic, much more so than I have ever before seen, and that may continue. Obviously, there is a risk factor here. The recent strengthening in equity markets perhaps offsets some of the reduction in the asset values of homes. Lower consumer energy prices, of course, have been an offsetting factor, and labor market strength and increases in compensation have been very important. But there’s an upside risk that we will continue to have very, very strong consumption instead of having our error correction go back toward more saving.

    Second, with respect to investment, we have had orders above shipments for quite some time, but we have had investment actually declining, or at least not growing as we would expect. Overall in this recovery we have had weaker investment growth, and we have had very high profitability. That raises another puzzle for me: Why have we seen somewhat weak investment over the long run and especially more recently, given that most measures of consumer confidence and business confidence have been positive, equity markets seem to be positive, spreads seem to be low, and so forth. Why are we not seeing more investment? Investment may turn around in the next quarter or so, and then we’ll be out of the woods. But I think the conditions that we predict will lead to an investment turnaround have been there for quite some time, and we haven’t seen the investment turnaround; and that is a puzzle to me.

    Third, with respect to inflation, obviously we are all pleased that the numbers have been coming out with greater moderation. But I have a discomfort about exactly what is driving that moderation. We have good short-term stories about how the slowdown in energy prices in the second and third quarters and some other temporary factors with respect to owners’ equivalent rent could be bringing down inflation. But when we consider a longer period and try to look at the systematic data, we don’t see those kinds of relationships. Are we just in some sort of regime shift? Are those correlations not very good because we just haven’t had a lot of variation in the data over the past ten to twenty years, and so those forces are actually there, but we just find it very difficult to pull them out econometrically? For me that is a puzzle, to be able to tell a short- term story with each of these pieces, but when I go to the staff and ask, “Well, what is the systematic evidence on it?” they say, “Well, it really isn’t there.” That is a bit disturbing for me in trying to figure out where things are likely to go.

    Things have moved in a benign way. I don’t think there’s a strong expectation that they would move in a nonbenign way. But I don’t have a lot of confidence that I understand why they have moved as they have. So my concern is that various shocks or other factors could come in to move them in a way that is not nearly so benign. Broadly, however, I share the views that most people have expressed around the table that we have good growth prospects going forward and so far reasonable moderation of inflation. But precisely because we have those good growth prospects and because we may have had some temporary factors that have kept down inflation, we have to be ever mindful of the upside risk to inflation.

  • Thank you. Governor Mishkin.

  • Thank you, Mr. Chairman. Well, I’m last in this line, and I’ll try to be brief so that we can get to dinner soon. I do see signs of stabilization in the housing market, and the way to think of it in terms of spillovers is that we do expect some spillovers through the natural effect of weaker housing on aggregate demand and on wealth. But we’re not seeing anything out of the ordinary or a persistent pattern, and that gives me more confidence that nothing really bad is going to happen here. My view is that the risks to the downside have decreased substantially. Also, the tone of the recent data actually indicates that what is happening concerning aggregate demand is stronger than we would have expected. As a result, I’m a bit more optimistic than the Greenbook in terms of what is going to happen next year with aggregate demand. Actually, I see, if anything, a little more risk to the upside, so I slant a bit in that direction.

    The inflation numbers have been very good recently, and one view is that they are just temporary blips in the data. I tend to be a little more sanguine here because I think that there are good reasons for inflation to gravitate toward what are solidly anchored inflation expectations. That has been very important in terms of the cycle and is one reason that I’m a little more optimistic than the Greenbook on inflation. I do think that inflation expectations are strongly grounded around 2 percent on the PCE deflator. As a result, I expect us to go to 2 percent inflation over the next year and then stay there but not go below there. I don’t actually like to think of this in terms of “persistence.” It is one reason that I’m unwilling to think that things will get better than that. But I do think that we will likely have a more benign path of inflation than we might have thought earlier.

    Even if you think that there’s a more benign path to inflation, which I’m willing to consider though we’re not sure about it, it is still true that aggregate demand has blipped up recently. That is an indication that the neutral real interest rate has moved up, which is very much reflected in the Greenbook assessment. That’s important because, even if you’re happy about what’s happening with inflation, you have to be more worried about the fact that the economy is going to be stronger. That does have some implications for the way we think about policy going forward. Thank you, Mr. Chairman.

  • Thank you. This was an exceptionally interesting, useful discussion. I thought I would try to summarize what I heard around the table. If you have comments on that, please give them to me, and then I’ll add a few comments of my own.

    Members noted considerable economic strength during the intermeeting period. Labor markets remain taut, with continuing wage pressures in some occupations. Consumption grew strongly in the fourth quarter, with some momentum into the first quarter, reflecting a strong job market, lower energy prices, and higher profits. Overall, investment seems likely to grow at a moderate pace given good fundamentals. Business people seem generally optimistic, and financial markets are robust.

    We still have what people have been characterizing as a two-track economy. Housing, although a drag for now, does show some tentative evidence of stabilization. However, some warned about drawing too strong a conclusion about housing during the winter months. Some also noted issues of credit quality. The general view was that housing would cease to subtract from growth later this year. Some softness in parts of manufacturing, especially in industries related to housing and automobiles, still exists. But in part this weakness may be an inventory correction that may be reasonably far advanced at this point. Despite the weakness in housing and some parts of manufacturing, there are yet no signs of spillover into employment or consumption, although some raised the possibility that we may see those later on. Some, but not all, members agree with the contour of the Greenbook that has economic growth somewhat slower in the near term, strengthening later this year, with a modest increase in unemployment. The Committee is generally more optimistic about potential growth than the Greenbook, mostly because the members assume that labor force growth will be greater than the Greenbook assumes. Overall, downside risks to output appear to have moderated, while an upside risk has emerged that growth will not moderate as expected.

    On the inflation side, people noted that recent readings have been favorable, although there was disagreement about the cause, whether it was energy prices, well-anchored inflation expectations, less structural inertia, or perhaps just statistical noise. Most still expect gradually slowing inflation but are cautious and consider upside risk significant, perhaps even greater than late last year. The primary upside risk to inflation is economic growth above potential in tight labor markets, which may lead to inflation in the future if not in the near term. Others noted that inflation expectations may be too high to allow continued progress against inflation. So overall, the general tone was for a somewhat stronger economy, perhaps a slightly improved outlook on inflation, but, in any case, a clear view that the upside risks to inflation are predominant. Are there any comments?

    Let me add just a few points. Everything has really been said, but not everyone has said it, as they say. [Laughter] Our goal has been, in some sense, to achieve a soft landing, and the question is whether we have missed the airport. [Laughter] We have seen a good bit of strength in the intermeeting period, and I think the real crux of the issue is what’s going to happen to the labor market. If the labor market continues where it is or strengthens further, we will see both stronger growth, because of the income effects and job effects, and continued pressure on inflation. Again, the central issue will be whether we will see enough cooling in the economy to have a bit of easing in the labor situation. This is, obviously, difficult to say. I do believe that the most likely outcome for the first half of this year is for some moderation in growth, perhaps to modestly below potential. If you look at the various components of spending and production, you note, for example, that personal consumption expenditures are likely to slow from the very high levels we have just seen recently. In particular, a lot of the spending recently was for durable goods, which tend to be more negatively auto-correlated—that is, they tend to drop more quickly when they are high in the short run. We have seen some moderation in investment, in both equipment and structures. Net exports were a major contributor to growth at the end of the year; that should probably reverse, as the Greenbook notes. A special factor there is that the good weather reduced oil imports, which led people to spend on domestic production rather than on foreign production. If that situation reverses and we go back to normal net exports, that will subtract from GDP. Also, the staff noted some likely reversals in government spending. So my sense is that we’re likely to see something a little less hectic in the first half of this current year.

    I think it also remains reasonable that growth will return close to potential later this year. There is certainly uncertainty about that. Clearly, we have seen some signs of stabilization in the housing market. I was going to note the effects of the winter months and the weather. I think that we should acknowledge that stabilization but not ignore the possibility that we may see further deterioration there.

    Against the view that growth may moderate this quarter, or next quarter perhaps, there is opposing evidence that consumption and employment are awfully strong. Economists tend to think of consumption, in particular, as being a very forward-looking variable, and it’s consistent with views that we see, for example, in consumer sentiment that people do feel reasonably optimistic about the labor market and about the state of the economy. So I agree that there is certainly some risk that the economy will be stronger going forward than we have been projecting. I don’t have an answer other than to say that we obviously have to monitor the situation very carefully and continue to be willing to reassess our views as the data arrive.

    Let me say a bit about inflation. Recent readings have been favorable. A couple of aspects of inflation I do find encouraging. First is that the moderation we’ve seen in inflation the past few months has happened despite the lack of any substantial moderation in shelter costs. Owners’ equivalent rents are actually a constructed, imputed variable. They are not seen by anybody. Nevertheless, they are essentially the entire reason that inflation is remaining above our target zone at this point. I know it’s a bit of a joke that I always refer to the short-term inflation numbers, but I’ll do it again anyway. [Laughter] Just to illustrate, over the past three months, core CPI inflation excluding just owners’ equivalent rent was 0.2 percent at an annual rate. Over the past six months, it was 1.20 percent at an annual rate. Over the past twelve months, it was 1.82. We also get numbers for PCE core inflation excluding owners’ equivalent rents that are all below 2 percent. Obviously that is just carving the data, and there are lots of problems with doing that. But to the extent we think that rents will continue to moderate, and I think there is scope for them to do that, that’s one factor that should make us a little more comfortable. Another factor is that there is a fairly broad-based slowing. I won’t take a lot of time to go through the evidence, but particularly in the CPI there are some encouraging developments on the services side in terms of inflation to go along with the slowing in goods prices.

    Now, I am the first to acknowledge that lots of interpretations of the recent developments are possible. We hope that favorable structural factors are at work. One possibility certainly is that the wage increases are a catch-up for previous productivity gains and that we’re seeing a normal restoration of capital-income/labor-income relationships. In that case, this may be in some sense a transitory adjustment that will restore those relationships and not necessarily contribute to inflation going forward. Another possibility is that energy price effects are somewhat larger than we thought. There seems to be some evidence that they are. A third possibility is that what we saw earlier last year was, as Governor Kohn mentioned, a transitory upside, some of which has simply passed, and we are going back to the more fundamental rate of inflation. So there are some structural reasons that inflation might be moderating.

    My having said that, we should certainly acknowledge the statistical noise that is inherent in these measures. The monthly standard deviation of core inflation in 2006 was about 8 basis points. If the true underlying inflation is 0.2 percent, then you have a very good chance of getting either 0.3 or 0.1. Therefore, we and the financial markets ought to be braced for the possibility that we will get 0.3—I hope not worse—in the next few months. I agree with the view that has been expressed that the trend has not yet been established, and we’ll have to follow its development. Another very important point that has been raised—President Moskow, I think, was the first to raise it—is that, given the lags from economic activity to inflation that we see in standard impulse-response functions and so on, these improvements may be real but nevertheless temporary and the underlying labor market pressures and so on may lead to inflation problems a year or eighteen months from now. I agree that it is a concern, and it goes back to my point earlier that we need to be very alert to changes in the pattern of aggregate demand going forward. As President Poole mentioned, one element that will help us is the endogeneity of financial conditions. We haven’t done anything since the last meeting, but long-term real interest rates rose about 30 basis points. The yield curve is still inverted by about 30 basis points. So I think even the markets themselves have the ability to raise real rates quite significantly, enough certainly to make a difference in the mortgage market if the data continue to be strong and if inflation does not continue to subside. Then we would have a bit more latitude as we try to determine whether the fourth quarter was a blip or a trend. I think that’s still an open question.

    So let me just say that I broadly agree with what I heard. The economy does look stronger. That is an upside risk to which we need to be paying close attention. Inflation looks a bit better, at least in the short term, but there are some long-term considerations that we need to keep in mind. Finally, the basic contours of the outlook are not sharply changed, but I agree with the sentiment around the table that upside risk to inflation remains the predominant concern that the Committee should have. Are there comments? Yes, President Poole.

  • We have two important pieces of information coming in at 8:30 tomorrow morning. I hope the staff can give us a quick first read to start our meeting. I know that instant analysis is risky, but I ask for it anyway. [Laughter]

  • And I will provide it. [Laughter]. Whether it’s worth anything or not, I don’t know. [Laughter]

  • We’ll start the meeting with the data. Anything else? There’s a reception and dinner in Dining Room E. It’s for those who wish to attend. If you have other plans, please feel free to pursue them, and we’ll see you tomorrow morning at 9:00.

  • [Meeting recessed]