Okay, let me talk in a measured manner. [Laughter] First of
all, I think there’s no question now that this recovery is broad, deep, and evolving into a sustainable
expansion. Indeed, I have the suspicion that a very unusual factor in this recovery allows us to
project it further than is usually the case. Corporate management is very conservative and not prone
to anticipate a recovery and, hence, to move ahead of it. Moving ahead of the recovery usually
means putting in plant facilities more quickly, expanding the company’s labor force well before the
additional workers are needed, and making all the other expenditures that corporations have made in
past recoveries, with the result that capital investment plus inventory accumulation has invariably
exceeded internal cash flow.
In 2003, for the first time since 1975, cash flow exceeded capital investment, which suggests
that there is a very considerable hurdle—in terms of spending decisions—to which the business
community is still responding. And I suspect that it relates to the corporate scandals and other
corporate concerns that have emerged in the last couple of years and are still lingering. We are
seeing very considerable gains in corporate profits, and margins are up very significantly. Cash
flow in the first quarter was quite strong, and analysts are continuing to raise their estimates for the
second quarter. In short, business managers are being pulled along by the data rather than being
anticipatory. This is not unusual because we’ve had a very shallow recession and we’re not getting
the usual rebound in any respect, with the exception of the very strong growth in profitability.
All of this leads me to conclude—and I think this view is held pretty much universally as
well as within this Committee—that we have completed our period of accommodation, which was
an endeavor to address the rather substantial contractionary forces that became evident in mid-2000.
In retrospect our policy accommodation appears to have worked. Whether we will look back upon
this period two years from today and say that our policy was the right policy is going to depend on
how we come out of this period of accommodation.
With regard to the outlook for inflation, we have a number of indicators that we look at. For
one, as many of you have mentioned, we have the “gap.” I am uncomfortable with the gap analysis
basically for two reasons. One is that it requires that we view the inflation projection from the
perspective of regression analysis, and that kind of analysis always has a large element of potential
error in it. If the projected inflation rate is above the current rate, we’re never quite sure whether
there has been a fundamental change in the structure of the economy, which isn’t captured by the
regression, or whether the actual inflation rate is eventually going to move up. As a consequence,
unless our projections are right on the money all the time, which they almost invariably are not,
there are always serious questions about whether our gap regression analyses are really telling us
something that we need to know.
Second, there is the question of whether a single figure describes the process. A number of
you have mentioned the skilled labor shortage. The very soft rise in wages and salaries in the
production worker data is suggestive of the development that we’re all aware of—namely, that the
skill differential has been rising fairly dramatically. As a result, we have a shortage of skilled
workers and a corresponding surplus of lesser-skilled workers. And as I’ve argued in certain
speeches recently, what we are failing to do in this country is to raise the degree of skill in the
workforce as a whole sufficiently quickly to create a more balanced skill supply–demand situation
and in the process to remove the surplus of the lesser skilled so that we end up with an overall
balance. We don’t have that at this stage. I’m wondering whether or not the differential pressures
of stronger wage growth in skilled areas and weaker wage growth in lesser-skilled areas create
problems in doing this type of evaluation. In my view that is at least open to question.
As a consequence, I think that it is important to look at the structure of underlying costs.
Because profit margins tend to be constrained, within limits, the issue we ought to be looking at
when we are trying to evaluate the behavior of inflation is not the core PCE or the core CPI but
underlying unit costs in the economy, as best we can judge them. One way of analyzing this is to
look at a set of data composed of nonfinancial, non-energy corporations that account for maybe
55 percent of the GDP but obviously a significantly higher proportion of the growth of the business
sector. If we look at those data, we see that the acceleration in costs has been very limited. Indeed,
over the last four quarters this sector has registered an average price rise in the neighborhood of
1 percent. And it turns out that two-thirds of that rise is reflected in higher unit profits and that
actual underlying unit costs are rising very modestly, the result of a combination of declining unit
labor costs and declining unit interest costs, offset in part by rising costs of energy, indirect business
taxes, and business transfers.
I understand the issue of whether we mis-evaluated the data on prices last year and, hence,
have been operating under a presumption that inflation had gotten lower than it actually did. But I
think that the more important question here is what unit costs are doing. Consequently, trying to get
a long-term projection of where inflation is going may require that we start from a higher base than
the one we’ve been assuming is currently the base. As I think David Stockton mentioned, we have
now reached the point where changes in unit labor costs have become positive. We have to assume
that there has been some upward movement in unit energy costs and probably in unit interest costs.
But one has to remember that, whenever we are talking about unit costs, if the denominator is rising
at a fairly rapid pace, it holds down unit costs, all else being equal. So it is not clear to me that unit
interest costs are in the process of going up. Nevertheless, I think the point here is that we are not
yet in a position where we are seeing underlying cost structures moving significantly. To be sure,
they have picked up in the last several months. In fact, my recollection of the data is that
productivity growth from December through March, as distinct from the first quarter over the fourth
quarter, is in the area of just under 4 percent. In fact, if I sort all the pieces of paper in front of me, I
may actually come up with a number. [Pause] Voila! The staff estimate of output growth per hour
between December and March is 3.9 percent at an annual rate. Compensation per hour,
interestingly enough, is up at a 5 percent rate for the same period, reflecting a 3.1 percent increase in
wages and salaries and significant increases in other labor income. The latter increase, as you saw
in the ECI, is to a large extent pension costs and medical insurance costs.
So we are beginning to see a process of increasing costs. But the productivity numbers are
still sufficiently strong to suppress the overall rise. Remember, the major difference between 1994
and today is productivity growth. In 1994 we didn’t have any productivity growth to speak of, and
we had to move very fast to contain inflationary pressures. The reason we have been able to be
patient in this recent period is that we knew unit labor costs were falling fairly abruptly, and
whatever the price data showed was frankly irrelevant in that respect.
I think we have a set of data here that, as far as I can judge, seems to be consistent with a
gradual building-up of inflationary forces. But I fully recognize that we can’t measure that by
looking at different simulations as we try to do in certain respects in the Greenbook. I’m
uncomfortable with the very narrow ranges that the Greenbook’s alternative simulations show.
That’s because, if we look back over the last several years or maybe the last decade or so and ask if
we were wrong at times because we misforecast the exogenous variables, I’d say “only partly.”
Mostly, the reason we were off was that the model structure was changing. The coefficients inside
the model were moving, and that created a wholly different environment from the one we had
expected. We alter the exogenous variables in our simulations, but we do not change the structure
of the models. Of necessity the simulations are based on the assumption of a fixed model structure,
and at this stage, I am a little concerned that that may be giving us some false sense of complacency,
if that is indeed what we have.
Still, the change in unit labor costs in March, if we’re going to take the staff’s figure, is zero.
And with profit margins apparently continuing to rise, that is suggestive of a unit cost change that
on a monthly pattern is not exhibiting any acceleration. In that respect, I think we can state that the
pace at which we’re likely to remove our policy accommodation is going to be “measured.” The
data could run away from us, and obviously that would create a problem.
In any event I would say that we have to position ourselves for the possibility of moving at
some meeting, unless we want to take the very unusual step of making a move between meetings.
That, I will tell you, would create some extraordinary impact in the marketplace largely because we
are perceived as highly credible. So, if we eliminate that option, we either move today, or we wait
until June. We are not going to move today in part because we are awaiting, and will soon get, a
couple of major statistical reports that could cause us some difficulty, to say the least, if they differ
radically from what we expect. And the point of waiting until June is to be sure that we are
positioned to move at the June meeting if we desire to do so then.
When I say “move,” I mean by 25 basis points. I mention that partly because of the
experience of February 1994. Those of you who were here then may remember that there was a
groundswell opinion within the Committee in favor of moving rates up not 25, but 50 basis points.
And I went berserk for the first time and, I hope, the last time at an FOMC meeting, on the grounds
that, whatever we did, the markets were going to respond fairly exceptionally, which in fact they
did. So, on the basis of that particular history, I would say that we should not move more than
25 basis points in June. We may move 75 basis points in August. I don’t know what we will decide
then. But the point at issue is that, if we’re not going to move more than 25 basis points in June,
then the type of statement proposed in the Bluebook—which was more recently revised by Vincent,
and I’ll read the specific rewording—strikes me as an appropriate response to the data we now have.
The sentence as it now reads is, “At this juncture, with inflation low and resource use slack, the
Committee believes that policy accommodation can be removed at a pace that is likely to be
Frankly, I think that positions us appropriately, considering our lack of knowledge. I know
that President Poole has raised the question of putting in something about the economic outlook. I
have no objection to that particularly. I’m not sure it adds anything, frankly. It does add words, and
I think the fewer words that we put in these statements, the better off we are. You will have
observed that we are spending more time on this statement than we have on previous statements,
which is fine. Indeed, since we’re limiting ourselves to very few issues, in my judgment that says
that this process is turning out to be the right way to do this. In any event, to repeat myself, my
recommendation is that we stay where we are and make the few changes in the statement that
Vincent suggested. I would be curious to hear your reactions and get the conversation going again.
Who would like to start? Governor Gramlich.