Thank you, Mr. Chairman. At the time of your March meeting, you
had just received a string of surprisingly strong readings on demand and activity. The
tone of that information motivated the decision to shift the balance of risks statement
to neutral, and many of you expressed concern that the momentum of economic
expansion would begin to erode margins of unutilized capital and labor resources
before long. That prospect suggested that you soon would need to consider starting
the process of moving to a more sustainable policy stance.
However, the data received over the intermeeting period suggest appreciable
moderation in the pace of expansion, leaving open the question of when demand will
be strong enough to generate increases in output capable of reducing those excess
resource margins. In the staff forecast, little progress is made on reducing the
unemployment rate over coming months, and capacity utilization just edges higher, as
growth is restrained by continuing declines in net exports and by only a gradual
recovery of investment. As Karen discussed, it appears that foreign economies,
although picking up, are still on the receiving end of impetus from the U.S. economy,
rather than a net source of strength to the United States. Moreover, the dollar’s fall
over the intermeeting period seems at least partly a response to disappointment in the
vigor of the U.S. expansion, limiting the extent to which it will be a net plus for the
pace of growth here.
For business, capital spending, orders data, persistently downbeat business
attitudes, and the ongoing drag from excess capacity all suggest that the strengthening
of investment is likely to be damped for a time. One indication of the weaker near term outlook for capital spending is the appreciable decline in equity prices over the intermeeting period, which was triggered in part by pessimistic assessments of sales prospects by technology firms, indicating that sellers of high-tech equipment and software are not seeing an imminent revival of demand.
Measures of underlying price and labor cost increases becoming available over the intermeeting period dropped further from already low levels. In the staff forecast, inflation remains quite damped—and slightly lower than in the previous forecast, reflecting a reassessment of potential output, as Dave explained. The higher current level of potential output now seen in the wake of the upward revisions to estimates of structural productivity growth in recent years means that the shortfall of actual output relative to its potential now is larger than previously thought. This larger gap thereby exerts greater downward pressure on compensation and price increases. The greater growth of structural productivity going forward keeps the unemployment rate from falling as fast and damps cost increases.
By itself, an upward revision in the productivity growth rate would tend to boost the equilibrium real interest rate. However, the staff assumes that higher structural productivity growth is not news to financial market participants and the earnings implications of faster growth have already been incorporated into equity prices, cutting off one channel through which stronger productivity raises interest rates. Moreover, with the upward revision to the level of potential output in the past, in retrospect a lower interest rate now appears to have been needed all along to spur spending enough to keep the economy producing at this elevated potential. This resulting downward revision in the level of the equilibrium rate carried forward from history more than offsets any remaining tendency for higher growth in structural productivity to raise the equilibrium rate. Thus, r* was revised down, moving closer to the current real funds rate. But the narrowing of the estimated interest rate gap occurs just as you might otherwise desire to widen the spread of r below r* to counter the larger perceived shortfall of actual output from its potential. This reduced degree of effective policy stimulus relative to the output gap means that, as in the staff forecast, the federal funds rate can remain at its current level for longer without an increase in inflationary pressures.
With the strength of economic activity still in doubt and inflation headed down and with the output gap perhaps larger and policy not quite as accommodative as you had thought, the Committee would seem to have a strong rationale for leaving policy unchanged at this meeting. Even if you suspect that the expansion will be stronger and price pressures less damped than in the staff forecast, slack in resource utilization should still be sufficient to hold inflation in check for some time, suggesting little potential cost to waiting before beginning your tightening until some of the current uncertainties about final demand begin to be resolved. Moreover, the potential benefit from postponing action could be considerable should the firming of demand, in fact, turn out to be more gradual than you expect.
These uncertainties and revisions supporting the current stance of policy, however, do not alter the basic policy issue you are likely to face later this year—that is, the timing and trajectory of a rise in the funds rate from its current unsustainably low level. A related issue you face today is how to communicate your intentions to the public to foster realistic and constructive expectations. These are complex issues, and I’ll offer comments on only two aspects this morning—the use of benchmarks to measure and discuss progress toward a more sustainable policy stance and the balance of risks assessment for this meeting.
One such benchmark cited by some Committee members at recent meetings—and even more frequently by financial market commentators—is taking back the so-called insurance cuts made after the September 11 attacks as a first set of steps in the tightening process. Whether this construction will be helpful to guide your actions or market expectations is questionable in my view. It is impossible to know what the funds rate would have been absent the attacks. Conditions in the weeks leading up to September 11 arguably were already developing in such a way as to call for more policy easing, and much has changed or been learned about the economy in the eight months since then that ought to influence policy. As a consequence, the pace of tightening and the desirability of a pause at some point probably will need to be decided at each meeting by evaluating the existing stance of policy relative to your goals and expectations for the economy and prices, regardless of how that policy stance was arrived at.
A second benchmark, cited for the ultimate level of the federal funds rate, is its estimated equilibrium value. This too needs to be used with caution. This is an abstract construct, which like its close relative, the level of potential output, can never be observed but only inferred imprecisely from the behavior of other variables and estimated relationships. This movable target can be expected to vary over time with anticipated changes in underlying economic conditions. And as we have just discussed, its estimated value at any given point in time fluctuates with new assessments of the lasting influences on demand and potential supply. It is thus necessarily only a rough approximation of the sustainable stance of policy over a number of years—and one that the Committee has deviated from in the past for long periods in the interest of stabilizing output and prices.
Still, the real federal funds rate is far enough below a reasonable range of estimates of its equilibrium value to indicate that policy will have to be tightened at some point to forestall increasing inflation pressures. The balance of risks statement is one way you have of informing the public and the markets about how you are weighing your concerns about this longer-run inflation risk of the existing policy stance against the nearer-term prospects for growth and inflation. With the funds rate well below any plausible notion of its equilibrium, as time passes and if data are reasonably close to expectations, the risk of rising inflation pressures should come closer and increase, while concerns about shortfalls in growth should recede and diminish. Adopting a statement of unbalanced risks toward heightened inflation pressures at this meeting would convey that the Committee believes that this progression is occurring and has gone far enough to cause you to shift the major focus of your concerns. Although near-term growth forecasts have been marked down, the first-quarter surprises mean that the levels of GDP and final demand are expected to be at least as high in the second quarter as the staff had previously projected. Moreover, some developments over the intermeeting period—including further indications of faster increases in health care costs, higher oil prices, and the decline in the dollar—will be putting greater pressure on costs and prices than had been expected. In addition, as Dave emphasized, disentangling the signal about ongoing structural productivity increases from the noise of one-off level changes in the recent data has been especially difficult. If more of the recent gains turn out to be of the one-time variety than the staff has inferred, increases in unit labor costs may not be as well contained as in the staff forecast. A statement of inflation risks would have particular appeal to the Committee if you thought that following the recent declines in interest rates markets had not priced in adequate tightening soon enough. The announcement of your heightened inflation concerns would tend to elevate rates appreciably and well out the yield curve.
In fact, both the market and the staff have seen the inflation risks receding a bit over the intermeeting period, with expected tightening pushed out by at least one meeting. If you shared this assessment that potential inflation pressures were, at worst, no closer or stronger than in March, retention of the statement that risks were balanced would seem to be appropriate. To be sure, near-term expectations about policy in the financial markets are heavily influenced by your speeches and statements. But interest rates have fallen appreciably all the way out to ten years, and surveys tend to confirm that the public’s long-term inflation expectations remain damped, despite the gentler and later trajectory for policy tightening and the rise in energy prices.
As I already discussed, the staff has marked down its forecast of inflation pressures because of an assessment that output is further below its potential than previously estimated. But as the Greenbook noted, a mechanical reading of recent productivity would have justified raising structural productivity even further. If you saw the incoming price, wage, and productivity data as suggesting that the level and growth rate of potential output were more likely to be higher than estimated by the staff than lower, inflation pressures would be even less than in the Greenbook forecast and the turnaround in prices pushed out even further. Indeed, you might be concerned that the possibility of higher potential output carried with it a risk that inflation could run for a while at levels that would not provide an adequate cushion for policy to operate against downside output shocks if they occurred. Such a concern would reinforce the assessment that, for the foreseeable future, the threat to your objectives from the longer-term risks of heightened inflation pressures were at least balanced by the shorter-term risks of rising output gaps and declining inflation rates.
The market expects you to view the risks as balanced, and so such a statement should have minimal effects on expected interest rates. As the Bluebook noted, from the perspective of market participants, such a statement would not limit your future flexibility inasmuch as many observers who anticipate a tightening in June or August do not expect that you will first move to unbalanced risks to signal your intentions.