As shown in the top panel of exhibit 1, the probability of a 25 basis point firming at this meeting implied by federal funds futures quotes trended down over the intermeeting period. Policy expectations were boosted briefly by higher-than-expected inflation readings, but those increases were more than offset by Federal Reserve policy communications and several economic data releases—most recently, the July employment report—that came in weaker than market participants had anticipated. The pattern of declining expectations of firming at the upcoming meeting stands in sharp contrast to the previous experience in this tightening cycle, in which market expectations of firming generally rose over intermeeting periods, converging to a level close to 100 percent by a day before the FOMC meeting. But the current situation is similar to the previous episodes in that markets arrived at a high degree of certainty about the outcome several days in advance of the meeting.
Still, as shown in the middle left panel, primary dealers responding to the Desk’s survey have, since last November, evidenced both increased disagreement among themselves (the light blue bars) and greater uncertainty individually (the dark blue bars) about policy actions to be taken at the next meeting two weeks ahead of that meeting. Presumably these developments reflect a realization that, with policy accommodation essentially removed, policy actions have become less pre-programmed and more dependent on the evolving outlook.
Regarding your statement today, as indicated in the right-hand panel, dealers anticipate language that expresses more conviction that economic growth has moderated, acknowledges the recent elevated inflation readings, expresses concern about inflation risks, and indicates that future policy actions will be dependent on the data. Although dealers expect your statement to cite inflation risks, implying a likelihood of further policy firming, slightly less than half see any further tightening in this cycle, and all of those anticipate at most ¼ point either today or in September. As shown by the black line in the bottom left-hand panel, the peaking of rates implied by fed funds futures at just 5.31 percent suggests that investors see only 1-in-4 odds that you will take another firming step in this cycle. Indeed, looking further ahead, the black line in the middle panel illustrates that market participants continue to anticipate policy easing to commence before long, and their projected downward trajectory for the federal funds rate steepened somewhat over the intermeeting period. Investors seems to remain surprisingly assured in these views: As shown in the right- hand panel, measures of market uncertainty about policy six and twelve months ahead, the black and the blue lines, respectively, have crept higher of late but are quite low by historical standards.
Reflecting our own sense of uncertainty about the Committee’s future actions, in the August Bluebook we presented four, rather than the usual three, alternatives for Committee consideration, spanning a fairly wide range of policy approaches: alternatives A and B, which would keep the stance of policy unchanged at this meeting but are distinguished by different risk assessments; and alternatives C and D, which would involve a 25 basis point firming today but are similarly differentiated by their risk assessments.
A case for holding the federal funds rate unchanged today is summarized in the top left-hand panel of exhibit 2. Based on an assumption of an unchanged federal funds rate, the staff forecast is for economic growth to run slightly below the expansion of the economy’s potential over the next six quarters. As shown in the top right-hand panel, real GDP growth is projected to average about 2¼ percent over the second half of 2006 and 2007, and the unemployment rate is forecast to creep up to 5¼ percent. The negative output gap that develops by the end of next year is small and exerts only very modest restraint on inflation; but the leveling-out of energy prices that was assumed in the staff forecast has a more noticeable effect, and core PCE inflation in the Greenbook edges down slowly over the forecast period. Should the Committee find this outlook likely and, in the circumstances, acceptable, it might be inclined to maintain its current stance at this meeting.
The model-based estimates of the equilibrium real federal funds rate portrayed in the middle left panel present another perspective that might be seen as arguing for holding steady at this meeting. Over the past two years, seventeen consecutive policy actions have brought the real federal funds rate from a quite low level to the middle of the range of estimates of the equilibrium (shown in red). This configuration might provide some comfort that leaving the stance of policy unchanged for six weeks is unlikely to turn out to be a serious mistake—that is, unless the Committee is particularly concerned that inflation expectations could become unmoored by further bad news on inflation in circumstances in which policy evidently had gone on hold.
Moreover, some monetary policy rules reported in the Bluebook suggest holding policy steady at this meeting. For example, the first-difference rule using an inflation target of 2 percent, which is portrayed to the right, points to only ¼ point of additional policy firming through the end of next year, based on the staff baseline forecast. However, even if the Committee thought that leaving the stance of policy unchanged was appropriate for this meeting, it might—as noted immediately below the panel—continue to see several sources of upside risks to inflation: most notably, high levels of resource utilization, which might be a larger concern now that labor cost pressures look to be greater than previously perceived; elevated energy and other commodity prices; and the potential for further increases in those factors—the latter possibility highlighted by yesterday’s news from Alaska. In these circumstances, the Committee might see the language of alternative B, communicating a judgment that “some inflation risks remain” and referencing a potential need to address those risks, as appropriate in conjunction with an unchanged stance of policy.
At the same time, the Committee might perceive emerging downside risks to the economic outlook, as noted in the first bullet in the bottom left-hand panel. Output and employment have decelerated substantially in recent months, and certainly a sharper-than-expected further deceleration cannot be ruled out. In particular, housing may be slowing more quickly than anticipated. The housing slump scenario presented in the Greenbook illustrates the possible consequences of a realization of that risk. Under that scenario, not illustrated in this exhibit, policymakers following the Bluebook’s outcome-based rule respond to emerging slack by lowering the federal funds rate to 4¾ percent by the end of next year. Even without particular concerns about such risks, an outlook along the lines of the Greenbook baseline forecast might be consistent with alternative A if policymakers judge such inflation performance to be satisfactory in light of the below-trend projection for output growth, as in the optimal control policy path with an inflation target of 2 percent. Moreover, the Committee’s past behavior as captured in the estimated forecast-based rule would, as shown in the bottom right-hand panel, suggest a slight easing of policy, given the staff outlook. In these circumstances, the Committee might find it reasonable to leave the stance of policy unchanged at this meeting and not have any predilection for the likely direction of policy going forward, as in alternative A.
However, as discussed in the top panel of exhibit 3, even if the Committee thought that downside risks to growth were becoming more palpable, it might still wish to firm policy another notch at this meeting. If the Committee saw significant potential for inflation to exceed expectations, it might believe that another 25 basis point increase in the federal funds rate is necessary to balance the risks. Alternatively, the Committee might feel, given the already relatively high level of inflation, that a significant upside surprise to inflation could be quite damaging and would exceed the cost of a downside surprise to growth. If so, the Committee might be willing to tighten policy a bit further to provide more insurance against persistent high inflation. The Committee might also believe that a rate increase today could be a useful signal of its anti-inflationary resolve while, as under alternative C, suggesting that it was not necessarily expecting to firm policy further.
All that said, members may have reservations in current circumstances about suggesting that the risks are balanced, even after the 25 basis point firming of alternative C. Such reservations may motivate the Committee to consider alternative D, discussed in the remainder of your exhibit. Under this alternative, the Committee would both raise the federal funds rate 25 basis points at this meeting and imply that further increases may well be in store. As noted in the middle panel, members might be inclined to adopt alternative D for several reasons. First, the Committee might agree that the staff forecast presents the most likely outcome for the economy and inflation should the federal funds rate be held at its current level over coming quarters, but it may prefer a steeper decline in inflation than in that forecast and be willing to tolerate a slower pace of economic growth to achieve it. Indeed, as reproduced in the bottom left-hand panel, the optimal control simulations presented in chart 7 of the Bluebook suggest that considerable policy firming lies ahead if the Committee wanted to pursue a 1½ percent inflation objective—especially should it seek to attain that rate within a few years. The Committee also might believe that appreciable further policy firming could be in prospect because it does not expect
growth to slow as much as the staff expects or because it is concerned that inflation
pressures could turn out to be more durable than forecast by the staff, a risk that is
illustrated by the “persistent inflation” scenario. As shown by the black line in the
bottom right-hand panel, if those incremental inflation pressures were fully
anticipated, optimal policy would call for boosting the federal funds rate about
75 basis points above baseline over the next year. In the optimal control case with
gradual learning (the dashed red line) or with the empirically estimated rule that
reacts only to outcomes (the dashed blue line) the policy response is more drawn out
but is eventually of similar dimensions. Should the Committee see a significant risk
of persistent inflation pressures along these lines, it may wish to continue to point to
upside risks in its announcement if it firms 25 basis points at this meeting, as in
Your final exhibit is the version of table 1 that was distributed on Friday. Thank you. That concludes my prepared remarks.