Thank you, Mr. Chairman. I’ll be referring to the package of charts distributed during the break entitled “Material for Briefing on Monetary Policy Alternatives.”
Your monetary policy discussion today takes place against a backdrop of significant revisions to the economic outlook and substantial changes in financial market prices. As shown in the upper left-hand panel of exhibit 1, market interest rates rose considerably over the intermeeting period, pushed higher by a steady stream of data releases suggesting greater momentum to aggregate spending and output, some signs of heightened inflation pressures, and indications from policymakers that measured firming would continue in coming months. Yields on nominal Treasury securities climbed 45 to 50 basis points, bringing the 10-year yield above 4.4 percent. As shown in the upper right-hand panel, one-year forward rates ending one year ahead through 10 years increased appreciably, although the larger part of the increase occurred near the front end of the curve—a common pattern when yields respond to signs of strength in the economy.
The middle left-hand panel indicates that real yields as read from inflation- indexed Treasury issues rose about in line with nominal rates. As shown in the middle right-hand panel, market participants evidently expect that you will counter the perceived increase in aggregate demand and inflation pressures with additional policy restraint, as CPI-based inflation compensation rose less than 10 basis points on net over the intermeeting period. Inflation expectations thus appear to have been remarkably little affected by the $5 per barrel further rise in spot oil prices over the intermeeting period (the black line in the lower left-hand panel) and the more than $3 increase in far futures crude prices (the red line) to record high levels.
Likewise, equity prices, shown in the lower right-hand panel, seem to have been held back little by the further rise in energy prices. Indeed, boosted by strong earnings reports, the Wilshire 5000 index climbed 2¼ percent while the Nasdaq surged 4½ percent. The apparent enthusiasm about business prospects was mirrored in corporate bond spreads, not shown, with the spread on high- yield issues dropping more than 60 basis points.
Market participants sharply marked up their expectations for monetary policy firming. As shown in the upper left-hand panel of your next exhibit, investors appear to have boosted their forecast for the peak federal funds rate from around 3¾ percent as of the last FOMC meeting (the dotted line) to just above 4¼ percent (the solid line). And whereas previously investors had anticipated a slowing in the pace of tightening this autumn, the steepening visible in the left- hand part of the panel indicates that market participants have significantly raised their expectations for policy action over the next several months.
This revision in near-term policy expectations can be seen even more clearly in the step-path in the upper right-hand panel, which portrays market expectations for your actions at each of the four remaining meetings this year, as given by our reading of fed funds futures quotes. The uptick for the August meeting from 3.46 percent to 3.49 percent indicates that investors have gone from fairly sure to essentially certain of a 25 basis point move at this meeting. Especially striking are the upward revisions to expectations for the November and December meetings. Previously, only a very small probability was assigned to a move in December, but that likelihood has now been marked up to above 50 percent. Despite these upward revisions, the 4.09 percent rate after the December meeting suggests that investors still see high odds that you will take a pass at one of the meetings over the balance of the year, most likely in December.
This pattern of expectations is reflected in the Desk’s survey of the 22 primary dealers. As shown in the lower left-hand panel, on average dealers assigned a 93 percent probability to a 25 basis point move at this meeting, 84 percent for September, and 76 percent for November. For each of those meetings, both no action and a 50 basis point move were also seen as possibilities, with the likelihood of a pause still slightly outweighing that of a policy acceleration.
As indicated in the middle panel, for today’s meeting, dealers almost unanimously expect you once again to judge the current stance of policy as accommodative, to assess the risks as balanced, and to retain the “measured pace” language.
As shown in the right-hand panel, dealers were also surveyed as to their estimates of the neutral nominal funds rate. Their average estimate of the most likely neutral nominal federal funds rate—4¼ percent—is consistent with that suggested by the pattern of money market futures quotes. However, dealers were also asked about their range of estimates, and the average responses, indicated by the “low” and “high” entries, suggest a significant degree of uncertainty. Dealers’ average forecast that core PCE inflation will be about 2 percent in mid-2006, not shown, seems to suggest that their 4¼ percent average estimate for the nominal funds rate translates into roughly a 2¼ percent estimate for the equilibrium real funds rate.
As shown in the top panel of exhibit 3, an equilibrium real federal funds rate in a range of roughly 2 to 2¼ percent is also consistent with both a range of model-based staff estimates (the red band) and the Greenbook forecast (the green dashed line). As indicated in the upper part of the lower panel, the range of model estimates has narrowed substantially this round. In the June Bluebook, the right-hand column, the estimates went from 1.5 percent at the low end to 2.8 percent at the high end, but in this Bluebook they are relatively tightly clustered roughly between 2 to 2¼ percent.
The width of the red band, however, should not be interpreted as a confidence interval. Rather, 70 and 90 percent confidence intervals capturing uncertainty about model specification, coefficients, and the level of potential output are denoted, as usual, by the dark and light shaded areas in the chart. According to these rather wide intervals, the real funds rate could already be above its equilibrium level or remain well below it.
Moreover, at least some of these estimates of the equilibrium funds rate are subject to uncertainty regarding the outlook for a range of exogenous variables. This point is made using a different framework in exhibit 4. This exhibit shows the results of a benchmark scenario and two alternative scenarios that are prepared using the version of the FRB/US model with forward-looking investors and assuming optimizing policymakers whose outlook is similar to the staff’s. The benchmark scenario, denoted by the black lines, captures economic conditions and inflation pressures as interpreted judgmentally in the Greenbook and extended through 2012. But in the benchmark scenario as well as the two alternatives, policymakers pursue an optimal policy rather than following the funds rate path of the Greenbook or a Taylor rule. Specifically, policymakers minimize the sum of squared deviations of unemployment from the NAIRU, deviations of inflation from an assumed 1½ percent target, and changes in the federal funds rate. Under that benchmark scenario, the federal funds rate moves up gradually to about 4½ percent, a little higher than in the Greenbook, and then drops back to 4 percent, as core PCE inflation tilts down toward its assumed target of 1½ percent and the unemployment rate varies narrowly between 5 and 5¼ percent. This scenario, by the way, assumes that the currently very low term premium in bond yields rises gradually, reaching its historical average level in 10 years.
The red lines are based on the “stronger demand” scenario that was discussed in the Greenbook, with personal consumption, residential investment, and business investment expenditures all considerably stronger than in the baseline scenario. Here, policy tightens much more steeply than in the baseline. And, with financial markets immediately recognizing both the positive shock to demand and the resulting tightening of monetary policy, nominal bond yields promptly jump to about 5¼ percent. As shown in the lower panel, inflation initially drops below baseline under this scenario because the sharp tightening of monetary policy induces a substantial appreciation of the dollar and because the modest initial decline in unemployment below the NAIRU, the middle panel, imparts little momentum to inflation.
The blue lines in this chart focus on a topical issue—the unusually low term premium in bond rates. This scenario addresses the question: What would happen if the term premium jumps 80 basis points, thus reverting immediately to its historical average? Here, the assumption of forward-looking policymakers and markets is key. To offset the incipient upward pressure on bond yields arising from the increased term premium, the Committee eases policy considerably relative to baseline. Investors see right away that you are, and will be, taking countervailing action. Consequently, as shown in the upper right- hand panel, the effect of the higher term premium on bond yields is essentially offset by markets’ correct anticipation that the stance of policy, as gauged by the nominal funds rate, will be easier over the next 10 years. As shown by the lower and middle panels, this policy is nearly completely successful in eliminating the effects of the term premium shock on the real economy and inflation.
Certainly, these alternative simulations contain some extreme elements—the large shock to aggregate demand in the first, the immediate substantial jump in the term premium in the second, and the assumption of immediate recognition of the shocks and a high degree of forward-looking behavior in both simulations. But they nonetheless illustrate some useful lessons. First, it is easy to imagine that the economy or financial markets could evolve in such a way as to require a federal funds rate notably above or below the rather concentrated 4 to 4¼ percent center of gravity that currently seems to be suggested by the R* measures, fed funds futures, and dealers’ expectations. And the second scenario in particular suggests the potential value to policymakers of being able to decompose changes in nominal bond yields into expectation and term-premium components.
Even acknowledging the uncertainties illustrated by these scenarios, though, the weight of the evidence seems to suggest that monetary policy will need to firm at least somewhat further in coming months. Accordingly, the Bluebook once again presented three policy alternatives, summarized in your final exhibit, that each would involve a further increase in the federal funds rate at this meeting.
As shown in the second column, under alternative A the funds rate would be boosted a quarter point today, but the language in your announcement would hint at an imminent downshift in the pace of tightening. With the real funds rate currently at only about 1¼ percent, it seemed implausible to propose statement language suggesting that the end of the tightening cycle was just around the corner; a suggestion of a pause, with further tightenings to come, seemed a bit more relevant to current circumstances.
At the other end of the spectrum, alternative C, the fourth column, could be
motivated by a sense that the real funds rate is currently well below its
equilibrium, possibly far enough below that an intensification of inflation
pressures could already be in train. To move more rapidly to close the real rate
gap, this alternative would raise the funds rate 50 basis points at this meeting.
Moreover, the statement would convey fairly serious concern about both the
strength of aggregate demand and rising cost pressures. With a move of this
size, the Committee would presumably no longer express a view that future
policy moves would occur at a measured pace and might take the opportunity to
eliminate other forward-looking elements of the statement as well.
Under alternative B, the Committee would stick with its established program
by firming policy another 25 basis points today, retaining the assessment that
the risks to growth and inflation should be balanced with appropriate policy
action, and reiterating that policy firming likely can continue at a measured
pace. However, the proposed language in the “rationale” sentences of the
announcement—those characterizing real activity and inflation—have been
modified significantly. These changes could be read by investors as conveying
a bit more concern about the pace of demand growth and the degree of inflation
pressures than they had expected.
In weighing alternative approaches to near-term policy, policymakers as usual
would seem to have to make some key judgments. These include, for example,
whether the staff is correct in its assessments that only a bit of slack remains in
the economy, that current financial conditions are consistent with a near-term
slowing in the growth of aggregate demand to a pace in line with that of the
economy’s potential, and that core PCE inflation will probably remain near 2
percent over the forecast horizon with a continuation of gradual tightening. The
staff could be wrong in those assessments, but if so it will likely have a good
deal of company among financial market participants.
That concludes my prepared remarks.