Thank you, Mr. Chairman. As I sat down to deliver my briefing at the last FOMC meeting, I was feeling pretty good. After all, the sizable acceleration in aggregate output in the second half that we had been projecting for some time seemed to be materializing. Even the more controversial aspects of our forecast—a pickup in capital spending and a turnaround in the labor market—were receiving some support from the incoming data. To be sure, it was early and considerable risks remained, but I thought the case would be easier to make than it had been in months past. Indeed, I figured that by 10 o’clock I’d be relaxing with a doughnut, listening to Vincent execute the more difficult assignment of laying out a 3 by 3 by 3 Rubik’s cube of policy objectives, options, and risk assessments. [Laughter]
So, needless to say, I was not prepared for the full extent of the resistance that our forecast met at the last meeting. In contrast to the situation in June, when our projection of a 4 percent annual rate increase in real GDP in second half of this year was widely viewed as too optimistic, there was considerably less consensus at the last meeting about the nature of our error. Some of you argued that the economy would not strengthen as much as we were projecting and certainly not to the point of eroding the margin of slack in labor markets as quickly as we were anticipating. In contrast, others of you appeared to be skeptical that we could hold the funds rate so low for so long without generating a larger boom in output growth, greater inflationary pressures, or both.
For two reasons, I thought I would address your critiques head on this morning. The first reason is that, from time to time, it is useful to remind the Committee that I did graduate summa cum laude from the “Mike Prell School of Charm.” [Laughter] Second, the issues that you raised at the last meeting were serious, central to your policy deliberations, and ones that we have continued to struggle with over the past six weeks.
So why do we believe that the economy will be strong enough to put a sizable dent in the slack that has developed in labor markets over the past few years? We start from the premise that monetary and fiscal policy will continue to provide a substantial dose of stimulus to aggregate demand in coming quarters. Real interest rates are low, and risk spreads have come in—making the cost of capital favorable to businesses and households. The stock market has increased markedly since March and is expected to rise still further over the projection interval. Those increases should encourage business investment and help to repair household balance sheets. Meanwhile, the exchange value of the dollar has fallen noticeably and is expected to edge down further, buoying the competitive position of U.S. producers on world markets.
The improvement in financial conditions has no doubt been a key factor supporting the recent upturn in capital outlays. Real spending on equipment and software seems likely to post an increase at an annual rate of about 14 percent in the second half of this year, with spending on both high-tech and more traditional capital equipment contributing to the upswing. From the vantage point of the second half, our projected increase in real E&S spending of 18 percent next year doesn’t look to us like too much of a stretch. After all, the cost of capital is projected to remain very low, and given the usual lags, the recent sharp acceleration of business output, sales, and cash flow should provide considerable impetus to investment spending well into next year. Moreover, the impending expiration of the partial-expensing provision should provide an additional fillip to spending in 2004.
The household sector also has been receiving a lift from expansionary fiscal policy. Consumer outlays soared this summer, as disposable incomes jumped in response to lower personal income taxes. Spending hit a bit of a pothole this autumn, but we believe that it will pick back up in coming months. The figures on motor vehicle sales in November provide some encouragement to that view, though broader reports on recent retail sales have been mixed. Households will receive another large slug of disposable income in 2004 from this year’s tax legislation. Lower taxes along with a pickup in hiring are expected to boost real disposable income by 5 percent in 2004, and real PCE is projected to increase about 4½ percent.
Monetary and fiscal policy are not the only sources of upward impetus to output. Inventory dynamics should also be lifting production in coming months. Indeed over the next four quarters, a gradual strengthening of inventory investment is expected to add nearly ¾ percentage point to the growth of real GDP. Even that trajectory for stockbuilding is sufficient only to flatten out the inventory-sales ratio by the middle of next year at a level noticeably below our estimate of the long-run target. The recent data suggest that manufacturers are boosting production enough both to stem the inventory liquidation that has occurred for most of the year and to respond to the improvement in their order books. After falling earlier this year, manufacturing IP was up 3½ percent at an annual rate in the third quarter. And given the data in hand, factory output is likely to increase nearly 1 percent in November and more than 5 percent at an annual rate for the fourth quarter as a whole. So even the lagging manufacturing sector is showing reasonably widespread signs of life.
Will this faster pace of overall spending and production prove to be a temporary blip? That possibility still can’t be ruled out. As I noted at the last meeting, estimating the short-run consequences of the tax cuts involves more in the way of educated guesswork than hard science. The recent softness in consumer spending could give one pause. On the other hand, the widening scope of the economic improvement that we are witnessing, including increased capital spending, an end to inventory liquidation, an upturn in hiring, and rising factory output, suggest that the forces at work are broader than just income tax cuts.
Of course, even if we are roughly correct about the course of spending over the next few quarters, our projected decline in the unemployment rate to 5¼ percent by the end of next year could be wide of the mark. Last Friday’s report on the November labor market provided mixed evidence on our progress. Private payrolls rose 50,000 in November and have been increasing about 90,000 per month, on average, over the past three months. That’s a bit less than we had incorporated in the December Greenbook. However, the workweek increased again last month, and aggregate hours worked actually came in a little above our expectations. Moreover, the unemployment rate declined another tenth, to 5.9 percent.
Our projection assumes that something akin to a cyclically normal recovery in employment begins by midyear. Because we are assuming that the participation rate will recover somewhat, after having fallen so much over the past few years, the ½ percentage point decline in the unemployment rate that we are projecting is actually a bit slower than the cyclical norm. Of course, that doesn’t mean that it couldn’t be slower still. The timing and magnitude of the improvement in the labor market, in addition to depending on the strength of aggregate demand, is a function of the ability of firms to continue to extract greater efficiencies from their operations. As an empirical matter, we lack any precise gauges here, and we can’t rule out that we have been too pessimistic about the trajectory of structural productivity. We explored that possibility in an alternative simulation in the Greenbook. The consequences of such an outcome are both a weaker labor market and much lower price inflation than in our baseline projection. Although the recent data have certainly been encouraging, the step-up in the pace of the expansion is still relatively recent, and some combination of weaker aggregate demand and stronger aggregate supply could result in an economy that is slower to absorb the existing slack in resource utilization and produce even lower inflation than we are projecting.
However, as some of you have noted, there are sizable risks on the other side of our projection as well. Most notably, holding the real federal funds rate close to zero for another year and then only moving it up gradually in 2005 could set off a substantial boom in activity, higher inflation, or both. With real rates so low, why aren’t we projecting a stronger expansion over the next two years—one perhaps that resembles a more normal cyclical recovery? There are several reasons. For one, some of the usual contributors to the upsurge in activity in the early stages of recovery are not expected to play their typical roles. In particular, outlays on housing and consumer durables have already increased steeply over the past couple of years, and while we expect low interest rates to help maintain that spending, we project outlays in these areas to decelerate over the next two years. Meanwhile, some other sectors have been and are likely to remain lackluster over the next year or so. Nonresidential construction activity still appears to be adjusting to high vacancy rates and weak rents, and we anticipate only gradual improvement in that sector next year and into 2005. Moreover, despite the past and prospective decline in the dollar and the modest recovery abroad, the external sector is expected to subtract from growth over the next two years. Finally and importantly, fiscal policy swings from a source of considerable stimulus early next year to some small restraint in 2005. From the perspective of our forecast, the shift in fiscal policy is doing some of the work that would otherwise be required of monetary policy.
Another concern raised about our forecast was that perhaps we will experience more inflation with output growth that is the same or weaker than we are projecting. This implicitly is a concern that we are too optimistic, in some respect, about aggregate supply. The outside consensus forecast appears to embody this view by combining higher interest rates, weaker activity, and more slack, with faster inflation. The basic contour of our inflation forecast hasn’t changed since the last meeting. We continue to expect that declining energy prices will push down headline inflation and that core prices will increase in 2004 and 2005 at about the same pace as this year. The sources of that subdued inflation picture also remain the same. Economic slack is expected to diminish only gradually. Rapid increases in structural labor productivity hold down costs, and the markup of prices over unit labor costs, which has increased sharply in recent quarters, levels out. With headline inflation coming down, inflation expectations are anticipated to hold steady or drift lower. One hears a variety of stories expressed to support less favorable outlooks for inflation. One argument is that speed matters. Perhaps it is not the level of resource utilization but the change in resource utilization that influences inflation. The problem is that we can find little to no empirical support in the U.S. data for this story. The economy grew at rates well above trend in the early 1980s and early 1990s. And despite noticeable declines in the unemployment rate, core inflation moved down, not up. That casual observation is confirmed by a lack of econometric evidence for the existence of economically meaningful speed effects.
Another concern has been that the rapid rise in commodity prices could be signaling the emergence of more-intense inflation pressures. But it is very common for commodity prices to rise sharply in the early stages of recovery without having much influence on the prices of final goods and services. Primary commodities have low labor content and are sold on auction markets that are very sensitive to changes in demand. They constitute a very small share of the value added of most finished goods and services, which typically are much more sensitive to movements in labor costs. As an aggregate inflation shock, we believe the recent surge in commodity prices is likely to be of minor consequence.
Another possibility is that inflation expectations will deteriorate over the next year or so in response to strong economic growth and our assumption of continued policy patience. This would seem to be a more serious risk, and we explored its consequences in an alternative in the Greenbook. But we don’t think that that’s the most likely outcome. Looking at Treasury indexed securities, inflation compensation over the next five years has moved up since the summer but only to the top end of the range in which it has fluctuated over the past few years. Likewise, inflation expectations from the Michigan survey have moved back up in recent months along with energy prices, but haven’t broken out to the upside. We don’t see in our projection the types of developments that would likely result in a serious erosion of your credibility.
Perhaps the most obvious source of upward risk to our inflation projection is that most or all of this year’s slowing in core inflation reflected transitory factors that will be absent or—worse yet—be reversed next year. For example, the smaller increases in residential rents, motor vehicles, and medical services may prove short-lived. As you know, we discounted a great deal of the slowing observed earlier this year, and the bounceback in the data in subsequent months has been very close to our expectations. But perhaps we haven’t discounted enough of this year’s low core inflation. If so, then price increases next year will be higher than we are currently projecting. However, if that were to occur, it will be important to bear in mind that this acceleration of prices reflects the unwinding of favorable developments this year and is not the result of an overheating economy capable of generating ongoing increases in inflation.
In summary, we acknowledge that there are very large risks to virtually every important dimension of the staff projection. There almost always are. If it provides you with any comfort, we have placed at the very top of our holiday wish list the acquisition of shiny new models that will allow us to make it all clear for you in the coming year. But barring that unlikely outcome, we will simply need to be content knowing that, with the recent run-up of commodity prices, our lump of coal will at least go a little bit further this year than it has in the past. [Laughter] Karen Johnson will now continue our presentation.