Transcripts of the monetary policymaking body of the Federal Reserve from 2002–2008.

Thank you, Mr. Chairman. I’ll be using the packet with the green lettering on the cover entitled “Staff Presentation on Nonfinancial Developments.” Over the intermeeting period, the data we received on real activity were considerably weaker than we had been expecting. That, combined with the intensification of financial turmoil since mid-September, led us to significantly mark down our near- term and medium-term projections for economic activity.

Your first exhibit focuses on the near-term outlook. As shown by the blue bars in the top left panel, we currently expect real GDP to fall at an annual rate of slightly more than 1 percent, on average, in the second half of 2008—a reduction of about 2 percentage points from our projection in the September Greenbook (the red bars). One factor that has informed our thinking about the near-term forecast is the labor market, which looks weaker than at the time of the last FOMC meeting. As you know, payrolls fell steeply in September. Since then, initial claims for unemployment insurance (the black line in the top right panel) have been quite elevated, even after adjusting for factors that are temporarily boosting claims (the red line). As shown in the inset box, the latest claims data point to another sizable drop in employment this month.

Turning to spending, sales of light motor vehicles (plotted in the middle left panel) have been dismal of late and are expected to stay that way at least through the end of the year. Motor vehicle sales have been depressed, in part, by financing constraints, limited sales incentives, a retreat by the automakers from leasing, and worsening consumer assessments of car-buying conditions. More broadly, as you can see by comparing the black and red lines in the panel to the right, consumer spending excluding motor vehicles has been significantly softer in recent months than we were expecting. In addition, the conditions influencing consumer outlays have worsened considerably, including a sharp drop in household wealth, tepid real income gains, a weakening labor market picture, historically low levels of sentiment, and reduced credit availability. Consequently, as reported in the inset box, we substantially revised down the projection for overall real PCE in the second half of the year. In the housing sector, single-family starts, shown in the bottom left panel, fell to about 550,000 units in September—6 percent below our expectation. Even with the ongoing cutbacks in production, the weak demand has left the months’ supply of unsold new homes (not plotted) very elevated, and we expect starts to decline well into next year. In the business sector, the spending data in hand are somewhat stale— tomorrow morning we receive the advance reading on durable goods shipments and orders in September—but the information we do have points to softening business investment in the third quarter. Moreover, as shown on the right, the first available surveys on business activity in October plunged to very low levels.

Exhibit 2 summarizes the enormous changes to the key conditioning factors that we confronted in putting together the staff forecast. As shown in the top left panel, reflecting the recent plunge in equity prices, the stock market path in this projection is markedly below the path anticipated in our September forecast. This downward revision, together with the projected declines in house prices that Bill Bassett presented in his briefing, leaves the level of the wealth-to-income ratio, plotted to the right, substantially lower than in the September Greenbook. As a result, over the next two years, household wealth exerts a much greater drag on consumer spending than we assumed earlier. Yields and spreads on corporate bonds, illustrated by the Baa rate in the middle left panel, soared over the intermeeting period. We expect the higher cost of capital in this forecast to weigh on business capital spending over the projection period. A further drag on economic activity in the medium term is the recent jump in the exchange value of the dollar, shown to the right. While we expect the dollar to decline a touch more quickly than in the September Greenbook, by the end of 2010 it remains more than 4 percent above the level assumed in our previous forecast. In addition, as Linda Kole will discuss shortly, the outlook for foreign activity has deteriorated. A partial cushion to these factors depressing activity is the plunge in oil prices over the past few weeks; the bottom left panel shows the spot price of West Texas intermediate crude oil. The path for oil prices over the projection period, based on futures quotes, averages nearly $30 per barrel below the September Greenbook path and should provide some countervailing support to household purchasing power and consumer spending. As noted to the right, according to our standard forecasting models, the lower level of equity prices, the higher bond rates, and the higher exchange value of the dollar—all of which are intertwined with the intensification of financial turmoil—exert a considerable drag on real activity over the next two years. Through conventional wealth, cost-of-capital, and terms-of-trade channels alone, these developments would lead us to revise down real GDP growth about 1¼ percentage points, on average, in 2009 and 2010. But these effects likely understate the full extent of the fallout on real activity from financial turmoil. This is because our standard models do not explicitly account for the additional effects of such factors as tighter lending standards and heightened uncertainty.

Consequently, for some time we have been using supplementary analyses to try to account for these credit-channel effects in our judgmental projection. Your next exhibit provides some detail on how we updated these adjustments in light of the intensification of financial stress during the intermeeting period. Two measures that we have found useful for measuring the extent of financial turmoil are plotted in the top row of your third exhibit. On the left is an index of financial market stress, and on the right is an index of bank credit standards derived from the Senior Loan Officer Opinion Survey. Both indexes have skyrocketed lately, reflecting the sharp deterioration of financial conditions. As discussed in the past two Greenbooks, we use two basic empirical approaches to try to quantify the effects of financial turmoil on real activity that are not captured by our standard models: One is based on the historical correlations between these financial turmoil measures and errors in FRB/US spending equations, and the second method incorporates these indicators of turmoil into small-scale vector autoregressions.

The middle left panel shows estimates of the cumulative effect of our judgmental adjustments for financial turmoil, outside the conventional channels noted earlier. The effects are shown relative to the level of real GDP in the fourth quarter of each year. The solid black line is the judgmental estimate built into the current Greenbook forecast, whereas the red dashed line plots the estimates used in the September projection. The shaded area shows the range of results from the model-based estimates detailed in Part 1 of the October Greenbook. As you can see by comparing the black and red lines, we now expect that financial turmoil, outside the usual channels, will impose a markedly greater drag on real activity than we projected in the last Greenbook. For 2008, we think that much of the unexpected weakness observed recently in the spending data reflects financial turmoil effects, which puts our judgmental adjustment near the bottom of the model-based range. In contrast, our adjustment for 2009 is in the middle of the range of model-based results, whereas for 2010 our adjustment is near the top end of the range. We are more optimistic than the models for 2010 in part because none of the model-based estimates fully accounts for what we assume will be the likely restorative effects over time of the actions taken by governments to mitigate the problems afflicting the financial system. As shown in the middle right panel, these restraining influences, taken together, led us to mark down our assumed path for the federal funds rate. We now assume that the funds rate is lowered to ½ percent by early next year and is held at that level until mid-2010.

Although the path for the funds rate is appreciably lower than we had assumed in the September Greenbook, the additional monetary easing only partially offsets the greater restraint on activity from the other factors shaping the projection. All told, as shown in the first line of the table at the bottom of the page, we project that real GDP will fall at an annual rate of nearly 1 percent in the first half of 2009 and then turn up modestly in the second half. In 2010—with the drag on activity from the strains in financial markets beginning to ease, housing market conditions stabilizing, and an accommodative monetary policy in place—activity accelerates further, and real GDP increases 2.3 percent over the four quarters of the year. The contributions of selected domestic spending categories to changes in real GDP are shown in lines 3 to 5. As you can see, we think that consumption will begin to recover next year and that the drag from housing will diminish over time. In contrast, we expect business fixed investment to remain quite weak next year, reflecting in part the lagged effects on investment of declining business output, the high cost of capital, and heightened uncertainty. Although each of the major components of private domestic demand contributes to the acceleration in economic activity in 2010, the contribution to growth from net exports (line 6) is expected to turn slightly negative late next year.

As shown in the top panels of exhibit 4, the margin of slack both in labor markets (the panel to the left) and in the industrial sector (the panel to the right) is expected to remain substantial through the end of the projection period. We expect this persistent slack to be a source of downward pressure on inflation. Other influences are also likely to hold down inflation over the projection period. As shown in the middle panels, energy prices and core goods import prices decelerate sharply from their recent elevated paces. The projected path for consumer energy prices (the left panel) largely reflects the effect of the intermeeting plunge in oil prices, and the forecast for core import prices (the right panel) reflects both the sharp drop in commodity prices and the stronger dollar. As shown in the bottom left panel, while the Michigan survey readings on near-term inflation expectations have remained elevated (the black line), those on longer-term inflation (the red line) have more than retraced the run-up observed earlier this year. Taken together, as shown in line 7 of the bottom right panel, we now expect core PCE inflation to move down to 1½ percent in 2009 and to slow further to 1¼ percent in 2010, roughly ½ percentage point less in each year than projected previously. Total PCE inflation (line 1) is projected to run at about the same rate as core PCE inflation in both years.

Turning to exhibit 5, a critical feature of the staff forecast is our assumption that the strains in financial markets will ease gradually over the next two years. However, the current situation is so extraordinary, in terms of both the financial disruptions and the policy responses to those disruptions, that an extremely wide band of uncertainty surrounds this assumption: Matters could easily turn out much worse or much better. To give some sense of possible magnitudes, this exhibit reviews two alternative scenarios from the Greenbook.

In the first scenario, outlined in the top left panel, financial turmoil intensifies further over the projection period rather than gradually abating, and the accompanying economic fallout turns out to be more severe than in the baseline projection. Specifically, risk premiums on loans, corporate bonds, and equity jump a further 50 basis points and are slower to fall back over time; in addition, the level of house prices falls an additional 10 percent relative to the baseline. We also assume that credit-channel and other nonconventional effects are even more restrictive in 2009 and 2010 than those built into the staff forecast—to a degree more in line with the bottom end of the range of empirical estimates I presented earlier. As shown by the red line in the middle left panel, with the intensification of the financial turmoil and the larger judgmental adjustments for the impact of financial stress on economic activity, real GDP is significantly weaker than in the baseline (the black line). As a result, the unemployment rate (plotted to the right) rises faster and farther, peaking at nearly 8½ percent at the end of 2010, more than 1 percentage point above the baseline. Reflecting the greater accompanying slack, core PCE inflation (shown in the bottom left panel) moves down appreciably faster than in the baseline, reaching just ¾ percent at the end of 2010. With substantial slack and a low and falling inflation rate, the funds rate remains pinned through 2010 at ½ percent and continues at that level through 2012 in the extended simulation presented in the Greenbook.

In the second scenario, outlined in the top right panel, the stress weighing on financial institutions and markets lifts much more quickly than in the baseline, perhaps in response to the extraordinary recent government actions. Here, we assume that risk spreads recede by early next year to the levels that were projected in the September Greenbook, and as a result, equities reverse most of their recent losses by the middle of next year. In addition, we cut back the size of the judgmental adjustments for financial turmoil to their September Greenbook levels. As shown by the blue lines in the middle panels, economic activity responds fairly vigorously to the improvement in financial conditions, with GDP growth reaching about 4½ percent by the end of 2010 and the unemployment rate moving down to 5¾ percent. As shown in the bottom left panel, the narrower margin of slack in the alternative scenario tempers the decline in core PCE inflation relative to baseline. Finally, as shown to the right, the federal funds rate, under an optimal control monetary policy, declines briefly to 1 percent early next year but then moves up steadily as it becomes clear that the financial strains are lifting rapidly. Linda Kole will now continue our presentation.

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