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

Thank you, Mr. Chairman. In the run-up to Halloween, we have had a witch’s brew of news. Sorry. [Laughter] The downward trajectory of economic data has been hair-raising—with employment, consumer sentiment, spending and orders for capital goods, and homebuilding all contracting—and conditions in financial and credit markets have taken a ghastly turn for the worse. It is becoming abundantly clear that we are in the midst of a serious global meltdown. Like the Board staff, I have slashed my forecast for economic activity and now foresee a recession with four straight quarters of negative growth starting last quarter. I wish that I could claim that I place a lot of confidence in the sobering forecast, but I am sorry to say I can’t. In fact, I think we will be lucky if the adverse feedback loop that is under way doesn’t wrench us into a much more pronounced and more protracted downturn. The outlook for inflation has shifted markedly, too, with the days of heightened upside inflation risks behind us. In fact, I am concerned that beyond next year we run the risk of inflation falling below the level consistent with price stability.

Even before the extraordinary deterioration in financial market conditions over the past few weeks, there were numerous signs that the economy had weakened dramatically. I won’t recite the litany of disappointing data but instead try to touch upon some high, or I guess I should say low, notes based on what my contacts tell me. They are consistent with President Fisher’s observations. Consumer purchases of durable goods, especially motor vehicles, have been particularly hard hit by the one–two punch of tight credit and reeling consumer confidence. The mood on showroom floors is downright grim. One auto dealer in my District reports that he is now experiencing the worst period in his thirty-plus years in the business. A home appliance retailer adds that he has never seen more uncertainty and gloom from both the retailers and the vendors. This sentiment is echoed by a large retailer who says simply, “The holiday shopping season is going to stink.”

Businesses are under siege from weak demand, high costs of borrowing, curtailed credit availability, and pervasive uncertainty about how long such conditions will last. Our contacts report that bank lines of credit are more difficult to negotiate. Many have become more cautious in managing liquidity and in committing to capital spending projects that can be deferred. They are even cutting back trade credit to customers. Even firms that are currently in good shape report that they are hunkering down, cutting back on all but essential spending, and preparing for the worst. Our venture capital and private equity contacts tell us that they are instructing their portfolio companies to cut costs, put expansion plans on hold, and draw down existing credit lines. The market for commercial mortgage-backed securities has all but dried up, and lenders have also become less willing to extend funding. With financing unavailable, I am hearing talk about substantial cutbacks on new projects and planned improvements on existing buildings, as well as the potential for distress sales of properties whose owners will be unable to roll over debt as it matures. The deterioration in overall financial conditions since the September FOMC meeting is truly shocking. Even with today’s 900-point increase in the Dow, broad indexes are still down about 20 percent, and the latest data suggest house prices in a freefall. Baa corporate bonds are up about 200 basis points since our last meeting, low-grade corporate bonds are up a staggering 700 basis points, and to top it all, the dollar has appreciated nearly 10 percent against the currencies of our trading partners. The sharp deterioration in financial and credit conditions will weigh heavily on economic activity for some time. In addition, prospects for the one remaining cylinder in the engine of growth—namely, net exports—are bleak owing to the slowdown in global demand and the appreciation of the dollar.

We now expect real GDP to decline at an annual rate of 1¼ percent in the second half of this year and to register two more negative quarters in the first half of next year. That forecast is predicated on cutting the funds rate to ½ percent by January, as assumed in the Greenbook, and also is premised on another fiscal package. An absolutely critical pre-condition for the economy to recover next year is for the financial system to get back on its feet. In that regard, I have been greatly heartened by the important actions that the Treasury, the FDIC, the Fed, foreign governments, and other central banks have taken in recent weeks to improve liquidity and inject capital into the financial systems. But we are fighting an uphill battle against falling home prices, an economy in recession, and collapsing confidence. It is not clear whether these steps will reopen credit flows to households and businesses, especially those with less than sterling credit. Under the Greenbook forecast we will see further large declines in housing prices over the next two years. Banks and other financial institutions will likely suffer larger losses than many had anticipated, and that will mute the impact of recent capital injections. The interaction of higher unemployment and rising delinquencies raises the potential for even greater losses by banks and other financial institutions and for an intensification of the adverse feedback loop we have worried about and are now experiencing. Such a sequence of events plausibly could lead to outcomes described in the “more financial fallout” alternative scenario in the Greenbook.

There are considerable downside risks to the near-term outlook as well. As I mentioned, the most recent economic data have consistently surprised on the downside, and I see a real risk that the data may continue to come in weaker in the near term than the Greenbook has assumed. For example, a dynamic factor model that my staff regularly uses is much more pessimistic in the near term than is the Greenbook. This model aggregates the information contained in more than 140 data series. Based on the most recent economic and financial data available, this model predicts that real GDP will fall 2½ percent in the fourth quarter. The model’s pessimism reflects the combination of the recent weak data releases for the month of September, followed by the abysmal data that we have available so far for October, including financial market prices, regional business surveys, and consumer sentiment.

Turning to inflation, the most recent data have been encouraging. Looking forward, the sharp decline in commodity prices, especially oil prices, will bring headline inflation down relatively quickly. More fundamentally, the considerable slack in labor and product markets will put downward pressure on the underlying rate of inflation over the next few years. A number of my contacts already report that their businesses are working on lower margins in the more challenging economic environment. I expect headline PCE price inflation to decline to about 1½ percent in 2009 and core PCE price inflation to be 1¾ percent next year. I expect both inflation rates to edge down to 1¼ percent in 2010. Given the sizable downside risk to the forecast for growth, the risks to the inflation forecast are likewise weighted to the downside.

In conclusion, I think the present situation obviously calls for an easing of policy, as I assumed in my forecast. Given the seriousness of the situation, I believe that we should put as much stimulus into the system as we can as soon as we can.

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