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

Thank you, Mr. Chairman. Business and consumer sentiment in the Fifth District has deteriorated markedly. Even though economic conditions were already decelerating heading into our September meeting, a discrete shift in outlook seems to have occurred. It seems to me to have originated during the week of September 15 or shortly thereafter. Our business contacts express anxiety about the national economy, and they express uncertainty about the meaning for their firms’ prospects of the astonishing sequence of events that began unfolding that week. Both consumers and firms have been increasingly unwilling to make long-term commitments and engage in discretionary expenditures. Consumers are delaying large and discretionary expenditures. Firms have adopted a wait-and-see attitude on investments.

Our regional survey released this morning shows a substantial drop in business conditions as well. Our business survey respondents report that obtaining business loans is more difficult than three months ago, and there are widespread reports of lenders tightening credit terms and seeking to reduce exposures. Most respondents, however, also indicated that they would still be able to satisfy their borrowing needs. When you listen to bankers, they will tell you that they are tightening standards, but they also report that they are still extending credit to solid borrowers with high-quality deals.

I find it difficult right now to pin down the real effects of the financial market turmoil of the last few weeks. As the Greenbook notes, assessing such effects “poses significant identification challenges.” Specifically, it is hard to disentangle the effects of the increased cost of bank capital from those of the deterioration in the economic environment facing borrowers. Personally, I suspect the latter are playing the more prominent role in the tightening of credit terms right now.

Looking on the bright side, the near-term inflation picture has eased noticeably since our September meeting, mainly because of the decline in oil and other commodity prices. The Greenbook carries this moderation into its long-term forecast, where PCE inflation now converges to 1 percent in 2013. I did a double-take when I saw that—it had me wondering whether the Greenbook was ghost-written this month by President Plosser. [Laughter] Whoever’s forecast it is, the longer-term projected moderation in inflation relies heavily on the opening-up of a large and persistent output gap. In the current circumstances, I am not sure how plausible that story is. In particular, I have been struggling with how to think about the effect of credit market disruptions on the concept of potential output. To the extent that we think of these disruptions as analogous to shocks to intermediation technology—and that is what the models of these kinds of credit channel effects generally tell you to do—it seems to me that we should see them as pulling down potential as well as actual output. I believe this point has been made at previous meetings. We have also talked before about the tenuous nature of the Phillips curve relationship, and it is difficult to forecast. The slope is sort of flat. We had been scheduled to discuss inflation dynamics, and we postponed that, for good reasons I believe. I hope we can get back to it soon because I think it’s going to be relevant to how we see our way through this. In any event, I think we should be careful not to be overly optimistic about the forecast of an inflation decline driven by a large output gap. The shift in the Greenbook’s long-term inflation projection is noteworthy for another reason, I believe. We are getting closer to a 1 percent target federal funds rate, and we may actually reach 1 percent at some meeting soon. The last time this happened it sparked a widespread discussion of and concern about the zero lower bound on nominal interest rates.

I want to make a couple of related observations. First, a key to conducting monetary policy at the zero bound is being able to keep inflation expectations from falling and thereby increasing real interest rates. From this perspective, the revision of the Greenbook’s forecast from 1.7 percent one meeting ago to 1.0 percent for five-year-ahead inflation implies that we run a monetary policy regime in which five-year-ahead expected inflation varies pretty significantly in response to contemporaneous shocks. I don’t think that variability in long-run inflation projections can help our ability to manage inflation expectations at the zero bound. We’d be better if we ran a policy in which long-run expected inflation was more anchored, more stable. You can tell where I’m going with this, I’m sure. This highlights the value of an explicit inflation objective as well as the value of being able to communicate clearly about how we view the functioning of monetary policy at the zero bound. Second, I will just note briefly that the economics of monetary policy at the zero bound are closely related to the economics of paying interest on reserves at close to the target rate. In fact, if I’m not mistaken, they are virtually identical. I think progress on both fronts would be useful right now.

Finally, let me just comment on financial market conditions. My sense is that what the public has seen—the large failures, the variety of resolution techniques, the deliberations leading up to the Congress’s adoption of the bill it adopted—taken together have added up to significant pessimism on people’s parts and have altered optimal strategy for a lot of financial institutions. So I think that is altering how people allocate portfolios and has led to further volatility in certain markets. It has led some institutions to adopt a wait-and-see attitude, to see how particular programs are going to be implemented. I think that we are seeing at least some dead-weight loss associated with the burdens of shifting financial flows between things that are covered and things that aren’t and we are seeing a good deal of rent-seeking behavior as well. What we are seeing is going to have the effect of masking the evolution of underlying fundamentals. It is going to make it harder to see our way through this and understand just what is happening. I think that is going to be a thicket that we will need to cut through in the months ahead. That concludes my comments, Mr. Chairman.

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