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

Thank you, Mr. Chairman. The contours and basic outcomes of Atlanta’s forecast are similar to the baseline of the Greenbook forecast. So I want to focus my remarks this morning on the underlying assumptions in both forecasts—assumptions that I view as pivotal and if we miscalculate could result in a longer-term policy error.

It seems that at every meeting there’s great uncertainty around the outlook, and this juncture is no different. I perceive considerable uncertainty and debatable assumptions in the base-case scenario. As I see it, the key assumptions broadly are that housing stabilizes, perhaps as indicated by housing prices, in the second half of ’09. Inflation pressures intensify in the near term but then abate because of economic slack and lower commodity prices and, as discussed, core import prices. Recent declines in oil prices stick, and prices remain more or less flat. Certainly since the Greenbook was published, we note the fluctuations just in the past few days that were referred to earlier, and I also can’t dismiss geopolitical risks and the potential of a severe shock. Finally, financial market stress will persist for some months but diminish next year. These assumptions, using the respectable term “assumptions,” have the feeling to me of “bets,” not so respectable a term. The policy assumption integral to both the Greenbook and the Atlanta forecasts could be added to this, and that is that rate rises starting in 2009 won’t choke off improving growth and will be enough to blunt remaining inflation pressures.

So I’ll devote my comments to input from regional and other contacts that either serve to confirm or cast doubt on these assumptions. We oriented this cycle’s questions to our Atlanta and Branch directors to, first, evidence of wage pressures and pass-through of higher costs. In interpreting the feedback, we noted some confusion between a business’s management of its labor costs versus general wage pressures. We heard that businesses are working to keep their total wage bills in check by raising wages for key talent but letting less critical employees go or cutting their work hours as an offset. The reduction in hours is attributed to some combination of weaker product demand and increased average productivity. Rising unemployment appears to be keeping wage demands in check. There are exceptions, such as the oil field services industry, for which qualified staff are in short supply, and certain skilled industrial and business trades in which local bottlenecks exist. In businesses enjoying strong export demand, some employers are utilizing bonuses rather than commitment to permanent wage increases. So our regional contacts did not indicate the development of broad-based underlying pressures on labor costs reflecting wage demands. As for inflation pass-through, our contacts reported widespread and growing efforts to pass through higher input costs. Pass-through efforts appear to be the rule rather than the exception. As one Branch director put it, people are passing through costs like crazy using high energy costs as cover.

The reports of my supervision staff regarding banking conditions indicate a continuing decline in asset quality and a very nervous interbank funding market. Foreclosed properties, both single-family and condo, are making up the majority of house sales and slowing the absorption of the oversupply of new homes. Some contacts are very concerned about the prospect of a second wave of foreclosures as option ARM mortgage borrowers, mostly concentrated in large states like Florida and California—these are borrowers who are currently paying less than the accrued interest—run up against maximum loan-to-value ceilings. New, higher GSE standards are resulting in fewer borrowers being qualified, putting downward pressure on house prices and bringing more foreclosures. Virtually all comparables for Florida residential valuation are based on forced sales and foreclosures, we are told. Beyond the deterioration in real estate portfolios, banks are reporting growing problems in credits to food distributors, restaurants, trucking, and other petroleum fuel or input-intensive industries.

Based on my calls with financial market contacts, it seems that—no surprise—much of the attention in financial markets has shifted from private fixed-income markets to Fannie and Freddie. Fixed-income markets for private securities appeared to have improved relative to their lows since the current financial turmoil began. Although significant concerns remain, it appears that leveraged-loan deals are getting done. Volume is down, spreads are up, and the deals are very conservative, but deals are getting done. That said, one of the patterns in my calls over the past year has been that, every time one concern abates, another seems to jump up and take its place. Although the recent legislation appears to have alleviated concerns about the Fannie and Freddie senior debt, my contacts indicate that there is widespread uncertainty about what will happen to junior securities if the Treasury injects funds. Furthermore, more than once I heard the view that foreign holders of GSE debt are concerned that their positions are not as safe as they believed. One contact mentioned that the 18-month term of the guarantee is reportedly affecting some holders’ maturity choices. In response to my question about the relative weakness of European banks, one contact suggested that they have booked much of their troubled assets in the “hold to maturity” account, suggesting slower recognition of losses and difficulties ahead. We confirmed with one large regional bank CFO significant deterioration of HELOCs in their portfolio and, by implication, broadly among regional banks. The option ARM problem, by contrast, is perceived to be possibly the next shoe to drop but, as I said earlier, not uniformly distributed across the country. Finally, we heard the view that markets perceive banks as facing protracted difficulty raising capital.

To conclude, the downside risks to growth have not diminished in my opinion. On the flip side, I agree that the upside risks to inflation are obviously a serious concern. In particular, I put a fair amount of weight on the possibility that inflation will not moderate sufficiently without a more substantial tightening of monetary policy than that projected in the Greenbook baseline. My intermeeting internal and external discussions make it difficult for me to dismiss some of the alternative scenarios in the Greenbook, specifically the “severe financial stress” scenario, the “typical recession” scenario, and the “inflationary spiral” scenario; and in a high-uncertainty environment, I don’t view any of these scenarios as exclusive of another. That said, I see the risks to both the inflation and the growth objectives as very roughly in balance at this time. Thank you, Mr. Chairman.

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