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

Thank you, Mr. Chairman. Economic activity in the Eighth District has remained roughly stable during the summer. Activity in the services sector has increased slightly, and except for the auto industry, manufacturing activity is also stable to slightly higher. Automotive contacts reported a variety of plans to lay off workers or to idle production, and at least three automotive parts suppliers will close plants in the District. Contacts in the auto industry are not optimistic that production will increase in the short term. Retail and auto sales have softened in recent weeks, and some District retail contacts have expressed concerns about summer sales. Many contacts continue to emphasize commodity price levels as a key factor in business decisions. They are concerned both about the necessary business adjustments, given the new pricing structure, and about the implications for the overall level of inflation going forward.

The residential real estate sector continues to decline. Across four of the main metropolitan areas in the District, home sales through May declined about 18 percent compared with 2007, whereas single-family construction permits declined about 40 percent. The number of foreclosures in the St. Louis area in the second quarter increased to about 6,300 filings, up about 77 percent from last year. I am impressed, however, with the regionalism in the foreclosure situation, as some areas of the nation continue to have far higher foreclosure rates than others. In contrast with the generally positive reports in commercial real estate activity for the earlier part of 2008, recent reports have indicated more uneven conditions in the nonresidential real estate sector across the District.

Turning to the national outlook, I was encouraged by the recent GDP report for the second quarter, which showed growth at an annual rate of 1.9 percent. Real final sales increased at an annual rate of 3.9 percent. It now appears that the worst quarter associated with the current episode of financial turmoil was probably the fourth quarter of 2007, when the economy abruptly stalled. The slow- or no-growth period was through the winter, with the economy gradually regaining footing through the spring and summer. If there were no further shocks, I would expect the economy to grow at a more rapid rate in the second half of this year. But there has been another shock—namely, substantial increases in commodity and energy prices. I think it’s important to be careful not to confuse the effects of this latter shock with the effects of the housing-sector shock.

My sense is that the level of systemic risk associated with financial turmoil has fallen dramatically. For this reason, I think the FOMC should begin to de-emphasize systemic risk worries. My reasoning is as follows. Systemic risk means that the sudden failure of a particular financial firm would so shock other ostensibly healthy firms in the industry that it would put them out of business at the same time. The simultaneous departure of many firms would badly damage the financial services industry, causing a substantial decline in economic activity for the entire economy. This story depends critically on the idea that the initial failure is sudden and unexpected by the healthy firms in the industry. But why should this be, once the crisis has been ongoing for some time? Are the firms asleep? Did they not realize that they may be doing business with a firm that may be about to default on its obligations? Are they not demanding risk premiums to compensate them for exactly this possibility? My sense is that, because the turmoil has been ongoing for some time, all of the major players have made adjustments as best they can to contain the fallout from the failure of another firm in the industry. They have done this not out of benevolence but out of their own instincts for self-preservation. As one of my contacts at a large bank described it, the discovery process is clearly over. I say that the level of systemic risk has dropped dramatically and possibly to zero.

Let me stress that, to be sure, there are some financial firms that are in trouble and that may fail in the coming months or weeks depending on how nimble their managements are at keeping them afloat. This is why many interest rate spreads remain elevated and may be expected to remain elevated for some time. These spreads are entirely appropriate for a financial system reacting to a large shock. But at this point, failures of certain financial firms should not be regarded as so surprising that they will cause ostensibly healthy firms to fail along with them. The period of substantial systemic risk has passed. Of course, we have also endured a bout of systemic risk worries stemming from the operations of the GSEs. However, my view is that the recent legislation has addressed the systemic risk component of that situation as well. Because of these considerations, my assessment is that the chances of unchecked systemic risk pushing the U.S. economy into a severe downturn at this point are small, no larger than in ordinary times.

Unfortunately, while the threat from this source is retreating, another threat is upon us— namely, a substantial shock from increased energy and certain commodities prices, which is leading many to forecast slower growth during the fall. Real automotive output subtracted 1.1 percentage points from real GDP growth in the second quarter. Many contacts seem to attribute this largely to consumer reaction to increased gasoline prices. If this is true, then it seems to me that some of the most visible reaction to this shock may have already occurred, being pulled forward into the second quarter.

Labor markets have been weak, but I am not as pessimistic as most on this dimension. So far this year, the U.S. economy has shed about 387,000 nonfarm payroll jobs as compared with a drop in employment of 402,000 jobs during the first seven months of 2003 or 315,000 during the first seven months of 2002. Neither of these latter two episodes is associated with the recession label. These two years might provide better historical guides to the behavior of today’s economy than those associated with the recession label, such as 2001, 1990–91 or 1980–82. This is one reason that I think the labeling game can mislead us in our thinking about the economy.

The main contribution that the FOMC can make to the economy is to keep inflation low and stable. The headline CPI inflation rate is running close to 5 percent measured from one year earlier. The University of Michigan survey of inflation expectations one year ahead reflects this reality with the most recent reading at 5¼ percent. The June CPI annualized inflation rate was a 1970s- sounding 13.4 percent. Of course, much of this is due to energy prices. Still, with these kinds of numbers we’re going to have to do more than talk about inflation risks. Thank you.

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