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

Thank you, Mr. Chairman. Since we met at the end of January, there has been an utter dearth of good news concerning both the real and the financial sides of the economy. On the real side, I just can’t recall any intermeeting period in which nearly every single data point was dismal. On the financial side, there have been occasional good days, but the net changes over the intermeeting period have been negative across the board in both the equity and the credit markets, so financial conditions have unambiguously tightened. These developments are familiar to all of us, and I won’t take up time to review the specifics.

My overall sense at this point is that the effects of the severe and prolonged housing downturn, the financial market implosion, and the price increases for oil and other commodities have now spread to most corners of the economy, including the major segments of consumption and business fixed investment. Exports represent about the only source of strength, and while that is welcome, I must say that the economy is pretty clearly in trouble when the contribution to real GDP growth from exports exceeds overall real GDP growth, as may well happen this year. The bottom line is that, like nearly everyone else, I have downgraded my economic outlook substantially. Assuming that the stance of policy is eased substantially at this meeting and additionally by midyear, I see the economy as essentially in recession during the first half before picking up somewhat in the second because of the effects of monetary and fiscal policy.

However, I certainly see large downside risks to my forecast, and I think the Greenbook’s view that recessionary nonlinearities have already set in seems to me to be within a reasonable range of outcomes. In fact, we have also been looking at monthly data on coincident business cycle indicators, and that examination suggests to us that the NBER may well date the beginning of the recession to last November.

The prospect of this outcome has been made more palpable for me by the rather sudden increase in the frequency and intensity of pretty dire comments I am hearing from my contacts. First, I have heard widespread reports of reductions in capital spending plans due to caution or pessimism regarding economic growth. For example, a large manufacturer and retailer of outdoor sports equipment reported that technology and infrastructure spending has been cut by at least a third in 2008. In another example, a large player in commercial real estate in the San Francisco Bay area described how projects are being canceled because the financing spigot has been shut. Indeed, nonresidential construction is one sector where I think the Greenbook may be too optimistic. I envision growing weakness there.

Second, my retail contacts suggest that spending has softened further in the wake of a weak holiday season, and expectations are for continued weakness at least through spring. For example, the CEO of a large high-end national retail operation reports that for January and February he has seen declines in sales that haven’t been experienced for almost fifteen years. These declines have created tremendous pressure on inventory levels requiring large markdowns with negative effects on profits. Vendors are reeling from the cancellation of orders, the return of goods, and sharp reductions in new orders.

Third, a number of contacts have provided comments reinforcing the view that a significant credit crunch is under way. Slightly more than half of the comments received on this topic indicate that credit standards have tightened significantly in recent months. In one example, the CEO of a bank in my District reports that several of the nation’s largest mortgage lenders have suspended withdrawals from open home equity lines out of concern that borrowers could now owe more than their homes are worth. As a final anecdote, a banker in my District who lends to wineries noted that high-end boutique producers face a distinctly softening market for their products, although sales of cheap wine are soaring. [Laughter]

Now let me turn to inflation and inflation expectations. Of course, much of the recent data have been disappointing, having been pushed up by rising energy and other commodity prices. Though I was heartened by Friday’s CPI report, this one observation hasn’t changed my overall impression that prospects for core inflation this year have worsened a bit since we met in January, and I have raised my projection for core PCE inflation about ¼ percent in 2008, to 2¼ percent. These data raise the issue of whether cutting rates as much as needed to fight a recession may risk persistently higher inflation and inflation expectations. But I tend to think this risk is manageable.

First, as I have said before, I view inflation as less persistent now than it once was, tending to revert fairly quickly to its longer-run trend. We have recently reviewed and updated our econometric evidence for this and found it to be even more convincing now than it was a couple of years ago. Of course, it is important to remember that the current lack of persistence presumably is due to our enhanced credibility, so we do have to be careful to maintain it. Recent increases in inflation compensation in Treasury markets highlight the risk that our attempts to deal with problems in the real economy possibly could lead to higher inflation expectations and an erosion of our inflation credibility. But inflation compensation is just one indicator of inflation expectations. I very much like the Board staff’s approach, which is in the current Bluebook, of combining the information from a wide variety of indicators into a principal- component-type model. I found it reassuring that the resulting index of inflation expectations and uncertainty is still within the range of variation that we have seen over the past decade or so.

Second, I tend to think that developments in labor compensation are an important part of the transmission process for monetary policy to inflation. Before we get into too much trouble with inflation and inflation expectations, I would expect to see labor compensation begin to rise more rapidly. I find it reassuring that both our broad measures of compensation have expanded quite moderately over the past year, and productivity growth has been fairly robust. So after incorporating its effects, unit labor costs are up less than 1 percent over the past four quarters.

Finally, the more pronounced slowdown that I expect for economic activity is likely to put somewhat greater downward pressure on inflation going forward. Overall, I expect core PCE inflation to fall below 2 percent next year under an assumed leveling out of energy and other commodity prices and the projected weakening of labor and product markets.

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