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

Give me one second. On balance, the news we have received since the December Greenbook has been disappointing. The top panel of your first exhibit sorts some of the main indicators into two categories—those that were surprisingly weak and those that came in to the upside of our expectations. As you can see, the list to the left is long. Private payrolls fell in December, and the unemployment rate jumped to 5 percent. Manufacturing output has declined since the summer. Single-family housing starts, new permits, and home sales have fallen further. New orders and shipments of capital goods were disappointing, although a little less so after today’s release of December data. Business sentiment deteriorated, joining already unusually low readings on consumer confidence. Finally, stock prices have tumbled, and credit conditions have tightened. Not all the news was bad. Nonresidential construction activity has continued to be surprisingly robust, and defense spending looks to have been higher last quarter than we anticipated. Moreover, retail sales in November came in stronger than we predicted, and the figures for September and October were revised up. Overall, we read the incoming data as implying an increased risk of recession. The middle left panel provides some evidence for this assessment. As was discussed at yesterday’s Board briefing, based on the signal provided by 85 nonfinancial indicators (the black line), the estimated probability of being in recession now or over the next six months stood at 45 percent in December, up from 19 percent in June. A similar exercise carried out using 20 financial indicators, the red line, yields an even bigger jump in the estimated likelihood of recession, from 14 percent at midyear to 63 percent this month.

As you know, we are not forecasting a recession. While the model estimates of the probability of recession have moved up, they are not uniform in their assessment that a recession is at hand. Another argument against forecasting recession is that, with the notable exception of housing, we see few signs of a significant inventory overhang. In addition, the recent weakness in the labor market and spending indicators is still limited; for example, initial claims have drifted down in recent weeks rather than surging as they typically do in a major downturn. Finally, a good deal of monetary and fiscal stimulus is now in process that should help support real activity. That said, it was a close call for us. Even without a recession, our assessment of the underlying strength of aggregate demand has revised down markedly since the summer. This is illustrated in the bottom panel by the recent decline in the Greenbook-consistent estimate of short-run r*, the value of the real funds rate that would close the output gap in 12 quarters. By our estimate, short-run r* has fallen more than 2 percentage points since the middle of last year and 1¼ percentage points since December. A jump in the equity premium accounts for most of the downward revision since the last Greenbook, although a further deterioration in the outlook for residential investment is also a factor.

Your next exhibit summarizes the current forecast. So, how did we respond to all this bad news? As shown in the panel at the top, we boosted real GDP growth a little from 2007 through 2009. In 2008 and 2009, however, this faster growth is not demand driven but instead reflects upward revisions to the supply side of our forecast that I will discuss in a moment. For 2007, the upward revision to real GDP in the fourth quarter—noted in the panel to the right—reflects the stronger data on nonresidential construction, defense spending, and retail sales that I just mentioned. However, because the incoming data point to a weaker trajectory for real activity in the near term, we have trimmed our forecast of GDP growth for the first half of 2008, and we have marked down final sales growth (not shown) quite a bit. Beyond the middle of the year, we project real output to expand at a rate close to its potential. Under these conditions, we project greater labor market slack than in December, with the unemployment rate—shown in the middle left panel—now expected to edge up to 5¼ percent by next year. And as shown in the bottom two panels, we continue to expect both core and total PCE prices to decelerate noticeably by 2009, although inflation this year is likely to run a little higher than we previously projected.

Your next exhibit provides an overview of some of the key factors influencing the outlook. As shown in the upper left panel, we conditioned our forecast on an additional 50 basis point cut in the funds rate at this meeting and then held it flat at 3 percent. We made this revision in response to the weaker underlying level of demand in this projection but with an eye to keeping inflation on a long-run path to 1¾ percent—the midpoint of the range of 2010 inflation projections that you provided in October. Another key element in the outlook is our assumption that concerns over financial stability and a possible recession will begin to abate once the economy gets through a rough patch in the first half of this year. As Nellie will discuss in more detail, this assumption implies that risk premiums on bonds and corporate equity should drift down over time. As a result, we project that equity prices, shown to the right, will stage a partial recovery over the second half of 2008 and in 2009. These and other financial market developments, coupled with an improvement in business and consumer sentiment, should help to support consumption and investment over time.

As regards fiscal policy, odds now seem high for the passage of a fiscal stimulus package, although the details are still up in the air. As a placeholder, we built a $125 billion package into the baseline, with two components—$75 billion in tax rebates that households will receive in the third quarter and a 30 percent one-year bonus depreciation allowance that should cost the Treasury about $50 billion in 2008. Our judgment is that the rebate component will provide a significant, albeit temporary, boost to the level of consumer spending during the second half of this year and in early 2009, the period over which we expect most households to spend their checks. In contrast, we think that bonus depreciation will have only a small effect on equipment and software outlays. As indicated by the blue bars in the panel to the right, these assumptions imply a large fiscal-driven contribution from PCE and E&S to real GDP growth in the second half of this year, followed by a similar-sized negative contribution in the first half of 2009. As a result, the long-run contribution to real GDP growth from these two factors is essentially zero. We have assumed that inventories and imports in the short run will offset a substantial fraction of the swings in domestic demand, thereby muting the overall effect of the fiscal package on real GDP growth (the green bars).

As I noted earlier, we also have reassessed our supply-side assumptions—shown in the bottom left panel. Specifically, we have raised our estimate of potential output growth from 2005 to 2009 about ¼ percentage point per year, partly in response to the solid gains in output per hour recorded last year. These revised estimates have two important implications. First, the upward revision to potential output translates roughly one for one into faster growth in actual output during the projection period because of its implications for permanent income and hence consumption and investment. Second, the revisions to potential output in history imply that the output gap—shown to the right—currently is lower than we previously thought, and we expect it to remain lower.

Your next exhibit provides some details on the real-side outlook. As shown in the top left panel, we have once again revised down the projection for new home sales in light of weak incoming data, including those received after we put the Greenbook to bed. However, we continue to expect that sales will reach bottom in the first half of this year and then begin to edge up as mortgage credit availability improves. This stabilization in demand should allow single-family housing starts (shown to the right) to level out at about 660,000 units by midyear, well below our December projection. Thereafter, we anticipate a slow pickup in starts. As shown in the middle left panel, builders still have a long way to go to bring the backlog of unsold homes down to a more comfortable level, and this overhang should restrain construction activity into next year. We have also revised down the near-term outlook for real business fixed investment—the middle right panel—in response to slowing sales, tighter credit conditions, and some deterioration of business sentiment, but we now expect a greater cyclical rebound starting in the second half of this year as overall conditions start to improve. The bottom left panel shows our projection for consumption, the blue bars, together with the profile for spending excluding the effects of fiscal stimulus, the green bars. Absent the stimulus package, we would expect consumer spending to increase only 1 percent this year but then to pick up around 2¼ percent in 2009 as confidence recovers and credit conditions ease. However, the tax rebates will likely obscure this cyclical pattern by inducing saw-tooth swings in spending, with actual growth realigning with longer-run fundamentals only in the second half of next year. As shown to the right, some of these fundamentals are less favorable than before; we estimate that wealth effects will hold down PCE spending growth by ½ percentage point this year and almost ¾ percentage point in 2009.

Your next exhibit reviews the inflation outlook. As indicated by the blue line in the upper left panel, monthly readings on core PCE inflation have moved up since the summer. We are inclined to take only a small signal from this movement, much as we did early last year when price increases were unusually subdued. In part, this is because a portion of the recent pickup was attributable to the erratic nonmarket component and quarter-to-quarter fluctuations in this category tend to fade away quickly. In addition, while market-based prices also came in higher than expected, we are interpreting some of that surprise as a reversal of some earlier low readings in particular categories. That said, we also think that a portion represents somewhat more persistent inflation pressure coming into 2008. We project both core and total PCE inflation to moderate over time because of several factors. To begin with, futures prices for crude oil imply the sharp deceleration in energy prices shown to the right. We also expect food prices (the middle left panel) to decelerate into 2009, partly as result of the increased production of beef and poultry that is now under way. In addition, the impetus to inflation from core import prices (the middle right panel) should diminish over time, although by less than projected in December because we now anticipate a faster rate of dollar depreciation. These developments, coupled with the additional economic slack built into this projection, should help to keep inflation expectations anchored, allowing actual inflation to fall below 2 percent in the longer run. Indeed, survey measures of long-run inflation expectations (the blue and red lines of the bottom left panel) remain stable. TIPS inflation compensation (the black line) jumped following the intermeeting fed funds rate cut, as Bill pointed out. But as was discussed in the memo by Jonathan Wright and Jennifer Roush that was circulated to the Committee, we are inclined to attribute most of this increase to changes in inflation risk and liquidity premiums, not to a rise in inflation expectations per se. Putting all this together, we project core inflation—the first column of the panel to the right—to remain at 2.1 percent this year but then to drop down to 1.9 percent next year, the same as in December. Similarly, we continue to expect that headline inflation will slow to 2¼ percent this year and slide to 1¾ percent in 2009 as energy prices moderate. I will now turn the floor over to Nellie.

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