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

Thank you, Mr. Chairman. I broadly agree with the Greenbook forecast for economic growth this year and with the assessment that the downside risks to that forecast are considerable. The severe and prolonged housing downturn and financial shock have put the economy at, if not beyond, the brink of recession. My forecast incorporates fiscal stimulus of the same magnitude as the Greenbook and monetary stimulus that is somewhat larger. I have assumed a 50 basis point cut at this meeting and an additional 25 basis point cut during the first half. My forecast shows growth of 1½ percent in 2008, like the Greenbook, but it has a more pronounced acceleration in 2009 as the monetary and fiscal stimulus kickstarts the economy. The unemployment rate edges up this year to 5¼ percent before dropping gradually next year toward the natural rate of 4¾. I am especially concerned about the outlook for consumer spending. The combined hits to equity and housing wealth will extract a considerable toll, and consumer spending will be further depressed by slower growth in disposable income due to weaker employment growth. Delinquencies and charge-offs on most forms of consumer debt have already risen, and slower job growth seems likely to exacerbate this trend, prompting financial institutions to further tighten credit standards and terms. In my forecast, such developments reverberate back negatively onto economic activity.

Like the Greenbook, I downgraded my economic outlook substantially since our last in- person meeting. The December employment report was probably the single most shocking piece of real side news prompting this revision. But knowing that it is unwise to put too much weight on any single piece of data, I have been examining the question of whether that report was more signal or noise. The drop in initial UI claims to relatively low levels in recent weeks makes such an assessment important. Because the behavior of both series may have been affected by seasonal factors near year-end, it seems worthwhile to examine a broad range of data bearing on the labor market. My conclusion is that the labor market has indeed been weakening since mid-2007, and the extent of weakening, while relatively modest thus far, is quite typical of patterns seen when the economy is tipping into recession.

Independent evidence of a weakening in the labor market comes from the household survey. Even when adjusted for definitional and measurement differences from the payroll survey, the household survey shows a fairly smooth trend of declining employment growth during 2007. The drop in payroll employment in December helped bring the establishment data into closer alignment with the household employment data. In the payroll survey, the slowdown is concentrated in construction and finance. In the household series, higher unemployment is actually widespread across sectors. The household survey also contains other signs of a weakening job market: a 25 percent increase in the unemployment rate for job losers, which accounts for the lion’s share of the overall increase in aggregate unemployment; an increase in the number of newly unemployed job losers, which can be thought of as a broader measure than UI claims of inflows into unemployment; and an increase of 5 to 10 percent in the estimated expected completed duration of an unemployment spell, suggesting a reduced pace of outflows from unemployment. The labor force participation rate of men and women of age 16 to 24 years has also fallen notably in recent months. Labor force participation rates for this group have been edging down since the last recession, but the decline accelerated in 2007, and historically this group is among the first to respond to weakening labor market conditions.

Data from the JOLTS survey, which we discussed in the Q&A round, confirm the weakness revealed elsewhere. The job openings, or vacancy, rate is down, consistent with the reduced pace of outflows from unemployment, as reflected in continuing UI claims and unemployment durations, and layoffs and discharges are up sharply. Other data cited in the Greenbook, Part 2, such as net hiring plans for Manpower, and NFIB and survey measures of job availability and unemployment expectations further corroborate a slowdown. With the aggregate unemployment rate now up only 0.6 percentage point off its low, I would describe the deterioration in the labor market thus far as modest, but it is noteworthy that an increase in unemployment of this magnitude, in the space of 12 months, has occurred only twice since 1948 outside of recessions.

While my modal scenario contains a near-term slowdown rather than a contraction, it is actually pretty rosy compared with what I fear might happen. My contacts have turned decidedly negative in the past six to eight weeks, and further financial turmoil may still ensue. On consumer spending, two large retailers report very subdued expectations going forward following the weak holiday season, which involved a lot of discounting. On hiring and capital spending, my contacts have emphasized restraint in their plans due to fears that the economy will continue to slow. A serious issue is whether the tightening of credit standards that is under way will deepen into a full-blown credit crunch. The new Senior Loan Officer Opinion Survey shows a noticeable tightening in lending standards, and this is confirmed by my contacts. For example, senior officers of a large bank in my District recently described a variety of new steps they are taking to protect against credit losses. They are tightening underwriting practices across the entire consumer lending and small business loan portfolio. A recent strategy has involved classifying MSAs according to whether their real estate markets are stable, soft, distressed, or severely distressed, using both historical and prospective views of property values. Based on these designations, the company has reduced permissible combined loan-to-value ratios in their home equity portfolio, and going forward they intend to apply them across the entire consumer portfolio. On the positive side, though, they note that lower interest rates have spurred a surge in applications for mortgage refinancing, and a recent analysis shows that the reduction in the prime rate is having a significant impact on ARM reset expectations, shifting a large number from increases to reductions at reset. In fact, an analysis conducted before our most recent rate cut that assumed a 7 percent prime rate in February 2008—and it is now at 6½—estimates that two-thirds of the subprime ARM portfolio would now experience a decrease in their monthly payments at reset. This is a sharp contrast from an analysis in June 2007 with a prime rate of 8 percent.

Now let me turn briefly to inflation and inflation expectations. I project that inflation will decline over the forecast period to around 1¾ percent, and I see the risks around that forecast as balanced. Admittedly, though, the recent data on inflation have been worrisome, and they raise the issue of whether or not we can afford to cut rates as much as needed to fight a recession without seriously risking a persistently higher rate of inflation and inflation expectations. I tend to think this risk is manageable, largely because of the credibility we have built. It appears to me that this credibility has reduced the response of inflation to all the factors thought to influence it, including energy prices, the exchange rate, and business cycle conditions. Thus I consider it less likely that rising energy prices are going to push up core inflation very much or that the pass- through that does occur will easily get built into inflation expectations. So I view inflation as less persistent now than it once was, tending to revert fairly quickly to the public’s view of our inflation objective. I do hope that our long-run inflation forecast will help people identify what that objective is. But even if inflation expectations turn out to be less well anchored than I think, I still see the inflation risk going forward as roughly balanced. With less well anchored inflation expectations, there is greater risk that higher energy and import prices will pass through into core inflation and inflation expectations. By the same token, there is also a greater likelihood that inflation will decline should a recession occur. We looked at the behavior of core and total inflation in the first three years following recessions from 1960 to the last one in 2001, and inflation declined in most of these episodes. The exception is 2001, when core inflation remained essentially unchanged—which seems consistent with my view that inflation has become less responsive to the business cycle over the past decade or so as we have acquired more credibility.

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