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

Thank you, Mr. Chairman. In my view, the decision we took on January 21 reflected a broad consensus that economic fundamentals were weakening at a rapid pace in an environment of continuing, even heightened, concern about financial market stress and fragility. My contacts over this last week in the business and financial markets may add a little texture to the picture on which we based our January 21 policy action. Conversations with these contacts in various industries provide information generally consistent with a downward revision of the outlook. Forward-looking sentiment of the directors of the Federal Reserve Bank of Atlanta turned decidedly pessimistic in January. Retail contacts noted quite disappointing results through mid-January and are taking a conservative approach to 2008 in terms of hiring and inventory. Regarding the residential construction industry, regional weakness continues and is spreading from coastal markets to interior markets. In addition, I had a conversation with the CEO of a large public homebuilder of national scope. He cited historically high contract cancellation rates, especially on the West Coast and the D.C. area, because of the buyers’ difficulty selling existing homes and getting financing. This limits their market to first-time buyers. His judgment is that a change in market atmosphere will require inventories falling to around six months. He pointed out that the spring is traditionally the key season for sales, so the next several months will be particularly telling.

Weakness in the region’s commercial real estate market appears to be spreading. The retail segment is continuing to experience declining leasing activity, and weakness is now emerging in the warehouse and office markets as well. In partial contrast, reports from the manufacturing sector are more mixed. Activity remains very weak in housing-related industries. One CEO, reflecting the concern of others, predicted business failures in lumberyards and construction supply firms because of excess capacity and the slow response to a lower building environment. The trucking sector continues to slump. However, industries related to oil and gas production; import-substituting industries, such as steel, aerospace, and defense; and the foreign brand auto sector are all performing quite well. Atlanta’s national forecast is largely consistent with the Greenbook in direction, and our differences with the Greenbook in magnitude and timing are not material. Like the Greenbook, we premise our forecast on a lower funds rate at the level of 3 percent.

So the principal risk to the forecast in my view is the fragility of the financial markets. Uncertainty and fear continue to loom large. I made a number of calls to financial market players, and my counterparts cited a variety of concerns relevant to overall financial stability. For instance, one of the recent concerns, as Bill Dudley depicted, has been the situation of the monoline credit insurers. Several of my contacts had comments, but I spoke to the newly appointed interim CEO of one of the two monoline insurance firms most prominent in the news, and he characterized the firm’s solvency and liquidity fundamentals as in question only toward the far end of current independent forecasts of subprime losses. Perhaps predictably, he contrasted his assessment with what he views as alarmist atmospherics resulting from press coverage, quixotic rating agency actions, and state regulator political positioning. A regional bank’s CFO cautioned that more data on actual mortgage performance in 2007 will soon be available, and that could force restatements in 2007 bank earnings. Commenting on market illiquidity, one source said that in some fixed-income markets, where many on the buy side currently depend on moderate leverage to achieve the required rates of return, banks have greatly reduced their lending. He also indicated that, even though there are real money investors—as he called them—interested in return to the structured-finance securities markets but currently on the sidelines, they are reluctant to expose themselves to volatility that arises under mark-to-market accounting using prices set in such illiquid markets. These anecdotal inputs simply point to the continuing uncertainty and risk to financial stability with some potential, I think, for self-feeding hysteria.

I share with my colleagues on the Committee worries about the heightened levels of inflation and uncertainties around my working forecast that inflation will moderate in 2008. The assumptions about energy prices are the most precarious. Nevertheless, I am prepared to take the position that the economy, with its apparently rapid deceleration compounded by continuing financial volatility, is a greater concern than inflation at this juncture. Thank you, Mr. Chairman.

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