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

Thank you, Mr. Chairman. My colleagues and I will be referring to the packet entitled “Staff Presentation on the Economic Outlook.” Your first exhibit summarizes our economic forecast. As shown in the top panels, we have edged up our forecast for the growth of real GDP this year and next. Taken by itself, the increase in interest rates that Bill Dudley mentioned was a negative for our growth outlook, but it was outweighed by a variety of other factors, including the higher stock market, the upward revision to wages and salaries, and the more favorable composition of real growth during the first half of this year. As shown in the middle pair of panels, we have trimmed our forecast of the unemployment rate—partly in response to the latest readings on this series and partly in light of the slightly stronger outlook for real output—and we now have it ending 2008 just below 5 percent, our estimate of the natural rate. As shown in the bottom right panel, core PCE inflation in the current quarter appears to be running at an annual rate of 1.4 percent, considerably less than the 2.2 percent we expected as of the May Greenbook. However, as I will discuss later in more detail, we have interpreted most of that good news as likely to prove transitory and so have taken down our forecast for core inflation over the projection period only 0.1 percentage point.

Exhibit 2 turns to the market for single-family housing. The yellow stripes in the top left panel mark major downturns in single-family housing starts since 1970. As can be seen in the box to the right, the current contraction now ranks among these major episodes in terms of magnitude. It differs importantly from previous ones, however, in terms of its origins because this one did not result from a round of monetary tightening aimed at taking economic activity down to bring inflation under control. That difference has important implications for the likely contour of the recovery. In earlier episodes, once the desired reduction in inflation appeared to be in train, the policy rate was brought back down and longer-term interest rates often came down as well. But this time, as shown in the middle left panel, with policy assumed to hold at its current position, we are not banking on any reduction in mortgage interest rates from here forward, suggesting that the housing recovery may be more subdued than it often has been in the past. One factor that poses some downside risk is the overhang of unsold homes, shown in the middle right panel. Months’ supply remains at a very high level. As we illustrated in one of the alternative simulations in the Greenbook, the contraction in the housing sector could be a good deal deeper than the one in our baseline if builders decide to bring inventories down more quickly. Another factor that will be important in shaping the recovery is the pace of sales, shown in the bottom left panel. In light of the tighter conditions in the subprime loan market and the recent backup in rates, we have sales moving a little lower over the next few months but then stabilizing and beginning to edge up around the turn of the year. The data on both new and existing home sales that were released earlier this week were consistent with our Greenbook forecast. I should also note the situation with regard to the price of single- family housing. As you know, home prices have decelerated greatly, and over the projection period, we have them remaining close to their current levels on a national-average basis. But our ability to judge the alignment of prices with fundamentals is limited, to say the least, and a substantial move downward is certainly possible. The bottom right panel illustrates that risk by presenting the estimated valuation error according to the very simple model that we showed you two years ago in our special presentation on housing. To be sure, other models deliver different answers, but this one judges the misalignment of the price-rent ratio to be historically large. If prices break more sharply because builders decide to clear out inventories more quickly, construction activity might well recover faster, even as other consumer spending is crimped by the damage to household balance sheets. Which effect would predominate in terms of overall aggregate demand is not entirely clear.

Exhibit 3 focuses on business fixed investment. As shown in the top left panel, sales of medium and heavy trucks have more or less fallen off a cliff thus far this year, reflecting the influence of new EPA regulations that took effect on January 1, and this has been an important factor holding down overall equipment spending. We think that this dynamic should be coming to a close over the next few months and are looking for truck purchases to begin trending up sometime during the second half of this year. As shown in the top right panel, orders and shipments of nondefense capital goods hit an air pocket around the turn of the year, apparently driven down in part by the trials of the motor vehicle and construction industries. However, the orders and shipments data for March and April—the latest that were available to us when we were putting together the Greenbook, encouraged us to think that a rebound of at least modest proportions is in train, and this morning’s release came in close to our Greenbook expectations. Moreover, surveys of business conditions, including the two orders-based indexes shown in the middle left panel, suggest that businesses concur that the situation has brightened somewhat in the past few months. As shown in the first line of the middle right panel, we are projecting that, over the next six quarters, equipment investment will post respectable—if unspectacular—increases. Two of the variables conditioning that view appear at the bottom of the page. As shown on the left, we expect real business output to grow a little more slowly over the forecast period than in the preceding few years, suggesting—all else being equal—somewhat more modest growth in investment than in earlier years. Similarly, as shown on the right, we expect the user cost of capital for high-tech equipment, the red line, to continue to decline at about the average pace of the past few years, and we expect the user cost for non-high-tech equipment, the black line, to be about unchanged, much as it has been over the past year and a half. All in all, these factors point to a steady outlook for business investment.

Exhibit 4 takes a slightly longer term perspective on the inflation outlook by comparing our current projection to the one that we had in the January Greenbook—the last time you submitted projections for a Monetary Policy Report. As shown in the top left panel, since January we have revised up our near-term forecast for overall PCE price inflation but not our longer-term outlook. Part of the near-term revision is due to faster food price inflation— the top right panel—which in turn reflects, among other things, the greater pressure that ethanol production has placed not only on the price of corn but also the prices of other foods that are produced using corn as an input, such as beef, dairy, and poultry. By the end of this year, though, we assume that the livestock and poultry sectors have adjusted to the higher level of corn prices, so we have food prices coming back in line with core inflation. Another part of the upward surprise in overall PCE inflation is due to a steeper climb in consumer energy prices—the middle left panel—reflecting crude oil prices that have been running about $10 per barrel above our January assumption and refinery outages that have kept utilization below typical levels. But as with food, we have energy price increases moderating greatly over the projection period.

Excluding food and energy—the middle right panel—core PCE price inflation has looked a little tamer thus far this year than we expected in January. Nonetheless, our projection for core inflation next year is unrevised, on net, relative to the January Greenbook. The absence of any net revision since January reflects a mix of considerations. For one thing, not all the news related to inflation has been good; both import and—as I just noted—energy prices have been running higher than we expected and thus have been generating more upward pressure on inflation than we had foreseen. For another, some of the recent good news seems likely to prove relatively short- lived. For example, as shown in the bottom left panel, nonmarket-based prices, which account for about 20 percent of the core index, have been rising less quickly thus far this year than we expected in January. Historically, however, fluctuations in nonmarket prices have not conveyed much information about the future behavior of this series, so we have trimmed our projection for the increase in this component of prices over the second half of this year by only a tenth. As shown to the right, both tenants’ rent—the black line—and owners’ equivalent rent, or OER—the red line—have decelerated lately but, as shown by the bars at the bottom of the panel, OER has slowed by noticeably more. Historically, differences of this magnitude have not persisted long—see, for example, the bulge that emerged and then disappeared in 2003; moreover, these divergences have tended to be resolved in favor of tenants’ rent. Accordingly, we expect the increases in OER over the projection period to look more like the recent increases in tenants’ rent rather than the other way around. In the end, these influences happen to roughly offset one another, leaving our core inflation projection for next year unchanged from January.

Exhibit 5 focuses on the recent behavior of inflation expectations and, as noted in the top left panel, asks whether those expectations have moved above levels that were typical from mid-1996 through mid-2004—a period when actual core PCE inflation was mostly between 1 percent and 2 percent. As noted in the last bullet in the box, the answer varies by series. In the next three panels, I use shaded bands to indicate levels of each series that were typical during the eight-year reference period—the darker bands marking the middle 50 percent of the series’ observations and the lighter bands marking the middle 80 percent of the observations. As shown in the top right panel, the short-term expectations measure from the Michigan survey of households has indeed been tending to run above the levels that were typical of the earlier period. Roughly, those higher readings seem to reflect the steep climb in energy prices over the past few years. In contrast, as shown in the middle left panel, longer-term inflation expectations from that survey have remained remarkably stable. They have drifted slightly higher relative to the levels that were typical during the reference period, but even so the latest reading sits just at the edge of its 50 percent band. The middle right panel shows a measure of short-term inflation expectations from the Philadelphia Fed’s Survey of Professional Forecasters; the most recent reading on this series is near the center of its 50 percent band. As you know, the measure of ten-year expectations from the SPF, not shown, has mostly been stuck at 2.5 percent since 1998 and was slightly below that in both the first and the second quarters of this year. Unfortunately, the TIPS market is too young to allow an apples-to-apples comparison on the basis used here. On the whole, however, we interpret the evidence as suggesting that inflation expectations have been quite stable recently. We assume that they will remain so over the projection period and thus will not be an important influence on the inflation contour this year and next. The bottom left panel plots our projection of the unemployment rate and our estimate of the NAIRU. We expect the small amount of upward pressure currently being generated from this source to be relieved over the projection period as the unemployment rate drifts up and resource utilization eases. The bottom right panel summarizes our inflation outlook. Relative to the May Greenbook, our forecast for core PCE inflation in 2007 as a whole is down 0.3 percentage point; as I noted earlier, our forecast for the second half of this year and for next year is down only a tenth. Nellie will continue our presentation.

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