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

All in all, there still seems to be general agreement that the risks to inflation remain to the upside and remain the predominant concern. Is that a reasonable summary? Are there any comments?

Let me present just a few essentially random thoughts at this point. First of all, from my perspective, the biggest puzzle about what’s happening is the behavior of the labor market, which is continuing. We’ve had slow growth. Unemployment is at least not falling anymore, but it remains stable at a fairly low level. My scenario for the soft landing plus some moderation of inflation involves some cooling of the labor market from here. I still think it will happen, but admittedly, there is only the slightest suggestion so far that it is happening. In particular, we have not yet seen the decline of construction employment, which I have continually referred to and continue to expect. There have been a number of discussions about why we haven’t seen that response yet. Some have noted the possibility that a lot of the workers are undocumented and, therefore, are not being counted by the usual measures. However, they seem to have been counted when the market was expanding. So it is a little puzzling why suddenly they are not being counted. Thus I still think there will be some moderate softening in the labor market over the next year. If that does not happen, then we will be at some risk of higher upside growth than we anticipate and higher inflation pressures than we anticipate. So for me that is a central thing to look at. I think in talking about this, it is important to note how uncertain we are about what the natural rate of unemployment is and that entire concept. Judging from the FOMC’s 2009 projections, most of us think that the natural rate may be a bit below 5 percent, and I would note that the unemployment rate was in the mid to low 4s for four years in the late 1990s and has been in that range now for about two and one-half years. So it is not entirely evident where the natural rate is, and it does make some difference obviously. Again, I expect to see some moderation in the labor markets, and I believe that is critical to our scenario.

Like everyone else, I think the housing situation continues to involve downside risks. I would reiterate what President Poole said—that this is an asset market; that therefore price changes are inherently, at least to some extent, unpredictable; that a lot is going to depend on confidence, which is going to depend on results, which is going to depend on confidence; and therefore, that we need to be very careful, just the same as with inflation, about declaring victory too soon on the housing front. In particular, there is an interaction between the mortgage market and financial markets. There has been discussion of that already today, but there is the potential for some trigger to lead to what would amount to an effective tightening in financial markets, which would affect not only housing but also potentially, for example, corporate credits. Although that remains just a risk, I think it’s one we need to keep in mind.

I agree with the general view around the table that, except for housing, the economy looks to be healthy. Capital spending is not going gangbusters, but it does seem to have come back to some modest trend. I also agree with what a number of people said about the strength of the world economy. We shouldn’t get too carried away with the export sector. What we’re hoping for here is that net exports will not be a net drag on growth. [Laughter] Nevertheless, that is an improvement over the past, and the strong world economy should on net be helpful to our economy.

Like everyone else, I’m encouraged about the incoming inflation data. I agree that some of these good numbers may be partially transitory. However, when you analyze this, there has been a decided step-down in the past three or four months in the shelter component. I would make two observations. One is that, excluding shelter, core PCE inflation is now at the lowest number since the end of 2003; if the shelter numbers of the past three months were to persist, then that would automatically arithmetically give us some additional progress on inflation. Now, that may not happen. Clearly we have month-to- month variations, as we have mentioned many times; but I think some slack could combine with some more moderation in rents. On the inflation expectations issue, I thought David Wilcox’s graphs were very instructive. I do very much believe that inflation expectations influence actual inflation and that the anchoring of inflation expectations is very important. But I don’t think they’re anchored at 2.000; I think that they’re anchored at a general range somewhere around 2 percent. What David’s graph showed was that the level of expectations that we observe seems also to be consistent with 1.8 or 1.7. So I don’t think that’s an absolute barrier, though I concede that expectations play an important role. Two, I would also just comment about the statistical issue. I was among a number of people who talked about the statistical significance of the change in inflation that we have seen and noted that these month-to-month changes are subject to a lot of variable shocks. But let me just say that I think it’s probably worth noting that, in the classical statistical significance tests and everything we’re doing here, we’re Bayesian decisionmakers, and we’re trying to make a decision based on our best estimate of where we are at a given moment. Even if we concluded that inflation’s decline is not statistically significant in a classical sense, we still ought to act as if there has been some decline in inflation. As a thought experiment, I would ask what we would be saying now if we had gone up 0.6 percentage point from where we were in May. I think that would have led to a somewhat different tone around the table. So while acknowledging the statistical variability and the transitory nature, I think that there has been some improvement and that it is showing through into our thinking about the economy.

One last thought—a number of people have mentioned the distinction between core and total inflation. I agree that our communication on this issue really needs some work. I was just in Chicago, and several people, including directors and employees, asked me, “Don’t you guys drive? Don’t you eat?” [Laughter] Clearly, we understand why we do this, but I think we need to improve our communication on that particular front. That’s a little segue into what we’ll be talking about tomorrow. So if you will bear with me—I know it is six o’clock, but I’d like to ask Vincent just to give us a brief introduction to the monetary policy discussion we’ll be having tomorrow. That will save us some time tomorrow and give us a chance to think overnight about the subject.

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