Thank you, Mr. Chairman. Two personal notes to start: First, I am the last person between you and British food, which means that I’m not sure whether it is in your interest for me to speak quickly or slowly. [Laughter] Second, this week marks the first anniversary of the Committee’s last policy action—the quarter-point firming that brought the federal funds rate to 5¼ percent. Paper is the traditional present, and my gift to you is the material labeled “FOMC Briefing on Monetary Policy Alternatives.”
The intermeeting period saw considerable upward revision to investors’ expectations for the setting of monetary policy. As the shift from the dotted to the solid line shows in the top left panel of the first exhibit, the path of the expected federal funds rate rotated up, posting increases of 15 basis points at the end of this year and about 50 basis points by the end of next year. The starting point for both the May 8 and the June 26 lines, though, is the same: Market participants continue to believe that you will keep the federal funds rate at 5¼ percent at this meeting. Judging by the Desk’s survey of primary dealers, you are also expected to keep the wording of the statement mostly intact.
Not much of this rise in market yields occurred in narrow windows surrounding the release of economic data and speeches by monetary policy makers. Rather, the economic data, which ran somewhat stronger than anticipated, and Federal Reserve communications, with the steady repetition of the assessment that upside risks to inflation remained, seemed to induce a rethinking of the economy’s prospects and the attendant need for monetary policy support. This rethinking is most evident in the middle left panel, which shows that the latest primary dealer forecasts of the federal funds rate at year-end (the blue bars) have shifted notably compared with the survey forecasts just before the May meeting (the dashed line).
The revision to investors’ views was associated with the increase of 20 to 50 basis points in the nominal Treasury yields plotted in the right panel (and seen as the shift from the top dotted black line to the solid black line). The pricing-out of near- term policy ease probably explains the now-shallow portion at the front part of the yield curve. The rise in nominal yields can mostly be attributed to an increase in real yields of 30 to 50 basis points, shown in the lower portion of the same panel. Our term-structure models suggest that virtually all the rise in real yields is due to fatter compensation for bearing risk. Because the shifts in the two sets of yield curves did not match, the spread between the nominal and the indexed yields, which measures inflation compensation, widened somewhat at longer maturities. Here, too, the models suggest that some of that larger gap reflects a higher risk premium—this time for bearing inflation risk—leaving their estimates of inflation expectations only modestly higher.
In recent days, concern about risk-taking, brought into the spotlight by the problems of two hedge funds managed by Bear Stearns, reversed some of the upward tug of yields imparted by the revision to the outlook for the economy and policy. As can be seen in the bottom left panel, the cost of credit protection for subprime mortgage pools packaged over the past 1½ years has risen over the past few weeks as the fear of a fire sale of the collateral seized by lenders to the Bear Stearns funds depressed prices and raised concerns about a more general spillover to other entities and markets. These fears also seem to have set off flight-to-safety flows that pulled Treasury yields lower in recent days. As noted in the table at the bottom right, the ten-year Treasury yield had risen about 50 basis points from the May meeting to when we put the Bluebook to bed (the first column). The outbreak of skittishness in recent days trimmed several basis points off that run-up (the second column) and put equity prices into the red. I wonder if the recentness of these events, which unfolded after much of the staff briefing work was wrapped up and your own interventions were mostly written, means that they have not been completely incorporated into your outlook. If so, this nervousness in financial markets probably adds to the list of reasons for keeping a low profile in your policy action at this meeting by ratifying prevailing expectations—that is, to choose the unchanged policy stance of alternative B in the Bluebook.
Some of the other reasons are the subject of exhibit 2. In the staff forecast, summarized in the top left panel, output growth runs a bit below that of its potential in the near term, and inflation settles in at 2 percent. If you find that both a plausible and an acceptable outcome, you might also align yourself with the policy assumption of an unchanged federal funds rate upon which that forecast is based. Moreover, you were satisfied with keeping the funds rate at 5¼ percent at your May meeting. If you have filtered the incoming economic information in a manner similar to the staff— seen in the Greenbook as a slight upward revision to the growth of real GDP and a slight downward revision to core PCE inflation—you probably also believe that circumstances have not changed enough to warrant a recalibration of policy. It is true that financial market restraint has ratcheted up somewhat as investors’ forecast of the federal funds rate path has risen—proxied in the top right panel by the year-end expected federal funds rate in futures markets—but the staff expected this to happen over the next year or so, which has been a sentiment shared by some of you at the past few meetings. The adjustment in financial markets over the intermeeting period now brings market pricing into better alignment with the Greenbook assumption— shown by the black dots—and that this adjustment took place on a more compressed schedule than expected should probably not make for a material change to the outlook. As seen in the middle panel, the current real federal funds rate, at 3¼ percent, matches the Greenbook-consistent estimate of its equilibrium level. That is, if maintained, the current real rate would be consistent with the output gap closing within three years, at least in the Greenbook outlook. An unchanged nominal funds rate at this meeting is also consistent with many policy rules, including an estimated one that captures your practice over the past twenty years and that is plotted as the solid line in the bottom left panel. Of course, if you take into account forecast uncertainty, as is done by the light and dark green regions, you can pitch a pretty large tent with such policy rules. There is less doubt about the course of monetary policy in financial markets. As shown by the red bars at the bottom right, options on Eurodollar futures imply a distribution for the federal funds rate six months from now that is tightly clustered around the current setting. Here might be another reason for keeping the fed funds rate unchanged today: For all this year you have been hinting that prevailing market expectations for the fed funds rate were too low. Now that market participants have adjusted in your desired direction, you might not want to surprise them.
Many of you noted that problem with the version of table 1 that circulated in the Bluebook, a subject discussed in exhibit 3. In the May statement, inflation was characterized as “somewhat elevated,” as in row 3 of the left column. But favorable data since then have put the twelve-month change in core PCE inflation at 2 percent, a level that some of you might find tolerable. As yet the Committee has not spoken with one voice on the subject. We dropped that contentious phrase in the Bluebook and softened the balance-of-risks language as well. As a result, the release of the wording in the Bluebook version of alternative B would likely trigger a decline in money market yields. The new version of alternative B in the right column turns the heat back up somewhat by inserting in row 3 words to the effect that the Committee is not convinced that the present step-down in inflation will persist. This draft also makes clear in row 2 that the characterization of recent economic growth is based on the first half of this year and returns the language in row 4 to that used in the May statement.
Even if you are willing to keep the funds rate at 5¼ percent for now, you might foresee policy action sometime soon, in which case the changes to the statement probably do not represent your views. In particular, as shown in the top left panel of exhibit 4, the unemployment rate (the red line) has bounced around 4½ percent for almost a year. If you believe that this represents a taut labor market, you may be concerned about inflation pressures, particularly given that the manufacturing sector seems to have gone into a higher gear, as shown by recent readings on the ISM’s new orders index, the black line. You might not be alone in being concerned about inflation prospects. As plotted in the middle left panel, five-year, five-year-forward inflation compensation has risen 30 basis points from its recent low. It might be noise, it might be a wider risk premium, or it might be increased inflation expectations. If it is the last, you may want to position yourself now for policy firming sometime soon on the theory that an early demonstration of your displeasure with a rise in inflation expectations will effectuate a less costly decline. Some suggestions for doing so were offered in alternative C in the Bluebook, a few highlights of which are given in the bottom left panel. In particular, the alternative C draft reverses the order of the description of economic activity in row 2 to downplay the qualification “despite the ongoing adjustment in the housing sector.” More important, it retains the judgment that “core inflation remains somewhat elevated” and gives more reasons that inflation many come under pressure. If you have a frame of mind favorable to finer shades of meaning, you can always try dialing down the modifier of elevated inflation from “somewhat” to “slightly.”
More substantial changes might be required if you are inclined toward alternative A, arguments for which are shown in the right-hand column. Regardless of the reason behind the run-up in market yields, households borrowing to buy a house now face higher mortgage rates (as shown in the top panel). This may both dissuade potential new purchasers of homes and disappoint those households that were hoping to refinance on more-favorable terms as the lock-in periods on their extant ARMs end. Both will act as a drag on spending and perhaps more substantially so than in the staff forecast. Months’ supply of new homes, plotted in the middle right panel, has edged higher. The staff projection has the feature that the efforts of builders to bring inventories back into line will be a drag on production for some time but that residential investment will begin to turn up by the second half of next year. However, this is a projection, and if you are more pessimistic on that score or want to give greater weight to downside possibilities from a risk-management standpoint, you might want to show some leaning toward policy ease in the statement. The language of the draft statement in alternative A may do so. As summarized in the bottom right panel, that draft pointed to “ongoing weakness in the housing sector” in row 2, excises the reference to “somewhat elevated” inflation in row 3, and moves the risk assessment to balance in row 4.
The pieces of what I have just been talking about have been put together in your last exhibit, which represents an ever-so-slightly revised version of table 1 that circulated on Monday. In particular, in row 3 of alternative B, the word “sustained” has been inserted in the middle sentence to raise the bar as to what it takes for the Committee to be convinced that inflation has moderated. That concludes my prepared remarks.