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

Thank you, Mr. Chairman. In this forecast round, you, as policymakers, were faced with an identification problem similar to that which we, as econometricians, so often confront. Although the Greenbook forecast is essentially the same as it was in March, several observationally equivalent hypotheses could explain this outcome. First, abject laziness on the part of the staff; second, brilliant prescience on our part; or third, what I assume is your working null hypothesis— dumb luck. [Laughter] Well, I can assure you that abject laziness can be ruled out. It took much agonizing, endless meetings, and a lot of hard work to do nothing. We are, after all, still part of the federal government. [Laughter] As for prescience and luck, they did combine to leave the outlook pretty much as it was at the time of the last Greenbook. We still believe that the economy has been growing at a pace less than its potential, held down by the ongoing slump in housing activity. As the drag from residential investment abates, growth of real output is expected to pick up. But that reacceleration of activity is limited by a diminishing impetus to consumer spending from housing wealth and a reasonably restrictive monetary policy.

Let me begin by citing a few areas of the forecast in which developments have unfolded much as we had anticipated. I’ll then move on to some of the areas of notable surprise that luckily had offsetting effects on the outlook. First, the BEA’s advance estimate of real GDP in the first quarter showed an increase of 1¼ percent that was close to our forecast both on the total and in the particulars. As expected, the decline in residential investment took a significant bite out of first-quarter growth, as did net exports and defense spending. Outlays for equipment were also quite soft. We view the meager gain in real GDP posted in the first quarter as exaggerating the weakness early this year. In particular, we are anticipating defense spending to bounce back in the second quarter to a level more consistent with appropriations, and we expect net exports to largely reverse their first-quarter drop. As a consequence, we are projecting real GDP to advance at a pace of a bit more than 2½ percent in the second quarter. Smoothing through the temporary ups and downs, we believe that the economy probably has been expanding at a pace of about 2 percent in the first half of this year, the same rate that we had projected in the March Greenbook.

A second major piece of our story that appears to be receiving support from the incoming data is our forecast that consumption growth would slow noticeably. A projected step-down in the growth of consumption is an important reason that in our forecast, even as the housing contraction eventually wanes, growth in real GDP remains below the pace of its potential. Although it is far too early to claim victory, consumer spending on goods has flattened out in recent months after sharp increases at the turn of the year. The shallow trajectory of spending as we move into the second quarter, a lower level of real disposable income, and sluggish chain store sales suggest that our forecast of 2 percent growth of real PCE in the current quarter is within comfortable reach. However, I would like it noted for the record that I am not characterizing this as a “slam dunk.” [Laughter]

A third key element of our story in the last Greenbook was that, even though equipment outlays had weakened over the past few quarters, we did not believe that this weakness was the front edge of a more serious retrenchment in capital spending. In that regard, we received a bit of reassurance from an upturn in the shipments of nondefense capital goods in March and an even larger jump in new orders for these goods. Those data suggest that high-tech investment remains on a solid uptrend, whereas investment outside high tech and transportation seems poised for a modest upturn in the second quarter after sizable declines over the preceding six months. As expected, purchases of heavy trucks remain the area of most notable weakness. Needless to say, the data for investment are so volatile that we remain cautious about concluding that the downside risk to capital spending has abated much. But given our recent track record in this area, you might consider it good news when the staff reports no news.

A fourth element of our story that, at least for now, seems to be panning out is that the inventory overhangs that emerged in the second half of last year would be worked off relatively smoothly, rather than cumulating into something more serious. In the motor vehicle sector, steep production cuts in the second half of last year and early this year, coupled with a moderate pace of sales, have brought days’ supply of light vehicles down to comfortable levels. Indeed, the automakers have scheduled some increases in production in the current quarter. Outside motor vehicles, manufacturers appear to have adjusted production reasonably promptly to the unintended buildup of stocks. Indeed, manufacturing IP excluding motor vehicles declined at an annual rate of 1½ percent in the fourth quarter and increased only a paltry 2 percent in the first quarter. Some book-value measures of inventory-sales ratios remain elevated, but measures of days’ supply from our flow-of-goods system have shown an improvement that parallels reports from purchasing managers of fewer inventory problems among their customers. Moreover, factory output increased sharply in March, and the available physical product data and the readings from the labor market report point to another sizable increase in April. So the evidence seems to suggest that the inventory correction is abating. I should note that yesterday’s figures on wholesale inventories in March came in below what was assumed by the BEA in the advance estimate of GDP. All else being equal, those data suggest a downward revision in first-quarter real GDP growth of about ¼ percentage point. In response, we’d probably add a similar amount to our second-quarter estimate of real GDP.

Finally, another central element of our forecast has been that labor demand would slow in lagged response to the downshift in the growth of overall activity. We have been counseling patience in the face of data in this area that persistently surprised us to the upside. Last week’s labor market report provides at least a shred of evidence in support of our story. Private payrolls increased 63,000 in April, and there was a downward revision of 24,000 in February—leaving the level of employment below that incorporated in the May Greenbook. Gains in private payrolls have averaged about 90,000 per month over the past three months, and we expect that pace to be maintained over the remainder of the quarter. The unemployment rate increased to 4.5 percent last month, also in line with our projection.

Putting these pieces together, we are feeling a bit more confident of our story that activity is increasing at a subpar 2 percent pace in the first half of the year. We are also a bit less worried about the upside risks posed by labor demand and consumption and about the downside risks posed by investment spending and inventories—but just a bit less worried.

Our longer-term outlook has changed little as well. We have revised down our forecast for the growth of real GDP this year by 0.1 percentage point, to 2 percent, and revised up our forecast for 2008 by a similar amount, to 2.4 percent. I would like to argue that these very small adjustments are a testament to our prescience, but I’ll have to admit that we seem to have benefited more from dumb luck. In brief, the negative consequences of a weaker outlook for housing activity and higher projected oil prices were just about offset by the positive effects of higher equity prices and a lower foreign exchange value of the dollar.

Turning first to the housing market, the surprise has not been in actual construction activity, where starts have exceeded our expectations a bit. Rather, the real news has been on home sales—in particular, the sales of new homes. Not only did new-home sales drop in March to a level below our expectations, sales were revised down in the preceding months as well. As a consequence, the months’ supply of unsold new homes has moved up sharply further in recent months instead of tipping down as we had earlier expected. Moreover, sales cancellations, which had appeared to be heading down, turned back up in March. Some of this further weakening may reflect the continuing fallout from the pullback in subprime lending. But we also think that housing demand more generally has continued to soften. With sales now projected to flatten out a lower level than we had previously thought and with the months’ supply of unsold homes at a higher level, we anticipate that the production adjustment will be deeper and longer than was incorporated in our March forecast. Moreover, these developments also led us to trim a bit from our house-price forecast. Another source of downward revision in our outlook for real activity was a $6 per barrel increase in the price of imported oil over the intermeeting period. As Karen will discuss shortly, oil prices have backed off some since the completion of the Greenbook, but they are still running above our March forecast. The effect of higher crude prices has been amplified by a jump in gasoline margins. Those margins have soared as both planned and unplanned refinery outages have resulted in a substantial drop in gasoline inventories. All else being equal, higher consumer energy prices will likely put a noticeable dent in household incomes and consumer spending in coming months.

Of course, not all else has been equal. Stock prices are about 7 percent above the March Greenbook assumption, and in our forecast, the associated higher level of household net worth provides greater support to consumer spending and largely offsets the effects of lower real incomes. Another positive offset to weaker housing and higher oil prices is the lower projected path for the dollar. The dollar dropped about 2 percent over the intermeeting period and is expected to remain below our previous projection by about that amount. A lower dollar and the accompanying higher prices for imports provide added impetus to domestic production as foreign and domestic demands are shifted toward domestic producers. With near-term developments unfolding about as we had expected and our longer-term projection benefiting from some powerful crosscurrents, we continue to present you with a reasonably benign outlook. Growth slows but doesn’t falter as actual output moves into alignment with potential.

In contrast to our forecast of real activity, we have made some notable changes to our projection of overall price inflation in the near term. In particular, the recent run- up in gasoline prices is leaving a clear imprint on headline inflation. A steep jump in consumer energy prices is projected to boost overall PCE price inflation, which ran at a 3¼ percent pace in the first quarter, to a rate of 4¼ percent in the current quarter— an upward revision of 1½ percentage points from our March forecast. Meanwhile, core inflation has, on net, come in right in line with our expectations. The core measure for February was 0.1 percentage point higher than we had expected and for March was 0.1 percentage point lower. For the first quarter as a whole, core PCE prices increased at a pace of 2¼ percent, the same pace that we had projected in the last Greenbook. We are anticipating a similar-sized increase in the current quarter.

Looking ahead, I guess our luck with offsetting errors ran out when it came to the inflation forecast. We accumulated a number of small changes in the key determinants of our inflation projection, and for the most part, they pointed in the same direction. Higher energy costs, higher import prices, a bit tighter labor and product markets, and a slightly lower estimate of the growth of structural productivity suggest somewhat greater upward pressure on price inflation. Each of these influences was small, but taken together, they caused us to revise up our forecast for core PCE inflation by 0.1 percent in both 2007 and 2008. Despite these revisions, we continue to expect core price inflation to edge down next year, from 2.3 percent this year to 2.1 percent next year, as the effects of higher energy and import prices wane, as resource utilization eases a bit, and as inflation expectations hold roughly steady. Karen will continue our presentation.

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