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

Thank you, Mr. Chairman. My assessment of the economic outlook and the risks to it is largely unchanged since our last meeting. The data since that meeting have been mixed. On the one hand, the very sluggish real GDP growth in the first quarter gives me pause concerning potential downside risks. Much of the first-quarter weakness, of course, was due to housing, and I really don’t see that sector starting to turn around at this point. My homebuilder and banking contacts report stricter underwriting standards for all mortgages, not just subprime ones, so residential investment could remain a significant drag on the economy over the near term as the Greenbook now envisions. Indeed, whereas the Greenbook assumes that national house prices are flat going forward, I am worried that they may actually fall. On the other hand, the improved picture of auto inventories along with some positive glimmers on manufacturing and business investment suggests that those sectors may prove to be less of a drag on the economy going forward. With respect to inflation, the recent news has also been somewhat mixed with lower-than- expected readings on core consumer prices and labor compensation offset by higher prices for energy, other commodities, and imports.

Taking a longer view, I anticipate real GDP growth over the next two and a half years of about 2.6 percent, just a bit below my assessment of potential. My forecasts of both actual and potential growth are a tenth or two stronger than the Greenbook forecasts; but the basic story is very similar, and the underlying assumptions, including the path for the nominal funds rate, are essentially the same. I view the stance of monetary policy as remaining somewhat restrictive throughout the entire forecast period. The key factors shaping the longer-term outlook include continued fallout from the housing sector, with housing wealth projected to be roughly flat through 2008. Given the reduced impetus from housing wealth, household spending should advance at a more moderate pace going forward than over the past few years.

This slowdown in consumption is reinforced by more-moderate gains in personal income, as the unemployment rate gradually rises, reaching 5 percent in 2009. Although I anticipate that the labor market will remain fairly tight over the next year, I do not expect faster compensation growth to exert significant upward pressure on prices. I expect it instead to restrain profits, given that labor’s share of income is now at an exceptionally low level. I also anticipate that various temporary factors that have been boosting inflation, such as the run-up in owners’ equivalent rent and the pass-through of energy prices, should dissipate, while inflation expectations remain well anchored. Overall, I’m more optimistic regarding inflation than the Greenbook and anticipate that core PCE price inflation will edge down below 2 percent after next year.

One of the more interesting questions about the outlook, as David noted in the questions to him, is how to reconcile the strong labor market performance with the weak growth in output or, equivalently, how much of the recent slowdown in productivity growth is likely to persist. And that is something that we have been thinking about, too. Over the four quarters of 2006, nonfarm business productivity rose 1.6 percent, about half as fast as the average pace set from 2000 through 2005. Whether these recent lower numbers reflect a transitory drop in growth or a downshift in the trend rate is an important issue. A lot of excellent research has been done on this topic by staff at the Board and elsewhere in the System. My reading of the evidence at this point is that the recent decline in productivity growth does largely reflect cyclical factors. I think productivity growth has fallen significantly below trend because of labor hoarding and lags in the adjustment of employment to output.

We have also been giving close scrutiny to the behavior of the residential construction sector and productivity in that sector. My staff has done some work on estimating what productivity growth has been over the past year or so in residential investment and in the nonfarm business sector outside residential investment. They estimate that essentially all of last year’s slowdown in labor productivity growth is due to the behavior of productivity in residential construction. We estimate that residential construction productivity dropped 10 to 15 percent in 2006, whereas productivity in the nonfarm business sector outside residential investment was well maintained. Exactly why those lags exist, again, is a mystery to me as well as to David and others.

But going forward, it seems to us that, as the adjustment lags work themselves out, residential construction employment will likely post significant declines, and productivity in that sector and the economy as a whole will rebound. That said, the pace of structural productivity growth may also have declined slightly as the Greenbook hypothesizes. Relative to the second half of the 1990s, both the pace of productivity growth in the IT sector and the pace of investment in equipment and software have slowed, and these factors have probably depressed trend productivity growth slightly in recent years and are likely to continue depressing it somewhat going forward. But the hypothesis that the recent decline in productivity growth is mainly structural does not seem to me to square well with the broad range of available evidence. Recall that in the 1990s there was a whole constellation of evidence—including a booming stock market, robust consumption, and rapid business investment—that was consistent with a hypothesis of a lasting increase in the rate of productivity growth. In contrast, over the past year or so, business investment in equipment has been very sluggish and more so than seems warranted by the deceleration in business output. So such weakness could reflect lower assessments by companies of their ability to improve productivity through the installation of new capital, and that is, I think, consistent with the lower trend of productivity growth. But you would think that a marked slowdown in secular productivity growth would also result in downward revisions to the expected paths of future profits and real wages, weakening equity market valuations and crimping consumption growth. I have seen no signs over the past year that household perceptions of their future wealth accumulation have been downgraded.

In sum, the data seem consistent with the view that the recent slowdown in nonfarm business productivity represents a temporary cyclical drop that is concentrated in residential construction combined with a modest decline in the trend. So I remain optimistic that the underlying productivity trend is at or only slightly below 2½ percent.

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