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

Thank you, Mr. Chairman. Conditions in the Seventh District have improved modestly since my last report. The overall pace of business activity is still rather restrained, but we have seen some pickup in our manufacturing sector. The key issues regarding the national outlook are the same as the ones the last time we met. How will the residential investment puzzle settle out, and can we explain this puzzling weakness in business fixed investment?

Based on the data that we’ve received since March and my contact calls this round, I’ve become somewhat more optimistic about investment and somewhat more pessimistic about housing. At the same time, higher gasoline prices have the potential to weigh on consumer spending. So on balance our growth projection for ’07 and ’08 is a bit lower than it was in March. We now think that growth will average moderately short of potential over the remainder of ’07 and then run close to potential in 2008. However, our GDP numbers are a bit higher than the Greenbook’s, reflecting both a smaller shortfall from potential this year and a somewhat higher assumption about the rate of potential output growth.

Indeed, there has been some good news regarding the near-term outlook. First, the international outlook continues to improve. Many of our contacts noted exceptionally strong demand from abroad, particularly for capital goods. Second, although we’ve been actively looking for spillovers from the problems with subprime mortgages, we have not yet seen major effects on pricing or the supply of credit in other markets. That is not to say that we have not heard of any effects. One of our directors, the CFO of a major national homebuilder, noted that tighter underwriting standards are reducing housing demand somewhat outside the subprime sector. Consumers still appear to have ample access to financing. For example, the head of GM noted that banks were making more auto loans with six- or seven-year maturities in order to lower monthly payments for liquidity-strapped consumers.

Finally, as I noted earlier, we feel a bit more confident in our assumption that the weakness in BFI will turn out to be relatively transitory. I don’t want to make too much out of one month’s noisy data, but the latest readings on capital good orders and the PMI (purchasing managers’ index) were encouraging, and most of the comments from my business contacts have been positive in this regard. The impression I have from these discussions is that the pause in investment spending is showing early signs of ending; but this is very early, and we clearly need to keep monitoring developments carefully.

Beyond the near-term cyclical developments, the changes in structural productivity in the Greenbook highlight an important source of risk to the longer-run outlook for sustainable non- inflationary growth, as Janet just discussed. There is a lot of uncertainty about the components of structural productivity. In our view, we haven’t seen enough evidence yet to mark down structural productivity as much as the Greenbook has. Consequently, our estimate of potential output growth is a bit higher than that of the Greenbook.

With regard to inflation, the incoming information has caused the forecasts from our indicator models to come down a bit. They now project that core PCE prices will rise 2¼ percent this year and 2.1 percent in ’08. But we do not see any progress beyond that. If we carry our models out to ’09, they have inflation staying at 2.1 percent, higher than my preferred range. Furthermore, I see some upside risks to this forecast. Neither our GDP projection nor the Greenbook’s generates any meaningful resource slack over the projection period, and then there are the higher costs for energy and other commodities and increases in import prices. So we will be relying heavily on stable expectations to keep inflation in check. I believe we are currently achieving some implicit tightening of policy by keeping rates on hold during this period of sluggish activity, but this restraint will wane if the real economy returns to potential by early next year as we expect. So I continue to think that the risks to price stability dominate the risks to sustainable growth.

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