Commercial real estate activity generally remains solid, although some observers expressed concern about the sustainability of the quite strong pace of office construction in Northern Virginia. Our survey measures of manufacturing-price trends seem to have moderated since the beginning of the year, consistent with sluggish demand in that sector. On the services side, price trends seem to have declined somewhat since the first half of last year, although measures of services prices have been choppy and trendless over the past few months as a whole.
Turning to the national economy, housing news has been disappointing, but news about business investment and manufacturing has been encouraging. However, the overall outlook hasn’t changed terribly much since our last meeting. Housing begins to stabilize in the second half of this year, business investment in equipment and software picks up, and consumer spending remains relatively healthy. As a result, I expect real growth to return to trend in ’08. Although my outlook broadly agrees with that of the Greenbook, there are some minor differences—but I should emphasize that they are minor. First, I remain a tad more optimistic about trend growth. I’m expecting something closer to 2¾ than to 2½. Second, I still think that residential investment will bottom out in the middle of the year rather than continue to slide into ’08. Of course, it is quite difficult to have a lot of confidence in any one scenario for the housing market, in part because the recent data have been fairly choppy. The figures for homes sales, which late last year suggested that housing demand had stabilized, now suggest that demand may be taking another step downward. If so, this would increase the size of the cumulative reduction in starts relative to new-home sales that will be needed to work off the inventory overhang. It’s very hard to know, however, just how far housing activity needs to fall before it comes back into stable alignment with income and preferences. But my hunch is that the drag on growth will not last quite as long as the Greenbook says, and I still see reasonably good prospects for stability in the housing sector in the second half of this year. I also think that the housing correction will have only limited effects on spending outside residential investment. In particular, I’m a bit more optimistic than the Greenbook about household spending.
As for inflation, the Greenbook now has us waiting until the third quarter of ’08 before we see a moderation in core inflation. Even then, we get only 0.1 percent. I would view this outcome as fairly disappointing. But if I had been asked for an unconditional forecast, I probably would have submitted something a lot like that. Instead, we were asked for a projection conditional on what, in our judgment, would be an appropriate monetary policy. So the projection I submitted has core PCE inflation at 1.8 percent next year and 1.6 percent in 2009. Under what, in my judgment, would be an appropriate monetary policy, we use the Chairman’s July testimony to announce that the FOMC’s objective is for PCE inflation to average 1½ percent and that the Committee intends to reduce inflation to that level within two years. While such an announcement would not necessarily shift inflation expectations immediately downward, I project that consistent communications from Committee members accompanied by further rate increases when downside growth risks abate later this year would bring expectations into line with our objective by early next year. Although growth would be weaker this year than in my unconditional forecast, it would ultimately return to trend in 2008, and the properly measured sacrifice ratio would turn out to be significantly smaller than is often assumed or inferred from standard Phillips curve estimates. I mention this scenario simply to reiterate that I believe that there’s a feasible alternative to the hypothesis that inflation will settle in around 2 percent or higher unless we engineer a substantial output gap.