Thank you very much. The last time we met, one theme was the greater uncertainty, and Governor Kohn mentioned that he is feeling greater uncertainty now than he ever had. I am not sure that greater uncertainty has been the tenor of the comments here today, but I think it has been greater uncertainty with downside risk. So the key issue from last time that I think is still with us is that we certainly saw evidence of the slowdown and, as President Stern mentioned, that sometimes we have to acknowledge reality, and we did have much slower growth than many people had been expecting in the two previous meetings. The Greenbook suggests that the slowdown is unlikely to persist—and I broadly agree with that view, as do many people around the table—but I want to review five key uncertainties that we talked about last time and to discuss how they developed and where they are likely to go.
The first uncertainty is investment, and of course, a lot of us have spoken about that. I would rate the level of uncertainty as still elevated there. I am not going to use color coding to rate that uncertainty, but I would say it is still elevated. We have recently gotten some more-solid numbers, but those are just recent; and I think it is still more a glimmer of hope than something we can bank on that we are going to get a turnaround in investment. That we have seen some better numbers in ISM, durable goods, and so forth says that the direction is perhaps a little more positive than we were thinking six weeks ago. But there is still a reasonable amount of uncertainty about whether the pickup in business investment will help offset any slowdown in consumption to make sure that we continue to grow in the 2 percent range going forward.
The second uncertainty is productivity and potential output. Obviously that is still at an elevated level. As far as I am concerned, it is one of the biggest challenges for us to think about in the intermediate run. In particular, a downside scenario that concerns me is that, if we do not have a pickup in investment, we are unlikely to see a sustained rise in productivity growth. If perhaps one reason for the lower investment is that there are concerns about productivity growth or returns from that investment, we could have a fairly negative scenario in which we get much lower potential output. Offsetting that concern is that we are seeing some glimmers of hope on investment. With respect to potential, I think it is appropriate that the Greenbook has raised participation rates a bit, given that older people seem to be healthier than previous cohorts were and seem to be more willing to work. However, I think the big question mark is, exactly as David said, that not until August will we get a better feel for which way the data revision will go because the difference between the two sides of the balance sheet is fairly big. Broadly, I share Gary Stern’s optimism that it is not a good bet to bet against the U.S. economy and against ultimately good productivity growth. But I have the concern that I do not fully understand the slowness of the investment recovery and some of the productivity slowdown. There is potentially a worrying downside scenario there.
Third is the uncertainty about the housing market and subprime. Well, obviously, uncertainty on subprime was highly elevated then, and it has come down quite a bit. We have seen some tightening of lending standards, particularly at the lower end. The survey of senior loan officers asked for a differentiation between subprime and prime lending standards. It showed a very dramatic increase in subprime standards, which is exactly what we would expect in this kind of market, certainly potentially reducing demand at least in the lower end of the housing market. About the housing market in and of itself, the uncertainty is still there. We still have a lot of uncertainty about whether the numbers are telling us about weather or about the actual strength of the market. As I think I have mentioned to a number of you before, we need to have, besides Dave, a meteorologist on the staff to forecast the weather because every number we hear on the housing market is not a number in which we can put any stock; it all has to do with heat or cold or rain or snow or whatever other thing that Mother Nature may throw at us. So I still think there is a pretty mixed picture there. As I said, we have seen very little evidence of spillovers from the subprime market. The main concern, and this is a variation of what Governor Warsh said, is that something we or the Congress might do might cut off this market. We have to be mindful of any actions that we may be taking with respect to guidance, as well as of any actions that the Congress may be taking, that could reduce this market more than otherwise.
The yield curve is favorable for a lot of the variable-rate subprime borrowers to move into fixed-rate products, with payment shock of perhaps no more than 50 basis points. The delinquencies we have been seeing have not been due to resets or to payment shock. They have been due primarily to the so-called juvenile delinquents—the early defaulters going bad. That means that we do not know what is coming down the line because we have not really seen the experience of the resets. Now, with the recently benign yield curve, that situation could reasonably be worked out. The key is whether any equity is left. If no equity is left and the resets come, these guys are likely to walk. If they have been doing risk layering—putting really no money down—and the prices go down, that will be a problem. So I think that may be a bit of a slow burn. Coupled with the broader misalignment that we are seeing now of a little increase in housing starts, which in some ways we would see as a positive, is a sort of negative given that housing sales seem to be declining so much. Thus there seems to be a disconnect between supply and demand, and I think the Greenbook is now quite wisely saying that we will likely have a longer transition in the housing market.
A fourth area of uncertainty that we talked about last time was the financial markets—the dramatic spike up in volatility. That volatility spike has come down, but we, being good economists, can never be satisfied with either high volatility or low volatility. Low volatility is of concern to us, and I very much share the concerns that Tim, Cathy, Kevin, and others have mentioned. Not only in the United States, but also in the rest of the world, are some of those spreads a bit narrower than they otherwise would be. In particular, there are concerns about banks chasing private equity deals going covenant-free. In many of my discussions with private equity folks, instead of saying, well, bring us on more capital, those contacts are the ones saying that the banks are pushing them to take greater leverage than they otherwise would want. Now, if that isn’t the fox guarding the henhouse, I do not know what is. You want the banks to be the disciplinary force, and that they would potentially be taking on very large risks is a real concern.
The fifth area of uncertainty was consumption. We have seen a bit of a step-down in consumption growth, but there is still a lot of uncertainty, and I share the exact concerns that Governor Kohn articulated; given that there are likely to be some wealth effects, even though we have some offsetting effects in the stock market, I do not want to bet on those offsetting effects in the stock market being there for the next three quarters. Housing wealth seems to be flattening, if not coming down, with the Case-Shiller index on average for those ten markets down 3 to 5 percent. If people’s thinking about their consumption pattern is based on some increase in housing wealth, the saving rate should at least gradually increase. At some point, that reality may be biting and leading to some concern.
On the inflation front, once again, we will have continuing uncertainty about what drives short-term to intermediate-term inflation. As I mentioned last time, we get very, very mild effects from the traditional things that we think that make a difference. Oil, energy, commodity prices, and resource utilization don’t seem to have that much force, but in both the short and intermediate terms I think they are leaning on the positive side rather than on the negative side. We still have the owners’ equivalent rent issue that is coming in with the transition in the housing market and is still to some extent temporarily pushing up our measured inflation rates. Inflation expectations continue to seem to be quite well contained, and that, I think, is key because, given that these other forces do not seem to be important in the short to intermediate run, inflation expectations are very important. So my bottom line is that, although I see some downside risks on growth, I think the Greenbook scenario is a reasonable central tendency one, and I see some important upside risks on inflation.