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

Thank you. Let me try to summarize the discussion around the table and take any comments on the summary, and then I would like to add just a few thoughts. Broadly speaking, the outlook of most participants has not substantially changed since March. Housing remains weak, and it is the greatest source of downside risk. Whether the demand for housing has stabilized remains difficult to judge, in part because of subprime issues. It is also unclear whether builders will seek to return inventories to historical levels, and if so, at what rate. There is yet no indication of significant spillover from housing to other sectors, although that remains a risk. The downside risks to investment have moderated since the last meeting, although investment seems unlikely to be a strong driver of growth. The inventory cycle is now well advanced, and production is strengthening. Consumption growth seems likely to moderate, reflecting factors such as weakness in house prices and high energy prices. However, the labor market remains strong, particularly in the market for highly skilled workers. Incomes generated by the labor market, together with gains in the stock market and generally accommodative financial conditions, should provide some support for consumption going forward. Financial markets are priced for perfection, which implies some risks on that score. Foreign economies remain strong and should be a source of support, although some are undertaking monetary tightening. Overall, the economy is in a soft patch and will likely grow below trend for a while. Growth should return to potential later this year or in 2008, depending on the evolution of the housing market. The rate of potential growth remains hard to pin down. Several participants seem a bit more optimistic than the Greenbook on potential growth and the NAIRU, although there are risks.

Inflation has improved a bit, and most see continued but very slow moderation. However, there are upside risks to inflation, including compensation, the dollar, energy prices, and a slowing in productivity. Moreover, a rise in inflation from current levels would be costly, particularly if it involved unhinging inflation expectations. Vigilance on inflation must, therefore, be maintained. Overall the risks and uncertainties seem a bit less pronounced than at the last meeting, and participants seemed relatively comfortable with the outlook. Although there are some potentially significant downside risks to output, arising particularly from the housing sector and the possible spillover to consumption, the group still appears to view a failure of inflation to moderate as expected to be the predominant risk to longer-term stability. Are there any comments or questions?

Hearing none, I will just add a few points. First, following President Yellen, I think that the tension between slow growth and a strong labor market remains central to understanding what’s going on. Okun’s law is supposed to work better than this. [Laughter] I looked at recent history. Over the past twenty years or so, there has been no exact parallel to what we are seeing now. There was a jobless recovery in ’91-’93 in which unemployment remained high even though growth was picking up, and we had a midcycle slowdown in ’95 and ’96, which was relatively short and not very severe, in which the unemployment rate got temporarily ahead of growth. So there have been some deviations. Interestingly, after the 2001 recession, despite lots of talk about jobless recoveries, Okun’s law worked pretty well. So we are in an unusual situation—instead of a jobless recovery, we have growthless job growth. [Laughter]

Interpreting this correctly is very important. The staff forecast essentially assumes that Okun’s law will revert to historical tendency. I think that assumption is reasonable, particularly since the staff is not exceptionally optimistic about potential growth and, therefore, that particular source of error is moderated. That would suggest that labor hoarding is probably a good part of what is happening here. If there is one area in which labor hoarding appears to be significant, it would be construction, as President Yellen mentioned. I asked the staff to do a simple study of this relationship, to which Dave Stockton referred. Andrew Figura and Adam Looney of the Board’s staff performed a regression analysis in which they regressed all construction employment against all investment in structures quarterly with lags going back to 1985. The reason to look at all construction in terms of both employment and production is that there is a lot of substitutability between those two categories. That regression approach should also account for unmeasured labor, including undocumented workers and the like. In this analysis they found that employment is roughly proportional to construction activity, but with substantial lags, which again is somewhat surprising. Indeed, the model fits well through the fourth quarter of ’06 but then begins to underpredict significantly in the first quarter of ’07. If this model is correct, then given what is already in the pipeline in terms of reduced construction activity and then going on with the forecast in the Greenbook, we should begin to see fairly significant declines in construction employment on the order of 30,000 per month over the next year, which would be sufficient in itself, with all else being equal, to add 0.2 to 0.3 to the unemployment rate. So if labor hoarding explains the failure of Okun’s law, then we may soon see some gradual rise in the unemployment rate, which would also be consistent with the view that the staff has taken that a good bit of the slowdown in productivity is cyclical.

It is actually fairly difficult to calculate the contribution of the construction sector to productivity because it involves not just construction workers but also upstream production of various kinds. But one estimate, which comes from discussions with the Council of Economic Advisers, had the implication of employment hoarding in construction being about ½ percentage point on productivity growth. We will see how that develops. Even though I believe, as does the staff, that we will see some softening in the labor market, I should say that the evidence is still quite tentative. We saw a bit of weakness in the last labor report, but unemployment insurance claims remain low, and we do not really see a significant indication.

The other major issue is the housing market. Again, as a number of people pointed out, this is an inventory-cycle problem. The two main determinants of an inventory cycle are (1) what the level of final demand is and (2) how quickly you move to bring inventories back to normal. There does seem to have been some step-down in final demand over the past few months. Assuming that homebuilders would like to get not all the way to but significantly toward their last ten years’ inventories by the end of 2008 implies fairly weak construction, not only in the second quarter but going into the third quarter as well. Only in the fourth quarter will we see a relatively minor subtraction from GDP. That’s also relatively speculative, but residential construction does seem fairly likely to me to be more of a drag than we previously thought and to continue to be a problem into the third quarter.

There will also be a slowdown in consumption. We have been having rates near 4 percent, which is certainly not sustainable. We already see indications that consumption may be closer to 2 percent in the second quarter. I think the house-price effects are going to show up. Gasoline prices will have an effect. The labor market is strong, but it is going to slow a bit. So it looks to me as though underlying growth is roughly 2 percent and will be so for a couple of quarters to come. Notice in the thinking about the underlying case that there has been quite an asynchronicity between private domestic final demand and production lately. For example, for the second quarter we expect to see weaker private domestic final demand but probably a stronger GDP number because of rebounds in net exports and the like. But we should look past that—those are just quarter-to-quarter variations—and observe that growth is moderate, an observation that is supported by the sense that industrial production and manufacturing seem to be picking up. To summarize, I think that the notion of moderate growth with some uncertainty and with return toward potential later in the year or early next year is still probably about the right forecast.

On inflation, there’s the famous stock market prediction that prices will fluctuate. That seems to be true also for inflation. I mentioned at the last meeting that the monthly standard deviation in inflation numbers is about 0.08, and so between 0.1 and 0.3 there is not necessarily a whole lot of information. We have a few pieces of good news. I think vacancy rates are rising for both apartments and single-family homes. At some point we will begin to see better progress on owners’ equivalent rent and shelter costs. Also, the quarterly average of medical cost increases was much more moderate than in the first two months, which suggests that maybe this risk is not as serious as it may have looked. However, as many people pointed out, there are a number of negatives, including the dollar, energy, food prices, commodity prices, and most importantly, the labor market. The compensation data remain quite mixed—in particular, the ECI, which was a very soft headline number. The 1.1 percent quarterly wage and salary number, or 3.6 percent for twelve months, is now more or less consistent with what we’re seeing in average hourly earnings. If productivity falls below 2 percent, then we are beginning to get to a range in which unit labor costs will be putting pressure on inflation. So I am quite comfortable with the view expressed around the table that, although inflation looks to be stabilizing and perhaps falling slowly, there are significant risks to inflation and we should take those very seriously.

Very much a side point—I did have some interesting discussions with the staff about the role of the stock market in the forecast. This is not the staff’s fault, but there is a sort of tension in how the stock market is treated. On the one hand, the stock market is assumed to grow at 6½ percent from the current level. On the other hand, the forecast has profit growth going essentially to zero by the third quarter but interest rates coming up. Those two things are a little hard to reconcile. The difficult problem is which way you should go to reconcile it. On the one hand, it could be that the forecast is right, and therefore the stock market will in fact be weaker; that will have implications for stability, for consumption, and so on. On the other hand, perhaps we should be taking information from the stock market in making our forecast. So it is a very difficult problem, and I just wanted to point out the tension that we will have to see resolved over the next few quarters. One partial resolution is that, as has been noted, the stock market and the economy as a whole can be decoupled to some extent because of overseas profits. This is an interesting example of how financial globalization is creating stability for domestic consumption—you know, decoupling domestic consumption from domestic production. Again, we had a very good discussion with the staff about this issue, and I think it is just something we will need to think about going forward.

In summary, in the last meeting we felt that uncertainty had risen. There has been perhaps a slight moderation of those concerns at this point—a little less inflation risk, a little less growth risk. Nevertheless, the balance of risks with inflation being the greater still seems to me to be a reasonable approach. Let me now turn to Vincent to begin the policy go-round.

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