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

Thank you, Mr. Chairman. I’ll be referring to the materials that were passed around during the coffee break. For the past few years, the Committee has taken a “belt and suspenders” approach to providing guidance to financial markets by characterizing both the likely direction of interest rates and the risks to its dual objectives. In March, you loosened the belt a few notches by replacing the reference to “additional firming” with more-balanced language but retained the macroeconomic assessment that inflation risks were the more serious concern. The top left panel of your first exhibit provides one way to score the immediate market consequences of that change. The black and red bars, respectively, plot the changes in two- and ten- year Treasury yields in the one-and-a-quarter-hour window bracketing the 2:15 p.m. release of statements for the past two years. As some of you predicted, market participants saw particular significance in the March announcement that the Committee was apparently no longer presuming that its next action would be a firming, and two- and ten-year yields fell 10 and 5 basis points, respectively, the biggest moves in the sample shown.

After a bit of confusion about what the statement really meant, markets ultimately got the message, aided in part by Chairman Bernanke’s testimony, your speeches, and the minutes. I take from this the sense that the wording of the statement is important [laughter], but that there are also other opportunities to provide a more-nuanced policy message. The message that market participants got both from you and from the incoming data, on net over the intermeeting period, is seen in the top right panel by the shift from the dotted red to the solid black line depicting the path of the expected federal funds rate. Futures quotes now imply a consensus that policy will be kept on hold today and at the June meeting but then will be eased ¾ percentage point by the end of next year. This modest upward repricing of money market futures yields accompanied a reemergence of remarkably benign financial conditions, the subject of the three middle panels. Corporate bond spreads (at the left) and implied volatilities on equities and money market futures (in the middle) retraced much of the run-up of late February to end the period at relatively low levels by historical standards. Equity prices, at the right, gained 7 percent to reach new highs. As you’ll see a little later, this addition to household wealth pushed up estimates of the equilibrium real federal funds rate and may importantly influence your thinking about near-term economic prospects.

In the bottom left panel, I trot out the usual suspects for why stock prices rose. First-quarter earnings reports were solid, so higher share value may just be a bet on rising domestic and foreign profits—the latter seeming especially more secure in light of the apparent vigor of the global economy. Our estimates of the equity premium— one of which is shown at the bottom right as the spread between the forward earnings-price ratio and the long-term real interest rate—narrowed a bit, suggesting that investors were more accepting of risk. Also, investors may see less risk, as in answer C. Potentially bad things that seemed palpable as the subprime market melted down did not go bump in the night—that is, downside risks to the outlook appeared to ease. What is the right answer to this multiple choice test? I think (D), all of the above, in that the world’s growth prospects seem a little more assured and, as a result, investors see fewer risks and are more willing to take them on.

That backdrop leads naturally to a discussion of policy choices, which begins by examining the case for alternative B, which is in your next exhibit. The last time that you sat at this table to consider the setting of policy, you chose to keep the federal funds rate at 5¼ percent. The way the staff has filtered the flow of information since March has produced only minor changes to their outlook for real GDP growth, the top left panel, and core PCE inflation, the top right panel. So, if you were content in March, would you not be so in May? Keeping the nominal funds rate at 5¼ percent is consistent, as plotted in the middle panel, with the real federal funds rate, the solid black line, rising to continue to match the Greenbook-consistent measure of its equilibrium value, the dotted green line. If you believe that framework, this stance of policy should return the level of output to its potential within three years. Some of you might argue that such an outcome is not good enough. With core PCE inflation lingering above 2 percent, a more forceful working down of inflation—perhaps even at the cost of creating some slack—may be required for acceptable economic performance. While that may be a relevant consideration, risk-management issues may tug in the opposite direction. In particular, and as shown by the solid line in the bottom panel, the staff forecast puts real GDP growth in the neighborhood of 2 percent for the next six quarters. Times in which economic growth has been at or has dipped below 2 percent—the dashed horizontal line—have often been followed by recession—the shaded regions. Concern that the economy would be flying close to stall speed may stay your hand from dealing more aggressively with inflation.

Indeed, concerns about growth may incline you to believe that your next policy action will be an easing—the subject of the left column of charts in exhibit 3. As has been true for some time, the case for alternative A rests importantly on your assessment of the housing market. New-home sales, the solid black line in the middle panel, have taken another step down, further elevating the months’ supply of unsold new homes, the dotted red line. This inventory correction will impose a drag on residential investment for some time—and could get worse if the availability of funds tightens some more in light of the woes in the subprime mortgage market. You also might now harbor doubts that businesses will step up their spending, which would otherwise have cushioned any slowing in the growth of aggregate demand. While the latest readings on orders and on shipments of capital goods, plotted as the solid black and dotted red lines, respectively, in the bottom left panel, were encouraging, you might dismiss those as one month’s noisy signal around a downward-pointing trend. In addition, you might see financial markets as ripe to correct, once investors come to appreciate that earnings prospects are as tepid as in the Greenbook forecast.

But risks to economic growth are not the Committee’s sole concerns. In March you identified the failure of inflation to moderate from its current elevated level to be the predominant concern. The case for alternative C, presented in the right panels, probably hinges on the view that inflation is not clearly on a downward trend, seen in the middle panel by inflation as measured by the core PCE price index (the solid black line) and the market-based core PCE index (the dotted red line). In addition, the outlook for inflation may now be seen as less favorable than in March, given the run-up in the prices of oil and other commodities. As shown in the bottom right panel, futures-market participants have revised up their forecasts for the prices of these items well into the future. If the pace of moderation of core inflation turns out to be even slower than previously anticipated, you might be concerned that long-run inflation expectations will drift up, making for difficult policy choices going forward. The prevailing expectations of inaction, shaped in part by official comments, may take alternatives A and C off the table for today. But any inclination to favor the arguments in either the right or the left columns should influence your choice of language in the statement, the subject of your last exhibit. This exhibit is just table 1 repeated from the Bluebook with no emendation.

I note that, in the discussion of communications, the Committee thus far has been reluctant to specify an inflation goal consistent with its dual mandate. However, by describing current inflation as “somewhat elevated,” as was the case in March, you are implicitly characterizing the upper limit of your tolerance for inflation, just as you delimited its lower bound in the summer of 2003 with talk of “unwelcome disinflation.” Market participants will read much into your choice of words when the time comes to change that characterization. So, at some point, you will have to come to terms with your preferred specification of your inflation goal, either directly through deliberations on communication policy or indirectly through the wording of the statement. That concludes my prepared remarks.

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