At the time of the last FOMC meeting, we were feeling as though the incoming spending data were coming in pretty darn close to our expectations and were pretty consistent with our story about entering a period of below-trend growth. As we noted, and President Moskow quizzed us about, the big fly in the ointment with respect to our story was the labor market and its ongoing strength. Since then, as Larry noted, the spending data have moved toward the labor market data rather than the labor market data moving toward the spending data. The developments have certainly brought into sharper focus the upside risk associated with buoyant consumer spending. If we made an important policy-magnitude type error, it might be that the third quarter was just a period of low measured GDP growth but basically we haven’t moved much below trend. I think that you would need to take that risk very seriously as you thought about the current setting of policy.
There are some critical reasons for remaining patient about whether, in fact, we have or have not moved below trend. I think that we still haven’t seen the full effects of the housing shock that we had in the second half of 2006. I suspect that we are going to see more of the employment effects associated with that going forward. I don’t think that we’ve seen the full multiplier accelerator effects of that, and we certainly haven’t seen, if our estimated econometric models are anywhere close to right, the lagged effects of the slowing house prices and consumer wealth that we think will be part of the reason for motivating a higher saving rate. So we’ve raised the forecast, and we’ve raised it significantly, but I don’t think we’re yet surrendering the notion that this current setting of policy can produce a period of modestly below trend growth. Now, I think that the upside risk continues to be the labor market strength.
As Larry said, even given the overall dimensions of the housing shock, we’ve been encouraged about our story of stabilization. But I remember that, as we went into the investment shock earlier in this decade, we just didn’t have enough imagination about how bad things could get, and we kept thinking that we were seeing signs of slowing or stabilization, that the new technology was still great, and that there should be reasons or underlying motivation for investment. Perhaps what we’ve seen recently as stabilization are the beneficial effects of the drop in long-term interest rates that occurred from last summer into the fall and pulled some people forward, but really we may not have fully made the adjustment yet. The overhang of unsold homes out there is very large, and we could be underestimating the size and duration of that. So even given the recent stronger data on spending, I still don’t see all the risks on that side of things. I still think there are some significant downside risks that you ought to be at least concerned about.