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

Some day we’ll have the Super Bowl at the Seventh Federal Reserve District. But turning to the business at hand, business activity in our District continues to expand at a somewhat modest pace, but the tone of my business contacts was more positive than at our last meeting. Manufacturing activity in the District is currently a bit soft. The Chicago purchasing managers’ index fell from 51.6 in December to 48.8 in January, and this number will be released tomorrow morning.

Many of my contacts are expecting a significant pickup in activity in the second half of the year. We heard this from manufacturers of building materials, agricultural equipment, construction machinery, autos and steel, temporary-help firms, and even from several retailers. Though a number of manufacturers thought that the recent softness was temporary and reflected the need to work off some modest inventory buildups, they said the final demand for their products remains solid. The steel industry is a good example of this kind of dynamic. Industry production has fallen sharply since the summer; but when I recently talked to the head of a major steel company, he noted that demand from end users had remained quite stable, and he expected it to stay that way. The production cutbacks were mainly the result of inventory fluctuations at the service centers, which buy bulk quantities of steel to process and distribute to final customers. The analysts in the industry are divided on when this inventory correction will be complete, but even the pessimists think that it will be done by late spring. With the steady demand from end-use customers, my contact thought that production and prices would definitely be rising by the second half of the year. There was an article in the paper today that mentioned that Nucor is trying to raise prices by $20 a ton in March. My auto contacts had mixed views about 2007. Last year was especially tough for the Big Three. High gas prices shifted sales from SUVs to cars, and then the mix of sales shifted from retail toward fleet sales, where their margins are lower. GM thought that gas prices probably have fallen enough to stabilize the market share of light trucks and that retail sales were now down near their long-term trend levels. Ford was not as sanguine about either of these developments. Finally, the strength of foreign demand and the weaker dollar seem to be showing through to increased export demand for a number of our District’s manufacturers, and this situation supports the comments in the chart show.

The national economy is clearly showing more underlying strength than we thought in December. Moreover, the downside-risk scenarios now seem less likely. The housing markets look to be nearing the bottom, and the spillover to other sectors now seems likely to be minor or is being offset by other positive factors. Importantly, tight labor markets and lower energy prices are boosting consumer spending. We continue to expect that growth will be modestly below potential in the first half of the year, but like my business contacts, we expect activity to pick up in the second half and growth to be a touch above potential by 2008. Unlike the Greenbook, this projection is conditioned on market expectations for interest rates, which impart some degree of accommodation next year. So currently I see the risks to the growth forecast as being fairly well balanced. On the downside, we could be wrong about the stabilization in housing, and on the upside, consumer spending could remain robust or demand from abroad could accelerate.

Overall, the recent data on inflation have been positive. As a result, the forecasts from our inflation models are lower by a tenth or two. The models estimated using data only since 1984 predict that core PCE inflation will be flat at 2.3 percent through 2008. So I’m less optimistic about inflation than the Greenbook. In my mind, there are two key questions concerning the inflation outlook. First, what happens in 2009 and beyond? As we were discussing before, in chart 6 in the Bluebook, for whatever reason, inflation is moving up, and I think that’s a concern. Second, there’s the issue of longer-run inflation expectations. In the Greenbook forecast, by the end of ’07, inflation would have been at or above 2¼ percent for a year and a half with no change in the fed funds rate and a reasonably strong economic environment. I think markets might interpret this inaction as a signal that we’re satisfied with 2¼ percent inflation, not the 1 percent to 2 percent comfort zone that many of us have said we prefer. This view was shared by the participants at our recent gathering of academic and business economists—we have an advisory committee that meets a few times a year. Indeed, several academics thought we were already at this point. In their minds, the current policy stance and inflation picture revealed that we were satisfied with inflation stabilizing at or a bit above 2 percent. The business economists also were predicting that we would find ourselves in the position of needing to increase rates some time this year in order to put inflation on a pronounced downward path.

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