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

Thank you very much, Mr. Chairman. The New England regional economy continues to grow at a moderate pace with relatively slow job growth, low unemployment, and moderating measured price trends. Consumer and business confidence is solid, and while retail contacts reported an uneven holiday season, manufacturers were generally upbeat about business prospects. Skilled labor continues to be in short supply and expensive. In every one of the New England states, there is concern over the long-run prospects for labor force growth, given their mutual low rates of natural increase, out-migration of 25 to 34 year olds, and dependence on immigration for labor force growth. New England is an expensive place in which to live, and concerns abound about how to attract and retain the highly skilled workers that are needed for its high preponderance of high value added industries. Obviously, there’s nothing new or particularly cyclical about the foregoing comments. But I’ve been to quite a few beginning of the year “let’s take stock of things” conferences in all the states recently, so perhaps I’ve become more impressed than usual by the medium-term to long-term challenges facing the region. In the short run, however, the positive overall trend of the regional economy does seem to be a powerful offset to the continuing decline in real estate markets. At our last meeting it seemed as though New England’s real estate problem was more significant than that in the rest of the country. But now it appears that both are similarly affected whether one looks at prices, sale volumes, inventory growth, or declining construction. As with the nation as a whole, there are signs of stabilization; but at least in New England, making any judgment about the imminent revival of real estate markets in midwinter is foolhardy at best.

On the national scene, the data have been more upbeat since our last meeting. Apparently the holiday season was a bright one, with consumption likely growing at a pace of more than 4 percent in the last quarter. That’s remarkably strong given the continuing decline in residential real estate and proof—to reiterate what President Stern said—that the U.S. economy continues to be unusually resilient. Supporting consumption are tight labor markets, lower energy prices, tighter though still reasonably accommodative financial conditions, strong corporate profits and some signs of revival in business spending after declines related to housing and motor vehicle expenditures, and continuing strong foreign growth. Even inflation has moderated a bit, with three-month core price increases in both the PCE and the CPI trending down. Our forecast in Boston and that of the Greenbook are virtually indistinguishable. The last quarter of ’06 was stronger than expected. The first quarter of this year will be slightly better as well, but after that, the trajectory remains the same as it has been for the past two or three meetings. An increasing pace of growth in ’07 and ’08 as the housing and motor vehicle situations unwind, a slight rise in unemployment, and a fall in core PCE inflation to nearly 2 percent by the end of the forecast period. In many ways, this is the definition of perfection, a forecast that is seemingly getting better each time we make it, with growth a bit higher, unemployment a bit lower, and inflation ebbing slightly more. The underlying mechanics that produce this outcome are relatively straightforward, but I wonder whether we should have a heightened sense of skepticism about such a halcyon outlook. Let me focus on two reasons for such skepticism.

First, all other things being equal, inflation could be less than well behaved. One reason that inflation ebbed in earlier forecasts was that slower growth brought about a small output gap and rising unemployment. Now, the output gap is virtually eliminated, and unemployment remains below 5 percent. Ebbing inflation is solely the product of recent favorable inflation readings, which are assumed to persist: lower energy prices, declining import prices, and falling shelter prices. It’s hard to tell at this point whether the recent readings on core inflation are the result of fundamentally lower inflation pressures or just luck or maybe a combination of the two. I think a similar range of uncertainty applies to oil prices and the strength of the dollar. With virtually no output gap, it seems to me that, while the baseline best guess might be lower inflation, for all of the reasons discussed in the Greenbook one should approach that analysis with some caution.

Second, demand could well be stronger. The baseline forecast assumes that consumers somehow get the message some of us have been trying to deliver about the need for an increase in private saving. The saving rate moves from a negative 1 percent to a positive 1 percent, the highest saving rate in several years. As I noted before, I have to ask myself why this is likely to happen over the next coming months when it hasn’t in the wake of the housing situation in 2006. Clearly, the downturn in residential real estate, an important political issue in all our Districts and certainly devastating for subprime borrowers in particular, hasn’t affected consumer spending in general. In fact, household net worth as a share of disposable income remains quite high, buoyed in part by a likely overestimate of real housing values but also by rising equity markets. The timing of the needed increase in the personal saving rate could well be further out in the future, creating some version of the buoyant consumer alternative scenario instead of the baseline. Again, with no output gap, the potential for increased inflationary pressure is obvious.

In sum, the Greenbook forecast remains in my view the most likely baseline. There are downside risks, as I mentioned before, for the seven alternative scenarios do anticipate some downside risks; but if the housing situation is beginning to stabilize, I find it hard to believe that broader anxiety about it will affect business spending or the consumer as some of these scenarios contemplate. The bigger risk may well be that business spending picks up in light of consumer strength, unemployment stays low, growth exceeds our current projections, and resource pressures become more intense. I am concerned that risks to inflation have grown somewhat since our last meeting. I think I’m still in a “wait and see” mode, as I do believe there are downside risks to the evolution of housing markets. But if the Greenbook growth forecast is right, the best risk management on our part may have to be to seek tighter policy sooner rather than later.

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