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

Yes. But here are some data to put this statement in perspective. The contact from the largest company reports that cancellation rates, which were running at 50 percent in their most stressed markets, particularly in California and Florida, have come back to 20 to 25 percent—relatively good news. One aspect worth noting is that they are getting relief from their subcontractors—they estimate, on average across the industry, about 10 percent cost relief. Another predictable behavior pattern becoming manifest is that the large contractors with very strong balance sheets are looking to buy the distressed smaller contractors. David, I agree with you that we haven’t seen all the downturn in housing yet in terms of its effect on the economy, but we may well come out of it with an even more tightly consolidated industry. The bottom line on growth from the Eleventh District perspective is a Wagnerian summation—that is, the economy’s growth dynamic is not as bad as we thought it was sounding when we last read the score. I would summarize it by saying that the tail in terms of the risk of recession has become much slimmer.

However, my conclusion is the opposite with regard to inflation—that is, on reflection and working with our staff and listening to CEOs, I think the tail in terms of risk of higher inflation has fattened, and this is reflected in several reports. Just very quickly—because of my Australian DNA—Anheuser-Busch decided to raise beer prices 2 to 3 percent at year-end. That doesn’t bother me. What bothers me is the price of skilled workers who drink that good beer in terms of what’s happening for wages and total compensation of skilled and unskilled labor. You know that I have talked about the massive projects that Texas Utility plans for coal to gas conversion and whether they get the so-called Dirty Dozen that they’re planning or just a handful. I did go over with the CEO the studies that McKinsey, BCG, and Bechtel have provided for them, and some interesting data points came out that I want to summarize. In the summer of ’05, they estimated that all-in labor costs for these plants, which they estimated per plant, would take 4.6 million worker hours at $36.25 an hour. Today they don’t believe they can get the job done for less than $44 an hour; and because of worker quality issues, they now believe it will take 5.2 million worker hours for each plant. So if you have a 21 percent per hour increase and a 13 percent increase in hours, one wonders about the ability to see a short-term reduction in skilled and unskilled labor costs. These numbers, by the way, take into account the recent slippage in oil rig activity, which is down for the fifth straight week, and also the slowdown in housing and some initial slowdown in commercial construction. It dovetails with reports like that of BP’s to us that they decided to pay all their salaried operators, to whom only two years ago they were offering incentive packages to leave, $25,000 bonuses per year for the next two years to stay. Fluor’s CEO reports that they are having the largest year in their history of hiring college graduates, and the 900 mechanics who work for a large truck dealer with which I regularly talk are now fetching $35 an hour.

Another piece of data comes from a study by McKinsey and BCG, and I want to talk about it very briefly in terms of the intermodal transportation system of our country. The shippers tell me that port congestion is very high. The fleet utilization rate is running at about 95 percent. You know that I like to talk about Panamax ship rates because of their size and liquidity. Prices have not eased since we last met, and the interesting factoid is that the ten-year-old fleet is available for purchase at the same price as the fleet expected to be delivered two and a half years from now. These ships run $39 million apiece before their add-ons, which tells you that there’s a short-term tightness. If you talk to the rails and the effective two operators—there’s really a duopoly in this country between Burlington Northern and Union Pacific—their pricing is based on opportunity costs because they do not foresee the ability to expand their networks. This may well facilitate an upward price spiral as all the infrastructure projects currently on the drawing boards begin, whether TXU’s or some other liquefied natural gas companies’ projects that we have heard about.

A couple of other points with regard to inflation that I think bear watching: These inputs are anecdotal, but I think we have a pretty good survey in terms of the oil and gas operators. Most of the major oil and gas operators would not be surprised to see $40 oil and to see a range between $40 and $60 oil—that fits with the Brown-Yücel model that we developed in Dallas—and for natural gas prices to ease to a level of about $5 in the spring. That’s the good news.

I want to mention two other negative news items. One was referred to earlier, and that regards corn prices. The price for corn was $2.30 a bushel last year, if you looked on the graph that Bill, I think, presented earlier. Corn is now running $4.00 a bushel, and the food production companies we talked to project the price to be $5.00 by the end of the year. Now, this is good for farmers. It’s good for John Deere. It’s not good if you raise a chicken, a cow, or a pig, and it’s certainly not good if you’re a human who eats at Whataburger, one of my other new contacts. I won’t use the language that the CEO used, but he reports that his margins are coming under pressure.

The second development may be a bit more disturbing; it concerns the cost of imported goods from China into Wal-Mart’s network. According to Wal-Mart’s CEO for international operations and their vice chairman, Chinese import prices into Wal-Mart’s network were depreciating at an annual rate of between 2 and 5 percent. Recently, however, the rise in China’s labor costs for their suppliers net of the increase in productivity is leading to import price costs that are increasing at a rate of approximately 1 percent. To me this development raises an issue that I think President Moskow touched on regarding our views on inflation and perhaps rates going forward, which we’ll talk about tomorrow. At home, we’re seeing unacceptably high and sustained wage developments for certain critical components of labor, which I mentioned earlier. Abroad from Germany to China, we’re seeing economic growth rates that are well above sustainable trends, which is why I asked the question about your gap analysis earlier. My own staff calculates that, if you do a gap analysis—that is, if you compare current growth to what they estimate trend growth to be—there is no significant inflationary pressure. However, if you analyze capacity utilization rates in the G7 countries and in the BRICs, we are getting closer, given the economic growth that has been experienced, to more heavily used capacity and to igniting inflationary pressures. The bottom line for inflation from our perspective is that what was once a tailwind generated by globalization may be closer to becoming a headwind than our models indicate and our limited understanding of the effect of globalization otherwise leads us to understand. Thank you, Mr. Chairman.

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