Thank you, Mr. Chairman. Conditions in the Third District have continued to evolve much as they have for most of the past several months. Economic activity is still expanding. I think I can use the word “moderate”—I don’t think anybody else has used that yet, and our contacts expect the pace to be maintained in the coming months. There has been little change in the pattern of activity over the sectors. Retailers in our region indicated that their holiday sales were about as they expected or somewhat better. Housing continues to weaken at a somewhat orderly pace, but there are signs of stabilization of demand. Inventory has remained elevated, and construction continues to decline. However, the weakness in residential construction is being offset by continued strength in nonresidential construction. Office vacancy rates continue to decline in Philadelphia and in the near suburbs as well. The net absorption of office space has increased for the past twelve quarters. Manufacturing activity in the region hit a soft spot in the fall, as I indicated in previous meetings, but our most recent Business Outlook Survey, in January, presented somewhat positive but also somewhat mixed signals. The general activity index returned to positive territory with a reading of plus 8, indicating a slight increase in manufacturing activity, and there was a significant rebound in shipments. New orders, however, remained close to zero. That’s somewhat of an aberration because new orders and shipments tend to move very much together, and so there are some inconsistencies there, which is why I said the situation is a bit mixed. According to our survey, however, the firms expect a rebound of general manufacturing activity and orders over the coming six months. Indeed, most of our business contacts see moderate growth in the region continuing for the foreseeable future. Their positive attitudes are consistent with the recent positive news we’ve had about conditions in the nation. Firms remain concerned about their ability to hire both skilled and unskilled labor. Labor markets are tight for many of the reasons that President Minehan described in New England; we have some of the same things going on in the Third District.
Regarding national conditions, the unusually warm weather in December may have temporarily buoyed some of our numbers; but based on incoming information, I’ve become increasingly confident that the national economy has a positive underlying momentum. At the time of our last meeting, there was a contrast between the mixed data on consumption and production and the relatively strong indications from the labor market. The picture that appears to be emerging from the latest economic information is one of stronger underlying growth that has been temporarily weakened by housing and autos. There is little, if any, evidence that the housing and auto corrections are spilling over into the other sectors of the economy. We’ve been looking for those spillovers for the past six months and have yet to see any significant evidence that they are occurring or are about to occur. Of course, spillovers may yet materialize with a long lag, but that likelihood to my mind is diminishing as we have begun to see some hopeful signs of stabilization in housing. Labor market conditions remain firm, and manufacturing indicators improved in December as did capital goods orders. Although I didn’t talk to the chairman of Disney, I did talk to a small manufacturing firm with total revenues that come to $2 million. He has been very positive about the outlook. His sales depend a lot on construction, and he said that, after the most miserable August and September he had ever seen in his twenty years of running the business, the pickup began in late November, continued through December, and has continued into January as well. Other contacts from banks, particularly credit card issuers to whom I’ve talked, suggest that banks are seeing numbers coming across their books on credit card purchases continuing to be strong even after Christmas. So that also is good news.
All of this suggests that the downside risks to growth have receded since our last meeting. I believe this is the market’s assessment as well, as expectations of future policy firm. My outlook is that the economy will return to trend growth, which I put at about 3 percent this year, and will continue at that pace into 2008. Of course, as everybody has indicated, that’s a little stronger than the Greenbook’s outlook, and it is, again, based on my view that potential growth or trend growth is somewhat higher than the Greenbook has stated. I expect the unemployment rate to rise slightly, maybe to 4.8 percent by the fourth quarter of this year, and then to stabilize into next year. I think this is going to be accompanied by employment growth of nearly 1 percent, and again, that’s what accounts for the difference in the trend growth.
I anticipate a decline in core PCE inflation of about 0.4 percent by 2008. I would like to underscore that this forecast is not driven by a lower pass-through of oil prices, which have declined. My reading of the empirical evidence, including work done by some people on the Philadelphia staff, is that it’s very difficult to attribute movements in core inflation of six months to twelve months or longer periods to changes in oil prices. In fact, there’s growing empirical evidence that neither movements in oil prices nor Phillips curve type factors significantly improve our root mean square error forecasts of core inflation two or more quarters ahead. I note that this refers to forecasts of six months or longer and not to short-run high-frequency movements. This suggests that we should be careful in the language we use describing the reasons for our projections of future inflation to avoid perpetuating views of inflation processes that we can’t empirically substantiate.
In my view, core inflation will not come back down until monetary conditions, which I believe have been very accommodative over the past few years, have tightened sufficiently. The Greenbook forecast has a slightly smaller decline in core PCE inflation to about 2 percent in 2008, but incorporates a less restrictive monetary policy than I believe is likely to be appropriate given my view of the strength of the underlying economy and of the fundamentals that we are seeing. Indeed, over the past two meetings, my feeling was that the slowdown in economic activity that we might be seeing, combined with a constant fed funds rate, might have been enough to bring inflation back to a more acceptable level. Now I’m less convinced that price stability will be achieved without further action on our part some time later this year. But I will leave that discussion to the policy go- round. Thank you.