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

Thank you, Mr. Chairman. I thought I’d provide just a couple of perspectives, first on the 2006 economy and then, by extrapolation, on the trends in ’07. With respect to 2006, I think the economy outperformed market expectations and Greenbook expectations, for probably at least four reasons. The first is the underlying strength of the employment market, which has been much discussed today. Second, the strength and durability of household finance, which, as Vice Chairman Geithner said, turned out to be far more determined by W-2 income than some of the household balance sheet items like home equity and stock market effects. But we need to take another look at that trend in 2007. Third, the economic outperformance in ’06 had much to do with the resilience of the U.S. capital markets as evidenced in credit spreads and other financial instruments, particularly in the face of some rather seismic events—one-time, potentially systemic events like the Amaranth Advisors collapse; cyclical price spikes with respect to commodity prices that may well have been somewhat demand-driven; a series of supply shocks driven by oil; and a seeming transition to slower growth in the middle of the year. Fourth were the continued powerful sources of liquidity that smoothed the transition over the several bumps in the road.

I also looked at what the most reliable and the least reliable indicators of the state of the economy in ’06 were to see whether those signposts might hold for ’07. I think the tax receipt information that we saw in ’06 was telling us that incomes were likely ahead of trend—tax receipts for ’06 were up a total of 11.6 percent. Corporate profits, which were up 92 percent in the past four years, had another remarkable year, up in the mid-teens. Stock prices, obviously closely related to corporate profits, were up 84 percent in the past four years and up about 15 percent in 2006. Credit spreads continued to trend tighter; high-yield spreads were down about 100 basis points from September. Another couple of reasonably reliable indicators for ’06 were the household survey of employment, which suggested early and often that employment growth was likely to be ahead of expectations, and merger and acquisition pipelines, which suggested a degree of confidence in the markets by business leaders and other folks involved in finance.

A less reliable indicator for 2006 growth was the shape of the yield curve, and the suggestion from most of us around the table to the markets was that the yield curve wasn’t predicting much by way of recession in the short term. Another less reliable indicator was the consumer confidence and business confidence surveys, which seemed to snap all over the place, perhaps more because of geopolitical events and some short-term data than any really driving profile. With respect to inflation, it is hard to find any indicators that were very good at telling us its path, but I do think that the TIPS spread, even when there was much talk in the spring and the summer about rising inflation, seemed to stay relatively well anchored and not to move too much based on some of that noise in the data. So that indicator seems to have been reasonably good. As was mentioned earlier, monthly CPI and PCE core measures seemed to be moving around rather significantly, so it was hard for us to determine too much from them as 2006 went forward.

Taking all of that into account, as I think about 2007, I find that analyzing those indicators is not without significant peril, but let me attempt doing so. The trends appeared supportive of strong, balanced economic growth for 2007, and although inflation expectations are well anchored and recent high-frequency data appear promising, I remain much more concerned about inflation prospects than about growth. Having said that, I do think that as an institution we go into 2007 with probably even heightened credibility on the inflation front and in terms of our perspectives on the economy, which should help us over the next twelve months.

Two key themes summarize my views on 2007. First, strong employment trends should continue to support consumer spending. Second, strong corporate balance sheets and balanced global growth should support capital expenditures. Now, of those two themes, I would note that I have considerably more confidence in the former than in the latter. I’ll spend another moment on that shortly. The tone of the markets appears to be exceptionally strong. Spreads have tightened, even as yields have trended back to 5 percent. Over November and December, we had three weeks, each with more than $11 billion being priced in the high-yield market. Just to give some perspective on that fact, for the year 2000 there was a total of $50 billion in the high-yield market. But what has happened in the past six weeks that might be able to inform our judgments? Double B spreads have tightened about 25 basis points, single Bs have tightened 50 basis points, and triple C spreads have tightened 70 basis points in the past six weeks, all of which continues to signal to me that the economy maintains a relative strength and that investors feel confident about the bets that they’re making. In summary, I would say there are significant tails on both sides of this rather strong base case for the economy, but the economy is more likely to track above the expectations of the Greenbook.

Let me spend a couple of moments on the consumer. Contacts from two large credit card companies to whom I spoke last week expect and have seen in January the same kind of strength that they saw in December. The first three weeks of January look to be a continuation of the late but positive trend in the fourth quarter. For what it’s worth, the contacts’ own projections are that the first quarter will be rather strong, much like the fourth quarter ended up being. Today, we’ve all tried to wrestle with what the Greenbook referred to as the “unexplained strength” of household spending during 2006 to determine its effect on ’07. Let me spend a couple of moments on a hypothesis that the contacts proffered regarding that strength, which the Greenbook references in its “buoyant consumer” simulation.

What that strength may well prove is that employees worked more, earned more, and had more savings from their household balance sheets to fund consumption than the data to this point are suggesting. I think that could turn out to be the case in 2007. First, people worked more. The benchmark payroll survey on total job creation may well be revised upward again significantly, like the revision of last year. Gains in service jobs may well be less counted than some of the losses in other kinds of jobs—another bias for upward revisions. The JOLTS data to which President Pianalto referred continue to be very positive, suggesting a real dynamism in the economy that may well be accelerating. Participation rates may continue their recent spike as new workers selectively choose to enter this marketplace. Average hours worked moved up in the fourth quarter to an annual rate of 2.2 percent, and that trend could continue. So monthly employment gains have not proved much harder to achieve as we approach what we thought was full employment, and the NAIRU may be lower than estimated. Second, people certainly may well have earned more. Average hourly earnings were up 4.2 percent for ’06, an acceleration that was rather widespread from ’05 measures. Though the data on compensation continue to be mixed, they do seem to be trending in that direction. The divergence between profits and compensation suggests to me at least that there is large upside potential for unemployment to stay low and for wages to accelerate, perhaps in a catch-up for wage gains that we didn’t see earlier in the cycle. Third, as a result of working more and earning more, I suspect that workers may continue to spend more, particularly with the gift of what seems to be relatively low oil prices, in the mid-fifties. The oil price seems to me to have less of a risk premium and now appears to reflect some elevated supply and at least modestly lower demand. In sum, with respect to the consumer side, I am reasonably well confident.

I’ll spend just a moment on the business side of the equation. Fourth-quarter profits appear to be quite good, with two-thirds of companies beating estimates. As many of these companies are challenged to have double-digit earnings in 2007, they may look for other avenues in which to buy those earnings—in the M&A world—or increase cash outlays through share repurchases from their excess cash on the balance sheet to maintain earnings per share growth in the double digits. Another alternative is that they might choose to increase cap-ex as many of us, including myself, would have expected them to do earlier in this cycle. Doing so could have a negative effect on short-term earnings but would show some real confidence in their long-term investment and growth plans. As already mentioned, shipments and orders fell in the fourth quarter, and our working explanation is that much of that fall is really an inventory adjustment. We’ve had that discussion for a while. I would expect business investment and industrial production to pick up. If it doesn’t do so in the first quarter, my confidence about this side of the economy, about this leg of the stool, will be significantly reduced. Between now and the next time we meet, we will have a better sense of whether that turn on the business side of the economy is real or whether we just saw a false start in December. So I think we’ll be able to come to a much firmer view when we meet in six weeks. All in all, I remain reasonably confident and optimistic about the forecast. Thank you, Mr. Chairman.

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