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

Thank you. This was an exceptionally interesting, useful discussion. I thought I would try to summarize what I heard around the table. If you have comments on that, please give them to me, and then I’ll add a few comments of my own.

Members noted considerable economic strength during the intermeeting period. Labor markets remain taut, with continuing wage pressures in some occupations. Consumption grew strongly in the fourth quarter, with some momentum into the first quarter, reflecting a strong job market, lower energy prices, and higher profits. Overall, investment seems likely to grow at a moderate pace given good fundamentals. Business people seem generally optimistic, and financial markets are robust.

We still have what people have been characterizing as a two-track economy. Housing, although a drag for now, does show some tentative evidence of stabilization. However, some warned about drawing too strong a conclusion about housing during the winter months. Some also noted issues of credit quality. The general view was that housing would cease to subtract from growth later this year. Some softness in parts of manufacturing, especially in industries related to housing and automobiles, still exists. But in part this weakness may be an inventory correction that may be reasonably far advanced at this point. Despite the weakness in housing and some parts of manufacturing, there are yet no signs of spillover into employment or consumption, although some raised the possibility that we may see those later on. Some, but not all, members agree with the contour of the Greenbook that has economic growth somewhat slower in the near term, strengthening later this year, with a modest increase in unemployment. The Committee is generally more optimistic about potential growth than the Greenbook, mostly because the members assume that labor force growth will be greater than the Greenbook assumes. Overall, downside risks to output appear to have moderated, while an upside risk has emerged that growth will not moderate as expected.

On the inflation side, people noted that recent readings have been favorable, although there was disagreement about the cause, whether it was energy prices, well-anchored inflation expectations, less structural inertia, or perhaps just statistical noise. Most still expect gradually slowing inflation but are cautious and consider upside risk significant, perhaps even greater than late last year. The primary upside risk to inflation is economic growth above potential in tight labor markets, which may lead to inflation in the future if not in the near term. Others noted that inflation expectations may be too high to allow continued progress against inflation. So overall, the general tone was for a somewhat stronger economy, perhaps a slightly improved outlook on inflation, but, in any case, a clear view that the upside risks to inflation are predominant. Are there any comments?

Let me add just a few points. Everything has really been said, but not everyone has said it, as they say. [Laughter] Our goal has been, in some sense, to achieve a soft landing, and the question is whether we have missed the airport. [Laughter] We have seen a good bit of strength in the intermeeting period, and I think the real crux of the issue is what’s going to happen to the labor market. If the labor market continues where it is or strengthens further, we will see both stronger growth, because of the income effects and job effects, and continued pressure on inflation. Again, the central issue will be whether we will see enough cooling in the economy to have a bit of easing in the labor situation. This is, obviously, difficult to say. I do believe that the most likely outcome for the first half of this year is for some moderation in growth, perhaps to modestly below potential. If you look at the various components of spending and production, you note, for example, that personal consumption expenditures are likely to slow from the very high levels we have just seen recently. In particular, a lot of the spending recently was for durable goods, which tend to be more negatively auto-correlated—that is, they tend to drop more quickly when they are high in the short run. We have seen some moderation in investment, in both equipment and structures. Net exports were a major contributor to growth at the end of the year; that should probably reverse, as the Greenbook notes. A special factor there is that the good weather reduced oil imports, which led people to spend on domestic production rather than on foreign production. If that situation reverses and we go back to normal net exports, that will subtract from GDP. Also, the staff noted some likely reversals in government spending. So my sense is that we’re likely to see something a little less hectic in the first half of this current year.

I think it also remains reasonable that growth will return close to potential later this year. There is certainly uncertainty about that. Clearly, we have seen some signs of stabilization in the housing market. I was going to note the effects of the winter months and the weather. I think that we should acknowledge that stabilization but not ignore the possibility that we may see further deterioration there.

Against the view that growth may moderate this quarter, or next quarter perhaps, there is opposing evidence that consumption and employment are awfully strong. Economists tend to think of consumption, in particular, as being a very forward-looking variable, and it’s consistent with views that we see, for example, in consumer sentiment that people do feel reasonably optimistic about the labor market and about the state of the economy. So I agree that there is certainly some risk that the economy will be stronger going forward than we have been projecting. I don’t have an answer other than to say that we obviously have to monitor the situation very carefully and continue to be willing to reassess our views as the data arrive.

Let me say a bit about inflation. Recent readings have been favorable. A couple of aspects of inflation I do find encouraging. First is that the moderation we’ve seen in inflation the past few months has happened despite the lack of any substantial moderation in shelter costs. Owners’ equivalent rents are actually a constructed, imputed variable. They are not seen by anybody. Nevertheless, they are essentially the entire reason that inflation is remaining above our target zone at this point. I know it’s a bit of a joke that I always refer to the short-term inflation numbers, but I’ll do it again anyway. [Laughter] Just to illustrate, over the past three months, core CPI inflation excluding just owners’ equivalent rent was 0.2 percent at an annual rate. Over the past six months, it was 1.20 percent at an annual rate. Over the past twelve months, it was 1.82. We also get numbers for PCE core inflation excluding owners’ equivalent rents that are all below 2 percent. Obviously that is just carving the data, and there are lots of problems with doing that. But to the extent we think that rents will continue to moderate, and I think there is scope for them to do that, that’s one factor that should make us a little more comfortable. Another factor is that there is a fairly broad-based slowing. I won’t take a lot of time to go through the evidence, but particularly in the CPI there are some encouraging developments on the services side in terms of inflation to go along with the slowing in goods prices.

Now, I am the first to acknowledge that lots of interpretations of the recent developments are possible. We hope that favorable structural factors are at work. One possibility certainly is that the wage increases are a catch-up for previous productivity gains and that we’re seeing a normal restoration of capital-income/labor-income relationships. In that case, this may be in some sense a transitory adjustment that will restore those relationships and not necessarily contribute to inflation going forward. Another possibility is that energy price effects are somewhat larger than we thought. There seems to be some evidence that they are. A third possibility is that what we saw earlier last year was, as Governor Kohn mentioned, a transitory upside, some of which has simply passed, and we are going back to the more fundamental rate of inflation. So there are some structural reasons that inflation might be moderating.

My having said that, we should certainly acknowledge the statistical noise that is inherent in these measures. The monthly standard deviation of core inflation in 2006 was about 8 basis points. If the true underlying inflation is 0.2 percent, then you have a very good chance of getting either 0.3 or 0.1. Therefore, we and the financial markets ought to be braced for the possibility that we will get 0.3—I hope not worse—in the next few months. I agree with the view that has been expressed that the trend has not yet been established, and we’ll have to follow its development. Another very important point that has been raised—President Moskow, I think, was the first to raise it—is that, given the lags from economic activity to inflation that we see in standard impulse-response functions and so on, these improvements may be real but nevertheless temporary and the underlying labor market pressures and so on may lead to inflation problems a year or eighteen months from now. I agree that it is a concern, and it goes back to my point earlier that we need to be very alert to changes in the pattern of aggregate demand going forward. As President Poole mentioned, one element that will help us is the endogeneity of financial conditions. We haven’t done anything since the last meeting, but long-term real interest rates rose about 30 basis points. The yield curve is still inverted by about 30 basis points. So I think even the markets themselves have the ability to raise real rates quite significantly, enough certainly to make a difference in the mortgage market if the data continue to be strong and if inflation does not continue to subside. Then we would have a bit more latitude as we try to determine whether the fourth quarter was a blip or a trend. I think that’s still an open question.

So let me just say that I broadly agree with what I heard. The economy does look stronger. That is an upside risk to which we need to be paying close attention. Inflation looks a bit better, at least in the short term, but there are some long-term considerations that we need to keep in mind. Finally, the basic contours of the outlook are not sharply changed, but I agree with the sentiment around the table that upside risk to inflation remains the predominant concern that the Committee should have. Are there comments? Yes, President Poole.

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