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

Thank you, Mr. Chairman. I have to admit that this time around I found it pretty challenging to read the tea leaves on economic activity. The data are providing distinctly contradictory signals. For example, several key indicators of aggregate spending have come in below expectations, and the Greenbook now sees real GDP growth this quarter and the next averaging a mere 1½ percent. At the same time, the labor market continues to be strong and shows no clear signs of weakening, as evidenced by the November employment report. The latest information on inflation has been fairly favorable; but even with some signs of easing, the underlying trend in core consumer price inflation remains above my comfort zone.

The last time we met I described the situation as a bimodal economy with strength in most sectors and weakness limited to just two sectors, housing and domestic auto production. This description by and large remains apt. The correction in the housing sector has continued, even sharpening somewhat compared with our expectations. Still, there are some encouraging signs that the demand for housing may be stabilizing, probably assisted by recent declines in mortgage rates. After a precipitous fall, home sales appear to have leveled off. In addition, equity valuations for homebuilders have continued to rise in the past couple of months, suggesting that the outlook for these businesses may be improving. Finally, the gap between housing prices and fundamentals may not be as large as some calculations suggest because real long-term interest rates have fallen quite a bit recently, raising the fundamental value of housing. That said, the housing sector on balance is a source of downside risk, and the risk could be magnified if mortgage rates were to rise again as foreseen by the Greenbook.

Outside residential investment, GDP growth has remained solid. Consumption has continued to be strong; indeed, I think there are upside risks to consumer spending, given the Greenbook’s forecast of a significant rise in the saving rate. But recent indicators of nonresidential investment and activity in the manufacturing sector have come in below expectations. The key question is whether these data hint at a crack in the economy’s armor that could widen. It’s obviously too early to tell, but these weaknesses bear careful monitoring.

Overall, the data on spending paint a clear picture of an economy growing well below trend, but it seems as though the BEA hasn’t delivered this message to the BLS. [Laughter] The very latest data show payroll employment growing steadily. The household data are even more alarming. The unemployment rate has declined ½ percentage point over the past year and now stands at 4½ percent, ½ percentage point below our estimate of the NAIRU. My business contacts tell me the same thing. Labor markets are tight, and jobs are hard to fill, especially for skilled positions. But some other indicators suggest that labor markets may have softened a bit. In particular, the Conference Board index of job market perceptions, based on a survey of households, declined in both October and November. This index is historically very highly correlated with the unemployment rate, but now it’s sending a different signal, suggesting that labor markets are roughly in balance. Similarly, in November fewer firms reported openings that are hard to fill.

The fall in the unemployment rate this year is hard to square with Okun’s law. Over the past four quarters, GDP growth has averaged 3 percent, just 0.3 above the Board’s estimate of potential GDP growth. A standard Okun’s law calculation suggests that this should have led to a decline in the unemployment rate of only about 0.1 percentage point. In fact, however, it declined 0.5 percentage point. Of course, labor markets do adjust with a lag, so we may just need to be patient and wait for Okun’s law to reassert itself as assumed in the Greenbook forecast. An alternative possibility is that the output gap is more positive than assumed in the Greenbook because of lower growth in potential output or more-rapid growth in actual output. In his presentation, David noted the possibility that the growth rate of potential output may be lower than even the downwardly revised estimate in the Greenbook. It is also possible—and, in fact, there are indications—that actual output growth may have been faster than the pace reflected in measured GDP. Growth in domestic income has outpaced GDP growth by ¾ percentage point over the past year. Now I know that when someone mentions the statistical discrepancy, eyes start to glaze over. But I raise this issue because it could have important implications for the outlook. If the gross domestic income measure ends up being more accurate, then the decline in the unemployment rate this year would not be surprising. Going forward, more-rapid output growth would imply a lower path for unemployment, potentially adding to inflation pressures.

Turning to inflation itself, the news has been pretty good on balance since our last meeting. We expect core PCE price inflation to edge down from just under 2½ percent this year to about 2 percent in 2008. We came to this forecast balancing two main pieces of news. On the one hand, recent labor market data point to a lower path for the unemployment rate than before, and all else being equal, this boosts our inflation forecast a bit. Offsetting this effect, on the other hand, is the huge downward revision in compensation per hour. When these data came out, I let out a big sigh of relief. The revised data are more consistent with the indications we were getting from the employment cost index and suggest that wage growth has remained contained. In contrast, my contacts report intensifying wage pressures, resulting in part from more-frequent employee quits and outside offers. Even so, my contacts do not report that these developments are exerting significant pressure on their profit margins or prices, suggesting continued strong productivity growth. But that, in turn, conflicts with the data on productivity growth in the nonfarm business sector, which have been weak, not strong. Output per hour in the nonfarm business sector increased only about 1½ percent over the past year, well below its trend. But there is reason to believe that this decline may overstate the slowing in productivity growth, given continued strong growth in productivity in the nonfinancial corporate sector. At least part of this discrepancy between nonfinancial corporate and nonfarm productivity growth reflects the gap I mentioned before between gross domestic income and gross domestic product. If the GDI numbers are, in fact, more accurate, that alone could add nearly 1 percentage point to nonfarm business productivity growth, perhaps reconciling the reports by my contacts of intensifying wage pressure along with an absence of pressure on prices and margins.

In summary, I continue to view a soft landing with moderating inflation as my best-guess forecast, conditional on maintaining the current stance of policy. But there are sizable risks on both sides to the outlook for growth, and the downside risks are now more palpable. There is, likewise, a great deal of uncertainty about inflation going forward; in this case, the risks remain biased to the high side.

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