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

Thank you, Mr. Chairman. As many of you have remarked, the incoming data on spending at least have been consistent with our basic outlook for economic activity. Weakness in housing and autos will hold activity to below the growth rate of potential for a few quarters but with limited spillover to other forms of household spending. As inventory overhangs in these two sectors are dealt with, growth will return to something like the growth rate of potential. From some perspectives, the recent data have actually suggested diminished downside risk to the story. Stabilizing house sales, recovering mortgage applications, and improving consumer attitudes toward home purchases may be the signs of a housing market beginning to find a bottom. The expected downward path of prices in the Case-Shiller index futures market has actually been revised higher over the intermeeting period; it is still sloping down but not as much. Auto producers have held production steady in the fourth quarter and announced a small increase in production for the first quarter. Moreover, consumption outside autos has remained on a healthy track.

Now, the downside risks in these areas may be smaller, but they certainly haven’t been eliminated. The Greenbook projection has starts stabilizing at the current level, but we have yet to see hard evidence of that stability. The last data point was a substantial decline that was larger than we expected. Inventory overhangs in the housing sector are large and will be worked down fairly slowly in the staff forecast. Heads of households may be just coming to the realization that their kids’ tuition and their retirement will not be taken care of by further outsized increases in the value of their homes.

A bit more troubling than the housing and consumption data—and perhaps indicative of other sources of downside risk—have been the rise in inventories and the softness in manufacturing production outside the auto and construction-related sectors. Much of the downward revision to private final demand from the last Greenbook to this one, taking into account both the third and the fourth quarters, was in business fixed investment, and it occurred when profits remained robust and sales—excluding autos and residential housing—strong. Evidence of broader weakness in the manufacturing sector seemed to account for at least a portion of the reaction of the financial markets over the intermeeting period.

There are a number of reasons to think that this weakness is limited. The underlying economy remains in good shape. Commodity prices have continued to climb, probably partly reflecting the weaker dollar but also indicative of underlying strength in global demand. Firms are adding to payrolls in a way they wouldn’t if they were sensing the possibility of softness spreading outside manufacturing. Equity prices and risk spreads suggest expectations of continued good growth, even if in the eyes of investors it might take some easing of policy to produce that outcome. As President Stern noted, anecdotes—as reflected in the Beige Book and what we’ve heard from visitors, including the Reserve Bank chairs and vice chairs who were here very recently—suggest that businesses are experiencing and expect continued good business conditions. These anecdotes very markedly contrast to the fall of 2000, when by November the tone of the feedback from businesses had turned decidedly gloomier.

The Committee has been focused on housing and consumption, but the recent data and the financial market’s response may suggest the possibility that something else could be going on. Perhaps the removal of policy accommodation has affected other forms of spending more than we had anticipated. I think that the basic story of growth strengthening to potential over the next year remains valid and that it will be strong enough to withstand a rise in longer-term interest rates that would accompany a flat fed funds rate as in the Greenbook. Moreover, the overall downside risks to that forecast probably haven’t increased very much, but they may have changed source or character. We will need to be alert to possible sources of weakness that we hadn’t anticipated.

With regard to the inflation outlook, I, like the staff, have characterized the incoming data as leaving expectations for a very gradual decline in inflation intact, if the economy follows something like the Greenbook path. To be sure, core PCE inflation did not ease back, but the CPI did quite a bit. Labor cost pressures appear to be less than we had previously estimated, and various measures of long-term inflation expectations remain within their ranges of the past several years.

My presumption, like that of the staff, is that at some point lagging spending growth will be reflected in labor markets and will help to remove inflation pressures. But for now, the risks around the expected downward trend in inflation remain skewed to the upside. Unit labor costs are still accelerating, although not as much as we thought they were, and businesses won’t readily absorb higher costs and reduced profit margins. The unemployment rate remains low. The index of capacity utilization in manufacturing continues to be above its long-term average, suggesting continued pressures in resource markets and, by extension, in markets for goods and services, which will contribute both to higher costs and to the ability of businesses to pass them on. The forecast path to inflation is sufficiently gradual that upward deviations from it could entail outsized costs in terms of embedding another notch up in underlying inflation and inflation expectations. Thank you, Mr. Chairman.

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