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

Thank you, Mr. Chairman. Let me confine my remarks to a couple of discussions of the economy that bolster the themes that several of you have noted. At the outset, I’ll say that I continue to be more concerned with the level of inflation and our progress regarding it than I am with growth. The economy appears to be on track, and I think, unlike the Greenbook projections, that there’s a prospect for some upside surprises on growth. So let me spend a few moments looking at the labor markets, the corporate profit markets, household balance sheets, and consumer spending before coming back to the capital markets a little more broadly.

First, on the labor market side, as has been noted previously, we continue to have surprisingly strong job gains, particularly at this point in the cycle. The trend on revisions, regardless of the data series, tends to be continuing upward. The labor markets continue to accept new workers into the labor force more smoothly, with the participation rate the highest since 2003, which suggests a dynamism in that market. Hiring plans of small businesses have moved to their highest level in nearly two years and tend to be a pretty good forward-looking indicator, perhaps a better indicator than large companies. In light of all that, I think the Greenbook rightly acknowledges that the household survey may imply even greater strength than the payroll data suggest.

Second, turning to the profits picture, there continue to be remarkable profits for the S&P, the Dow, and the broader markets, predicated on strong cash flows and record profit margins. Broad-based NIPA profits are up 30 percent pre-tax for the third quarter. S&P delivered 20 percent profit gains in the third quarter. I think the trend there is particularly telling. That is, estimates by earnings analysts continue to surprise on the upside. As we move through the quarter, those bottom-up estimates continue to track very, very positively. I think that’s probably a good indication of why we’ve seen equity prices increase. When we look at where estimates are for the fourth quarter, bottom-up estimates for the S&P 500 are at about 9.1 percent. For 2007, year-over-year increases of about 9.3 percent are expected. These numbers are very strong, but they are significantly down from the high double-digit numbers that we’ve seen over the past couple of quarters. My own sense is that continues to suggest good news for the equity markets and good news for corporate profits. I expect that equity prices will outperform over the next couple of months if the numbers move up from 9 percent into the double digits. If that trend is reversed and we see disappointing corporate earnings, we could see a pretty rapid pullback in the equity markets, with some implications for the broader economy. I mention this discussion of profits and recognize that, though there is some correlation between corporate profits and the broader economy, we are continuing to see a disproportionate share of total income coming from this sector. So it’s a sector that we need to continue to evaluate.

Third, turning to household balance sheets, net worth grew $3½ trillion over the past four quarters, as the Fed’s flow of funds data suggest. Assets are growing faster than liabilities, whether we include or exclude housing, if we look at just the past four quarters. Continuing remarkable levels of household and corporate liquidity continue to suggest very good news. Although in these data we do see growth of household debt relative to income, this is a trend over the past twenty-five years, and I don’t really note anything overly disturbing there. So when we look at those three measures—labor, profits, and balance sheets—I come to a pretty encouraging conclusion in terms of an underlying sturdiness to the economy, particularly in regard to individual consumption.

Let me turn to consumption, with a bit of a short-term focus here on the fourth quarter. I think the Greenbook suggested anecdotally that November might turn out to be a little softer than October and a little softer than expectations. My own sense is that some real upside surprises are there. I had discussions with contacts and reviewed data from two large credit card companies, which in total represent about 35 percent of all of consumer buying over this period. This real- time information ends in November and looks across demographics. It excludes subprime lenders: The only subprime folks in these two portfolios are those who began in the primary market and found their way into the subprime market. So I recognize that we are missing an important piece. However, when you look at consumer spending for November, you see little to no deterioration in credit quality—credit is still incredibly strong across regions and income groups. I pushed each of the two companies to find areas of weakness, and they found this exercise to be pretty tough. Their own internal credit measures have not shifted. They had built in some softening in November and December Christmas spending, which they have not seen. They continue to see a huge reservoir of untapped credit, and they do see some de-leveraging by folks in key consumer groups, which they think suggests that consumers are in very good shape. The consumer spending trend from these two contacts continues to be very positive. They expected to see growth in November on the order of 4 percent; they saw growth of 5½ and 6 percent. Though it’s too early to call this Christmas season a success, they are much more positive than they were before November began, in terms of both dollar purchases and transaction swipes. So my own sense is that the consumer appears to be quite strong.

Having now listed four areas that I think have rather remarkable strength, I want to spend a moment on another topic that has been discussed around this table, which is manufacturing. As we look at the manufacturing base and we try to evaluate how we will know which inflection point the economy turns on, the manufacturing data are likely to be quite telling. I’ve been surprised and disappointed by poor manufacturing ISM (Institute for Supply Management) data and other weak data, and I’ve asked myself whether the weakness shows some spreading beyond autos and housing, which we’ve all discussed for some time. When I look behind those data, I am comfortable that much of the weakness that we see in manufacturing really is consistent with that theme—that is, second-order and third-order suppliers into the auto and housing sectors. Other weakness does appear to be related to certain machinery and equipment, but I have seen that weakness more in the data than in the anecdotes. As President Minehan suggested, I think that these data end up being somewhat weak, but the weakness is transitory. The share prices of most of these large multinational manufacturing companies continue to outperform. The tone that these companies have when they’re meeting with their analysts continues to be quite positive, so this signal may well be false, but we have to focus a bit more on it. By the time we meet in the first quarter we’ll have a better sense of whether the manufacturing base, in terms of volume and productivity, is giving us any indication of what’s happening in the broader economy.

Let me turn, finally, to the capital markets. Capital markets, as has been mentioned around this table, continue to function well. The Board staff has rightly observed that long-term forward corporate credit spreads are widening somewhat, showing that these markets, while awash in liquidity, are responding to price signals and are starting to focus increasingly on credit. In a couple of instances, issuers that tried to come to market, both in Europe and in the United States, were beaten back, which was, frankly, good news from the perspective of market discipline. The securities that they were trying to issue were PIK notes. These are paid-in-kind securities by which the company can pay off the investors either in cash or through additional paper, and the pool of liquidity for such notes is not so deep. That kind of discipline in the markets should encourage us. Having said that, I consider the debt capital markets to be incredibly robust. I talked previously about remarkable pipelines that were at record levels. They have all now priced at significantly beneficial terms. In November, as I think Dino noted, high-yield corporate issuances were at a record. The leveraged-loan market was also at a record, and we found instances in which issuers obtained better terms by issuing in larger volumes. That tells us that some people in the investor base really want to get their full allocations. If they can get their allocations, they’re willing to pay a premium for doing so. The backlogs priced remarkably well, and I think those markets are functioning well.

Let me enter the discussion about trying to reconcile the bond markets and the equity markets by making four points. First, the leveraged buyout data that Dino discussed are one explanation. That is, you don’t need to have a leveraged buyout of a vast majority or of even a significant number of companies in the S&P for those values to find their way into the markets. My view is that an LBO floor valuation now exists across more sectors than we could have anticipated before—into technology, for example—and companies that, because of their size, were previously out of reach for the private equity players. Part of the growth that we’ve seen in the equity markets has occurred because the LBO prices that could theoretically be paid, with balance sheets that are probably much less conservative, have raised the prices that are paid in the capital markets for these same companies. Second, the difference between the equity and the bond markets is about earnings growth and not multiples growth. On a price-to-earnings basis, the suggestion is that earnings in 2007 will be up something like 9 percent over this year, and the price-earnings multiples don’t look out of whack. You end up with earnings that, if they are delivered for another year or two, don’t make these companies look all that expensive. Third, in reconciling these markets, I’d suggest that the difference is really about us. The markets think that, if the trajectory for the economy softens significantly, the Fed will be responsive to it, notwithstanding what we’re saying currently—that dependence on the data means that we will be agile and we won’t be stuck in our words of yesterday in judging the economy that’s forthcoming. So they believe that we will effectively lower rates to achieve a very soft but successful landing. Finally, expectations are built into the bond markets that rate cuts are ahead. The discount rate in evaluating cash flows for these companies obviously comes down as well, further bolstering their value. So I suspect that these markets are perhaps a bit more consistent than some market prognosticators would say. But we must continue to evaluate them over the next several weeks and months. Thank you, Mr. Chairman.

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