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

Thanks, Mr. Chairman. I will be referring to the material that was distributed labeled “Material for FOMC Briefing on Monetary Policy Alternatives.” Financial market conditions eased noticeably on balance over the intermeeting period. As shown in the top panels of exhibit 1, ten-year nominal Treasury yields dropped 30 basis points, the dollar declined nearly 2 percent, and equity prices rose more than 3 percent. As portrayed in the middle left-hand panel, the decline in Treasury yields seems to have been prompted in part by incoming spending and production data that were generally weaker than investors anticipated and inflation figures that were viewed as relatively benign. The labor market reports for October and November, however, came in at or above market expectations, interrupting the general downward trend in rates. As shown in the middle right-hand panel, inflation compensation was little changed for the next five years, after adjustment for carry effects, and was only a little lower for the subsequent five years. Thus, almost all the decline in nominal yields represented a drop in real rates.

The bottom left-hand panel indicates that one-year nominal forward rates at the two-year and three-year horizons dropped the most, but the decline in yields was spread across the forward rate curve. The fact that relatively near-term forward rates declined steeply seems consistent with an interpretation that investors marked down their views of the cyclical strength of the economy, but the considerable drop in far forward rates seems to suggest that investors believe that more-persistent factors are also at work. As shown to the right, however, primary dealers and Blue Chip forecasters revised down their forecasts for GDP growth over the five quarters ending late next year by only about ¼ percentage point, and private forecasts of long-run or potential GDP were essentially unchanged, leaving unanswered questions about the source of the drop in rates.

As can be seen in the top left-hand panel of exhibit 2, our three-factor term- structure model attributes the decline in the ten-year Treasury yield over the intermeeting period primarily to lower term premiums, the green portion of the bars. Ten-year term premiums are estimated to have declined from 31 to 12 basis points, leaving them almost invisibly thin and around their record lows. Expected future rates over the next ten years, the blue portion of the bars, are estimated to have accounted for only 9 basis points of the decline. However, we have some doubts about this estimated decomposition, in part because a sizable drop in the term premium, which at least conceptually represents compensation for interest-rate risk, seems hard to square with measures of interest-rate uncertainty. As shown to the right, implied volatilities on Treasury yields, the black line, have edged up in recent weeks, and uncertainty about the Eurodollar rate six months ahead, the red line, has risen quite noticeably. Also, as shown by the blue bars in the middle left-hand panel, the average individual uncertainty that primary dealers expressed about the stance of policy three meetings ahead has crept up since the summer.

In any case, both market participants and market economists on average anticipate that policy easing is not far off. As indicated in the middle right-hand panel, primary dealer economists expect that the federal funds rate will average 5.16 percent in the first quarter and 4.82 percent in the fourth quarter of 2007. Quotes on fed funds futures, the right-hand column, suggest that investors see an even steeper easing of policy, with the funds rate expected to drop about ¾ percentage point over the next year. As shown by the red bars in the bottom left-hand panel, the downward shift of rate expectations over the intermeeting period has been accompanied by a greater leftward skew of the distribution. As noted in the bottom right-hand panel, dealers uniformly expect you to keep the federal funds rate unchanged today, and most anticipate little change to the wording of the statement apart from updating the characterization of the economic situation. A week ago, a minority expected a more significant softening of the statement, perhaps by referencing downside risks to growth or possibly even by describing the risks to growth and inflation as balanced; but informal reports suggest that some have backed off such expectations in view of Friday’s employment report.

If Committee members see significant odds that the market expectation of a near- term easing of policy could prove warranted, they might wish to start adjusting the policy statement in that direction, as in the Bluebook’s alternative A, discussed in the top left-hand panel of exhibit 3. While Committee members might remain concerned about the upside risks to inflation with an unchanged federal funds rate, they might also believe that the substantial slowing in the housing sector, relatively high inventories in some sectors, and the sluggishness of manufacturing mean that the downside risks to economic activity have increased and now roughly balance the upside risks to inflation. Such an increase in downside risks could be a result of the gradual weakening of the near-term outlook, particularly if members place some weight on the possibility of nonlinear effects as economic growth slows. Moreover, while we do not fully understand what investors are reacting to, policymakers may be concerned that the decline in market rates could be signaling a degree of economic weakness that we do not yet appreciate. Also, our estimated policy rule indicates that maintaining rates at their current level would be consistent with the Committee’s past behavior.

On the other hand, the Committee might see the recent easing of financial conditions as one of several considerations tilting it toward alternative C. As noted in the top right-hand panel, financial markets evidently are imparting increased stimulus to aggregate demand even as labor market conditions have tightened further. Members may view that stimulus as unwarranted and undesirable if their view of economic fundamentals hasn’t changed much and may believe that at least some of it should be offset by a firmer stance of monetary policy. Moreover, while core inflation has edged lower by some measures, it may not be seen as convincingly on a downward trend. And even if the Committee does believe that inflation is gradually ebbing, it may be dissatisfied with the anticipated pace of that decline. These considerations may motivate the Committee to consider firming policy today.

However, the Committee might once again conclude that holding policy steady at this meeting is likely to be consistent with achieving its goals over time while perceiving that, if anything, modest additional firming may be required, as in alterative B. Although the Greenbook forecast for near-term activity has been marked down slightly, the medium-term outlook is essentially unchanged, and as illustrated in the middle left-hand panel, the real federal funds rate remains at the upper end of the range of model-based estimates of its short-run equilibrium and slightly above the Greenbook-consistent measure. In the Greenbook, maintaining the current stance of policy over the next two years produces economic growth a bit below that of potential in 2007 and core PCE inflation that edges down slowly to about 2 percent by 2008. While you would likely prefer stronger output growth and lower inflation, you might find the outcome projected in the Greenbook to represent both a plausible outcome and a reasonable balancing—given your dual objectives—of what is actually achievable in the circumstances. As noted previously, maintaining your stance for the near term would also be consistent with the Committee’s past behavior, as captured in our estimated outcome-based policy rule. Similarly, as shown in the panel to the right, optimal control simulations based on the extended Greenbook projection and an inflation objective of 2 percent would call for holding the federal funds rate at its current level over the next several quarters before easing slightly.

While maintaining the current stance of policy, the Committee might believe that the risks remain tilted to the upside, as noted at the bottom of the exhibit. The unemployment rate is below most estimates of the NAIRU, suggesting that labor market strains could be putting upward pressure on prices, and the Committee may consequently be concerned that inflation may not decline as in the staff’s outlook. Moreover, with core inflation recently running around 2¼ to 2½ percent, somewhat above the preferred ranges cited by some of you, the Committee may continue to feel that risk-management considerations argue for an assessment that the risks remain tilted toward higher inflation, as in alternative B.

Table 1 as it appeared in the Bluebook is included as exhibit 4 for your reference. Under the formulation of alternative B shown in this table, the Committee would refer to the “substantial” cooling of the housing market, indicate that “the recent pace of growth appears to have been somewhat more subdued than anticipated,” but still conclude that “the economy seems likely to expand at a moderate pace on balance over coming quarters.” This alternative would retain paragraphs 3 and 4 as they appeared in the October statement. If you found that version of section 2 too broad, you might prefer the version of alternative B presented in exhibit 5, shown in seasonally appropriate colors. [Laughter] Under this formulation, in section 2 the first sentence and the second clause of the second sentence would be identical to that presented in the Bluebook. However, the first clause of the second sentence would indicate that “some recent indicators of production and spending have been slightly weaker than anticipated.” This formulation may be seen as superior in that, first, it characterizes recent indicators without making a pronouncement about overall growth for the fourth quarter and, second, it suggests that not all economic indicators have been weak. Both the exhibit 4 and the exhibit 5 versions of alternative B seem broadly in line with market expectations. Thank you, Mr. Chairman.

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