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

Thank you, Mr. Chairman. I cannot recall the precise baseball analogy employed by David Wilcox at the last FOMC meeting, but I have a vague recollection he speculated that I was either due for a forecasting hit or due to be hit by the forecast. [Laughter] In any event, since the Greenbook was completed last Wednesday, we have made several trips to the plate with consequential economic statistics on the mound. And how is the team doing? I guess I=d say, better than the Washington Nationals, not as well as the New York Mets.

Last Thursday, we received retail sales figures for August. As you know, we focus on the retail control component of spending, which strips out sales at auto dealers and building material and supply stores. The August increase in this category was 0.2 percent, a bit stronger than we had expected. But both June and July were revised down, and on net these data were a touch weaker than those incorporated in the September Greenbook. Retail inventories for July also were a bit below our expectation. Housing starts for August were released yesterday. In line with our forecast, single-family starts dropped nearly 6 percent, to 1.36 million units, and the permits data point to some further declines in the months ahead. But multifamily starts declined somewhat more that we had expected. If we had to redo the forecast today, we would probably lower the increase in real GDP in the second half of this year to 1½ percent at an annual rate.

Last Friday=s report that both headline and core consumer prices increased 0.2 percent in August was right in line with our forecast. The major components of yesterday=s PPI actually came in below our expectations, most especially the core finished goods index, which declined 0.4 percent in August. The only sour note was an increase in the PPI for medical services. The PPI for medical services is used by the BEA in constructing the core PCE price index, and it caused our estimate of core PCE prices for August to revise up from a high 0.2 percent to a low 0.3 percent.

All in all, however, the incoming data over the past week left our forecast pretty much unscathed. I am relieved about that, because, if I do say so myself, it=s a beautifully constructed forecast. [Laughter] After all, with no further tightening of monetary policy, the economy eases into an extended period of slightly below-trend growth led by a retrenchment in the housing sector. That slower growth of activity opens a small output gap by the middle of next year but does not trigger a more precipitous cyclical contraction. Then, as the downturn in housing wanes and the associated multiplier and accelerator effects largely play out, the growth of real GDP picks back up toward potential in 2008. Meanwhile, the output gap that develops over the next year or so, in combination with inflation expectations that remain well anchored and a near flattening out of oil and other commodity prices, is projected to impart a mild tilt down in core inflation—to 2¼ percent in 2007 and 2 percent in 2008.

So, what should you make of this forecast? Is it a construction as elegant and durable as say the Eiffel Tower in Paris, or is it more like the Eiffel Tower in Las Vegas—it looks pretty good a few blocks away but isn=t that impressive upon closer inspection? [Laughter] In that regard, you could not be faulted for wondering whether this forecast represents our averaging of two possibly more plausible outcomes that we simply didn=t have the courage to choose between.

One view could be that this forecast is far too pessimistic. After all, our projection for growth in the second half of this year and in 2007 is now well below the consensus. Most of the available measures of aggregate activity remain solid. Real GDP is estimated to have increased 3½ percent over the year ending in the second quarter, about in line with its pace over the past several years. More recently, despite some notable month-to-month swings, manufacturing industrial production is up at a 5 percent annual rate over the three months ending in August. An even more timely economic indicator, the level of initial claims for unemployment insurance, has moved sideways through the middle of this month and does not yet suggest any inflection point in activity. Moreover, oil prices are down, the stock market is up, and financial conditions in the corporate sector remain favorable. These developments could cast doubt on our projected slowdown in real GDP.

The other view might be that our forecast is too optimistic. Cyclical contractions are often precipitated by large imbalances in the economy that cause a great deal of pain and extensive damage when they get rectified. Certainly, housing is looking increasingly like a sector that could play that role. Starts and sales have dropped sharply in recent months, inventories of unsold homes are still soaring despite cutbacks in production, and prices are rapidly decelerating. This jolt is occurring while households are still dealing with the substantial hit to their purchasing power from the higher energy prices that they have encountered over the past several years. Yet all of this results, in our forecast, in only a very modest and gradual rise in the unemployment rate over the forecast period.

I must admit that there were times over the past several weeks when I felt as though I=d seen this forecast before—specifically, in the summer of 1990 and in the autumn of 2000. At those times, the staff saw that forces of restraint were in place, and we projected a noticeable shortfall of growth from potential. But we failed to anticipate much in advance the impending cyclical downturn in the economy—and I doubt that we will when such an event occurs again in the future. I can assure you that we spent a great deal of time examining both of these possible critiques of our forecast, but in the end, we still view something like our projection as more likely than either of these two alternatives.

So let me lay out the logic of the forecast and along the way address some of these concerns. As I noted earlier, we are now projecting the growth of real output in the second half of the year to be around 1½ percent at an annual rate, about ½ percentage point less than in the August Greenbook. The lower scheduled vehicle assemblies announced by the automakers were part of the downward adjustment. But the major source of the projected weakness in aggregate demand lies in residential construction, which is now expected to lop off nearly 1½ percentage points of growth in real GDP in the second half.

If it doesn=t really feel to you like an economy that is growing as slowly as 1½ percent, there may be a good reason. Our assessment is that, except for the housing sector, the economy is growing at a pace of roughly 3 percent. So far the collateral damage from the downturn in housing has been limited, and for the most part, we expect it to remain that way, at least for a time. A pickup in nonresidential construction activity has offset some of the weakness in residential construction. Moreover, the recent declines in energy prices seem likely to cushion some of the near-term effects of the housing contraction by restoring some lost purchasing power to households and by helping to support consumer spending. With overall business sales holding up reasonably well so far, the cost of capital still low by historical standards, and financial conditions solid, outlays for equipment should move forward at a fairly rapid clip for the remainder of the year.

But it seems implausible to us that the downturn in housing will not have multiplier-accelerator consequences that hold down growth going forward. Along those lines, we expect employment growth to slow more noticeably by the end of the year. Slower job gains and a further deceleration in housing wealth should damp consumer spending as we move into next year. The result is a steady, though gradual, rise in the personal saving rate over the next two years of about 2 percentage points. With the usual lags, slower growth of sales and output cause a mild deceleration in equipment spending. At the same time, fiscal policy is becoming progressively less stimulative over the forecast period. These forces are attenuated, but not offset, by the boost to spending generated by a higher estimated level of labor income and by a lower trajectory of consumer energy prices in this forecast. All told, we see these influences as likely to hold the growth of real GDP below potential over the next two years.

Still, we are not anticipating the weakening in activity to cumulate into outright recession. In our forecast, the fact that the implications of the housing downturn for the broader economy are relatively limited rests importantly on two suppositions, both of which are open to question. The first is that the slump in housing produces a sharp slowdown in house prices but not a large nationwide decline in those prices. In the past, housing prices have been relatively sticky on the downside, with homeowners resisting price cuts and keeping their homes on the market longer. Our forecast envisions something similar occurring in this episode. The second assumption is that housing wealth affects consumer spending like other forms of wealth and that there are no other channels of influence of house prices and housing finance on consumption. For example, we have not incorporated any significant negative effects on consumer sentiment that might accompany a rapid deceleration of house prices. We have also made no special allowance for the decline in mortgage equity withdrawal to restrain consumption because we find the empirical evidence of such a connection to be fragile. Previous Greenbook simulations have demonstrated that turning on any of these channels would amplify the effects of a weak housing market on the aggregate economy. Their absence in our baseline forecast is one of the reasons that the economy bends but doesn=t break in response to our projected housing slump.

As you know from reading the Greenbook, not all of the action was on the demand side of our forecast. In fact, we revised down aggregate supply by virtually the same amount that we revised down aggregate demand, leaving the output gap nearly unchanged from the August Greenbook. I would not be surprised if some of you were suffering a little reverse “sticker shock” from the low rates of GDP growth that we are now projecting, much of which can be traced to the downward adjustments that we made to potential output in each of the last two projections. The growth of potential is estimated to be about 2¾ percent this year and next and 2½ percent in 2008. Although we still could be characterized as productivity “optimists” with our projection of gains in structural productivity of 2¾ percent per year—a figure that is above many of the outside forecasts that we monitor—we are increasingly looking like potential output “pessimists” because of our expectation of only meager gains in available labor input. As you know, we are projecting a steepening downtrend in labor force participation and a slowing in the working-age population as the front edge of baby-boom retirements arrives late in the projection period. Our views are significantly below the consensus here. However, as we have noted in the past, if potential GDP ultimately proves stronger than we are forecasting, actual GDP will likely be stronger as well. So to a first approximation, the GDP gap and the assumed accompanying path of the funds rate would be largely unaffected by errors in our forecast of potential labor input.

Much like the real side of the projection, our inflation forecast had some large moving pieces that, on net, left us pretty much in the same place as our August projection. On the favorable side of the ledger, oil prices are projected to average around $10 per barrel below our previous forecast. Taken in isolation, this development would have led us to revise down our projection of core PCE prices about 0.1 percentage point next year. But there was news on the unfavorable side of the ledger as well. On the basis of unemployment insurance tax records, the BEA revised up the growth in hourly labor compensation to an annual rate of 13¾ percent in the first quarter of the year. Once again, we are confronted with a huge difference between the signal provided by nonfarm business compensation and the employment cost index (ECI) measure of compensation, which increased at a rate of just 2½ percent in that quarter. Such wild discrepancies have led some inflation forecasters to employ reduced-form price equations that circumvent measures of labor compensation altogether. We are sympathetic to that approach, and those types of models are in our stable of forecasting equations. But we think it unwise to ignore entirely the issue of labor costs, given that they constitute two-thirds of business costs.

So what do we make of this first-quarter jump in hourly labor compensation? As you know, one of the principal differences between the two major measures is that stock option exercises are included in the nonfarm business measure of hourly compensation but not in the ECI. Our colleagues at the New York Fed have been monitoring data on option exercises by company insiders, and those data suggest that an outsized jump in exercises in the first quarter probably helps to explain an appreciable fraction of the jump in hourly compensation. But that doesn=t seem to be the full story, as wages and salaries were revised up in categories, such as construction, where options probably do not figure prominently in employee compensation. In our forecast, we have assumed that stock option exercises and other nonrecurring nonwage payments provided a temporary boost to the level of income in the first quarter, about half of which will be reversed by the third quarter.

What about the consequences of these higher measured labor costs for prices? Models that take the data simply at face value want to revise up the forecast of core consumer price inflation forecast between ¼ and ½ percentage point in 2007. However, these data should not be taken entirely at face value, at least as a measure of incremental business costs. As we have argued in the past, option exercises are not likely to represent a marginal cost of production and, at the very least, are probably misleading with regard to the timing of any such cost increase. Thus we have discounted the price implications of the first-quarter surge in compensation per hour, adding just a tenth to our inflation forecast for this factor. This exactly offsets the negative effects of the lower energy prices and leaves our projection of core PCE inflation unchanged at 2¼ percent in 2007.

After that, a further waning of energy and other commodity cost pressures, the emergence of a small output gap, and the assumption that long-term inflation expectations continue to be reasonably well behaved cause inflation to drop to 2 percent in 2008. In that regard, the better core inflation figures of the past two months, the fall in oil prices, and the drop in various readings on inflation expectations over the intermeeting period provide us with some encouragement that inflation pressures will gradually fade over the projection period. But we would hasten to note that none of these developments cinch the case that we have turned the corner on inflation. Karen will continue our presentation.

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