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

Thank you, Mr. Chairman. My contact calls and director reports this round point to moderate growth in overall economic activity. Both nationally and in our District, housing is weak. Domestic auto production is slowing from last year, but activity in other sectors remains on a solid footing.

Starting on the downside, one of our Detroit directors from Pulte Homes characterized the slowdown in housing as broad and deep, and he said that they face a rocky road for the next year or two. With regard to motor vehicles, GM noted that their lower production in the fourth quarter largely reflected the retooling of five plants for their new truck platform, reduced low-margin sales to rental fleets, and lowered desired inventory holdings by dealers because of higher interest rates. Both GM and Ford are trying to reduce their reliance on sales to rental fleets.

In contrast, a wide array of capital goods manufacturers reported continued strong growth. The two major temporary help firms headquartered in the District pointed to modest but steady growth in billable hours. Importantly, no contact was worried about a protracted slowdown in the economy. Indeed, my directors were quite optimistic. This is an important change from six weeks ago, when we were hearing comments that the expansion had become long in the tooth and concerns that we were headed for a period of sustained weakness. This more upbeat assessment was in line with the sentiments I heard at the International Manufacturing Technology Show, which was held in Chicago earlier this month with over 90,000 attendees from more than 100 countries. Now, I did not have a chance to talk to all of them, [laughter] but the ones I did talk to were quite optimistic about increasing demand for U.S.-made high-tech capital equipment. The most amazing and impressive new technology that I saw was something that looked like a large ink-jet printer, but it spit out metal dust to fabricate intricate parts without traditional tools or dies. This was really quite unusual and impressive.

Turning to inflation, there was little change in most reports regarding price pressures. Labor compensation continued to increase at elevated rates. Our contacts from temporary help firms noted a further step-up in wages for highly skilled workers, whereas our retail contact said he was paying 8 to 10 percent more for entry-level sales personnel. Of course, the energy picture on the cost side looks better. Several contacts expressed relief at the recent declines and hoped that they would lead to reductions in fuel surcharges and related costs.

Turning to the national outlook, we agree with the Greenbook’s assessment that growth in the third quarter appears to be somewhat weaker than we anticipated at the time of the August meeting. However, in contrast to the Greenbook, we do not think the sluggishness will persist for long. Current financial conditions do not appear to be a restraint on activity. Labor markets are in good shape, so growth in jobs and wages should continue to support household spending. We are getting a welcome boost to real incomes from lower energy prices; and given the increase in business optimism that I noted earlier, I am less concerned that cautious animal spirits will cause businesses to pull back on spending. Housing remains the major downside risk, but I get the impression that thus far the weakness in residential investment is not spilling over to the other sectors of the economy. Of course, we have talked about this at great length.

So our overall assessment is that by early next year growth will be much closer to potential than the Greenbook projects. Accordingly, we do not think that any meaningful resource gaps will emerge to restrain inflation. Indeed, our inflation models based on data since 1967 look for core PCE inflation to be 2.7 percent in ’07 and 2.6 percent in ’08. The models that use data only since 1984 come out somewhat lower, at 2.4 in ’07 and 2.3 in ’08.

In thinking about the differences between these forecasts, I found the background paper that Dave circulated quite useful, as several others have said. Our models allow for permanent shocks to the level of inflation, and as the paper noted, such shocks appear to have been much smaller since 1984. But as also discussed in the paper, we have no way of knowing whether these permanent shocks will be small in the future. I think the most likely interpretation of the reduction in the volatility of these permanent shocks is that policy has done a better job of anchoring inflation expectations. The public is more convinced than they were in the past that we will maintain low and stable inflation. But if our actions fail to confirm this belief, we would lose credibility, leading to higher inflation expectations and imparting more persistence to the current inflation shock. An inflation shock that is permanent rather than transitory is our responsibility.

Our forecasts remind me of this risk. True, so far this is just a risk. We have not yet seen any broad-based increases in long-run inflation forecasts by private-sector economists or in the five-year to ten-year TIPS inflation compensation. Indeed, TIPS have even moved down recently. This news is welcome. But even if inflation expectations have not moved up, another concern is the level of long-run inflation expectations—and I thought Jeff Lacker raised a good point last time in reminding us about it. Long-run inflation expectations of around 2½ percent for the CPI translate into a core PCE rate well above the middle of my comfort zone of 1 to 2 percent. Even the Greenbook expects core PCE inflation to be above 2 percent through ’08. I am concerned that even now the public could be questioning our resolve to bring inflation into what many of us have said is our comfort zone. I am already hearing this sentiment from some market analysts. Even without an increase in expectations, it is not clear to me that inflation will settle back to a level that I view as being consistent with price stability without further policy action.

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