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

Thank you, Chairman Bernanke. Overall, economic activity continues to expand in the Third District. The consensus in the regional business community is for moderate growth in the months ahead, but some sentiment has turned more cautious in the intermeeting period.

We have seen a slowdown in regional manufacturing activity over the past month. Our business outlook survey, which remains confidential until noon tomorrow, weakened somewhat in September with general activity falling just barely into the negative area, at -0.4, from an 18.5 number in August. This is the first negative reading we’ve seen since April 2003. The diffusion indexes for shipments, new orders, and unfilled orders also turned slightly negative. I don’t want to read too much into one survey. The April 2003 dip was very short-lived, and we saw a similar pattern in our survey in the mid-1990s, when growth slowed but then picked back up again fairly quickly.

Part of the slowdown in manufacturing is at firms that supply the housing industry, reflecting a slowdown in residential real estate, which has become more pronounced in our District since our last meeting. Building permits and home sales were down in July and August. Inventories of homes on the markets, like much of the nation, continue to increase. House-price appreciation has slowed, but we have not yet seen outright declines. Despite an increase in cancelled sales of new homes, builders generally indicate that their backlogs will keep them relatively busy through the rest of the year. However, some real estate contractors have begun to lay off employees in anticipation of slower activity.

A pickup in activity in nonresidential real estate markets has been helping to offset the decline in residential construction. Office vacancy rates continue to edge down, and net absorption of office space continues to be positive. However, over the next year, some moderation in nonresidential building construction in our three states is expected. In response to a special question in our manufacturing survey this month, about one-third of the firms report that they plan to lower their expenditures on new structures next year compared with this year. Only one-tenth of our firms expect to raise spending on structures. When we asked a similar question a year ago, about half the firms expected to raise their expenditures on structures in 2006, and, in fact, we did see that this year. For other categories of capital spending, however, firms by a large margin anticipate expenditures in ’07 to be the same as or higher than those in ’06. At some small banks in our District there has been a recent pickup in nonperforming loans, which is concentrated in their commercial real estate portfolios.

Conditions in other sectors of our region are little changed since our last meeting. Retail sales of general merchandise edged up, but sales of back-to-school merchandise, especially fall apparel, did not seem to meet manufacturers’ expectations. Payroll employment continues to expand in our three states at a somewhat slower pace than in the nation as a whole, which is typical of the region. The unemployment rate, which had edged down slightly in June, edged back up in July but remains below 5 percent. While many employers continue to report difficulties in filling positions, the Philadelphia staff’s forecast is for employment in our region to grow at a pace of about 1 percent over the next year, slightly lower than this year. Unemployment rates in the region are expected to increase modestly maybe over the next year.

Growth continues at a moderate pace, but we see little indication of receding price pressures in the District. The index of prices received in our manufacturing survey edged up in September. There was some minor moderation in prices paid, but that index remains at an extremely high level. Employers in a number of industries in the region report that wage and salary levels have been moving up at a somewhat faster pace than they did a year ago.

Turning to the national economy, my view is not much different than it was at our last meeting. My main concern remains the outlook for inflation and the risk it poses for our credibility. In my view, the Fed’s most important contribution to a healthy economy is achieving and maintaining price stability. As expected, incoming data continue to indicate a moderation in growth to potential or somewhat below potential. On the negative side, housing has weakened more sharply than many expected, and auto production seems to be turning down for the rest of the year. On the positive side, as has already been mentioned by a number of others, business investment and corporate profits remain firm. Employment continues to rise at a moderate pace. The revised wage and salary data are now more consistent with the strength in consumer spending that we’ve seen, and continued growth in income and perhaps lower gas prices will help offset the possible negative effect that we may see from a deceleration in housing prices. On balance, I am somewhat more optimistic than the Greenbook about the growth side of the economy. I, too, see growth somewhat below potential over the next four quarters, but that’s driven predominantly by a slowdown in the near term—that is, in 2006. Then I see a return to potential more or less in 2007, although my estimate of potential is probably slightly higher than the Greenbook’s estimate.

Now, given the level of precision of our output measurements and forecast of potential GDP growth, I’m really not overly concerned about the forecast at this point. The adjustment in the housing sector to more-sustainable levels is forecast to occur without triggering a recession and without triggering much of an increase in unemployment. I believe we should not attempt to stand in the way of that happening. It’s a mistake to think that the forecasted moderation in growth will bring inflation back to a level consistent with price stability. Indeed, the Greenbook’s baseline forecast of core PCE inflation remains above 2 percent through the end of 2008. Even in the alternative Greenbook simulation of a slump in housing, in which aggregate demand weakens and real GDP growth slows to just 0.6 percent in 2006 and barely above 1 percent in the first half of 2007, core inflation hardly changes and remains above 2 percent in 2008. Thus, it seems to me that language from us in the press that indicates that moderating growth will help to restrain inflation is not really consistent with our forecast. I think it imputes a degree of precision to an estimated Phillips curve that we just don’t have.

Over the intermeeting period, we have had some hopeful news on the inflation front. Core CPI inflation has not accelerated further in the past two months, and oil prices seem to be down. Thus, headline inflation, as I pointed out, is likely to be way down in September, and we will seem quite omniscient. The measure of expected inflation over the ten-year period in our Survey of Professional Forecasters has not changed—it remains at 2½ percent. The August rise in the Michigan survey of one-year-ahead inflation expectations seems to have been reversed in the preliminary September numbers, largely because of the decline in oil prices. However, both compensation per hour and unit labor costs have been trending up, not down as the earlier data suggested, although I will note that the usefulness of the compensation numbers in predicting inflation is quite weak. Although core inflation has stabilized, its level is still above our so-called comfort zone.

To my mind, the inflation outlook is quite uncertain. We do not yet know if the positive developments in oil prices will stick or not. I hope they will, but certainly we’ve seen energy prices retreat only to move back up again, and the hurricane season isn’t over yet. Thus, we should not become too sanguine about inflation from one or two data points. Moreover, we do not know if the upward revision to labor compensation will pass through to core inflation, as built into the Greenbook baseline, or if measures of medium-term inflation expectations will continue to decrease. What we do know is that core inflation has been above 2 percent for two and a half years and is expected to be there, according to the forecast, for another two years. Put another way, there is little evidence in the forecast that policy actions to date will bring core inflation back below 2 percent before sometime in 2009. I think that should concern us.

I see two inflation scenarios as being plausible, and I struggle with which one I believe to be the correct one. In the first scenario, core inflation is elevated primarily because of transitory factors, like the pass-through of higher oil prices, and reflects an adjustment to these changes in relative prices. As oil prices stabilize, assuming that they do, we’d expect to see core inflation presumably fall and fall faster than indicated in the baseline Greenbook forecast. The Greenbook forecast appears to me to incorporate an assumption of relative price stickiness that is inconsistent with some recent studies on microdata. Thus, in this scenario, I see inflation falling, perhaps more in line with the Greenbook’s alternative scenario of less persistent inflation. This story is appealing and plausible to me, but it rests on the transitory nature of the current measures of inflation. Even in this most desirable of scenarios—seeing inflation fall back to 2 percent or slightly less in 2007—we have to recognize that we will have essentially ratified a higher price level driven by oil price increases, and we should ask ourselves whether or not we are comfortable with that.

In the other scenario, stimulative monetary policy during the past five years has been a major contributor to the rise in core inflation. In this case, we wouldn’t expect to see a deceleration of core inflation until monetary policy has firmed enough to take out the cumulative effects of that accommodation. The Committee has now moved rates up considerably from historical levels. If potential growth is now lower, as the staff indicates, the equilibrium real rate may be slightly lower, suggesting that monetary policy may be slightly firmer now than previously thought. Even so, it has only recently reached that level. But given the imprecision with which we estimate potential output or equilibrium real rates, I really don’t take much comfort from such measurements. Thus, to my mind, there is a significant risk that policy is not yet firm enough to achieve the desired outcome.

Regardless of which of these two scenarios you think more likely, I think we must be concerned that our credibility and the consequences of allowing inflation to remain above our comfort zone for so long are at question. If scenario 1 comes to pass and inflation falls faster than suggested by the Greenbook baseline, then we would all breathe easier. But that scenario seems largely a bet on oil prices and on the presumption that past accommodative policy is not playing any role, and that makes me nervous. I would much prefer to believe that scenario 1 is the operational one. However, again, I find it hard to believe that a four-year to five-year period is transitory, so I have to consider the alternative. If the first scenario is wrong and inflation evolves as in scenario 2, then our credibility is seriously at risk if we fail to take further steps to curtail price increases. We might be lucky. But we might risk finding ourselves in a situation in which inflation expectations become unhinged, making it more costly to bring inflation back down. As has been mentioned, in the Greenbook alternative forecast in which inflation expectations become unanchored, inflation remains near 3 percent with only a slight decline in 2008, and growth slows below 1¾ percent next year and remains well below trend through the forecast period. To me, 3 percent inflation and 1½ percent real growth is not a comfortable place to be and would make restraining inflation in the future even harder for us.

I’d like to conclude my remarks by thanking the Board staff for their research on inflation dynamics and the possible reduction in the level of persistence in recent years. I think this is an important area for research, but I encourage the staff to continue its work to try to identify structural models of these dynamics in addition to reduced-form models. I agree with the staff that the monetary policy implications of the reduced-form findings presented in the memo depend on how one chooses to interpret them. The results presented by the staff and others suggest that, since 1990, inflation has become less persistent and appears to be less related to other macro variables as well. We do not know whether these changes are due to a more aggressive stance of monetary policy against inflation and to our credibility or to fundamental changes in the domestic or world economy. If we suppose that lower inflation persistence is due to enhanced policy credibility, then it is incumbent upon this Committee to maintain that credibility. That is, we should not expect inflation persistence to remain low if the Fed acts in a manner that is inconsistent with its commitment to price stability or risks its credibility by neglecting to take actions that return the economy to price stability in a reasonable period of time. We shouldn’t ignore the fact that the longer we allow deviations from price stability to persist, the higher is the risk to our credibility and the higher is the risk that recent high inflation readings will raise longer-term expectations, thereby putting us in a very awkward position a year from now. Thank you.

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