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

Thank you. Let me just start with the broad contours of our outlook. Growth has obviously slowed. The second half is likely to be relatively weak, but the only place we see pronounced weakness is in housing, and we expect a return to moderate growth going forward. Core inflation seems to be easing a bit, and it may have peaked in the second quarter, if you look just at the three-month annualized numbers. But inflation remains uncomfortably high, and our forecast assumes only a very gradual moderation over the next two years. In terms of numbers, we expect the real economy to grow at around its 3 percent potential rate in ’07 and ’08. We expect core PCE inflation on a Q4/Q4 basis to come in just below 2½ percent in ’06 and to moderate to about 2 percent in ’07 and 1.8 percent in ’08. Our outlook is largely unchanged from August. It’s conditioned on a path for policy that is flat at current levels for two to three quarters. This puts us slightly above the level that is currently priced into the risk-adjusted Eurodollar futures curve.

In terms of uncertainty and risk, we see somewhat greater downside risks to demand growth than we saw in August, but the inflation risks still seem likely to be to the upside. Weighing the balance among these competing risks, we believe, as we did in August, that inflation risks should remain the predominant concern of the Committee, not so much, to borrow the Chairman’s formulation, because the probability of a higher inflation outcome is substantially greater than that of a much weaker growth outcome but because the costs of an erosion in inflation performance would be more damaging.

On the growth outlook, we’re seeing a somewhat greater adjustment in residential investment than we anticipated, but this has not yet induced or been accompanied by a significant weakness outside housing. Of course, the outlook for the economy as a whole should not be particularly sensitive to plausible estimates of the direct effects of the remaining adjustment, whatever it is, left in residential investment. What seems more important, of course, is the potential effect of what’s happening in housing on consumer and business spending. We just don’t see troubling signs yet of collateral damage, and we are not expecting much. The fundamentals supporting relatively strong productivity growth seem to be intact. The acceleration of the nominal compensation growth that appears to be under way, combined with the moderation of headline inflation that we expect as energy prices moderate, should produce fairly strong growth of household income, even with the moderation in employment growth to trend.

Corporate balance sheet profitability remains strong. Domestic demand growth outside the United States is expected to remain quite robust even though there has been some moderation in current measures of activity in some markets. Of course, the level of interest rates is not particularly high in nominal or real terms. Equity prices and credit spreads suggest a reasonable degree of confidence in the prospects for future expansion. Financial market participants report very strong continued demand for credit and for risk generally and very ample liquidity. This strength may reflect other factors that are operating on demand for financial assets, but still survey-based measures of confidence have not deteriorated dramatically. This, of course, may prove too optimistic on the growth outlook, and the risks seem weighted to the downside.

On the inflation front, recent data have not altered our forecast or, really, our assessment of the risks to that forecast. Although there are signs of moderation in underlying inflation, the core PCE and a range of alternative measures continue to grow at levels that are uncomfortably high. We expect further moderation to occur only gradually over the forecast period. The latest data have been somewhat reassuring, and inflation expectations at various horizons have behaved relatively well since our last meeting. The acceleration in compensation growth and unit labor costs does not justify a higher inflation forecast in our view, provided that expectations remain well anchored, business markups fall, the ongoing moderation in growth reduces pressure on resource utilization, the futures curve proves a reasonably accurate prediction for the path of energy prices, the dollar declines only modestly, and so forth. These are reasonably good arguments, but we still think the risks are to the upside. Over the past two years, we have consistently revised up our forecasts for inflation. I’m not sure we really yet understand the forces behind the unanticipated acceleration in underlying inflation. Medium-term inflation expectations, while not rising at stated levels, may be higher than is consistent with an inflation objective in the range the Committee has talked about in the past. Containing these upside risks should be the dominant focus of policy until we see a more-pronounced moderation in current and expected underlying inflation. As my comments imply, we don’t have a lot of differences with the Greenbook on the contours of the outlook. The Greenbook shows slower growth relative to lower potential but also more inflation than we do. It also shows more slack with more inflation and a little less confidence in the strength of demand growth than we do for the reasons I hope I explained.

I see certain questions as key. On the growth front the question is, Will weakness cumulate? If we see a more-pronounced actual decline in housing prices, will that have greater damage on confidence and spending? But the more interesting questions are really on the inflation forecast, and let me just talk very briefly about two.

First, does the Greenbook forecast produce enough moderation in inflation soon enough to keep inflation expectations anchored? The baseline forecast has inflation falling to 1.5 percent, at least based on the last time we saw a long-term forecast, only over a very protracted period—a period that is significantly longer than the one many central bankers would consider an acceptable deviation from an inflation target. We have already seen a bit of troubling speculation from people who write about us. This Committee may have more inflation tolerance or a higher implicit target than its predecessor. Should we try to achieve a more rapid moderation of inflation? How should we evaluate the costs and benefits of trying to achieve a quicker and more substantial moderation of inflation, particularly given the tenuous state of the evidence on inertia and persistence? Is this gentle and gradual expected moderation in inflation optimal, given the softness of the outlook for demand? These are questions that are worthy of a more explicit discussion by the Committee, particularly if we’re going to talk about moving toward a quantitative definition of price stability with more disclosure around the forecast.

The second and related question is about inflation in our forecast: With the stance of monetary policy that is now priced into the markets—this is a softer path than the one in August—how confident can we be that we are likely to achieve the forecast of sustained growth and gradually moderating core inflation? I think we can be less confident than the confidence you might read into current market expectations and the uncertainty that surrounds them. Of course, the behavior of long-term inflation expectations in financial markets suggests that this risk is not particularly high at present and that we can take some more time to get a better handle on the evolution of the economy before deciding what is next in terms of monetary policy actions. But I think that we may have more to do, and we should try to avoid fostering too much confidence in the markets that we’re done. We need to preserve the flexibility to do more if that proves necessary to keep inflation expectations anchored. Thank you.

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