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

Thank you, Mr. Chairman. I’d like to make four points, a couple of which have been stated by my colleagues this morning, and then spend a little time on each of them. First, like many of you, I am more concerned about the upside risks to inflation than downside risks to output and employment. Second, the markets responded quite positively to the last FOMC, so they’ve been going in the right direction. The stock market has been up, the bond market has been up, energy and commodities are down, and TIPS inflation compensation measures are down. Six months ago I would have taken some comfort from that; now, six months into being a central banker, I’m worried. [Laughter] So I join the ranks of Jack and the rest of you who have been here a bit longer than I have. Third, for the first time since I’ve been here, I’m a little less sanguine about the supply side of the economy in looking at the business base, the cap-ex base, and the manufacturing base. But I find myself today probably more comfortable, or at least as comfortable as I’ve been, with the strength and resilience of consumer demand. The fourth point I would like to spend a couple of minutes on is that I think we are at the beginning of a major test of market liquidity that’s happening in real time in the fixed-income markets. So let me take each of those in turn.

First, on the consumer side, consumer spending appears to be strong and resilient. As was noted at the outset, there was a strong July PCE reading, on par with the strongest gains of the year, suggesting to me that consumer demand may actually be accelerating from the second quarter into the third quarter. The Greenbook estimate of 3 percent PCE for the third quarter and 2.75 percent PCE for the fourth quarter may actually be understating the strength of the consumer, particularly with falling gas prices.

I’m also comforted by income growth and labor market conditions, which I see as likely to be far more important to consumer spending than housing wealth. Consumer income gains appear to be rising. I’ve made note previously of very strong tax receipts. Although they’ve tapered off somewhat, they continue to be robust. Tax receipts for the year are up about 12.4 percent. The past couple of months would suggest they are in the high single digits, and though there is some noise in those data, I do take some comfort from them. Other recent corroboration of labor income, with the revised NIPA data and other measures, suggests that real wage and salary income again may be accelerating. It has been noted this morning that stock options and bonus payments may have had an effect in the first quarter, creating a bit of noise in those data. However, they should also remind us of the wealth effect of equity gains, which may partially offset the negative wealth effect from housing, particularly with 100 million members of the investor class. I think that’s something that needs to be considered in our thinking about the strength of the consumer during the forecast period. Finally, as I think Governor Bies noted, the labor markets remain reasonably tight. Despite the softness in housing, unemployment insurance claims and unemployment rates remain quite encouraging.

Turning for a moment to business, about which I am perhaps a little less optimistic than I’ve been before, industrial production is still reasonably strong but, perhaps disappointingly, has flattened for August, even though the July numbers appeared to be on an upward trend. When I looked back over the past 24 monthly readings for 2004 and 2005, both of IP and retail sales, I found that each declined about six times, so I’m not sure that we’re seeing a new trend here. My own sense of where IP is in September is that it’s remarkably strong, but, again, I have some caution that I didn’t have before. One other note—unlike the Greenbook, I sense that exports are likely to make a real, meaningful contribution to GDP during the forecast period.

In terms of capital expenditure growth rates, another survey I’d like to mention is the Business Roundtable survey that came out a couple of days ago. It was more negative on capital expenditures than it has ever been. I would say that the group has a mixed record in calling inflection points, but the survey results, nonetheless, suggest that only a little less than 40 percent expect increased cap-ex in the next six months, whereas about half said that cap-ex would remain constant over that period. Perhaps that’s an effort to protect margins with higher costs that could be only partially passed through. As I’ve noted before, earnings growth continues to meet or beat expectations, certainly through the second and third quarters, and my own sense is that fourth-quarter earnings will also be fine, probably still at the double-digit rates of about 10 or 11 percent. Perhaps that explains some of the taking the foot off the accelerator in terms of capital expenditures.

In terms of housing, to add a bit to the previous discussion, my own sense is that the residential sector may have, in fact, crowded out some nonresidential loans during the most recent boom and that nonresidential construction was marked up sharply in the second quarter, to an annual growth rate of 22 percent. My sense is also that the market’s capital allocation function is working well. C&I loans are growing about 15 percent or more, perhaps the highest rate in the past 20 or 25 years, and we’ll probably see a little more capital allocation to this nonresidential sector. Whereas the Greenbook assumes a significant deceleration in this group, I think that there’s reason for some upside surprise. As a result, I expect stronger GDP for the second half of ’06 than the Greenbook does.

Turning to inflation, I think that inflation risks have not materially receded, though we’ve probably seen acceleration stopping. That is, we’ve seen the top, but the new direction is not clear. One measure that I’ll look to over the next six weeks is what’s going on in the capital markets. Since we last met, ten-year yields have probably moved down about 15 basis points, and the Greenbook reports that there should be a slowdown in business debt financing. That statement of the Greenbook is probably reflected in the data that we’ve seen in July and August in terms of the capital markets. But the test of liquidity to which I referred will be a big supply/demand test over the course of the next six or seven weeks. Perhaps $150 billion in funding is coming to market from the bank loan market, the leveraged loan market, high yield and investment grade. Admittedly, in that $150 billion number, which stacks up as a big number even compared with only a couple of years ago, when we would see financings over a year of $175 billion, there are some elephant deals, and they are probably distorting that number a bit. HCA is coming to market with a $20 billion deal, as well as a couple of other major leveraged buyouts.

The liquidity in those capital markets appears to be incredibly robust at this moment; there are massive pipelines. You hear words like “euphoria.” I would say that the capital markets are probably more profitable and more robust at this moment, or at least going into the six-week opportunity, than they have perhaps ever been. A significant variety of participants are playing. This is a function of huge sovereign debt inflows and of significant liability management by issuers—some of the CFOs to whom Governor Bies was speaking. Investors at this moment appear to have very little leverage in terms of the pricing of these deals or in terms of some of the covenant protections that were referenced at an earlier meeting. Previously, I had said that, particularly in the investment-grade market, we were seeing issuers hesitate to come to market because they didn’t want to negotiate their covenants away. In the event that they were to be taken out by a leveraged-buyout player, they wouldn’t want to have a change-of-control premium. Now that these markets are as robust as they are, those same brand-name issuers are coming back to the market, and at this point it seems as though they will likely get their pricing done. So, I do not yet have a final determination of what this pipeline looks like; but if all goes through, it will suggest to me that there has been rather massive liquidity during this period. Other measures of liquidity appear to be somewhat more encouraging from my perspective. The commodities markets have been mentioned. They’ve probably had some hot money come out of them, with a lot of retail investors, both directly and through pension funds, coming in too late and maybe exiting for good, as well as some very encouraging news about the TIPS markets, which were referenced previously.

In sum, I would say that the markets seem to be very impressed by our letting the economy develop, particularly in the next couple of quarters, and I’m impressed by the market’s confidence in us. I think that it puts a significant responsibility on us and is probably the only way I can reconcile the rather robust gains in the equity markets and in the debt markets over this period. That is, the markets believe that somehow we’re going to manage to thread the needle and nail the perfect landing. There is, I think, increasingly a one-way bet in the bond markets in that they believe that there is a degree of accommodation and they have built in a degree of loosening in the forecast period, which we don’t have a proper understanding of. Only a couple of months ago we were describing, and the Chairman described, an economy in transition and the very wide tails around that. We still have the wide tails, but the markets seem to think that we’re going to nail this landing.

I think the minutes from the last meeting faithfully captured our concerns about the appreciable upside risks remaining. Either the markets didn’t buy that description, or they were convinced that we were going to act with an incredibly deft touch to stop that inflation. All in all, I would say that in the markets there is less dispersion of views than is probably healthy and less dispersion of views over these different scenarios than we found ourselves discussing some time ago. So with that, I think we’ll have a more robust discussion in the next round. Thank you, Mr. Chairman.

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