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

Thank you. Let me just summarize quickly what I heard around the table, and then I’d like to make some additional comments of my own on the economy. The sense is that, on the real side, there’s a two-tier economy. There’s the housing sector and maybe autos, and there’s everything else. On housing, there’s agreement that a significant correction is occurring, but the views of the risks vary among participants. In particular, some feel that this still could be a quite deep correction, and others say that the fundamentals, such as incomes, interest rates, and so on, will ultimately support housing. With respect to the rest of the real economy, there were some mixed reports; but on the whole, people characterized it as a full employment economy. We’re generally more optimistic than the Greenbook both for later this year and for 2007. In particular, people noted higher incomes and stock prices and lower oil prices, which should support consumption growth and business activity. At least for now, I heard only a few participants being particularly concerned about the possible knock-on effects of housing on consumption and investment. The labor market remains solid, and as we’ve been noting for a number of meetings, attracting more highly skilled workers remains difficult.

On inflation, some noted somewhat better intermeeting news, with the possible exception of the higher compensation data. But a lot of uncertainty was expressed about where inflation will go, reflecting in part our incomplete knowledge of the determinants of inflation and also some mixed anecdotal evidence. However, I hear very clearly a definite unhappiness with the level of core inflation and with the amount of time that is projected to return it to a level of less than 2 percent. The principal concern is that our credibility will be damaged if inflation remains too high for too long. So I would summarize the discussion—I hope reasonably accurately—by saying that inflation remains the predominant risk but there is still quite a bit of uncertainty about the evolution of the economy in the next few quarters.

Let me add a few comments to this—first about inflation and then about the real economy. I do believe that the intermeeting news on inflation was more good than bad, particularly relative to the fact that inflation is a lagging indicator and that it would not have been incredibly surprising if we had gotten 0.3 readings the past two months. I’ll talk first about some of the positive news, and then I’ll address some of the risks going forward.

First, there is evidence that the momentum of inflation has reversed. When I gave my speech on June 5, which many of you followed up on, I emphasized the three- and six-month rates of inflation as indicating that an acceleration, a rising inflation pattern, was occurring. It now appears that the three-month rate of inflation peaked in May. So, for example, in May, the core PCE was 3.06 on a three-month basis; in July, it was 2.24. The market-based core PCE was 3.00 in May, and in July it was 2.11. The core CPI was a high 3.79 in May, and as of the last reading in August, it was 2.95. So in some sense the direction has turned, and the momentum has been broken, and I think that has been reflected in views in the marketplace.

Now, there hasn’t been much discussion of the details of this inflation report, and I think it’s actually quite significant. In particular, a very important factor in both the level and the change in inflation is owners’ equivalent rent (OER); we’ve discussed this issue before. OER is 41 percent of core CPI and 19 percent of core PCE. Although OER has been decelerating recently, it’s still at a three-month rate of 4.4 percent, relative to an annual rate of 2.66 percent in 2005. So that difference accounts for a great deal of the change between where we are today on a three-month basis versus where we were in 2005. The good news is that OER and other measures of rent of shelter have been coming down more quickly than many outside economists expected but in line with what our staff more or less expected; indeed, the number was 3 percent for August. So if it just stayed there or came down a bit more, we would see better short-term numbers for inflation going forward.

Other positive news on inflation obviously includes energy and commodity prices. For energy the dominant factors are supply-side factors over which we have no control—hurricanes or the lack thereof and geopolitical factors. But it’s also interesting that metals and some other commodities are off their peaks. That suggests to me that, at least on the margin, some prospect of slowing economic activity and rising interest rates around the world may have taken a bit of the pressure off the commodity prices. We also have had some indication since the last meeting that the economy will be slower than we thought. Clearly, the news on autos and housing was in a negative direction, and granting the flatness of the Phillips curve, all else being equal, that will take some pressure off utilization and pricing power. Finally, I would argue that expectations are, in fact, really quite well contained. Around this table, we’re getting used to talking about core inflation. The inflation that people see, of course, is headline inflation, and ultimately that should be our target as well. Over the past year or two, headline inflation has gone well above what we would consider reasonable levels, and yet TIPS indicators, survey indicators, and outside forecasters have not markedly changed their long-term inflation forecast. So I take the credibility issue very seriously, but I don’t think that there is much evidence yet that our credibility has been seriously impaired.

On the negative side, the main piece of news was the higher compensation in the first and second quarters. There is not yet much evidence that labor costs are affecting inflation. We’ve already discussed the issues with the measurement of compensation per hour. Let me just note that, if you look at the components of inflation that have moved the most, you get things like rent, airfares, used cars, and things of that sort. You don’t see much movement in services, for example, which are more labor intensive. So I don’t think that labor costs have yet infected the inflation rate; indeed, we know there’s a weak correlation between these labor cost measures and inflation. However, and let me be clear about this, I think that the key risk to our inflation forecast is that markets will be tighter, labor markets will be tighter, and wages will grow more quickly, and that will produce more inflation than we would like. So I would summarize the inflation situation as having had some modest improvement, some encouragement, but I certainly agree with the general sentiment around the table that the level of core inflation is certainly too high.

On the real side, we paused at the last meeting to observe the lagged effects on real activity of our previous interest rate moves. The evidence suggests that, indeed, interest- sensitive sectors did worsen over the intermeeting period. We saw the second significant markdown in a row by the Greenbook for housing, and we’ve seen autos decline as well. To this point, I agree that the economy except for housing is reasonably strong and that there are factors supporting consumption particularly, going forward.

So as we look forward, I think there are two issues. The first is how severe the contraction in housing will be. To be honest, we don’t really know. We’re talking, again, about an asset price correction, and it’s difficult, in principle, to know how far that will adjust. The second issue is how much spillover there will be from any housing correction to the rest of the economy. I don’t have quite as much confidence as some people around the table that there will be no spillover effect. Any spillover effect would be a lagged effect, and it remains to be seen how much effect there might be. But I agree that the economy except for housing and autos is still pretty strong, and we do not yet see any significant spillover from housing.

Please look at the figure that was distributed.2 I want to talk a bit about the risks in both directions as we think about policy. Let me just describe the two panels to you and then draw a conclusion from them. The top panel shows the four-quarter difference in the unemployment rate—that is, the unemployment rate in the fourth quarter of this year minus the unemployment rate in the fourth quarter of last year, going back to about 1950. The blue bars show recession periods. The dashed line is at zero, and the solid horizontal line is at 0.3 percentage point. What you see is that, without exception, every time since 1950 that the unemployment rate has risen as much as 0.3 percentage point over a year, it has continued to rise, and we’ve seen a recession. That suggests that having unemployment rise just a few tenths and keeping it there is not quite so easy as our linear models might suggest. In the bottom panel, you see four-quarter changes in the growth of real GDP. The dotted line shows zero, and the solid line arbitrarily shows 2 percent real growth. Again, these are four-quarter differences. With the minor exception of 1956, again in no case was real GDP growth below 2 percent sustained for four quarters without an NBER recession. I think a very interesting case is 1995-96—the famous soft landing that was engineered in the mid-1990s. You’ll notice the line just touches the 2 percent zone without crossing it. [Laughter]

So what am I saying here? I’m only saying that, if we believe that we need to have output below potential to help arrest inflation pressures, it is a delicate operation, and we may have a very narrow channel to navigate as we go forward. We should pay very close attention to how the economy is evolving at this particular moment because I think the uncertainty and the potential nonlinearity at this juncture are greater than what we normally face. I’ll stop there, and we can begin our second round. Oh, I’m sorry—Vincent. [Laughter]

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