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

Thank you, Mr. Chairman and some participants. [Laughter] Over the intermeeting period, tumbling oil prices, better-behaved inflation, and the minutes of the August meeting, which conveyed a more widespread disinclination to tighten than investors suspected, pulled nominal interest rates lower. As can be seen by the solid line in the upper left panel of your first exhibit, the rate on three-month Eurodollar futures expiring this December declined a touch, on net, and is now consistent with the federal funds rate remaining at 5¼ percent for the remainder of the year. Investors seem to expect policy easing thereafter, in that the contract expiring one year later has a rate about ½ percentage point lower. This can be seen most clearly by the black line in the upper right panel, which shows that the path expected for the federal funds rate over the next two years has a decidedly negative slope.

As indicated by the shift from the black dotted to the black solid line in the lower left panel, this revision to policy expectations was associated with a roughly parallel step downward in the term structure of nominal Treasury yields over the intermeeting period. The yield curve for indexed securities moved up closer to its nominal counterpart—the shift from the dotted to the solid red line—implying that the difference, inflation compensation, declined.

These relative movements can be made more precise by putting them in terms of

changes in implied forward rates, as at the right. Nominal forward rates (the top

panel) declined in a relatively uniform fashion, from 8 to 15 basis points. The

rotation up in the real yield curve, however, was associated with sizable increases in

short-term real forward rates and declines at longer horizons. The arithmetic

difference between the two is plotted in the bottom right panel: Inflation

compensation fell noticeably at short horizons, but the decline tapered off as the

maturity lengthened.

One way to tie these disparate movements into a neat package is to argue that the substantial decline in oil prices in recent weeks represents a disinflationary impetus that is anticipated to be only partly offset by you. That is, nominal rates will move lower but by less than the drop in inflation so as to keep real interest rates higher for a time. In this story, the decline in oil prices represents an opportunity to disinflate—an opportunity that investors expect you to take by being slow to lower nominal interest rates. The same story, however, can take on a darker hue if it is argued that the fall in the prices of oil and other commodities evidenced a slowing in global activity brought on at least in part by your previous 17 policy firmings—that is, this opportunity for disinflation could be one of your own making.

Either explanation—one of omission or one of commission—produces a moderation in spending and a drift down in inflation that would seem to be consistent with holding the funds rate at 5¼ percent for now, a possibility examined in more detail in exhibit 2. At its August meeting, the Committee assessed the risks to be such that it could hold policy unchanged given its expectation that growth would moderate and inflation decline. The information received since then would seem to strengthen that determination. As shown in the top left panel, inflation compensation measured in the Treasury market is about unchanged at the longer horizon (the red line) and distinctly lower in the near term (the black line). How much of this decline represents a drop in inflation expectations as opposed to a decline in inflation risk premiums is hard to say, but the evidence at the right may be suggestive. Merrill Lynch conducts a monthly survey of global fund managers about their views of macroeconomic risks and portfolio inclinations. More than 200 of them typically reply, and last month an increased share of them were of the view that inflation would be lower, rather than higher, than in recent months. This view seems to be underpinned by the expectation that economic growth will moderate so that resource slack will open up, perhaps as in the staff forecast in the middle left panel. Indeed, when asked about global economic growth, the fund managers surveyed by Merrill Lynch mostly expected it to slow, as at the middle right, with more of them of that view than earlier in the year.

As can be seen directly below, the slowing is not anticipated by investors to be so precipitous as to tip the world economy into recession. More than 90 percent of the managers view such an outcome as unlikely. Thus, they wouldn’t seem to be putting much weight on the flatness of the yield curve, plotted at the bottom left, as a leading indication of recession—nor would you if you’re inclined to keep policy on hold. In that regard, as the chart makes clear, the yield curve has had some predictive power for recession over the past forty years. For instance, the inversion of the term structure in 2000 was sending a signal that, in retrospect, might have warranted a response. This indicator may seem less compelling now for two reasons. First, a flattening yield curve has sent false signals as well over the years, including of recessions that didn’t occur in the mid-1990s. Second, much of the downward tilting of the term structure seems due to a decline in term premiums, which might be a sign of reduced uncertainty rather than a sign of increased economic vulnerabilities.

Indeed, some Committee members may be far from seeing the economy as vulnerable—perhaps to the point of inclining them toward firming policy 25 basis points, as in exhibit 3. In particular, financial market participants do not seem to have heard the message of the August statement that the risks were tilted toward higher policy rates. Rather, as shown in the top left panel by the spread of the December 2007 Eurodollar futures contract below the December 2006 one, about 50 basis points of easing is expected next year. This expectation of ease may be contributing to low credit spreads (the top center panel) and the recent rise in equity prices (the top right panel). This financial impetus might be seen as a reason that spending will not moderate sufficiently to make a noticeable dent in inflation.

Even if those expectations are wrung out of financial market prices over time—as in the staff forecast—the resulting path of inflation may not be acceptable to the Committee. As shown in the middle panel, core PCE inflation is projected by the staff to remain above 2 percent through the end of 2008, which would mark the fifth consecutive year of such an outcome. The survey expectations of CPI inflation— plotted at the bottom left—similarly remain well above 2 percent. While survey responses came down over the intermeeting period, you might discern a slight uptrend in the past few years that could be taken as an erosion of the public’s confidence. In such a circumstance, members may believe that more-acceptable progress toward price stability will likely involve a firmer stance of policy, a judgment that would be strengthened if you thought the spike in the growth of compensation per hour plotted at the right was not as likely to roll back as the staff projects.

The Bluebook lived up to its title, “Monetary Policy Alternatives,” by offering the five different options given in exhibit 4—three formal ones and two variants (which are shaded) that were discussed in the text. If your intent is to solidify current market expectations of easing, switching to balanced risks, as in A, probably has some appeal. The words of alternative B were designed to leave market rates about unchanged, whereas B+ emphasizes that tightening is more likely than easing. It doesn’t really say anything new, but we thought the force of repetition might get the attention of market participants. The alternative labeled C- couples tightening with a removal of the rate bias, signaling that the Committee may be done, whereas C imposes considerable additional restraint by retaining an assessment of upside risks even after firming.

Your last exhibit repeats table 1 from the Bluebook with a minor change noted in red in the second row.

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