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

Thank you, Mr. Chairman. Judging by the standards of the last few meetings, perhaps the biggest news is that we have made no major changes to our Greenbook forecast since it was published last Wednesday. Of course, I’ll admit that it helps when there are few data to get in our way. But even reaching back to the August projection, much of the incoming data on production and spending have, on balance, come in pretty much in line with our earlier expectations that the expansion would regain its footing as we moved into the second half. Indeed, last week’s release of industrial production indicates that a solid expansion remains under way in the factory sector. Manufacturing output increased ½ percent last month after an upward-revised increase of nearly 1 percent in July, and gains in recent months have been widespread across industries. Reports from regional and national purchasing managers have been similarly upbeat. For the quarter as a whole, factory output appears likely to increase 6¼ percent at an annual rate.

Likewise, the spending data have, for the most part, remained firm. Purchases of light motor vehicles averaged nearly 17 million units at an annual rate in July and August, about ½ million units above the pace of the first half of the year. These figures along with the retail sales data put real PCE on track for a 3¾ percent increase in the current quarter, considerably faster than the 1½ percent pace registered in the second quarter. Housing starts—just released this morning—reached 2 million units at an annual rate in August. Ongoing strength was especially evident in the single- family sector, where starts edged up to 1.67 million units from an already elevated level. Business spending, as well, looks to be advancing smartly. Orders and shipments for a broad variety of capital goods have been moving up, and backlogs of unfilled orders in many industries have continued to mount. Real spending on equipment and software is projected to increase 13 percent in the current quarter, about in line with the sizable second-quarter advance. Meanwhile, nonresidential construction activity has surprised us to the upside, and the odds are looking better for a continuation of the recovery that appears to have gotten under way earlier this year. Even the government is chipping in, led by a surge in current-quarter outlays for defense. All in all, the catalogue of positive developments has been encouraging that the expansion is not faltering. On balance, the incoming data leave our estimate for the level of real GDP in the current quarter about the same as projected in the August Greenbook.

If that is all that had transpired over the past six weeks, this would have been a reasonably quiet forecast round. But it was not. At the considerable risk of finding myself classified in the taxonomy of Governor Schwarzenegger as an economic girlie-man, [laughter] let me admit to harboring some pessimistic perspectives on recent developments. While near-term GDP was not much affected by the incoming data, we had to deal with a slug of incoming information that suggested to us that the economy has less momentum going forward than we had previously been expecting. Chief among our concerns has been the employment situation. Gains in payroll employment in recent months have been well short of our earlier expectations. At the time of the August Greenbook, we were projecting employment gains to average about 300,000 per month in the second half. With two months of data now in hand, private payrolls appear more likely to increase in the neighborhood of 120,000 per month in the current quarter, and we have lowered our fourth-quarter projection to gains of 200,000 per month. A higher workweek and somewhat larger increases in average hourly earnings have provided some offset to the weak hiring, but we still have a substantial shortfall in labor income in recent months relative to our August expectations. In addition, wage and salary income was revised down considerably in the first half of this year on the basis of unemployment insurance tax records. Those revisions and the weaker employment gains of recent months have pushed the personal saving rate below 1 percent in the current quarter—nearly ¾ percentage point below our August projection. All else being equal, the lower level of income implies somewhat greater restraint on consumption going forward, and thus a steeper rise in the saving rate than we had incorporated in our previous projection.

Another negative for the outlook was the loss of prospective stimulus from inventory investment. The pace of stockbuilding in the second quarter of this year now appears to have been considerably faster than was estimated last month. That step-up in the pace of stockbuilding along with weaker final sales appears to have brought inventories into more comfortable alignment with sales sooner than we had been expecting. Indeed, in our August projection, inventory investment was a source of stimulus to production in the second half of this year. It now appears that the bulk of that stimulus is already behind us. We have also had to contend with less favorable news from the technology sector. The recent shipments figures for computers and communications equipment were to the soft side of our expectations. Moreover, reports from a number of leading technology companies have been relatively downbeat about the outlook for earnings and sales. Intel, Cisco, and Gartner Group have all indicated some deterioration in near-term prospects. There has also been a noticeable slowing in the pace of high-tech production, concentrated in computers and semiconductors. We do not believe that these developments are signaling the start of a serious slump, but they have led us to temper our outlook for high-tech investment this year and next. Proving that we can find dark clouds on even the brightest horizon, the recent lower-than-expected readings on price inflation implied that our August path for the nominal federal funds rate was, in real terms, exerting a bit more restraint on demand over the projection period.

Putting these pieces together, we had a forecast in which no progress was made in reducing the margin of slack in resource utilization and in which price inflation notched still lower. That outcome led us to flatten the assumed trajectory for the funds rate by 50 basis points by the end of next year—an adjustment that was sufficient by our reckoning to result in a gradual reduction in the output gap. I should note that market participants also appear to have marked down their expectations for policy at the end of next year by a similar amount. As a consequence, we still have a shallower assumed uptrend for the funds rate than is currently embedded in fed funds futures. In our projection, the funds rate is assumed to move up to 2¼ percent by the end of next year and to 2¾ percent by the end of 2006—an endpoint roughly 60 basis points below current market expectations.

We see several key features of the current economic landscape as suggesting to us that such a gradual tightening of policy will be sufficient to contain inflation pressures while promoting an eventual elimination of the output gap. First, fiscal policy is expected to swing from the substantial stimulus of the past three years to mild restraint in 2005. We are probably already experiencing the front edge of that diminishing stimulus. In our projection, fiscal policy over the next year is doing some of the work that would otherwise be required of monetary policy. Second, as I noted earlier, the reversal of the low level of the saving rate imposes restraint on spending going forward. Not only is the current level of the saving rate below our estimate of the target, but the target itself is likely to be moving higher as interest rates increase. Third, the external sector is expected to be a considerable drag on activity in the United States, as domestic and foreign demands are increasingly directed away from U.S. producers. By 2006, real net exports are expected to knock more than ⅔ percentage point off the growth of real GDP. Karen will have more to say on this issue shortly, but suffice it to say here that our widening external deficit creates a stiff headwind for the economy. Finally, our shallow path for the funds rate also reflects our relatively optimistic outlook for price inflation. In our projection, the remaining margin of slack in resource utilization, a small decline in domestic energy prices, and a leveling out of non-oil import prices result in an edging down of projected core consumer price inflation from about 1½ percent this year to 1¼ percent over the four quarters of 2006.

Even with our revisions, we see some clear downside risks to the projection. While the incoming data have been encouraging of the view that the soft patch is receding, the data have hardly been definitive on that point. The run-up of energy prices this year could well be exerting greater restraint on household spending than we have allowed for in our projection. Moreover, it has created yet another source of uncertainty with which businesses must cope. Indeed, the vocabulary of business caution seems to have crept back into discussions of the hiring and capital spending plans of our industry contacts. If these concerns are more pervasive or more severe than we have implicitly recognized in the projection, the soft patch could prove more persistent in coming months.

Of course, we readily concede that we may have overreacted to some of the softer economic indicators of recent months. There are a number of reasons that one could be concerned that the low level of the funds rate assumed in our projection will stimulate faster economic growth, higher price inflation, or both. For one, simple historical relationships between the real funds rate and the output gap suggest that the level of the funds rate assumed in our projection has, on average in the past, resulted in a much more rapid closing of the output gap than we are forecasting. We used such a simple relationship to calibrate an alternative simulation for the Greenbook, and the accompanying surge in demand in that simulation not only closed the output gap but resulted in some overshooting of potential by the middle of next year. Our problem with adopting something like this for the baseline is that we don’t currently see the harbingers—stronger asset-price appreciation, a weaker exchange value of the dollar, or more-rapid increases in interest-sensitive spending—that we think would both signal and stimulate a more vigorous track for activity.

Another resolution to this possible tension is that the output gap could already be much smaller than we are estimating. In other words, the low real funds rate of the past few years may already have done its work. Of course, the implication going forward is that the economy has less room to grow than we think. Again, we illustrated this possibility with an alternative simulation that embodied a higher estimate of the NAIRU and a lower estimate of the trend rate of labor force participation. On our assumed path for the funds rate, the economy again overshoots potential, and core price inflation moves up steadily from current levels. Such an outcome is, no doubt, plausible. Our ability to measure the economy’s productive potential is limited, and the profession has not distinguished itself in this endeavor in the past. Moreover, some employers are reporting that it has become difficult to locate workers with the skill sets that they need, providing a hint that the labor market may be tighter than we are estimating. But in the end, we are unpersuaded. The participation rate and the employment–population ratio are very low, and the declines in those measures in recent years coincided with the weakening labor market. Also, survey evidence suggests that, while household and business perceptions of the labor market have improved, those perceptions remain well short of the conditions that prevailed at other times when inflation pressures emerged.

The actual inflation data themselves are considerably more ambiguous on the question of whether we have overshot potential. Certainly, the recent data have been more encouraging. After hitting a high of 2¼ percent at annual rate in March, the three-month change in the core PCE price index through August appears to have receded to below 1 percent. Just as the earlier pace likely overstated the emergence of inflation pressures this year, the most recent figures probably overstate the dissipation of those pressures. Our best guess is that the underlying pace of core consumer price inflation is about 1½ percent at present. That still represents some pickup from last year’s 1¼ percent pace. We believe the acceleration in core prices this year can largely be explained by the indirect effects of the steep increases in energy prices and by the larger increases in import prices. But we can’t rule out the possibility that labor and product markets are tighter than we currently estimate.

In sum, we are expecting moderate above-trend growth, moderate erosion of the output gap, a moderate drop in inflation, all brought about by a moderate rise in the federal funds rate. Yes, we too know that it will never come to pass; but we are satisfied that we have produced a forecast in which we don’t know the most likely direction of the surprises.

Before handing the baton to Karen, let me return to the dark clouds for a moment. Here, I don’t mean the ones that the staff has conjured about the outlook, but rather the ones real people see when they look out the window. As the Greenbook went to press last week, Hurricane Ivan had yet to make landfall. The storms of the past month are bound to leave an imprint on the economic data, though most of the effects will be on the income side of the accounts. A big jump in economic depreciation is likely to be matched by lower rental income, lower proprietors’ income, and reduced corporate profits. As far as real activity is concerned, we simply don’t have enough information yet to reach an informed judgment about the possible magnitude of any effects on spending or production. But as devastating as these events have been for so many people, we are not expecting the effects to be large enough or persistent enough to have any implications for your policy.

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