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

Thank you, Mr. Chairman. I agree with what seems to be the general assessment around the room that the data since our last meeting have confirmed our expectation that the soft spot in the economy wasn’t that soft or prolonged and that the economy is on a fairly reasonable track. But I think we all have noted that recent information, including the anecdotes, has also suggested that underlying demands and the path for the economy going forward are not as strong as expected. This latter observation extends a string of downward revisions to actual and projected growth over the year. These revisions reflect the fact that, although economic growth has been good this year, it is considerably less than one might have anticipated from the unusual degree of fiscal and monetary stimulus in place.

The rise in oil and energy prices must be an important part of the story, but the extent of the shortfall this year seems to be too much to ascribe to energy prices. And the fact that inflation as well as output has been coming in below expectations since June suggests that whatever factors are holding back the economy of late should be viewed primarily as having the characteristics of a demand shock. For the most part, the unexplained shortfall relative to model forecasts so far seems to be in business investment spending, and we’ve cited “business caution” to explain it. Like President Stern in his reference to “reluctance to hire,” I think this is just another way of labeling our ignorance. Perhaps businesses have been held back by heightened terrorism or other geopolitical uncertainties, risks of further oil price increases, and the fallout from governance scandals on risk appetites. However, the longer business caution persists, the more I suspect that we’re missing something more fundamental.

The bottom line, in my view, is that we just don’t have full understanding of what is damping the response of the economy to accommodative policy. The facts that there are these restraining forces and that our understanding of them is incomplete have important implications for the strategy of policy going forward in terms of helping to foster both solid growth and stable prices. Rates do need to rise, but it’s impossible to prejudge the appropriate path when we don’t have a good understanding of the important dynamic forces at work.

Tightening today is called for. I agree with most of my colleagues that it will bring the real funds rate into positive territory. It will mean that the increase in rates is larger than the increase in underlying inflation over the last year. Tightening today is built into the yield curve; on that yield curve intermediate- and long-term rates remain very low and consistent with very supportive financial conditions. But in my view, uncertainty about the economy implies that the path hereafter to achieve our objectives should be decided flexibly, meeting by meeting, depending on incoming information. And I think the burden of proof for skipping a meeting or for slowing down the pace of tightening should not be unusually high.

Markets have reacted to recent incoming data by reducing the expected pace of tightening beyond this meeting. They think we can and will skip taking action at some meetings if the data suggest we should. These expectations could reverse quickly should incoming data on activity or prices strengthen. I believe these types of reactions are quite constructive and impart an important automatic stabilizer to the economy. I hope we don’t do or say anything that will leave the impression that we are not ourselves prepared to adapt to changing circumstances. Moreover, I believe that flexibility is still most likely to be called for around a very gradual path of tightening. Incoming data have reinforced the perception that the risk of accelerating prices has diminished and that relatively low intermediate- and long-term interest rates could well be required to sustain solid growth. Both markets and the staff have marked down their expectations for policy.

In addition, the case for gradualism in the face of uncertainty is well known—nicely summarized by Governor Bernanke earlier this year. A related strain of research has shown that, when the FOMC is uncertain about the levels of the natural rate of unemployment or, as in the current circumstances, about the natural rate of interest, paying attention to inflation and growth rates is useful to avoid policy mistakes. In the Bluebook table depicting policy rules, there are two rules in which formulas for the funds rate are derived from changes in inflation and output, and those illustrate this approach. They suggest a shallow upslope to rates, not too different from the assumption in the Greenbook. Undoubtedly, this will not prove to be the appropriate path for policy, but I’m not sure in what direction the path should deviate, and we will need to look at the data to make that judgment. Thank you, Mr. Chairman.

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