Thank you, Mr. Chairman. The news that we have to deal with for this meeting relates to the mysterious soft spot that is affecting or trapping the economy. We’ve had soft spots before, blamed variously on the hangovers from the 1990s, the Iraq War, Enron, and Sarbanes–Oxley. Let’s face it, none of these is a credible explanation for the current slowdown. At the last meeting, I thought the problem was an oil shock. While I still think the economy is suffering the effects of an oil shock, I’m beginning to think that more is going on. If one goes back to our forecast earlier in the year or looks at the Greenbook forecast revisions or the Blue Chip forecast revisions lately—and this is the point that Don just made—both inflation and output forecasts are down. Perhaps this suggests that we may have a plain old demand shock out there mixed in with the oil shock.
Whatever the shock is, there also seems to be a strong international dimension to it. Taking the International Finance Division’s forecasts of yesterday, if one could imagine the world economy without the United States and China, domestic demand would be deficient in country after country. The countries that are doing well are those that trade a lot with the United States or China or both. And in general they are doing well because of exports, not anything related to domestic demand. It is too strong to say that there would be a world recession without the U.S. and Chinese economies, but there would certainly be global sluggishness. And this sluggishness would be greatly magnified, as we discussed a minute ago, if the dollar started slipping, which it might do at any point. As I am told, John Connelly once said, “Our dollar, your problem.” [Laughter]
So what do we do about all of this? With weakness emanating from some unknown source, seemingly on the demand side, do we continue our program of gradually raising or re- equilibrating rates? I would say “yes” for this meeting, but I’m getting much less certain about future meetings. To rationalize my vote for continuing to re-equilibrate, my own personal view is that up to now the re-equilibration process has gone very well. Since we began raising rates in late June, the funds rate has risen 50 basis points, yet ten-year bond rates have fallen 65 basis points over this span, and even the TIPS long-term rate has fallen 30 basis points. A 35 basis point decline in long-term nominal rates would be fully explainable within the context of orthodox macro theory; that is, either the Fed showed it was concerned about inflation, or inflation just plain dropped and the inflation premium in long-term bonds was reduced. As for the 30 basis point drop in real interest rates, there are technical explanations, but the most likely cause is that the real economy has weakened. Whatever the explanation, why fight it? We have an opportunity to bring the financial system closer to equilibrium. We can lessen the chances that we’ll be caught with inordinately low interest rates should inflation suddenly speed up, and we most likely can do this with minimal effect on real long-term rates, perhaps even a negative effect if there is some sort of expectations effect. This win–win situation can’t go on indefinitely. If it were to do so, lots of macro textbooks would have to be rewritten. But it does seem a likely result for today and, again, why not take advantage of it?
One broader point should also be kept in mind. Re-equilibration means re-equilibration in several different markets more or less simultaneously. The funds market is now something like 3 percentage points out of long-term equilibrium, as defined mechanically according to past averages. The long-term market may be about half or perhaps a little more than that out of equilibrium, defined the same way. I don’t know that there is any theorem that re-equilibration will happen at an equal pace in different markets, and maybe it shouldn’t puzzle us much if the pace of re-equilibration is different.
So my judgment on what we should do today is clear. We seem to have a situation where we can restore equilibrium a bit without damaging the economy, at least for a stretch. This is a good horse to ride, and we ought to keep riding it for now. When we get to the next meeting, it may be time for the “pause that refreshes,” or it may not be. Markets seem to be responding to the data, and perhaps we should as well. Thank you.