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

Thank you, Mr. Chairman. As others have indicated, the U.S. economy appears to be poised to pick up gradually from the soft patch that afflicted it over the late spring and early summer but, as others have also said, perhaps more gradually than we had thought at the last meeting or earlier this year. In response to that reality, the Greenbook has undergone another makeover, with the new forecast pointing to a more subdued growth outlook while still featuring stable inflation. The staff has extended the forecast period, and we now see that the output gap does not close until late 2006. I have no strong objections to this new forecast, and unlike the last two meetings when I was very anxious about the downside risk to the baseline, the risks around this baseline seem to me somewhat more balanced, although the range of uncertainty is still quite large.

I might give a litany of the risks or list why I buy into the forecast, but I’d like to move on to the question that Janet and others raised: Why, with all the stimulus in the pipeline, is the economy facing a prospect of very low inflation and a resource utilization gap that closes only at the end of 2006, when the so-called recession was extremely mild and so many years behind us? I, of course, don’t have the answer to that question, but I’m going to offer a few hypotheses.

One I’d like to reject is the oil price spike. I think Governor Bernanke and others have it right that that seems to have been part of the negative supply shock in the early part of the year. But with oil prices waning, I think that seems unlikely to be the real source of the problem that the economy is facing.

Let me mention two or three more likely options. One is that the bursting of the asset bubble and the series of shocks that have hit the United States since early 2001 may have been more problematic than we originally thought. And here I disagree a little with the tone that Ned took. As we’ve learned from the Japanese experience, it can take many years to counteract the fallout from the bursting of an asset bubble. And it may be, even with the better policy mix we’ve had here than in Japan, that it still could take longer than anyone originally expected to deal fully with the fallout of both the bursting high-tech bubble and the series of subsequent shocks, all of which I think have been fairly significant. We’ve seen this reflected in the phenomenon that’s being called “business caution.” I, maybe more than others, think that there’s something to this. As I’ve read the views of Reserve Bank directors that you have communicated in your letters relating to their discount rate decisions, a number of boards of directors have at least some members—in several Banks, many members—who buy into the view that there’s a sense of caution among businesses. If one looks at various surveys such as the NFIB survey and the survey from Duke University of 200 CFOs, they all talk about a malaise story. The survey of CFOs indicates that they expect growth to be only 2.8 percent over the next four quarters, noticeably lower than even our staff forecast. I think this business malaise issue is very important to watch and, as firms go into their capital planning cycle, I believe we’ll get some more information on it. But I do not think it’s something we can reject quickly.

A second factor affecting our economy is what has been described as “global imbalances.” But the imbalances are not between this country and the rest of the world. I think the imbalances are within the other economies, and Ned picked up on some of this. First, we’ve seen that the financial indicators in almost all of the major industrial economies have been marked down or have shown some expectation of slower growth going forward, just as ours has. Market participants in Japan, the euro area, the United Kingdom, Switzerland, Australia—in the industrial economies around the world—have been marking down their forecasts of economic growth. The second point to make about the rest of the world is that domestic demand has been incredibly weak in almost all of those economies. I think Ned covered this quite well, and I won’t take the time to repeat all of it except to note something that no one else has observed— namely, as was pointed out very clearly in the Greenbook Part 2, domestic demand in the euro area was growing only 0.6 percent. Net exports there accounted for almost all of the growth. And obviously we’ve seen a marking down of growth expectations in Japan, which again has been driven primarily by net exports. So we really are the only engine of economic growth in the world. And we are in this interesting dichotomy with China and the rest of the world, which may in fact play into some of the issues that Karen was talking about earlier.

The third possible explanation is that investment in new capital goods, such as high-tech goods, may be less urgent than we had thought. This could be for two actually quite different reasons. One is that there may be a deeper pool of productive capital than we had envisioned and one that is also longer lived than we had originally thought. The combination of both more- productive and longer-lived capital would support highly productive and profitable businesses, which we have seen, but would also reflect an environment in which demand for new investment is not so great. One important finding in this regard is from some work that two staff members, Rochelle Antoniewicz and Erik Johnson, did at my request. I asked them to divide up the entire Compustat data base into six or seven non-overlapping industry groups and to examine the financing gap in each. They found that the gap in each industry group except oil and gas has declined over the 2000-04 period. The overall drop in the financing gap in this analysis was $291 billion, which is really quite a big swing across the industrial sectors they looked at. So it may well be that businesses view their existing capital goods as fully adequate to deal with the outlook that they see.

The other aspect of this possible explanation is that the slow growth in capital expenditures may indicate that the new high-tech investments now coming on board are not nearly as attractive as the prior generation of such equipment. One piece of evidence that supports this theory is that both our staff and the BLS have estimated that the deflators for various classes of high-tech equipment, such as desktops, servers, and laptops, have all fallen relatively little since 2001. For example, our staff estimates that the deflator for desktops has shown only a 10 to 20 percent decline year over year from 2002 to 2003. That seems like a fairly large decline in the deflator, but in fact if one goes back to 2000 and 2001, that number was 50 percent. All of this suggests that there may not be, as I’ve said many times, a “killer ap” out there. In more technical terms, there’s not a technological advancement that might catalyze new investments. So we may be confronting a phase where some of the positive supply shock that we experienced before has worn off and businesses see that and aren’t so eager to invest. That may explain why one of the areas of weakness that we are dealing with is equipment software.

So those are two or three different hypotheses. But whatever the explanation that ultimately proves true—and it may not be any of those—I think the macroeconomic result is the same. In a textbook sense, the IS curve seems to have shifted down toward the origin, which gives both a lower effective equilibrium real interest rate and lower income. Overall, we seem to be confronting a new, less attractive set of interactions or dynamics that include growth in final demand but relatively slow growth compared with potential, low investment in both high-tech equipment and perhaps inventory, and some slowing of growth in the demand for labor and in hours worked. While all of this is still positive, it’s slower—more punkish if you will.

How should we handle this range of outcomes? I think here the Greenbook and the new interest rate assumptions the staff has made may give us the appropriate hint. I’ll just pick up on the same words others have used by saying that I’m “quite comfortable” with moving rates up 25 basis points at this meeting. But going forward I think we should be more “pragmatic”—if I can use a word that’s not so attractive in this community—or more “flexible,” to pick up on Don’s word. We have to let the data and changed outlook lead us going forward. That may imply a pause at some point in the not-too-distant future, or it may imply a pickup in the pace of our policy moves at some time in the foreseeable future. It also may imply some change in language—not at this time, but at some point in the not-too-distant future. Thank you, Mr. Chairman.

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