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

Thank you, Mr. Chairman. With the help of the first exhibit in the material distributed at the break, I want to begin by pointing out several notable features in financial markets over the past six weeks likely bearing on your policy deliberations. As shown by the solid line in the top left panel, short-term interest rate futures indicate that market participants currently expect the Committee to tighten gradually over the next year and a half, with the funds rate reaching 2⅞ percent by early 2006. Compared with the interest rate sentiment prevailing in the markets at the time of the August meeting (the dotted line), this path is a little firmer in the near term and shallower later on. Apparently, investors read recent statements by policymakers as confirming a desire on your part to continue to remove accommodation and interpreted data releases—especially subdued readings on inflation—as indicating that a lessened cumulative amount of firming will be required to deliver satisfactory economic performance. The shift over the intermeeting period was small relative to that in the run-up to the August meeting, when the weak employment report for July was released between the publication of the August Greenbook and your last meeting. Current market expectations relative to those at the time of that Greenbook (the dashed line) are about ½ percentage point lower one and one-half years from now—similar to the revision to the staff’s policy assumption from Greenbook to Greenbook.

The top right panel focuses on near-term expectations by plotting the policy path that is consistent with the futures curve and assumes that the Committee will move only at regularly scheduled meetings. Those expectations indicate a near certainty of a ¼ point hike today—which is also what dealers told the Domestic Desk in its regular survey—and put the funds rate near 2 percent at year-end. Thus, market participants expect you to pause sometime soon in the process of removing policy accommodation—probably in December. These expectations seem to be held relatively firmly, in that implied volatility on near-term Eurodollar futures rates (given in the middle left panel) has trended lower, a phenomenon not unique to this market. Despite subdued readings on interest rate volatility, market prices have responded forcefully to key data releases. The middle right panel compares the change in the ten-year Treasury yield (plotted on the vertical axis) in the half-hour surrounding the release of the employment report with the surprise in the nonfarm payrolls (or the actual value less a survey measure), which is given along the horizontal axis. As shown by the red regression line, the average response to employment surprises in the last year has been considerably more marked than in the prior ten years. As President Geithner noted, one possibility linking the two middle panels is that the explicitly conditional nature of your statements has lowered uncertainty about your actions and focused attention on a few indicators. The arrow in the figure points to the observation corresponding to the release of the August employment report on September 3, which is a bit of a puzzle. The monthly gain in payrolls was a touch weaker than market participants expected, yet rates rose considerably. You might rationalize this as owing to backward revisions to the employment data, but I think it also shows the market’s judgment that the data were not soft enough to halt your process of removing policy accommodation.

The net effect of other data over the intermeeting period, however, more than offset this one-day rise in rates. The downward revision to policy expectations was associated with a considerable relaxation in financial conditions, in that, as shown in the bottom panel, corporate yields are lower, equity prices posted sizable gains, while the exchange value of the dollar moved sideways. How you interpret this easing no doubt influences your decisions today both on the funds rate target and on the words of the statement.

Members might view the decline in yields and the concomitant rise in share prices as the dawning recognition among investors that a lower track for the real risk-free rate of interest will be necessary to support economic growth. As discussed at the top of exhibit 2, a decision to hold the funds rate at 1½ percent would no doubt encourage an even more substantial revision to the outlook for policy. While the Committee may be convinced that a sustainable economic expansion is in place, it may be concerned that the pace of output growth will not be sufficiently vigorous to ensure satisfactory progress in reducing economic slack.

As shown in the middle left panel, the advance in payrolls has been fitful in recent months and perhaps indicates a lingering hesitancy on the part of businesses to make commitments, which several of you have already mentioned. If that hesitancy continues for too long, then it may also be reflected again in capital spending and begin to dent consumer confidence. Persisting slack has also rolled back a portion of the turn-up in inflation of the first half of the year. As can be seen in the middle right panel and as noted by President McTeer, the three-month change in the CPI has dropped back to the levels of last year, when worries of the possibility of deflation surfaced. And market participants apparently have lowered their expectations for inflation going forward. For instance, as plotted in the bottom left panel, the nominal one-year forward rate ten years ahead, which has been quite sensitive to longer-run inflation sentiment, has edged down to just below 6 percent. If resource slack persists, inflation could fall to levels that the Committee might find uncomfortably low, given the limits to conventional policy maneuvering posed by the zero bound to nominal interest rates.

I’d add that the “measured pace” language would not seem to pose an obstacle to pausing in the process of firming, in that futures rates indicate that financial market participants already anticipate inaction at one of the next three meetings—although evidently not at this one. Indeed, a pause at this time might be seen as having the benefit of ensuring that market participants do not come inappropriately to view the “measured pace” language as a promise to firm policy 25 basis points at every meeting. There is, however, an important obstacle to putting the process of tightening on hold at this meeting: The universal conviction in markets that you will not do so implies that the reaction to inaction could be sizable. A pickup in mortgage hedging flows could magnify any initial downdraft in yields. The rally in fixed- income markets in recent weeks has pulled down the thirty-year mortgage rate to 5¾ percent, which is shown as the vertical line in the bottom right panel. According to an estimate of the cumulative distribution of rates on outstanding mortgages, about 35 percent of them could be refinanced economically given current pricing. Because of the wave of refinancings last year, outstanding mortgages are tightly clustered at rates not much lower than the prevailing level. As a result, further reductions in longer-term yields would likely lead to substantial prepayments of mortgages. The experience of last year suggests that the resultant shortening of the duration of mortgage-backed securities would prompt purchases of other longer-term securities, amplifying the decline in rates and elevating volatility. Deviating from the currently expected path of measured firming would seem to risk a considerable easing of financial conditions, which may not be judged as appropriate at this time.

But the most compelling reason not to opt for alternative A is that you see merit in tightening, the subject of exhibit 3. The Committee may believe that the economic expansion will remain on a desirable track under current financial conditions, which incorporate market expectations of gradual policy firming. In such circumstances, it would seem appropriate to validate those expectations by tightening 25 basis points at this meeting, as in the B and C alternatives presented in the Bluebook. As can be seen in the middle left panel, even with the two tightening steps that the Committee has taken to date, the real federal funds rate is still close to zero and near the bottom of the range of equilibrium values estimated by the staff. A modest boost to the nominal funds rate would also be consistent with a number of monetary policy rules shown in the middle right panel. And given the forces likely to impinge on aggregate demand in coming quarters—including the efforts by households to rebuild savings, the swing from fiscal impetus to restraint, and the intensifying drag of net exports— the Committee may find a quarter point move to be a sufficient step in removing policy accommodation at this time.

As to the wording of the statement—which is the only distinction between alternatives B and C—if the Committee put much weight on the possibility that growth will rebound sharply, it may believe that the scope of its future action is unduly constrained on the upside by the “measured pace” language and may prefer to drop the last two sentences from the statement. That may be especially so if you interpret the decline in risk spreads and increases in the price–earnings ratio shown in the table at the bottom left as evidence of an increased appetite for risk-taking. In that case, you may be concerned that the spur to spending of a lower cost of funds and higher wealth poses the risk that the growth of aggregate demand would quickly outstrip that of potential output. While such an outcome may be welcomed if the output gap were as large as in the staff forecast, you might share President Guynn’s fear that the prospects for aggregate supply were described not by the Greenbook baseline but by the “less room to grow” alternative simulation. In that alternative, the NAIRU is higher, and the labor force participation rate does not rise any further to augment labor inputs going forward, putting inflation on an upward march toward 2 percent, as shown in the bottom right panel.

Removing the last two sentences would certainly surprise market participants, who would presumably build in expectations of more-substantial action to come. Therefore, you probably would not want to consider acquiring the flexibility associated with alternative C unless you also desire an immediate tightening of financial conditions. Alternative B would provide the comfort of aligning your decision with prevailing expectations while giving only limited and highly conditioned guidance on your future actions. Retaining the risk assessment of August would seem appropriate if you believe that you will have to be cautious about the extent and speed with which policy accommodation should be removed. After all, it is not yet firmly established that the economy has exited its soft patch, and you may prefer to await more information on that score.

Your last exhibit updates table 1 from the Bluebook in light of comments received since its distribution on Thursday. In particular, as shown in bold, it seemed clearer to link the description of the performance of output and the labor market in the rationale paragraph by writing, “After moderating earlier this year partly in response to the substantial rise in energy prices, output growth appears to have regained some traction and labor market conditions have improved modestly.” That concludes my prepared remarks.

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