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

Thank you, Mr. Chairman. Economic activity in the Twelfth District continues to gain momentum. For example, retailers in the West had an encouraging holiday season, with considerably stronger sales this year than last year. Spending by businesses is also picking up. The bulk of our contacts say that they will increase capital spending going forward, citing plans to replace both IT and non-IT equipment. One machine tool maker tells us that her order book is full for the entire year. District computer makers like Hewlett-Packard have seen sharp increases in demand, helping to boost output for semiconductors and in turn semiconductor equipment. Commercial aerospace has yet to see a pickup in capital spending; however, folks in Washington State breathed a sigh of relief when Boeing decided last month to go forward with developing the new 7E7 and to assemble the planes in the Seattle area. Overall, the labor markets in the west have improved over the past year, especially outside California. In fact, nonfarm payrolls in the Twelfth District outside California are back up to pre-recession levels.

In California, a new governor and to some extent an improved economic outlook have motivated lawmakers to break the gridlock and tackle the state’s accumulated and long-term budget shortfall. In late December, legislators voted to place a long-term deficit reduction bond and a state reserve fund requirement on the March 2 ballot. The deficit reduction bond would refinance the state’s accumulated deficit from the current and previous budget years. At this point, polls show limited public support for the initiative, but the governor and the state’s comptroller have started a big push to convince voters to approve the ballot measures. A few weeks ago, the governor turned his attention to the state’s long-run structural gap, proposing a multiyear workout plan. For the 2004-05 fiscal year, the plan calls for $9 billion in permanent spending cuts and programs saving $6 billion in loans and deferrals. We will see some fee increases such as for higher education, but new broad-based taxes are not in the plan. So far the governor’s proposal has received more positive than negative feedback. The independent legislative analyst’s office called the plan a solid first step. The state comptroller, a Democrat, and several members of the legislature from both parties have stated that they will work with the governor to craft a final agreement. That said, significant hurdles to enacting a budget remain. A formidable group of lawmakers wants to raise taxes, and several of the governor’s proposed spending cuts and spending deferrals may not withstand legal challenges. One example is the proposal to reduce fees for MediCal doctors. Some of the governor’s revenue hopes also may not be realized. He wants to get a larger share of revenue from tribal gaming, but the U.S. Department of the Interior probably will not cooperate since it has blocked similar contracts in recent years.

Turning to the national outlook, recent data on spending confirm that economic activity is on a path of robust growth. We expect GDP to grow about 5 percent this year and about 4¼ percent next year. This forecast assumes that policy remains on hold until the fourth quarter of this year and then tightens gradually until the funds rate reaches 2½ percent by the end of 2005. Under this scenario, resource utilization would rise over the next two years, and the unemployment rate would fall to about 5¼ percent by the end of this year and to 5 percent by the end of 2005. Here I must admit that the unusual behavior of payroll employment and labor force participation raises questions about the amount of labor slack going forward.

The latest data on core inflation have come in very low indeed. These data together with earlier revisions imply that the core PCE price index rose hardly at all over the past year after adjusting for bias. In response, we have lowered our forecast of inflation, and we now expect core PCE inflation to come in at 1 percent this year and slightly above 1 percent next year. The new data also raise the possibility that inflation will decline further to uncomfortably low levels. Although the probabilities of upward and downward movements in inflation may be balanced, the cost of a bit higher inflation appears smaller than the cost of a bit lower inflation. To me, the inflation and employment data argue strongly for leaving policy unchanged despite the strong growth in real GDP. Further, some long-run simulations carried out by my staff suggest that a policy of leaving the funds rate at 1 percent through the end of this year leads to unemployment and inflation paths that are virtually indistinguishable from those generated under the optimal policy, assuming an inflation goal of somewhere between 1 and 2 percent. Thank you.

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