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

Thank you, Mr. Chairman. Once again I’m an outlier in terms of my projection of the strength in GDP growth for this year, as I can see from the charts we looked at this morning. I want to note, however, that someone else is even more ebullient than I am, but that person has not yet “fessed up.” [Laughter] For me, the lesson of the second half of last year was confirmation of the strong response of the economy to fiscal and monetary stimulus once the restraint of falling equity prices, capital overhangs, business caution, and geopolitical risks had faded. In fact, the response was stronger and quicker than I anticipated. Consequently, for next year I expect the fallback from the 6 percent plus growth of the last half of 2003 to be limited.

Fiscal stimulus ebbs fairly gradually as we saw on a chart this morning. Household spending held up better than expected at year-end despite weak labor markets, suggesting that its earlier strength was based on more than just rebate checks and newly liquefied home equity. Low interest rates, rising wealth, and increasing confidence about the future surely played important roles, and these factors will continue to boost spending. Indeed, financial conditions have become even more stimulative over the last several months, and that will have its effect this year. Since September of last year, equity prices have risen 14 percent, rates on corporate bonds have fallen as much as 1 percentage point or more, and the dollar has depreciated nearly 5 percent on the broad index. The largest declines in bond rates were on the riskiest issues, and the growing willingness to take risks in capital markets is echoed in increasing optimism about future profits and sales by businesses more generally—a development certainly witnessed by many of the reports we heard this morning. Lower costs of capital and growing confidence should interact with accelerating output, strong profits and cash flow, and the need to make up for previously postponed replacement spending to support considerable ongoing strength in business capital expenditures. In effect, we are beginning to see greater feed-through of strong productivity growth to spending both by households responding to rising equity prices and by businesses reacting to profit opportunities in new investment.

Given financial conditions, fiscal policy, growing confidence, and strong growth in productivity, real GDP growth of 5 percent or more is not a stretch at all. It is well within the normal response pattern, and this suggests to me that there are upside as well as downside risks to such a strong forecast. In a sense, though, the growth forecast isn’t all that interesting. I agree with President Broaddus that the interesting and more difficult questions are on the supply side of the economy. How fast will potential grow, how will it interact with demand, and what are the implications for the output gap and inflation? The staff has a favorable story here. Strong underlying productivity boosts actual and expected profits, equity prices, and anticipated income streams, raising demand. But actual productivity growth slows some, so strong demand shows through to a closing output gap. At the same time, compensation growth remains moderate, labor’s share of income remains fairly low, and workers only begin to catch up with the higher underlying productivity growth. As a result, the slowing growth of actual productivity doesn’t raise unit labor costs very much, and it keeps core inflation at recent levels.

This seems a reasonable projection, taking account of the surprising behavior of productivity and labor costs in recent years, but there are considerable uncertainties around this most likely outcome and appreciable skews to the probability. For one, the staff did not allow the higher trend productivity of recent years to show through to a larger output gap, and Sandy gave some good reasons for this. But we did see more disinflation than expected last year, and while special factors contributed, price behavior could point to a greater probability that the gap is larger and not smaller than the staff’s estimate. Moreover, the staff has interpreted some of the recent productivity gains as pushing the level of productivity above its trend, and this gap disappears once business confidence rebounds further. But given the uncertainty about the origins of the astounding productivity gains in recent quarters, there would seem to be a good chance that they won’t be reversed. So, actual labor productivity might not slow as much as in the Greenbook forecast, keeping unit labor costs on a lower trajectory.

Other risks point to the potential for greater price pressures. Compensation could accelerate more as labor markets tighten, allowing higher productivity to pass through to labor more quickly. Productivity advances could begin to show through more forcibly into demand, in effect raising the natural interest rate more quickly than in the staff’s forecast. At this point, however, since we have experienced repeated productivity surprises and insufficient demand to tighten labor markets, while some measures of wage gains continue to trend down, I judge the risk on inflation arising from the supply side of the economy still to be tilted toward the downside.

These uncertainties and skews have implications for policy strategy. Given the lags in compensation behind productivity, this most recent productivity surprise bears a resemblance to the mid-1990s. Then we took some of the temporarily favorable output–inflation tradeoff resulting from the productivity surprise in output—the unemployment rate fell to 4 percent—and some in lower inflation, as core PCE fell from 2½ percent in 1994 to 1½ percent in 1997. At this time, with the core inflation rate in the neighborhood of 1 percent, it would be important to take as much as possible of the productivity surprise in output, not in lower inflation. So in my view, the supply-side uncertainties, together with the skews in those uncertainties pointing toward a higher probability of inflation coming in below expectations, reinforce the rationale for being very, very cautious in moving off our current highly accommodative policy stance. This is a subject I assume we will come back to in the next part of the meeting. Thank you, Mr. Chairman.

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