Thank you, Mr. Chairman. I’ll be referring to the material that Carol Low is handing out. There is a Zen koan—which is a meditation riddle spelled K-O-A-N, not a relative of the Governor—that holds that the most difficult act of all is to do nothing well. This sentiment seems to apply to today’s meeting.
As can be seen in the top right panel of your first exhibit, market participants have scaled back the path expected for the federal funds rate as much as ½ percentage point in 2005, with the nominal funds rate seen opening 2006 at 3 percent. This path of the expected funds rate is consistent with a probabilistic assessment that the median expected date of the start of tightening, seen as the peak of the dashed line at the right, rose from around five months to about ten months, the solid line. As judged by options on money market futures (shown in the middle left by the red bars plotting the implied probability distribution that prevailed yesterday), investors are somewhat surer that the funds rate will trade around 1 percent six months hence than they were at the time of the December meeting (the dashed line). While considerable weight is placed on the possibility that policy will firm, some weight—and more than at the last meeting—is placed on policy easing. In the latest survey of primary dealers conducted by the Desk, the greatest number of respondents judged—as shown at the middle right—that the onset of tightening would take place in the second half of this year, although a sizable portion thought it would come sooner or later than that.
As to the specifics of the statement to be released this afternoon, as shown in the bottom left panel just one primary dealer foresees a change in the assessment of output risks, and only a couple more view the risks to inflation as anything but balanced. In that regard, I would not view that consensus on balanced inflation risks as a change in your assessment. While the Committee’s last statement indicated a balance slightly skewed toward lower rather than higher inflation, market participants mostly interpreted this as “balanced.” Thus, the four respondents calling for “downside” risks are more likely predicting that you will scale back the current setting toward odds favoring disinflation. The staff has interpreted a goodly portion of the rally in financial markets over the intermeeting period as resulting from a downward shift in market expectations toward our assumption that policy tightening will not take place until next year. That there remains considerable mass on the possibility of earlier tightening embedded in financial market prices implies that there is a potential for the rally to be extended as expectations correct more to the Greenbook baseline. Why market participants might still expect earlier and more- significant firming is evident in the bottom right panel: A survey of economists at eight dealers indicates that their outlook for inflation is decidedly less subdued than the staff’s, even with a growth forecast that is less robust than the staff’s. A distinct possibility is that many in the market have a gloomier view of the prospects for the growth of aggregate supply, a point that came out in the exchange between President Poole and Dave Stockton.
One of the more interesting market developments over the intermeeting period was the further decline in yields on Treasury indexed debt, seen in the top left panel of your second exhibit as the shift from the dotted to the solid line. The real yield curve remains steeply upward sloped, but this has prevailed because both short- and longer-term yields, shown in the top right panel, have moved lower. These movements have two implications relevant for setting policy. For one, the low level of longer-term TIPS yields may signal that real rates need to be very low to encourage private spending, suggesting that forces of restraint still loom large, including an equity premium on the high side of historical experience and a desire on the part of households to raise the saving rate to something more in line with historical norms. If the Committee puts much weight on such possibilities, it might be inclined to ease policy, or at least to project a willingness to do so, as is the subject of the middle left panel. In particular, a sense on your part that business confidence would remain impaired might lead you to seek a policy offset. While the anecdotes about spending are encouraging, firms have yet to put their money where their mouths are when it comes to new hiring or additions to inventory stocks. The recent sluggish performance of the monetary and credit aggregates, shown in the table at the bottom left, may raise your discomfort level on that score. Another possibility is that we are seeing additional once-off increases in productivity that, as the simulations in the Greenbook and the extended scenarios in the Bluebook suggested, imply that the increase in aggregate supply is actually outstripping that of aggregate demand, thereby generating additional resource slack and putting further downward pressure on inflation. Even if you are satisfied that spending has settled onto a sustainable and acceptable upward track, the recent sluggish readings on inflation may be worrisome, either because they suggest that the level of inflation is already on the low side of your preferred range or that it may be poised to go lower.
The second implication follows from the steepness of the indexed debt yield curve, which could be taken as a measure of the gap between the currently very low real short-term rate and its longer-run equilibrium value. If aggregate demand is sluggish, then such a configuration would be appropriate. However, you might be concerned that—as related in the middle right panel, which makes the case for policy firming—too much financial accommodation is in place. If the Committee was comfortable with the level of the nominal funds rate at its December meeting, it might believe that, as in the bottom right panel, the decline in longer-term yields, the run-up in share values, and the depreciation of the dollar since then warrant a policy offset, as President Geithner was mentioning. Such concerns would be more intense if you believed that the staff was a bit too optimistic about the prospects for inflation to remain subdued. If events unfold similarly to the “more inflation pressures” scenario in the Bluebook, the Committee would probably want to begin firming sometime soon.
Of course, there is an obstacle in doing so: The last sentence of your past four statements held that policy could be kept accommodative for a considerable period, thereby constraining the flexibility of your actions. But as related in exhibit 3, such a constraint may not really be binding on your current rate decision. In particular, the case for keeping policy on hold could rest squarely on your confidence and satisfaction with the general contours of the staff forecast, in which the economy is expected to grow briskly, resource slack to narrow, and core PCE inflation to remain at around its current level. Indeed, in the alternative long-run simulations reported in the Bluebook and repeated in the bottom four panels, the nominal funds rate could remain at 1 percent until next year if the Committee’s inflation goal were 1 percent (the black lines) or until 2006 if the goal were 1½ percent (the blue lines). Given the limitations of our ability to model the economy, such simulations are really only for illustrative purposes. Your policy decision involves weighing a variety of costs and benefits in a probabilistic setting. And in that regard, 1 percent may look like an appropriate level for the funds rate if you view the costs associated with a firmer policy—should you be wrong about aggregate demand expanding vigorously—as large relative to those incurred by running a little easier policy and risking a more vigorous expansion if aggregate demand proves more robust than you now expect. Committee members might be reassured in that regard from the fact that measures of longer-term inflation expectations, the top right panel, remain subdued as well as from the staff’s assessment that resource slack remains considerable and that potential output will be a target that is moving rapidly upward. However, as opposed to the past few meetings—given the buoyancy of financial markets—you might be less confident about that tradeoff going forward, and therefore be more reluctant to make promises about your future action, which brings me to your final exhibit.
At times over the past six months, members have chaffed at the constraint imposed by the commitment to keep policy accommodative for a considerable period. But by being explicit to the public about this self-imposed constraint, you did help limit the tendency of market participants to build in unhelpfully aggressive expectations of policy firming, thereby keeping financial conditions accommodative at a time when you might have been concerned about the efficacy of alternative monetary policy actions. In the event, the expansion of aggregate demand did not falter, and there was no need to dig deeper into the toolkit of policymaking. But the fact that insurance was not needed ex post does not imply that it was unwise to purchase it ex ante.
Three options for the wording of the statement are laid out in the middle panel. For one, you could decide to retain the sentence, which would be particularly appealing if you were confident that the economy was likely to evolve in a relatively benign manner at an unchanged funds rate for some time, as in the staff forecast. That option would be even more appealing if you thought inflation was currently on the low side of your desired outcome. In addition, as President Moskow and Governor Bernanke have pointed out, the news on the conditioning elements of the statement—inflation and slack—moved in a way over the intermeeting period that would seem to have extended the considerable period. And that is how the markets took those developments as well. Given that most market participants appear to expect retention of the “considerable period” sentence, you might want more time to prepare the way more for its deletion, perhaps using the opportunity provided by the Chairman’s upcoming semiannual testimony. As another possibility, you could drop the sentence, as would be appropriate if you either anticipated tightening within the next few meetings or were no longer confident that you could rule it out. If you viewed aggregate demand as growing along a self-sustaining track and were worried that inflation pressures might pick up, you might welcome a check on the extent of financial stimulus. Even if the Committee put low odds on tightening policy sometime soon, it might view either delaying needed tightening or reneging on its commitment should inflation pressures pick up as sufficiently damaging to its credibility to warrant dropping the sentence preemptively.
But if you are concerned that the reaction to dropping the sentence might be outsized, a third option would be to soften the sentence. In the Bluebook, we suggested adopting the notion of “patience” that the Chairman introduced in a recent speech, which market participants would probably take as implying that the Committee viewed events as such that it could be gradual in firming policy. We suggested the sentence: “With inflation quite low and resource use slack, the Committee believes that it can be patient in adjusting the very accommodative stance of monetary policy.” In the feedback I’ve gotten since the publication of the Bluebook, some members expressed concern that describing policy as very accommodative, which has not been a feature of previous statements, might be taken as too strong a signal that significant tightening would soon be under way. Another possibility, as shown in the bottom panel, would be to have the Committee characterize itself as “patient in removing its policy accommodation.” I would advise, however, that you run the statement through a spell checker, something I forgot to do. That concludes my prepared remarks.