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

Thank you, Mr. Chairman. There has clearly been a narrowing of uncertainties surrounding the outlook as well as a considerable amount of good news for the economy since the March Greenbook was completed. The successful and expeditious completion of the war in Iraq has alleviated some of the pressing concerns that had been weighing on participants in the energy and financial markets. Indeed, with OPEC production higher, remarkably little damage to oil fields in Iraq and, as yet, few signs of negative political spillovers elsewhere in the region, oil prices have tumbled. The spot price of West Texas Intermediate crude oil is expected to average about $9 per barrel lower in the current quarter than we had anticipated in our previous forecast.

In financial markets, stock prices began to move noticeably higher just as we were completing our March projection. The lifting of war-related uncertainties and the better-than-expected earnings reports for the first quarter boosted equity prices about 13 percent above the level assumed in our last projection. Risk spreads on corporate bonds have narrowed as well, especially for lower-tier firms. Households too seem to be feeling better. Consumer confidence has rebounded in recent weeks, retracing much of the decline that had occurred since last fall. Finally, one of the key upside risks to the projection that we had highlighted earlier appears to have materialized, as the defense spending implied by the recently enacted supplemental is considerably more than we had incorporated in our previous projection.

So with all of that apparent good news, our forecast might come as something of a disappointment. We have revised down the growth of real GDP throughout 2003, and the 2.8 percent increase projected for the year is nearly ½ percentage point less than in the March Greenbook. To be sure, greater stimulus from the factors that I just mentioned does produce more-rapid growth next year. But even with the sharper pickup in activity that eventually develops in our forecast, the level of real GDP is lower and the GDP gap higher, on average, in 2004 than in our previous projection.

Our principal motivation for this downward revision has been a fairly steady drumbeat of negative news on the real economy. To start, the spending data have been coming in somewhat weaker than we had anticipated in March. Consumption and investment taken together rose just 1½ percent at an annual rate in the first quarter, more than ¼ percentage point slower than in our last projection. Moreover, at least in the household sector, we aren’t entering the second quarter with much momentum. Outside of motor vehicles, consumer spending has been relatively flat in recent months. Sales of new motor vehicles improved to 16.4 million units at an annual rate in April, up from a 16 million unit pace in March. But that incentive- stimulated increase was aimed at alleviating the inventory problems that had developed this winter, and the cutbacks in production scheduled by the manufacturers will continue to be a drag on aggregate activity in the current quarter. Moreover, our business contacts in this industry report that the response to the recent boost to incentives has, if anything, been disappointing. Housing activity has not been as buoyant as we had expected. Starts and permits have had a softer tone, and we now expect a flattening out in this sector in coming months instead of modest gains.

Business spending also has presented some downside surprises. On net, the readings on orders and shipments of capital goods in February and March were below those anticipated in our previous forecast. In the high-tech area, outlays for communications equipment have shown notable strength of late, but computer spending is growing less vigorously than we had expected. Outside of high-tech, a projected increase in current-quarter equipment spending does not appear sufficient to reverse a now larger estimated decline in the first quarter.

The mildly negative innovations in the spending data, taken by themselves, would not have justified the size of the downward adjustments that we have made to private demand for the remainder of the year. Our thinking about the underlying strength of the economy was more heavily influenced by the surprisingly weak recent readings on the labor market and industrial activity. Private payrolls have been contracting at an average monthly rate of 85,000 since the turn of the year, and with initial claims for unemployment insurance averaging close to 450,000 in recent weeks, there are few signs that businesses have, as yet, stopped shedding workers. Moreover, the employment decline and the sharp drop in the workweek in April point to another contraction in hours worked this quarter. Perhaps this is more good news on productivity—and quite likely it is. But I don’t think that’s the whole story. We are now expecting a decline in total industrial production of ½ percent in April and a drop in the manufacturing component of about ¾ percent. Activity in the factory sector has generally been contracting since the fall. That weak picture seems to line up very well with negative readings from purchasing managers and the continuing downbeat tenor of the reports that we have received from business contacts.

It is, of course, possible that we have overreacted to the incoming data. I should stress that we are still working with readings on the economy that, for the most part, were taken before or during the war. We have interpreted the greater weakness in that information as suggesting that underlying activity has been softer than we had earlier estimated. But we can’t confidently rule out that the war-related restraints on the economy were more intense than we have been allowing for. Beyond the readings from commodity and financial markets, we still know very little about the postwar economy. In brief, we have received more favorable readings on consumer confidence and chain-store sales and less favorable readings from initial claims.

As I noted at the outset, defense spending is one element of final demand that is likely to be considerably stronger than was anticipated in our previous forecast. Indeed, our projected increase in outlays for defense now accounts for more than half of the GDP growth that we are projecting for the current quarter. That made us nervous enough to canvas our brothers and sisters in the forecasting community, both inside and outside government. We got pretty much the same answer from everybody: “Gee, that’s interesting; we haven’t really thought much about it yet.” Armed with that helpful guidance, we tried our best to steer a balanced course. To the upside of our forecast, the CBO is estimating noticeably higher defense spending for fiscal year 2003 than we have incorporated in this forecast. With only two quarters remaining in the fiscal year, their figures imply some whopping increases in Q2 and Q3. To the downside, OMB’s latest take on Iraq-related defense spending is about as far below our forecast as CBO’s is above. But even the OMB figure is consistent with a somewhat faster spendout of recently enacted budget authority than was observed after the Gulf War. The bottom line is that the confidence interval around this feature of our forecast is very wide.

Although our revisions to private and government spending, on net, resulted in somewhat slower growth in real GDP, we continue to show growth picking up in the second half. The basic logic of that forecast remains the same as in the last Greenbook—forces are in place that will work in concert to produce a pickup in real activity over the second half of this year. Accommodative monetary policy, another dose of fiscal stimulus, waning negative wealth effects, improving consumer and business confidence, and lean inventories are the key ingredients in our forecast of reacceleration in spending and production.

Vincent remarked to me after the last meeting that President Minehan’s description of all the things that had to go just right to get the staff forecast had made me sound a bit like the guy on the Ed Sullivan show who would come out and start spinning ever greater numbers of plates on the end of sticks. As more plates were added to the mix, each one had to be spun with precision and speed to maintain the balance of the entire delicate construction. While I am reluctant to endorse this characterization of the forecast, I will admit that my arms have been getting a bit tired waiting for a big finale. [Laughter]

Obviously, there remain serious risks to both the timing and magnitude of the acceleration in real activity that we are projecting. The recent gains in equity markets and declines in risk spreads could be signaling that a stronger-than-expected rebound is in the offing. As you know, we have made much of gloomy sentiment and heightened caution as factors that have retarded business spending over the past year or so. But it would be a mistake to equate caution on the part of businesses with inaction. In fact, they appear to have been hard at work. Balance sheets have been strengthened, aided importantly by an environment of low interest rates. Firms have become leaner through workforce reductions, reorganizations, and more-effective utilization of their existing capital stock. And with a few exceptions, businesses have kept inventories very lean in relation to sales. These adjustments could be setting the stage for a more-vigorous expansion ahead.

But there also remain ample grounds for skepticism about the reacceleration in activity that we are projecting to occur in the second half. We continue to believe that unusual forces have been holding back investment spending and that these forces will gradually dissipate. It is possible that this story is just wrong. Perhaps investment has been weak because there are relatively few profitable investment projects available. In other words, perhaps our model is misspecified, and the recent pace of investment spending reflects fundamentals that are less favorable than we recognize. In this case, the acceleration in equipment spending would likely be less impressive than anticipated in our forecast. There are risks to household spending as well. As we discussed at the last meeting, the personal saving rate remains well below its long-run equilibrium. We have been comfortable that households are making adjustments to consumption and saving of about the size and on roughly the time line anticipated by our models. Still, we cannot rule out the possibility of a more abrupt upward movement in the saving rate—associated perhaps with heightened job insecurity should the labor market remain in the doldrums. This too would produce a more muted pickup in activity than we are projecting.

Even if we have the basic elements of the reacceleration of real activity about right, considerable uncertainty remains about the timing of the step-up in growth. The process of repair and recovery from the bursting of the asset bubble and the myriad other shocks that have hit the economy in the past few years could take longer than we are anticipating. At this point, timing does matter. Core consumer price inflation has been moving lower in recent quarters, and in our forecast most major measures are expected to move into a range that encompasses zero inflation, once allowance is made for likely measurement error. Any serious delay in the recovery or shortfall in its magnitude would imply a larger output gap, at least for a time, and by our analysis would result in an even lower inflation rate. As you know, for this round, we updated the calculations for the probability of deflation that we presented last December. Because the baseline forecasts for both output and inflation have been revised down since then, we now estimate that the probability of deflation—defined as core PCE price inflation falling below ½ percent by the end of 2004—has risen from about 28 percent to about 35 percent. I’d take these figures with a grain of salt. But it doesn’t take complex stochastic simulations to recognize that, with inflation this low, any reasonable confidence interval would include a sizable probability that the aggregate price level could fall. Karen will now continue our presentation.

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