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

Mr. Chairman, the Twelfth District expansion continues to be sluggish but seems only mildly affected by the Iraqi war and the SARS epidemic in East Asia. The main impact of both events was a sharp reduction in international travel, especially from East Asia. As a result, airlines suspended some regularly scheduled East Asian flights, and load factors on remaining flights fell by half or more. Some firms have reported increased difficulties in maintaining overseas supply chains due to travel restrictions and scattered plant shutdowns in East Asia. However, the production and supply effects of SARS have been quite limited to date, and a recent pickup in domestic tourist travel suggests that war-induced anxieties are subsiding. More generally, the lack of bad news on the consumer side has been striking. Solid automobile sales were fueled by generous incentives. And while sales of most small retail items have been slow, they did not fall noticeably because of the war. Moreover, the existing vigor in housing markets was largely maintained throughout the District.

On the business side, firms have remained reluctant to expand employment or capacity in anticipation of improved demand and bottom lines. Moreover, some firms stated that their caution was not directly tied to the war with Iraq. Businesses have been investing in new information technology equipment but mainly for replacement and upgrade purposes, and District tech contacts are not especially sanguine about short-term prospects in the industry. For example, the search for cost savings has led to increased reliance on overseas suppliers— especially in China, where firms have undercut domestic production of some tech products. Of course this has an upside as well, with U.S. technology leaders such as Intel seeing strong exports of their products for use in low cost assembly operations overseas.

On a final negative note, District states are still struggling with budgetary woes. Revenue flows have been uneven lately; and despite some successful efforts to bring spending in line, most District states still face a large current year budget gap. Moreover, preliminary data for April suggest that revenue in California may fall below even the more modest targets that it set in January. That increases the need for borrowing and for other measures to ensure short-term cash flow.

Let me turn to the national economy. In light of weaker-than-expected economic data, we like nearly everyone else revised down our real GDP forecast for this year. We now project growth of about 2¾ percent, which is below most estimates of the potential rate. The risks to the outlook have shifted in a favorable direction with the end of the armed conflict in Iraq, and it’s certainly possible that this will lead to the rebound in activity that we’ve been looking for. But substantial downside risks related to external developments remain, including the aftermath of the war and ongoing geopolitical concerns, as do the risks from a well-known list of more fundamental domestic economic concerns. These downside risks, combined with the expectations for subpar growth, could have rather serious consequences in view of the low level of inflation. With excess capacity in labor and product markets likely to remain at or above current levels through the end of 2004, we expect core PCE inflation to fall to just over 1 percent both this year and next. As Dave mentioned, the Greenbook has a similar forecast. After adjusting for a reasonable estimate of measurement bias, the two forecasts imply true inflation of about ½ of 1 percent. An analysis by the San Francisco staff of typical forecast errors for core inflation suggests an uncomfortably high 20 percent probability that true inflation could fall below zero next year. Of course, as we’ve just heard and as we read before in the Greenbook, the Board staff puts this probability at 35 percent.

This possibility brings to mind familiar research suggesting that, given the long lags in the effects of policy, it’s best to move sooner rather than later when the economy is within range of deflation and the zero bound. Therefore, as insurance against downside surprises to both economic activity and inflation in the future, it would seem prudent to ease policy further. Thank you.

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