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

Thank you, Mr. Chairman. The news on economic activity in the Third District has changed little since our mid-April conference call. The data suggest that our region experienced a somewhat larger slowdown in growth in the first quarter than the nation did. But since the end of hostilities in Iraq, I’ve sensed an improvement in tone from our business contacts. The data show that economic activity in the Third District remains subdued. Our business outlook survey showed a further decline in regional manufacturing activity in April. The index of general activity deteriorated to minus 8.8 in April from minus 8.0 in March, and the indexes of new orders, shipments, and employment all fell as well. Respondents attributed some of the decline in orders over the past two months to the start of the war in Iraq. Most of the firms, however, said that such war-related declines were slight or moderate.

Regional labor markets also remain weak. The recent benchmarking of state employment data shows that the decline in employment in our three-state area in 2002 was not as large as originally reported. But there were declines nonetheless, and employment in the region has continued to contract this year. Residential construction, which has been one of our stronger sectors, has eased in recent months. The demand for office and commercial space continued to be soft in the first quarter. Retail sales in the District in late March and early April were running below year-ago levels in all lines of merchandise. And retailers attributed lower spring sales to a combination of unseasonably cold weather, the timing of Easter, and the war in Iraq.

But amid these reports of subdued activity, I’ve noticed some renewed optimism since the end of the war. During April and May I typically travel the District, holding a series of meetings with our bankers and business leaders. My exchanges with them over the past few weeks reveal an improved outlook and higher confidence that the recovery will begin to develop some traction in the second half of the year. They’re not expecting a strong rebound in activity but a rebound nonetheless. Some of my contacts tell me that their firms are starting to undertake major capital investments, feeling that they’ve sat on the sidelines long enough. This is a definite change in mood since our March meeting and our mid-April conference call.

My view on the national economy is similar. The hard data on the real sector have generally been on the weak side. The initial estimate for first-quarter GDP was weaker than I was expecting, and we continue to see job losses. But the softer information from anecdotal reports and the developments in the financial markets have been positive. Equity prices and corporate profits are up. Credit risk spreads and oil prices are down. In March we acknowledged that it was difficult to discern how much of the economic weakness was due to concerns about geopolitical uncertainty and how much was due to a weaker underlying economic dynamic. We also acknowledged that a short-lived and successful war in Iraq would resolve some of the uncertainty but that we wouldn’t have much data on the real side of the economy soon after the war ended, given the lags in the receipt of those data. We pointed to data on oil prices, financial market indicators, and anecdotal evidence as the initial pieces of information we could look to as a way to assess postwar economic conditions.

Indeed, that is the situation in which we find ourselves today. Most of our real sector data are dated, so they continue to reflect the influences of the war and therefore are less helpful in discerning economic conditions going forward. The data from financial markets and on consumer confidence, which do reflect postwar conditions, have been quite favorable. Accordingly, I have little to say about the Greenbook and its attendant forecast. The baseline forecast seems right, and the alternative forecasts were helpful to see the sensitivity of the results. However, given that forecasting generally depends somewhat on retrospection, I don’t receive the usual comfort from the staff’s effort this time around. That’s not a criticism of the effort but rather a manifestation of the time period we are in.

That said, I would like to react to the deflation exercise in the Greenbook. The simulation exercise implies that the probability of deflation by the end of 2004 is about 35 percent. I might quibble with the Board staff’s definition of deflation; ½ of 1 percent may seem reasonable, but recent academic work suggests that the bias in price indexes is declining. More to the point, however, I think our concern about deflation is a concern that the economy may exhibit behavior associated with deflation psychology, which includes an expectation of continued price declines. I’m not sure that a four-quarter 50 basis point benchmark captures this very well. Further, I question how sensitive the staff’s estimate is to using a random selection of shocks from 1970 to 2000—a time period that includes the 1970s, a decade characterized by both volatility and a higher level of inflation. I wonder what the impact would be of using a sample period over which the economy was less volatile and the average rate of inflation was lower— starting, say, in 1980. My questions regarding definitions and time periods are in part a reaction to the results of this exercise. The results, in short, are troubling. A 35 percent probability is not trivial.

Nonetheless, given the current accommodative stance of monetary policy and the prospects of more accommodative fiscal policy, it appears wise to wait to see what additional data tell us about postwar conditions before deciding how to respond to the slowness of growth exhibited in the data. If the sluggishness continues in the period after the war, then a reduction in rates may be in order. In the meantime, I think we should remain alert to new information and evidence of changes in either direction in the real economy. Thank you, Mr. Chairman.

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