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

Thank you, Mr. Chairman. I think the answer to President Minehan’s questioners—who I suspect are really her alter egos or perhaps she’s been speaking into the mirror in the mornings—as to what will lead to higher growth ahead is that some of the factors restraining growth over the last few quarters should be abating. Many of the developments over the intermeeting period have made me a little more confident in that judgment. It seems to me more likely that the expansion will indeed strengthen going forward and break out of the 1 percent to 2 percent growth path that it has been on since last summer.

As others have observed, the ebbing of geopolitical risks has bolstered confidence, lowered the oil price tax faster than anticipated, and fostered better conditions in financial markets. The signs of improvement go beyond the reduction in geopolitical risks. Increasingly, it looks as though the restraint is lifting from the other persistent force we have cited as holding back the economy—the unwinding of the excesses of the late 1990s. These include the fallout from bad credit decisions, deficiencies in corporate governance and transparency, the drop in equity prices, and the overshoot in capital spending. Risk spreads in credit markets have more than retraced their run-up of last summer, appropriately so in my view since bond default rates have also come down substantially. Market reactions to occasional new revelations of corporate malfeasance have been much more measured, suggesting that investors have greater confidence in the information they are getting from most businesses even before they’ve had the benefit of new leadership at the Accounting Oversight Board! [Laughter] As could be seen in Dino’s charts, the implied volatilities in bond and stock markets have also fallen to the levels of last spring. As a consequence, although surely some of the caution from governance scandals is lingering in business decisions, the cost of capital to businesses has decreased, and firms need to have much less concern about conserving cash for fear of overreaction to earnings announcements in skittish markets.

Equity prices have not retraced all of their losses of last summer, but they are well off their lows of that time and have been for a while so that the force of the negative wealth effect should be decreasing over time. The latest real side data show a little less weakness in nonresidential construction. The most recent data do indicate a tentative pickup in orders for equipment, reinforcing the assessment that most capital overhangs have largely dissipated and raising hopes that replacement demand may be strengthening. Moreover, demand will be further supported by a lower dollar, which notably has occurred without any perceptible adverse effects on U.S. asset prices. Surely lower oil prices, greater consumer confidence, and more accommodative financial conditions will work together with stimulative fiscal and monetary policies and continuing gains in real income from rising productivity to strengthen growth. You can try that in the mirror, Cathy, to see if it works.

But as the Chairman noted in his recent testimony, the extent and timing of the pickup are uncertain. We still don’t have enough new information to sort out whether the marked weakening in February and March was almost entirely related to the close onset of war or also reflected more-persistent problems that will damp the upturn. We still don’t have enough information to judge how much the better conditions will feed through to spending and production. What is not uncertain is that whatever recovery the economy experiences will be starting from a much weaker position than I had expected just a few months ago. The data we’ve received over the last two intermeeting periods were considerably softer than I had anticipated, and my expectations for growth this year have been revised down a lot since January. In addition, consumer inflation has come down faster than I thought it would.

The staff has interpreted what we’ve seen as partly reflecting weaker underlying demand as well as war-related jitters. So, the level of output in the Greenbook remains below the level of the January forecast through the entire projection period. Even so, the staff has incorporated a prompt and sharp strengthening of growth in coming months just to hold the economy on a slightly lower path. These judgments seem reasonable, though as I just implied it may be too early to make this call with much confidence.

As for the risks, I don’t have anything useful to add to the sense of risk on both the upside and the downside that Dave and many of you have mentioned. What I do want to emphasize is that this lower starting point for activity and prices makes a rebound of at least the dimensions and persistence envisioned in the staff forecast—if not a stronger rebound—all the more critical for economic welfare, and it has potentially important implications for policy. The output gap is wider than expected; and without a very strong rebound, it will remain wider at a time when there is no reason to accept the loss of income and production longer than necessary. Moreover, the slack in resource utilization implies that inflation is poised to go lower from levels already consistent with price stability. I don’t believe the current low inflation rate is itself an impediment to economic prosperity. I don’t see evidence, for example, that the zero bound on wages is raising actual or steady-state unemployment rates. My guess is that most of the bellyaching about the lack of pricing power or current inflation rates would evaporate if demand were stronger and capital utilization rates higher.

But there are risks from low and declining inflation rates. For the most part inflation expectations have been stable. I’m not sure, however, that people have taken on board the very low level of underlying inflation. Especially if that inflation falls much further, inflation expectations could decrease in coming quarters as headline inflation moves lower following the energy price declines. This would tend to raise real interest rates, absent offsetting policy action. Also, even at high levels of employment, very low, steady-state inflation—by keeping the federal funds rate and other interest rates down—could limit our room to maneuver were the economy subsequently to be hit with a downward shock. Such risks at the current rate of underlying inflation or one that was only a few tenths lower probably aren’t large. But I would be concerned if it looked as though we were on a glide path that would leave inflation at considerably lower levels. For all these reasons, it’s important that we soon see the economy strengthening, and by quite a bit, in order to reduce the output gap and limit the decline in inflation. I’m looking forward to the discussion of the stance of monetary policy in light of this imperative. Thank you, Mr. Chairman.

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