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

Thank you, Mr. Chairman. In preparation for any FOMC meeting it obviously seems appropriate to make some judgments about three different forecasting issues. The first is whether the baseline forecast is both reasonable and acceptable. The second is how the forecast has evolved over a period of time, either between meetings or even going back a little further in time. And the third is what the risks are around the baseline. So let me tell you how I, at least, look at each of those three issues.

On the first, I’d argue that the Greenbook baseline forecast may well be reasonable. Certainly with the end of the military phase of the Iraqi war, financial conditions have clearly improved, as others have already indicated. Equity prices are rising. Risk spreads have narrowed somewhat, though they are still relatively wide by historical standards. Reductions in oil prices, as expected, have become clearer, and we’ve seen an improvement in consumer confidence and a small uptick in corporate profits. All of those developments I would argue might well be consistent with the basic contours of the baseline forecast.

Taking that baseline as at least a reasonable outlook at this stage, the second part of my first question is, Is it acceptable? To that my answer is a resounding “no”! I don’t think the baseline growth outcome is sufficient. The output gap envisioned in the baseline persists for several quarters; it is not closed during the forecast period. Unemployment rates remain well above any that are reasonable for a well-performing U.S. economy. In addition, the composition of GDP growth is an issue. At least in the near term, the acceleration in GDP growth is heavily dependent on government defense spending, and indeed, private demand is noticeably weaker than one would like. Importantly, as others have mentioned, the inflation prospects offered in the baseline are a concern. In the context of our price stability targets and recognizing some uncertainty about measurement, I also judge the inflation outlook to be verging on unattractive. On this point I want to make a slight distinction to explain the nature of my concern. This is not a question in my mind about deflation per se. It’s certainly not a question of going back to the experience of the ’30s. This is really much more a question about further disinflation, which is troubling for a number of reasons. One reason is its implications for the effectiveness of monetary policy. A second is the vulnerability of an already weak economy to any additional shock that might emerge from either internal or external sources.

Also, I would say that having price inflation drop even lower than is currently forecast increases the possibility of what I think of as some self-fulfilling negative ramifications for both households and businesses. So I’d argue that even if the baseline is reasonable—as I believe it is— I don’t think it’s necessarily acceptable and we should be vigilant in that regard.

The second issue that one thinks of in terms of forecasts is exactly how the forecast has evolved. As David already pointed out in his prepared remarks, there have been significant downward revisions in the staff’s forecast since March. I think Cathy compared it with the projections of about a year ago. I went back to the September 2002 Greenbook and looked at each one of the Greenbook forecasts since then. With one exception, the GDP outlook has been marked down each time. There has also been a marking down in the rate of inflation. That clearly reflects the fact that the data have been coming in weaker and weaker during every one of these successive periods, which does at least undermine to some degree the confidence one might have in the Greenbook forecast.

What the staff has done in the context of incoming data that have been weaker and weaker has been to reduce the expectations for the first part of 2003, reduce a bit the expectations for the second part of 2003, but ramp up quite dramatically the expectations for 2004. As I read it, they’ve done that but have given exactly the same set of reasons for growth that at one point was thought to be around 3.5 or 3.6 percent in 2004 and is now projected to be 4.8 percent in 2004. So we do have a bit of a problem in that we’re starting, as Don Kohn said, from a much lower base and hoping to get a much bigger pickup in 2004. I trust that this is not the triumph of hope over experience and reality.

Let me go to the third question, which involves the issue of risks. I would say that the risks are in some sense balanced, but I think we have to be very cautious in that assessment. In order to see any upside risks with respect to the baseline forecast, I think two things have to emerge and they have to do so very soon. One is that the tentative nature of the various conversations many of us have had with business people has to turn quickly to a revelation of a great deal of pent-up demand either for business fixed investment or for inventory. I don’t see that that’s going to come from the structural side of investment whatsoever, for reasons that several of the Presidents have already indicated. I think President Poole, President Pianalto, and perhaps someone else raised the question of whether or not investment in another firm’s excess capacity ends up being a positive with respect to the economy as a whole. So while it’s possible to argue that there is some upside risk on the real side of the economy, I would say that it’s a fairly tentative argument.

I think there are some reasons to be concerned about the downside risks to the real economy. One is that conditions are not as accommodative as one might think. In the context of inflation that has been coming in lower and lower and an economy that has been getting weaker and weaker, monetary policy in fact is not as accommodative as some have been saying. When we get to our policy discussion, I’m sure somebody will point out that the little dot on the Bluebook chart that depicts the location of monetary policy has moved firmly back within the range of the real equilibrium interest rate. It is no longer below the equilibrium rate, so monetary policy is not as stimulative as we would like to believe.

On the fiscal side, we’ve had some colloquy about that already, and I would only add that it does seem likely that we’ll have fiscal stimulus based just on the nature of government expenditures that are already planned. It is possible, though not certain, that there will be additional fiscal stimulus. So we should be careful there.

Having indicated the risks I see with respect to the real economy, they seem to me balanced at best or perhaps tilted a little to the downside. With respect to the inflation picture the risks seem almost all to the downside. In the context of an economy with so much underutilized capacity, it is really hard to imagine a case in which suddenly we will have an outbreak of inflation that we have to worry about. It is unpalatable but not impossible to imagine that we may have too much price stability and will have to worry about that. I’d close by recognizing that indeed the market is expecting very little of us in terms of a policy action today, and we have to take that into account when we get to that part of the discussion. But I would say, If not us, then who? And if not now, then when? [Laughter]

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