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

Thank you, Mr. Chairman. I’ll be referring to the materials that Carol is handing out now. The marked shifts over the intermeeting period in market participants’ expectations about monetary policy are evident in the top panel of your first exhibit, which plots the evolving probability that the funds rate would be ¼ point lower by this afternoon implied by the May federal funds futures contract. Over the latter part of March and early April, before hostilities with Iraq were settled, investors talked about the possibility of an intermeeting easing, making them relatively confident that the funds rate would be below 1¼ percent by the end of today. The cessation of hostilities and the related rally in the equity and corporate debt markets, along with the perception that the Federal Reserve was not preparing the market for easing, deflated that notion. As a consequence, market prices are now consistent with about a 1-in-4 chance of action, about where that expectation has been for the past two weeks.

Market participants still expect the Committee to ease though and ultimately by more than anticipated at the March meeting. As shown by the solid red line in the middle left panel, the current path of expectations of the federal funds rate touches 1 percent by November and has shifted about 50 basis points lower at a longer horizon. Indeed, the option-implied probability distribution of the funds rate this fall (the middle right panel) suggests that investors are placing considerable weight on a level well below 1 percent.

Evidently, a string of weak economic releases—especially on production and employment—more than offset the lift to the economic outlook that presumably attended the decline in uncertainty, the fall in oil prices, and the run-up in share prices over the intermeeting period. It is worth noting that the decline in uncertainty about interest rates, the bottom panels, was pronounced all along the yield curve. The narrowing of the width of the 90 percent confidence band for the federal funds rate 150 days hence derived from options on Eurodollars, at the left, was paralleled by those posted by one- and ten-year-ahead forward rates on swaps, at the right.

A more favorable backdrop of financial and commodity markets might be one of the factors inclining the Committee to keep policy on hold at this meeting, a subject treated in more detail in your next exhibit. The case for holding policy unchanged would be supported if the Committee viewed, as noted in the top panel, the staff forecast to be likely and, over the period that could be reasonably thought to be influenced by action today, acceptable. Underlying that forecast is the judgment that economic fundamentals will spark a relatively quick pickup in the growth of aggregate demand over the balance of the year even holding the funds rate at 1¼ percent. This can be seen by the blue bars in the middle left panel, which show the staff’s forecast that the growth of real GDP will step up from its sub 2 percent pace to a rate first closer to and then beyond that of potential. While it will take some time for this growth to eat into the prevailing level of economic slack, especially given the lackluster performance thus far this quarter, monetary policy action taken today would mostly be felt—at least according to the staff forecast—when the economy already has gained a full head of steam.

You may have reason to believe that economic acceleration will be quicker, implying, as given by the second item in my list in the top panel, that economic slack would be worked down sooner and disinflation would be less likely than in the staff forecast. For example, while the extent of fiscal impetus in the current baseline forecast is a bit larger than in the previous one, the Committee might believe that the political compromise likely to be struck will take part of all the proposals currently on the table so that the total ends up significantly larger than now envisioned. To give you a sense of the upside risk, the Greenbook included an alternative simulation with both higher government spending and lower taxes. As shown by the red bars in the middle left panel, that would be sufficient to boost the growth of real GDP 1 percentage point this quarter and hold growth at the baseline thereafter. Even if you are not confident that fiscal stimulus will be forthcoming—as gridlock is always a possibility—you might want to wait for those prospects to come into sharper focus before adding monetary policy easing into the mix.

Another reason the Committee might not view the time as right to ease—even if it were leaning in that direction—is that it might be worried that financial markets could react adversely to such action, as noted by the third item in my list. As shown in the middle right panel, markets have been on a tear in the past nine weeks, with equity prices up 16 percent from the March 12 low and riskier corporate yields ¼ percentage point to 1½ percentage points lower. That rally came even as expectations of very near-term monetary policy ease, as I already described, were being rolled back. Investors might wonder how weak the Committee considered the outlook to be that it was necessary to augment the already appreciable relaxation of financial conditions since mid-March. Moreover, such an action would stand out all the more in comparison with your recent behavior. The bars in the bottom panel record the immediate surprises associated with Committee decisions over the past three years, measured as the actual target rate decided at each of the meetings less the expected funds rate gotten from futures markets the day before. As can be seen, a surprise today on the order of 20 or 45 basis points, as would be the case if you ease 25 or 50 basis points, respectively, would be an outlier.

Alternatively, you might see the need for easing, discussed in exhibit 3, as too compelling to be countered effectively by arguments about timing and reception. As noted in the first bullet point, in the Greenbook outlook resources remain underused throughout the forecast period, shown in the middle left panel by the unemployment rate, which stays at or above 6 percent in this and the next four quarters. While a ¼ or ½ point easing may not materially influence the near-term contour of that path, the projected almost 1 percentage point spread of the unemployment rate over its natural rate at the beginning of next year is more likely to be within the ambit of your influence.

You may not be so sure that the economy will deliver even that performance, particularly if you believe that chief executives still see capital stocks as excessive or you believe that the prospects for economies abroad are especially gloomy. A failure to get the forecasted rebound in growth raises the possibility that households’ support to the economic expansion will finally sag, setting in motion adverse dynamics that may be difficult to stop by future easing. Market concern about the economy may be growing in that the implied probability of the funds rate sinking below 1 percent by the autumn (the middle right panel) has risen of late. The insurance provided by a prompt easing may be attractive when, as in the second bullet point, downside risks to demand are more likely or more costly.

Third, even if the Committee believes in a forecast that, to a first approximation, meets its responsibility to foster sustainable economic growth over time, it has another objective as well. Easing may be favored on the concern that, as in the third point, inflation may fall further from an already low level and jeopardize your commitment to price stability. The four-quarter growth in the consumer price index is 1.4 percent at the end of the staff forecast, which is shown by the horizontal line in the bottom panel. While such an outcome or lower has occurred about 30 percent of the time in the postwar period, it has happened in only two years since 1965. True, for part of that time the Federal Reserve had lost the anchor provided by price stability, but you may have concerns that some costs arise from being in a region so seldom traveled.

Whatever the choice about the level of the federal funds rate, you will still have to grapple with the risk assessment, as discussed in the last exhibit. The elevated uncertainties of March that led the Committee not to characterize the balance of risks have abated. Indeed, those uncertainties have probably diminished to the point where the same rationale as in March could not plausibly be repeated to refrain from stating the balance of risks. Still, judging from a recent survey of primary dealers, informed outsiders are confused about the Committee’s next step. As reported in the top panel, about half the dealers expect an announcement of balanced risks, while the rest are split between a tilt toward economic weakness and no assessment at all.

I think that there are three possibilities to consider. First, keeping policy unchanged or easing modestly is unlikely to change materially the evident downside risks to the path of inflation over the next several quarters, and the relative distribution of the risks to sustainable economic growth would remain debatable. If that is the period over which the Committee defines the “foreseeable future,” then it could reassert the old language tilted toward economic weakness on the logic that the weighted average of those risks represents a downside threat to its objectives. However, March’s deferral of a risk statement might make May an appropriate time to drop the statement altogether, the option listed second. That might be particularly attractive if you have been troubled in the past by the misperception fostered by the existing language of trading off economic growth and inflation and the ambiguity attached to the notion of the foreseeable future. In that case, this afternoon’s statement could relate that the balance of risk assessment is no longer seen as helpful in conveying the Committee’s views to the public. On the theory that you can’t beat something with nothing, I’ve listed a third option: The Committee could augment the risk assessment portion of the statement. One possibility would be regularly to include two declarative sentences that describe the risks individually to the goals of price stability and maximum sustainable growth and a third that summarizes the balance of those risks. While this may convey the Committee’s view of the outlook more clearly, it probably would be greeted with bewilderment by some Fed watchers at the onset.

While your deferral in March opened a window to change the balance of risk assessment, you might want a bit more time than available today to deliberate on a matter that will set a precedent. However, the problem that you face is that anything you do today will be read as precedential. That concludes my remarks, Mr. Chairman.

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