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

Any other comments? If not, let me move on using a somewhat different approach to recent developments, and I hope that we will come out with some agreement on how to handle a number of issues.

There is no question that the financial data have improved quite dramatically very much across the board. I have in mind not only the narrowing of credit spreads and the dramatic decline in the premiums for credit derivative default swaps but the very significant drop in the level of interest rates on BBB and even higher-yield obligations. The fall in those rates has reduced the cost of capital to a substantial part of the business community, which for a considerable period of time had been blocked out of the lending market by rates that were close to prohibitive for lower-rated borrowers. To be sure, a decline in the cost of capital does not necessarily mean that capital investment will pick up. Such investment depends on the extent to which business executives see real investment opportunities. And in line with what Jack Guynn was mentioning, I suspect that people who are beginning to say in private that they feel a bit optimistic nonetheless are not inclined to voice their convictions in public because optimism is not at this point the conventional wisdom.

The truth of the matter is that the data on nominal orders and on backlogs for nondefense capital goods excluding aircraft are behaving better than the rhetoric. Backlogs have been rising for the last three months, not significantly but they have turned up. We also are seeing upward revisions to the data. It’s a small point, but the revised data on durable goods orders for the month of March that were released on Friday were raised significantly. The upward revision stemmed from data that came in higher than the estimates of unavailable data that had been plugged into the initial report released by the Bureau of the Census. In short, the numbers look better than the rhetoric. That reminds me of what Mark Twain once said about Wagner’s music—“it’s not as bad as it sounds.” [Laughter]

It is clear that we are getting some fairly substantial improvement in the financial numbers—those for the stock market obviously and, indeed, for all the credit markets. While it is true that the markets are being driven in part by improved profit figures, to date they have not been supported by evidence that economic activity is experiencing accelerating growth. The question one has to raise in this context relates to history, which tells us that more often than not, perhaps much more often than not, financial data of the type we have been looking at in recent weeks point to an eventual strengthening in economic activity. That does not happen all the time. There have been occasions when for one reason or another it didn’t happen. But the recent financial indicators suggest that the burden of proof is on those who argue that the economy will not pick up. Those who make that argument must presume that there are no significant investment opportunities. I find that most unlikely. Indeed, the expansion of the communications network that was going on prior to the huge decline in capital investment as risk premiums rose in 2000 was by any measure that we know not completed, and the longer-term outlook for such investment still looks reasonably solid. We also know that considerable advances in productivity continue to be made, and that is telling us that the underlying profit opportunities for new investments have to be there in one way or another.

There’s a very interesting question as to whether the most recent anecdotal reports that we heard around the table, which do not indicate any new momentum in the economy since the end of the Iraqi war, are in fact accurate. The Federal Advisory Council met with the Board on Friday, and I came away with the impression—in fact the FAC members said this—that they suddenly are getting a sense of optimism among their business contacts. The reason I find that important is that the banking community has a special window on what their customers are doing well before actual data on their activities become available. I was struck by these comments and by the fact that they came from all twelve Federal Reserve Districts.

This morning Don Kohn got a note from our good friend, Bill Dunkelberg, at the National Federation of Independent Business. They have just run their survey—the data are not yet published, and I don’t know when they will be published—and it shows that their index of confidence, which is the overall index they employ, rose 5 points in April. I believe that is a monthly record. It is a huge increase. The report also indicated that the index rose to a level of 100 or not far from where it was in 1999 and in earlier years. In other words, if anything it’s close to normal based on longer-term patterns, after being at its lowest level in March since 1993. According to the report, hiring plans jumped substantially. Capital expenditure plans also were up, and plans to add to inventories remained strong. There are 1,400 firms in this sample. Those results don’t quite square with those from the Institute of Supply Management, but it is possible in one sense to reconcile them. All of the surveys of the Institute of Supply Management are taken in the first half of the month, even though the institute waits two weeks to publish the data. So the National Federation results could be an indication that something different has been happening more recently. We don’t know yet. These surveys are useful. They’re all diffusion indexes. They’re not hard data. But they are the first indication that something may be changing.

The data that we have been getting on production and employment have been, just to state it as simply as I know how, awful. We can ascribe the weakness in the employment data in part to the fact that business firms have displayed an extraordinary capability in recent quarters to meet a tepid but still rising real demand for goods and services with ever lower employment. This is another way of saying that the ability to increase productivity is there, but it can’t be the result of large capital expenditures because we’re not getting such capital investment. My hypothesis—and I frankly don’t know whether it is true, but it would explain what is going on— relates to the fact that in the 1995 to 2000 period we had very substantial capital expansion. We had growing markets and very high perceived rates of return on new production facilities as distinct from investments made for cost-cutting reasons. As a consequence, there was an inordinately large emphasis in the business community on investing to expand facilities. A result was that business firms paid little attention to the inefficiencies that invariably arise as they are building new plants, adding new equipment, and revising the structure of doing business. Those inefficiencies build up over time, but if the costs of those inefficiencies are relatively modest compared with the rates of return on new facilities, businesses essentially forget the inefficiencies. What I think has happened is that, when the spending boom ended in the year 2000, there was a cumulative level of inefficiencies sitting there that were available for exploitation with a relatively modest amount of additional investment. That exploitation has gone on for several quarters. The implication, of course, is that the underlying structural productivity gains from 1995 to 2000 were in a sense actually greater than the published numbers because there were negatives associated with those gains that were not part of the actual evaluations.

This means essentially that going back and cleaning up the barn so to speak is turning out to be a highly profitable activity. The first-quarter earnings numbers are nothing short of spectacular in the sense that, after they were revised up very late in the quarter, they surprised everybody. Now, I don’t know whether the gains are being sustained in the second quarter. They still seem to be holding up, but it’s too soon to be sure. We do know that there has been a tendency for analysts to revise their forecasts down repeatedly for a quarter as they go through the quarter. They are doing that now but at a much slower pace than is typical, implying that the productivity spillover is still significantly there.

I don’t know what the short-term behavior of the economy will turn out to be in terms of the GDP numbers. I do know that, if we look at outside forecasts that are done in very considerable detail on the bases of both working down from the macro data and building up from individual company data, we find that JP Morgan Chase and Salomon Brothers/Smith Barney both have 4.0 percent rates of increase in GDP for the third quarter. So does Goldman Sachs, which has, of course, been on the bearish side of these forecasts. I myself find it difficult to believe that such growth is in prospect because, if it is, that has to mean that by a few weeks from today growth of real GDP estimated on a monthly basis has to move up appreciably or else 4 percent growth cannot realistically be achieved in the third quarter. That forecasters at these three organizations believe that it can be achieved I find somewhat startling. It may be that they are beginning to pick up what the Dunkelberg data are picking up, namely evidence that suggests to them that something significant is happening that will boost GDP growth. To be sure, the Goldman Sachs numbers tail off after the third quarter, but they’re still higher than the second- quarter numbers that we are now looking at, which are not all that good.

In any event, we did get a report this morning of a sharp increase in chain store sales. I don’t know how much of the increase may reflect a poor seasonal adjustment for Easter, but it is a very big increase. In fact, in the last four weeks the Bank of Tokyo-Mitsubishi seasonally adjusted weekly index on chain store sales went up 3¾ percent, and that rise is not at an annual rate. It’s the increase over the four weeks.

The evidence bearing on the economic outlook is a mixed bag at this stage. The difficulty in all of this is that a deflation process may be sneaking up on us. It is not doing so in a way that I anticipated in that, no matter which set of price indexes one uses, the rate of inflation has fallen fairly dramatically during the last six months. Incidentally, the issue I was raising with respect to the owners’ equivalent rent was not that the other smaller components of the index are not falling. Indeed, some are falling more, but I’m seriously questioning whether in fact the owners’ equivalent rent in the current environment of very rapidly changing homeownership is best proxied by the way the BLS does it. This involves taking a sample of rents on rental properties that have the same physical characteristics as single-family homes. I’m not arguing about the data as such but in terms of whether in fact we are looking at true deflationary processes. Indeed, remember that the 35 percent probability of deflation in the staff baseline forecast includes falling inflation as a consequence of improving productivity. The real issue that we have to get at when we’re looking at the notion of deflation is not only what prices are doing but also why they are doing it. An economy in which prices are falling at, say, a 5 or 10 or 15 percent annual rate but where rising productivity is matching the decline such that the nominal rate of return on capital is stable or rising tells us that we do not have a destabilized economic system. So price declines per se don’t tell us very much without advertence to the concurrent rate of return on capital and whether in fact we have a stable environment. Indeed, I would argue that a necessary condition for the type of deflationary problems experienced in the Great Depression is not only a decline in product prices but of necessity a decline in asset prices. If product prices are declining but asset prices are not, the likelihood I would submit is that individual companies may be having pricing problems but they’re not having productivity problems. The rates of return are there, and that’s the reason that asset prices are high.

I do think we have a concern here. In my view we cannot avoid the fact, as Governor Bernanke pointed out, that we face an asymmetry. We know what to do with inflation when it rises. The Committee has taken action to counter it many times and has succeeded in doing so many times. We haven’t confronted the problem of potential deflation in a very long time, and I find that possibility to be something on which this Committee must have an ever-increasing focus. We have to be careful, however, about how we think about this process and make sure that we’ve got it right and that we’re not merely looking at the zero bound issue. This is a far larger issue that involves the mechanism by which the economy functions rather than just how pricing affects products as distinct from assets.

My general view with regard to the policy implications is that we probably would be wise to move the funds rate lower unless we see a fairly substantial pickup in economic activity. I would suggest, however, that it would be a mistake to ease policy today. The reason relates to the issue that several of you have mentioned. I did try, incidentally, during my congressional testimony last Wednesday to open up the possibility that we might ease today. I raised for the first time the notion that falling inflation would be unwelcome, and I did emphasize a couple of times during the testimony that we, the Federal Open Market Committee, do have further room to move lower. I think reactions to my remarks did briefly lower somewhat the May federal funds rate futures, but the stock market then rallied and pulled back down the probability of an easing action.

The reason I think we have to proceed cautiously is that the recent strengthening of the stock market and financial markets generally, including the narrowing in yield spreads, is a potentially fragile situation because it is not as yet being supported by positive developments in the real economy. So if we were to come out today with an easing move that the market does not expect, the question would arise as to what we in the Federal Reserve know that those in the market do not. Because we are in such an unsettled period, we have the capacity of completely reversing the nascent rise in financial market values. If that rise continues, it will lift the economy with it. As a consequence, I think we need to be careful. I subscribe to Bill Poole’s general edict about not trying to fool the market. It doesn’t serve our purposes. The ideal monetary policy is to have nothing happen in the market every time we move because market participants have fully discounted our action. That creates the best general environment except for those rare occasions when we want to change the state of psychology. That is what we did in very early 2001, when we went out of our way to move rates sharply lower at a time the market did not expect us to do that. We did it because we wanted to alter general attitudes, but at this point I think we’re far better off not to surprise the market. That’s largely because, even though a number of us may think that we know how the markets will respond, things happen that we don’t expect. I submit to you that we currently are dealing with a very chancy situation, but we are reasonably sure that if we do what the market expects, then nothing will happen. We do not know with any degree of accuracy how the market is going to behave in the event that we do something one way or the other. Frankly, I don’t know how the market will respond if we move the funds rate lower today. But as a commentator in the Wall Street Journal said today, if the Fed were to do something the market would respond wildly. The reporter did not specify in which direction. [Laughter] I suspect the reason is that he didn’t have a clue, and I can understand that.

In any event, I think we have a tricky policy issue in front of us today. Ordinarily, as you know, our procedure is for the members to express their views in the policy go-around, vote, and then look at a draft press statement. I’d like to do something different today. We’ve drafted a statement that tries to capture some of these issues. I’d like to circulate it around the table and have it as a point of discussion as members comment on policy. I would appreciate it if my colleagues would distribute the statement. Vice Chair.

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