In Other News, Dahlia Lithwick Convinces Me That Clarence Thomas and His Clerks Are All Clinically Insane…
Eric Platt Misreads the Fed Transcripts...

Why We Listen to Paul Krugman: The Balance of Macroeconomic Risks in the Summer of 2006 Department

We listen to Paul Krugman because he looks at what is around him and says what he sees:

September 2006:

Dallas Fed President Richard Fisher: Mr. Chairman, the Eleventh District economy remains strong and continues to grow at a stronger pace than the rest of the country, with employment growth continuing at roughly twice the nation’s pace. Incidentally, home sales have not turned down in our District, so we haven’t been singing yet what we call the “coastal blues” as far as the homebuilding market is concerned. I think that’s enough said about Texas and the Eleventh District.... According to these business contacts, the outlook for economic growth is better than it sounds, whereas the dynamic of inflation is worse than it sounds. Just a few anecdotes here for, if not similitude, verisimilitude. By the way, all the interlocutors are fully aware of the shape of the yield curve—these individuals are sophisticated— and they are especially aware of what is happening in the housing market. As one CEO told me, the only subject that has been more analyzed than the housing situation is the birth of Brad Pitt’s baby. [Laughter] According to this view, if we have not discounted what has been happening in the housing market, we have been living on Mars, and I think that is an important point to take into account…

June 2006:

Paul Krugman: Over the last few weeks monetary officials have sounded increasingly worried about rising prices. On Wednesday, Richard Fisher, the president of the Federal Reserve Bank of Dallas, declared that inflation "is running at a rate that is just too corrosive to be accepted by a virtuous central banker."… [T]he real issue is whether there's a serious risk that inflation will become embedded in the economy…. [I]s that a realistic fear? Only if you think we can have a wage-price spiral without, you know, the wages part. The point is that wage increases can be a major driver of inflation only if workers consistently receive raises that substantially exceed productivity growth. And that just hasn't been happening….

It would be an exaggeration to say that there's no inflation threat at all. I can think of ways in which inflation could become a problem. But it's much easier to think of ways in which the Federal Reserve, wrongly focused on the phantom menace of a new wage-price spiral, could be slow to respond to bigger threats, like a rapidly deflating housing bubble…


Meeting of the Federal Open Market Committee September 20, 2006 http://www.federalreserve.gov/monetarypolicy/files/FOMC20060920meeting.pdf:

A meeting of the Federal Open Market Committee was held in the offices of the Board of Governors of the Federal Reserve System in Washington, D.C., starting at 8:30 a.m. on Tuesday, September 20, 2006.

CHAIRMAN BERNANKE. Good morning, everybody.

ALL. Good morning....

[...]

MS. MINEHAN. One small thing. On the other side of the devil and the deep blue sea, there is such a sharp contraction of residential investment, which lasts basically for a year and a half—the forecast does attenuate the rate of decline into ’07, but the contraction lasts pretty much a year and a half from where we are. Could it be faster? Could builders see that it is in their best interest to stop building now so that prices do not go down on new homes faster than they have gone already and inventories do not build anymore. Could that contraction be shorter, and could we come out of it faster?

MR. STOCKTON. The answer to that is “yes,” and I think there is some risk. One feature of our forecast is the fact that we are not projecting large declines nationwide in house prices. We are expecting a deceleration but not any outright declines. One could imagine that more of the adjustment could take place more quickly by a big drop in house prices that in some sense clears out that inventory through higher sales and maybe less production adjustment. On that side, you would probably get a quicker housing cycle than the one that we are projecting. However, it also brings with it some downside risk in that households would realize how much their net worth had fallen, which could have consequences for consumption both directly through the wealth effect and perhaps through sentiment. That correction could be quicker and maybe deeper, but then the rebound could be faster. That is a risk we have certainly contemplated. We were a little nervous about being too adventuresome on the house-price forecasting. We are not very good at forecasting asset values, we never understood how prices got as far out of alignment as we think they are, and we are not sure exactly what the process of correction is going to look like. So we have taken a middle stance between two models: one model that basically forecasts house prices off pure momentum and another one that takes seriously the analytical apparatus, which we showed you a year and a half ago at our special briefing on housing, that looks at the error-correction process of house prices to rents. The latter model actually does forecast outright declines nationwide in house prices by 2008. We are between a momentum model, which expects house prices to slow less than we are forecasting, and this error-correction model, which shows bigger declines....

[...]

CHAIRMAN BERNANKE. Thank you. President Fisher.

MR. FISHER. Mr. Chairman, the Eleventh District economy remains strong and continues to grow at a stronger pace than the rest of the country, with employment growth continuing at roughly twice the nation’s pace. Incidentally, home sales have not turned down in our District, so we haven’t been singing yet what we call the “coastal blues” as far as the homebuilding market is concerned. I think that’s enough said about Texas and the Eleventh District....

According to these business contacts, the outlook for economic growth is better than it sounds, whereas the dynamic of inflation is worse than it sounds.

Just a few anecdotes here for, if not similitude, verisimilitude. By the way, all the interlocutors are fully aware of the shape of the yield curve—these individuals are sophisticated— and they are especially aware of what is happening in the housing market. As one CEO told me, the only subject that has been more analyzed than the housing situation is the birth of Brad Pitt’s baby. [Laughter] According to this view, if we have not discounted what has been happening in the housing market, we have been living on Mars, and I think that is an important point to take into account. If you remember, Dave, I have been more pessimistic than the staff in terms of the depth of the housing downturn....

All the retailers I talked to—from 7-Eleven to JCPenney to Costco to Home Depot—report that they feel that they have bottomed out and that things are picking up, with one exception. That exception is Wal-Mart, and I think some of that situation relates to the internal dynamics of the way Wal-Mart is positioning itself in the market....

I want to spend just a minute on the inflation picture. I’m not going to go through anecdotes from the CEOs, though it pains me greatly as the son of an Australian to note that Anheuser-Busch has told its retailers that it is going to raise the price of beer 3 percent starting in January 2007. But I do want to explain why our board voted 7 to 1 to raise the discount rate. As you know, we measure inflation at the Dallas Fed by the trimmed mean. Our numbers show trimmed mean inflation running at 3.1 percent in July and a twelve-month rate of 2.7 percent and, not unimportantly, with 57 percent of the component elements increased at a rate of 3 percent or more. Now, of course, we cannot update those numbers until the next PCE number comes out, so you might argue that they are very stale. But the recent CPI release was not comforting. Dave, you mentioned 0.2 percent. Taking that at face value, you can say that consumer inflation is unchanged from July. But if you really look at those numbers, the rate for July was 0.19 percent, and the rate for August was 0.24 percent. If you annualize those numbers, that is a difference between 2.36 percent and 2.9 percent....

MS. YELLEN. Thank you, Mr. Chairman. Since our last meeting, the data bearing on the near-term economic outlook suggest both slower economic growth and a bit less core price inflation going forward. In terms of economic activity, the recent news has been uniformly negative, resulting in a significant downward revision to growth in the Greenbook. Indeed, compared with the outlook of other forecasters, the Greenbook’s projection of real GDP growth for the second half of this year is quite pessimistic; it would now rank in the lower 5 percent tail of the distribution of individual Blue Chip forecasters. I think this pessimism is not completely unfounded, however, largely because of my worries about the housing sector. The speed of the falloff in housing activity and the deceleration in house prices continue to surprise us. In the view of our contacts, the data lag reality, and it seems a good bet that things will get worse before they get better.

A major homebuilder who is on one of our boards tells us that home inventory has gone through the roof, so to speak. [Laughter] He literally said that. With the share of unsold homes topping 80 percent in some of the new subdivisions around Phoenix and Las Vegas, he has labeled these the new ghost towns of the West. In fact, he described the situation at a recent board meeting in Boise. He had toured some new subdivisions on the outskirts of Boise and discovered that the houses, most of which are unoccupied, are now being dressed up to look occupied—with curtains, things in the driveway, and so forth—so as not to discourage potential buyers. The general assessment is that this overhang of speculative inventory implies that permits and starts will continue to fall. Inventory ratios will rise, and the market probably will not recover until 2008. So far, builders remain hesitant to cut prices, fearing that doing so will cause a surge in cancellation rates on sold but unfinished homes. However, builders now routinely offer huge incentives, and price cuts appear inevitable. We have been following the Case Schiller house-price index, which is based on house-price data in ten large urban markets, three of which are in California. Beginning in May of this year, futures contracts on this price index also began trading; they suggest that house prices will be falling at an annual rate of about 6 percent by the end of this year. Of course, trading in this new futures market is still somewhat thin, but it is a signal that we need to keep a very close eye on the incoming data and watch whether the housing slowdown is turning into a slump.

Turning to inflation, core measures of consumer price inflation remain well above my comfort zone, but the latest readings on consumer prices have been modestly better. Unlike the Greenbook, I think the outlook for inflation has actually improved a bit since our last meeting largely because of the recent drop in commodity and crude oil prices. The relief on energy prices is, of course, very welcome, but we do have to be careful not to overestimate the extent to which past energy price pass-through has been boosting core inflation. For example, airfares might seem like an obvious case in which outsized consumer price increases reflect energy price pass-through. However, our staff recently calculated the share of jet fuel costs to total airline operating expenses and estimated that the jump in those costs likely accounted for less than half the rise in airfares this year. Instead, airfares may reflect strong demand and constrained capacity as indicated by very high airline passenger load factors. Still it seems likely that energy pass-through has played at least some role in the run-up of core inflation this year, so any energy price pressure on core inflation is likely to dissipate over time....

Recently our staff examined persistence at a more disaggregated level and found that the same general pattern also holds for each of the major components of the core PCE price index, with price inflation for durables only slightly more persistent than price inflation for nondurables and services. In the current situation, this suite of regressive models indicates that core PCE inflation should fall to just below 2 percent by the middle of next year. I am not quite as optimistic as these simple models, but on balance my concerns about the inflation outlook have been slightly alleviated by recent developments....

MR. LACKER. Thank you, Mr. Chairman. The Fifth District’s economy has grown at a somewhat faster pace in recent weeks, reflecting a solid uptick in manufacturing.... The housing data certainly have been weaker than anticipated, and I now expect a somewhat steeper decline, as does the Greenbook. Forecasting this housing adjustment is particularly difficult because, as President Minehan pointed out, we have only one or two episodes for comparison in the post-Reg Q regime, and as David Wilcox pointed out, they don’t seem to closely resemble our current situation. I find this Greenbook’s more pessimistic outlook for housing itself plausible, but I’m still fairly skeptical of large indirect spillover effects on employment or consumption. For overall activity, I expect real GDP growth to be somewhat below trend, especially this quarter, but above the Greenbook through the end of next year.

My views on the inflation situation have not changed much since our last meeting. The lower reading on July’s core PCE was encouraging, and the easing of energy prices is clearly providing some relief on headline inflation. However, July’s lower numbers were not particularly broad based, and the August CPI report shows a significant rebound in core inflation, as President Fisher noted. While labor compensation numbers have been hard to interpret, they also appear to point in the direction of greater price pressures, which I take it to be the staff’s view.... Overall, regarding inflation, I’m quite apprehensive about waiting for core inflation to decline as slowly as it does in the Greenbook or about letting a new reduced-form model do our work for us....

MR. PLOSSER. Thank you, Chairman Bernanke. Overall, economic activity continues to expand in the Third District.... My main concern remains the outlook for inflation and the risk it poses for our credibility. In my view, the Fed’s most important contribution to a healthy economy is achieving and maintaining price stability.... I see a return to potential more or less in 2007, although my estimate of potential is probably slightly higher than the Greenbook’s estimate. Now, given the level of precision of our output measurements and forecast of potential GDP growth, I’m really not overly concerned about the forecast at this point. The adjustment in the housing sector to more-sustainable levels is forecast to occur without triggering a recession and without triggering much of an increase in unemployment. I believe we should not attempt to stand in the way of that happening. It’s a mistake to think that the forecasted moderation in growth will bring inflation back to a level consistent with price stability. Indeed, the Greenbook’s baseline forecast of core PCE inflation remains above 2 percent through the end of 2008. Even in the alternative Greenbook simulation of a slump in housing, in which aggregate demand weakens and real GDP growth slows to just 0.6 percent in 2006 and barely above 1 percent in the first half of 2007, core inflation hardly changes and remains above 2 percent in 2008. Thus, it seems to me that language from us in the press that indicates that moderating growth will help to restrain inflation is not really consistent with our forecast. I think it imputes a degree of precision to an estimated Phillips curve that we just don’t have.... [W]e do not know if the upward revision to labor compensation will pass through to core inflation, as built into the Greenbook baseline, or if measures of medium-term inflation expectations will continue to decrease. What we do know is that core inflation has been above 2 percent for two and a half years and is expected to be there, according to the forecast, for another two years. Put another way, there is little evidence in the forecast that policy actions to date will bring core inflation back below 2 percent before sometime in 2009. I think that should concern us.

I see two inflation scenarios as being plausible.... In the first scenario, core inflation is elevated primarily because of transitory factors.... In the other scenario, stimulative monetary policy during the past five years has been a major contributor to the rise in core inflation. In this case, we wouldn’t expect to see a deceleration of core inflation until monetary policy has firmed enough to take out the cumulative effects of that accommodation..... I think we must be concerned that our credibility and the consequences of allowing inflation to remain above our comfort zone for so long are at question.... If the first scenario is wrong and inflation evolves as in scenario 2, then our credibility is seriously at risk if we fail to take further steps to curtail price increases. We might be lucky. But we might risk finding ourselves in a situation in which inflation expectations become unhinged....

MR. HOENIG. Mr. Chairman, I’d characterize the Tenth District’s economy as quite healthy right now.... As to housing, we are in fact, as all have noted, squeezing out of that sector the speculative excesses that developed with the low interest rates of recent years—and doing so is unavoidable if we want to correct the sector. The adjustment process has obviously been painful for some, and it has not yet run its course. However, we perhaps see ourselves getting a little closer to the bottom than we might think right now.... Although the recent inflation data have not caused me to alter my inflation outlook, I am in one sense more confident in the forecast of moderation than I was a month ago or so. On balance, as we look at all this, I agree that we still have some upside risks to inflation that we have to remain aware of as we look to the policy discussion ahead. Thank you....

[...]

CHAIRMAN BERNANKE. I think we can reconvene. Vice Chairman Geithner.

VICE CHAIRMAN GEITHNER. Thank you. Let me just start with the broad contours of our outlook. Growth has obviously slowed. The second half is likely to be relatively weak, but the only place we see pronounced weakness is in housing.... Core inflation seems to be easing a bit, and it may have peaked in the second quarter, if you look just at the three-month annualized numbers. But inflation remains uncomfortably high, and our forecast assumes only a very gradual moderation over the next two years.... Weighing the balance among these competing risks, we believe, as we did in August, that inflation risks should remain the predominant concern of the Committee, not so much, to borrow the Chairman’s formulation, because the probability of a higher inflation outcome is substantially greater than that of a much weaker growth outcome but because the costs of an erosion in inflation performance would be more damaging....

On the inflation front, recent data have not altered our forecast or, really, our assessment of the risks to that forecast. Although there are signs of moderation in underlying inflation, the core PCE and a range of alternative measures continue to grow at levels that are uncomfortably high. We expect further moderation to occur only gradually over the forecast period.... Medium-term inflation expectations, while not rising at stated levels, may be higher than is consistent with an inflation objective in the range the Committee has talked about in the past. Containing these upside risks should be the dominant focus of policy until we see a more-pronounced moderation in current and expected underlying inflation....

The second and related question is about inflation in our forecast: With the stance of monetary policy that is now priced into the markets—this is a softer path than the one in August—how confident can we be that we are likely to achieve the forecast of sustained growth and gradually moderating core inflation? I think we can be less confident than the confidence you might read into current market expectations and the uncertainty that surrounds them. Of course, the behavior of long-term inflation expectations in financial markets suggests that this risk is not particularly high at present and that we can take some more time to get a better handle on the evolution of the economy before deciding what is next in terms of monetary policy actions. But I think that we may have more to do, and we should try to avoid fostering too much confidence in the markets that we’re done. We need to preserve the flexibility to do more if that proves necessary to keep inflation expectations anchored. Thank you.

CHAIRMAN BERNANKE. Thank you. Vice Chairman ... Governor Kohn. [Laughter]

MR. KOHN. Thank you, Mr. Chairman. Whatever you want to call me is fine. [Laughter] I’m just glad to be here. [Laughter] I don’t think I can follow that up. Given the initial conditions—the doubling and more of energy prices over the past two years, the overexuberant housing market coming to grips with a renormalization of interest rates, a very low personal saving rate, and an uncomfortable increase in inflation this spring—a period of modestly below-trend growth and gradually ebbing inflation, as in the Greenbook forecast, is about as good an outcome as we can expect, as Dave Stockton noted. In that regard, several developments over the intermeeting period have made me a bit more comfortable with the plausibility of such an outlook.

The weakness in housing has deepened and is more definitively leading to growth of output below potential. In fact, in my view the behavior of the housing market constitutes the main downside risk to sustained moderate economic growth. We’re in the middle of a housing adjustment, which has been hard to forecast, especially because it involves the unwinding of an unknown amount of speculative demand. With inventories rising and reports of price cuts getting greater prominence, the market isn’t yet showing signs of clearing and stabilizing. In the Greenbook forecast, residential investment, though weak, is supported by continued growth of income and relatively low mortgage rates, while house prices basically level out in nominal terms. As the Greenbook notes, however, this forecast leaves some aspects of the existing disequilibrium intact, most notably the high level of prices relative to rents. Also, the cutback in construction doesn’t completely offset the apparent excess building of the boom period. As a consequence, I see the housing forecast in the Greenbook as very far from the worst-case scenario that President Minehan characterized it as. And, we are just beginning to see the effect of the downshift in house-price inflation on consumption starting to play out.

Outside of housing, however, recent developments should help to sustain continued economic expansion...

I still see significant upside risk to such a path for inflation. In part, this reflects my uncertainty as to the reasons for the rise in inflation this spring and summer. Feed- through of energy and other commodity prices must have contributed to some extent.... [W]e can’t dismiss the possibility that other forces were at work—for example, more general pressure of demand on potential output. A reduction of those types of pressures is still only a forecast.... I’m a bit more comfortable with something like the path for the economy and inflation in the Greenbook forecast, but uncertainties are quite high. They might even justify the “higher than usual” description. The downward path for inflation remains at risk, and as others have noted, the costs of exceeding that path could be disproportionate. Thank you.

CHAIRMAN BERNANKE. Thank you. Governor Bies.

MS. BIES. Thank you, Mr. Chairman.... People are focusing on the fact that delinquency rates in mortgages still look good. However, we’ve seen a very rapid increase in debt service ratios since 2004. I’m concerned, again, with the amount of adjustable-rate mortgages out there that will reprice in the months ahead. If, as we think, some of these loans, particularly subprime loans, were made mainly on the collateral value of the house and not on the affordability of the mortgage, we could see more distress in the borrowers’ markets coming forward. If that’s the case, it could have spillover effects on consumer spending more broadly....

MR. WARSH. Thank you, Mr. Chairman.... I am more concerned about the upside risks to inflation than downside risks to output and employment....

MR. KROSZNER. Thank you very much. Unfortunately, I think we find ourselves in an uncomfortable position like that of six weeks ago, with a continuing mix of inflationary pressures and decelerating economic growth at the same time. I think the fundamentals are in place for a continued moderation of growth but not a contraction, much as the Greenbook describes. Obviously, housing is a risk that everyone has talked about. But the key, as many people have also mentioned, is maintaining contained inflation expectations, and that comes down to thinking about whether some of the factors that we’ve been seeing have been more transitory or more persistent....

Housing is one of the worst areas for data. It’s very difficult for us to have any concept of what prices are doing because it’s not a market like any other. We do have the Case-Schiller index, and we do have some better indexes that people are now betting on, but they’re still very poor indicators of prices relative to the indicators we have in other markets. We also know that there can be queues and that extras can be thrown in, so there’s a lot of uncertainty with respect to where prices are going. That concerns me quite a bit because I think we just don’t have a good handle on it. Permits and starts have continued to come down from where they were at our last meeting and are now at levels of the beginning of 2003 or even starting to slip into 2002. If they flatten out there, the housing sector is still historically reasonably good. But there’s no indication that we’re necessarily at a turning point and that things are going to flatten out. There is the wealth effect, the direct effect on people’s consumption behavior of lower wealth going forward, and also the confidence effect. We don’t have a perfect analogy with the previous times in which we’ve seen these housing downturns— we have a different context in that the economy is broadly more robust—and so I think it’s less likely that we’re going to see a major housing problem. But I think it is a real risk, and we have to be sensitive to it....

As many people have said, we can’t become complacent. Inflation expectations have behaved reasonably well since we paused at the last meeting, which is heartening in that the markets believe that inflation is reasonably under control in the near to medium term and even in the longer term. It’s hard to find evidence of increases in inflation expectations, but as many people have said, that does not mean that we don’t have to worry. We have to worry a lot because the key is keeping those expectations well contained. I think we’re in a situation in which we can do that. Slowing growth is not going to give us more of a benefit. The flatness of the Phillips curve, which people have talked about, is what the data have been over the past ten to fifteen years in the United States and most other countries. So even if there is a bit more slowdown, we are not necessarily going to get the potential benefit in significantly lower inflation pressures—maybe a little but not very much. So we still have to worry about the upside on inflation, and that’s why maintaining our credibility is of utmost importance....

MR. MISHKIN. Many of you know I have an upbeat personality—some might actually say loud—but certainly upbeat. The way I look at the forecast and the situation with the economy is quite positive in the sense that what we’re seeing, really, is a return to normalcy and a more balanced economy. The excesses in the housing sector seem to be unwinding in an acceptable way, so I think it is quite reasonable in terms of the Greenbook forecast to think that the spillover here is not going to be a big problem because we’re actually moving resources from a sector that had too much going into it, into sectors that need to have more resources at the present time. So in that sense, I’m actually quite positive. The other thing that I am quite comfortable with in the Greenbook forecast—though, clearly, there’s uncertainty—is that we’re going to see a decelerating core inflation rate. Furthermore, when we look at inflation expectations, they seem to be very well contained and seem also to have responded well to the pause at the last meeting.

However, I should say that, although we’ve seen that inflation expectations are well anchored, there’s a question about whether they’re anchored at quite the right level. They seem to be anchored somewhere around 21⁄2 percent on the CPI, and that is probably with a differential between the CPI and the PCE of about 1⁄2 percentage point, or 50 basis points. It still seems to be somewhat on the high side in terms of what many people on the Committee have expressed is their comfort zone. So I think that is a concern....

CHAIRMAN BERNANKE. Thank you. Let me just summarize quickly what I heard around the table, and then I’d like to make some additional comments of my own on the economy. The sense is that, on the real side, there’s a two-tier economy. There’s the housing sector and maybe autos, and there’s everything else.... [A]s we look forward, I think there are two issues. The first is how severe the contraction in housing will be. To be honest, we don’t really know. We’re talking, again, about an asset price correction, and it’s difficult, in principle, to know how far that will adjust. The second issue is how much spillover there will be from any housing correction to the rest of the economy. I don’t have quite as much confidence as some people around the table that there will be no spillover effect. Any spillover effect would be a lagged effect, and it remains to be seen how much effect there might be. But I agree that the economy except for housing and autos is still pretty strong, and we do not yet see any significant spillover from housing....

[I]f we believe that we need to have output below potential to help arrest inflation pressures, it is a delicate operation, and we may have a very narrow channel to navigate as we go forward. We should pay very close attention to how the economy is evolving at this particular moment because I think the uncertainty and the potential nonlinearity at this juncture are greater than what we normally face....

MR. POOLE. Am I the only taker to be number one? [Laughter] Thank you, Mr. Chairman. I want to start with two observations. First, the distribution of the market’s outlook for the federal funds rate six months ahead... accords with my own view—a one-third chance that we will stay where we are, a one-third chance that it will be appropriate to ease, and a one-third chance that we will want to increase the rate. I come out with a very symmetrical view myself. I think of the views around the table—some people are probably there, some people are probably skewed on one side and some on the other side, but I come out very much in the middle.

My second observation continues a point that Tim Geithner made a few minutes ago. I had several conversations at Jackson Hole with Wall Street economists and journalists, and they said, quite frankly, that they really do not believe that our effective inflation target is 1 to 2 percent. They believe we have morphed into 11⁄2 to 21⁄2 percent, and no one thought that we were really going to do anything over time to bring it down to 1 to 2. I think that is very unfortunate because so many of us have talked about 1 to 2....

I do not want the explicit reference to housing to be in the statement is that I would take that position even if housing were continuing to struggle, because I think it is extremely important that we not allow inflation to ratchet up. If housing is a casualty of that policy, we had better accept that situation. I would not like to see a mixed market signal because I would not want the market to believe that continuing weakness in housing would deflect us from acting as necessary to keep inflation from rising further. I think the explicit reference to housing in the statement conditions the market to think about our policy going forward in the wrong way....

MS. YELLEN. Thank you, Mr. Chairman. It is still too early to know whether our current policy stance will succeed in lowering inflation to an acceptable level over time, but the data since our last meeting reassured me that our decision to step off the escalator was wise, and I think we should remain on the sidelines today. Recent inflation readings have contained no adverse surprises. Inflation expectations remain contained. I think the inflation outlook is slightly improved because of the reduction in energy and commodity prices, and growth during the second half of the year now appears quite likely to fall short of trend. I view the risks to the attainment of our objectives as more balanced than they were in August, and I certainly judge the downside risks to growth to have increased. Your discussion of nonlinearities, Mr. Chairman, was interesting, and it is important to be sensitive to that possibility. That said, I think that the upside risks to inflation still outweigh the downside risks to growth. With inflation projected to remain uncomfortably high over a sustained period and with the economy still likely operating beyond potential, I favor alternative B and think it’s important that we do at least hint at an upward bias for fed funds rate changes....

CHAIRMAN BERNANKE. Thank you all. Our pause at the last meeting was a benefit-cost calculation. The benefit of pausing was to give ourselves more time to assess the state of the economy and the effects of our previous interest rate actions. The potential cost of pausing was that we would lose some credibility, that inflation might move adversely, and we would get behind the curve in terms of that very important goal. The intermeeting developments have shown a somewhat weaker economy in real terms than we had expected and, I think I can safely say, no reduction in uncertainty. Although inflation remains above where we would like it to be, I think we can’t say that the inflation situation has deteriorated during the intermeeting period. Therefore, it’s reasonable for us to continue to pause.... I’d like to make a few other comments about some of the conversation around the table. I’m bemused by the de facto inflation targeters that we have become here [laughter] with the 1.5 percent goal. Let me just make a couple of comments on that. First, flexible inflation targeting does respond to things other than the target itself. In particular, we saw a surprising increase in inflation earlier this year, which took us above or further above our implicit target. The optimal response to that is to return to target, but only slowly and with the amount of time to take to get back to the target depending positively on the initial deviation. Second, the speed at which you return to the target ought to depend on the state of the real economy. The extent to which we’re concerned about potential recessionary effects should make us be a little more cautious and make us move a little more slowly. I would add that, although a number of us, including myself, have mentioned this 1 to 2 percent zone, it has also been noted around this table that it may not, in fact, be the right zone. If we do determine that we want to announce a target and it is 1.5 percent, we should lay out a plan for getting to that level over a period of time and not immediately. But we might choose as an alternative possibility, for example, 11⁄2 to 2 percent, in which case we would be somewhat closer to that target in a shorter time....

Let me turn to the statement. I would like to discuss certain elements of it. I’d like to propose that we use alternative B, and let me note a few points. First, I’m sure that everyone noted that in section 2, in the phrase “reflecting a cooling of the housing market,” we are eliminating the word “gradual” and doing so indicates a somewhat stronger degree of cooling. Second, in response to President Poole, I think this is not intended to be anything other than a pure description of the economy and our sense of what is happening in the economy. It actually does have a bit of a forward-looking aspect as well, Vice Chairman Geithner; and it is factual in that, if you look at the forecast, the slowdown in construction accounts for almost all the decline from potential. So I don’t think it’s in any way focusing our policy decision on the housing sector.

In section 3, the addition of “reduced impetus from energy prices” is useful, I think. We have been criticized for, among other things, being too sanguine about the disinflation and arguing implicitly that a modest amount of slowing in the economy would be sufficient to achieve disinflation. We do not actually believe that, and one of the reasons we forecasted a decline in inflation is that we expected to see a reduced impetus from energy prices going forward. We now have actually seen the fall in energy prices, and so we don’t even have to appeal, for example, to the futures market. We can simply state that we have seen this decline in energy prices, and I think that makes our story a little more complete and makes it look more understandable to the public about why we think that inflation should decline slowly over time.

I propose to keep the assessment of risk as it stands. It’s very clear that our bias is toward resisting inflation...

Comments