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Meeting of the Federal Open Market Committee
June 27-28, 2000

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., on Tuesday, June 27, 2000,
at 2:30 p.m. and continued on Wednesday, June 28, 2000, at 9:00 a.m.
PRESENT: Mr. Greenspan, Chairman
Mr. McDonough, Vice Chairman
Mr. Broaddus
Mr. Ferguson
Mr. Gramlich
Mr. Guynn
Mr. Jordan
Mr. Kelley
Mr. Meyer
Mr. Parry
Mr. Hoenig, Ms. Minehan, Messrs. Moskow and Poole, Alternate
Members of the Federal Open Market Committee
Messrs. McTeer and Stern, Presidents of the Federal Reserve Banks
of Dallas and Minneapolis respectively
Mr. Kohn, Secretary and Economist
Mr. Bernard, Deputy Secretary
Ms. Fox, Assistant Secretary
Mr. Gillum, Assistant Secretary
Mr. Mattingly, General Counsel
Mr. Baxter, Deputy General Counsel
Ms. Johnson, Economist
Mr. Stockton, Economist
Ms. Cumming, Messrs. Eisenbeis, Goodfriend, Howard, Lindsey, Reinhart,
and Simpson, Associate Economists
Mr. Fisher, Manager, System Open Market Account
Mr. Winn, Assistant to the Board, Office of Board Members,
Board of Governors


Mr. Ettin, Deputy Director, Division of Research and Statistics,
Board of Governors
Messrs. Madigan and Slifman, Associate Directors, Divisions of
Monetary Affairs and Research and Statistics respectively,
Board of Governors
Mr. Porter 1/, Deputy Associate Director, Division of Monetary Affairs,
Board of Governors
Messrs. Freeman, 2/ Oliner, 3/ Struckmeyer, Whitesell, and Ms. Zickler, 2/
Assistant Directors, Divisions of International Finance, Research and
Statistics, Research and Statistics, Monetary Affairs, and Research
and Statistics respectively, Board of Governors
Mr. Reifschneider, 1/ Section Chief, Division of Research and Statistics,
Board of Governors
Mr. Bomfim 2/ and Ms. Garrett, Economists, Division of Monetary Affairs,
Board of Governors
Ms. Low, Open Market Secretariat Assistant, Division of Monetary
Affairs, Board of Governors
Ms. Pianalto and Mr. Stone, First Vice Presidents, Federal Reserve Banks of
Cleveland and Philadelphia respectively
Messrs. Hakkio, Hunter, Lang, Rasche, and Rosenblum, Senior Vice
Presidents, Federal Reserve Banks of Kansas City, Chicago,
Philadelphia, St. Louis, and Dallas respectively
Messrs. Altig, Fuhrer, Judd, Ms. Perelmuter, and Mr. Weber, Vice
Presidents, Federal Reserve Banks of Cleveland, Boston, San
Francisco, New York, and Minneapolis respectively

1/ Attended portion of meeting relating to the Committee's discussion of the economic
2/ Attended portion of meeting relating to the Committee's long-run policy.
3/ Attended Wednesday session only.


Transcript of Federal Open Market Committee Meeting of
June 27-28, 2000
June 27, 2000--Afternoon Session
CHAIRMAN GREENSPAN. Good afternoon, everyone. Bill Stone will be
representing the Philadelphia Bank today and the rest of the members are here, I presume. Shall
we get started and approve the minutes of the May 16th meeting?
SPEAKER(?). So move.
CHAIRMAN GREENSPAN. Without objection they are approved. I would like a
motion to elect David J. Stockton as Economist to serve until the election of his successor at the
first meeting of the Committee after December 31, 2000. Is there a motion?
CHAIRMAN GREENSPAN. Is there a second?
SPEAKER(?). Second.
CHAIRMAN GREENSPAN. Without objection. Peter Fisher, please.
MR. FISHER. Thank you, Mr. Chairman. I will be referring to the package of charts
in front of you that begins with the chart on forward rates.1
In the top panel on U.S. dollar forward rates you can see
that for much of the last few months the 9-month forward and the
6-month forward 3-month rates have been trading right on top of
one another. They are both down a bit from their levels prior to
the June 2nd release of the nonfarm payroll report and have
returned roughly to where they were trading after the release of the
ECI on April 27.
Looking down the page at the euro forward rates, it is clear
that their 9-month and 6-month forward rates have also been
trading on top of one another for some time. This leads me to the
following inference: Notwithstanding a great deal of verbal
intervention from the official sector in Europe about how the
growth differentials between Europe and North America are likely

A copy of the charts used by Mr. Fisher is appended to this transcript. (Appendix 1)


to narrow and reverse over the coming year, the short-term interest
rate markets do not seem to share that assessment. If they did, it
would seem to me that the euro forward rates would show more
forward upward lift than they do.
At the bottom of the page, you can see that the Japanese
forward rates have begun to tick up again of late as the melodrama
continues about whether the Bank of Japan will or won't raise rates
sometime soon. The speculation regarding a rate increase goes on
apace and we see again the modest ticking up of forward rates.
Turning to the second page, it is clear that over the last four
maintenance periods the fed funds rate has behaved rather well,
trading right around the target with very low volatility since your last
meeting. There really isn't much interest or excitement in our
management of the funds rate per se.
As you can see on page 3, however, behind the veil of a
nice stable funds rate is a rather different development having to
do with the scarcity of Treasury collateral beginning to show
through in the repo markets. Depicted on the chart in red is the
30-day moving average of the spread between the repo rate on
general collateral for Treasury securities and the fed funds rate as
we get a snapshot of it each morning. The solid blue lines
represent 6-month averages over the periods encompassed by
those blue horizontal lines. Clearly, over the last two years that
average has been trending lower, with a widening of the negative
spread at which Treasury collateral trades under the funds rate.
Two developments have in all likelihood taken place here.
One is the scarcity of Treasury collateral; it is at a premium and
will trade under the funds rate. There is also an element of
defensiveness among the major institutional investors and money
managers during a period when the Committee has been
tightening, as they look for the safety of Treasury collateral. But
to my mind the march down of those average rates is impressive.
And I will note that one major dealer has said to me that they can
fund themselves at 50 basis points under the funds rate with
Treasury collateral, so acute is demand of their customer base for
Treasuries as a safe haven cash management vehicle.
On the fourth page I have tried to summarize our reserve
management operations this year as they relate both to the growth
of reserve needs and the mix between outright and RP operations.
I used as my base here the February 9th maintenance period, which
gets us out of the year-end effects of the seasonal and the Y2K


buildup of cash and to a reasonable starting point for a base case.
In the top part of the page I have shown changes in supply of Fed
balances from the February 9th period to the current June 28th
maintenance period. Autonomous factors have drained a little over
$1 billion net over that period of time; that’s overwhelmingly
comprised of currency. We have had redemptions of $4.9 billion
since that time, adding to reserve needs. And $6.9 billion has been
added through SOMA purchases plus net changes in RPs over that
period, leaving us a very marginal change in the total of
nonborrowed Fed balances.
Let me first work down the page rather than across; I will
come back to the figures at the upper right in a moment. The mix
of activity involved in getting to that marginal change included
outright purchases, here expressed in par values, from the end of
January through June of $12.9 billion in Treasury securities,
distributed as shown in the middle table on the page. Moving down
to the next set of figures, we had a mix of a little over $11 billion in
short-term RPs of under 15 days and $8-1/2 billion of long-term
RPs in the February 9th period, for a total of nearly $20 billion
outstanding at the beginning of February. We have decreased the
amount of short-term RPs and increased the amount of long-term
RPs, so that currently the level of RPs outstanding is $2.6 billion
under 15 days--but that number bounces around every day--and $14
billion in longer-term RPs.
At the bottom of the page is a memo item giving the mix of
collateral that we had in February compared with what we have
today. Currently 42 percent of the collateral we have in the 15-day
or longer RPs is Treasury collateral, 16 percent is agency debt, and
42 percent is mortgage-backed securities.
Going back to the top of the page, at the upper right I have
shown projected reserve factors for the period from now to the
September 6th maintenance period, which begins just about the
time of your next meeting. We expect a little over $8 billion to be
drained by currency, but over $15 billion to be drained as a result
of net redemptions, principally from the 35 percent limit being
applied to bills. That leaves us with a need to add about $23
billion on net from now until the beginning of September.
There is one other issue with respect to Treasury supply
that I would like to mention. It just occurred to me that this is a
matter that may become public before your next meeting. For
over 20 years the Treasury has given foreign central banks
preferred access, if you will, to the auction process in Treasury


securities, providing a mechanism through us for those
institutions to bid in the auction. They have an “add on” in that
they can always get their needs filled in the auctions.
This has created a problem for the Treasury in an era of
declining issuance in that the Treasury can end up with more cash
than it actually wants as the foreign central banks exercise their
right to add on to the auction. The Treasury is very anxious to
find a way to end this process, which gives them some uncertainty
about the amount of cash they will raise. They are trying to cap
the amount the foreign central banks can bid for in the auction at a
set dollar figure, and they would like to cap that amount at a
rather low level. No matter how you slice this--and we are
working with the Treasury to come up with different formulas-the big accounts will have to find some way of bidding for
Treasury securities other than through the noncompetitive foreign
accounts mechanism. That is something we do for the Japanese,
for example. We at the Desk are working with the Treasury to try
to find a way to take care of the very small accounts--those of the
developing economies all over the world that have very small
cash balances and want to reinvest in bills. We are attempting to
come up with a procedure that will ensure that those countries are
taken care of through an automatic process but one that will
require the big countries to look elsewhere.
This is overwhelmingly an issue involving the Ministry of
Finance of Japan. It means finding some way for them to deal
with their rather large investment needs, which they like to park in
the short end of the market. Both the domestic and the
international sides of the Treasury have been working on this and
we have been giving them technical advice on different ways that
it could be worked out. I don't know how it will be worked out,
but it is likely that the Treasury will want to announce something
in conjunction with their refunding at the beginning of August--at
least that is when I understand they would like to move forward
with this. So I just wanted to warn you of that upcoming event.
Mr. Chairman, we had no foreign exchange interventions
in the intermeeting period. I will need a vote to ratify our
domestic operations since your last meeting. We distributed
copies of the draft announcement summarizing the operational
changes we discussed at the Committee’s last meeting and, as my
note explained, we've gone over these with the Treasury. In
addition to any questions on my briefing, I would be happy to
take any comments or suggestions on that document, which the
Committee members may now have. Thank you.


CHAIRMAN GREENSPAN. Questions for Peter on any of the subjects he has
MR. MCTEER. I thought you were supposed to be very nice to your large creditors!
MR. FISHER. We are going to be as nice as we can be to our large creditors! We
have for some time, in our rather modest participation in the Ministry of Finance’s auctions, had
to compete directly by putting in competitive bids to buy Japanese Treasury bills. We have had
no preferential treatment in Japan. Their procedure has been to
we can only submit bids through their dealers. We will still permit foreign central
banks, even the Ministry of Finance in all likelihood, if they wish to submit a competitive bid
through us. We will accept it, but they will have to choose the rate. We will not give advice on
rates or take part in that process. But it is a fact of life that the Treasury is now trying to find a
way to work down its cash balances and the amount they issue at each auction without ending
up with an uncertain and higher amount of cash than desired. It is a real mechanical problem.
MR. MCTEER. Are the amounts from the Japanese too big just to let them submit
noncompetitive bids?
MR. FISHER. Yes. The Treasury, I think, would like to have the total of foreign
noncompetitive bids be around $1 billion, summing up the needs of all the small countries. The
Japanese Ministry of Finance is routinely rolling over

in Treasury

bill auctions.
CHAIRMAN GREENSPAN. What would happen if there were only noncompetitive


MR. FISHER. That is clearly a problem. I don't think the Treasury can go that way;
part of the answer here, no matter what else is done, is to get the big accounts into the
competitive process. Obviously, they can’t sustain an auction process in which--.
CHAIRMAN GREENSPAN. I just thought you would be so imaginative that you
could figure out a way! [Laughter]
MR. FISHER. I hit a wall there! I'm open to suggestions and I'll be happy to relay
them to the Treasury. But if someone isn't prepared to put out a few prices as to where they
think the market will clear, I’m not sure we can get there.
CHAIRMAN GREENSPAN. I am. I know you can’t! [Laughter] Other questions?
If not, would somebody like to move to ratify the transactions?
VICE CHAIRMAN MCDONOUGH. Move approval of the domestic operations.
CHAIRMAN GREENSPAN. Thank you, Mr. Vice Chair. Without objection they
are approved. Let's move on to what we used to call the “Chart Show” and I guess we probably
still ought to do so. David.
MR. STOCKTON. I think we will! I, along with Karen Johnson and Larry Slifman,
will be referring to the materials labeled “Staff Presentation on the Economic Outlook.” 2
Your first chart provides a brief overview of our outlook
for the U.S. economy over the next year and a half. As you know
from reading the Greenbook, we lowered our projection for the
growth of real GDP a bit, in response to our perception that the
pace of activity may be slowing a touch faster than we had
forecasted in May. But the basic contours of the projection have
changed little. We continue to anticipate that past and prospective
increases in the federal funds rate will lead to a substantial
deceleration in the pace of real domestic spending--the red line in
the upper panel of your first chart. Domestic spending, which has
been rising at more than a 5-1/2 percent pace over the past two
years, is expected to increase just 3-1/2 percent in 2001.

A copy of the materials used by Mr. Stockton, Ms. Johnson, and Mr. Slifman is appended to this transcript.
(Appendix 2)


Continuing improvement in real activity abroad and our
projected depreciation of the dollar combine to direct more
demand here and abroad toward U.S. producers. This mutes some
of the effect that slowing domestic demands might otherwise have
had on the growth of output. As a result, growth of real GDP
slows only about a percentage point to 3-1/2 percent next year.
Pressures in labor markets are expected to remain
relatively intense over the next year and a half. With some lag,
our projection of below trend growth results in an upward drift in
the unemployment rate next year, but only to a little more than 4
Tight resource utilization and some continued acceleration
in non-oil import prices provide a further boost to core PCE price
inflation--the red line in the lower panel--over the projection
interval. However, the effect of that gradual pickup on the
headline price measure--the black line--is swamped by the sharp
swings that we are projecting for energy prices this year and next.
The increase in total PCE prices steps up to a 2-1/2 percent pace
this year and drops back to a 2 percent rate in 2001.
The financial assumptions underlying our projection are
the subject of your next chart. We continue to believe that a
further tightening of financial conditions will be necessary to
begin to relieve some of the inflationary pressures that appear to
be building in the economy. The additional 75 basis points of
tightening that we have assumed would push up the real federal
funds rate a bit above the upper end of the range observed over
the past decade. But given the upward influence of faster
productivity growth on “equilibrium” real interest rates, our
assumption on the funds rate implies less monetary restraint than
it would have five years ago.
The degree of additional tightening that we have assumed
would come as a surprise to market participants, and we would
expect real rates on corporate bonds--the middle left panel--to
resume the upward trajectory that has been apparent over the past
year and a half. Thus far, that rise has done little to damp
enthusiasm in equity markets. But, going forward, further
increases in interest rates, coupled with a slowing in the growth of
corporate profits, are expected to hold equity prices flat at about
the level they have averaged thus far this year.
In the lower panel, I have attempted to summarize some of
the financial crosscurrents at work in our projection with the aid


of a model simulation. The most notable of these crosscurrents
has been the strength of the stock market in the face of the
considerable increase in interest rates that has occurred over the
past year. The red bars in the chart plot the depressing effects on
the growth of real GDP that would be expected by the model to
accompany the actual and projected increase in the real federal
funds rate since last June. These effects are calculated assuming
that the stock market, long-term interest rates, and the exchange
rate evolve according to the model’s expectations. As you can
see, some effect on growth would have been evident in the first
half of this year, with the restraint mounting noticeably in the
second half of 2000 and in 2001.
Of course, financial developments are not unfolding in the
manner predicted by the model. In particular, stock prices have
risen more than 12 percent over the past year and are projected to
remain flat going forward. By contrast, the model expected a
drop of 13 percent over the past year and projects a further decline
in coming quarters. The offsets provided by this surprising
behavior are shown by the blue bars in the chart. As can be seen,
the resilience of the stock market damps considerably the
restraining effects that normally would be expected to accompany
a substantial run-up in the funds rate. The total net effect of these
influences is shown by the black bars.
Focusing on the black bars, this analysis suggests that, on
average in the first half of 2000, there is little reason to have
expected much restraining effect yet from the change in financial
conditions over the past year. But moving forward--given both
the lags in response to past rate increases and our assumption of
some further tightening--the restraining influence of financial
conditions should begin to show through more noticeably, with
the effect turning negative in the second half of this year and
becoming more so in 2001. In a nutshell, that’s the basic rationale
for our forecast of a significant, but not precipitous, slowing in
activity over the next year and a half.
The transmission of this restraint to household spending is
the subject of your next chart. As we noted in the Greenbook, the
buoyancy of consumer sentiment--shown in the upper left panel-has led us to discount the recent weakness in the retail sales figures
as signaling the start of a more abrupt down-shift in spending.
That said, we do see the underlying determinants as pointing to
decidedly slower growth in consumer outlays. Although there
have been some big ups and downs in the stock market thus far this
year, for the most part prices have moved sideways--a trend, as I


noted, that we are projecting will continue. As a consequence, the
household wealth-to-income ratio--the black line in the upper right
panel--is expected to fall back and the personal saving rate--the red
line--to drift up. That manifests itself in our projection as a fairly
steady deceleration of consumer spending this year and next--the
red bars in the middle left panel.
Housing appears to be the area where higher interest rates
are leaving the clearest mark on demand. As depicted by the red
line in the middle right panel, there has been a significant
deterioration in consumer perceptions of home buying conditions.
Builders’ ratings of new home sales--the black line--also have
become less favorable. As can be seen in the lower left panel,
rising interest rates and higher home prices have lifted monthly
payments relative to personal income over the past year. And,
given our projection of higher rates, this burden is likely to
increase further in coming quarters. When combined with slower
income and employment growth and a diminishing impetus from
rising wealth, we are projecting total housing starts to slide from
1.67 million units in 1999 to about a 1.5 million unit pace by the
end of next year.
In contrast to the reasonably clear signs of slowing in
residential investment, the recent indicators of capital spending by
businesses have remained very strong. As seen in the upper left
panel of chart 4, new orders for nondefense capital goods moved
up in recent months and have remained above shipments. The
accumulating backlog of orders should provide considerable
support for equipment spending in coming months.
Total real E&S--shown on the right--is expected to slow
only a little from its recent rapid pace. Information technology is
expected to continue to contribute the lion’s share of the growth
in real E&S--the red shaded area in the panel--while outlays for
other equipment--the gray area--are expected to slow appreciably.
A sharply declining relative price for IT equipment-shown in the middle left panel--should provide ample incentive
for continued strong growth of investment in the tech area. The
deceleration of business output that we are projecting, plotted at
the right, is likely to leave a small mark on investment in
information technology, but to be a more noticeable drag on other
types of capital outlays.
Another area of spending that seems likely to respond to
the slowdown in output growth is nonresidential construction,


shown in the lower left panel. The recent boom in activity in this
sector appears at odds with the slowdown in price appreciation
and rents that we have observed, especially for office buildings
and retail structures. In an environment of rising interest rates,
somewhat less ample provision of credit, and slower growth of
output, we are anticipating a considerable drop back in the growth
of activity in this sector.
The enormous strength we have witnessed in business and
household demand in recent quarters has coincided with a steep
drop in the inventory-sales ratio, plotted at the right. However,
there are few reports that businesses have felt uncomfortable with
these low levels of stocks, and we expect this ratio to drift down
further, on net, over the forecast interval, and for inventories to be
an essentially neutral influence on the growth of real GDP.
Karen will now continue our presentation.
MS. JOHNSON. Your next chart reviews developments in
selected international financial markets since the February
meeting. As can be seen in the top left panel, the average foreign
exchange value of the dollar in terms of the currencies of the other
major industrial countries--the black line--has risen on balance so
far this year, although it has most recently given back some of
that appreciation. Through May, the dollar continued its upward
trend in terms of the euro. After falling to a value of about 90
cents, the euro strengthened for a time, amid signs that in the near
term European real growth would start to compare favorably with
that in the United States, before relapsing in recent days. In terms
of the yen, the dollar today is little changed from where it started
the year. Three-month market interest rates, reported on the panel
on the right, have risen in the euro area and in the United States,
in line with tightening moves by the two central banks. In Japan,
the zero interest rate policy remains in place, but market
participants expect that may soon be changed.
The middle panels report financial data for selected Asian
emerging market countries. After the turbulence of 1997-98,
these currencies have tended to recover, and the dollar has
depreciated against them. However, the Indonesian rupiah, the
blue line, has continued to be buffeted by political developments
in that country. Despite the recent slide in the rupiah’s value, the
Indonesian short-term rate and the dollar spread--shown on the
right--have moved down a bit on balance since the end of January.
That’s partly in response to the IMF finding that the conditions


for further disbursements from the Indonesian program have been
The approach of the Mexican election has imparted some
upward pressure on the dollar relative to the peso, the blue line in
the bottom left panel; Mexican interest rates have edged down on
balance but are up from their lows in April. In contrast, the most
recent moves of the dollar against the Brazilian real--the red line
at the left--have been toward depreciation, and short-term
Brazilian rates have eased considerably.
Your next chart provides an update on recent trade
developments. As can be seen in the upper left panel, the increase
in the value of exports from December to April was limited by the
effects of the strike at Boeing on aircraft exports--line 2--which
have not yet fully unwound. With some allowance for that
transitory element, export growth in the first third of the year has
been moderately strong, particularly for other capital goods--that
is, machinery and equipment, shown on line 3. The small panels
to the right illustrate that our exports have expanded rapidly to
Canada and Mexico, where real output growth has been robust
and investment strong, and are on an upward trend in western
Europe. Exports to Asian trading partners have still not returned
to their pre-crisis peaks.
Imports are shown in the lower left panel. The increase
this year through April significantly exceeds that of exports, even
when adjusting for aircraft. Other than oil--line 2--the increase in
imports is largely in the categories of capital equipment and
consumer goods--lines 3 and 6. As is visible in the lower right
panel, the expansion of real imports has been rapid over the past
few years, while real exports clearly show the effects of the global
crisis in 1997 and 1998. As a consequence, the gap between the
two has widened impressively.
Global prices of traded goods are the subject of your next
chart. We were guided primarily by the futures prices in writing
down our forecast for oil prices, shown in the upper left panel.
Nothing in the announcement last week by OPEC of an increase
in quotas of 700,000 barrels per day has led us to second-guess
the downward trend we have put in these prices, although current
low inventories could contribute to continued volatility in spot
prices for some time. Non-oil commodity prices, on the right, are
expected to recover in the near term from recent declines that
reflect particular supply fluctuations and then on average to move


up at a moderate rate over the forecast period, reflecting the path
of quotes in futures markets.
We continue to expect that the real exchange value of the
dollar, the middle left panel, will depreciate on balance over the
forecast period. We have little basis on which to pinpoint the
timing of downward moves in the dollar so we have spread the
depreciation over the next six quarters. Of course, more volatile
episodes of exchange rate adjustment are more likely than
extended gradual change.
The middle right panel shows the paths of industrial
country prices--the black line--and non-industrial countries--the
red line--expressed in dollars over the forecast period. In the
recent past, dollar appreciation has tended to offset inflation in the
other industrial countries, resulting in no trend to date in the black
line. Going forward, we expect to see a positive trend in this
measure, largely accounted for by the projected nominal
depreciation of the dollar. Developments in the non-industrial
countries have been imparting upward pressure on dollar import
prices since mid-1998 when those currencies hardest hit by the
crisis reached turning points. Over the next six quarters, that
upward pressure will continue, explained primarily by domestic
inflation in those countries.
The upward slope to these two forecast lines accounts for
the shift up in projected inflation of the prices of imported core
goods that is shown in the bottom panel. Core import prices are
expected to accelerate to an annual rate of increase of about 3
percent, after experiencing significantly lower increases and even
decreases since 1997.
The staff outlook for growth of real GDP abroad is
summarized in the top panels of your next chart. Foreign growth
rebounded last year to an average rate comparable to U.S. growth.
In some countries, growth in the first quarter was surprisingly
robust, putting our estimate for average foreign growth in the first
half at a particularly high pace. Going forward, we look for
foreign growth to moderate some and to remain comparable to
U.S. growth. As can be seen on the right, there are important
differences among our foreign trading partners, with the Asian
developing countries (the red bars) resuming growth at rates that
are significantly higher than those of the Latin American
countries (the blue bars) and the foreign industrial countries (the
black bars). For most countries, our thinking is that the very rapid
growth of 1999 and early 2000 reflects a recovery in activity that


has been possible because of the availability of unutilized
resources. As the amount of slack in these economies diminishes,
growth will have to come down from what are unsustainable
This pattern is particularly evident in the Asian emerging
market economies, shown in the middle panels. Korea, in
particular, has recorded an extremely rapid increase in industrial
production--the red line in the left panel--that has already eased
off. As can be seen in the table on the right, on average these
countries experienced very rapid growth last year that seems to
have continued into the first half of this year. Although there are
variations across countries, we look for some moderation of
growth in them. Some slowing in the growth of exports likely
will contribute to this process, as will policy adjustments in the
countries themselves.
In Latin America, illustrated in the bottom panels, the
recent strength of activity is importantly accounted for by Mexico,
where industrial production--the blue line at the left--has spurted
this year. Growth in Brazil has been solid, and Argentina is
showing tentative signs of recovery from its sharp downturn. Our
forecast for real output growth--the panel to the right--projects
lower growth in Mexican output over the next six quarters, as
U.S. growth slows.
Your next chart reports recent developments and our
forecast for the major foreign industrial countries. As can be seen
in the top left, measures of business confidence have generally
risen over the past several quarters in these countries, even in
Japan--the green line. Unemployment rates, shown in the right
panel, have come down significantly, except in Japan, as activity
in these countries has accelerated.
The improved confidence by those in the business sector
and the progress in lowering unemployment rates open the
question of whether these countries might be in the early stages of
strong investment demand, rising productivity, and improved
potential output growth. Right now, we have little firm evidence
that such developments are occurring, except possibly in Canada.
As a consequence, we have been fairly conservative in our
forecast for real GDP growth, shown in the middle left panel. We
project that on average real output growth in the industrial
countries will slow some over the remainder of the forecast
period, but that slowing is largely accounted for by Japan. We
continue to expect that domestic demand growth in Japan, shown


on the right, will falter as fiscal stimulus wanes and as needed
structural reforms limit any improvement in labor market
conditions, restraining consumption spending as a result.
We are expecting some moderation of growth in Canada
also, as lower real output growth in the United States and the
effects of recent and prospective monetary tightening slow
economic expansion in Canada to a more sustainable pace. In the
euro area and the United Kingdom, we are projecting sustained
robust growth, supported by continued growth of domestic
demand, shown on the right.
With business confidence strong, we look for fixed
investment to be an important source of demand stimulus.
Investment as a share of GDP, shown in the lower left panel, has
risen noticeably in Canada during the current expansion. There
are signs of a slight upward trend in France as well, but less so in
Investment in capital goods and processes that embody the
new IT developments is one channel by which productivity
enhancement could develop in Europe. Some indication of
support for that activity is shown in the lower right, where
measures of venture capital for the purposes of early-stage
financing and expansion financing are shown as a share of GDP.
This measure has risen sharply in the 1990s in Germany, from an
admittedly low base, and somewhat less in the United Kingdom.
Increases have also occurred in the United States and Canada,
where venture capital activity is already substantial and where
gains in productivity are more evident in production data. In
contrast, these data suggest little use of venture capital in Japan as
a device for financing investment in new technologies. Our
current judgment is that moderate growth will be sustained in
Europe, but we cannot confirm a major impact at the
macroeconomic level yet from new IT developments.
Your final international chart summarizes our analysis of
the U.S. external sector. In the top panels, the growth of exported
goods other than agricultural products, semiconductors, and
computers--that is, core exports--is expected to remain moderately
strong, with foreign growth (the red bars) providing firm support
while relative prices (the black bars) switch from restraining to
boosting exports. Over most of the forecast period, the growth of
core exports will continue to be outdone by rapid growth of core
imports, shown in the middle panel. U.S. GDP--the red bars-remains the principal factor determining growth of these imports.


The projected slowing of U.S. output growth next year should
reduce import growth, as will relative prices, the contribution of
which will move from a moderate positive to a small negative
factor. As shown in the top right panel, we look for the
contribution of total exports (the black bars) to U.S. GDP growth
to strengthen in the second half of next year. The positive boost
from exports to U.S. GDP should about offset the effect of
imports (the red bars), resulting in a neutral impact on GDP from
the external sector.
As can be seen in the middle left panel, with the trade
deficit widening further and investment income showing larger
deficits, we expect the current account deficit will exceed $500
billion at an annual rate by the end of 2001, nearly 5 percent of
GDP. To date, the United States has had little difficulty financing
the widening current account deficit. The strength of the U.S.
dollar is one indication of this. Another is the large scale of
private capital inflows. As shown in the panel to the right, foreign
private purchases of U.S. securities remain at extraordinary levels,
despite the ongoing net selling of U.S. Treasury securities by
foreigners. Foreign direct investment in the United States, which
has been elevated in part by the general merger wave, declined
somewhat in the first quarter but remains high, at a pace about
comparable to U.S. direct investment abroad.
The panels at the bottom depict two simulations done with
the staff’s global model. The solid black line indicates the
Greenbook path for the U.S. current account through 2001 and the
extension that was constructed for the Bluebook for 2002. The
simulation labeled U.S. dollar depreciation--the blue line--plots
the implications for the U.S. current account balance of a uniform
rise in the risk premium on U.S. assets. This shock induces an
immediate 5 percentage point decline in the trade-weighted value
of the dollar starting in the third quarter of this year. This
alternative path for the dollar has a small but perceptible effect on
the current account balance, improving it about $30 billion by the
end of 2002.
The alternative scenario also involves dollar depreciation,
but that depreciation results from a tightening of 100 basis points
in short-term interest rates relative to our baseline in the euro area
and the United Kingdom and of 25 basis points in Japan. Such a
development could occur if generally stronger activity abroad
leads those central banks to react strongly, without taking fully
into account similar moves being made elsewhere. In this case,
the weighted average dollar depreciates about 3-1/2 percent by the


end of the period shown, reflecting substantial moves down
against the euro and the pound. As you can see, a dollar
depreciation brought about by such a policy move abroad does not
improve the U.S. current account balance within the interval
shown; in fact, the deficit widens. This results from the negative
impact on foreign GDP of the monetary policy tightening moves
abroad, which offsets the stimulative effect of dollar depreciation
on U.S. export demand and leaves U.S. real net exports and U.S.
GDP little changed. With foreign GDP weakened by the
monetary tightening, U.S. earnings from assets held abroad fall,
and the current account deficit widens, despite the weaker dollar.
These simulation results highlight the fact that the implications of
dollar depreciation for U.S. external balances depend importantly
on the factors inducing the decline in the dollar.
MR. SLIFMAN. Your next chart presents our
productivity forecast. The upper left panel provides some longerrun perspective, while the upper right panel magnifies the current
situation. We are projecting that the rate of growth of structural
productivity in 2000 and 2001 will be a bit higher than it was in
the preceding two years. Indeed, at a 3.2 percent annual rate this
year and next, our projection is clearly at the high end of the range
of outside estimates.
The acceleration of structural productivity evident since
1995 reflects both a quickening in the pace of capital deepening
and a pickup in the growth of multifactor productivity. The
middle panels address the capital deepening issue. Capital input,
shown on the left, measures the services derived from the stock of
physical assets. As you can see, the index of capital services from
information technology equipment and software (the red bars) has
been accelerating since 1973, while the growth of other capital
inputs (the gray bars) has remained close to the 2 percent annual
rate observed over the past quarter century. Of course, to go from
capital input growth to capital deepening, the trend growth in
hours of work--currently about 1 percent annually--must be
subtracted off.
In calculating the contribution of capital deepening to
productivity growth, changes in capital-labor ratios are weighted
by capital income shares. The middle right panel shows the
capital income share of information technology equipment and
software. The steep advance of this share, combined with the
acceleration of IT capital input, has been the primary source of the
pronounced pickup in the contribution of capital deepening to
structural productivity growth--line 2 of the table. Between 1973


and 1995 (the first column), capital deepening added seven-tenths
of a percentage point per year to productivity growth, compared
with 1.6 percentage points in the late 1990s (the third column).
Multifactor productivity growth--line 4--which reflects the effects
of such things as new technology, economies of scale,
improvements in managerial skill, and changes in the organization
of production, picked up nearly half a percentage point over the
same period. Going forward, our investment forecast is consistent
with more capital deepening, while ongoing improvements to how
business is conducted will show through to even faster growth of
multifactor productivity.
Despite the favorable productivity performance, we still
are forecasting a build-up of inflation pressures. Focusing on the
upper panels of chart 12, you can see that both core CPI and core
PCE prices have accelerated recently, measured at either the
three-month, six-month, or twelve-month frequencies--the red,
blue, and black lines respectively. In the case of the so-called
“pipeline” inflation indicators, presented in the middle panels,
twelve-month changes in both the core intermediate goods PPI
and the core crude goods index have moved up distinctly over the
past year or so. Similarly, the index of prices paid in the NAPM
manufacturing survey shows that since late last year a sizable
number of firms have reported paying higher prices for their
materials and supplies. It should be noted, however, that
industrial commodity prices and the NAPM index have softened
of late, as manufacturing output has moderated.
During the last two periods of rising inflation pressures-1988-89 and 1994-95--widespread bottlenecks and shortages were
reported as firms in a number of industries--for example, primary
metals, textiles, paper, and plastics--were operating at very high
utilization rates. Currently, however, capacity utilization is well
below the levels reached in those episodes, and bottlenecks and
shortages seem to be few, apparently reflecting the rapid growth
of capacity during recent years.
To illustrate the point, in the lower panel I have listed a
sample of the items that purchasing managers reported to be in
short supply during the two previous periods of rising inflation as
well as the complete list shown in the most recent NAPM survey.
Consistent with the numerous press stories on the subject, the
purchasing managers do report shortages of one critical group of
products--electronic components; and, as noted in the Greenbook,
those shortages are having an effect on computer prices. But
that’s pretty much it. There are no reports of shortages for such
basic materials as aluminum, steel, or industrial chemicals.


So, where does that leave us in terms of the outlook for
inflation? Chart 13 presents part of the staff’s view. The first part
of our story has to do with sustainability--or lack of it, to be more
precise. One way of demonstrating this point is illustrated in the
upper panel. The idea behind the picture is one that the Chairman
has discussed many times and is based on a modification of the
growth accounting identity. That is, arithmetically the growth of
domestic demand equals the sum of the growth of productivity,
population, the participation rate, and one minus the
unemployment rate, plus the contribution of net imports. The
chart shows the role of three of those items: falling
unemployment and rising participation--that is, a shrinking pool
of available workers--as well as the widening trade deficit. So,
for example, during the four quarters ending in 2000:Q1,
domestic demand rose 5.7 percent, of which 1-1/2 percentage
points was met by the factors shown on the chart.
In terms of the sustainability issue, there are two ways to
satisfy above-trend growth of domestic demand: We can make the
goods here or foreigners can make them for us. If we make them
here, we can do it by drawing more people into the workforce or
by increasing productivity. But the pool of available workers
can’t be drawn down forever; likewise, the trade deficit can’t
widen forever. The upper panel is one way of scaling the extent
to which we have been relying on these two “safety valves” to
maintain demand growth.
By this measure, the growth of domestic demand has been
relying on these unsustainable sources for most of the past seven
years, which has contributed to a widening GDP gap--the middle
panel. Indeed, currently we estimate that the level of actual GDP
is about 3 percent above the level of potential.
The lower panel shows the historical relationship between
the GDP gap and price acceleration, as well as the staff
projection. The horizontal axis plots the GDP gap measured at
the end of year “t-1” and the vertical axis is the acceleration in
core PCE prices during year “t”. Although there are one or two
obvious outliers, for the most part the points cluster around the
fitted regression line, plotted in blue. The regression suggests that
a 3 percent imbalance between aggregate demand and aggregate
supply at the end of last year is likely to be associated with a 0.6
percentage point step-up in inflation this year. Although the
approach we actually use for projecting inflation is more complex
than this simple bivariate relationship, the forecast suggested by


the regression is reasonably in line with what we’ve written down
in the Greenbook for the average acceleration in core PCE prices
during 2000 and 2001--the red dots on the chart.
An alternative, but certainly not independent, way of
thinking about the inflation process is presented in Chart 14. Here
I show a cost accounting of inflation for the nonfinancial
corporate sector. This is just an extension of the tables I send the
Committee shortly before each meeting. The logic of this
approach is based on the identity that relates inflation to changes
in unit labor costs, unit nonlabor costs, and unit profits, where
output is measured in value-added terms from the income side.
The upper panel shows fourth-quarter-to-fourth-quarter increases
in compensation per hour and productivity--the components of
unit labor costs. As you can see, with aggregate demand growing
more quickly than supply and with labor markets extremely tight
over the forecast period, we expect hourly compensation growth
to pick up. At the same time, we think that productivity growth is
likely to slow, as employers catch up on some hiring while output
is slowing. The result is an acceleration in unit labor costs for the
nonfinancial corporate sector over the next two years.
The middle panels show the other two components of the
identity. We are projecting a continuation of the modest increase
in nonlabor costs posted over the past year or so, primarily
reflecting higher interest costs. Finally, unit profits, which
climbed sharply earlier in the expansion, are projected to drop
back somewhat over the next year and a half, as a competitive
business environment makes it difficult for firms to fully pass on
higher unit costs.
The bottom panel illustrates how this all adds up for the
nonfinancial corporate deflator. Note that because this is a sectorwide price index, it includes energy and food. The jump in unit
labor costs expected this year leads to a pickup in inflation from
about 1/2 percent during 1999 to 1-1/4 percent over the four
quarters of 2000. In 2001, however, the further acceleration of
unit labor costs is offset by the projected drop in profitability, and
price increases slow a bit. This contour is roughly similar to the
one shown for total PCE prices in the bottom panel of Dave’s first
MR. STOCKTON. In Chart 15, I offer a few shreds of
evidence on the question raised at the last meeting about whether
we might be in the process of overdoing this period of tightening
to an extent that could result in a hard landing for the economy.


The upper panel dusts off a statistical technique developed by my
colleague Glenn Rudebusch at the San Francisco Fed when he
was on staff here at the Board. In brief, the technique analyzes
the index of leading economic indicators and assesses whether its
recent behavior conforms with patterns observed in periods
immediately prior to or during a recession. I have plotted here
this model’s estimate of the probability that the economy is in or
will be in a recession within six months. By this measure, that
probability is less than one percent.
A somewhat different approach is employed in the middle
panel. In this exercise, we use our large-scale econometric model
to produce a one-year-ahead forecast starting in each quarter since
1973. Then, using stochastic simulation, we estimate how
vulnerable the economy was in each of those periods to random
shocks. Specifically, we calculate the frequency with which
random shocks are able to produce two consecutive quarters of
negative GDP growth during the one-year forecast period. That
estimated probability is plotted here. As can be seen, this
measure tends to rise prior to economic downturns. For the
second quarter of this year, the probability of encountering two
consecutive quarters of GDP decline in the next year is about 71/2 percent. Although the probability has drifted up over the past
year, it is well below levels preceding past downturns, and even
below the probabilities that were estimated for the 1994
tightening period.
While I hate to end our presentation on what might be
considered somewhat of a downer for the staff, the lower two
panels are intended to provide some perspective on how much
comfort you should take from the upper two panels. I went back
and looked at the Greenbooks that were prepared six months prior
to the business cycle peaks of 1981 and 1990. In the lower panels
I have plotted the projections for real GNP growth taken from
those Greenbooks--the black lines--and actual outcomes as
reported in the Survey of Current Business shortly after those
periods--the red lines.
In January 1981, the staff was projecting considerable
weakness for that year and for 1982. However, we did not foresee
the onset of the largest recession of the postwar period, which
began in the summer of 1981 and gathered force that autumn.
In the January 1990 Greenbook, we correctly projected a
continued step-down in the growth of real GNP, but missed
calling for a peak in activity that summer and the contraction of


output that began in the fall. To be sure, no one was expecting the
invasion of Kuwait and the accompanying spike in oil prices. But
that’s part of the point. It’s difficult to foresee the shocks that can
knock an economy off track, and neither we nor other forecasters
have been very successful at that endeavor in the past. So there is
probably some justification for the sweaty palms that a number of
you admitted to at the last meeting.
But in the end, we do not see the likelihood as high that
the economy is in danger of overshooting on the down side. And,
we remain comfortable with our projection of a steady slowing in
growth this year and next. Moreover, I would not want this
analysis to leave the impression that we see the risks as
asymmetric. This economy has demonstrated much greater
resilience than most forecasters had anticipated, and, with total
and core measures of inflation having moved up over the past
year, clear inflation risks are present.
The final chart presents your forecasts for 2000 and for
2001. The central tendency of your forecasts anticipates some
slowing in the growth of real GDP between this year and next,
with the unemployment rate remaining near or slightly above its
current level. Inflation, as measured by the PCE price index, is
expected to edge down next year.
CHAIRMAN GREENSPAN. Thank you. As an aside, the probability distribution
based on the leading indicators looks remarkably good, but my recollection is that about every
three years the Conference Board revises back a series that did not work during a particular time
period, so the index is accurate only retrospectively. I’m curious to know whether these are the
currently officially published data or the data that were available at the time. I know the answer
to the question and it is not good! [Laughter]
MR. STOCKTON. Right. We use the data as they are currently published and the
probabilities per se as they are calculated by reestimating the model on those data. Though that
index looks reasonably good, it clearly did not do very well, even on these reestimated data, in
that 1990 episode. Even when we were in a recession, the index was still suggesting that the
probability of being in a recession was only 50 percent. So that was a relatively weak indicator.
And I think to some degree the same criticism could be leveled at the middle panel, which


probably overstates the ability of that model and technique to signal oncoming recessions
because that also reflects the structure of the model as it currently exists, estimated on current
data. So I think both probably overstate the probabilities.
CHAIRMAN GREENSPAN. The second, however, is a more complex structural
model from which we would expect something like that. The alleged advantage of the leading
indicators, which may be viewed as a simple reduced form small sample forecast, is that they
are supposed to do all the macro model is supposed to do. So in a sense they are leading us
astray more than a leading indicator should, if I may put it in those terms.
Let me ask a question relevant to a crucial conclusion that is coming out of all of this.
How would the Greenbook, and eventually the Bluebook, look were we to do all of our
simulations with the NAIRU equal to the unemployment rate?
MR. STOCKTON. In the Bluebook I think there is a simulation that has a NAIRU
that’s basically the current unemployment rate.
CHAIRMAN GREENSPAN. I am raising the issue, in a sense, more in the
Greenbook context. What I am trying to get at is how crucial the NAIRU estimate we have
now, which is 5-1/4 percent, is to the conclusions that are emerging. That’s because, as Larry
points out, we are dealing with unit labor costs, which essentially are moving at a lower pace
than at any time in the most recent period. On the surface, the immediate response is that the
way to describe the inflation emerging in the context of that set of data is this: The gap between
the NAIRU and the unemployment rate is putting pressure on the compensation numbers, which
works through to a rate of change that is in excess of productivity growth, and this leads
algebraically to an acceleration in unit labor costs. The gap between the NAIRU, as defined in
the model, and the unemployment rate has been very large for a very long period. And, clearly,


we have not seen the process that is described in the Greenbook forecast emerge. The reason I
raise the question is that how we structure policy, through what will be a very difficult period in
the months and quarters ahead, is going to depend crucially on how we view the various
underlying forces that are emerging. I am just asking, with the evidence that we have to date,
how comfortable you are with the conclusion that the single-point estimate of the acceleration
of inflation in the Greenbook, which as you point out is in opposition to market expectations,
has a high probability of occurring.
MR. STOCKTON. I guess the first thing I would say is that within the context of the
Greenbook forecast, in an economy with no additional tightening we would see the
unemployment rate drifting down a bit further from where it is currently. So even if one were
to take as the NAIRU the 4 to 4-1/4 percent unemployment rates that have prevailed over the
past year or so, our expectation would be that we could be running below that level. So, unless
one wanted to argue that the NAIRU may be moving down even further, there would still be-CHAIRMAN GREENSPAN. I purposely defined it as being equal to the
unemployment rate. Let me stipulate that. I don't want to go too far. The law of supply and
demand says that there is a level of the unemployment rate that must of necessity drive
compensation increases beyond the rate of increase in productivity. But there is a crucial issue
here, which is the specification of the way this process occurs. It is quite different from the
general view, which is unquestionably verifiably true--namely, that as the unemployment rate
falls, the pressure on compensation per hour must rise or the law of supply and demand has no
relevance to anything. It is the very special specification of the structure of this model, which
stipulates that a specific gap exists, that has worked rather well in years past. But the recent
evidence of that is at least seriously questionable. And the reason I raise the issue is very


honestly because if I believe the Greenbook forecast and if I believe the Bluebook forecast, I
would say that we are well behind the curve at this particular stage in monetary policy. And I
don't believe that. In fact, due to great substantive insights on our part and more importantly a
great deal of luck, I think that is not the case.
But it is terribly important that a precise specification of how a particular economic
event materializes rests at the base of the structure of our model. We have a very large, very
elaborate, and very sophisticated econometric model. But at the core of the conclusions we are
looking at today, a specification of how the NAIRU is defined relative to the unemployment
rate and the marginal effect of that gap on compensation per hour is a crucial driving force in
the forecast. If we were to create a reduced form of this model, it would have this specification
essentially at the core of the conclusion. So the real question that I am asking is essentially the
degree of confidence we should have in this. I wonder whether there should be a wider range of
uncertainty about the specification, mainly because of the poor performance of these
relationships over the last several years. That is, the relationships between NAIRU, the
unemployment rate, and hourly compensation have behaved in a far less impressive manner
than they clearly did in earlier years. The presumption here is that the relationships will return
to where they were--or at least I assume that is the case. That may well be true. Indeed, we
have to be very wary because that may in fact be the case. I raise the concern that I have in the
form of a question mainly because I'm trying to ask it more as the devil’s advocate than I may
very well believe in light of the fact that it is crucial to our deliberations.
MR. STOCKTON. Let me make a couple of comments. One, I would not want to
overstate how well this paradigm has worked in the past either. It's not as if this “fit like a
glove” previously and suddenly something has gone so far off track that we can clearly see


evidence of considerable structural change. Two, to answer your question about how confident
I am, I would refer you to Chart 4 in the Bluebook, which presents confidence intervals around
these forecasts that are based, in essence, on our econometric model, not necessarily judgmental
forecasts. As you can see, those confidence intervals are really rather considerable, but I think
that chart probably is a pretty reasonable representation of the kind of uncertainty we think you
are confronted with in making policy. A 70 percent confidence interval on the extension of the
Greenbook forecast could imply stable inflation. Even with an unemployment rate below the
NAIRU, an inflation rate that runs at just 2 percent, which is essentially where it has been
running, is within those confidence intervals under the structure of this model.
CHAIRMAN GREENSPAN. And these are picking up structural misspecifications
as well as exogenous data input errors?
MR. STOCKTON. Yes, in the sense that these are full confidence intervals.
CHAIRMAN GREENSPAN. But I'm trying to understand what the confidence
interval is in fact measuring.
MR. STOCKTON. It is measuring all of the above--the uncertainty about the model,
based on how it has performed in the past, as well as the uncertainty about what goes into that
CHAIRMAN GREENSPAN. In other words, in a sense, analytically it is the
structural specification errors, missing variables, misspecified coefficients, as well as inaccurate
exogenous inputs into the forecast system?
MR. STOCKTON. Yes, pretty much. I suspect this does not include the coefficient
uncertainty about the parameters on variables; it has a coefficient uncertainty in terms of the
intercepts in the models. But as you can see, that confidence interval widens out to over 2


percentage points on price inflation, so there is considerable uncertainty. Obviously, the staff
forecast is a forecast of what we think will happen under a given path of the funds rate. It is not
a prescription for policy or for how policy should be conducted when faced with uncertainty
about the structure of the model. In fact, I would interpret the Committee’s behavior in recent
years as having responded to the widening uncertainty about the structure of the model and the
economy by reacting less forcefully to incoming economic developments than you might have
had you had full confidence in the structure of the model. I think it is important to remember
that about the forecast--that it is not a prescription, but a forecast. And that forecast has
considerable uncertainty in a number of dimensions. You have mentioned a couple in terms of
the structure of the wage/price sector. But the model has been off considerably in many other
areas that are also important for your considerations--for example, the behavior of equity
markets and how they might respond to further changes in the federal funds rate. It all adds up
to a lot of uncertainties and some pretty big confidence spans; and I would imagine it suggests
caution on your part in interpreting the forecast that we provide you.
CHAIRMAN GREENSPAN. That is useful. Thank you.
GOVERNOR MEYER. Could I just follow up on that? I think the staff provided
some very good information that in my view is quite responsive to the Chairman’s concerns
when they ran a simulation with a NAIRU that is a percentage point below the staff estimate.
Maybe you would like to talk about that simulation. I think it is a good way of dealing with
some of these questions in terms of seeing how different some of these-CHAIRMAN GREENSPAN. I saw that; that was helpful.
MR. POOLE. Mr. Chairman, on the same point, if I may? Dave, let me ask the
question the way I interpret the Chairman’s query--or maybe I don’t have quite in mind what he


does. Suppose you set the NAIRU in the model simulation arbitrarily equal to the current
unemployment rate. That short-circuits all of the wage/price mechanisms that come from the
gap. Is there a mechanism in the model that under those circumstances will pin down the rate
of inflation or the price level or however you want to put it? Or does the whole wage/price
mechanism in the model flow from a gap?
MR. STOCKTON. In a model in which the NAIRU in essence was last period's
unemployment rate, I think you would still be able to pin down inflation. Monetary policy will
ultimately determine the rate of price inflation even in a model with that specification of
wage/price behavior. I'm not sure if there is a mechanism-CHAIRMAN GREENSPAN. Governor Meyer actually had the floor. This is a very
important discussion, so let's do it in a sequential manner. Governor Meyer.
MR. MEYER. The dynamics are important here, and that is what I was thinking
about. You don't need just the reduced forms in some sense, the static ones; you need the
dynamic process. And the disequilibrium process through the gap is the mechanism that gets
you from one inflation rate to another. I’m not sure, but I think if you increased the rate of
monetary growth in that model and you didn't have the dynamics working through the gap,
you’d have no mechanism to get you from one inflation rate to the other. So, what I would
urge-MR. STOCKTON. We do have inflation expectations.
MR. MEYER. Well, if there is no mechanism to generate higher inflation, why
would inflation expectations go up?
CHAIRMAN GREENSPAN. We didn't have it in the 1970s. We had stagflation,
which did not involve a gap problem.


MR. STOCKTON. You can always produce a series of shocks.
MR. MEYER. That's right. If you have an increase in the price level that's fine, but
not if you have an increase in the rate of growth in the money supply or some stimulus like that.
You won't have a determinant process.
MR. STOCKTON. You can still produce a series of shocks for that model that cause
the unemployment rate to change and to create in essence a series of temporary gaps, which I
think could move the inflation rate.
MR. MEYER. The point here is that I think it would be dangerous to throw away a
disequilibrium mechanism that underlies the inflation/wage dynamics without having anything
to replace it. That's my concern. The issue is not the nature of the wage/price dynamics but
what the critical value of that is that gives rise to the process. And, of course, there’s a lot of
uncertainty about that. But that’s why I thought the simulation was very interesting. Actually,
it was a bit surprising that if you put in a NAIRU that is a percentage point below the staff
estimate, the qualitative story was not that different.
MR. STOCKTON. I would just say the reason for that in part is that we see the
growth of structural productivity as requiring some increase in interest rates eventually. That is
not obviated by a low NAIRU. That is still there producing potential inflation if the funds rate
is held at its current level.
MR. KOHN. I think there are two sources of upward pressure on prices in this low
NAIRU case, aside from the fact that the current unemployment rate is a tiny bit below even the
low NAIRU. One is the depreciation of the dollar. The assumed depreciation of the dollar is a
pretty powerful inflationary force in these simulations partly because it just continues on and on
and on. It's powerful enough to raise the NAIRU by 1/4 point and probably a little more; we


rounded down to get that 1/4 point. So that's one thing that produces upward pressure on prices.
I suspect another thing is that there is some cumulated pent-up pressure here in the sense that
real wages in the past haven't quite caught up with the increase in productivity. So, workers
haven't realized all the gains of the productivity increase and as a consequence if productivity
stopped growing or stopped accelerating and the NAIRU were lower, the labor force would end
up getting a little more in real wages. And that, at least for a while, would put some upward
pressure on prices. So I think we have some pent-up real wage increases and also some further
depreciation of the dollar in here producing this uptick in inflation.
CHAIRMAN GREENSPAN. The crucial assumption here is that the second
difference on productivity goes to zero.
MR. KOHN. Actually, I think it could occur if we put the third derivative negative.
That is, productivity could still be accelerating but if it were accelerating more slowly over
time, the same mechanism would work slowly.
CHAIRMAN GREENSPAN. I grant you your algebra. [Laughter]
MR. KOHN. I did have a simulation run this morning with the optimistic
assumptions on the supply side--a low NAIRU and accelerating productivity--and no
depreciating dollar. And that is enough to stop inflation from rising, at least for a number of
years. But we need all three to stop the inflation rate from rising here.
MR. POOLE. My instinct is that in a model that runs off the interest rate--there are
no monetary quantities pinned down by this model, the policy assumption runs off the federal
funds rate--the price level has got to be indeterminate. It just has to be, if you short-circuit the
price-setting process by setting the NAIRU always equal to the current unemployment rate. It


can't be pinned down by expectations because expectations have to be pinned down by
something that determines the price level.
MR. STOCKTON. Which is usually the monetary authority.
MR. POOLE. Which is usually the monetary authority. So, one really can't just run
a simulation on the funds rate and short-circuit the wage/price mechanism.
CHAIRMAN GREENSPAN. If I may argue, the fact is that the unemployment rate
can only go to zero and there is a gap. You can redefine a structure, which is the unemployment
rate minus zero, as a gap and you'll get the same structural response that you'll get from a
NAIRU model. In other words, a fall in the unemployment rate will create inflation even
without advertence to the existence of the NAIRU in the model. It depends on what you specify
the relationship of compensation to. If you just put it literally at the unemployment rate with
some coefficient, you'll get the same response. You have to. The only thing I am arguing about
is that where you put the NAIRU relative to the unemployment rate alters the extent and the
rapidity of the response, but not the sign. And that is what concerns me with this type of
forecast in which I think the direction has to be right, but the order of magnitude is very crucial
to how we respond to it monetarily.
MR. POOLE. Clearly this is a pretty complex discussion about the model’s
properties under different assumptions.
CHAIRMAN GREENSPAN. But if you think about what our problems in monetary
policy formulation are, regrettably it does get down to this level because we're forecasting the
future. And how the future will respond depends on how we define the existing structure that is
driving the interrelationships in the economy today. And I think it is very important to be clear
on where we as a group believe those relationships are.


MR. POOLE. All I'm saying, Mr. Chairman, is that I think there is a different
possible conception of how these relationships work, which I don't have fully worked out in my
mind. I have a sketchy idea, and I don't think it all has to flow through this mechanism.
CHAIRMAN GREENSPAN. Clearly there are alternate means of doing this. I was
merely commenting about the suggestion that when you eliminate the NAIRU, the wage rate
and inflation become indeterminate. I don't think that's right; that's all I'm saying.
MR. STOCKTON. I don't know whether David Reifschneider would know the
answer, but I'm sure he could produce an answer for us. Take a wage equation, Dave, in which
in essence there is complete hysteresis that says last period's unemployment rate is this period's
natural rate. Is there a determinate inflation rate in the model?
MR. REIFSCHNEIDER. No, I don't think there is unless you pin down-CHAIRMAN GREENSPAN. Pin down? Well, the expectations become a function
of that relationship.
MR. POOLE. No, I think there is another way of doing it. One way would be to pin
down expectations by an assumption about the response of monetary policy. But if you don't
pin that down because you are specifying monetary policy in terms of some--I'll just say
“arbitrary”--federal funds rate, then that doesn't solve out.
MR. STOCKTON. That is absolutely true.
MR. MEYER. I think we are making this discussion more complicated than
necessary. We are not saying, “Let’s throw away this whole wage dynamics model,” but rather
the question is what is the value of the NAIRU. That becomes very important. Nobody could
dispute that.


MR. JORDAN. I don't know if this is going to be helpful or not! [Laughter] Instead
of talking about the unemployment rate, which is a highly visible, highly politicized figure, I
was going to cast the question slightly differently. Once a month people in a government
agency go out and take a snapshot of the inventory of individuals who are counted as willing to
work--they did something to try to gain employment--but were not working. That inventory is
about 5-1/2 million people. There is a lot of churning in that inventory, a lot of ins and outs.
We get all sorts of other information but we look at that number of 5-1/2 million--and the total
stock is growing by about 2 million a year--and we say, “Well, that number of 5-1/2 million is
too small.” We think technology--search engines, search techniques, or efficiencies of all sorts
in information communication--has moved down the inventory of many items that are needed
for building cars. But you are implying that this inventory of people not getting a paycheck
needs to be up around 7-1/4 million, otherwise the prices of goods rise, or rise at a faster rate.
Without repeating what you already said, draw me a connection that tells me that the inventory
of unemployed individuals needs to be 7-1/4 million instead of 5-1/2 million people.
MR. STOCKTON. You have recast the question, but it involves a gross correlation
in the data that Larry was pointing to--the GDP gap and the unemployment rate and the
acceleration of prices. I would argue that our downward revision to the natural rate of
unemployment--from the 5-3/4 percent or so that we had a number of years ago to 5-1/4 percent
now--reflects our belief that some of the forces you just described are indeed at work in the
labor market. That is, we can operate now with a thinner margin of excess capacity, in some
sense, that reflects this churning because of more efficient job search techniques, more use of
temporary help, and a variety of other factors that in fact have made the labor market more
efficient. At a macro level, all we are really asking, in terms of this pool of labor, is whether in


the past a certain pool has been associated with an acceleration of wage and price inflation.
And that's all these NAIRU estimates are really about. Or we can recast the question in terms of
a slightly more comprehensive measure of labor market slack. The uncertainties that we show
in those confidence intervals are just another reflection of the fact that there is a lot of looseness
in that relationship, which probably reflects some of the effects that you are talking about--some
of which may prove temporary and some of which may prove permanent. We have made our
best assessment as to how much of that we think is likely to be permanent and how much has
been temporary. But, obviously, there is room both for disagreement and considerable room for
MR. PARRY. Dave, the Greenbook mentions that core consumer inflation will be
boosted this year by higher energy prices. I assume that next year, as energy prices come down
according to the Greenbook forecast, core consumer inflation would be reduced. Could you
give me some idea of the size or the precise effects of that on the core consumer inflation rate?
MR. STOCKTON. Roughly speaking, depending on the particular model that we
look at, we think between 0.3 and 0.4 of the acceleration over the past year could be attributed
to the indirect effects of accelerating energy prices. Then, in 2001 when those prices retrace, we
get some of that back, which is part of the reason why in our forecast we see a more pronounced
acceleration in core inflation this year and not much further acceleration next year, despite the
fact that the unemployment rate moves up.
MR. PARRY. To try to understand what is happening to core inflation, I think it’s
important to make those adjustments because, when the effects of energy prices are factored in,
it looks as if we have a really significant acceleration that begins in 2001.


MR. STOCKTON. The acceleration is a much steadier upward process than one sees
in our forecast, which might give a slight impression that things are topping out a bit in 2001.
MR. PARRY. That’s exactly my point. Thank you.
CHAIRMAN GREENSPAN. Governor Gramlich.
MR. GRAMLICH. More on this NAIRU issue: First, I assume that Don Kohn is
going to talk about Chart 7 in the Bluebook. I guess I am one who does not want to throw away
the whole NAIRU model, but I do wonder about the estimates. I'll point out two things about
Chart 7. One is that the NAIRU there is about 4.6 percent, so it is still above the unemployment
rate we have now. Looking at the chart in the lower right-hand panel, it looks as if that
difference does not matter all that much--compared to the baseline--for growth in PCE prices.
So I think the other factors Don mentioned may enter into this analysis more than I had thought.
One of those--and now I’m going to switch to Chart 14, presented by Larry Slifman--is that if
we look at what's going on with unit labor costs in the projection, there is actually more kick
from the drop in productivity than from the rise in wages. I probably should have recognized
that, but that chart made it a little more vivid than I was aware of. So let me ask the parallel
question on that. How sure are we of that? What is the model used there? What's going on?
MR. SLIFMAN. As for how sure we are, the answer is our usual answer: There is a
wide range of uncertainty. The model that we use, as you probably know, is the so-called stock
adjustment model for the demand for labor. So our view, as I noted and as we said in the
Greenbook, is that even though output growth decelerates, hiring will continue, as firms that
right now are running with very stretched work forces try to get their work forces to more
preferred operating levels. That is the underlying logic. How confident are we that that’s what
is going to happen? Well, obviously, there is a wide range of uncertainty around this cyclical


component of our productivity projection. It could also be the case that we're too pessimistic
about underlying structural productivity growth, particularly total factor productivity, which
could give us some additional boost to overall labor productivity.
MR. GRAMLICH. And this is a period where we still have a lot of investment
coming on stream?
MR. GRAMLICH. And an increasing share of it is high-tech.
MR. SLIFMAN. Yes. The slowing in overall labor productivity is all happening, in
an accounting sense, as a slowing in total factor productivity. The capital deepening component
is still surging ahead because we are at such high levels of investment.
VICE CHAIRMAN MCDONOUGH. In his comment a few moments ago, Don
Kohn pointed out the degree to which this projection also depends on the model’s forecast of a
fairly significant depreciation of the dollar. The first quarter should remind us that the appetite
of foreigners for investing in the United States seems to be huge. I doubt that anybody in this
room is more frightened about the current account deficit than I am. But it is not at all clear to
me that the deficit could not grow to 4-1/2, 5, 5-1/2 or 6 percent of GDP and we could still
maintain a considerably stronger dollar than in the model. There might still be enough people
outside the United States who think this is a much more attractive place to invest than the
emerging market countries—or, heaven knows, Japan or even Europe with its structural
problems. That is just another area of uncertainty on top of the uncertainty about the NAIRU
that makes one rather humble about the reliability of the forecast. I must say that I commend
the attitude of this discussion with respect to just how wide the confidence intervals are.


MS. JOHNSON. If I might just put a footnote on that: From the point of view of,
say, Chart 7 or some of the others, the comparison of the baseline to the alternative that is being
depicted is, loosely speaking, independent of what we've assumed about the dollar. How much
difference the alternative makes to the baseline is what those charts illustrate. The issue of the
baseline path that we put in for the dollar arose because to get a longer-term view--asking the
model to extend itself in time--requires that it not encounter explosive developments. The
model just doesn't behave. And given the parameters driven by history, we have to put in a
sizable dollar depreciation to meet that, if you will, computing criterion. I don't dispute
anything Don said, but in thinking about the alternative versus the baseline--the aspect the
charts focus on--what we had to put in to get the model to resolve the current account problem
is really irrelevant.
CHAIRMAN GREENSPAN. I think a crucial element in here, which carries through
to a lot of different areas, is whether we are still to a significant degree involved in
technological expansion. If so, the ex ante rate of return on new facilities is either high or still
rising, and it does two things. It engenders a very large increase in capital investment and
capital deepening which, other things equal, moves unit costs down. But at the same time it
attracts foreign investment to finance the current account. In the simulations I suspect we
would find that if suddenly we took that implicit ex ante rate of return down a few notches, it
would create some truly awesome imbalances. In a sense it’s that propensity to invest here that
I think is a really crucial issue. And it’s not only foreigners investing here. Just look at the
backlogs of capital investment. It is really impressive at this late stage in the business cycle-more than we may have even remotely imagined. President Broaddus.


MR. BROADDUS. Dave, in light of this discussion, it might be helpful if you could
just refresh our memories about your estimate of the NAIRU as it is now and the kind of
confidence interval you have around it. I presume there’s an upside as well as a downside risk
to it, despite the recent experience. It might be helpful to have that benchmark.
MR. STOCKTON. Our current point estimate is about 5-1/4 percent. As I indicated
earlier, that is down from the 5 3/4 percent to 6 percent range we had before. We do see upside
and downside risks to that estimate. In the paper by Flint Brayton and David Reifschneider
circulated to the Committee through Don Kohn a few weeks ago, I think they reported a
reestimate of their wage and price equations. Their work suggests a NAIRU of 5-3/4 percent
even with the current set of data they’ve been looking at. They provided in the paper a variety
of reasons for why we might have experienced this particular combination of low
unemployment and low inflation. Now, we have other judgmental models that produce lower
NAIRUs. And we feel relatively comfortable with a number of the stories that, as I indicated
earlier, probably have helped to lower the natural rate. But the risks are not one-sided either.
CHAIRMAN GREENSPAN. Okay, can we start the Committee discussion? Who
would like to begin? President Parry.
MR. PARRY. Thank you, Mr. Chairman. The Twelfth District economy has
continued to expand at a rapid pace. The employment growth rate of 3.6 percent so far this year
is above the national rate of 3 percent. Employment growth was especially rapid in April and
May, with the surge in the latter month largely due to the hiring of temporary Census workers.
However, unlike the rest of the nation, the Twelfth District gained private sector jobs in May as


The California economy has been growing a bit faster than the rest of the District
and its 5 percent unemployment rate is near a 30-year low. Among the other states, Arizona
leads the nation in the percentage growth rate of jobs over the past year. The state’s
manufacturing sector has performed especially well this year, with strong job growth in hightech equipment manufacturing adding to the state’s ongoing aerospace expansion. More
generally, makers of semiconductors and related equipment in the District have been expanding
employment and output as demand for District exports has surged. The key exception is exports
of Boeing aircraft from the state of Washington, which fell further, though continued rapid
expansion of the computer services sector has kept growth solid in the Seattle area.
In recent months tentative signs of slowing have emerged in residential real estate
markets. The pace of home sales, construction, and price appreciation has slowed in states
besides California, where demand remains very strong relative to supply and housing starts and
home prices have continued to rise rapidly. On the commercial side, conditions also have
remained quite tight in California. The most extreme example is the San Francisco Bay area.
In the first quarter, the office vacancy rate was only 1 percent in San Francisco and in the
Silicon Valley, and lease rates jumped 25 percent or more in that quarter alone.
Turning to the national economy, recent developments have been somewhat
encouraging. The pace of economic activity apparently slowed to a moderate, more sustainable
rate in April and May. And core inflation returned to the moderate rates that had prevailed prior
to the spike in March. It is far too early to conclude that the economy has gone into a sustained
slowdown. However, recent developments provide room for optimism that inflationary
pressures can be contained, perhaps with less monetary policy tightening than seemed likely
when we met in May.


With regard to our forecast, we have revised down our estimate of real GDP growth
in the second quarter by a full percentage point to 3-3/4 percent. We expect real GDP to grow
4-1/4 percent this year and 3-3/4 percent next year. This deceleration is due mainly to
tightening financial conditions. We have assumed that the funds rate will be unchanged at this
meeting but will rise another 25 basis points in August, and that equity values will remain
unchanged in real terms through the end of next year. These two factors are expected to have
especially large effects on consumption and housing. Despite this slowdown, tight labor and
product markets can be expected to put upward pressures on core inflation, even after allowing
for accelerating structural productivity. Higher oil prices have boosted overall consumer
inflation so far this year and also have affected core inflation to a lesser extent. Like the
Greenbook, our forecast assumes that oil prices will decline from the third quarter of this year
through the end of 2001. If that occurs, it is likely to reduce core inflation a bit next year and
partially obscure an upward trend in the underlying rate. We expect the core PCE price index to
increase 2.1 and 2.2 percent this year and next, well above last year’s 1.5 percent rate. Overall,
my concerns about inflationary risks have lessened somewhat since we met in May. But I
would still say that going forward the balance of risks for inflation is pretty clearly on the up
side. Thank you.
MR. MOSKOW. Thank you, Mr. Chairman. Since our May meeting, the number of
reports suggesting slowing in activity seems to have increased, but our assessment is that the
Seventh District economy is still quite healthy given that the slowing has been from high levels
of activity. Housing industry contacts describe activity as still strong but slowing. Retailers
indicate that sales have been below expectations in part due to unfavorable weather. Contacts


report slowing in sales of building materials but also tell us that sales of appliances, electronics,
and home furnishings are still strong, reflecting the typical lags in the housing markets. Light
motor vehicle sales have come down from the first quarter’s record pace but are still at very
high levels, with the auto makers currently estimating that June sales will be in the 16-1/2
million to 17 million unit range.
In terms of manufacturing, the latest Chicago Purchasing Managers’ Survey results
show activity picking up in June, with both production and orders moving higher. This
information should be treated confidentially since it won’t be publicly released until this Friday.
That report also suggested some modest easing in price pressures from May and indicated that
factory employment declined in June. A national temporary help firm headquartered in our
District reported that demand for temporary manufacturing workers was definitely weaker than
a year ago, particularly in the Midwest, although overall demand for workers was still up. More
generally, our labor markets are still very tight.
When giving speeches lately I’m starting to get almost as many questions about high
gasoline prices in the Midwest as I am about interest rates. Special factors seem to have
contributed to large but transitory price increases. Inventories were low to begin with,
particularly for gasoline that met the area’s new reformulated gas requirements, and there were
a couple of pipeline disruptions in the Midwest. And while few seem to mention this, consumer
demand for gasoline seems to be stronger than had been anticipated. Not unexpectedly, the
increase in gas prices has sparked considerable political interest. The State of Indiana has
suspended its 5 percent gasoline sales tax, effective July 1, and the Governor of Illinois has
called a special legislative session to consider doing something similar.


Last week the Chairman attended our board meeting at which our Chicago and
Detroit branch directors discussed the impact of e-commerce and the Internet on their
companies and their industries. This was a follow-up to a similar discussion that we had at our
June 1999 meeting. And this year we will be compiling and distributing a summary to you, as
some of you requested.
The consensus among our directors was that there has been a definite acceleration in
productivity in their industries over the past three years as a result of investment in information
processing equipment and utilization of the Internet. Their firms have shifted their focus toward
B2B and away from B2C applications over the last six to twelve months. In fact, it was
reported that the number of online marketplaces nationwide has increased from 600 to 1800
over the past year. Most firms, especially the small and medium-sized companies, are just
beginning to scratch the surface in terms of realizing the potential of the technology to enhance
productivity and improve operations. One of our directors told us about a new service that his
company offers that would have been unprofitable without the Internet. They now make
available to any used car buyer, whether a consumer or a dealer, a complete report on the
history of any vehicle in the system for a $10 or $20 fee. That report includes information on
major accidents, retitling of the vehicle as a result of its previously having been totaled or been
in a flood, and so forth. There are about 35 million used car transactions in the United States
annually and about 10 percent involve cars that had major mechanical or structural flaws. This
new service is based on information the company already collects, which tracks all motor
vehicle titles and registrations in the country; the data are maintained on line and linked via
unique vehicle identification numbers. The new service has grown rapidly and now has 11,000
participating dealers and 112 other Web partners. So, in summary, our directors agreed that the


new technology has allowed them to lower costs and provide new services. Although they
found it difficult to quantify the value of these innovations, they are convinced that they are
very significant.
Turning to the national economy, our outlook for real GDP growth and core PCE
inflation is essentially the same as that in the Greenbook, although our assumptions are
somewhat different. The intermeeting data suggest a modest slowing in the pace of economic
activity, but I share the Greenbook’s caution against giving those data too much weight in the
current projections. If the next few months show similar signs of moderation, then that would
be significant.
Last week we convened a group of academic and business economists at our Bank to
discuss the current outlook. The academics argued that monetary policy had been overly
expansionary throughout 1999 and even perhaps earlier. In their view, the current stance of
policy is only mildly restraining and is insufficient to remove the previous policy stimulus. On
the other hand, some of the business economists felt that monetary policy is currently quite tight
and is largely responsible for the recent softening in the reported data. A common element in
each group’s discussion was uncertainty about the FOMC’s current inflation goal. They felt
that the Committee’s recent shift in focus to the lower PCE inflation measure instead of the
consumer price index had complicated matters. But regardless of the measure used, our core
inflation forecasts are all tilted upward, and that’s troublesome. My own view is that inflation
should be lower than our current forecast and that we need to articulate that clearly as we
contemplate further actions.
CHAIRMAN GREENSPAN. President Minehan.


MS. MINEHAN. Thank you, Mr. Chairman. Economic activity in New England
continues to be vibrant. The region’s job growth, though below that of the nation, is above its
long-term trend, and unemployment in the area is the lowest of any region in the country.
Prices as measured by the Boston CPI rose in the latest month at a rate better than a percentage
point higher than prices for the country as a whole, driven by shelter and fuel costs. In addition,
house prices continued to rise more steeply in New England than nationally, with Vermont
leading the regional pack with a 10 percent increase between 1999 and 2000. So the question
we’ve been asking is: Where is the slowdown? Locally it seems more evident in the anecdotes
than in the data. To be sure, the manufacturing sector continues to lose jobs regionally. Export
growth of manufactured goods, which had accelerated quite a lot in 1999, flattened over the
year-end and the beginning of 2000. And studies at the Bank indicate that the region’s defense
intensive manufacturing businesses appear to be losing market share. On the anecdotal side,
one of the Bank’s small bank directors reported just last week that auto sales in New Hampshire
seem to have fallen off a cliff. That is about the only anecdote of slowing that I have right now.
As for anecdotes on the other side, contacts tell us that it remains difficult to find
workers of almost any type. Planned wage increases are reportedly in a bit higher range than
earlier, especially for high-tech workers, and we have started to hear more frequent reports of 10
to 20 percent increases for various classes of workers. Seasonal inflows of workers--college
students, for example--have not eased supply constraints as they had in previous years. Rather,
as one temporary staff firm owner reported, “All the new college graduates were hired even
before they graduated, and that’s the first time I’ve ever seen that.”
On the national scene, we agree with the Greenbook and just about everybody else
that there is a bit of slowing in the works, including slower consumption growth, driven by the


interest-sensitive sectors, especially housing, as well as sideways financial markets. We talked
about uncertainties in the forecast before, and it was a daunting conversation to get into, but
there is a range of uncertainty about a lot of things. We have a range of uncertainty about trend
productivity, as well as the NAIRU and the implications of the trade deficit for the dollar. If we
put a lower rate of trend productivity growth and a lower NAIRU into what I’m sure is a
simpler model than the one used at the Board--and assume no further monetary tightening than
we have already--we get a slowing of real GDP in 2000 to about 4 percent. That gives us a
slowing to 3-1/2 percent in the second half of this year and growth at about that same rate in
2001. However, under those assumptions, unemployment remains low and inflation, whether
measured by the CPI or the PCE, picks up. Thus, our sense of the appropriate path for
monetary policy involves further tightening, though probably not as much as reflected in the
Greenbook, largely due to our lower estimate of the NAIRU.
Now this forecast, like any forecast, has risks associated with it; but we think the
upside risks are predominant. First, there is some expectation of a slowing in PDE investment.
And while such slowing makes some sense in the context of the model, I think there certainly
are some risks that business investment will grow at a faster pace than we have in our estimates.
Even more importantly, there is a reasonable possibility that the signs of slowing in the second
quarter are a statistical aberration borne of the mild winter and seasonal adjustments that work
in the direction of making current data look weaker than they really are. Perhaps, as some
private forecasters have noted, it would be sensible to keep in mind that if the first-quarter and
projected second-quarter numbers are averaged together, the growth rate for the first half of the
year would be above nearly all estimates of potential GDP. That measure may be a better
reflection of the current momentum in the economy than the very latest high frequency


observations. So the issue to me is not whether the economy is slowing now--and goodness
knows we want that to happen--but whether this is simply a pause or the beginning of a pattern.
Our model and the Greenbook forecasts suggest that it’s a pattern. But in the last two years
we’ve seen second-quarter pauses. Thus, it is probably wise to be a bit agnostic about whether
the long awaited slowdown is finally here. And if one is agnostic about that, then there may be
room for a greater level of concern about the up-creep in the price data and about the downside
risks that might be associated with less than vigilant monetary policy at this point.
MR. GUYNN. Thank you, Mr. Chairman. I would now characterize economic
growth in our Southeast region as moderately strong, with some emerging signs of slowing. Let
me first indicate what is different and what feels different from the situation at the time of our
last meeting. The most obvious and persistent signs of slowing are in our residential
construction industry. That industry is extremely important to our region. In fact, two of our
states, Florida and Georgia, are among the five states that produce 40 percent of the nation’s
new housing units. Both the data and anecdotal reports from directors and other contacts
confirm a slowdown in the pace of construction, which is most pronounced at the low end of the
market. Other industries in our region that feed off the regional and national housing industry-carpets, appliances, and building materials, for example--are also feeling some impact from the
slowdown in construction. While less of a trend at this point, our contacts are now also
reporting some noticeable falloff in consumer spending for big ticket, high-end products.
Our financial institutions are telling our lead Bank examiners that their best days in
terms of credit quality may be behind them and, consequently, there are more reports of
tightening credit standards and more cautious and less accommodative lending. One banker


noted that fortunately there seem to be few signs of stupid competition. There has been a
noticeable pullback in lending to marginal companies, including real estate deals where the
tenants are to be dot-com companies. In contrast to these signs of some moderation, other
sectors where we continue to see good to very good growth include tourism, most
manufacturing industries, including auto makers and auto suppliers in our region, ship building,
oil production, and commercial construction.
While our regional employment growth continues to outpace the nation’s and our
labor markets remain tight, we are getting a number of reports of some emerging relief in the
sector where we first saw tightening, the construction trades. My developer and builder
contacts say that subcontractors who were often too busy even to return phone calls are now
beginning to call in search of future work. The new tightest area for skilled workers seems to
be nurses. The points of greatest price pressure remain the same. Clearly, health care costs,
including pharmaceuticals, are escalating at a faster pace and that is expected to continue. And
prices of petroleum-derived products and transportation surcharges have clearly risen. Basic
wage increases are still generally constrained, although I continue to hear many people say that
the soft costs of various perks and concessions to workers are probably not being fully
On the national front, I see some of the same early signs of moderation. Those
appear to me most obvious in residential construction, where the pace has leveled off or even
slowed. Two weeks ago I had occasion to make a presentation and to stay for a candid
roundtable discussion among the directors of the Harvard University Joint Center for Housing
Studies, which is part of their School of Government. That group of some 50 CEOs and other
top officials of the largest national homebuilders and their suppliers reported a marked slowing


in the pace of building and future commitments to build. Again, the slowing is most evident at
the low end of the market. That group also reported some evident relief in the availability of
labor and the perception of some new buying power over their suppliers of construction
I’m also encouraged to see some evidence that consumer spending is slowing, at least
somewhat. But if income gains and confidence remain strong, and if asset values do not erode
further, it is not likely that consumer spending will drop precipitously. Business investment
spending, at least for equipment including computers and telecommunication equipment, is
likely to remain strong. And the relatively positive outlook for most of our trading partners
suggests to me that demand from the foreign sector could offset some of the slowing in
domestic demand. For me, as others have already suggested, the key questions today and
tomorrow are whether the tentative signs of slowing we see are likely to persist and where we
are in terms of the lagged response to the tightening we’ve put in place over the last year. It’s
my sense that the 50 basis points of tightening that we did at our May meeting got people’s
attention. A moderation in some sectors and some less accommodative financial conditions are
now showing through, as some of our models had predicted and as we had hoped to see.
While I remain concerned about the apparent upward drift in most measures of core
inflation, I continue to think we’ve been at least modestly preemptive. Moreover, our Bank’s
latest modeling work suggests that we should get a significant further bite from the tightening
we’ve put in place. While there is probably a better than even chance that we’ll need to tighten
at least a bit more, given the upside risks, our staff work does not indicate the need to take rates
quite as high as the Greenbook suggests or to hold them so high for so long. I think we could
reasonably stand pat tomorrow and not tighten further, allowing us time to get a better read on


where policy is, so long as we don’t inadvertently signal that we’ve concluded tightening and
that our work is done. Thank you, Mr. Chairman.
CHAIRMAN GREENSPAN. First Vice President Stone.
MR. STONE. Thank you, Mr. Chairman. Some signs of slower growth have begun
to emerge in the District’s economy since our last meeting, most notably in manufacturing. The
region’s manufacturing activity slowed sharply in June based on reports concerning both
shipments and new orders. Other sectors where modest signs of slowing have occurred include
retail, banking, and both residential and nonresidential construction. Employment growth has
also slowed recently. Nevertheless, the District’s economy overall continues to operate at a
high level and labor markets remain very tight. Unemployment rates in the District are now
slightly below the national average. Anecdotal evidence suggests that tight labor markets are
increasingly perceived by businesses as a constraint on growth. Our District’s ocean resort
areas, which normally rely on U.S. students to fill summer job openings, have needed to bring
in foreign workers and to recruit senior citizens to offset the shortage of available students.
Businesses continue to report upward pressure on wages. In addition, increases in health care
costs are often mentioned as an even greater concern. Manufacturers continue to report rising
input prices, but many still note the inability to pass on these rising costs because of competitive
pressures. Some manufacturers, however, have been able to put through what they call selected
moderate price increases and some have reported adding surcharges to their base prices based
on specific input cost increases. Other manufacturers have responded to higher input prices by
searching for lower cost suppliers, primarily through the use of the Internet, as a way to
maintain profit margins.


Comments from business people around the District suggest that good economic
times have made people less wary about the riskiness of some business ventures. A principal
with a venture capital firm reported that there are still plenty of investors looking to put their
money at risk and plenty of entrepreneurs, primarily in technology, looking to take investors’
money. But, there is at least some greater attention being paid to how those ventures might
become profitable. Our contact said he believes the days of irrational exuberance are over and
now we just have exuberance. A banker noted that he believes the economy is near a turning
point based on his investment index. He observed that when one sees doctors and lawyers
investing in and opening new restaurants, a slowdown is usually around the corner. [Laughter]
Other bankers have noted that business borrowers are more frequently falling short of their
revenue targets and profit projections than they were a year ago. Despite these concerns about
risk-taking and despite recent signs of slower growth, most businesses are optimistic that the
region’s economy will continue to grow at a good pace during the rest of the year.
Turning to the nation, our economic outlook for the remainder of the year and for
2001 is similar to the Greenbook’s in terms of real GDP growth and the unemployment rate.
We are slightly more optimistic about core inflation but agree that monetary policy will have to
tighten further before we are through. The signs of slower growth in the recent monthly
economic data for the nation are encouraging but not conclusive. In past years in this expansion
we have seen signs of a slowdown and then the economy has rebounded and grown very
strongly again. So, it’s too early to say that the economy is definitely slowing to a sustainable
pace and that inflationary pressures are abating. Most measures of inflation over the past twelve
months are higher than they were a year ago, suggesting that we ought not be complacent that
inflation will not accelerate. What’s more, the most recent increases in oil and gasoline prices


will mean higher CPI and PPI inflation figures in the months ahead. In my view the risks of
greater inflationary pressures, potentially leading to expectations of increasing longer-run
inflation, remain our primary concern. Thank you, Mr. Chairman.
CHAIRMAN GREENSPAN. Thank you. President Jordan.
MR. JORDAN. Thank you. The best way to summarize the sentiment of executives
of older manufacturing industries in our region is “hostile.” Following the surprisingly strong
demand that we saw in the second half of last year and the first quarter of this year, it was
probably inevitable that the inflection from that, when it came, would catch at least some
manufacturers by surprise. And they are embarrassed, one might say, about having extrapolated
a pattern that was clearly unsustainable. As I’ve noted before, manufacturing employment in
our District is much higher as a share of total employment than the national average, and that in
turn is concentrated primarily in motor vehicles and their suppliers. So when truck and auto
sales are rising and rising rapidly, order books are filling up and everyone is happy. But when
truck sales start to decline first--and they have--and then auto sales ease back somewhat, as they
now have, inventories rise and new orders are weaker. Production levels in the current quarter
are going to be reported out as quite good, probably at record highs. But manufacturers are very
grumpy about the order book outlook for the second half of the year. Steel production in the
current quarter and the entire first half was very high. But in that industry inventory levels also
are high and rising, and weak incoming orders together with those inventories are putting some
downward pressure once again on steel prices. A nationwide distributor of carpets and other
floor coverings has reported that sales in this quarter are running about 8 percent below sales in
the same quarter a year ago. That’s in line with what Jack Guynn was saying about housingrelated industries. A banker claims that he’s seen a noticeable slowing in commercial loan


demand and he expects overall growth of earning assets to be very slow to nonexistent in the
second half of the year.
Generally, labor markets in our region were described by our contacts as less tight
this spring than previously. A survey of tourist destinations around the region, notably the
amusement parks and other places that typically hire thousands and thousands of young
people--or increasingly retirees--to work during the summer months, said that they did not have
difficulty hitting their hiring targets this year. They’ve stepped up their programs for recruiting
foreign employees; up to about one-fourth of their total summer labor force is comprised of
foreign students they bring in for the summer. It’s now reported that one can hire construction
workers in Ohio. They are available as long as the employers speak Spanish. Another director
reported that all the horse farm workers he sees in Kentucky are Spanish-speaking. We have
flexible labor markets!
Let me turn to the national economy. A year ago at this time, getting ready for the
midyear meeting, I was bothered by a general lack of caution on the part not only of bankers but
their customers--though the bankers would usually attribute that attitude to their customers. We
would ask the bankers how well positioned their customers were for an upward shift of 100 or
200 basis points in the yield curve. They said their customers’ response would be, “You don’t
get it. Interest rates can never go up again because inflation can never go up again because we
have a new economy a new era” and so on. And even if the banker made a sincere effort to
instill a bit of balance to the customers’ perspective of the risks that were involved, the message
was difficult if not impossible to convey. I don’t sense that at all now. I think we have
delivered a very effective and important wake-up call to people that there are various risks
associated with their business behavior and their household behavior. I think that is healthy and


I believe it will help to sustain this expansion. Even the post May meeting commentary about
how high we might have to see rates go, as wrong as it turned out to be, was constructive to this
process of rebalancing people’s assessment of the risks. People have learned that stock prices
can go down. They have learned that IPOs can fail and that even dot-com companies can go out
of business. Some businesses have learned that sales can decline. And we are probably going
to see that workers will learn that layoffs can and do occur. All of that I think is healthy to the
kind of decisionmaking that we ought to be seeing.
The surge in nominal spending growth in the second half of last year, which carried
into the first quarter of this year, was not forecasted and was probably unforecastable.
Unfortunately, we may have accommodated more demand than we would have liked. But it
didn’t continue. At our May meeting it was only conjecture that the acceleration might have
been moderating, but the data in the weeks since the May meeting have gone in the direction at
least of suggesting that we may have had an inflection there. While I agree with Cathy
Minehan’s comments about not over-interpreting the data of recent weeks or the couple months
of the spring, they do at least point in a slowing direction and we ought to be aware of that.
And the anecdotal stories that I’m hearing in my part of the country suggest that the second half
is going to be quite a bit weaker. As we know, surprises can have negative signs attached to
them as well as positive signs.
Let me make a couple of comments on oil prices. Even though oil overall is a
smaller percent of our GDP than it was 25 years ago when we were hit by the oil price shocks,
it’s still a significant factor. When oil prices to any importing country go up, and go up so
sharply, if the wealth lost to us in terms of trade is changed there are wealth redistributional
effects internationally. But probably more importantly, there are redistributional effects within


our country--by sector, by industry, and certainly by region. The effects are not at all uniform.
A couple of years ago manufacturers in our part of the country were quite happy with oil prices
of $10 to $12 per barrel. In Bob McTeer’s and Jack Guynn’s Districts they weren’t quite so
happy with those prices. Well, the situation has turned around. Maybe it will turn around
again; I don’t know. But for the moment we are seeing a lot of dislocations that I think will
take some time to work through the economy. Quite aside from the direct and indirect effects of
energy prices are the effects on various price statistics. There are differing implications for
consumption and production.
As for inflation trends, I suppose I’m not as worried as some of the commentators
I’ve heard today seem to be that inflation is definitely on a rising trend. That may be because a
couple of years ago I never believed that the core inflation rate was as low as indicated by some
measures. We may have regretted that we didn’t lock in a sustained lower inflation rate in an
opportunistic way, but the domestic and international situation simply didn’t allow for that.
Nevertheless, the movement up may be simply a return to the kind of trend that was actually
built in based on basic monetary fundamentals anyway. So I’m not as convinced that inflation
is accelerating from where it is.
CHAIRMAN GREENSPAN. President Broaddus.
MR. BROADDUS. Thank you, Mr. Chairman. Like many others who have
commented this morning, in looking at the regional information we’ve received since our last
meeting I’ve tried to focus particularly on whether the District evidence is consistent with the
national evidence that the expansion may be slowing a bit. And to some extent I think it is. But
I have to tell you that the reports are still very mixed.


In order to get a closer look at residential construction activity, we contacted last
week a fairly sizable number of real estate people and builders to see what they could tell us.
And it does appear that residential sales and building activity may have peaked sometime earlier
this year in our District. Several builders told us, as did the people you talk to, Jack, that they
have projected a big drop in their firms’ activity for the remainder of the year. But others told
us that to date they have not experienced a substantial softening in demand. A couple said they
still had more work than they could handle. And though I don’t have good hard data on this, the
anecdotal information I get on sales of existing homes is consistent with the national number
released yesterday. Sales still seem to be fairly strong and prices are rising. In the
nonresidential sector, one of our directors

reported that he is undertaking a

project on which the bids received were much, much higher than had been anticipated, mainly
because the general contractors to whom they are talking can’t find adequate subcontractors.
So, that’s the housing and construction part of it. Again, the reports are mixed and do not give
us a very clear picture at all.
Probably the strongest evidence we have of diminished activity in our District is in
sales of cars, furniture, and other consumer durables. From a number of car dealers we talk to
and from our directors we have reports of weaker car sales--and in one or two cases,
significantly weaker sales. But, as others have mentioned, it’s very hard at this point to get a
clear sense of whether this is likely to be a persistent decline or something more temporary,
following the extraordinarily robust sales increases we had in the first quarter. Labor markets
are still very tight in our District. Reported unemployment rates at the state level have drifted
up slightly in some of our District states, so that may mean that the situation is not getting any
tighter. But overall we don’t have a sense of any real sea change in labor markets in our area.


My final comment on the region is that we’ve had a lot of reports that business people generally
are much less optimistic now about near-term prospects than they were earlier in the year, due
to all of the things one would expect--rising interest rates, real estate prices, and so forth. But I
have the sense that sentiment could turn back up pretty quickly if we got a break on fuel prices.
I think the rise in those prices is playing a large role in attitudes currently.
My views are similar on the national outlook. There are signs that demand may
finally be moderating somewhat, but at this point I think we have to regard these signs as
essentially very preliminary. It’s not at all clear to me--and others have said this--whether the
moderation is going to persist and we will see a decline in the underlying trend growth of
domestic demand or whether it’s just a temporary deceleration. In that regard, I think it’s very
important to remember that we had a 10 percent annual rate of increase in domestic final private
purchases in the first quarter; and in a series like that, some offset in the next quarter would be
expected. So, I think the Greenbook projection of real GDP growth at close to potential for the
remainder of this year makes a lot of sense. And while the recent data may indicate that the
risks to the projections of real growth may be a little better balanced than they were two or three
months ago, I believe they are still probably skewed to the up side. In contrast to Jerry Jordan,
though, what I see in the price data in a somewhat longer-term context is an emerging trend of
higher core inflation and deteriorating prospects for inflation that I find worrisome. I certainly
would acknowledge that we’re not confronted with any kind of breakout in inflation yet. But as
I see it, both the core PCE and the core CPI now appear to have moved to a higher underlying
pace than in recent months. The baseline scenarios that we were discussing a bit earlier show
that in a fair number of different scenarios--and in a couple of cases even with a significant
further tightening in monetary policy--we get a continued increase in core inflation. Further


increases in trend productivity growth going forward may bail us out. But all in all my guess is
that the risks on the inflation front are higher now than we’ve seen in some time. Thank you.
MR. STERN. Thank you, Mr. Chairman. As far as the Ninth District economy is
concerned, the objective measures of economic activity remain very positive. Let me just give
you one fairly familiar example of this. Over the past year employment gains have continued to
be substantial; and unemployment rates in virtually all District states are at the same levels or
lower than they were a year ago--and they were quite low a year ago. Furthermore, this has
occurred with some sizable gains in the labor force. Other objective measures, whether we look
at manufacturing, construction, or consumer spending, all remain quite positive. The anecdotal
evidence is a bit more mixed, I think, and the doubts or concerns are coming principally from
the business community. I would not characterize the consumers in this way, but a number of
business people I’ve talked to recently have expressed some concern about financial market
developments. They obviously know that interest rates are higher. They know the course that
policy has been on. They know that equity values have leveled off and in some cases declined.
I think that has injected a note of caution into parts of the business community that I at least
didn’t detect a few months ago.
As far as the national economy is concerned, it seems to me that the outlook for real
growth remains at least satisfactory. For what it’s worth, our VAR model predicts real growth
of 3-1/2 to 4 percent over the next several years which, if anything, is a bit below the
Greenbook forecast. We also calculate the probabilities of a recession with our VAR, and the
probabilities are all very low. So, its take on the “hard landing” scenario is the same as that
presented by Dave Stockton and Larry Slifman.


As for the inflation outlook, I’m not sure that NAIRU is the right framework for
assessing that. I’ve been struggling with that concept and have been expressing some
reservations about it for some time. It certainly has not distinguished itself recently and I’m not
sure that it has distinguished itself much over the past 15 years or so. But I don’t have another
framework to offer at this point except to say that, presumably, what’s going to happen to
inflation over the next year or two is largely baked in the cake already, apart from whatever
further sharp gyrations we may see in energy prices or something like that. What will happen to
inflation over the next four to six quarters at least is largely baked in the cake and, though it
may not be popular to say this, beyond that it seems to me that the money supply ought to
matter increasingly. That may not have any unusual policy implications. That is, if one thinks
about what rate of monetary growth is appropriate with this kind of economic outlook, the
interest rate implications may be about the same as they are if one believes in the NAIRU
framework. But I haven’t worked out that exercise, so I suppose I have to leave that as a
question rather than a conclusion.
MR. POOLE. Mr. Chairman, my anecdotal information from the Eighth District
suggests that the situation is largely as it has been, except for some modest--and I emphasize
modest--slowing in the housing sector. I found the reports from my contacts at FedEx and UPS
interesting because both of them talked a lot with customers about their likely volume
requirements in the fall, which is of course the busiest season for both firms. In each case they
are expecting volume to continue very strong and, if anything, stronger than it has been. My
contact at UPS said he believes that particularly in December UPS is going to be pressing on
capacity. The company plans to work with the firms for which it ships goods in order to try to


move the shipping schedules up a bit, but UPS expects demand to be pretty vigorous. I heard
the same sort of message from FedEx. My contacts from both firms also mentioned the
pressures from rising fuel costs. FedEx has had a fuel surcharge in place for some time and sees
no effect on its volume from adding that surcharge. Of course, these reports from both firms are
confidential, but I was told that UPS is expecting to announce soon a fuel surcharge on its
package shipments, a fee it has not as yet had in place.
Both firms emphasized the difficulty that they continue to have in finding entry-level
workers. Although that situation is not new, it continues and, if anything, has become a bit
more intense. My UPS contact gave me a really good sense of what this has meant at his firm.
Most of the entry-level people, who sort packages in their hub locations, are part-time college
students. In fact in Louisville, as some of you may know, UPS has an arrangement with the
University of Louisville for classes to be held in the afternoon so the students can work in the
middle of the night for four hours unloading and loading planes. The straight wages for these
employees are probably in the neighborhood of

on top of that for

signing bonuses, attendance bonuses--if they stay employed with UPS for six months or
whatever--and tuition reimbursement. So the wage costs that are not explicit--those not going
out in the paychecks--involve supplements that have now risen to
is pretty amazing for people who are earning

which I think

as the standard wage. And this

same contact in Louisville said
to give you an idea of the labor force shortage that they are dealing with. I had a similar
kind of report from FedEx. My FedEx contact said that they also are having problems signing
up middle management employees. Finally, both firms expect their volume to continue to be
very strong, both in their international and U.S. businesses.


Let me go back to our discussion of the NAIRU and make a few comments.
Obviously, in a macroeconomic model, everything is simultaneously determined. So I want to
start off by saying that I understand that. But I think there are two different conceptions of
NAIRU that more or less have the causation running in opposite directions. The traditional
NAIRU formulation views the wage/price process as running off a gap--a gap measured
somehow as the GDP gap or the labor market gap. And the direction of causation goes pretty
much from something that happens to change the gap that feeds through to alter the course of
wage and price changes. I think there is an alternative model that views this process from an
angle that is 180 degrees around. It says that in an earlier conception, either through a
determination of a monetary aggregate or through a federal funds rate policy, monetary policy
pins down the price level or the rate of inflation and, therefore, expectations of the rate of
inflation. Then the labor market settles, as it must, at some equilibrium rate of unemployment.
Where the labor market settles is what Milton Friedman called the natural rate of
unemployment. But the causation goes fundamentally from monetary policy to price
determination and then back to the labor market rather than from the labor market forward into
the price determination. I certainly view the causation in that second sense. I think it is the
willingness of the Federal Reserve to stamp out signs of rising inflation that ultimately pins
down expectations of the price level and the inflation rate. Now, the labor market has been
clearing at a level that all of us have found surprising. But I don’t think that necessarily has any
particular implication for the rate of inflation, provided we make sure that we are willing to act
when necessary. As long as inflation expectations remain well under control and we are willing
to move, I think that pins down the rate of inflation in an adequate way. I understand that
everything is determined simultaneously, but I think there are two rather different directions of


causation that people have in mind. In the macroeconomic model used here, if we can count on
some way to arbitrarily pin down the expected rate of inflation, we can then solve the model
quite satisfactorily. Again, that’s an assumption that one puts in the model, but I think it flows
from the monetary policy that is being pursued. Thank you.
MR. HOENIG. Thank you, Mr. Chairman. Let me begin by noting that economic
activity in the Tenth District is still very solid. Having said that, it is also true that we are seeing
mounting evidence of slowing trends within the region. It starts with manufacturing, which
certainly has slowed, with firms clearly reporting smaller usage of capacity. Our latest surveys
of purchasing managers in the region--in the front range of Colorado--suggest that
manufacturing activity is slowing fairly substantially, at least more so than the national average.
Also, in some of the conversations we’ve had, business executives have indicated that some
projects are being deferred. We are also seeing evidence that retail sales have softened. In
addition, housing activity, which had weakened in April and May, is reported to have weakened
in June as well. Nonresidential construction activity remains relatively strong, but many of the
executives in that industry are telling me that a more cautionary attitude has emerged and that
they are expecting some slowing as recent interest rate moves begin to have a greater effect on
them. Our energy sector is benefiting from the current level of prices, especially the gas drilling
area, which is fairly active. But in that industry, of course, there has been a downsizing from
earlier periods, so it is harder to get skilled labor for drilling operations and, therefore, activity
is coming up rather slowly. One

involved in gas drilling

in a fairly significant way says that inventories are low now. Consequently, if demand were to


be strong as we go through the year, he feels there will be a surge in prices of natural gas as we
move into the winter.
District labor markets still are tight. We don’t hear quite the sense of urgency about
that situation as before but labor conditions clearly are very tight. And price pressures are
similar to what we’ve reported in the past: There are some efforts to raise prices but still a lot of
competitive pressure holding them down. Our farm industry, especially on the commodity side,
remains weak. But with recent additions to government payments, farm incomes will be steady
Turning to the national scene, recent indicators, in conjunction with various
developments in the District that I’ve mentioned here, leave me with the very clear impression
that the economy will slow and that recent inflationary pressures should ease over time.
Specifically, I have revised down my outlook for growth this year and next and am now
projecting about 3-3/4 percent for GDP growth over the forecast horizon. That is only slightly
below estimates of trend growth. However, unlike the Greenbook, we get those projections
with a fed funds rate that remains at its current level. There are a number of reasons for this
likely slowing, in my view. One is the moderation in stock market gains; another is the increase
in real interest rates. Certainly, the elevated oil and gas energy prices are a factor. And most
importantly from my perspective are our recent increases in the funds rate and more restrictive
monetary policy. While the evidence we are seeing is still mixed, I think we do have more hard
statistical evidence of a slowdown. Also, I am hearing more views from business people, as in
the examples I cited earlier, that higher interest rates have led to a slowdown in economic
activity and a change in business sentiment that I think is important.


Regarding the inflation outlook, I am aware that the effects of our previously
accommodative monetary policy and the passthrough of oil prices to the non-energy sectors are
continuing and will put some upward pressure on core inflation in the near term. But I am also
convinced that we will not necessarily see an acceleration in core inflation because we have
moved to a more restrictive policy over this past year and that tightening has not had its full
impact on the economy as yet. As long as we remain restrictive for some period of time, the
increase in inflation should be temporary, I think, rather than permanent. I’m looking for
inflation this year to be under 2 percent, as measured by the core PCE, and to rise somewhat, of
course, as we go into next year. But I don’t see an acceleration in inflation. I think we should
be mindful of that as we contemplate policy. Thank you.
MR. MCTEER. The economy in the Eleventh District has begun to show the same
signs of slowing as the rest of the country. Retail sales decelerated in May, which contacts
attribute to higher interest rates and weakness in the stock market. Private employment growth
has been weaker, although this may be the result of Census workers crowding out growth in a
very tight labor market. Higher interest rates continue to further the slowdown in the Texas
construction industry that began earlier this year. Despite the slowing in these interest-sensitive
sectors, the Texas economy overall has been chugging along nicely. A strong forward
momentum stems from the rebound in the energy and high-tech sectors. The energy sector
continues to respond to higher oil and natural gas prices. Oil price fluctuations have grabbed
the headlines but the strength of natural gas prices is the key to the health of the U.S. and Texas
energy industries. Environmental regulation is prompting electric utilities to stay with natural
gas even as its price has risen. Consequently, spot prices for natural gas have risen sharply and


the futures market suggests that current prices will be sustained until early 2001. In both Texas
and the nation natural gas continues to dominate drilling activity, which should remain strong in
the foreseeable future. On the oil side of the energy industry, strong crude oil prices and low
inventories of gasoline have combined to push up gasoline prices. Refineries will be running at
capacity to keep up with the demand for the duration of the summer. These forces have helped
the Texas energy industry to recover from the depressed levels of activity in late 1998 and much
of 1999.
The high-tech sector continues to rebound with the resurgence of the Asian
economies. Another surge of investment in new chip-making capacity is getting under way,
especially in Austin. That has prompted the Austin Chamber of Commerce to devote its efforts
to recruiting workers instead of companies to move to Austin. The wild card in the outlook for
the Texas economy is Mexico. The Mexican economy has been quite strong, but the usual
uncertainties--and then some--surround their presidential election on July 2nd. For the first time
in over 70 years, the outcome of the election is too close to call. And the possibility of political
turmoil is contributing again to concern about capital flight and a subsequent devaluation of the
peso. The cash manager of our San Antonio branch recently visited several border banks and
reported that Mexicans are holding increased levels of U.S. dollars, most likely in anticipation
of another peso devaluation. If there were to be a correction in the peso’s value, it would
hopefully be smaller this time around because the central bank has a much higher ratio of
foreign reserves to its monetary base, in contrast to the situation they had at the time of the last
crisis. This year’s run-up in oil prices, of course, is also helping the Mexican economy.
Turning to the national economy, our projections for growth and unemployment this
year are pretty close to the staff forecast. But I do see less inflation because of continued


productivity gains and no subsiding of competitive pressures on pricing. For next year our
outlook is for a continuation of growth at a rate comparable to this year’s, but with no
acceleration of inflation. From a policy perspective, the economy is at a delicate stage.
Interest-sensitive sectors are showing signs of a slowing in demand growth. Given that we’ve
recently put additional tightening into the pipeline, there could be considerable benefit to
waiting a while to judge the impact of what we’ve done. Core inflation this year is about where
it was prior to the Asian crisis. And absent the inflation spike that showed up in the numbers
for March, the inflation trend thus far in 2000 does not seem alarming. Given that the inflation
threat is neither severe nor immediate, the risk of adopting a wait-and-see posture seems
CHAIRMAN GREENSPAN. Governor Gramlich.
MR. GRAMLICH. Thank you, Mr. Chairman. It seems to me that this meeting is
much more about NAIRU than any of the other meetings we’ve had, at least in the recent past.
Until now the real economy has been rocketing ahead at a seemingly unsustainable rate and
there was at least a whiff in the air that underlying inflation was picking up. Now real growth
has slowed, quite quickly in fact, and the signs of acceleration in inflation do not look so strong
either. It is at least possible that the Fed has already done enough tightening and that we can
stand back and examine our work.
There are grounds for thinking that we have done enough already. If the long-run
core inflation rate is about 2 percent and the long-run real interest rate is around 4 percent-which can be read from either the TIP market or inflation-corrected nominal interest rates--the
nominal federal funds rate should be at least 6 percent for a balanced economy. Throw in 50
basis points for leaning against the wind or adjusting for the balance of risks and we are at the


present funds rate. In forecasting out at this funds rate, the Greenbook estimates that real
growth slows to 4.2 percent for next year, arguably close to the staff’s estimate of the growth of
aggregate supply. Hence, the unemployment rate drops only slightly in the flat funds rate
scenario of the Greenbook forecast. Even though the Greenbook as a whole does not point to
the wisdom of this particular policy approach, it suggests that there is at least the chance that
such an approach to policy will generate stable, noninflationary growth. But such a monetary
policy would be very unwise if the economy’s unemployment rate is still below NAIRU.
According to the Greenbook forecast, and even more the FRB/US econometric model, NAIRU
is still above 5 percent--well above in the case of the FRB/US model. If NAIRU really is that
high, we should view the present lull as just a temporary phenomenon and we should still be
tightening policy.
While I strongly believe that monetary policy should be preemptive and have been
generally on the hawks’ side of the issue when real growth was rocketing ahead, for a while
now I have not been convinced that the economy’s 4 percent unemployment rate is much below
NAIRU. In the econometric research you have all heard about, most fixed coefficient estimates
give a NAIRU of 5 percent or higher. The Kalman filter variable coefficient estimate of
Brainard and Perry has NAIRU down to 4 percent. But when the staff tries a similar approach,
they still get NAIRU estimates above 5 percent. Stock and Watson, and I suppose Greenspan,
find the whole exercise quite unconvincing and argue that whatever the estimate, it has
enormous standard errors. Much as I like econometrics, I’m afraid that I’m on the skeptical side
on this issue. The unemployment rate first dipped below the Greenbook estimate of NAIRU in
late 1996, three and one-half years ago. And yet the signs of acceleration in either prices or
wages are still rather scant. We have talked about these signs often and I worry about them as


much as anybody, but I think “scant” is the operative word. Some temporary factors slowed the
core inflation rate in 1998 and 1999 and these factors have now reversed, showing up as
somewhat higher core inflation in early 2000. Abstracting from this reversal, there has been
some but not that much of a rise in core inflation. Unit labor costs have decelerated up until
now, though Larry Slifman gave a disquieting forecast of this measure for the future. At the
same time he also gave some quieting information on items in short supply.
Nobody has mentioned long-term inflation expectations, but they have been
remarkably stable, remarkably unresponsive to the oil price increases. In addition, the Treasury
nominal/real interest rate spread looked as if it was increasing last month, but it has moved back
down to fairly acceptable levels.
Let me make one further comment on the hard landing scenario. While the risk of
recession was the last thing on everybody’s mind last month when the economy was rocketing
ahead, the sharp drop in real growth at least raises this issue. Given the strength of the present
investment boom, I am inclined to downplay any risk of recession. But the Committee should
be mindful of the risk of overshooting. Policy should be preemptive on the down side as well as
the up side.
Putting all this together, it is possible that the Fed has already done enough, that the
funds rate is already high enough to stabilize the economy. But I emphasize the word possible
because there is still significant risk that the NAIRU could be in excess of 5 percent and then
inflation could begin to heat up or, in Bill Poole’s terms, that the Fed won’t be perceived as
being tough enough on inflation. For now at least, I’m fairly comfortable reverting to our
previous watchful waiting mode, giving strong signals that we still think the balance of risks is


on the up side and that we are prepared to take appropriate action if the data become
disquieting. Thank you.
MR. KELLEY. Thank you. Mr. Chairman, we’ve been seeking a slowdown in the
expansion for a long time and perhaps we have it at last. Often when the economy moves into
what could be a paradigm shift, this Committee must go through a period when it is uncertain
about how to read the course of events. This appears to be such a time when policy decisions
have to be made. Please be patient with a 20 second review of recent history. In the fall of
1998 we eased policy not because a weakening economy called for it, but rather in response to a
looming international crisis that required quick, strong action. The pre-existing level of the fed
funds rate was restored over the second half of 1999, but the easing was no doubt a factor in the
strong surge of growth from mid-1999 until now. So far this year we have taken rates 100 basis
points higher, with half of that done only a month ago. Today the easing of 18 months earlier is
going away and the increases of the past five months are kicking in. If we believe it is certain
that further tightening will be required, it might be best to push ahead right now. Alternatively,
if we believe the opposite, we ought to tell that to the market with a symmetric statement and a
no change directive. But it is probably not that simple. We are in what I would call “maybe”
time. Maybe productivity will continue to be so strong that costs will stay in line and
overheating avoided for some time to come. Maybe the NAIRU in this era is a lot lower than
we thought and consequently the danger we perceive from it is a lot less than we believe.
Maybe the consumer, having bought everything in sight and run his and her debt service load
back up to the old record levels in the process, will continue to buy but at a more subdued pace
and thus will extend the moderating consumption pace of recent weeks. Of course, all these


suppositions could flow the other way. Maybe consumer spending, capital expenditures, and
the stock market, joined now by exports, will go ballistic again. Maybe, maybe, maybe. All
these maybes plus $3 will buy you a grande size latte at Starbucks! [Laughter]
But the good news is that there are some important certainties and near certainties. In
my opinion, near certainty number one is that inflation likely will creep up further but is
unlikely to explode in our faces over the forecast period. Near certainty number two is that
sales of housing and autos, two large cyclically sensitive sectors, are both slowing from their
peaks and seem likely to stay at lower levels for some time. Near certainty number three is that
the federal surplus is burgeoning and will provide a drag on growth at least through the early
months of the next Administration, which is our forecast horizon.
Certainties in my opinion include number one--while we know little about it as yet-that there is a slowdown of unknown magnitude presently under way. Certainty number two, as
we know of course, is that there is a substantial additional impact still in the pipeline from
tightening already in place. And certainty number three is that by our August meeting we will
be in possession of a large amount of invaluable additional data. We will know all about the
second quarter, including GDP, ECI, unit costs, and corporate profits. And we will have June
and July employment reports, data on consumer spending, and inflation numbers, among other
All of this tells me, Mr. Chairman, that before moving ahead we are in need of more
data and some time to assess it. Fortunately, both economic conditions generally and the
calendar seem to be ready to accommodate us. Thank you.


MR. MEYER. As you know, I love talking about macro modeling and I love talking
about NAIRU, and I like talking about the outlook too. But first things first. Let me start by
responding to President Poole's comments about whether there might be two different models of
the causal process of what determines inflation. I think there is only one model; I may not
convince you of that, but let me try to explain my reasoning. The Phillips curve is not a model
of what determines inflation. The vertical Phillips curve tells us that inflation is indeterminate
in that model. All the Phillips curve tells us is when inflation is constant, when it is rising, or
when it is falling. It's a model of the dynamics of the inflation process, but it's incomplete as a
full model.
What about the causality from money to prices? Well, that's very important. That's
an equilibrium relationship, which helps to pin down where along that vertical Phillips curve
inflation will really be. But what gets you from one inflation rate to another when money
growth changes? We have to have that dynamic model. That is what the Phillips curve does.
We need both parts. So the problem we have is that even with all of the skepticism about
NAIRU, we should understand that if we throw that concept away, we don't have another model
at this point, as I think President Stern suggested. That's the problem. Now we can still
question what the value of NAIRU is, but let's think for a minute what would be the situation if
we really believed that NAIRU was 4 percent. Then I would have to be asking myself: How
come inflation is so high? A core CPI inflation rate of 2.4 percent on a methodologically
consistent basis would be the same as it was in 1995. Now, during that period since 1995, the
unemployment rate was above NAIRU. We had all kinds of relative price shocks that were
lowering inflation. We got a productivity shock that was lowering inflation. So, how come


inflation is so high? One thing to keep in mind if we don't believe this framework is that it’s not
clear why we would bother to tighten if we wanted to slow down inflation.
Let’s move on to the outlook. I think the slowdown that's clear in the second quarter
raises two important questions for the Committee. The first is whether it is a pause or a more
sustainable slowdown. And if it is more sustainable, the question is whether it is sufficient to
achieve our objective of containing the risks of higher inflation. Now, I describe the May
employment report as incredible--meaning literally that it is not believable. It is not believable
that private payrolls in effect fell off the cliff in May, a cliff that was elevated by the sharp
increases over the previous two months. That's not to say that there isn't information content in
that report, but it makes sense at least to smooth the data to get a better sense of the underlying
reality. Granted, we don't know whether we should smooth it backward or forward. Usually
smoothing it in both directions will be the norm. I think there is plenty of reason to smooth it
going backward because the economy soared in the previous three quarters to a degree that was
unanticipated by forecasters and their models. So part of this slowdown could simply be a
smoothing out of growth to an average more in line with fundamentals, in the process taking it
below the underlying rate for a while.
Now, as a private sector forecaster, I have to admit that I was frequently confronted
by unexpected data, data that contradicted my forecast. And in each case I had to decide how
much to respond by altering my forecast and changing my story. I developed two rules that I
believe served me well. Now, certainly, one could change the current-quarter forecast. The
question was what to do about the forecast over the next year or two. Rule number one was that
when the data disconfirm your forecast, initially you ignore the new data and defend the old
forecast. This is not simply stubbornness. Well, it's stubbornness to a degree, [Laughter] but


it's not only stubbornness. It also involves the recognition of the volatility in high frequency
data, the difficulties associated with seasonal adjustment, and the potential for revisions or
reversals in the data. Rule number two was to know when to say when. That is, when the data
continue to contradict the forecast, it is time to change the forecast. Otherwise, clients tend to
change their forecasters! And of course, really good forecasters know when to shift from rule
one to rule two.
As a forecaster, I'm still operating under rule number one, and I think the staff
appears to be following the same strategy. As was just noted, some slowdown was expected,
whether beginning in the second or the third quarter, after the unexpected and indeed
inexplicable surge over the previous three quarters. Now, part of this slowdown could also be
the cumulative effect of monetary policy tightening. But I think Chart 2 in the staff's outlook
packet suggests that tighter financial conditions cannot explain much of the second-quarter
Presumably, there are good rules of thumb for how policymaking should respond to
unexpected economic developments. In this case, I don't believe rule number one would be to
ignore the new data and continue to set policy based on the old forecast. The new data at the
very least raise the degree of uncertainty about the forecast. And this high order uncertainty
may reasonably justify a more cautious policy response to the old forecast. This difference
reflects the fact that the forecast is the mode of the probability distribution associated with the
outlook, while policymakers should take into account the full probability distribution associated
with the forecast.
Let me turn to a few comments on the inflation outlook. I was also quite surprised by
the very small increase in average hourly earnings in May. It altered my story, and I hate that!


And it interrupted what appeared to be a definitive change in the trend in the series, based on
the fact that average hourly earnings had increased at a 4-1/2 percent annual rate over the first
four months of the year, following a 3-1/2 percent rate over 1999. With the May data we have a
3.8 percent rate over the first five months, so the case for a change in the underlying trend is
less definitive. It seemed to me that this stable pattern in average hourly earnings contradicted
the anecdotal reports, which have been suggesting that pressures for wage change are building.
This contradiction was driven home in this room not too long ago when I had a
meeting with state bankers as part of one of the state banking association meetings. It was a day
after I had given my last outlook talk. The head of the bankers group took out a newspaper
article about my talk, which began by identifying me as an inflation hawk. It then went on to
report that I had said the data did not yet indicate a clear pattern of rising wage gains. He
wanted to have a little fun with me, obviously, so he said: What kind of a hawk is it who can't
see the clear change in wage pressures in the real world? I'm going to help you out, he
continued. We’re going to go around this table and we're going to let everybody straighten you
out. So, everybody at the table gave his or her story about how much wages were going up,
how many workers they were losing, what percentage wage gain those workers were getting
when they moved to their next job, and what it meant for recruitment and training costs to
business firms. To be sure, their view was that what had happened to date was raising wage
pressures and compressing profit margins, not increasing prices. So, I think it's interesting that
on the wage side the anecdotal stories seem to have become clearer but the data remain mixed.
On the price side it's just the reverse; the anecdotal stories about pricing leverage still suggest
that price performance remains fairly good. But it seems to me that the data on prices are clear
and that inflation is rising. It is rising whether one looks at overall inflation or at the core


inflation measures. I think President Parry made a very good point that the increase in inflation
to date, in core measures as well as the overall rate, can be pretty well attributed to the primary
and now the secondary effects of higher energy prices. So the impact of these rising wage
pressures has not been definitively felt yet on inflation. But in the staff forecast it will be, and
that is my judgment as well. Therefore, in the context of tomorrow's policy decision, the
tentative signs suggest some slowing in the economy of yet uncertain persistence and
dimension, but still with very tight labor markets and already rising trends in inflation.
CHAIRMAN GREENSPAN. Governor Ferguson.
MR. FERGUSON. Thank you, Mr. Chairman. I suppose I'm fortunate that I have
never tried to make a living as a forecaster because it's easier for me to look at the incoming
data as opposed to trying to throw it out. And based on what I've seen, my view is similar to
what others have said in that I believe there are some early signs of slowing out there. They
have appeared in the interest-sensitive sectors of housing and motor vehicles. Also, and I think
importantly, the most recent incoming data suggest that consumer confidence is starting to wane
a bit.
To me one of the major questions about the second quarter has come up a couple of
times in this discussion. And that is whether what we are seeing is simply the slowdown that
was to be expected after very rapid growth in the first quarter, whether it reflects some residual
seasonality, or whether something else is going on. One of the things I did during the recent
intermeeting period was to ask the staff to give me at least a sense of any evidence of residual
seasonality. They've done that. And in what they've shown to me, at least looking at this over
longer periods, there doesn't seem to be any systematic trend for the second quarter to be much
slower than any of the other quarters during the course of a year. So I think we can probably


rule out any systematic seasonality here. I think it is still possible that what we saw in the
second quarter may have been a bit the result of weather-related changes and some other special
factors that we can't pick up econometrically. But having said that, I'd still put a little weight,
and perhaps others have as well, on the fact that we see some early signs of a slowing. The
other place I would look for evidence of slowing is in the yield curve from the private sector
where--again using a normal mode of interpretation--those in the private sector seem to be
telling us by their behavior that they are seeing some slowing as well.
The final thing one might look to for evidence of a slowing is the interaction between
these very high gas prices and what one might expect from consumer behavior. Again, working
with the FRB/US model, it seems as though the increases we've seen in oil prices amount to
somewhere between $40 and $50 billion less money available for consumers to spend going
forward. And the effects of that might start to show up as soon as in the next quarter. So I think
there are two or three reasons to feel that perhaps the beginning of some slowing is actually in
sight here.
Having said that, as others have indicated, there also are clearly some signs that the
slowing is not as certain as one might like. Obviously the most recent signals that we've seen
with respect to the housing data suggest some uncertainty about this. Another factor that might
give rise to some uncertainty is that financial market conditions between this and our previous
meeting have become, if anything, a little more accommodative. Net corporate borrowings,
driven by bond issuance, seem to have picked up again during the intermeeting period. Finally,
as others have noted, there doesn't seem to be much let-up in resource utilization, particularly
with respect to the labor market. So we have signs on both sides that I think we need to be
mindful of as we deliberate.


I have two other points to make here. One is that it does seem, as Governor Gramlich
said, that there is a bit of good news in that most of the indicators of long-term inflation
expectations haven't moved up very much during this period. So I think that gives us some sign
that we have a little time on our side. And finally, as the staff presentation pointed out and as
Governor Meyer also noted, it is unlikely that what we've seen thus far reflects the full impact
of the tightening that has been undertaken. So there is, I believe, a certain amount of tightening
impact still left in the pipeline.
In sum, there is a sense that some slowing is in train. It might well continue if one
believes some of the market indicators. While it does appear, as Governor Meyer indicated, that
there is some pickup in inflation, it doesn't seem as though a break out is imminent or that
inflation expectations have gone against us. Nevertheless, since we have worked so hard over
the last year with respect to interest rates, we may have to do some more tightening. But at this
stage I think we could comfortably take a bit of a pause, look at the incoming data a bit more
closely, and judge whether or not the slowing is one with which we are comfortable. In doing
that we should be careful not to signal that we're done, because in fact we don't know for sure if
we're done. Nevertheless, I think we can take a bit more cautious attitude toward possible
further tightening at this stage. Thank you, Mr. Chairman.
VICE CHAIRMAN MCDONOUGH. Mr. Chairman, economic growth in the
Second District is minusculy slower than it was the last time we were together, but the slowing
is almost imperceptible. As I interpreted the comments of other Reserve Bank Presidents, I
think the slowdown in the Second District is not as much as that in other Districts,


On the energy question, I had the good fortune to spend about an hour and a half
today with the energy minister of

and I think his insights are worth

sharing. He feels that there is inadequate emphasis placed on the effects from the period of very
low prices in two respects. First, the high-cost marginal suppliers were put out of business and
will stay out of business, so a part of the available supply simply has shut down and will stay
shut down. Secondly, the normal level of investment in new supply was reduced considerably.
Therefore, until about two years from now, when the current investment in new supply of
petroleum and other energy sources comes on stream, he believes we will continue to have a
fairly high price, unless the Gulf producers decide just to increase their output. In his estimate
they would have to increase production by about 1-1/2 million barrels a day, which does not
seem particularly likely. I note that the gentleman represents a point of view which would
prefer that the energy price be in the $20 to $25 per barrel area, and he is not very optimistic
about seeing that for another 18 to 24 months.
As for the national economy, some slowing appears to be evident, but I think we have
to be a bit careful because the data gave false signals of a slowing in the second quarter in both
1998 and 1999. That’s not unrelated to the fact that we haven't had a serious winter in this
country since 1997 and, therefore, the seasonals tend to give off some funny signals. However,
I think we can assume that the likelihood of some slowing is there. All of the research we've
done, going back to the early 1980s, on how long tightening takes to be effective would lead
one to believe that very little effect of the tightening we've done so far is in play. That’s
especially true if one agrees with the view that the first 75 basis points involved a correction or
undoing of the easing that we implemented, for understandable reasons, in the fall of 1998. So,
if we see some slowing already, with very little of the tightening having taken hold yet, then I


think it would be reasonable to believe that the economy will continue to slow over the future.
However, in my view, the main point is that we should conclude that we have time to watch and
reflect as developments unfold.
It seems to me that over the last several years our best judgment has been that we
have been willing to be reflective when we have been uncertain. Yet at the same time, because
of our firming action in 1994 and 1995 and our firming action in the present cycle, including the
most recent increase of 50 basis points, it seems to me that the Federal Reserve has maximum
credibility. And that gives us an opportunity to watch and wait when we think that that is the
right thing to do.
On the NAIRU, having become an arch skeptic about its usefulness, I went back and
reminded myself of what I had said in our discussions in 1994 when I certainly sounded like a
very true believer in the NAIRU. So if I have turned agnostic, it is a recent change and the
question, therefore, is whether it is enduring or whether I think the NAIRU is on vacation for a
while. I think it's probably the latter and that in fact the NAIRU is a useful tool, which we will
find more useful in the future when we are a bit more certain about how it is functioning and
where it really is.
I bring this up largely because I think we have to be very careful in our statements
about the NAIRU and about an ideal level of unemployment. If one listens to the discussion
today, everybody here, whether skeptical or believing in the NAIRU, views it as a tool and not
as a policy goal. Yet I think many observers, especially journalists, cannot make that
distinction. When we discuss the NAIRU in our public remarks, either in speeches or
interviews, in some cases at least we are coming across as if we believe that we need to have an
unemployment rate of “x”--which is considerably higher than what we have now--and if we


don’t, there is something wrong. The Congress of the United States never put us in the business
of having a certain unemployment rate as our goal. So if we want to use NAIRU as a tool, as I
think we certainly did in the past--some still wish to, and probably most of us will in the future-we ought to be very careful that we're talking about it as a tool and not as a goal. Very clearly,
and I think unwisely, we will lose the support of the American people if they think that what we
are trying to do is to increase the number of unemployed people by 1-1/2 percent of the
CHAIRMAN GREENSPAN. Thank you very much, everybody. Just as a reminder,
the dinner at the British Embassy is at 8:00 p.m. tonight. There will be Board vans at the
Watergate at about 7:30 p.m. to pick you up. Is there more than one set of cars? Does anybody
know whether or not those who are late and miss the 7:30 p.m. scheduled departure have to
walk? [Laughter]
MR. KELLEY. Several vehicles will be there.
CHAIRMAN GREENSPAN. There will be several vehicles. We will see you all at
dinner and then again tomorrow morning at 9:00 a.m.
[Meeting recessed]


June 28, 2000--Morning Session
CHAIRMAN GREENSPAN. Good morning, everyone. We have arrived at the
agenda topic relating to the long-term ranges for the monetary aggregates. As you know, this
topic stems from the Humphrey-Hawkins legislation--a term we no longer use except in an
historical context. Don proposed putting the long-run ranges for the monetary aggregates on the
agenda as a placeholder. But it is my intention, if it is all right with everyone, to forgo both a
discussion and vote on these ranges. We are no longer legally required to do that. The
Committee, as you know, has not been using the ranges for the aggregates to guide policy for
many years. Indeed, in recent years the ranges have become even more questionable
benchmarks for money growth at price stability because of the uncertainties about long-run
productivity growth and about what exactly we mean by price stability. The ranges were a
reporting and accountability mechanism in a part of the Federal Reserve Act that has now
expired. And it now seems that the most likely outcome of a proposal to renew such legislation
will require that we provide semi-annual reports on monetary policy to the Congress but will
not include a requirement for annual ranges.
So, unless I hear objections, I propose that we take advantage of this opportunity to
stop doing something that I sense all of us have become uncomfortable with over the years-establishing money ranges of questionable usefulness that no one takes very seriously, or at
least recently has taken very seriously. It is quite conceivable that such ranges may at some
point be useful again. But I personally feel uncomfortable engaging in an activity of this nature
when we do not actually employ the ranges for the specific purpose of formulating our
monetary policy. I think we have to monitor the various monetary aggregates because, indeed,
there is information in them. And it is conceivable that at some point they will emerge again


with some very useful relationships with respect to opportunity costs and income velocity. At
that point, obviously, we will make more use of them. This is not to say that money is not
relevant for the economy. For a central bank to say money is irrelevant is the deepest form of
sin that such an institution can commit.
The problem is that we cannot extract from our statistical database what is true
money conceptually, either in the transactions mode or the store-of-value mode. One of the
reasons, obviously, is that the proliferation of products has been so extraordinary that the true
underlying mix of money in our money and near money data is continuously changing. As a
consequence, while of necessity it must be the case at the end of the day that inflation has to be
a monetary phenomenon, a decision to base policy on measures of money presupposes that we
can locate money. And that has become an increasingly dubious proposition.
So, unless somebody has comments or objections, this is the way I believe we ought
to proceed, but that clearly is at the Committee's discretion. I am merely putting the issue on the
table for discussion.
MR. BROADDUS. Mr. Chairman, could I make a quick comment? I don't disagree
with your proposal. It is certainly true that in these meetings the operational importance and
significance of the money targets has diminished steadily over the years. And it is tempting to
think of dropping them as a sort of non-event. But I think it is important to keep in mind the
role that these targets played in a longer-term historical context. Given the degree of long-term
correlation between money growth and inflation, one can look on the adoption of these targets
initially in the 1970s as a sort of implicit agreement between the Congress and the Fed that the
Fed was ultimately responsible for containing inflation. In a sense one can think of these
targets--as I do--as the closest thing we have to a formal mandate for low inflation. And even


though we have not used them in any significant operational way recently, they have provided
an occasion for us to take a longer-term, more strategic view of our policy objectives at least
twice a year at these meetings. And they have provided at least a whiff of quantitative
institutional accountability. We lose this, I think, with the lapsing of the requirement that we set
these targets. In a formal sense it puts us in an almost totally discretionary operating mode.
CHAIRMAN GREENSPAN. Actually, I agree with that. But I think we can resolve
that issue without going through the formal process that has been required under statute. I don't
see any reason why we can't have something on the agenda, which essentially involves a
discussion of the long-term inflation imbalances or whatever we want to call it. Don, let me ask
you a question on this. We formally went to two-day FOMC meetings for those meetings
preceding the Humphrey-Hawkins testimony. Is it contemplated that for the future we will still
have two-day meetings? Do we still need two days? What will we be doing in the additional
time at these meetings? Is there any reason, for example, why we can't put on the agenda
instead of the long-term monetary aggregates something that covers this area in a more generic
way so that we could have a presentation by the staff and a Committee discussion?
MR. KOHN. No, there is no reason we couldn't do that. I actually thought we
wouldn’t change the format of these meetings significantly since the Committee has been
spending at most a half-hour or so on the monetary aggregates. Just in terms of preparation for
your Congressional testimony twice a year, I thought the Committee might want to take a bit
longer view--as Dave, Karen, and Larry helped to do yesterday--and look a little more deeply
below the forecast. I thought the Committee would want to continue to do that.


CHAIRMAN GREENSPAN. So there is no reason why we can't utilize the half-hour
we used for arguing about the numbers and how they are perceived and instead talk about the
real substance of inflation.
MR. KOHN. Yes, there’s absolutely no reason.
MR. BROADDUS. That would certainly help me a lot. I think that would be very
desirable for the Committee to do. I would go one step further. Just speaking for myself, I
would rather see a formal institutional substitute for the topic of the money targets rather than
just a discussion, although I certainly think the latter would help. I know we can’t agree on that
this morning. We have talked about inflation targeting before. That is now a procedure that a
number of other industrial countries have used with at least some success. There is a pretty
broad consensus, I think, in the profession that it is an idea worth looking into. We have now
had a sustained period of the coexistence of low inflation and rapid growth. That experience
may have begun to erode the popular attention that for so long has been given to the Phillips
curve. So, I think this would be a good time for us to revisit that issue and consider as a
Committee recommending the adoption of an inflation target at some point.
CHAIRMAN GREENSPAN. You mean a recommendation to the Congress?
MR. BROADDUS. Yes, after due deliberation and consideration here. Even if it
doesn't fly, it would still provide you with an opportunity, Mr. Chairman, to restate and
reinforce a view that I believe is a widely held consensus in the economics profession. That
view is that putting inflation first gives us not only the best inflation outcome, but also the best
output and employment outcome as well.
CHAIRMAN GREENSPAN. I agree with that last statement. But it is still too soon
to make a judgment as to whether official inflation targeting actually works. And we won't be


able to make that judgment unless such targeting is tried by a diverse group of countries and we
can determine that those with official inflation targeting did better than others. At the moment,
one cannot make such a distinction because inflation has been down everywhere and the results
are not sufficiently dispersed statistically for us to say that official inflation targeting actually
matters. That is a distinct issue from that of endorsing a general overall philosophy, largely
based on the last statement that you made, rather than a formalized process. But, clearly, if we
get into a period where inflation rates start to differ among countries and it is evident that those
with official targeting are doing better than other countries, I think we will all grab onto
inflation targeting as an obvious solution. It is very difficult at this stage to make that case up
on the Hill. Making that effort can't do any harm, but what will happen then is that those who
are really not all that enamored with keeping inflation under control will argue against it. They
worry that we can trade off inflation against employment, and there is still a lot of that kind of
thinking up on the Hill. So at this stage I don't think we could successfully move toward a
statutory inflation target with the evidence that currently exists. I suspect that if we eventually
get diverging inflation outcomes across a range of countries, with those on official inflation
targeting regimes experiencing significantly more favorable inflation results, then it would be
an easy sell. I don't think it is now.
MR. BROADDUS. I certainly respect your point of view, Mr. Chairman. I would
simply hope that we would keep some inflation targeting proposal at least in our back pocket, or
maybe even in our front pocket. I’d look for an opportunity to advance that view because for
me at least it is an uncomfortable situation not to have some kind of institutional anchor like
that. I think such an anchor is highly desirable and we do not have one now.


CHAIRMAN GREENSPAN. I fully agree. I think the way the statute is written is
essentially the result of a Congress that over the years has had considerably divergent views that
they could not square. And what we got was a statute that was designed to do all things for all
people so long as it was good. I would be the first to go up to the Hill and try to get something
done if I thought it was even remotely feasible. Right now a bill which specifically and
exclusively restricted us to an inflation target would not get through the Senate Banking
Committee and probably would not even get to the House Banking Committee for discussion.
That’s my view of the state of play. We are going to need more evidence before we move
forward on that.
MR. BROADDUS. We have to build a case.
MR. POOLE. Mr. Chairman, I was going to make a comment very similar to the one
that Al Broaddus made. I think the discussion of monetary targets has been a highly imperfect
way of nevertheless getting at an important point on which we ought to have some agreement
around this table--namely, what the inflation target is that the Committee itself has in mind. I
believe there are divergent views around the table as to what the inflation target ought to be. I
would rather see our discussion focused on the inflation target itself. Whatever the attitude in
the Congress, we need to have some working assumption. At the present time we have different
working assumptions around the table as to where we would like to go, say, in the medium
term, or in what direction we would like to work. There are some people around the table who
would like the inflation rate to be lower than it has been and is likely to be. I would count
myself in that camp. I think there are others who are quite satisfied with the current rate or
would be willing to see it go somewhat higher before we come down very hard, in policy terms,


to try to do something about it. So, although highly imperfect, I think the discussion of the
monetary aggregates has had implicitly in the background a focus on the Committee's long-run
objectives for inflation, which I think it would be desirable to clarify.
CHAIRMAN GREENSPAN. Actually, I’d characterize the nuances that are
involved in a slightly different way. If we took a vote on whether, all other things equal, we
around this table would like to see the inflation rate lower than it is today, I bet we would get
unanimity. Where the differences will show up is at what cost or tradeoffs. That’s where the
differences will arise. I don't think the issue is a lack of commitment on the part of any of us to
getting as close to stable prices as possible. I would presume we are all pretty much in
agreement that at stable prices, other things equal, we get maximum long-term sustainable
growth. The issue, however, is that there are differing views in this Committee regarding the
actual mechanism that is involved and what the tradeoffs are with respect to various aspects of
the economy, at different rates of inflation, employment, interest rates, and the like. I agree
with you that there are doubtless differences around the table on what the cost/benefit tradeoff is
under certain conditions. And until there is a squaring of a conceptual framework to which we
all adhere, there will be differences.
For example, take the discussion we had yesterday about the model. Suppose we all
agreed that that abstraction of reality was a wholly valid view, in a reduced form, of the way the
world actually works. In that case, we would all by definition have exactly the same view as to
where prices should be, what the tradeoffs are, and the exact mechanism that enables us to get
there. My view is that we all have different ideas about how to alter that model; and that
exactly replicates the differences around this table on the question of the role of inflation in our
complex economy. I see no way to resolve this in any sensible manner other than by imposing


some artificial number. But everyone around the table will be qualifying that number in the
back of their minds in one form or another. And I’m not sure that helps. I do think the basic
view among Committee members is that inflation is fundamentally a destructive force in an
economy and a society, that inflation destroys jobs, and all other things equal that a stable price
level, however defined, contributes to maximum sustainable growth. What I’m saying in effect
is that on a whole series of generalized propositions the philosophy of the members of this
Committee is remarkably uniform. The differences we have are far less than those in some
earlier FOMCs on which I and some of you have served. So in that regard we are closer
together than any earlier FOMC I have been associated with. But any effort to enforce a sharp,
single, reduced form focus on a specific price level, irrespective of what is required to get there,
will create marginal differences among the members of this group. I don't think we can work
with that sort of focus because it won't stick. Unless we can reach agreement on a very explicit,
reduced form model of the way the economy works--and we all sign off on it and say our
monetary policy votes will be determined exactly by that particular model--the best I think we
can do is to reiterate our basic concerns about inflation, argue with each other at the margins,
and hopefully get closer to agreement. I do believe that the discussions we have had around this
table have affected all of us, in the sense of bringing us closer together. But I would be very
hesitant to try literally to reach agreement on a formal inflation range of, say, 0 to 2 percent, or
0 to 1 percent, or zero, or what have you, largely because I don’t think it is going to add to the
effectiveness of the Committee. At least that is my view. Vice Chair.
VICE CHAIRMAN MCDONOUGH. Mr. Chairman, I agree 100 percent with the
substance of what you said. Let me suggest a procedure. I think there is great benefit to our
practice of discussing the goals and strategy of monetary policy in detail twice each year. I say


that because at most of the other meetings, even though we wander in and out of discussions of
strategy, mainly what we are doing is talking about tactics. I would suggest that we not indicate
in the minutes of this meeting that we are planning to discuss a formal inflation target. First of
all, I have a very strong view that that is the purview of the Congress, not of the FOMC. And if
it were made public that we were going to establish an inflation target, I believe many people in
the Congress--and I would be one if I were in Congress--would say, ”Well, if you’re going to
talk about that, please come up here and discuss it with us.” I think that would be highly
counterproductive. I also agree very much that trying to pinpoint a number that we all agree on
would be a specious exercise in precision. Even though some of us come at it from different
directions, I really do believe that the degree of unanimity on this Committee is quite
extraordinary. And in my view arguing about a number would be counterproductive, not
MR. MEYER. I always look forward to these opportunities to have broader
discussions on long-term goals and strategies, and I agree with the Vice Chair that it would be
good to do this on a regular basis at each of these two-day meetings. Let me give you a few
thoughts on both the monetary aggregates and inflation targeting.
I agree with Presidents Broaddus and Poole that one of the desirable features of our
discussions of the monetary aggregate ranges was that there really was in that process an
implicit inflation targeting. So, while we are not prepared to have an explicit discussion and pin
that target down, we did it implicitly when we set the ranges. Secondly, I am one who still
believes that there is information content in monetary aggregates and that they are very much
worthwhile monitoring. I quite agree with the Chairman's proposal: If we no longer have to set


ranges for the monetary aggregates for Congress as part of the Humphrey-Hawkins process, it
would be reasonable not to set ranges because we don't pay enough attention to them as a
Committee to justify that. As for myself, I do pay attention to the monetary aggregates. I get a
briefing on them before each FOMC meeting. And I'm going to ask the staff now to prepare a
packet as part of that briefing with ranges that I feel are more reasonable and from which the
information content can be extracted visually. So I think that is still useful to do.
In terms of inflation targeting, I make a big distinction between inflation targeting as
strategy, particularly when it means going to a single objective for monetary policy, and setting
an explicit target for inflation as part of our present dual mandate. I think it is a very big
distinction. There are also distinctions about inflation targeting today as a methodology; it is an
approach to hitting inflation as well as a procedure that has a numerical target for inflation. I
am very much committed to a dual mandate. I think that is the right way to go. But, as you
know, if we think about that dual mandate and how to achieve it from the perspective, say, of
the Taylor Rule, we are forced to put some number in there for our inflation target. I am always
amused to get the “rules packet” because when I open it up I see 2 percent in there. Where did
that come from? Well, that was John Taylor's target. So we sit around the table and we look at
simulations from the rules packet based on John Taylor's thoughts on what is the appropriate
inflation target. I think it might be reasonable for us to tell the staff what our inflation target is
and have the packet done that way.
Would it really matter? In other words, are we fighting over something that is not
that important? Well, I agree that there is a good deal of consensus among us, but there is a
range of views. I have a view--I call it price stability plus a cushion--that may be a little higher
than some others would have, but I think it is useful for us to have coherent internal discussions


and appropriate transparency regarding what we're trying to do. I believe we should try to agree
among ourselves and communicate to the public where we are trying to go because the public
could say they are not really sure where we are going. Is 2 percent for the CPI just about right?
Do we understand what that means and if we achieve that rate for the CPI is everything fine?
Or are we really heading for zero? Well, that is a big difference. Do we know?
So, I think at least some further discussion of this issue is worthwhile. And while I
don't see us moving any time soon, I think having an opportunity to voice such issues around
the table when we have these two-day meetings and to make some incremental progress toward
a consensus is really valuable. I have enjoyed this discussion this morning. Thank you.
CHAIRMAN GREENSPAN. Governor Gramlich.
MR. GRAMLICH. I have enjoyed the discussion, too. Let me cut it a slightly
different way. On the inflation targeting issue I think there are three levels on which we can
confront this. One is internally in our own heads. At that level I actually find inflation targeting
quite useful. I have often thought in terms of that and in my statements have described what we
ought to do in those terms, and I will probably continue to do that. There is a second level that I
would call internally within the Committee. I agree with others that twice a year it would be a
very good idea for Don to put on the agenda a topic that involves our talking about long-run
strategies for monetary policy. Maybe the designation of that agenda item could be something a
bit less pejorative--for example, “anchors of monetary policy” or something on that order. But I
do think it is a good idea for us to have these issues on the agenda for discussion twice a year at
a specified time. Maybe as we do that we will converge on what our targeting strategy could be
and what kinds of specific targets we might have. Perhaps we won't converge, but I think the
exercise would be good for us and we will learn as we talk whether we can converge.


There is a third or external level, which is the Congress. That includes whether
Congress ought to be giving us inflation targets and that sort of thing. Frankly, I have always
thought that these issues are awfully subtle and not easily adapted to Congressional decisionmaking. If Congress gives us an inflation target, it is going to be pretty rigid; there are going to
be times when that target is valuable and there will be other times when we find it very rigid
and very confining. So I would get off the train at that point. But on the first two levels,
internally in our own heads and internally within the Committee, I would welcome our thinking
about monetary policy in these terms; I think that is a good idea. But externally I don't think it's
a good idea.
CHAIRMAN GREENSPAN. Governor Ferguson.
MR. FERGUSON. Thank you, Mr. Chairman. I want to express agreement with
what I take to be the main message of Governor Gramlich’s remarks and also the Vice Chair’s
statement. Also, I agree with your proposal to move away from voting on ranges for the
monetary aggregates since we haven't really been following them very closely. But obviously,
as you suggest, I don't believe we would be credible central bankers if we didn't all in our own
individual ways look at the aggregates at every meeting. And, in fact, I certainly did look at
them coming into this meeting. So, I think continuing to keep track of them is part of what we
are expected to do.
With respect to inflation targeting, I think we should not undercut ourselves.
Members have expressed very clearly their support of a qualitative inflation target, which is that
we want inflation to be so low and stable that it is actually no more a point of discussion in
decisionmaking among businesses and unions, et cetera. And through a combination of good
policy and some other factors I believe we have managed to achieve that objective and we are


fighting now to hold onto it. But I want to make sure we are clear that we do actually have a
qualitative target; we are not completely without anchor.
I agree that it would be useful to have a strategy discussion, as Governor Gramlich
indicates, twice a year. That seems to make sense. I will say on the quantitative target, having
spent some time traveling around and talking to other central bankers, that as you suggest there
doesn't seem to be much evidence yet that it leads to better policy. I recently read a speech by
Lars Heikensten, the first deputy governor of the Bank of Sweden which has a formal inflation
target, that suggests that the Bank is dealing with a couple of problems. One concern is the risk
of losing credibility when they miss that target--either explaining why it was that they chose to
miss the target or alternatively could not bring the economy to hit the target. The second
concern they seem to have is that the public believes there is a bit of bias--that the central bank
will be more willing to let inflation creep up rather than creep down. So they are struggling
with a sense of an asymmetrical inflation target.
I am entirely in agreement with you that as we think about this issue we have to be
mindful that perhaps inflation targets have built up credibility where there wasn't any. At this
stage we have pretty good credibility. And the other industrial economies that have adopted
inflation targeting have discovered that while on balance they may like it, it also creates some
problems that weren't expected. So I think we should be very, very careful about going down
that path at this stage. And those problems are in addition to what Governor Gramlich had to
say about a nuance here, which is that if we go too far down this path, we may discover
ourselves handcuffed in a way that undercuts our credibility and reduces our effectiveness rather
than the opposite. So with that, let me stop.


CHAIRMAN GREENSPAN. Any further comments? Well, assuming that
legislation proceeds in the form we expect, why don’t we endeavor to have such a discussion at
the next appropriate meeting. Presumably, we will continuously alter the focus and get closer to
the Committee's general view of the type of discussion we want to have. Let’s move on then
and go to current monetary policy. Don, you have the floor.
MR. KOHN. Thank you, Mr. Chairman.
As background for your discussion today, you received a
paper by Flint Brayton and Dave Reifschneider that used the
FRB/US model to examine the economic performance of the U.S.
economy in recent years. Not surprisingly, their work suggested
that a continuing pickup in productivity provided the major
impetus to the extraordinary run of noninflationary growth. But it
was not the only influence. The model results also emphasized
the role of growing federal surpluses and an appreciating dollar in
holding down interest rates and inflation, even as the labor
markets tightened.
The study was undertaken in large part because we wanted
to see whether the model could shed some light on imbalances in
the U.S. economy that have become such a prominent element in
discussions of the outlook and policy, particularly internationally.
In fact, the performance of recent years has left the economy with
some potentially troublesome imbalances--most notably, from the
perspective of the staff model, the imbalance between the levels
of aggregate demand and sustainable supply. But it has also
produced other, subsidiary, imbalances between elements of
spending and income, including a large current account deficit
with its resulting buildup in net foreign indebtedness, and a low
rate of private saving that has been associated with a sizable
accumulation of debt by households and businesses. The latter
two imbalances have been stoked by a rise in the dollar on foreign
exchange markets and a rise in equity prices to levels well in
excess of those likely to be sustainable over time.
In the Brayton-Reifschneider study these asset price and
balance sheet imbalances are the natural consequence of the
forces that have shaped the economy. Under reasonable
assumptions on how those forces will evolve, the imbalances tend
to work themselves out, or at least to stop getting worse, without
major dislocations when you, the FOMC, concentrate on the


overall macroeconomic task of setting aggregate demand equal to
potential aggregate supply. But in real life, the adjustment is not
likely to be so smooth. The risk is that the balance sheet
overhangs and elevated asset values leave the economy more
susceptible to sharp corrections that could produce considerable
economic instability.
Concern about this possibility has led some observers to
advocate that U.S. monetary policy not look solely at overall
macroeconomic balance but also pay special attention to asset
prices or to savings-investment flows perceived to be in serious
and potentially destabilizing disequilibrium. In concept, shaping
policy in part to address these issues directly, while incurring a bit
of extra economic cost in the form of different unemployment and
inflation rates than would otherwise prevail over the short run,
might avert larger costs and more difficult situations later.
With respect to asset prices, central banks have usually
argued that they should not take account of such prices beyond
factoring them into their assessment of the overall balance of
aggregate supply and demand. Central banks are not confident
they can identify dangerous asset price disequilibriums, or that
they could calibrate policy actions to forestall further problems
without adding unduly to economic instabilities. Many of the
same sorts of arguments about the difficulties of identification and
gauging the appropriate response could be applied to policies to
address saving imbalances and debt buildups. Moreover, in the
case of some of these imbalances, it’s not obvious what role
monetary policy could play, even if it wanted to. In particular,
raising interest rates is likely to have little effect on the current
account deficit. Although tighter policy would reduce imports by
damping domestic demand, it also would tend to appreciate the
dollar, raising the cost of U.S. goods and services and shifting
demand away from U.S. producers. So, while the sanguine
outcomes of Brayton-Reifschneider might seem implausible, there
may be little the Committee can do in advance about potential
problems. Instead, your best posture might be to concentrate on
fostering overall macroeconomic balance, and to stand ready to
react to sharp movements in asset prices or other spillovers from
balance sheet corrections when they occur.
Nonetheless, the Committee’s policy choices cannot be
divorced entirely from consideration of the possible effects of
asset price and balance sheet disequilibriums. Assumptions about
how they will evolve are an inescapable aspect of projecting the
economy and can be an important influence on the outlook. With


respect to both equity prices and the dollar, the staff has adopted a
middle ground in the Greenbook and its extension in the
Bluebook. We have built in declines in wealth-to-income ratios
and the foreign exchange value of the dollar, but we have not
made the full adjustments to what might look like more
sustainable levels. The fall in wealth relative to income helps to
raise private saving, but the declining dollar is a significant source
of demand and inflation pressure over the forecast horizon.
The baseline simulation traces out the implications of the
Greenbook forecast. Several key judgments about the supply side
of the economy are important in that forecast. One is that the
unemployment rate is now substantially below its sustainable
level. Second, that productivity growth is picking up further this
year, but that thereafter growth will level out at this higher rate.
The labor market imbalance, which persists under the impetus
from strong aggregate demand, together with the depreciation of
the dollar and the catch-up of real wages to previous increases in
productivity, produces an upward trend in inflation in the baseline
unless the Committee tightens policy substantially.
Moreover, several of the alternative simulations built off
the baseline suggest that even more optimistic views of the level
and growth rate of potential supply may not remove the risk that
inflation will head higher under the Greenbook policy
assumption. A lower NAIRU than the staff’s estimate of 5-1/4 or
5-1/2 percent and additional pickups in structural productivity
growth do help to contain inflation over the next few years at
current low unemployment rates, but pressures still build. The
staff forecast does not embody the tightening of fiscal policy and
appreciating dollar that Brayton and Reifschneider identified as so
important to holding down demand and price pressures from 1995
on. The low NAIRU does not cancel the need for real wages to
rise enough to capture the full effects of the previous increases in
productivity. The cost-raising implications of this catch-up will
be postponed if productivity growth is headed still higher quickly
enough, but ultimately will show through as productivity growth
levels out. Moreover, higher productivity growth implies even
higher equilibrium real interest rates and the need for policy to
tighten by more than in the baseline to keep the resulting increase
in demand from outrunning the pace of potential supply and
adding to inflation pressures.
Even with a more favorable path for potential supply,
then, the Committee might be concerned that it will need to
tighten further to stop inflation from rising--and before very long


if it is intent on keeping inflation near current levels rather than
having it drift higher. Skepticism about either the lower NAIRU
or additional upward speed in trend productivity would tend to
add to perceptions of inflation risks, strengthening the case for
action at this meeting, as in alternative C. In circumstances in
which labor resource utilization was already unusually high and
inflation by some measures had already picked up, the Committee
might not want to take the risk that aggregate demand could
rebound. You might desire greater assurance that financial
conditions had firmed enough to keep the economy on a slower
growth track, especially in light of the easing of financial
conditions in many market sectors since your last meeting.
Markets would be surprised by a tightening at this meeting. Such
a strong signal that you did not share their optimism on inflation
would not only raise interest rates immediately, but would set the
stage for more sober reactions to incoming information than were
in evidence over the recent intermeeting period. If the Committee
were sufficiently worried about inflation to raise rates at this
meeting, it likely would view the resulting path of asset prices as
more consistent with a sustainable expansion of aggregate
However, as noted, the staff forecast rests on a view of
continuing strength in aggregate demand, supply side constraints,
and dollar depreciation. You may see the incoming data as at
least creating added uncertainty about these assessments. If you
are not very confident of oncoming inflation risks, there are
reasons to pause in your tightening, at least at this meeting.
In many of your internal discussions and public speeches
you have signaled that you would like to follow something akin to
a two-stage strategy to determine how much tightening you may
need to undertake. Stage one is damping aggregate demand
growth enough to bring it into line with the growth of potential
supply so as to ensure that pressures on labor resources do not
intensify. When the clear and present inflationary danger of
worsening resource pressures seems less worrisome, in stage two
the Committee would then assess whether the resulting level of
resource utilization was too high to be sustainable. Given
uncertainties about NAIRU, you may not be willing to enforce a
specific view of the appropriate level of resource utilization
without supporting evidence in hand.
The evidence of slowing in the economy, along with the
likelihood that a portion of the financial restraint put in place
since year-end has yet to be fully felt, raises the possibility that


you may be close to accomplishing stage one. At a minimum, the
incoming data have increased uncertainty about the path of the
economy and its response to policy actions. An appropriate
reaction to such an increase in uncertainty is to move policy more
gradually; in these circumstances, getting a better handle on how
the economy is evolving should reduce the odds on overdoing
policy restraint. Especially in light of the size of your action in
May, that might suggest a pause at this meeting.
To be sure, such a pause probably would not be
appropriate if there were reasonably clear evidence that current
levels of resource utilization were unsustainable, or that inflation
expectations were rising. Recent data have tended to show core
prices rising faster than they did a year ago. But, a good deal of
the pickup in core inflation may be attributable to the secondary
effects of the rise in energy prices, rather than to excessive
tightness in labor markets; at least the verdict is still very
ambiguous. The only new data on labor compensation over the
intermeeting period--average hourly earnings--did not suggest a
rising trend that might confirm a sizable output gap. And, longerterm inflation expectations have not responded to short-term
swings in published inflation, suggesting that even if incoming
data on prices were to be adverse, the economy likely would not
incur an especially high cost if the Committee decided not to act
at this meeting. You will have an unusually full slate of new
information by the time of your next meeting to make judgments
on the strength of the economy and price pressures--essentially
two months of new data, including an update on the ECI.
Whether the Committee raises rates or leaves them
unchanged at this meeting, it might still want to indicate that the
risks to good economic performance remained unbalanced toward
higher inflation over the foreseeable future. As noted, a wide
variety of simulations have suggested that this is indeed the case.
More practically, the unusually high level of labor utilization,
along with the increase in core inflation and rise in energy prices
that could feed through to inflation expectations, would seem to
reinforce the notion that tendencies toward higher inflation still
are most likely to be your major problem going forward. If, for
some reason, policy inaction nonetheless were taken
inappropriately by the markets as a sign that you believed the risk
of inflation pressures had subsided, the Chairman has an
opportunity in his semi-annual testimony on monetary policy in
three weeks to align market expectations better with your sense of
the balance of risks.


CHAIRMAN GREENSPAN. Questions for Don?
MR. JORDAN. Don, in reading the Bluebook and listening to you now, it seems that
a critical part of the analysis involves a wage-lag hypothesis. At a micro level the idea--this is
not your language but the way I interpret it--is that the value of the marginal product of labor as
individuals has risen but there may be some lag in the perception of this. And as reality dawns
on the worker that he is more valuable, he’d want to be compensated in the paycheck for this.
So, what we would expect to observe if that is going on is that for a while returns to capital rise
relative to returns to labor. That is an imbalance; it needs to be adjusted. Over time, returns to
capital will fall relatively while returns to labor rise and balance will be restored somehow. If
the owners of the capital and the labor are one and the same, though, that is not an issue. So
there is some notion that these are different participants in this economy and that those who are
the owners of capital gain for a while relative to those who are the workers. Maybe.
At the same time, in some of our analysis of what is going on in the economy we
have something called wealth effects. There the idea is that people in this long sustained
prosperity have reduced their concerns about layoffs, have seen various aspects of their
current/future consumption tradeoff altered, and perceive that their permanent income has risen.
In a lifecycle sense they say, “We are richer: Our 401(k)s are doing better, our company's
pensions are better, and our probability of being laid off is lower.” Somehow they perceive that
they are richer and can afford to consume more in the present as well as in the future. And thus
being richer, even if they perceive that their wages currently have lagged behind the increase in
the value on the margin of their labor, if they have a wealth effect in a sense there is no wage
lag. There is no catch-up and rebalancing of returns to capital and returns to labor implied.
There is no adjustment to be made.


MR. KOHN. I agree with the first part of what you said in terms of describing what
is going on here. Basically the initial returns from the innovation in productivity accrue to the
owners of capital, to the businesses who wake up one morning and realize that there are
efficiency-generating capital investments and changes in production processes they can make.
The first thing that happens is that they enhance their profits by making those innovations, by
buying that capital investment and trying to expand their operations. And as they compete with
each other, prices initially are held down. Over time, their efforts to expand their operations
increase the demand for labor, but that occurs with a bit of a lag. So we can depend on the labor
demand catching up slowly with the increasing profitability of businesses, as businesses
compete against each other first in the goods markets and later in the labor markets. Prices in
the goods market are less sticky than prices in the labor market. So initially the added demand
doesn't drive up the price of labor as much as it otherwise would. But ultimately that demand
feeds through. Workers realize that they’re more productive, and both the supply and demand
of labor will adjust to the higher productivity. You are right in concluding that that type of
lagged process, a staged process, is what is built into the models. And it’s what we think helps
to explain why the productivity surge first seems to have damped inflation and why we then
expect rising real wages to catch up over time.
As for the second part of your comment, I’m not sure that the effects would be what
you suggested. It is true that it is workers who ultimately own capital in one form or another,
but the distribution of human capital and the ownership of physical capital are very, very
different. So very different people are benefiting from the increasing profits. That’s one thing.
Secondly, I think economic efficiency--in terms of the appropriate use of labor and capital-would suggest that over time their prices better adjust to the productivity of capital and the


productivity of labor if we are going to have the optimum combination of utilization of labor
and capital. So despite the distribution of human capital and of physical capital--even if owned
by exactly the same people--I think their prices would still have to change in order to give the
appropriate signals to businesses and to labor on the proper mix. They need to know how much
labor to supply to the markets and how to mix capital and labor in the production process in
order to end up on the production possibility frontier. So I think those prices still have to adjust
to enhance economic efficiency.
MR. JORDAN. Can I follow up, Mr. Chairman? I have two points on that. The
more we believe that the distribution is quite different between the owners of capital and
workers--and that certainly is true to some extent--the more trouble we have with wealth effect
arguments as the catalyst stimulating consumption. If the workforce and this other group that
owns the capital are totally different, driving consumption spending off the so-called wealth
effects coming from technological innovation and rising productivity is a difficult case to make.
The other point, though, is that innovation per se involves creative destruction, reducing the
value of something old. And it doesn't matter whether it is technological innovation, managerial
innovation, or whatever. That reduction in the value of something old--this is partial analysis-especially if it involves labor substitution kinds of innovations, does not increase the value of
the marginal product of at least some workers. And the idea of worker insecurity as an
hypothesis drives in the other direction in terms of whether or not these people perceive that
there is a wage lag that needs to be rebalanced.
MR. KOHN. I think we perceived that worker insecurity, at least initially in this
productivity pickup, was another reason why wages tended to lag, aside from the stickiness of
wages relative to prices. But one would think that that insecurity has been overcome, in light of


an extraordinarily low unemployment rate and very tight labor markets, and has dissipated
mostly if not entirely. And that should begin to show through; we should begin to see the
process of the catch-up of real wages to productivity.
MR. PARRY. Don, I think the long-run simulations were interesting and useful and
helped us to consider some of the strategic issues we face. The longer-run simulations assume
that the value of the dollar falls rather sharply after 2001--by approximately 5 percent per year, I
think. That boosts the path of the fed funds rate that is necessary to contain inflation. We know
that projections about the value of the dollar are rather uncertain, and I was just curious about
how crucial the size and timing of the dollar’s decline is to the outcome of these simulations. It
looks as if it is a very significant factor.
MR. KOHN. It is a significant factor and I tried to indicate that in my briefing. I
don't have a simulation that has everything else the same and holds the dollar constant. But as I
mentioned to the Committee yesterday, I had asked our modelers to run what they call the “rosy
scenario” simulation, which had both a lower NAIRU and faster productivity growth with a
constant dollar. Interestingly, the lower NAIRU/faster productivity growth simulation does not
obviate the rise in nominal and real federal funds rates in order to hold inflation to, say, around
2 to 2-1/2 percent. It does lessen the amount of the increase. And if we add the constant dollar
to that, having all three of those things meant that the nominal funds rate could stay around the
current level over the next two years and we would still get inflation coming in at about 2
percent. So it does make a big difference. In our judgment, a difference of about a percentage
point on the nominal funds rate after a couple of years would be needed to accomplish the same
inflation objective. I think Karen Johnson would like to speak to this.


MS. JOHNSON. I would, in the sense that the 5 percent number gets one's attention
shall we say. It is not that we have a view that a 5 percent decline is necessarily going to
happen or that we have even a clue as to when the decline would start or how fast it would
proceed. The problem is that in order to do a simulation with relationships that define exports
and imports we have to have in the model their effective relative prices and the accumulating
net investment position of the United States, and so forth. Those relationships are built on
historical experience at this point. We have no alternative that we trust that would lead us to go
in and adjust those arbitrarily because of something we think is going to happen for which there
is no precedent in history. Those relationships tell us that any depreciation of the dollar that is
less rapid than 5 percent causes the net investment position to explode at some point in the
future. And that is just not something an econometric model can handle. It can't provide us
with a useful long-run simulation with something like the net investment position extrapolating
ever faster to larger and larger positions. So, in order to make the model have other features
that are not disturbed by this exploding net investment position, we have to put in a value of the
dollar that keeps that investment position behaving. Consequently, one reasons back and back
and back and one ends up with that 5 percent. Does that mean the dollar will start falling by 5
percent in 2002 or 2004 or 2005? Not necessarily. But there is a germ of truth in this analysis
unless we start seeing in the data something that says the historical relationships and elasticities
no longer apply. Were the dollar to remain strong and were that to give us a more favorable
outcome on the federal funds rate, it would be creating another problem--one that is growing
insidiously--which is this net investment position.
MR. PARRY. Thank you.
CHAIRMAN GREENSPAN. Governor Gramlich.


MR. GRAMLICH. I actually wanted to get in on the previous discussion between
Jerry Jordan and Don Kohn. As I interpret Jerry’s argument, it is that we could get a
productivity shock and, perhaps because of the wealth effect, wages will not catch up. Frankly,
I would like to believe that. I think we would all like to believe that. But in addition to the
answer that Don gave, a problem I would have with that analysis is this: If the worker is not in
possession of physical capital, the way the wealth effect would work is through some sort of
expectations regarding future earnings. And those future earnings are the wage rates
themselves. So I don't see where the wealth effect on human capital comes from if wages don't
catch up. While I would like to share Jerry’s optimism about this matter, I guess I am with Don
in believing that eventually wages do have to catch up even to make the wealth effect work.
CHAIRMAN GREENSPAN. Further questions for Don?
MR. JORDAN. May I respond on that?
MR. JORDAN. That is not clear to me if part of the manifestation of the wealth
effect on the part of the work force is in their rights to future consumption that is contained in
their pension plans, their 401(k) profits, or whatever.
MR. GRAMLICH. If they have savings.
MR. JORDAN. Their claims on future streams of consumption rise and that does not
necessarily have to pass through a paycheck.
CHAIRMAN GREENSPAN. Anything else? If not, let me begin.
I think the evidence that the expansion is slowing to a certain extent is pretty much
unambiguous. Usually, a useful clue to watch is the relationship between short-term forecasts
of statistics that get published against the actual outcome to see whether the outcomes are


higher or lower. We have had a fairly significant run of outcomes that have fallen below the
forecasts, and that usually is an indication that something significant is occurring. In the home
building area--I think with the exclusion of the home mortgage application numbers released by
the Mortgage Bankers Association, which belie everything else we are observing in the housing
sector--there is a fairly uniform characterization of the housing market as clearly negative and
continuing to erode except in California. The rise in mortgage interest rates is beginning to
exert an effect in large part because of the flat yield curve. In the past, ARMs captured a lot of
homebuyers who were ready to accept lower short-term interest rates and take the risks involved
in that. But the option of lower rates is no longer available because the current rates on ARMs
do not differ significantly from those on fixed rate mortgages.
Demand for motor vehicles clearly is easing, especially after adjustments for
incentives. Part of the explanation doubtless stems from the gasoline price increases, but I think
there is more to it than that. There has been a general view that motor vehicles are proliferating
to the point where the number of vehicles per household is exceeding the number of people in
the household. I'm sure that is false, but it sounds right! Another way of putting it is that we
are inadvertently converting a goodly part of our highway system into parking lots, and once
complete gridlock occurs no one is going to be able to find a way to unwind it. That leads me to
the household inventory issue. It has been raised in the Greenbook on successive occasions,
and it may very well be starting to exert an effect in the sense that the buildup of inventories of
durable assets held by households is beginning to have a feedback effect on consumption. This
would be consistent, obviously, with a flattening out of the wealth effect. The data for a
slowdown in consumption outlays are fairly conclusive in that not only are sales of motor
vehicles going down, but the weekly chain store figures have been flat since the second or third


week of May. If anything, the chain store numbers display a slight downward tilt, and they
imply that the consumer inventory problem may be affecting the market for consumer
appliances as well as that for motor vehicles.
What we tend to get as a consequence of the household inventory adjustment process
is that as final demand for consumer durables softens, we expect to see the effect filter down to
the underlying industries of the old economy. And to be sure, steel production is down. The
incipient evidence of appreciation in steel prices has turned around. Notions held by a number
of old economy producers that they were gaining pricing power seemingly have stalled. We are
getting the type of economy which, were it not for the underlying high-tech momentum, would
correspond to the early stages of what we would usually begin to worry about as a recession.
As an aside, I ought to point out that in the old days we used to worry about more
recessions than actually occurred. The National Bureau of Economic Research identified
numerous peaks during cyclical expansions that never turned into recessions so they are not
official peaks. In other words, if we look at the NBER charts and are not given, say, 12 to 15
months of hindsight, we will identify about three times as many “cyclical peaks” as recessions
that actually emerged. We clearly are experiencing one of those phenomena now.
In any event, I think the evidence of an actual recession at this point is belied by the
fact that there is no evidence of which I am aware that suggests any significant deterioration in
productivity growth. Indeed, even the evidence that there is a decline in the second derivative-we will get to the third derivative very promptly [Laughter]--is not conclusive by any means.
Long-term earnings expectations of the security analysts, which we presume reflect the views of
corporate management, have not diminished. Indeed, they continue to move up for both the
high-tech and the old economy firms. Actually, there has been a slight downward tick in long-


term earnings expectations for high-tech firms, but it is very small considering the fact that the
stock prices for that sector have come down so markedly. Presumably, that market decline did
damp some views of future earnings, but there's very little evidence of that in the data.
The orders coming into the capital goods companies--high-tech, intermediate-tech,
whatever--have remained very strong, and backlogs continue to build. Incidentally, in a certain
sense there is no low-tech equipment anymore. One would be hard pressed to find any old type
of equipment that is not infiltrated with various kinds of microprocessors and other high-tech
components. Even the old weaving loom in use today, which goes back to the beginnings of the
Industrial Revolution, would be unimaginable to textile workers of 50 years ago. It is a wholly
different piece of equipment. In fact, there are no sizable numbers of textile workers anymore.
Their work is all automated. What we have are software writers and computer operators, and
the whole production process just basically runs. But as I said, what we find is that the backlogs
are still building up in the capital goods industries. What that essentially says is that the
prospective rate of return on new facilities must still be high ex ante, if not rising, or else people
are just making investments with no reasonable judgment as to their basis.
These high earnings expectations are held not only by domestic producers but by
foreign investors as well. The reason is that if the rate of return were not holding up in the
United States, the dollar would surely be under very significant downward pressure, given the
signs of the growing current account deficit. So in a sense, the strength of the dollar is an
indirect piece of evidence that prospective rates of return are holding up and are in fact fairly
substantial and solid.
This leads to a very interesting set of possible outcomes. What we have in the
Greenbook in this context is not only slow economic growth but also slowed multifactor


productivity and as a consequence slowed labor productivity. The latter effectively keeps the
unemployment rate down in the context of a slowing rate of GDP growth. This scenario is
consistent with the beginning of a rise in both unit labor costs and the NAIRU, which we
discussed yesterday, and that is what is creating an upward set of pressures on prices. The
alternate scenario is that we are indeed seeing some slowing in the expansion of demand largely
because of the wealth and the consumer stock adjustment effects. But it is also perfectly
conceivable that after the fact we are going to find that multifactor productivity did not go
down, that labor productivity growth did not slow down, and that indeed the unemployment rate
went up--not a great deal, but some. But that behavior would be consistent, depending on how
one views the NAIRU effect, with a different price forecast.
At this particular point I would say that I know of no evidence that conclusively
would suggest which of those two scenarios is true. Successive Greenbooks have been
continuously forecasting a decline in multifactor productivity growth. And accordingly, since
the capital investment has been pretty clear-cut and therefore capital deepening has been very
easy to forecast, we end up with a forecast of slowed productivity growth, a slowed rate of
economic expansion, and accelerated inflation. That slowdown hasn't happened. Multifactor
productivity has been running at a fairly strong pace and, if anything, has been rising. As a
consequence, we have two potential scenarios here. And while the structure of the model that
we employ for the Greenbook necessitates only one outcome, I submit that it is quite possible to
reconfigure the structure of the model, depending on one’s view of how the real world actually
works, and come up with the second alternative. In fact, I know we can do that, but I don't think
we can realistically make a judgment about which of the two scenarios is accurate. I suspect we
may not be able to until after the fact.


Given that uncertainty, and echoing some of Don Kohn’s remarks, I think we have a
fairly substantial amount of monetary tightening still in the pipeline, at least if we believe what
we say about the lags and if a goodly part of the softening that has occurred in the economy to
date is only modestly related to our monetary policy tightening. There is no question that the
increase in fixed rate mortgages has been a crucial element in housing. It is not clear that it has
been a big deal in motor vehicles, although there is some anecdotal evidence, which suggests
that buyers are backing away in part because of financing costs. But I am suspicious of that as
being the crucial issue in the market for motor vehicles. Gasoline prices obviously are
something we haven't focused on, but the implicit reduction in effective disposable income
associated with the rise in gasoline prices is just too large to be disregarded. So a number of
forces can be identified that are slowing this expansion prior to advertence to monetary policy
considerations. And if monetary policy still has a backlog of tightening effects that could be
quite significant, it strikes me that, owing to the uncertainty surrounding the potential outcome
we have in front of us, the wise move at this stage is basically to do nothing today.
No matter what we do, I believe it is utterly essential that we retain a statement in our
press release expressing our view that the risks remain unbalanced toward conditions that may
generate heightened inflation. Given how we all weigh the prospects for various outcomes, the
probability that we are through tightening in this cyclical expansion has to be less than 50-50.
To be sure, that probability is higher than it has been. It certainly is higher than it was at the
time of the last meeting or the meeting before, but we are nowhere, as far as I can judge, up to
even money on this. And until we get there I think we should be very careful about suggesting
in any way that we might be at the edge or even contemplating that our move at the last meeting
was our last in this cycle. Vice Chair.


VICE CHAIRMAN MCDONOUGH. Mr. Chairman, I support your
MR. POOLE. Mr. Chairman, I support your recommendation. The futures market
has built in another 1/4 point at our August meeting. I believe that is a reasonable bet at this
time, but I think the data over the coming weeks will decide that issue and the market will move
rates in the appropriate direction.
CHAIRMAN GREENSPAN. Governor Ferguson.
MR. FERGUSON. Mr. Chairman, I support your recommendation. I think we have
done a great deal of work thus far and it is not unreasonable to take a pause, given the degree of
uncertainty and the other factors to which you have alluded.
CHAIRMAN GREENSPAN. Governor Gramlich.
MR. GRAMLICH. Mr. Chairman, I support your recommendation.
MR. KELLEY. Mr. Chairman, I support the recommendation. But I would like to
add that I hope the statement we release to the public will be quite strongly worded. I think this
recommended action is exactly what the market consensus expects and I would hate to see an
overly euphoric reaction to it, which I believe is quite possible. We may indeed need to tighten
more--perhaps quite soon and perhaps by a considerable amount. And I hope we put the market
very clearly on notice to that effect.
CHAIRMAN GREENSPAN. We can do that in one of two ways--either in a
statement, which presumably would be merely a reiteration of our previous remarks, or in the
Humphrey-Hawkins testimony, where we can surely fine-tune it.


MR. KELLEY. However, I would like to see a statement today that is a little
stronger than the words we have used in the past.
CHAIRMAN GREENSPAN. I’m not sure I would agree with that for lots of
reasons, but let's hold that and see what the rest of the Committee members say.
MR. KELLEY. Fine. I just want to put it on the table.
CHAIRMAN GREENSPAN. Okay. President Parry.
MR. PARRY. Mr. Chairman, I support your recommendation.
MR. MOSKOW. Mr. Chairman, I support your recommendation.
MR. STERN. I don't see any reason to deviate from the pattern! [Laughter] I
support the recommendation.
MR. MEYER. Mr. Chairman, I support your recommendation, too. I should note
that this was the position I felt comfortable with as I went home for the weekend. And when the
Bluebook came and I opened it, I found that it was sort of arguing with me and questioning
whether I should feel comfortable with that decision, given my views. It noted, for example,
that this position would be appropriate if I wasn't sure that inflation would intensify going
forward. I guess that depends on what we mean by “sure.” That is a word that forecasters are
loathe to use under any circumstances. But I do think that inflation is more likely to rise. The
next thing the Bluebook said was that this position would be appropriate if I was less convinced
than the staff that output is beyond potential. Well, I am at least as convinced as the staff that
output is beyond potential. So I am certainly struggling with this.


Then, as if that wasn’t enough, the Bluebook went on to say that if you want to take
the view that interest rates should go up you should hold the following views: First, that
indications of slower expansion are still tentative. Okay, I believe that. Second, that resource
utilization is still quite high. Well, I believe that, too. Third, that some of the earlier financial
restraint has been unwound by the recent rally in bond and equity markets. That is factually
true. And fourth, I should be in favor of tightening especially if I believe that growth may have
to slow to below trend to unwind the prevailing excess in the labor market. Well, I believe all
those things, so I did have to struggle more than most with this decision.
I don't put extraordinary weight on what goes on at one meeting. I think getting the
direction and the overall response right is what is really important. So, I can feel comfortable
with holding pat today because we have moved so decisively since last June and also because I
believe that the data are likely to show the wisdom of moving further perhaps as early as by the
next meeting. And given what we have done in the past, I am confident that we will do what
needs to be done at that time and get it done in a timely fashion to insure a favorable outcome.
So, I support your recommendation with the confidence that we have taken steps to
mitigate the risks of higher inflation, but also with the belief that our work is not yet done.
CHAIRMAN GREENSPAN. President Minehan.
MS. MINEHAN. I agree with your recommendation, Mr. Chairman, particularly the
part that keeps the Committee on record both in the press statement and in the HumphreyHawkins testimony that the risks are still on the up side. I agree with Governor Kelley's point
on this, although I would be a little concerned about changing the wording of our statement
much because the market seems to overreact and overanalyze every word we put in there. So, I


think it is probably better to stay with a stable set of words and allow you to fine-tune the
message in the Humphrey-Hawkins testimony.
I happen to believe that the recent data with regard to the slowing of the economy are
perhaps a little less definitive than some around the table may believe. I also have some level of
concern about the employment data. And I agree with you totally that it is impossible to discern
which of your two models accurately reflects what is going on now because I don't think we
know conclusively whether the unemployment rate is going up or down. Everything we see in
the markets based on real-life experience would suggest that the labor markets are just as tight
as they have been and that the unemployment rate, if anything, is going down, not up.
In any event, I was concerned coming into this meeting that if we thought inflation
was likely to rise in the future, we would be better off acting sooner rather than later because
appropriate early action tends to ameliorate the longer-run effects. But I don't see any
difference between moving now or moving at our August meeting, and by August we will have
a lot more data. So, I agree with your proposal.
CHAIRMAN GREENSPAN. President Broaddus.
MR. BROADDUS. Mr. Chairman, if I could take a bit of time here, I would like to
look more closely at the Bluebook's baseline forecast. I found it very helpful in trying to think
through the longer-run implications of what we do today. I think it's important that we do that.
The baseline is not the only scenario, but it is a plausible scenario and it has implications that I
think are important and not terribly comforting. The baseline takes as a starting point that the
economy is currently operating above its potential and it assumes a NAIRU over 5 percent.
Obviously, that is questionable. You questioned it yesterday, and that is perfectly reasonable.
But there is certainly a good chance that there is a NAIRU that we should be thinking about


analytically in making our decisions and that it is, in fact, above 5 percent. So I believe we need
to consider carefully what the economic outcome of that assumption might be. And we also
need to consider the cost of that outcome, even if the likelihood of it is now lower than it may
have been before. So if we just accept that provisionally and follow the baseline, the idea is that
we have been able to operate below the NAIRU up to now because rising productivity growth
has made it possible for firms to increase wages without pushing up unit labor costs.
Now, productivity growth could, of course, keep rising and that would tend to bail us
out, if I could put it that way. But in a mature economy like this, I think it would clearly be
unwise to make that assumption. The baseline scenario does not make that assumption. It
assumes that trend productivity growth continues at its current rate for the rest of the decade,
which would mean at some point fairly soon an increase in wages and presumably in unit labor
costs would emerge. In the baseline case then, this implies that the unemployment rate has to
move up toward the assumed 5-1/4 percent NAIRU just to keep the core PCE from rising above
3 percent. And for that to happen, in turn the real funds rate has to go up a percentage point.
To summarize: That baseline, which again I think is a plausible scenario, has us
raising the nominal funds rate almost 2 percentage points at a time when the unemployment rate
is rising sharply. And even that doesn't really hold the line on inflation because inflation moves
up close to 3 percent and obviously could go higher. So this baseline scenario, a carefully
worked out analysis, with a certainly plausible and possible outcome, is not very comforting.
And it will be difficult to pull it off, I think, because it requires us to raise the funds rate
significantly at a time when unemployment is rising. The bad news in my view is that if we are
dealing with the situation assumed in that scenario, then we really do run the risk of finding
ourselves behind the curve both with respect to actual inflation and with respect to inflation


expectations. That could at some point force us to take strong action, which could put an end to
this expansion. So there is a lot at stake.
Quickly, what are the options? One is we could wait maybe not only at this meeting
but even longer and hope to get rescued, and that is certainly possible. Productivity growth
could continue to rise. Also, we have higher credibility now and the NAIRU may well be
below 5 percent. All of those things are possible and also plausible. But my own view is that if
we accept that hypothesis and follow that option, perhaps we ought to supplement it with a
word of prayer from time to time! [Laughter]
Our other option, as I see it, is to be more preemptive and raise the funds rate more
aggressively before unemployment begins to rise. Markets now appear to expect a funds rate
approaching 7 percent at the end of the year. Early next year we could move it up closer to, say,
7-1/2 percent, and to some degree begin that process now. In that way we might shore up our
credibility, keep inflation expectations from rising, and limit the amount by which we would
actually have to increase the nominal funds rate over the course of the whole cycle. Obviously,
this is not without risk. This approach could cause the economy to be weaker than it really has
to be if the assumptions in that scenario are not accurate. But with the labor markets as tight as
they are, that seems to me to be a risk worth taking. That’s because--and this is really the key
point for me--if we do fall behind the curve and inflation breaks out, then we are very likely at
some point to be in a situation where we have to create a recession in order to restore price
stability and our credibility. That means that we will go back to the stop/go monetary policy of
years past, and I think that is the worst possible outcome.
So, I guess that’s a long way of saying that I think a solid case could be made for a
further move today. I can certainly accept your proposal and I understand the reasons for it.


But I would say that the primary support for that proposal has to do with the evidence of a
slowdown. We do have a lot of data suggesting a slowdown, but I think the evidence is still
quite preliminary so we have to be careful about how much weight we give it. I certainly think
we need an asymmetric directive. I would make this point too: There’s a long period of time
before our next scheduled meeting, and in the month of July we will be getting a lot of
additional information on the behavior of the economy in June, which will either confirm the
earlier data or not. If some question arises, I think it would be particularly appropriate in this
intermeeting period to have a call, maybe at the end of July or early August to take another look
at the situation. I would hate to wait until late in August, a couple of months before an election,
and find ourselves in a real bind. So I make that suggestion. Thank you.
MR. HOENIG. Mr. Chairman, I support your proposal. I don't know if we have
moved as far as we need to, but I suspect that right now there are still a lot of monetary policy
effects in the pipeline from the actions we have taken here recently that are not yet fully in play.
We ought to let them work and observe where that is taking us. And as others have said, a lot
of data will be coming in over the next several weeks that I think will provide us useful
information from which to make a further judgment on the effects of our earlier tightening
moves. One of the side benefits is that our press statement last time indicated that the balance
of risks was on the up side and today we are not acting on it, and I believe that is a healthy thing
to do as well. So, I think your recommendation is a very good one.
MR. GUYNN. Thank you, Mr. Chairman. Let me just note very briefly--I should
have added this yesterday, perhaps--that in our discussion of different models and various ways


of looking at how the economy is working at this time, I would have joined those yesterday who
expressed some uneasiness about the NAIRU construct. Like our colleagues in Minneapolis,
and I believe some from other Reserve Banks, we have been using a VAR model to try to gauge
different inflation paths given different fed funds assumptions. Our modeling work suggests
that the restraint we have already put in place is going to deliver an inflation path that is close to
100 basis points lower than we would have had without that tightening. We also ran an
experiment last week after getting the Greenbook and we used the same amount of substantial
additional tightening as assumed in the Greenbook. Our VAR model suggested that such an
aggressive degree of further tightening would involve considerable risks to the real economy.
So there are risks on that side as well, it seems to me.
I would join those who have underscored the importance of maintaining the bias in
our balance of risks statement this time. As we have heard each other say, we are seeing not
only the direct effects of the higher rates but maybe even more importantly a sense of caution
and prudence among the people we talk to, as a result of the tightening we have put in place.
And I think it is absolutely essential that we keep that in place and not lose it at this point.
Thank you, Mr. Chairman.
CHAIRMAN GREENSPAN. First Vice President Stone.
MR. STONE. Mr. Chairman, I support your recommendation. Particularly in light
of the action taken at the last meeting and also because the forecast of long-run expected
inflation has remained stable, I think we have time to take a look at whether the economy is
truly slowing at this point. Thank you.


MR. JORDAN. Thank you, Mr. Chairman. For this meeting I support the
recommendation for no action. And in line with the Vice Chairman's remarks yesterday, if a
recommendation to raise the federal funds rate--whether at this meeting or a subsequent
meeting--had an underlying objective of raising the unemployment rate or opening up a gap
between potential output and actual output, I would oppose that. I think it is too easy for these
kinds of exercises and scenarios derived from models to become objectives, if not of the
Committee at least in the minds of some observers. I cannot imagine Chart 3 of the Bluebook
appearing in the monetary policy report to Congress. I simply cannot picture the reaction if that
chart were to be included in such a document. Like Governor Meyer, in reading the Bluebook I
tried to find out what it was telling me regarding what position I should take. With regard to
inflation objectives, the Bluebook tells me that at this meeting I should support a 50 basis point
increase in the funds rate with an announcement--in line with President Poole’s remarks at
previous meetings that it is not nice to surprise the markets--that we will increase the funds rate
by another 50 basis points at each of the subsequent four meetings this year because we plan to
raise the funds rate to 9 percent by December. Now, the reaction to that would be chaos in the
financial markets. We would not produce the results indicated if we did that, of course. No
model would tell us what results we would get because we can’t forecast what would happen if
we were to announce to the market 250 basis points of additional tightening between now and
December. So, I don't know what use the exercise is in guiding me as to what position I ought
to be taking to support a price stability objective.
MR. MCTEER. I agree with your recommendation.
CHAIRMAN GREENSPAN. Would the Secretary read the appropriate language?


MR. BERNARD. The language comes from page 19 in the Bluebook: “The Federal
Open Market Committee seeks monetary and financial conditions that will foster price stability
and promote sustainable growth in output. To further its long-run objectives, the Committee in
the immediate future seeks conditions in reserve markets consistent with maintaining the federal
funds rate at an average of around 6-1/2 percent.” And the sentence going into the press release
would read: “Against the background of its long run-goals of price stability and sustainable
economic growth and of the information currently available, the Committee believes that the
risks are weighted mainly toward conditions that may generate heightened inflation pressures in
the foreseeable future.”
Chairman Greenspan
Vice Chairman McDonough
President Broaddus
Governor Ferguson
Governor Gramlich
President Guynn
President Jordan
Governor Kelley
Governor Meyer
President Parry


CHAIRMAN GREENSPAN. Don, would you read the proposed statement?
MR. KOHN. I think Lynn Fox has the statement.
CHAIRMAN GREENSPAN. Do you want to circulate it?
MR. KOHN. Yes, we're going to circulate it. Why don't we just let people read it.
CHAIRMAN GREENSPAN. [Pause] Any comments?
MR. POOLE. Mr. Chairman, it would seem to me logical to take the third paragraph,
which refers to the signs of slowing as being tentative, and put that right after the first sentence


of the second paragraph, which refers to real activity, and move the comment about core
inflation down.
CHAIRMAN GREENSPAN. What is the view of the Committee on this?
SPEAKER(?). I like it the way it is.
CHAIRMAN GREENSPAN. Is there any support for President Poole's
recommendation? Is this draft generally acceptable as it stands?
CHAIRMAN GREENSPAN. Thank you very much. It is a little early to go to
MR. BERNARD. Coffee is out there. Lunch will be served at noon. [Laughter]