January 9, 2008 1 of 60 Conference Call of the Federal Open Market Committee on January 9, 2008 A conference call of the Federal Open Market Committee was held on Wednesday, January 9, 2008, at 5:00 p.m. Those present were the following: Mr. Bernanke, Chairman Mr. Geithner, Vice Chairman Mr. Evans Mr. Hoenig Mr. Kohn Mr. Kroszner Mr. Mishkin Mr. Poole Mr. Rosengren Mr. Warsh Ms. Cumming, Mr. Fisher, Ms. Pianalto, and Messrs. Plosser and Stern, Alternate Members of the Federal Open Market Committee Messrs. Lacker and Lockhart, and Ms. Yellen, Presidents of the Federal Reserve Banks of Richmond, Atlanta, and San Francisco, respectively Mr. Madigan, Secretary and Economist Ms. Danker, Deputy Secretary Ms. Smith, Assistant Secretary Mr. Skidmore, Assistant Secretary Mr. Alvarez, General Counsel Mr. Baxter, Deputy General Counsel Mr. Sheets, Economist Mr. Stockton, Economist Messrs. Connors, Fuhrer, Kamin, Rasche, Sellon, Slifman, Tracy, and Wilcox, Associate Economists Mr. Dudley, Manager, System Open Market Account Mr. Blanchard, Assistant to the Board, Office of Board Members, Board of Governors Mr. Struckmeyer, Deputy Staff Director, Office of Staff Director for Management, Board of Governors Mr. English, Senior Associate Director, Division of Monetary Affairs, Board of Governors Mr. Dale, Senior Adviser, Division of Monetary Affairs, Board of Governors January 9, 2008 2 of 60 Mr. Luecke, Senior Financial Analyst, Division of Monetary Affairs, Board of Governors Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of Governors Messrs. Judd, Rosenblum, and Sniderman, Executive Vice Presidents, Federal Reserve Banks of San Francisco, Dallas, and Cleveland, respectively Mr. Altig, Mses. Mester and Mosser, and Mr. Weinberg, Senior Vice Presidents, Federal Reserve Banks of Atlanta, Philadelphia, New York, and Richmond, respectively Mr. Krane, Vice President, Federal Reserve Bank of Chicago Mr. Weber, Senior Research Officer, Federal Reserve Bank of Minneapolis January 9, 2008 3 of 60 Transcript of the Federal Open Market Committee Conference Call on January 9, 2008 CHAIRMAN BERNANKE. Good afternoon, everybody. Thank you for coming, and I am sorry about the awkward time. I am also sorry I wasn’t able to talk to many of you in advance of the meeting. I just got back from Basel yesterday, and so I have been out of the country. Let me tell you why I called this meeting. I have become increasingly concerned that our policy rate is too high to fully address the downside risks to growth. We have cut 100 basis points since September, and I think that may possibly have roughly offset the credit factors and the housing factors, but I don’t think that we can claim that we have done anything in the way of taking out insurance against what I think are some potentially significant downside risks. Meanwhile, since our last meeting in December, the data have been on the whole negative. The fourth quarter looks all right, but since then we have seen a number of indicators that the economy is sliding. So I thought it would be worthwhile for us to have an intermeeting meeting, so to speak, just to get an update on the situation and to have some discussion of our policy strategy. As you know, we circulated a draft policy statement for the contingency that the Committee might want to act on rates today. After getting some feedback, and with some thought, unless the sentiment of the Committee to move today is especially strong, I am not going to propose a policy action at this meeting. What I would really like to do, instead, is get a sense of where the Committee is and a sense of your willingness to be somewhat more proactive in terms of addressing the downside risks that we are seeing in the growth situation. Part of the reason it is scheduled today is that tomorrow I have a sort of well-publicized speech on the outlook and next week I have a testimony. I would like to be able to give some signal of where January 9, 2008 4 of 60 the Committee is going forward toward the end of January. I think that would be very beneficial. The markets in part are suffering from just simple uncertainty about whether the Fed is willing to be proactive in addressing the downside risks, and I think if I am able to give some signal about our inclinations that would be quite helpful. So, in short, the purpose of the meeting today is not to take any action, but rather it is my attempt to consult with you, so that when I speak in public tomorrow and next week I will be representing the broad consensus of the Committee. With that, I would like to begin with some short briefings by Bill Dudley in New York on markets and by Dave Stockton in Washington on the forecast—I think you received materials today—and then give time for Q&A. Following that, I would like, because I called the meeting, to give you my own views on why we need to be somewhat more proactive in risk management. Following that, we will open the floor, take comments, and sort of see where we are at the end of the day. I hope that works for everybody. Okay. If there are no comments, let me call on Bill Dudley to discuss the market situation. MR. DUDLEY. 1 Thank you, Mr. Chairman. I’ll be referring to the chart package that I hope you have in front of you. Market function has improved somewhat since the December FOMC meeting. This can be seen most notably in the term funding, foreign-exchange swap, and asset-backed commercial paper markets. In addition, some of the risks of contagion—for example, from troubled SIVs and from financial guarantors to money market mutual funds or the municipal securities market—appear to have lessened slightly. However, while market function has improved and contagion risks have diminished somewhat, the underlying strains on financial markets remain severe and may even have intensified. This can be seen in a number of areas, including (1) the wide spread of jumbo mortgage rates relative to conforming mortgages, (2) the equity prices and credit default swap spreads of a broad range of financial institutions, (3) developments in the commercial mortgagebacked securities market, and (4) corporate credit spreads and credit default swap spreads. Put simply, market participants believe that the macroeconomic outlook has deteriorated significantly and financial asset price movements broadly reflect that shift in expectations. Turning first to the better news, term funding pressures have moderated considerably over the past few weeks. As can be seen on the first page of the handout 1 The materials used by Mr. Dudley are appended to this transcript (appendix 1). January 9, 2008 in exhibits 1, 2, and 3, term funding spreads have fallen sharply for dollar, euro and sterling rates. For example, the one-month LIBOR–OIS spread is now 31 basis points, down from a peak of more than 100 basis points in December. However, the narrowing in three-month term spreads has been much more modest, and neither spread is back to where it was in late October or early November. Much of the recent improvement is undoubtedly due to the passage of year-end. But coordinated central bank term funding actions, including the term auction facility (TAF) and the dollar term funding auctions conducted by the ECB and the SNB, appear also to have been helpful. The first two TAF auctions went well, with bid-to-cover ratios of around 3 to 1 and stop-out rates below the 4.75 percent primary credit rate. Interestingly, term funding spreads narrowed notably on the two days when these auctions settled. This supports the notion that the TAF auctions did contribute to a lessening of term funding pressures. Moreover, market participants have generally reacted favorably to the news that the TAF auctions would continue and that the size of the January auctions would increase to $30 billion per auction. As hoped and anticipated, stigma appears to have been less of a factor for the TAF compared with the primary credit facility. The stop-out rate rose slightly in the second auction relative to the first, and some less healthy institutions bid more aggressively in the second auction. This suggests that, as depository institutions gain experience with the TAF, that might lead to an even further diminution of stigma. As term funding markets have improved, the foreign exchange swap market has also improved in terms of function. Bid-asked spreads have narrowed, and transaction sizes have increased. The all-in cost of funding via foreign exchange swaps has fallen back down to approximate the cost of straight dollar LIBOR financing. Improvement in market tone is also visible in the interest rate swap market. As can be seen in exhibit 4, swap spreads have fallen notably from the peaks reached in the fourth quarter. Another positive development has been the improvement in the asset-backed commercial paper market. The volume of ABCP outstanding has stabilized, and the spread between the thirty-day ABCP rate and the one-month OIS rate has narrowed sharply. The spread relative to one-month LIBOR is about back to what it was before the financial market turbulence began in August (exhibit 5). Bank sponsors have generally stepped forward to take problem SIV assets back on their balance sheets, and this has reduced the risk of asset fire sales. Also, the roll-up of SIV assets onto bank balance sheets has reduced the risk of further contagion to the money market mutual fund industry. Finally on the positive side of the ledger, although the financial guarantors remain under significant stress (as shown in exhibits 6 and 7, there has been no recovery in the share prices or CDS spreads for the two major financial guarantors—MBIA and Ambac), this has had only a modest effect on the municipal securities market. Apparently, investors have decided that the quality of the underlying municipal securities is quite good—the historical default experience after all has been very low—and therefore have not been that troubled by the decline in the quality of the insurance on these instruments. That said, any actual downgrade of the financial guarantors’ credit ratings could still disturb the municipal market, in part, through its potential impact on insured 5 of 60 January 9, 2008 municipal bond funds, which use the AAA ratings obtained from the insurance as a selling point to retail investors. Despite these positive developments in terms of market function, financial conditions have tightened as balance sheet pressures on commercial and investment banks remain intense and as the macroeconomic outlook has deteriorated. This can be seen in a number of respects. First, large writedowns and larger loan-loss provisions are cutting into bank and thrift capital and pushing down equity prices. For commercial and investment banks, the willingness of sovereign wealth funds and other investors to replenish capital has kept bank CDS spreads from widening back to the peaks reached a few months earlier. In contrast, major thrift institutions face greater difficulties in attracting new capital because their core business has soured. As a result, their CDS spreads have soared. The spread between fixed-rate jumbo mortgages and fixed-rate conforming mortgages has climbed again (see exhibit 8). This reflects the impairment of the mortgage securitization market and the lack of spare balance sheet capacity for commercial banks and thrift institutions. Second, corporate credit spreads and credit default indexes have widened sharply in the past few months, with a significant rise registered since year-end. As shown in exhibit 9, for investment-grade debt, the widening in spreads has roughly offset the fall in Treasury yields. As a result, investment-grade corporate bond yields have been relatively steady. In contrast, for non-investment-grade corporate debt, the widening in credit spreads has dwarfed the decline in Treasury yields. As a result, noninvestment-grade corporate debt yields have climbed sharply. Although actual corporate default rates have remained unusually low, forecasts of prospective default rates have become much more pessimistic. For example, Moody’s announced yesterday that it had raised its speculative corporate debt default estimate for 2008 to 5.3 percent from 4.7 percent earlier. Exhibit 10 illustrates that, since mid-October, credit default swap spreads have been rising in both the United States and Europe. Third, equity markets are under pressure. For example, as illustrated in exhibit 11, the S&P 500 index declined in the fourth quarter and, up through yesterday, has fallen about 5 percent so far this year. Moreover, the equity market weakness has broadened out beyond the financial sector. For example, as of yesterday’s close, the Nasdaq index, which has little weight in financials, had fallen 8 percent this year. Global stock market indexes have also generally weakened. Interestingly, the dollar has been relatively unaffected by the deterioration in the macroeconomic outlook. After rallying into year-end, the dollar has given back much of these gains over the past week. But over the past few months, the dollar has mainly been range-bound as opposed to being in the downward channel that applied for much of 2007 (exhibit 12 illustrates what the dollar has done lately against the yen and the euro). As the economic outlook has deteriorated, market participants’ expectations of monetary policy easing have increased markedly. As shown in exhibit 13, the federal 6 of 60 January 9, 2008 7 of 60 funds rate futures market now anticipates about 100 basis points of additional easing by midyear. As shown in exhibit 14, the Eurodollar futures market anticipates a bit more than 125 basis points of further easing by year-end 2008. Currently, as shown in exhibit 15, options prices on federal funds futures imply a probability of about 50 percent of a 50 basis point move through the January 29-30 FOMC meeting. Interestingly, market expectations for an intermeeting move appear to be relatively low. Although it is difficult to be precise about this, my best guesstimate is that the market has priced in about a 1-in-4 chance of a 25 basis point intermeeting rate cut. Although that means that a rate cut today would be a big surprise to market participants, it probably would be well understood in hindsight. The sharp downward skew in rate cut expectations that has been evident in recent months persists. As shown in exhibit 16, which looks at the expected distribution of Eurodollar futures rates 300 days ahead, the mode is 3.25 percent, well above the mean of the distribution. This likely reflects market participants’ collective judgment that there are two distinct scenarios. The first (and more likely) scenario is one of an economic slowdown and a modest rise in the unemployment rate. This scenario is associated with perhaps 100 basis points of additional easing. The second scenario is a much darker one of a full-fledged recession. In this scenario, the unemployment rate would move up more sharply, and the magnitude of cumulative rate reductions would be much larger. Finally, despite the rise in headline consumer price inflation, the uptick in core consumer price inflation, and the atmospherics created by firmer gold and oil prices, market-based measures of inflation expectations remain very well behaved. As shown in exhibit 17, both the Barclays market-based measure of five-year, five-yearforward breakeven inflation and the Board’s measure have narrowed since early November. Thank you. Of course, I’m happy to take any questions now or after David’s presentation. CHAIRMAN BERNANKE. Thank you, Bill. Why don’t we take a few questions for Bill. Does anyone have questions for Bill? President Fisher. MR. FISHER. Bill, on the five-year, five-year-forward, doesn’t the Markets Group also have its own measurement, and is it as low as the Board measurement? MS. MOSSER. This is Trish Mosser talking. Yes, we do have our own measure. It is somewhat less noisy than the Barclays measure; but because it is based on market prices, it is closer to the Barclays measure than to the Board’s measure, which of course is based on the staff’s yield-curve model. January 9, 2008 8 of 60 MR. DUDLEY. I think the important thing is that all three of these measures are moving in the same direction. So I wouldn’t want to put a lot of weight on the level of these three measures, which differ because they adjust differently for liquidity and on-the-run/off-the-run comparisons, but they have all moved down pretty meaningfully since November. CHAIRMAN BERNANKE. Other questions for Bill? MR. FISHER. I agree that we shouldn’t place a whole lot of weight on this thing. We have been talking about this, Mr. Chairman, on the morning call. There may be some anomalies here, but I wouldn’t place a whole lot of weight on that. I just wanted to get a sense of how the Board’s measurement was different. It looks to me to be more range-bound, just to use your term, Bill, but that’s not a point worth spending much time on. Thank you. MR. DUDLEY. Well, as I have said in past briefings, I think the Board’s measure has a better analytical foundation. If I had to pick one measure, I would probably pick the Board’s measure because I think it is trying to do a more precise estimation of comparing apples with apples in terms of comparing TIPS with nominal Treasury securities. This comparison is difficult because you have to make assumptions about what the liquidity premium is on nominal Treasuries that are on-the-run versus off-the-run and versus TIPS. So I think that it is probably useful also to see if movements in the Board’s measure are or are not corroborated by movements in other measures. MR. FISHER. Thank you. CHAIRMAN BERNANKE. Other questions for Bill? All right. If there are no other questions for Bill, let’s turn to Dave Stockton for an update on the forecast. MR. STOCKTON. 2 Thank you, Mr. Chairman. Earlier today along with Bill Dudley’s materials we circulated a note describing some of the revisions that we have made in our projection since the December forecast. I should caution the Committee 2 The materials used by Mr. Stockton are appended to this transcript (appendix 2). January 9, 2008 that this projection has not been the result of running the complete machinery that sits behind the staff’s forecast. Rather, we’ve done our usual, I hope, careful job of doing the near-term adding up, and then we’ve used the model simulations and rules of thumb to adjust our medium-term outlook to reflect changes in the data and changes in the conditioning assumptions that we’ve taken on board here. That said, I do feel reasonably comfortable that what we’re showing you here puts us in the right ballpark in terms of how the data and how changes in some of the major conditioning assumptions are likely to affect the forecast that we will be showing you in a few weeks. Several key features of note in this revised forecast: Growth in real GDP in the fourth quarter of last year has been revised up by a noticeable amount. However, we will revise down growth in real GDP in both 2008 and 2009 also by a noticeable amount. Unemployment runs higher throughout the projection period. Despite that higher level of the unemployment rate, total and core inflation are higher in 2008 than in our December forecast because of sharply higher oil prices incorporated in this forecast. Inflation is roughly unchanged in our 2009 projection. So let me touch briefly on each of these elements. As you can see in the table, we’ve revised up our estimate of GDP growth in the fourth quarter from a forecast that was basically flat at the time of the December meeting to an increase of about 1¼ percent at an annual rate. Much of that revision reflects the stronger retail sales data that we received shortly after the last FOMC meeting as well as the stronger consumption of services that we received in the personal income release late last month. In addition, the incoming data on construction put in place for November were much stronger than we anticipated for nonresidential structures and for state and local construction. Not all the data that we’ve received, however, have been on the positive side. Housing continues to outflank us on the low side. Both starts and permits for November came in well below our forecast, and sales of new homes were much weaker than we’d expected. We now think the trough in housing starts, which we still see as likely to occur in the first half of this year, will be deeper than our previous forecast and by a considerable amount—nearly 10 percent deeper is what we’ve built into this revised provisional forecast. The other major negative surprise was the employment report for December. Private payrolls contracted by 13,000 last month. We’d been expecting an increase of about 50,000. Moreover, the unemployment rate jumped 0.3 percentage point in December. That increase was certainly eye-catching from our perspective. As we noted in the handout, higher average hourly earnings offset the weaker employment so that the labor income actually is not too much different than we had expected at the time of the December forecast. Still the labor market appears to us to have softened noticeably last month, and we’ve taken signal from that and revised down expected employment growth going forward. Our forecast for economic growth in the first quarter is unrevised at an annual rate of ¾ percentage point. We do carry a little more momentum in consumer spending 9 of 60 January 9, 2008 10 of 60 and a little more momentum in nonresidential structures into the first quarter, but that is offset by the substantial downward revision that we’re making to the housing forecast. Beyond the near term, we’ve had a lot of negative influences to contend with. I’ve already noted that we’ve taken down our housing forecast. That revision alone was sufficient to knock another tenth off GDP growth in 2008, bringing the total subtraction of housing from GDP growth in this projection in 2008 to ¾ percentage point. Oil prices are about $6 per barrel higher on average than was incorporated in our December forecast. The impact of those higher oil prices on purchasing power and consumption are large enough to reduce projected GDP growth in both 2008 and 2009 by a tenth each year. I should note that households are on the verge of experiencing another stiff increase in gasoline prices over the next couple of months, and households are probably not yet aware that that’s on the way, except for those that actually follow oil futures markets—I assume that’s a relatively small group. We’ve lowered the path for equity prices by 7 percent in this forecast. About half of that revision reflects the change that occurred since we put the December Greenbook to bed. The forecast that I circulated today doesn’t include yesterday’s decline or today’s increase. We basically used Monday’s close. The other half of the decline in equity prices that we’ve built into this baseline forecast currently reflects the fact that, for purposes of this provisional forecast, we made no change in our assumption about the path of the federal funds rate from our December Greenbook. Obviously, the December path assumed no change in the funds rate at the January meeting. That would come as a significant disappointment to the markets, and by our normal calibration, we estimate it would take about 3½ percent off the level of equity prices going forward. So that gets us to the 7 percent. House prices have come in a touch lower than we had forecast. We have also lowered our projection on the level of house prices about 1 percentage point in this forecast. Taken together, those lower equity prices and the lower house prices take 0.1 off growth in 2008 and 0.2 off GDP growth in 2009. Turning to the labor market, the jump in the unemployment rate in December in combination with our weaker outlook for growth in real GDP going forward has led us to raise our projected level of the unemployment rate to 5.2 percent at the end of 2008 and 5.3 percent at the end of 2009. As for prices, the recent news on inflation has been disappointing. Total and core PCE prices came in above our expectations in November. As can be seen in our table, we’ve raised our estimate of total PCE price inflation in the fourth quarter to 4 percent, and we’ve increased our estimate of core PCE price inflation to 2.7 percent. Both those figures are ½ percentage point above our estimates in December. Some of the upward revision in the core price measure is due to higher figures for nonmarket prices, but market-based prices were higher than we had expected as well. Going forward, the higher oil prices that I referenced earlier also leave a clear imprint on projected inflation. We’ve raised our headline price inflation to 2.4 percent in 2008, up 0.4 percentage point from our previous projection. With January 9, 2008 11 of 60 energy prices expected to edge off in 2009, total PCE inflation recedes to 1.7 percent. For core inflation, we’ve added 0.1 percentage point to our projection this year, reflecting the indirect effects of higher energy prices. Our forecast for core inflation in 2009 is unchanged. Some lingering indirect effects from higher energy costs are offset in this forecast by a wider margin of slack in resource utilization. Let me just say a few words about how the risks to the forecast have changed. I believe that the adjustments that we have made to this provisional forecast actually are quite reasonable in light of the developments and the data that we have been contending with, but I’d have to admit that the downside risks to our projection have become more palpable to me. Despite a year of nearly continual downward revision, we just can’t seem to get in front of the contraction in housing. The steep descent in sales and construction of new homes has not let up, and there seems to me to be more downside risk than upside risk to our house-price projection. Another area of concern would be the recent readings on the labor market, which have been very soft. Although quite volatile on a week-to-week basis, initial claims for unemployment insurance and insured unemployment have been trending up. Moreover, both the payroll survey and the household survey deteriorated noticeably in December. As I noted earlier, private payrolls contracted last month, and a jump of 0.3 percentage point in the unemployment rate in a single month is rare, though not unprecedented, outside of recessions. The steep decline in the manufacturing ISM in December was both unexpected and of a magnitude well outside the normal volatility in the data. The drop in consumer confidence has pretty much matched our expectations, and it didn’t continue to worsen in December; but the total drop that we have seen in recent months is similar to drops seen before previous recessions. Any one of these indicators taken by itself would not be especially troubling; but taken together, they certainly deserve attention. We are not ready to make a recession call yet. The spending data still have exceeded our expectations by a noticeable margin, especially consumer spending. Motor vehicle sales at a 16.2 million unit rate in December certainly don’t look like a recessionary development, and business spending has slowed but certainly not slumped thus far. Furthermore, the anecdotes—at least my read of the anecdotes—still seem more consistent with the weak economic growth that we are projecting rather than outright contraction. But at this point we do feel as though we are on very high alert. I’d be happy to take any questions from members of the Committee. CHAIRMAN BERNANKE. Thank you, Dave. Are there questions for Dave? President Lacker. MR. LACKER. Yes, Dave. So there is a lot written about nonlinearity and macroeconomic dynamics. There are these regime-switching econometric models characterizing real data. There is the 0.3 thing—I think it is 0.3— that people talk about regarding the January 9, 2008 12 of 60 unemployment rate: It doesn’t go up by more than 0.3 without going up by a ton. You guys are surely aware of those econometric properties or those methods of characterizing the data, and while your econometric models may be strictly linear in some sense, what you give us is your best judgment, right? Am I to take your forecast as reflecting the probabilities of nonlinear dynamics or not? If it doesn’t, are nonlinear dynamics something you believe in, that you think we should internally adjust your forecast with, or not? MR. STOCKTON. I believe in nonlinear dynamics. [Laughter] I think I have even experienced them, and probably you have as well on occasion, in terms of the difficulty that we have in forecasting recessions. Our forecast isn’t just some sort of “push a button on a linear model and here is the result.” But I do think the current situation illustrates to me why it is, in fact, so hard for us and why we don’t forecast recessions very often. As I indicated, I think there is a configuration of a number of indicators that make it easy for me to imagine you looking back on next June and saying, “Indeed, what you saw back there in December—in terms of the jump in the unemployment rate, the drop in the manufacturing ISM, and the uptick in initial claims— were all precursors of a recession.” The point of my remarks is that I am pretty darn worried about that possibility. But it is hard at this point to make that call—we are coming off the data in the fourth quarter, which have exceeded our expectations considerably. As I noted, not all the things that you might expect to be highly sensitive to a business cycle downturn, such as motor vehicle sales, have moved in that direction. I know this is unfortunate, and we really cannot be as helpful to you as I would like. We are saying, in effect, “Yes, we’ll call the recession when we see the weak spending data.” But the weak spending data will already be lagged one or two months, and that is the reason that we will be looking back, if we’re lucky to be able to do it in March, saying, “The spending data indicate that a recession January 9, 2008 13 of 60 may have started in December.” The current forecast is our best judgment. But I think it wouldn’t take much more in the way of negative news for us at this point to regime-shift, as you said, into recession mode. We are not quite there yet, but we are certainly worried about that possibility at this point. CHAIRMAN BERNANKE. Other questions for Dave? President Fisher. MR. FISHER. Dave, you very eloquently summarized in your statement that downside risks are more palpable. Certainly they seem to be more palpable. But the bigger adjustments I see in your numbers, at least for the first quarter of 2008 and for the year 2008—even larger than the adjustments you made on economic growth—are those on inflation. I’m wondering if you could just comment on that, please, and give us a sense of that palpability, as it were. MR. STOCKTON. So, indeed, I think this combination of weaker economic growth and higher inflation is an unfortunate situation for you as policymakers. I do think there are some upside risks that you face on inflation, and the recent rise in oil prices probably intensifies those upside risks. We are taking some comfort from two other pieces of information in the constellation of the inflation data that the process isn’t slipping away to the upside on inflation. One is, as Bill noted, that we haven’t really seen any deterioration in the TIPS-based measures of inflation expectations. We have seen an uptick in the Reuters/Michigan survey of households in the last month or so, on both near-term and long-term inflation expectations. That does tend to happen in periods when gasoline prices are spiking up. I would hate to throw that observation out completely, but I guess as we look at this, we don’t really see as yet convincing evidence that there has been a deterioration in inflation expectations. The other thing is that we haven’t really seen anything in the way of serious deterioration on the labor cost side. So those two things combine, at least in my mind, not to eliminate but probably to limit some of the upside risks that January 9, 2008 14 of 60 you’re facing on the inflation side. But, clearly, anecdotes are there—not just the data but also anecdotes—that suggest that businesses are facing some considerable cost pressures associated with higher energy and other commodity prices. MR. FISHER. Thank you. CHAIRMAN BERNANKE. Are there other questions for Dave? If not, if I could kick off the general discussion, I will talk a bit about how I see the economy. I have two main points to make. First, I think the downside risks to the economy are quite significant and larger than they were. Speaking as a former member of the NBER Business Cycle Dating Committee, I think there are a lot of indications that we may soon be in a recession. I think a garden variety recession is an acceptable risk, but I am also concerned that such a downturn might morph into something more serious, and I will talk about that in a moment. My second point is that I think that 100 basis points of easing may or may not be a rough offset, in terms of expectations, to the decline in demand that we have seen, but I don’t think that we have done really very much at all in terms of taking out insurance against what I perceive to be the greater risk at this point. So let me address those questions just a bit. President Lacker already anticipated me in mentioning the regime-switching models of recession. Those suggest a nonlinear process: There are two states of the world—a growth state and a recession state—and the behavior of the economy is different in those two states. Those models fit pretty well, although, of course, like many econometric models they are mostly retrospective. But some of the indicators suggesting a switch are things like falling equity prices, slower manufacturing growth, rising credit spreads, and—an often very effective indicator—the fact that the federal funds rate is so far above twoyear interest rates at this point. Those would all be indications that the regime is about to switch, if it hasn’t already. January 9, 2008 15 of 60 President Lacker also mentioned the idea of a stall speed. I presented some figures on that in a meeting in 2006. There have been situations of a 0.3 percentage point increase in the unemployment rate in a month that have been reversed, but there has never been in our case a 0.6 increase over a period of time that didn’t translate into a recession and a much greater increase in unemployment. Similarly, there has never been a sustained GDP growth rate below 2 percent— and we have a 1 percent forecast for 2008—that has not turned into a recession. Indicative of the kind of behavior that we have seen in the past, let me just refer to the last two recessions. Unemployment was 5.2 percent in June 1990, having been there for about two years. It jumped to 5.5 percent in July, by the next June it was 6.9, and the following June it was 7.8. In December 2000, unemployment was 3.9, it was 4.3 at the cyclical peak in March 2001, and ultimately it hit 6.3 in June 2003. So there is some tendency, once a stall speed is reached, for the economy to slow quite considerably. Again, like David, I don’t know if we’re there yet. Obviously, ex ante it’s extremely hard to tell, but I do think the risks are at least 50 percent at this point that we will see an NBER recession this year. Now, as I said, the concern I have is not just a slowdown but the possibility that it might become a much nastier episode. The main mechanism I have in mind—there are several possibilities, but I think the financial markets are the main risk. Let me talk a bit about banks, which are at the center of this set of issues. I’m going to talk a bit about the 21 large, complex banking organizations (LCBOs). I have had some data worked up for me by the supervisory staff. Since August these 21 LCBOs have announced $75 billion in extraordinary markdowns associated with various credit issues. They have, on the other hand, either raised or plan to raise $50 billion in capital. Therefore, one might say, “Well, that looks pretty good.” I think, though, on net that there is really actually quite a fragility here. January 9, 2008 16 of 60 Several factors are going to put pressure on bank capital going forward. First, they have been taking assets on the balance sheet, as you know—about $250 billion so far of semi-voluntary additions coming from off-balance-sheet conduits and others. It is hard to say how much contingent additional exposure they have. There are a lot of different estimates. For these 21 banks, the Board supervisory staff identified between $250 billion and $300 billion more of potential exposures to bring back on the balance sheet. The BIS, at the meeting I attended over the weekend, looking at the 20 largest international banks, estimated $600 billion. We don’t know how much it is going to be, but the banks themselves are somewhat unsure about potential exposures. Loan-loss reserves are quite low for this stage in the cycle, about 1.4 percent, compared with, say, 2.5 percent during the headwinds period of the early 1990s, and that is partly a result of the SEC regulations, which have forced banks to keep their reserves low. There is a lot of concern in banks about additional credit losses and downgrades, concern about financial guarantors, and, of course, macro concerns. Finally—and I think this is one of the most worrisome things to me—we are beginning to see some credit issues outside of housing and mortgages. Credit card delinquencies have jumped in a few banks’ home equity lines. There are concerns in commercial real estate, particularly in some regions like Florida and California. And with fair value accounting, as pricing goes down, even if you don’t yet see a cashflow effect, you get immediate effects on capitalization. The implications of this, even if the economy continues along, say, the Greenbook’s estimates, are that lending is going to be quite tight. Banks are reluctant to take loans onto their balance sheets because of the capital constraints. They are, in fact, raising their internal capital targets because of their concerns about credit losses and about additional off-balance-sheet January 9, 2008 17 of 60 responsibilities. We have seen contraction not only in the primary mortgage market but also in home equity lines of credit, and I suspect we will see tighter conditions for credit cards, CRE lending, and non-investment-grade corporates. A question is high-grade corporates. There has even been some deterioration in, say, A-rated corporations. I have had a lot of opportunities to talk to bankers. We had a meeting over the weekend in Basel between the central bankers and about 50 private-sector representatives. The thrust that I got was that things are going to be pretty tight. “We are going to meet our regular customers’ needs, but all of this is conditioned on no recession.” As one banker put it in our meeting, “There is no Plan B.” So a concern that is evident is that, if economic conditions worsen notably, the effects on bank capital, on credit risk, and so on will create a more severe credit situation, which could turn a garden variety downturn into something more persistent. The other issue, of course, is housing. Credit markets and housing are interacting very closely. I think that residential construction is going to stop subtracting so much from GDP growth because there is a non-negativity constraint. Eventually, the declines in residential construction will have to stop, but we are pretty far from the non-negativity constraint on prices, and I think that is where the issue is. I have reviewed the staff’s analysis of house prices. They make perfectly reasonable guesses about what house prices will do. But it is inherently very difficult, and there is a very wide range of possible outcomes. If the housing market continues to be weak and if credit continues to be tight, then the possibility of a much more significant decline in house prices, particularly in some regions, is certainly there; and that, in turn, would have significant effects on credit markets and on the economy. So I have tried to be quick; I don’t want to take too much time; but I see a lot of indications that a recession may well happen. Given the additional considerations of credit January 9, 2008 18 of 60 markets and housing markets, I am concerned that we might get something worse than, say, 2001. The other question I raised was, Have we done enough? We have done 100 basis points. Of course, it is hard to know. A few indicators: The Greenbook-consistent medium-term r*, which is an indicator of the real funds rate that leads to full employment in three years, was 3.3 percent in August 2007. It is currently about 1.8 percent, so that is a decline of 150 basis points. That is just one rough indicator of the decline in aggregate demand. I have not redone the Taylor rules, but for December the estimated forecast- and outcome-based Taylor rules showed a rate of about 4.0 to 4.1. Again, that would not include any risk-management considerations. That is just sort of an average over periods of both inflation risk and growth risk. I guess I would also mention the 2001 pattern, the most recent episode. The FOMC—many of you were there, I was not—dropped the rate 250 basis points in a little over four months in early 2001. Obviously, that was a much more aggressive episode. What about inflation? The fact is that we are in a tough bind here, and we don’t have any easy, simple solution. We are going to have to balance risks against each other. We are going to have to do it in a forward-looking way, and we are going to have to try to make some judgments. I’ll make a couple of comments. First, even assuming no recession, as the staff does, the staff has core and total inflation back into a reasonable approximation of price stability by 2009. As they note, wage growth has slowed; that doesn’t seem to be incorporating any inflation pressures. The other thing I would say is that, if we do have a recession, inflation during recession periods does tend to fall fairly quickly. In the 1990 episode I mentioned before, between June 1990 and June 1993, core PCE inflation fell from 4.4 to 2.7 percent. Of course, in the 2001 episode, despite 550 basis points of easing, we went from 2.2 percent in the fall of 2001 to unwelcome January 9, 2008 19 of 60 disinflation in 2003. So should there be a recession, the inflation problem would probably take care of itself. Now, there is an argument—and Governor Mishkin’s speech on Friday makes the case pretty well—that, when you have these kinds of risks, the best way to balance the growth and inflation risks is to be aggressive in the short run but to take back the accommodation in a timely way when the economy begins to stabilize. I realize this is not easy to communicate, but I think if we attempt to do so we can make some progress on that front. So, to summarize, we have a very difficult situation, but I do think the downside risks have increased and are quite significant. I don’t think that our policy thus far has gotten ahead of the curve, so to speak, in terms of taking out insurance. Although, again, I’m not recommending any action today, I think we need to be cognizant of this issue as we go into the January and subsequent meetings. So let me stop there and open the floor for your reactions and comments. I’d like to know if you are comfortable not acting today—waiting until the January meeting. On the other hand, I am also interested in knowing if you share my assessments or if you don’t. Let me be clear: I am not asking now for a commitment to any particular action in January. I am not asking for carte blanche. I am simply trying to see if we are all on the same page, or more or less on the same page, so that we can collectively communicate more effectively and I hope take the right actions when the time comes. So let me stop there, and Debbie will call on members. President Lacker. MR. LACKER. Thank you, Mr. Chairman. On the threshold question about acting today, I don’t think we should act today. Intermeeting moves are relatively rare, they tend to be headline-grabbing, and in retrospect they turn out to mark—and are usually intended to signal— dramatic breaks from previous practice or reaction functions. From that point of view, I think in January 9, 2008 20 of 60 the current context a move at this call would inevitably be interpreted as a reaction to the increase in the unemployment rate, just given the timing of when the data have come out and when the move is. I don’t think that would be a good idea. I share the sense that recession is a definite risk now and that the risk has gone up. I think that is persuasive. We have gotten real growth numbers that are weaker now. I think the outlook has to be weaker now than it was several weeks ago. But I am worried about inflation, too, and I wonder what a more proactive approach means for our strategy for inflation. The staff forecast that David presented marked down the real GDP forecast for ’08 by 0.3 and marked up the overall inflation forecast by 0.4. The usual Taylor rule puts a bigger weight on the inflation part than on the GDP part, and it doesn’t suggest a knee-jerk aggressive move down. I’m not saying that’s not what is required now, but it suggests some questions. Would a more proactive approach bring our expectations about our reaction closer to the market’s view? Is that how you interpret what you are advocating here? Or is this to move us beyond what the market expects? Related to this, are you asking for some shift in our strategy on inflation? I mean, are you asking that we be willing to tolerate an increase in inflation or an increase in inflation expectations? In the current circumstances, and what looks likely for the next several months, it is hard to picture reversing course really rapidly. If things play out the way the staff forecasts, it is just hard to imagine us turning around and raising rates 50 or 100 basis points if inflation rises 1 or 2 percentage points. It is heartening that inflation expectations numbers haven’t risen more than they have, and I take comfort from that. But they are around 2½ percent on the CPI. It is not clear that what they reflect isn’t that occasionally we get it down to 2 but most of the time it bounces around above that. Without our having a clear sense of what our strategy is about where we want to bring inflation, I just question what you are advocating means for inflation strategy. January 9, 2008 21 of 60 CHAIRMAN BERNANKE. Let me just respond quickly. Obviously, I am not advocating any change in our objectives. I just think that at this point we have not quite balanced the risks to our objectives appropriately, and you could think of it as a level adjustment, if you’d like, and not a change in path. I would just note the risk of having what could be a strictly inefficient outcome, in which the growth situation gets so far out ahead of us that inflation falls too much, as happened in 2003. I believe that we can make essentially a level adjustment and try to get a little ahead of the risks here. So long as the market expects the economy to slow—and I note that they are already expecting quite a bit of easing and inflation expectations aren’t moving—I think we can do that in a safe and reasonable way. I am not in any way advocating changing our objectives. I am suggesting that we are not quite calibrated properly to achieve our objectives. President Rosengren. MR. ROSENGREN. Thank you, Mr. Chairman. My views are actually very consistent with your own. I would support lowering the fed funds rate 50 basis points, and, if it were up to me, I would support doing it right now. The employment report last Friday was weaker than I expected. In conjunction with the likelihood of several quarters of economic growth below potential, the risk that the economy is in, or could be going into, a recession is too high. Continued declines in housing prices and stock prices raise my concern that deteriorating household wealth will constrain consumption more than we anticipate. I am also worried that weaker labor markets are likely to exacerbate problems in the housing market. Should housing prices fall further and foreclosures rise more rapidly as a result of weak labor markets, financial markets may experience even more turmoil than we have experienced to date. Commodity and oil prices have risen, but I expect that the weakening in labor markets will be sufficient to January 9, 2008 22 of 60 restrain inflation. The downside risks to the economy are significant, and I think we should take aggressive action to mitigate that risk. Thank you. CHAIRMAN BERNANKE. Thank you. President Yellen. MS. YELLEN. Thank you, Mr. Chairman. I agree with both the concerns that you expressed and the analysis that you offered. Based on the data we now have in hand, I support a 50 basis point reduction in the federal funds rate in the near future. I think a very good case can be made for moving down 25 basis points today, and it would be my preference. According to what Bill Dudley said, markets apparently do attach some probability to a move of that magnitude before the January meeting. I could also support a 50 basis point move today, but I am concerned that it might be taken as a sign of panic by the Committee and somehow wrongly indicate that we have inside information showing that things are even worse than markets already think or, alternatively, be seen as an overreaction to the employment report. But if we don’t move today, I do think we need to take decisive action in January, and I hope you will give a strong signal that we will do so in your speech. I agree with the staff’s assessment that the outlook for economic growth has weakened since December, and I also see the downside risks to the forecast as having increased since then. We have revised down our 2008 forecast also because of the sharp increase in energy prices and the deterioration we have seen in financial conditions just since December. It is good that conditions in money markets have improved somewhat, but equity prices have fallen very substantially—I guess around 6 percent since our last meeting. Credit spreads are up, and borrowing rates for many borrowers are higher in spite of a decline in Treasury yields. I also find the labor market developments worrisome. I try not to put too much weight on any single monthly observation, but I find it entirely believable and consistent with everything else we are January 9, 2008 23 of 60 seeing that we have entered, at best, a period of slow employment growth. It is something that we have been expecting all along. It helps to resolve some of the puzzles we have been discussing about why labor markets have been so strong relative to goods markets. It is true that consumer spending has been amazingly robust so far, but I find it unimaginable that it can continue when slow growth in disposable income is added to everything else that is weighing on households, particularly rising energy prices, accelerating declines in house prices, and falling stock prices. It seems to me that, with the stagnant or contracting labor market, the odds of a recession—and, as you argued, a potentially very nasty one—have risen. I am also very worried about the possibility of a credit crunch if higher job losses begins to make lenders pull back credit. It is true that on the inflation front the recent news hasn’t been particularly good. It certainly is true that there are upside risks. But I do take comfort from the fact that inflation compensation has remained well behaved and that we already have slack in the labor market and more seems likely to develop. I support a significant rate cut not only because of the downgrade to the economic forecast since December but also because I think the stance of policy even now with the actions we have taken—I agree with you—is still within the neutral range. Given current prospects and the asymmetric nature of the risks, particularly the high tail risk associated with the credit crunch, I believe that policy should be clearly accommodative. So having revised down my forecast, I would support a significant funds rate cut as a way to catch up with where policy should be. CHAIRMAN BERNANKE. Thank you. President Stern. MR. STERN. Thank you, Mr. Chairman. I largely share your assessment, so let me just make a few comments about the situation as I see it and about the timing of our action here. I January 9, 2008 24 of 60 have talked frequently, of course, about the resilience of the economy. But I need to remind myself that that resilience isn’t infinite, and it appears to me that the fundamental positive momentum of the economy is diminishing significantly at this point. This likely will affect not just the next quarter or two but the intermediate-term outlook as well. Moreover, we shouldn’t lose sight of the fact that at least some of the economy’s much-vaunted resilience is arguably the effect of appropriate policy responses in the past. At least we can’t dismiss that possibility, and so we need to bear that in mind as we consider our actions going forward. I think you made an effective case that resilience in this situation could be further inhibited by potentially serious problems in the banking system. I have been concerned for a long time, as you know, that we don’t have incentives right there. While certainly this isn’t proof of anything, I guess we can’t dismiss the possibility that some of the chickens are coming home to roost, and that could affect the outlook as well. Also, attitudes, at least in some quarters, seem quite sour today. In particular, the closer people are to Wall Street, the more negative the attitudes appear to be. So all of this suggests to me that the outlook at the moment is not very promising, and a significant policy response on our part is appropriate. As far as the timing of action is concerned, I do think on balance it is preferable to wait until the end of the month. Other things being equal, I’d like us to be seen as proceeding in an orderly way. Also, if we do that, I think it will provide the opportunity for a more thorough discussion of the economic and inflation outlook and a more comprehensive consideration of the state of the economy, the potential policy path going forward, and the production of a coherent statement at the end of the day. So for all those reasons, on balance, I would prefer waiting until the end of the month. January 9, 2008 25 of 60 One footnote, since you mentioned it—this is a discussion for another day—as you know, I viewed at the time and I continue to view the 2003 disinflation experience a bit differently than you do, and I think we may want to be careful about the lessons we draw from that experience. Thank you. CHAIRMAN BERNANKE. If one of the lessons is that we need to take the accommodation back, I agree with you on that one. President Fisher. MR. FISHER. Thank you, Mr. Chairman. Like you, I am increasingly concerned about the downside on the economic growth side of the equation. I would very much appreciate— perhaps all of us would appreciate—getting sort of a transcript of the numbers you gave us and perhaps some of the BIS data between now and the time we meet because it might be most helpful in our analyzing the situation. I just have a couple of comments. First, I agree with President Stern and President Lacker—this is not the time to make a decision that is of this import. I think it would frighten the markets, and it would perhaps add to the urgency of concern that you are concerned about. In other words, it would compound our problems rather than solve our problems. I am not sure where I stand as far as the upcoming meeting is concerned. I would like to get some more data. I think we will have a little more inflation data by that time. We will have a better sense other than just the employment numbers and, again, if we are able to study what you learned at the BIS, will be better informed. I don’t like the idea of making a decision of this nature outside normal channels. In fact, I think the impression that you, sir, have given directly to the markets is that you don’t feel comfortable either making a fed funds decision outside the normal channels. I am always concerned when we talk about what market expectations are because in this recent cycle, and the mood that the market is in, as one of my friends put it, we give the market a January 9, 2008 26 of 60 gift of a rate cut and then they burst into tears and run outside the room after they have unwrapped the package. I think we have to be very careful here about thinking that we are going to satisfy markets somehow. I don’t think the market is in that kind of mood, and my experience as a market operator indicates that, almost in any context, we are not going to get it just right with markets. I think we have to do what is right for the economy. The other point I would make is in terms of the 1990-93 experience and the 2001 experience. This is something that we need to think through a bit further, at least here in Dallas. There is a difference in the sense that a lot of the inflationary pressures we are feeling are demand-pull inflationary forces that are coming from newly emergent economies that are at a point in their growth cycle where they are kicking in to caloric and BTU intake at a much faster rate than the rate that they are growing. If we were a closed economy, of course, the issue of labor prices and so on would bear an enormous amount of weight, and the concerns that have been expressed would be most consequential. They are still consequential, but I am not convinced at this point in the evolution of the global economy that we are likely to see as much mitigation as the staff is forecasting. It is just a question mark, but I think we should be aware of it. So, in summary, I don’t think we should decide at this meeting. I think it would be the wrong signal to send. It goes outside the norm, including the norm that I believe you yourself have expressed. On the questions you asked about signaling, we just received a memo from the representative from Nashville—that is, Governor Kohn—about being very careful what we signal in our speeches. I think that is a very delicate thing to do, Mr. Chairman, in terms of building expectations that may or may not be fulfilled or may be misinterpreted. So I have the same concerns that President Lacker expressed on being proactive. January 9, 2008 27 of 60 One last comment. No matter what you say, and in terms of representing our views and your views, it is very, very important to remind everyone that we have a dual mandate. The mandate is, of course, about employment growth, but we also have a mandate on the inflationary front. I still have concerns that we might be planting some seeds that could later germinate more rapidly than we would like to see them germinate if indeed we don’t have the kind of weakness that we are all afraid of currently. So I think it is constantly helpful, especially coming from you as our leader, to make sure that we reinforce the dual mandate without scaring the markets that we are not aware of the potential tail risk of severe economic weakness. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. I will certainly do that. President Evans. MR. EVANS. Thank you, Mr. Chairman. I would not have thought to call an intermeeting videoconference. I tend to think of the in-person meetings as those where we make the decisions and do the analysis. But since you made us think about it, I agree with your assessment of the economy. I think that things are noticeably softer. I don’t think there is much accommodation in place at a funds rate of 4¼ percent. To influence aggregate demand noticeably we probably need accommodation on the order of what you are talking about, which is about 100 basis points from a neutral federal funds rate. That range is probably on the order of 4½ to 4¾, so that would put such accommodation at 3½ percent. We have to recognize that monetary policy, if it is going to have any influence on aggregate demand, is going to do so with a lag. That is what all our analysis assumes and suggests, and so if we want to influence aggregate demand to limit midyear weakness, I think we need to take action sooner rather than later. January 9, 2008 28 of 60 In terms of the data developments that you talked about, one thing that is taking place right now is that uncertainty is being resolved. The weakness that we are seeing I am currently interpreting tentatively as sort of an unraveling of things that we haven’t seen so far, not necessarily a deeper weakness. The December data have been weaker. The employment data were poor, and the unemployment rate was a lot higher. In constructing my outlook for the economy in 2008 and beyond, I had been more optimistic than many that consumer spending would hold up in part because of the positive labor market situation. Taken at face value, the December employment report puts a crack in that supporting foundation. It is now likely, it seems to me, that consumer spending will soften with these labor developments. Dave Stockton went through a bit of analysis of the indicators that might lead to a recession. President Lacker and you, Mr. Chairman, mentioned regime-switching as well. I just want to mention that in Chicago we have been publishing our Chicago Fed National Activity Index for a number of years. We started out right at the onset of the 2001 recession, as it turns out. As you know, Mr. Chairman, this index is very closely related to your data-rich environment analysis with Jean Boivin and Stock and Watson. If you do an analysis where you try to assess these regime-switching events, this indicator has done a fairly good job of picking that out when it goes below a threshold of, say, minus 0.7. That is some of the probabilistic analysis that I did with this back then. If you take some of the developments in the employment report at face value, I think that this is headed for a probability of recession this year that is higher than 50 percent. So we have to be a little concerned about that. Anyway, that is the economic situation that I worry about a good bit. What about inflation? Clearly there are risks, and the risks are evident. Core inflation rates are projected to be higher in the near term. Headline inflation has been significantly above January 9, 2008 29 of 60 core for long enough to make people wonder about underlying inflation, but inflation expectations have remained contained. With energy prices traversing high levels over a short time, the possibility of pass-through during a period of economic weakness cannot be dismissed. We also have to be concerned about the reputational cost of inflation going up. But, again, I agree with you, Mr. Chairman, that if we do end up with significantly weaker economic activity, it would limit the inflation risk. What is hard in this period is balancing the risks of going slowly on monetary policy if we really think that the risk of a recession is higher. I agree with what you said and Governor Mishkin’s thinking about being aggressive in the near term to respond to weakening aggregate demand and then making sure that we take back any excessive accommodation at the appropriate time. I know that’s hard, but I think that’s what we should do. I would actually favor action today on the order of 50 basis points because I think that’s about the only way to get to 3½ in a quick enough period of time by our next meeting. That’s what I would prefer. Anyway, those are my comments. CHAIRMAN BERNANKE. Thank you. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. I agree with a lot of what I’ve heard around the table. I am certainly open to the idea that we will have to reduce rates at our next meeting at the end of the month. I am not necessarily opposed to that. Even if I were certain of that, though, I do agree with what a lot of people have said already—I don’t think an intermeeting cut is either wise or appropriate at this point. As a general proposition, I oppose the idea of intermeeting cuts unless a really immediate action is necessary to deal with some severe crisis such as September 11 or something of the like. I am not going to reiterate all the concerns that others have shared about the risk of an intermeeting cut; I don’t really want to belabor that. I do January 9, 2008 30 of 60 think, though, that I would just add one point. Even if we were aggressive now, it is not going to get us off the hook later. I am afraid that, if we took an aggressive cut today, an intermeeting cut, the markets would respond by just wanting even more going further out. I’m not sure that we want to put ourselves into that bind. Nor do I want us to be perceived as responding to nearterm numbers or other pressures from the market. So I am definitely open to further cuts at the end of the month. I share your concern about the economy. It certainly has taken on a sour note in recent data. But I also would note that we are going to get a lot more data between now and the end of the month that will help us sort through perhaps the severity or the dimensions of the slowdown. I would certainly like to have those in hand before I make a final decision. We are in a bind. I share the view, or at least I’m sympathetic to the view, that aggressive cuts in the context of declining demand are supportive. But I also share the view of President Lacker that, although we may want to take accommodation back quickly, the history of this institution is that it doesn’t do that very well. Given the forecast that the staff has provided us, I think that is going to be very difficult. I worry that, if such a scenario comes to pass and we need to take it back, we will not act promptly enough. Certainly, we all can say that now, as we are making the cuts and supplying the accommodation; but I worry that, when the time comes to remove it, we will be reluctant to do so. Having said that, I am sympathetic about the concerns. My outlook is certainly weaker than it was a few weeks ago, but I would not like to see us do something today. I will leave it at that. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. Many of my thoughts have already been stated by others, so I think I can be relatively brief. I appreciate the approach that you are taking. I am inclined to be more proactive and would even support an intermeeting move if I felt that the January 9, 2008 31 of 60 market were better prepared. I supported—actually, I argued for—a 50 basis point cut on December 11, and the prevailing view at that time was that 50 basis points plus the TAF would spook the market. As I recall, in your summary you said something to the effect that, if it were 0 or 50, you would probably go with 50 but, since we had the option of 25 plus the TAF, you supported that approach. I saw greater risks to the downside in December, and I still do. But like President Stern—I think President Plosser said essentially the same thing—I’d prefer that we preserve the appearance of being a bit more orderly. So I have some misgivings if we go forward with a 50 basis point cut today, and my concerns really relate principally to tactics. In my conversations with people over the holidays, I sensed a great deal of angst. I think I mentioned this to you in New Orleans the other day. They worry that there is no one in charge, and therefore I think the appearance of this move today would conceivably put our credibility at risk. You can argue that point perhaps either way. If we were to move today and it worked well, then it would preserve and enhance credibility. But let me just say that I am concerned that the sequence of actions from December through a possible move today would appear to be panicky and a bit incoherent. I think in many respects that is what President Stern said. So to summarize, I am very likely to support a 50 basis point rate move later in January or even intermeeting in a week or so after more preparation of the market. I think it’s important that we husband our credibility at this time, and obviously I agree that we have to watch inflation and indications of changing expectations very carefully. I am not unconcerned with that, but I see the risks as greater to the downside. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Pianalto. MS. PIANALTO. Thank you, Mr. Chairman. I, too, am troubled by the weakness in the real economy data that we are seeing. Our Beige Book contacts confirm the weakness, and my January 9, 2008 32 of 60 business contacts to whom I have been talking report more weakness than they did before our December meeting. However, they are not flashing signals about a recession. Next week we will learn more about just how weak the fourth quarter was through the retail sales and industrial production releases for December. Next week we are also going to get the December CPI report. In my view, the October and November reports were very disappointing. In November, 60 percent of the CPI market basket prices increased at rates of 3 percent or greater. On learning of today’s meeting, I was concerned about making a large policy move ahead of the December CPI report for fear that we would be damaging some of our credibility on price stability, so I did not want to make a move at today’s meeting. However, I can support a 50 basis point reduction at our meeting at the end of the month if we are regarding that reduction—and regarding our cumulative policy actions—as just offsetting the decline in the equilibrium real rate and we are not being aggressively accommodative. That would be, in my view, appropriate policy given my concerns about inflation. But the public could interpret our actions as being aggressively accommodative and that we are downplaying inflation risks. So I hope, Mr. Chairman, that you will be able to communicate your thinking on this, as you have with us today, in some of your upcoming public statements. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you very much. President Hoenig. MR. HOENIG. Thank you, Mr. Chairman. I recognize that the risks on the economy are elevated. I have recognized it for some time. My concern is that the risks are elevated as dangerously, if you will, for inflation as for the slowdown. We have at this point a situation in which we have revised up our inflation numbers and yet that is after we have cut 100 basis points, which we have not seen the full effect of. Those rate cuts are in process now, and they are not going to address the housing issue, given its circumstances, and they are going to work January 9, 2008 33 of 60 slowly through the rest of the economy as we move forward. We have revised up in our estimates the fourth-quarter real GDP numbers, and I think that is important to note even though I know our risks overall are elevated for growth, given some of the data coming in. Job growth came in disappointingly. It did so also in September, and it was revised up significantly after that. I don’t know if the numbers will be revised up, but I would like to go cautiously, recognizing that they have been revised up in the past. I think there are tail risks. There is an important risk of the economy slowing, perhaps going into recession. I think that there is an elevated risk of the inflation numbers continuing to creep up as they have over the past several months. If these inflation numbers continue to rise as we decrease interest rates, there is a very serious cost that will have a very significant detrimental effect on the economy in the long run, which we need to keep sight of. My concern—as others have expressed, but it is a very serious concern on my part—is that we say we can reverse the policy position or raise interest rates later. But it is extremely difficult, and understandably so, because the earlier actions will still be having an effect while the economy shows a slowing. When it starts to pick up, we won’t be sure, just as now, whether we really are going to accelerate and whether the economy is going to pick up. So we delay in reversing those actions, understandably so. So that is why I want to be very cautious about coming down with our interest rates because we will be very cautious going up with our interest rates on the other side of that. I am very pleased that you have not put an actual proposal on an action today. I would be very uncomfortable with that. I think we need to have a full discussion with more information before we commit to any kind of interest rate moves at our month-end meeting. I understand the January 9, 2008 34 of 60 risk, but I think it requires a lot of analysis as we look both at inflation and what that may mean to us if it’s rising and at the real danger of a recession. Thank you. CHAIRMAN BERNANKE. President Poole. MR. POOLE. Thank you, Mr. Chairman. I put a very high weight on policy regularity, and I believe that improved regularity has had a lot to do with policy success in the last quartercentury. But it is worth discussing this for just a minute because of some of the issues you will have to face in the context of signaling. If we were to cut rates today in an intermeeting action, immediately the market would be wondering what happens on January 30. Are they going to just stand pat on no change, then, on January 30, or will there be more? Those issues would be very difficult to resolve by any of us. We would not want to make a flat statement that we would rule out further action on January 30. On the other hand, it would be very uncomfortable in explaining what that would be. So we would increase volatility in the markets and increase questions about our policy strategy and policy direction. So I think it is wise not to act today. I think we should reserve those actions for days or conditions when immediate action is required that can’t wait three weeks until the next regular meeting. Now, in terms of the signaling issue—and I share all the concerns that have been expressed both about inflation and about the state of the real economy—next week we get important information on the real economy. We get retail sales and industrial production. We also get housing starts and permits and the PPI and the CPI. One reason for maintaining a policy strategy that focuses on reserving the decision to the time of the regularly scheduled meeting is that we can say that at that time we will incorporate all the information at hand and not try to make a judgment in advance of that information when we don’t really have to reach that judgment. If today were the regularly scheduled meeting, I could support 50 basis points for the January 9, 2008 35 of 60 reasons that people have been saying. But it’s not a regularly scheduled meeting, so you’re going to have the same problem in terms of signaling that we would have if we were to make an intermeeting decision. Now, you could avoid this issue by talking about baseball, I guess, or some other subject; but, in fact, that would be totally inappropriate, so you’re going to have to say something. You can’t be totally noncommittal. If you look at the options market, there is apparently a 0.6 probability of a 50 basis point cut on January 30, when we make that announcement. I would certainly not favor trying to nudge that dramatically one way or the other. It seems to me the most important thing to communicate is the overall strategy that we follow. If you were to quite deliberately nudge that a lot higher, trying to push that probability to 1.0, then you could be—we don’t know, but you could be and we could be—in a very uncomfortable position if we got outsized increases much higher than anticipated in the inflation numbers that come next week. Indeed, you could have upside surprises in the real economy numbers as well. Then, having almost committed ourselves to the 50 basis points on January 30, we would be in the very uncomfortable position of how we take that away. So it seems to me that the signaling strategy should be to concentrate on the way in which we reach decisions by incorporating the best information that we can gather and the most thorough analysis that we can apply to the problem and by making the decision at the time that we have the regularly scheduled meeting. If the data on the real economy continue the trend that we have already seen and if the inflation numbers are more or less as expected, the market is going to bid up that probability of a 50 basis point cut. If we then reach exactly the same conclusion, we will have a very good synchronization of our policy and market expectations. It seems to me that what we don’t want January 9, 2008 36 of 60 to do is produce a signal that then produces a risk of an immediate conflict between that signal and the incoming data. Thank you. CHAIRMAN BERNANKE. Thank you. Governor Kohn. MR. KOHN. Thank you, Mr. Chairman. I certainly share your concern that the current federal funds rate is too high. You said that you thought we had about offset the effects of tighter credit and declining house prices on demand. I’m not so sure that we have actually done enough to make that offset. Certainly, if you look at the staff forecast, we haven’t. They have the unemployment rate rising to 5¼ percent, half a point over the NAIRU, at the current funds rate, which suggests to me that the current funds rate is substantially above neutral, not at neutral. If you look at the market—and, President Fisher, I assure you I am not going to get pushed around by the market—I do think the market is telling you that there are a lot of people out there who think that the funds rate has to drop 100-plus basis points more, and they don’t think that will be consistent with a pick up in inflation. Now, they could be wrong. I’m sure they probably are and often are. But I think there is some signal there about the degree of pessimism out there about underlying demand that we shouldn’t throw away entirely just because it is coming from the market. So in my view, policy is probably still restrictive rather than neutral. I don’t think we fully adjusted to the deteriorating condition we saw in December. What we saw then was that the credit constriction had spread and would be bigger and more prolonged than we had thought previously. We saw a steeper, more intense housing decline, with multiplier–accelerator effects, and wealth effects on the decline in house prices. We saw the beginning of spillovers to other sectors, and I don’t think our 25 basis points really adjusted to all that new information. Moreover, the incoming information, although it hasn’t lowered the near-term GDP, does imply January 9, 2008 37 of 60 weaker growth going forward. With regard to the labor market, it is true that it is one month, but it is three different sources of data—the household survey, the establishment survey, and the initial claims—all telling us the same thing. Now, we will get more information over the next couple of weeks on at least the initial claims part of that and the continuing claims. I think we should treat the labor market information as more than just one series for one month. It’s three series for one month, and there is probably a little more weight there. In addition, the new orders and the ISM survey, housing, and stock market wealth have declined substantially since the meeting. So I would say, obviously, we have no insurance. I’m not even sure we’re at neutral, and I see the downside risks that you, Mr. Chairman, Dave Stockton, and many others have talked about, particularly from the credit markets and credit conditions. I agree that the inflation situation is somewhat concerning. Now, some people have cited the increase in the staff’s inflation forecast for 2008 of 0.4 percentage point; but of course that’s the energy price situation. I think so far through this cycle the feed-through of energy prices into core inflation has been pretty darn low. The staff has built in a little here. Inflation expectations do remain anchored. To be sure, the core inflation numbers came in a little higher, so they’re a little worrisome, too. I think there is going to be less pressure on resources than we thought. The unemployment rate is higher, capacity utilization will be lower, and I think the competitive pressures are going to constrain compensation and prices. As somebody pointed out, the fact that even at a 4½ percent unemployment rate we really have seen very little, if any, pickup in labor costs suggests that my concern about that occurring at a 5 and a 5¼ percent unemployment rate would be very, very low. If the staff is right—and, of course I just heard the Romers lecture me about how the staff was right and the Committee wasn’t—[laughter] then a 50 basis point January 9, 2008 38 of 60 decline would just about put interest rates at neutral. It wouldn’t be accommodative, and therefore, I don’t think would be particularly inflationary. I agree with everyone else. If I thought that a decline in rates would increase the most likely forecast for inflation—put it on an upward track—that would be unacceptable. Or if I thought a decrease in rates would increase inflation expectations, which would then give legs to an increase in inflation, that would not be acceptable either. But I think a decrease in rates at this time under these circumstances doesn’t really have that risk. It does shift the balance of risks a bit. If you take a little of the downside risk out of growth, you are presumably taking some of the downside risk out of inflation, maybe shifting that risk on inflation at the same time. But I think a substantial decrease in interest rates at this time would not shift those risks on inflation so that they would deviate from the general path over the next couple of years that most of us saw in our projections in October. So I’m not as concerned as President Lacker about that. In sum, I agree that we need to reduce rates substantially just to get close to buying insurance. I would do it sooner rather than later. I would have been prepared to support an intermeeting move today. I think the data are weak enough; we are far enough behind the curve. To me, looking at the equity market declines, what we have seen since the middle of December is a bit of a loss in confidence in the financial markets that we will do enough soon enough to keep the economy on an even keel. So I think there has been a palpable deterioration in confidence in the Federal Reserve out in the financial markets. I am concerned that we are going to get three weeks of bad news and that the erosion of confidence will just gather steam. But I see the issues and the negatives also. An orderly FOMC process is to be protected. We are at risk of scaring the markets or looking as though we are lurching. I think we are at risk, if we move, of creating market dynamics such that they would constantly be in volatility and on alert January 9, 2008 39 of 60 as to when the next intermeeting move is. So there are a bunch of negatives here; and I guess on balance the case for moving—especially if it’s not supported generally by the Committee because I think it has to be supported generally by the Committee—is not overwhelming. Obviously, I am prepared to wait and make a substantial move at the meeting, but I agree that you should signal something in your speech tomorrow that we are likely to move against the emerging economic weakness. I don’t think, President Fisher, that a speech that the Chairman makes after consulting with the whole FOMC is comparable to the speeches we make as individuals. He doesn’t have the risk of misleading the market when he has heard from all of us at the same time. This is a very different situation from the situation that many of us were in during the previous intermeeting period. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. Just a few notes. First, on financial markets and financial market functioning, I think as Bill Dudley suggested that they are much improved from our last meeting. I take that as a very, very good sign, and I think that the improvement in financial market functioning will be useful to us to help calibrate the effects of changes in monetary policy. We spent some time even today talking about where we are on some range between neutral and accommodative and where we want to go. When the markets aren’t working, then any policy that we could conceive of would in effect be restrictive, if the markets weren’t willing to take our action and do something with it to provide credit. So I think we were right to focus on getting the markets back to work, which is a process that isn’t complete, but I think the trends are our friend there. Second, concerning financial intermediaries, I would underscore the point that the Chairman made at the outset. The problems among large financial institutions are very serious, and unlike financial market functioning, which has improved, I January 9, 2008 40 of 60 think the state of these institutions has not improved since we met last. While it is true that they have been raising capital, both in the form of equity and convertibles, the process of writedowns and capital-raising is far, far from being complete. I think we continue to have some headline risk, both in the United States and among non-U.S. institutions, between now and our meeting at the end of the month as well as throughout the first quarter. The good news is that the real economy data have superseded those data with respect to financial institutions. The bad news is that these top twenty or so institutions are still largely illequipped to facilitate credit or to be shock absorbers here to any great degree. If you think about that in terms of other shock absorbers that might be available, including fiscal policy, I think there is reason for the seventeen of us on this conference call to feel relatively lonely in thinking about policies that can be brought to bear, both from the private sector and the public sector. With respect to the real economy, even if one isn’t as pessimistic in terms of probabilities of a mild recession or as pessimistic on the chance of a really, really ugly scenario much more dire than that, I still think that risk management suggests going in the direction that the Chairman emphasized for reasons that have already been discussed by many others on this call. As I mentioned, I think there is more burden on monetary policy as I think about fiscal policy and some of these other measures. That gives me a view that perhaps we should be erring on the side of reaching for a little more by way of rate cuts than we would in a parallel universe where we had financial institutions and fiscal policy that were likely to be quite useful. I’m somewhat less certain that either of them will be able to stand here in the fray. With respect to tactics, I think the right course of action is, as Governor Kohn just referenced, for the Chairman to provide some direction to the markets in his speech. That direction will not be perfect. They will not understand exactly our posture, but I think they do need to hear from him a sense of January 9, 2008 41 of 60 where we are collectively, and tomorrow provides a really good opportunity to do that. It would be good for them not to be surprised to any great degree when we meet in a few weeks, and I think the Chairman will rightly focus them on the real economic data. So as the data change, their own expectations of policy could change as well. Governor Kohn talked about the possible erosion in confidence in our ability to put policy in place, and I think that by meeting today and hearing one another’s views, having the Chairman go tomorrow, and then meeting to finalize our judgments on policy action, given all our constraints, is the best course of conduct. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. MR. KROSZNER. Thank you very much. I, too, as everyone around the table has said, think that there is significant heightening of the downside risks over the last few weeks. As I mentioned at the last FOMC meeting, in talking with a contact at a large credit card company, I saw a very sharp deterioration in consumer behavior. I subsequently spoke with another credit card company that focuses more on the higher-end consumers and found exactly the same issues there of slowing payments—even taking into account the seasonals—more delinquencies, et cetera. So it wasn’t just a middle market phenomenon; it was also happening on the higher end. The quick change between October and December–January, unfortunately, seems to be consistent—or is potentially consistent—with the regime-shift model that we have been talking about. Also, the sharp rise in the unemployment rate could be consistent with that. I just returned from Europe, where concern is growing and there are some especially sharp changes. Spain is seeing some very sharp changes in their housing sector as well as in consumption, and consumption is going down in the United Kingdom. From discussions there, I also had the feeling that they are going to be relatively slow to react to the challenges. So I think we will be January 9, 2008 42 of 60 getting less support than we have been getting from exports. Also, given that a lot of rate resets are coming, we know that there are going to be more delinquencies and foreclosures. That is kind of baked into the cake. So we know that there are going to be more challenges in the financial system, regardless of everything else, over the next nine months. It does make a lot of sense to think about taking out some insurance against those kinds of risks. I very much agree with the Chairman’s characterization of the challenges that we will have in the banking and financial system because I think it is not a traditional credit crunch, when there is a sharp contraction, because so much has been brought onto financial institutions’ balance sheets. Not only has a lot been brought on but also there is a really dramatically reduced ability to get things off the balance sheets. Basically, over the last five years or so, the reason that financial institutions could provide so much intermediation and so much support is that things didn’t stay on the balance sheets. Now, because there is an impaired ability to get things off the balance sheets, it requires much more capital to support the same amount of funding that had occurred in the past. Just to try to keep funding at the same old levels is going to require dramatically more capital. They will get more capital, but they are not going to get dramatically more, so that will mean that it will be more and more difficult for them to support funding of operations going forward. So it is very important to think about taking out insurance now. With respect to inflation, as a number of people have mentioned, there are some disturbing readings recently. But something that is heartening, and for me is really the most important thing, is that I don’t see much evidence so far of a significant change in expectations, because that is really where the long-term costs of our policy moves come in. If there is a temporary slight movement up in inflation, if inflation expectations don’t become unanchored, then the cost is relatively low, particularly given the very large downside cost of a regime-shift to January 9, 2008 43 of 60 a recessionary scenario. Although I am certainly supportive of a fairly bold move at this point, I do think it would be better to wait a few weeks. I think we achieve some of that by clarifying where we stand through our public discussions. But as a number of people have said, I really think we have done a very good job, despite a lot of pressure with respect to our reaction functions, in how we react to data, forecasts, and such. I think we would lose some of that if we were to move today. That doesn’t mean that we should never move, but I do think it would be a bit of a loss because people could misinterpret what we’ve been doing and, exactly as Governor Kohn said, set up a bad dynamic. After our FOMC meeting at the end of this month, however, we actually have an enormous amount of data that come out because GDP comes out just as we’re finishing up our meeting. Then the details come out after that. We get another GDP report. We’re going to get two employment reports. So I certainly, in some sense, want to keep my powder dry with the possibility of an intermeeting move in the future, but I think that’s a time when we’re going to be getting a lot more data about which we may want to say it’s the time to move. It would be better from our broader communications policy standpoint to say that there have been enough data showing that we really do need to make a move. Thanks. CHAIRMAN BERNANKE. Thank you. Governor Mishkin. MR. MISHKIN. Thank you, Mr. Chairman. I agree with the Chairman’s general assessment of the risks to growth, and I think that currently we are well behind the curve and that we need to act much more aggressively in terms of monetary policy. However, I want to say that, even though I take the view that we need to be much more aggressive, I do not think that today is the day to do it. There are really three reasons that I am not in favor of doing a move today. The first is that it is very important to keep moving in the direction that I have hoped we are moving in, which is to be much more systematic in terms of thinking about monetary policy January 9, 2008 44 of 60 and actually communicating that to the markets and the public. Moving today would have the potential to indicate that we are being much more discretionary than I think would be appropriate, and that could be very problematic. I also would be concerned that it might give an impression that we would be overreacting to one piece of information—the employment report— and I think that would also be dangerous. There is serious potential for this to be viewed by the markets as our panicking, and that would, again, be very harmful in the current environment. In terms of where I think we should be heading with monetary policy, I definitely think that given the information we have today, though things clearly may change in the next couple of weeks, we would need to move at least 50 basis points at the next meeting. Actually, I don’t want to rule out the possibility of doing even more at the next meeting or talking about having a contingent move, for which we’d prepare the markets, so that it would be more systematic in terms of a possible intermeeting move afterwards because there is important information— another employment report, retail sales, and so forth—that will come out shortly after the next FOMC meeting. As I talked about at the last meeting—and I will go into this in more detail in a speech on Friday—I think it is very important to be ahead of the curve and react aggressively to financial market disruptions. There is an issue of very strong nonlinearity that makes the normal response, which we think about in terms of doing optimal policy—the standard linear quadratic framework we often work in—not the correct one. In a situation such as the one we are dealing with now, with a lot of potential for nonlinearity, it is extremely important to get ahead of the curve. This argues for quite aggressive action at this point—as I said, not particularly today but in the near future. January 9, 2008 45 of 60 One concern that people have raised is the potential upside risks to inflation. I am less worried about that than some other members of the FOMC for the following reasons. Very importantly, inflation expectations seem very solidly grounded. We have had no indication of any deterioration in terms of inflation expectations, despite our previous easing moves and the very high increases in energy prices. Second, when I think about what drives inflation and what are the dynamics of the inflation process, what is important are expectations not only with respect to inflation but also with respect to the future path of output gaps. In particular, I do not see at this juncture that people are worried that we are going to allow the economy to get overheated. In fact, it is the opposite right now. We are more worried about the downside risks, where there will be increased economic slack in the economy, and of course, that is consistent with the forecast coming from the Board staff. So when I think about the inflation process, I think in terms of underlying inflation, which is inflation not over the next year but over the longer run, which is appropriate for monetary policy and when we can have an effect. I do not see that the upside risk is huge there; in fact, this is very important in terms of allowing us to be aggressive in this situation of financial disruption. One issue that I think is very important, which other participants here have raised, is that there is a fear that we might overshoot if we ease aggressively. In fact, two things could indicate that we may have gone too far. One is that we frequently see financial disruptions dissipate very quickly. That is what I hope happens, so it is not something that I would be depressed about. I would be very pleased about it because, if things start going the right way, just as you can get an adverse or a negative feedback loop when these financial disruptions occur, you can actually get a virtuous feedback loop, and that can happen fairly quickly. If that occurs, we should be very ready to take away some of the insurance that we have provided by aggressive easing. The January 9, 2008 46 of 60 second is, of course, inflation expectations. If aggressive easing led to the unhinging of inflation expectations, that would be a terrible thing. The most important thing that I think we do is to ground inflation expectations; it is a key part of our success and of central banks throughout the world in recent years. So I think we have to monitor very carefully what is happening to inflation expectations. If our easing looks as though it’s causing a problem in terms of inflation expectations, then we have to act accordingly. I would argue that the way we have to think about policy is that we need to think about it being less inertial but maybe more systematic. When we talk about risk management, I think in the past there was some element of thinking that risk management was just discretion. We have to think about risk management in terms of being more systematic and to think about how we might react to changes in conditions so that we would not be inertial. By so doing and indicating to the market that we were thinking that way, we could alleviate some of these fears. So the bottom line is that I think that we have to be ahead of the curve. I am actually very sympathetic to President Evans’s view that we are going to have to move more than 50 basis points, certainly, over a longer period than just the next meeting. I also think that we have to think about that hard and about doing this in a systematic way and prepare the markets to understand why we are reacting the way we are, so that we are not seen as being discretionary but as operating very much consistently with our dual mandate. Thank you. CHAIRMAN BERNANKE. Thank you. Vice Chairman. VICE CHAIRMAN GEITHNER. Thank you, Mr. Chairman. Let me just say briefly that I completely support the basic framework that you laid out at the beginning, and I think you gave an excellent description of the risks that are ahead for us, the challenges we face, and the basic strategy we have to adopt. The dominant imperative for monetary policy now is to get rates January 9, 2008 47 of 60 down to the point at which we are providing a substantial degree of insurance against the risk of a very adverse growth outcome and a more damaging financial crisis. This is going to require substantial further policy action, and we are better off getting there sooner. I think there is more risk to us now in gradualism than in force. Of course, inflation has accelerated, but I think it is very important that inflation expectations have moved down since December, despite the move in headline and core and despite a very substantial downward move in the expected path of the fed funds rate. Other than that, I would just reinforce the basic framework you presented. I would take a fair amount of comfort from the fact that I hear a lot of agreement around the room both on your diagnosis of what is happening and in a general recognition of the extent of deterioration in the outlook and the extent of the increase in terms of the risks to the outlook. That gives us a better basis for a pretty solid consensus in the Committee on the outlook ahead. Thanks. CHAIRMAN BERNANKE. Thank you. Well, in this less than two hours, we have covered intermeeting moves, policy strategy, assessment of the economy, and inflation dynamics. I think it has been pretty productive. Seriously, I very much appreciate it. I promise to try not to do this too often, but getting this intermeeting update has been very useful for me. I very much appreciate it. I think we are a little better prepared for the next meeting when it comes, although obviously, as President Poole pointed out, we will be seeing a lot of data and certainly there is no pre-commitment to any specific action. But I do think there is at least a reasonable amount of support for the idea that some insurance is worthwhile, and we should keep that in mind as we go forward. Are there any other comments? President Hoenig. MR. HOENIG. Mr. Chairman, just a question. Will you let the world know we had this meeting? I ask only because I have a directors’ program tonight and a directors’ meeting January 9, 2008 48 of 60 tomorrow morning, and I don’t know what the circumstances are about acknowledging this meeting or anything else. So I would appreciate some information. CHAIRMAN BERNANKE. It will be described, I assume, in the minutes, which will be three weeks after the next meeting, so it will be six weeks before this is reported. It will be reported, I assume, as a consultation and discussion of the economy. I would advise you not to discuss this with your directors. If it gets into the market, it could cause confusion and uncertainty. So if possible, I would not discuss it. MR. HOENIG. I appreciate knowing that. Thank you. CHAIRMAN BERNANKE. Thank you. President Lacker, do you have a point or a comment? MR. LACKER. Yes. At the outset, in your discussion you said you were doing this in part to seek our views before you made a speech and testified and wanted our views before you engaged in overt signaling to the market. Someone else mentioned this, but I wanted to support this as a practice. I don’t expect you to consult us before every public utterance you make but I would just compliment you on this innovation in Federal Open Market Committee practice. So thank you very much. CHAIRMAN BERNANKE. Thank you. Any other comments? If not, have a good dinner. Thank you very much, and we will see you in Washington at the end of January, if not sooner. Thank you. END OF MEETING January 21, 2008 1 of 32 Conference Call of the Federal Open Market Committee on January 21, 2008 A conference call of the Federal Open Market Committee was held on Monday, January 21, 2008, at 6:00 p.m. Those present were the following: Mr. Bernanke, Chairman Mr. Geithner, Vice Chairman Mr. Evans Mr. Hoenig Mr. Kohn Mr. Kroszner Mr. Poole Mr. Rosengren Mr. Warsh Mr. Fisher, Ms. Pianalto, and Messrs. Plosser and Stern, Alternate Members of the Federal Open Market Committee Messrs. Lacker and Lockhart, and Ms. Yellen, Presidents of the Federal Reserve Banks of Richmond, Atlanta, and San Francisco, respectively Mr. Madigan, Secretary and Economist Ms. Danker, Deputy Secretary Mr. Skidmore, Assistant Secretary Ms. Smith, Assistant Secretary Mr. Alvarez, General Counsel Mr. Baxter, Deputy General Counsel Mr. Sheets, Economist Mr. Stockton, Economist Messrs. Clouse, Connors, Kamin, Sullivan, and Wilcox, Associate Economists Mr. Dudley, Manager, System Open Market Account Mr. English, Senior Associate Director, Division of Monetary Affairs, Board of Governors Mr. Dale, Senior Adviser, Division of Monetary Affairs, Board of Governors Mr. Levin, Deputy Associate Director, Division of Monetary Affairs, Board of Governors Mr. Luecke, Senior Financial Analyst, Division of Monetary Affairs, Board of Governors Messrs. Judd, Rosenblum, and Sniderman, Executive Vice Presidents, Federal Reserve Banks of San Francisco, Dallas, and Cleveland, respectively January 21, 2008 Ms. Mester and Mr. Weinberg, Senior Vice Presidents, Federal Reserve Banks of Philadelphia and Richmond, respectively Mr. Hakkio, Senior Adviser, Federal Reserve Bank of Kansas City 2 of 32 January 21, 2008 3 of 32 Transcript of the Federal Open Market Committee Conference Call on January 21, 2008 CHAIRMAN BERNANKE. Good afternoon, everybody. Thank you for taking time on your holiday. The purpose of this meeting is to update the Committee on financial developments over the weekend and to consider whether we want to take a policy action today. I would like to start with a brief update on the markets from Bill Dudley and take any questions for him, and then I will introduce the issue, make a recommendation, and ask for your comments following that. Bill, would you like to give us a short review? MR. DUDLEY. Thank you, Mr. Chairman. Since our videoconference on January 9, the market functioning in terms of the bank term funding markets has generally continued to improve, with the one-month and three-month LIBOR relative to the overnight index swap rates coming back very sharply. They are now as narrow as they’ve been since the market turmoil began. But elsewhere in terms of market functioning, we started to see a step backward last week—especially late in the week—when we viewed the asset-backed commercial paper market beginning to deteriorate again, and there was some flight to quality into the Treasury bill market late last week. More important, the macro outlook and broader financial market conditions have continued to deteriorate quite sharply. The S&P 500 index, for example, fell 5.4 percent last week; it is down almost 10 percent so far this year. Today it fell another 60 points, or 4.5 percent, so that means that the cumulative decline in the S&P 500, if it opens near where the futures markets closed today, will be nearly 15 percent since the start of the year. Global stock markets were also down very sharply today—Monday. Depending on where you look, the range of decline was anywhere from 3 percent to 7½ percent, pretty much across the board. Corporate credit spreads and credit default spreads have continued to widen, and bank mark-tomarket losses and loan-loss provisions keep increasing. The Merrill Lynch and Citigroup earnings announcements last week generally suggested a widening in terms of the scope of losses, not just in subprime but also in terms of credit card receivables and other loans. A newish wrinkle here in terms of bank markdowns reflects the deterioration of some of the monoline guarantors. Merrill Lynch, for example, announced a multibillion dollar charge for its exposure to ACA, which is the most impaired of the monoline guarantors. The other monoline guarantors are in better shape, but they’ve either been downgraded, such as the case of Ambac by Fitch on Friday afternoon, or are under review for being downgraded by a number of different credit-rating January 21, 2008 4 of 32 agencies. The problem with the monoline guarantors is that raising capital has become much more difficult. Ten days ago, for example, MBIA issued 14 percent surplus notes, which are now trading at about 70 cents on the dollar. It’s not clear how much additional capital is needed to keep the AAA rating. The goal posts keep moving. S&P, for example, raised its loss estimates on subprime mortgages about a week and a half ago, and this has implications for the monoline insurers in terms of their capital adequacy. So the bottom line is that, unless the monoline insurers raise significant additional capital soon, further rating downgrades seem very, very likely. This has three potential consequences that are noteworthy. First, in the money market space, a number of money market products are wrapped by the monoline guarantors, including variable-rate demand notes, auction-rate securities, and tender option bonds. Some of these securities have liquidity support, so if the securities can’t be rolled over, they’ll go to the banks, and this will increase the pressure on bank balance sheets. For those without liquidity support, either they will be converted to longer-dated securities, which the investors will be surprised to find out they are holding, or the dealers will have to take them back on their books to prevent the auctions from failing. A second consequence from monoline guarantor downgrades would be to the municipal bond funds. The loss of AAA insurance raises the question of what the retail bond investors do. Do they start pulling out their money and run? So far things are pretty calm on that front. For example, last week the net asset values of some of the major muni bond insurance funds actually increased a bit for the week. So there are no signs of a run there yet, but we haven’t really explored this fully, given the fact that only one major monoline guarantor has been downgraded and that happened late, late last week. Third, financial institutions have to mark down the value of the guarantors’ insurance as their financial conditions worsen. In contrast, the monolines don’t have to mark to market. Downgrading the monolines frontloads the hit to capital and potentially aggravates the magnitude of the hit to capital because market valuations can overshoot. So it is not trivial to transfer this risk from the monolines to the financial institutions given the distinction that the monolines do not have to mark to market but financial institutions that use their insurance do. At this point, monetary policy expectations have priced in a lot of easing over the near term. As of Friday’s close, there were about 67 basis points priced in through the January meeting at the end of the month and about 110 basis points priced in through the March meeting (if you look at the April federal funds futures contract). There is likely more than that now given the decline in the equity futures market that we saw today. So the markets are expecting quite a bit from the Fed. I’ll be happy to take any questions, of course. CHAIRMAN BERNANKE. Are there questions for Bill? President Lacker? MR. LACKER. Can you explain that third consequence of monoline downgrades? I didn’t quite get that. January 21, 2008 5 of 32 MR. DUDLEY. The monoline insurers don’t have to mark to market the consequences of the deterioration in, say, the structured-finance product they insured. All they have to do is pay out, as it is incurred, the interest that the structured-finance product can’t pay out. So their losses are going to be realized only very gradually over a long period of time. There is no sort of foreshortening of all that into the present. In contrast, if a monoline guarantor gets downgraded and so the financial institution no longer has the support of that monoline guarantee, they have to write down instantaneously the value of the assets that were wrapped by that guarantee. So it’s quite a big difference in terms of the market impact as you transfer that risk from the monoline guarantors to the financial institutions that bought that insurance. CHAIRMAN BERNANKE. Other questions for Bill? President Hoenig. MR. HOENIG. Yes, Mr. Chairman. I don’t want to get ahead of what you might be saying, but if Bill could give us a sense of what the markets are doing overseas, I would appreciate just his sense of things. MR. DUDLEY. Well, the market on Monday morning in Asia was down somewhere around 3, 4, or 5 percent, and it was everywhere, including some of the emerging markets that up to now had performed pretty well. India took one of its biggest one-day hits, for example, in a very long time. Then, we got to Europe, and the declines in Europe were actually a little bigger than the declines that we saw in Asia. For example, the Dow Jones STOXX 50 Index, which is an index of 50 large European companies, was down 7¼ percent on Monday. The market went down sharply at the open, it rallied back up a bit during the day, and then it came sharply down again at the close. So for both indexes you are basically at or very close to the low for the day. Bond markets reacted as you might expect. Bond markets rallied as people became more pessimistic about the stock market. In the currency market, we saw the sort of normal risk- January 21, 2008 6 of 32 aversion behavior. The euro underperformed, the dollar was in the middle, and the yen appreciated as people were reducing their risk appetites. I talked to some people about what was going on in Europe. I didn’t really feel as though my contacts there were focused exclusively on the financial guarantors. That was part of the story, but there were other parts of the story, including the idea that maybe decoupling isn’t going to happen to the degree that we hoped. Also, part of the story was that the risks of recession in the United States were increasing. So financial guarantors got part of the blame for the stock market decline in Asia and Europe, but that by no means was the whole story. CHAIRMAN BERNANKE. Other questions? If not, let me just talk about the issue here. I was reluctant to call this meeting, both because of the holiday and because the Committee did express a preference on January 9 for not moving between regularly scheduled meetings and I accepted that judgment on January 9. However, I think there are times when events are just moving too fast for us to wait for the regular meeting. I know it is only a week away, but seven trading days is a long time in financial markets. As Bill described, over the holiday, global stock markets have been falling very sharply, both in Asia and in Europe. As he mentioned, even though the U.S. markets are closed, the S&P 500 was off about 60 points today, close to 5 percent. That makes the cumulative decline in the S&P 500 since our last FOMC meeting 16½ percent. Obviously, it is not our job to target stock values or to protect stock investors, but I think that this is a symptom of both sharply mounting concerns about the economy and increasing problems in credit markets. On the economy, the data and the information that we can glean from financial markets reflect a growing belief that the United States is in for a deep and protracted recession. Moreover, as we saw from the global markets today, the concern is rising that that recession will January 21, 2008 7 of 32 have global consequences. Consequently, we saw, for example, an 8 percent drop today in the German stock market. The dollar rose today, reflecting I think increasing belief that other central banks will have to follow us in cutting rates, and oil prices are down to about $87, reflecting expectations of slowing global demand. So it is not necessarily a U.S.-only story. On the financial side, as Bill noted, a lot of things are going on. The latest is the likely downgrade of one or more of the monoline insurers, which would cause banks and other financial institutions to have to mark down billions more of their holdings. I think there is a general sense—I certainly feel in talking to market participants—that it is not just subprime anymore and that there are real concerns about other kinds of consumer credit—credit cards, autos, and home equity loans—and that there is fear of housing prices falling enough that contagion will infect prime mortgage loans. There is building in the market a real dynamic of withdrawal from risk, withdrawal from normal credit extension, which I think is very worrisome. Would a rate action today, before the start of trading tomorrow, be of help? I don’t know. In some sense it was a lucky break that today was a holiday because in the middle of the day we got a very good read on what the markets are doing tomorrow, and so we can get ahead of things as opposed to being forced, after a couple of disastrous days, to respond. Again, I don’t know if this would help, but I think that indicating that the Fed is on top of the situation and that we are proposing to address economic and credit risks aggressively would help. In any case, it would at least make clear that the Fed was in touch with the situation. I think we have to take a meaningful action—something that will have an important effect. Therefore, I am proposing a cut of 75 basis points. I recognize that this is a very large change. I would not do that if I thought that the size of the cut was inconsistent with our medium-term macroeconomic objectives. Let me discuss that a few minutes. January 21, 2008 8 of 32 As I said to some of you, on Friday I had a briefing from Dave Stockton and his team about their Greenbook forecast for next week’s meeting. They have not made an explicit recession call, but they do forecast very weak growth going forward. More important, in order to get that positive economic growth, they revised down their assumed path of the federal funds rate by 100 basis points—50 basis points next week and 50 basis points in March. That gives a cumulative decline in the staff’s fed funds assumption of 200 basis points since August, which is consistent both with the markets and with a 225 basis point decline in medium-term r*, which is an indicator of the neutral rate, as well as the optimal policy rate that they calculate. Importantly, of course, we have lowered the funds rate only 100 basis points so far, so I think at first approximation we are about 100 basis points behind the curve—something in that general area— in terms of the neutral rate, and that itself doesn’t even take into account what I believe at this point is a legitimate need for risk management. With respect to risk management, these credit risks obviously have the potential to feed back into our financial system and to affect the economy going forward. I hope to be able to talk next week more about a simulation the staff is working on, which shows that a severe recession would create extraordinary credit losses for our financial institutions, with implications obviously for credit extension and for financial stability. It is just one indicator, but a paper by Carmen Reinhart and Ken Rogoff has been circulated in the past couple of days, which compares some indicators of our economy with other major financial crises and finds that we rank at the moment among the five largest financial crises in any industrial country since World War II. Given what their indicators show, they conclude that, if we have only a mild recession in the United States, it would be a very fortunate outcome. Now, I am not saying that this is necessarily evidence, but I am saying that there are risks and that a careful approach should January 21, 2008 9 of 32 allow for some easing with respect to risks. Governor Mishkin is not here. He is aware of this meeting, but he is on the slopes—I think in Idaho somewhere. He has made I think a case for being more aggressive initially, trying to address the problem, and then removing accommodation as the situation calms down. I think there is a case for doing that, given the fact that we have done 100 basis points and that we seem to have not really made a dent. Now, of course, there is also the issue of inflation. Many of you have valid concerns about inflation. Let me just make a few comments on that. First, in the Greenbook, despite a 100 basis point drop in the rate assumption and the scenario that I take as being in some sense optimistic in that it avoids an outright recession, the preliminary Greenbook forecast for 2009 has total PCE inflation at 1.7 percent and core PCE inflation at 1.9 percent. This does not take into account any disinflationary effects that would arise if we did have an NBER recession or worse. Again, I note that we have, for example, effects working through oil prices, which the Greenbook doesn’t take into account directly. So I think, obviously, that we have to continue to watch inflation and inflation expectations carefully. It is very important to do so. But at this point we are facing, potentially, a broad-based crisis. We can no longer temporize. We have to address this crisis. We have to try to get it under control. If we can’t do that, then we are just going to lose control of the whole situation. So that is my case. I think we really have no choice but to try to get ahead of this. A statement has been circulated. Those of you who wish to comment on the proposal—of course, you can. You may wish to comment on the statement as well. But let me just stop there and see what comments the Committee has. President Plosser? MR. PLOSSER. Just as a point of clarification, I have not received the statement. I have not had access to encrypted e-mail. May I ask that it just be read? January 21, 2008 10 of 32 CHAIRMAN BERNANKE. Certainly. Let me do that. I had one word in the second paragraph—the word “broader”—which I will come to. “The Federal Open Market Committee has decided to lower its target for the federal funds rate 75 basis points to 3½ percent. The Committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader—add that word—financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets. The Committee expects inflation to moderate in coming quarters, but it will continue to monitor inflation developments carefully. Appreciable downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.” President Evans. MR. EVANS. Thank you, Mr. Chairman. I strongly support this recommendation. At our last videoconference, I was in favor of action at that time. The situation has deteriorated since then. I think the macroeconomic outlook supports this type of move. As we look at the data, we are on the edge of a more serious downturn. It is not exactly clear how large that will be, but we ought to be pricing in at least 100 basis points of accommodation against what I think of as sort of a medium-term neutral rate of about 4½, and this is a move that takes us there. I January 21, 2008 11 of 32 think the growth risks are definitely greater, and the real question after this is what it means for our meeting next week. But I strongly support this. CHAIRMAN BERNANKE. Thank you. President Stern. MR. STERN. Thank you, Mr. Chairman. I largely share your assessment of the situation and certainly support this action and taking it now. What has really caught my attention is the breadth of the weakness of the incoming data and the extent of the financial problems, some of which Bill Dudley covered. I don’t have the sense at this point, given both the nature of the incoming data and the state of many of the financial markets we pay attention to, that there is a lot of latent or underlying strength in the economy. So that affects my view of the outlook as well, and I think it is important that we move aggressively, decisively, and in a timely way. Of course, the inflation numbers haven’t been all that I might have hoped for, and even core inflation has been running a little higher than I thought it would. But even if we were in some sort of more formal inflation-targeting regime—and, of course, we are not—I have always assumed and always argued that, when you are confronting these kinds of conditions, you would deal with that situation as effectively as you can first and return to your inflation objective when conditions permitted. So I don’t have any trouble taking such aggressive action at this point. CHAIRMAN BERNANKE. Thank you. President Yellen. MS. YELLEN. Thank you. I strongly support your proposal for a 75 basis point funds rate cut today, and I like the proposed wording of the statement. The outlook has deteriorated, not only since December but since our conference call. The downside risks have clearly increased. I think the risk of a severe recession and credit crisis is unacceptably high, and it is being clearly priced now into not only domestic but also global markets. Even so, I put the stance, as best I can judge it, of monetary policy within the neutral range. Policy should be January 21, 2008 12 of 32 clearly accommodative. We also need a cushion against severe downside risks. We need strong action, and your speech has prepared the markets for actions of this sort. At this point, they are expecting at our next meeting more than 50 percent odds of a 75 basis point cut. An intermeeting move will be a surprise, but I think it will show that we get it and we recognize we have been behind the curve. I think it will be assumed with this statement and action today that we will move somewhat further as well at our next meeting. That is something we should recognize—the statement creates that expectation. CHAIRMAN BERNANKE. Thank you. President Rosengren. MR. ROSENGREN. I, too, strongly support reducing the federal funds rate 75 basis points. I am very concerned about financial market conditions detailed earlier by Bill. It is widely viewed in the business community that we are slipping into a recession. Problems with consumer debt are growing. I am concerned not only that we might be in, or about to be in, a recession. I am concerned also how severe a recession could be. It is time to take decisive and aggressive action, and I agree that, even with this cut, downside risks remain. Thank you. CHAIRMAN BERNANKE. Thank you. President Poole. MR. POOLE. Thank you. I accept all the discussion about the risks of recession and the risks of the financial markets. All those are relevant to what we do next week. But the key issue for me is what we get by acting now rather than nine days from now. I note that the stock market has declined, despite the fact that the market has built in the expectation of 50 basis points, with some probability of 75. If we do today pretty much exactly what is expected of us nine days from now, it is not clear that we are going to accomplish a lot that is positive, and I believe that we run the risk of upsetting things in a couple of ways. January 21, 2008 13 of 32 First of all, whenever we act between meetings, we set a precedent, and what this will do in the future, maybe even in the very near future, is that whenever we have a stock market decline of this magnitude, if we get some more of them—and we could easily—or whenever we have some bad economic data—and we certainly could have some—there will be speculation in the market as to whether the FOMC is going to jump in with an intermeeting policy action. So we have to be confident in our own minds that we are not setting a precedent that we will live to regret. Second, this action will not be viewed in the marketplace as anything other than a direct response to the stock market. I understand the comments about the other strains in the financial markets. Although the thing that we have most commonly pointed to, and it has occasioned the most market discussion, has to do with the behavior of the LIBOR rate, LIBOR seems to have settled down. It is trading below fed funds, and the further out you go in the future, the lower is LIBOR. So it seems to me that that situation has largely returned to normal. So before I am willing to support, I need to hear compelling arguments as to what we gain from acting today rather than nine days from now and what the risks of acting today are. I think there are downside risks in acting today rather than nine days from now, and to me that needs to be the focus of our discussion. I agree that the economy is weak, and I agree that there are a lot of problems in the financial markets. Thank you. CHAIRMAN BERNANKE. Thank you. Who is next? Would anyone else like to speak? Vice Chairman. VICE CHAIRMAN GEITHNER. Mr. Chairman, of course, I support your recommendation. I think it is the right thing to do. Even with this move, I think we are likely to have to move significantly further. It is hard to know how much more and what the optimal January 21, 2008 14 of 32 timing of further actions is going to be. It is very important, in the context of a move, that we signal—as your statement does—that we will do what is necessary to provide a meaningful degree of accommodation, a meaningful degree of insurance against a more adverse set of financial and economic outcomes. If we were to wait until the meeting, we would be taking just too much risk. I think it would be irresponsible to take the risk that we would see a substantial further deterioration in confidence and in market prices, which would do substantially more damage to market functioning than we have witnessed so far. I think you said on January 9, Mr. Chairman, that the risk we have to worry about is not so much that we have simply a mild, short, and shallow recession but that we face a much deeper and more protracted economic downturn with much more damage to the financial system that would ultimately require, if it were to happen, much more action in terms of monetary policy with perhaps more-adverse consequences for future incentives and for the economy as a whole. I think that that is a risk we have to worry about. It is very hard to judge what the probability of that risk is. None of us can know for sure what the next nine days would be like if we did not act. None of us can know the probability that the market will work through this stuff on its own. It is a matter of judgment, and I think your judgment on this is right. I strongly support it. I just would say again, although I don’t think any of us can support this with hard, quantifiable evidence, that conditions are so fragile and so tenuous now that by not acting tomorrow morning we would be taking an irresponsible risk that we would see substantial further erosion in confidence. That would put us in a much weaker position to mitigate these risks going forward. CHAIRMAN BERNANKE. President Hoenig. MR. HOENIG. Yes, Mr. Chairman. I am troubled by this, I will admit. I understand the arguments, and it is difficult to argue against dodging a crisis. It is a very daunting thought to January 21, 2008 15 of 32 think about a crisis that you might have avoided had you just taken certain actions. I would echo Bill Poole a bit in terms of understanding what we will get out of this and how we will deal with backing away from this in the future because part of the reason we have the problem today, of course, is the last crisis. The desire is to intervene, to get the market rates down, and to bring confidence; but then our ability to pull out of that is compromised because we can’t be sure in an uncertain world of how strongly the economy might be coming out of something. Therefore, we often delay and create the next issue that we have to deal with—as we are today. So I am troubled. I know the risk coming in tomorrow. I know we are being driven heavily by these markets. At the same time, I think doing an intermeeting move commits us to another move down the way. It will be hard to stay at rates that are not going to at least invite another series of problems down the road because I see us at 3 percent by nine days from now. So how do we deal with that? I would at least like to hear some discussion as we consider this pretty substantial action tonight. Those are my comments. CHAIRMAN BERNANKE. Thank you. President Lacker. MR. LACKER. I can support a 75 basis point cut in the funds rate this month, Mr. Chairman. I had been thinking of something less. The data last week were clearly negative, clearly disappointing, so I could support 75 at our meeting. Like President Poole, I have real reservations about moving now rather than waiting until our meeting. I think that in the situation this is inevitably going to be viewed as a reaction to the falloff in equity markets. Interpreters are going to take into account that we could have moved last week, after the slew of real data— Thursday afternoon, for example, after the housing report—or we could have waited until our meeting ten days from now. I worry about the message that this tactical choice sends about our strategy. I worry about what it says about what drives our reaction function and what we believe January 21, 2008 16 of 32 that we can control or offset. I share President Poole’s concern that what we gain isn’t clear. I can appreciate the possibility of financial market fragility, but I don’t see the level of the funds rate as real closely tied to conditions of fragility. I don’t think a funds rate change is going to save the monolines. I don’t think it is going to save financial institutions from the monolines. So I have reservations and would rather wait until our meeting. But I can support moving 75. CHAIRMAN BERNANKE. Thank you. President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. In the earlier discussion on January 9, as I recall, I not only supported a move but suggested that I would support an intermeeting move if the conditions merited, and I do think they merit it. I am really in the same camp as President Geithner. I am not sure I see what is to be gained by waiting another eight or nine days. I think the psychology here is bordering on, shall we say, a spiral quality. A preemptive move like this—preemptive on two dimensions, the rate dimension and the timing dimension—has a shot at changing the overall psychology of the moment, including perhaps even creating an atmosphere in which support for the monolines, if they are having trouble raising capital, might very well be a more rational decision on the part of some investor. I think we would appear much less panicky than we might have on January 9. We are not doing this in combination with the TAF. The TAF actually appears to have done its work pretty well, and the need for the TAF may be diminishing. Not much more data will come in the next few days, if I have my schedule correct. I think we are at a kind of juncture now where the spillover from the financial markets is not really much debatable; it is very clearly happening, with risk of a dynamic that feeds off itself. So I am very supportive of this move, and that is really my position. Thank you very much, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Fisher. January 21, 2008 17 of 32 MR. FISHER. There are some pros to moving now, and there are some cons. Clearly, one of the pros is that we would have the element of surprise. It is a holiday. We have the benefit of some knowledge of new data and what has happened in the market starting in Asia and rolling through Europe, which Bill walked us through. I do have some concerns, however, Mr. Chairman. I know you know what they are. I articulated them in a speech in Philadelphia, and we discussed these a bit. I have basically the same concerns that President Poole, President Hoenig, and President Lacker have. The question is, What do we get for this? What expectations do we build in for future decisionmaking? My biggest concern, however, is that I have yet to see convincing evidence that we are seeing movement on the inflation front. If we were to cut rates to this level today, as of now, in terms of the headline CPI and PCE numbers, we would have a negative real rate of interest, and I don’t understand quite fully what the consequence of that would be. The projections in the Greenbook are just that—they are projections. They can be right, and they can be wrong, as thoughtfully as they are constructed. Unlike President Rosengren, although I am only about 30 percent of my way through my CEO calls in preparing for the meeting, I don’t hear a widespread expectation of recession. I do hear a concern about slowing down, and we have seen that in all of the indexes that I like to talk about in the meetings from the credit card payables, delinquencies in payments, the Baltic index, et cetera, et cetera. But the words “severe recession” I have yet to hear from the lips of anybody but those in the housing business, and for them, it gets more severe with each passing moment. So I am not convinced of the economic case, and yet I can see where there are some benefits to moving now. The real question is, What do we do next? If the markets react by blowing us off, does that mean that we will be expected to move aggressively at the next meeting and then the next meeting after that? Or as President Poole has mentioned, does that mean that January 21, 2008 18 of 32 we will have to have some more interim meetings? I am a little worried about being trapped by this concept of being behind the curve. There is a fine line between being behind the curve and what may be an overreaction. But, Mr. Chairman, I don’t have a vote at this meeting, and I would just ask you to consider the arguments that have been put forward by Mr. Poole, Mr. Hoenig, and Mr. Lacker and the ones that I have just given. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Pianalto. MS. PIANALTO. Thank you, Mr. Chairman. I support your proposal for a 75 basis point reduction in the fed funds rate today. At the time of our last call, I was hesitant about moving because it was in advance of some important data. Obviously, we got those data, and they were very weak. Financial conditions, as many have indicated, have also deteriorated. My conversations with the bankers in my District indicate that the earnings reports that are coming out will demonstrate that problems have spread beyond just the mortgage sector. They are also seeing deterioration in credit card and other consumer debt. I think that it is important that we move in a timely and an aggressive way. I don’t think that there is much to gain by waiting another week. In this environment, I do believe that we should make every effort to make sure that we are more accommodative and not stay inadvertently restrictive, as the evidence suggests we are today. So I do support moving 75 basis points today. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. I think we are in a very, very difficult position. I don’t want to reiterate many of the points that have been already made. I certainly appreciate and am sympathetic with the point of view that markets are fragile. Market expectations, in terms of what they seem to be building into the path of the economy going forward, seem to me extraordinarily volatile and pessimistic. I am very concerned about that. January 21, 2008 19 of 32 That bothers me. But at the same time I also am very concerned about the expectations this sets. While the U.S. market was closed today, we have heard what has gone on in the foreign markets. I am very concerned that we are going to be interpreted as reacting to the stock market declines, and I think my concern is that lowering the funds rate terribly rapidly with intermeeting moves is going to set up a dynamic that is going to drive us into more and more of these and drive the markets into expecting more and more from us. It is not clear to me that the fragility that exists in the market in fact will be solved by rapid cuts in the funds rate. I share President Lacker’s concern that it is not clear that lowering the funds rate is a solution to the problem of the monoline insurance companies or others. Having said that, I nonetheless would certainly be supportive of a very dramatic action at our regularly scheduled meeting. Frankly, I am very torn right now as to whether to support this intermeeting cut. My gut instinct tells me “no,” but I also have to recognize the views shared by a number of our colleagues who are concerned about the fragility of the markets and the signals we are sending. If we decide to go through with this today, I think that we will find ourselves in a very tough position at our next meeting as to how much more will be expected from us and at what rate. President Poole or President Lacker pointed out that it was partly our aggressive ratecutting in some periods that helped foster some of this, and we may be setting ourselves up for another fall. I share Governor Mishkin’s view that if, in fact, we are to get aggressive, we also have to be willing to take it back when times change. I understand that view, and I can live with it, except the history of this institution is that we haven’t been very aggressive in doing that or demonstrating our ability to do that. So I have a lot of concern and caution about this move. I think it is going to affect expectations of us as we move forward, and I think we need to be realistic about what it is we are January 21, 2008 20 of 32 buying with this. I am not sure we are buying very much. Maybe we will calm some market nerves. If so, that would be great, and it may be of short-run benefit, at least over the next nine days. I worry what it is going to mean for us over the next nine months as we move forward. So those are my views. I am not a voting member at this meeting, but I just wanted to share those views. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Poole, did you want to intervene? MR. POOLE. Yes, if I may. I have a question of fact first and then a further question. Do we know at all what the ECB and the Bank of England are considering given that the markets were open and they are the ones who have seen markets and know what is going on there today? CHAIRMAN BERNANKE. We don’t know what they are considering, but just to anticipate my response to some of these comments, I think the situation in the United States, the fundamental situation, is much more severe at this juncture than in Europe or the United Kingdom. The basis for this move is not to calm markets per se but rather to get the funds rate closer to where it ought to be on fundamental grounds. But to answer your question, I don’t know what the ECB and the Bank of England are contemplating. You had a second question. MR. POOLE. I think the market’s view, then, is going to be that we are responding to the markets abroad. Our own market has been closed. I understand the futures market, but there are a lot of people who don’t understand the futures market or know of its existence. So I think that the investor on the street, if you will, will be saying that we are responding to foreign markets. In terms of the problems in the financial markets, the monoline insurers and others, that is a problem of the capital of those firms. Cutting the funds rate does nothing to build up capital for those firms. I still come back to the point that I do not see a convincing argument for acting today rather than nine days from now, and I see lots of downside to acting today because of the January 21, 2008 21 of 32 problems that it is going to create for us in the future. I really believe that, and I just don’t see the argument for acting today. CHAIRMAN BERNANKE. Governor Kohn. MR. KOHN. Thank you, Mr. Chairman. I strongly support your proposal. As I noted in our conference call a couple of weeks ago, I think our reaction to the incoming data and to the change in financial conditions, even as of a couple of weeks ago, was much smaller than it needed to be to stabilize the economy. We had a long way to go, and the situation has deteriorated since then, a little bit on the data side—the consumption data were a little weaker than we expected—but much more in the financial markets. We have a vicious cycle in housing between the financial markets and the housing markets, where the decline in the housing markets is feeding into the credit markets, which is feeding back on the housing market. I think there is evidence, as others have cited, that it is spreading geographically a bit to other countries, which means that the export support that we were counting on may not be as strong as it was, and spreading to other markets like the consumer credit markets. I agree that the equity markets per se aren’t our goal, but declines in equity prices destroy wealth. I think they are symptomatic, as you indicated, Mr. Chairman, of a fear and a declining confidence in where this economy is going. That dynamic of declining confidence and growing fear argues for early action despite a number of reasons to wait for the next meeting. I agree with President Poole that no one can be certain what the market reaction will be and what kind of responses we will get now and in the future. We could look panicky. We could set up expectations in the future that we would regret. But I think the greater risk would be in not acting. Given the dynamic out there, living through another nine days before the next meeting has a very high degree of risk that we could come into that meeting in a very, very January 21, 2008 22 of 32 adverse spot in terms of where the markets are and what is expected of us. So there is no guarantee of success here. That is for sure. But if I were going to place my bets—and I guess I am as a voting member of the Committee—I would place it on acting now rather than later. President Lockhart talked about the potential positive effects on psychology. I think that is part of it. There are also just the normal channels through which monetary policy works on the economy. Lowering interest rates will help in terms of asset prices, and it will help financing costs; and given the risk of waiting, I think we should get to that right away. I agree that it is not going to do anything directly for the monolines or for the other institutions that need capital. But part of what is driving this fear and eroding confidence is the concern about recession. I think lowering interest rates, doing it promptly, and doing it emphatically with 75 basis points, as well as acting through the usual channels, will help ameliorate that fear. In terms of taking it back, the point that President Hoenig made, I think the history of what we have done is pretty complicated and more complex maybe than that we are always too late taking it back. If we were always too late, we would have seen an upward trend in inflation. But we haven’t. We have seen a downward trend in inflation for the past 25 years. So it seems to me that the proof of the pudding is in the inflation eating, and I don’t think we have been reluctant to—I mean, yes, you can argue that we should have done it one meeting sooner or that sort of thing. That is all 20/20 hindsight. You know, you can always make that argument. But I think basically monetary policy has accomplished its objectives pretty darn well over this period, reacting to financial market distress and then taking it back when we see the distress being alleviated. I think, President Hoenig, if we keep our eye on the inflation forecast, if we make sure that we are forward-looking in that regard, that we will take it back in a timely way. Even if we get started a meeting or two too late, we can move up faster after we start. So I don’t think January 21, 2008 23 of 32 our history is so unambiguous that we are always late taking things back. I don’t think the results support that kind of assertion. I agree with you, Mr. Chairman, that we cannot take our eyes off inflation, particularly inflation expectations. If we had a build in inflation expectations, that would set into motion a very serious and destructive dynamic, especially with the dollar. But I do think that declining resource utilization, a soft economy, even if it’s not in recession, will exert competitive pressures on both workers and businesses as they consider raising prices. Our focus right now, as several of you have remarked, given the risk to the economy, must be on financial stability and its implications for the economy. That is where we need to focus our attention at the moment. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. Let me just make a few brief points. First, during the discussions on this call, we have described these financial markets as fragile. That strikes me as rather euphemistic for what we have been witnessing really since the first of this year, particularly what is being witnessed overseas today. The losses appear to be selfreinforcing. Panic appears to be begetting further pullbacks by investors, retail and institutional alike. There seems to be continued interest in the safest currencies, and this pullback strikes me as quite nondiscriminate, geographically and in terms of sectors, companies, and even entire asset classes. Certainly, we shouldn’t be responding to those moves unless, when we think about our credibility, we think about it both with respect to our inflation-fighting credibility and, I think as Governor Kohn just said, our financial stability credibility. I think the standard for moving between meetings is a very high one; but looking at the evidence, both in the financial January 21, 2008 24 of 32 markets and in the real economy, and thinking about our own credibility, my sense is that we rather convincingly meet that standard. My judgment would be, if we chose not to act today, that we would in all likelihood not make it until next week. There can’t be a ton of conviction that by virtue of 75 basis points today we are going to redress some of this fear and some of the psychology that is working against us in the markets. But just because we don’t have a panacea, just because monetary policy can’t solve the monoline problem and can’t solve some of the other problems, doesn’t mean that we shouldn’t be doing our part. It strikes me that by taking action today we are doing our part. We are showing the financial markets and the real businesses that we do get it. Speaking for myself, I am glad that the interbank funding markets are working better. That puts them in a better position to take more advantage of changes in monetary policy. Through the TAF and through time they are now lending to each other. But based on what has happened in the last several days, it doesn’t look as though they are going to be lending to many others. So our action today needs to be focused very much on that front. With all that said, Mr. Chairman—and recognizing how quickly the decoupling hypothesis seems to have raced away from these markets as quickly as it found its way into their collective wisdom—we look to emerging markets and look to markets here in the United States. I think our actions today will go some small way to ensure that markets come back to a more realistic assessment, but we shouldn’t fool ourselves that somehow we in any way are going to be solving this problem between now and the next time we meet. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. MR. KROSZNER. Thank you very much, Mr. Chairman. I think it is very clear that the numbers have weakened significantly from where we were before. In some sense, the pieces are January 21, 2008 25 of 32 starting to fall in the puzzle, and we were uncertain before—we are still uncertain—but there is a lot more evidence of significant downside risks. So things, unfortunately, have been clarified on that side. We have also gotten some data that are not particularly welcome on inflation, which suggests that there are still some challenges there, both in headline and in core. At the last meeting, a lot of us focused a lot on the potential for a regime switch. We haven’t really talked about that much here, but I think this evidence suggests that there is much higher probability of a fairly rapid shift from a growth state to a recession state. That is being reflected in the financial market, so it is just a different way of saying similar things that the Chairman, Governor Kohn, and others of you have said. I think Bill would also say that the credit default swap spreads on a number of the financial institutions have been going up, even as some of the liquidity issues have been coming down. There are very strong concerns about significant losses coming down the line—concerns not only about the monolines but also, as the Chairman said, about losses just because of the problems in the consumer sector—increasing delinquencies in a variety of areas, not just in subprime mortgages. That is going to put a lot of stress on bank balance sheets. Even though the banks have been nimble in bringing in a lot of capital, they have also had astonishingly large losses. If they continue to have these losses going forward, they just will not be able to churn out the funding that is necessary to keep an economy growing certainly at anything that is close to potential, probably nothing that is close to a positive rate of growth. So it seems that it is sensible to buy some insurance and buy it through taking a bold, decisive action now. The question, of course, is whether we do that now or whether we do that in nine days. People have talked about the tradeoff that we have between the value of acting now and averting the possibility of very negative outcomes over the next nine days and some January 21, 2008 26 of 32 concern about developing a bad expectations dynamic and problems of people thinking that we are responding to the equity markets in and of themselves, not what the equity markets are signaling about the real economy. But I think things are different now than they were earlier in the month, when I was not very supportive of moving at that time. First, we now have more data in a variety of areas, and we have the concerns about the monolines. We have a more substantive basis on which to move, so it doesn’t look as though we are responding to just one particular thing; the pieces are there together. Second, there is a much clearer foundation from the Chairman’s testimony and speech, in which he made it very clear that we would be thinking about and seriously contemplating bold action. So now there is a foundation for this. This is not just coming out of the blue or coming out of some rumors in the market. I think that is a very different situation from the one we had before. Third, I think it is actually beneficial that we have the meeting coming up in nine days. That gives us an opportunity to refine the message fairly quickly if we feel we need to and to take further actions if we need to. So I come out, on balance, thinking that the risks are too high not to act now. I acknowledge some of those downside risks, but I see that there are very strong benefits to acting now. But I do hear some of the concerns that people have raised, and I had some of these concerns also, particularly with respect to inflation. I might suggest that in the last paragraph in the proposed FOMC statement, which I am fine with, perhaps a way of showing a little more concern about some of the inflation issues is in the second half of that sentence, where you say “but it will continue to monitor inflation developments carefully,” to say instead “but it will be necessary to continue to monitor those inflation developments carefully.” That might buy us a little there because the statement is a fairly large move away from what we have said before. This phrase is about the only one that we have repeated from before, and I think strengthening January 21, 2008 27 of 32 that phrase may be beneficial. But I am supportive of the statement as is. Perhaps it could be improved with a little strengthening there to address some of the concerns, but I am very much supportive of the overall 75 basis point move now. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Hoenig, does a language change on inflation help you at all? MR. HOENIG. It is, I guess, helpful, but let me ask this. A point that was made earlier, when you said that we are moving to where we need to be, in terms of the real rate, taking total inflation, we are moving to real rates that are negative. I am fairly confident that, while this is a bold move, it is also a precursor to another move a week or nine days from now, which would put us in an even more negative position, when we are projecting the economy to be slowing and when, in fact, total inflation is above—currently at least, year over year—4 percent. I understand the concerns about the markets and people’s uncertainty. But we are taking these very dramatic actions right now, more perhaps than what we need when you say “where interest rates need to be.” If we were to go 50 basis points now and 50 basis points at the next meeting, we are still moving down, but we are taking it in a more measured form. I am not convinced that isn’t a better way of going, given where we are with the economy and given where we are with our projections looking forward. That is really something that maybe you could at least address— the negative levels of the real rate in terms of your comfort going forward and where we need to be. CHAIRMAN BERNANKE. All right. Thank you. Let me make a few comments. Thank everyone for your input and your concerns, which I appreciate. This is a very, very difficult situation, and no one can know exactly how this is going to work out. But let me try to respond to a few points that were made. First of all, as I indicated earlier, I would not be January 21, 2008 28 of 32 proposing this if I didn’t think that we were seriously behind the curve in terms of economic growth and the financial situation. I said that on January 9, and since then the markets and the data have only gotten significantly worse. I do believe that we are at least 100 basis points behind the curve in terms of neutrality, and so I am quite comfortable with this order of magnitude of move. Frankly, I think the evidence is very much in favor of it. With respect to what the real rate is, I would combine my response to you with a comment to President Fisher, which is that real rates depend on expected inflation, not past inflation. Inflation is a lagging indicator. We cannot wait until inflation is down before we begin to act. We have to look at the future. We have seen oil prices down $10 already. We just have to make a judgment. With the economy slowing and with oil prices likely to moderate, the best guess is that inflation will be well controlled going forward. If that is not the case, we can begin to address it. But I do believe that, from a forecast viewpoint, we don’t have a negative real interest rate, and we don’t necessarily have inflation above 4 percent. I would like to address the issue of the lesson of 2001. I don’t think that the problem with 2001 was the rate at which the interest rate was cut. The interest rate was cut more than 500 basis points, including three intermeeting moves of 50 basis points each in 2001. Nevertheless, at the end of that episode, inflation was too low, which is evidence I think that in some sense the response was even inefficiently slow. Not that they could have necessarily done better, but clearly it was not the cut itself that led to inflation problems. Governor Kohn’s points notwithstanding, and it was very difficult to know ex ante what was right, if there is a concern there it has to do with how quickly the rate was raised starting in 2004 going forward, when the economy was already on a growth path. I think we have learned from that. I think we will be very sensitive to that. January 21, 2008 29 of 32 Let me just add that I do intend to be talking more about the outlook and about policy. I am sure that I will do my best to communicate where I think we are and how we are going to manage policy going forward. I have talked specifically about the need to be aggressive in the short run, particularly when financial stability is at stake. So again, my fundamental point is that we are behind the curve. We need to do something to get up there. Why does that help markets? Well, I think there are issues of psychology and dynamics and damage that could be done if we let the markets twist and turn for another nine days. But the fundamentals are also involved. The markets essentially—in their incredible efficiency—are bringing into the present concerns about very bad outcomes that might happen in the future. With fair value accounting, mark to market, and all of those things, the risk that house prices might fall 20 or 30 percent, even the small risk, is affecting today’s credit ratings and credit markdowns. We can help the markets in a fundamental sense by assuring them that we are aware of these risks and that, though we are not going to necessarily stop a slowdown, we will do our best to minimize the tail risks of a really bad outcome that are right now driving today’s market reactions. That would help the monoline insurers in the sense that, if the markets become convinced that those risks are much smaller, then the obligations of the monolines insurers will be less, and the willingness to advance capital might be greater. Again, if I thought that we were where we should be and this was just a question of placating the markets, I would not be here talking to you. But I think that we need to move, and if we move now, we will get a bonus in terms of at least some hope of reducing the fear and the uncertainty that is currently in the markets. So I do think it matters whether we move today or move nine days from now. I recognize the risks, but in the two years that I have been here in this position, we have not moved intermeeting. We waited a long time to move in September after January 21, 2008 30 of 32 our intermeeting statement. I don’t think that we are trigger happy. I don’t think we are perceived as trigger happy. I think that we need to be catching up to where the right interest rate is, and that is the essence of the issue. I guess that is all I have to say. As I said, Governor Mishkin is not here. For what it is worth, he authorized me to say that he supports the action and the statement. We are currently at a very critical juncture. We are being watched very carefully. We have to demonstrate our willingness to address these very, very serious risks. I think we ought to go ahead and take this step, and I hope that you can support this action. Are there any other comments? President Hoenig. MR. HOENIG. Mr. Chairman, I hear you, and I appreciate your concerns. I do understand that there is a psychology in the market that is having its effect. I think if we make this statement as strong as we can about the need to watch inflation, and if we understand among ourselves that, as we take this action today and the follow-up actions that I am certain we are going to take, we will watch these inflation numbers, including broad asset values—I know we don’t prick bubbles and that sort of thing, but watching these broad asset-price movements—that would be very, very important, at least to think about. I do not wish to be dissenting on this, as troubled as I am about it. I do understand the psychology of it. For those reasons, I am willing to go along with this. But I worry about our ability to deal with reversal as this takes place, especially given where our projections for growth are right now and my concern that we already have inflation above 4 percent. So I defer to you at this point. I would vote for it because I think the psychology of the marketplace is, of course, rather fragile, and I will leave it at that. Thank you. CHAIRMAN BERNANKE. Did you want to accept Governor Kroszner’s suggestion? January 21, 2008 31 of 32 MR. HOENIG. Yes. I think the strongest language as we can give would make me much more comfortable. CHAIRMAN BERNANKE. Okay. Governor Kroszner’s suggestion was to say, “The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.” Does that work for everybody? All right. If there are no further comments, I would like to call the roll, please. MS. DANKER. I will read the directive and then the statement and call the roll. “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 reducing the federal funds rate to an average of around 3½ percent.” The statement goes, “The Federal Open Market Committee has decided to lower its target for the federal funds rate 75 basis points to 3½ percent. The Committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets. The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully. Appreciable downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.” January 21, 2008 Chairman Bernanke Vice Chairman Geithner President Evans President Hoenig Governor Kohn Governor Kroszner President Poole 32 of 32 Yes Yes Yes Yes Yes Yes No MR. POOLE. And you could add this sentence of explanation, “President Poole does not believe that current market conditions justify policy action before the regularly scheduled meeting next week.” MS. DANKER. Thank you. President Rosengren Governor Warsh Yes Yes Thank you. CHAIRMAN BERNANKE. Okay. Thank you very much. Again, I am sorry to interrupt your holiday, and we will see you next week in Washington. Thank you. The meeting is adjourned. END OF MEETING January 29–30, 2008 1 of 249 Meeting of the Federal Open Market Committee on January 29–30, 2008 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, January 29, 2008, at 2:00 p.m., and continued on Wednesday, January 30, 2008, at 9:00 a.m. Those present were the following: Mr. Bernanke, Chairman Mr. Geithner, Vice Chairman Mr. Fisher Mr. Kohn Mr. Kroszner Mr. Mishkin Ms. Pianalto Mr. Plosser Mr. Stern Mr. Warsh Messrs. Evans, Lacker, and Lockhart, and Ms. Yellen, Alternate Members of the Federal Open Market Committee Messrs. Hoenig, Poole, and Rosengren, Presidents of the Federal Reserve Banks of Kansas City, St. Louis, and Boston, respectively Mr. Madigan, Secretary and Economist Ms. Danker, Deputy Secretary Mr. Skidmore, Assistant Secretary Ms. Smith, Assistant Secretary Mr. Alvarez, General Counsel Mr. Baxter, Deputy General Counsel Mr. Sheets, Economist Mr. Stockton, Economist Messrs. Connors, English, and Kamin, Ms. Mester, Messrs. Rosenblum, Slifman, Sniderman, Tracy, and Wilcox, Associate Economists Mr. Dudley, Manager, System Open Market Account Mr. Parkinson,² Deputy Director, Division of Research and Statistics, Board of Governors Mr. Struckmeyer,¹ Deputy Staff Director, Office of Staff Director for Management, Board of Governors _______________ ¹ Attended Wednesday's session only. ² Attended portion of the meeting relating to the analysis of policy issues raised by financial market developments. January 29–30, 2008 2 of 249 Mr. Clouse, Senior Associate Director, Division of Monetary Affairs, Board of Governors Ms. Liang and Messrs. Reifschneider and Wascher, Associate Directors, Division of Research and Statistics, Board of Governors Ms. Barger² and Mr. Greenlee,² Associate Directors, Division of Banking Supervision and Regulation, Board of Governors Mr. Gibson,² Deputy Associate Director, Division of Research and Statistics, Board of Governors Mr. Dale, Senior Adviser, Division of Monetary Affairs, Board of Governors Mr. Oliner, Senior Adviser, Division of Research and Statistics, Board of Governors Messrs. Durham and Perli, Assistant Directors, Division of Monetary Affairs, Board of Governors Mr. Blanchard, Assistant to the Board, Office of Board Members, Board of Governors Mr. Small, Project Manager, Division of Monetary Affairs, Board of Governors Mr. Bassett,³ Senior Economist, Division of Monetary Affairs, Board of Governors Mr. Doyle,³ Senior Economist, Division of International Finance, Board of Governors Ms. Kusko,³ Senior Economist, Division of Research and Statistics, Board of Governors Mr. Luecke, Senior Financial Analyst, Division of Monetary Affairs, Board of Governors Mr. Driscoll, Economist, Division of Monetary Affairs, Board of Governors Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of Governors Ms. Green, First Vice President, Federal Reserve Bank of Richmond Messrs. Fuhrer and Judd, Executive Vice Presidents, Federal Reserve Banks of Boston and San Francisco, respectively _______________ ² Attended portion of the meeting relating to the analysis of policy issues raised by financial market developments. ³ Attended portion of the meeting relating to the economic outlook and monetary policy decision. January 29–30, 2008 3 of 249 Messrs. Altig and Angulo,² Mses. Hirtle² and Mosser, Messrs. Peters² and Rasche, Senior Vice Presidents, Federal Reserve Banks of Atlanta, New York, New York, New York, New York, and St. Louis, respectively Mr. Hakkio, Senior Adviser, Federal Reserve Bank of Kansas City Mr. Krane, Vice President, Federal Reserve Bank of Chicago Mr. Weber, Senior Research Officer, Federal Reserve Bank of Minneapolis _______________ ² Attended portion of the meeting relating to the analysis of policy issues raised by financial market developments. January 29–30, 2008 4 of 249 Transcript of the Federal Open Market Committee Meeting of January 29-30, 2008 January 29, 2008—Afternoon Session CHAIRMAN BERNANKE. Good afternoon, everybody. Today is the last meeting for our friend and colleague, Bill Poole. Bill has been here for 81 meetings, 80 as a Reserve Bank president and one as an adviser to the Federal Reserve Bank of Boston. I thought I would read to you the transcript from March 31, 1998, when Bill first joined the table. “Chairman Greenspan. I especially want to welcome back an old colleague, Bill Poole. I didn’t realize the last time he sat in this room was 25 years ago. Mr. Poole. I was sitting back there along the wall. Chairman Greenspan. It has taken you 25 years to move from there to here? [Laughter] Mr. Poole. Baby steps.” [Laughter] We’ll have a chance to honor Bill at our farewell luncheon on March 18, at our next meeting, but let’s take this opportunity to thank you for 10 years of service and collegiality. MR. POOLE. Thanks, Mr. Chairman. I came here 10 years ago with a boom. I’m going out with a pause. [Laughter] CHAIRMAN BERNANKE. We’ll let Bill have the last word on that. [Laughter] Okay. Today is the first regular meeting of the year. This is our organizational meeting, so we have some housekeeping things. Item one, nomination of the Chairman. Governor Kohn. MR. KOHN. It’s an honor and a privilege to nominate Ben Bernanke to be the Chairman of this Committee. CHAIRMAN BERNANKE. Thank you. Second? SEVERAL. Second. MR. KOHN. A pregnant pause. January 29–30, 2008 5 of 249 CHAIRMAN BERNANKE. Other nominations? Without objection, thank you very much. We need a nomination for Vice Chairman. MR. KOHN. I can do that, too. It’s another honor and a privilege to nominate Tim Geithner to be the Vice Chairman of this Committee. CHAIRMAN BERNANKE. Second? MR. KROSZNER. Second. CHAIRMAN BERNANKE. Other nominations? Without objection. Thank you. Ms. Danker will read the nominated staff officers for the Committee. MS. DANKER. Secretary and Economist, Brian Madigan; Deputy Secretary, Deborah Danker; Assistant Secretaries, David Skidmore and Michelle Smith; General Counsel, Scott Alvarez; Deputy General Counsel, Thomas Baxter; Assistant General Counsel, Richard Ashton; Economists, Nathan Sheets and David Stockton; Associate Economists from the Board, Thomas Connors, William English, Steven Kamin, Lawrence Slifman, and David Wilcox; Associate Economists from the Banks, Loretta Mester, Arthur Rolnick, Harvey Rosenblum, Mark Sniderman, and Joseph Tracy. CHAIRMAN BERNANKE. Any questions? We’ll need a vote. All in favor? [Chorus of ayes] Opposed? [No response] Thank you. Item two on the agenda: There are some cosmetic changes to the Committee rules. Scott Alvarez and Debbie Danker circulated a memorandum. Are there any questions? If not, I’ll need a vote in favor. [Chorus of ayes] Opposed? [No response] Thank you. Item three: We need to select a Federal Reserve Bank to execute transactions for the System Open Market Account. I have been informed that New York is again willing to serve. [Laughter] All in favor? [Chorus of ayes] Opposed? [No response] Thank you. January 29–30, 2008 6 of 249 We need to select a manager for the System Open Market Account. Bill Dudley is the incumbent. Are there other nominations? Well, if not, in favor? [Chorus of ayes] Opposed? [No response] Thank you. All right. We turn now to annual authorizations for Desk operations. Bill circulated a memo that had one revision to the authorization for foreign currency operations. Are there any questions about that change? If not, all in favor? [Chorus of ayes] Opposed? [No response] Thank you. There are no changes proposed for the authorization for domestic open market operations, the foreign currency directive, or the procedural instructions with respect to foreign currency operations. All in favor? [Chorus of ayes] Opposed? [No response] Thank you. All right. We turn now to the business of the meeting. Let me call on Bill Dudley to give us the Desk report. MR. DUDLEY.1 Thank you, Mr. Chairman. I’ll be referring to the handout that you should have in front of you. Over the past month, term funding pressures for banks have generally subsided. But the bigger story remains the continued pressure on bank balance sheets, the tightening of credit availability, and the impact of this tightening on the outlook for economic activity. The travails of the monoline financial guarantors—some of which have already been downgraded by one or more of the rating agencies—have exacerbated the worries about the potential for further bank writedowns and have created risks that some financial instruments that rely on monoline guarantees might no longer be viable. At this juncture, whether the major monoline guarantors will receive the new capital needed to keep or restore their AAA ratings remains uncertain. I’ll start today by noting that U.S. and global equity and fixed-income markets have behaved in a way consistent with a darker economic outlook. As shown in exhibit 1, the major U.S. indexes have fallen sharply since the December 11 FOMC meeting. These declines in the stock markets have been mostly matched abroad, as shown in exhibit 2. At the same time, corporate credit spreads have risen in tandem with the equity markets’ decline. As shown in exhibit 3, high-yield corporate bond spreads are up more than 100 basis points since the December FOMC meeting, pulling the interest rates on high-yield debt significantly higher. Investment-grade spreads have also widened. But for investment-grade debt, the decline in Treasury yields has been larger than the rise in spreads, lowering somewhat the absolute level of yields. Global credit default swap spreads have also increased sharply, as shown in 1 The materials used by Mr. Dudley are appended to this transcript (appendix 1). January 29–30, 2008 7 of 249 exhibit 4. Market price risk has increased. This is most visible in the rise of most market measures of implied volatility. For example, the VIX, which measures implied volatility on the S&P 500 index, recently climbed back to the peak level reached in August (exhibit 5) and the MOVE index, which measures volatility in the Treasury coupon market, has climbed to its highest level since 1998. The problems of the financial guarantors have been an important part of the story. In recent years, the major financial guarantors have diversified into insuring structured-finance products, including collateralized debt obligations (CDOs). Currently, their exposure to all structured-finance products is about $780 billion. Exhibit 6 shows the distribution of exposure across three buckets: U.S. public finance, U.S. ABS and structured finance, and the total non-U.S. exposure for the six major monoline guarantors. Because the structured-finance guarantees have typically been issued against the highest rated tranches at the very top of the capital structure, until recently the rating agencies did not think that these guarantees would result in meaningful losses. However, as the housing outlook has continued to deteriorate and the rating agencies have increased their loss estimates on subprime and other types of residential mortgage loan products, the risk of significant losses has increased sharply. This is particularly the case with respect to these firms’ collateralized debt obligation exposures—a portion of their total structured-finance exposure. As I discussed in an earlier briefing, given the highly nonlinear payoffs built into these products, modest changes in the loss assumptions on the underlying collateral can lead to a sharp rise in expected losses on super senior AAA-rated collateralized debt obligations. Unfortunately, the CDO exposures of several of these financial guarantors are quite large relative to their claims-paying resources. As shown in exhibit 7, statutory capital for even the biggest firm is less than $7 billion; the total capital for the entire group is slightly more than $20 billion; and total claims-paying resources for this group from all sources is about $50 billion. Exhibit 8 compares these claims-paying resources with the subset of CDO exposures that contain some subprime mortgage-related collateral. For four of the six major guarantors, these CDO exposures represent more than 200 percent of their total claims-paying resources. These exposures and the uncertainty about how these exposures will actually translate into losses are the proximate cause for the collapse in the financial guarantor share prices and the widening in their credit default swap spreads. This is why new sources of capital have been either prohibitively expensive or dilutive or both to existing shareholders. As I noted in last week’s briefing, credit rating downgrades of the financial guarantors would likely lead to significant mark-to-market losses for those financial institutions that had purchased protection. For example, in its fourth-quarter earnings release, Merrill Lynch wrote down by $3.1 billion its valuation related to its hedges with the financial guarantors; $2.6 billion of this reflected writedowns related to super senior ABS CDO exposures. Unfortunately, there is not much transparency as to the counterparty exposures of the guarantors on a firm-by-firm, asset-class-by-asset-class, or security-by-security basis. However, major broker-dealers have considerable nonABS CDO exposures to the financial guarantors. For example, they are thought to January 29–30, 2008 8 of 249 have hedged an even larger amount of the super senior tranches of synthetic corporate CDOs with the financial guarantors. This suggests the potential for significant additional mark-to-market losses for commercial and investment bank counterparties should the financial guarantor credit ratings get further downgraded. In addition, such downgrades would increase market anxiety about counterparty risk because there would be considerable uncertainty about the magnitude and incidence of the prospective losses such downgrades might trigger. Financial institutions are also exposed to the monoline guarantors via the wraps these guarantors have issued on certain money market securities, including auction rate securities, tender option bonds, and variable rate demand notes. The amount of these securities outstanding is significant. The total market size for these three types of securities is estimated to be about $900 billion. The major risk here is that the loss of the AAA-rated guarantee from the financial guarantor could undercut the demand for these securities. In the case of tender option bonds and variable rate demand notes, this could trigger the liquidity backstops provided by major commercial banks and dealers, leading to further demands on their balance sheets. In the case of the auction rate securities market, the dealers would be faced with a difficult Hobson’s choice. They could either allow the auction to fail or take the securities onto their books to prevent a failed auction. In the case of a failed auction, the investor receives a higher interest rate but has to wait until the next auction to try to redeem the securities. If failed auctions were to persist, as would be likely, then the securities would essentially become long-term rather than short-term obligations. Failed auctions would undoubtedly distress clients that had purchased the securities on the assumption that they would be liquid and could be redeemed easily. Failed auctions would also likely lead to broader distress in the associated municipal and student loan securities markets. We have already experienced a number of failed auctions for auction rate securities. Moreover, the recent downgrades of Ambac and FSA have led to significant market differentiation among tender option bonds and some upward pressure on municipal bonds wrapped by weaker monoline financial guarantors. If the monoline guarantors are unable to find additional equity or other forms of support, these pressures are likely to intensify in coming weeks. The travails of the financial guarantors have added to the pressure on major commercial and investment banks. As shown in exhibits 9 and 10, commercial and investment bank equity prices and credit default swap spreads have generally continued to widen. The cumulative writedowns reported for a selected group of large banks has now reached $100 billion over the past two quarters (exhibit 11). Coupled with balance sheet growth and other factors, such as acquisitions, these writedowns have put significant downward pressure on bank capital ratios. For example, although all of the top five U.S. commercial banks can still be characterized as “well capitalized,” there has been significant erosion of their capital ratios over the past two quarters (exhibit 12). This balance sheet pressure helps to explain why commercial bank counterparties continue to complain about their access to credit, the tightening in lending standards, and the wider spreads for assets such as jumbo January 29–30, 2008 9 of 249 residential mortgages, commercial mortgages, and leveraged loans that can no longer be readily securitized and distributed into the capital markets. Shifting now to what market participants expect from us from this meeting: Monetary policy expectations continue to shift in the direction of more cuts that are delivered more quickly. As shown in exhibit 13, the federal funds rate futures market currently implies that market participants now expect additional rate cuts totaling about 100 basis points by midyear. Further out, as shown in exhibit 14, the Eurodollar futures curves indicate that about another 25 basis points is anticipated during the second half of the year. But these expectations are volatile and have been shifting considerably day to day. The primary dealer survey tells a similar story. The modal forecast of the primary dealers shows a federal funds rate trough slightly below 2.5 percent (exhibit 15). Compared with the previous dealers’ survey conducted for the December FOMC meeting (exhibit 16), the trough has moved down about 75 basis points. As of last Friday, seventeen of the twenty primary dealers expected a 50 basis point rate cut at this meeting. This sentiment appears to be generally shared by market participants. As shown in exhibit 17, as of last Friday, options on federal funds rate futures implied a rate cut at today’s meeting, with the highest probability on a 50 basis point rate cut to 3 percent. However, it is important to recognize that the probabilities shown in exhibit 17 put a zero weight on the notion of another intermeeting cut in February—so they should not be taken literally as to the outcome at today’s meeting. The distribution of yields on Eurodollar futures 300 days ahead suggests that there has been a regime shift since the December FOMC meeting. As shown in exhibit 18, not only have expectations shifted down sharply, but the skew has reversed direction. The mode of the distribution is at 1.75 percent, and the skew of the distribution around that mode is toward less extreme rate outcomes. This could be viewed as market participants now pricing in considerable risk of a severe recession but maintaining some hope that a milder downturn might occur or that a recession could possibly be averted altogether. As shown in exhibit 19, the intermeeting rate cut was accompanied by a rise in inflation compensation at the five-year to ten-year time horizon. However, it is unclear that this represents a genuine deterioration in inflation expectations for several reasons. First, the rise occurred, in part, because breakeven inflation at the five-year horizon has fallen as nominal five-year Treasury yields have dropped sharply. It is this decline that has lifted the five-year, five-year-forward measure. I would agree with the memo by Board staff that was distributed to the FOMC yesterday on this issue: The rise in five-year, five-year-forward inflation compensation likely reflects a greater liquidity premium for nominal Treasuries. The rise in interest rate volatility is also a factor. According to TIPS traders, the rise in five-year, five-year-forward inflation reflects technical factors such as a temporary increase in the demand for shorter-dated Treasuries, month-end index extension flows, and a greater liquidity premium for nominal, on-the-run Treasuries. The general rise in interest rate volatility is probably also a factor. Second, the rise in five-year, five-year-forward expectations has not been accompanied by a broad set of other signals consistent with deteriorating long-term inflation expectations. For January 29–30, 2008 10 of 249 example, the four- to five-year-forward breakeven inflation measure shows a much smaller rise, the dollar has been relatively stable, and estimates of bond term risk premiums remain low. On the other side, gold prices have increased sharply in the past week. Third, in our primary dealers’ survey, there was very little change in longterm inflation expectations. Finally, it is worth noting that following the 50 basis point rate cut in September, which was more aggressive than expected, the five-year, five-year-forward rate also rose, but the rise proved temporary. I would also like to briefly discuss the state of play in bank term funding markets—some good news. As shown in exhibit 20, the spreads between the onemonth LIBOR and the one-month OIS rate and the three-month LIBOR and the threemonth OIS rate have fallen sharply since year-end. However, over the past week, there has been considerable volatility in these spreads. This could be due to a variety of factors—including a temporary increase in the demand by Societé Générale for term funds and the sharp shift in expectations about the near-term federal funds rate path. Currently, these spreads are close to the narrowest we have seen since the market turmoil began last August. Although the passage of year-end was the predominant factor behind the decline in term funding spreads, the term auction facility (TAF) also appears to have been helpful. Exhibit 21 shows the results for the first three U.S. auctions. Completing the exhibit, the results for the fourth auction, which was conducted yesterday, were minimum bid rate, 3.10 percent; stop-out rate, 3.12 percent; propositions, $37.5 billion; bid-to-cover ratio, 1.25; and number of bidders, 52. In general, the pattern is one of declining bid-to-cover ratios and a declining spread between the stop-out rate and the overnight index swap rate. The results for the ECB and Swiss National Bank auctions show a similar pattern. At the latest auction, the ECB had $12.4 billion of bids, a bid-to-cover ratio of 1.24, and their number of bidders fell to 19 from 22 at the previous auction. The Board of Governors has said that on February 1 it will announce plans for the TAF in February. The staff has recommended to the Chairman that the auctions continue on a biweekly basis, that the size be maintained at $30 billion per auction, and that the minimum bid size be cut to $5 million from $10 million to make it easier for smaller institutions to participate. Finally, there was no foreign currency intervention activity during this period. I request a vote to ratify the operations conducted by the System Open Market Account since the December 11 FOMC meeting. Of course, as always, I am happy to take any questions. CHAIRMAN BERNANKE. Thank you, Bill. Are there questions? President Poole. MR. POOLE. Bill, could you talk about the role of foreign banking organizations? What fraction roughly are they responsible for? January 29–30, 2008 11 of 249 MR. DUDLEY. We have been very cautious about talking about the role of the foreign banks, but they’re definitely a significant factor. The best way to look at it is just to look at the New York District, which is taking an overwhelming share of not all but most of these auctions, and most of that is foreign. Regarding the participation in terms of number of bidders, the split is more even between domestic and foreign; in terms of the actual takedown of dollars, it does skew a bit to the foreign side, but it has been variable. It is not the same in each auction. MR. POOLE. If I may make a comment about that—I think everyone is aware of my view that the TAF does not change the marginal conditions. It’s entirely an inframarginal operation. What it does is to save banks the spread between what their cost of funds otherwise would be and what they get at the TAF. So it increases bank earnings by that amount. It seems to me that there is potentially some reputational risk to the Federal Reserve in the long run if a significant share of the benefit is going to foreign banking organizations. I guess one question that I would pose is, If we think that this information would be terribly sensitive to release, shouldn’t we be careful about whether we continue if the foreign banking organizations are taking a very large fraction? CHAIRMAN BERNANKE. President Lacker. MR. LACKER. Yes, I have a couple of questions. I want to start with the issue about foreign banks, though. Why are we sensitive about talking about foreign banks—I mean, is this a public stance, or is this in the Committee? The information about the identity of the winning bidders was sent to every Reserve Bank. MR. DUDLEY. I don’t think we’re particularly sensitive, but I think other central banks would be very sensitive. MR. LACKER. Well, these are confidential proceedings—this is a consequential policy matter. January 29–30, 2008 12 of 249 CHAIRMAN BERNANKE. Brian. MR. MADIGAN. Mr. Chairman, if I could. I think, President Lacker, just one point is that the detailed information on the bidders was sent only to those Reserve Bank presidents and Board members who specifically asked for it, so it was not distributed unilaterally. MR. LACKER. Just the winning bidders? MR. MADIGAN. Yes. Well, the spreadsheet of bidders. MR. LACKER. I thought that every Bank, all the discount officers, received the identity of the winning bidders, and the other information about all the bids went only to those who requested it. MR. MADIGAN. That is correct, yes. The second point I would make is that I do not think there is particular sensitivity about foreign banks but instead sensitivity about taking any chance of identifying who the bidders are at all because of the great concern about avoiding stigma from the TAF. MR. LACKER. I wanted to ask a couple of questions about the term auction facility. First, I’d like to hear more from you about what your understanding is of the effects the term auction facility had on the funding market. The first question under that would be, To your knowledge, were these completely sterilized or just partially sterilized? Another question would be, For the recipients, were these additional funds that they wouldn’t have otherwise borrowed, or did they displace some other borrowing? The next question would be, This crowded out something, and if it didn’t change materially the total amount of reserves in the system, some lending ought to be shifted from the recipients to someone else—so what do we know about other spillover effects in the markets? The focus of our attention probably for data reasons was the LIBOR market, but there was also discussion in December of the term fed funds market. What do we know about the January 29–30, 2008 13 of 249 behavior of that since then? I’d be interested in your sense of whether bidders were riskier than nonbidders and whether riskier institutions bid more than nonrisky institutions. We’ve done a bit of empirical analysis—it’s preliminary—but I’d be interested in your folks’ sense of that. About the foreign institutions, I’m interested in learning about what the advantage was of our lending dollar balances via this mechanism to foreign banks versus the alternative of having them borrow dollar balances from their central bank, perhaps funded by a swap or out of the foreign central bank’s own dollar balances. Finally—and this is sort of the most important question—how should we evaluate whether this has been a success or not? To what sort of objective evidence should we look to decide whether we achieved our objectives? Related to that, can a case be made for ending this facility soon in light of the fact that the LIBOR–OIS spread is now half of what it was in September, when we decided that it had come down enough to shelve the plan? MR. DUDLEY. Those are a lot of questions. [Laughter] Okay, I’ll take the easy one first. The TAF is completely sterilized. For every dollar that goes into the TAF we drain reserves, and we’ve been doing that mainly by redeeming maturing Treasury bills. Regarding whether these are additional funds to those entities, it is hard to know what they would have done if the TAF facilities hadn’t been available. This may have funded some assets on their balance sheets that they otherwise would have decided not to fund. I think it is very difficult to know what that counterfactual is. It is hard to believe that in the system as a whole it led to a lot of additional funding. I would be surprised by that, especially given that we did sterilize reserves and didn’t allow expansion of the balance sheet. In terms of the issue of crowding out, the way I think about the TAF is changing the composition of our balance sheet and changing the composition of the banking system’s balance sheet. It’s not crowding out. We are basically supplying Treasury securities by redeeming bills, and then the Treasury issues more bills that the markets want, and we January 29–30, 2008 14 of 249 are essentially absorbing collateral from the marketplace that’s hard for them to finance elsewhere. So it is a change in the composition of the balance sheet. That’s how I would think of the way it works. In terms of how we should evaluate the success, we don’t know how much was the yearend. We don’t know how much was monetary policy easing. But market participants view the TAF as very positive. I think that, if we were to discontinue it abruptly, they would be unhappy. There’s no evidence to suggest that the TAF has caused any great harm. It looks as though the benefits, to my mind, are likely to significantly exceed the costs even though we can’t measure those benefits very accurately. Regarding the foreign institutions issue—the choice between dollar balances from us versus dollar balances from foreign central banks—I think it was a little more complicated than that because, if I remember how we got to the foreign exchange swaps, they were essentially more or less conditional on our doing the TAF. They were willing to do the swaps if they could get the auctions in tandem with our term auction facilities. So my judgment would be that we probably didn’t really have a choice of getting the dollars to those foreign banks through the ECB if we hadn’t done the term auction facility. MR. LACKER. If I could just follow up. MR. DUDLEY. Did I miss any? MR. LACKER. Well, on the last point, that’s a matter of the ECB’s willingness to lend to those institutions. You’re saying that they would be willing to lend themselves to those institutions only if we did this. It’s not about the economics of their borrowing from their central bank versus borrowing from us—nothing about the market functioning. MR. DUDLEY. I wouldn’t say it’s about their willingness to lend to their institutions. It’s their sense of what their responsibility is in terms of providing dollar liquidity to their institutions. January 29–30, 2008 15 of 249 To the extent that they could just passively take the dollars and funnel them through this auction process in which their auction was very passive—their auction was essentially a noncompetitive auction that was based off ours—they were willing to do that. They were less willing to do something in which they were taking responsibility for the problem and saying that they were going to get the dollars and supply them to those banks. MR. LACKER. Do market participants view foreign banking organizations as broadly riskier than comparable-sized institutions based in the United States? MR. DUDLEY. Well, it’s difficult to say. If you look at credit default swaps, that would say not. But as President Rosengren and I were talking before the meeting, those credit default swaps may also contain different appetites to recapitalize banks when they get in trouble in the United States versus abroad. So the one thing that we can probably say with confidence for the period is that there’s more anxiety that things are hidden in certain foreign banks that are probably not as likely to be hidden in U.S. banks. There’s better disclosure in the United States on a faster and more real-time basis. The market sense is that there isn’t really the same kind of quarterly disclosure process abroad that happens for U.S. institutions. MS. MOSSER. May I add one factual comment to that? MR. LACKER. Absolutely. MS. MOSSER. During the height of the dislocations in December, the fed funds rate overnight was regularly trading substantially higher early in the morning—this happened also in August for a while—either early in the U.S. trading session or before that. Our understanding from market participants was that the reason for those higher rates in the morning was excess demand from European-based institutions to borrow in the funds market, and when the U.S. institutions became more active later in the day, the funds rate would then go back down to the target. January 29–30, 2008 16 of 249 MR. LACKER. Thanks. Going back to the LIBOR–OIS spread—that was what motivated this. It has fallen a lot. The bid-to-cover ratio is falling. If we try to lend $30 billion three more times, we could get to a point at which we satiate the market in term funds. MR. DUDLEY. Well, first of all, continuing that $30 billion is not supplying any additional dollars, so we’re just going to be rolling over maturing auctions. MR. LACKER. Yes, but the bid-to-cover ratio keeps falling. MR. DUDLEY. Right. But, second, I would caution you that this last auction was right before an FOMC meeting and that may have diminished the appetite. We don’t know with certainty, but our supposition is that the demand would have been higher if the auction had been a week later, if that’s how the schedule had fallen. Third, February might be fine, but March is a quarter-end. Lastly, the fact is that, while the term funding pressures seem to be better, a lot of other things seem to be worse, and clearly the pressure on bank balance sheets has not diminished at all. If anything, it has grown more intense. So to remove this prematurely would be a risk, especially when market participants view this as helpful and it gives them a sense of confidence that the Fed is there. CHAIRMAN BERNANKE. President Fisher. MR. FISHER. The questions that President Lacker asked covered one of the questions I wanted to ask. But as we go down in terms of the number of bidders as we proceed, is the portion that is foreign increasing, relatively speaking? Do we know? MR. DUDLEY. I don’t remember any strong sense of that. MR. LACKER. It’s decreasing. MR. DUDLEY. What has happened, as the auction has proceeded, is that people have bid more tightly around where they think it’s going to come, except for a few institutions who just say, January 29–30, 2008 17 of 249 “I want the money,” and they bid at very high rates because it’s a single price auction. You usually see some behavior like that. MR. LACKER. Mr. Chairman. CHAIRMAN BERNANKE. Yes. MR. LACKER. Foreign banks were $19 billion out of $20 billion at the first auction; $18 billion out of $20 billion at the second auction; and a declining fraction thereafter, President Fisher. MR. FISHER. Thank you, President Lacker. CHAIRMAN BERNANKE. President Lockhart. MR. LOCKHART. Bill, in your remarks, you devoted quite a bit of time to the deteriorating situation in the monolines, the implication being that the risks they may have affect the whole system. In the normal course, do we have direct contact with them to get any insight beyond what we get through analysts and rating agencies? I think you said that they are not terribly transparent in terms of asset class and individual securities as to what they really hold. Have we had any direct dialogue just to inform ourselves as to what the real situation is? MR. DUDLEY. I haven’t had much contact with them. I don’t know if Tim has. VICE CHAIRMAN GEITHNER. Mr. Chairman. CHAIRMAN BERNANKE. Vice Chairman. VICE CHAIRMAN GEITHNER. We have not been in touch with them directly to get a sense about their risk profile and so forth. We have had extensive conversations with the New York State Insurance Commissioner, who is the lead supervisor of many of them, but not all of them. It turns out that office also has very little information, particularly on the stuff that is on the leading edge of concern, which is to whom they sold credit protection and on what. But it is in the process January 29–30, 2008 18 of 249 of trying to remedy that, and we have been giving them a little help in trying to figure out what they need to ask for. MR. DUDLEY. Another thing that is not very well known is what their assets consist of. We have rating buckets, but we don’t know what those ratings actually apply to. We don’t know who they have reinsurance with. Some people think that they’re reinsuring each other to an extent or they have reinsurance with subsidiaries that they own so that the insurance is not at arm’s length. So there’s quite a bit of cloudiness about what their true condition is. VICE CHAIRMAN GEITHNER. We have better information on the protection that banks purchased from the monolines—by monoline and by underlying asset—and it is important, of course, to have that. CHAIRMAN BERNANKE. President Rosengren. MR. ROSENGREN. Yes. I would just note with the TAF experience, going back just for a minute, that the Boston financial community has been overwhelmingly supportive. I don’t know whether you have gotten the same sense when you talk to the financial community in New York, but whether people were bidding or not, they actually thought that it was quite a fruitful exercise. In terms of the credit default swaps, just looking at some of the institutions that were involved, it seemed as if the U.S. institutions, if you look at individual organizations, may have had much higher credit default swap rates than many of the foreign institutions. As you noted, many of the foreign institutions were substantially lower than at least a couple of the U.S. ones that were involved, and we obviously thought the U.S. ones were sound, or we wouldn’t have been willing to have them participate. We should look at the LIBOR rate, but I think we should also look at the Treasury securities market because you don’t have to do as much in open market operations if you’re doing some of it in the TAF, and we’ve had the interest rate on Treasury securities quite low. January 29–30, 2008 19 of 249 So I’m wondering whether, when we think about the analysis, we look not only at things like LIBOR but also at the functioning of the Treasury market, and whether that was actually helped out by this process. I don’t know if you’ve done any work on that, but it would be of interest to know if that had helped with the better functioning of the Treasury market. MR. DUDLEY. Well, I think the presumption is very much that it went in the right direction in terms of the Treasury market because basically the Treasury has auctioned off larger weekly one-month, three-month, and six-month bills to replace those that we were redeeming. So the floating public supply of bills went up. CHAIRMAN BERNANKE. President Poole. MR. POOLE. Very quickly, we should not be surprised that banks like the TAF. It increases the bank’s profits because of the difference between the funding costs. The issue is whether the TAF improves the way the markets are functioning, not whether it’s feeding profits into the banks and whether they happen to like it. VICE CHAIRMAN GEITHNER. Mr. Chairman. CHAIRMAN BERNANKE. Vice Chairman. VICE CHAIRMAN GEITHNER. I think it’s clear in Bill’s presentation that there’s a very strong case that the TAF, the associated measures by other central banks, and, as important, the commitment and the signal that we would continue the TAF longer than was necessary have been very important to the improvement of market functioning and very important to the improvement and confidence in liquidity and markets going forward. It is very hard to know how important it has been to that, but I think it has absolutely been very important, and I think it is very important for us to continue it until we can comfortably say it is no longer necessary in this context. I think we are far from the point that we can claim that. It was 24 basis points in October, President Lacker, and January 29–30, 2008 20 of 249 there are a lot of reasons that we should be expecting to be living with a long period of fragility in markets going forward. We all debated the merits of this going forward. There’s a set of good, principled objections to this kind of stuff, and I didn’t expect that those objections would change on the basis of the experience with this thing, and I don’t think we’ve learned anything new about the merits of those objections, except that there’s a very good basis of evidence for suggesting it has been important to the improvement in confidence and market functioning. One of our jobs is—and I think we’ve been pretty successful in doing it—trying to give some confidence to people that we as the central bank have provided a quality of liquidity insurance more powerful than we can through our classic instruments. I think it has been very successful in this context. To take it back prematurely would be damaging to the improvements we’ve achieved. CHAIRMAN BERNANKE. Are there any other questions for Bill? If not, I need a vote to ratify domestic operations. MR. KOHN. I move that we ratify the operations. CHAIRMAN BERNANKE. Objections? Without objection. Thank you. We turn now to the economic situation. We begin with Dave Reifschneider, whenever you’re ready. MR. REIFSCHNEIDER. 2 Give me one second. On balance, the news we have received since the December Greenbook has been disappointing. The top panel of your first exhibit sorts some of the main indicators into two categories—those that were surprisingly weak and those that came in to the upside of our expectations. As you can see, the list to the left is long. Private payrolls fell in December, and the unemployment rate jumped to 5 percent. Manufacturing output has declined since the summer. Single-family housing starts, new permits, and home sales have fallen further. New orders and shipments of capital goods were disappointing, although a little less so after today’s release of December data. Business sentiment deteriorated, joining already unusually low readings on consumer confidence. Finally, stock prices have tumbled, and credit conditions have tightened. Not all the news was bad. Nonresidential construction activity has continued to be surprisingly robust, and defense spending looks to have been higher last quarter than we anticipated. Moreover, retail sales in November came in stronger than we predicted, and the figures for September and October were revised up. Overall, we read the incoming 2 The materials used by Mr. Reifschneider, Ms. Liang, and Mr. Sheets are appended to this transcript (appendix 2). January 29–30, 2008 21 of 249 data as implying an increased risk of recession. The middle left panel provides some evidence for this assessment. As was discussed at yesterday’s Board briefing, based on the signal provided by 85 nonfinancial indicators (the black line), the estimated probability of being in recession now or over the next six months stood at 45 percent in December, up from 19 percent in June. A similar exercise carried out using 20 financial indicators, the red line, yields an even bigger jump in the estimated likelihood of recession, from 14 percent at midyear to 63 percent this month. As you know, we are not forecasting a recession. While the model estimates of the probability of recession have moved up, they are not uniform in their assessment that a recession is at hand. Another argument against forecasting recession is that, with the notable exception of housing, we see few signs of a significant inventory overhang. In addition, the recent weakness in the labor market and spending indicators is still limited; for example, initial claims have drifted down in recent weeks rather than surging as they typically do in a major downturn. Finally, a good deal of monetary and fiscal stimulus is now in process that should help support real activity. That said, it was a close call for us. Even without a recession, our assessment of the underlying strength of aggregate demand has revised down markedly since the summer. This is illustrated in the bottom panel by the recent decline in the Greenbook-consistent estimate of short-run r*, the value of the real funds rate that would close the output gap in 12 quarters. By our estimate, short-run r* has fallen more than 2 percentage points since the middle of last year and 1¼ percentage points since December. A jump in the equity premium accounts for most of the downward revision since the last Greenbook, although a further deterioration in the outlook for residential investment is also a factor. Your next exhibit summarizes the current forecast. So, how did we respond to all this bad news? As shown in the panel at the top, we boosted real GDP growth a little from 2007 through 2009. In 2008 and 2009, however, this faster growth is not demand driven but instead reflects upward revisions to the supply side of our forecast that I will discuss in a moment. For 2007, the upward revision to real GDP in the fourth quarter—noted in the panel to the right—reflects the stronger data on nonresidential construction, defense spending, and retail sales that I just mentioned. However, because the incoming data point to a weaker trajectory for real activity in the near term, we have trimmed our forecast of GDP growth for the first half of 2008, and we have marked down final sales growth (not shown) quite a bit. Beyond the middle of the year, we project real output to expand at a rate close to its potential. Under these conditions, we project greater labor market slack than in December, with the unemployment rate—shown in the middle left panel—now expected to edge up to 5¼ percent by next year. And as shown in the bottom two panels, we continue to expect both core and total PCE prices to decelerate noticeably by 2009, although inflation this year is likely to run a little higher than we previously projected. Your next exhibit provides an overview of some of the key factors influencing the outlook. As shown in the upper left panel, we conditioned our forecast on an additional 50 basis point cut in the funds rate at this meeting and then held it flat at January 29–30, 2008 22 of 249 3 percent. We made this revision in response to the weaker underlying level of demand in this projection but with an eye to keeping inflation on a long-run path to 1¾ percent—the midpoint of the range of 2010 inflation projections that you provided in October. Another key element in the outlook is our assumption that concerns over financial stability and a possible recession will begin to abate once the economy gets through a rough patch in the first half of this year. As Nellie will discuss in more detail, this assumption implies that risk premiums on bonds and corporate equity should drift down over time. As a result, we project that equity prices, shown to the right, will stage a partial recovery over the second half of 2008 and in 2009. These and other financial market developments, coupled with an improvement in business and consumer sentiment, should help to support consumption and investment over time. As regards fiscal policy, odds now seem high for the passage of a fiscal stimulus package, although the details are still up in the air. As a placeholder, we built a $125 billion package into the baseline, with two components—$75 billion in tax rebates that households will receive in the third quarter and a 30 percent one-year bonus depreciation allowance that should cost the Treasury about $50 billion in 2008. Our judgment is that the rebate component will provide a significant, albeit temporary, boost to the level of consumer spending during the second half of this year and in early 2009, the period over which we expect most households to spend their checks. In contrast, we think that bonus depreciation will have only a small effect on equipment and software outlays. As indicated by the blue bars in the panel to the right, these assumptions imply a large fiscal-driven contribution from PCE and E&S to real GDP growth in the second half of this year, followed by a similar-sized negative contribution in the first half of 2009. As a result, the long-run contribution to real GDP growth from these two factors is essentially zero. We have assumed that inventories and imports in the short run will offset a substantial fraction of the swings in domestic demand, thereby muting the overall effect of the fiscal package on real GDP growth (the green bars). As I noted earlier, we also have reassessed our supply-side assumptions—shown in the bottom left panel. Specifically, we have raised our estimate of potential output growth from 2005 to 2009 about ¼ percentage point per year, partly in response to the solid gains in output per hour recorded last year. These revised estimates have two important implications. First, the upward revision to potential output translates roughly one for one into faster growth in actual output during the projection period because of its implications for permanent income and hence consumption and investment. Second, the revisions to potential output in history imply that the output gap—shown to the right—currently is lower than we previously thought, and we expect it to remain lower. Your next exhibit provides some details on the real-side outlook. As shown in the top left panel, we have once again revised down the projection for new home sales in light of weak incoming data, including those received after we put the Greenbook to bed. However, we continue to expect that sales will reach bottom in the first half of January 29–30, 2008 23 of 249 this year and then begin to edge up as mortgage credit availability improves. This stabilization in demand should allow single-family housing starts (shown to the right) to level out at about 660,000 units by midyear, well below our December projection. Thereafter, we anticipate a slow pickup in starts. As shown in the middle left panel, builders still have a long way to go to bring the backlog of unsold homes down to a more comfortable level, and this overhang should restrain construction activity into next year. We have also revised down the near-term outlook for real business fixed investment—the middle right panel—in response to slowing sales, tighter credit conditions, and some deterioration of business sentiment, but we now expect a greater cyclical rebound starting in the second half of this year as overall conditions start to improve. The bottom left panel shows our projection for consumption, the blue bars, together with the profile for spending excluding the effects of fiscal stimulus, the green bars. Absent the stimulus package, we would expect consumer spending to increase only 1 percent this year but then to pick up around 2¼ percent in 2009 as confidence recovers and credit conditions ease. However, the tax rebates will likely obscure this cyclical pattern by inducing saw-tooth swings in spending, with actual growth realigning with longer-run fundamentals only in the second half of next year. As shown to the right, some of these fundamentals are less favorable than before; we estimate that wealth effects will hold down PCE spending growth by ½ percentage point this year and almost ¾ percentage point in 2009. Your next exhibit reviews the inflation outlook. As indicated by the blue line in the upper left panel, monthly readings on core PCE inflation have moved up since the summer. We are inclined to take only a small signal from this movement, much as we did early last year when price increases were unusually subdued. In part, this is because a portion of the recent pickup was attributable to the erratic nonmarket component and quarter-to-quarter fluctuations in this category tend to fade away quickly. In addition, while market-based prices also came in higher than expected, we are interpreting some of that surprise as a reversal of some earlier low readings in particular categories. That said, we also think that a portion represents somewhat more persistent inflation pressure coming into 2008. We project both core and total PCE inflation to moderate over time because of several factors. To begin with, futures prices for crude oil imply the sharp deceleration in energy prices shown to the right. We also expect food prices (the middle left panel) to decelerate into 2009, partly as result of the increased production of beef and poultry that is now under way. In addition, the impetus to inflation from core import prices (the middle right panel) should diminish over time, although by less than projected in December because we now anticipate a faster rate of dollar depreciation. These developments, coupled with the additional economic slack built into this projection, should help to keep inflation expectations anchored, allowing actual inflation to fall below 2 percent in the longer run. Indeed, survey measures of long-run inflation expectations (the blue and red lines of the bottom left panel) remain stable. TIPS inflation compensation (the black line) jumped following the intermeeting fed funds rate cut, as Bill pointed out. But as was discussed in the memo by Jonathan Wright and Jennifer Roush that was circulated to the Committee, we are inclined to attribute most of this increase to changes in inflation risk and liquidity premiums, not to a rise in inflation expectations January 29–30, 2008 24 of 249 per se. Putting all this together, we project core inflation—the first column of the panel to the right—to remain at 2.1 percent this year but then to drop down to 1.9 percent next year, the same as in December. Similarly, we continue to expect that headline inflation will slow to 2¼ percent this year and slide to 1¾ percent in 2009 as energy prices moderate. I will now turn the floor over to Nellie. MS. LIANG. As discussed earlier, Treasury yields and stock prices are down sharply since the December FOMC meeting on news that indicated greater odds of a recession and large writedowns at financial institutions. As shown by the blue line in the top left panel of exhibit 6, the fall in stock prices pushed up the ratio of trend forward earnings to price. The difference between this ratio and the real Treasury perpetuity yield, shown by the shaded area and plotted to the right, is a rough measure of the equity premium. As you can see, this measure jumped in the past few months and is now at the high end of its range of the past twenty years. In the corporate bond market, the spread on high-yield corporates, the black line in the middle panel, widened sharply, and investment-grade spreads, the red and blue lines, also rose. Forward spreads (not shown) rose especially in the near-term, suggesting particular concern about credit risk in the next few years. In the forecast, we assume that the equity premium and bond spreads will recede some from their recent peaks as the risk of recession recedes and activity picks up, but they will remain on the wide side of their historical averages. As shown in the bottom left panel, our most recent indicators suggest that the OFHEO national purchase-only house-price index, the black line, fell 2¾ percent in the fourth quarter; we project further declines of about 3¼ percent in both 2008 and 2009. In some states with many subprime mortgages— such as California, Arizona, Nevada, and Florida—house prices, the red line, began to fall earlier and have declined by more. Reports of spectacular writedowns from some financial firms may also have caused investors to assign greater odds of tighter financial conditions. As noted in the bottom right panel, financial firms took writedowns and loan-loss provisions of more than $80 billion in the fourth quarter. Most of the reported losses were from subprime mortgages and related CDO exposures, but many banks also increased loss provisions for other types of loans. In response, financial firms raised substantial outside capital and cut dividends and share repurchases. Still, the risk remains that writedowns and provisioning will grow larger if house prices or economic activity will slow more than currently anticipated or if financial guarantors are downgraded further. Moreover, many of the largest firms are still at risk of further unplanned asset expansion from previous commitments for leveraged loans and their continued inability to securitize non-agency mortgages. Consequently, these firms are likely to be cautious in managing asset growth. Your next exhibit focuses on business financial conditions. As shown by the black line in the top left panel, top-line operating earnings per share for S&P 500 firms for the fourth quarter are now estimated to be about 23 percent below their year-ago level, dragged down by losses at financial firms. For nonfinancial firms, the green line, earnings per share are estimated to be up 10 percent from a year ago. Analysts’ estimates of Q1 earnings for nonfinancial firms were trimmed a bit last week but suggest continued growth. Robust profits since 2002 have put most January 29–30, 2008 25 of 249 businesses in strong financial shape. As shown in the right panel, loss rates on highyield corporate bonds, the black line, have been near zero for more than a year as very few bonds defaulted and recovery rates were high. However, we project that bond losses will rise gradually in the next two years as the nonfinancial profit share slips from its currently high level. In commercial real estate, the middle left panel, the net charge-off rate at banks, the black line, was low in the third quarter of last year despite a slight tilt up mostly from troubled loans related to residential land acquisition and construction. We project that this rate will rise fairly steeply, reflecting weakness in housing and expected softening in rents for commercial properties. A similar outlook may lie behind the tighter standards for business loans reported in the January Senior Loan Officer Opinion Survey. As shown by the orange line in the middle right panel, the net percentage of domestic banks reporting having tightened standards on commercial real estate loans in the past three months reached 80 percent, a notable increase from the October survey. In addition, one-third of domestic banks tightened lending standards on C&I loans in the past three months. Large majorities of the respondents that tightened standards pointed to a less favorable or more uncertain outlook or a reduced tolerance for risk. Despite wider spreads, borrowing rates for investment-grade firms are lower than before the December FOMC meeting. As shown by the red line in the lower left panel, yields on ten-year BBB-rated bonds, the red line, fell about 25 basis points, and rates on thirty-day A2/P2 nonfinancial commercial paper, the blue line, have plummeted about 200 basis points since just before year-end. In contrast, yields on ten-year high-yield bonds, the black line, are up and now are close to 10 percent. Net borrowing by nonfinancial businesses, shown in the right panel, is on track in January to stay near the pace of recent months. Net bond issuance, the green bars, has been sizable in recent weeks with most of that issuance by investment-grade firms. Unsecured commercial paper, the yellow bars, rebounded after substantial paydowns ahead of year-end. Your next exhibit focuses on the household sector. As shown in the top left panel, delinquency rates at commercial banks for credit cards, the blue line, and nonrevolving consumer loans, the black line, edged up in the third quarter, as did rates for auto loans at finance companies through November. Some of the recent rise in delinquency rates for credit cards is in states with the largest house-price declines, and could represent spillovers from weak housing markets. As shown to the right, delinquency rates on subprime adjustable-rate mortgages, the solid red line, continued to climb and topped 20 percent in November, and delinquency rates on fixed-rate subprime and on prime and near-prime mortgages also rose. Looking ahead, we expect delinquency rates on consumer loans to rise a bit from below-average levels as household resources are strained by higher unemployment and lower house prices. These developments have spurred lenders to tighten standards on consumer loans. As noted in the middle left panel, responses to the January Senior Loan Officer Opinion Survey indicate a further increase in the net percentage of banks tightening standards on credit cards and other consumer loans in the past three months. Banks also January 29–30, 2008 26 of 249 reported substantial net tightening of standards for subprime and prime mortgages, with the latter up considerably from the October survey. In addition, spreads on lower-rated tranches of consumer auto and credit card ABS jumped in January amid news that lenders were increasing loan-loss provisions. That said, interest rates on auto loans and credit cards, not shown, are not up, and most households still appear to have access to these forms of credit. As shown to the right, issuance of securities backed by these loans was robust through January. Securitization of nonconforming mortgages, the grey bars in the lower left panel, was weak in the fourth quarter of last year, and there has been little, if any, this month. But agency-backed securitization, the red bars, was quite strong in the fourth quarter and appears to be again in January. Moreover, as shown to the right, interest rates have fallen appreciably. Rates on conforming thirty-year fixed-rate mortgages, the blue line, and one-year ARMs, the red line, fell, and offer rates on prime fixed-rate jumbo mortgages, the black line, are also down. The six-month LIBOR, the rate to which most subprime ARMs reset, plunged in January, although, even at this level, the first payment reset will still be substantial for many households. The next exhibit presents our outlook for mortgage defaults. The top left panel shows cumulative default rates for subprime 2/28 ARMs by year of origination. A default here is defined as a loan termination that is not from a refinancing or sale. The default rates for mortgages originated in 2006 and 2007, the red and orange lines, respectively, have shot up, and for mortgages originated in 2006, about 18 percent will have defaulted by the loan age of eighteen months. This rate is higher at every comparable age than for mortgages made in 2005, the blue line, and the average rate for loans made in 2001 to 2004, shown by the black line, with the shaded area denoting the range across years. Softer house prices likely played an important role in defaults on 2006 and 2007 loans because borrowers had little home equity to tap when they lost their jobs or became ill, or they walked away when their mortgages turned upside-down. These mortgages have not yet faced their first interest rate reset. As shown to the right, we expect a sizable number of borrowers to reset to higher payments, about 375,000 each quarter this year, if these mortgages are not prepaid or rates are not reduced. While many borrowers still have time to refinance or sell before the first rate reset, lower house prices and tighter credit conditions are likely to damp this activity. As noted in the middle left panel, to project defaults on subprime ARMs, we use a loan-level model that jointly estimates prepayments and defaults. The model considers loan and borrower characteristics at origination, subsequent MSA- or state-level house prices and employment fluctuations, interest rates, and “vintage” effects. As shown to the right, with data for the first three quarters in hand, we estimate that defaults in 2007 about doubled from 2006 and predict that they will climb further in 2008 and stay elevated in 2009. These estimates imply that 40 percent of the current stock of subprime ARMs will default over the next two years. An important source of uncertainty around our projections is how borrowers will behave if falling house prices push their loan-to-value ratios above 100 percent. As shown in the first line of the bottom left panel, we estimate that 20 percent of January 29–30, 2008 27 of 249 subprime borrowers had a combined loan-to-value ratio of more than 100 percent in the third quarter of last year. If we assume that national house prices fall about 7 percent over the forecast period, as in the Greenbook, an estimated 44 percent of subprime mortgages would have combined LTVs above 100 percent. A similar calculation for prime and near-prime mortgages, shown in the second line, indicates that a not-inconsequential share, 15 percent, of these would also be upside-down by the end of 2009. While prime borrowers likely have other financial assets upon which to draw in the case of job loss or sickness, such high LTVs pose an upside risk to our baseline projection of defaults. Another source of uncertainty—this one on the positive side of the ledger—is how loan modifications can reduce defaults or loss of a home. We have limited information, but recent surveys indicate that loan workouts and modifications were modest through the third quarter of last year but likely accelerated in the fourth quarter. Servicers are strained working on the large number of loans that are delinquent before the first reset. One survey indicated that servicers assisted about 150,000 subprime borrowers in the third quarter, which would represent about 15 percent of those with past-due accounts, but were not addressing current accounts with an imminent reset. As highlighted in the top panel of your next exhibit, we summarize our projections for credit losses in the next two years for major categories of business and household debt. These projections rely on the paths for house prices, unemployment, interest rates, and other factors from the Greenbook baseline. We also present projections based on the Greenbook recession alternative with the additional assumption that national house prices fall 20 percent. In this alternative scenario, real GDP growth turns negative in 2008, and the unemployment rate rises above 6 percent in 2009. As shown in the first column of the bottom panel, if we use the loss rates over the past decade or two as a guide to approximate losses under average economic conditions, total losses, line 6, would be projected to be $440 billion over the next two years. Such losses could be considered what might be expected by lenders of risky debt in the normal conduct of business. But conditions over the next two years are not expected to be normal, even under the baseline scenario. As shown in the second column, losses under the Greenbook baseline are expected to be considerably higher than average and total $727 billion, given our outlook for only modest growth. These losses might not greatly exceed the amounts that investors already have come to expect given signs of slowing activity. The above-average losses are especially large for residential mortgages, line 1, including those for nonprime mortgages, line 2. In contrast, losses for consumer credit, line 3, and business debt, line 4, are only a touch higher than normal. In the alternative scenario, in which business and household conditions worsen further, losses are projected to rise even more, not only for mortgages but also for other debt. Losses of this dimension would place considerable strains on both households and financial institutions, creating the potential for more-serious negative feedback on aggregate demand and activity than is captured by our standard macroeconomic models. Nathan will continue our presentation. January 29–30, 2008 28 of 249 MR. SHEETS. Your first international exhibits focus on the recent strength of the U.S. external sector. As shown in the top panel of exhibit 11, U.S. exports are now seen to have expanded at a moderate 4½ percent pace in the fourth quarter, following the 19 percent surge in the third quarter. With import growth in the fourth quarter stepping down to 2 percent, net exports are estimated—as shown on line 3— to have made a positive arithmetic contribution to real GDP growth of 0.2 percentage point. Going forward, we see the external sector contributing 0.5 percentage point to GDP growth in 2008 and 0.3 percentage point in 2009. Exports are expected to expand at a crisp 7¼ percent pace in both years, supported by stimulus from the weaker dollar. The pace of import growth, after stepping down on average in the first half of this year, should pick up some through the forecast period, broadly mirroring the contour of U.S. growth. As shown in the bottom left panel, some additional impetus to import growth should come from a projected decline in core import price inflation, due to moderation in both exchange-rate-adjusted foreign prices (the red bars) and commodity price increases (the blue bars). Returning to line 4 of the upper panel, we estimate that the current account deficit increased to 5½ percent of GDP during the fourth quarter, driven up by a surge in the oil import bill. We see the deficit declining to 4¾ percent of GDP in 2009, as the non-oil trade deficit narrows to just 1½ percent of GDP. As shown on the bottom right, the oil import bill—which has increased from around 1 percent of GDP early this decade to about 3 percent of GDP at present—looms as an increasingly important factor influencing the evolution of the current account balance. Your next exhibit examines U.S. external performance from a longer-term perspective. As shown in the top panel, the arithmetic contribution from net exports was persistently negative from 1997 to 2005, subtracting ¾ percentage point on average from the growth of U.S. real GDP. The contribution from net exports, however, has swung into positive territory over the past two years, adding about ½ percentage point to growth, and we expect net exports to continue to make a positive contribution over the next two years. As shown in the middle left panel, this upswing in the net export contribution has reflected—in roughly equal measure—an acceleration in exports and a slowing of import growth. Over the past two years, export growth has stepped up to 8½ percent, more than twice its average 1997-2005 pace, and it is projected to moderate only slightly in 2008 and 2009. In contrast, import growth over the past couple of years has fallen off to less than half its 19972005 average and is expected to remain soft through the forecast period. The individual contributions of exports and imports to U.S. GDP growth have both risen about ½ percentage point in recent years. This swing in U.S. external performance has been driven in large measure by the cumulative effects of the decline in the dollar (shown on the middle right). Since its peak in early 2002, the dollar is down more than 20 percent in broad real terms, including a 30 percent fall against the major currencies. We project that going forward the broad real dollar will depreciate at a pace of a little less than 3 percent a year, with this decline coming disproportionately against many of the emerging market currencies (including the Chinese renminbi), which have moved less since the dollar’s peak in early 2002. The bottom panel highlights another factor that has supported the shift in U.S. external performance. January 29–30, 2008 29 of 249 From 1997 to 2005, U.S. growth was on average just ¼ percentage point below that of our trading partners. In recent years, U.S. growth has slowed relative to foreign growth, and this gap has widened substantially, reaching 1½ percentage points on average in 2006 and 2007. This has, consequently, restrained imports relative to exports. Our forecast calls for this gap to narrow only slightly through the forecast period. But this projection depends crucially on the resilience of growth abroad—an issue that is examined in your next exhibit. Recent data have confirmed our expectation that foreign activity slowed markedly in the fourth quarter. As shown in the top left panel of exhibit 13, economic sentiment in the euro area fell in December for the seventh consecutive month, and the ECB’s survey of bank lending pointed to further tightening of credit standards for both households and firms. In addition, euro-area retail sales volumes and industrial production (not shown) have moved down in recent months. In the United Kingdom, the preliminary reading on fourth-quarter GDP growth was surprisingly strong, but other indicators seem to point to some softness going forward. As shown on the right, the Bank of England’s new survey of credit conditions indicates a further decline in the availability of credit to corporations during the fourth quarter, and the level of new mortgage lending has plunged. Other indicators, including consumer confidence, have also slid of late. The Japanese economy may be weakening as well. As shown in the middle left panel, the December Tankan survey showed a further retreat in business confidence, including a softening of sentiment among both large manufacturers and large nonmanufacturers. Housing starts have declined dramatically lately, as the construction sector adjusts to new, tighter building standards. We also see signs that labor market conditions may be weakening. As shown in the bottom panel, our assessment is that total foreign GDP growth slowed to about 2¾ percent during the fourth quarter, distinctly down from the 4 to 4½ percent pace recorded through 2006 and the first three quarters of 2007. Notably, the fourthquarter slowdown was broadly based. We estimate that growth in Mexico (line 8) declined sharply, in line with a contraction in U.S. manufacturing output. Chinese GDP data, which were reported after the Greenbook went to press, indicate that growth in the fourth quarter remained below its double-digit pace in the first half of the year, with exports posting a contraction. The middle right panel summarizes what we see as the key sources of this nearterm slowing. First, a number of countries have experienced headwinds from the ongoing financial turmoil; this is particularly the case for the euro area, the United Kingdom, and Canada. In addition, sharp recent declines in equity markets have occurred in a much broader set of countries. The softening of U.S. growth is a second factor weighing on activity abroad, especially for countries like Canada and Mexico and many in emerging Asia that have sizable trade linkages with the United States. Third, through 2006 and 2007, many of the foreign economies enjoyed exceptionally rapid cyclical expansions, so some eventual moderation in the pace of growth seemed inevitable, and we have been projecting a deceleration for some time. Returning to the bottom panel, we see these factors as continuing to weigh on foreign activity through the first half of the year. Thereafter, growth should gradually strengthen, to January 29–30, 2008 30 of 249 3 percent in the second half and to 3.4 percent in 2009, as financial turmoil subsides and as the U.S. economy rebounds. Nevertheless, we expect that growth will remain well below the heady pace recorded over the past two years. As shown in the top left panel of exhibit 14, our foreign outlook is also supported by projected easing of monetary policy abroad. Given mounting evidence of economic weakness and continued financial stress, we see the ECB and the Bank of Canada cutting policy rates 50 basis points by the middle of the year, and the Bank of England easing 75 basis points. Given the persisting inflation risks, this is admittedly an aggressive call. But we see the case for monetary action as compelling and believe that these central banks will be persuaded, notwithstanding their recent hawkish rhetoric. The futures markets also appear to be pricing in some easing, albeit at a more gradual pace than we envision. Finally, we now expect the BoJ to remain on hold until the end of 2009. To be sure, there are a number of risks surrounding our forecast, most of which are on the downside. First, the prevailing financial headwinds or the slowing of U.S. growth may be larger or more protracted than we currently project. Second, we do not yet have a good sense of the extent to which many foreign financial institutions have been affected by the recent turmoil, and the release of year-end financial statements over the next six weeks or so could bring some bad news. A third risk is that overly optimistic expectations of decoupling may lead to policy mistakes. Specifically, to the extent that foreign authorities are convinced that they have decoupled from the United States—or that they are immune from spillovers due to the financial turmoil—they may be too slow to ease policy to address weakening demand. Policy abroad may also be restrained by too narrow a focus on the recent rise in inflation, a topic to which I will return momentarily. Finally, housing markets in some countries may be vulnerable. As shown in the bottom left panel, many countries have experienced run-ups in house prices in recent years that are similar to or even exceed those recorded in the United States, and house prices are now decelerating sharply in a number of these countries. Further weakening of house prices poses the risk of adverse wealth effects. Notably, of the major economies shown in the right panel, only the United States has yet seen a marked downward swing in the contributions from residential investment to GDP growth. Your final international exhibit discusses our projections for foreign inflation. As shown in the top panel of exhibit 15, average foreign inflation jumped up to an annual rate of 4½ percent in the fourth quarter, with marked increases in both the advanced foreign economies (line 2) and the emerging markets (line 7). The sources of this rise in inflation—including rapid increases in the prices of food and oil—have been well documented. Going forward, we see average foreign inflation moving back down to an annual rate of 2½ percent in the second half of this year and continuing at that pace in 2009. Despite the run-up in realized inflation rates, readings on long-term inflation expectations have remained well anchored. As shown in the middle left panel, breakeven inflation rates for the advanced foreign economies have continued to hover around 2.3 percent on average, and long-term inflation forecasts have stayed near 2 percent. For the emerging markets, average long-term inflation forecasts (shown on January 29–30, 2008 31 of 249 the middle right) have remained between 3 and 3½ percent in recent years. The bottom panels show four-quarter percent changes for the prices of oil, food, and metals. Given the marked slowing of global activity, the stage seems set for some deceleration in commodity prices; indeed, metals prices are already on a downward trajectory. Thus, in line with quotes from futures markets, we see the pace of increases in oil prices and food prices as declining significantly over the next few quarters. Nevertheless, we have been wrong on this score before and freely acknowledge that there are upside risks to this projection. Brian Madigan will now continue our presentation. MR. MADIGAN. 3 I will be referring to the separate package labeled “Material for FOMC Briefing on Economic Projections.” Table 1 shows the central tendencies and ranges of your current forecasts for 2008, 2009, and 2010. Central tendencies and ranges of the projections made by the Committee last October are shown in italics. As for conditioning assumptions, most of you see the appropriate near-term path of the federal funds rate as at or below that assumed in the Greenbook. Eight policymakers explicitly assumed somewhat more near-term easing than in the Greenbook. However, several of you assumed that policy would need to begin firming no later than 2009. Many of you also projected that the funds rate would exceed the level forecasted in the Greenbook by the end of the forecast period. As shown in the first row, first column, of table 1, the central tendency of your forecasts of real growth for 2008 has been marked down about ½ percentage point since last October. Most of you remarked that a range of factors had prompted you to lower your growth expectations for the current year, including the continued turmoil in financial markets and the resulting tightening of credit conditions, the persistent deterioration in the housing market, incoming data suggesting slower consumption expenditures and business investment growth, and higher oil prices. A few of you suggested that stronger export demand as well as fiscal stimulus would provide some offset to weakness in private domestic demand, particularly beginning later this year. Your half-yearly projections, not shown, suggest that you all think that, more likely than not, the economy will skirt recession. On average, you see real GDP growing at an annual rate of about ¾ percentage point over the first half before picking up to a 2½ percent pace in the second half. As shown in the second row, in view of the weak growth forecast for this year, most of you revised up your expectations for the unemployment rate in the fourth quarter about 0.4 percentage point, to around 5¼ percent. Most of you project slightly brisker growth this year than the Greenbook does—perhaps partly reflecting the assumption that a number of you made that there would be more near-term monetary ease than the staff assumed. As shown in the third and fourth sets of rows, with incoming inflation data a bit higher than previously expected and despite projected weaker real activity, the central tendencies of your projections for total and core PCE inflation this year have increased about 0.3 percentage point. That upward revision is a bit larger than the 0.2 percentage point upward revision to the Greenbook inflation forecasts but leaves the level of your projections close to those in the Greenbook: Most of you see total and core 3 The materials used by Mr. Madigan are appended to this transcript (appendix 3). January 29–30, 2008 32 of 249 inflation this year at a little above 2 percent. But as shown in the bottom section, the upper limit of the range of your overall inflation projections for this year has moved up to 2.8 percent. Your forecasts for total PCE inflation this year remain a bit higher than for core inflation, reflecting the expectation of higher energy, food, and in some cases, import price inflation. Looking ahead to next year, your forecasts indicate that you expect economic growth to pick up as the drag from the housing sector dissipates and credit conditions improve. The midpoint of the central tendency of your forecasts for real GDP growth is 2.4 percent. Your growth forecasts for next year are mostly above the staff’s forecast of 2.2 percent, perhaps again because a number of you assumed moreaggressive policy easing in the near term and perhaps because at least some of you appear to see potential output growth as a bit brisker than the staff does. With most of you evidently seeing growth a bit above trend next year, the unemployment rate begins to edge lower, but the central tendency of your unemployment projections still remains distinctly above that in October. Although you are generally optimistic about improving conditions next year, your views have become considerably more dispersed: As shown in the lower section, the width of the range of the growth projections for 2009 has nearly doubled, as has the width of the range of the unemployment projections. The third and fourth sets of rows in the upper panel indicate that most of you see overall and core inflation as moving below 2 percent next year. Some of you said that those declines reflect less pressure from energy prices and, with the unemployment rate above the NAIRU, the emergence of some slack in the labor market. It is worth noting, however, that despite the easing of pressure on resources during 2008 and 2009, the central tendencies of your inflation projections for next year are essentially unchanged from October. This development presumably reflects your perception of some deterioration in the near-term inflationoutput tradeoff, perhaps prompted in part by the publication of surprisingly high inflation data for the fourth quarter of 2007 and an expectation that those effects will linger in 2009. Turning to 2010, the interpretation of your longer-term projections is a bit less straightforward than it was in October. It was noted during the trial-run phase that a time may come when the economy is seen as unlikely to be in a steady state by the third year of the projection. To some extent, that time seems to have already arrived. In particular, a comparison of the central tendencies for unemployment in 2010 from your January and October projections suggests that you now see a bit of slack persisting that year. The central tendencies and ranges of your total and core inflation projections for 2010 have changed just a bit from those in October, but those changes might be viewed by outside analysts as significant. In particular, the central tendency for total inflation in 2010 has inched up 0.1 percentage point, and the lower limit of the central tendency for core inflation has increased the same amount. Absent guidance to the contrary, some analysts might now conclude that your “comfort zone” has edged up to 1¾ to 2 percent from 1½ to 2 percent. To counter this impression, presumably the published “Summary of Economic Projections” should suggest that, because a bit of economic slack is expected to persist at the end of 2010, inflation January 29–30, 2008 33 of 249 could continue to edge lower beyond the projection period. This discussion, however, raises not only a presentational point but also a substantive one, and that is, Why should your inflation projections for 2010 have revised up at all? True, the inflation-output tradeoff appears to have deteriorated a little recently, but as Dave Reifschneider noted, some of that deterioration is likely to be temporary. Also, higher inflation than otherwise might in principle be a consequence of taking out some insurance now against especially weak economic outcomes. But given the significant negative shock to aggregate demand embedded in your modal forecasts and the associated upward revision to slack across all three years of your projections, as well as the absence of any upward revision to your inflation projections for 2009, even the small upward revision to your inflation projections in 2010 seems somewhat surprising. Turning to the uncertainties in the outlook, the upper panel of exhibit 2 shows that even more of you than in October judge that uncertainty regarding prospects for economic activity is higher than its historical level. Even with the significant reductions in the target funds rate already in place and, for many of you, an assumption of more easing to come, the lower panel illustrates that most of you still see the risks to growth as tilted to the downside. As reasons, you again cited tighter credit conditions for households and businesses emanating from further disruptions in financial markets as well as the persistently deteriorating housing outlook. As shown in the upper panel of exhibit 3, more of you than in October see the uncertainty around your total inflation forecasts as close to that of the past two decades, while a smaller minority viewed uncertainty as greater than in the past. As shown in the lower panel, fewer of you now see the inflation risks as predominantly to the upside. On balance, as in October, downside risks to growth were more frequently cited than upside risks to inflation, which seems broadly consistent with each of the alternative policy statements that were in Bluebook table 1. Thank you. CHAIRMAN BERNANKE. Thank you. That’s quite a bit of information to digest. Does anyone have questions for our colleagues? President Evans. MR. EVANS. Thank you, Mr. Chairman. I have a couple of questions that are somewhat different. On the labor front, I’m curious if you could offer some thoughts on how deterioration in the labor market might be coming about—whether or not it would be from the hiring front or the job-destruction front. As the research literature has evolved over a long time, I think it has moved a bit away from job destruction playing the key role and more toward reductions in hiring. I wonder how this informs the way you look at the data. Any insights you have into that would be quite helpful. Then I wonder if you could just talk a bit more about the interesting memo that was January 29–30, 2008 34 of 249 distributed on inflation compensation and the implications for expectations. As I read it, it seemed to indicate that inflation expectations, if anything, were coming down from the five-year forward but that inflation compensation was higher. So does that mean that the variance of inflation is higher? Are people talking about the possibility of disinflation during this period? I would expect it to come with that type of compensation. Your thoughts on that would be great. MR. REIFSCHNEIDER. Do you want me to take that last question, or do you want to? MR. MADIGAN. Well, I could start if you would like. MR. REIFSCHNEIDER. Go ahead. MR. MADIGAN. I think the points we are trying to make in that memo regarding inflation compensation were that, first of all, it’s very difficult to make these judgments about what is going on with inflation expectations, inflation risk premiums, and so on; but our best reading of the evidence was that probably inflation expectations have not moved up significantly recently. We base that on a variety of indicators. I won’t go through all of them now, but to me the most compelling evidence to support that point is that inflation compensation over the next five years has actually come down over the intermeeting period, and it is a little hard to rationalize why inflation expectations would have risen so far out, whereas in the near term they seem, if anything, to be declining. Of course, various factors can affect inflation compensation, including relative liquidity and inflation risk premiums, and we certainly don’t want to exaggerate our ability to decompose these changes into these various factors. It is possible that inflation risk premiums, in particular, have moved up, and some evidence does suggest that. MR. EVANS. I neglected to say how interesting that memo was. The analysis is really very good. I look forward to seeing more of it. January 29–30, 2008 35 of 249 MR. REIFSCHNEIDER. The only thing I would add to Brian’s statement is that I think uncertainty about inflation in the long run could be moving up noticeably without really bringing into play disinflation or something like that. In other words, you could be more worried about going down to 1½ or 1¼ than you were before—I don’t know—it could be more just as it was in the forecast. MR. MISHKIN. May I have a two-hander on this? CHAIRMAN BERNANKE. Governor Mishkin. MR. MISHKIN. When you think about what’s going on, it is plausible that it is both up and down. That’s the key point here. Because if you also look at the projections, there is a lot more uncertainty about what’s going on in the real side of the economy. That could mean that inflation could drift down and longer-run inflation expectations could drift down if, in fact, there’s some uncertainty about what the objectives of this Committee are. On the other hand, we actually did take a very sharp interest rate cut, and that could indicate that the Committee might tolerate somewhat higher inflation. So even though the action that was related to the big jump in inflation compensation was a cut in interest rates, I think there is a plausible argument that it could be symmetric in terms of increasing uncertainty on both sides. MR. EVANS. That’s what I was focusing on—the mean-preserving nature of that. MR. MISHKIN. I think it is consistent with your view, but I just wanted to clarify. MR. REIFSCHNEIDER. On job destruction versus a slower pace of new job creation, it’s hard to answer that one. Some of those patterns have changed over time; and in monitoring labor market developments, we’re trying to keep track of those two elements and that sort of thing. Whether that would materially change the way we would look at, say, just what payroll employment growth was doing, it would still be one of our main reads coming in. As to exactly how that worked January 29–30, 2008 36 of 249 out behind it, I’m not sure it would make too much of a difference. I don’t know whether Dave might want to add something to that. MR. STOCKTON. Obviously, we would be monitoring those developments. We are monitoring the gross flows in the labor market, and I think to a large extent the slowing that we have seen thus far in employment growth has come more from a slower pace of hiring than it has from an increase in layoffs. More recently, in the JOLTS data as of November, there has been a significant increase in layoffs and discharges, and there has been some further slowing in hiring. If we were to truly move into a recession, you would still see a lot of layoffs, and there would be a fair amount of job destruction, so the cyclical aspect would still likely show through pretty strongly. MR. EVANS. I guess I was thinking that, if you talk to people, you hear more about the job destruction aspect, but you don’t hear quite the same information about hiring, except you might hear more nervousness. That’s all. MR. STOCKTON. Hiring plans have come off a bit in most of the surveys that we follow, but just a bit—not a lot yet. CHAIRMAN BERNANKE. President Lockhart, did you have an interjection? MR. LOCKHART. Yes. My staff is suspicious that the employment numbers have actually been weaker than the data have shown. They have been focusing on the birth-death model and the payroll survey is based upon assumptions related to the birth of construction firms, which logically would not be creating jobs in this environment. Do you have a take on that issue? MR. STOCKTON. Well, if Bill Wascher, who is our expert in this area, wanted to say something, I would certainly let him go ahead and say something. January 29–30, 2008 37 of 249 MR. WASCHER. Sure. The birth-death model basically assumes that the cyclical properties of births and deaths are the same as for continuing establishments. The BLS has only about five years of experience with the birth-death model, so I think it is pretty difficult to judge whether they need to make any additional adjustments in births and deaths, other than the same pattern that occurs in terms of net employment changes in continuing firms. But without much to go on, they don’t take a very strong stand on whether they do a very good job of picking up the turning points because they don’t have any history on which to base their analysis. So I think there are reasons to suspect that that is possibly the case, but I don’t think there is any strong evidence that it is, and it is important to note that they do assume some cyclicality in births and deaths in their procedures. CHAIRMAN BERNANKE. President Poole. MR. POOLE. Thank you, Mr. Chairman. Brian, I want to ask you about the projections. Well, it is more than an exercise now—the projections that we are offering are for real. What is the message that comes out of the projections—that is, if I am talking to the press or to others and they say, “What do I make of all of this?” My question to you is, What do you make of all of this? What is the message for the implications for policy or the implications for anything? You know, the data don’t really speak for themselves. We are throwing out a lot of stuff here to the market, and what is the market supposed to make of it? MR. MADIGAN. Well, that is a hard question, actually. You know, obviously in some sense the numbers at some level do speak for themselves. MR. POOLE. Okay. What are they telling us? [Laughter] MR. MADIGAN. I think they say that the Committee is expecting relatively slow growth in the period immediately ahead but that the economy avoids a recession. There is some January 29–30, 2008 38 of 249 recovery over the subsequent years. It is not extraordinarily brisk. It is a fairly gradual recovery in terms of growth. The unemployment rate moves up a little, as you would expect with a period of growth below trend, but does not get extraordinarily high; and inflation, after coming under some upward pressure of late, gradually edges back down to levels below 2 percent. I am not sure that I am saying anything terribly enlightening here. Of course, one point that I should emphasize is that the full summary of economic projections, we hope, gives more texture than I was just able to give to the Committee’s views about the modal outcome and to the Committee’s concerns about the risks to both growth and inflation. MR. POOLE. The reason I raise the question is that it seems to me very important that we have some interpretation as to what we make of all this and what we want the market to make of all this. In particular, let’s say the observation that the projections or the risks are weighted to the downside. You might get some people saying, “Well, if we get some employment reports or others that in fact come in weaker than anticipated, that means that the Committee is on the edge of pulling the trigger to respond to it.” That might be a possible message that people would take from this. If that is not the message that we want to convey, then we had better be very careful how we talk about these. CHAIRMAN BERNANKE. President Poole, I would just point out that when these are released it will be simultaneous with my testimony to the Congress, and so I will have opportunities to put some context on it at that time. MR. POOLE. I guess my question is directed as much to the Chairman as it is to Brian, which you will answer in the testimony. CHAIRMAN BERNANKE. I will answer in the testimony. [Laughter] President Fisher. January 29–30, 2008 39 of 249 MR. FISHER. First, I, too, wanted to thank you all for the paper on forward inflation compensation. I agree with the conclusion that it is difficult. Especially in times of strained trading conditions, I think that is the conclusion—whether you interpret the outcome the way it was interpreted in the paper or the way I do it more cynically, I think that is the key underlying point. I thought that was a very valuable, useful paper, and I want to thank you, Governor Mishkin, for commissioning it. My question is to Nathan on your inflation projections. Reading through the Greenbook—even though the section on the international side is very thin—with the exception of China, where I think we can sell a lot of “Whip Inflation Now” buttons, and of Argentina, where the numbers are rigged, but even in those countries, what I took home was that everybody was surprised on the upside in every country ranging from the advanced countries, as we call them, to Turkey. Then, if you look at the exhibit 15 that you just presented to us, those numbers are confirmed in the fourth quarter, and then there is a sharp falloff proceeding from there. You gave us a good analysis of the risk to the foreign outlook in growth, and then you concluded your comment on inflation by saying that we have been wrong before, that there is some upside risk. So my question is, What are the risks on the inflation side? Could you elaborate on them, just as you elaborated on the risks to growth in the foreign outlook? MR. SHEETS. We are happy to hear that there is demand for a bigger international section. [Laughter] You had better be careful what you wish for. MR. FISHER. But I am very serious about this. Suddenly there is a falloff. Would you give us a sense of the risk? It can’t be all one-sided. MR. SHEETS. Right. Just a word of background. The rationale for the falloff is the expected decline in these commodity prices and the expected slowing of global demand. Now, January 29–30, 2008 40 of 249 thinking about the risks, I am reasonably convinced that global demand is going to slow, which I believe will translate into reduced demand for many of these commodities that have driven up inflation. However, that says something only about the demand side of these commodity markets. There is also a lot going on on the supply side. At the last FOMC meeting, we talked about ethanol and the fact that many of these emerging-market countries are wealthier, that they want to eat better than they used to, that the relative price of energy has risen, and that it takes a lot of energy to raise these crops. So there are supply factors as well as demand factors at work in driving up these commodity prices. It is very hard for us to forecast the supply side of these markets. It is driven by things like weather and geopolitical developments and so on and so forth. On the commodities, my sense is that demand is going to shift in to some extent. As long as the supply doesn’t shift in as well, we should be able to see a decline, or at least a slower rate of increase, in these prices. A very important point here is that, in order to get less of an impetus coming from commodity prices and inflation in these countries, we don’t necessarily need oil prices to come down in level terms. We just need them to stop going up at such rapid rates. If we get slower rates of price increases, that will be disinflationary relative to where we have been. That is how I would characterize the risks around this forecast, mainly on the supply side of these commodity markets. MR. FISHER. Thank you. CHAIRMAN BERNANKE. Vice Chairman? VICE CHAIRMAN GEITHNER. Thank you, Mr. Chairman. Nellie, I have two questions for you. One is on exhibit 9, where you forecast in the middle right panel the rate of increase in defaults on subprime ARMs. If you compare that with your reset rate estimate and your house-price assumption or the house-price assumption in the market, I wonder whether that January 29–30, 2008 41 of 249 looks a little optimistic. Can you just say a little more about why, under the baseline scenario, given what has happened to house prices already and what is ahead, you wouldn’t think that would be substantially greater? MS. LIANG. We have revised this forecast up quite a bit since the first time we looked at this maybe in June or August, in part because of lower house prices and tighter credit conditions. The model requires as inputs defaults and prepayments, and the prepayment rates have been fairly slow but not zero. The 2006 vintage, as it approaches its first reset, has been that 20 to 25 percent are able to prepay. They are able to find something. So we don’t want to assume that none of them will be able to. The model would approach both of those, so that is the positive side. The downside is that our forecast, with the national house-price assumption of roughly minus 7 over the forecast period, does imply house-price declines on the order of minus 20 percent a year or more in California, Florida, and some other places. That does leave the loan-to-value ratio, as I mentioned, pretty high for many borrowers. We have never had this kind of episode, so we have to make a judgment about the point at which subprime borrowers walk away from their houses. The current assumption is that at about 140 percent we just say you are out; but it has to be almost an assumption that, if by then you hadn’t defaulted, we would push you out. So there is an upside. On the other hand, saying 40 percent of the outstanding stock will default over two years sounds like a big projection as well. So we tried to balance. There are risks on both sides, for sure. VICE CHAIRMAN GEITHNER. Thank you. My second question is about your projected credit loss, and I apologize if you said this in your introduction. Are these losses across all holders of that credit risk? January 29–30, 2008 42 of 249 MS. LIANG. Yes. We have not distinguished between who is holding the securities— banks or investors—so mortgages would include the 20 percent or so that are commercial banks, and it would also include those held by investors in the primary form. VICE CHAIRMAN GEITHNER. We, being the Fed, know a fair amount about what banks hold. Do you have a crude estimate of what share of this banks hold, or what share of this would end up being eaten by banks? MS. LIANG. In mortgages, 20 percent is actually probably a pretty good estimate. VICE CHAIRMAN GEITHNER. For all the credit? MS. LIANG. They have that much of the business sector and that much of the mortgages, so that pretty much covers it. VICE CHAIRMAN GEITHNER. I am just trying to get at how you interpret this. So 20 percent of the additional $600 billion relative to normal or relative to bank capital cushions now, is what? Is it a lot or not so much? MS. LIANG. One issue here is whether you want to do it relative to current capital cushions. Banks can raise capital. If they anticipate that they will need to raise capital, they can cut dividends further. I haven’t done that sort of exercise. One way to think about this is that the average long-run rate is about 60 basis points on debt; in the Greenbook baseline it runs to about 1 percent, and in the alternative, it gets close to about 1½ percent of debt. So, it is not outside the realm of history. It is on the high side. VICE CHAIRMAN GEITHNER. We have had some bad points in history. I am not trying to force you to give a prediction, but were you reassured by this or troubled by it, fundamentally, in terms of the capacity of the financial system to absorb it? January 29–30, 2008 43 of 249 MS. LIANG. No, I understand. I think the third alternative gets beyond what most are expecting at this point. VICE CHAIRMAN GEITHNER. Yes, I would agree with that. MS. LIANG. In that sense, it does represent a risk that you are going to get dynamic feedback between losses and household spending and lending—it is a high risk. So I wouldn’t say “comforted.” I think we were saying that this is beyond probably what our models could respond to in our typical way or it would be another dynamic feedback loop of some sort that we don’t typically adjust for. CHAIRMAN BERNANKE. President Plosser. Oh, I am sorry—a two-hander. MR. ROSENGREN. Just a quick followup, this doesn’t include losses from securities. It is only the loans, right? MS. LIANG. The loans could be packaged in securities. This is debt. It includes all debt. Now, whether it is repackaged into an MBS, it would be there. It wouldn’t be if it got in a CDO or something. MR. ROSENGREN. Just in corporate bonds, for example. MS. LIANG. Yes. It includes corporate bonds. MR. ROSENGREN. Okay. Thank you. CHAIRMAN BERNANKE. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. I have three questions. Let me go to Brian first. This is more of a comment. In your description of the forecast, you referred several times to the notion that there might be slack in the economy in 2010 based on these numbers. I guess my reaction to that, while I was kind of skeptical, I am not sure exactly how you infer that from what was reported. Certainly, that seems to be true in the Greenbook forecast, but trend growth January 29–30, 2008 44 of 249 seems to be as good as or better than it was in the last projection. In 2010, inflation—true—is a little higher. The unemployment rate may be a 0.1 or 0.2 percentage point higher. But unless you infer something about what people thought the NAIRU might be, I don’t know how you would necessarily infer that the reason inflation went up in these forecasts was that there was slack in the economy in these projections. So I just wanted to caution about the language we use in how we describe what we see here without necessarily inferring something about whether, in any individual person’s forecast, there may or may not have been slack. In mine, there wasn’t in 2010, but I don’t see that necessarily follows from what these numbers look like. That was my only observation here. MR. MADIGAN. Maybe I can respond to that. It is very inferential, and it is based partly on the two-tenths’ difference from the October exercise when it was actually clear—I think clearer at that time—from participants’ forecasts that many participants characterized their NAIRU as being in the vicinity of 4¾ percent. Unfortunately, the writeups this time were not all that explicit on this point, but it is the comparison with October that I was leaning on fairly heavily. MR. PLOSSER. I have two other questions that I would like to pose. One is the change in the Greenbook’s assumption about the increase in potential GDP. In particular, I am curious because what it essentially does, it seems, is to build in a significant amount of slack or output gap in 2009 and 2010 that didn’t exist in the last Greenbook. I am inferring that part of the reason the more-aggressive easing in the policy assumption does not have any effect on inflation to speak of is that it is offset by the increased gap that you have built in. So I would like a little more explanation about the justification for building in a greater gap or a higher potential. But I am also curious to know, if you hadn’t done that, what your forecast for growth and inflation January 29–30, 2008 45 of 249 would look like in, let’s say, 2009 and 2010. Could you give some guesstimate of how that might have affected it? MR. REIFSCHNEIDER. In terms of the rationale for increasing potential going back over history, some of that, as I think I mentioned, was just that actual productivity performance has been better than the last time we reviewed this in the summer, and we are taking that on board. That is part of the motivation. Another part of the motivation is what we perceive is a somewhat growing tension between the way we saw labor market slack developing and the way we were looking at slack in terms of the product side through the output gap. We had arrived at a point this round where those tensions had increased over time, and this revision mitigates some of that tension, so those two things are in better alignment with each other. We also were taking the opportunity, when we opened up, to look at some other technical factors we used that get involved in going from, say, the nonfarm business sector to GDP, that sort of thing, and those also pushed us in the direction of being a bit more optimistic on growth going back. So we did view it, if you look at it in terms of product markets, as that there was more slack now than we had previously been thinking and that there was also more slack in the labor market—but that was from the actual data that came in. Going forward, we have more slack. We have more slack just in the labor market because we have revised up the unemployment rate. With that, and taking on board these assumptions of potential output, we have more slack on the output side. Now, one question would be, to address your second question, how would things have changed if we hadn’t taken that on board? Well, going forward, we would have written down a lower GDP forecast because what we are really saying here is that it is not that households and firms have changed their perceptions; this is just us, the poor econometricians, trying to infer what is out there in the real world. So the poor econometricians have inferred that potential January 29–30, 2008 46 of 249 output is growing stronger. We have to look at it and say, “Well, so the prospects going forward for permanent incomes, corporate earnings, and that sort of thing, will be stronger, and that implies basically a one-for-one ratcheting up.” If we had said, “Well, no, potential output growth going forward won’t be stronger,” we would have revised down the GDP growth rate with it, so there wouldn’t have been any change in the output gap from that. That would have been shifting one for one. It wouldn’t have changed our sense of what resource utilization would be going forward. MR. PLOSSER. So are you saying that your path of the gap would have been unchanged? MR. REIFSCHNEIDER. The path of the gap would have been to a first approximation unchanged going forward. Some of the greater resource utilization now and going forward is a combination of the fact that we haven’t really changed our view on the labor market, aside from once we took on board the new unemployment rate data, but that we did change on the product market. Going forward, the way it evolves further on, we see the labor market gap opening up a little more and the output gap opening up a little more—that is driven primarily by our sense that the economy in an underlying sense is weaker—and we have made an adjustment for that with the monetary policy assumption. But it is not quite enough. We haven’t lowered the funds rate as much as we would have needed to do to totally wipe out that fact and keep resource utilization constant going forward on the product side. This is a difficult question. It was a difficult one for us, definitely, going through it because we had many moving parts. MR. PLOSSER. Well, it does really change the character of the forecast substantially, I think. January 29–30, 2008 47 of 249 MR. REIFSCHNEIDER. If you think about the forecast as resource utilization and inflation, then it has an effect on resource utilization that is bigger now going forward in the product market. We also see a bigger effect in the labor market, and if that were the only thing, it would have put more downward pressure—but not a lot—on inflation. But as I mentioned, we are coming into this forecast with somewhat worse inflation performance lately, and we think that has some persistence. So that is helping balance it out. MR. PLOSSER. My last question is also related to some adjustments that struck me in the panel you talked about where you constructed the revised estimates of r*. The first item on your list that you talk about was that the equity premium had gone up, and that was a big factor. So I have a couple of questions. That was an adjustment factor. Now, the way I would think about the stock market declining would be primarily having a wealth effect that works its way through consumption—that would be the normal channel. Yet the Greenbook and this discussion seem to suggest that somehow there was an additional adjustment made because of the rise in the equity premium. Is that correct or not, or is it just the wealth effect that you are talking about? Are these separate? MR. REIFSCHNEIDER. No, it is not separate; the equity premium is a large reason that we had the big drop in stock values. MR. PLOSSER. But is the mechanism through a wealth effect on consumption growth? MR. REIFSCHNEIDER. Mostly, but not totally. MR. PLOSSER. Well, what does that mean? MR. REIFSCHNEIDER. I would say a couple of things. One, you can think of the cost of raising capital through equity as having some small influence on business investment. That is pretty small. The big effect would be primarily on consumption, as you mentioned. Wealth January 29–30, 2008 48 of 249 effects to a smaller extent would affect housing as well. But I think of that as a wealth channel. But there is a bit of a cost-of-capital effect through raising funds through equity that you might think of as well. Another thing I would say is that the difficulty here is distinguishing the equity premium from general risk concerns, risk premiums in general, or increased compensation for higher risk or default risk in a number of these credit spreads we are talking about; those are sort of related. It is hard to keep these things separate in any kind of an accounting. Also, these things tend to be correlated with consumer and business sentiment. Again, that is another thing that is hard to keep separate. MR. PLOSSER. So are these “extra channels”— if you want to call them that—typically part of the forecast change and how you evaluate? That is to say, in the fall, when the stock market booms 10 percent, are we going to get another kicker upward in r* due to these same factors? MR. STOCKTON. Yes. MR. REIFSCHNEIDER. It might not happen. I mean, you could have a situation in which business sentiment would not take a hit, for example, simultaneously with the stock market tumbling, and you would not see some risk premiums on bonds going up. That would be very unusual. MR. PLOSSER. I am just reacting to this very large change in your estimate of r* and attributing it to equity premiums, and I was just trying to figure out both. MR. STOCKTON. We just had a really big drop in the stock market, and that is the biggest piece of what is going on. But we have also marked down considerably our housing forecast. That is in an exogenous shift in aggregate demand, the IS curve. That is another chunk of what is going on here. We have had some increase in risk spreads, not just in the equity January 29–30, 2008 49 of 249 premium. Despite the fact that Treasury rates have fallen, corporate bond yields have not as much, and we don’t have as much there, so there is in general a widening of risk premiums. MR. PLOSSER. Well, I am just trying to sort out how much of this is really due to the stock market moving around. MR. STOCKTON. A big chunk of this is due to the stock market, so I don’t know what we can do other than to take that on board in our forecast. As Dave noted, there are a few other, small wrinkles, and we didn’t just invent those extra wrinkles this time around. They have always been there. But most of this is working through the wealth effect on the consumer spending side. So it is a weaker stock market and much weaker consumption. That is the aggregate demand channel. The other piece is housing, which I don’t want to minimize because, in fact, that is another nontrivial factor holding down demand and, we think, depressing our estimate of the equilibrium funds rate here over the intermediate term. MR. PLOSSER. I didn’t understand that this was just primarily the wealth effect or whether you were referring to something different. MR. STOCKTON. No, nothing different. Again, the way the stock market and other elements of spending operate is a little more complicated than just a consumer spending channel, but it really is wealth effect. CHAIRMAN BERNANKE. I wonder if I could entice anybody for a cup of coffee. [Laughter] Why don’t we take a fifteen-minute break, and then we’ll commence with the goround. Thank you. [Coffee break] CHAIRMAN BERNANKE. If it is okay with everybody, we can start the economic goround at this point. President Poole, you are up. January 29–30, 2008 50 of 249 MR. POOLE. Thank you, Mr. Chairman. I am not sure how I got to be first here, but I guess I was being unusually agreeable when Debbie asked me. [Laughter] The general tenor of comments that I hear from our directors and people around the Eighth Federal Reserve District— these are the community bankers and smaller firms—is that things are slow but not disastrously slow. The comments that I hear from a series of phone calls to much larger national companies are decidedly more pessimistic, with one exception that I will talk about in a moment. My contact at a large national trucking firm says that they are in a 20-month recession in transportation. They are cutting their capacity, cutting the number of trucks, and I think the numbers on their cap-ex illustrate the situation: for 2006, $410 million; for 2007, $336 million; and their plan for 2008 is $200 million. That is down a little more than 50 percent in two years, so they are really cutting back. I also called friends at UPS and FedEx, and generally things are not a whole lot different but a little weaker than they have been. Neither firm has any particular issues with labor supply. Domestic express business is flat, and customers are switching to the lower-priced services instead of overnight delivery at the end of the afternoon, shifting to ground services, and that sort of thing. On international business, U.S.-outbound volume for FedEx is up 6 percent. That would be consistent with the export increases that we have seen. Reports are that Asia is a bit slower but is still growing very rapidly. Asia to the United States is up 80 percent, 20 percent to Europe and Latin America. The freight market is dead—that is the way my contact put it—down 5 percent year over year. That is consistent with my trucking industry contact—and pretty much the same with UPS. My contact with the fast food industry—the quick-serve restaurant, or QSR, business—says the demand there is definitely weak. They are coming in roughly flat, I guess, or actually down so far this year. Prices are up because of the increase in food costs. The casual dining industry is in worse shape than the fast food industry. January 29–30, 2008 51 of 249 My contact also follows retail in general pretty closely and finds that retail business in general is weak. That is consistent with a lot of the reports that we have been receiving. A major exception is in the IT area—software. I have contact with a large software company, and the contact noted that, as announced, Microsoft had a fantastic quarter. The earnings were up sharply. PC hardware sales are growing at a rate of 11 to 13 percent expected in the first half of this year, so we see strong growth in the PC market. Consumer demand is stronger than business demand. Both, however, are pretty strong. The international business is doing better, in part because the industry is having some success in reducing the amount of software piracy. The biggest problem is finding software engineers. This particular company is running 8 percent behind its hiring forecast and cannot find software engineers. Positive for us old guys; some of the retirees are coming back to write code. [Laughter] Thank you. That is all I have. CHAIRMAN BERNANKE. Thank you. President Yellen. MS. YELLEN. Thank you, Mr. Chairman. I broadly agree with the Greenbook forecast for economic growth this year and with the assessment that the downside risks to that forecast are considerable. The severe and prolonged housing downturn and financial shock have put the economy at, if not beyond, the brink of recession. My forecast incorporates fiscal stimulus of the same magnitude as the Greenbook and monetary stimulus that is somewhat larger. I have assumed a 50 basis point cut at this meeting and an additional 25 basis point cut during the first half. My forecast shows growth of 1½ percent in 2008, like the Greenbook, but it has a more pronounced acceleration in 2009 as the monetary and fiscal stimulus kickstarts the economy. The unemployment rate edges up this year to 5¼ percent before dropping gradually next year toward the natural rate of 4¾. I am especially concerned about the outlook for consumer January 29–30, 2008 52 of 249 spending. The combined hits to equity and housing wealth will extract a considerable toll, and consumer spending will be further depressed by slower growth in disposable income due to weaker employment growth. Delinquencies and charge-offs on most forms of consumer debt have already risen, and slower job growth seems likely to exacerbate this trend, prompting financial institutions to further tighten credit standards and terms. In my forecast, such developments reverberate back negatively onto economic activity. Like the Greenbook, I downgraded my economic outlook substantially since our last inperson meeting. The December employment report was probably the single most shocking piece of real side news prompting this revision. But knowing that it is unwise to put too much weight on any single piece of data, I have been examining the question of whether that report was more signal or noise. The drop in initial UI claims to relatively low levels in recent weeks makes such an assessment important. Because the behavior of both series may have been affected by seasonal factors near year-end, it seems worthwhile to examine a broad range of data bearing on the labor market. My conclusion is that the labor market has indeed been weakening since mid-2007, and the extent of weakening, while relatively modest thus far, is quite typical of patterns seen when the economy is tipping into recession. Independent evidence of a weakening in the labor market comes from the household survey. Even when adjusted for definitional and measurement differences from the payroll survey, the household survey shows a fairly smooth trend of declining employment growth during 2007. The drop in payroll employment in December helped bring the establishment data into closer alignment with the household employment data. In the payroll survey, the slowdown is concentrated in construction and finance. In the household series, higher unemployment is actually widespread across sectors. The household survey also contains other signs of a January 29–30, 2008 53 of 249 weakening job market: a 25 percent increase in the unemployment rate for job losers, which accounts for the lion’s share of the overall increase in aggregate unemployment; an increase in the number of newly unemployed job losers, which can be thought of as a broader measure than UI claims of inflows into unemployment; and an increase of 5 to 10 percent in the estimated expected completed duration of an unemployment spell, suggesting a reduced pace of outflows from unemployment. The labor force participation rate of men and women of age 16 to 24 years has also fallen notably in recent months. Labor force participation rates for this group have been edging down since the last recession, but the decline accelerated in 2007, and historically this group is among the first to respond to weakening labor market conditions. Data from the JOLTS survey, which we discussed in the Q&A round, confirm the weakness revealed elsewhere. The job openings, or vacancy, rate is down, consistent with the reduced pace of outflows from unemployment, as reflected in continuing UI claims and unemployment durations, and layoffs and discharges are up sharply. Other data cited in the Greenbook, Part 2, such as net hiring plans for Manpower, and NFIB and survey measures of job availability and unemployment expectations further corroborate a slowdown. With the aggregate unemployment rate now up only 0.6 percentage point off its low, I would describe the deterioration in the labor market thus far as modest, but it is noteworthy that an increase in unemployment of this magnitude, in the space of 12 months, has occurred only twice since 1948 outside of recessions. While my modal scenario contains a near-term slowdown rather than a contraction, it is actually pretty rosy compared with what I fear might happen. My contacts have turned decidedly negative in the past six to eight weeks, and further financial turmoil may still ensue. On consumer spending, two large retailers report very subdued expectations going forward January 29–30, 2008 54 of 249 following the weak holiday season, which involved a lot of discounting. On hiring and capital spending, my contacts have emphasized restraint in their plans due to fears that the economy will continue to slow. A serious issue is whether the tightening of credit standards that is under way will deepen into a full-blown credit crunch. The new Senior Loan Officer Opinion Survey shows a noticeable tightening in lending standards, and this is confirmed by my contacts. For example, senior officers of a large bank in my District recently described a variety of new steps they are taking to protect against credit losses. They are tightening underwriting practices across the entire consumer lending and small business loan portfolio. A recent strategy has involved classifying MSAs according to whether their real estate markets are stable, soft, distressed, or severely distressed, using both historical and prospective views of property values. Based on these designations, the company has reduced permissible combined loan-to-value ratios in their home equity portfolio, and going forward they intend to apply them across the entire consumer portfolio. On the positive side, though, they note that lower interest rates have spurred a surge in applications for mortgage refinancing, and a recent analysis shows that the reduction in the prime rate is having a significant impact on ARM reset expectations, shifting a large number from increases to reductions at reset. In fact, an analysis conducted before our most recent rate cut that assumed a 7 percent prime rate in February 2008—and it is now at 6½—estimates that two-thirds of the subprime ARM portfolio would now experience a decrease in their monthly payments at reset. This is a sharp contrast from an analysis in June 2007 with a prime rate of 8 percent. Now let me turn briefly to inflation and inflation expectations. I project that inflation will decline over the forecast period to around 1¾ percent, and I see the risks around that forecast as balanced. Admittedly, though, the recent data on inflation have been worrisome, and they raise January 29–30, 2008 55 of 249 the issue of whether or not we can afford to cut rates as much as needed to fight a recession without seriously risking a persistently higher rate of inflation and inflation expectations. I tend to think this risk is manageable, largely because of the credibility we have built. It appears to me that this credibility has reduced the response of inflation to all the factors thought to influence it, including energy prices, the exchange rate, and business cycle conditions. Thus I consider it less likely that rising energy prices are going to push up core inflation very much or that the passthrough that does occur will easily get built into inflation expectations. So I view inflation as less persistent now than it once was, tending to revert fairly quickly to the public’s view of our inflation objective. I do hope that our long-run inflation forecast will help people identify what that objective is. But even if inflation expectations turn out to be less well anchored than I think, I still see the inflation risk going forward as roughly balanced. With less well anchored inflation expectations, there is greater risk that higher energy and import prices will pass through into core inflation and inflation expectations. By the same token, there is also a greater likelihood that inflation will decline should a recession occur. We looked at the behavior of core and total inflation in the first three years following recessions from 1960 to the last one in 2001, and inflation declined in most of these episodes. The exception is 2001, when core inflation remained essentially unchanged—which seems consistent with my view that inflation has become less responsive to the business cycle over the past decade or so as we have acquired more credibility. CHAIRMAN BERNANKE. Thank you. President Lacker. VICE CHAIRMAN GEITHNER. Excuse me. Could I ask— CHAIRMAN BERNANKE. Vice Chairman. January 29–30, 2008 56 of 249 VICE CHAIRMAN GEITHNER. President Yellen, I think you answered this, but could you say a bit more about your monetary policy assumption in your forecast. How did you get to an additional 75? MS. YELLEN. We assumed 50 at this meeting. VICE CHAIRMAN GEITHNER. Fifty plus 25. MS. YELLEN. We assumed an additional 25, which would be held in place through 2009:Q1, and then a gradual rise. VICE CHAIRMAN GEITHNER. I mean the “why,” not the “what.” Sorry. MS. YELLEN. The “why”? VICE CHAIRMAN GEITHNER. Yes. Why that much rather than— MS. YELLEN. A larger amount? I wouldn’t attach too much significance to the precise figure—it’s somewhat more. CHAIRMAN BERNANKE. President Lacker. MR. LACKER. Thank you, Mr. Chairman. The Fifth District economy has shown additional signs of softness in recent weeks. According to our surveys, manufacturing activity drifted lower in the past few months, although we also heard reports of stronger overseas demand for U.S. goods. Revenue growth in the District’s services firms also weakened in January, and our index for that sector dipped into negative territory for only the second time in the past four years. Our retail index, which in December had blipped up to neutral after three negative months, dived again in January. Our retail respondents say that the holiday sale season finished up weaker than expected and that big ticket categories continue to slump, especially furniture and appliances. Business spending seems to have softened as well in recent weeks, as an January 29–30, 2008 57 of 249 increasing number of firms reported that they were delaying capital spending projects such as IT upgrades. At our December meeting, I reported on a former director who headed a firm that owned a large portfolio of retail properties and said that he described the sector as in the best shape he had ever seen in his life. Well, he is singing a different tune. Although his portfolio is in good shape so far, he is hearing a lot about cancelled projects as a result of financial constraints from lenders or equity interests, and he says that the environment that he is operating in is completely different from what it was when he talked to me sixty days ago. We are hearing very similar comments from a wide range of contacts in commercial real estate and community bankers. Residential real estate markets in the District remain generally weak. Home sales and construction remain dormant in many markets. Several Realtors reported seeing more prospective buyers, but they seem interested only in kicking the tires, in part because of difficulties in selling their current homes. Turning to prices, concerns about rising input costs were more widespread among our contacts in recent weeks. Our survey measure of manufacturing raw material prices was up sharply in January at 4.3 percent, the second highest reading in the fourteen-year history of the survey. The prices-paid measure in manufacturing was a touch lower but still in an elevated range. Expected price trends in manufacturing were off sharply, however, perhaps reflecting the softening in demand that many respondents said they expected. In the service sector, both current and future price trends picked up outside of retail. Labor market conditions in the Fifth District have deteriorated in the last month. In a noticeable shift from previous surveys, numerous contacts told us they had begun to trim payrolls. The job cuts were concentrated in machinery and building material manufacturers, financial services firms, and general contractors. January 29–30, 2008 58 of 249 In some regions, however—Northern Virginia, for example—some labor markets remain tight, and we continue to hear of difficulty finding highly skilled workers. I spent a bit more time than usual on our regional picture because right now I am placing a bit more weight than usual on our District reports and what I read in the Beige Book. One can be skeptical about the incremental value of anecdotal reports in typical times, but at times like these, I believe they can and do provide a more timely read on what is going on. These regional reports have shaded my outlook to the downside relative to the picture painted by the national data, which is itself a somewhat discouraging picture. Home construction has continued to decline, and the fall in permits last month suggests that further declines are in store. Consumer spending appears to have slowed somewhat at the end of last year and seems to be carrying less momentum into this quarter, as the Greenbook likes to put it. The December employment report certainly was weak and has added considerably to fears of a recession. The Greenbook forecast just skirts the border of an outright recession. My own projection is fairly similar but a bit weaker in the first half and with the weakness stretching out a bit longer this year. I am inclined to see the bottom in housing as occurring later than in the Greenbook, which has housing starts flattening out relatively soon, and I am a bit less hopeful about business investment, particularly structures. I agree with the Greenbook that the main effect of a stimulus package will be to shift consumption growth from ’09 to late ’08 but that the effects are uncertain. I think the risks are on the side of a smaller boost to spending, though. But there is a chance that many rule-ofthumb consumers will find that their rule is telling them to pay down debt. In sum, I expect very weak growth in the first half of this year with only gradual recovery to trend. While I think weak growth is the most likely scenario, similar to President Yellen, I do think that a recession is a January 29–30, 2008 59 of 249 quite distinct possibility this year. If that happens, I think it will be due to a more sizable pullback in nonresidential construction than we are expecting right now. Turning to inflation, it is hard to put a good face on the recent numbers. The Greenbook describes the recent upside surprise as transitory and expects inflation to diminish this year. Indeed, we have been getting some relief on retail gasoline prices in recent weeks. But I don’t think our problems with inflation are transitory, and I don’t want to lose sight of them in the midst of the current weakness. If you look back over the past four years, the overall PCE price index has averaged 2¾ percent. On a 12-month basis, the index has been below 2 percent only four months in that span. Now, one could interpret this as a regime of 2 percent inflation with a series of misses that happen to be virtually all on the plus side. Alternatively, you could view this as a regime in which inflation fluctuates around a mean of 2¾ percent. Market measures of inflation expectations seem more consistent with the former right now. But the longer that inflation averages well above 2 percent, the more risk we run of seeing expectations rising to match actual inflation rather than the other way around. Another way to see this is that the fragility we need to focus on now is our credibility. I mention all of this because it is why, in my economic projections this round, I wrote down a relatively sluggish recovery after the first half of this year. I am skeptical that we have seen nothing but positive inflation misses around a 2 percent trend for four years because of chance alone, and I am not optimistic about inflation coming down in a sustained way on its own. As a result, I believe that, in order to keep expectations from drifting up and to bring inflation down, we will need to raise rates later this year, even if that means a longer and slower recovery. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Plosser. January 29–30, 2008 60 of 249 MR. PLOSSER. Thank you, Mr. Chairman. You know, listening to the staff discussion I have certainly come to understand why everyone continues to believe that economics is a dismal science. [Laughter] It is quite a dismal picture. But more seriously, recent economic data have certainly helped feed that view, and the Third District is no exception. Economic activity has weakened in our District since December, and to double the fun, firms continue to face increasing price pressures—not a very comfortable position for monetary policymakers. The Philadelphia staff’s state coincident indicators indicate that overall economic activity has been moderate in New Jersey, flat in Pennsylvania, and declining in Delaware over the past three months. Our Business Outlook Survey of manufacturers fell sharply in January. The index fell to minus 20.9 from minus 1.6 in December. Now, some of that we have to remember is sentiment, in the sense that the question has to do with general activity and doesn’t necessarily reflect just their firm. But it is a sentiment of pessimism that certainly is more prevalent than it once was. A reading that low, of minus 20, indicates declining manufacturing activity in the region and is usually associated with very low GDP growth or perhaps even negative GDP growth at the national level. More related to the firms’ own performance, though, the survey’s indexes of new orders and shipments also declined in January, and both are now in negative territory, although much less so than the general activity index. On the other hand, while expectations of activity six months from now have moved down somewhat this month, they remain firmly in positive territory, and firms’ capital spending plans over the next six months remain relatively strong. District bankers are reporting weaker consumer loan demand, but business lending continues to advance at a moderate pace from their perspective. Loan quality has shown slight deterioration, mainly in residential real estate and auto loans, to a lesser extent in credit cards, and to an even lesser extent on the business loan January 29–30, 2008 61 of 249 side. This downtick in quality follows a period of extraordinarily low delinquencies and default rates and thus is well within historical norms, so it has not greatly alarmed our banking community. Thus far, our District banks apparently have largely escaped the credit problems plaguing the larger money center banks and investment banks. While there has been some tightening in credit conditions and standards around the District, most non-real-estate-related firms I spoke with are not finding it difficult to obtain credit for any reasonable project they want to do, and so they have not identified largely with the credit crunch scenario. Despite the softness in the activity, firms in our District report higher prices in their inputs and outputs. As President Lacker said, inflation seems to be alive and well. The current prices-paid and prices-received indexes in our Business Outlook Survey accelerated sharply in January and are at very high levels, almost record levels, of the past twenty years. Firms also expect prices to rise over the next six months. These forward-looking price indexes, too, are at very elevated levels relative to their twenty-year history. I am hearing from business contacts and from one of my directors, for example, that they are planning to implement price increases to pass along costs they are experiencing. Thus, even though they are pessimistic about growth in the future, they are not pessimistic about price increases. This adds to my skepticism about arguments that link inflation too closely with resource utilization. The national near-term economic outlook is also deteriorating, as we have been hearing, and I have revised down my growth forecast for 2008 compared with my October submission. It is hard to find much positive news in the data released since our last meeting, and the Board staff has summarized that quite eloquently, and so I won’t repeat them. Nevertheless, in general, my forecast is probably slightly less pessimistic than the Board’s forecast. However, I must add that, at the same time that growth has slowed, inflation has trended up. Both the core CPI and the January 29–30, 2008 62 of 249 core PCE accelerated in the second half of ’07, compared with the first half. The core CPI advanced at a 2.6 percent rate in the second half of ’07, compared with a 2.3 percent rate in the first half, and the core PCE was up at a 2.4 percent rate in the second half compared with 1.9 in the first half. As we know, the PCE price index gets revised. Recent research by Dean Croushore, one of our visiting scholars, has shown that between 1995 and 2005 the average revision from initial release until the August release the following year was positive on average for both the core PCE and the total PCE. This suggests that inflation is likely to be even higher in the second half of ’07 than the current estimates indicate. I am also concerned that, over the past 10 year period, core and headline inflation for both the PCE and the CPI have diverged on average about 50 basis points. Headline rates have exceeded core rates in 8 of the last 10 years for the CPI and 9 out of the last 10 years for the PCE. While I would like to believe that these two rates should be converging on average, I am concerned that core rates may not be as indicative of underlying trend inflation as we might have thought. This line of thinking also leads me to question estimates of ex post real funds rates calculated by the staff and presented in the Bluebook, which are based on subtracting core PCE from the nominal funds rate. I am not convinced that the core PCE is the right measure of inflation in this context. Even if you thought it was, then the reported real rates are likely to be overstated for recent quarters given the apparent systematic bias in the preliminary estimates of the PCE that I have noted before. Moreover, some measures of inflation expectations are not encouraging: In particular, the Michigan survey one-year-ahead measures and five-year-ahead measures are up. We have already discussed a bit the acceleration in some of the TIPS measures. I will return to that in a minute. The Livingston survey January 29–30, 2008 63 of 249 participants have also raised their forecast for CPI inflation in 2008 from 2.3 percent to 3 percent. My forecast overall is similar to the Greenbook’s, and I expect a weak first half and a return toward trend growth later this year and into ’09 and inflation at the 1.7 to 2 percent range. But the policy assumptions that I make to achieve the forecasted outcomes for the intermediate term are different from the Greenbook’s. The ongoing housing correction and poor credit market conditions are a significant drag in the near term on the economy, and I expect growth in the first half of the year to be quite weak, probably around 1 percent. As conditions in the housing and financial markets begin to stabilize, I expect economic growth to improve in the second half of the year and move back toward trend, which I estimate to be about 2¾ percent, about 50 basis points higher than the Greenbook, I think, in 2009. The slowdown in real activity suggests a lower equilibrium real rate. How much lower is difficult to measure with any precision. Ten-year TIPS have fallen about 100 basis points since the beginning of September. In such an environment, optimal policy calls for the FOMC to allow the funds rate to fall as well. And we have; the funds rate is down 175 basis points since September—or more if we cut today. But we also must remain committed to delivering on our goal of price stability in this environment of rising prices. To my mind, that means we must continue to communicate that commitment to the markets and to act in a manner that is consistent with that commitment. I want to stress that while many of us, myself included, have argued that inflation expectations remain well anchored, we cannot wait to act until we see contrary evidence to such a claim because by then it will be too late and we will have already lost some credibility. I also might add that the staff memo on inflation compensation, which I thought was very good, suggests that one reason for the increase in forward inflation January 29–30, 2008 64 of 249 compensation might be a greater inflation risk premium rather than a rise in expected inflation. That may, in fact, be true, and I think the memo was very well done. But if that is the case, if the rise is in the inflation risk premium, then I think it might be worth asking ourselves if the increase in inflation uncertainty might be an early warning sign of our waning credibility. This perspective leads me to a different policy assumption from the Greenbook’s. In particular, once the real economy is stabilized, the FOMC must act aggressively to take back the significant easing it has put in place in order to ensure that inflation is stabilized in 2010. Employment is a lagging indicator, so we will likely have to act before employment growth returns to trend, should output growth pick up in the second half of the year as forecasted. Thus, I expect we will need to begin raising rates by the fourth quarter of this year and perhaps aggressively so. In contrast, the Greenbook assumes a flat funds rate at 3 percent throughout the forecast period. Despite the real funds rate remaining below 1 percent—and well after the economy has returned to trend growth—inflation expectations remain anchored in the Greenbook. In my view, this seems somewhat implausible or, at best, a very risky bet. It appears that the Greenbook achieves this result through an output gap—related to the question I was asking earlier this afternoon. I think all of us understand the very real concerns that many researchers have with our ability to accurately estimate the level of potential GDP. Furthermore, in the recent research on inflation dynamics that we have discussed—and President Yellen was referring to this—inflation becomes less persistent and appears to be less related to other macroeconomic variables as well. We do not know whether these changes are an outcome of a more aggressive and credible stance of monetary policy against inflation or are due to some fundamental changes in the world economy. If the lower persistence is due to enhanced policy January 29–30, 2008 65 of 249 credibility, then it is incumbent upon this Committee to maintain that credibility. Otherwise, we cannot expect inflation persistence to remain low. Thus, if the economy performs as forecasted on the growth side, with a return toward trend growth in the second half, I would be very uncomfortable leaving a real funds rate below 1 percent. The Bluebook scenarios involving risk management indicate that the inflation outcome is poor when there is a gradual reversal of policy. Better outcomes are achieved under a prompt reversal strategy. Given that forecast, I believe we must begin thinking now about what our exit strategy from this insurance we have put in place is going to be. How we communicate our monetary policy strategy will also be crucially important because of the effects such communications will have on expectations. We need to better understand in our own minds, I think, what our reaction function looks like so that we can be more systematic and articulate in our implementation of policy. Thank you. CHAIRMAN BERNANKE. Thank you. President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. In my view, the decision we took on January 21 reflected a broad consensus that economic fundamentals were weakening at a rapid pace in an environment of continuing, even heightened, concern about financial market stress and fragility. My contacts over this last week in the business and financial markets may add a little texture to the picture on which we based our January 21 policy action. Conversations with these contacts in various industries provide information generally consistent with a downward revision of the outlook. Forward-looking sentiment of the directors of the Federal Reserve Bank of Atlanta turned decidedly pessimistic in January. Retail contacts noted quite disappointing results through mid-January and are taking a conservative approach to 2008 in terms of hiring and inventory. Regarding the residential construction industry, regional weakness continues and January 29–30, 2008 66 of 249 is spreading from coastal markets to interior markets. In addition, I had a conversation with the CEO of a large public homebuilder of national scope. He cited historically high contract cancellation rates, especially on the West Coast and the D.C. area, because of the buyers’ difficulty selling existing homes and getting financing. This limits their market to first-time buyers. His judgment is that a change in market atmosphere will require inventories falling to around six months. He pointed out that the spring is traditionally the key season for sales, so the next several months will be particularly telling. Weakness in the region’s commercial real estate market appears to be spreading. The retail segment is continuing to experience declining leasing activity, and weakness is now emerging in the warehouse and office markets as well. In partial contrast, reports from the manufacturing sector are more mixed. Activity remains very weak in housing-related industries. One CEO, reflecting the concern of others, predicted business failures in lumberyards and construction supply firms because of excess capacity and the slow response to a lower building environment. The trucking sector continues to slump. However, industries related to oil and gas production; import-substituting industries, such as steel, aerospace, and defense; and the foreign brand auto sector are all performing quite well. Atlanta’s national forecast is largely consistent with the Greenbook in direction, and our differences with the Greenbook in magnitude and timing are not material. Like the Greenbook, we premise our forecast on a lower funds rate at the level of 3 percent. So the principal risk to the forecast in my view is the fragility of the financial markets. Uncertainty and fear continue to loom large. I made a number of calls to financial market players, and my counterparts cited a variety of concerns relevant to overall financial stability. For instance, one of the recent concerns, as Bill Dudley depicted, has been the situation of the January 29–30, 2008 67 of 249 monoline credit insurers. Several of my contacts had comments, but I spoke to the newly appointed interim CEO of one of the two monoline insurance firms most prominent in the news, and he characterized the firm’s solvency and liquidity fundamentals as in question only toward the far end of current independent forecasts of subprime losses. Perhaps predictably, he contrasted his assessment with what he views as alarmist atmospherics resulting from press coverage, quixotic rating agency actions, and state regulator political positioning. A regional bank’s CFO cautioned that more data on actual mortgage performance in 2007 will soon be available, and that could force restatements in 2007 bank earnings. Commenting on market illiquidity, one source said that in some fixed-income markets, where many on the buy side currently depend on moderate leverage to achieve the required rates of return, banks have greatly reduced their lending. He also indicated that, even though there are real money investors—as he called them—interested in return to the structured-finance securities markets but currently on the sidelines, they are reluctant to expose themselves to volatility that arises under mark-to-market accounting using prices set in such illiquid markets. These anecdotal inputs simply point to the continuing uncertainty and risk to financial stability with some potential, I think, for self-feeding hysteria. I share with my colleagues on the Committee worries about the heightened levels of inflation and uncertainties around my working forecast that inflation will moderate in 2008. The assumptions about energy prices are the most precarious. Nevertheless, I am prepared to take the position that the economy, with its apparently rapid deceleration compounded by continuing financial volatility, is a greater concern than inflation at this juncture. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Hoenig. January 29–30, 2008 68 of 249 MR. HOENIG. Thank you, Mr. Chairman. Let me talk a bit about the region. The Tenth District is generally moving forward at a fairly steady pace, but there are some mixed data. The obvious wide variances are in real estate. Housing is weak—not as weak as some parts of the country but still weak. Also, it is interesting that commercial real estate in each of our major cities right now continues to do well. I recently talked with several developers. They are all doing well but are very concerned, and they are beginning to cut back on their plans and move away from them. So you can see the worry carrying forward in terms of what actions they are taking. In the agricultural area and in the energy area, real estate is a different story. It is booming. Land values have gone up in the ag part—non-irrigated land, something like 20 percent over the past year. If you are near an ethanol plant, it has gone up 25 to 30 percent. It is also interesting that the ag credit system is helping to fund that. Their increase in lending was about 12 percent this past year. That is up from about 9 percent the year before, so they are providing that. They are also now involved in lending to these ethanol plants in a very significant way, helping to carry that boom forward. That gives me some pause in terms of what is going on in some of the rural areas. Related to that, the energy and lease values are also accelerating at a fairly high rate. I found it reminiscent and somewhat disturbing in talking to a couple of individuals when they noted that the land values have about doubled over the past two or three years in some areas, and they said that I should relax because on current ag prices they should have tripled. [Laughter] Where have I seen that before? On the other side, actually, manufacturing in our region has held steady. We have a lot of aircraft manufacturing, which is really strong, and some other smaller manufacturers providing support in both ag and energy, and they seem to be doing well. Technology is also doing well in the region, especially in the mountain areas—the Colorado and Denver areas. Engineering firms January 29–30, 2008 69 of 249 are still very strong—the strong demand for engineers and the unfilled positions continue. They are supplying that service across the globe and see continued demand there. So it is mixed, but overall probably our region is doing better than average relative to the rest of the nation. On the national level, my projections suggest that we are going to grow below our potential growth rate. I am not as pessimistic as the Greenbook. I also have inflation coming down, but that is on the assumption that we are able to reverse our monetary policy at a fairly quick pace as we move through this year and into 2009. I will leave it there. Thank you. CHAIRMAN BERNANKE. Thank you. President Stern. MR. STERN. Thank you, Mr. Chairman. Let me talk about the economic outlook. My initial comments are organized kind of along the lines of Dave Reifschneider’s exhibit 1. There are certainly still some positive things going on: growth in exports, and I think that is likely to continue; strength in the agricultural sector and in natural resources in general, outside of lumber and wood products; state and local construction spending—there seem to be a lot of schools, hospitals, sports stadiums, et cetera, being built now; and the labor market may be a bit better than the December household and payroll surveys depicted, given the low level of initial claims. But I think those considerations are really overwhelmed by several factors on the negative side, and let me summarize those quickly. First is the breadth of the negative news on the national economy that we have received recently. The vast bulk of the news has been negative. It doesn’t suggest to me that there is a lot of positive momentum or latent strength left in the economy. The second factor I would cite—and this is not new—is the persistence of a large volume of unsold, unoccupied houses, with implications for activity in that sector, for prices, for wealth, and for foreclosures. Of course, as somebody already noted, many recessions turn out to be inventory recessions. If we have one, this will be an inventory recession, too; and January 29–30, 2008 70 of 249 the inventory in question is housing. Third, maybe even more important, are the financial conditions themselves—prominently but not exclusively, the impaired capital positions of large banks and likely prospects for growing credit quality problems in auto loans, in credit cards, in commercial real estate, and perhaps in other areas as well. Adding up those considerations, I think what we confront resembles the aftermath of the 1990-91 recession, when so-called headwinds restrained growth in real GDP, and my forecast anticipates something similar going forward, something like the persistent weakness scenario in the latest Greenbook. So I expect subpar growth both this year and next year before better growth resumes in 2010. I further expect lots of inertia in both core and overall measures of inflation this year and next before some diminution below 2 percent in 2010. Thank you. CHAIRMAN BERNANKE. Thank you. President Fisher. MR. FISHER. First, Mr. Chairman, I want to say a good word about President Poole. I have sat next to him since I got here. I would give him hyperbolic praise if he hadn’t handed me the IT Oversight Committee; otherwise, I think he is a wonderful human being. [Laughter] Much of what I was going to say has been said. I think President Plosser, President Lacker, and others have summarized what I would have said about my own District. We continue to grow, but at a decelerated pace, and our current forecast is for employment growth of 2 percent for our District for 2008. That is relatively healthy, and I really am not going to take more time on that subject. I am delighted to hear all this anecdotal evidence. We were talking, Governor Mishkin and I, about Woody Allen earlier. If I remember correctly, he had a wonderful quip—that he cheated on his metaphysics exam by looking into another boy’s soul. [Laughter] Basically, what we are doing at this time of transition is almost cheating on the data by looking at the January 29–30, 2008 71 of 249 anecdotal evidence. My broader CEO soundings indicate pretty much the same as what we are seeing in our District and what others have mentioned—shipping, rail, express delivery, manufacturing, and other activities are much slower. Retail sales are soft. As President Poole and others pointed out, truckers are suffering. Receivables are being stretched out. Delinquencies are rising. I could bore you with specifics company by company, as I am tempted to do, but I will not unless you wish me to. The point is that, while there are tales of woe, none of the 30 CEOs to whom I talked, outside of housing, see the economy trending into negative territory. They see slower growth. Some of them see much slower growth. None of them at this juncture—the cover of Newsweek notwithstanding, a great contra-indicator, which by the way shows “the road to recession” on the issue that is about to come out—see us going into recession. I will just give you two indicators there. If you look at MasterCard and dig into their data, their December retail sales ex-auto, ex-gas, were up 5 percent and in January to date were up 4 percent. President Poole mentioned UPS, and President Lockhart has the incoming CEO of UPS on his board. Year over year to January, they are up 2 percent. So it is anemic. It is not negative. The expectation is not to be negative. My CEO soundings indicate pretty much what we have forecast as a group—much slower growth, not necessarily a recession. Where the difference comes, Mr. Chairman, is on the inflation front. Others have spoken eloquently about inflation. I just want to make a couple of comments here. It is uncanny in the charts that we show in exhibit 5, for example, that we have food PCE prices and energy PCE prices peaking almost as we speak. That may be true in the spot markets. That is not the way it works in reality. AT&T has 100,000 trucks. Southwest Airlines has I don’t know how many airplanes. They contract and hedge out forward their energy costs, and the kick-in of any turndown does not occur immediately but rather is stretched out over a time period. I would ask January 29–30, 2008 72 of 249 our staff, as we go forward, to try to get a better feeling for that. We are certainly struggling with that in Dallas. As far as food prices are concerned, which again I remind you are twice the weight of energy prices in the headline PCE and the CPI, I heard some very disturbing news. Frito-Lay, for example, which when we last met I reported was going to increase prices 3 percent, has inched them up another 3 percent, to 6 percent, and that is their planning for the year. This is the first time in memory, according to my contacts, that grocery prices are rising faster than restaurant food. Yet it is not simply food where we are seeing this kind of pressure, and I want to come back to the lag effect that occurs. This morning the CEO of Burlington Northern told me that the so-called rail adjustment factor, which captures fuel, labor, supply, and other costs from the previous quarter and is contractually input into contracts for the coming quarter, rose at the highest rate in history—11 percent. That means that even if you are shipping lumber, even if you are shipping whatever goes into housing, by contract—of course, that can be negotiated, I am sure—for the coming quarter the price rise from the shippers, the railers, will be 11 percent. Finally, going back to food and other items bought by consumers—when you drill down deep into Wal-Mart, which has 127 million customers, and you talk about the specifics of their sales, their expansion is not coming from unit sales, it is coming from price inflation. A senior official there tells me that they are budgeting a 2 to 3 percent increase for nonfood items for ’08, 6 to 7 percent for food items. It is the first time in his fifteen-year history at the company that they are going to use their price leadership strategy on the plus side of the inflation ledger. So I do worry about inflation expectations, Mr. Chairman. I will summarize with the statement that was in today’s New York Times by the CEO of Tyson Foods, who said, “Because of the unanticipated high corn and soybean meal costs, we have no choice but to raise prices January 29–30, 2008 73 of 249 substantially.” That is my major concern besides the additional weakness we are seeing in the economy. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Evans. MR. EVANS. Thank you, Mr. Chairman. My assessment of the national economy is that we are in the midst of a period of very weak growth and that there is a significant chance of a serious downturn. The three-month average of our Chicago Fed National Activity Index in December was minus 0.67. Historically, by my calculation, such a value has been associated with a recession about 70 percent of the time. Now, in the Board briefings yesterday and again today, I noticed that Thomas Laubach’s estimate is 45 percent based on the same data, and that is certainly large enough for concern. Reports from my business contacts seem broadly consistent with this slow but positive growth scenario. The most positive news I received was from firms whose international businesses were strong. As one would expect, the most dire reports were from those in residential construction and related industries. While I was surprised to hear from the CEO of a national specialty retail chain that its business over the past 60 days was the worst he has seen in 45 years, much of his business is in housewares and furniture; but he indicated that many other segments of the retail sector were also struggling. I also spoke with the CEO of General Motors. His outlook was a lot like what President Fisher was just mentioning from other CEOs. They are looking for slow economic growth overall, and they are concerned about the risk of a serious downturn. That is not what they are planning on. The industry is clearly facing softer demand, but his expectation for 2008 as a whole is for only a moderate decline in light motor vehicle sales, down to a pace of about 15¾ million units. GM’s current production plans are not premised on recession-level sales, but they are prepared to cut production quickly if they see the January 29–30, 2008 74 of 249 economy turning down. He also reported that, while the performance of GMAC’s auto loans currently was okay, the credit quality of prospective buyers—people coming into showrooms— has declined and that lenders have tightened underwriting standards for those loans. In addition, if auto loans became more difficult to securitize, it would be a big additional problem. Apparently, so far they are robust, though. Turning to the forecast details, my modal outlook for 2008 is close to that in the Greenbook. I expect that we will eke out positive growth in the first half of 2008. This expectation largely reflects the judgment that businesses have not begun to ratchet down spending plans in the nonlinear fashion that characterizes a recession. My assessment also has been influenced by some positive developments that we have seen. The most notable ones in my mind are that UI claims have moved down, that major banks are having some success raising capital from a variety of sources, and that the orders data today were better. For the second half of 2008, I see growth increasing toward potential by year-end. This assessment depends importantly on accommodative monetary policy and expansionary fiscal policy. Our cumulative actions following this meeting should provide noticeable stimulus to the economy by midyear. Tax rebates should also help somewhat this year. In addition, the financial system should continue to sort through its difficulties, making further headway in price discovery and repairing capital positions. So in the absence of further negative developments, growth should improve in the second half of this year. I then see real GDP rising at a pace a bit above potential in 2009. Although this seems like a plausible projection, it has the feel of threading the needle, which brings to mind nimbleness, and Governor Kohn is our expert at nimbleness, so I start thinking about how his nimble fingers will be critical for threading this needle. The downside risks are large, and the recession scenarios are quite possible. Any of the factors currently January 29–30, 2008 75 of 249 holding back growth could intensify. For example, a reduction in bank lending capacity could make financial conditions much more restrictive. This, along with increased business pessimism and caution, could cause a more pronounced cutback in investment and hiring. Even a moderately weaker job market would add to the factors already weighing on consumer spending. Now, unfortunately, even while we are dealing with concerns on the growth front, the inflation picture is difficult and quite uncertain. The inflation outlook will likely be affected by more crosscurrents than usual. Headline inflation has been quite high, driven largely by increasingly high energy, food, and commodity prices. Although our best assessment is that these pressures will come off later this year, these influences have lasted longer than typical and could well continue to do so. I had calculated the same type of statistics that President Plosser calculated, but only since 1999. Headline PCE inflation has been running about 0.4 percentage point higher than core PCE since that time. This is a source of some concern and cautions us against relying too heavily on core inflation measures. I don’t think that is a big issue today, but we need to be thinking about that in our inflation strategy. In addition, core inflation has not improved as much as I expected. As the Greenbook discusses, the decline during the second quarter of last year may have reflected technical quirks in the indexes rather than true improvements in underlying inflation as I had hoped. The weakening U.S. economy is likely to diminish inflation pressures somewhat in 2008, but it is unclear how big a factor this will be or, given our projection that growth improves, how long it will last. So I think that inflation risk will be rising next year. Consequently, recalibration of short-term interest rates will be an important element of monetary policy in 2009. Looking at the write-up, it seemed to me as though 10 out of 17 participants had that viewpoint—different timing. Our inflation projection has core PCE running 2.1 percent in 2008 and edging off to 2 percent by 2010. In the context of January 29–30, 2008 76 of 249 what Brian was talking about in terms of slack, we have a higher inflation path and inflation coming down with a bit of slack. Much of the Committee’s discussion today has suggested that 2 percent is slightly higher than most participants’ benchmarks. For me, the trajectory of my outlook is satisfactory as long as I see inflation prospects continuing to improve as we move beyond the end of our current forecast period. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Pianalto. MS. PIANALTO. Thank you, Mr. Chairman. In my view, economic conditions have deteriorated significantly since our December meeting. Taken as a whole, the stories that have been relayed to me by my Fourth District business contacts have been downbeat, and several of the contacts are concerned that we may be slipping into a recession. I’m hearing that consumer spending has declined appreciably since the soft December retail sales numbers were reported. The CFO of one of the nation’s major department store chains told me last week that her company’s January sales are shaping up to be the worst that they have seen in the past twenty years. She said that they had already cut back some of their buying plans because of the weak holiday sales, but after seeing the numbers for the first three weeks of January, she is concerned that they have not cut back buying plans enough. In December I had heard some upbeat assessments about the demand for capital goods and exports, but in January the incoming numbers are softer, and expectations for the coming year are less optimistic than they were just a month ago. I’m also concerned that I’m now detecting the first signals of a credit crunch. Bankers in my District tell me that they’re finding it much more difficult to issue debt and that they are safeguarding their capital. I’ve heard several motivations for this, depending on the institution. Some bankers are simply preparing for further losses. Some are expecting to have to bring some downgraded assets back onto their balance sheets. Even those bankers who have adequate capital January 29–30, 2008 77 of 249 say that they have become much more disciplined about how they’re going to allocate that capital. Collectively, the concerns that bankers have expressed to me about capital have convinced me that credit will be less available and more expensive than it has been in quite a while. Deals that bankers would have done for creditworthy borrowers not long ago are simply not being done today. Of course, it’s possible that nonbank financial companies will step in and fill the gap, but it is not clear to me that they have the capital and the risk appetites to do so. These developments have had a significant influence on the economic projection that I submitted for today’s meeting. Like many around the table, I continue to mark down my outlook for residential and nonresidential investment in response to the incoming data and also in response to greater business pessimism about the economic prospects. In addition, I’ve built in a sharper and more protracted slowing in consumer spending stemming from greater deterioration in the household balance sheet and tighter credit market conditions. These adjustments have caused me to cut my 2008 GDP growth projection about 1 percentage point since the December meeting, and some of that weakness spills over to the out years. If credit conditions deteriorate further than I have expected, then my projection would more closely resemble the persistent weakness alternative scenario described in the Greenbook. But that isn’t my projection for the economy. Rather, my projection is roughly in line with the Greenbook baseline. My inflation outlook hasn’t changed much from where it was in December—or October, for that matter. Like the Greenbook, I still project inflation to moderate as commodity prices level off and business activity wanes, but the risks to my inflation outlook have shifted to being weighted to the upside. The December CPI report was not much improved from the troubling November data, and my business contacts continue to report that commodity prices are being passed downstream. So I have less conviction in the inflation moderation than I did a month ago. That said, the January 29–30, 2008 78 of 249 downside risks to the economy still dominate my thinking about the outlook today. I do believe, however, that our policy response to date combined with an additional rate cut tomorrow will allow the economy to regain some momentum as we move into the second half of 2008. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Rosengren. MR. ROSENGREN. Thank you, Mr. Chairman. The contours of our forecast are broadly in line with the Greenbook: Growth well below potential for the first half of this year results in additional slack in labor markets with a consequent reduction in the core rate of inflation over time. Our forecast returns to full employment by 2010 only if we reduce interest rates more than they are in the Greenbook. Thus, our baseline forecast assumes that we reduce rates 50 basis points at this meeting followed by additional easing in 2008, which eventually results in core inflation below 2 percent and the unemployment rate settling at our estimate of the NAIRU, somewhat below 5 percent. But even with this easing, there are significant downside risks to this forecast. Historically, increases in unemployment in excess of 0.6 percent and forecasts of two or more quarters of real GDP growth below 2 percent have almost always been followed by a recession. In fact, a variety of probit models looking at the probability of recession in 2008 indicate an uncomfortably high probability of recession, in most cases above 50 percent. Several factors make me concerned that the outlook could be worse than our baseline forecast. First, we have consistently underestimated weakness in residential investment. While our forecast assumes a gradual decline in real estate prices, it does not have a substantial feedback between rising unemployment rates causing further downward pressure on real estate prices and the health of financial institutions. Were we to reach a tipping point of higher unemployment, higher home foreclosures, increased financial duress, and falling housing prices, we would likely have to January 29–30, 2008 79 of 249 ease far more than if we were to act preemptively to insure against this risk. Second, our weak consumption is driven by negative wealth effects induced by weakness in equity markets and modest declines in real estate prices. However, the heightened discussion of a potential recession could easily result in a larger pullback by consumers. This would be consistent with the behavior of rates on credit default swaps of major retailers, which have risen significantly since the middle of December. Third, banks are seeing increasing problems with credit card debt. Capital One, one of the few concentrated credit card lenders, has had their credit default swap rate rise from less than 100 basis points to more than 400 basis points as investors have become increasingly concerned about the retail sector. While liquidity concerns have abated, credit risk for financial institutions has grown. Rates on credit default swaps for our largest banks have been rising since December, despite the announcement of additional equity investments. In addition, the greatest concern I hear raised by the financial community in Boston is a risk posed by the monoline guarantors. The movement in equity prices last week as a result of highly speculative statements on resolving the monoline problem indicates a sensitivity of the markets to significant further deterioration in the financial position of the monolines. Fourth, our model does not capture potential credit crunch problems, although supplementary empirical analysis conducted by the Boston staff suggests that such problems pose additional downside risks to our outlook. Bank balance sheets continue to expand as banks act in their traditional role of providing liquidity during economic slowdowns. While the balance sheet constraints are likely to be most acute at our largest institutions, further deterioration in real estate markets is likely to crimp smaller and midsize banks that have significant real estate exposures. Given my concerns that we could soon be or may already be in a recession, I believe the risks around our forecast of core inflation settling below 2 percent are well balanced. Inflation rates January 29–30, 2008 80 of 249 have fallen in previous recessions, and I expect that historical regularity to be maintained if growth is as slow as I expect. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Vice Chairman. VICE CHAIRMAN GEITHNER. Thank you, Mr. Chairman. Let me just start by saying it’s not all dark. [Laughter] MR. MISHKIN. Don’t worry; be happy? VICE CHAIRMAN GEITHNER. I’m going to end dark, but it’s not all dark. The world still seems likely to be a source of strength. You know, we have the implausible kind of Goldilocks view of the world, which is it’s going to be a little slower, taking some of the edge off inflation risk, without being so slow that it’s going to amplify downside risks to growth in the United States. That may be too optimistic, but the world still is looking pretty good. Central banks in a lot of places are starting to soften their link to the dollar so that they can get more freedom to direct monetary policy to respond to inflation pressure. That’s a good thing. U.S. external imbalances are adjusting at a pace well ahead of expectations. That’s all good, I think. As many people pointed out, the fact that we don’t have a lot of imbalances outside of housing coming into this slowdown is helpful. There’s a little sign of incipient optimism on the productivity outlook or maybe a little less pessimism that we’re in a much slower structural productivity growth outlook than before. The market is building an expectation for housing prices that is very, very steep. That could be a source of darkness or strength, but some people are starting to call the bottom ahead, and that’s the first time. It has been a long time since we’ve seen any sense that maybe the turn is ahead. It seems unlikely, but maybe they’re right. In the financial markets, I think it is true that there is some sign that the process of repair is starting. We have seen very, very substantial adjustment by the major financial institutions; very, January 29–30, 2008 81 of 249 very substantial de-leveraging ahead as the institutions adjust to this much, much greater increase in macroeconomic uncertainty and downside risk; very, very substantial early equity raising by major firms; pretty substantial improvement in market functioning; and easing of liquidity pressure. Those are useful, encouraging things. There is a huge amount of uncertainty about the size and the location of remaining credit losses across the system. But based on what we know, I think it’s still true that the capital positions of the major U.S. institutions coming into this look pretty good relative to how they did in the early 1990s. Of course, as many people have said many times, there’s a fair amount of money in the world willing and able to come in when investors see prices at sufficiently distressed levels. One more encouraging sign, of course, is that the timing, content, and design of the stimulus package look as though the package will be a modest positive. It could have been a worse balance of lateness and poor design, but I think it looks to be above expectations on both timing and design, and it will help a little on the downside and take out some of the downside risk. Having said that, though, I think it is quite dark still out there. Like everyone else, we have revised down our growth forecast. We expect very little growth, if any, in the first half of the year before policy starts to bring growth back up to potential. The main risk, as has been true since August, is the dangerous self-reinforcing cycle, in which tighter financial conditions hurt confidence and raise recession probability, causing people to behave on the expectation that recession probably is higher, reinforcing the financial headwinds, et cetera. The dominant challenge to policy is still to arrest that dynamic and reduce the probability of the very adverse outcome on the growth side. Of course, we have to do that without risking too much damage to our inflation credibility and too much damage to future incentives and future resource allocation. Like many of you, I think the inflation outlook for the reasons laid out in the Greenbook is better than it was. It’s not terrific, but it’s better. The risks are probably balanced around the January 29–30, 2008 82 of 249 inflation outlook. Our inflation forecast still has core PCE coming down below 2 percent over the forecast period. There’s obviously a lot of uncertainty around that, but I really think that you can look at inflation expectations in the markets as somewhat reassuring on the credibility front to date. So again, I think the key question for policy is how low we should get real short-term rates relative to equilibrium, and our best judgment is that we’re going to have to get them lower even with another 50 basis points tomorrow. We’re still going to need to try to reinforce the signal that we’re going to provide an adequate degree of accommodation or insurance against this very dangerous risk of a self-reinforcing cycle in which financial weakness headwinds reinforce the risk of a much deeper and prolonged decline in economic activity. CHAIRMAN BERNANKE. Governor Kohn. MR. KOHN. Thank you. Thank you, Vice Chairman Geithner, for a little less gloom here. I didn’t expect the bright side from that source. [Laughter] Like everyone else around the table, I have revised down my forecast, which looks very much like the Greenbook: a couple of quarters of very slow growth before a pickup in the second half of the year spurred by monetary and fiscal stimulus. The collapse of the housing market has been at the center of the slowdown, and most recent information was weaker than expected. There is no sign in the data anyhow that a bottoming out is in sight. Sales of new homes have dropped substantially, and that must reflect reduced availability of credit, especially for nonprime and prime nonconforming loans, and perhaps buyers’ expectations of further price declines. As a consequence, a steep drop in housing construction has made only a small dent in inventories, and those will continue to weigh on activity and prices. Indeed, house-price declines in the Case-Shiller index picked up late last year. I think we just got November. January 29–30, 2008 83 of 249 It looks increasingly as though other sectors are being affected as well, slowing from the earlier pace of expansion and slowing a little more than expected. You can see this in broad measures of activity, as President Stern pointed out: industrial production, purchasing manager surveys, and the employment report. I think it is also evident in some measures of demand. Retail sales data suggest a deceleration in consumer spending late in the fourth quarter. Orders and shipments for capital equipment excluding aircraft picked up in December, but that followed a couple of months of flat or declining data. A slowdown in consumption and nonhousing investment probably reflects multiplier-accelerator effects of the drop in housing, a decline in housing wealth, and additional caution by both businesses and households given the highly uncertain and possibly weakening economic outlook. Certainly the anecdotes we’ve heard around the table reinforce the sense of business caution. But like other people, I see the softening outlook and the spread beyond the housing sector as importantly a function of what’s going on in the financial sector and of the potential interaction of that over time with spending. We have seen improvements in short-term funding markets, in spreads, and in the leveling out of the ABCP (asset-backed commercial paper) outstandings, but investors and lenders seem increasingly concerned about the broader economic weakness and spreading repayment problems, and they are demanding much greater compensation for taking risk in nearly every sector. To me one of the defining characteristics of the period since, say, midNovember is the spreading out from the housing sector of lending caution to other sectors in the economy. Nonfinancial corporations have experienced declines in equity prices. Credit spreads on both investment-grade and junk bonds have increased. A substantial portion of banks reported tightening terms and standards for C&I loans. Commercial real estate sector lenders are very concerned about credit. Spreads on CMBS have risen substantially, and most banks—like January 29–30, 2008 84 of 249 80 percent—tightened up on commercial real estate credit, and that has to affect spending in that sector over time. Banks tell us that they are being more cautious about extending consumer credit, as President Yellen noted. A number of large banks noted a pullback in this area and deterioration in actual and expected loan performance when they announced their earnings over the past few weeks. There have also been increasing doubts about how robust foreign economies will remain, and this was evident in equity markets around the globe and in rising risk spreads on emergingmarket debt. The staff has marked down its forecast of foreign GDP growth again this round. The total decrease in projected foreign growth in 2008 since last August has been around ½ percentage point, and this is at a time when we are counting on exports to support economic activity. The extraordinary volatility in markets is, I think, indicative of underlying uncertainty, and that underlying uncertainty itself will discourage risk-taking. The uncertainty and the caution are partly feeding off the continued decline in housing, the still-unknown extent of the losses that will need to be absorbed, and the extent to which those losses are eroding the capital of key institutions like the monolines. The monoline issue raises questions about who will bear the losses and provides another channel for problems spreading through the credit markets, through losses being felt or credit being taken back on bank balance sheets, making them more cautious, and even more directly, into the muni market through the monolines. Despite these developments, my forecast for 2008 was revised down only a few tenths from October. But that is because of the considerable easing of monetary policy undertaken and assumed in my forecast. I assumed 50 at this meeting, and unlike that piker, President Yellen, I assumed another 50 over the second quarter. MS. YELLEN. I’ll see you and up you. [Laughter] MR. KROSZNER. This is a bad dynamic. January 29–30, 2008 85 of 249 MR. KOHN. I thought we needed some insurance, and I also assumed some fiscal stimulus as in the Greenbook. I still see, despite these policy responses, risks around my outlook for activity as skewed to the downside, and it’s because of the potential further increases in required compensation for risk and tightening standards for extending credit and the feedback on demand. Although inflation has been running higher than expected of late, and that is troubling, I expect it to ease back even with my more accommodative policy. The combination we’ve seen of slower income growth and higher inflation suggests elements of a supply shock, and that’s obviously coming from the energy sector and its spillover into food. It is true, as President Fisher pointed out, that some of those increases in food and energy prices are coming from demand from emerging-market economies, but to the extent that such demand is putting upward pressure on our prices and it’s not really sucking exports from the United States at any great rate, I think that it acts more like a supply shock on the U.S. economy than a demand shock. Energy and other commodity prices should level off in an environment of slower global growth, and they’ve started to do that. They have at least showed signs of leveling off recently. Greater slack in resource utilization and product markets should discipline increases in costs and prices. At least some of the reports about airlines suggest that they have tried to pass through fuel surcharges and have been unable to do so, and I think that’s an encouraging sign from the inflation perspective. Any easing of inflation pressure does require that inflation expectations not begin to ratchet higher. I agree with everyone else. I’m persuaded that the balance of evidence is that they have not, despite the rise in five-yearforward inflation compensation and despite the persistently higher rate of increases of total headline than of core inflation. But this is something we will need to monitor very carefully. I interviewed Paul Volcker yesterday afternoon for our oral history project. The discussion with him reminded January 29–30, 2008 86 of 249 me again of the high cost of reversing a rise in inflation once higher inflation expectations become entrenched. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. I will endeavor to stay out of the growing, creeping pessimism caucus. [Laughter] You can judge for yourselves whether I’ve been successful doing so. Let me talk briefly about two economies that are in a tug-of-war, and rather than reference the housing and nonhousing economies, let me try to talk about it in the context of the economy of financial services versus the real economy. On one level, of course, financial services are not so large a share of GDP that they could threaten the macroeconomy. But the transmission mechanism between credit markets and the real economy, whether it be through the credit channel or other channels, while imperfectly understood, is having very negative effects on the cost and availability of credit for real businesses and households, with the risks there to the downside. Financial institutions, as many of you said, are open for business, but I would say somewhat less so than when we met in December. As we approach the credit line renewal season, that is happening amid a period of depleted credit availability and significantly tighter lending standards. In addition, financial institutions as a group are, in my view, undercapitalized, even with the recent capital infusions. Finally, the dynamism that I would be hoping to see among financial institutions is clearly lacking; and while I think, as President Pianalto referenced, that there are new market entrants like hedge funds that are pretty keen to provide mezzanine financing, it’s a pretty slow process to match providers and users of capital. So at least for the near-term forecast, I wouldn’t expect that to come much to our rescue. If the U.S. financial institutions were an economy all to themselves, they would probably already be in a recession. While that doesn’t necessarily equate to a recession for the broader January 29–30, 2008 87 of 249 economy, it sure doesn’t help. The repair process that President Geithner referenced among financial institutions strikes me as very fragile and quite incomplete. Income statement shortfalls due to falling profits, poor visibility, weaker pipelines, and the need to reduce headcounts very meaningfully strike me in some ways as a more urgent and troublesome issue for large financial institutions than their balance sheet weakness. On the balance sheet front, however, I’m also concerned that more impairments are to come for large financial institutions and more dilution is expected for current shareholders. Although the window for foreign investment is open now, I wouldn’t expect that window to stay open throughout 2008. So even though I’d say that income statement concerns should be more pressing for them, these balance sheet issues are very real. In some way these institutions have been built, or I should say rebuilt, over the past six years to prepare themselves for a low volatility, high liquidity world, and what they found is the exact opposite. They are at different levels of understanding the new world, and it will take them quite some time to rebuild their businesses to be profitable in it. Rolling capital calls across financial institutions are continuing. Many are hoping to play for time, but I think there’s a risk that time will run away from them as new events find their way into the front pages. Virtually no financial institution strikes me as immune to these pressures, and while we see that new problems and new acronyms are emerging daily, they strike me as having the same underlying problems affecting different asset classes. Regional banks have begun to fund their balance sheets successfully—certainly a good sign—but I suspect that they are also in the early stages of needing to raise considerably more capital. As Governor Kohn said, there is a hope and an expectation that global institutions would be a source of strength, at least in financial services. Again, in financial services, my sense is that nonU.S. financial institutions, especially those in the United Kingdom and Europe, are in the midst of January 29–30, 2008 88 of 249 playing catch-up to their U.S. counterparts. I expect the year-end reporting process for them, which really begins now but will be at full speed by mid-February through early March, will find many of the Landesbanks needing to be recapitalized. I think we’re going to find that both large and small institutions are having a hard time getting through the bank reporting season in Europe. Equity prices in Europe and CDS spreads are already giving us some indication of what’s on the horizon. It’s not just about subprime in Europe, contrary to some of the indications we received. Perhaps even more than U.S. institutions, many European financial institutions have incorrectly believed that high credit ratings across asset classes would in and of themselves serve as protection. The overreliance on credit ratings that we see in the United States strikes me as even more pronounced in Europe. The shocks caused by these financial institutions could have a dramatic impact on their economies, probably more so than the effect of U.S. financial institutions here in the United States. That obviously has a consequence in terms of a further shock and also a consequence on the real side in terms of U.S. exports. Let me turn to the other side of that, that is, the real economy itself, excluding financials. I think many of you referred to the labor market data, which strike me as mixed. I’m perhaps a touch more optimistic that we’re going to see some improvement at least in the short term there, but I can’t have the conviction that I’d like. The real economy is doing its best to resist these financial shocks. We can see that fight playing out around E&S spending, around business fixed investment, and around cap-ex more generally. You have nonfinancials with strong corporate balance sheets, excess cash, and high profit levels that are debating in corporate boards about the uncertainty posed by the macroeconomy. It’s hard to say which side is going to prevail in that battle. The backdrop, as many of you mentioned, has weakened, with risk premiums widening across the board. Real PCE for January is not showing much of a snapback from a weak December but also, I would say, January 29–30, 2008 89 of 249 not much more deterioration from December levels according to the credit card companies that I spoke to. The bottom line on the real economy—the trends in the real economy may be a bit more positive coming into the first quarter from the fourth quarter than the Greenbook projections, but I would say I am a little less optimistic that the fiscal stimulus package is as likely to be as constructive as the Greenbook would have us believe. The forecast, as a result, overall depends on the ability of nonfinancial corporations to hire and invest despite this macroeconomic uncertainty. I have some confidence that the Fortune 500 will be willing to continue to push along this path of moderate growth; but small companies, particularly those that are really the source of job creation, may be more negatively affected while the credit channel is impaired, and this is happening at a critical time. The Greenbook base case or the “faster recovery” pace depends to a degree on improvement in credit intermediation or at least not another shock, and it’s that other shock that worries me. If deterioration among credit intermediaries continues, the real economy will suffer. Of course, the correlation is hard to pin down. Finally, on the inflation front, I share the concerns expressed by several of you that the persistence of recent inflation information coming into this period is a cause for concern. I’m less sanguine than the Greenbook that we’re going to see the power of that inflation fade in the event that the economy softens some. The backdrop of stubbornly high commodity prices, despite lower global demand in recent weeks, and a lower exchange value of the dollar are likely to put pressure on the inflation front. The data, as we have all talked about, on core and total inflation are not promising, so I would consider that also to be an upside risk. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. January 29–30, 2008 90 of 249 MR. KROSZNER. Thank you very much. Well, if that’s the optimistic scenario, I think we had all better pray. But I think it’s a relatively balanced scenario that accurately reflects the risks that are there. The Greenbook has done a very good job of trying to thread the needle, and I think making a close call for contraction but not actually calling it seems to be very reasonable. The kinds of insurance discussions in both the Greenbook and the Bluebook and that we’ve had preliminarily here make a lot of sense. Our models have never been successful at assessing turning points, and that is true whether they are the typical linear models, nonlinear models, probit models, Markov switching models, or other things like that. We sort of know once we’ve switched, but it’s hard to get that transition. As many people have suggested, there are an awful lot of indicators that would go into those kinds of models that would flash for contraction being likely. I think that is correct, but that makes it very difficult for us to assess what will happen. So I think—as well reflected in the projections—a lot of downside risk is there. I do share some of the optimism about improvements that we’ve seen in the financial markets, but I had that feeling in October and November, and it is hard for me to really understand exactly what drove the subsequent deterioration. Certainly there were some issues around year-end, but it seems that more issues than just the year-end were driving the fairly significant reversal of improvement that occurred during October through mid-November and the fairly sudden backing up. So I’m concerned that, since I don’t really understand what happened there, I don’t want to take too much comfort from what has happened so far. But I also don’t want to dismiss what has happened so far because it’s certainly conceivable that things will move in a more linear way forward for improvement. One issue that I raised both at the last FOMC and in our various conference calls related to some discussions I’ve had with the major credit card companies, which in some sense have a very January 29–30, 2008 91 of 249 good feeling for real-time consumption. I’ve talked with two major credit card companies, and they both had very negative views of what had happened in the very sharp transition consistent with a switch into a contractionary state from the discussions before the October FOMC versus before the December FOMC. But in the most recent discussions, basically it flattened out. It’s certainly not recovering, but it is not a continuing downward trend, which at least in my view provides a great deal of comfort because I was very concerned about the nonlinear break to a very low consumption state, and I think there’s less evidence of that. I won’t go through the specifics of what they said, but basically we’re still seeing challenges and increases in personal bankruptcies, slower repayment rates, more people slipping from 30 days overdue to 60 days overdue, et cetera, et cetera. But it’s not as dramatic a change, and it’s sort of within the range that they have been anticipating given the data from December. Also as someone mentioned, and I have forgotten who, these numbers are still at relatively low levels. Now, the change is in a very bad direction and certainly could move very quickly, and we’ve seen that in other recession scenarios. But fortunately it seems, at least from this anecdotal evidence, that it isn’t a significant change to the downside, and it’s possible that it could just be re-flattening out. My concern is still that sort of “slow burn” scenario that I’ve talked about and that Nellie and others have fleshed out on the pressures on banks’ balance sheets. I liked Nellie’s very politically correct phrase “unplanned asset expansions.” That’s a very nice way of putting like “oh, my goodness, something is suddenly on the balance sheet that we didn’t expect”—SIVs, asset-backed commercial paper, and so forth. I think people are still waiting for the other shoe to drop, and the other shoe certainly could drop. There may be things that we haven’t fully anticipated, but we know that there are still leveraged loans that they can’t get off their books, a pipeline that’s still coming on. We know that many banks are still making mortgage loans and January 29–30, 2008 92 of 249 cannot get those off their books—at least the jumbo ones. It’s conceivable that raising the limits at Freddie Mac and Fannie Mae may help in the short run even if there may be costs in the longer run. A number of other things could suddenly come on the balance sheets. The example of what happened at SocGen is just another uncertainty that could be out there. So even at a major financial institution that was generally quite well respected, something like this could happen. A lot of finger pointing and a lot of uncertainty can come from that, and that’s broadly reflected in the CDS spreads. About the point that Bill Dudley made in conversation with President Rosengren about being careful to say, well, CDS spreads are lower in Europe and that suggests there’s less risk in Europe—you have to take into account the reaction function by the governments, by the regulators, in terms of recapitalization, as Governor Warsh made reference to. There are very real challenges, but overall we have seen these CDS spreads go up quite a bit. So I think that concern about the negative dynamic scenario that people talked about is real, and that’s why it is very important to be thinking about buying insurance. With respect to inflation, certainly some of the numbers have been worrisome. It is clear that inflation uncertainty is up. We can disagree as to exactly what that means either about credibility or whether it is just uncertainty or whether it’s upside or downside scenarios, but I think it is up and that is something we should be concerned about. We should carefully craft our message to take that into account because uncertainty can lead to unanchoring of inflation expectations, and that is something that we certainly don’t want to see. I don’t see evidence of unanchoring yet, but I do see a potential first step in that direction, which does concern me. The simple fact that a memo had to be written about what was going on with respect to some of these sharp movements suggests that it’s not clear. Although the memo was excellent, I think there are elements in it that suggest we don’t fully understand and we need to be very careful about that. Thank you. January 29–30, 2008 93 of 249 CHAIRMAN BERNANKE. Thank you. Governor Mishkin. MR. MISHKIN. Thank you, Mr. Chairman. I think we’re all trying to be cheery here. It reminds me a little of one of my favorite scenes in a movie, which is Monty Python’s “Life with Brian.” I remember the scene with them there all on the cross, and they start singing “Look on the Bright Side of Life.” [Laughter] So let me talk a bit about my views on this. My personality does do that, but it is really that I’m strapped a bit to the cross. My view on the economy is that we are going to have quite a weak first part of 2008, in which we’re going to skirt recession. This is my modal forecast. I do think that the economy will be stronger in 2009 and 2010, but that’s because I decided to be even less of a piker than Governor Kohn. He accused President Yellen, but I was going to accuse him because I did actually assume a 75 basis point cut at this meeting and then another 50 basis point cut at the meeting following. Then I hoped that afterward we would be able to reverse. Of course, this is something to discuss tomorrow, but it has to do with my views on how you deal with financial disruptions and risk management. So I’ll talk about that tomorrow. Even though I have a scenario that looks okay, I do want to point out that four very significant downside risks really worry me. We all talked about them. Of course, the first is housing. But I worry about a particular dynamic, which is that the negative price movements that we currently see could be getting worse. People could be expecting that they’re getting worse, and therefore, they want to hold off from buying a house because the effective cost of capital is higher. As somebody who stupidly is just going to contract on a new house because I have to please my wife, I actually thought exactly along these lines and was thinking about pulling out but then decided that my marriage was more important. MR. STERN. It was close. [Laughter] January 29–30, 2008 94 of 249 MR. MISHKIN. By the way, if you know my wife, no it wasn’t close. The second issue is that the potential for weaker house prices, which really is a significant possibility, not only could lead to lower household wealth but, more important, also could reduce the value of collateral for households and as a result mean that the relaxation of credit constraints that collateral affords is no longer there. That could have major implications in terms of household spending, so it is also a very substantial downside risk to PCE. The third issue is that we also see that the financial disruption has already gotten worse. The good news is that there has been improvement on the liquidity front, and I give a lot of credit to the TAF, which was superbly thought out by our staff and has been quite helpful. However, credit conditions have worsened. Particularly worrisome—and something that hasn’t been discussed much—is that the Senior Loan Officer Opinion Survey had substantial tightening. Usually when you see this kind of tightening, it could indicate that we could have serious negative economic consequences. Again, that actually makes me very nervous. Finally, to get even more depressed, there really is potential for a negative feedback loop that has not yet set in. The financial disruption that we’re seeing right now could then mean a more substantial worsening of the aggregate economy, and that could make the financial markets have even more strain, and you have a problem. So I really worry about the downside risks and think that they are very substantial and that we should be very concerned about them in thinking about what the appropriate policy stance is. On the issue of inflation, I’m more sanguine. I see inflation going down to 2 percent by 2009. The key here is that I think that inflation expectations are grounded—in fact, are grounded at a level that is consistent with my inflation objective, around 2 percent on PCE, which might be different from others’ views, but that’s where I am right now. In that context, given that inflation expectations plus expectations about future slack in the economy are the primary drivers of inflation January 29–30, 2008 95 of 249 dynamics, I actually think that inflation will come down. It is true that the recent inflation numbers have been very bad; but in thinking about the overall risks, I’m a bit different from the average person on this Committee because I think the risks are balanced and actually somewhat to the downside. The reason I say this is that I think that inflation expectations are grounded. At the same time, there is a substantial downside risk in the economy that could really widen slack in the economy, and that would mean that inflation would come down. I don’t want to be too sanguine on the issue of inflation expectations being grounded. In fact, one thing that I think we have to monitor very closely is what’s happening in terms of inflation expectations, particularly financial markets’ views of inflation expectations. In a sense, I think of that as the canary in the coal mine. We are also going to want to look at expectations spreading to professional forecasters and to households, but I think information would come in first in terms of the financial markets for the reason that they put their money on the table and react quickly. That’s one reason I think it’s very important to look at things like inflation compensation. But we do need to look at this and do the analysis. My reading of the analysis that the staff gave and my thinking about the issue is that there is just no evidence that inflation expectations have gone up. The story is extremely hard to tell to go in that direction. However, it is very easy to tell a story that inflation uncertainty has gone up a lot, and this is something that President Evans talked about and we talked about at the very beginning of a long day. In this context, that does concern me, and it really tells me that we have to think about whether we can better anchor inflation expectations. So I think that this is something that we have to be concerned about, but I do not think that what has happened in inflation compensation is that the canary is dropping dead at this stage. But we do have to monitor this very, very closely, and again, it’s part of the risk-management strategy that I think we have to pursue. Thank you, Mr. Chairman. January 29–30, 2008 96 of 249 CHAIRMAN BERNANKE. Thank you, and thank you all for succinct and very insightful comments. [Laughter] I’m going to try as usual to summarize what I’ve heard; but even more so than usual, no warranty is expressed or implied. Again, trying to bring together some of the comments, we noted that incoming data since the last meeting have been broadly weaker than expected, and anecdotes generally suggest slower growth, in some cases significantly slower growth. Housing demand, construction, and prices have continued to weaken, and inventories of unsold homes are little changed. Housing weakness has implications for employment, consumer spending, and credit conditions. With respect to households, consumption growth has slowed, reflecting falling house and equity prices and other factors, including generally greater pessimism about the labor market and economic prospects. The labor market has softened by a range of measures, with unemployment jumping in December. However, workers in some occupations remain in short supply. Together with financial indicators, weaker labor and consumption data suggest that the economy is at a risk of recession; in any case, it is likely to grow slowly for the first half of the year. The second half of the year may be better, the result of easier monetary policy, fiscal stimulus, and possible improvement in housing and credit markets. However, there are significant downside risks to growth, including the possibility of an adverse feedback loop between the economy and credit markets. Reports by firms are mixed. Investment may have slowed, reflecting uncertainty and slower growth in demand. Commercial real estate activity may be constrained by tighter credit conditions. Manufacturing is slow to mixed, though IT, energy, and some other sectors continue to be strong. Financial markets remain stressed. Credit conditions more generally appear to be worsening, and the problems may be spreading beyond housing. Additional risks are posed by the problems of the monoline insurers. Credit losses have induced tighter lending standards, and a key question is how January 29–30, 2008 97 of 249 severe those may become and how persistent they may be. One offset is the ability of banks to raise capital. Core inflation and headline inflation have remained stubbornly high and are a concern. One risk is the ability of some firms to pass through higher input costs. Inflation compensation has risen at long horizons, reflecting some combination of higher inflation expectations and inflation risk premiums. Going forward, a slowing economy, anchored inflation expectations, and possibly stabilizing food and energy prices should lead to more moderate core and total inflation. However, some see upside risks, especially the possibility that higher headline inflation might affect inflation expectations. So that’s my attempt to summarize. There’s a great deal more detail and a great deal more color in the conversations around the table. Let me try to add a few points. Again, much of what I’ll say has been said. I do think that there has been a significant deterioration in the outlook for economic growth and an increase in the downside risks to growth. It was sufficiently severe as to prompt me to call the January 9 videoconference that we had, and I think that since then we have had further deterioration. A number of things have happened and are going on. Very important, perhaps most important, is the continued further deterioration in the prospects for the housing market. Housing, of course, feeds directly into the real economy through employment, income, and wealth, and I think there are some indications that spillover from the housing sector to the rest of the economy is increasing. However, the critical aspect of the housing outlook is the relationship to the financial system, which I’ll come back to. Consumer spending has slowed. I think there’s little doubt about that at this point. There are a lot of factors now that are acting as headwinds in the consumer sector. Let me just point out the basic fact that most households in the United States have very little in the way of liquid financial January 29–30, 2008 98 of 249 assets. Therefore, when they, on the one hand, are denied access to home equity if they see tighter credit conditions on cards, autos, and so on, and if at the same time they see greater uncertainty in the economy and the labor market, then their natural tendency would be to be much more conservative in their spending. I do note that fiscal action may be of some help, particularly for people in that kind of situation. Like President Yellen, I think the indicators of a weakening labor market are broader than just the payroll report. There are a number of other things as well. We may get a better report this week. The UI claims are a little encouraging, but I do think that the weakening economy is going to drag down the labor market to some extent. Certainly the financial markets have deteriorated, reflecting greater concern about recession. We see it in the equity markets but also in short-term interest rates and a variety of credit measures as well. Finally, just going through this list of items, we continue to see problems—credit issues, banks concerned about additional losses not just in mortgages but perhaps in other areas as well—with the potential implication of a further tightening of credit conditions. Those are some of the developments that we’ve seen since the last meeting. On our January 9 call, I talked about the regime-switch model and those ways of thinking about the business cycle. Others have talked about that today. I think many of those models would suggest that the probability of recession at this point is quite high, at least 50 percent or more. I don’t think any of us would be happy to see a garden variety NBER recession; but if we had that, there would probably be a few benefits, including correction of some imbalances that we’re seeing in the economy and perhaps some reduction at the edge in the inflation picture. But, like others, I am most concerned about what has been called the adverse feedback loop—the interaction between a slowing economy and the credit markets. A phrase you might have heard, which is getting great currency among bankers, is “jingle mail.” Jingle mail is what happens when otherwise prime January 29–30, 2008 99 of 249 borrowers decide that the value of their house is worth so much less than the principal of their mortgage that they just mail their keys to the bank. (I wonder if that 140 percent is the right loan-tovalue number. Maybe it’s less than that.) Even if prime mortgages hold up—and I think in some regions of the country there will be significant problems with prime mortgages—there is a lot of other potential trouble. We’re just beginning to enter the period of maximum subprime ARM resets. Second lien piggybacks and home equity loans are all questionable at this point. We haven’t begun to address the option ARM issue, which is about the same size as the subprime ARM category, and of course, we have the issues with the monolines and private mortgage insurers. Outside of mortgages, expectations for credit performance are worsening in a range of areas, including commercial real estate and corporate credit. So I think that even under the relatively benign scenario that the Greenbook foresees, we’re going to see a lot of pressure in the credit markets and perhaps a long period of balance sheet repair, tight credit, and a drag on the economy. Again, our experience with financial drag or headwinds has been that it can be quite powerful and deceptively so, and I think that’s a significant concern. Now, the central issue here, though, ultimately comes back to the housing market. Certainly by this point there must be some pent-up demand for housing. We’ve had obviously very low sales for a period. House prices are soft. Mortgage rates are low. Affordability is better. What’s keeping people from buying houses is the fact that other people aren’t buying houses. If there were some sense that a bottom was forming in the market or in house prices, we probably could actually see a pretty quick snap-back, an increase in housing demand, and that in turn would feed back into the credit markets, I think, in a very beneficial way. So there’s the possibility that, if the housing market can get restarted, we could get a relatively benign outcome. MR. MISHKIN. I hope so. January 29–30, 2008 100 of 249 CHAIRMAN BERNANKE. However, there appears to be a law of nature that the turnaround in the housing market is always six months from the present date. We simply don’t have any evidence whatsoever that the housing market is bottoming out. We have guesses and estimates about how far prices will fall and how far demand and construction will fall. The key issue is prices, and we are far from seeing the worst case scenario that you could imagine in prices. So long as we don’t see any stabilization in the housing market or stabilization in house prices, then I don’t think we can say that the downside risks to the economy or to the credit system have been contained. Until that point, I think we need to be very, very alert to those risks. Everyone has talked about inflation, as should be the case. I am also concerned. The pickup in core inflation is disappointing. There are some mitigating factors, such as the role of nonmarket prices, which tend not to be serially correlated. We haven’t discussed owners’ equivalent rent in this meeting for the first time in a while, but we know that it can behave in rather odd ways during periods of housing slowdowns. The hope is that energy and food prices will moderate; in fact, if oil prices do rise by less than the two-thirds increase of last year, it would obviously be helpful. Nominal wages don’t seem to be reflecting high inflation expectations at this point. So I think there are some reasons for optimism; but as many people pointed out, there are upward pressures, including the point that President Fisher made that the lagged effects of the previous increases in energy, food, and other commodity prices have probably not been fully realized in core inflation. Furthermore, as we’ll talk about more tomorrow, to the extent that we decide at this meeting to take out some insurance against downside risks, then implicit in that insurance premium might be a greater risk of inflation six months or a year from now. So we have to take that into account as we think about policy and about our communications, as President Plosser and others have pointed out. In particular, as Governor Mishkin and others have noted, we need to think about a policy strategy January 29–30, 2008 101 of 249 that will involve not only providing adequate insurance against what I consider to be serious downside risks but also a policy strategy that involves removing the accommodation in a timely way when those risks have moderated sufficiently. So my reading of the situation is that it’s exceptionally fluid and that the financial risks, in particular—as we saw, for example, after the October meeting—can be very hard to predict. There are a lot of interactions between the financial markets and the real economy that are potentially destabilizing, and so we are going to have to be proactive in trying to stabilize the situation, recognizing that we have a confluence of circumstances that is extraordinarily difficult and that no policy approach will deliver the optimal outcome in the short term. We’re just going to have to try to choose a path that will give us the best that we can get, given the circumstances that we’re facing. All right. Any further comments or questions? We will reconvene tomorrow at nine o’clock. There is a reception and dinner, optional, available in the Martin Building. Thank you. [Meeting recessed] January 29–30, 2008 102 of 249 January 30, 2008—Morning Session CHAIRMAN BERNANKE. Good morning, everybody. Let’s begin our meeting by calling on Dave Stockton to report on the GDP data. MR. STOCKTON. 4 Thank you, Mr. Chairman. My dictionary defines a miracle as an event so improbable that it appears to defy the laws of nature. Along those lines, we distributed a GDP report that compares our forecast with the actual number that was published this morning, and they are exceedingly close. [Laughter] As you can see comparing the Greenbook and advance estimate columns, in fact, it wasn’t just close on the top line, but it was really quite close in terms of the various components. Personal consumption and business fixed investment were very close to our estimate. Residential investment was not quite so weak in the advance release as it was in our forecast; that might reflect either a different estimate by the BEA about cost per start or something they know about additions and alterations that we don’t. In the opposite direction, federal spending—in particular, defense spending—was weaker in the advance estimate than we have incorporated in the Greenbook estimate. At the bottom of the table are the price indexes. Both total PCE and core PCE were spot-on with the forecast. Really, I didn’t see anything in this report that would alter our outlook at all going forward. I would just note, obviously, that both the advance estimate and our Greenbook estimate are based on partial data. There is still a lot left to be learned about the fourth quarter, and even more about the first quarter going forward. One other piece of information that became available this morning was the ADP report for private nonfarm payroll employment. That report showed an increase of 130,000. Looking at that report and thinking about our forecast of 20,000, we’d probably up our forecast to about 50,000 for the month, following our normal rules of thumb in responding to that. Quite frankly, I don’t think that particular piece of information would alter my view about the state of the labor market going forward. As we noted yesterday, we have seen a fair number of other indicators suggesting that there has been some softening in the labor markets. I think that is probably still the best bet going forward, so I don’t think at this point we would change too much our employment forecast. CHAIRMAN BERNANKE. Thank you. Are there any questions for Dave? If not, Brian, would you like to talk now? MR. MADIGAN. 5 Thank you, Mr. Chairman. I will be referring to the package labeled “Material for FOMC Briefing on Monetary Policy Alternatives.” Your policy decision today takes place against an unusually complicated and uncertain backdrop. Over recent months, reverberations from the contraction in the housing sector have 4 5 The materials used by Mr. Stockton are appended to this transcript (appendix 4). The materials used by Mr. Madigan are appended to this transcript (appendix 5). January 29–30, 2008 103 of 249 spread to the subprime mortgage market, to financial markets and institutions more generally, and now evidently to the broader economy. It seems clear, based on the Senior Loan Officer Opinion Survey and numerous other sources of information, that these factors are interacting, with mortgage-related writedowns and concerns about the economic outlook triggering a broad and substantial tightening of credit to businesses and households and the tightening of credit feeding back onto the housing market and the economy. At the same time, recent inflation performance has been disappointing, the near-term policy tradeoff appears to have deteriorated somewhat, and inflation compensation has risen. Meanwhile, investors have been rather skittish and, in the environment of heightened uncertainty, have sought more clarity in your communications and more assurance about policy prospects than you can reasonably provide. The combination of all these factors has left financial market prices unusually volatile. In these circumstances, the Committee faces a difficult task in reaching judgments as to the outlook and the balance of risks, gauging the appropriate policy course, and communicating your views to the public. To provide some assistance in your policy deliberations today, a box in the Bluebook explored the possible implications of addressing pronounced downside risks to growth through monetary policy, and the charts from that box are replicated in exhibit 1. The panels in the left-hand column consider the possible benefits of risk management under the assumption that a recession does develop. The recession considered in this exercise is the same as that examined in an alternative scenario in Part 1 of the Greenbook. As you may recall, that scenario was calibrated to match the typical degree of weakness relative to fundamentals in expenditures other than those for housing in six past recessions. The dotted line shows the results, as gauged using the FRB/US model, if the Committee were to respond to emerging evidence of an unfolding recession by adjusting policy in a manner similar to its past behavior, as captured by the staff’s estimated outcome-based policy rule. In this case, the Committee lowers the federal funds rate gradually to about ¾ percent by mid-2009. The unemployment rate peaks at about 6.1 percent, and inflation eventually falls below 1½ percent. The blue line shows the results that would be predicted if, instead, the Committee responded more aggressively. Here we have arbitrarily assumed that the Committee lowers the federal funds rate to 1½ percent this quarter and holds the rate at that level through the second quarter. From that point forward, it follows the outcome-based rule. If the recessionary conditions do eventuate, the timely policy stimulus moderates the downturn in activity, trimming about ¼ percentage point off the peak unemployment rate, and helps keep inflation from falling toward a region that some of you might find uncomfortably low. Although aggressive policy easing would help mitigate economic weakness, it would also raise the risk that policy could add unduly to inflation pressures should recessionary weakness not develop, a possibility explored in the right-hand column. The simulations underlying this column are carried out under the baseline Greenbook scenario. As shown by the blue line, the cost of an aggressive near-term easing in the absence of a recession could be limited if policymakers were to recognize quickly that the economy was not weakening to the degree feared and boosted the federal January 29–30, 2008 104 of 249 funds rate rapidly. In this simulation, the Committee increases the funds rate about 2½ percentage points in six months—that is, at a pace of more than 50 basis points per meeting—to around 4 percent. This prompt reversal brings the funds rate 1 percentage point above the baseline, providing an offset to the earlier period of excessively easy policy. In this case, core inflation would run slightly higher than baseline for a couple of quarters—as shown in the bottom right-hand panel by the distance between the solid blue line and the dotted black line—but would subsequently return to baseline. In contrast, as shown in the dashed red line, if policymakers were slow to recognize that no recession was in train and so reversed policy more gradually after the first two quarters—that is, in line with your historical behavior—considerable momentum could be imparted to economic activity, with the unemployment rate, the middle panel, running roughly ¼ percentage point below baseline into 2011. The cost of responding more aggressively to the risk of a recession in this case could be inflation that remains 0.1 or 0.2 percentage point above the baseline path for several years, the bottom right-hand panel. Concern about such an outcome could give you some pause as you consider how much insurance you wish to seek at this and coming meetings. Your concerns in this regard may also be exacerbated by the fact that the inflation picture seems to have deteriorated somewhat in recent months. Your current projections reflect some worsening of the inflation–output tradeoff, with more slack apparently required over the next three years to push inflation down toward what would appear to be your preferred outcomes. Also, as was discussed yesterday, fiveyear-forward inflation compensation increased notably over the intermeeting period. While there are reasons to question whether much of that rise represents an increase in inflation expectations, it might be due in part to a higher inflation risk premium, perhaps signaling that inflation expectations are becoming more loosely moored and are hence more prone to drift in response to various shocks. If you were particularly concerned about a possible unmooring of inflation expectations, you might be inclined toward alternative D, shown in the right-hand column of table 1, which is included as the next page. Under this alternative, you would hold the stance of monetary policy steady at this meeting but would indicate that the risks to growth remain tilted to the downside. However, based on the interest rate assumptions provided with your forecast submissions, the recommendations of most Reserve Banks to reduce the discount rate by 50 basis points, and your comments yesterday, it appears that most if not all of you see some easing today as appropriate. Consequently, I will dispense with a detailed discussion of alternative D. Rather, the questions for today’s meeting would seem to be not whether to reduce rates but how much and what to say about the outlook for growth, inflation, and policy. Under alternative C, the Committee would reduce rates 25 basis points today. The rationale section of the statement would note that financial markets remain under stress, cite the tightening of credit availability, and mention the deepening of the housing contraction and the softening of labor markets. With regard to inflation, the January 29–30, 2008 105 of 249 Committee would note its expectation that inflation should moderate, but it would also cite a range of factors that could put upward pressure on inflation. The statement would conclude by indicating that the policy action, combined with actions taken earlier, should help promote moderate growth over time, but it would also warn that downside risks to growth remain. The Committee might see alternative C as appropriate if it believes that some further easing of policy is warranted by the deterioration in the economic outlook and the associated risks but feels that a moderate move is preferable today, given the policy steps you have taken to date, the possibility that the fiscal stimulus could still turn out to be larger than currently envisaged, and questions about how firmly inflation expectations are anchored. Market participants currently put considerably greater odds on a 50 basis point move today than on a 25 basis point action. Moreover, market participants reportedly expect you to issue a statement similar to the January 22 announcement, but the addition of the sentence on inflation risks in the third paragraph would likely suggest to investors that you have significant concerns about inflation. The combination of a smaller-than-expected policy move and the statement drafted for alternative C would likely suggest to investors that monetary policy had shifted into an incremental mode. Shorter-term interest rates would likely rise somewhat, and equity prices could decline noticeably. Should the Committee see an outcome along the lines of the Greenbook forecast as most likely, it might be attracted to the 50 basis point easing of alternative B. Under alternative B, the Committee would issue an announcement that closely resembles the January 22 statement. However, the fourth paragraph would include a sentence indicating that the policy actions to date should help to promote moderate growth over time and to mitigate downside risks to growth. In the second sentence of that paragraph, the word “appreciable,” used in the January 22 statement, would be dropped from the characterization of the risks, presumably in recognition of the significant further adjustment of policy under this alternative. As discussed yesterday, the Greenbook-consistent measure of r* has declined more than 1¼ percentage points since the December meeting, to about ¾ percentage point. A 50 basis point move today would leave the real federal funds rate just below 1 percent, gauged on the same basis as our r* measure. Thus, by the r* metric, policy would remain slightly restrictive under alternative B, consistent with applying modest downward pressure to inflation going forward. Policymakers might view such a policy stance as appropriate if they saw the downside risks to growth as roughly balanced by the upside risks to inflation following such a policy action. However, given the views expressed in your economic projections—in particular, the assessment expressed by many that the trajectory for the funds rate would probably need to be a little lower in the near term than assumed in the Greenbook—it seems more likely that you would prefer the approach of alternative B if you believed that further easing will likely be warranted but should be implemented somewhat gradually, perhaps to provide time to assess the effects of the policy easing already put in place. With investors placing greatest weight on a policy choice at this meeting along the lines of alternative B, this approach would likely prompt relatively little January 29–30, 2008 106 of 249 reaction in financial markets this afternoon. Given recent developments, the Committee may place a larger premium than usual on avoiding policy surprises. If you have lowered your economic outlook even more sharply than the staff or if you see the downside risks as particularly large, you might not see moderation as a virtue and prefer to ease policy aggressively by 75 basis points at this meeting, as in alternative A. This approach would seem consistent with the concerns and policy assumptions expressed by many of you in your forecast narratives. Indeed, some of you have espoused a risk-management approach to policy in which the federal funds rate is lowered sharply in the near term to provide greater assurance of continued economic expansion and then that policy easing is reversed quickly once it becomes clear that risks are diminishing. As suggested by the risk-management simulations that I discussed earlier, this approach relies heavily on your ability to recognize promptly that the stimulus is not needed and to reverse field rapidly. Binary options on target fed funds futures suggest that, over the past few days, market participants have essentially priced out the possibility that you will take such aggressive action today. Thus, money market rates would likely decline sharply in response to implementation of this alternative, downward pressure on the foreign exchange value of the dollar could increase, and equity prices could rise somewhat, although any rally could be damped by a sense among investors that you were motivated to take this action by concerns about pronounced economic weakness. Obviously, a significant concern with a step of this magnitude today would be the possible implications for inflation expectations and inflation uncertainty. Although the relative contributions of various factors to the recent increase in inflation compensation can be debated, last week’s policy move seemed to be well understood at the time as a response to incoming evidence of a sharply deteriorating economic outlook. By contrast, the motivations for a larger-than-expected move today might be less clear to market participants, potentially elevating the risk of loosening the inflation expectations anchor. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Are there questions for Brian? Governor Mishkin. MR. MISHKIN. I would like to ask a question and possibly make a comment about the risk-management strategies. Am I correct in understanding that the treatment of expectations is basically backward-looking? MR. MADIGAN. That is correct, Governor Mishkin. MR. MISHKIN. So even though you know I am a fan of—well, let’s put it this way, you said moderation, and I am not a fan of moderation in many dimensions. But there is a potential January 29–30, 2008 107 of 249 cost here that is not articulated, which is that if there is a very aggressive easing and it has an effect on inflation expectations, then the more benign scenario that we have in terms of cost may not be there. This is one of the reasons that, if we think about a risk-management approach, we have to think about whether we can do it more systematically. What kind of communications would be attached to it? Also, what kind of information would we have to watch out for to make sure that we don’t unhinge inflation expectations? So although I think this is a terrific box and it was very, very useful, there is a bit of a qualm here. It is also very hard to model the issue of what would happen to expectations. So I am not complaining in any way about the usefulness of this; but we should have another concern, which is how we would manage inflation expectations if we pursued an approach like this. Thank you. CHAIRMAN BERNANKE. President Evans. MR. EVANS. Thank you, Mr. Chairman. My question is related to what Governor Mishkin just asked about. The risk-management analysis was very helpful; it was a very good addition, and it captures a number of things that we have talked about. One is sort of a quick policy reversal or the potential for that if things go well. My question is, How do you see the path of communications likely to evolve? What is it going to look like? What will it sound like if we are thinking about reversing policy, and we get to the bottom, and then we start taking it back a little more quickly than normal? A lot of times when we have done this before you heard the phrase that markets need to be prepared for this and they have to understand it. Would that somehow get in the way of the stimulus? I think this gets a bit at what Governor Mishkin was talking about in terms of expectations. In particular, do you have any thoughts about how the slope of the yield curve might help inform how people are going to be thinking about this? Are we going to move from something that is potentially inverted or flat to a rising yield curve that January 29–30, 2008 108 of 249 could inform a better outlook, and then raising rates could maybe in a parallel fashion move the yield curve up? I am just curious whether that could be helpful for the communications strategy. MR. MADIGAN. I think my response is that it is very difficult to say how your communications should or will evolve going forward at this point because of the very substantial uncertainty in the economic outlook, which shows up very clearly in the Committee participants’ economic forecasts. Presumably, what you say will depend on evolving circumstances. In terms of the yield curve, again, I think that is difficult. That will depend on the interaction of market participants’ perception of incoming economic information with their sense of your own policy reactions. MR. EVANS. I’m just curious if, in the path of this simulation, the yield curve behaves in that fashion or not. This gets at what the mechanism is for the stimulus. Is it to improve market liquidity, market functioning, long rates, or an expectation of short rates? If they start expecting a tightening, is that going to get in the way of something, and so we are going to view that as more difficult to move at that time? I think everybody is quite committed to the idea that we need to do the right type of policy reversal when it is called for, but it is going to be very difficult to identify in the moment. So the yield curve could help. MR. MADIGAN. In these simulations, the standard channels of monetary policy are working through things like the yield curve, asset prices, the foreign exchange value of the dollar, household wealth, et cetera. MR. EVANS. Thank you. CHAIRMAN BERNANKE. President Lacker. MR. LACKER. Thank you, Mr. Chairman. Brian, I want to compliment you and the staff for presenting these risk-management strategies. I think it is really useful for the January 29–30, 2008 109 of 249 Committee to see and think about these in terms of strategies rather than sort of one-off policy choices, and thinking through a sequence of actions like this is very, very helpful. Governor Mishkin asked about expectations and noted that they were backward-looking, and I wanted to ask about that. You guys have described to us before that there are firms and wage setters and then there are financial markets. Is there a forward-looking part in the financial markets, or is that backward-looking as well? MR. MADIGAN. The financial markets are forward-looking in these simulations. MR. LACKER. As you know, in applied macroeconomics, there is a range of approaches to handling expectations, and the rest of the range is filled out with more forwardlooking approaches. In this instance—in the instance of a recession—you hear and read a lot about recession. In fact, there was a story in the paper today about businesses preparing for a recession. So you get the sense that market participants might be understanding that this is a special episode of economic dynamics called a recession and look back to past recessions and think of it in sort of a forward-looking way. That to me, more than in the usual circumstances, heightens the value of thinking through or at least exploring the implications of a forwardlooking approach to expectations. I say that in particular thinking about these strategies because we get only a few trials on recessions. They are pretty rare, and so the inferences a set of market participants are going to make about recessions is going to be influenced by their past recessions. This is going to be the last chance to influence their perceptions about how we behave in the next recession. So I am really interested in thinking through our strategy for this recession from the point of view of, well, what if from now on market participants expect us to adopt the strategy that we do adopt in this. That is why I would like to see some analysis that says, “Well, all right, if this is the strategy and it is understood by agents that this is our strategy, how does the January 29–30, 2008 110 of 249 economy behave?” So we adopt a strategy, and it is one that we think we can sustain and one that we would like to choose again in the future if it is understood. Related to that, Governor Mishkin mentioned inflation and inflation expectations, and I was a little confused about the discussion yesterday because I always thought of us as wanting to minimize the distortion in the rate of return on money, and that suggests minimizing the rawreturn gap between nominal and real securities. So I am not quite sure that we don’t care nearly as much about the variance in inflation or the risk premiums due to inflation as we do about expected inflation. Is that your understanding when you guys think through optimal monetary policy? I know you do scenarios like that. I mean, how do the fluctuations and the variance in inflation fit in? MR. MADIGAN. I don’t think they fit in in a direct way. We still have a lot of work ahead of us, despite the progress that we have made in modeling in recent years, to consider things like the distribution of different economic outcomes and how skewness in those distributions, both with respect to output and with respect to inflation, would interact with riskaversion in monetary policymaking. I don’t think our science has quite gotten to that stage yet, but I agree that these are worthwhile things to study further. MR. LACKER. One thought I had in that discussion about expected inflation, you noted that the one-to-five-year rise in inflation hadn’t been affected much, but the five-to-ten-year rise had. If it is well understood by agents when going through something like a recession, which comes around only every once in a while, maybe it is ratifying current inflation and not bringing it down. You might expect that the inference would change about how inflation behaves in the next recession, which would come five to ten years from now. Wouldn’t it? January 29–30, 2008 111 of 249 MR. MADIGAN. I see the point you are making, and that sounds plausible. You know, again, our thought was that, if investors were concerned that monetary policy makers were making an inflationary mistake, it would begin to affect inflation in the near term, meaning within several years rather than seven or eight years ahead. CHAIRMAN BERNANKE. I have just a technical question on inflation expectations. You presented to us at some point a variation of the model in which the policy action itself was fed into the model for inflation expectations. Is that part of the model at this point? MR. STOCKTON. No. It is not part of the baseline model that we are running off of. MR. REIFSCHNEIDER. That is operating here very much. It is the same mechanism, but it works differently in the two cases, because in the case where the recession actually shows up, whether you take the gradualist approach or you take the risk-management approach, they see the recession, and the easing in monetary policy doesn’t surprise them very much, although we can take our risk-management approach and respond a bit more than usual. But then, things behave as they expect, and so not too much happens to inflation expectations. In the other case, in which recession doesn’t emerge, they say, “Oh, this was an easing that wasn’t expected,” and then it becomes critical how long you hold it. If you hold it and you get rid of it only gradually, then inflation expectations start to shift up. They think the Fed’s inflation goal has changed. In the case where you take it away quickly, they say, “Okay, you took it away quickly,” and so not much happens to long-run inflation expectations. CHAIRMAN BERNANKE. So the answer is that the funds rate is affecting inflation expectations in these simulations. MR. REIFSCHNEIDER. In both cases. But the question is whether it is viewed in the context of what is happening to output and inflation, whether they say, “Yes, that fits with the January 29–30, 2008 112 of 249 historical pattern of stabilization,” or whether, because the recession didn’t emerge, this looks as though it was after the fact an ease in policy that was not warranted. Then the question is, Do you take it away quickly, or do you take it away slowly? MR. LACKER. Okay. So in the case where we are doing the risk-management approach, do they understand that we are more likely to reverse course, or do they just mark down their whole expected path for policy? MR. REIFSCHNEIDER. No, they don’t know that you are more likely to reverse course in that case. So when you think of a communication strategy, which is not in these simulations, it says, “Oh, we’re going to do this, but in the event that the recession doesn’t occur, we will take it away more quickly than we might have based on historical averages.” But it doesn’t make too much difference in the simulation, because it is taken quickly. Just because the funds rate is down surprisingly low for a quarter or two, that is not long enough to have much of an effect on long-run inflation expectations in that simulation. What it would do in the real world is different. MR. LACKER. We are trying to model the real world. CHAIRMAN BERNANKE. Vice Chairman. VICE CHAIRMAN GEITHNER. There is a “castle in the sand” quality in this discussion. Let me make just three points on what I took from this and see if I got it right. One is, in the staff’s judgment, at 3 percent—in that view of the world, which is not way off from where the discussion was yesterday—policy is not providing any degree of insurance or accommodation against the adverse outcomes that may be ahead. The second thing I took away is that this framework seems like a good way of thinking about how you think about moving lower, how you think about what mistake we’re going to make or we want to make. We are going to make a mistake, but it is good to think about what January 29–30, 2008 113 of 249 mistake is more costly and what mistake is easier to correct. It seems to me it tells us almost nothing, frankly, about when we are going to be in a position where we are going to want to start to take it back. It also probably tells us very little about how quickly we are going to want to take it back. I would have thought that the most remarkable thing in these paths is how little difference the variance is in the outcomes a year out. I mean, they must be so far within the range of uncertainty in this context, and for us to start thinking now about how to design the optimal exit and communicate it, not just for President Evans’s reasons but many others, just basic humility, it seems to me kind of premature. I have a lot of sympathy for the fact that we will want to make sure that we are choosing which error we are going to make. I have a lot of sympathy for thinking through how we correct for that error. But for us to assert, because we are worried about the implications of that, that we are going to start focusing now on the design of the exit, sounds to me a bit like a statement of the obvious. Of course we are going to move with alacrity to take back and make sure those inflation expectations stay anchored at a reasonable level. Of course we are. To suggest otherwise and to assert it would look kind of insecure—a lack of confidence in what we are here to do. The third thing I took away from it is that it seems to say that, if you make policy in a way consistent with the response of this Committee over the past decade and a half or so, you have pretty good outcomes in the strategy in which you take out enough risk against the downside error. Now, life could be uncertain. Maybe that is too charitable to the past, but it seems to be kind of reassuring in that way. CHAIRMAN BERNANKE. I think that it is hard to generalize. You say there are so few recessions, so the specific communication that is undertaken—for example, in the last episode there was actually communication that leaned against the rapid reversal—you know, January 29–30, 2008 114 of 249 “considerable period” and so on. So rather than trying to generalize from two examples, I think it would much more have to do with how we present the outlook and communicate our intentions. Other questions for Brian? Governor Mishkin. MR. MISHKIN. Yes. I just want to make a comment about what President Geithner said and follow up on President Evans’s question. One thing that the simulation doesn’t get at is the adverse feedback loop. It’s just not built into the model. So the benefits of pursuing a riskmanagement approach are not as clear as they would be if they were included in the simulation. However, I would like to focus on President Evans’s issue because I think it really is critical. He asked about how we might know whether or not we should reverse and talked about things like the yield curve. But one thing that is important to recognize in this scenario is that I think it is very unusual in terms of this Committee’s past behavior. But I don’t know. Don, you are my man who is the ancient mariner here. Have we ever reversed this quickly in past episodes? MR. KOHN. By “this quickly,” what do you mean? MR. MISHKIN. What the path of the prompt reversal is. MR. KOHN. I think it depends. As the Chairman was saying, there hasn’t really been a typical recession. Right? We have had two recessions in the past twenty years, and I think in both cases we stayed down longer because of the circumstances. So in 1992-93, we had a zero real funds rate while the economy was growing for two years. Then when we started raising, we did raise very quickly. So I think that was mixed. I can remember presenting to the Board, as a staff member, charts in 1990 showing how interest rates always reversed with the trough of the recession, a couple of months this way, a couple of months that way. And that was just wrong. I mean, it was just a different circumstance because of the 50 mile an hour headwinds. So it is going to be very hard to set expectations about what we are going to do that will influence people January 29–30, 2008 115 of 249 in the future because each episode is so different. As the Chairman was saying, we were very worried in 2003-04 that people would generalize from 1994 and see us reversing rather quickly, so we got into this verbal gymnastics to try to modify their expectations because we thought the rapid reversal in that case would not be consistent with macroeconomic stability. This is a case in which we are just going to have to judge when we get to the circumstances what is necessary without knowing ahead of time what the pattern is going to be. MR. MISHKIN. So let me turn back to President Evans’s question because there is an issue about what kind of information might tell us that we took out insurance and then it wasn’t needed. I think some pieces of information that the staff has been looking at are relevant. Particularly important in this regard is that there are a lot of indicators of financial stress. What is different about this episode is that the reason we are so worried about downside risk is the financial strains, and there are a lot of pieces of information that the staff has been producing that could be very important in terms of looking at this. They have a financial—I don’t know what you call your indicator, but you have something that you have been using in your model, Dave, that takes up spreads and volatility and— MR. STOCKTON. Principal components. MR. MISHKIN. —principal components of these things. MR. STOCKTON. There are a lot of financial variables. MR. MISHKIN. Also an issue that the Chairman raised yesterday was that the housing market is a big component of our downside risk. The market’s concerns about future declines in housing prices are causing a very sharp decrease in demand for housing. That could turn around very quickly as well. Even now we should be thinking about these issues, and Governor Kohn’s use of the word “nimble”—I like “flexibility,” but I think “nimble” is probably a better word—is January 29–30, 2008 116 of 249 really I think key here. It is somewhat of a departure from normal—exactly what the Chairman said. This episode is different from past episodes. So we do need to start thinking about this, and the staff will need to think about exactly these issues. CHAIRMAN BERNANKE. President Poole, you had an interjection? MR. POOLE. Yes. I am older than Governor Kohn, so I can answer. [Laughter] MR. MISHKIN. It is not age. It is how long you have been in the System. MR. POOLE. 1958 was just about like that. MR. LACKER. Like what? MR. POOLE. Like that prompt reversal. MR. LACKER. Oh, interesting. MR. POOLE. It was very much a sharp V. CHAIRMAN BERNANKE. President Evans. MR. EVANS. I just wanted to point out that the reason I asked the question about how you think about the exit strategy is that, since we are putting a lot of discussion weight on the reversal, it is going to color how you think about the next move potentially, if not today then another day. So I think it brings the future into the present very quickly. CHAIRMAN BERNANKE. President Lacker. MR. LACKER. If I could just continue the dialogue with Governor Kohn. It has been observed by some that the past two recessions differ from previous post-war recessions in some key dimensions, and some have drawn the conclusion that it is the changing nature of the business cycle after the Great Moderation. Both have been characterized as shallow and longer lasting. I take the point that one’s inferences about a third instance are going to be very tenuous, naturally. But it is also natural to look back to those episodes and see what we can draw out of January 29–30, 2008 117 of 249 them. You mentioned headwinds in 1990, and we had some special stuff that kept us from raising rates with nimbleness in 2003 and 2004. To what extent do you think that is likely coming out of this episode, that the types of things that kept us from raising rates in the 1990s and in both of these episodes are likely to recur? VICE CHAIRMAN GEITHNER. May I answer that? MR. LACKER. Well, I asked Governor Kohn, but if he gets to respond. VICE CHAIRMAN GEITHNER. I will follow Don. MR. KOHN. I think we are really getting into the policy discussion right now, and the issue, really, will be the headwinds, the financial market restraint. So it is reasonable to think that we are facing at least 25 mile an hour headwinds. I also think that it is going to take a while for the headwinds to abate. It is going to take a while to rechannel these credit flows, to restart many of the secondary markets in mortgages. So my personal view is that I wouldn’t be surprised to see us having to run with a real federal funds rate that is below the historical average for some time. But as everyone has been saying, it is highly uncertain and very dependent on how the financial markets evolve and how the real economy responds to those markets. MR. LACKER. For follow-up before President Geithner responds, to the extent that we place greater likelihood on that, should these simulations suggest that we should take that into account in how rapidly we cut now? CHAIRMAN BERNANKE. I don’t think so. I would just point out that with the 1990-91 episode, inflation after the recession—after the whole episode was over—was significantly lower than in the period before it. So if there are headwinds that are bringing the economy below potential and are causing high unemployment, for example, there has to be a mechanism. Expectations have to be tied to something, and there has to be some way in which January 29–30, 2008 118 of 249 excessively low interest rates are stimulating inflation, through either commodity prices or wage pressures or some other mechanism. If those pressures aren’t there because of headwinds or some other factor, then unusually low interest rates will not by themselves create inflation. Vice Chairman, did you have anything else you wanted to add? VICE CHAIRMAN GEITHNER. I really couldn’t tell, President Lacker, what inference you were going to draw from that. But I would just reinforce the point that, if you are more worried and uncertain now about the magnitude of the headwinds and the duration, I think it has to mean that you err on the side of going lower sooner. But the main point is that we just don’t know much about it, and I think it is worth a lot of humility. I mean, think how surprised we have been by so much over this period, even with all our thinking through three years ago about alternative paths for housing. So I would just vote for humility. But the basic point is that we have to err on the side of being worried about reducing the risk that you end up with 75 mile an hour headwinds rather than 25 for a long period of time. CHAIRMAN BERNANKE. Could we start our policy round? President Pianalto. MS. PIANALTO. Thank you, Mr. Chairman. Like the Greenbook, my projection for the real economy incorporates a sharp decline in the equilibrium real fed funds rate. Given the large risks facing the real economy, I think we need to take precautions against having a restrictive fed funds rate target. I think a 50 basis point cut in the target fed funds rate today may be large enough to eliminate that possibility, although there is plenty of uncertainty around that estimate, as we have been discussing. Based on my analysis, comments from my business contacts, and what I have heard from all of you at this meeting, I feel very comfortable supporting this position today. The economic environment has been volatile and highly uncertain, and I realize that my outlook could change appreciably in the weeks and months ahead. I can imagine that my January 29–30, 2008 119 of 249 economic projections will evolve in a way that supports even further reductions in the fed funds rate target. At the same time, as I said yesterday, I am concerned about inflation risks and that they may now be elevated. I can also imagine scenarios that would lead me to want to pursue a more restrictive policy than would be appropriate based on the downside risk to growth alone. At some point, on the margin, inflation concerns could become my dominant concern. We know that inflation expectations play a crucial role in determining the inflation outlook. We have been talking about that. But, unfortunately, we don’t really know all that much about what it is going to take to unanchor inflation expectations. It is hard to know for certain how far out on the ice we can skate without needing to worry that the ice has become too thin. I know that we are bringing our best thinking to bear on this issue by developing diagnostic tools such as the decomposition of inflation compensation into its component parts, as we talked about yesterday and this morning. I hope that we are going to come to learn that these tools are useful guides to policy, but we just don’t have enough experience with them to know how much confidence to place in their estimates. Yesterday Governor Kohn told us about his conversation with Paul Volcker and that Paul Volcker told him that unfortunately we do have experience of seeing the erosion of public confidence in our ability to meet our price stability objective, and we know from this experience that it makes the attainment of price stability more costly. But today I support the policy directive expressed in alternative B. My concerns today are more with the downside risk to economic growth. Given what I know today, I think it is the right course of action. I have discovered during the past couple of weeks that I can be very nimble when it comes to the January 29–30, 2008 120 of 249 reduction in our fed funds rate target. If inflation developments require, I want to be just as nimble in the other direction. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Hoenig. MR. HOENIG. Thank you, Mr. Chairman. Given the discussion I have heard so far, it is apparent to me that we will most likely move to a 3 percent fed funds rate today. If we do so, I think we should be prepared to stop at this point and let the market work through the disturbances that only time and market adjustments will correct. While I would not pre-commit to no further cuts, I would give no hint of them either. I think that is important. The discussion we just had around this table is that we cannot know the future, there are always headwinds, and we will make a mistake. Therefore, we should limit ourselves to some extent. As I have expressed in this Committee before, I think we should narrow the range to which we are willing to move the fed funds rate. My judgment is that to move to levels outside the reasonable range that, yes, I know would be debated, but a reasonable range of neutral, is as likely to introduce disturbances into the economy as it is to moderate the economy’s performance. I find an approach to policy that focuses on the real equilibrium rate compelling. I think it is good theory, and it is common sense and can be explained to the public. I understand that we cannot observe the equilibrium rate, but we cannot observe the NAIRU, potential GDP, or most other criteria. The real rate is at least related to the policy tool that we focus on, which is interest rates. When you systematically move below or above the neutral rate, you systematically stimulate or restrict the economy. With that in mind, and since monetary policy works with a lag, I would recommend that we follow a policy in which we stop moving rates and let the market work once we are notably below or above the long-run neutral rate based upon a reasonable estimate. This is a credible approach to policy. Today, a nominal 3 percent fed funds January 29–30, 2008 121 of 249 rate would provide for an actual inflation-adjusted rate that is less than 1 percent. That is quite stimulative. That will serve to support the real economy as the financial sector adjusts, and it has to adjust. To stimulate the economy further at our current inflation rate is to invite, or at least to increase the probability of, higher inflation or encourage the next asset bubble or both, and it will undermine our credibility in the long run. Turning to the press statement, I have three brief comments. First, in paragraph 2, I would begin by putting the economic rationale before the financial market reference, which would most appropriately align our recent actions with our concern for the downside risk to the economy and place our concern for financial market stress in better perspective. Second, I believe that a detailed discussion of inflation risk may not be helpful at this time, and the less said the better. Therefore, I prefer the language in paragraph 3 of alternative B rather than any other of the options. Finally, I believe we should modify the risk assessment to provide more flexibility for future decisions. Most important, it should place less emphasis on the possibility of future rate cuts and better position us to return to a neutral position later this year and early next. Therefore, I would rewrite paragraph 4 along the lines that President Plosser suggested. To summarize, I suggest that we act at this meeting, explain our action as I suggested, and hold at that point. Thank you. CHAIRMAN BERNANKE. Thank you. President Rosengren. MR. ROSENGREN. Thank you, Mr. Chairman. I support alternative B, though I think a case can be made for alternative A. The Boston model indicates that even after a 50 basis point reduction, we still need more easing to return to an economy with both full employment and inflation below 2 percent. Taking out insurance against more-severe downside risks would imply even more easing than our baseline forecast. Given our recent move and the additional January 29–30, 2008 122 of 249 easing in alternative B, I am comfortable waiting to take more aggressive action only if incoming data warrant it. However, I will not be surprised if we find further action is indeed needed. What would be the arguments against taking an aggressive tack? Certainly, one argument might be that elevated oil and commodity prices and core inflation currently above 2 percent warrant a more restrained approach. However, I would note that in previous recessions the inflation rate has declined significantly, even in the 1970s, in the midst of historic surges in energy and food prices. Whether we skirt a recession or experience a recession, I expect core inflation to trend down. A potential second argument is that we have responded too slowly to the need for tighter policy in the past, so we should be more reluctant to ease in the present. While it may be true that we raised rates too slowly at the onset of previous expansions, I see no reason for this Committee to behave in a manner that it believes is suboptimal. As a Committee, we seem to have consensus on the importance of maintaining low inflation rates, and I am confident we have the will to raise rates with the same alacrity that we reduced them, should economic conditions warrant such action. CHAIRMAN BERNANKE. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. Since September, this Committee has lowered the federal funds rate 175 basis points. My estimate is that the real funds rate before any action today is 1 percent or slightly below that, and that is very low by historical standards. The slowdown in growth suggests that the equilibrium real rate really has fallen, and the Committee has appropriately allowed the nominal funds rate to fall as well. Do nominal rates need to go lower and, if so, about how much? Part of this depends on what you think the equilibrium real rate of the economy is now. The Bluebook indicates that estimates of r* vary considerably by the model and the process they use to calculate them. The 70 percent confidence interval around January 29–30, 2008 123 of 249 them is 3 percentage points. Moreover, the estimates of r*, as we talked a bit about yesterday, can be quite volatile. It troubles me that the estimate of r* consistent with the Greenbook has changed by 140 basis points from December to today. I am uncomfortable using an estimate that is so variable and so sensitive to stock markets as a guide to setting policy. I also want to note that the Bluebook indicates that the appropriate funds rate, based on a range of Taylor rule specifications, is anywhere from 40 to 120 basis points above where we currently are today. That includes forecast-based versions of the rule that rely on the weak forecast found in the Greenbook. While I don’t want to suggest that such guidelines are definitive, they do suggest that the current level of the fed funds rate is clearly accommodative and that we have taken out insurance against downside risk. When do we stop taking out more insurance? If we do cut 50 basis points today, which is the amount the market is expecting, it would bring, to my mind, the real funds rate down to below ½ percent. That is based on expectations of about 2½ percent inflation, which in fact may be conservative. To my way of thinking, that is a very accommodative policy by any standard. Moreover, I don’t believe that enough time has elapsed for us to realize the full effect of the cuts that we have already put in place. I share President Hoenig’s concern that only the market can solve many of the problems that we see out there, and we must give the market time and patience to do so. The last time real rates were this low was in 2003-04, when the real rate was in fact apparently negative. But that was different. Inflation was running around 1 percent or less, and our concern was possible deflation. Today, we are not worried about deflation in the near term. We are worried about inflation; inflation has been moving up. Lowering rates too aggressively in today’s situation would seem to me a risky strategy, fueling inflation; possibly setting up the next boom-bust cycle, which I worry about; and delaying the January 29–30, 2008 124 of 249 recognition of losses on bank’s balance sheets but not eliminating them. The main effect of the rate cut will be after the first half of the year, if the economy begins to recover. I think we need to be very cautious not to get carried away in our insurance strategies with lowering rates too much. In my view, we are on the verge of overshooting, and I worry about the broad range of consequences for our credibility and the expectations of our future actions such behavior may have. That is closely related to President Lacker’s comments about what people interpret that behavior to mean about what we may do in future episodes. But two things are even more important, in my mind, about what we may do and what we do today. First, we need to be very careful about our communications and not to excessively reinforce the market’s expectation that further rate cuts are coming. In particular, I would feel much more comfortable with supporting a moderate 25 or 50 basis point cut if the statement language today were more agnostic about the balance of risks, as I suggested in my memo before the meeting. The market interprets our saying that there are downside risks to growth as that we are planning to cut rates again. I do not think we should encourage those beliefs. I worry that the balance of risks portion of our statements has come to be a code for predicting the path of our federal funds rate. I think that is not a good position for us to be in, nor should we condone it. Given the Greenbook forecast, I don’t believe that negative real rates are called for, and signaling further cuts clearly sends the message that negative real rates are on the way, if not already here. When our forecasts are released, the public will get our assessments of the risks in our outlook. We don’t need to say anything more about it in the statement. That, of course, does not preclude us from cutting rates again if our forecast deteriorates further. But until it does, I am reluctant to encourage the perception that more rate cuts are forthcoming. January 29–30, 2008 125 of 249 Second, as I said in the last go-round, we need to be able to better understand how we are going to unwind these cuts that we have implemented as insurance against the macroeconomic effects and financial disruptions. Of course, this was the theme of the discussion we had before the go-round. Unwinding those cuts too slowly not only risks our credibility on inflation but also risks setting up the next boom–bust cycle. Hindsight, of course, is always 20/20, but as we discussed in Monday’s videoconference, the Fed’s being slow to raise rates back up after the deflationary scare was over in 2003 may indeed have contributed to the conditions we are facing today. Thus, it is crucially important, to my mind, that we do have a plan for unwinding the significant cuts we have implemented as insurance against the financial turmoil. If the market turmoil subsides, I believe this Committee needs to have clear signals as to what we are going to look at and what has to happen before we start to remove the accommodation. I believe that the Committee must undo the accommodation as aggressively as we put it in play. We need to determine what indicators we will be looking at to determine when that process should begin. When we know ourselves, we want to help the markets and public understand what our process will be as well. I strongly believe that we must be both credible and committed policymakers, and our communications must signal not a particular funds rate path but articulate and focus on the contingent nature of that path and help the public understand and appreciate the systematic part of our policies and our policy decisions. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. I think the best course of action today is to lower the fed funds rate by 50 basis points as in alternative B. I’ve heard cogent arguments that 50 basis points would be restrictive and likewise accommodative. Yesterday I had a chance to look at the disabilities-related display in the elevator lobby on the Concourse Level, and I took some January 29–30, 2008 126 of 249 comfort in the fact that many great people are or were bipolar. So whether it’s restrictive or accommodative, I can be convinced either way. I can live with the idea that this does not incorporate a great deal of insurance against the downside, provided that the language doesn’t preclude further timely action as we have been using the word “timely.” So regarding paragraph 4, my preference is for language that, first, serves to signal that the Committee is fully aware of the situation and not behind the curve, a signal that’s reassuring and confidence enhancing, and, second, preserves our nimbleness, our flexibility, meaning that it doesn’t preclude any options to respond to developments, including further moves and intermeeting actions. I think the straightforward phraseology “downside risks to growth remain” as opposed to what was suggested in alternative A, which included “may well,” is preferable because the alternative A language strikes me as a bit too clever and risks appearing out of touch. I also think that repetition of the “in a timely manner” language from the January 22 statement preserves the options to move in an intermeeting action if necessary. So I think alternative B language is acceptable because it is spare, straightforward, and familiar, and it’s the least likely to confuse the markets in the near term. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kohn. MR. KOHN. Thank you, Mr. Chairman. Like President Lockhart, I agree with the action and the language of alternative B. As I noted a few minutes ago, I don’t think a real interest rate of around 1 percent, which is where we would be after this action, is really all that aggressively low, given what we’re facing in financial markets and the uncertainty that’s constraining business and household behavior in terms of spending. I guess I wouldn’t obsess so much—a loaded word there—about where we are exactly relative to some estimate of the neutral federal funds rate. As President Plosser pointed out, our band of confidence around that is huge. It moves around a lot January 29–30, 2008 127 of 249 when it’s defined in the short-term, three-year window that the staff has been using, but I think we just need to concentrate on the forecast, where we think this path of rates would have us go. The forecast central tendencies that we looked at yesterday look like a pretty good set of tradeoffs between getting back to full employment and damping inflation. I think one message from this longer-term forecast exercise is where the Committee thinks the Taylor curve is and where we would like to end up on it in terms of trading off inflation and output variability. If I heard Brian correctly, these results encompass not only a fairly universal assumption of 50 basis points at this meeting but at least ten of the cases see further rate cuts after that. In my case, I assumed further rate cuts but that they would start to be taken back in 2009. So it seems to me, heading where we’re heading, and maybe even moving a little lower if circumstances permit over future meetings, is perfectly consistent and is consistent in the view of the majority of the Committee with some pretty reasonable outcomes for the economy given the shocks we’re facing and the circumstances we’re in, whatever it implies for where we are relative to some long-run neutral real rate that might pertain over ten or twenty years. Implied by that—and the Vice Chairman said this a few minutes ago—is that it’s not clear that the 1 percent real rate has much, if any, insurance built into it relative to the kinds of headwinds we’re facing. I agree that a 1 percent real rate is not sustainable indefinitely, but as I pointed out before, we ran with a zero real rate for two years in ’92 and ’93. I don’t think that had any adverse effects on inflation expectations at the time. We explained why we were doing it. We explained the circumstances that were forcing us into that. We kept our eye on inflation expectations. You might remember that at the time there was a lot of political pressure that we should lower the rate even further, and we resisted that pressure in part by keeping our eye on inflation expectations and making sure they weren’t moving higher. January 29–30, 2008 128 of 249 So if circumstances dictate, I think we could sustain, as the Greenbook has us doing, a 1 percent real federal funds rate for some time without any adverse effects on inflation expectations going forward. I don’t think 50 implies an unacceptable inflation risk. I think it’s consistent with the gradual reduction in inflation that we’ve outlined in our forecast. In these circumstances, we need to concentrate on addressing the economic and financial stability issues that we’re facing. That’s the bigger risk to economic welfare at this time than the risk that inflation might go higher, and the 50 basis points in my mind is just catching up with the deterioration in the economic outlook and the financial situation since the end of October. We are just getting to something that barely takes account of what has happened, with very little insurance. Now, I agree that if we got into a situation where we went lower, then these subtle tradeoffs between risk management and the inflation outlook would come into play, but I don’t really see them in play at the level of interest rates that I’m suggesting we be at at the end of this meeting under the current circumstances. I do agree with President Plosser. We need to think about the circumstances under which we would begin to take back the easing. In the staff forecast we don’t have to think about this for two years, if they’re right. But they may not be right, and if we go further and have insurance, then I think that’s a more important issue. One point that I took from President Evans’s discussion was that there might be a risk in talking about taking it back right now because it would undermine the effects of the ease you put in place. So as a Committee we need to think about the circumstances. It’s a very subtle and tricky issue. The Chairman can perhaps cover this in his testimony, and obviously we’ve talked about it. It must be reflected in the minutes. But going out front with hammering in public how we’re going to take it back is going to undermine the effects of the ease itself. So we can talk about those circumstances, but I think we need to be careful about overemphasizing the “taking it back” idea, particularly from the current level. January 29–30, 2008 129 of 249 I’m comfortable with the language of alternative B. I think the first sentence of paragraph 4 does help to say that we think we’ve done something considerable that’s going to be helpful. It is a change from the last thing we put out. Removing “appreciable” in terms of downside risk is also a change, and I agree with that. But I do think there are downside risks even after we move today, and it would be a mistake to avoid that topic. Those risks are still going to be there, even after the funds rate is 3 percent, until the financial markets begin to stabilize and for more than a few weeks. We had a bit of a head fake in October, right? They seemed to be stabilizing. We said the risks were roughly in balance, and then the financial markets collapsed. I think we need a period of stable financial developments so that we can gauge the effect on the economy before we go to a balanced risk statement. Right now the risks are still tilted toward the downside on real activity, and that should be our focus. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Yellen. MS. YELLEN. Thank you, Mr. Chairman. I support alternative B in the Bluebook. If we cut the federal funds rate a further 50 basis points today, we will have done a lot in just a week and a half, but I think these actions do represent an appropriate response to a substantial deterioration in economic conditions. As I said in my comments on the economic situation, I basically agree with the Greenbook forecast for this year and perceive the risks to be to the downside. With the fiscal package, a funds rate of 3 percent will likely promote growth in the second half of this year that’s moderate after a brush with recession in the first half. I’m comfortable with this action because I believe our inflation objective is credible, and I do have confidence that we will be able to reverse the accommodation we’re putting in place when it’s appropriate to do so. But our discussion does highlight the important point that alternative B seems to be appropriate monetary policy in the context of the modal forecast. It just brings the real funds rate down to the Greenbook estimate of January 29–30, 2008 130 of 249 neutral, around 1 percent. If the economy were to go into a recession, additional easing would be needed and would be appropriate. Also, as Governor Kohn and others have emphasized, alternative B still doesn’t seem to incorporate much of anything for insurance against recession. So, indeed, there is a case for doing more than B. There is a case for A, but I wouldn’t go there today. I think we can wait, and I think we can watch as developments unfold and monitor data. With respect to language, the skew in the risks toward a downside surprise and the possible need for insurance against that possibility, especially if we see some further deterioration in financial conditions—that strongly inclines me toward the assessment of risk sentences in alternative B with their asymmetry toward ease. We need to be absolutely clear, to state clearly today, that we recognize the continued existence of downside risk and communicate that we stand ready to cut further if necessary. Therefore, I would definitely retain the sentence in alternative B, paragraph 4, that states, “However, downside risks to growth remain.” However, I could see a case, following President Plosser’s suggestion, to substitute the wording from the last sentence of the December 11 statement to the wording in the last line in alternative B. That is, we could substitute the words “will act as needed to foster price stability and sustainable economic growth” for the words “will act in a timely manner as needed to address those risks.” This seems to me to be a small change that would, taken together with the new first sentence in paragraph 4, slightly dial down the perceived odds of further cuts relative to the proposed wording in B. Even without the change that President Plosser suggested, though, the fact that we have added the new first sentence in paragraph 4 does seem to me to change the wording of the assessment of risk enough relative to our intermeeting statement to communicate to markets that we will view future policy moves after the one today somewhat differently going forward. Today’s move and the intermeeting move are January 29–30, 2008 131 of 249 essentially catch-up, to put us where we think we need to be, and moves going forward will respond to the evolution that we see in the markets. CHAIRMAN BERNANKE. Thank you. President Poole. MR. POOLE. Thank you, Mr. Chairman. I can support alternative B, down 50 basis points, although as I’ll try to argue in a moment, I don’t think it makes a whole lot of difference whether it’s down 50 or down 25. I would support the Plosser recommendation on paragraph 4, and I would also note that the statement as it’s written recognizes the credit market problems and the housing problems, but it seems as though a critic from the outside might say it’s oblivious to the fact that inflation rose somewhat last year. So I would propose adding a sentence at the beginning of paragraph 3 along the following lines: “Although the inflation rate rose somewhat over the past year, the Committee expects inflation to moderate.” It seems to me that we should recognize the fact that inflation rose because it’s parallel with the recognition of what has been going on in the credit markets and in the real economy. Now, let me make a couple of fairly general comments. I’m very much of the view that the natural state of the U.S. economy is full employment and output growth at potential. That’s where the economy tends to gravitate, and firms and markets respond relatively quickly on the whole to shocks. A particularly good example was the shock of September 11. In the following three months, the companies shed a million jobs out of nonfarm payrolls, responded pretty quickly, and slashed production inventories, and in fact, it was that shock that ended up creating the case for that being labeled a recession. Without that, I don’t think it would have been labeled a recession. Anyway, the shock last August did not lead to a sharp retrenchment in the real economy. Putting housing aside now, it aggravated the housing problem that was already under way. Firms and markets are making many necessary adjustments. Housing starts are down. House prices are January 29–30, 2008 132 of 249 falling, which I think they have to do. Banks are raising more capital. Risk spreads are rising from abnormally low levels, and lots of other kinds of adjustments are occurring that need to be made and are ongoing. I just do not see in the data today the sort of “in your face” data suggesting that the economy is in recession. It might happen, but I don’t see it right now. We may not have the luxury of a policy that avoids recession. We don’t know that. Our choice may end up being whether we accept a mild recession this year or whether we follow a policy that is so expansionary that we end up with some further increase in inflation and a deeper recession later. I have no doubt where I come down. I would rather take the risk of a mild recession now rather than the risk of an increase in inflation and a larger recession later. Now, I said that I didn’t think that it made all that much difference whether we choose down 50 or down 25. A number of people have commented on the critical role of communications going forward to try to stabilize the situation, particularly the market’s expectations about the Federal Reserve’s monetary policy, and the burden here is going to fall primarily, 98 percent worth, on the Chairman. I think that we need heightened attention to longer-run concerns. So much of the market commentary seems to revolve around the possibilities of a recession, recession, recession. I don’t see very much attention to longer-run concerns. I think those longer-run concerns are important, and we need to emphasize them. I think monetary policy needs to be based on our best estimate of what is happening. We spin out alternative scenarios so that we are prepared for things that might happen, but the actual policy decision has to be based on our best guess as to what is, in fact, happening. I think that we are at risk that inflation expectations might rise. We monitor them closely, but once we start to see inflation expectations rising, it’s going to be difficult and costly to rein them in. It’s going to create a big problem for us. So we can take some comfort that it hasn’t happened yet—I don’t think it has happened—but that doesn’t say that we can leave that issue January 29–30, 2008 133 of 249 alone. I think that the recent policy actions and policy statements have not adequately balanced the near-term concerns over economic weakness or potential weakness and the longer-run inflation risks. Now, this is the question. Should we try to indicate to the market that it is now time for a pause in the funds rate target changes, assuming that we go down 50, given that we’ve now come down 225 since September? Should we try to give that direction? Well, let me recount a bit of history here, and some around the table, particularly Don, will remember this and may correct what I’m saying if I have the details wrong. The FOMC has really been struggling with this question of forward guidance since it first began to issue statements at the conclusion of every meeting. The first time we did it, we were using the bias or tilt language. The very first time we did it, there was a reaction in the marketplace that we regarded as excessive and undesired. That led to the communications committee that Roger Ferguson chaired. I sat on that committee, and Don was fully involved with that effort, which led to the balance of risks language. Now, my judgment is that, over time, the forward guidance that we’ve used in that balance of risk language has not been successful. There’s always a problem of putting the language in, and there’s always a problem of taking it out when you want to take it out without giving impressions that you really don’t want to give. We have always understood around this table that incoming data can change the situation, but the market doesn’t know when the incoming data will trump the guidance that is in the statement. Hence, I think that the statement or a more formal tilt or balance of risks language has created some of our communications problems. That was clear last fall, when we tried to give an indication that we thought we had done enough for the time being and it was overtaken by incoming data, and that created a lot of problems in the market in understanding where we were coming from. So it seems to me that we’d be better off focusing on as clear an explanation as we can of why we have taken January 29–30, 2008 134 of 249 the actions that we have. That’s the best chance we have of providing guidance to the market of how we might respond under similar circumstances in the future that we can’t predict. I think we need to concentrate on explaining the policy responses. The Committee’s task is—and again, as I emphasized, I think it falls principally on the Chairman—I’ll say to “restore,” because I don’t think that that’s an unfair word to use here, a greater degree of policy predictability. That cannot mean unconditional because we don’t know how the data and how events are going to move the world that we have to respond to. But we need to create a better understanding in the market of how the policy changes are conditional on incoming information, given the policy objectives that we share and that are given to us by the Congress. Thank you. CHAIRMAN BERNANKE. Thank you. President Evans. MR. EVANS. Thank you, Mr. Chairman. I favor 50 basis points today. I think that a 3 percent funds rate may be reasonably positioned for the economy given our forecast. That’s the Greenbook path assumption. That certainly seemed reasonable, and today’s data gave us no indication that reasonably changed that path. I, like President Geithner, did find it remarkable that risk-management paths were not really that different either way. Now, surely risks abound, and it’s tough to capture that in models, and I’m all in favor of humility. I just don’t know which direction humility argues for in this case—more action or less action. Anyway, those are my preferences. We have talked a good bit about the potential of reversing our policy action sooner than we often have done in the past. I just think that it’s going to be difficult in the moment. The Bluebook path that I’ve been looking at has this reversal starting when the unemployment rate is peaking. I think it’s unknowable that it is actually the peak. There will be a lot of uncertainty, but still, that’s the situation that we face, and so I sort of accept that. But because of that, I would prefer to be a little more careful about how far down we go. Three percent could be the bottom of a funds rate cycle. January 29–30, 2008 135 of 249 It’s very difficult to know. From here on out, I’d like to be hopeful for positive news but mindful of further deterioration that we would certainly act on. In terms of the statement, I guess from some discussions over the weekend, I wasn’t expecting to hear much movement in that. But the suggestions of President Plosser and President Yellen seem to make a lot of sense from my standpoint. So I think it would be nice if there were a little more discussion of that, and I thought President Poole’s suggestion on inflation was also helpful. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Lacker. MR. LACKER. Thank you, Mr. Chairman. Our Vice Chairman urges humility. I strongly support that. I agree with President Evans that it’s not obvious that the greater one’s humility, the greater one should favor ease. I think we should be humble about the path of inflation going forward, whether it’s likely to fall on its own. I think we should be humble about our understanding of the output gap. I think we should be humble about whether that’s even a sensible way to think about how real and monetary phenomena interact. The Phillips curve itself embodies a relationship. It is uncertain, but it embodies expectations of our future behavior. I think we should be humble about what those expectations are in the present circumstance. Times in the past when we’ve gotten in trouble on inflation have often been when we were oversolicitous about weak economic growth, and I think we should be humble about whether we’ve completely gotten past those inflation dynamics or not. I think we should be humble about the willingness of our future selves to reverse course, and a lot has been said about that. For some it seems to counsel greater ease now, but I think the opposite argument can be made that the extent to which we think we may be hindered or feel impeded in raising rates, even if we think it’s warranted in the future, should cause us to be more cautious about lowering rates now. It always seems in recoveries that there’s always January 29–30, 2008 136 of 249 something that looks fragile, that looks likely to threaten economic growth. You know, one month it will be the commercial paper market and CDO writedowns, and this month it’s monolines. There will be headwinds. I predict we’ll be talking about headwinds a fair amount in the next couple of years. But if those are genuinely going to impede us, we need to be realistic about that, and I think we need to take it on board now. I agree with President Poole. We need to be humble about our ability to prevent a recession. I think we should also be humble about the extent to which what we see in terms of both growth and financial markets is presumptively inefficient and needs remedial action on our part. You spoke several meetings ago, I think a year or two ago, Mr. Chairman, about our need to retain a concern about inflation but not be seen as inflation nutters. I think we need to care about financial fragility but not be fragility nutters. If left to my own devices, I could have chosen a 25 basis point cut today. I recognize that would surprise markets, but judging from the policy paths that you all have submitted for your projections, a whole lot of us think that we’re going to have to surprise markets some time in the year ahead. Having said that, I can support a 50 basis point cut now. But more broadly I think inflation is just going to have to keep influencing our policy path. I don’t think that episodes of weakness in real growth mean that we put part of our mandate aside. I think it has to temper the extent to which we lower rates and temper our behavior on the other side as well. As for semantic tactics, I support President Plosser’s suggestion, seconded by President Yellen, and I support President Poole’s suggestion as well. CHAIRMAN BERNANKE. Thank you. President Stern. MR. STERN. Thank you, Mr. Chairman. We had a fairly extended discussion yesterday about concerns about the condition of various financial markets and some financial institutions and their implications for the economic outlook, and I certainly share those. In this environment, I favor January 29–30, 2008 137 of 249 alternative B—a 50 basis point reduction in the federal funds rate target. My own forecast is below the Greenbook forecast for this year and next, and so my guess is that we’re going to wind up moving further before we’re done. But that said, I don’t have enough confidence in my forecast to advocate that we do more right now. As far as language of alternative B is concerned, I am certainly happy in general with what we have as written, and I share President Hoenig’s view, although perhaps for a different reason, that the less we say about inflation right now, the better. The reason is that, in some sense, we haven’t adequately expressed to at least some market participants that we understand where the risks lie right now. In trying to remind people that we are not inflation nutters but are serious about maintaining price stability, we’ve kind of garbled our message, in my opinion, and I think people in the marketplace know this central bank is committed to price stability. I don’t think we have to remind them with every statement. Thank you. CHAIRMAN BERNANKE. Thank you. President Fisher. MR. FISHER. Well, Mr. Chairman, I’ve seen the discount rate tally. I’ve listened carefully to all my fellow Presidents and to Governor Kohn. I suspect I know what your fellow Governors are going to recommend. I’m in a distinct minority at this table. This weekend, by the way, I searched the newspapers for something to read that didn’t have anything to do with either a rogue French trader or market volatility or what the great second guessers were blabbing forth at the chat show in Davos; and in doing so I happened upon a delightful article. I hope you saw it in the Saturday New York Times on the search for a motto that captures the essence of Britain. My favorite was nemo ne inclune lacet, which very loosely translated, I think, means “never sit on a thistle.” [Laughter] Well, that’s where I am. I’m going to risk sitting on the thistle of opprobrium January 29–30, 2008 138 of 249 for my respective colleagues by making the recommendation that we not change the funds rate and that we stay right where we are. Now, for the record, I would have supported last week’s 75 basis point cut for the reasons that it would put us ahead of the curve and bought adequate insurance against a recession. I told you that directly, Mr. Chairman, and I mentioned it to Governor Kohn as well. Judging by the policy rules on page 21 of the Bluebook, as well as by the adjusted rule that our economist Evan Koenig has developed in Dallas, we are, indeed, ahead of the curve from the Taylor rule standpoint as we meet today with the rate of 3.50. As was mentioned earlier, we have not been docile. We have cut rates 175 basis points in a matter of months, and we’ve taken some new initiatives that I think are constructive and useful. I’d like to see more along the lines of the TAF. To be sure, in the discussion that we had in that emergency meeting, I had the same concerns that President Hoenig expressed in the call, but with the wording change that was put forward by Governor Kroszner I ended up where President Hoenig did. I regret not voicing my discomfort with the penultimate sentence in the statement—the one dealing with appreciable downside risk after the move we took—as I felt that it undercut the potential effect of our decision. During that call, you may recall that I pointed out the pros and cons. I began my intervention on that call by saying that there’s a very fine line between getting ahead of the curve and creating a sense of panic. I also expressed concern of the need to be mindful of inflation, as many have at this table today. There are some critics who say we panicked in response to the market sell-off of that Monday. I do not believe that’s the case, and I don’t believe it’s the case because I find it impossible to believe. As I’ve said repeatedly in this room, other than in theory, markets are not efficient, and on the banks of the Hudson or the Thames or the Yangtze River, you cannot in practice satisfy the stock market or most other markets, including the fed funds futures market, in the middle of a mood swing. When the January 29–30, 2008 139 of 249 market is in the depressive phase of what President Lockhart referred to as a bipolar disorder, crafting policy to satisfy it is like feeding Jabba the Hutt—doing so is fruitless, if not dangerous, because it simply will insist upon more. But attempting to address the pathology of the underlying economy is necessary and righteous, and that’s what we do for a living, and I think we are best sticking with it. We’re talking about the fed funds rate. I liken the fed funds rate to a good single malt whiskey—it takes time to have its ameliorative or stimulative effect. [Laughter] But I’m also mindful of psychology, and that’s what I want to devote the remainder of my comment to, and then I’ll shut up. My CEO contacts tell me that we’re very close to the “creating panic” line. They wonder if we know something that they do not know, and the result is, in the words of the CEO of AT&T, Randall Stephenson, “You guys are talking us into a recession.” To hedge against that risk is something to them unforeseen, even after they avail themselves of the most sophisticated analysis that money can buy. CEOs are, indeed, doing what one might expect. They are tightening the ship. They’re cutting head counts to lower levels. They’re paring back capex where they can beyond the levels they would otherwise consider appropriate after imputing dire assumptions of the effects of housing. I’m going to quote Tim Eller, whom I consider the most experienced and erudite of the big homebuilders, which is Centex, who told me, “We had just begun to feel that we were getting somewhat close to at least a sandy bottom. Then you cut 75 basis points and add ‘appreciable downside risks to economic growth remain’ in your statement, and it scares the ‘beep’ out of us.” He didn’t use the word “beep.” These are his words, not mine. Imagine scaring a homebuilder already living in hell. The CEOs and CFOs I speak to from Disney to Wal-Mart, to UPS, to Texas Instruments, Cisco, Burlington Northern, Southwest Airlines, Comerica, Frost Bank, even the CEO of the felicitously named Happy State Bank in Texas, repeated this refrain, “You must see something that we simply do not see through our own business January 29–30, 2008 140 of 249 eyes.” They do see a slowdown. They are worried about the pratfall, as I like to call it, of housing. They’re well aware of California’s and Florida’s economic implosion and broader hits to consumer welfare across the national map. I recited some data points from those calls yesterday. But they do not see us falling off the table. They worry aloud that by our words and deeds we are inciting the very economic outcome we seek to cut off at the pass by inducing them to further cut costs, defer cap-ex, and take other actions to hedge against risk. They can’t fathom it but assume that we can. Our Beige Book contacts and the respondents to the business outlook survey in Dallas say pretty much the same thing. One of those actions is to fatten margins by passing on input costs. Now, I mentioned the rail adjustment factor yesterday, and I’m troubled by the comment that I quoted yesterday from the CEO of Tyson Foods. “We have no choice but to raise prices substantially.” I mentioned that Frito-Lay has upped its price increase target for ’08 to 7 percent from 3 percent. Kimberly-Clark notes that it is finding no resistance at all to increasing prices in both its retail and institutional markets, and I mentioned that Wal-Mart’s leaders confirm that, after years of using their price leadership power to deflate or disinflate the price of basic necessities— think about this—from food to shoes to diapers, they plan in 2008 to apply that price leadership to accommodate price increases for 127 million weekly customers. This can’t help but influence inflation expectations among consumers. I experienced a different kind of price shock two weekends ago, when I went to buy a television so I could watch President Rosengren’s football team demolish President Yellen’s. [Laughter] I was told that they had doubled their delivery and installation fees because of a “fuel surcharge.” Well, I reminded the store clerk that I had been there about the time of the Army-Navy game, around Thanksgiving, and that gas prices had not doubled since the Army-Navy game, and he said, “Mr. Fisher, we’re selling less, and we will take what we can get away with however we January 29–30, 2008 141 of 249 can get away with it.” With one-year-forward consumer expectations, according to the Michigan survey, already above 3 percent, everyone from Exxon to Valero to Hunt Oil and our own economists in the Greenbook telling me that oil is likely to stay above $80, and the national average price therefore above $3, this mindset really worries me. I’m going to add one more very troubling little personal anecdote. Driving home from work last week I heard a commercial for Steinway pianos. The essence of the advertisement was that manufacturing costs had increased and that you could buy a piano out of their current inventory at the “old price” that was in place in 2007; but come February 1, there would be sizable price increases, so you’d better purchase your piano quickly. It has been thirty years since I have seen advertisements to go out and buy now before the big expected price increases go into effect. Now, this is an isolated, little bitty incident, but I fear this may be just the beginning of the more pervasive use of this tactic. Everyone in this room knows how agnostic I am about the predictive value of TIPS and the futures instruments comparing TIPS with nominals, like the five-year, five-year-forward. I’ve sent around an eye popping chart that shows the predictive deficiencies of the professional forecasters that were tracked by the Philadelphia Fed. I know that dealers are telling us that inflation is contained, but I have spent many years in the canyons of Wall Street, and I would caution against their disinterest in the predictions that they offer. When I see that every measure of inflation has turned up, learn from studying the entrails of the last PCE that 83 percent of the items therein experienced a price upswing, consider the shortcomings of the few tools we have for evaluating expectations of future inflation, and then hear from microeconomic operators of the economy that, by golly, we’re going to take what we can while the getting is good, I can’t help but feel that we cannot afford to let our guard down by becoming more accommodative than we have already become with our latest move. January 29–30, 2008 142 of 249 Mr. Chairman, you know because we’ve talked about this that I’ve anguished over this. In fact, to be politically incorrect in a government institution, I have prayed over it. It is not easy to go against the will of the people you have enormous respect for, but I have an honest difference of opinion. I truly believe we have it right at 3½ percent right now. I think that, even with some important language changes, we risk too much by cutting 50 basis points at this juncture and driving the real rate further into what I perceive, even on an expectations-adjusted basis, is getting very close to negative territory. Mr. Chairman, I think we’ve gone as far as is prudent for now, and that 3½ percent, together with the other initiatives we’ve taken to restore liquidity, is sufficient. So I ask for your forbearance in letting me sit on the thistle of recommending no change. I do want to say as far as the language is concerned, since obviously we’re going to go with alternative B despite my vote against it, that I strongly recommend you consider the changes that were given by Presidents Plosser, Yellen, and Poole, and I would strongly advocate particularly at the end adding that we will act as needed to foster price stability and sustainable economic growth. I thank you for paring back alternative B, paragraph 3, in terms of getting away from discussing only energy, commodity, and other import prices. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Why don’t we take a coffee break and come back at 11 o’clock? Thank you. [Coffee break] CHAIRMAN BERNANKE. Okay. Why don’t we recommence. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. I support alternative B for several reasons, not least of which because it actually seems to reasonably capture what we talked about yesterday. So I think it has that benefit. To state the obvious, we are in a very tough spot. There are clearly risks on both sides of the mandate, and for folks who are of differing opinions, I don’t think that they would January 29–30, 2008 143 of 249 either deny the tough spot we’re in or say that we have a lack of worries on either side. I think President Geithner said in the Q&A at the beginning of this round that we’re choosing which policy error we’re prepared to make or, more charitably, we’re deciding where our worries are the greatest. It does strike me that alternative B does that reasonably well. To step back for just a minute, I think that the tough spot we’re in is a function of issues that were very long in the making and will take a long time to work out. That probably has two implications. First, as to what Governor Kohn said, it’s easy for me to feel more comfortable with our judgment by saying that we’ll be able to undo it really, really soon; but if it is going to take a long time for this to work out, I don’t want to take any false comfort in that. The other implication is that, when I say that this is long in the making, I mean particularly for financial institutions. It has taken them a long time to dig themselves into this hole for the credit-intermediation process to be as deeply disturbed as I take it to be at this point. So when I think about what policies we would make on the monetary policy front, I wouldn’t want to excuse or somehow allow them to get off scot-free; by going with alternative B, I don’t think that would be the case. Financial institutions have far more work to do than we have yet to do on monetary policy. I think they are further from recognizing where they need to get. That will take some time. In listening to other people’s perspectives on the elixir of a 3 percent fed funds rate, I think it would be a nice luxury to give 3 percent a chance, but it’s probably not practical for the following reasons. I have tried to convince myself that the monetary policy moves in the last nine or ten days were a one-time step-function change, by which we were setting a level based on where we think the real economy is, and we need to get back to normal monetary policymaking. I think dropping the word “appreciable” as in alternative B is one way to do so. The goal would be for monetary policy to get back to sort of normal business in tough times. January 29–30, 2008 144 of 249 Another point, just of commentary, is that, by taking this action along the lines of alternative B, it would be nice if we weren’t going to be lowering the value implied by the markets of where the rate will end up. So my support of alternative B is nonetheless with this worry as well—that the markets might think that we have more-dramatic actions and that we will have to go lower longer than is currently implied. I don’t mean to give them additional credit there, but I don’t think that we have a great alternative. As to the point about market expectations, I would note that we will—and necessarily at some level should—during the course of our next several meetings disappoint market expectations, and that is not something I think we need to run from. I think that will be part of the discipline function, but this is probably not the right time to do it. As a final point, alternative B is consistent with the narrative that we’ve started based on the data we saw in mid-December, based on the Chairman’s speech earlier this month, and based on our meetings over the past several weeks. It strikes me that it would be prudent at this time of financial stability risks and uncertainty in the markets for us not to add volatility—not to throw out a different nuance or try to be too clever. So while I have sympathy for some of the ideas and amendments that have been suggested in this discussion, we’ve come to a pretty tough place, as I said at the outset. It’s a tough fork in the road. We should all feel to some degree uncomfortable about the choice we make, but the choice we’re making today needs to be as clear as it can be. Even if we’d get some comfort in being a little cute, a little clever, and a little nuanced, I’m afraid we might be undoing some of the clear bet that we have to put on the table. So with that, I support alternative B as written. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. MR. KROSZNER. Thank you very much. I also support alternative B. I think by any measure 125 basis points of easing within a month is a lot and perhaps it is a nearly unprecedented January 29–30, 2008 145 of 249 level of insurance that this Committee has purchased in such a short period of time. But I think it makes sense to have done it in these circumstances because we have the risk of a substantial tightening of credit and financial market conditions. There are still lots of shoes that may be left to drop and, in Nellie Liang’s great phrase yesterday, “unplanned asset expansions can occur.” Just today we heard that UBS increased by $4 billion the report of their expected losses from what they reported last month, and that is not their final report. They’re not going to come out with the final numbers for another month, and so it’s certainly conceivable that more could be there. The SocGen situation is obviously another thing that is potentially unsettling, and so I think it’s very important to be buying some insurance, particularly when the slow-burn scenario that I’ve talked about for a long time is the one that I see as the most likely. There is not going to be just some immediate credit crunch or some immediate problem of impairment of capital at an institution. But just given the increase in the cost of raising capital, given the difficulty of getting things off the books, given that other things have to come on, or given just that the old securitization machines that at a given level of capital sustained a very high level of activity, which can’t be done now because you can’t get the things off the books, the machine can’t churn at the same rate that it did even with the same amount of capital. Then with all these other challenges, we have to be wary of that. So the fragility is still there. As we talked about before, we had some dramatic improvements in October, through early November of last year, and suddenly they reversed, and I just don’t feel comfortable that I understand where those went. That said, however, I think the very recent data that we have gotten provide just a glimmer of hope. I mean, we’ve had relatively low claims numbers. The ADP number was relatively low. I’m not sure how much information content is in that, but with the claims number it makes a notimplausible case that there wouldn’t be a dramatic negative number in the employment report and January 29–30, 2008 146 of 249 potentially it could be on the positive side. I don’t think GDP is quite so miraculous, as we heard the very humble Dave Stockton tell us that they nailed it. But also look at some of the places in which there was some weakness now that may come up next quarter. Over the next couple of quarters probably we’re going to see a payback in government spending, whether it’s through direct stimulus or through more expenditures on the military. The advance durable goods number, which no one really mentioned, was on the positive side. I don’t want to put too much weight on that, but it suggests that there are at least some mixed signals going forward. So I think that means that we need to leave our options open. We need to worry about those downside risks, but we shouldn’t dismiss the possibility that the forecast that Dave and the team have put out not only has nailed it for this quarter but also has not done such a bad job for the quarters going forward. That means we have to think a lot about what we want to say in the statement. How do we get that balance right? Clearly, it’s important that we take out the word “appreciable,” and the markets will see that. The concern that President Fisher raised is a real one. If we continue to talk about “appreciable risks” after 125 basis points of cutting in a month, I think that would be unsettling to market participants. But I think the markets are expecting us to take that back. Actually if I could just for a moment get clarification from President Yellen. My understanding was that what she suggested about the change to the fourth paragraph and the assessment of risk was to change only the last sentence back to the December 11 statement. MS. YELLEN. That’s correct. I was suggesting changing only the very last sentence. MR. KROSZNER. Which is different from what President Plosser proposed. MS. YELLEN. He proposed, as I recall, changing two sentences, eliminating the one that referred to downside risks and also changing the last sentence. I would not want to see the downside risk sentence eliminated; I would change only the very last sentence. January 29–30, 2008 147 of 249 MR. KROSZNER. Yes, I would agree that I would not want to see that sentence changed. I’m open to the possibility of simply changing the last sentence to go back to December 11. Now, that clearly would be taken by the market as a signal that we were moving back. Another proposal that has been put on the table is to add something about inflation concerns or acknowledgement of the inflation situation in the rationale, starting off with something like “although inflation pressures remain.” I’d probably end up coming down with President Stern on that—at this point, I’m not sure we gain that much by saying that. That is something we may need and want to say the next time that we undertake a policy action. I’m not sure it’s necessary to do so now, although if there were a strong desire to say something like “although inflation pressures remain,” I would not be opposed to that. But I do think it might be reasonable to at least consider moving back to the December 11 formulation for the last sentence of paragraph 4, but that’s certainly a step back. I don’t think that closes off options for us going forward, but I’m certainly open to those concerns because I don’t want to close those options off. Finally, on the broader issue of communications, particularly with respect to reversals, something that worries me is that there has been a lot of discussion about Japan. After they would provide more liquidity or a rate cut, they would say, “Well, we really didn’t want to do that, and we’re going to take this back as soon as we can.” So they kept providing more and more liquidity, and it had less and less effect. It was the classic pushing on a string. I think that shows the very important role of expectations. So at this point, given that I think we want to leave our options open, I don’t think we want to be emphasizing that. It’s extremely healthy for us to be discussing that internally, but until we see how things play out, I’m not sure it’s wise to do that because we could really undermine the effectiveness of our monetary policy actions. That is the last thing we want to do because that might force us to go down further than we would otherwise like and cause January 29–30, 2008 148 of 249 more volatility in the markets, more uncertainty with more potential for unanchoring expectations. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Mishkin. MR. MISHKIN. Thank you, Mr. Chairman. As you know from my discussion of the economy, I think that we’re skirting a recession, but I see very large downside risks. When we looked at the Greenbook, I agreed with the view that the equilibrium fed funds rate has dropped substantially, at least 125 basis points from the last FOMC meeting in December. When I think about a 50 basis point cut in this meeting, which is clearly the consensus of the Committee, my view is that it is consistent with the downward revision in the modal forecast but it does not take out any insurance; and this is something that the Vice Chairman alluded to before. So all else being equal, I would actually advocate a 75 basis point cut at this meeting because I do think there is a need to take out insurance. However, there are mitigating factors, so I do not feel as strongly as I did at the full FOMC meeting in December, when I took the view that we should take out insurance and aggressively cut more than the consensus of the Committee, but felt that dissent would not be helpful in terms of the perceptions of the Committee and the Federal Reserve and so was willing to vote with the majority. In this case, I don’t feel as strongly, so I am more comfortable with 50 basis points, although everything else being equal, I think that insurance is warranted, and I get nervous that we are not getting sufficiently ahead of the curve. So what are the mitigating factors that allow me to be more supportive of the consensus of the Committee? One is that I do worry that markets might think we are panicking. This is the issue that President Fisher raised. A 50 basis point cut would be a cut of 125 basis points in a month. There has been a lot of discussion in the media about our panicking on this, so there is a danger in this regard, and that is a mitigating factor for my not pushing hard for a 75 basis point cut. The January 29–30, 2008 149 of 249 second issue is that we saw a sharp move up in inflation compensation after the 75 basis point cut at the last conference call meeting. Actually there’s no evidence at all that this was a result of higher inflation expectations, but I do think it illustrated that there was more uncertainty about inflation and where our long-run inflation goals might be. This is a reason that the Committee needs to get to more clarity on our inflation objectives. You know, it is no surprise to people that I’m not completely happy with where we are now in terms of the range. Exactly in a situation like this, just as in 2003, you may drift up to the top of the band and be happy to stay there or drift to the bottom of the band and be happy to stay there. I do think there is a cost. This illustrates a cost to our communications strategy, and I hope we would reconsider that at some point in the future. The third mitigating factor is that there is an issue about taking out insurance when the Committee is not completely prepared and we have also not prepared the markets to think about how we might think about reversals if they were necessary in the future. The whole insurance strategy is one in which you can’t take out insurance and then have it be seen as always easing and thus unhinge inflation expectations and lose the strong nominal anchor. So the Committee has to think more about conditions under which it would reverse course and actually prepare the markets for that. As I said, there are two kinds of information that I think we get fairly quickly, along with others—particularly information on inflation expectations and information on whether financial market strains are easing. I think we need to clarify that in terms of the public. It is a point that Governor Kohn made, and I want to return to it in a second. But the bottom line is that I support the 50 basis point cut in the funds rate, so I support alternative B. On the statement, I am probably the only person who likes the alternative A, paragraph 3, rationale. But I am sympathetic to President Stern’s concerns—the less said the better—so I’m not going to push it. But I am comfortable saying that inflation expectations are currently well January 29–30, 2008 150 of 249 anchored and that there is some expectation of easing of slack in the economy, and so my view is that the upside risks to inflation are not the serious concern right now. I’d be willing to state that if it were me personally, but the issue that President Stern has raised that maybe the less said the better is fine with me. Again, I’m perfectly comfortable with alternative B as it is written now. One last point, which is to address an issue that Governor Kohn mentioned: I think he’s absolutely right that we should not be saying or thinking that we expect to reverse right now. Even if we actually did a 75 basis point cut at this meeting, which we’re not going to do, I would not take the view that it would mean that we plan to reverse it. When you put these projections out it’s tough to indicate that you would be willing to reverse but the reality is that we’re taking out the insurance because we think that the financial strains will last for a long time. That is our best prediction, and on that basis, to give an impression that we want to take it away would create problems. This is the issue that Governor Kroszner talked about in terms of Japan, where clearly expansionary policy was not working because they kept saying, “We’re going to take it back.” As a result, from the viewpoint of expectations, the policy was not expansionary. I do think policy needs to be expansionary at this point. However, I’m not sure that I agree that we should not talk about the issue of reversals. It’s a question of the way we talk about it. It’s not that we expect that we would be reversing quickly, but conditions could change, which we’re not expecting, but we really would like that to happen. We’d be hopeful, in particular, that the financial strain is turned around quickly, which in the past we have seen happen in some cases. In some cases, it takes a very long time. The episode in the early 1990s was one in which those financial strains took a very long time to dissipate. Similarly, we don’t talk about it as much, but in the early aftermath of the 2000-01 recession, there was a sequence of financial strains, particularly things like Enron and the lack of confidence, that lasted a heck of a long time. So I would say that we do need to think and talk about January 29–30, 2008 151 of 249 it, but it is not that we want to reverse it. We are ready to reverse, but the conditions must be such that we’re actually getting information that tells us that reversals are appropriate. Thank you very much. CHAIRMAN BERNANKE. Thank you. President Poole. MR. POOLE. Just very quickly, given the number of people who have talked about reversals, it seems to me that the minutes need to say something about it because the minutes have to be true to the ultimate transcript as published. CHAIRMAN BERNANKE. Vice Chairman. VICE CHAIRMAN GEITHNER. Thank you, Mr. Chairman. Let me just say that I am completely comfortable with the way you just framed the case, not just for thinking about and talking about strategies for how we take this back at the appropriate point, but I also don’t have any problem with the way you talked about how you’d frame it in public. I thought that was fine. When I talked about the need for humility, it was just in our capacity to design optimal strategies for the timing and the slope of the path to reversal at this stage. I think it’s going to require more time. A few things about the policy action and the statement. Obviously I support 50, and I support the language in alternative B, paragraph 4, as written. The Chairman laid out in public earlier this month a basic strategy that said that policy would be directed at providing an adequate degree of insurance against the downside risks, given the nature of those risks. It was said with more nuance and eloquence, but basically that was the thrust of the strategy. I think that the balance of evidence we have—even with all the uncertainty about what equilibrium is, what the appropriate level of the real rate is, and what it actually is—suggests that we have not gotten policy to that point. Therefore, getting that strategy in place is likely to require further action. It’s very hard to know when or how much. It’s very hard to know what should frame that choice now for us, I think. As January 29–30, 2008 152 of 249 many of you said, markets have to go through a further set of adjustments, and I think that has to work through the system. Our job, again, is not to artificially interfere with that process or to substitute our judgment for what the new equilibrium should be in that context. Our job should be to make sure that adjustment happens without taking too much risk that it tips the financial system and the economy into a much more perilous state that would be harder for us to correct and require much more policy response. There’s a big difference between a world in which housing prices fall 20 percent and one in which they fall 40. If everybody thinks they have to prepare for a world in which they fall 40, we’re going to take much greater risk that we have a scale of financial trauma and credit crunch that would produce the odds of a deeper recession. What we face now is not the choice, as I think President Poole said, between a mild recession now and higher-than-expected inflation over time. The risk we face, as the Chairman said several times, is the choice between a mild, short recession and a deeper, more protracted outcome. The scale of financial market fragility we now face, you could even say solvency in parts of the financial system, is a function of the confidence we create in our willingness to get policy to a point that provides meaningful protection against an adverse outcome. I think the experience of the past five or six meetings suggests that we cannot carefully enough design a message that can lean against expectations in the market about the likely path of policy that we judge to be excessive and that makes us uncomfortable without taking too much risk that it will just undermine confidence in our willingness to get policy right. We just don’t have that capability. We thought about it and tried it in lots of different ways, but everything we experienced over the past four months justifies the judgment that we can’t lean against those expectations without taking too much risk that we undermine confidence in our capacity to get policy to the point at which we’re giving some insurance. January 29–30, 2008 153 of 249 It would be a mistake to try to recalibrate expectations now relative to the stance of policy as stated in the Chairman’s statement and our statement last week. It would be a mistake to recalibrate back to a point that looks more like October. Everything we know suggests that it’s probable that the data will get still worse from here and that the financial markets will be in a state of considerable fragility and tenuousness for some time. To sort of zig at this meeting, to recalibrate more toward a sense of balance in the face of that reality, just means that we’re likely to have to zag back again. I just think that would risk our looking as though we’re ambivalent and have to correct again because of that. That would just be uncomfortable. It’s hard to know—I think Governor Kroszner said it right in many, many meetings—whether we face the risk of a grinding, downward, self-reinforcing set of pressures on balance sheets that raises the risk of deeper trough in housing and creates more caution and deleveraging and the economy moves slowly down or whether we face the risk of much more acute cliffs in asset prices with much greater consequences for confidence and the fragility of the financial system. It is hard to know, but I think both would be very uncomfortable for us. Again, I strongly support the language in B as it is. Even though I understand the rationale, I’d be very uncomfortable with dialing back that statement as it now exists to something that suggests we’re closer to balance. CHAIRMAN BERNANKE. Thank you, and thank you all. Let me make a few comments. The recent period has been more ragged in terms of policy and communications than I would have liked. In particular, during the past few months I think a perception has developed that we are tentative and indecisive and are not communicating clearly enough to the markets and to the public. Now, whether that’s fair or not, that perception is there and has to be addressed. I think we have begun to address it with our recent communications and the strong policy action that we took last week. For my part, I plan to speak more often and more clearly in public about the economy and January 29–30, 2008 154 of 249 our policy strategy, and to do that I will need your continued thoughtful input and support. All that has happened notwithstanding, I think we now have the opportunity to get policy to about the right place. As we have all noted, the pace of economic activity appears to have slowed sharply around the turn of the year. I am very hopeful that the labor market report this Friday will be positive. However, as I mentioned yesterday, there is as yet no evidence whatsoever that the housing market is stabilizing, as the new home sales data show. So long as house prices keep falling, we cannot rule out some extremely serious downside risks to our economy and to our financial system. We need to be proactive and forceful, not tentative and indecisive, in addressing this risk. I recommend a 50 basis point cut at this meeting, to 3 percent. This is the value that the Greenbook forecast requires to achieve modest growth later this year and price stability by next year. A decline of 225 basis points since last August fits well with both constructed indicators, like the staff’s medium-term r*, as well as market indicators such as short-term nominal interest rates. A 3 percent funds rate is lower than most Taylor rule prescriptions, but the Taylor rule makes no allowance for current unsettled conditions in financial markets, including spreads and bank capital constraints, which make a given value of the funds rate less accommodative today than it would be in normal circumstances. In contrast, the Greenbook analysis attempts to take those financial conditions into account. Even at the 3 percent level, assuming that the Greenbook analysis is in the right ballpark, we would be making little or no allowance for risk-management considerations, as several people have pointed out. For that reason, it’s instructive to note that the Greenbook has a flat path that doesn’t reverse, and the reason is precisely that they’re in a certainty-equivalent framework without any insurance having been taken out. If you accept risk-management principles, then we should be considering the possibility of cutting below 3 percent and then reversing when January 29–30, 2008 155 of 249 that insurance is no longer needed. However, 125 basis points of ease in two weeks is certainly a good amount, and I don’t think that going further at this time is advisable. Regarding the statement, I recommend alternative B. It is very similar to our statement of last week in the description of the economy. There are two main differences, both in paragraph 4. First, and very important, we acknowledge our two recent policy actions, including today, and note that they should lead to moderate economic growth and to mitigation of risks. The latter part is strictly true because a cut will certainly mitigate risks, but it may be read to say that we think we’ve taken out a little insurance, which is, as I said, somewhat debatable. That’s something we can discuss in the future. Second, the downside risks are no longer described as “appreciable.” I think both of these steps will serve to moderate expectations of further rate reductions by indicating that we think that our actions thus far go a substantial distance in addressing the downside risks. I strongly counsel, however, against taking out the sentence referring to downside risks. First of all, it’s not plausible that downside risks that were appreciable just last week are no longer an issue today; and indeed, in the projections that we’ve submitted, the Committee overwhelmingly saw a downside risk to economic growth. We have to be honest about that. Second, although I realize what the intent of that change would be, which would be to say that we’re not promising further cuts, it could actually be read in quite the opposite way, which is that we are saying we’re not making further cuts even if the conditions warrant, and that would put us back in the situation we were in at the end of October, when the market was confused about whether or not we were willing to respond to circumstances. We have to maintain a posture of flexibility and responsiveness in this fluid situation, and drawing a line in the sand is not the way to do that. I’m also reluctant to make the other changes that have been suggested. I understand the purposes behind them, but I’m very conservative about changing wording that has just been used a week ago in a January 29–30, 2008 156 of 249 statement and less than three weeks ago in my speeches. It’s just so risky to give the impression that we are changing course when we have just simply now identified the downside risk and have taken aggressive action in that direction. Now, I understand that several of you will be quite unhappy with the nature of that statement, and let me try to reassure you in the following way. Rather than trying to convey all the subtleties of our policy strategy in the statement—and here I agree with President Poole, who has pointed to the limitations of the statement—I propose to supplement the message of the statement, as I said, by commenting more on the economy and the policy in public speeches and in testimonies. Between now and the next FOMC meeting I have a testimony the week after next, I have the Humphrey-Hawkins testimonies, and I have a speech, and in each of those I will talk about the economy and the policy strategy that we are taking. In particular, subject to your counsel and individual, perhaps even collective, consultation, in my public speaking I will try to make three main points. First, I will try to reinforce the message of the statement, which is that the Federal Reserve recognizes the downside risks to economic activity and we are on the case. We have already moved aggressively and proactively, and we are prepared to respond in a timely manner as needed to mitigate the risks of very bad outcomes. Conveying the message that the Fed will be active and willing to mitigate tail risk is critical for achieving financial stabilization, which in turn is necessary for achieving economic stabilization. We have to show that we’re in touch. But—and let me now address these points in particular to President Plosser and others who have raised concerns—the second point I will make is that the Fed is not on autopilot for further rate cuts. Monetary policy takes time to work, and our recent actions will do little for the economy over the next few months. Thus, some weak economic news is to be expected in the near term and is not a prima facie case for January 29–30, 2008 157 of 249 additional easing. Instead, we will be data-dependent in the specific sense that we will respond to the incoming information that affects the medium-term outlook and to our assessment of the risks. The third point I will make in my public comments is that, to the extent that we are being proactive in addressing downside risks to the economy, we must also be proactive in removing accommodation once the economy is on a sustainable recovery path, and we must be clear about the circumstances that will prompt that reversal. Again, in saying this I reiterate that it’s not clear that we have yet taken out a great deal of insurance; nevertheless, I think that point needs to be made. The need for making a policy reversal at an appropriate point, which may not be the next six months but when the conditions warrant, is important; moreover, I think it’s actually credible. If you look at the dealer surveys or the fed funds futures, they show a hockey stick. They do show a response and then change, coming back later this year or next year. So that’s what I’d like to do. I’d like to be conservative with the statement. Given some of the problems we’ve had, I don’t want to do any right turns or U-turns or add any confusion. I want to continue on message in terms of where we have been in the past few weeks. But recognizing the subtleties of our policy approach, the concerns that we have about inflation and about financial conditions and economic growth, I will be making a concerted effort to try to explain in public the subtleties of our strategy and of our economic outlook. I hope we can present a united front to the public behind the strategy to the extent possible. Again, I appreciate your support and understanding of the very difficult pressures and conflicting forces that we face. So that’s my recommendation. I would be happy to take any further comments. If none, Debbie, can you call the roll? MS. DANKER. Yes. The vote is on the language for alternative B as it is in the Bluebook and in Brian’s handout and on the directive from the Bluebook, which I will read. January 29–30, 2008 158 of 249 “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 reducing the federal funds rate to an average of around 3 percent.” Chairman Bernanke Vice Chairman Geithner President Fisher Governor Kohn Governor Kroszner Governor Mishkin President Pianalto President Plosser President Stern Governor Warsh Yes Yes No Yes Yes Yes Yes Yes Yes Yes CHAIRMAN BERNANKE. Thank you very much. We’ll take just a very quick recess for the Governors to meet, and then we’ll come back for our presentation. [Meeting recessed] CHAIRMAN BERNANKE. Okay. Let’s reconvene. We have a special presentation on policy issues raised by financial crisis. Let me turn to Pat Parkinson to introduce the presentation. MR. PARKINSON. 6 Thank you, Mr. Chairman. The first exhibit provides some background on efforts to analyze the policy issues raised by recent financial developments and an overview of today’s briefing. As indicated in the top panel, in response to a request from the G-7, at its meeting last September the Financial Stability Forum (FSF) created a Working Group on Market and Institutional Resilience. The working group’s mandate calls for it to develop a diagnosis of the causes of the recent financial market turmoil, to identify weaknesses in markets and institutions that merit attention from policymakers, and to recommend actions needed to enhance market discipline and institutional resilience. The working group has been asked to prepare a report for consideration by the FSF at its meeting in March so that the FSF can complete a final report to the G-7 in April. The President’s Working Group on Financial Markets (PWG) is conducting its own analysis along the same lines and will ensure coordination among the U.S. members of the FSF working group. Chairman Bernanke, Vice Chairman Kohn, and President Geithner asked the Board’s Staff Umbrella Group on Financial Stability to organize and coordinate staff support for their participation in the FSF working group and the PWG’s effort. Specifically, they asked the 6 The materials used by Mr. Parkinson, Mr. Gibson, Ms. Hirtle, Mr. Greenlee, and Mr. Angulo are appended to this transcript (appendix 6). January 29–30, 2008 159 of 249 staff to analyze the nine sets of issues listed in the middle panel. Subgroups of staff from the Board and the Federal Reserve Bank of New York were formed to address each set of issues, and work is well under way on all of them. The first four of these issues will be discussed in today’s briefing. As shown in the bottom panel, today’s briefing will consist of three presentations. I will start by presenting a diagnosis of the underlying reasons that losses on U.S. subprime mortgages triggered a global financial crisis. This diagnosis will suggest that among the most important factors were (1) a loss of investor confidence in the ratings of structuredfinance products and asset-backed commercial paper (ABCP), which caused structured-credit markets to seize up and ABCP markets to contract, and (2) the resulting losses and balance sheet pressures on financial intermediaries, especially many of the largest global financial services organizations. In the second presentation, Mike Gibson and Beverly Hirtle, to my left, will present an analysis of issues relating to credit rating agencies and investor practices with respect to credit ratings. Then, further to my left, Jon Greenlee and Art Angulo will make the final presentation, which will focus on risk-management weaknesses at large global financial services organizations and the extent to which bank regulatory policies contributed to, or failed to mitigate, those weaknesses. I should note that also at the table today we have Norah Barger, who worked with Art Angulo on the regulatory policy issues, and Brian Peters, who worked with Jon Greenlee on the risk-management issues. Turning to the next exhibit, the diagnosis begins with the extremely weak underwriting standards for U.S. adjustable-rate subprime mortgages originated between late 2005 and early 2007. As shown by the solid line in the top left panel, as housing prices softened in 2006 and 2007, the delinquency rate for such mortgages soared, exceeding 20 percent of the entire outstanding stock by late 2007. In contrast, the dashed line shows that the delinquency rate on the stock of outstanding fixed-rate subprime mortgages increased only 2 percentage points over the same period, to around 7 percent. Nearly all of the adjustable-rate subprime mortgages were packaged in residential mortgage-backed securities (RMBS), which were structured in tranches with varying degrees of exposure to credit losses. The top right panel shows indexes of prices of subprime RMBS that are collateralized by mortgages that were originated in the second half of 2006. The blue line shows that prices of BBB minus tranches already had fallen significantly below par in January 2007 and continued to decline throughout last year, falling to less than 20 percent of par by late October. Prices of AAA tranches (the black line), which are vulnerable only to very severe credit losses on the underlying subprime mortgages, remained near par until mid-July, but they slid to around 90 percent of par by early August. After stabilizing for a time, they fell more steeply in October and November and now trade at around 70 percent of par. As shown in the middle left panel, from 2004 through the first half of 2007, increasing amounts of subprime RMBS were purchased by managers of collateralized debt obligations backed by asset-backed securities—that is, ABS CDOs. High-grade CDOs purchased subprime RMBS with an average rating of AA, whereas mezzanine CDOs purchased subprime RMBS with an average rating of BBB. The middle right panel shows the typical ratings at origination of high-grade and mezzanine CDOs. In the case of high-grade CDOs, 5 percent of the securities were rated AAA, and a further 88 percent were “super senior” January 29–30, 2008 160 of 249 tranches, which would be exposed to credit losses only if the AAA tranches were wiped out. Even in the case of the mezzanine CDOs, the collateral was perceived to be sufficiently strong and diversified that 14 percent of the securities issued were rated AAA at origination and 62 percent were super senior. As delinquencies mounted and prices of RMBS slid well below par, the credit rating agencies were forced to downgrade (or place on watch for downgrade) very large percentages of outstanding ABS CDOs. The bottom left panel shows that such negative actions were quite frequent throughout the capital structures of both highgrade and mezzanine CDOs, even among the AAA-rated tranches. Moreover, the downgrades frequently were severe and implied very substantial writedowns, even of some AAA tranches. When this became apparent to investors, they lost not only faith in the ratings of ABS CDOs but also confidence in the ratings of a much broader range of structured securities. Likewise, sophisticated investors who relied on their own models lost faith in those models as writedowns significantly exceeded what the models led them to expect. As a result, large segments of the structured-credit markets seized up. In particular, as shown in the bottom right panel, issuance of all types of non-agency RMBS declined substantially over the second half of 2007. Although comprehensive data for January are not yet available, conversations with market participants suggest there has been very little or no issuance. Your next exhibit focuses on two other markets that were affected by a loss of investor confidence—the leveraged-loan market and the ABCP market. The top left panel of that exhibit shows that spreads on credit default swaps on leveraged loans (the solid black line) already had come under significant pressure in June. By July these spreads had widened about 150 basis points. Investors had become concerned about a substantial buildup of unfunded commitments to extend leveraged loans (the dashed blue line), which in the U.S. market eventually peaked at $250 billion in July. As shown in the top right panel, as many segments of the structured-credit markets seized up, issuance of collateralized loan obligations dropped off significantly in the third quarter, adding to the upward pressure on spreads on leveraged loans. Nonetheless, the CLO markets continued to function much more effectively than the non-agency RMBS and ABS CDO markets. As shown in the bottom left panel, from 2005 to 2007, the U.S. ABCP market grew very rapidly. Much of the growth was accounted for by conduits that purchased securities, including highly rated non-agency RMBS and ABS CDO tranches, rather than by more traditional “multi-seller” conduits that purchased short-term corporate and consumer receivables. As investors became aware that some of the underlying collateral consisted of RMBS and ABS CDOs, they pulled back from the ABCP market generally, even to some extent from the multi-seller programs. Between July and December, total ABCP outstanding declined about $350 billion, or nearly one-third. The bottom right panel provides additional information on the growth of ABCP by program type. As shown in the first column, during the period of rapid growth from 2005 to July 2007, ABCP issued by structured-investment vehicles (SIVs) and CDOs grew far more rapidly than any other program type. The second column shows that, when investors pulled back from the ABCP markets, those program types shrank especially rapidly. The only program type that declined more rapidly during that period was single-seller programs. The single-seller category included a significant amount of paper issued by nondepository mortgage companies to finance mortgages in their private securitization pipelines, and this paper has almost completely run off. January 29–30, 2008 161 of 249 The next exhibit focuses on how the seizing-up of structured-credit markets and the contraction of ABCP markets adversely affected banks, especially many of the largest global banks. As you know, a combination of balance sheet pressures, concerns about liquidity, and concerns about counterparty credit risk made banks reluctant to provide term funding to each other and to other market participants. The top left panel of exhibit 4 lists the principal sources of bank exposures to the recent financial stress: leveraged-loan commitments, sponsorship of ABCP programs, and the retention of exposures from underwriting ABS CDOs. The top right panel shows the banks that were the leading arrangers of leveraged loans in recent years. The three largest U.S. bank holding companies (BHCs) head this list. As spreads widened and liquidity declined in the leveraged-loan market, these banks became very concerned about potential losses and liquidity pressures from leveraged-loan exposures. Although these exposures were smaller at the U.S. securities firms, those firms were even more concerned because of their smaller balance sheet capacity. However, to date the adverse impact on banks and securities firms from these exposures has been relatively modest and manageable. The middle left panel shows the leading bank sponsors of global (U.S. and European) securities-related ABCP programs—that is, programs that invest in asset-backed securities, including SIVs, securities arbitrage programs, and certain hybrid programs. As the conduits that issued the ABCP encountered difficulty rolling their paper over, many of these banks, fearful of damage to their reputations, elected to purchase assets from the conduits or extend credit to them, which proved in many cases to be a significant source of balance sheet pressures. This list is dominated by European banks. Indeed, the only U.S. bank among the top nineteen sponsors is Citigroup. However, Citigroup was the largest sponsor of SIVs, which, in addition to issuing ABCP, issue substantial amounts of medium-term notes. Citigroup, like nearly all SIV sponsors, eventually felt obliged to provide full liquidity support for all the liabilities of its SIVs, which amounted to around $60 billion at year-end. The memo item shows that some other U.S. banks sponsored securities-related ABCP programs that were relatively small in absolute terms but significant as a share of their total assets. But losses from leveraged-loan commitments and conduit sponsorship have paled in comparison to the losses some banks and securities firms have incurred from the retention of super senior exposures from ABS CDOs. These include exposures that the underwriters never sold, exposures that originally were funded by ABCP issued by the CDOs that was supported by liquidity facilities provided by the underwriters, and relatively small amounts of exposures purchased from affiliated money funds for reputational reasons. The middle right panel shows the leading underwriters of ABS CDOs in 2006-07. Merrill Lynch, Citigroup, and UBS head the list. Each of those firms has suffered very large subprime CDO-related losses, and Citigroup and UBS still reported very significant exposures at year-end. As shown in the memo items, among the other very largest U.S. bank holding companies, only Bank of America has suffered significant losses or still has significant exposures from underwriting ABS CDOs. I should note that the exposures shown in the exhibit are net of hedges purchased from financial guarantors, and most of these firms have hedged a significant portion of their exposure. As you know, there are concerns about the ability of the guarantors to honor their obligations under the hedging contracts. Indeed, some firms have begun to write down the value of their hedges with the most troubled financial guarantors. January 29–30, 2008 162 of 249 The bottom left panel shows total risk-based capital ratios for the four largest U.S. bank holding companies. All four remained comfortably above the 10 percent minimum for wellcapitalized companies at year-end. Of course, Citigroup was able to do so only by raising substantial amounts of capital at a relatively high cost, and each of the other companies also announced capital-raising efforts. Moreover, Citigroup’s year-end ratio of tangible common equity to risk-weighted managed assets was 5.7 percent, well below the 6.5 percent target ratio that several of the rating agencies monitor and that Citigroup seeks to meet. The bottom right panel shows credit default swap spreads for the three largest U.S. BHCs. On balance, spreads for all three have moved up about 60 to 70 basis points since the market turmoil began. The spread for Citigroup has been elevated since October, when investors began to become aware of its subprime CDO exposures. The spreads for Bank of America and JPMorgan were in line with a broad index of bank spreads at year-end but jumped in early January on Bank of America’s announcement of its planned acquisition of Countrywide and JPMorgan’s announcement of substantial additions to its loan-loss reserves. Spreads for all three companies fell back more in line with the index last week. Thank you. I will now take your questions on this presentation before you proceed to Mike and Beverly’s presentation. CHAIRMAN BERNANKE. Are there questions for Pat? President Lacker. MR. LACKER. You characterized underwriting as weak, and I guess the document circulated had some heavy criticism for the credit rating agencies. I want to understand more what the nature of that assessment involves. Basically is it ex post regret, or do we have objective evidence about the quality of the decisionmaking ex ante? That evidence, of course, would involve assessments of the probability they should have placed on things we saw. MR. PARKINSON. Mike is going to address that in his briefing. I guess I’d prefer to delay and just simply say that I think we can point to aspects of their methodology that look fairly weak so that it wasn’t simply an ex post result but one that should have been foreseen at least to a degree if they had had a stronger methodology ex ante. Obviously that’s Monday morning quarterbacking, but still you can point to specific things that were weaknesses. MR. LACKER. Okay. CHAIRMAN BERNANKE. President Poole. January 29–30, 2008 163 of 249 MR. POOLE. I have a question on exhibit 2, the top right corner: Are those AAA examples rated as of January 1? MR. PARKINSON. I think that was the rating at origination. MR. POOLE. At origination, not afterward. Okay. The other question I have is really a comment. On exhibit 1, the middle panel, it seems to me something that needs to be explored here, given that this is not the first time that banks have made a lot of bad bets, is the way in which the management incentives are designed. I just get the impression—and there has been some stuff in the paper recently, the Wall Street Journal or somewhere—that a lot of people are really given incentives to push these products and to make these deals. They walk away with big bonuses, and who in the heck cares what happens some time later. So I think that the management incentives are something very important to investigate in order to have an idea of how that works, and we might be of some assistance in designing something that would be helpful here. CHAIRMAN BERNANKE. President Hoenig. MR. HOENIG. Yes. Your exhibit 4 and your risk-based capital ratios, fourth quarter, are those as of December 31? MR. PARKINSON. Yes. MR. HOENIG. Okay. And do these reflect losses already taken in capital rates? MR. PARKINSON. Yes. They reflect the developments in terms of the changes in their financial statements during the fourth quarter until the year-end. MR. HOENIG. Okay. Thank you. CHAIRMAN BERNANKE. Do you have a question, President Yellen? MS. YELLEN. I wanted to support President Poole’s comment. I remember very well back at Jackson Hole in 2005 that Raghuram Rajan presented a paper in which he emphasized the January 29–30, 2008 164 of 249 misalignment of incentives between investors and managers and the fact that almost everyone down the line right up to the investors themselves should have had incentives here. I don’t know what they were thinking, but everybody was rewarded for the quantity and not the quality of originations. He warned us before any of this happened that this could come to no good, and I think he did have some suggestions about compensation practices. These were not popular suggestions. So I think this is worth some thought. I don’t know what the answer is in terms of changing these practices. Maybe the market will attend to them, but it seems to me that we have had an awful lot of booms and busts in which this type of incentive played a role. Your presentation and the paper started from the fact that you note the deterioration in underwriting, but we should go one step backward. I suppose another issue here is what we saw in our supervision and whether we acted appropriately given what we saw. That raises a number of issues that I won’t go into at the moment but that I think we need to be sensitive to. CHAIRMAN BERNANKE. President Rosengren. MR. ROSENGREN. Just a question on exhibit 4, the bottom two panels. You have the four banks there, and when you look at the capital ratios, it doesn’t look that discouraging. But when I look at the credit default swaps, it looks a little less encouraging. So if I put Wachovia on this, I believe Wachovia’s credit default swaps now are up to 166, which would be much higher than your scale is right now. So it would be interesting actually to add Wachovia to that list. The second thing is what you take from the fact that the capital ratios don’t look so bad but the credit default swaps and what the markets are looking at indicate that, in the past month and a half, people— despite the capital infusions—are actually exhibiting more concern about the default experiences that might occur. January 29–30, 2008 165 of 249 MR. PARKINSON. Right. Well, particularly with respect to developments in the last month or two, obviously the economic outlook is cloudier. As you know, I don’t think we try to reflect that fully in the capital ratios, and there is an element of stress testing and whatnot, but your other important effects are essentially looking through the cycle. So that may be part of it. Also, if you look at the credit default swap spread behavior compared with that for lots of other financial intermediaries out there, these look like very modest changes. I don’t know—if Mike or someone could help me out—to what extent these would translate into significant increases in actual implied default probabilities, but I wouldn’t think it would be all that large an increase. CHAIRMAN BERNANKE. Vice Chairman. VICE CHAIRMAN GEITHNER. Thank you. I agree with President Poole and President Yellen about the need to focus on compensation structures and incentives, but just two observations. One is that, if you look at compensation practices among the guys who actually look as though they did pretty well against those who didn’t do so well—I’m not talking about in a mortgage-origination sense but in the major global financial institutions—the structure of compensation doesn’t vary that much. What varies a lot is how well people control for the inherent problems in the basic compensation structures. Remember Raghu’s presentation was mostly about hedge fund compensation, and I think he is mostly wrong when you think about that and the incentive structure. The difference really is how you design your limits to make sure that your traders’ incentives are more aligned with the incentives of the firm as a whole. The biggest errors and differences are in the design of the process of the checks and balances to compensate for the inherent problems in the compensation structure. That’s important to know because a lot of these things, if you look at the formal attributes of the risk-management governance structure across these firms, don’t look that different. What distinguishes how well the guys did is much more subtle around culture, January 29–30, 2008 166 of 249 independence, and the quality of judgment exercised at the senior level, and this is important because, when you think about what you can do through supervision and regulation, to affect that stuff is hard. I have a question for Pat. Pat, not to overdo this, but where do you put in your diagnosis of contributing factors the constellation of financial conditions that prevailed during the boom and what those did to housing prices? You know, there’s a tendency for everybody to look at regulation and supervision and the incentives that they have created or failed to mitigate, but there is a reasonable view of the world that you wouldn’t have had the pattern of underwriting standards of mortgages without the trajectory of house prices that occurred. Sure, maybe what happened in the late stage of the mortgage-origination process contributed to the upside, but if you look at a chart, the rate of house-price appreciation started to decelerate about the time you had the worst erosion in underwriting practices. Anyway, my basic question is, Where do you put the constellation of financial conditions, not so much just what the Fed was doing but what was happening globally that affected long rates, expectations of future rates, et cetera? MR. PARKINSON. Well, partly what I would say, in general, about the pricing of risk is that many, many people, including people in the Federal Reserve, were concerned about how narrow spreads were, were concerned about some of the slippage of practices, and were predicting that trouble lay ahead. But—and I’m certainly speaking for myself—I never expected this magnitude of trouble. What I’ve been focusing on are some of the factors that essentially made a bad situation much worse than we expected it to be. But there is no question that we entered the period with risk being priced very cheaply and a fundamental reassessment of risk. Again, I think that shouldn’t have surprised anyone, but almost everyone except the most extreme pessimists has been surprised by just how much trouble that repricing of risk has caused. Some things that we January 29–30, 2008 167 of 249 have focused on certainly were not anticipated, and we think they made the situation markedly worse than we expected it to be. CHAIRMAN BERNANKE. Are there other questions for Pat? Okay. We can continue the presentation. MR. GIBSON. As noted in the top left panel of exhibit 5, we would like to stress two key points on the rating agency and investor issues. First, credit rating agencies are one of the weak links that helped a relatively small shock in the subprime mortgage market spread so widely, though certainly not the only one. This is not just our staff working group’s view—most market participants have also expressed the opinion that rating agencies deserve some of the blame. Second, the way that some investors use ratings for their own risk management has not kept up with financial innovations, such as the growth of structured finance. These financial innovations have made a credit rating less reliable as a sufficient statistic for risk. The top right panel provides a roadmap to our presentation. To start, I’ll expand on some of the points that Pat made on the role of rating agencies in the financial crisis. My aim is to show why credit rating agencies were a weak link, which will lead naturally to our recommendations on rating agency practices. As we go, I’ll point out several places where the rating agency issues link up with the investor practices issues that you’ll hear about next from Bev. We feel strongly that the ratings and investor issues are really just two angles on the same underlying issue. The crisis began in the subprime market, the subject of the next panel. The subprime mess happened—and keeps getting worse—in part because of the issues associated with rating agencies (though as I said earlier, there is plenty of blame to go around). Our staff working group was asked whether the rating agencies got it wrong when they rated subprime RMBS. The answer is “yes”—they got it wrong. Rating agencies badly underestimated the risk of subprime RMBS. Last year, Moody’s downgraded 35 percent of the first-lien subprime RMBS issued in 2006. The average size of these subprime RMBS downgrades was two broad rating categories—for example, a downgrade from A to BB—compared with the historical average downgrade of 1⅓ broad rating categories. As indicated in the exhibit, the rating methodologies for subprime were flawed because the rating agencies relied too much on historical data at several points in their analysis. First, the rating agencies underestimated how severe a housing downturn could become. Second, rating agencies underestimated how poorly subprime loans would perform when house prices fell because they relied on historical data that did not contain any periods of falling house prices. Third, the subprime market had changed over time, making the originator matter more for the performance of subprime loans, but rating agencies did not factor the identity of the originator into their ratings. Fourth, the rating agencies did not consider the risk that refinancing opportunities would probably dry up in whatever stress event seriously threatened the subprime market. Of course, the rating agencies were not alone in this. Many others misjudged these risks as well. Some January 29–30, 2008 168 of 249 have suggested that conflicts of interest were a factor in the poor performance of rating agencies. While conflicts of interest at rating agencies certainly do exist, because the rating is paid for by the issuer, we didn’t see evidence that conflicts affected ratings. That said, we also cannot say that conflicts were not a factor. The SEC currently has examinations under way at the rating agencies to gather the detailed information that is needed to check whether conflicts had a significant effect. In the next panel, I turn to the ABS CDOs that had invested heavily in subprime. Rating agencies got it wrong for ABS CDOs. The downgrade rate of ABS CDOs in 2007 was worse than the previous historical worst case, just as it was for subprime. AAA tranches of ABS CDOs turned out to be remarkably vulnerable: Last year, twenty-seven AAA tranches were downgraded all the way from AAA to below investment grade. As indicated in the exhibit, the main reason that rating agencies got it wrong for ABS CDOs was that their rating models were very crude. Rating agencies used corporate CDO models to rate ABS CDOs. They had no data to estimate the correlation of defaults across asset-backed securities. Despite the many flaws of credit ratings as a sufficient statistic for credit risk, the rating agencies used ratings as the main measure of the quality of the subprime RMBS that the ABS CDOs invested in. And the rating agencies did only limited, ad hoc analysis of how the timing of cash flows affects the risk of ABS CDO tranches. As a result, the ratings of ABS CDOs should have been viewed as highly uncertain. As one risk manager put it, ABS CDOs were “model risk squared.” A final point on ABS CDOs is that the market’s reaction to the poor performance of ABS CDOs makes it clear that some investors did not understand the differences between corporate and structured-finance ratings. Because structured-finance securities are built on diversified portfolios, they have more systematic risk and less idiosyncratic risk than corporate securities. They will naturally be more sensitive to macroeconomic risk factors like house prices, and by design, downgrades of structured-finance securities will be more correlated and larger than downgrades of corporate bonds. Turning to the bottom panel, as Pat noted, in August of last year the subprime shock hit the ABCP markets, especially markets for ABCP issued by SIVs. Rating agencies also got it wrong for the SIVs. More than two-thirds of the SIVs’ commercial paper has been downgraded or has defaulted. The problem with the ratings was that the rating agencies’ models for SIVs relied on a rapid liquidation of the SIVs’ assets to shield the SIVs’ senior debt from losses. While this might have worked if a single SIV got into trouble, the market would not have been able to absorb a rapid liquidation by all SIVs at the same time. Once investors began to understand the rating model for SIVs, even SIVs with no subprime exposure could not roll over their commercial paper. Investors who thought they were taking on credit risk became uncomfortable with the market risk and liquidity risk that are inherent in a SIV’s business model. The next exhibit presents the staff subgroup’s recommendations for addressing the weaknesses in credit ratings for structured-credit products. A common theme of our recommendations is drawing sharper distinctions between corporate ratings and January 29–30, 2008 169 of 249 structured-finance ratings. First, we recommend that rating agencies should differentiate structured-finance ratings from corporate ratings by providing additional measures of the risk or leverage of structured-finance securities to the market along with the rating. We don’t make a specific recommendation on exactly what measures of risk or leverage because we believe rating agencies and investors should work out the details together (on this and the recommendations to follow). Second, rating agencies should convey a rating’s uncertainty in an understandable way. The ratings of ABS CDOs were highly uncertain because the models were so crude. This is what I call the Barry Bonds solution—put an asterisk on the rating if you have doubts about the quality. [Laughter] Third, we recommend more transparency from rating agencies for structured-finance ratings. What we need is not just a tweak to the existing transparency, but a whole new paradigm that actually helps investors get the information they want and need. For example, why can’t the rating agency pass on to investors, along with its rating, all the information it got from the issuer that it used to assign the rating? Fourth, we recommend that rating agencies be conservative when they rate new or evolving asset classes. Fifth, the rating agencies should enhance their rating frameworks for structured products. For example, when they rate RMBS, they should consider the originator as well as the servicer as an important risk factor. Our last recommendation is addressed to regulators, including the Federal Reserve. When we reference a rating, we should differentiate better between corporate and structured-finance ratings. Sometimes we do that already, but we could provide some leadership to the market by doing more. Now Bev will discuss the work on investor practices. MS. HIRTLE. Mike has described how the rating agencies treated structuredcredit products; a closely related issue is how investors used these ratings. Did investors rely too much on ratings in making their investment decisions? Did they take false comfort from ratings and not really appreciate the risks they were assuming, leading to excessive growth of the market for subprime structured credit? As noted in the top panel of exhibit 7, our approach was to examine these questions through the lens of one representative type of institutional investor: public pension funds. Public pension funds are an informative example of investor use (and misuse) of credit ratings for several reasons. First, public pension boards of directors are composed largely of representatives of the employees and retirees covered by the pension plan and have only limited financial expertise in some cases. Second, survey evidence suggests that a high portion of these funds use credit ratings in their investment guidelines. Finally, relative to some other investors, many public pension funds provide significant public information about their activities. While we need to be cautious in generalizing, we believe that practices in the pension fund sector reflect the tensions faced by other institutional investors in making risk assessments and investment decisions. We examined the investment practices and fund governance of 11 public pension plans. These plans ranged from the largest fund—CalPERS, with $250 billion in assets—to six much smaller plans with assets of $6 billion to $11 billion. We used the funds’ 2006 comprehensive annual financial reports, which were generally the most recent available, and the funds’ websites to generate our information. We focused specifically on the funds’ fixed-income segments, since this January 29–30, 2008 170 of 249 is the asset class in which structured-credit products would likely be held and for which credit ratings are used. The middle panel lists some key conclusions from this review. The first is that these funds have developed workable market solutions to address inexperience or lack of financial sophistication among their managers and board members. These include hiring professional investment managers to make investment decisions on their behalf and, perhaps as significantly, hiring investment consultants to structure asset-allocation strategies, to select investment managers and develop mandates guiding their actions, and to monitor and assess fund performance. While these funds clearly obtain significant professional advice in managing their investments, our review suggests several ways in which these arrangements could be improved in light of recent financial innovation. Specifically, the mandates guiding investment managers have not always kept pace with the growth of structured-credit markets. These mandates typically require managers to meet or exceed returns on a benchmark index or of a peer group of investment managers, while constraining the risk the managers may assume. Credit ratings play an important role in these risk constraints—for instance, by imposing a minimum average rating for the portfolio or a minimum rating on individual securities. However, few of the funds we profiled made significant distinctions between structured-credit and other securities in these credit-rating-based constraints, although there were sometimes other limits on the aggregate share of asset-backed positions. The failure to make this distinction provides scope for investment managers to generate higher returns by moving into structured-credit products, without raising warning signals about the additional risk these positions entail. This is not necessarily a “naïve” use of credit ratings by investment managers, as they could well have recognized that higher-yielding structured-credit products embodied significant additional risk relative to similarly rated corporate debt. Instead, it reflects a previously effective mechanism used by fund boards to convey risk appetite to these managers falling out-of-date with the emergence and rapid growth of a new form of credit instrument. As indicated in the bottom panel, our key recommendation is that the pension fund industry and other investors should re-evaluate the use of credit ratings in investment mandates. In a narrow sense, these mandates should distinguish between ratings on structured credit and those on more traditional corporate credit. However, the more fundamental point is that mandates would do a better job of enforcing desired risk limits on the overall portfolio if they acknowledged differences in risk, return, and correlation across instruments rather than relying on generic credit ratings. A second important point is that investors should ensure that their investment consultants have independent views of the quality and adequacy of credit ratings for the types of positions in their portfolios. This is particularly important if mandates guiding investment manager behavior feature credit ratings as a key risk constraint. That completes our prepared remarks. We would be happy to take your questions before we proceed to the final presentation. CHAIRMAN BERNANKE. Questions? President Lacker. January 29–30, 2008 171 of 249 MR. LACKER. I am still confused. How much of these weaknesses would have been identified by an impartial observer in January 2006, say, without knowledge of what has happened since then? MR. GIBSON. Are you talking about the credit rating agency weaknesses? MR. LACKER. Yes. MR. GIBSON. There are plenty of investors who said, “We are staying out of that ABS CDO market because we don’t trust the ratings and we don’t think we have an ability to model it.” But there are also enough who were willing to take on that risk. So I think it is a combination. CHAIRMAN BERNANKE. President Fisher. MR. FISHER. Going back to exhibit 5, the second panel, your point that we have no evidence of conflicts of interest having an effect on ratings, I am thinking about the investorpractices presentation. There is an inherent conflict of interest because the issuers pay the raters. By one account, Moody’s earned 44 percent of their revenue in 2006 from rating structured products. I have always wondered—and by the way, I have been on the side of the table that has worked a rating agency and have gotten what I wanted—what about just a common sense solution, which is that the investors rather than the issuers pay the rating agencies? MR. GIBSON. That used to be the way it was before 1970—the investors paid. I think the common explanation for why that model faded was that, once photocopy machines came into existence, there was no way to constrain the information that they were providing just to subscribers. MR. FISHER. I am well aware of that. But is there an inherent conflict of interest in the process? January 29–30, 2008 172 of 249 MR. GIBSON. There is. We are not denying that there is a conflict of interest. We looked at some of the mechanisms that rating agencies have put in place to address conflicts of interest, and that is something that every rating agency is aware of. The only question is whether the mechanisms that are in place to address conflicts of interest were working or whether they need to be enhanced. Our conclusion was that we don’t really have the detailed information to know whether there were specific conflicts of interest, and we are looking to the SEC to provide that detailed information. But lots of other things seemed to go wrong with the rating agencies that don’t rely on conflicts of interest as an explanation. I think people who have looked at the question of the issuer’s paying versus the investor’s paying feel that, given how costly it is to rate these things even in the mediocre way that it has been done, it would be difficult to generate enough revenue through a pure investor-pay model. That is not to say there couldn’t be more competition between the two kinds, and there are some proposals out there to do that. MR. FISHER. Again, remember how costly it has proven to investors to have that builtin conflict of interest. That’s all. That’s my say. CHAIRMAN BERNANKE. Governor Mishkin. MR. MISHKIN. Actually, I wanted to focus on the same issue—conflict of interest. This is something I did a little work on in the past. When you look at the standard corporate ratings market, the move to have the issuer pay really did not create a problem in the market. There clearly is an inherent conflict of interest, but there are things that can counter that—in particular, reputation. MR. FISHER. Arthur Andersen. MR. MISHKIN. We could talk about Arthur Andersen, too, because I am going to talk about the more complicated issues of conflicts of interest. With plain vanilla conflicts of January 29–30, 2008 173 of 249 interest, if there is enough information, the market frequently can solve the problem because if you know that if you do what the issuer wants and you give a good rating, then you lose your reputation. Then, if it has no value, issuers won’t pay for it. What is interesting here is that for the subprime market, you didn’t find any evidence of conflicts of interest, and I am not surprised by that, because those securities are much more straightforward. Where I really do worry about the conflict of interest is in the structured products because one thing that happened was that it became less plain vanilla. You actually had consulting practices inside the credit rating agencies; these structures are very complicated, and you need to slice here and dice here, and consultants were providing advice on structuring them and making a lot of money, and then it was much less transparent. What I wondered about here is that you didn’t say this for the first one, subprime RMBS. You said you didn’t find the evidence. I buy that. But what about the CDOs and the SIVs, for which I would expect that this problem would have been more severe? In the book that I wrote with others on conflicts of interest in the financial services industry, we actually said that there was not a problem with the plain vanilla products because the markets have the information, but we worried about exactly this issue in terms of the structured products. I am just wondering whether or not it was an accident that you said for the plain vanilla that there was less problem. Could there have been an issue here? The reason this gets complicated is that the standard view of conflicts of interest in Arthur Andersen was in the firm’s compensation scheme. Actually, the conflict of interest was that the Texas unit did not worry about and weakened—not their ethics, but what is it? The center has rules for its branches so that they don’t screw the overall firm, and that is what got weakened during the fight between the consulting part and the auditing part. January 29–30, 2008 174 of 249 So do you have any information on these very complicated elements, particularly the nontransparent parts? Was it an accident that you said for subprime that you didn’t find evidence, and for these is there more possibility that there was a problem? That really does have important implications for the nature of the regulation and accreditation agencies and also their ability to give good ratings for these very complex nontransparent products. You talked about investor practices later, Bev, when you said that we should differentiate between plain vanilla and this very complex stuff. I don’t know whether or not you have views on this. MR. GIBSON. There is certainly a possibility that conflicts of interest were occurring in all these areas. We are taking a somewhat neutral position because we don’t really have the detailed information to say more. MR. MISHKIN. Right. But this is the typical Federal Reserve cautiousness, and I am pushing you a little harder. MR. GIBSON. I know, but I am a Federal Reserve economist. I would agree with your point that separating out these nonrating businesses from the rating businesses is important, and rating agencies have announced some changes along these lines. When we looked at our recommendations, we didn’t really feel as though, even if they separated out rating businesses from nonrating businesses and even if they did all the things that people who are concerned about conflicts of interest want them to do, it would solve the problem. MR. MISHKIN. There would still be problems. MR. GIBSON. We think the real problem is that they didn’t differentiate well enough between structured-finance ratings and corporate ratings, and that is where we would like to put the focus. Securities regulators are already focused on conflicts of interest, and there are codes of conduct regarding how rating agencies have to behave, and those are monitored. So, coupled January 29–30, 2008 175 of 249 with the SEC’s already doing examinations, that wasn’t an area we chose to focus on, but we really can’t say for sure what was going on. MR. MISHKIN. One quick follow-up on that—is one implication that we might take from this that structured products are just so complicated that they may never get good ratings or sufficiently good ratings, so the market really has to shrink? Could the rating agencies just fix themselves up so that they actually could do decent ratings? I’m trying to get a feel for this. It really relates to the issue that Bev raised, which is you want to differentiate between the two. But is there something inherently problematic so that maybe people should just realize that these structured products are just not such a great thing. Financial engineering can go too far. MR. GIBSON. I agree. In fact, ABS CDOs are disappearing or have disappeared. Investors don’t have any appetite for them. SIVs are disappearing as well. MR. MISHKIN. But they could come back. I think subprime lending will come back under a different business model. MR. GIBSON. Really, the question is, What sort of market forces would produce that outcome? It certainly seems as though things should move in that direction, and we feel that some of the recommendations we are making on the differentiation between structured-finance securities and corporate securities would encourage the rating agencies to put more scrutiny on the structured-finance side of it. Yes, those ratings should be lower, especially when you factor in things like the complexity and the uncertainty. CHAIRMAN BERNANKE. President Hoenig. MR. HOENIG. My comment is on the conflicts of interest as well. The only thing I would like to add is that this is not the first time the rating agencies have miscalculated the risk and put that out there. The incentives are designed to do exactly that, and it will occur again. I January 29–30, 2008 176 of 249 think this statement is too generous to the rating agencies. The incentives are driving them to do this, they did it, and they will do it again in the future. It is just inherent that, when you are going to make that kind of money and if you can get it down to working with them and pushing this stuff out, it really is a matter, for those who use them, that you get what you pay for. CHAIRMAN BERNANKE. President Poole. MR. POOLE. I didn’t know anything about SIVs before last summer, but I must say when I began to learn something about them, I was astonished because it would seem to me that, in Finance 101, you don’t finance long-term, risky assets with short-dated paper. There’s a maturity mismatch, and there’s a rollover risk, and we’ve known about that kind of thing for 100 years, I suppose. So my question is, Could these things have been marketed as standalone entities without the banks’ sponsorship, which was there in, I guess, most cases? Second, if they wouldn’t really fly as standalone entities, it would seem to me that the regulators should have insisted that they be consolidated on the books of the bank. MR. GIBSON. A lot of the SIVs were standalone entities managed by independent assetmanagement companies that were set up to do that. MR. POOLE. And they collapsed? MR. GIBSON. All the SIVs are in the process of winding down now, and in the immediate aftermath of what happened in August, that was when there was a crunch in the ABCP market. MR. POOLE. But when you say the asset-management companies, are they providing at least in principle some liquidity support or something? MR. GIBSON. SIVs had partial liquidity backup lines from banks covering one week’s maximum withdrawal or two weeks’ maximum withdrawal. That was the way to a rating. The SIVs were operating under the regulation of the rating agencies. The rating agencies modeled their January 29–30, 2008 177 of 249 portfolios, and they modeled the inflows and outflows, so I think it’s fair to blame the rating agencies at least partially for allowing the SIVs to grow to $400 billion or whatever it was. MR. PETERS. There is a large, independent SIV not affiliated with a bank, named Gordian Knot, that is still in existence. It’s under severe pressure, but it has been weathering the storm. One can argue it might have been more conservative than some of the other SIVs. CHAIRMAN BERNANKE. Governor Kohn. MR. KOHN. Thank you, Mr. Chairman. My question is on exhibit 6, and the question is, Are we making any progress here? In particular, are the rating agencies stepping up to the process of doing different ratings, different nomenclature for the structured finance? My impression is that there is a lot of resistance, at least there was as of a few weeks ago. MR. GIBSON. Your impression may be more informed than mine, but I would say that the rating agencies are doing a lot of self-examination now. I haven’t seen them willing, in my opinion, to go far enough in the directions that we’ve outlined. A lot of their recommendations focus on managing conflicts of interest and doing a better job of separating compensation from the rating and things like that. I would say that I haven’t seen enough on the sort of recommendations that we are pushing. CHAIRMAN BERNANKE. Did you have any questions? MR. WARSH. I’d add only that I think where the rating agencies are now is trying to come up with cleaner boxes and better governance—Sarbanes-Oxley types of structures, ombudsmen, liaisons, Chinese walls. The core issues that Mike and his team bring up seem highly resistant to change, but you know, there will be nothing like three months of public hearings, if not hangings. [Laughter] That could change that dynamic, but that’s in the early stages. MR. MISHKIN. Torture works. January 29–30, 2008 178 of 249 CHAIRMAN BERNANKE. Governor Kroszner. MR. KROSZNER. A few different points. One, on the conflict of interest issue, with respect to traditional corporate credits, it seems that credit rating agencies do pretty darn well and certainly have done very well before this. So it’s clear that it’s not just fundamental to the model that it can’t work. I think it’s clear enough to remind people of that and that people trusted those ratings throughout all the turbulence during the summertime. But that said, it gets back to some of the other points that have been raised. What was special about these particular areas that led to a breakdown? The question is, Well, why did they have bad models? If they were able to develop good models for these other things, in principle they are capable of developing good models, but they seem to have developed poor models here. Now, that could be succumbing to a conflict of interest, or it could be something specific in this area. I am reminded that another area in which they are perceived to have done a very poor job was in sovereign ratings back a couple of decades ago. I don’t know whether it’s worthwhile to drill down into the characteristics of where this model seems to be successful and doesn’t seem to be subject to significant conflicts of interest or where it does, whether it relates to particular information issues. Also, one thought that I had with respect to these structured products—and you should tell me whether this is true or not—is that most times when a corporation comes to get a rating they’ve decided to issue a particular security—that is, if GM comes, their CFO has decided to issue ten-year debt. If you come to a credit rating agency, however, the credit rating agency can say, “Well, why don’t you issue six securities rather than one? If we chop it up in these different ways, I can make more revenues off that, so I have more of an incentive to work with you on this.” MR. GIBSON. I definitely agree with you that it’s more difficult to rate structured-finance securities than corporate securities because with structured-finance securities you have a lot of January 29–30, 2008 179 of 249 quantitative modeling of future cash flows with a lot of uncertainty. Clearly the ABS CDOs are very complicated structures because it’s a two-layer securitization—a securitization that invests in securitizations—and the rating agencies didn’t drill all the way down to model the ultimate underlying loans. They relied on simplifying assumptions and aggregations that were very crude. But because they were branded as CDOs, people usually understood them to be corporate CDOs that invest in 100 corporate bonds, which is a simpler, one-layer structure. So the rating agencies were willing to rate these much more complicated things and investment banks were willing to market them to investors who were willing to buy them because they all were willing to believe that a CDO is a CDO is a CDO, and, in fact, that wasn’t really true. MR. KROSZNER. Yes, it might just be interesting to drill down and see where the successes are and where they haven’t been successful and whether it has something to do with the model. MR. GIBSON. Oh, it’s definitely not a random sample of asset classes that we chose to look at. The rating agencies have done a great job in many other places, I agree. MR. KROSZNER. Right, but just thinking about those differences, I think sometimes the rating agencies may be excessively maligned. They actually do provide something that’s very useful, and we don’t want to throw the baby out with the bath water. But also on that, there is a severe lack of competition among rating agencies, and we’ve tried to address that through some legislation, which doesn’t seem to have been very successful at addressing that issue. This is getting back to Governor Mishkin’s point and some other points about why competition doesn’t get us to a better solution. It seems that part of it is a regulatory structure that strongly discourages competition. Did you think about addressing that issue? January 29–30, 2008 180 of 249 MR. GIBSON. The regulatory structure has been changed now as a result of the law that was passed in 2006, at least if you’re talking about getting the regulatory stamp of approval from the SEC to become a nationally recognized statistical rating organization. That’s now just a notification process by which, if you meet some minimum requirements, the SEC is required to okay you. So entry is now easy whereas before it used to be restricted by the SEC. In some sense there’s a bit of a natural monopoly going on because, if you really had a couple of rating agencies that you trusted, it’s not clear why someone would be willing to transfer from an established to a new one. But if you were to take some of our recommendations to the next level and talk about how you would actually implement this and how you would go about making this have some success, one thing people have suggested is that maybe we should help investors set up their own rating agencies— maybe they don’t want to do that now—and maybe more transparency from the existing rating agencies and from the issuers. It would then be easier for a new rating agency that’s funded by investors to get going and get some traction if there were more transparency around the whole process. That’s just one possibility MR. KROSZNER. For sure, although I think we tried something like that with the Sarbanes-Oxley issues of independent research—because this in some sense is a parallel to independent research—and even required funding of that, and that doesn’t really seem to have taken off. So it seems as though the model, even with its flaws, is the only one that seems to be sustainable. But drilling down more into where those flaws are, in some sense we’re seeing a privatization—I’m not quite sure what the right word is—with some of the very sophisticated investors effectively building their own internal credit rating agencies. That’s what hedge funds do, and so you’re getting in some sense a loss of the public rating—a kind of free rider problem or whatever is the right way to characterize it. In some sense there may be a loss because you’re January 29–30, 2008 181 of 249 getting this to be just purely private, but maybe that’s a gain because those are the only guys who should be in this game. It certainly makes it difficult to sustain the credit rating agency or industry. MR. GIBSON. We have kind of a dual problem in that we want investors to do a better job of evaluating the risks, and maybe better ratings would help on that. At the same time, the existing rating agencies did a bad job, so we have to criticize them. We have to find some way to reconcile those. CHAIRMAN BERNANKE. I have President Evans for a two-hander and then President Lockhart and President Lacker. I also see that President Plosser has a two-hander, and I think at that point we should probably go onto the last presentation. MR. PLOSSER. I can pass if it gets too long. That’s okay. CHAIRMAN BERNANKE. Okay. All right. So President Evans, President Lockhart, and President Lacker. MR. EVANS. I had an elementary question that Governor Kroszner’s question kicked off. The background briefing was very well written and very clear, which made me think that I understood things, and I probably don’t. But you used the term “get a rating,” and at other times you talk about it as if it’s a sufficient statistic and how the agencies were warned that it’s not a sufficient statistic. There are transition matrices to downgrade, and yet they violated that themselves because you said that for the ABS, they thought of it as a sufficient statistic themselves. Is a lot of this inherently a multidimensional risk model that’s required for some of these structuredfinance vehicles, whereas for the corporates it’s closer to a single dimensional risk model? MR. GIBSON. Yes. MR. EVANS. Thank you. CHAIRMAN BERNANKE. President Lockhart. January 29–30, 2008 182 of 249 MR. LOCKHART. I’d like to ask as a practical matter what weighting we should put in our expectations or even our recommendations on reform of the rating system versus the expectation that investors would actually reduce their reliance on ratings. My impression is that many institutional investors, especially public pension funds, are notoriously understaffed. Then they work for, as you pointed out in your presentation, boards that either represent the beneficiaries or in some respects are quite political in nature and not necessarily financially sophisticated. That would lead me to the conclusion that, as a practical matter, they’re going to be highly reliant on ratings. The ratio of professional employees to the volume of investment is so low that they have to choose their restaurants by stars because they don’t have time to do the tasting themselves or they’re not given the budgets to do that now. So I’m curious about this tension between getting the rating system right versus having the investors reduce their reliance on ratings. MS. HIRTLE. Well, I think you’ve identified the key problem that many of these funds face, and the important entities in many ways are these investment consultants. At least the funds we looked at all hire one or more of these investment consultants. Many of them are from large, globally active firms, and the role that those consultants play is precisely to address the issues that you’ve raised. They help them select the asset manager who is doing the investing. They help them design the mandates or instructions. They help them monitor what the asset managers are doing and assess their performance. So to some extent those consultants are a kind of sweet spot for these funds in terms of where the additional layer of sophistication that doesn’t run just off the rating could come from. MR. LOCKHART. But is your impression that those supplemental parties, the consultants and the asset managers themselves, have the credit analysis and valuation capability to address sophisticated structured products? January 29–30, 2008 183 of 249 MS. HIRTLE. We didn’t do an evaluation of them, but some of them are from very, very large firms. They are advising funds in the trillions of dollars across all their different clients. That is the service they are selling, and so they should be—they had better be—in a position to do that. MR. FISHER. May I just suggest that you reexamine that proposition? They usually evaluate performance principally after going through initial screening devices. They almost never, that I’m aware of, provide the kind of analysis that you’re assuming. So I would reexamine that proposition. CHAIRMAN BERNANKE. President Lacker. MR. LACKER. My memory of Finance 101 is that you don’t buy long-term, risky assets funded by short debt without sufficient compensation. So the neglected aspect of the whole episode we went through was how people would have been compensated in other circumstances, but that’s a different discussion. I think these recommendations make sense, and confirmation of that is that the market is moving in that direction anyway. I don’t know how many of these recommendations were put forward by those market participants you cited who two years ago were not trusting these ratings—I think that’s a key question. But the broader thing here is that the world of finance now is a world of competing econometric analysis, and we’re never going to rate the model risk if you ask the question, What would you expect the behavior of a market like that to display? You’d expect occasional big misses from erring assumptions. You’d expect those misses to be corrected by people reflecting and improving practices going forward. A sort of Schumpeterian process in this is going to generate model risk and big model misses, and so I think it’s being careful to keep track of whether the insights we’ve gleaned are hindsight or should have been known ahead of time. CHAIRMAN BERNANKE. Okay. Thank you. Why don’t we continue with the final portion? January 29–30, 2008 184 of 249 MR. GREENLEE. Thank you. To support the Financial Stability Forum’s Working Group on Market and Institutional Resilience, as noted in the top panel of exhibit 8, supervisors from France, Germany, Switzerland, the United Kingdom, and the United States formed the “senior supervisors group” in late October. Participating U.S. supervisors included the OCC and SEC as well as the Federal Reserve. The group’s goal was to develop a common understanding, through a series of interviews with selected firms, of how the risk-management systems of core financial institutions performed during the financial market turbulence. The top right panel of exhibit 8 shows the 11 banking firms that supervisors interviewed. This effort was not a complete review of all firms and events. For example, we did not meet with Bear Stearns or Morgan Stanley as part of this effort. Rather, it was designed to inform supervisory authorities about the general effectiveness of risk management at global financial institutions. The supervisors have prepared a paper detailing their findings, which will be conveyed to the FSF and released publicly. The bottom panel lists some observations about the firms’ overall performance. Most large financial services firms, while affected by market developments, generally avoided significant losses. Although most firms’ risk-management processes worked as intended, there were some definite outliers. Some firms recognized the emerging additional risks and took deliberate actions to limit or mitigate them. Others recognized the additional risks but accepted them. Still other firms did not fully recognize the risks in time to mitigate them adequately. Moreover, the risk-management practices varied by firm and by strategy, as did the range of outcomes to date. I should note that the primary risk-management weaknesses observed here are not new. They have been observed in past episodes and are thoroughly discussed in existing risk-management literature and supervisory guidance. As noted in the top panel of exhibit 9, the senior supervisors group identified four primary factors that differentiated the organizations that suffered larger losses from those that did not: (1) the effectiveness of senior management oversight of balance sheet, liquidity, and capital positions; (2) the effectiveness of communications among senior management, business lines, and risk-management functions; (3) the sophistication, diversity, and adaptability of risk measures utilized; and (4) the attention devoted to valuation issues. With respect to senior management oversight, as indicated in the bottom panel of exhibit 9, the more effective firms were more disciplined in measuring and limiting these risks in advance of the crisis and proved to be more agile in reducing exposures or hedging when the crisis occurred. These firms focused on maintaining a strong balance sheet with strong capital and liquidity positions throughout the entire organization. Senior management of these organizations had established adequate capital and liquidity buffers that could sustain the firm through a period without access to the market for funding. They have created and effectively enforced internal pricing mechanisms, capital allocation methodologies, and limits that provided effective incentives for individual business line managers to control activities that might otherwise lead to significant balance sheet growth or contingent liquidity demands. Conversely, the less effective firms were not as focused on the overall strength of their balance sheet across all legal entities and thus operated with more limited liquidity and capital buffers. These January 29–30, 2008 185 of 249 organizations had weaker controls over their balance sheets and were more focused on earnings growth or defense of a market leadership position. These firms did not have limit structures that were consistently or effectively enforced, which allowed business lines to grow balance sheet exposures rapidly and increase contingent liquidity exposures. They did not properly aggregate or monitor off-balance-sheet exposures across the organization, including the exposure to contingency back-up lines of credit to ABCP programs and generally did not have in place effective financial controls, including capital allocation processes, commensurate with the business strategy. The top panel of exhibit 10 provides additional detail on the importance of effective communications among senior management, business lines, and riskmanagement functions. The more effective firms emphasized a comprehensive, firmwide, consolidated assessment of risk. Senior managers of these organizations were actively engaged and had in place a disciplined culture and well-established processes for routine discussion of current and emerging risks across the business lines, risk management, and the corporate treasury function. Senior managers at these organizations collectively made decisions about the firm’s overall risk appetite, exposures, and risk mitigation strategies rather than relying solely on the judgment of business lines. They were able to effectively leverage the assessment of risks from one business line to consider how subprime exposures, for example, might affect other businesses. As a result, the more effective firms had a more timely and wellinformed perspective on how market developments could unfold. In some cases, senior management had almost a year to evaluate the magnitude of the emerging risks from subprime mortgages on its various business lines. This, in turn, enabled them to implement plans for reducing their exposures while it was still practical and more cost effective to do so. Conversely, less effective firms were siloed, did not effectively share information across business lines on emerging risks, and were comparatively slower in taking actions to mitigate exposures as each business line had to assess and consider emerging risks on their own without the benefit of views or actions taken by other business line managers. With regard to the risk measures utilized, as shown in the bottom panel, the more effective firms used a wide range of risk measures and analytical tools to discuss and challenge views on credit and market risk broadly across different business lines within the firm in a disciplined fashion. These firms have thought more thoroughly about the interplay of their risk measures than the other firms and used a combination of different risk measures and scenario analysis to understand risk exposures. It also appears that the more effective firms had committed more resources to riskmanagement and management information systems. As a result, they had more timely and scalable management information systems and in large part did not have to create new management reports to understand risks and exposures. Conversely, the less effective firms were too dependent on a single quantitative risk measure, and they did not utilize scenario analysis in their decisionmaking and tended to apply a “mechanical” risk-management approach. Management information systems also January 29–30, 2008 186 of 249 were not as scalable, and there was a need to develop a number of ad hoc reports to help senior management understand the risks and exposures of the company. The top panel of exhibit 11 elaborates on the fourth factor that proved critical, which is the attention devoted to valuation issues. The more effective organizations were more disciplined in how they valued the holdings of complex or potentially illiquid securities. They employed more-sophisticated valuation practices and had invested in the development of pricing models and staff with specialized expertise. These organizations were skeptical of and less reliant on external ratings and emphasized mark-to-market discipline in their businesses in ways that others did not. Less effective organizations in some cases did not have key valuation models in place prior to the market disruption, relied heavily on third-party views of risk, and tended to have a narrower view of the risks associated with their CDO business as mainly being credit risk and did not actively seek market valuation information. The bottom panel explains how supervisors are planning to address the specific deficiencies. As I mentioned earlier in my presentation, the risk-management deficiencies identified during this exercise are not new, and existing supervisory guidance addresses these issues. Therefore, supervisory efforts will include addressing risk-management deficiencies at each company through the supervisory process and re-emphasizing the importance of strong, independent risk management through a series of speeches, industry outreach, and possible re-issuance of existing guidance. In addition, supervisors plan to complete the work already under way within the Basel Committee on Bank Supervision to update liquidity risk management guidance to strengthen industry practices. A review of existing Federal Reserve guidance on market and liquidity risk management is under way to ensure that it effectively outlines the need for banks to use a number of tools to include multiple ways of viewing quantitative and qualitative risk analysis, including VAR, stress tests, and scenario analysis. Finally, supervisors plan to develop, on an interagency basis, guidance related to the management of the originate-to-distribute model to ensure that banking organizations effectively manage the credit, market, and operational risks of this activity. I will now turn it over to Art Angulo to discuss related regulatory policies. MR. ANGULO. The top panel of exhibit 12 sets forth the question we sought to address—namely, to what extent did regulatory incentives contribute to or fail to mitigate weaknesses exposed by the recent turmoil? In doing so, we defined the term “regulatory incentives” to encompass both regulatory capital and financial reporting requirements. In addition, we distinguished between policies that may have mattered for the buildup to the market turmoil and those that have made managing the turmoil more challenging. Our conclusions are summarized in the middle panel. Not surprisingly, incentives to minimize regulatory capital are a much more important driver of bank behavior than financial reporting incentives. Moreover, the current regulatory capital framework is not neutral as to how banks structure risk positions. Both the leverage ratio and the Basel I risk-based capital framework have encouraged banks to securitize low-risk assets and, importantly, to support securitizations of higher-risk assets through instruments with low mandated capital charges, such as 364-day liquidity facilities. Financial reporting incentives were not critical to banks’ January 29–30, 2008 187 of 249 decisions, although certain financial reporting issues—particularly disclosure practices—have been a factor in how the turmoil has been unfolding. Before I turn to specific recommendations, it is important to emphasize that improvements were already in train even before the market difficulties emerged last summer. Most significantly, the Basel 2 advanced approaches and related improvements greatly enhance the risk sensitivity of the regulatory capital framework and create incentives for better risk management. In the bottom panel are three examples relevant to the issues we have been discussing this morning. First, capital charges for most unused short-term credit and liquidity facilities have been increased to more adequately reflect the risk exposure. Second, new standards for banks to hold capital against the default risk of complex, less liquid credit products in the trading book are being finalized, as the Basel Committee is currently seeking public comment on principles for calculating a so-called incremental default risk charge against such products. I should note that the work to develop the incremental default risk principles was done by a joint Basel Committee–IOSCO working group co-chaired by Norah Barger. Third, the securitization framework in Basel 2, which builds on previous unilateral U.S. enhancements, establishes a more risk-sensitive capital treatment for securitization exposures—it bases capital charges on estimates of underlying risk rather than on an exposure’s legal form. I will now turn to recommendations in exhibit 13, beginning first in the top panel with those related to regulatory capital. First, notwithstanding the improvements brought about by Basel 2, there is scope for reassessing the treatment of securitizations involving ABS CDOs. The risk weights and resulting capital charges for these “re-securitizations” were calibrated under the assumption that loss correlations within a pool of securitized assets would be no greater than those exhibited by CDOs backed by traditional corporate bonds. It is now apparent that the actual loss correlations within such re-securitizations—especially for the most highly rated tranches—may be much higher. At its December 2007 meeting, the Basel Committee agreed to take up this issue. The second recommendation addresses the issue of “reputational” risk. There have been several occasions over the last 6 months in which banks have elected to purchase assets from, or extend credit to, off-balance-sheet vehicles they had organized and money market and other investment funds they managed, even though they were not contractually obligated to do so. Whether a bank management will provide support in excess of its contractual obligations is a business decision. Thus, it is not practical to attempt to design an explicit capital charge for reputational risk. Instead, supervisors should exercise supervisory oversight to ensure that banks sufficiently consider reputational risk and its implications for capital and liquidity buffers. The third and fourth recommendations deal with the issue of the procyclicality of capital regulations. The existence of fixed capital requirements (as well as rating agency expectations for capital ratios) discourages banks from drawing on their January 29–30, 2008 188 of 249 capital cushions in times of stress. It is therefore very difficult to devise changes in capital regulations that would allow capital to function more effectively as a shock absorber without compromising safety and soundness objectives. Nonetheless, these last two recommendations are aimed at mitigating the potential procyclical effects of a more risk-sensitive capital framework. The third recommendation is based on elements of the Basel 2 framework that were designed to allow supervisors to address both safety and soundness and procyclicality concerns. The advanced internal ratings based approach of Basel 2 requires that banks’ loss-given-default estimates reflect economic downturn conditions and that stress tests of their advanced systems include consideration of how economic cycles affect risk-based capital requirements. Rigorous supervisory evaluation of these two elements can help ensure that (1) regulatory capital embeds forward-looking forecasts of recovery rates and (2) banks manage their regulatory capital positions in a manner that enables them to accommodate variations in the amount of minimum required capital over an economic cycle. The fourth recommendation is to explore ways to encourage inclusion in the regulatory capital base of debt instruments that mandatorily convert into equity when a banking organization is under stress. The automatic conversion of debt instruments into equity under such circumstances is appealing from a supervisory perspective as well as from a broader macroeconomic policy perspective. This concept has not yet been examined in depth by the staff, but we believe it merits further study, including an assessment of the past experiences of banks with such instruments, to determine its feasibility. Let’s now move to the recommendations in the bottom panel. These deal with improving disclosure practices, which can help to reduce the uncertainty that has been a key feature of the recent turmoil. First, financial institutions—especially those in the United States—improved their disclosures about subprime-related exposures as the turmoil wore on. Nonetheless, supervisors and regulators should continue to push market participants to make timely and detailed disclosures about the size and composition of subprime-related exposures. The second and third recommendations focus on disclosures related to asset-backed commercial paper programs. In view of the potential exposure associated with reputational risk, market participants appear to desire additional details about banks’ dealings with ABCP programs. Disclosing information about the distribution of assets underlying such programs by type, industry, and credit rating would bring the disclosures on par with those provided for on-balance-sheet assets. Similarly, in view of the extent to which investors in assetbacked commercial paper have retreated from rolling over or purchasing paper that they suspect may be supported by subprime-related assets, banks and asset managers that sponsor ABCP conduits should improve disclosures to investors, particularly for conduits other than the traditional multi-seller programs. That completes our prepared remarks. We would be pleased to take your questions at this time. CHAIRMAN BERNANKE. Thank you. Questions? President Rosengren. January 29–30, 2008 189 of 249 MR. ROSENGREN. It is great to see some bank supervision people at this table, and I would just highlight one of the comments that you made about silos. It is interesting that this morning we have been discussing issues of bank balance sheet constraints and how that would occur, and it might be useful to think structurally within our own organization whether there are ways to do a better job of getting people in bank supervision to understand some of the financial stability issues we think about, and then vice versa. Maybe having some bank supervision people come to FOMC meetings might be one way to actually promote some of this. In terms of the things that you were talking about, another issue that I think has been important is that we’ve been talking about the effect of dropping housing prices. I know a horizontal stress review was done about a year ago, and I’m sure Brian or Jon remembers that the large financial institutions did the stress testing. When they did that stress testing, what was striking was that there were four institutions—I think it was Citigroup, JPMorgan Chase, Wachovia, and Bank of America—in that stress test, and all four concluded that a housing-price reduction of between 10 percent and 20 percent would affect earnings but wouldn’t affect capital. Obviously, in retrospect that doesn’t seem to have been a good forecast. One, since we do think that stress testing is useful, maybe understanding that and going back to those same four institutions and understanding their stress testing might be a useful exercise to do. Two, if you did that exercise, we’d learn something about how they’re thinking about housing prices and the indirect effects that might occur because one of our concerns around the FOMC table is that there may be unintended consequences if housing prices drop more than they have historically. Just as the banks have to think about those kinds of stress tests and what they have already learned from the fact that they didn’t pick up some of the indirect effects, our own knowledge would be supplemented if we thought about some of those indirect effects as well. January 29–30, 2008 190 of 249 So the horizontal stress testing was interesting in that I think some of those institutions are on the good side and the bad side of your things. The horizontal stress testing isn’t what generated the decisions—and I do agree with your conclusion that most of the decisions were made by senior management. Some organizations didn’t do subprime mortgages at all. I’m not so sure it was generated from the stress testing as much as a gut feeling by senior bank management that they weren’t going to engage in subprime mortgages. I think that’s true for a lot of these activities. It’s interesting who’s at the top of the list and who’s at the bottom of the list for a lot of these activities. Ideally, over time, both bank supervision and bank risk management would get to the point that it’s not just a gut decision by a person at the top but is a little more systematic and that the riskmanagement process does that. Are you thinking of ways that we could actually encourage that kind of interaction so that it becomes less gut from senior management and more integrated into the risk management? I know that was kind of a long entry. MR. ANGULO. Well, I would just comment on the first point that you made in terms of silos. I guess we would fully agree we’re having a great time here, so we would love to see more interaction between supervision and the FOMC. VICE CHAIRMAN GEITHNER. Be careful what you wish for. MR. ANGULO. You know, when people debate whether to have supervision with a central bank or not, one of the key arguments is that only we can bring to bear the resources of the entire central bank and also provide input from the supervision side. So clearly, that’s something I think we need to do more of. In terms of the second question, do you want to take a fresh crack at that, Brian? MR. PETERS. Yes. My perception is that the people who were further down on the list made active decisions to get out of the business or reduce their scale of the business, not necessarily January 29–30, 2008 191 of 249 just on gut feeling but because they had invested earlier on in the staff and the models to evaluate the product space. So they understood that the economics of the subprime business had deteriorated and that the risk relative to the return was rising, and they made an active decision, usually, to retract a bit from that space. Now, they may have made those decisions gradually and incrementally over the year from mid-2006 forward. It wasn’t one stress test, but it was a thorough understanding of the economics of the actual business that drove their decisionmaking. MR. ANGULO. I would also agree that your general point about banks being more exacting in their stress testing is a good one because it’s something we and other supervisors, to be honest with you, continually look at, and many times the response that banks get internally from either owners or managers or through supervisors is that, well, if it’s too extreme, it’s not really plausible, and you can’t really act on it. The other argument you sometimes hear is, well, it costs a lot of money to integrate that across the firm and do it the right way, and that’s a tough sell. So I agree with your point that we need to do more and then push harder on stress testing. The way that you suggest is kind of novel: You do a back test and show it to them. That’s an interesting concept. MR. GREENLEE. I might add one thing to that. In interviews we did with some firms, one point that they made was that stress testing was informative and important, but a next step they’re trying to take is what it would take to cause that stress event to happen for different types of assets. So they are trying to anticipate—not so much that they just assume a 10 percent drop but how they would get to a 10 percent drop. What would be the events that would cause that to happen? Then they think that through in a more systematic way. I know some companies have learned what their highly rated things are that are viewed as stable-value assets elsewhere on their balance sheets and are thinking about how those could start to unwind or to deteriorate. January 29–30, 2008 192 of 249 MR. PETERS. We need to be careful with the nomenclature. Stress testing right now in the industry encompasses a lot of things, and people will tell you that they do stress testing, but they are really doing static shocks. What we are talking about is not a historical analysis but a kind of forward-looking scenario that builds in your view of the world. Those are the firms that, again, made more-active decisions to reduce their exposures. CHAIRMAN BERNANKE. President Hoenig. MR. HOENIG. I think this was very interesting, and I have a suggestion and then a question. The suggestion is that this morning we had the Federal Open Market Committee meeting. This afternoon we should have the Federal Market Oversight Committee meeting, and that is what we’re doing right now in looking at some of these institutions. My question is, As you look at these and you compare the most effective and least effective, are you in the process and shouldn’t we be in the process—because we go back and look at these horizontal reviews—of looking at what lessons we’ve learned about more-effective institutions and less-effective institutions during the horizontal review so that we can be more proactive in terms of the outcomes that we’re now seeing? If we do that in a systematic fashion over time, we could anticipate not all—we learned a long time ago that you cannot anticipate it all—but some of these differences and put more pressure on some institutions that were not doing good risk analysis to step up to it before it becomes a crisis. I don’t know if we’re doing lessons learned for ourselves in that regard. MR. PETERS. I would say we’ve looked at a lot of that. The one place I would highlight most articulately is the degree of international coordination and cooperation we’ve had under way. The core firms in the United States are one portion of this system now, with a number of very significant global competitors. So the coordination between us, the OCC, the SEC, the U.K. FSA, and the other senior supervisor groups has been really necessary for everyone to get a good January 29–30, 2008 193 of 249 understanding of practices. It’s perhaps more valuable to some of the foreign supervisors who have only one or two large firms under their jurisdictions. But even from our vantage point of what our direct supervisory responsibility is, the consolidation within the industry has collapsed the number of firms that we view directly. MR. GREENLEE. I might add that we are trying to look at this. It’s not just an issue of guidance, but we are going back through the supervisory process in terms of what we’ve learned through these interviews and challenging our beliefs and prior assessments. MR. HOENIG. I think that is good because, if you think about it, we have the Basel capital standards coming forward, which involve the advanced method—relying on those institutions to a great degree in terms of judging their capital and their capital levels. When they are under pressure, they will tend to work the model. It is natural. As we have said before, the incentives are that they will work the model. So if we are not taking lessons learned from this in terms of anticipating those behaviors, I think we will repeat history in the surprises that we get. CHAIRMAN BERNANKE. Vice Chairman. VICE CHAIRMAN GEITHNER. Just very quickly, you did a terrific job. I think it’s important, though, to recognize that this isn’t done yet, and we’re not going to know fundamentally how we feel about the relative strengths and weaknesses in the system until we see how this plays out. Don’t let these initial presumptions—either the diagnosis or the prescription, particularly your list of prescriptions—harden too much because there are some judgments that we’re just not going to be able to make until the dust settles and we have a little time for reflection in that context. I think a lot of damage has been done to the credibility of our financial system. It’s not clear how much damage because we don’t know how this is going to play out. But damage has been done, and we are going to bear a lot of the burden of figuring out how to craft a compelling policy January 29–30, 2008 194 of 249 response, recognizing of course that regulation may be part of the problem and won’t necessarily be part of the solution. Anyway, mostly I just meant to compliment you. You did a great job, and I think it’s helpful really to have this much work done early on in getting us to the point where we know what we’re going to do to the system to make it less vulnerable to this in the future. Even as we manage the crisis, I think it’s good to have made that investment and a good tribute to the strength of the system that we were able to devote these quality resources even though we’ve all been busy managing the storm. CHAIRMAN BERNANKE. Let me also thank the staff for an excellent presentation. This is just the tip of the iceberg in terms of the work that’s being done on all these different topics, and in turn we’re collaborating with our colleagues here in the United States and abroad, and I guess we’ll keep working and hope to find some valuable lessons out of this experience. I’ve been asked to remind people that you have until tomorrow close of business if you wish to revise your projections. Brian Madigan raised a few questions about consistency. If you want to think about that, of course, feel free to do so. Our next meeting is March 18. I look forward to seeing you then, and there’s a lunch available for those of you who can stay. Thank you very much. The meeting is adjourned. END OF MEETING March 10, 2008 1 of 39 Conference Call of the Federal Open Market Committee on March 10, 2008 A conference call of the Federal Open Market Committee was held on Monday, March 10, 2008, at 7:15 p.m. Those present were the following: Mr. Bernanke, Chairman Mr. Geithner, Vice Chairman Mr. Fisher Mr. Kohn Mr. Kroszner Ms. Pianalto Mr. Plosser Mr. Warsh Ms. Cumming, Messrs. Evans, Lacker, and Lockhart, and Ms. Yellen, Alternate Members of the Federal Open Market Committee Messrs. Hoenig and Rosengren, Presidents of the Federal Reserve Banks of Kansas City and Boston, respectively Mr. Sapenaro, First Vice President, Federal Reserve Bank of St. Louis Mr. Madigan, Secretary and Economist Ms. Danker, Deputy Secretary Mr. Skidmore, Assistant Secretary Ms. Smith, Assistant Secretary Mr. Alvarez, General Counsel Mr. Baxter, Deputy General Counsel Mr. Stockton, Economist Mr. Kamin, Ms. Mester, Messrs. Rosenblum and Sniderman, Associate Economists Mr. Dudley, Manager, System Open Market Account Mr. Clouse, Deputy Director, Division of Monetary Affairs, Board of Governors Mr. Struckmeyer, Deputy Staff Director, Office of Staff Director for Management, Board of Governors Mr. Leahy, Associate Director, Division of International Finance, Board of Governors Ms. Liang, Associate Director, Division of Research and Statistics, Board of Governors Mr. Blanchard, Assistant to the Board, Office of Board Members, Board of Governors March 10, 2008 2 of 39 Mr. Luecke, Section Chief, Division of Monetary Affairs, Board of Governors Messrs. Fuhrer and Judd, Executive Vice Presidents, Federal Reserve Banks of Boston and San Francisco, respectively Mr. Altig, Ms. Perelmuter, Messrs. Rasche, Sellon, Sullivan, and Weinberg, Senior Vice Presidents, Federal Reserve Banks of Atlanta, New York, St. Louis, Kansas City, Chicago, and Richmond, respectively Ms. Logan, Assistant Vice President, Federal Reserve Bank of New York March 10, 2008 3 of 39 Transcript of the Federal Open Market Committee Conference Call on March 10, 2008 CHAIRMAN BERNANKE. Good evening, everybody. I am sorry, once again, to have to call you together on short notice. We live in a very special time. We have seen, as you know, significant deterioration in term funding markets and more broadly in the financial markets in the last few days. Some of this is credit deterioration, certainly, given increased expectations of recession; but there also seem to be some self-feeding liquidity dynamics at work as well. So the question before us is whether there are actions we can take, other than monetary policy, to break or mitigate this adverse dynamic. There are two actions on the table, which I think we should just try to consider together, if possible. The first is the proposed term securities lending facility—I know you received the documentation on this without much notice, but we will get some explanation in the meeting. The second item—we have received formal requests from the European Central Bank (ECB) and from the Swiss National Bank (SNB) to expand and extend the currency swap lines that we have with them. As you recall, in December we had a coordinated action, which involved the ECB and the SNB doing dollar funding auctions that piggybacked on our term auction facility. They stopped doing that after the turn of the year, but they would like to return to doing that now for some time. They think that dollar funding conditions warrant it. They are requesting that we raise their swap lines. The ECB’s line is currently $20 billion. It would like to raise its line to $30 billion, so it can do two $15 billion auctions a month. The Swiss National Bank would like to have its $4 billion line raised to $6 billion, so it can do one $6 billion auction each month. That would be a coordinated effort. We would have a joint statement, along with the United Kingdom and Canada, and also supporting statements from Sweden and Japan. So it would be a March 10, 2008 4 of 39 type of coordination similar to the one we saw in December. Again, the request is to increase the swap lines and to extend them, and we propose to extend them through September 30. That requires a vote of the FOMC, and so, again, we have two items for your discussion. I would like to proceed as follows. I am going to turn first to Bill Dudley and his colleagues in New York to give us a brief update on market conditions and then to outline for us the proposed term securities lending facility and how it would work and what we hope it would do in the markets. I don’t think extensive exposition of the swaps is necessary, but any questions are welcome. After New York’s presentation, we have Bill, Brian Madigan, Scott Alvarez, and other staff here, if you have any questions. Following that, we would have a go-round and get comments and positions, and then we proceed to votes. So without further ado, let me turn to Bill in New York to start with a market update and then to talk a bit about the proposed facility. Bill. MR. DUDLEY. Thank you, Mr. Chairman. Financial conditions have worsened considerably in recent days. Credit spreads have widened, equity prices have declined, and market functioning has deteriorated sharply. Although there are many factors that can be cited to explain what we are seeing—including the acute weakness in the U.S. housing sector, a deteriorating macroeconomic outlook, and the loss of faith in credit ratings and structured-finance products—we may have entered a new, dangerous phase of the crisis. Major financial intermediaries are pulling back more sharply and along more margins than previously—shrinking their collateral lending books and raising the haircuts they assess against repo collateral. For a time, this adjustment was occurring in a relatively orderly way, but we appear to have passed that point about ten days ago. The failure of Peloton—a major hedge fund—and the well-publicized problems of Thornburg Mortgage and Carlyle Capital Corporation in meeting margin calls have triggered a dangerous dynamic. That dynamic goes something like this: Asset price declines—say, triggered by deterioration in the outlook—lead to margin calls. Some highly leveraged firms are unable to meet these calls. Dealers respond by liquidating collateral. This puts downward pressure on asset prices and increases price volatility. Dealers raise haircuts further to compensate for the heightened volatility and the reduced liquidity in the market. This, in turn, puts more pressure on other leveraged investors. A vicious circle ensues of higher haircuts, fire sales, lower prices, higher volatility, and March 10, 2008 still lower prices, and financial intermediaries start to break as a liquidity crisis potentially leads to insolvency when assets are sold at fire sale prices. This dynamic poses significant risks. First, it impairs the monetary policy transmission mechanism. We have seen that in recent weeks in the sharp widening between mortgage rates on an option-adjusted basis and Treasury bond rates. Second, as hinted at above, there is a systemic issue. If the vicious circle were to continue unabated, the liquidity issues could become solvency issues, and major financial intermediaries could conceivably fail. I don’t want to be alarmist, but even today we saw double-digit stock price declines for Fannie Mae and Freddie Mac. There were rumors today that Bear Stearns was having funding difficulties: At one point today, its stock was down 14 percent before recovering a bit. Third, the problems in one financial market disturb others. We have seen the problems move from subprime to alt-A mortgages to jumbo prime mortgages and now even agency mortgage-backed securities. Commercial-mortgage-backed security spreads and corporate credit spreads have also widened, and we have seen considerable distortions in the municipal market. The deterioration in market function can be seen in a number of ways. First, term funding spreads have widened back out. For example, the one-month LIBOR–OIS spread today is 56 basis points, up from its low point in 2008 of 16 basis points, which was reached in January. Second, haircuts for residential MBS have increased sharply, and if anything, the rate of deterioration in terms of haircuts has accelerated markedly in the last week. Third, bid-asked spreads for transactions on many types of financial instruments have widened, indicating a growing liquidity problem in the market. To address these issues, the Federal Reserve has responded by increasing the size of the TAF program and by implementing a large, term, single-tranche RP program. Together, these two programs will likely cumulate to total outstandings of about $200 billion. In addition, as the Chairman mentioned, the ECB and the SNB today have submitted requests to increase their foreign exchange swap draws and restart their term funding auctions. But there are limits to what these programs can do. The TAF provides liquidity only to depository institutions—this liquidity is not necessarily passed on readily to primary dealers and to other financial institutions. Although term RPs do provide some assistance to primary dealers, these operations are limited to the highest quality collateral—Treasuries, agencies, and agency mortgage-backed securities. Moreover, as both programs are scaled up, there is a large impact on reserves that must be offset by Treasury redemptions, sales, or reverse repurchase operations. Frankly, there are limits to our ability to adjust our portfolio quickly without our actions becoming a source of disruption to financial markets. For this reason, the staff has proposed a new facility, the term securities lending facility, or TSLF. A memo from the New York Fed staff and a term sheet were circulated to the FOMC earlier today, and these documents discuss in some detail this 5 of 39 March 10, 2008 proposal. Let me give a summary of what I see as the most important points. In brief, this facility would expand the Federal Reserve’s securities lending program for primary dealers by lending securities secured for a term of 28 days, rather than overnight, by a pledge of other securities—Treasuries, agencies, agency mortgagebacked securities, or AAA-rated private-label mortgage-backed securities. The last category is not currently eligible for open market operations (OMO). Currently, our securities lending program is overnight and exchanges only Treasuries for Treasuries. The purpose of this facility is to help alleviate the rapidly escalating pressures evident in term collateral funding markets. So how would this facility help to accomplish this? By providing the ability to swap illiquid mortgage-backed collateral for Treasury securities, the program would reduce the uncertainty among dealers about their ability to finance such collateral. The expanded supply of Treasuries obtained in the collateral swaps would improve the ability of primary dealers to finance the positions on their balance sheets. This should, in turn, increase the willingness of dealers to make markets across a range of securities. Better market-making, in turn, should lead to greater liquidity for these securities. This, then, should reduce price volatility and obviate the need for dealers to assess higher haircuts against such securities. The liquidity option provided by the TSLF should reduce liquidity risk more generally. The program should help slow, or even reverse, the dynamic process of reduced liquidity, greater price volatility, higher haircuts, margin calls, and forced liquidation. Why does the staff recommend that the scope of collateral be broader than OMOeligible collateral? The staff believes that a program based only on OMO collateral could help improve liquidity in those markets. An improvement in liquidity in these core markets could help other related markets. Despite this, the staff recommends that the TSLF go one step further and also accept AAA-rated private-label residentialmortgage-backed securities in this program. The staff believes that it is important to take this additional step because the level of dysfunction in the non-agency mortgagebacked securities market is pronounced, this market is large, and steps to improve market function in this asset class are likely to have positive consequences for the availability and the cost of mortgage finance. In other words, improvement in this area would make monetary policy more effective and would likely generate significant macroeconomic benefits. To limit the credit risk exposure of the Federal Reserve, the facility for nonOMO-eligible collateral would be limited to AAA-rated residential-mortgage-backed securities assets not on review for downgrade. In addition, the securities would be repriced daily, and appropriate haircuts would be applied against such securities. Why not go further? Although the SOMA lending facility could be extended to include other asset classes such as commercial-mortgage-backed securities, corporates, and municipals, the staff recommends against such a broader extension for two reasons. First, these markets are not under the same degree of duress as the residential-mortgage-backed securities market. Second, adding additional asset 6 of 39 March 10, 2008 classes would increase the operational complexity and risk of the program—for example, by requiring additional auction cycles. What are the risks of such a program? We think there are several risks that are particularly noteworthy. First, we cannot be sure that the program will have its intended impact. Experience with the TAF suggests that it will, but there is no guarantee of this. Second, the TSLF could increase moral hazard. If the program is successful in preventing losses that would have arisen from an inability to obtain funding, the TSLF would be a form of insurance that could conceivably induce broker–dealers to run smaller liquidity cushions during normal times. Third, Federal Reserve credit risk would increase as the SOMA portfolio accepted lower-quality collateral from primary dealers. On the first point—Will it work?—the TSLF would be quite large, perhaps cumulating to $200 billion, the same size as the TAF and the term RP program combined. We can make it even bigger if we desire. So we think we have the muscle here to have an impact on term funding markets. On the second point—the moral hazard issue—the staff believes that the TSLF will increase moral hazard somewhat. Ideally, this type of program would also be accompanied by prudential regulation to ensure that primary dealers hold adequate liquidity buffers across the typical business cycle. On the third point—the issue of credit risk to the Federal Reserve—we conclude that there will inevitably be some increase in credit risk. But this risk should be controllable. We know our counterparties, we are not accepting securities that are on watch for downgrades, and the non-agency MBS securities will be AAArated. Moreover, we plan to limit the exposure to the more robust AAA-rated MBS by not accepting private-label MBS with CDO-type structures and characteristics. And if securities are put on watch, we can demand substitution. Fully cognizant of these risks and others—which are outlined in more detail in the memorandum circulated to the FOMC earlier today—we conclude that the benefits are likely to significantly exceed the costs of the program. The staff believes it is important to take those steps necessary to restore the monetary policy transmission mechanism to working order and to short-circuit the vicious dynamic now evident in financial markets. Debby Perelmuter will now describe the TSLF program in more detail, focusing on how it will operate in practice, now that I’ve outlined the theory. Debby. MS. PERELMUTER. Thanks, Bill. Should the Committee approve the proposal for the TSLF, we intend to announce tomorrow to the public the total program size envisioned as of today—as Bill mentioned, up to $200 billion. It will consist of $100 billion against pledges of OMO-eligible collateral and $100 billion against pledges of TSLF-eligible collateral beyond the OMO-eligible. Together the two tranches will be comparable in size to the TAF program plus the recently announced 28-day single tranche RPs. 7 of 39 March 10, 2008 For an immediate impact, we are thinking about auctioning $50 billion in each of the tranches at the outset, with the first auction occurring during the week of March 24. Specifically, the plan is to hold separate 28-day auctions for each main category of collateral in successive weeks with our primary dealer counterparties. We will auction the first tranche against pledges of OMO-eligible collateral on Thursday, March 27, to settle the following day (T+1) and to mature 28 days hence, and we will auction the second tranche against pledges of the non-OMO-eligible collateral on the following Thursday, April 3, also for T+1 and for a period of 28 days. The auctions will be held at 2:00 p.m. and will close at 2:30 p.m. with results posted shortly thereafter. We plan to auction in this pattern, each Thursday, alternating between the two collateral tranches for the duration of the facility. The auctions will be based on a fee rate, in a bonds-versus-bonds construct. It is similar to our daily securities lending operations, and it is very familiar to our primary dealers. The fee rate bid will represent the spread, in basis points, between the cost of 28-day financing of general collateral Treasury securities and the cost of 28-day financing of the respective basket of collateral in the respective tranche. As with the TAF auctions and our daily securities lending operations, a minimum fee will be set by the Federal Reserve Bank of New York for each of the collateral tranches ahead of each auction. The fee will be set by a competitive single-priced auction process in which the accepted dealer bids will be awarded at the same fee rate, which shall be the lowest fee rate at which bids were accepted. Similar to our temporary open market operations, haircuts for the OMO-eligible collateral pledged will be the same, given that the facility is open to the same set of counterparties—the primary dealers—and the collateral in this tranche is identical. In addition, the Federal Reserve Bank of New York will use the services of the major clearing banks, BONY and JPMorgan Chase, and all transfers of collateral will be made through the borrower’s clearing bank account. This is how we do things for our open market operations. Overall, the terms and conditions are similar to those of the TAF auctions in the following ways. There will be a 28-day fixed fee determined via a single-price centralized auction. The TSLF will have a minimum fee rate, and settlement will be forward settling. The term of operation will be 28 days except for holiday conflicts. The TSLF will have a minimum bid amount ($10 million as opposed to $5 million in the TAF). The maximum number of bids per participant will be two. The total propositions for each bid submitted and the total award may not exceed a specified percentage of the announced offering amount. We are contemplating a 20 percent limit per dealer. If a participant ceases to qualify for the TSLF (if it is no longer a primary dealer, for instance), the Federal Reserve Bank of New York may accelerate the unwinding of the loan, making the return of any pledged collateral immediately due. The main differences between the TAF and the TSLF are as follows. They involve different sets of counterparties. The TAF provides direct funds, and the TSLF will provide securities. A different range of collateral is accepted: The TSLF 8 of 39 March 10, 2008 9 of 39 is limited to OMO-eligible collateral and AAA non-agency residential-mortgagebacked securities. We expect to assess higher haircuts on non-OMO-eligible collateral as loans will be to the primary dealers and not to depository institutions. Overall we expect haircuts to be higher than those in normal times but lower than those in extremis. The haircuts on non-OMO-eligible collateral are expected to be higher than those on OMO-eligible collateral. We expect to develop the terms and conditions of the TSLF more precisely after consultation with the primary dealers and the clearing banks. Should the Committee approve the proposal this evening, we expect these conversations to begin shortly following the announcement. Thank you. CHAIRMAN BERNANKE. Thank you very much. We have all the staff here. Are there any questions about any aspect of the presentation or about the swaps? President Hoenig. MR. HOENIG. If I understand this, the ability to go outside our normal collateral and into, say, these jumbos and so forth is based upon section 13 (3) in the Federal Reserve Act. Am I right on that? As you talked about moral hazard, did you have any concerns that, should the market not accept this and things deteriorate further, we would find ourselves going down the road to greater acceptance of greater varieties of collateral that we need to think about in the future? CHAIRMAN BERNANKE. Scott, do you want to answer the first part about section 13(3)? MR. ALVAREZ. Yes. President Hoenig, you are correct. We are relying in part on section 14, the open market operations piece, even for accepting collateral that is not section 14 collateral because it does have an effect in improving the market for U.S. government securities, but there is a very strong component of this that is providing liquidity to the primary dealers, and to satisfy that we are relying on section 13(3) authority. MR. HOENIG. I assume that to try to handle the issues around moral hazard, the fact that we are confining it to the primary dealers is an important consideration? March 10, 2008 10 of 39 MR. ALVAREZ. That is right. We are relying on market conditions, on limiting it to primary dealers, and on limiting the types of assets that we will accept as collateral. MR. DUDLEY. You asked a question about broadening it potentially to other asset classes. I don’t think there is any presumption. That is certainly not our intention, but obviously we have to be responsive to the way things evolve. We are certainly not intending to do that, but I can’t say categorically that we would want to rule it out. MR. HOENIG. I don’t oppose this. I just want to make sure that I understand some of the implications because I assume that part of this, given the circumstances in the markets, is to create a floor under this that is, in effect, trying to stanch the momentum and keep the losses down. So that logic will apply more broadly should the markets deteriorate, and that is kind of the path we are on. This is a crisis, I admit, and I just want to make sure that we are clear on what it is we are initiating here. CHAIRMAN BERNANKE. We would not be setting a price floor for the asset, but we would be trying to reduce the liquidity premium. If there were further deterioration in price associated with the credit risk, that would still show through. MR. HOENIG. Okay. CHAIRMAN BERNANKE. President Fisher has a question. MR. FISHER. Mr. Chairman, you wanted to have a go-round, but I do have some questions. CHAIRMAN BERNANKE. This is the question phase now. We will have a chance for everyone who would like to speak to do so. MR. FISHER. Well, Bill, you used the term “presumably prudential regulation,” I think it was. We are talking about broker–dealers. This gets to a broader concern that I have, which is March 10, 2008 11 of 39 the stick part of this. I can understand the carrot side of this thing, and we are doing it for the reasons that you stated, and I am very sympathetic to the argument. The question is, What do we get in return, and how do we make sure that, since we are not the regulator of these dealers, there is indeed discipline? I would like to know what your answer is. Do we have an arrangement with the SEC, or how do we work with the other regulators to make sure that discipline is applied here? In essence, as I understand this in my simple fashion, obviously we are taking lesser-quality paper in return for high-quality paper over the defined time frame that you stated and under the conditions that you stated. But I am just a little worried about being taken advantage of here. So the question is specifically about the “prudential regulation” of those people that we’re dealing with. Then, I have other questions to follow. MR. DUDLEY. Well, the first thing I would say, President Fisher, is that we are doing this collateral swap for a fee and for one that is higher than the normal fee in normal markets. So in no way is it free. In terms of the prudential regulation, I think there will be a lot of lessons learned from this crisis that will be addressed in the fullness of time, and this is one lesson that we are going to have to remember when we look at what we have learned from this experience. CHAIRMAN BERNANKE. I would like to note that I did talk to Chairman Cox today about this and got his strong support. MR. FISHER. Again, I think it would be helpful, Mr. Chairman—you and I talked about this a little last night—to have a full understanding of that strong support because it is critical input. Just to move on, on the question of the haircut, as I understand it from the paper, on the non-OMO eligible collateral, we are talking about an 8 percent haircut—is that correct? MR. DUDLEY. That is the working assumption for the time being. We are going to have conversations with our primary dealers, and that is where we are going to really fine-tune March 10, 2008 12 of 39 what the appropriate haircut is. But I think the general operating principle here is to have haircuts that are considerably higher than the market during normal times but lower than the market during times of crisis, which we would argue that we are in or are close to being in right now. MR. FISHER. The only thing I would caution about is the sentence in the paper that said “conservative relative to pre-crisis levels.” Those were fantastically low spreads that were out of touch with reality, which we now know. Obviously, you are going to be prudent about this, but it seems to me that 8 percent is not much more than what we have on the TAF now. Is it 7 percent that we apply as a discount? MR. DUDLEY. For AAA collateral, I think it is actually lower than that. I think it is 3 percent, so we would expect that the haircut should be higher because we are dealing with primary dealers rather than depository institutions as our counterparties. So we certainly accept the fact that there should be higher haircuts. CHAIRMAN BERNANKE. Other questions? MR. FISHER. Well, I had some other questions, Mr. Chairman, but I don’t want to bore the group. I would like to listen to the conversation. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. The question relates to what President Fisher was pursuing, which, if I understand correctly, is our chance of actually incurring a loss in holding the less creditworthy paper. That would relate to a default on the part of a broker–dealer in unwinding the swap and then an ultimate loss in how we dispose of the paper over time if we were to hold it. So the question is, Are we aware of any primary dealers who are really in serious condition at this stage and constitute a “first way out” risk? March 10, 2008 13 of 39 MR. DUDLEY. We have the right to limit our exposure to primary dealers that we have less confidence in. In fact, that is what we would actually do in the implementation of this kind of program. CHAIRMAN BERNANKE. Any other questions? President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. If I could, I have basically three clarifying questions, a couple of them related to other comments. The first is on this issue of haircuts and discounts on the collateral. If I understand from looking at what we do for the TAF and for the discount window, the haircut that is given depends on the duration of the security, and it ranges from 8 percent to 3 percent. As I think Bill Dudley suggests, it is lowest for very short term duration buckets. But those haircuts apply, at least in my understanding, only to assets for which there are in fact market prices being quoted somewhere. For assets that are committed, even AAA assets, for those types of collateralized mortgages where there are no market prices, the haircut is 20 percent. So are we then accepting only collateral for which market prices in fact exist, or would we be following what we do at the discount window and take a substantially higher haircut for securities that we don’t observe market prices for? That is my first question. MR. DUDLEY. My understanding is that we are going to take only securities for which market prices exist. MR. PLOSSER. Okay. The second concern—I want to go back to President Fisher’s and President Hoenig’s comments—I am a bit nervous about the slippery slope here. Once we start taking assets of a particular class that is in distress, are we setting ourselves up for potential risks down the road, when all of a sudden some other asset class that is commonly used in both trading and securities, whether by mutual funds or banks, comes under greater duress and for which spreads widen significantly? Are we going down a path here in which we are going to March 10, 2008 14 of 39 implicitly provide support for a whole range of potential asset classes? I worry a bit about where this might lead us over a longer period of time. That is related to my question. Maybe I missed it reading the document or in the discussion. This facility is different from the traditional lending facilities that we have in place primarily because of the term, even for the non-schedule 1 assets. Are we going to bill this as something different, and if so, does that mean we can remove it at some point? How long do you anticipate this facility being in place, and how do you think about the magnitude of the operations that we want to open the door for? CHAIRMAN BERNANKE. President Plosser, I would make just a couple of comments, and Bill can follow. On the slippery slope, it requires an FOMC vote to add assets. So if we come to that point, you will have your opportunity to vote “no” or to object. Again, we don’t propose to do that—but, you know, time consistency. I’m sorry, what was the other thing? Oh, you asked about the duration. The section 13(3) legal basis for this operation requires an affirmation that market conditions are significantly impaired. If we couldn’t honestly make that affirmation, our legal basis would disappear. So I think we would have to remove it once conditions had normalized. Bill, do you have anything to add to that? MR. DUDLEY. I think you answered the question very well. CHAIRMAN BERNANKE. Gee, thanks. [Laughter] Charlie, did you have other questions? No? President Rosengren. MR. ROSENGREN. I just want to follow up on one of Bill Dudley’s comments. I noticed in the terms and conditions that it included that the New York Fed reserves the right to reject or declare ineligible any bid entirely at its own discretion. Under the TAF, we require that people be qualified under the primary credit program. Are we planning on using a credit March 10, 2008 15 of 39 standard equivalent to what is done for the TAF for the broker–dealer community? Do we currently have the capacity to make that determination? MR. DUDLEY. I think the answer to that question is that we are going to make a determination but we don’t have the same level of knowledge about the institution because we are not the primary consolidated supervisor. CHAIRMAN BERNANKE. President Pianalto, do you have a question? MS. PIANALTO. Yes. I just wanted to clarify that we are being asked to authorize the acceptance of different collateral. Who determines the size of the lending program on an ongoing basis? Is that determined by the Desk? MR. DUDLEY. We are proposing the rough size of the facility today. As we gain experience with the facility and examine market conditions, we will be keeping the FOMC apprised of the programs and certainly seeking the input of the Committee on how to take this going forward. I hope that we will get a lot of feedback as we go through this auction process. If the bidding is very strong and if the markets are under tremendous distress, then we would probably want to increase the size of the program. Conversely, if the bidding is weak and if the markets settle down, then we would want to wrap up this program pretty quickly. MR. ALVAREZ. The resolution that the FOMC will be asked to vote on today will have an outside limit of $200 billion as the total size of the term securities lending facility. If it were to go above that, it would have to come back to the FOMC. CHAIRMAN BERNANKE. President Evans. MR. EVANS. President Pianalto asked my question. CHAIRMAN BERNANKE. Okay. President Fisher, do you have another question? March 10, 2008 16 of 39 MR. FISHER. Yes, sir. I want to come back to President Rosengren’s question, just so I understand this. Bill, let’s take an example. What I think Eric is referring to is footnote 6 on page 9 of 10: “The Federal Reserve Bank of New York reserves the right to restrict individual primary dealer use of the program, even at the outset.” Do we have the capacity, for example, going back to your introductory comments on what happened in the markets, to evaluate Bear Stearns as a participant in this program and to say, “No, you can’t participate”? If we did that, what would that do to Bear Stearns? MR. DUDLEY. Well, the first thing is that almost all of these primary dealers have the SEC as their primary consolidated supervisor. So it is important to understand that it is not as though there isn’t an entity looking at the financial strength and stability of these institutions. We have the right not to accept collateral from any of the primary dealers, should we decide to do that. It is not going to be public. We are not going to be making a statement. This is just going to be a bilateral arrangement between us and the given primary dealer. MR. FISHER. I guess my concern is that the safety-and-soundness disciplines that we apply don’t appear to be applied to these broker–dealers. I guess the real question is that we can fly blind for a little time and we can try something—and I am for trying something—but if this doesn’t lead to some broader regulatory authority or some change in the nature of the regulatory authorities, if we are indeed going to have counterparties in this sense that are outside our realm of regulation, I just wonder what the end game here is. Mr. Chairman, I am saying that I think we need to really think that through. We can react to what we are seeing going on in the marketplace, but I would feel much more comfortable as we go through time if we could understand what the end game is and what we want to get in return long term for providing this hopefully short-term solution to the liquidity crisis—that is the point I am trying to make. March 10, 2008 17 of 39 VICE CHAIRMAN GEITHNER. Mr. Chairman, maybe I could say something in response to this. I agree with the concerns expressed about giving access to liquidity when we haven’t done it before without a full capacity to affect the supervisory constraints these guys operate under. We are not doing this for them, though. We are doing it because we think it is necessary to help improve market functioning more generally. We do not have the capacity in these circumstances to redesign the regulatory framework to give us, as a condition of access to something that we are doing for market functioning, the ability to affect and constrain the risktaking behavior of those institutions. All primary dealers, except for one, I believe, are subject to consolidated supervision in some form. Those primary supervisors, with which we have a very close-running relationship, often subject those institutions to a set of constraints, including in the investment banks a consolidated capital regime and a set of other constraints on liquidity. We will, of course, be in very close contact, as we have been with those primary supervisors, about the evolving financial conditions of those institutions. If we have evidence, directly or through the supervisors, of some material erosion in the financial business of those institutions from a solvency perspective, that will cause us to reflect on what we do with those institutions going forward. I wish it were the case that we could condition this step on a change in the regulatory regime that would give us that capacity. But we just don’t have that ability now. Are we protecting ourselves carefully against that risk? We are protecting ourselves carefully, but not perfectly, against that risk. One last comment. The Desk has a lot of experience in affecting the incentive that primary dealers have—how much they can actually bid for, particularly in circumstances where the condition of the primary dealer is eroding quickly. That is not perfect, but it gives us some experience and some chance to make sure that we don’t put ourselves in a position where we March 10, 2008 18 of 39 allow an institution that is deteriorating rapidly to take a progressively larger amount of a particular auction in that context. So although I agree with the concerns and I really am sympathetic to the objective, the reality today is that we can’t remake this messy system we have in this context to give us that additional comfort. MR. FISHER. Just a comment, Tim, if I may. You are right, and we can’t stuff this ugly genie back in the bottle. But I think we should be thinking longer term as much as we can as to how we can reshape things, taking advantage of our franchise. I am not arguing against the program. But we are taking a risk here, and we want to mitigate the risk as much as possible. I am just saying that (a) we need to use this as leverage somehow over the longer term, as we become more comfortable with this, to exert our authority, and (b) in the way you just explained this, we need to have a good way of explaining it to the public because we are going to get severe criticism. I can see the criticism of almost lending blind, taking substandard collateral. That kind of cogent explanation is going to be very, very important, Mr. Chairman. We need to be prepared to explain this to our critics because we are going to have a lot of criticism on this front. So I thank you, Tim, for your response. CHAIRMAN BERNANKE. I agree, President Fisher. We have deficiencies in our regulatory system. Even this change would take us short of what the ECB routinely already has because they don’t have this division of commercial and investment banks, and they have essentially a much broader ability to take collateral. There is a problem, and it is a long-term issue. But the Treasury, for example, is looking at some of these regulatory structure issues going forward. Are there other questions? President Evans. MR. EVANS. This discussion stimulated a question that I didn’t anticipate. If we decide that there is a broker–dealer that we can’t allow to enter into this program and then it ends up not March 10, 2008 19 of 39 doing very well and going under, is there some type of risk that we are taking on by hastening that in making that determination? Do we have the right information to take that action? VICE CHAIRMAN GEITHNER. I agree that we face that risk. As many of us have learned over the past six to nine months, even the primary supervisors of these institutions have limits around their capacity to understand in real time what is actually happening. So we face that vulnerability—I agree with you—and that will limit, realistically, how much protection we are going to be able to take for ourselves in this context. I think that is a necessary and uncomfortable risk in taking this next step. I am not sure it is dramatically different from the risk we face with the discount window generally and with the TAF. It is different, of course, because of our limited supervisory reach over at least five of the institutions. But I think that you stated the risk well and that it is important to recognize that risk. MR. EVANS. The interesting difference is that with the window and the TAF it is voluntary that you could come in. I suppose this is voluntary, but if we pick out somebody and say, “You can’t participate,” and if it’s wildly successful— VICE CHAIRMAN GEITHNER. But this is voluntary like the TAF. In that sense, it is equivalent. But you are right; it would be a consequential act for us to say to a primary dealer, “We are going to restrict you to X” or “We are not going to consider you eligible any more to bid.” It would not be, we would hope, a visible act. But, of course, in taking the action we would be responsible, in some sense, for contributing to the failure of that institution. CHAIRMAN BERNANKE. But not in a legal sense. MR. DUDLEY. However, if we did improve market function, we would be helping that dealer. March 10, 2008 20 of 39 CHAIRMAN BERNANKE. I think President Evans is asking if we would have liability in some legal sense, and I don’t think we would. We have the right to decline any counterparty. MR. EVANS. Okay. Thank you. CHAIRMAN BERNANKE. President Hoenig. MR. HOENIG. Just a comment. When I read this paper, I sensed that you have to get comfortable with the fact that we are extending the safety net to a group with the goal of settling the markets, which reflects, in fact, the reality that we now have with this very integrated, much more complicated marketplace. As we do this, I think moving back from it will be much more difficult than we are anticipating. That is why going into this we make a pretty clear decision that we have opened the safety net to a broader group for the purposes of managing this crisis and that we will probably revisit this again, depending on whether we stanch this now or whether it continues forward—the question that we have been asking ourselves for several months. I think this is the way that we will find ourselves continuing down, depending on how long this lasts—that we are going to extend the safety net. CHAIRMAN BERNANKE. I think we have moved into the commentary period. [Laughter] President Yellen, did you have a question? MS. YELLEN. No, I don’t have a question. CHAIRMAN BERNANKE. All right. Let’s start with President Lacker, then. President Lacker. MR. LACKER. Thank you, Mr. Chairman. As all of you know, throughout this episode I have opposed measures using our balance sheet to attempt to arrest credit market developments, and so it will come as no surprise that I oppose, respectfully, this measure as well—and for similar reasons. These measures are all aimed, one way or another, at altering the March 10, 2008 21 of 39 relative prices of some financial claims. I think the burden of proof ought to be on those who are advocating such measures to provide evidence of some sort of market failure. I have yet to see a plausible case for market failure that would warrant such intervention by a central bank here. In this case, I don’t think the concerns raised by the New York staff memo really come close, and it strikes me that they could equally well rationalize buying tech stocks in late 2000. More broadly, our efforts to ameliorate credit market conditions appear to be motivated by the notion that exogenous malfunctions internal to credit markets endanger the real economy. But it seems much more plausible to me now that the credit market phenomena we have been seeing over the past year are driven entirely by the evolution of expectations regarding the fundamental real return on mortgages and other primitives. I have a deep concern that is particular to this proposal. This proposal crosses a bright line that we drew for ourselves in the 1970s in order to limit our involvement in housing finance. Legislators at that time were proposing various schemes that would involve using our balance sheet to fund various housing initiatives of one sort or another. In the current climate, legislators seem to be casting about for funds to bail out mortgage borrowers. Given the extent to which we have been singled out far more than any other federal regulators as scapegoats for this episode, it would be natural for them to contemplate raiding our portfolio—not to mention, in fact, that our portfolio is larger than other regulators’ portfolios. Whatever one feels about the advisability of fiscal policy of that sort, I think the legal memo did a creative job of interpreting the Federal Reserve Act as allowing direct ownership of this form. But I think we should view opening up this sort of expansive interpretation of the act as a relatively irreversible step because it will be next to impossible to put this interpretation back in the bottle and argue that the act prevents us from holding particular mortgage-backed March 10, 2008 22 of 39 securities outright. Setting this precedent is going to measurably weaken our ability to resist congressional proposals to use us and our balance sheet for off-budget fiscal policy. So, again, Mr. Chairman, I respectfully oppose this term securities lending facility. CHAIRMAN BERNANKE. Thank you. Governor Kohn. MR. KOHN. Thank you, Mr. Chairman. I thought I would begin, if it is okay with you, Mr. Chairman, with talking a bit about what I heard in Basel this weekend. I just got back this afternoon from Basel. I think it is fair to say that Bill’s description of what is going on in U.S. financial markets is going on much more broadly. Liquidity has dried up in London and other European markets in particular, but elsewhere as well. There is really no price discovery. There is aggressive deleveraging and a flight to safety and soundness. Spreads have widened everywhere. It is true that the EURIBOR–OIS spreads haven’t widened very much in the one-month and three-month areas, unless something happened today. But the people from the ECB in Europe reported that they had widened beyond three months, suggesting that people expect this crisis to go on for quite a while. Even in European government bond markets, spreads have widened among different governments that are part of the ECB for the first time since the ECB was founded, reflecting probably liquidity rather than differences in perceived credit risk. Prices were perceived in European markets as well as in U.S. markets to be well out of alignment with any plausible path for economies. That is, the risk spreads were way out of whack with anything that might possibly happen to the economy. There was no price discovery. The prices that were out there were just being driven by fear. Liquidity and solvency were becoming intertwined. The dysfunction in the securities markets and the banking sector were intertwined, and there was just a very vicious spiral going on in many financial markets. “Dysfunctional” was the word that a lot of people used to describe March 10, 2008 23 of 39 their home markets. Even in the emerging market economies, which so far had been relatively “decoupled”—in the current vogue phrase— from the industrial economies, there at least the financial markets were becoming coupled to our markets. One emerging market economist— this is in my CGFS, my global financial system group—reported that locally owned banks in his market were refusing to advance funds through their New York affiliates and their London affiliates to U.S. and European banks. I think I will pause there for the irony to sink in for a second. Those economies that had multinational banks operating in them said that the multinational banks with headquarters in Europe or the United States were definitely selling assets in emerging market economies, not only their portfolios in order to raise funds and hoard liquidity but also subsidiaries were being shopped around in order to conserve their capital. It was broadly viewed that way by everybody, and my global financial system group probably has 35 countries—I don’t know the exact number, but every industrialized country and a half a dozen emerging-market economies are represented. When I summarized the meeting just as I did for you and I asked if anyone disagreed with that summary, no hands went up. In that context, the G-10 governors were very concerned about what was going on and about the turn that financial markets had taken over the last couple of months, but especially over the past week. Any number of them said that they had been getting calls on Thursday and Friday from lots of market participants reporting the same type of dynamic that I was just describing to you and being very, very worried. In that context, they suggested—it didn’t require any urging by me, I can assure you—that a coordinated announcement such as was undertaken in December would be an appropriate step to take. In addition to the swap actions, the United Kingdom and Canada are planning special auctions in their term funding markets much as they did in December, a similar combination. That will be announced tomorrow in conjunction with our stuff. March 10, 2008 24 of 39 Let me go on to the TSLF and the swap lines. I support these steps, but I agree with the thrust of the questions. This is not an easy decision. It hasn’t been easy for me in any regard. I think in many respects this is a logical next step. We are broadening the collateral. We’re expanding securities lending. We’re lengthening terms. We’re being more aggressive in the term funding markets. We’re holding auctions. This is an extension of what we’ve been doing all along in response to this crisis, and this is just the next step. Other central banks have been doing exactly the same thing, reaching out to counterparties, taking more collateral, and doing more at longer maturities. As you pointed out, Mr. Chairman, one very critical difference between us and the other central banks is that they are dealing with universal banks, so they don’t have this division between investment banks and commercial banks in the United Kingdom and Switzerland and in Europe. When they do an open market operation, it’s with the investment banks as well as the commercial banks because they are one and the same thing. I think this facility is aimed at the critical piece of the market, the mortgage markets. This is where the problems are most acute and from where they are radiating out into the rest of the market, where the liquidity, price, and solvency interactions are most intense in this downward spiral that Bill described. As Bill and Debby noted, this swap, which can be expanded rapidly, is a very efficient way to try to address this problem, and we don’t present the Desk with the issues of absorbing the reserves. But I also acknowledge, as many of you pointed out, that we are crossing a line because of the combination of the collateral and counterparty. It is not so much the asset class—that’s not the line we’re crossing because we already crossed that line at the discount window. We’ve taken many classes of assets at the discount window for a long time. The line we’re crossing is the combination of the collateral and the counterparty. That’s why this has to be a combination of March 10, 2008 25 of 39 sections 14 and 13 of the act. We are setting a precedent of a sort. I mean, I think we can step back when markets improve, but it is a precedent. There are moral hazards. There are risks. There are reputational risks. I agree with all of those things, and as Chairman Bernanke can tell you, I was resistant to this idea when it was raised a little while ago. But I have changed my mind, and I have changed my mind for a variety of reasons. The first and most important of them is the downward spiral that we’re in. I had changed my mind before I went to Europe, but certainly hearing the people in Europe describe the same thing happening on a global basis just reinforced it. That is the most important thing that has happened. We are in dysfunctional markets, and we have to try what we can to help them along. I think there are sensible steps here to limit the costs. The degree that the safety net is being extended is small, but the perception that it is being extended is there. I think we’ve limited it as best we can. If I thought that price discovery was occurring in these markets, I would be hesitant to do anything that might interfere with it. But there isn’t any real price discovery happening. So I don’t think this is a case that, if we could only get out of the way, the markets would find their prices, and then the prices would be low enough, and people would step in, and price and liquidity would be restored. That’s not what’s happening. The markets just aren’t operating. There are no guarantees that this will work. We’re not addressing the solvency issues that are to a certain extent at the heart of this. But I do think liquidity and solvency are interacting in a particularly difficult and vicious way right now. To the extent that we have even a chance of breaking that spiral by intervening on the liquidity side—which is what the central banks are here for—and can help at least stabilize the situation, it may encourage the dealers to make markets if they know that we’re behind there in terms of the AAA mortgage-backed securities tranche as well as the agencies and the agency mortgage-backed securities. I think it is well worth taking the March 10, 2008 26 of 39 chance in the current situation. One of the members of the CGFS said toward the end of our meeting on Saturday that “sometimes it’s time to think the unthinkable,” and I think that time is here for us right now, Mr. Chairman. Thank you. CHAIRMAN BERNANKE. Thank you. President Yellen. MS. YELLEN. Thank you, Mr. Chairman. I strongly support the proposed term securities lending facility. I certainly agree that we face a situation in which systemic risk is large, and it’s escalating very quickly. A dangerous dynamic has set in. Bill, Don, and all the memos did a great job in describing it. I think financial stability is truly at stake here, and although there are financial and reputational risks in pursuing this approach, it is a creative and well-targeted approach, and it is worth taking these risks to try to arrest the downward spiral in market conditions. Our monetary policy efforts have been seriously thwarted by the spread-widening that’s taking place, and the rapid escalation we’re seeing in these spreads—large increases in a matter of just the past couple of days in the absence of significant news that relates to the real creditworthiness of borrowers—suggests to me that the spread increases are, indeed, related to deteriorating liquidity conditions and not primarily to higher underlying credit risk. I think it is absolutely right to worry that liquidity problems are escalating into solvency problems. So as with the TAF, I am not 100 percent convinced that this is going to work, but I definitely think it is a good idea to move ahead and to do so quickly. CHAIRMAN BERNANKE. Thank you. President Rosengren. MR. ROSENGREN. Market conditions have deteriorated and are likely getting worse. I strongly support both the swap and the TSLF to help mitigate those problems. In the longer run, I think we do need to consider how to better assess counterparty risk to primary dealers. Thank you, Mr. Chairman. March 10, 2008 27 of 39 CHAIRMAN BERNANKE. Other comments? President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. I have just a couple of observations and a question. I am not terribly confident that this will have the effect we desire. I thought I heard Governor Kohn saying that the ECB actually does take this sort of risk and collateral and it’s not working particularly well. So I’m not sure we ought to hold out a whole lot of hope that it will have the desired effect here. That doesn’t mean we shouldn’t try it, but I’m a little dubious. I am concerned with the comments that President Lacker and Governor Kohn made about crossing a line. However, having said that, I can go along with this proposal; but to be honest, I am concerned about the exit strategy here. Mr. Chairman, you said that we would stop when the markets were no longer impaired. I’m not exactly sure how we would define that at some point. I wonder whether it might be worthwhile thinking about putting this facility in place and doing it for a fixed period of time—I don’t know, three months or whatever—and then having it automatically expire or to be renewed by a conscious act of this Committee rather than having an ongoing process where there was some vague notion of how we would define when we would remove it. I just offer that as an idea for doing this. I guess that’s all I have to say. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Fisher. MR. FISHER. Well, Mr. Chairman, extraordinary circumstances require extraordinary responses. I am very worried about this vicious cycle or, as Governor Kohn put it, vicious spiral of liquidity constriction. I have a lot of questions about the program, and I have, like President Plosser, a sort of end game concern, but I would vote in favor of this program. I think it is something we have to take a risk with. I would like very much for us to think through collectively or under your leadership, again, how we can use this to strengthen our franchise and at least influence this odd regulatory structure we have, which I think is insufficient. I have the same concerns that President March 10, 2008 28 of 39 Rosengren has, which I expressed about having counterparties over which we don’t have great influence, even though we have communication with other regulators. I also think it would be worthwhile, once we have set up this thing and are moving forward, to have some kind of decision tree on all the risk parameters that were outlined in the memo. If we inappropriately affect the pricing of financing credit or if the scale is too small or all the other risks that we’re concerned about occur, what do we do under those circumstances? Where do we go next? What are the cutoff points? This is a fine piece of work that took an awful lot to put together, but it would be helpful at least to me and I think it would be helpful to the Committee if we knew where these different branches would go under different circumstances and what our responses are likely to be so that we can be prepared to go forward. Having said that, I support the program with the different concerns that I have, and I would vote for it. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. On exit strategies, we do get a lot of feedback from the auction itself, of course, in terms of demand and price, and we can monitor the market conditions. Obviously, we’ll keep you well apprised of developments in the markets and in the auction. I’m a little worried about having a firm cutoff date ex ante. If we want the dealers to make markets, we need them to feel that there will not be an arbitrary cutoff when the situation is still in a turbulent state. But that’s just a thought. President Evans. MR. EVANS. Thank you, Mr. Chairman. I support the extension of the swap and the term securities lending facility of up to the $200 billion amount that you’re talking about. This can improve market functioning, as I understand the discussion; and it targets action to markets with major liquidity shortfalls, so I think that it is effectively targeting policy to the right place. It has some risks definitely, but it is important to do something innovative like this. I hope that, after these March 10, 2008 29 of 39 actions, market conditions might improve somewhat so that ultimately fewer adjustments in the funds rate might be called for. If so, then it’s possible that the inflation risks that come with those adjustments might be more limited. That’s not obviously true because the stance of policy depends on overall accommodation, including in financial markets, but that could be the case. If this works, as you were alluding to, we will get a lot of information from the auctions and the market conditions themselves. Removing this might be a lot easier than actually removing the funds rate accommodation that we talked about as being so important. So targeting this could have another beneficial effect on policy. I would guess that we would review or at least have some assessment of how the policy is working at each of the upcoming FOMC meetings, and that would be a natural time for the Committee to talk about that further. Thank you. CHAIRMAN BERNANKE. Thank you. President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. Just a couple of comments. I, too, am supportive. I think the escalating and lengthening crisis really justifies this, and I see the TSLF action really as a measured and incremental response. In that respect, I am somewhat concerned that it may be too small and that the market may react that it’s too little and not preemptive enough. Having said that, I do think it’s an appropriate step, and it has a chance of reversing the dangerous dynamic that Bill Dudley referred to because it helps housing finance and may have some positive effect on housing prices ultimately, and that’s critical to stabilization. So I support both the TSLF and the swap. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Other comments? If you’re prepared to take a vote—oh, I’m sorry. You know, it’s very late here in the East Coast. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. My comments will be short. I share the assessment that Bill Dudley and others made in terms of the market functioning, and I think the March 10, 2008 30 of 39 rolling capital call that we discussed at videoconferences appears to be accelerating, particularly in recent days. The most recent catalyst, as was pointed out, was counterparty weakness driven by large balance sheet exposures and a lack of term funding. Highly leveraged institutions are uncertain about a lot of things, but let me highlight two of them: first, the value of their collateral and, second, their ability to secure financing. I think today’s action is an attempt to hit the second and not hit the first, and in so doing hopes to respect a pretty important line. As I heard the discussion today and the discussion of the markets, it’s as though three horses are competing in a race. The deleveraging horse seems to have raced ahead. The policy reaction function horse is the one we’re working on now. The most important horse is the horse that represents fresh capital, and again, I think the goal of our policy is to get that third horse to go. I am trying to figure out what our objective function is here, and I think it is principally to help provide liquidity for high-quality assets held by a class of highly leveraged financial institutions so that we can do three things: buy time to facilitate price discovery, improve market functioning, and improve the efficacy of open market operations. We are not trying to establish asset values. We’re not trying to buy assets. Those aren’t our goals, and it strikes me that they shouldn’t be. The hard question that came up at the outset is whether these actions can stabilize some part of the capital structure of financial institutions to help us achieve those objectives. For me, as Governor Kohn said, this is a very difficult call, but in the end I do support the judgment. I think we’re going to have to continue to watch the extent to which the healing that might happen in the agency market and in the AAA MBS market moves down the quality spectrum, and we have to be alert to ensure that they don’t come to us seeking solutions there but that we get that third horse back into the race. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. March 10, 2008 31 of 39 MR. KROSZNER. Thanks. I, too, support this facility, but I share with Governor Kohn some of the struggles over it. Are we crossing certain lines? Are we going a bit further than we might feel comfortable doing? Those questions are very serious ones, and the questions that have been raised about the program are quite valid. But given the conditions in the market and, at least as far as I’m concerned, the clear connection between solvency issues and liquidity issues and the fact that the only way we have to get indirectly at the solvency issues is through these liquidity provision mechanisms, I think that we should go forward with something like this. It is crossing a line in terms of counterparty risk understanding and control. That’s something that I’m certainly concerned about. We have pretty good relations with the SEC, but it’s always different to be having good relations with the supervisor as opposed to actually being the supervisor or having the experience of supervising those institutions. So I think that is an important issue. There are concerns about the interpretation of what we are doing that could lead to moral hazard concerns. There are also concerns that this may be just another step along a path that we haven’t really defined well. That is very important, and I very much agree—actually, I have forgotten who made these comments earlier—that we really need to think about the full path of where we’re going because we did the TAF and that seemed to have a good effect initially but it doesn’t seem to be having quite the same effect as we had hoped. I don’t really understand why some of the risk spreads have blown out again in the last week or two. That doesn’t mean that we need to study it to death and that we can act only after we understand the origins of it. But I think we need to have a bigger-picture view to see what is going to go next and how to respond going forward to people who say, “Well, you’ve tried five different little things, and none has really worked, or they work as temporary palliatives.” So I think we really need to understand the origins of this better to better understand how we can respond. We March 10, 2008 32 of 39 may have to respond very boldly in ways that we haven’t done before, but trying to get that big picture of that direction could be helpful to the markets. We may not actually have to take some of those steps if they see that we could go there, but we would understand better what we will be needing to do down the line. I’m hopeful that this could stop some of the problems, but I fear that it may be like the TAF initially. We’ll do something that gets us in a good place for a short time, but then some of the bad dynamic between liquidity and solvency can come back, and we’ll be back at a similar place in the not-too-distant future. I am supportive of this, but I do think we have to think about the bigger picture. Thank you. CHAIRMAN BERNANKE. Any other comments? Vice Chairman Geithner. VICE CHAIRMAN GEITHNER. Thank you, Mr. Chairman. Just a few final things. I support both of these steps, of course. I think monetary policy can’t bear the full burden of dealing with these kinds of pressures, dangerous dynamics, in markets that Bill and Don described so well. This proposal is the best of a bunch of bad options. It is very hard to know how much effect it is going to have. It is very possible it will get overwhelmed by the sheer magnitude of the selling pressure, risk reduction, and forced deleveraging still under way. It is very hard for us to know now how much of that is necessarily ahead of us, even in a world where there is less uncertainty about the macro outlook. I think all of you who said this are right. There’s some risk in doing this that we’ll just face much more pressure to do more. But I think that pressure will be with us anyway, and it would intensify even without action in this context. The important thing is that the Congress gave us the authority, although they may not fully have envisioned the world we live in today, to do a range of things to address these kinds of pressures. Not to use that authority in carefully designed, responsible ways because of the fear that we could not resist pressure to expand is not, in my view, March 10, 2008 33 of 39 a good argument not to do things that we think would be sensible in mitigating these pressures. I think we are a stronger institution than we were. Jeff, you invoked the 1970s. We’re a substantially stronger institution than then, and we have the ability to decide what we think is enough and what line we’re not prepared to cross, and we should be confident that we’re willing to draw that line and that we can sustain it. Where do we go from here? If only we knew. I would like nothing more than to be able to sit here today and say, “If X, then it’s obvious we would do Y, and if we do Y, then we could be confident we could contain it.” But I don’t think anybody can sit here and say that today. I think none of the options out there beyond this look good. The other options are much worse than this, and if we do not escalate now in this context, I think then we face much more risk that will get to much more uncomfortable options with much worse moral hazard concerns for us and the system as a whole. So let me just say that I completely agree with the concerns expressed about this. They were eloquently stated by all of you, but I think it’s very important that we continue to demonstrate through what we say and what we do that we are willing to do practical things that we think have some prospect of alleviating these pressures on market liquidity. So just to repeat, I support both the swap expansion and reauthorization and this new securities lending facility. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. So, there are different ways to look at this. We’re crossing certain lines. We’re doing things we haven’t done before. On the other hand, this financial crisis is now in its eighth month, and the economic outlook has worsened quite significantly. We are coming to the limits of our monetary policy capability. The Congress has passed a fiscal March 10, 2008 34 of 39 program. I do not know how much political capacity there is to do additional things, although I assure you that we will be thinking hard about it and I hope you will be, too. So I view this really as incremental, and I think we need to be flexible and creative in the face of what are really extraordinary challenges. This is a combination of circumstances—a deep and abiding financial crisis, a serious slowdown, and inflation pressures. This combination is really a very challenging and an almost unprecedented combination. I think we need to be flexible, creative, and thoughtful in going forward. I think this is a very creative idea. It’s well put together. We will have to do our very best to report regularly to the FOMC for your governance and your oversight of this process. It’s not without risks, but I do feel that this is the next step. Whether we will have to take additional steps, we’ll come back to you if we think we do or if you think we do. But right now I agree with Vice Chairman Geithner that this is probably the best option that we have, and it comes at a critical time in terms of where the markets are. If there are no other comments, I’d like to ask Scott to tell us what is required of us to move forward. MR. ALVAREZ. You’ll be asked to vote on three resolutions today—one that deals with the term securities lending facility and two that deal with the swaps. The Board is also voting separately to authorize part of the term securities lending facility. One matter I would note, because the rate on the TSLF must be set in the same way that other discount rates are set, we do need a recommendation on how to set the rates. However, because this facility involves just securities lending from the SOMA portfolio, it will be sufficient to receive a rate recommendation from just the New York Reserve Bank, and so the resolutions would not be needed from the boards of directors of the other Reserve Banks at this point. With that, I’ll read the resolution for the term securities lending facility, and I will ask for a vote on that. March 10, 2008 35 of 39 “In addition to the current authorization granted to the Federal Reserve Bank of New York to engage in overnight securities lending transactions, and in order to ensure the effective conduct of open market operations, the Federal Open Market Committee authorizes the Federal Reserve Bank of New York to lend up to $200 billion of U.S. government securities held in the System Open Market Account to primary dealers for a term that does not exceed thirty-five days at rates that shall be determined by competitive bidding. These lending transactions may be against pledges of U.S. government securities, other assets that the Reserve Bank is specifically authorized to buy and sell under section 14 of the Federal Reserve Act (including federal agency residential-mortgage-backed securities), and nonagency AAA-rated residential-mortgage-backed securities. The Federal Reserve Bank of New York shall set a minimum lending fee consistent with the objectives of the program and apply reasonable limitations on the total amount of a specific issue that may be auctioned and on the amount of securities that each dealer may borrow. The Federal Reserve Bank of New York may reject bids which could facilitate a dealer’s ability to control a single issue as determined solely by the Federal Reserve Bank of New York. This authority shall expire at such time as determined by the Federal Open Market Committee or the Board of Governors.” CHAIRMAN BERNANKE. President Lacker. MR. LACKER. Scott, I’d like you to elaborate a bit on this last part. This was a little confusing. This lending apparently is by the New York Bank. How does it relate to the System Open Market Account? Is it by the New York Bank out of the System Open Market Account? MR. ALVAREZ. That’s correct. This is securities lending by the New York Reserve Bank out of the SOMA. March 10, 2008 36 of 39 MR. LACKER. So while these securities we take in are on our books, they’re on the System Open Market Account’s books. MR. ALVAREZ. Correct. MR. LACKER. Okay. Thanks. CHAIRMAN BERNANKE. Any other questions? Debbie, could you call the roll? MS. DANKER. Chairman Bernanke Vice Chairman Geithner President Fisher Governor Kohn Governor Kroszner President Pianalto President Plosser Governor Warsh President Yellen Yes Yes Yes Yes Yes Yes Yes Yes Yes Thank you. CHAIRMAN BERNANKE. Thank you. We turn now to the swap authorization. MR. ALVAREZ. There are two swap resolutions. The first: “The Federal Open Market Committee directs the Federal Reserve Bank of New York to increase the amount available from the System Open Market Account under the existing reciprocal currency arrangement with the European Central Bank to an amount not to exceed $30 billion. Within that aggregate limit, draws of up to $15 billion are hereby authorized. The current swap arrangement shall be extended until September 30, 2008, unless further extended by the Federal Open Market Committee.” MS. DANKER. Chairman Bernanke Vice Chairman Geithner President Fisher Governor Kohn Governor Kroszner President Pianalto Yes Yes Yes Yes Yes Yes March 10, 2008 President Plosser Governor Warsh President Yellen 37 of 39 Yes Yes Yes Thank you. CHAIRMAN BERNANKE. Finally, the Swiss. MR. ALVAREZ. “The Federal Open Market Committee directs the Federal Reserve Bank of New York to increase the amount available from the System Open Market Account under the existing reciprocal currency arrangement with the Swiss National Bank to an amount not to exceed $6 billion. Draws are authorized up to the full amount of the swap. The current swap arrangement shall be extended until September 30, 2008, unless further extended by the Federal Open Market Committee.” MS. DANKER. Chairman Bernanke Vice Chairman Geithner President Fisher Governor Kohn Governor Kroszner President Pianalto President Plosser Governor Warsh President Yellen Yes Yes Yes Yes Yes Yes Yes Yes Yes Thank you. CHAIRMAN BERNANKE. Thank you. There will be an announcement at 8:30 a.m. Eastern time tomorrow simultaneously with four other central banks and supporting statements from Japan and Sweden, just like in December. Brian, why don’t you quickly read the announcement? MR. MADIGAN. Okay. “Since the coordinated actions taken in December 2007, the G-10 central banks have continued to work together closely and to consult regularly on liquidity pressures March 10, 2008 38 of 39 in funding markets. Pressures in some of these markets have recently increased again. We all continue to work together and will take appropriate steps to address those liquidity pressures. To that end, today the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing specific measures.” There is a section called “Federal Reserve Actions.” “The Federal Reserve announced today an expansion of its securities lending program. Under this new term securities lending facility (TSLF), the Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA-rated privatelabel residential MBS. The TSLF is intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally. As is the case with the current securities lending program, securities will be made available through an auction process. Auctions will be held on a weekly basis, beginning on March 27, 2008. The Federal Reserve will consult with primary dealers on technical design features of the TSLF. In addition, the Federal Open Market Committee has authorized increases in its existing temporary reciprocal currency arrangements (swap lines) with the European Central Bank and the Swiss National Bank. These arrangements will now provide dollars in amounts of up to $30 billion and $6 billion to the ECB and the SNB, respectively, representing increases of $10 billion and $2 billion. The FOMC extended the term of these swap lines through September 30, 2008. March 10, 2008 39 of 39 The actions announced today supplement the measures announced by the Federal Reserve on Friday to boost the size of the term auction facility to $100 billion and to undertake a series of term repurchase transactions that will cumulate to $100 billion.” Finally, there’s a section on related actions being taken by other central banks with links to the other central banks’ websites. CHAIRMAN BERNANKE. Okay. Thank you all. Again, thank you for the short-notice meeting. I apologize for that. We’ll see you next week in Washington. The meeting is adjourned. END OF MEETING March 18, 2008 1 of 127 Meeting of the Federal Open Market Committee on March 18, 2008 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, March 18, 2008, at 8:30 a.m. Those present were the following: Mr. Bernanke, Chairman Mr. Geithner, Vice Chairman Mr. Fisher Mr. Kohn Mr. Kroszner Mr. Mishkin Ms. Pianalto Mr. Plosser Mr. Stern Mr. Warsh Messrs. Evans, Lacker, and Lockhart, and Ms. Yellen, Alternate Members of the Federal Open Market Committee Messrs. Hoenig and Rosengren, Presidents of the Federal Reserve Banks of Kansas City and Boston, respectively Mr. Sapenaro, First Vice President, Federal Reserve Bank of St. Louis Mr. Madigan, Secretary and Economist Ms. Danker, Deputy Secretary Mr. Skidmore, Assistant Secretary Ms. Smith, Assistant Secretary Mr. Alvarez, General Counsel Mr. Ashton, Assistant General Counsel Mr. Sheets, Economist Mr. Stockton, Economist Messrs. Connors, English, and Kamin, Ms. Mester, Messrs. Rolnick, Rosenblum, Slifman, Sniderman, and Wilcox, Associate Economists Mr. Dudley, Manager, System Open Market Account Mr. Parkinson, Deputy Director, Division of Research and Statistics, Board of Governors Ms. Bailey, Deputy Director, Division of Banking Supervision and Regulation, Board of Governors Mr. Clouse, Deputy Director, Division of Monetary Affairs, Board of Governors March 18, 2008 2 of 127 Mr. Struckmeyer, Deputy Staff Director, Office of Staff Director for Management, Board of Governors Ms. Liang and Messrs. Reifschneider and Wascher, Associate Directors, Division of Research and Statistics, Board of Governors Mr. Gagnon, Visiting Associate Director, Division of Monetary Affairs, Board of Governors Mr. Blanchard, Assistant to the Board, Office of Board Members, Board of Governors Mr. Carpenter, Assistant Director, Division of Monetary Affairs, Board of Governors Mr. Small, Project Manager, Division of Monetary Affairs, Board of Governors Mr. Luecke, Section Chief, Division of Monetary Affairs, Board of Governors Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of Governors Mr. Judd, Executive Vice President, Federal Reserve Bank of San Francisco Messrs. Altig, Rasche, Sellon, and Sullivan, Senior Vice Presidents, Federal Reserve Banks of Atlanta, St. Louis, Kansas City, and Chicago, respectively Mr. Olivei, Vice President, Federal Reserve Bank of Boston Mr. Pesenti, Assistant Vice President, Federal Reserve Bank of New York Mr. Hetzel, Senior Economist, Federal Reserve Bank of Richmond March 18, 2008 3 of 127 Transcript of the Federal Open Market Committee Meeting on March 18, 2008 CHAIRMAN BERNANKE. Good morning, everybody. Let me extend a welcome to First Vice President Sapenaro, who is sitting in for St. Louis this morning. A quick comment on special topics: I’m sure we’re all disappointed that we won’t have further conversations on the communications strategy, [laughter] but that being the case, we have the opportunity to have special topics again. In April we will be discussing interest on reserves, as we mentioned before. We asked for suggestions for October, and a number of Banks proposed to look at inflation modeling, which seems obviously a good and policy-relevant topic. So that is what we propose to do in October. We look forward to Reserve Banks taking the lead on presentation and research in this area, and there will be meetings among the research directors and the System Research Advisory Committee to figure out how to go forward, but obviously we have about seven months to get to that. We look forward to having special topics. So the first item, Mr. Dudley, if you’re ready. MR. DUDLEY.1 Thank you, Mr. Chairman. To start, I just want to update people on what happened overnight in markets. Equities rebounded a bit in both Asia and Europe, and bond yields reversed some of the decline that they saw on Monday. The dollar was slightly weaker against the yen and the euro but still in the range that it established. It did not go back below the lows that it reached early on Monday. I would say that generally the markets’ function was okay. The big issue was bank funding pressures in Europe were evident for dollar funding. The funds rate bid as high as 3¾ percent, which is quite surprising on the eve of a meeting in which we are likely to reduce the federal funds rate target. Term funding pressures, if you look at the onemonth or three-month LIBOR–OIS spread, are basically unchanged from Monday, when they were up quite sharply from last Friday. Before talking about what markets have been doing over the six weeks since the last FOMC meeting, I’m going to talk a bit about the Bear Stearns situation. In my view, an old-fashioned bank run is what really led to Bear Stearns’s demise. But in this case it wasn’t depositors lining up to make withdrawals; it was customers moving their business elsewhere and investors’ unwillingness to roll over their collateralized loans to Bear. The rapidity of the Bear Stearns collapse has had significant contagion effects to the other major U.S. broker–dealers for two reasons. First, these firms also are dependent on the repo market to finance a significant portion of their balance 1 The materials used by Mr. Dudley are appended to this transcript (appendix 1). March 18, 2008 4 of 127 sheets. Second, the $2 per share purchase price for Bear Stearns was a shock given the firm’s $70 per share price a week earlier and its stated book value of $84 per share at the end of the last fiscal year. The disparity between book value and the purchase price caused investors to question the accuracy of investment banks’ financial statements more generally. The contrast in the behavior of investment bank equity prices versus credit default swap (CDS) spreads is revealing. Share prices fell sharply, but the CDS spreads narrowed a bit, indicating a lower risk of default. For example, Lehman’s stock price fell 19 percent, but its CDS narrowed by 20 basis points, to 450 basis points, yesterday. This underscores the difference between the $2 per share buyout price for Bear Stearns—less value than people thought—and the introduction of the Primary Dealer Credit Facility (PDCF)—a reduction in the risk that a liquidity problem could drive a firm into insolvency. I have a few words about the PDCF, before moving to a discussion of market developments since the January FOMC meeting. The PDCF should help to restore confidence among repo investors. It essentially creates a tri-party repo customer of last resort—us. When investors have concerns about the ability of a dealer to fund itself, they are reluctant to roll over their own repo transactions. The reason is the fear that the clearing bank may not send their cash back the next morning when the overnight repos mature. This fear may not be misplaced. If the clearing bank is worried about whether investors will stay put, the clearing bank may decide to keep the cash. In that case, the investors would be stuck with the securities that collateralize the repo transactions. The PDCF should break that chain of worry by reassuring the clearing bank that the Fed will be there as a lender to fund the repo transactions. The repo investors are reassured that the clearing bank will send back their cash the next day and thus are willing to roll over their repo transactions. At least that’s the theory. As noted, the PDCF should provide some comfort to the counterparties of these firms that these firms will, in fact, be able to fund their obligations. Yesterday, the major money market mutual fund complexes did roll their outstanding repos with the major investment banks. However, the jury is still out on whether the PDCF will be sufficient to stabilize confidence. High use of the PDCF would result in a large increase in the amount of reserves added to the banking system. I think it is important to go on record on that because, if that were to occur, over the short run the New York Desk might not be able to drain reserves sufficiently quickly to keep the federal funds rate from trading extremely soft to the target. We will make all efforts to make the “short run” as short as possible. But realistically, there is a good chance that the federal funds rate could trade soft relative to the target, especially through the end of the current reserve maintenance period. In fact, yesterday we saw that, although it started the day quite firm, the funds rate crashed at the end of the day, and the effective fed funds rate for the day was 2.69 percent. It depends, in large part, on the volume of use of the PDCF. March 18, 2008 5 of 127 Stepping back from developments of the past few days, recent weeks have been marked by rapid and, at times, disorderly deleveraging of financial holdings within the global financial system. As I discussed last week, the most pernicious part of this unwinding has been the dynamic of higher haircuts, missed margin calls, forced selling, lower prices, higher volatility, and still higher haircuts, with this dynamic particularly evident in the mortgage-backed securities market. I’ll be referring to the handout from here. Over the past six weeks, we have surveyed a number of hedge funds and one REIT about the haircuts they face for financing different types of collateral. As shown in exhibit 1, the rise in haircuts has been most pronounced in non-agency mortgage-backed securities. But even agency MBS have seen a significant widening of haircuts in recent weeks. The collateral funding pressures have been particularly evident for residential-mortgage-backed securities collateral. This is due to several factors including very unfavorable fundamentals for housing, a high level of uncertainty about the ultimate level of losses, and an overhang of product for sale, both currently and prospectively. In our discussions with market participants, unleveraged players have been unwilling to step in to buy “cheap” assets for several reasons. First, there are few signs that housing is close to a bottom. Second, a significant amount of product sits in weak hands and, thus, could be dumped on the market. Third, this particular asset class has characteristics that exacerbate price volatility and, therefore, risk. For example, when spreads widen and yields climb, prepayment speeds slow. This extends duration. When the yield curve is upward sloping for longer maturities, the rise in duration generates an increase in yields. The rise in yields also reduces housing affordability, which puts further downward pressure on home prices, increasing prospective losses on the mortgage loans that underpin the securities. Signs of distress in this market include the following. First, a sharp widening in option-adjusted mortgage spreads—as shown in exhibit 2, option-adjusted spreads for conforming fixed-rate mortgages have widened considerably since the January 30-31 FOMC meeting, though they have come in quite a bit over the past couple of days. That’s good news. Second, jumbo mortgage spreads relative to conforming mortgages rates remain very wide. As shown in exhibit 3, this spread has averaged more than 100 basis points this year. The current yield on prime jumbo loans is around 7 percent, a margin of about 3½ percentage points over ten-year Treasury note yields. Third, mortgage securities prices continue to fall. For example, as shown in exhibit 4, the prices for AAA-rated tranches of the ABX 07-01 vintage continue to decline. Fourth, Fannie Mae and Freddie Mac reported large fourth-quarter losses, and their stock prices and CDS spreads have performed accordingly (exhibit 5). The sharp decline in the equity prices has made the companies reluctant to raise new capital, despite the prospects of higher-margin new business, because additional share issuance at the current share prices would lead to massive dilution for existing shareholders. Fifth, the yield levels on many mortgage-backed securities have climbed significantly above the yield on the underlying mortgages that underpin the securities. This is the opposite of how securitization is supposed to work. This March 18, 2008 6 of 127 phenomenon reflects the glut of supply of such securities on the market and the added risk premium attached to assets that are typically held on a mark-to-market basis. Although the residential mortgage market is the epicenter of the crisis, distress has been evident much more broadly—with the municipal market fully implicated in the period since the January meeting. The deleveraging process evident among financial intermediaries operating outside the commercial banking system has led to a widespread repricing of financial assets. When available leverage drops, riskadjusted spreads have to rise for leveraged investors to earn the same targeted rate of return as before. This helps explain why the problems in the residential mortgage market have infected financial markets more generally, leading to wider credit spreads (exhibits 6 and 7) and lower equity prices (exhibit 8) both in the United States and abroad. As leverage is reduced and spreads widen, financial arbitrage implies that all assets should reprice. The risk-adjusted returns from holding different asset types should converge—recognizing that the degree of leverage that is available in markets may differ across asset classes in accordance with divergences in price volatility, liquidity, transparency, and other characteristics. Of course, the notion of convergence to equivalent risk-adjusted returns is an equilibrium concept, and we are not in equilibrium. The events of the past week underscore that point. But there are plenty of other examples of disequilibrium at work. For example, for mortgage-backed securities, the losses implied by the prices of the AAA-rated ABX index tranches appear to be high even relative to the darkest macroeconomic scenarios. The municipal bond market is also a good example of how market valuations can become unusually depressed when supply increases rapidly. Then the value inherent in the securities becomes broadly known, this mobilizes new money, and risk-adjusted returns come back down relatively quickly. Term funding spreads also indicate greater stress within the financial system. As shown in exhibits 9 and 10, the spreads between one-month and three-month LIBOR– OIS spreads have widened sharply in recent weeks, even before Bear Stearns’s demise. We are sitting today at 56 basis points for the one-month LIBOR–OIS spread and 77 basis points for the three-month LIBOR–OIS spread, about the same as yesterday morning. As you are all aware, we have been active in responding to the growing market illiquidity. Exhibit 11 illustrates the results of the TAF auctions. Note how propositions and the number of bidders have increased recently and the spread between the stop-out rate and the OIS rate has risen over the past few weeks. Even before the Primary Dealer Credit Facility was implemented this weekend, we were in the middle of a historic transformation in the Federal Reserve System’s balance sheet. We are increasing the supply of Treasuries held by the public (either outright or borrowed) and reducing the supply of more-illiquid collateral held by the private sector. Even excluding the uncertain impact of PDCF borrowing, this shift will speed up noticeably over the next month or two. Our current plans are to increase the size of the TAF to $100 billion, scale up the single-tranche RP book to $100 billion, renew and increase the size of the foreign currency swaps with the ECB and the SNB March 18, 2008 7 of 127 to $36 billion outstanding (if fully subscribed), and implement a $200 billion TSLF program. Exhibit 12 shows how these programs are likely to change the composition of the Federal Reserve’s SOMA portfolio. As can be seen, when all the current programs are fully phased in by May, Treasury holdings will have shrunk to about 45 percent of the total portfolio, down from about 97 percent last July. At the same time that financial markets have been under severe stress and the macroeconomic growth outlook has deteriorated, the inflation news has also been disturbing. Several market-based indicators are adding to investors’ concerns about the inflation outlook. First, commodity prices have increased sharply. As shown in exhibit 13, the increases have been concentrated in both energy and agricultural prices. Of course, subsidies to stimulate the production of ethanol from corn have been an important factor. By diverting corn production to this purpose, the linkage between energy and grain prices has been significantly strengthened. Second, the dollar, after a period of stability that lasted from mid-December into February, has begun to weaken anew (exhibit 14). This has gotten considerable attention in the press and abroad as the dollar has hit new lows against the euro and has fallen below 100 against the yen. Up to now, the decline has generally been orderly, and the downward slope of the broad real trade-weighted dollar trajectory shown in exhibit 14 has not changed much. The foreign exchange markets are clearly very skittish. In particular, there has been considerable focus on China and the Gulf Cooperation Council (GCC) countries and their willingness to maintain their pegs against the dollar. For China, investors expect its crawling peg to move faster. As shown in exhibit 15, the Chinese yuan is now expected to appreciate about 11 percent against the dollar over the next year, up from an 8 percent pace at the beginning of the year. For the GCC countries, there is speculation that some of these countries might decouple from the dollar. However, on a one-year-forward basis, market participants are currently building in only a couple of percentage points of expected appreciation. Breakeven rates of inflation have continued to widen. As shown in exhibit 16, both the Board staff’s and the Barclays measures have broken out above the ranges evident in recent years. It is difficult to differentiate how much this widening reflects a higher risk premium due to greater uncertainty about the inflation outlook versus higher expected inflation. But either way, it is probably fair to say that inflation expectations have become less well anchored over the intermeeting period. I will say, however, that yesterday breakeven rates of inflation came down very sharply—the move was 15 to 20 basis points. Today, we are back in the range we were in, but that is only today. Short-term rate expectations continue to move lower. As shown in exhibit 17, federal funds rate futures now anticipate a trough in yields a bit below 1.5 percent. The yields implied by Eurodollar futures prices have also shifted sharply lower, as shown in exhibit 18. The trough in yields is expected to be reached in late summer or early fall. March 18, 2008 8 of 127 Our formal survey of primary dealers, which we normally show you, was conducted more than a week ago, and it is clearly out of date (these exhibits are included in the appendix to the handout). So let me focus on what the dealers’ expectations were as of yesterday. They changed quite a bit over the past week. Most dealers expect either a cut of 75 or 100 basis points: There are eight for 100 basis points, ten for 75 basis points, and two for 50 basis points. This compares with the slightly more than 100 basis points built into the April federal funds rate contract (yesterday the April fed funds contract implied a 1.95 percent effective fed funds rate for the month). There were no foreign operations during this period. I request a vote to ratify the operations conducted by the System Open Market Account since the January 30-31 FOMC meeting. Of course, I am very happy to take questions. CHAIRMAN BERNANKE. Are there any questions for Bill? Vice Chairman. VICE CHAIRMAN GEITHNER. May I say just one thing, Mr. Chairman? I want to point out that not only has Bill, along with a whole range of people in New York and on the Board staff, been working 24 hours a day for about five days, not only did he write a terrific statement for the FOMC just now, despite all of those other preoccupations, but he sat with his wife through major surgery on Thursday and Friday and with her as she recovered. Just a remarkable, terrific performance. I compliment him and just note that the burden he has been carrying is considerable even in comparison with the burden of so many others. CHAIRMAN BERNANKE. We thank you. President Lacker. MR. WARSH. You’re still going to get questions apparently. [Laughter] MR. LACKER. I hope your wife is doing well. MR. DUDLEY. She is doing well, thanks. MR. LACKER. First, just about breakevens. Breakevens came down a lot yesterday, but my understanding is the five-year, five-year forwards did not come down nearly as much. I think the figures I have are 3 basis points on the Board’s measure and just 11 on New York’s measure. Is that right? March 18, 2008 9 of 127 MR. MADIGAN. Three is right on the Board’s measure. MR. DUDLEY. I don’t have a number. MR. LACKER. I am concerned about this late-day softening problem with the Primary Dealer Credit Facility. Everything else we have done has been fairly straightforward to sterilize, but because with this the quantity is activated late in the day, the funds are just going to flow into the market. You know, you’re in the position of predicting something with a huge variance, the take-up on that. Now, this could unravel. If late-day softness becomes the norm, because of the arbitrage that’s available to banks within the maintenance period for holding reserves, this could erode our ability to hold the target. Now, you people have been really creative about lending money, so I was wondering if maybe you could turn your creative talents toward this problem. The thing that comes to mind is some mechanism for sucking up funds at the end of the day on an automated basis. The natural thing would be for us to do sort of the opposite of repos late in the day for return the next morning. Have you given that some thought? Are you working on that? MR. DUDLEY. We have given it some thought, but the press of other business, frankly, has overwhelmed us in the very short run. But I think it is a good point. I would say two things about the Primary Dealer Credit Facility and our ability to keep the funds rate at the target. One, if this works the way we hope it works, there are not going to be many people showing up at the Primary Dealer Credit Facility. We hope, over time, none—because if we reassure the repo investors that they can roll their repo, we think that will dominate coming to the Primary Dealer Credit Facility. So if this works out the way we imagine it could work, the Primary Dealer Credit Facility use will be very nominal, so we won’t have this issue. The second thing I would say is that, if people do come to the Primary Dealer Credit Facility and that leads to softness in the federal funds rate, by definition it will make the Primary Dealer Credit Facility less attractive because, March 18, 2008 10 of 127 remember, the Primary Dealer Credit Facility cost is tied to the target federal funds rate not to where the federal funds rate actually trades in the market. So that also will obviate some of that issue. But look, we haven’t done this before. We have now had one day of experience. We’re going to have to work on the issues that you raised, and we’re going to have to see how it goes, frankly. VICE CHAIRMAN GEITHNER. Mr. Chairman, could I just add one thing on this? I think the delicacy of the whole tri-party repo thing is hard to overstate. For better or worse, mostly for worse, the full tri-party repo market generally has spread over the last few years well beyond Fedeligible securities, and until we get to the other side of this, there is a lot of risk in that stuff on repo that goes further out the eligible collateral quality spectrum. Even in a world where confidence comes back around the primary dealers as counterparties, the thing is there’s just some natural risk that that stuff is going to have to be financed in some other form. The hardest thing in this balance now is to try to do something that doesn’t increase the incentives so that we become the counterparty to everybody. We’re trying to make sure that it’s a backstop, but not a backstop that’s so attractive that they come, and that’s going to be a very hard line to walk. I say that, Bill, because, just to lower expectations, the necessary cost of the choice we’ve made is that we’re going to take the risk that we end up funding a bunch of stuff like that, and the commitment to do that is the only way this helps. It is very hard to know. Again, even if confidence holds, there is a reasonable probability that some of that stuff is just going to have to move into different forms and other hands, and that could be a delicate transition, particularly if people read into that a broader loss of confidence in this stuff. The other thing that’s important to point out is that it is just not realistic to expect, even with the force of the things that we announced on Sunday night, that we don’t still have a wave of deleveraging ahead of us. There is still just a huge part of the world that knows they are really long March 18, 2008 11 of 127 on risk in a fragile environment and have not yet gotten to that point. With everything that’s happened in markets, their leverage is going up as the world goes against them, and they’re going to want to keep bringing it down. That really is going to work against the effect of all the things we’re doing. So just be prepared under the best of circumstances for a sustained period of substantial fragility. But to underscore your point, Jeff, we agree with your point and had been discussing in what we thought was a slightly calmer world over the past two weeks exactly that mix of things, and we’ll be on it together and consulting. CHAIRMAN BERNANKE. President Lacker. MR. LACKER. Yes, I just want to emphasize that what we have done so far has had this separability about it, and except for the brief period in late August last year, it has not threatened our ability to manage the federal funds rate in a way we thought appropriate for the whole economy. If we don’t cure this problem soon, it will become visible; it will become well known; it will get priced in, and to some extent it will overtake this Committee’s deliberations in the sense that it rather than our target rate will run the fed funds rate. I think that would be a fairly dangerous outcome, and it just strikes me that this is incredibly urgent. CHAIRMAN BERNANKE. You make a good point, President Lacker. President Fisher. MR. FISHER. More mundane questions, but by the way, Bill, thank you for your service. Everybody agrees with what the Vice Chairman said, and I hope you took note of it. Now that I’ve made you feel better, I have just a very simple question. On the TAF, has the portion of foreign participation gone down? MR. DUDLEY. I don’t think there has really been a shift. There’s no meaningful shift. MR. FISHER. So it’s still pretty much where it was. March 18, 2008 12 of 127 MR. DUDLEY. It’s high. It will be interesting now with the reintroduction of the swap. You know, the ECB will essentially have a noncompetitive auction with us on this coming Monday. It will be interesting to see how that affects the TAF auction results. MR. FISHER. Then the second question, Bill, which I raised on the phone. I don’t remember an answer. Is it correct that German bunds have now traded through Treasuries in terms of default risk, and is that meaningful at all? MR. DUDLEY. I think there was a day that that might have happened, but I don’t really know the answer to that. I’m not sure what that really means. MR. FISHER. That’s my question. Does it mean anything? MR. DUDLEY. If that were to happen, I’m not sure what I would make of it. That would probably reflect more what’s going on between different countries in Europe than to have anything really to do with us versus Germany. That’s how I would interpret it. MR. FISHER. Thank you. CHAIRMAN BERNANKE. President Rosengren. MR. ROSENGREN. I’d like to commend the New York Fed staff for what I know has been a very difficult time over the past week. My question is almost the opposite of President Lacker’s. He raises some interesting points, but I wonder. Given the stigma issues involved and what’s just happened with Bear Stearns, you would think that borrowing at any kind of penalty rate for an investment bank, which arguably is more susceptible to runs than the typical commercial bank, is something that no one would take advantage of because of concerns about stigma. Is there any evidence that there’s more stigma? How are the primary dealers viewing this, and have they raised concerns about confidentiality and what would be disclosed? March 18, 2008 13 of 127 MR. DUDLEY. Yes, we have certainly gotten questions about how this will be disclosed. Now, there will be a disclosure. There will be a line item in the H.4.1 release, but it will just show the total dollar amounts extended through this facility. It is all bid through the New York District, so the total primary dealer borrowing will be shown in that release. The stigma issue is a legitimate issue, and that is why we have to be very careful about how we talk about this and take tremendous care not to disclose who or even what type of institution uses it. But at the end of the day, if you can’t fund your repo and your only choice is to come to the PDCF, that is probably what you are going to do. Now, to come back to Vice Chairman Geithner’s point, I think that is exactly right, though. The fact that to the extent that there is stigma, they are not going to want to come, and that is going to reinforce the deleveraging process that is clearly under way, as is the fact that they just saw Bear Stearns go from a troubled but viable firm to a nonviable firm in three days. The lesson from that for a lot of firms is going to be, oh, I need more liquidity, I need to be less leveraged, and that lesson, from what happened to Bear Stearns, isn’t going to go away. CHAIRMAN BERNANKE. Governor Warsh. MR. WARSH. I’m under the impression—Bill, you correct me—in the earnings call from the investment banks today and tomorrow, the four remaining are going to do all they can to destigmatize this facility with answers to the effect that “we haven’t tapped the facility yet, but we would be very open to do it in the right circumstances” and to provide some comfort that it is not stigmatizing in their own minds. For the strongest of those firms to say that should provide some halo for the rest. But to Bill’s point, I think we will have to evaluate that as we go. CHAIRMAN BERNANKE. I think it is incumbent upon me to point out that the Board staff was also very involved, and I mention Brian Madigan, Pat Parkinson, Scott Alvarez, March 18, 2008 14 of 127 Deborah Bailey, and others as well. So it was very much a joint effort. Other questions for Bill? If not, we’ll turn to Dave Stockton. Oh, I am sorry, we need a vote to ratify the open market operations. MR. KOHN. I move that we ratify the open market operations. MR. FISHER. Second. CHAIRMAN BERNANKE. Without objection. Thank you. Now to Dave Stockton. MR. STOCKTON. Thank you, Mr. Chairman. As you know, we have made some very large changes to the economic projection in this round—so large, in fact, that we had to adjust the scale on the forecast evolution charts that we put in the back of the Greenbook. Obviously, the most notable change has been our adoption of the view that the economy is moving into recession. I thought it would be helpful to briefly review this morning our reasons for making that call at this time. In addition, I will lay out the rationale for the depth and duration of the weakness in real activity that we are now projecting. Finally, I will explain why, with so much more projected slack in resource utilization, inflation has, on average, been revised up from our January projection. We have noted on several occasions in the past few months that our decision to stick with a forecast in which the economy muddles through its current difficulties without falling into recession was a close call. Well, over the intermeeting period, we continued to accumulate a bleak array of economic indicators. Consumer confidence moved still lower and, in the case of the Reuters/Michigan measure, dropped to levels last registered in the early 1990s. Regional indexes of business sentiment continued to deteriorate noticeably, with steep drops in the measures reported for New York, Chicago, and Philadelphia. Although the weakness was less pronounced in the national ISM surveys, the composite indexes for both manufacturing and nonmanufacturing were below 50 in February. Small businesses—as reported in the survey conducted by the National Federation of Independent Businesses—and larger businesses—as captured by the Duke University Survey of Chief Financial Officers— have turned very pessimistic. These indicators taken alone, or even in limited combination, might not be that troubling. But when viewed as a whole and especially when taken in conjunction with the many financial indicators that have been flashing recession signals for some time, the pattern of recent readings is disturbing. Furthermore, recession signals are no longer limited to surveys and financial indicators. Private payroll employment is estimated to have dropped 101,000 in February, and there were sizable downward revisions to earlier months that left employment showing declines in both December and January. Industrial production dropped 0.5 percent in February, and manufacturing IP fell 0.2 percent. The weakness in industrial production occurred not only in the series in which we use March 18, 2008 15 of 127 production worker hours to estimate output but also in series where we have measures of physical product. For both payroll employment and industrial production, diffusion indexes indicate that the weakness has been spread widely across industries. This morning’s data on housing starts also suggest little end in sight to the ongoing recession in housing. Single-family starts fell more than 6½ percent, to 707,000 units, in February, and permits dropped a similar amount. Both figures were very close to our expectations. Multifamily starts moved up to 360,000 units, but that figure follows some low figures late last year, and we wouldn’t attach much signal to that reading. Moreover, while I certainly am not going to try to predict what the NBER will ultimately do, a number of the series consulted by the dating committee appear to have peaked late last year or early this year—at least on the currently published data. Real personal income, industrial production, payroll employment, and real manufacturing and trade sales all have local peaks sometime between October and January. All told, the evidence of a serious weakening of the economy appears to us more palpable now than it did in January. If one grants that the economy, from time to time, exhibits nonlinear behavior, then our forecast will need nonlinear changes to avoid making outsized errors. At this point, we’ve seen enough to make us think that recession is now more likely than a period of weak growth, and that is what we are forecasting. But having made that discontinuous change to our projection, I want to impress upon the Committee just how much this remains a forecast of recession; a lot has to happen that we haven’t seen yet to be confident of this call. Indeed, there are several reasons to be skeptical that we have transitioned into recession. One striking feature of several surveys of business sentiment is that businesses appear more pessimistic about the overall economic picture than they do about the prospects for their own firms. Another cautionary reading comes from the motor vehicle sector. Sales have softened noticeably over the past couple of months, but they haven’t tumbled as they might have if the economy had already moved into recession. In labor markets, initial claims for unemployment insurance, which had risen earlier in the year, have leveled off of late, with the four-week average running about 360,000 in recent weeks. That level of claims is not yet high enough to clearly signal the declines in private payrolls of between 150,000 and 175,000 that we expect will be occurring this spring. Finally, orders and shipments for nondefense capital goods flattened out late last year but as yet have not shown any signs of serious deterioration, which will be necessary shortly if our projected downturn in capital spending is to come to pass. For now, we are willing to treat these readings as suggesting that there is some upside risk to our forecast of a modest recession. One of the key features of past recessions, as viewed through the lens of our models, is a tendency to observe large negative residuals that are correlated across the major spending equations. We have built that feature into this projection. But this also remains a forecast because a pattern of correlated negative residuals is not yet clearly evident in the data. To gain some perspective on how the forecast would have looked had we not built in these recession effects, we showed an alternative scenario March 18, 2008 16 of 127 in the Greenbook that effectively removed these residuals. The result is a forecast that is similar to, though in the near term a bit weaker than, the one we showed in the January Greenbook largely because of higher oil prices and weaker housing prices. But we have marked down the baseline forecast considerably more than would be suggested by these factors alone. To be sure, we may have overreacted by moving to a recession call. But that possibility is counterbalanced by some clear downside risks even relative to this more pessimistic forecast. The recession that we are forecasting is relatively shallow. In our forecast, the depth of the downturn is limited in the near term by tax rebates, which provide a substantial boost to disposable income starting in May. This should help to buffer some of the drag on spending that is anticipated to result from declining employment, higher oil prices, and weaker household net worth. Moreover, domestic production benefits appreciably from the past and prospective decline in the exchange value of the dollar and the continued growth in the economies of our major trading partners—factors that help to provide a sizable boost to net exports this year and next. These influences result in a small upturn in real GDP in the second half, and the unemployment rate rises only 1¼ percentage points, to 5¾ percent. That is a small increase in unemployment even by the standards of the past two mild recessions. As I’ve noted, well-timed macro policies and substantial support from the external sector lead us to expect that this time will be different and that the unemployment rate will rise less than usual. But you should always be wary of forecasts that expect this time to be different. Another notable feature of our forecast is that, although the projected downturn in activity is shallow, the period of weak aggregate demand is lengthy, especially given the assumed low level of the real funds rate. For those of you so inclined, this might be a good time to check your Blackberries for e-mail or to get in a couple of games of BrickBreaker because I can assure you that I will not be offering much in the way of scientific insight on this issue. In our forecast, the growth of real GDP picks up next year for several reasons. Housing demand finally bottoms out, and accordingly, construction activity begins to arrest its steep decline. In addition, given our forecast of a flattening of crude prices, the drag from higher oil prices on consumer spending is expected to wane next year. Importantly, we also assume that there will be a gradual lifting of the restraint on spending as financial stress abates. The last influence is now assumed to lift more gradually than in our previous forecast and, along with an intensifying drag from lower house prices, accounts for much of the lingering weakness in this projection. Correspondingly, the unemployment rate falls to only 5½ percent at the end of 2009. In our previous forecast, we had the effects of financial stress fading over this year, on the thought that, as it became apparent that the economy would avoid recession and that housing was bottoming out, risk spreads would narrow, credit conditions would loosen up, and spending restraint would ease. Obviously, in our current forecast, the economy experiences recession this year, and housing doesn’t show much sign of stabilizing until next year. As a consequence, we don’t begin to phase out the unusual restraint on spending resulting from financial stress until next year. March 18, 2008 17 of 127 This aspect of our forecast, even more than others, is largely guesswork. We just don’t have much in the way of historical experience on which to calibrate the projection. In recognition of that uncertainty, we included in the Greenbook two alternative simulations. In the “faster recovery” alt sim, we assume a stabilization of housing later this year and a reversal of most risk spreads by the middle of next year. Under these assumptions, growth picks up more noticeably, and a tightening of monetary policy is required next year. Alternatively, one cannot rule out some further deterioration in financial conditions and an even longer period of subpar economic performance. In the “greater housing correction with more financial fallout” scenario, a steeper decline in home prices results in a deeper contraction in construction activity, a further widening of risk spreads, tighter lending conditions, and an additional deterioration in household and business sentiment. Although this scenario might sound extreme, it only pushes the outer edge of the 70 percent confidence interval for real GDP and unemployment. It is also sobering to recognize that this simulation results in a nominal funds rate path that skirts the zero bound. The bottom line: We know with probability 1 that the baseline forecast will be wrong. But with the downward adjustments that we have made to this forecast, we feel that there is significant probability mass on both sides of our projection. Despite marking down our forecast of real activity substantially this round, our projection of consumer price inflation, both headline and core, has been revised up in 2008 and is largely unchanged in 2009. Those revisions reflect marginally worse news on the incoming price data as well as further deterioration in some of the key determinants of price inflation. As for the news, our reading of the recent price figures is that core PCE prices probably did not rise as rapidly in January as is currently published but that they likely rose faster in February than might be suggested by a cursory examination of last Friday’s CPI report. As we noted in the Greenbook, barring offsetting influences, we believe that the currently reported increase in core PCE prices of 0.3 percent in January will be revised down to 0.2 percent after the BEA incorporates the low reading on medical care services that was shown in the January PPI. As for February, the core CPI being unchanged was a favorable development. But a sizable fraction of the good news was in rents and medical care; rents receive a much smaller weight in PCE prices than in the CPI and, as I just noted, the PCE price index uses the PPI, not the CPI, for measuring medical costs. Incorporating medical care prices from this morning’s PPI release suggests to us that core PCE prices rose about 0.15 in February. All told, we are projecting an increase in core PCE prices of 2.5 percent at an annual rate in the first quarter, 0.1 percentage point more than in January. We have also incorporated into this forecast a further jump in the cost of crude oil and higher import prices associated with the weaker dollar and more-rapid gains in commodity prices. Moreover, we have read the survey measures and TIPS spreads as suggesting that there may have been some deterioration in inflation expectations of late. Taken together, these less favorable developments more than offset the projected emergence of some slack in resource utilization. As a consequence, we are March 18, 2008 18 of 127 now projecting core PCE prices to rise 2.3 percent this year, up ¼ percentage point from our January projection. Despite an unemployment rate that runs nearly ½ percentage point above our previous forecast, we have left unrevised our projection of core PCE prices in 2009 at 1.9 percent. Higher food and energy prices have resulted in a further upward revision to total PCE price inflation of nearly ¾ percentage point, to 2.9 percent, in 2008. Total PCE price inflation for 2009 is unrevised at 1.7 percent. Before turning the floor over to Nathan, I want to let the Committee know that the three research divisions are undertaking a review of the structure of our policy documents. The Greenbook and Bluebook have grown in length and complexity over the past decade. Our objective in this review will be to improve the focus and flow of the documents and to eliminate the redundancy that has crept in over time so as to reduce the burden on you in reading the documents and the burden on the staff of producing them. We will, of course, consult with the Committee before implementing any substantive changes. Nathan will now continue our presentation. MR. SHEETS. The global economy has likewise seen some extraordinary developments during the intermeeting period. Notably, the spot price of WTI has surged more than 15 percent, briefly reaching $110 per barrel, and many nonfuel commodities prices have moved up by similar magnitudes. The exchange value of the dollar, which had been relatively stable since November, has returned to a depreciating path, falling more than 5 percent against the major currencies since midFebruary and reaching a post–Bretton Woods low. The global financial stresses that began last summer have further intensified. Also, as Dave has outlined, recent data suggest that the U.S. economy has continued to weaken. Nevertheless, not all the news from the foreign sector has been grim. Indeed, given the shocks that have materialized, the foreign economies appear to be showing somewhat more resilience than we would have expected. Total foreign real GDP growth in the fourth quarter of last year stepped down to 3.2 percent from the rapid 4.5 percent rate that had prevailed through the previous three quarters, as the pace of activity slowed in both the advanced economies and the emerging market economies. This fourth-quarter out-turn, however, was about ½ percentage point stronger than we had expected, reflecting an upside surprise in the emerging markets. Available indicators of first-quarter activity paint a mixed picture. In the euro area, economic sentiment fell in February for the ninth consecutive month, but the purchasing managers index for the services sector and the German IFO index of business conditions picked up. In addition, industrial production and retail sales posted stronger readings in January. The ECB’s bank-lending survey indicates a tightening of lending standards, but measures of bank credit to the corporate sector have continued to expand. Indicators of activity in the United Kingdom have also been mixed. Consumer confidence in February slid to a five-year low, but business confidence and conditions in the services sector have been more upbeat. In emerging Asia, while the impetus from external demand is clearly diminishing, Chinese retail sales have continued to grow robustly; industrial production in Korea, Singapore, and March 18, 2008 19 of 127 Taiwan moved up in January; and domestic consumption in the ASEAN countries has remained solid. Taken together, these data seem to indicate that growth abroad has cooled but has not stalled. Our forecast thus seeks to balance several offsetting considerations. On the one hand, the projection for U.S. growth this year has been cut by a sizable 1½ percentage points; this has particularly stark implications for countries like Canada, Mexico, and some in emerging Asia that have close trade ties with the United States. The further deterioration in global financial conditions should also weigh on activity abroad. On the other hand, the incoming data suggest that the foreign economies are not yet following the United States into recession, and the red-hot commodities markets also lead us to believe that activity is holding up in some corners of the world. Weighing these factors, we have cut our forecast for total foreign growth in 2008 to 2.3 percent, down from 2.9 percent in the last Greenbook, with much of this markdown reflecting softer growth in Canada and Mexico. Our projections for emerging Asia have also been reduced, but we see these economies still expanding at a moderate pace. Clearly, there are both upside and downside risks around this forecast. On the downside, the adverse spillovers from the U.S. slowdown and continued financial stresses may be more severe and more broadly felt than we envision. On the upside, the apparent resilience in foreign demand to date suggests the possibility that growth abroad may hold up better than we now expect. In 2009, foreign growth is projected to rebound to 3½ percent, in line with the expected easing of global financial stresses and economic recovery in the United States. With commodities prices increasing sharply, foreign inflation has continued to rise. Notably, in the euro area, 12-month headline consumer price inflation climbed to 3.3 percent in February, well above the ECB’s 2 percent ceiling, driven up by food and energy prices. In China, 12-month inflation in February surged to 8.7 percent, at least in part reflecting sharp increases in food prices due to severe winter weather. In an effort to temper these pressures, the Chinese authorities have introduced temporary price controls for some basic necessities and this morning announced plans to raise reserve requirements another 50 basis points. We now see average foreign inflation in 2008 as coming in at around 3¼ percent, up ¾ percentage point from the last Greenbook. Central banks have responded to this cocktail of slowing growth and higherthan-desired inflation in divergent ways. To date, the ECB has held its policy rate firm at 4 percent, citing the level of headline inflation, possible second-round effects from commodity price increases, and risks from ongoing wage negotiations. Given these concerns, we now expect the ECB to remain on hold a while longer but, in response to a projected further slowing of activity, to cut rates 50 basis points later this year. The Bank of England, in contrast, has reduced its policy rate 50 basis points since the fall—and we expect another 75 basis points by year-end—in an effort to cushion the economy against financial headwinds and slowing in the housing and commercial real estate sectors. Finally, the Bank of Canada has reduced rates March 18, 2008 20 of 127 100 basis points since the autumn, in response to downdrafts from the United States and the strong Canadian dollar, and the Bank has indicated that “further monetary stimulus is likely to be required.” Thus we see another 50 basis points of easing in the second quarter. As noted earlier, the dollar has depreciated more than 5 percent against the major currencies since mid-February as the widening divergence between the path of policy rates in the United States and other industrial countries, particularly the euro area, has weighed on the dollar. As a related factor, the tone of the recent U.S. economic data has been much softer than for most other advanced economies. In broad real terms, the path of the dollar in our current forecast is about 2½ percent weaker than in the January Greenbook. Going forward, our forecast calls for the broad real dollar to decline at a 3 percent annual rate, with this depreciation expected to come disproportionately against the currencies of the emerging market economies. I conclude with a few words regarding the performance of the U.S. external sector. The January trade data showed exports continuing to rise at a healthy pace while nonpetroleum imports contracted. Imports of consumer goods were particularly soft. For 2008 as whole, we now expect the external sector to contribute a substantial 1.2 percentage points to growth, about twice as much as in our previous forecast. To be sure, much of this larger arithmetic contribution from net exports reflects a contraction in imports caused by the slowdown in U.S. demand. However, part of the reduction in imports is also due to the decline in the dollar. Exports this year are seen to grow at a pace of nearly 7 percent, just a touch less than in the last Greenbook, as the effects of the weaker dollar almost offset the markdown in foreign growth. In 2009, imports rebound as the U.S. economy recovers, and the positive contribution from net exports accordingly shrinks to about ⅓ percentage point. Finally, yesterday the BEA reported that the current account deficit narrowed to 4.9 percent of GDP in the fourth quarter, its smallest share of GDP since 2004. We had expected the rise in oil prices to drive up the deficit, but this was more than offset by a marked improvement in net investment income, partly as earnings received by foreigners on their investments in the U.S. financial sector declined, reflecting the effects of the ongoing financial turmoil. We will now be happy to take your questions. CHAIRMAN BERNANKE. Thank you. Questions? President Fisher. MR. FISHER. If I put the two comments together, one of the messages I receive is that we are less confident in the linkage between U.S. slowing growth and rest-of-world slowing growth than we or conventional wisdom was before. You mentioned, in the discussion of the international side, the downside and upside on growth. There is also a downside and an upside on inflation. I just want to ask about our thoughts on this from a staff standpoint. Clearly, the March 18, 2008 21 of 127 downside price pressures come from our housing crisis and all of the other related issues and, I presume, from the building of slack and rising unemployment and, therefore, restrained wage demands. That is the domestic side. At the same time, I think I hear you saying that on the global side it is not happening in that fashion elsewhere. The emerging countries, particularly China, are still growing at a rapid pace. However, it may become somewhat slower. My question is, Do we feel that there is as much an offset to our domestic disinflationary/ deflationary forces as we thought before? Are these global demand-pull inflationary forces basically mitigating our expectations of the contractionary domestic forces? How has your opinion—the two of you—changed in the intermeeting period? I hope that is a clear question, but I think you get the point that I am making. MR. SHEETS. Over the intermeeting period we have lived through an experience that manifests the upside risk to our inflation forecast; and I would indicate that, with the ¾ percentage point markup to headline foreign inflation in 2008 in our forecast, the vast majority of that is a reflection of these red-hot commodity markets, which then presses the question to us, Well, what is going on there? Certainly, in the case of the demand in these markets, by now I would have expected to have seen some attenuation or a bit of softening. Really, it seems to be quite the opposite. The demand since the first of the year has accelerated. Some other factors are at work as well—idiosyncratic supply stories, electrical outages that made it harder to smelt aluminum and copper, and so on. So there are some supply factors as well. The demand side seems to be important, and to the extent that demand remains strong, I am not sure where these commodity prices are going to top out. The futures path is a reasonable guess at sort of the balance of supply and demand. There is also some upward pressure on these prices from the March 18, 2008 22 of 127 depreciation of the dollar. But to the extent that commodity prices move up, I would say that we will probably be marking up our forecast of foreign inflation next time. Just a broader comment on the linkages between the U.S. and the foreign economies— again, I was surprised at the strength of demand in these commodity markets. I would have expected by this point to have seen more marked evidence of slowing in the foreign economies. So we have marked down our forecast for 2008 in line with these prospective developments, the further slowing in the United States, and the financial stresses. But we didn’t mark down our forecast very much, just a tenth or two, and mainly in Canada in Q1; and the data that we have in hand are not pointing to a dramatic slowing. We are expecting more of that to come through in the second and the third quarters. MR. STOCKTON. President Fisher, I will just basically reiterate what I said earlier and amplify many of the same things that Nathan just said in terms of the influences on our headline forecast. We revised up ¾ percentage point as well, and that really is coming from higher energy prices, higher food prices, and higher commodity prices, all of which we think are already showing through to some extent and we expect to continue to show through to headline inflation. Despite the fact that we run with a much larger output gap in this forecast, we haven’t revised down our forecast for 2009 because of the lingering effects of the run-up in commodity prices that we are expecting. As I indicated, we think there has probably been some small deterioration in inflation expectations as well. MR. FISHER. Thank you very much. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. President Evans. MR. EVANS. Dave, my question is basically about the influence of the financial stress on the outlook. I was talking to an official at the Bank of Canada last week, and she had an March 18, 2008 23 of 127 intriguing calibration by which she said that, since last August, they thought that financial stress for Canada was worth about 25 basis points of restraint at the outset and now they thought it was more like 50 basis points for their economy, which is doing quite well. I guess the impossible question is, Have you thought about that type of calculation and how it influences the way we think about interest rates for your forecast? The way that I am thinking about this and that President Lacker and others have thought about this is that we are trying to separate the effects of standard monetary policy and of the innovative policies. Any separation that affects financial markets directly helps us think about the more normal calibration of policy. But, of course, with financial stress we have these add-on effects. So that is why I think that would be interesting. MR. STOCKTON. We have thought about that, and the difficulty at this point is trying to identify the truly exogenous features of the current financial stress that is operating over and beyond the channels that are normally incorporated in our models. Our models, obviously, have asset prices, such as house prices and stock prices, and have interest rates and interest rate spreads, and as those things have changed, we have been able to incorporate them into our forecast. But then, over and above that, we think that the model doesn’t really capture a lot of the credit-availability channels. There is a lot more stress in the market beyond that captured by the interest rates in our models. So taking this with more than a grain of salt, we think roughly ¾ percentage point on the level of GDP this year—over and beyond the effects of lower house prices, the weaker stock market, and the higher interest rate spreads—that basically lingers on into next year and only then begins to gradually phase out. That is an important factor as to why this forecast is based on such a low real federal funds rate. Obviously, if you came to a different conclusion either about the depth of what is likely to be occurring in the next few months in terms of the restraint—not just from these financial stress conditions but also from our call that March 18, 2008 24 of 127 we are moving into a recession—or about the way that restraint fades out over the forecast, that would have a huge influence on the projected path for the funds rate. So it is important to recognize that this forecast is conditioned on one in which those effects linger quite significantly into next year. MR. EVANS. Thank you. CHAIRMAN BERNANKE. Other questions? If not, we will begin our economic goround. President Hoenig. MR. HOENIG. Thank you, Mr. Chairman. I thought I would talk a bit about some events in our region that I think have global implications—that is to say, I will talk a bit about agriculture. You have heard others here this morning talk about some of the price movements, and I think it is worth perhaps spending a few minutes on their effects. First of all, agricultural commodity prices have surged to record highs, driven by obviously strong demand, lean supplies, and a weak dollar. Since the fall of 2007, winter wheat prices have doubled, and corn and soybean prices have risen about 70 percent, to record highs. Rising crop prices are boosting farm income. In real terms, U.S. net farm income is expected to climb to the second highest level on record, trailing only 1972, when abrupt sales of U.S. wheat to Russia pushed up farm income. An emerging concern is the growing disarray in futures markets for agricultural commodities caused by a surge in investment by index and hedge funds going forward. Recent reports indicate that hedge and index fund investment in futures markets for corn, soybeans, and wheat rose from $10 billion in January 2006 to $45 billion this past January. Early this month, index funds held more than 40 percent of the long positions on wheat contracts on the Chicago Board of Trade. At this rapid pace of investment—since the beginning of this year averaging March 18, 2008 25 of 127 $1 billion per week—the funds would own the nation’s entire 2008 corn, wheat, and soybean crops by early 2009. Now, that is obviously theoretical, but that is how much money is going into this market. The resulting market disarray is constraining the traditional use of commodity futures to hedge market risk. Grain elevators, which use futures to hedge their contracts to purchase crops from producers for future delivery, are facing much larger than normal margin calls on their futures positions. Some reports indicate that lenders are beginning to restrict their funding of elevator hedges. As a result, an increasing number of elevators are limiting their contracts for crop purchases to no more than sixty days in advance of the delivery instead of the normal one to two years. Now, this surge in crop prices and farm income is pushing up farmland values. According to our bank’s agricultural credit survey in the fourth quarter of 2007, non-irrigated cropland values jumped 20 percent over 2006 levels, with strong gains also reported in irrigated cropland and ranchland. Our directors and other contacts report a further strong gain since the beginning of the year, and some have reported as much as a 20 percent increase in the first quarter alone. Adjusted for inflation, the average price of farmland across the nation now tops the early 1980s peak, which immediately preceded the plunge in the early to mid 1980s. To date, crop production budgets suggest that the recent run-up in farmland values is supported by current revenues from crop production. However, farm input costs have also risen sharply, driven by higher energy costs, suggesting that a drop in crop prices could quickly erode farm cash flow and undermine these values. District bankers report a surge in farm capital spending. In February, sales of four-wheeled major equipment rose 45 percent above 2007 levels, and combine harvester sales were up 13 percent. Farm equipment prices have risen sharply, and our directors and other contacts report that some equipment dealers are rationing March 18, 2008 26 of 127 purchases among their customers. In the past month, anecdotal reports from District contacts indicate that nonfarm investors have boosted their farmland purchases. Our contacts at a national farm management company based in Omaha stated that the number of inquiries for farmland purchases by corporate interests has jumped significantly recently. Similarly, one of our directors reported that a hedge fund with assets of more than $7 billion is expected to invest $500 million in cropland from Texas and Nebraska. This fund recently purchased nearly 25 square miles of corn acreage in western Nebraska. Now, we continue to watch for signs of rising leverage, but to date farm debt levels have risen modestly only, and agricultural banks seem to remain healthy. Bankers report continued use of cash to finance farmland purchases, but I would note that leverage is being brought into the picture, and I think that will accelerate as opportunism and greed have their way. Total farm lending in the District banks has increased a modest 14 percent over the past four years, with most of that growth being in farm real estate lending. But District bank examiners and respondents to our surveys reported that the Farm Credit System was being more aggressive in funding farm real estate transactions. Real estate mortgage loans held by the Farm Credit System rose about 12 percent in 2007. Asset quality at our ag banks remains, at this point, solid. Noncurrent assets—all assets, not just farm loans—at ag banks are up only slightly from a year ago and remain well below historical averages. Net loan losses are still very low. Earnings have remained solid primarily because of cost control and very low loss provisions. I am very pleased, but I will tell you that, going forward, in terms of the surveys with the kinds of pressure and price appreciation going on, I think the push for leverage is just beginning. March 18, 2008 27 of 127 At the national level, in terms of the Greenbook, every indication is that the economy is slowing. Whether it is recession or very slow growth is a matter of degree, but I think our projections are in the same direction as the Greenbook. Turning to the inflation outlook, I am concerned, as I have said before, about the upside risk to inflation. Though I certainly agree with others around the table that weaker economic activity may put some downward pressure on goods price inflation, I think we can also agree that a number of factors could push inflation higher, including rapidly rising commodity prices worldwide and a weaker dollar. As discussed in the Bluebook, there is some indication that inflation expectations may be moving higher as well. As I have indicated before, I am increasingly concerned that, in our need to respond to signs of economic weakness, we risk losing our hard-won credibility on inflation. For the past four years, core PCE inflation has averaged about 2.1 percent, considerably above the numbers that this Committee has put forward in its long-term projections. Frankly, I do not think that many people outside this room think that this Committee can deliver the longer-run projections that we have put forward. I don’t think that we can keep inflation expectations anchored only by talk if actual inflation rises further in the months ahead and we continue to ease policy in a rising inflationary environment. This is something that we need to keep in mind as we discuss our policy options today. Thank you. CHAIRMAN BERNANKE. Thank you. President Rosengren. MR. ROSENGREN. Thank you, Mr. Chairman. Since our last meeting, the economic data have continued to indicate a very weak economy and that, in all likelihood, we have entered a recession. Like the Greenbook, my outlook is particularly influenced by indications of significantly weaker labor markets and a housing market that is as yet showing no signs of March 18, 2008 28 of 127 reaching bottom. Private payroll employment fell 101,000 in February, and the sum of the downward revisions in December and January was about the same magnitude. Not only have we had three months of declining private payroll employment, but also the decline has been widespread across most industries. The Blue Chip economic forecast, the Greenbook forecast, and our own forecast have the unemployment rate peaking somewhere between 5½ and 6 percent. While most analysts are in the process of downgrading their forecasts from skirting to actually having a mild recession, the risk of a more severe downturn is uncomfortably high. A major determinant of the severity of a downturn will be the housing market. Because recent developments in the housing market are so different from most postwar history, I remain very concerned that the effects of substantial declines in housing prices will be difficult to capture in statistical models based on historical data. The Case-Shiller index indicates that housing prices fell approximately 10 percent in 2007, and a decline of similar magnitude this year would mean that many homes purchased in the past several years are in a negative equity position. Elevated foreclosures and large inventories of unsold properties are providing abundant opportunities to purchase homes at heavily discounted prices financed at low interest rates by historical standards. But widespread concerns that prices will continue to fall have resulted in many prospective buyers deferring purchase decisions. To date, the housing market has been quite weak, despite relatively low unemployment rates. But if our forecasts are right, job losses this year are likely to exert a significant further drag on housing prices as rising unemployment rates force additional home sales or foreclosures. Falling housing prices are likely to have a collateral impact on consumption. Perhaps reflecting this risk, the credit default swap rates on retailers have been rising, and we are increasingly hearing of retailers that are closing stores or postponing expansions. Retailers, like consumers, are aware that high oil March 18, 2008 29 of 127 prices, increasing job losses, and losses of wealth in the stock and housing markets are not likely to be conducive to robust consumption. Exacerbating the negative economic news is the continued deterioration in financial markets. Credit spreads have widened significantly over the past six weeks, with many spreads more than 50 basis points higher than at the last meeting. Hedge fund and money managers that I talk to are acutely aware of the counterparty risk and are very carefully managing their collateral. Most firms with excess collateral are in the process of managing that position down. The deleveraging that is going on has reduced the willingness of banks and other financial intermediaries to finance their positions. In addition, as concerns with liquidity rise, we are once again seeing renewed pressure on the asset-backed commercial paper market. The rise in credit default swaps for companies like Washington Mutual and Lehman Brothers indicates increased concerns for the solvency of other large financial institutions with large exposures to mortgages. The potential for a further episode of financial market dysfunction and for runs on additional financial firms is significant. My primary concern at this time is that we could suffer a severe recession. Falling collateral values and impaired financial institutions can significantly exacerbate economic downturns. Some indicators of inflation are higher than we want, but during previous recessions, commodity prices and inflation rates fell. Given my forecast for the economic outlook, I expect substantial excess capacity to significantly reduce inflationary pressures going forward, and I see little evidence that higher commodity prices are causing upward pressures on wages and salaries. CHAIRMAN BERNANKE. Thank you. President Yellen. MS. YELLEN. Thank you, Mr. Chairman. Since we met at the end of January, there has been an utter dearth of good news concerning both the real and the financial sides of the March 18, 2008 30 of 127 economy. On the real side, I just can’t recall any intermeeting period in which nearly every single data point was dismal. On the financial side, there have been occasional good days, but the net changes over the intermeeting period have been negative across the board in both the equity and the credit markets, so financial conditions have unambiguously tightened. These developments are familiar to all of us, and I won’t take up time to review the specifics. My overall sense at this point is that the effects of the severe and prolonged housing downturn, the financial market implosion, and the price increases for oil and other commodities have now spread to most corners of the economy, including the major segments of consumption and business fixed investment. Exports represent about the only source of strength, and while that is welcome, I must say that the economy is pretty clearly in trouble when the contribution to real GDP growth from exports exceeds overall real GDP growth, as may well happen this year. The bottom line is that, like nearly everyone else, I have downgraded my economic outlook substantially. Assuming that the stance of policy is eased substantially at this meeting and additionally by midyear, I see the economy as essentially in recession during the first half before picking up somewhat in the second because of the effects of monetary and fiscal policy. However, I certainly see large downside risks to my forecast, and I think the Greenbook’s view that recessionary nonlinearities have already set in seems to me to be within a reasonable range of outcomes. In fact, we have also been looking at monthly data on coincident business cycle indicators, and that examination suggests to us that the NBER may well date the beginning of the recession to last November. The prospect of this outcome has been made more palpable for me by the rather sudden increase in the frequency and intensity of pretty dire comments I am hearing from my contacts. First, I have heard widespread reports of reductions in capital spending plans due to caution or March 18, 2008 31 of 127 pessimism regarding economic growth. For example, a large manufacturer and retailer of outdoor sports equipment reported that technology and infrastructure spending has been cut by at least a third in 2008. In another example, a large player in commercial real estate in the San Francisco Bay area described how projects are being canceled because the financing spigot has been shut. Indeed, nonresidential construction is one sector where I think the Greenbook may be too optimistic. I envision growing weakness there. Second, my retail contacts suggest that spending has softened further in the wake of a weak holiday season, and expectations are for continued weakness at least through spring. For example, the CEO of a large high-end national retail operation reports that for January and February he has seen declines in sales that haven’t been experienced for almost fifteen years. These declines have created tremendous pressure on inventory levels requiring large markdowns with negative effects on profits. Vendors are reeling from the cancellation of orders, the return of goods, and sharp reductions in new orders. Third, a number of contacts have provided comments reinforcing the view that a significant credit crunch is under way. Slightly more than half of the comments received on this topic indicate that credit standards have tightened significantly in recent months. In one example, the CEO of a bank in my District reports that several of the nation’s largest mortgage lenders have suspended withdrawals from open home equity lines out of concern that borrowers could now owe more than their homes are worth. As a final anecdote, a banker in my District who lends to wineries noted that high-end boutique producers face a distinctly softening market for their products, although sales of cheap wine are soaring. [Laughter] Now let me turn to inflation and inflation expectations. Of course, much of the recent data have been disappointing, having been pushed up by rising energy and other commodity March 18, 2008 32 of 127 prices. Though I was heartened by Friday’s CPI report, this one observation hasn’t changed my overall impression that prospects for core inflation this year have worsened a bit since we met in January, and I have raised my projection for core PCE inflation about ¼ percent in 2008, to 2¼ percent. These data raise the issue of whether cutting rates as much as needed to fight a recession may risk persistently higher inflation and inflation expectations. But I tend to think this risk is manageable. First, as I have said before, I view inflation as less persistent now than it once was, tending to revert fairly quickly to its longer-run trend. We have recently reviewed and updated our econometric evidence for this and found it to be even more convincing now than it was a couple of years ago. Of course, it is important to remember that the current lack of persistence presumably is due to our enhanced credibility, so we do have to be careful to maintain it. Recent increases in inflation compensation in Treasury markets highlight the risk that our attempts to deal with problems in the real economy possibly could lead to higher inflation expectations and an erosion of our inflation credibility. But inflation compensation is just one indicator of inflation expectations. I very much like the Board staff’s approach, which is in the current Bluebook, of combining the information from a wide variety of indicators into a principalcomponent-type model. I found it reassuring that the resulting index of inflation expectations and uncertainty is still within the range of variation that we have seen over the past decade or so. Second, I tend to think that developments in labor compensation are an important part of the transmission process for monetary policy to inflation. Before we get into too much trouble with inflation and inflation expectations, I would expect to see labor compensation begin to rise more rapidly. I find it reassuring that both our broad measures of compensation have expanded March 18, 2008 33 of 127 quite moderately over the past year, and productivity growth has been fairly robust. So after incorporating its effects, unit labor costs are up less than 1 percent over the past four quarters. Finally, the more pronounced slowdown that I expect for economic activity is likely to put somewhat greater downward pressure on inflation going forward. Overall, I expect core PCE inflation to fall below 2 percent next year under an assumed leveling out of energy and other commodity prices and the projected weakening of labor and product markets. CHAIRMAN BERNANKE. Thank you. President Stern. MR. STERN. Thank you, Mr. Chairman. Well, the baseline forecast in the Greenbook looked to me a lot like the 2001 recession experience—very brief and very mild. If things turn out that way, we will have been very fortunate, frankly. The forecast I submitted at the last meeting was lower than most around the table, and now my bottom line is that I think the recession that, if we are not in, we are confronting is more likely to resemble that of 1990-91, which, while brief, wasn’t that mild. There were a couple of quarters, as I recall, where the economy contracted by at least 3 percent in real terms. I am not sure that this recession is likely to be as brief as the previous two either. I have tried to use the 1990-91 experience and its aftermath as sort of a guide to thinking about where we are today and how things might unfold and evolve because there are some significant similarities as well as some significant differences between the periods. But it is also a way for me to start to organize things and think about this. So let me just describe a few of what I think are relevant features from that experience and how today’s circumstances are either similar or different. If you compare our circumstances today with what we were confronting back in 1991, on the positive side inflation and inflation expectations are both lower today. The unemployment rate is lower than it was going into that recession. Nominal and real interest rates appear to be March 18, 2008 34 of 127 lower today than they were back then. I think that nonfinancial business balance sheets are in better shape today on average than they were going into the 1990-91 experience, and depository institutions overall are in better shape today than they were back then, although of course they are having some very high profile problems. Of course, that was the period when we saw more or less the virtual demise of the thrift industry and problems of major banks. There was also a significant correction in housing activity, which commenced in 1987 and ran through into 1990. It wasn’t as sharp as the one we are experiencing, but it was significant nevertheless. There was also a credit crunch back then, and that was given a lot of responsibility not only for the recession but for its aftermath—that is, the relatively sluggish recovery that occurred once the recession ended—because it was alleged that financial institutions, nonfinancial businesses, and households were all trying to strengthen their balance sheets simultaneously, and so there was a good deal of caution throughout the financial sector. So there are a number of similarities as well as a number of differences. When I think about today’s circumstances, a couple of things come to mind. One is, as President Yellen summarized, that the breadth of negative news about the economy is striking to me. On top of that, I think today’s financial problems are, without question, more severe and more intense than they were back then. They have engulfed many financial markets, as we are well aware. While there were declines in housing prices and housing values in some markets back then, the decline we are experiencing today is both more widespread and is likely, before it is done, to be a good deal deeper. So I think that at least a reasonable parallel is the kind of thing we experienced back in 1990-91. Now, on the inflation side, let me start with policy. We weren’t targeting the federal funds rate back then. We were still wedded to the monetary aggregates, more or less. But the March 18, 2008 35 of 127 funds rate, nevertheless, provides some useful information. The funds rate, in early 1989, was around 9¾ percent. It got to 3 percent by September 1992, where it stayed until early 1994. I cite that because inflation, whether you look at core or at headline, actually diminished through that period. So while some people have been worried, and perhaps justifiably, that this is going to shape up like the late 1960s or much of the 1970s as far as inflation is concerned, all I would say about that is it is not a foregone conclusion if you look at history. I don’t know that it is easy to distinguish how this is likely to play out, but that was a very significant series of policy moves undertaken back then, and inflation, nevertheless, diminished. The only other comment I would add to this—and it is not going to lift the gloom right away, certainly—is that these financial problems are going to persist. Even if they bottom out and conditions start to improve, I would expect that they will exert headwinds on the shape of the recovery. My view is that 2009 is not likely to be as healthy as the Greenbook envisions, largely as a consequence of the hangover of financial problems. Thank you. CHAIRMAN BERNANKE. Thank you. President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. Reports from my directors and business contacts are consistent with what others have said this morning—that overall economic growth has slowed appreciably since the beginning of the year. Pessimism about the near-term outlook has increased. At the same time, many are troubled by the continued elevation of prices and price level increases and are apparently becoming less convinced that inflation will moderate any time soon. In my view, the deliberations this morning and the decision we make must be about, first, financial system stability—the threat to the broad economy of severe financial instability— and, second, inflation risk and the role of rate policy in response to immediate problems. One addition to the list of concerns is the continuing dollar depreciation since we met last and its role March 18, 2008 36 of 127 in price pressures and overall uncertainty. In the run-up to this meeting, I heard little that casts doubt on where the economy is trending. My assessment is that we have entered recession territory. Previous forecasts premised improvement in the second half on the stabilization of house prices and financial markets. Neither has materialized, nor are there early encouraging signs. In the current circumstances, financial stability must be priority one. That said, the inflation picture has become quite troubling. Headline inflation, perhaps excluding last month, has been elevated since late summer, as have measures of core inflation, though less so. The expected easing of pressures hasn’t yet convincingly set in. A longer view leads to the conclusion that inflation has been relatively high, on average, since 2005. We must be mindful of this as we address financial stability concerns. I mentioned the dollar’s trajectory when I listed what in my view are the relevant considerations today. I am concerned about what I perceive as growing mention of the possibility of a dollar currency crisis. Although only one conversation, I also heard mention of a developing dollar carry trade fueled by interest differentials, expected rate cuts, and possibly the view that recessionary conditions will persist for some time. Policy is often a balancing act, but I see our current constraints as tightening. The real side has entered recession in all probability. There is increasing risk to the inflation objective. Financial stability is profoundly in play, exacerbated by the trajectory of the dollar, although to be measured about this, I think the current round of financial market problems has not yet thrown the economy irreparably off balance. I intend to support a downward rate move today, but with reservations about the utility of continuing cuts in addressing financial stability problems. Discussion in the policy round may March 18, 2008 37 of 127 address this, but I will comment now that balancing our policy objectives in such a risk-laden environment may require decoupling rate policy from liquidity measures. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Pianalto. MS. PIANALTO. Thank you, Mr. Chairman. Through my conversations with people in the Fourth District financial community, I get the clear impression that some credit channels are closing down. Given the uncertainties in financial markets, some of the large banks in my District are finding it challenging to ascertain potential loss exposures in certain asset categories, especially to residential real estate developers. Two large banks in the District have seen their asset quality deteriorate more quickly than they had projected in January. Clearly, banks and other financial institutions are getting squeezed from both sides of their balance sheets, and the most highly leveraged institutions are getting squeezed the hardest. Many of the large banks in my District are going to considerable lengths to stay liquid and to conserve capital. The largest and most complex institutions are attempting to raise more capital. The deteriorating environment in the financial markets is clearly affecting business conditions. Most manufacturers in the District have seen a slowing in business activity. Those that are doing better are doing so because they are being helped some by stronger export demand. Pessimism over economic prospects is now prevalent among the CEOs that I talked with, and many are scaling back their business plans for 2008 by a considerable amount. The faltering business prospects are making the financial environment even more uncertain—a pattern that conforms to the adverse feedback loop that Governor Mishkin and others have been warning about. Like others, I have once more cut my growth projections for 2008 and, again, by a relatively large margin. As in the Greenbook, I have factored into my projection the weaker March 18, 2008 38 of 127 than previously expected estimates of spending and employment as well as the sharp run-up in energy costs. An especially important element in my current thinking is the future path of housing values. Many of my contacts have told me that they don’t see how financial market conditions can stabilize without more confidence about where the bottom of the housing market lies and, as a corollary, where the bottom of the residential-mortgage-backed security prices might lie. Unfortunately, I haven’t seen evidence that we are seeing a leveling out in housing prices. The Greenbook baseline projection carries with it nominal house-price declines of about 5 percent this year and next. A month ago that may have seemed like a reasonably good assumption to me, but today I fear that projection may be too optimistic. Certainly, the decline in house values that one sees in futures markets for the markets that are covered by the Case-Shiller index indicates a decline of twice that magnitude. My own baseline projection is closer to the “greater housing correction” alternative than the Greenbook’s baseline projection. Even the “greater housing correction with more financial fallout” alternative seems somewhat plausible to me. Turning to the inflation outlook, at our January meeting my modal outlook was one in which the inflation trend declined to just below 2 percent in 2010. At the same time, I was one of the few participants who said that the inflation risk had shifted to the upside. I still hold to those views—that is, I still expect the trend of inflation to fall below 2 percent by 2010, but I still worry that we are going to continue to experience upside surprises to that inflation outlook. Indeed, I can’t recall a single conversation that I have had with my business contacts recently that hasn’t touched on the increasing cost pressures that they are facing. In most cases, they are now successfully passing along price increases to their customers. March 18, 2008 39 of 127 Nevertheless, as I assess the economic environment this morning relative to where I was in January, particularly given the prospects of yet larger wealth losses stemming from the real estate market and certainly the chance for even greater impairment to the functioning of our credit markets, I think the downside risks to economic growth continue to outweigh the upside risks to inflation. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Evans. MR. EVANS. Thank you, Mr. Chairman. Clearly, the incoming data on activity have been weaker than we expected. I think they point to a downturn in GDP in the first half of the year similar to that in the Greenbook. While the February CPI report was welcome news, on balance I think the inflation picture continues to be troubling. I noticed a marked change in the sentiment of my business contacts this round. Many more are now telling me that the problems on Wall Street are affecting their financing. Credit availability is now an issue. With regard to borrowing from banks, these reports seem consistent with the Senior Loan Officer Opinion Survey. Credit is an issue for those tapping nonbank sources as well, as in the comments that President Yellen made. As an example, back in December a major shopping center developer indicated that, even though the commercial-mortgage-backed security market had dried up, he was still able to obtain financing on reasonable terms from other sources, such as life insurance companies. Last week he told me that these sources had dried up, too. He’s now trying to raise equity funding, which he considers very costly and an unappealing alternative. Many contacts also expressed increased nervousness over the economic situation and its likely impact on demand for their products. Manpower’s CEO told me that their business had deteriorated in recent weeks. Some of his clients were trimming staff because of a lower current demand, and many others were being cautious and cutting back in expectation of future weakening. March 18, 2008 40 of 127 Still, even though restrictive financing and heightened caution are weighing on households and businesses, there is a sense from my contacts that spending is not collapsing at this point, and exports of capital equipment in the agricultural sector continue to do well, similar to President Hoenig’s comments. Another common theme I heard from my contacts is that, while the Fed’s innovative response has helped, they do not expect that these measures will do a lot to solve the financial sector’s fundamental problems. I doubt that any of us disagree with that. As one of my directors put it, “Monetary policy is not enough. We need a solution to the subprime mess. Once that happens, the contagion will run in reverse.” I believe our innovative policies are helpful for facilitating market functioning, but they don’t address the root problem. Markets want a firmer sense of where prices for stressed assets will bottom out and of the magnitude of the portfolio losses that will be taken by major financial players. Unfortunately, it will take a good deal of time before these uncertainties will be resolved, and I’m not sure what we can do to speed the process. After all, a number of these losses are going to stem from mortgage delinquencies that have not yet occurred and perhaps from homeowners who have not even contemplated that outcome. This means that financial headwinds likely will be weighing on the real economy for some time, as President Stern said. I agree with his comments there. The substantial uncertainty over the length and breadth of this process adds uncertainty to the medium-term outlook for growth. So while I am hopeful that the economy will begin to recover in the second half of the year, I’m a lot less confident of that outcome than I’d like to be. Turning to inflation, Friday’s CPI report was about the only good news I heard during the intermeeting period (I think last time the reports weren’t very good either, President Yellen), although as the Greenbook Supplement points out, the less favorable translation to PCE prices takes March 18, 2008 41 of 127 out some of the luster. It’s no surprise that many of my contacts pointed to increasing pressures from higher costs for food, energy, and other commodity inputs. I also heard numerous reports of higher costs being passed downstream. One notable case was for wallboard. Even though demand is weak and the industry had plenty of excess capacity, higher costs for energy inputs were resulting in the first increase in wallboard prices in 20 months. The director who reported this was concerned that pricing behavior is moving toward a cost-plus mentality. This is, after all, his industry. If so, this would have negative implications for inflation expectations. However, I see this as a risk and not a base case scenario because the resource gaps opening up in the economy should bring inflation down. Firms will find it difficult to pass through cost increases in an environment of weak demand. Businesses and financial market participants will be aware of this difficulty in passing through costs, which should help keep down their inflation expectations. That said, even in a weak economy, firms will have only so much room to absorb costs, and pressures from higher prices for energy and other commodities and for imported goods pose a risk to the outlook. In addition, while I expect inflation expectations to be contained, there are risks on this front, too. Some can see a low fed funds rate path, such as that assumed by the Greenbook, as an indication of a lack of resolve on inflation. I don’t agree with that assessment, but it’s an increasing risk that we will be running, particularly if the inflation news breaks in the wrong way. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Lacker. MR. LACKER. Thank you, Mr. Chairman. We’ve seen two striking macroeconomic developments since our last meeting. We now have compelling evidence that a recession is in train. We now have compelling evidence of erosion in our inflation credibility. Information from our District corroborates a recession call. Various survey indicators and reports from contacts point to March 18, 2008 42 of 127 weakness in manufacturing, commercial real estate, and consumer spending. No signs have yet emerged of a bottom in housing. The national reports on employment and retail sales for February have sealed the case for recession. It now appears that payroll employment peaked at the end of ’07 along with real income and household spending, and to make matters worse, anecdotal reports suggest that the January fall in nonresidential construction is only the beginning of a sustained deterioration. I’m now expecting a period of declining employment, declining nonresidential construction, and flat-to-sluggish consumption. Equipment and software spending may decline as well. Past contractions suggest a trough later this year. More severe scenarios seem unlikely to me, however. The Great Depression, for example, involved us keeping real rates well above 5 percent for several years as activity slowed and the price level declined 30 percent. It will take some time before the ultimate size of mortgage foreclosure losses is known well enough to substantially reduce the uncertainty attached to mortgage-backed security returns, and it is not clear that interest rate changes will affect that timetable much. In the meantime, I would expect to see repeated bouts of financial turmoil. When particular markets or entities come under stress, I would also expect to see even wider speculation about and calls for new Fed lending. It’s even possible that fluctuations in the perceived prospects for such intervention add to financial market volatility, much the way conjectures about IMF programs seemed to add to market volatility in the 1990s. After a string of adverse inflation reports, the CPI came in virtually flat for February. While this certainly helps for many reasons, including those Mr. Stockton cited, I’m not inclined to make much of one month’s report. The overall CPI is still up over 4 percent year over year, and given the recent behavior of oil and gasoline prices, inflation is likely to be high again in the March report. In any event, I think there is no comforting way to rationalize the substantial rise in the five-year, five- March 18, 2008 43 of 127 year-ahead inflation compensation we’ve seen since the beginning of the year. This measure of inflation was previously ratcheted upward by similar amounts in early 1999, early 2001, mid-2003, and early 2004. In each of these episodes, our actions and statements communicated an increase in our concern about growth prospects, and market participants seem to have inferred a corresponding reduction in our commitment to price stability. The net result over that period is that five-year, fiveyear-ahead inflation compensation has drifted up significantly over the past ten years, from below 2 percent to now above 3 percent. This expectational drift is likely to overwhelm, in my view, any transitory effect of increasing slack. I believe inflation expectations no longer qualify as well anchored. Moreover, they no longer seem consistent with the credibility of even a 2 percent inflation objective. I believe that this substantial erosion in our credibility is occurring because of our aggressive policy moves and the perception that the hierarchy of our macroeconomic priorities has changed. It wouldn’t surprise me if our recent credit market interventions are bleeding over into a skepticism about our general approach to time-consistency problems. It cannot help to allow our credibility to drift around. I do not think we want a regime in which long-run inflation expectations ratchet up whenever growth slows significantly. Ultimately we will be forced to act to restore credibility. This just adds needless volatility to financial markets and the economy. I believe we need to adopt a strategy of easing much less aggressively going forward than we have to date and than markets expect. President Stern cited the 1990-91 recession and the fact that both the federal funds rate and inflation came down during that recession. But surely the pace of easing then had something to do with the fact that inflation came down. Unless we’re willing to let inflation expectations continue to drift, we have to disappoint markets sometimes. Thank you, Mr. Chairman. March 18, 2008 44 of 127 CHAIRMAN BERNANKE. Thank you. First Vice President Sapenaro. MR. SAPENARO. Thank you, Mr. Chairman. Eighth District economic conditions have softened, but with considerable variability across industries and local areas. The outlook for District agriculture is very strong in the context of high commodity prices. This prospect is reflected in prices of agricultural land, which in areas within the District have risen at a rate of 20 to 25 percent over the past year in active markets. Production of agricultural equipment for the 2008 crop season is fully booked, and prices of used equipment are at or very close to prices of new equipment. There was major activity in the District energy industry, with significant construction projects of coal-fired generation facilities and rapidly developing exploration and production in the Fayetteville Shale play in Arkansas. Total natural gas production from this source roughly quadrupled during 2007. In a recently published study, it is estimated that the direct impact on Arkansas output from exploration and production will average about $2.5 billion per year for the next five years. For perspective, this is about 2.8 percent of the 2006 Arkansas gross state product. Overall activity in the Evansville, Indiana, metropolitan area is particularly strong. The unemployment rate there has declined year over year from 4.6 to 4.2 percent, and nonfarm employment has grown 1.4 percent from January ’07 to January ’08. A major investment in the auto parts industry is in the works for this area. Activity in housing markets in the District is soft, with building permits in the four largest metro areas down on average 16.8 percent during 2007. Nevertheless, house prices in the District have held up much better than the national experience. In 21 District metropolitan areas, house prices increased an average of 2.5 percent in 2007, with decreases in house prices reported in only 3 metro areas. However, in contrast to other parts of the nation, these areas did not experience major house-price inflation before 2007. From 2000:Q4 through 2006:Q4, the average annual price March 18, 2008 45 of 127 inflation in these areas was only 5.3 percent. Foreclosures have increased in 2007 in three of the four largest District metro areas but at much lower rates than nationally, and 2007 foreclosure rates are at or below national averages in three of these four areas. I solicited information on the national economy from a number of sources. Contacts in the air and ground cargo industry report significant cost pressures from higher energy prices. These affect everything from fuel costs to the cost of snow removal. Respondents indicate that these cost increases are significantly but not completely passed through to their prices. International cargo traffic is reported to show strong growth, but with some customers substituting sea for air shipment and choosing less rapid delivery service to reduce cost. Year-over-year traffic out of Asia to both Europe and North America has grown at double-digit rates. One contact indicated that volume appears to have bottomed out in the first half of 2007 and has slowly but steadily improved since. In contrast, a contact in the over-the-road trucking industry reported that there was not much change in the past two months. In his view, the industry has been in recession since December 2006. He sees improvement for his firm going forward not because of increased demand but because of small competitors exiting the industry through bankruptcy. Excluding fuel surcharges, freight prices are flat to down. A contact at a major credit card bank reported that their credit card activity indicates that retail sales, excluding autos, were flat in February and are likely to be flat to down in March. These February data were confirmed by the advance retail sales report last week. He also reported that a smaller percentage of customers are making full payment on their credit cards and that a larger percentage are making only the minimum required payment. He sees delinquencies spreading to credit cards. A contact at a major software producer indicates that revenue growth was robust prior to the first quarter of 2008 and, while remaining strong, has slackened since the beginning of the March 18, 2008 46 of 127 year. He reports strong retail sales, but that was possibly influenced by reductions in prices. He sees business IT spending in the United States remaining strong and no deterioration in the collection of receivables. Nevertheless, he is less optimistic about the industry outlook now than in January. Finally, a contact in the quick service restaurant industry, or fast food, sees business as stable at the moment, not getting worse but not getting better. He notes that while historically this industry is affected least when the economy slows down, this particular time he sees gasoline prices as a significant factor, with many consumers making fewer trips to purchase low-ticket items. He also views financial markets as closed to all but the largest and most highly rated nonfinancial corporations. In his words, there is no market for deals. The national economy certainly appears headed for a weaker first half of 2008 than seemed likely at the January meeting. A model estimated by our staff economists for forecasting recessions suggests a probability in the neighborhood of 60 percent that the NBER dating committee will label the current experience an official recession. Unlike some, I am not an optimist on the effect of the fiscal stimulus program on consumer demand. Economic theory and past experience with such oneoff stimulus programs do not provide a basis for assuming a strong response. In the current situation, with many consumers heavily leveraged, it is likely that the stimulus to consumption will be less than historical averages. Notwithstanding the February CPI report, the inflation situation is deteriorating and appears likely to continue deteriorating. Beyond the immediate issue of containing systemic risk, the most important issue is the subsequent economic recovery. We have eased aggressively already. We must not lose focus on the lagged effect of current policy actions on that recovery. We must preserve the credibility of our commitment to low and stable inflation. The greatest danger is a relapse into a period of higher inflation, which then promotes a policy response that could generate March 18, 2008 47 of 127 a future recession and start a vicious cycle of increasing inflation and increasing unemployment. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. As anticipated, Third District business activity showed continued weakness in February and March. Reports from retailers, manufacturers, bankers, and other business contacts remain somewhat downbeat. At the same time, there has been little moderation in price pressures facing our firms and consumers. There is little new in the regional housing markets. So rather than dwell on housing, let me talk about some of the information that we have received since our last meeting. Banks in the Third District have generally been relatively unscathed by the toll on the financial markets. Many had not been in the subprime market and did not have instruments based on subprime. They do, however, hold a high proportion of commercial real estate and residential mortgage loans in their portfolios. So to the extent that the commercial real estate market slows as we expect, our banks are likely to be feeling the effects. Bankers, thus, have become somewhat more pessimistic over the past six weeks or so. They don’t expect financial conditions to improve any time soon, and several noted signs of declining business loan demand, which they had not been seeing earlier. Bankers also report some deterioration in personal-loan credit quality and are expecting increases in credit card delinquencies. Despite these increases, these delinquencies and default rates so far remain well within historical norms. Manufacturing outlook activity in the District remains weak. Our March business outlook survey is confidential until we release it this coming Thursday. It will show a little improvement in February’s dismal readings. Since the beginning of the year, the general activity index has been at a level typically associated with either a national recession or a substantial slowdown in economic March 18, 2008 48 of 127 growth. So despite the modest improvement, it doesn’t move us out of negative territory. Responses to a special survey question in February indicate that the majority of our firms considers their inventories to be at an appropriate level, and firms are unlikely to substantially replenish these inventories until midyear or later. But it doesn’t seem as though there will be more-dramatic reductions in inventories—as, for example, in the Greenbook’s basic story, where there’s a very large inventory correction, it appears. Despite the weakness in activity, there has been little moderation in price pressures in the District. The current prices-paid index in our business outlook survey continues to accelerate, and both the prices-paid and prices-received indexes over the past three months are at very high levels relative to the last twenty years. Firms in various sectors, not just manufacturing, were reporting significant increases in prices, particularly of imported inputs. Although our firms are expecting continued weak real activity, they expect prices to rise over the next six months. Indeed, the forward-looking price indexes in the survey are at very elevated levels, and the future-prices-paid index is at its highest level since the early 1980s. Our firms seem to be as skeptical as I am of the arguments of the critical link between inflation and resource utilization. Turning to the national outlook, I struggled coming into this meeting with a growing level of discomfort. There are four dimensions to my concerns: first, the outlook for growth; second, the outlook for inflation; third, the calibration of monetary policy given that outlook; and fourth, the turmoil in the financial markets. First, in terms of near-term economic growth, the outlook has deteriorated somewhat since our last meeting. I expected weak growth in the first half of the year, but the incoming data suggest that growth will probably be somewhat weaker than I anticipated. I and many private-sector forecasters, like the MA or the Blue Chip survey summaries, have responded to the incoming data with downward revisions to our forecast for certainly the first half March 18, 2008 49 of 127 of 2008. But our changes are considerably smaller than the revisions in the Greenbook’s forecast, which have revised down personal consumption in 2008 from 2.3 percent in the January forecast to zero in the current forecast while incorporating significantly more monetary policy stimulus. I realize that the Board’s staff has a good track record, but I am not wholly comfortable with the Greenbook’s forecast, which I think incorporates a number of judgmental adjustments that are responsible for taking it pretty far away from where private-sector forecasts now are. Second, I’m just less comfortable with the inflation outlook. I’ve said before that, if inflation expectations become unhinged, we will face an even more difficult problem as monetary policy will feed more quickly and directly into higher inflation outcomes. The ensuing loss of credibility will be costly to regain. I wish we had the luxury of waiting for unambiguous evidence that expectations have lost their anchor. But if we wait until then, it will be too late. This means that we have to look for early warning signs so we can take appropriate action to ensure that expectations remain anchored, and I am concerned that we are seeing those warning signs. Despite last Friday’s CPI numbers, headline and core inflation have been trending up. Oil prices are at record highs. Commodity prices continue to trend up, and the dollar has fallen sharply. Our business and consumer contacts are consistently stressing price pressures as a concern. These developments concern me partly because research indicates that inflation actually may have become less persistent since the 1990s, and I think we have to be careful not to interpret the lack of persistence independent of what monetary policy actions are taken. Moreover, inflation expectations measured by surveys and market-based measures have all risen over the last couple of months. Inflation risk premiums have risen, which could be an early warning signal of a waning credibility or commitment on the part of the Fed. The National Association for Business Economics March 18, 2008 50 of 127 survey in early March shows that a third of the respondents think that monetary policy is now too stimulative, and that is up from less than 10 percent just a few months ago. According to a special question on our November Survey of Professional Forecasters—I reported on this several meetings ago—half of those forecasters, 23 out of the 45, believe that the FOMC has an inflation target. Of those 23 forecasters, 20 believe that long-run inflation over the next ten years will be 50 basis points or more above what they view our inflation target is. I might be able to shrug off one or two of these, but the predominance of these signals has me concerned about the risk to our credibility. I’m also concerned that the public seems to perceive that the Fed has effectively set aside one part of its mandate, price stability, in our all-out efforts to promote economic growth. Said differently, it seems to suggest that not only are we incorporating new data into our loss function as our forecasts change but we are changing the coefficients on that loss function. I don’t believe that we are necessarily doing that, and I don’t believe that’s the right way to make policy, but I do believe that ultimately it’s up to us to make that clear to the public as best we can. Third, we have to calibrate the appropriate level of the funds rate and not just its rate of change. This is not an easy task, especially in the current circumstances. We have reduced the targeted funds rate by 225 basis points since August and 125 basis points in just the last six weeks. It is simply too soon for the economy to have felt the full effects of these rate cuts. While the recent deterioration in the outlook might suggest that we need easier policy, I believe that the recent increases in inflation expectations mean that the real funds rate has already fallen either below zero or close to zero depending on how we measure it. For example, the real funds rate is now minus 1 percent, which is below the more pessimistic Greenbook-consistent r* of minus 0.5 percent given in the Bluebook, if you measure the real rate as the nominal funds rate minus the Greenbook’s one- March 18, 2008 51 of 127 quarter-ahead forecasted headline PCE. The Greenbook suggests that the real funds rate can be negative over the next two years and inflation will continue to decelerate as upside inflation pressure is offset by greater slack in product and labor markets. I am skeptical. This outcome is predicated on inflation expectations remaining well anchored despite aggressive and persistent easing for a sustained period of time. Given the current fragility of inflation expectations, this seems very unlikely to me. The alternative Greenbook scenario with more inflation pressure from oil and imported goods suggests a steeper policy path and higher inflation by 2010-12. Fourth and finally, like everyone else, I am very concerned about the developments in the financial markets. I’ve been supportive of the steps we’ve taken to enhance liquidity in the markets through the TAF, the TSLF, the PDCF, or whatever. CHAIRMAN BERNANKE. AEIOU. VICE CHAIRMAN GEITHNER. Don’t say IOU. [Laughter] MR. PLOSSER. Well, I’ve been supportive of those, and I want to compliment the New York Desk and the people who have worked on this because I think they are very innovative. I’m not clear how successful these instruments will be, and they are not without their own set of risks of creating some potentially dangerous expectations regarding future Fed behavior, which eventually we must deal with. But I think they are worth trying as long as they are removed in due course. I can also support a further narrowing of the spread between the funds rate and the primary credit rate, although I would eventually like to see a review of what we think that spread ought to be in more normal times and what our exit strategy might be like as we move toward that. Giving some thought down the road to that I think would be helpful. So while I believe that we have appropriately reduced the funds rate in response to the worsening economic outlook for the real economy, I am less convinced that reducing the funds rate March 18, 2008 52 of 127 further will do much to stem the liquidity problems in the market or to lower risk premiums. Uncertainty about valuations seems to be the root cause of liquidity problems. The price discovery process needs to continue, and it may take a while. In this case, I think the Fed needs to continue to do its job to reassure markets that it will act as an appropriate lender of last resort, but we must be careful that a lower funds rate, if that is the path we take, doesn’t become just a form of forbearance that contributes to delaying the necessary writedowns and the price discovery process itself. Yes, the financial markets can have spillovers to the real economy to which the Fed needs to react with monetary policy, and I believe we have. At the same time, we need to keep focused on both parts of our mandate. We put our credibility at risk if we do not do so, and this would be a cause for severe problems later when we may need to act to regain it. We will have to face the fact at some point that we will disappoint the markets with their ever-increasing forecast of a lower funds rate. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Okay. Thank you. It’s 10:35. Why don’t we take twenty minutes for coffee. Thank you. [Coffee break] CHAIRMAN BERNANKE. Okay. Why don’t we reconvene. Let’s start with President Fisher. MR. FISHER. Thank you, Mr. Chairman. Mr. Chairman, today is my 59th birthday, and I can’t think of a better group of people to spend it with—or a less happy time to do it. MR. KROSZNER. We sure know how to take the punch bowl away from this party. [Laughter] MR. FISHER. Well, listen, I know we are suffering because our Deputy Secretary here sitting to your right, Mr. Chairman, just gave me a candle and had me blow it out with no cake March 18, 2008 53 of 127 attached. [Laughter] I want to use very quickly just four examples of what I think is going on with the economy. The first is that 21 miles of boxcars that are 89 feet in measurement each and usually carry lumber are laid up on railroads. The second is that there’s a labor shortage in the Yangtze River Basin, according to one of my interlocutors. The third is that Exxon is rolling $39 billion in cash in overnight deposits. The fourth is, just to keep you listening, that I am going to come back to my ninth birthday in conclusion. As to the 21 miles of boxcars, the average length of a flatbed car that carries lumber is 89 feet. Burlington Northern has 21 miles of it laid up. I mention that because, according to my contacts at the happy housing group that I talk to that builds a significant portion of homes in this country, this housing setback, as they put it, is worse than ’75, ’81, and ’91 combined. I have been a bear on housing from the first time I came to this table, and I agree with everything that has been said about the downside pressure that is being exerted by housing. I would add a couple of points just to underscore that. One is the 21 miles of flatbed cars that are laid end to end. The other is a concern I have from my interlocutors at UPS in that the past six weeks they have seen a downturn in their volume of 2 percent. The CEO describes that as a very unusual swing from an up 3 percent in January and something that he has not seen before, and I want to remind you that he was a CFO for many years. The third point is on the growth side, something that perhaps we can monitor going forward: Wal-Mart now polls one million customers. They started doing so last April. There are some imperfections in their polling. They find that 67 percent are concerned about the economic situation, particularly about their financial matters, driven largely by perceptions of their decreasing wealth in their homes but also, more importantly, by cost-of-living factors such as gas prices and the cost of money. March 18, 2008 54 of 127 With regard to the comment on China, at a conference in Paris recently, Governor Kohn, Presidents Evans and Yellen, and I had the pleasure of listening to Mr. Yi, who is the Deputy Governor of the People’s Bank of China. He made the comment that there is a shortage of labor in the Yangtze River Basin, which I found quite startling. I followed up with him on that conversation more in depth, and because of that, I am not surprised to hear about the inflationary forces that were spoken about at this table. It goes beyond energy, Mr. Chairman, and it goes beyond food, although I want to make some comments on food. I talked to several food producers, and they are all intending to pass through price increases of somewhere between 5 and 15 percent. Most distressing to me was Anheuser-Busch, since I am a beer lover. The cost of input of hops and barley has gone up 3½ percent. When you add aluminum, transportation charges, and other things, it totals almost 15 percent, and they expect at the retail level for the price of beer to be passed through at about 5.7 percent. So, say, 5 to 6 percent. Combine that with the largest producer of pizza crusts, who is expecting a 20 percent increase in the price sought for their product, then you get a sense of a broader issue at hand on food. Let me summarize that broader issue. I want to come back to Wal-Mart. They sell 10,000 food items. They expect an average price increase across those 10,000 items that they are budgeting for this year of a little over 5 percent. According to a senior official, “We will be aggressive about pricing. We are lagging in terms of our price increases as price leader, and now we are working aggressively to catch up.” That leads to concern on my part. I am well aware of the fact that we have not seen increasing demands from labor, but I don’t consider labor to be a domestic phenomenon. I consider it to be a global phenomenon, and I am concerned that you are hearing such reports in areas where our producers have offlaid certain manufacturing processes and sourcing of inventory, including in China. I, therefore, would suggest that they bear watching. March 18, 2008 55 of 127 With regard to the comment about Exxon’s rolling cash, to me this gets to the heart of the issue, and that is that I don’t believe, as Mr. Evans said, that monetary policy is addressing the root problem. The root problem is a problem of liquidity, solvency, and trust. When you have a sophisticated operation like that rolling cash in overnight bank deposits, it raises significant alarms to me because it indicates a lack of trust in the system through which you might otherwise conduct your cash and liquidity operations. I liken the situation, Mr. Chairman, to the following—and forgive my simplicity. I’ll use a hydraulic rather than a medical example, which I am often wont to do. We are the water main, and yet the grass is turning brown. The water is not getting to the grass because the piping is clogged with all the hair and residue and all of the ugly stuff that has been building up in this Rube Goldberg piping device that we allowed to happen over a long period of time. I don’t believe that cutting the fed funds rate addresses the issue. I do believe that the measures we have undertaken recently to enhance liquidity, to improve the functioning of the system, and to address the solvency issues are of significant import. Earlier you mentioned the Duke survey of CFOs. Seventy-five percent of those CFOs said fed funds rate cuts were not helping their business operations. I would have expected otherwise. After the last meeting, praying against my own vote, I hoped that everything that we had hoped would go up would go up and everything we had hoped would go down would go down—spreads et cetera. Yet if you look to the chart book—the Bluebook, for example, or the presentation earlier this morning—almost every single graph of what we had hoped would go down went up and vice versa; and I think that indicates that there are limits to the efficacy of cutting the fed funds rate. I said I would conclude with my ninth birthday. When I was nine years old, three-month Treasury bills were trading where they are today. Thank you, Mr. Chairman. March 18, 2008 56 of 127 VICE CHAIRMAN GEITHNER. Mr. Chairman, may I ask one clarifying question? CHAIRMAN BERNANKE. Certainly. VICE CHAIRMAN GEITHNER. President Fisher, did you just say the efficacy of “any” cut in the fed funds rate? MR. FISHER. I believe that the efficacy of the cuts that we have undertaken has been diminished by virtue of the liquidity–solvency crisis. VICE CHAIRMAN GEITHNER. I completely agree with that. But just to make sure that I didn’t misinterpret you, did you say the efficacy of “any” further cut? MR. FISHER. I think it is pretty clear that I am not going to vote for further cuts. VICE CHAIRMAN GEITHNER. No further cuts. MR. FISHER. At this juncture. Look, Tim, we cut rates 50 basis points last time. I was in a minority of one, and I respect the group around this table more than I respect myself. Here is the point: Everything that we wanted to go down went up, and everything that we wanted to go up went down. So I just wonder about the efficacy of the cuts as opposed to the measures that we have undertaken. VICE CHAIRMAN GEITHNER. I wasn’t debating. It was just a clarifying question. CHAIRMAN BERNANKE. Okay. Governor Kohn. MR. KOHN. Thank you Mr. Chairman. I agree with the others around the table who have said that the prospects for economic activity have taken another sizable leg down over the intermeeting period. I think we have been, for a time, in that adverse feedback loop between financial markets and spending that everybody—Governor Mishkin and others—has been talking about. That is not an unusual kind of loop to be in during a soft economic period. I think it is probably characteristic of a lot of slow growth and recessionary periods. But certainly it has March 18, 2008 57 of 127 been more intense this time because the financial turmoil has spread well beyond housing and has intensified significantly over the intermeeting period. The incoming data on spending, employment, and production were weaker than expected. House prices are moving lower by more than we or the markets expected. All of these data have accentuated concerns about the creditworthiness of households and businesses and, hence, about the creditworthiness of the people who lend to them, especially those who lend in the mortgage market. As perceptions of risk and risk aversion rose, there was a flight to safety and liquidity. I think we see that a little in the growth of M2 over the past couple of months, which has been very, very strong and suggests that households are retreating to money market funds, probably the ones that hold government securities, and to insured deposits. In wholesale markets there has been unwillingness to take positions and rising concerns about an array of intermediaries. Bill described this process much better than I could—illiquid markets, extreme volatility, deleveraging, margin calls, forced sales, especially in mortgage-backed securities, wider spreads, equity prices falling, and lending and funding tenors collapsing toward the overnight, again. So financial conditions have tightened for everybody but the government—and some of the European governments have seen them tighten, I guess. Mortgage rates have risen, and business bond yields have risen as well, even with Treasury rates going down. Tighter credit and declining equity and house prices are reducing wealth, and all of this weakens spending further. Now, to this process, the staff has judged that the economy has entered a recessionary state in which we can expect household and business spending to fall short of normal levels, given income and interest rates. I am not sure how much weight to put on this. I am a bit uncomfortable with constructs that don’t have a clear story behind them. But I must say that, looking at the sentiment indicators and listening to what I have heard around the table today from March 18, 2008 58 of 127 almost every Federal Reserve District reporting, I now put more credence in Dave’s recessionary state than I did before the meeting started. Obviously, something is going on that is undermining confidence and making people much more cautious than you would think, given the exogenous variables. I do think talking about the recessionary state underlines the extraordinary uncertainty we are dealing with. President Stern pointed out the 1990-91 precedent. There are some precedents for some aspects of this, but we don’t have many; and I think it is really difficult to know how financial markets will evolve and how that will feed through to the variables that affect household and business spending—the reaction of households, businesses, and state and local governments to tighter credit conditions. I agree with President Stern, President Evans, and others who said they thought that the financial stresses are deeper and will last longer than we thought and will, therefore, put more restraint on spending. Until markets stabilize on a sustained basis, the risk to satisfactory economic performance by the U.S. economy will remain skewed very much to the downside. Now, Federal Reserve liquidity tools that we have used are necessary to reduce the odds on even more-intense, downward-spiral crises and market liquidity feeding back onto spending. So I think our innovations here have been useful to reduce the downside risks a little and thereby to promote spending. But I agree with the others who say that they don’t directly deal with the underlying macro risk, which is really a story about capital, solvency, wealth, and prices. I think monetary policy easing is a necessary aspect of addressing these macroeconomic risks. I agree with President Fisher, President Plosser, and others that there is more going on and that monetary policy easing may not be a sufficient way of addressing these risks. But I do think, as long as the economy is weakening the way it is and we have these risks, that easing monetary policy will be helpful. It will help bolster asset prices. It will make the cost of capital March 18, 2008 59 of 127 lower than it otherwise would be. It may not be sufficient to turn the thing around, but I do think that without the easing that we have done— and that I hope that we do today—the situation would be far worse than it otherwise would be. We need to ease to compensate for the substantial headwinds that we are facing. Now, the forecast for inflation has not been marked down despite the greater output gap. As others have remarked, this output gap is offset, to a considerable extent, by the upward pressure on prices from oil and commodities and import prices as the dollar has fallen and prices have risen in our exporting partners—China, for example. I have to confess that I don’t really understand what has been happening to commodity prices in recent months. I don’t think the rise has been justified by the news on the underlying conditions of supply and demand. It is much larger than the dollar weakness has been, and the dollar–commodity price has always been a weak relationship. So, in fact, commodity prices are rising in a bunch of currencies. This isn’t just a dollar weakness problem. I have to believe that there is a speculative element here. Partly as a consequence, I am comfortable with the forecast of a flattening commodity price picture in the future—it might even decline, but at least a flattening out. I do think a shift from financial assets, especially dollar assets, into commodities is going on, and mostly this has been triggered by concerns about the U.S. economy and financial markets. In some sense, that shift is okay. It is driving down the dollar, and that is helping to stabilize the economy. The decline that we saw in oil prices yesterday suggests that, when people get more confidence about where those financial markets are going, some of those commodity prices will actually fall as the concerns about the U.S. economy are alleviated. It is sort of an upside-down relationship, but I do think we saw a bit of it that way. But I also sense that some of the rise in commodity prices and the fall in the dollar reflects concerns about the March 18, 2008 60 of 127 inflation outlook here. It is not surprising to me, in a very volatile and uncertain environment, that inflation expectations are not as well anchored and that they fluctuate a lot in response to new information. I expect that inflation will come down as commodity prices level off; then the output gap will increase, and that in turn will keep inflation expectations down. Still, navigating this appreciably weaker economic outlook for the real economy and the threats to financial stability, on the one hand, and the tenderness of inflation expectations, on the other, will require some discussion in the next section of our meeting, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. To join the growing chorus in the discussion today, I would say that there are very significant policy challenges across five areas on both sides of our mandate. First, the real economy is materially weaker. Second, inflation risks are quite discomforting. Third, we have genuine issues with respect to financial stability. Fourth, we have very real problems with respect to the credit channel and credit availability. Finally, as I think a couple of others have said, we have risks in terms of possible disorderly moves on the dollar. In terms of what markets believe that we believe are the big concerns, I think they rightly understand that we are very worried about downside risks to the economy. They believe that we are very focused on financial stability risks; and with the three new facilities announced in recent periods, they are coming to believe that we are finding an effective means to deal with a credit intermediation system that is, to perhaps overstate only a little, broken. But market participants may not yet believe that we are as concerned as we ought to be about inflation risks and about risks with respect to the path of the exchange value of the dollar. With that summary having been made, let me talk, first, about financial market conditions. About the deterioration in market functioning since the last FOMC meeting, Bill March 18, 2008 61 of 127 spoke in great detail. Over the past couple of weeks, not just in the episode with Bear Stearns, counterparty risk has become the dominant concern in markets. As has been pointed out around this table, it is increasingly difficult to separate liquidity issues from solvency issues. So what should we take from this deterioration in counterparty risks? If we look at a range of financial institutions that have different degrees of implied backstops by the government based on their size and their regulatory structure, we think about the GSEs that have an implied government guarantee and even Ginnie Maes, which have the full faith and credit backing of the U.S. government and about which the Board staff shared some data yesterday with us. The spreads on all of these look as though they have widened substantially. We have seen very real deterioration. But when you see that it is happening for the Ginnie Maes, just as with many of these other securities, it suggests that this is substantially, but not completely, about liquidity risk because the credit risk of Ginnies ostensibly can’t be called into question. Financial institutions, more broadly than financial markets, are having a hard time finding their way. We have talked around this table before about their balance sheet problems, and most recently we have talked about their income statement problems in figuring out what their core business is. In the markets in the last couple of days, we have had the broker–dealers with widening CDS spreads and falling share prices, and of course, that is about their mortgage exposure and liquidity concerns. But I think, most fundamentally, that the business model of investment banks has been threatened, and I suspect the existing business model will not endure through this period. As a result, the current architecture of the regulation of financial institutions and of the business model across ranges of financial institutions—commercial banks, investment banks, and hedge funds—will change through this period. The old model, at least in investment March 18, 2008 62 of 127 banking, of high imputed leverage works incredibly well in a world of high liquidity and doesn’t work as well when liquidity is in short supply. Why do I think this matters? It matters because it suggests that any catalyst for improvement from financial institutions feeding into the real economy for the rest of 2008 or even for the first half of 2009 is quite suspect. These institutions are spending all their time and attention on their own business models, figuring out how they can survive this period, not on providing credit to the real economy. So I don’t look to financial institutions to be very good shock absorbers or very good catalysts going forward. My concern, broadly, about financial institutions is highlighted when I think about the need, across all these institutions, to raise significant capital for safety and soundness purposes and, in addition, for credit availability purposes. It strikes me that this broad class is systematically undercapitalized, and we need to use all our tools to persuade them that it is in their interest and in the interest of the broad economy for them to raise capital. But finding capital, certainly over the next six months, will be a very real challenge. The capital markets are not in a very strong position to satisfy issuer needs at present. That obviously can improve over the next couple of months, but there is no certainty. Sovereign wealth funds and other sources of investment that we have been talking about for some time—and we saw their real interest in investing in financial institutions at the end of last year or early this year— are quite beaten down. Those that I talked to, who are very sophisticated investors from places in Asia and the Middle East, do not want to appear as though they are doormats for these financial institutions. Their own political structures make the losses they have had to endure front page news. I think the expectation that sovereign wealth funds are going to continue to be a source of funding in this period is well overstated. Moreover, private equity—the case for March 18, 2008 63 of 127 opportunistic capital—has little ability to get leverage in this environment, and so if they don’t reduce their target hurdle rates, I don’t expect them to be able to come to the rescue. All of that, again, suggests to me that the real economy will have to wait awhile for improvement as this repair is slow and not at all certain over the next six to nine months. Obviously, the implication for the real economy is hard to speculate about, but I think, looking at some rough measures, maybe a third of the credit availability of the real economy has been taken out during this period—maybe more than that. I would say that the last week makes it hard for us to judge how much more credit channel capability and balance sheet capacity have left the real economy, but it suggests a picture for the real economy that is worthy of real concern. Now, when I look to the real economy, I would just underscore the comments I have heard from others. A couple of CEOs who have been incredibly optimistic, at least in my discussions with them in the past couple of years—these are CEOs of leading consumer product companies—have thrown in the towel. They have given up trying to justify and explain away weakness. Across the auto sector, a couple of the new owners of the auto companies are now focused on a scenario in which units are in the 14.5 million range rather than the 15 million or 15.5 million range, largely because of weakness of consumption in terms of consumer purchases. But that really goes back to credit, and in some ways the credit availability to fund those auto purchases is a chance for another stepdown in the next month. I think that business cap-ex is as threatened as has been represented today. It is the only area for which my own sense is probably more negative than the Greenbook’s in terms of weakness to expect out of Europe and the United Kingdom. It is hard for me to think, as we go through this period, that Europe and the United Kingdom would stay as decoupled as recent data suggest. Their economies are tied to their banking system more concretely than we are tied to March 18, 2008 64 of 127 ours, and I suspect that their large financial institutions are going to suffer real problems during this upcoming period. If not, it is certainly a risk factor. Let me turn to the last two issues—inflation and currency. On the inflation front, there is little reason to be confident that inflation will decline. There are reasons to believe that our inflation problems will become more pronounced and, I fear, more persistent. The recent run-up in energy prices and commodity prices in the context of weaker global demand is troubling. No doubt partly it is a move to real assets by the financial community—that is, a hedge against all of this is certainly, to the Governor Kohn’s point, raising commodity prices. But I am not sure what catalyst will change that over at least the next six months. As the Board staff has noted, there has been some rise in inflation compensation and inflation expectations. There is acceleration in the fall of the exchange rate of the dollar, suggestive of increasing import inflation. Moreover, it is not obvious to me that a slowing economy in this cycle, in the short term at least, will do our work for us on the inflation front. Finally, let me turn to currency. Given this particular confluence of events, the accelerated depreciation of the dollar is troubling, and I think the risks of a disorderly move on the dollar in the upcoming six weeks are hard to discount. The catalyst of that could be a sudden de-pegging by certain countries in the Middle East. But even if that does not come to pass, there is an expectation in the market, where traders are looking for bets where they believe they can make money with certitude, that there is still a free one-way bet on the dollar. That is not healthy for currency movements, regardless of one’s view of where the dollar should ultimately be trading against the currencies of our trading partners. At this time, particularly, given our concerns about making sure that the U.S. economy remains open for foreign direct investment— that this is where others want to invest their capital—it strikes me as a reasonably dangerous March 18, 2008 65 of 127 prospect if the view is that the dollar will continue its accelerated path. Obviously, this suggests very difficult judgments for the next round of our discussion, and I will take up monetary policy in that context. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. MR. KROSZNER. Thanks. I’ve talked many times before about the slow burn from the financial markets that is spreading out elsewhere. Unfortunately, I think the fire is a bit hotter than I had expected in my earlier discussions, and it comes particularly through capital pressures in the financial institutions. What we’re seeing now is the simultaneity of stress in the housing market and stress in the financial markets, and they will be cured together. I think they are joined at the hip. Whether we have tools to address those directly is something we continue to discuss, but I think it is this direct connection that potentially leads to the negative feedback loop that we have discussed quite a bit. For housing, of course, there are the direct negative wealth effects but also the lingering uncertainty of what’s going to happen, as many people have mentioned. Part of this comes from just a change in behavior. People are acting very differently during this housing cycle from in the past, so it is very difficult to predict the evolution of foreclosures even given a particular macroeconomic outcome. There’s still the uncertainty of the macroeconomic outcome, but people are going delinquent much earlier—they are going delinquent on their houses before they go delinquent on their credit cards—and so it is really a different model of consumer behavior, which makes valuing the securities particularly problematic. This is, of course, in addition to uncharted territory in terms of real and nominal price declines. We’ll see exactly how people will respond to these things. Obviously the markets are closed, and the banks have to keep these on their books, with higher cost and more difficulty financing. Some of the changes that came in with the stimulus package to raise the conforming limits for Freddie Mac and Fannie Mae have done little to bring March 18, 2008 66 of 127 down the spreads because they have significantly increased the cost of the guarantees given this new environment. It’s not unreasonable to do that, but the potential benefit from the changes is lower than we might otherwise have hoped for. This is all having consequences for credit cards. Even though at first it was the mortgages, now we’re starting to see a significant uptick in delinquencies on credit cards and spending, and a number of people—President Rosengren, President Yellen, and First Vice President Sapenaro— have mentioned some of these things. I just want to report a bit from my conversations with some of the major credit card companies, which have kind of a window into real-time consumer spending. They are seeing a continuing flattening but not a falloff of growth. There’s no collapse but certainly a continued downtrend, as I’ve been reporting over the past few months—a continuing slowing of payments and a continuing increase in delinquencies. Their so-called roll rates of people moving from 30 days behind to 60 days behind to 90 days behind continue to go up. They are still going up, although not significantly. They are concerned about that, but it is not spiking up. They are mainly concerned about when the roll rate gets into 90 to 180 days. They’re not getting their money back. Personal bankruptcies are going up. The cure rates are much lower, and the recovery rates are much lower. So there seems to be a group of people who are getting into extreme financial difficulty. All the series that I’ve quoted are general averages. The contacts said that in areas of particular housing stress basically all of the numbers are three times as high. It is significantly more stressful there, showing a very clear link between stress in the housing market and these other stresses. Have they been responding? Well, because of very strong pressures that may be coming directly from us and certainly from Capitol Hill, the credit card companies don’t respond by changing interest rates. They respond by reducing the amount of credit available, and that’s exactly what they’ve been doing. So they’ve been cutting credit lines of a lot of people. Also, as I think March 18, 2008 67 of 127 President Yellen or a number of people mentioned, they’re also cutting back on the HELOCs because they have been concerned that people are taking money out when no equity is there, and so they really want to pull back on that. These overall tightening credit conditions are reflecting the continued stress on the balance sheets of banks and financial institutions more generally; as you see with the Bear Stearns example, it’s not just the depository institutions but a broader set of institutions that are creating pressures both on the asset side and on the funding side. We have had a lot of the SIVs and a lot of the other assets coming on board. Unplanned asset expansions may continue, particularly if the economy does go down. What now seem to be very good credits in the leveraged lending market may no longer be good credits. So the anecdotal evidence that you’ve been mentioning around the table could turn into further unplanned asset expansions if these things start to go south. Consumer write-offs, obviously, are another thing that is putting on funding pressure. Also as I think President Evans mentioned, interestingly there have been few actual losses that have occurred on many of these securities in terms of the inability to make the payments, although the losses in the value in the markets have been quite spectacular in some cases. Some of this has to do with the broad evaluation uncertainty. Some of it has to do with liquidity. I think this is where we have the direct link between liquidity and macro stability because the uncertainties in part are coming from the macro uncertainty about how housing markets will evolve. Obviously I have said this before. There are other factors that come in, but that’s a big one. So doing something to provide some insurance against that or to help provide comfort that these markets can come back is important because there’s a very close link between liquidity issues that we have been seeing, the unwillingness to finance, and the capital issues that have been coming from an incompleteness of markets. The markets just aren’t there for people to be trading in. They March 18, 2008 68 of 127 are valuing things off an index. The index can’t be arbitraged against the underlying markets because the underlying markets aren’t there. So the index is doing something else. It’s the only somewhat liquid market that’s providing some hedging. It’s driving that down, and people don’t want to buy the underlying security because they’ll have to take the mark against this index rather than the true value. If they have to take the mark against something that they think is going to be pushed down artificially, they’re not going to buy the security in the first place. These kinds of continuing stress make me feel a little less optimistic about the bounce-back in ’09 that’s in the Greenbook, although I don’t think it’s ruled out. Just turning quickly to inflation, we have a bit of a paradox in what has gone on recently as everyone has said—significantly slowing growth over the past four to five months but no evidence of slowing in the pressure on commodity, energy, and agriculture prices. That’s despite some slowing elsewhere in the world and expectations of slower growth. The PPI numbers that came out today raised some concerns that some of the good parts of the CPI will not be flowing through to PCE. Also, over the last year or two, when we’ve had the unemployment rate below 5 percent or 4¾ percent, whatever your favorite number is, where there would be pressure on wages, we haven’t seen much pressure on wages. So I’m not sure that, if the unemployment rate goes significantly above 5 percent, we’ll see much on the other side that will take pressure off wages to bring things down. So I do remain concerned there. But I think there’s a final risk that, if commodity, energy, and agriculture prices do significantly move down, it could have a major effect on some of the emerging markets and some of our other trading partners. So there’s a bit of a paradox here that, if there are some potential benefits of the slowdown to reduce these prices, that could actually also reduce export demand, which—as a number of people pointed out—is very important in the forecast for keeping this a shallow recession. So I remain concerned on both the growth front and the March 18, 2008 69 of 127 inflation front, but I do think that macro stability is probably the primary thing that we need to be thinking about right now. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Mishkin. MR. MISHKIN. Thank you, Mr. Chairman. Well, I’m quite depressed. That’s not my usual personality trait, but the reality is that we’ve had as bad a set of shocks as I could have imagined, and I want to talk about this set of shocks. We have been hit with things that are making our policy environment as complicated as I possibly could have imagined. The reality is that we are in the worst financial crisis that we’ve experienced in the post–World War II era. I don’t think we should be shy about saying it. We are in a financial crisis, and it is worse than we have experienced in any other episode of financial “disruption,” which is the word I use. I will not use “financial crisis” in public. “Financial disruption” is still a good phrase to use in public, but I really do think that this is a financial crisis. It is surely going to be called that in the next edition of my textbook. PARTICIPANT. When is it coming out? MR. MISHKIN. Wouldn’t you like to know! I believe that actually the Greenbook forecast of a mild recession is reasonable, but the possibility that we could have a severe recession is uncomfortably high, and I find the prospect pretty scary. The reality is that we are in this adverse feedback loop that I and others talked about. I think we’re deep into it. The credit markets have been deteriorating. That’s led to a sharp weakening of the economy’s prospects. This is reflected in the very large change in the Greenbook forecast, with which I do strongly concur, so I don’t think that it was out of line to put those in. Of course, that weakening has been feeding back to deteriorating financial conditions. So I think we’re really in a tough pickle, and there are costs not just in terms of the economy. One result is that we’ve just expanded the safety net to a much wider set of institutions, and we are in a brave new world here, and it is very disturbing. So the March 18, 2008 70 of 127 ramifications in terms of the economy weakening and the adverse feedback loop go beyond just the fact that we might have unemployment. It may have major effects on the way markets work in the future, and that, I think, is something that we should be worried about and should be a consideration as well. The bottom line on real activity for me is that the prospects are very poor, and I find the downside risk just plain scary. That’s the first part of my depression. The second part of the depression is that it’s bad enough that we had these contractionary aggregate demand shocks from the financial sector, but we also have had very negative supply shocks that are both contractionary and inflationary. So we are getting hit by the double whammy. The news on inflation has generally not been good, even with the recent CPI numbers. But then, of course, they are reversed by the PPI numbers today. I don’t put that much weight on the actual current numbers because, as you know, I take a view that the primary drivers of inflation and inflation dynamics are inflation expectations and expectations about future output gaps. So that’s the framework in which I’d like to discuss what will happen on the inflation front. We have two problems in terms of inflation expectations right now. One is the supply shock, which I think is having some effects on inflation expectations, and also the view—although I believe it’s incorrect, I do think that there’s a problem that this view is widely held outside, and President Plosser mentioned this—that we on the FOMC are focused only on growth and are not at all worried about inflation. This is a communication issue that is hard to deal with because, even though I’ve been advocating being more aggressive in terms of easing, I do worry very much about the issue that we also have to indicate that, if necessary, we’ll get out the baseball bat to keep inflation under control. That is not an easy thing to do. So when I look at inflation expectations, which I consider to be a key driver of inflation, I think that the evidence in the data is that we have had not a big increase but a slight increase in inflation expectations, on the order of about 10 basis March 18, 2008 71 of 127 points. There’s a lot of uncertainty about that; it could be a little more than that, but I don’t think a whole lot more. Also disturbing is that we certainly have had a big increase in long-run inflation uncertainty. That’s reflected not only in terms of inflation compensation but also in the fact that people are buying inflation caps, TIPS are becoming very popular, and so forth and so on. In fact, one of the negative things that happened to me as a result of taking this job is that I had my entire TIAA-CREF in TIPS and unfortunately I had to divest all of it because they are government securities, and that turned out to be bad. But that’s only one of the minor costs of being in this position. [Laughter] The issue here is that, although I don’t think that inflation expectations have gotten unhinged at this point—and I think that we can say that the phrase “reasonably well contained” is okay—there is a greater risk that they could get unhinged. Now, I want to be clear. I’m not talking about the 1970s. It’s not “That ’70s Show.” I have not been particularly happy with Allan Meltzer’s comments about a bunch of things. The issue here is not that inflation expectations would go to that kind of level, but it could be that inflation expectations go up to 2½ or maybe even a little higher and it would be costly to get that down. That’s the concern we have to worry about. But let me talk about the other side because, when I think about the inflation dynamics, it’s not just inflation expectations. I do not believe in the deus ex machina view of the inflation process. Something has to tie things down, and what ties it down is not current output gaps—which is why I think the standard Phillips curves don’t predict very well—but expectations about future output gaps. On that score, I worry that there could be a lot of downside risk to inflation from that. If really bad things happen, which I think unfortunately is a seriously possibility, inflation could fall. A key fact, by the way, is that if you look at past recessions, you do find that inflation falls in the 12 months after recessions. In a couple of cases with supply shocks, there was a rise in inflation at the March 18, 2008 72 of 127 beginning of the recessions. Seven out of eight are in that category. Particularly if it’s a severe recession, it’s much more likely for inflation to fall. So it’s not true that there’s just upside risk; there is downside risk as well, and that’s one reason that inflation uncertainty is not an issue just of potential upside. In fact, in the 2003 episode that President Lacker mentioned, the reason there was such a sharp rise in inflation compensation was not that people worried about inflation going up but that they worried that inflation would go down. Nonetheless, there’s still a cost to the fact that longrun inflation expectations are not as solidly grounded as they were before. So my view in general is that we are facing an incredibly unpleasant tradeoff. We basically have the risk of the economy turning very sharply and the risk of inflation getting somewhat unhinged. I want to discuss that later. I wasn’t going to discuss this, but I just really can’t not react to the comments that you made, President Fisher. There’s a view out there in the media that monetary policy has been ineffective. This was the statement that I think you made, and I think it is just plain wrong. So I want to discuss it because it’s actually really important in thinking about a policy stance right now, and it’s important to think about the economics of this. We have had a very nasty set of contractionary shocks from the financial sector, particularly the widening of credit spreads and the restriction of credit. So I want us to think about a counterfactual. Let’s think about a situation in which we had what’s happened and we did not lower interest rates. What would have been the outcome? Do you think that credit spreads would have lowered? I think credit spreads would have risen. In fact, when you think about what credit spreads are being driven by—I’ve argued this before—there’s a valuation risk—the fact that we can’t value assets, and that’s this price discovery problem that we really can’t do that much about. But there is also a macroeconomic risk, which is a lot of what’s going on right now, particularly in terms of the housing market where people don’t March 18, 2008 73 of 127 know where housing prices are going to bottom out. The view that they may keep on going down—and we had a very negative number on housing prices recently—means that even the AAA tranches now look as though they’re very vulnerable, and therefore, the credit spreads on them go up a whole lot. My view is that monetary policy has been very effective because things would be much, much worse if we hadn’t eased. On the other hand, we just had an incredibly nasty set of shocks as a result of what you described were the problems in these sectors. So I really think that this is very important. To finish up on this, the example of Japan is constructive because the Bank of Japan had a view very similar to the one that you’ve expressed, which is that they had all these problems in the banking sector, and the problems were not their fault. But they then took the view that they couldn’t do anything about it. Monetary policy was not the source of the weak economy, so they were very slow to lower interest rates. The Chairman has talked about this. Every monetary economist who went to the Bank of Japan during this period—I did it when I was with the New York Fed in the mid-1990s—told them that their monetary policy was too tight. They basically said, “Well, you know, it’s not too tight, and it’s not our fault that the banks are all screwed up because of poor regulation.” Well, the result was they ended up with deflation, and they lost ten years of growth. I’m being a little more blunt than usual, but I think that the economic arguments here are actually central in our discussion. MR. FISHER. Mr. Chairman, may I answer? CHAIRMAN BERNANKE. Well, let him finish. Are you done? MR. MISHKIN. I am done, yes. CHAIRMAN BERNANKE. President Fisher. MR. FISHER. Just very quickly, I said that the liquidity situation we’re in diminishes the efficacy of fed funds policy; I’m not saying it’s not a worthwhile tool. Second, I was fully March 18, 2008 74 of 127 supportive until we got to 3.5. Then we went from 3.5 to 3 percent. Everything we wanted to go one way then went the opposite way. So I just made the observation that it didn’t seem to be effective. Third, I think I spent even more time in Japan than President Geithner, who is an expert on Japan, and you cannot compare the two economies. They are geared totally differently, with totally different efficiency. I’d be happy to debate that at a later point. I think it’s a very poor analogy. Now, having said that, I respect the enormous macroeconomic downside risk that we have—and I have one of the most pessimistic forecasts—but there’s a price to be paid for what we’re doing unless it is efficient, and that price is reflected in inflation expectations. That’s my point, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Vice Chairman. VICE CHAIRMAN GEITHNER. Mr. Chairman, I’m going to cede all of my time to you, except to acknowledge and to point out that there’s much I agree with that has been said around the table, particularly with how people characterize the growth outlook and the risks and what’s happening in financial markets and to the outlook. I can’t say that stuff better than it has been said. But there’s much I disagree with in what’s been said, particularly on the inflation side, about the lack of credibility. I just want very quickly to say a couple of things about how we talk about this stuff based on what’s been said. First, some of you at this table may believe that we are losing credibility, and you may be losing confidence in the capacity of this Committee to mitigate the risk to our long-term inflation objectives. If you say that in public, you will magnify that problem, and just because you believe it does not make it true. I believe that you should have more confidence in the commitment of this Committee to do what is necessary to keep those expectations stable over time. Second, the stuff about capital and the financial system is very, very important. It is very hard to make the March 18, 2008 75 of 127 judgment now that the financial system as a whole or the banking system as a whole is undercapitalized. Some people out there are saying that. In some states of the world, particularly if there is no liquidity, then any financial system will be systematically insolvent. But based on everything we know today, if you look at very pessimistic estimates of the scale of losses across the financial system, on average relative to capital, they do not justify that concern. It is very important to make distinctions in what we say about that. It is very different to say that their distribution is uneven and to say that for some institutions those losses may be large relative to capital. That is obviously the case; we have already seen that to be the case. It is important to make the distinction between the average and the distribution. Although the average losses look relatively manageable relative to capital, the system is short of capital relative to what would be ideal, given that we’ve had the collapse of a very large part of the nonbank financial system. Banks as a whole are not large enough now, even with their capital cushions, to compensate for the scale of disintermediation of that type of nonbank finance. Those are very important distinctions to make in this case. There is nothing more dangerous in what we’re facing now than for people who are knowledgeable about this stuff to feed these broad concerns about our credibility and about the basic core strength of the financial system. So I just want to underscore the importance of exceptional care in how we talk about those things, even in private. A lot of people out there who should know better—none of us is guilty of this—are casting broad aspersions about solvency that are very dangerous in this context. May we get to the point where those concerns are justified? Of course we may get to that point. If we systematically mismanage policy, we may get to that point. But please be careful in that context. I’m sorry, Mr. Chairman. I meant to cede all my time to you. [Laughter] Finally, I have to state for the record that I did submit our forecast. To state the obvious, it’s close enough to the March 18, 2008 76 of 127 Greenbook on most things, and, given the range of uncertainty, there’s no material between our view and the Greenbook’s. CHAIRMAN BERNANKE. Thank you very much. Thank you for all of your comments. Let me just briefly summarize and add a few points. To summarize the discussion, incoming data have been weak, and some view the economy as having entered recession. Housing demand and construction have continued to decline sharply, and house-price declines have been somewhat greater than expected. Housing weakness has implications for employment, for consumer spending, and for credit conditions. It also leads to 21 miles of empty boxcars. [Laughter] Financial conditions have worsened considerably, reflecting weakness in housing prices, and credit markets in particular are highly stressed and illiquid. Wider spreads have offset some or all of the decline in safe rates for many credit products, and credit conditions are tighter for most borrowers. Financial conditions are likely to be a significant drag on economic growth. Some noted the risk that continued financial turmoil could lead to a more serious and prolonged recession, implying possibly large downside risk to growth. With respect to households, consumption growth has flattened out, and there was generally greater pessimism about the labor market and economic prospects. Consumer credit quality may be worsening. Payroll employment growth has turned negative. There was little expectation expressed of strong help from the fiscal stimulus package. Firms are generally more pessimistic and cautious but also remain concerned about cost pressures. Inventories look to be in balance. Exports continue to be an important source of final demand and will continue to contribute significantly to growth, although it’s possible that growth abroad may slow. Readings on core inflation have been mixed. Increases in energy and commodity prices are important sources of increased headline inflation, and some producers have adopted a cost-plus March 18, 2008 77 of 127 mentality. Agricultural prices, in particular, are up a good bit. Inflation breakevens are up somewhat, especially at the five-by-five horizon. The dollar has depreciated, potentially adding to longer-term inflation pressures and adding some risks. However, nominal wage increases are moderate, as are unit labor costs, and U.S. and global economic weakness could moderate gains in commodity prices and create domestic economic slack. Several members warned about the risk of losing inflation credibility. Any comments, thoughts? Let me make just a few comments. Again, I’m very sympathetic to what almost everyone has said around the table, in particular the fact that we’re facing a three-front war, if you will, which makes this extraordinarily difficult and delicate. I thought in January that we were in recession. That was my view at that time, and I certainly believe it now. The Greenbook has done a good job of trying to factor in the data and the other types of evidence. I think I’m actually slightly darker on growth than the Greenbook is. The reason is that I don’t see where the recovery is coming from in the beginning of next year. In particular, we won’t have a recovery until financial markets stabilize, and the financial markets won’t stabilize until house prices stabilize, and there is simply no particular reason to choose a time for that to happen. So I do think that the downside risks are quite significant and that this so-called adverse feedback loop is currently in full play. At some point, of course, either things will stabilize or there will be some kind of massive governmental intervention, but I just don’t have much confidence about the timing of that. I would like to say a word. I would just agree with Governor Mishkin about the efficacy of our policy. I think that it has had an effect and it has been beneficial. We obviously affect shortterm rates, including commercial paper rates and the like, which have implications for financing and for borrowing. We affect the dollar, which has mixed effects, but on the growth side has some positive effects. It’s true, as President Fisher pointed out, that medium-term and long-term rates March 18, 2008 78 of 127 have not fallen because lower Treasury rates have been offset by higher spreads, but again, the question is the counterfactual. Where would we be if we had not lowered rates? I think that lower rates have both lowered safe rates and offset to some extent the rising concerns about solvency, which have caused the credit spreads to widen. I think this argument can go either way. You can say that our policy is less effective and, therefore, we should do more of it. So there are two ways of looking at that. In addition, there may be some benefits for capital formation of low financing rates and a steep yield curve in keeping bank share prices from entirely collapsing. On inflation, I agree with much of what’s been said, and I’m very concerned about it. Let me make one simple point, though, which I don’t think has been adequately discussed. Ninety-five percent of the inflation that we’re seeing is either the direct or the indirect effect of globally traded commodity prices—food, energy, and other commodities. What is happening is that there is a change in the relative price of, say, oil and the wage of an Ohio manufacturing worker. There’s a relative price change going on. That has to happen one way or the other. It can happen either by overall increases in the nominal price of oil, which are reflected in overall increases in headline CPI inflation, or by lower or negative growth in nominal wages. Now, if we have temporary movements in these relative prices, I think all the theory tells us that the best way to let that relative price change happen is to let the shock feed through; let the prices of energy, commodities, and so on rise; accept a temporary increase in headline inflation; and focus on making sure that the increase in headline inflation doesn’t feed through into domestic core inflation, say, through wages or domestic prices. A good response to that is, well, we’ve had a lot of “temporary” shocks here and they have gone on for a long time. That’s certainly true. But again, it was very difficult to anticipate how these prices have moved. March 18, 2008 79 of 127 Looking forward, the futures markets have been wrong and wrong, but they are the best we have. In my view, if we think about the likely slowdown in the U.S. economy and the global economy, there are going to be some forces that will prevent commodity prices from continuing to rise the way they have been rising, which ought to take the pressure off the inflation process. That being said, I fully recognize that there has been a bit of movement in some of the indicators. I think I like the use of the index measure. It uses lots of different indicators. I don’t think we should overemphasize inflation compensation. For example, the one-year inflation compensation three and four years out has moved up less than the five-by-five, and I think for good reasons. The five-byfive could reflect, again, general uncertainty. It could also reflect more volatility in the relative price changes of oil, for example. If we think there’s more volatility in that, if it’s up or down, that would create more uncertainty about headline inflation and would feed through into that spread. Frankly, in thinking about inflation, I am concerned about inflation expectations and the general psychology. I’m hopeful at least that it will moderate as commodity prices moderate although, of course, no one can know for sure. I agree with Governor Warsh that, from a financial perspective on the inflation side, the greater dangers are in the currency area. Exchange rates are very poorly tied down by fundamentals, except over very long periods of time—I think Ken Rogoff had a paper in which he said that over maybe 600 years or so the PPP finally works. [Laughter] So a lot of psychology is there. I think that it is an important issue. We need to think about what the Treasury will say and those sorts of things. That is a concern, and I consider that in some sense a greater risk at this point. So there are risks on both sides. I think that the downside risks, including the financial risks, at this point are greater—not to belittle inflation risks, which I think are quite significant. We are obviously going to have to make tradeoffs about how to deal with these. Using both our policy March 18, 2008 80 of 127 tools and our communication is very important. I agree with Vice Chairman Geithner that we need and I need—and I have a very important role here—to maintain clarity in communication about our attention to inflation, that we are not ignoring that side of the mandate. Finally, let me just say, as I said last night at the dinner with the presidents, that I think we are getting to the point where the Federal Reserve’s tools, both its liquidity tools and its interest rate tools, are not by themselves sufficient to resolve our troubles. More help, more activity, from the Congress and the Administration to address housing issues, for example, would be desirable. We are certainly working on those issues here at the Board, and I will be talking to people in Washington about what might be done to try to address more fundamentally these issues of the housing market and the financial markets. So those are my comments. Why don’t we turn now to Brian for an introduction to the policy round. MR. MADIGAN. 2 Thanks, Mr. Chairman. I will be referring to the revised version of table 1 distributed earlier today in the package labeled “Material for FOMC Briefing on Monetary Policy Alternatives.” The revised table presents the same basic set of alternatives that was discussed in the Bluebook. However, we have proposed some changes in language that affect the statements for alternatives A and B. I will discuss those changes, shown in blue, shortly. Alternative D, presented in the right-hand column, would leave the federal funds rate unchanged at this meeting at 3 percent. Committee members might be inclined to favor this alternative if they were particularly concerned about prospects for inflation and if they believed that, with due allowance for lags, the monetary and fiscal stimulus in train would likely be sufficient to lead to a resumption of moderate growth over time. The wording of this alternative would acknowledge the downside risks to growth. But as shown in paragraph 3, the statement would indicate that inflation has been elevated, cite several factors that could put additional upward pressure on inflation, and state that the upside risks to inflation have increased. No net assessment of the balance of risks would be included. Under alternative C, the stance of policy would be eased by 25 basis points today. A modest easing of policy might be motivated by judgments that the economic outlook has weakened, but by appreciably less than in the Greenbook, and that the inflation outlook is troubling. Members might see financial strains as concerning but likely to exert less restraint on growth than in the Greenbook forecast. 2 The materials used by Mr. Madigan are appended to this transcript (appendix 2). March 18, 2008 81 of 127 In these circumstances, the Committee might want to be cautious about policy adjustments that could add impetus to inflation, particularly given the substantial easing of monetary policy to date and the lags in the effects of policy. The language proposed for alternative C would note that the tightening of credit conditions and the deepening of the housing correction are likely to continue to weigh on economic growth. The inflation paragraph for this alternative is the same as that for alternative D. As shown in paragraph 4, the Committee would make an explicit judgment that the downside risks to growth outweigh the upside risks to inflation. Under alternative B, the Committee would reduce the federal funds rate 50 basis points today, to 2½ percent. Such an approach could be seen as consistent with the Greenbook forecast. Indeed, under that forecast, the Committee is assumed to ease policy 50 basis points at this meeting and another 75 basis points over the next three months. The motivation for such a trajectory is provided partly by the 1¼ percentage point downward revision to the Greenbook-consistent measure of short-run r*. The Committee might concur with the staff’s assumption regarding the amount of cumulative easing that will eventually prove necessary and find a gradual shift in policy attractive, particularly in view of what seems to be some upward drift of late in inflation expectations. Such a path would also be qualitatively consistent with the optimal control simulations shown in the Bluebook for a 2 percent inflation target, in which the federal funds rate is eventually eased to around 1¼ percent. As shown in paragraph 2, the statement issued under this alternative would indicate that the outlook had weakened. We have suggested striking the reference to risks as that thought is picked up in the risk assessment. The statement would go on to mention several factors that could weigh on economic growth, and we have suggested adding “over the next few quarters.” With regard to inflation, the Committee would note that inflation has been elevated. It would also indicate an expectation that inflation will moderate in coming months and cite several factors that could contribute to that moderation but note that uncertainty about the inflation outlook has increased. Notably, the list does not mention “reasonably well anchored inflation expectations” or some variant of that phrase, which has been used recently in the minutes and other policy communications. Indeed, the first sentence of the paragraph notes that some indicators of inflation expectations have risen. Partly because inflation compensation includes a premium for inflation risk as well as inflation expectations, we thought that “indicators” of inflation expectations might be a better word than “measures” and have suggested that substitution. Over the past few days, inflation compensation as read from TIPS has plunged; however, we are skeptical that the decline represents primarily a drop in inflation expectations or inflation risk. Rather, we suspect that it is importantly a result of shifting liquidity premiums, as yields on nominal Treasury securities have fallen sharply partly because of increased demands for safety and liquidity. The final paragraph of alternative B would repeat the risk assessment issued after the January meeting. It would again indicate that downside risks remain and emphasize that the Committee will act in a timely manner to address those risks. March 18, 2008 82 of 127 Finally, under alternative A the Committee would lower the funds rate 75 basis points today. Given the extent of policy easing assumed in the staff forecast, this alternative could easily be consistent with an outlook along the lines of the Greenbook. This policy approach could also be motivated by concern about the possible implications for the economic outlook of the worsening in financial market conditions in the five days since the staff forecast was finalized or by a riskmanagement approach that gave particular weight to the downside risks around the outlook. The language proposed for the rationale section, paragraphs 2 and 3, of alternative A is identical to that proposed for alternative B. As with alternative B, the risk assessment paragraph says that policy actions should promote moderate growth over time and mitigate downside risks, but this version also alludes to the measures that the Federal Reserve has implemented to promote market liquidity. This language could also be used in alternative B. Rather than providing an assessment of the balance of risks, as we did in the Bluebook version, here in alterative A we have suggested simply indicating that downside risks to growth remain. Given the high degree of uncertainty, you might again prefer not to make an overall risk assessment. This paragraph differs from the corresponding part of the January statement also by indicating that the Committee will act in a timely manner as needed to promote sustainable economic growth and price stability. Thus, while the Committee eases 75 basis points, this language of alternative A would signal some increase in the Committee’s concern about inflation in several ways: by indicating that inflation has been elevated; by noting that some indicators of inflation expectations have risen; and by incorporating a traditional formulation of the dual objectives, including price stability, in the final sentence. As Bill noted this morning, market participants appear to place substantial odds on a 100 basis point policy move at this meeting. Thus, implementation of any of these alternatives would involve at least somewhat less easing than expected. Given what would appear to be very fragile market conditions and highly skittish investor sentiment, you might see somewhat greater risks than usual in diverging from market expectations, and obviously the risks would be larger the greater the gap between anticipation and your actions. At the same time, you might see good reasons for some divergence. First and most obviously, you might see a smaller move as appropriately calibrated given your outlook and sense of the risks. Also, some indicators do seem to suggest that inflation expectations have become a bit less firmly moored. Even if you see gradual dollar depreciation as likely to be appropriate given the weakness of the U.S. economy and quite possibly a necessary factor in fostering an improved current account balance over time, you may be concerned about the downward lurch in the dollar over recent days and the potential for disorderly conditions to develop. You may judge that a policy decision today to implement somewhat less easing than markets expect and a statement that implies somewhat greater concern about inflation could be helpful in leaning against inflation expectations and any sense in markets that you are indifferent to downward pressure on the dollar. March 18, 2008 83 of 127 Alternative A would likely prompt some increase in shorter-term interest rates; but given that the risk assessment would point to continued downside risks, market participants would infer that further easing is a likely prospect, and the effects on other financial asset prices and financial conditions more generally could be reasonably limited. The 50 basis point easing of alternative B, in contrast, would suggest to market participants that you are inclined to be considerably more cautious in easing policy further, even with the downside risk assessment, and short- and intermediate-term interest rates could ratchet considerably higher, equity prices decline, and credit conditions tighten—responses that presumably would be amplified, perhaps nonlinearly, under alternatives C and D. CHAIRMAN BERNANKE. Thank you. Bill. MR. DUDLEY. I just want to update the dealer survey. We got two more responses. Two people moved from 75 to 100. So right now as we speak, it is ten in the 100 camp, eight in the 75 camp, and two in the 50 camp. CHAIRMAN BERNANKE. Okay. Thank you. Questions? Vice Chairman. VICE CHAIRMAN GEITHNER. Mr. Chairman, it is kind of awkward to ask this in the midst of a meeting, but I think it is important. I think there was a pretty big change this morning at least in risk perceptions today across a bunch of markets. Can you tell what the fed funds curve has done this morning? MR. DUDLEY. I think that the April fed funds futures contract earlier this morning was priced at 1.99, and it was up by 4 basis points. I don’t know if it moved subsequently. MR. MADIGAN. Vice Chairman, it has moved up somewhat further at least as of maybe an hour ago. It looked as though, at least for this meeting, the odds were roughly evenly balanced between 75 and 100, in terms of what was priced in. MR. DUDLEY. Stocks are up about 2 percent. Both Lehman’s and Goldman’s earnings showed declines, but they were less significant than expected. So share prices for both of them have March 18, 2008 84 of 127 rallied a lot. Lehman’s stock was up 19 percent when I last looked—I don’t know where it is today. So a lot of reversals occurred yesterday in terms of the investment banks. VICE CHAIRMAN GEITHNER. Financial credit default swaps this morning are much, much narrower. May I raise a conceptual question around this, though? Maybe this is really for you, Mr. Chairman. How should we think about the tradeoff between what we do with the fed funds rate and whatever effect we have on liquidity and credit spreads, which are obviously in some ways working against the reduction of the fed funds rate? It doesn’t seem to me quite right to say that they are perfect tradeoffs. CHAIRMAN BERNANKE. No. VICE CHAIRMAN GEITHNER. I guess my question is, Don’t they have independent effects? I mean, they are separate and somewhat different in terms of how we think about mitigating the risk to the overall economy. CHAIRMAN BERNANKE. I would think of them as complementary—they are not strong substitutes, obviously—in the sense that, as is often pointed out, the liquidity measures can affect credit and solvency concerns. VICE CHAIRMAN GEITHNER. So maybe to echo the dialogue that you had with Governor Mishkin, if we were to be successful through taking out some of the liquidity risk of markets more generally and we got those spreads maybe back down to—I don’t know—50, in a crude proxy sense, that would be good and powerful but we would still be left with exceptionally tight financial conditions relative to the given target fed funds rate. Is that fair? I mangled that. MR. MISHKIN. Yes. I’m not arguing that lowering the federal funds rate narrows these spreads a whole lot. It certainly works in that direction, but there is a big independent movement because of both fear in the markets and some liquidity concerns, which is why I think it is very March 18, 2008 85 of 127 important for us to have both sets of tools. We have tools that can work on the issue of expectations about monetary policy and stance, but to the extent that we can use other tools, that’s also extremely helpful. It is not that we think we can solve all the problems, particularly because these shocks are so large. This is one problem that we are facing, which is that this disruption is really big, big time. So then the question is whether we want to use all the tools at our disposal that we can. CHAIRMAN BERNANKE. Brian. MR. MADIGAN. I just want to make one point to the Vice Chairman’s question. The way I think about this is that monetary policy tends to move continuously. Of course, the federal funds rate is essentially continuous, but what we are doing with liquidity measures is designed to combat nonlinearities to the extent that they’re discontinuities, and so I think they have a different qualitative feel. We’re attempting to prevent a breakdown in markets and allow monetary policy thereby to operate more normally in a more continuous way. VICE CHAIRMAN GEITHNER. I guess another way to frame the question is, If we are reasonably successful in mitigating this adverse feedback dynamic in markets and the effects that has on financial conditions, would we still need to lower the nominal fed funds rate further to achieve the forecast laid out in the Board staff’s Greenbook? MR. STOCKTON. The answer to that would be “yes.” When we layered on significant additional negative add-factors for this recession scenario, they really weren’t directly tied to our reading of liquidity in financial markets but a reading of the real economy. CHAIRMAN BERNANKE. Governor Mishkin. MR. MISHKIN. I think the issue here relates to the whole question about nongradualism that we’ve been talking about. Clearly, if we got lucky and financial markets turned around in a major way, then the stance of monetary policy would need to change, actually very rapidly. This is March 18, 2008 86 of 127 one of the issues facing us—a communication issue, which is how we indicate to the markets and the public in a serious way that we really care about keeping inflation under control. I’m not sure what the answer to that is. It is one of the great challenges that we’re facing at this particular juncture. Clearly, part of it is that we don’t want interest rates to be particularly low. In fact, the higher interest rates could be for us, the happier we would be because that would be an indication that financial conditions had turned around a lot. However, the problem, of course, is that inflation expectations get unhinged. CHAIRMAN BERNANKE. President Fisher. MR. FISHER. Mr. Chairman, Vice Chairman Geithner is asking in an elegant way about the issue of efficacy, which I was trying to touch on and did so in a less sophisticated way. I just want to make sure that I understand your answer. If we were to achieve the degree of success that Tim roughly estimated, we would lessen that pressure. From a staff standpoint, what degree of easing would you advocate? Would it be a lesser degree than what is imputed into the— MR. STOCKTON. I can’t really answer that question. Over this intermeeting period, we were coping with two important developments. One was that we saw some increase in overall measures of financial stress. As you know, we went to a forecast back in September when they first emerged and started marking down the level of GDP to account for that. We did a little more in this forecast to account for what we perceived to be an increase in financial stress. But the bigger factor in marking down our forecasts significantly this year was a reading that we were switching from a sense of a slow-growth scenario and moving into something like a more nonlinear downturn of the economy. That motivated the more significant portion of the downward movement that we had in the equilibrium real interest rate here. CHAIRMAN BERNANKE. Okay. President Evans. March 18, 2008 87 of 127 MR. EVANS. Well, I just want to clarify this because I didn’t get the answer I was expecting. I don’t think I understood exactly the question about financial stress because I thought the question was whether we would have to do more with the funds rate to achieve what was in the Greenbook. Did you mark down your outlook from the Greenbook? I don’t think I understood. MR. STOCKTON. I guess I was thinking more along the marginal change that we would make should the factors be more successful than we’re currently anticipating them to be. That would probably cause us to edge up our path of the fed funds rate to account for that. MR. EVANS. Okay. Got it. Thanks. CHAIRMAN BERNANKE. Any other questions for Brian? With your indulgence, it has been a very volatile period with a lot of changes in views. We’re also a little short of time. I think it might be more focused if I gave a proposal and had people react to it. President Plosser made the correct point that we need to think about the level of the funds rate. Where should it be? I think it needs to be lower, frankly. In our last meeting, at 3 percent, many of us viewed that as about neutral without much insurance. Since then we’ve seen, I believe, a much stronger indication of recession, an increase in downside risks. When I spoke about the downside risks in the Congress and in speeches, I cited three categories of risks: housing, finance, and labor markets. All of those have transpired in that direction. So I do think we have to respond effectively against that. For that reason I would recommend the 75 basis point reduction. I recognize the concerns people have, and I have them myself, about both inflation and the dollar. So I would make two comments regarding that. First, we will be even now disappointing the market somewhat. A more aggressive ease is built in. Second, as Brian already indicated, in a number of places in alternative A, which I am proposing, we have ratcheted up the language about inflation, notably in paragraph 3, where we talk March 18, 2008 88 of 127 about it being elevated and inflation expectations, and in the last sentence, where we reinstitute price stability and clarify what our dual mandate is. Minor comments: I’m open to anything, but I point out that in paragraph 3 we added the list of explanations for why inflation may moderate. We didn’t have that last time. If people are uncomfortable with that, we can take that out. The other thing we added in paragraph 4 was the comment about market liquidity measures. I think that’s useful. It shows that we’re doing other things. It creates a sense that there’s more going on besides monetary policy. But again, if people have strong objections, I have no strong feelings about that. In addition, my recommendation would include maintaining the discount rate difference of ¼ percentage point that we established on Sunday. So that’s where I would be. Why don’t we now have a rapid go-round? President Hoenig. MR. HOENIG. Mr. Chairman, I think this is a mistake. I want to take just a second. I understand why we’ve been lowering the rate, trying to keep the problems from spreading over to the real economy. I’ve been reluctant because our practice has been to go too low and to create a new set of circumstances that we have to deal with although I’ve understood, given the seriousness of this financial crisis, that we’ve had to go down. I have been and continue to be very supportive of the use of our TAF and our other vehicles to provide liquidity to the market to help address and stanch the panic. The fact of the matter is, though, that there is an enormous amount of loss. Whether there is enough capital in the banking industry, we know that there is a solvency issue out there, and these actions, while they provide liquidity, cannot solve that problem. That’s where fiscal policy goes. But I’m not sure that our continuing to lower rates isn’t allowing others who should be addressing this to look to us to solve the problem that is not ours to solve, and that concerns me about where we are. March 18, 2008 89 of 127 The fed funds rate at 3 percent nominal, I think, is a stimulative rate in terms of where the real fed funds rate is. In an environment where we now move down even lower than that, we are inviting other speculative activities. Liquidity has to go somewhere, and it is going there fast. I think there’s a danger in doing that, and this 3 percent will stimulate the economy forward. Two and a quarter will stimulate the economy forward and introduce other significant risks both to speculative activity and to inflation, and that’s why I think we should be more careful in going forward. Now, doing nothing will shock the market, but I’ll tell you that the market has been shocked as much by some of the new actions we have taken as if we said, “Here it is at 3 percent.” There are a lot of people on the sidelines waiting for us to stop so that they can come in and take advantage of the situation. So there are lots of reasons that I would much prefer to hold at this period, and I felt compelled to express that view. Thank you. CHAIRMAN BERNANKE. Certainly. President Rosengren. MR. ROSENGREN. News of the problems at Bear Stearns and the very fragile situation in financial markets complicate our decision today. Federal funds futures indicate that the market is anticipating a reduction of at least 75 basis points and probably more than that. Normally the expectations of financial market participants would not factor heavily in my decisionmaking. However, given the fragility in the market and my own expectation that, even with this move, further easing will be necessary, I strongly prefer alternative A. While I view alternative B as a significant action, I would have concerns about likely market reaction given the gravity of the situation in financial markets and the possibility that a recession may not be mild, given falling collateral values and financial difficulties at many of our major financial institutions. A 50 basis point move would merely offset the increase in credit spreads that we have seen since the past meeting. In addition, the Boston forecast and the Greenbook forecast with a 50 basis point ease March 18, 2008 90 of 127 leave the unemployment rate well above the NAIRU but with inflation rates below 2 percent by the end of 2009. Easing less than 50 basis points at this meeting would seem entirely inconsistent with the economic and financial deterioration we have seen since the last meeting. CHAIRMAN BERNANKE. President Lacker. MR. LACKER. Thank you, Mr. Chairman. We’ve spoken a lot about inflation expectations here today. Let me at the outset emphasize that what I’m referring to in the measures we have are the expectations of the public. They’re not necessarily my expectations or Governor Mishkin’s, Vice Chairman Geithner’s, or the Committee’s, and they don’t necessarily correspond to the reality of the distribution of inflation realized five years, five years hence, if each of us had our druthers or if the Committee as a whole lasted that long together and conducted policy the way it best saw fit. I trust that no member would deliberately encourage continued discrepancy between what they viewed as objective reality and the public’s expectations. But that said, that discrepancy is not the same as less commitment on our part. It’s certainly the same as less credibility about commitment on our part. I think and trust that most members when speaking in public about inflation expectations would endeavor to reduce that discrepancy. Presumably, each of us has a threshold for acceptable inflation expectations that, if it were crossed, would induce us to be willing to disappoint market expectations. Personally, my threshold has been crossed, so I think that, if we ease, we should ease much less aggressively than markets expect. More broadly, I think of this in terms of the following question: What strategy would we want people to believe we will follow in future episodes like this? As I pointed out in my letter to the Committee last week, thinking in terms of our strategy is different from a meeting-by-meeting approach that takes the public’s current expectations, wherever they are, as given. We should ask, I believe, what expectations we would have wanted them to have had about our behavior during March 18, 2008 91 of 127 episodes like this. Do we want people to believe that we will follow a policy that allows inflation and inflation expectations to ratchet up permanently whenever growth slows? I don’t think so, but that seems to be what the market believes we’re doing. Conceivably, we could try to use our statements and minutes to communicate our intention to bring inflation down, but at this point, my sense is that our statements about inflation appear to be taken as much less revealing than our actions. This is a uniquely challenging episode in the history of our economy and our institution. I have found it useful to remind myself from time to time about the limits of central banking. We cannot prevent this recession, and it’s doubtful to me that we could have or should have even if we had had perfect foresight. We are unlikely, as I said, to have much effect on the ultimate magnitude of mortgage losses at this point, and I don’t think we can do much to accelerate the resolution of uncertainty about those losses. We cannot resolve uncertainty about the fundamentals underlying the creditworthiness of financial market counterparties, and we cannot enhance the liquidity of any financial instrument without altering its relative price. What can we do? We can control inflation, and we can limit the extent to which uncertainty about our inflation intentions adds to market volatility. To do this, I like the idea of being clear about our strategy. I take that as consistent with what President Plosser was advocating, that we concern ourselves with what level we see as appropriate now and see as likely to be appropriate later this year. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Yellen. MS. YELLEN. Thank you, Mr. Chairman. I support your proposal for a 75 basis point cut and the language that’s proposed for alternative A. As I said in my comments, I’m very concerned about economic growth and agree basically with the Greenbook perspective. I think we are into an adverse feedback loop, and I agree with the Bluebook assessment that the equilibrium real funds March 18, 2008 92 of 127 rate has dropped substantially, maybe into negative territory. I don’t believe in gradualism in circumstances like these. I think the argument for more-aggressive action now is similar to when inflation is very low and we face the zero bound for nominal interest rates. I agree with Governor Mishkin’s comments about the lessons of Japan. I think that the sooner appropriate stimulus is put in place, the less likely it is that policy will end up facing very unpleasant consequences of essentially reaching the zero bound in this case because of a prolonged and severe recession. So I’d like to see the funds rate moved down to where it needs to go sooner rather than later. I think the appropriate level of the funds rate is one that would provide some insurance against really bad outcomes for the economy, and I don’t see this move as taking us into insurance territory yet. So I understand the constraints that you have weighed into this decision having to do with the psychology of inflation expectations and the dollar, and probably this is as far as we can go sensibly today, but I think it is important to move as much as we can. If the moves prove unnecessary, I think we can reverse the stance of policy quickly, with a good chance of avoiding inflationary problems. I agree with Governor Mishkin’s views on riskmanagement policy in the face of financial shocks. We had an interesting discussion last time about the possibility that a quick reversal might mean that we don’t have much stimulative effect on spending now because we may not lower long-term interest rates enough, and I think that was good food for thought. But having spent some time thinking about it, I think that a lower funds rate will actually lower long-term rates, in part because, by reducing the probability of a financial crisis, we will bring risk premiums down, which will lower long-term rates. A lower funds rate will also be stimulative because a good deal depends on short- and intermediate-term rates. I think there are also a number of other ways in which short rates matter to spending through channels like raising March 18, 2008 93 of 127 firms’ profitability and cash flow and lowering the stress from ARM resets. So I strongly support the action that you recommend. CHAIRMAN BERNANKE. Thank you. Governor Kohn. MR. KOHN. Thank you, Mr. Chairman. I also support your proposal, both the action and the language of alternative A. I think it’s an appropriate response to the developing situation, and I do think that the language will help us on the inflation front. Let me elaborate a bit. We’ve had a marked deterioration in the outlook, as everybody around the table has seen and has agreed with. I do think, as President Yellen and others have said, that a decline in the federal funds rate will be helpful in mitigating the recessionary tendencies in the economy. The decline of 75 basis points is not as much as the Greenbook r* decline, but I think it’s appropriate and reasonable to await more evidence about whether at some point we need to go further. The resulting real federal funds rate would be approximately zero using core inflation, and I think that’s a reasonable place to be, given the weight of the constraining factors in the economic outlook, particularly from the credit markets. I use core in thinking about the real funds rate because I do think that even a zero real funds rate under these circumstances, at least for a time, will be consistent with inflation coming down as commodity prices level out and as resource utilization goes down. I agree with Brian that there could be a bit of an adverse reaction in financial markets because it’s not quite as much as they’re expecting, but with that risk sentence in paragraph 4, it shouldn’t be too bad. I do think it’s consistent with heightened attention by the Committee to inflation and inflation expectations for the reasons you gave, Mr. Chairman. It’s less than the market expects, and both paragraph 3 and paragraph 4 increase the attention to inflation and inflation risk. Thank you. CHAIRMAN BERNANKE. Thank you. President Evans. March 18, 2008 94 of 127 MR. EVANS. Thank you, Mr. Chairman. I support your recommendation. I came in here thinking that I preferred 50 basis points, but I also recognize that I expected that we would have to go beyond that after this meeting. So I fully support 75 and the language that you discussed. I just want to take a minute to give my perspective on the discussion earlier about the 1970s and inflation expectations. I certainly didn’t expect when I came onto the Committee that we would be lowering rates as much as we have done, and I thought we would be more concerned about inflation, but this is where we are, and I think it is the appropriate response. Inflation expectations risk reminds me of Paul Volcker, hero of the Federal Reserve System. Why is that? He broke inflation expectations. How did he do that? Well, when I talked with my colleague, Larry Christiano, he reminded me that it wasn’t really by reducing money growth. M1 growth increased during that period, and yet financial conditions were restrictive. There was a big recession. There was a lot of resource slack, and that was really important for bringing inflation down. I agree. I think we’re in a situation where this is most likely a recession. I expect that it will reduce pressures on inflation. That’s my forecast. I think it’s consistent with the earlier period, and it’s hard to know exactly how much it will bring inflation down, but I think that it will lower inflation. The Greenbook is calling for a recession. They could be wrong, but we’ve been chasing them down the whole time, and I’d be very surprised if they were wrong. I would like to know where the bottom of the funds rate cycle is. Like financial market participants who want to know what the value of their mortgage securities is, I’d like to know where the bottom of the funds rate is. But that is wholly unrealistic at this point. We just don’t know. So I would be hopeful for eventually something like the Greenbook path assumption. But I support the recommendation. Combined with our separate attempts to relieve financial market stress, we have two prongs going, and that is very helpful. Thank you. March 18, 2008 95 of 127 CHAIRMAN BERNANKE. Thank you. President Stern. MR. STERN. Thank you, Mr. Chairman. Well, as somebody said recently, there are no altogether good choices. I strongly support the recommendation and the language that goes with it. A couple of weeks ago I thought the funds rate probably should go to 2½ percent. I got there basically by saying, well, given what I know about current conditions, the outlook, and everything, 3 percent is not a bad level. But there are a lot of things I don’t know, and it’s likely that some events are going to occur in the next couple of weeks or sometime in the future that may disturb things, and as a little insurance for that, 2½ would be a good idea. Well, those events—I’m talking about Bear Stearns and other disruptions—occurred sooner rather than later, so it seems to me that we need to go to 2½ and then ask ourselves whether we want some additional insurance. My answer to that is “yes.” So I’m perfectly comfortable with taking the funds rate down ¾ percentage point now. Does it strike the appropriate balance between our concerns about financial conditions and the outlook, and inflation and inflation expectations on the other side? I don’t know. But as I said at the outset of this, I don’t know that there are any altogether good choices. I think this is about as good as we can do under these circumstances. CHAIRMAN BERNANKE. Thank you. President Fisher. MR. FISHER. Well, Mr. Chairman, I don’t like being obtuse and, being a people person, I don’t like being unpopular. But I— MR. MISHKIN. We’re always going to love you, come on. [Laughter] PARTICIPANT. We don’t like being unpopular either. PARTICIPANT. Happy birthday! [Laughter] MR. FISHER. I just can’t bring myself to go that far, Mr. Chairman. I listened very carefully to what was said at the table, and implicit in Tim’s question to me was, Would you be March 18, 2008 96 of 127 willing to do something? The answer is “yes,” but not as much as you’re suggesting. I try as hard as possible, even though I’ve made my living in financial markets, to ignore the reports that we were just given as we started this conversation because what we’re paid to do and what I believe is our duty and obligation to do is what’s right for the long-term interests of the economy. I am more bearish now than before, and I was an outlier on the bearish side of economic growth. I’ve been at the lower end of the range, but I also believe that we have significant inflationary concerns. I have a further point to add to President Hoenig’s—I agree with his intervention. I think that, by being accommodative, we are encouraging others who have a role to play here—you mentioned them yourself, Mr. Chairman—to sit back and let us do the job. To me the combination of inflationary pressures, which I consider to be real, imputing into a much weaker economic growth scenario, which I have thought for a long time, means that we cannot do this job alone. The fact of the matter is that we have undertaken significant liquidity enhancement initiatives, and I think we’re going to have to do more, and I’ve been fully supportive of them, but I think 75 basis points, Mr. Chairman, is way too much. My thought is that it encourages the financial markets. They’re not going to be satisfied. I said this last time. It’s Jabba the Hutt. They will keep asking for more and more. We have to quit feeding them. I’m in a pizza mode, by the way, in this conversation. I do have a suggestion, however. MR. MISHKIN. You mean Pizza the Hutt, not Jabba the Hutt. [Laughter] MR. FISHER. Pizza the Hutt, that’s right. Vice Chairman Geithner made a very interesting point, and that was that we have to be very careful about how we talk about inflation and even saying what we think. What worries me about going down alternative A’s path, if that’s the wisdom of the Committee, is that the second paragraph says a little too much of what we think. It really says that we’re not done. If you want to say that, that’s fine; but it keeps hammering on, even March 18, 2008 97 of 127 after 75 basis points, that things are soft, things are soft, things are soft. You may disagree with me on that, but I would suggest that we take out the justification reflecting, in paragraph 3, “a projected leveling out of energy and other commodities.” To me that’s a wing and a prayer, and you suggested that you might be willing to take it out. Were I you, advocating 75 basis points, acting as I think you are about to act, with one dissent, I would take that wing and a prayer language out of there. Then I would suggest one other thing—in fact, I would ask for one other thing. In the very last sentence—“The Committee will act in a timely matter as needed to promote sustainable economic growth without sacrificing long-term price stability”—that’s really what we’re talking about on the upside and on the downside. So I would ask for that change because that’s really what we’re saying. You’re saying that we’re worried about the downside. We’re all worried about that, but we’re going to promote sustainable economic growth without sacrificing long-term price stability. Those are my suggestions, Mr. Chairman, and thank you for putting up with me. CHAIRMAN BERNANKE. Always a pleasure. [Laughter] President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. I came to the meeting preferring alternative B—50 basis points. I certainly can bring myself to support your proposal—75 basis points. I don’t view it as a fist pounder, but let me make the case for 50 basis points, at least as I think about it. First, I do think it is a movement that acknowledges financial instability and the growing real weakness. As I argued in my earlier remarks, it may set the scene for decoupling rate policy from liquidity actions if conditions allow. I think the action makes a minimal acknowledgement of inflation risk, and it may signal the view that lower rates can do only so much and that, best case, the market will have to proceed to sort out the market problems and, worst case, the fiscal authorities will have to deal with them. Although I am not a trained psychologist, let me March 18, 2008 98 of 127 just propose that, in dealing with market psychology, there may be some value in appearing to firm up our rate-movement policy and to set one element in the fluid situation with greater fixity than it has been in recent weeks. That might generate the kind of firming dynamic and even help produce a turn in psychology. That’s a lot to ask for simply 50 basis points, but I also prefer the language of alternative A to that of alternative B, and I think Brian said that you could conceivably apply alternative A language substantially to a 50 basis point cut. So in general I like that approach. Thank you, Mr. Chairman CHAIRMAN BERNANKE. Thank you. President Pianalto. MS. PIANALTO. Thank you, Mr. Chairman. I support your recommendation. As I said earlier, I do see the risks to the Greenbook baseline as being skewed to the downside because of the absence of any signs of a bottoming out in the housing market. As others have mentioned, I am concerned about the risk that we will have a more protracted recession. At the same time, the short-term inflation environment has deteriorated. I am also concerned about inflation expectations becoming unanchored. As Governor Mishkin and others have said today, we face some very unpleasant tradeoffs; but in the end, I support being more aggressive in our policy actions today. I am hopeful that, as others have said, the language that we have added in paragraph 3 about inflation risks and a reminder in the assessment-of-risk paragraph about our dual mandate will be helpful in keeping inflation expectations from rising further. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. First Vice President Sapenaro. MR. SAPENARO. Mr. Chairman, excluding for the moment the market’s expectations of a significant downward policy move at this meeting, I have a strong preference for alternative D, like President Hoenig. I see widespread evidence that the upside risk to inflation March 18, 2008 99 of 127 has increased appreciably, as evidenced by rapid money growth, a depreciating dollar, rising prices of energy and commodities traded on the world markets, and higher inflation compensation in bond markets. However, as we all know, the market does expect a significant reduction in the funds rate from this meeting, partly because of the state of the economy, partly because of the turbulence in the financial markets, and partly because of past statements and communications from Committee members. Consequently, under these conditions, I believe that a failure to accommodate much of this expectation would produce additional, major market turmoil. Hence, I was prepared to accept a 50 basis point reduction coming into the meeting and, with some trepidation, can accept a 75 basis point reduction. In my view, however, it would be desirable for the Committee’s communications going forward to emphasize that we have not lost our zeal to fight inflation and that further rate cuts cannot solve solvency problems without unacceptable future inflation. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. As I mentioned in my first go-round, and like Rick, I have been terribly depressed on multiple dimensions about what is going on and have struggled mightily in trying to think about what appropriate policy is going forward and, as President Lacker suggested, about what our strategy is as we move forward. I certainly believe that easing of policy is appropriate in a weaker economy, and I have supported that. But as I alluded to earlier—and, Mr. Chairman, as you said—I do believe that a weaker economy does not mean that we continue to cut rates as long as the economy is weak. We need to calibrate the level of the funds rate; I think it is very important. I think the markets seem to have the expectation that it is the rate of change, not the level, that matters. That concerns me and feeds into some of the problems that we are facing. I won’t elaborate any more about expectations, March 18, 2008 100 of 127 which I mentioned before. But I would prefer actions as well as language that reinforced our commitment to price stability and a pause today in our rate cuts. I think that the language of alternative D would accomplish that. But I also believe that a more modest cut, combined with language such as that in alternative D, might accomplish the same thing. I am afraid that an aggressive move combined with the language that we have in A or B feeds the belief that we have placed aside our commitment to price stability and the expectation that we will continue to cut rates for the foreseeable future and that there is no bottom in sight. We have talked a lot about taking out insurance around this table. I believe the time has come to buy some insurance against our waning credibility about restraining inflation. That does not mean that we couldn’t choose to continue to make rate cuts at some future date, should that be called for. Ultimately, if we wish inflation expectations to be well anchored, we must act in a way that is consistent with such an outcome. Words are simply not enough. Reputational capital, whether it be for a central bank, an academic institution, or the brand capital of a firm, is very hard to build. But most of us know, in the private sector and in other sectors, that capital can be easily squandered. We must not let that happen. I appreciate, Mr. Chairman, your comments regarding the idea that we may be reaching the limits of what monetary policy and the central bank can do. I very much agree with that. At the risk of maybe sounding a bit trite to some of my colleagues who are familiar with this—I don’t mean it that way because this expresses some of my concerns—I would like to remind my colleagues of a quotation of Milton Friedman, which he made in 1968, that “we are in danger of assigning to monetary policy a larger role than it can perform, in danger of asking it to accomplish tasks that it cannot achieve, and, as a result, in danger of preventing it from making the contribution that it is capable of making.” Thank you, Mr. Chairman. March 18, 2008 101 of 127 CHAIRMAN BERNANKE. Thank you. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. A couple of quick introductory points. First, I have total confidence in the Fed and the FOMC, certainly over the course of my couple of years here, in effectively handling these challenges, which is key to highlight at the outset of my remarks. I have total confidence in this institution’s ability, in particular, to handle both sides of the dual mandate. Moreover, I would say that I have total confidence in our ability to have a really robust discussion here and recognize, as President Geithner pointed out, the fragility in these financial markets. A lot of our strength comes from being able to have very open, tough discussions with each other and recognize that, if they were in the public square, they could be misinterpreted and destabilizing. I think he is right that we all need to take that into account, particularly over this next intermeeting period, which we all hope lasts six weeks. Moreover, I think that the power of our tools, our creativity, and our innovative abilities over November, December, and these recent weeks has been incredibly impressive. I think that those will work in concert with monetary policy. I would underscore a point that the Chairman made, which is that we have taken a huge burden on ourselves and that the burden will have to be matched by others here in Washington—and I suspect before we get too much into the second and third quarter by others around the world—which will go a long way toward helping us accomplish our objectives. Second, I have total confidence in U.S. financial institutions over the medium term to deal with these issues. They will come out of this thing stronger, smarter, and faster and will be huge net exporters of services, but that is going to take a while. My own view is that the capitalraising is good and very important. If the tail is as fat as we have discussed, capital-raising by March 18, 2008 102 of 127 these institutions should help them stave off safety and soundness issues that could arise. So I think that it is good prudential management by them and us alike. To the task at hand on monetary policy, I will support alternative A, as the Chairman recommends, and I take particular comfort in the narrative and language in A as being a very important next step for us to guard against risks on the currency front and on the inflation front. Now, these words themselves won’t do a ton in the short term, and they won’t have an immediate effect, but I do think it is important for us to take these and build on them in our private and public statements. So that gives me some comfort. On the decision of 50 points versus 75 points, I would be kidding myself if I thought that those 25 basis points were completely consequential. I wouldn’t ascribe virtue or vice to that sort of bid-asked spread. I would say that it is a hard call. I share the view expressed by some that these markets are going to need to be disappointed at some point here. That is the only way the words that we express will be properly understood and taken into account in the markets’ judgments, and I worry that we are not going to have any great opportunities to disappoint them over the course of the upcoming meetings. Finally, let me say this. I will end where I started in this discussion, which is, at the end of the day, it is this institution’s credibility that is paramount and that is increasingly the case at this point in the cycle. It strikes me that we have to continue to make the case in the upcoming months that we have the will, the wisdom, and the tools to tackle these issues. To the extent that monetary policy is perceived by pundits and Fed watchers as not working, it is important that we rebut those arguments and explain that our tools will work over time and that we are looking for assistance both in Washington and in other nations’ capitals. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. March 18, 2008 103 of 127 MR. KROSZNER. Thank you. Obviously, as I said before, we are in a very uncertain situation with respect to inflation. We have slowing economic growth, but we have also had very elevated prices. We had a very low unemployment rate and a very low rate of wage inflation, so we have to worry a little about whether we will get the benefits of lower resource utilization in terms of lower inflation. But when we look back historically at previous slowdowns, as President Stern mentioned about 1990-91 and as we have discussed about 1998-99, when we didn’t actually have a formal slowdown, the Committee cut rates, and we didn’t have a burst of inflation. Obviously, after the slowdown in 2001, the main challenge was concern about inflation getting too low rather than getting too high at that point. If we look over the past few cycles—and I think markets are aware of those—we see that you can have cuts in the federal funds rate that don’t lead to inflation getting out of control, both when the economy is growing strongly and when the economy is quite weak. So although I do think that the situation is uncertain, I don’t think that the markets would read a cut of 75 basis points today as a lack of commitment to inflation control. I think there is a lot of historical evidence that suggests that it is not necessarily inconsistent with that in any way. The slight uptick that we have seen in some but not all of the surveys doesn’t suggest that our inflation credibility has been lost. I think it is very difficult to read what the markets are saying because just look at the volatility over the past few days. Are those TIPS spreads really telling us about dramatic changes in the market’s views of our credibility regarding what we are going to do in fighting inflation? I don’t find that credible. There are a lot of other things that are going on that make it very difficult for us to read something out of that. So I support alternative A. My thinking is actually very much along the lines of President Stern’s—that we need to take out at least a little insurance going forward. The March 18, 2008 104 of 127 statement in alternative A does a very good job of talking about some of the concerns about inflation. With respect to whether or not we include the explanation of why we expect inflation to come down in coming quarters, one of the things that changed in this version relative to the earlier ones is that there is no explicit mention of inflation expectations, which I think is right because there is such uncertainty about how to measure those. That the uncertainty about the inflation outlook has increased is the thing that we can read from what the markets are telling us. The assessment of risk in paragraph 4, where it mentions not only the policy actions but also the measures to foster the liquidity, is valuable so that people see that these are complementary tools and that we understand how they can work together. The mention of price stability at the end and how that differs from our statement from last time is a good way to signal that. But I really don’t see evidence yet that we have lost credibility. If we look back historically at when we’ve done rate-cutting in either financially stressed times or actual economic downturns, at least over the past twenty-five years, it has not turned into inflationary challenges, and I don’t see any evidence that the markets think otherwise. So I support alternative A, as is. Thank you CHAIRMAN BERNANKE. Governor Mishkin. MR. MISHKIN. Thank you, Mr. Chairman. Obviously, we are facing a very difficult policy problem, and that is why, Charlie, we will go have a beer later, so that we can deal with our depression. MR. PLOSSER. How about two? MR. MISHKIN. Yes, maybe two. Clearly, we are challenged by the fact that we have to balance the risks of both underlying inflation and inflation expectations going up. Against that, we have to worry about the downside risks to the economy, and the financial sector could really go south. So that is really the policy problem that we face. March 18, 2008 105 of 127 I do support alternative A, but I would like to give some perspective on that because I may have a different take than others on this. If you are thinking about the risk-management viewpoint that I and some others have talked about, I want to emphasize that lowering the federal funds rate 75 basis points is not—and I want to repeat, is not—taking out insurance. If you look at the Greenbook projections, they have 75 basis points, and they have a further decline after that. The r* has dropped 125 to 150—well, it depends on which model, but quite a bit more than 75. So from an insurance perspective, we should actually be doing more than 75 basis points. But I am not going to argue for that. In fact, I would argue for that if some of the other things, such as negative supply shocks, hadn’t been happening. I also have a concern about a phenomenon that has occurred, which I don’t fully understand. Normally I would not worry about dollar depreciation. I gave a speech recently on pass-through—it was an opportunity for me to interact with Nathan’s staff and to read the literature—and the evidence is that there is just not a whole lot in terms of pass-through. But lately we have seen something that is very peculiar, which is that, every time we have had depreciation in the dollar, the oil price has gone up. That makes me much more nervous about dollar depreciation than I would usually be. I hope that it may be just coincidence, but it makes me a little more nervous. Another problem that we face is that we have not convinced the markets that we will be willing to bring out the baseball bat if inflation starts to get out of control. That is really a key part of the risk-management approach, and a key part of—I think Vince Reinhart called it postgradualism in his speech. He gave a very interesting speech the other day and called it postgradualism. But we have not yet convinced people about it, and part of the problem is that we really haven’t operated in that way in the past. This is one reason that it is worthwhile talking March 18, 2008 106 of 127 about this and saying that we need to think about operating in a different way. But it suggests to me that, if we actually were more aggressive than 75 basis points, it could have very negative reactions in the markets about our commitment to controlling inflation. So, that is one of the reasons that I strongly support the Chairman’s proposal. I should say, by the way, that even so, the 75 basis point cut, which I don’t think takes out enough insurance, does pose some risk that long-run inflation expectations will rise. But we have to realize that there is a lot of risk of really bad things happening that could mean that things really get out of control. The discomfort is that we now have a tough tradeoff. But then, when I think about the tradeoff, I am willing to say that we have to take the risk because otherwise the consequences could be very problematic. I should mention that I have one concern about the wording in the statement. I usually don’t make comments about the wording because I am just not subtle enough to get that. But I did worry a bit, for exactly the reason that Vice Chairman Geithner mentioned, about the issue that talking about inflation expectations getting unhinged could be actually very dangerous. The first sentence in alternative A says, “Inflation has been elevated, and some indicators of inflation expectations have risen.” Well, I worry about that. First of all, the evidence is not completely clear on that. It is true that there has been an increase, and I have said it is about 10 basis points. But there is other research, and there is a lot of uncertainty about these measures. I am wondering, if we put that in, whether it will actually cause a problem in terms of market reaction. So it worries me a little. I would probably be more comfortable with what we have in alternative C, which is that inflation has been elevated and then the reasons for upward pressure. I am not sure that this would be helpful. I don’t feel super strongly about it, but the comments of Vice Chairman Geithner made me a bit more worried about it than I otherwise would have been. CHAIRMAN BERNANKE. Thank you. Vice Chairman. March 18, 2008 107 of 127 VICE CHAIRMAN GEITHNER. Let me just begin with a question because I think it is really central. It goes to the issue of how accommodative policy is now. Fundamentally that must be critical to the magnitude of the risks we are taking that we are going to get it wrong and inflation in the future is going to be too high. Now, I am not really part of your profession, but I have always found this chart to be the most discouraging prism on the choices we face. CHAIRMAN BERNANKE. What chart is that? VICE CHAIRMAN GEITHNER. This is the Bluebook equilibrium real funds rate chart. But any way you look at it, the real fed funds rate is closer to best estimates of equilibrium than during any downturn of the past two decades or similar periods of time. There is no gap between the estimated real rate today and the center of the estimate of where equilibrium is. If you look back to what that gap was in 1992, in 2001-02, or in 2003, there was a substantial gap, as most judgments about policy would suggest was necessary. I understand that there is a huge amount of uncertainty about estimates of equilibrium, but we can’t be facing both the most serious risk of a financial crisis and of a deep, prolonged recession in 50, 30, or 20 years and at the same time the risk of having a very substantial rise in underlying inflation over the medium term. It seems to me that we are going to have one or the other. The choice we face, of course, is which risk we are prepared to take. Which mistake is the easier to correct for? It is a very hard judgment to make. But I think we have to be confident that, if we end up being successful in averting the risk of a very, very dangerous, damaging spiral in the financial markets with the consequences of a very deep recession or a deeper recession than in the early 1990s, then we will be able to deal with the likely consequences that we will have more inflation and less moderation than we now anticipate. I guess I don’t understand why we would not be confident in that. So let me just say March 18, 2008 108 of 127 that I don’t think this is easy. Like many of you, I think that it would be great if we got away with 50, but I think that is not tenable—not even close in this context. Even though it would be nice if we had a consensus in the United States about a set of fiscal measures that we think would be good on the merits, we can’t make monetary policy in a framework where we condition our actions on actions by the Congress. In an environment like this, it is not possible. If we do the right thing, does that mean it takes the pressure off them? Maybe, but probably not so much. But it can’t constrain us from doing what is appropriate now. Just one final thing: People who know this stuff quite well, who are reasonably calm people, say, “This is possibly the worst financial crisis in 50 years, and the most challenging set of pressures facing the central bank in 20 or 30 years.” Think about that in this context. Okay? It is no surprise that we disagree; it is no surprise that the range of agreement about what we see and what we should do is going to be wide in that context. But just think very carefully about the signal it sends to the world at this moment to be explicit in public about the degree of dispersion about our views. Just think carefully about it because this is a special moment. I fully support the language and the action in alternative A. President Fisher, I would not amend the last sentence to say “without sacrificing” partly because I think we need to project confidence in our capacity to manage long-term inflation outcomes. I am ambivalent, as you know, Mr. Chairman, about that clause that President Fisher suggested we delete about reflecting a projected leveling out. The virtue is that it explains and underpins, therefore, the basis for a medium-term forecast. The vice in it is that, as the Chairman himself said, the first part may seem like a thin reed on which to base our forecast, given what has been happening. I actually think, Governor Mishkin, that acknowledging some indicators of inflation expectations—it is really about uncertainty having increased—is helpful to our credibility. At the margin, it helps, March 18, 2008 109 of 127 even though, sure, you can say that we really can’t know what they are telling us about the market. MR. MISHKIN. May I just ask a question back? I do think that inflation expectations are a concern. It is just a question of how the markets—and I am not as good at this as the people who really follow the markets—and the press will react to this phrase because I think that the amount of movement here is still very small. You know, the kinds of numbers we are talking about for inflation expectations are on the order of 10 to 20 basis points. Will this mention, because it is new, raise a flag that will get more attention and more concern than, in fact, is justified? That is the tricky problem here. We should acknowledge it, but again, I am not good enough at wordsmithing to figure out how to do that. This is a bit of my concern here. I don’t know if anybody has any thoughts about how to handle it. CHAIRMAN BERNANKE. President Fisher, I think I agree on the last sentence. I would like to keep it something that we have used frequently before and that emphasizes, in fact, the symmetry of the dual mandate. Are there other thoughts on either the indicators of inflation expectations or the list of reasons that anyone would prefer to change from where we are? MR. KOHN. On inflation expectations, because they haven’t risen very much, I agree with President Geithner. I like the fact that we tell people we are aware, but we could say “have edged higher” or something like that instead of “risen.” MR. MISHKIN. We could use my “smidgen” word, but “edged higher” is better. MR. KOHN. Went up a smidge. CHAIRMAN BERNANKE. All right. President Evans. MR. EVANS. “Edged higher” is an unusual phrase. MR. MISHKIN. “Have risen somewhat”? March 18, 2008 110 of 127 MR. MADIGAN. I think an issue with “edged higher” is that it really does sound as though you have some very specific measures in mind. CHAIRMAN BERNANKE. Brian, do you have a thought on “risen” versus “risen somewhat” versus taking it out? MR. MADIGAN. I think if you take it out that very much raises the question of what to do with that language in red about the factors that would push inflation down. It would be tough to drop the inflation expectations thought and not have inflation expectations mentioned anywhere in the paragraph. There would just be vacant space where you had, at least in previous minutes, referred to it. CHAIRMAN BERNANKE. Anyone else? Bill. MR. DUDLEY. Adding just the word “slightly”—“risen slightly”—gets to your point. MR. MISHKIN. “Slightly” or “somewhat” risen. MR. WARSH. Brian, does “somewhat” mitigate it a little, or does that highlight it? MR. MADIGAN. I’m not sure. I mean, in my mind it mitigates it. VICE CHAIRMAN GEITHNER. Somewhat. MR. KROSZNER. Is “slightly” better than “somewhat”? MR. KOHN. “Somewhat” is bigger than “slightly.” MR. EVANS. That is 50 versus 25 in the old days. MR. LOCKHART. Mr. Chairman, if I understand the discussion about this, when you say “some indicators have risen somewhat,” you are getting into territory that seems sort of mealy-mouthed. CHAIRMAN BERNANKE. Right. MR. KOHN. “Risen a little”? March 18, 2008 111 of 127 MR. KROSZNER. What is wrong with “slightly”? CHAIRMAN BERNANKE. All right. President Hoenig? MR. HOENIG. Mr. Chairman, I don’t want to prolong this too much, but in response to the Vice Chairman’s comments, I am not sure I follow what you are saying. I think the model that you showed us, in terms of where the equilibrium rate is, is a short-term model. It is based upon a variety of estimates and output gaps, and I think there is plenty of room for disagreement around that model. So the fact that we have different views on this Committee is very healthy. Even to the world it can be very healthy because a lot of people out there have a different view of this and are wondering if there is any variance of views within this Committee. I think that can serve as useful a purpose as uniformity without objection. VICE CHAIRMAN GEITHNER. Let me say for the record that I agree with everything you just said. My only point is that there is no surprise that we disagree or that it is complicated and we have a different view of the balance. If anything, what this chart shows is how broad the range of uncertainty is around this. That was part of my point in saying it. But I do think that the value of the public display of dispersion is different when you have this degree of a confidence problem in markets generally. That is the only thing I was suggesting. I completely agree about the value of diversity of view in this context. It is no surprise that we disagree in this period. My only suggestion is in terms of how we think about talking about it publicly, given that we are at such a delicate moment. MR. HOENIG. Vice Chairman, we have a bubble developing in some parts of our area. I think they are aware of that, and so I think we have to be mindful of that in our discussion more broadly. That is why I think there are important differences that we should necessarily be able to—and should in fact—acknowledge publicly. March 18, 2008 112 of 127 CHAIRMAN BERNANKE. Okay. Having thought about this, I think that “some indicators” does tone it down a bit. Perhaps we could just leave it where it is? Who knows what reaction this will get. Again, there is some sense here of trying to ratchet up at least our verbal attention to inflation. Let me say to everyone that I went through each of these alternatives and tried to find one that didn’t make me intensely uncomfortable—and I am still going through them. These are very, very difficult decisions. We are all people working in good faith, and we are all doing the best we can. I appreciate the candor and the honest comments, and we will continue to work together and to address these very, very difficult issues that we have. If you are ready, then perhaps we could take a vote. MS. DANKER. The vote will encompass the directive I’ll read from the Bluebook and the statement for alternative A in the chart that you have in front of you. “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 reducing the federal funds rate to an average of around 2¼ percent.” Chairman Bernanke Vice Chairman Geithner President Fisher Governor Kohn Governor Kroszner Governor Mishkin President Pianalto President Plosser President Stern Governor Warsh Yes Yes No Yes Yes Yes Yes No Yes Yes CHAIRMAN BERNANKE. Thank you. We are going to recess for the discount rate. Unless there are objections, we are going to maintain the ¼ percentage point difference. [Recess] March 18, 2008 113 of 127 CHAIRMAN BERNANKE. Okay. The next meeting is April 29 and 30, Tuesday and Wednesday, a two-day meeting. We will talk about interest on reserves. And we will meet you shortly upstairs for a lunch in honor of Bill Poole. The meeting is adjourned. END OF MEETING April 29–30, 2008 1 of 266 Meeting of the Federal Open Market Committee on April 29–30, 2008 A joint meeting of the Federal Open Market Committee and Board of Governors of the Federal Reserve System was held in the offices of the Board of Governors in Washington, D.C., on Tuesday, April 29, 2008, at 2:00 p.m., and continued on Wednesday, April 30, 2008, at 9:00 a.m. Those present were the following: Mr. Bernanke, Chairman Mr. Geithner, Vice Chairman Mr. Fisher Mr. Kohn Mr. Kroszner Mr. Mishkin Ms. Pianalto Mr. Plosser Mr. Stern Mr. Warsh Ms. Cumming, Messrs. Evans, Lacker, and Lockhart, and Ms. Yellen, Alternate Members of the Federal Open Market Committee Messrs. Bullard, Hoenig, and Rosengren, Presidents of the Federal Reserve Banks of St. Louis, Kansas City, and Boston, respectively Mr. Lyon, First Vice President, Federal Reserve Bank of Minneapolis Mr. Madigan, Secretary and Economist Ms. Danker, Deputy Secretary Mr. Skidmore, Assistant Secretary Ms. Smith, Assistant Secretary Mr. Alvarez, General Counsel Mr. Baxter, Deputy General Counsel Mr. Sheets, Economist Mr. Stockton, Economist Messrs. Connors, English, and Kamin, Ms. Mester, Messrs. Rosenblum, Slifman, Sniderman, and Wilcox, Associate Economists Mr. Dudley, Manager, System Open Market Account Ms. J. Johnson,¹ Secretary, Office of the Secretary, Board of Governors _______________ ¹ Attended portion of the meeting relating to the implications of interest on reserves for monetary policy implementation. April 29–30, 2008 2 of 266 Ms. Roseman,¹ Director, Division of Reserve Bank Operations and Payment Systems, Board of Governors Mr. Frierson,¹ Deputy Secretary, Office of the Secretary, Board of Governors Ms. Bailey, Deputy Director, Division of Banking Supervision and Regulation, Board of Governors Mr. Clouse, Deputy Director, Division of Monetary Affairs, Board of Governors Messrs. Hammond¹ and Marquardt,¹ Deputy Directors, Division of Reserve Bank Operations and Payment Systems, Board of Governors Mr. Blanchard, Assistant to the Board, Office of Board Members, Board of Governors Mr. Struckmeyer, Deputy Staff Director, Office of Staff Director for Management, Board of Governors Ms. Edwards,¹ Associate Director, Division of Monetary Affairs, Board of Governors Ms. Shanks,¹ Associate Secretary, Office of the Secretary, Board of Governors Messrs. Reifschneider and Wascher, Associate Directors, Division of Research and Statistics, Board of Governors Mr. Gagnon, Visiting Associate Director, Division of Monetary Affairs, Board of Governors Ms. Martin,¹ Associate General Counsel, Legal Division, Board of Governors Mr. Carpenter,¹ Assistant Director, Division of Monetary Affairs, Board of Governors Mr. Dale, Senior Adviser, Division of Monetary Affairs, Board of Governors Mr. Oliner, Senior Adviser, Division of Research and Statistics, Board of Governors Ms. Allison,¹ Senior Counsel, Legal Division, Board of Governors Mr. Gross,¹ Special Assistant to the Board, Office of Board Members, Board of Governors Ms. Weinbach, Adviser, Division of Monetary Affairs, Board of Governors Mr. Small, Project Manager, Division of Monetary Affairs, Board of Governors _______________ ¹ Attended portion of the meeting relating to the implications of interest on reserves for monetary policy implementation. April 29–30, 2008 3 of 266 Mr. Luecke, Section Chief, Division of Monetary Affairs, Board of Governors Ms. Beattie,¹ Assistant to the Secretary, Office of the Secretary, Board of Governors Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of Governors Ms. Hughes,¹ Staff Assistant, Office of the Secretary, Board of Governors Mr. Fuhrer, Executive Vice President, Federal Reserve Bank of Boston Messrs. Hilton, McAndrews,¹ Rasche, Rudebusch, Steindel, Sullivan, and Weinberg, Senior Vice Presidents, Federal Reserve Banks of New York, New York, St. Louis, San Francisco, New York, Chicago, and Richmond, respectively Messrs. Clark and Meyer,¹ Vice Presidents, Federal Reserve Banks of Kansas City and Philadelphia, respectively Mr. Weber, Senior Research Officer, Federal Reserve Bank of Minneapolis Mr. Roberds, Policy Adviser, Federal Reserve Bank of Atlanta _______________ ¹ Attended portion of the meeting relating to the implications of interest on reserves for monetary policy implementation. April 29–30, 2008 4 of 266 Transcript of the Federal Open Market Committee Meeting of April 29-30, 2008 April 29, 2008—Afternoon Session CHAIRMAN BERNANKE. Let’s formally begin the meeting. Let me start by welcoming our new colleague, Jim Bullard from St. Louis, over there in the heartland section of the table. [Laughter] We welcome you, and we look forward to your contribution and to working with you. I want just to note that there has been some interest in doing more work collectively— Board members and Presidents—on various issues relating to bank supervision and regulation. We have some work streams planned, Governor Kohn will talk about this a bit tomorrow during our lunch, and we will discuss some of those things. Let me now turn to Bill Dudley to discuss Desk operations. Bill, if you would, also talk about some of the proposals for expanding liquidity support. Thank you. MR. DUDLEY. 1 Certainly. Thank you, Mr. Chairman. The financial market environment has improved markedly since mid-March. However, concern about the circumstances that led to the demise of Bear Stearns may have provided added impetus to the ongoing deleveraging process. The result has been improvement in the broader equity and fixed-income markets but heightened term funding pressure within the financial system. Turning first to the broader markets, improvement is evident across most broad asset classes both in the United States and abroad. As shown in exhibit 1 of the handout in front of you, the broad U.S. equity indexes have recovered much of their earlier losses. Although the financial sector still lags behind, financial share prices have, in the aggregate, recovered more than 10 percent off their mid-March trough. Credit markets have also improved. As shown in exhibit 2, corporate credit spreads in both the investment-grade and the high-yield sectors have narrowed somewhat. Moreover, global credit default swap spreads—as shown in exhibit 3—have fallen significantly. As shown in exhibit 4, measures of implied volatility in the Treasury, equity, and foreign exchange markets have declined. Signs of a recovery in risk appetite can be seen very clearly in the subprime mortgage-backed securities market and the municipal securities market, both which 1 The materials used by Mr. Dudley are appended to this transcript (appendix 1). April 29–30, 2008 5 of 266 had earlier experienced significant distress. Exhibit 5 shows the price performance of the AAA-rated tranches of the last four ABX subprime vintages. As can be seen, the AAA-rated tranches have recovered even though housing activity and home prices have continued to decline at least as fast as anticipated. In the municipal market, crossover buyers have entered, attracted by municipal bond yields that exceed those available on Treasuries of comparable maturities. As seen in exhibit 6, although the ratios of tax-exempt to Treasury yields of comparable maturities remain elevated, there has been considerable improvement during the past two months. This improvement has occurred even though the outlook for the monoline financial guarantors remains poor. Ambac’s announcement last week of a $1.7 billion loss in the first quarter made—thus far—barely a ripple in the broader market. The introduction of the primary dealer credit facility (PDCF) seems to have helped to stabilize the repo markets. That improvement, in turn, has caused the equity prices of the four remaining large investment banks to recover somewhat and their credit default swap spreads to fall sharply (exhibits 7 and 8). The PDCF backstop facility also appears to have helped break the negative dynamic of higher haircuts, forced asset sales, lower prices, higher volatility, and still higher haircuts that was in place in the weeks leading up to the Bear Stearns liquidity crisis. Although the collateral haircuts set by the major dealers for their hedge fund clients in our April 9 survey—shown in exhibit 9—are considerably higher than in the previous month, our contacts indicate that this rise occurred mostly around the time of Bear Stearns’s demise. Over the past few weeks, haircuts have stabilized. Despite the improvement in the broad market indexes and in the equity prices and credit default swap spreads of most major financial firms, term funding pressures have intensified rather than subsided. As shown in exhibits 10 and 11, the pressures have been evident at both the one-month and the three-month tenures in the United States, the euro area, and the United Kingdom. The additional deleveraging by the investment banks following the demise of Bear Stearns may have intensified the pressure on commercial bank balance sheets or the urge for banks to delever. The LIBOR indexes took a jump upward following a Wall Street Journal article that alleged that some of the 16 LIBOR panelists were understating the rates at which they could obtain funding. The British Bankers Association reacted by threatening to throw out any panelist that was not wholly honest in its daily posting of its costs of obtaining funds at different maturity horizons. The BBA announcement appears to have provoked an outbreak of veracity among at least some of the panelists. As shown in exhibit 12, the LIBOR fixing rose nearly 20 basis points in the few days immediately after the article. The dispersion in offered rates between the highest and lowest posting banks also increased. There is considerable evidence that the official LIBOR fixing understates the rates paid by many banks for funding. For example, as shown in exhibit 13, the all-in cost of FX swap financing into dollars out of euros has recently climbed to more than 30 basis points above the cost of LIBOR funding. April 29–30, 2008 6 of 266 The term funding pressures appear to be mainly the consequence of the deleveraging process that is still firmly under way. Balance sheet capacity has become strained in three ways. First, pressures to carry more assets on the balance sheet have increased in a number of ways. For example, some types of assets can no longer be securitized, and balance sheet assets are created when lines of credit are drawn upon. Second, loan-loss provisions and mark-to-market losses have cut into capital, at least until recently, faster than banks have been able to raise new capital. Third, desired capital ratios have undoubtedly risen as financial markets have become more volatile and the macroeconomic outlook has worsened. These pressures have sharply pushed up the shadow price of balance sheet capacity, and term funding spreads undoubtedly reflect that pressure. As evidence, note how the spread between jumbo and conforming fixed-rate mortgage yields in exhibit 14 has mostly tracked the trajectory of term funding spreads shown in exhibit 13. Because banks can securitize conforming mortgages but not jumbo mortgages, this widening spread likely reflects the rise in the shadow price of balance sheet capacity. The term funding pressures have also been evident in the strong demand exhibited in our biweekly TAF auctions. As shown in exhibit 15, the spread between the stop-out rate and the minimum bid rate has risen sharply since late January, despite the large rise in the size of the TAF auctions over this period. In contrast, the demand by primary dealers to borrow Treasury securities in our term securities lending facility (TSLF) has been less intense. It is unclear whether this reflects the large and immediate scale of these auctions ($175 billion offered over four weeks) or less need by primary dealers, who rely heavily on secured repo borrowing for their short-term funding needs. As shown in exhibit 16, two of the five auctions have not been fully covered. Besides providing liquidity to the primary dealers, the TSLF auctions have helped to generate a dramatic improvement in Treasury market function. As shown in exhibit 17, before the first TSLF auction, overnight Treasury repo rates were unusually low, and the Treasury market was distorted by a growing number of security failures (that is, dealers were unable to deliver promised securities) and a large number of securities trading special (that is, with a repo rate below the rate on general Treasury collateral). So have the TAF and TSLF auctions been helpful in improving market function? Although it is impossible to know what the counterfactual would have been without the auctions, most evidence suggests that these auctions have improved market function. Although a recent study by John Taylor and John Williams found no statistical evidence that the TAF auctions have had an effect on term funding, the choices in terms of econometric design made it very difficult for this study to have found an effect. Interestingly, minor changes in the specification used by Taylor and Williams produce statistically significant results with the expected sign—in other words, the TAF auctions reduced the spread. They say that a picture is worth a thousand words. Exhibit 18 documents the Federal Reserve’s major initiatives over the past eight months relative to the LIBOR– OIS spread. Note that virtually all the Federal Reserve initiatives aimed at improving April 29–30, 2008 7 of 266 market function have been associated with a decline in the LIBOR–OIS spread. Perhaps this just represents an announcement or placebo effect. More study is obviously needed. However, it is interesting that those market participants who are the patients have been clamoring for more medicine in the form of both an increase in the size of the TAF auctions and auctions with longer maturities. As the equity and credit markets have improved, market participants have reduced their expectations of the magnitude of further monetary policy easing. As shown in exhibit 19, the federal funds rate futures curve has shifted upward and is virtually flat around 2 percent from May though September—implying that market participants expect that tomorrow will likely be the last easing in this cycle. The Eurodollar futures curve, which is shown in exhibit 20, has shifted up even more sharply since the last FOMC meeting. In part, this reflects the rise in term funding spreads and, most important, the view that these spreads are likely to remain elevated relative to the target federal funds rate for the foreseeable future. Our Survey of Primary Dealers undertaken about ten days before each FOMC meeting shows more stability in dealer expectations (exhibits 21 and 22). Note that the dealer forecasts now anticipate somewhat greater easing than implied by the federal funds rate futures market and the Eurodollar futures market. This is quite different from the pattern in previous months. The average of the dealer modal forecasts has a trough in yields of about 1.50 percent, about ½ percentage point below the market forecast. In terms of this week’s meeting, there is little disagreement between the dealer survey and market participants. All 18 of the primary dealers that responded to our survey anticipate a rate cut at this meeting, with nearly all in the 25 basis point rate cut camp. As shown in exhibit 23, this is slightly more aggressive than the expectations embodied in federal funds rate options, which are pricing in a probability of a 25 basis point easing of almost 80 percent. The shift in interest rate expectations cannot be explained easily by developments on the inflation front. Although the continued surge in crude oil prices has pushed aggregate commodity indexes, such as the GSCI, higher, agricultural and industrial metal prices have been much more stable in recent weeks (exhibit 24). Despite the rise in energy prices, market-based measures of long-term inflation compensation have fallen in recent weeks. For example, as shown in exhibit 25, both the Board’s and Barclays’ fiveyear, five-year-forward measures have declined about 40 basis points from the peak reached in early March. Turning to the Desk’s operations, we get mixed grades over the intermeeting period. On the one hand, we have done a pretty good job of hitting the target on average (through yesterday, the daily effective rate since the last FOMC meeting was a miraculous 2.25 percent). On the other hand, this average conceals considerable intraday and day-to-day volatility. This can be seen in exhibit 26, which charts the daily federal funds rate range and the daily average effective rate. Notice how wide the daily range of trading has been. This reflects three factors: (1) the demand by European banks for federal funds, which has often caused the federal funds rate to be elevated early in the day before Europe closes; (2) stigma associated with primary April 29–30, 2008 8 of 266 credit facility (PCF) borrowing—the PCF rate is not a firm cap on federal funds rate trading; and (3) large unanticipated shifts in the autonomous factors that affect the level of reserves in the banking system—especially shifts in the level of PCF and PDCF borrowing. Note the big rise in PCF and PDCF borrowing since mid-March and the large daily shifts in the level of this borrowing shown in exhibit 27. We have little ability to forecast these daily shifts in borrowing. Thus, these shifts are mostly unexpected and do increase the volatility of the federal funds rate. Finally, let me briefly outline a number of policy recommendations for which we seek your approval. First, I will need approval for domestic operations. There were no foreign operations. Second, as noted in the memo that was circulated to you last week, we are recommending that the outstanding swap lines with Canada and Mexico be renewed for another year. Third, the staff is recommending approval of an increase in the size of the foreign exchange swap facilities with the European Central Bank and the Swiss National Bank. This recommendation is discussed in more detail in a memo that was distributed to the FOMC last Friday. For the ECB, the recommendation is to increase the size of the swap line to $50 billion from $30 billion, and for the SNB, to $12 billion from $6 billion, with maximum draws on these facilities of $25 billion and $6 billion, respectively. We also recommend extending the term of these swap facilities to January 30, 2009, from September 30, 2008. As before, these swap lines will be used in conjunction with our TAF auctions to increase the amount of 28-day term dollar funding available to banks with operations in the euro area and in Switzerland. At the same time, we understand that Chairman Bernanke intends to use his delegated authority from the Board to increase the size of the TAF to $150 billion from $100 billion. Fourth, we recommend that eligible collateral for the TSLF be broadened to include AAA-rated asset-backed securities (ABS). Currently, as you know, this facility accepts only AAA-rated residential-mortgage-backed securities and commercial-mortgage-backed securities. We believe that broadening the eligibility to AAA-rated ABS will help support the availability of consumer credit, including credit card, auto, and student loan credit. Spreads in AAA-rated ABS backed by auto loans and credit card receivables have risen sharply over the past six months even though the deterioration in the underlying performance of the assets in terms of delinquency and loss has been well within the bounds of past cycles. We do not recommend increasing the collateral eligibility by greater breadth than this. As we noted in last Friday’s memo, including additional classes of securities could increase operational costs to an extent that is not likely to be warranted by the marginal benefits. It could also expose the System to the risks associated with a range of complex structured finance products and, in the case of AAA-rated corporate securities, would not provide much benefit because the amounts of such securities outstanding are relatively small. Under this proposal, the maximum size of the TSLF would remain unchanged—at $200 billion—as would the other terms of the facility. I also want to inform the Committee of a small technical change that the staff plans to make in the TSLF program. We plan to eliminate the requirement that April 29–30, 2008 9 of 266 eligible AAA-rated securities not be on watch for downgrade. We plan to make this change because we have found that enforcing this rule has been very difficult operationally because the two clearing banks that manage the triparty repo system have a limited ability to perform this monitoring function on our behalf. In addition, I would point out that the added risks from this change are very small. If securities were downgraded, the primary dealer would have to substitute new eligible collateral. Also, it should be pointed out that the PDCF accepts most investment-grade securities—thus, we already have a broader collateral regime in place for our other primary dealer facility. CHAIRMAN BERNANKE. Thank you. Let’s have questions for Bill on financial markets, and then we will come back to a full discussion of the proposed actions. Questions for Bill? No questions? That is unusual. Yes, President Lacker. MR. LACKER. About consumer-loan-backed securities, spreads have widened and delinquencies and defaults have increased, but not out of line with past experience. You seem to have inferred that spreads have widened more than is warranted by the return on those securities. I would be interested in what computational exercises or what other analytics you and your staff have undertaken to document the hypothesis that these spreads are not warranted by the fundamentals. MR. DUDLEY. I am not so much saying that they are not warranted. I am saying that the spreads have widened a lot relative to the actual experience, given that we are in a period of weaker economic growth. The stress seems to be more on the spreads that the market is demanding for these assets as opposed to a deterioration in the underlying credit card loans or auto loans that back those assets. CHAIRMAN BERNANKE. Other questions? If not, let me just say a word or two about the proposed liquidity measures. First, as Bill noted, the interbank and short-term funding markets remain under some stress. In particular, as you know from the picture, the spreads in the dollar interbank market have gone above the U.K. and ECB markets. Although it is certainly April 29–30, 2008 10 of 266 difficult to identify precisely the size and the significance of the effect of our liquidity facilities, not just the banks and the market participants have been in favor of them. We have received very good reviews from international agencies such as the IMF, the OECD, and others, and I do think that it is worth continuing these efforts to try to strengthen liquidity availability. Therefore, with respect to interbank markets, first, as mentioned, I propose to use my delegated authority to increase the size of the term auction facility. Second, I would like to ask the FOMC to approve increases in our swap lines and an extension of the duration of the swap lines with the European Central Bank and the Swiss National Bank. As now, they would be auctioning money at the same time that we do in our TAF. The swaps with Canada and Mexico are routine. We have done these for a number of years. As I promised you at an earlier meeting, I checked with the Treasury, and they are all in favor of maintaining these facilities. I think it would be rather odd to end them at this particular juncture, so I ask for renewal of those swap lines as well. On the TSLF, the auctions that we have had have been undersubscribed, which may be good news. On the other hand, it may have something to do with narrowness of the collateral that is accepted. The TSLF is intended to help the functioning of the Treasury market because it puts more Treasuries into circulation. We do have some evidence that Treasuries are trading at lower spreads and with less volatility since we began these activities. In addition, there is some support for the collateral that is taken and general liquidity support for the market, although, again, it is really both sides of this equation that we are looking at. The current collateral that is accepted at the TSLF is basically RMBS and CMBS. The proposal is to increase the range of collateral to include AAA asset-backed securities, which include credit cards, auto loans, and student loans—basically mostly consumer-oriented credit. I think it makes a lot of sense in the April 29–30, 2008 11 of 266 context of what we have been doing. It would make the range of collateral more similar to that in our other facilities. It also would reduce the credit allocation aspects by broadening the range of collateral that we accept. On the other hand, as Bill mentioned, unless the situation becomes radically different, we probably don’t want to extend beyond this because of difficulties in assessing the credit quality of other assets. I put this item on the meeting agenda for your discussion because there are some political and public relations complications, and I wanted just to be up front and let you know what they are and get your response and your views. As you know, the student loan market has been dysfunctional, and we have received requests—perhaps you have as well—to do “something” about this problem. We received letters, probably about a month ago, from some House members, including Congressman Kanjorski, who asked us to extend our lending authority beyond the current institutions to others. I assume Sallie Mae, for example, would have been a possibility. We wrote back a very clear letter saying that we could not do that; that our 13(3) authority was reserved for unusual and exigent circumstances, which we interpreted as being systemically relevant circumstances; that the bar was very high for the use of that authority; and that, although we certainly want to strengthen the liquidity in the general markets, we didn’t see this as being a possibility. We received a second set of letters a couple of weeks ago, really one letter signed by a number of senators, mostly from the Senate Banking Committee, asking specifically that we expand the collateral in the TSLF to include student loans. Now we have the problem that this would do that, along with other much more significant, in terms of size, consumer loans. We wrote back to Senator Dodd and his colleagues last week and told them that, although we of course are always looking to improve the liquidity of markets and, in particular, we think student April 29–30, 2008 12 of 266 loans are a very worthy type of credit, we didn’t see the argument. First, student loans are already accepted as collateral in our other three facilities—the TAF, the window, and the PDCF. Second, we argued that the real problem with the student loan situation is on the legislative side. In particular, recent legislative changes have reduced the spreads that private-sector lenders can get from student loans. Given the increase in funding costs, they have become unprofitable, and so many lenders have withdrawn from that market. So we didn’t give any encouragement in that letter. That being said, if we take this action—which was suggested by the staff and which is, I believe, fully justified on its own merits—it would be part of a broader package, and I think we would get two different reactions. On the one hand, we would get, I would call it for short, a Wall Street Journal editorial that the Federal Reserve is once again the craven cur and the spineless—boy, I am getting good at this—[laughter] lackey of the Congress by accommodating this request. I take that seriously. I’m sure we all take seriously even the perception that we are catering to this request. On the other side, I suppose that there would be what I could call the USA Today editorial, which is, “Why won’t the Fed, which is bailing out Wall Street left and right, include asset-backed paper in their facilities, even though it is consistent with all of their other practices and they take it in all of their other facilities?” and so on. So I think there are PR and political risks on both sides of this. I am not going to try to downplay those, but I do think that on the substance this is a good move, and I will just put this on the table for your questions or comments. If a significant number of members of the Committee are uncomfortable with proceeding—and what we would do if we proceed is to put this all together in a package to be announced with the Europeans and the Swiss on Friday morning—then I would certainly be willing to table this last item. So let me open the floor for any comments. President Lacker. April 29–30, 2008 13 of 266 MR. LACKER. I think the political concern you raised and described is a very, very serious one for this institution. Even if we thought of this ourselves before Senator Dodd and others wrote to us—and apparently it is true that we did—we are never going to be able to convince a broad array of observers that this was not a direct response to a senatorial request. Given that, I think the perception that we included this and maybe added some other securities as a fig leaf sets just a disastrous precedent. It would be the use of our balance sheet to circumvent the checks and balances of the constitutional process for legislating about fiscal matters. I think that the integrity of our independence as an institution relies, to a substantial degree, on our lack of entanglement or our distance from the political fray. I would also question the value of this on the substance. What we are doing with the TSLF, as Bill’s chart showed, looks as though it has had a big effect on the GC repo rate. It is hard to see how some additional amount of Treasuries in the market, given the size of the Treasury market, is going to have a gigantic effect. It is also hard to see that there is much strain or dislocation caused by the most recent observation in his graph on the gap between the funds rate and the GC repo rate—which is actually, what, like 10 or 20 basis points or about what it has historically been. So I would question whether we really need this on the substance as well. On the other measures, the TAF is dominated by European institutions. Term funding spreads seem dominated by the term funding demands of European institutions. I don’t see why we don’t try to shift to European institutions the public policy responsibility for managing those situations. We already have an apparently well-functioning mechanism for supplying dollar balances to foreign official institutions to allow them to do that. I don’t see why we don’t limit our expansion of funding in that direction—to the swap lines—rather than expanding the TAF. Thank you. April 29–30, 2008 14 of 266 CHAIRMAN BERNANKE. President Hoenig. MR. HOENIG. A question—and just remind me—if we bring the student loans and these other assets in under this facility, do we have the right to swap out if the rating changes or questions come up? MR. DUDLEY. Yes. They are priced every day; and if they are downgraded, there will be an automatic substitution. So you are protected both on price and on the ability to substitute. MR. HOENIG. That was my first question. The second is that we have been entangled before in appearance issues. If we feel that we are doing the right thing, that doesn’t give me much concern. On the substance, do you judge that the tightness in the market is such that this action is necessary to facilitate liquidity, or will this only marginally improve things? If it is marginal, the appearance issue becomes more entangled, I think. If it is pretty clear that we have some liquidity issues and that this will address them, then I would feel much more comfortable with it. MR. DUDLEY. Well, I think the honest answer is that we don’t really know exactly where it is on the continuum of very modest to substantive. One thing we can say is that this should increase the demand at the TSLF auction, so it should increase the likelihood that more of the Treasuries are actually put into the market in exchange for such collateral because we are broadening the eligible collateral. But I don’t think the notion that this is a panacea is true. CHAIRMAN BERNANKE. Vice Chairman. VICE CHAIRMAN GEITHNER. I want to say just one thing in this context. The Chairman alluded to this, too. I think there is some value in taking this opportunity now to try to get a better balance in the relative attractiveness across these facilities. So in the scheme of things, it is better for us for the auction type of facilities to be relatively attractive compared with April 29–30, 2008 15 of 266 the open facilities for which demand is unknown and we can’t calibrate it—those are much bigger reserve-management things. I think our exit strategy from these things is easier if we evolve in that direction. One virtue of the package that the Chairman presented is that it is worth taking another shot at trying to get those interbank term premiums down in dollars because—to use a technical term—they are screwing up the transmission mechanism of U.S. monetary policy now. We are not quite sure how much effect we can have. There is a plausible case that increasing the size of the swaps will help on that front. It is worth doing now. Second, the broader package will buy a little more insurance against the risk that these liquidity pressures reignite and we have another wave of the adverse dynamic margin-spiral-downward-self-feeding thing. It is better to do that when other things are improving rather than wait until we are again at the edge of the abyss, although that is a tactical judgment. It is hard to know for sure. I think that Bill is absolutely right. It is not clear how much incremental benefit the expanded collateral in the TSLF will offer. We can’t be sure. But, Jeff, it won’t come because we are increasing the size of the TSLF. That would increase the amount of Treasuries we are putting in, and we are not increasing the size. It would come only through what effect it might have on the broader range of asset-backed securities we have there. Remember, at the beginning we framed this as an effort to address some unique constraints operating on securitization markets, particularly in ABS. So there is a possibility of some additional benefit in those markets—some greater insurance against another downward spiral in that case—but not that high. It is hard to judge the merits of that against the appearance risk you presented, but I think this is designed pretty carefully to be robust to that perception problem. Our job is to do what makes sense and what we can defend as sensible in this context, and we have to be prepared to April 29–30, 2008 16 of 266 do that even if people have made it awkward for us to do the right thing because of the perception problem. CHAIRMAN BERNANKE. President Rosengren. MR. ROSENGREN. Well, I certainly agree with the last statement that we should do what makes sense, and in this case, differentiating between kinds of collateral that are all AAA doesn’t make sense to me. We should broaden it out. I would say that in your presentation you didn’t have the asset-backed commercial paper market, but those rates actually have been quite elevated. Some rollovers for some of the large banks have not been working all that well, and the assets that tend to be in those conduits are the very assets we are talking about expanding. They are the student loans, the auto loans, and the various other things that go into these conduits. So I don’t know how big an effect it would be, but if you look at the asset-backed commercial paper rates, they would look a lot like the LIBOR rates. I think that there might be some net benefit, and it certainly does make sense to me that we would expand. There is no reason to differentiate among AAA collateral that has many similar attributes. CHAIRMAN BERNANKE. President Lacker, a two-handed comment? MR. LACKER. Yes. Mr. Chairman, you motivated the expansion of the term securities lending facility by the effect it would have by increasing the amount of Treasuries in the market. Vice Chairman Geithner, you appealed to the effect it would have on the asset-backed securities that would be offered on the market. We didn’t discuss the asset-backed securities market, except that I had this exchange with our Manager. I am not aware of any evidence that there is something wrong with the fundamentals of those markets. Now, admittedly, it is not clear that many of our arguments for some of these facilities have been based on some careful diagnosis of April 29–30, 2008 17 of 266 fundamentals. If this is about those asset-backed securities markets, that is another thing entirely. I was a little confused about that and wondered about the rationale. CHAIRMAN BERNANKE. I may have misspoken, but I think I had in mind both sides of the equation. The Treasuries have certainly responded. It’s harder to judge on the asset side, but I guess that the premise is the same—that all of these markets are suffering from withdrawal of the normal liquidity provision of money market mutual funds and other, less sophisticated investors. Banks and others are finding it hard to finance those assets, and that’s the liquidity backstop that we provide. So I think on both sides. MR. DUDLEY. If I may come back to the issue of the AAA securities and the spreads, those are AAA-rated securities for which the spread has widened hundreds of basis points. If the loss experienced is not unusual relative to the cycle, then it’s hard to understand why AAA-rated securities would be selling at several hundred basis points over Treasuries. It is impossible to square that circle. CHAIRMAN BERNANKE. Yes. MR. LACKER. If the payoff for those securities is unexpectedly low, it is likely to happen in a circumstance in which the economy is doing awfully poorly. Risk premiums are about variances and risk aversion, but they are also about correlation with aggregate states. Arguably, that would rationalize a widening of the risk premiums attached to a wide range of securities, mortgage-backed included. We have yet to see any evidence from our staff refuting that interpretation of the widening spreads we have seen. Mr. Chairman, with all due respect, what you describe is a lack of demand. I am not sure how that squares with viewing the market as somehow malfunctioning. April 29–30, 2008 18 of 266 CHAIRMAN BERNANKE. Well, we have seen the breakdown of a particular structure of lending that was based on the credit ratings. The credit ratings have proven to be false. Therefore, there is an informational deficit—an asymmetric information problem, would be my interpretation—which has, in turn, triggered a massive change in preferences. But I don’t think we are going to settle this at the table here. President Evans. MR. EVANS. Thank you, Mr. Chairman. The question that I have gets to the appearance issue, and it is not really about the immediate concerns. To the extent that the markets are not functioning that well, this could be useful, and so I don’t really have any disagreement with that. But the facilities that we are talking about currently have a temporary nature to them. The term auction facility is temporary, although of course the Board could make it permanent. The term securities lending facility is an expansion of a program. What’s the permanence of that and the primary dealer credit facility as well? As we allow other forms of collateral to be taken, what implications might that have for the future if we try to make these more permanent? This is simply a question; I don’t know what the answer is. Do we feel comfortable with these forms of additional collateral on a permanent, ongoing basis, if we were to do that; or do we think it would be possible to turn that off? How costly would it be? CHAIRMAN BERNANKE. The TSLF and the PDCF are emergency measures, and barring congressional action, we cannot maintain them. Presumably, they will be phased out as markets improve. If we are doing these things, I don’t see the argument for one set of collateral versus another. President Fisher. MR. FISHER. Along those lines, Mr. Chairman, I viewed these facilities as a liquidity bridge, an aqueduct, to getting over this credit crunch that we have had. I am not as concerned about having this facility accept the same collateral as the other facilities. I do have a question April 29–30, 2008 19 of 266 about the permanence, and it is a different kind of question, which is whether or not the Congress will encourage us to make these permanent. I think that is a risk, and we need to think about it. I don’t have an answer. I have been on the receiving end, as you may know, of enormous pressure from the Texas delegation on the student loan business, and we have talked about it with the staff quite a bit. I quoted you in my response, by the way, in your first series of letters. It doesn’t bother me to have egg on my face if we are doing the right thing—again, having the same collateral regime as we have for our other facilities. I am more worried, however, about whether it encourages them in interfering with the temporary nature of these facilities. That is just one point to think about. I have a question about the TAF—just to make sure that I understand. We are talking about taking it to $150 billion in outstandings—is that correct? CHAIRMAN BERNANKE. Yes. MR. FISHER. So $75 billion auctions. Okay. The third point, which is about optics, is a little different. I don’t know what we’re going to come out with in terms of policy. I know what my preferences are, and I sense what some other people’s preferences are. I’m a little concerned that we have to be able to express this in a way that doesn’t look as though we see something that no one else sees. So we need to think about that and the way we articulate it. The last time we had a disconnect between an action on the fed funds rate and agreeing to something and announcing it internationally, it didn’t really work well. They read more into it than was there. We all understood why we were having that time disconnect—it was because we needed to line up our ducks with our foreign counterparts. Maybe we should think about that as well—whether we should move it up to the same time that we announce the action of this Committee on the fed funds rate. I don’t know if that is physically possible. But I wouldn’t want in any way to convey that we see something that other people don’t see, that there is a problem in these particular April 29–30, 2008 20 of 266 markets. Everybody knows that GE is trying to sell a $40 billion credit card portfolio and they are not getting any bidders. So I can see the devious minds, or the minds of those who don’t necessarily think well of us, linking all these little pieces together and saying that we’re reacting or overreacting to something that may not be there. I just wanted to put that on the table for you to think about. I am not against the concept, since we have already gone down this path, of making this subject to the same collateral regime. But I do think—and I am glad you raised the subject—that, though I have interpreted it differently, we have to be concerned about the optics here. CHAIRMAN BERNANKE. President Fisher, the timing is dictated by the preference of the Europeans not to be tied into our monetary policy decision and the fact that Thursday is a European holiday. The problem you were alluding to earlier had to do with the very strong market expectation that we were going to act on liquidity measures. We disappointed both on that and on the rate. That was why we got the strong reaction, and there’s no such expectation to my knowledge here. At the same time, our press release, which we have already looked at in draft, and market expectations are very focused on the LIBOR issue and the interbank issue. Given that we have done so many steps in this direction, I don’t think that this would be misinterpreted as anything particularly overdramatic. MR. FISHER. Mr. Chairman, may I just raise one other point? I think President Lacker touched on this. I am concerned, in terms of the eventual optics, about the fact that the TAF is being drawn on predominately by foreign banks. My numbers here are that the last one was 78 percent foreign bank participation and the previous one was 91 percent. I think there we may have some political vulnerability. Again, I just put it on the table for us to consider. I am almost more worried about a backlash on that eventually than what we are talking about currently. April 29–30, 2008 21 of 266 CHAIRMAN BERNANKE. The problem is that European banks are structurally deficient in dollars and they have a time zone shift. It is a dollar market. MR. FISHER. It has been well presented. It’s hard to explain to a politician. That’s my point. CHAIRMAN BERNANKE. Governor Kohn. MR. KOHN. Thank you, Mr. Chairman. On the last point, I think it is helpful to expand both the swaps and the TAF at the same time. People understand that there are pressures in these funding markets, and we can address them both at home and abroad. They do feed back on our market, so I guess I am not too worried about that one. Also, it is quite logical to do the swaps and the TAF. I don’t see any issue. On the TSLF, I have been thinking about it less on the Treasury side than on the other side. I don’t think the TSLF will increase the demand for holding these securities in any major, direct way. My hope is that, sort of around the margin, it would make dealers more willing to make markets in them and to be on both sides of the market, including the buy side from time to time, because then they would see that they had a place to finance those securities if, at the end of the day, they had more. So if it helps, it will help the liquidity of those markets rather than increasing the ultimate demand for the securities. I think it is an indirect thing. My guess is that it might help at most around the margins. I don’t see how it can hurt. There is a certain logic to it. I don’t think it will help the student loans at all. The structural issues are just overwhelming any of the other issues in that line. If somebody asked you, Mr. Chairman, whether this was aimed at student loans, I think you could say that they just were along for the ride in the sense that they were part of the AAA ABS market and that we didn’t have any expectation that expanding that market would help them. Thank you. April 29–30, 2008 22 of 266 CHAIRMAN BERNANKE. Okay. President Bullard. MR. BULLARD. I am the new guy, but I will just put in my two cents here. Everyone seems to agree that there is no quantitative impact. I can’t see any quantitative impact. There are political implications. I don’t see why we are doing it. CHAIRMAN BERNANKE. To repeat what Bill said, I think it is hard to measure the quantitative impact, but my guess is that there is some. But the point is well taken. What I would like to do is go through the first votes, and then we will take a straw vote on the TSLF, and then decide what to do. Okay? First, we have to ratify domestic open market operations. MR. KOHN. So move. CHAIRMAN BERNANKE. No objection? Okay. Now the swap agreements with Canada and Mexico. MR. KOHN. So move. CHAIRMAN BERNANKE. Is there anyone who wants a roll call on this? Okay. If not, then no objection. Extend and expand the swap agreement with the ECB. MR. KOHN. So move. CHAIRMAN BERNANKE. Is there anyone who wants a roll call on this? Okay. Then, without objection. Expand and extend the swap agreement with the Swiss National Bank. MR. KOHN. So move. CHAIRMAN BERNANKE. Without objection. Okay. Now, on the TSLF, the proposal is to include this as part of the package. There will be no change to the facility except for the increase in the collateral range, to include AAA asset-backed securities. Are there any further comments on this? I am going to ask for a straw vote, just to get a sense. Abstentions are fine. If there are no further comments, how many people are in favor of this? I see 10, I think. April 29–30, 2008 23 of 266 MS. YELLEN. Are you asking voters only? CHAIRMAN BERNANKE. I’m sorry? MR. FISHER. Are you asking voters only or the entire table? CHAIRMAN BERNANKE. I would like to get a sense of all participants, if that is okay. Thirteen participants are in favor. All right. All participants against? Okay. Let’s go ahead and take a vote on this, then. Is there anyone who wants a roll call vote? If not, then no objection. MR. KOHN. So move. CHAIRMAN BERNANKE. No objection. Thank you. Let’s turn now to the economic situation. Dave Stockton. MR. STOCKTON. Nathan and I thought that we would alter slightly the structure of our briefing today so as to focus a bit more closely than usual on the global and domestic outlooks for inflation. I’ll start with a brief review of recent economic developments and our outlook for economic activity in the United States. Nathan will then discuss trade and foreign activity before turning to global commodity markets and our forecast for import prices. I will then explain how both foreign and domestic influences are shaping our outlook for U.S. inflation. Brian will conclude by presenting your forecasts. Let me turn first to the domestic economy. From a forecasting perspective, this intermeeting period turned out to be reasonably tranquil, at least by the standards of the past nine months. The incoming data were very close to our expectations and required few adjustments to either top-line GDP or to the individual components of spending. As we noted in the Greenbook, we continue to think it likely that the economy is in recession; and, with the data evolving pretty much as we had expected, we have seen little reason to back away from that call. Readings from the labor market support the view that, at the very least, a pronounced deceleration in aggregate activity is under way. Private payrolls fell about 100,000 in March, the third consecutive month with a drop of that magnitude, and the unemployment rate moved above 5 percent. Moreover, a notable weakening of labor markets is signaled by most of the indicators that we monitor. Surveys of hiring plans have continued to move lower; there are fewer job vacancies; businesses report that jobs are easier to fill; and household attitudes have continued to sour, including their views of the labor market. In the past, such a configuration of readings has been a reasonably reliable indicator of cyclical downturn. April 29–30, 2008 24 of 266 The spending data also have been consistent with our forecast of a marked weakening in aggregate demand and activity. After posting modest gains last year, consumer outlays and business equipment spending appear to have been at a near standstill since the turn of the year. Meanwhile, housing continues its steep descent and looks to be on track to subtract about 1½ percentage points from the growth of real GDP in the first half of the year—close to our March projection. Moreover, while we had anticipated a sharp deceleration in nonresidential construction in response to more-difficult financing conditions, that sector now appears to be turning down earlier and more sharply than we had projected. Finally, much as we had been expecting, weak domestic demand is receiving some offset from ongoing solid gains in exports. All told, we estimate that real GDP rose at an annual rate of ½ percent in the first quarter, just a few tenths above our March forecast. As you know, tomorrow morning, the BEA will release its advance GDP estimate for the first quarter. For the second quarter, we are projecting real output to decline at a 1½ percent annual rate, a few tenths weaker than our March forecast. On net, the outlook for activity in the first half is basically unchanged from the time of the last meeting. Looking further ahead, our medium-term forecast also hasn’t changed much over the past six weeks. The stock market is more than 5 percent higher than we had anticipated. But the favorable effects of that development on activity are nearly offset by the adverse effects of lower house prices and higher oil prices. Consequently, the GDP gap at the end of next year is unchanged from the March forecast. Our basic story remains the same. The contraction in activity that we are projecting over the first half of the year is expected to be relatively mild because of the boost to spending and activity from the tax rebates and because export demand remains solid. In the second half, real GDP turns up, but I wouldn’t really term this a recovery. After all, real GDP is projected to grow less than 1 percent at an annual rate, employment continues to decline, and the unemployment rate runs up to 5¾ percent. But we see a number of factors fostering a more noticeable acceleration of activity to a pace above its potential by 2009. First, the contraction in residential investment abates. Second, the drag on consumption growth from the rise in oil prices wanes. Third, financial conditions stabilize and then begin to improve, gradually reducing restraint on household and business spending. Finally, we assume that monetary policy remains accommodative. With the growth in real GDP running 2¾ percent next year, about ½ percentage point above the pace of potential, the unemployment rate drops slowly to 5½ percent. Obviously, there are large risks on both sides of our projection. On the upside, we could just be flat-out wrong about an imminent contraction in aggregate activity. Claims were running about 360,000 at the time of the March FOMC and are now averaging about 370,000. While that increase suggests some further softening in the labor market, the level of claims seems lower than would comfortably fit our forecast of payroll employment declines averaging about 160,000 over the next few months. Likewise, industrial production has weakened but hasn’t dropped off much. Because April 29–30, 2008 25 of 266 we don’t expect manufacturing to be at the epicenter of this business cycle, we aren’t looking for a plunge, but we are forecasting more noticeable declines than we’ve seen to date. In addition, although last week’s numbers for shipments of nondefense capital goods in March were close to our forecast, the orders figures were firmer than we had expected. In sum, while the data have not pushed us away from our recession forecast, they haven’t convincingly confirmed it yet either. More broadly, with bond spreads down, the stock market up, and market expectations for the path of policy revised higher, the situation certainly looks less menacing than at the time of the March meeting. But while we would agree that the risk of a very bad tail event seems to have declined, we are not ready to join others in heaving a sigh of relief just yet about the modal outlook. For one, we still see no signs of a bottom in housing. New homes sales—we received the numbers after the projection was completed—declined more than 8 percent last month to a level that we thought would be the bottom in the second half of this year. A second concern centers on consumption. With oil prices running around $115 per barrel, consumers will be facing sizable further increases in gasoline prices over the next few months from already elevated levels. Also, given the steep declines in employment that we are projecting, incomes and income uncertainty will be taking a hit. We’ve taken those factors on board as best we can, and we are counting on the tax rebates to provide a powerful offset, but we can’t rule out a more adverse reaction to what will be an accumulation of bad news. Furthermore, while there has been improvement in the general tenor of financial markets, I suspect that we’ve only begun to see the effects of tighter credit conditions on borrowing and spending. That restraint could prove larger and more persistent than is implicit in our baseline forecast. Finally, the mild downturn in activity that we are projecting also suggests some downside risk. Our projected rise in the unemployment rate of 1¼ percentage points from its low point last year to its high point at the end of this year is small—smaller than occurred in either the 1990–91 recession or the 2001 recession. This time could be different, but as I noted in March, that argument should always give you pause. Nathan will now continue our presentation. MR. SHEETS. Much as Dave just described for the domestic economy, our forecast for economic activity abroad also is little changed from the last Greenbook. Recent data have come in consistent with our view that the slowdown in U.S. activity and the ongoing financial turbulence will leave an unmistakable imprint on economic growth abroad. But the extent of this imprint appears to be somewhat less pronounced than was the case in the high-tech-led recession earlier this decade, particularly for the emerging market economies. Thus we continue to see foreign growth stepping down from last year’s 4 percent pace to near 2 percent during the second and third quarters of this year, as foreign activity is constrained by the weakening U.S. economy and headwinds from the ongoing financial turmoil. With these factors projected to abate, we see growth abroad rising back to near its trend rate of around 3½ percent in 2009. April 29–30, 2008 26 of 266 Suffice it to say, the risks around this forecast remain significant. On the upside, China’s surprisingly strong first-quarter GDP growth—which we estimate was nearly 11 percent at an annual rate—highlights the possibility that growth in emerging Asia, and perhaps elsewhere as well, may remain more resilient than we anticipate. On the downside, the softer-than-expected German IFO data last week and the negative tone of the Bank of England’s recent credit conditions survey suggest that growth in Europe may slow more than we now project. The exchange value of the dollar, after falling sharply in the month before the March FOMC meeting, has rebounded somewhat during the intermeeting period. Against the major currencies, the dollar is up almost 2½ percent, with a particularly sizable gain against the yen. Going forward, we continue to see the broad real dollar depreciating at a 3 percent pace, reflecting downward pressures associated with the large (albeit narrowing) current account deficit. This depreciation is expected to come largely against emerging market currencies (including the Chinese renminbi), which have moved less since the dollar’s peak in early 2002. Turning to the U.S. external sector, we now see the arithmetic contribution from net exports to first-quarter U.S. real GDP growth as likely to be around 0.3 percentage point, down a few tenths from the last Greenbook. Recent readings on exports have continued to point to strength, but imports in February bounced back from their December and January weakness more vigorously than we had expected. For 2008 as a whole, we continue to believe that the demand for imports will be significantly restrained by the weak pace of U.S. activity and, to a lesser extent, by the depreciation of the dollar and rising prices for imported commodities. We thus see imports contracting nearly 2 percent this year. In contrast, exports are expected to post 7 percent growth this year, supported by the weaker dollar. The projected contraction of imports, coupled with still-strong export growth, suggests that net exports will contribute nearly 1¼ percentage points to U.S. GDP growth this year— the largest positive contribution from net exports to annual growth in more than 25 years. In 2009, import growth is expected to bounce back to around 4 percent as the U.S. economy recovers, and the positive contribution from net exports should accordingly decline to just under ½ percentage point. Oil prices have continued their apparently relentless march upward, with spot WTI now trading at $115 per barrel. Since your last meeting, the spot price of WTI has increased $6 per barrel, and the far-futures price has moved up almost $5 per barrel. Over the past year, spot oil prices have risen a staggering 80 percent. While the high level of oil prices appears to be taking a bite out of oil demand in the United States and other industrial countries, the demand for oil in the emerging market economies—particularly in China and India—has been supported by the resilience of GDP growth there. In addition, fuel subsidies in some countries (including India) have sheltered consumers from the effects of higher oil prices. In line with these observations, India’s state-owned oil company recently released projections indicating that oil demand in the country will increase 8 to 10 percent this year. April 29–30, 2008 27 of 266 The supply-side response to the rising demand for oil has been only tepid. Stated bluntly, OPEC remains unwilling—or unable—to increase its supply to the market. Indeed, OPEC has actually cut its production over the past two years. In addition, oil production in the OECD countries has been on a downward trajectory, primarily reflecting the decline in the North Sea fields and in Mexico’s giant Cantarell field. Mexico’s state-owned oil company recently indicated that, for the sixth consecutive year, additions to its reserves had failed to keep pace with production. The grim outlook for Mexico’s oil industry has prompted the government to consider allowing foreign investment in the country’s energy sector, a move that would require constitutional reform. Finally, although the potential supply from non-OECD nonOPEC countries is substantial, production continues to be hampered by inadequate infrastructure and by uncertainties about property rights and the stability of tax regimes. In the absence of any better approach, we continue to base our forecast on quotes from futures markets, which see oil prices as likely to remain high—at or above $110 per barrel—through the end of the forecast period. But the confidence bands around this forecast are exceptionally wide given uncertainties surrounding the outlook for oil supply and demand. Nonfuel commodity prices have also been on a wild ride of late. The prices of many of these commodities increased particularly sharply in January and February, before peaking in early March. On balance, our index of nonfuel commodity prices rose at a hefty annual rate of 50 percent during the first quarter. We project a further 13 percent rise in the second quarter, but—again in line with quotes from futures markets—we see these prices flattening out thereafter. The underlying drivers of the sustained run-up in the prices of nonfuel commodities have been broadly similar to those for oil—sharp increases in demand (particularly from emerging-market economies) coupled with typically lagging and often muted supply responses. Notably, however, moves in nonfuel commodity prices since the March FOMC meeting have been quite varied. For example, copper and aluminum prices are up whereas nickel and zinc prices are down. For foods, corn, rice, and soybean prices have risen while wheat prices have declined substantially. The overall strength of commodity prices continues to put upward pressure on inflation in many countries and to complicate life for central banks. Notably, in the euro area, 12-month headline inflation in March rose further, to 3.6 percent, well above the ECB’s 2 percent ceiling. In the United Kingdom, inflation pressures stemming from rising utility, gasoline, and food prices are likely to push inflation toward 3 percent during the summer, raising the risk that Mervyn King will be required to write another letter to the Chancellor of the Exchequer explaining why inflation has deviated from the 2 percent target. Concerns about the inflation outlook have limited the willingness of both the ECB and the Bank of England to cut policy rates to address slowing growth. Perhaps even more striking, faced with upward pressures on inflation from rising food and energy prices coupled with still-solid economic growth, central banks in a broad array of emerging market economies tightened policy over the intermeeting period. This group included China, Singapore, India, Brazil, Russia, Poland, Hungary, and South Africa. In addition, some countries April 29–30, 2008 28 of 266 have recently responded to social unrest and other strains brought on by higher food prices by restricting exports of foodstuffs, particularly rice, and this has exacerbated upward pressure on the global prices of these commodities. The run-up in commodity prices, coupled with the weaker dollar, has pushed up U.S. core import price inflation of late. Core import prices are now estimated to have increased at a 7½ percent annual rate in the first quarter, more than twice the pace of increase in the second half of last year. Prices of material-intensive imports (including industrial supplies and foods) are seen to have surged at a surprisingly rapid pace of 20 percent in the first quarter, on the back of the rapid rise in commodity prices. Prices of imported finished goods (including consumer goods, capital goods, and autos) are estimated to have risen at a comparatively muted rate of 3¾ percent, but this also was up sharply compared with recent quarters. The acceleration in finished goods prices seems well explained by recent moves in the dollar, however, and does not suggest any notable increase in the extent of exchange rate pass-through. Going forward, we see core import price inflation remaining elevated in the second quarter, at around 6 percent. Thereafter, core import price inflation should abate, given the projected flattening out of commodity prices and the slower pace of dollar depreciation. MR. STOCKTON. Before explaining how the global developments that Nathan just described intersect with our domestic inflation forecast, I should briefly review some of the incoming information on prices. For the most part, the recent consumer price data have been running below our expectations. At the time of the March Greenbook, we were estimating that core PCE prices had increased at an annual rate of 2¾ percent in both the fourth quarter of last year and the first quarter of this year. We now are projecting increases of 2½ percent and 2 percent in the fourth and first quarters, respectively. Although we are estimating that core PCE prices rose 0.2 percent in March—just a couple of basis points below our previous forecast—there were noticeable downward revisions to the data stretching back to late last year, principally for medical services and nonmarket prices. Just as we had discounted some of the earlier elevated increases in core PCE prices, we are now inclined to discount the recent more favorable readings. The small increases in medical service prices are not likely to persist. Moreover, some of the recent slowdown is attributable to nonmarket prices, which we view as both noisy and mean-reverting. Still, we don’t think all of the good news on core PCE prices of late should be written off; and all else being equal, we would have taken down our forecast for the year as a whole in response to the incoming data. But, of course, all else was not equal. As Nathan has noted, there has been another sizable increase in crude oil prices; the prices of non-oil imports have increased more rapidly than we had expected; and more broadly, both imported and domestically produced materials prices have risen sharply thus far this year. In reaction, we have marked up our forecast for core PCE inflation for the remainder of the year, and that upward revision basically offsets the effects of the recent good news. April 29–30, 2008 29 of 266 For now, inflation this year looks likely to repeat the pattern of the past four years. Since 2004, headline PCE prices have risen at about 3 percent per year, and core prices have been up at a rate of about 2¼ percent. Due to a further steep rise in energy prices, large gains in import prices, and another above-trend increase in food prices, we are projecting headline PCE prices to rise 3¼ percent this year and core prices to increase 2¼ percent—similar to the averages over the preceding four years. Moreover, our forecast for 2009 bears a striking resemblance to the out-year forecasts that we have continued to make over the past four years. By now, in answer to the question of why inflation is expected to slow in the forecast, most of you could easily recite the staff’s catechism of disinflation. Based on readings from the futures markets, we expect consumer energy prices to flatten out next year and food prices to slow to a rate close to core inflation. With the dollar not expected to fall as much as it has over the past year and other commodity prices expected to move sideways, import prices are projected to slow. Those more favorable developments in combination with a noticeable increase in projected slack cause headline inflation in 2009 to slow to 1¾ percent and core PCE inflation to edge back to 2 percent. Both of those figures are 0.1 percentage point higher than our March forecasts, reflecting the indirect effects of higher prices for energy and other imports. As we have noted many times, a key element in our projection is the assumption that oil and non-oil commodity prices will flatten out as suggested by the futures markets. To put it mildly, that has not been a winning forecast strategy in recent years, but I’m not sure that we have a superior one to offer you. Obviously, there are some big upside and downside risks to our forecast of domestic inflation. Nathan has already covered some of those related to prices for oil and other imports, so let me say a few words about the outlook for retail food prices. Our outlook for food prices remains relatively sanguine, but there would appear to be more pronounced risks to the upside than the downside. Although most of the value of what’s in your morning cereal bowl is advertising, packaging, and transportation, some corn and wheat are in there also, [laughter] and those prices have been rising rapidly. Futures markets are predicting a leveling-out in crop prices, and that expectation is built into our forecast. But worldwide stocks of grains remain tight, and any serious shortfall in production could result in sharply higher prices. In that regard, while the growing season here is just getting under way, corn production is off to a slow start because unusually wet conditions have hampered plantings. Elsewhere, increasing supplies of livestock products and poultry have been a moderating influence on retail food prices in recent months. Again, while futures markets suggest relatively subdued prices going forward, there are a few worrying signs. Although cattle on feedlots have remained near record levels, new placements have fallen off of late, reportedly because of the higher cost of feed. In addition, the portion of feedlot placements composed of females was high last fall and through the winter, which points to a reduction in the size of the breeding herd this year and thus suggests some potential supply risks ahead. In recognition of the upside risks posed by both food and energy prices, we included in the Greenbook an alternative simulation in which oil prices climb to April 29–30, 2008 30 of 266 $150 per barrel next year and food prices continue to run at the elevated pace of the past three years. In this scenario, we also assume that another year of elevated headline inflation results in a further erosion of inflation expectations of about ¼ percentage point. Under these conditions, headline PCE price inflation posts another year north of 3 percent, and core inflation moves a bit higher to 2½ percent this year and next. It strikes me that this type of persistent upward creep to inflation, which would be difficult to positively identify in real time, is a more likely risk than a sudden upward surge in price inflation. There are, however, some downside risks to the inflation outlook as well. As you know, we upped our price forecast a bit in the last round because we saw the incoming readings on inflation expectations as suggesting that there had been some modest upward movement over the preceding few months. Some of that increase may have resulted from your aggressive easing of policy early this year. But going forward, the situation may be turned around. If our forecast over the next few quarters is in the right ballpark, and on our assumption that the easing of policy is coming to an end, you will be standing pat on policy even as payroll employment falls throughout the remainder of the year, the unemployment rate trends higher, and headline inflation begins to back down. It doesn’t seem a stretch to me that in that environment, inflation expectations could come down somewhat, a development not embodied in the baseline forecast. More broadly, one place that inflation expectations might be expected to manifest themselves in a way that would be most damaging to inflation would be in labor compensation. Despite the elevated headline inflation of the past four years, there is little evidence of any noticeable step-up in wage inflation. If that was the case when the unemployment rate was 4½ percent, it seems less likely that larger nominal wage gains will be secured when the unemployment rate rises to 5¾ percent. Indeed, increases in hourly labor compensation have been running well below our models for some time, pointing to some additional downside risks to our inflation outlook. For now, we see substantial risks to the inflation outlook, but those risks still seem twosided to us. Brian will complete our presentation. MR. MADIGAN. 2 I will be referring to the package labeled “Material for Briefing on FOMC Participants’ Economic Projections.” Table 1 shows the central tendencies and ranges of your current forecasts for 2008, 2009, and 2010. Central tendencies and ranges of the projections published by the Committee last February are shown in italics. Regarding your monetary policy assumptions (not shown) about three-fourths of the participants envisage a moderately to substantially higher federal funds rate by late next year than assumed in the Greenbook, a path perhaps similar to the one incorporated in financial market quotes. Most of you conditioned your projections on a path for the federal funds rate that begins to rise either in late 2008 or sometime in 2009, in contrast to the Greenbook path, which remains flat through 2009. Many of you were less clear whether you differed from the Greenbook path 2 The materials used by Mr. Madigan are appended to this transcript (appendix 2). April 29–30, 2008 31 of 266 over the near term; but with a little reading between the lines, it seems fair to say that most of you assumed a slightly higher funds rate over the near term. As shown in the first set of rows and first column of table 1, the central tendency of your real economic growth forecasts for 2008 has been marked down nearly 1 percentage point since January. Most of you pointed to weak incoming data, tight credit conditions, falling house prices, and rising energy prices as factors that prompted you to lower your growth expectations for this year. About half of you forecast a decline in economic activity over the first half of the year (not shown), with another quarter of you seeing a flat trajectory over that period. However, only four of you used the word “recession” to describe the current state of the economy. None of you has a more negative first-half outlook than the Greenbook. The downward revisions to your growth forecasts are roughly equal across both halves of 2008, and so the contour remains one of a rising growth rate over the year. Members’ projections for the speed of the recovery in late 2008 exhibit considerable dispersion, with some calling for a quick return to near-potential growth supported by monetary and fiscal stimulus, and others seeing a prolonged period of weakness owing partly to persisting financial headwinds. Most of you appear to expect growth to return to near its trend rate in 2009 (column 2) and to move slightly above trend in 2010 (column 3). The Greenbook forecast for real growth in 2008 is near the low end of the central tendency of FOMC members’ projections, but it is at the high end in 2009 and 2010. The second set of rows indicates that you have revised up your projections for the unemployment rate throughout the forecast period. Of those of you who provided estimates of the natural rate of unemployment, most expect unemployment to remain above the natural rate in 2010 with the others seeing a return to the natural rate. As shown in the third set of rows, your projections for headline PCE inflation in 2008 have been revised up a full percentage point, largely due to the surge in the prices of energy and other commodities. Incoming information has also prompted a small upward revision to your projections of core PCE inflation this year (the fourth set of rows). The rate of decline of core inflation in 2009 is essentially unchanged from that in the January projections, presumably reflecting the offsetting effects of the higher unemployment rates in the April projections, on the one hand, and the lagged pass-through of this year’s higher food and energy prices, on the other. By 2010 the prolonged period of economic slack pushes down core inflation to around the same rates that were projected in January. Although the central tendencies for headline inflation, the third set of rows, also decline markedly over the forecast period, overall inflation is projected to be about ¼ percentage point higher next year than you anticipated in January. Nonetheless, by 2010, headline inflation is expected to be in essentially the same range of around 1¾ to 2 percent that you forecasted in January. Your inflation projections for 2010 are close to their values in January, but more than half of you raised your projections for the unemployment rate in 2010 significantly more than 0.1 percent. To the extent that the higher unemployment rate projections are viewed as implying an economy operating below its potential in 2010, April 29–30, 2008 32 of 266 outside analysts may infer that you expect inflation to edge down further beyond 2010. Turning to the risks to the outlook, as shown in the upper left-hand panel of exhibit 2, a large majority of you regard uncertainty about GDP growth as greater than normal. The upper right-hand panel shows that most of you perceive the risks to GDP growth as weighted to the downside. Correspondingly, the risks to unemployment, not shown, are seen as weighted to the upside. You typically attributed the downside growth risks to the potential for sharper declines in house prices and persisting financial strains. Overall, the distributions of your views on the uncertainties and skews regarding growth are little changed from January. However, as shown in the lower panels, your perceptions of the risks regarding inflation have changed noticeably since January. As shown in the lower left panel, only half as many participants now see the degree of uncertainty regarding the inflation outlook as historically normal, and twice as many see the uncertainties as larger than usual. As indicated to the right, fewer see the risks to their outlook for overall inflation as balanced, and more see the risks as skewed to the upside. Your narratives indicate that you see the upside risks to inflation as deriving from the potential for continued increases in commodity prices, further depreciation of the dollar, and an upward drift in inflation expectations. That concludes our remarks. CHAIRMAN BERNANKE. Thank you very much. Are there questions for our colleagues? President Evans. MR. EVANS. Thank you, Mr. Chairman. The Greenbook is aggressive and effective at portraying the U.S. economy as being in a mild recession. They’ve overcome the statistical evidence, which often prevents us from forecasting a recession since they are mostly surprises. There’s a nonlinear step-down in the second quarter that begins this recession. So I’m a little curious as to why you didn’t follow this up by forecasting a jobless recovery. In the last two recessions, that has been an important element of what followed. I wonder if it is now a feature of the Great Moderation business cycle. If you look at equilibrium real funds rates, they tend to bottom out during the period of most troubling joblessness in the aftermath of the recession. So if we’re going to be relying on a period in which we’re doing something we haven’t done before, like buying a bit of additional inflation credibility, it will be unusual. I guess my question is why you made that choice. April 29–30, 2008 33 of 266 MR. STOCKTON. This year certainly is pretty close to a jobless year in terms of a full year of nothing but employment declines and then fairly modest employment gains next year. But the principal reason we didn’t predict a pattern like the one we saw in the earlier part of this decade is that we don’t think we’re going to get the kind of productivity surprises that were such an important feature of that recovery. As you may recall, we were stunned by the extent to which, even in a period of cyclical weakening, we kept getting much stronger productivity. I think it will be years before research is actually able to shed a lot of light on why that occurred. The part of the story that we still think was probably in play was that there had been an accumulation of technological advances that businesses were able to draw on over this period and that led to a period in which, even as growth was picking up, employment wasn’t. We don’t see that happening again—although we didn’t see it happening the last time either, so it’s possible. MR. EVANS. Thank you. That’s a fair point. CHAIRMAN BERNANKE. President Stern. MR. STERN. Dave, I have a couple of questions. One is technical, and one is a little more substantive. The technical one is that you have a very sharp decline in consumer spending on services in the fourth quarter of this year and then not much of a recovery in the first quarter of next year. I assume something special is going on there, but I don’t know what it is. MR. STOCKTON. What was going on there was probably—I don’t know if it was rational or irrational—inattention. But in looking at that over the weekend, it seemed like something that should not be considered as an analytical feature of the forecast. Just in terms of the falloff in consumption that we expect to follow from the end of the tax rebates, my guess is that the consumption folks were trying just to put it somewhere and some of it showed up in services. MR. STERN. “Services” seems like the least likely spot actually. April 29–30, 2008 34 of 266 MR. STOCKTON. I think I’m raising the white flag here. [Laughter] MR. STERN. Well, sorry. The more fundamental question is that I have been trying to get comfortable with an outlook that would have core inflation leveling off and maybe declining a bit, and that’s the forecast I have. But I took your presentation, which I think was certainly on the right topic, to say that the risks around the core inflation forecast seem to be symmetric at this point. Is that a fair characterization? MR. STOCKTON. I think that is a fair characterization. You know, one thing that we’re struggling with—and I assume you are as well in giving your own views about the uncertainty and the skewness around your forecast—is whether things have changed. Is the skew large enough for us to argue that, in fact, the risks look unbalanced? We thought about that and about the potential upside and downside risks. Clearly, as I indicated, upside risks would be associated with ongoing increases in underlying prices for oil and other commodities that would probably feed through indirectly into core inflation over time. On the downside, we have been struck with how little upward pressure there has been on labor compensation and labor costs. Now, if you pinned me down and said draw a fine line on this, I’d probably say that, given the pattern of the past few years, it would look to me as though there’s probably a little more upside risk than downside risk, but I don’t see that skewness as being material in the forecast. MR. STERN. Thank you. CHAIRMAN BERNANKE. President Fisher. MR. FISHER. Nathan, both you and Dave expressed the frustration that I think all of us have about relying on futures markets in terms of our forecast of lower prices. It just hasn’t been very helpful. Do we know or have a sense of how OPEC itself forecasts? Do they just look at futures markets? Second, to what degree do you impute into your own calculations the income April 29–30, 2008 35 of 266 elasticity of demand for the rapidly growing countries such as China? We know it is above 1 on oil. Third, linking the two, to what degree would, say, the Saudi royal family or the al-Sabahs of Kuwait be thinking about those high income elasticities of demand with those high growth rates offsetting what used to be their fear of a slowdown in their markets? In 1978, for example, they had only three markets to sell into really: the United States, Japan, and what we used to call Western Europe. Now they have hedges against the weaknesses in those markets. So I’m wondering as we think about alternative ways to wrap our arms around this—and it is a very difficult thing as the current indicator we have has been shifting all over the place and has not been very useful—have we tried to learn how the swing producers look at this and how they calculate and think about where prices are likely to go or whether they just look at the futures markets as well? MR. SHEETS. It is, quite frankly, pretty tough to get a straight and compelling answer out of the OPEC folks about how they think about the oil markets. A number of us have sat in international meetings and listened to various explanations. In fact, at one recent meeting in Basel, the representative from Saudi Arabia indicated that OPEC was not prepared to supply any more oil to the market because the market was already well supplied at the equilibrium price. It is really quite frustrating. Now, what they say in these meetings is that their analysis of supply-and-demand fundamentals would suggest a price of $70 a barrel, $80 a barrel, or something like that. Then they blame the residual on speculators and so on, and we spend a fair amount of time looking for such speculative effects in these oil prices, and we wouldn’t want to rule anything out. I mean, from what we’ve seen, there may be an explanation out there that eludes us, but there are a number of things that we would expect to see if it were speculation—for instance, run-ups in inventories—that we don’t see. We have also looked at the behavior of noncommercial traders, and it does not seem as though the noncommercial traders are actually predicting prices. Quite the opposite—they seem April 29–30, 2008 36 of 266 to be chasing the price, which is quite different from what we would have expected. Most recently, in a statement just this week, OPEC’s president linked the run-up in oil prices to the depreciation of the dollar and indicated that, for every 1 percent decline in the dollar, oil prices would rise $4.00 a barrel, which strikes us as being just absolutely extraordinary. We can see 1 percent on the dollar moving oil prices 1 percent, but to get a coefficient beyond that just seems—I don’t want to say “economically impossible,” but I’d like to see the model that generates it. Now, about how they actually talk about oil prices behind closed doors, I don’t have any additional insight to provide other than what I’ve heard them say in some of these international meetings. Certainly in our analysis we try to think through the outlook for demand from countries like China and India. In fact, quite regularly we do a full-blown supply-and-demand balance exercise in which we say, “Here is the price. What kind of supply-and-demand fundamentals would be necessary to deliver that price?” We use the IEA, the EIA, and others as input, but we actually do our own separate analyses. We try to think very granularly about the demand from these emerging market countries and the implications that that has on the price. As to the last part of your question, I think certainly it’s true, at least until recently, that there was a sense on the part of OPEC that, if they allowed the price to stay too high for too long, there would be a significant supply response that would end up driving the price back down. Now, the fact that they seem quite comfortable to live with the price of $115 or $120 a barrel suggests to me that maybe they have come to the conclusion that there is just more demand out there and, in some sense, they are going to ride the wave of this increasing demand in some of these emerging market economies. That said, the prices have risen a lot. They’re up 75 percent or 80 percent over the past year. A year ago I’m sure that that’s not what my predecessor was forecasting, and it’s hard for me to imagine that we’re going to see oil at $200 a barrel. Nevertheless, given the income and price April 29–30, 2008 37 of 266 elasticities of this thing, our view is that 1 percent greater global demand that’s not met by supply could very well push prices up at least 10 percent. It isn’t going to take a whole lot of surprise on global demand to have a significant impact on prices. As I said, I think that OPEC is aware of that and is willing to run the risk that there may be at some point a large supply response that could put significant downward pressure on the price of oil. MR. FISHER. Thank you for that long and thoughtful answer. CHAIRMAN BERNANKE. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. I have two questions. One, in comparing the staff’s forecast with a lot of the private-sector forecasts—what it looks like and its shape—one thing that is striking about the forecast is the very large adjustment swing that occurs in inventories. My interpretation is that one thing that is occurring in the way you’ve made adjustments to your forecast—or maybe this is more of a question—is that the spending of the tax rebates appears to be occurring out of inventories. Therefore, there is no production response, or less production response, to the presumably increasing demand that may materialize. Can you give me some feeling about why you chose that way of treating this? The second question goes back to inflation. I thought your discussion of the uncertainties around inflation was excellent. Part of what you talked about in the Greenbook was the uncertainty about pass-throughs of commodity price increases and oil price increases into various measures of consumer price inflation, which you indicated were imprecise and which we don’t really know much about. I was struck that, if there is more pass-through than the baseline says, we’re going to get more inflation in the near term, and then disinflation will be more rapid when you assume that commodity prices are going to come down. But if commodity prices only stabilize and don’t come down, then it’s going to be a more complicated picture. You do have an alternative scenario that April 29–30, 2008 38 of 266 says that commodity prices keep rising, but you allow expectations to move up only fairly modestly in the model. It seems to me that, particularly if expectations become more unanchored than that, the time paths of the funds rate that are implicit in the simulations become much more aggressive on the other side. I just want to make sure that my intuition is correct here. MR. STOCKTON. Your intuition on that last point is correct. Obviously, in that simulation we have inflation expectations deteriorate a little more from where we think they have deteriorated already over the past year or so. Again, this is really hard to pin down, but we think there has probably been an increase of maybe ¼ percentage point in longer-term inflation expectations over the last couple of years in the context of this step-up in headline inflation and the higher commodity prices that are associated with that increase. So in the simulation, we’re basically assuming that the process continues: If you have another year or two of high headline inflation, you may get additional deterioration of inflation expectations on the order of ¼ percentage point. You’re right that, if expectations truly became unhinged and people began to view the entire inflation process as generating some greater upward momentum, it would have implications both for inflation and— MR. PLOSSER. A lot bigger than just the rise in expectations. MR. STOCKTON. A lot bigger than just the rise in expectations, and the fed funds rate, of course, would have to rise considerably. On the inventory side of the forecast—again, you put your finger on the principal reason that inventories are as weak as they are in the near term, which is that we think there will be a pretty sizable spending response to the tax rebates but we don’t see that as showing up fully in activity in large measure because we think firms are going to understand that this will be a one-time increase in demand. So they will be somewhat cautious about responding with higher production to that demand and will, especially in the context of a relatively weak economy, be more content with April 29–30, 2008 39 of 266 having that run down inventories than actually with ramping up production immediately. Now, that’s guesswork on our part. Again, I feel pretty comfortable with that basic story, but it is going to require some fairly negative inventory figures shortly. There is a technical factor here as well. We have occasionally cited a residual seasonality in imports, and in the second quarter that residual seasonality pushes down imports a lot. But we see no residual seasonality in GDP, so we take it out of inventories. That has been a standard feature of our forecast for the past few years. Nathan and his crew have communicated quite frequently with the BEA complaining about the fact that they have a seasonal adjustment process that takes a relatively flat series and creates lots of noise. [Laughter] It does not seem as though it is probably the best thing, but it exaggerates the downward movement in inventories. If I had to cite something that would make me nervous about the weakness in our near-term outlook, I do worry that the inventory liquidation in our forecast is large. The decline in the inventory–sales ratio in our forecast looks a lot like the decline in the inventory– sales ratio that we saw in 2001 and 2002. So it’s not out of line with past cyclical behavior, but it’s an aggressive drop. MR. PLOSSER. In the theoretical literature there is a lot of discussion about inventory modeling now and what the appropriate way is to think about it. MR. STOCKTON. I think I can assure you that our models of inventory investment are not very good. CHAIRMAN BERNANKE. But they don’t take information and convert it into noise. [Laughter] Other questions for our colleagues? President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. Just to follow that up, Dave, how do you build your assumption on the spending response to the fiscal stimulus? April 29–30, 2008 40 of 266 MR. STOCKTON. That was based on our reading of the literature, especially of the last episode of fiscal stimulus, which was associated with the rebate package in the earlier part of the decade. We’re assuming a marginal propensity to consume out of those rebates of about ½—that seems reasonably in line with what the literature suggests—and that they will be spent out over the next few quarters. But, again, that’s based on one or two data points. We’re trying to draw some strong inferences from those data points, and it’s our best guess at this point. CHAIRMAN BERNANKE. President Plosser. MR. PLOSSER. Yes, just a follow-up. Another way to ask my question is, Given your assumptions about the fiscal policy stimulus and tax rebates, if I took the view that your estimate of spending was not really 50 cents, 40 cents, or 60 cents but really 10 cents—most of it will get saved and not spent—how would that affect your inventory assumptions and, therefore, the path over the next several quarters? MR. STOCKTON. Roughly, we’re offsetting about half the spending through the inventory drawdown, so you could basically take that. If you took away a significant fraction of the spending, we’d take away a significant fraction of the inventory liquidation, and the GDP effects would be moderated considerably. CHAIRMAN BERNANKE. Other questions? If not, let’s start our go-round. President Evans. MR. EVANS. Thank you, Mr. Chairman. I was pleasantly surprised that we have not had any major downside surprises since our March 18 meeting. So while I still recognize the economy’s downside risks, I’ve become less comfortable about signing onto the Greenbook’s judgment that a nonlinear step-down in activity currently is in train. On balance, our projection still looks for weakness in the near term and then has growth picking up as we move through 2008 and April 29–30, 2008 41 of 266 into 2009. We see a noticeable output gap opening this year but not one as large as in the Greenbook. Under this forecast, it is possible that some portion of 2008 might eventually be labeled a recession, but it is not yet conclusive that it will be. Indeed, given the highly unexpected development that events have proceeded as expected, I think the downside risks to growth have abated some. Some of the stress in financial markets has been mitigated by our new lending policies as well as actions by banks in recognizing losses and raising capital. Neither the incoming data nor the reports from my business contacts seem to be consistent with the bleak downside scenarios that I feared might transpire after we saw the December employment report early this year. In this regard, I will simply note a couple of observations from my contacts. A national shopping mall developer reported that his tenants experienced a small improvement in April retail sales compared with March. He was not expecting that. Similarly, Manpower indicated a small improvement in billable hours for temporary workers over the past month and a half, also unexpected. Now, I am not saying that I will be surprised if the outlook deteriorates further. I am saying that the likelihood of that event seems to be smaller today than I expected at our last two meetings. Accordingly, I think that current real interest rates are appropriately accommodative relative to the baseline forecast for economic growth and the risk to that outlook. As seen in chart 6 of the Bluebook, the real funds rate is essentially zero. Of course, this uses a core PCE measure of inflation and thus may overstate the true real rate since headline inflation has been consistently running above this core measure. There is the additional accommodation that is being provided by the range of new lending facilities we had put in place. The extra accommodation is appropriate to offset the large degree of restraint still being exerted from financial markets, and our expansion of the swap lines and the TAF adds to this accommodation. Furthermore, in the event of a nonlinear April 29–30, 2008 42 of 266 step-down in economic activity, as in the Greenbook forecast, our policy responses can be adjusted appropriately because we’re well positioned now for that. On the price side, on balance, the recent news has been good. My forecast has core PCE inflation falling to just under 2 percent in 2010 largely because of the increasing resource slack in the economy. However, I think there are substantial upside risks to this outlook. All of my business contacts have noted how high and rising energy and commodity prices are creating cost pressures that many are passing on to their customers. As Dave Stockton mentioned, with his inflation catechism, without reviewing the past transcripts I will speculate that we have been projecting a leveling-out of energy prices since the price of oil was $70 a barrel. Weak domestic demand may limit the degree to which producers can pass through these higher costs, but it is unlikely to prevent noticeable increases in some downstream prices. The depreciation of the dollar also imposes risks even beyond the effects operating through the commodity price channel. Now, I do agree that labor costs have not been cited as a problem for inflationary pressures, and so that does add somewhat to trimming out the risks there. Inflation expectations were also an issue. No matter how often we say that core inflation is a more reliable measure of underlying inflationary tendencies, I find it difficult to believe that the public’s inflationary expectations will not be affected by large and persistent increases in food and energy prices. The past five years have been unkind on this score. On average over this time, higher food and energy prices have pushed total inflation above core about ½ percentage point, and it is also sizable over the past ten years. Another challenge for inflationary expectations comes from our policy focus on the downside risks to growth during a time of rising headline inflation. Rightly or not, this could make the public question our attitudes toward inflation. We are accepting considerable inflationary risks when we hope that these concerns will disappear quickly with future April 29–30, 2008 43 of 266 adjustments to policy that have not yet been signaled. How we balance these conflicting risks should be an important component of our discussion tomorrow. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. In the Third District, there has been little change in economic activity since I reported in March. Business activity remained weak over the intermeeting period but no more or less than anticipated and than we reported in our March meeting. Manufacturing activity, residential construction, and employment remained modestly weak in the District. Retail sales were also sluggish. Our staff’s coincident indicators of economic activity, which summarize our regional data, show a decline in activity in Pennsylvania and Delaware but moderate growth in New Jersey in March and, on average, for the last three months. Overall, our firms are not very upbeat about nearterm growth; and like many forecasters, they have revised downward their expectations since the start of the year. For example, in response to a special question in our business outlook survey, the number of manufacturers saying that current demand for their products fell short of what they had expected at the start of the year exceeded those who had underestimated demand. More firms have decreased their capital spending plans, with 10 percent indicating that they either delayed capital spending or postponed it indefinitely. While growth in the District has been weak, price pressures facing our firms and consumers have intensified. Area manufacturers continue to report higher production costs, and the percentage of firms raising prices on finished goods is larger than earlier in the year. The indexes of prices paid and prices received are near 20-year highs for our firms, and firms expect to see prices move higher over the next six months. These firms have a very pessimistic outlook for inflation. April 29–30, 2008 44 of 266 Turning to the national outlook, I have revised down my growth forecast from what I submitted in January, as almost all of us have, but that revision occurred largely between January and March. There has been little or no change in my outlook since our March meeting. Compared with my January forecast, I now see real GDP growth coming in around 1.5 percent for 2008 and close to 2.6 to 2.8 percent in 2009–10. Overall, this is about ½ percentage point weaker for ’08 than my January forecast, but there is little difference in my forecast for ’09 and ’10. The indicators that have come in since our last meeting have generally been in line with my March outlook. Certainly they have pointed to continued weakness, but not worse than I had expected. Although some strains in the interbank markets remain, they do not appear to have intensified, and our alphabet soup of targeted tools seems to be having at least modest beneficial effect, even if only psychologically. I remain concerned, however, about inflation and our calibration of the appropriate level of the fed funds rate consistent with our goals. Inflation readings have abated marginally since our last meeting; but as the Greenbook suggests, there is reason to believe that this is a temporary reprieve and that the levels remained elevated—year-over-year CPI inflation was 4 percent in March, and year-over-year PCE inflation was 3.4 percent—well above their 2007 levels. As we have been noting, oil and other commodity prices continue to move up, and businesses and consumers continue to stress inflation as a concern. Near-term measures of inflation expectations have risen sharply. In the Michigan survey, one-year inflation expectations rose to 4.8 percent in April, up from 4.3 percent in March and 3.4 percent in December. Clearly, the greater media attention on inflation and the discussion among the public are bound to have some effect on expectations as time goes on. I have some concerns and difficulty interpreting the measure in TIPS given the disruptions in financial markets right now. So I take those with a little grain of salt. Nevertheless, five-year, April 29–30, 2008 45 of 266 five-year-ahead inflation compensation is 2.8 percent using the Board’s measure. This is down a little from early March but is still higher than it was at the end of 2007. In fact, the instability of these measures of inflation expectations itself is a cause of concern for me. It may suggest that markets question our willingness to take actions consistent with sustained and credible price stability. Now, we have often alluded to the idea that near-term weakness will help mitigate some of the inflation pressures. However, I would just like to remind us that this critically depends on inflation expectations remaining well anchored. I hope that going forward we can reinforce that conditionality of the statement about weakness helping us on the inflation side so that we do not perpetuate the notion that a stable Phillips curve is at work here and that a slowing economy will always lower inflation. I believe that the FOMC’s commitment to price stability remains credible at this time, but just barely. I worry that we may be resting too much on our laurels, trying to talk a good game, but unwilling to take the actions necessary to support and sustain that credibility. As I have said before in this group, we must not wait until expectations have broken out because by then it will be too late. Inflation has been well above at least our implicit goal for a sustained period. As the Bluebook points out, core PCE inflation has been above 2 percent since 2004 every year, and is projected to be so again this year, and the projections are even worse for headline numbers, either CPI or PCE. If we continue easing or maintaining a real funds rate well below zero for a sustained period despite inflation well above our goal, can we really expect inflation expectations to remain anchored? The Greenbook seems to think that we can. It assumes that the fed funds rate falls to 1.75 percent in June and remains there through the end of 2009. Given the inflation forecast, this means a negative or close to negative real funds rate for almost two years. Despite this, Greenbook April 29–30, 2008 46 of 266 baseline inflation expectations remain reasonably contained, and inflation is projected to decline over the forecast period even as growth picks up toward trend. To put it kindly, I have serious reservations about that scenario. The Greenbook discusses an alternative simulation in which there is greater inflationary pressure. The estimated Taylor rule funds path in that is somewhat steeper than in the baseline. Inflation ends up higher at the end of the forecast period—the end of 2011 and 2012—than in the baseline. More progress on inflation will require obviously a steeper path, but even in this alternative simulation, inflation expectations only drift up. They do not become unhinged. If they did, I would expect the policy path to have to be considerably tighter in 2009. Now, I know that talking about money in the context of monetary policy is not very fashionable these days. But I would like to note that the monetary aggregates as measured by M2 and MZM have exploded. Despite the flight to quality and the associated increase in the demand for money associated with that, M2 grew less than 5 percent during the fourth quarter of 2007. Since then, however, its growth rate has nearly tripled. In January it grew 8 percent on an annualized basis. In February after our rate cuts, it grew 18 percent, and in March it grew 13 percent. Growth rates of MZM are even worse over this interval—for the three months the annual rates were 14, 42, and 26 percent. Such rates suggest to me that there is substantial liquidity in the economy. While I don’t really like the old P* model and have had a lot of problems with it, at the back of the Greenbook the story it is telling is one of considerable inflation over the next couple of years. Combined, the growth in the aggregates, the substantially negative real interest rates, and the fact that most versions of the Taylor rule call for a higher fed funds rate than we have currently heighten my angst about the outlook for inflation and our credibility. Market participants reacted to the incoming data by appreciably tightening their policy expectations—at least as implied by the April 29–30, 2008 47 of 266 futures markets, as Bill Dudley pointed out—and that has had a negligible effect, certainly no negative effect, on markets or the economy more broadly. One interpretation is that the market participants have also become uncomfortable, as I have, with a fed funds rate that remains too low for too long. I take this as a healthy sign actually and one that we shouldn’t ignore. Indeed, we may just wish to use it to our advantage. I will stop there, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Yellen. MS. YELLEN. Thank you, Mr. Chairman. In looking at the latest Blue Chip forecasts for GDP growth, I noted that the range between the highest and lowest is among the largest on record. The 10 most optimistic forecasters are predicting over 2½ percentage points faster Q4-over-Q4 growth than the 10 most pessimistic ones. Such forecast dispersion is indicative of the unusually high degree of uncertainty that we are facing. The Greenbook presents one of the most pessimistic economic forecasts; yet I find its recessionary projection quite plausible and see downside risks that could take the economy well below that forecast. Although I found it especially difficult this time to decide on the most likely outcome for the economy, I ended up submitting a forecast that shows somewhat more growth in 2008 than the Greenbook, even though we shared the same assumption concerning monetary policy this year. My forecast projects 2008 growth of ¾ percent. This averages no growth in the first half and 1½ percent growth in the second. The unemployment rate increases to just over 5½ percent by the end of this year, a bit lower than the Greenbook. In one critical area—namely, the adverse effects of financial sector developments on the real economy—I remain just as pessimistic as the Greenbook. Although the likelihood of a severe financial panic has diminished, the risks are by no means behind us. Moreover, credit conditions have turned quite restrictive. This credit crunch April 29–30, 2008 48 of 266 reflects the drying up of financing both for markets that were important sources of business and consumer credit and from banks that are contending with capital-depleting losses and illiquid assets. Among banks, the latest Senior Loan Officer Opinion Survey noted a clear tightening of lending standards, and my own discussions with bankers confirmed this point. They say they are carefully reassessing and significantly curtailing existing home equity lines of credit as well as unsecured consumer loans of all sorts. Banks are also clamping down on the provision of revolving business credit, even to very creditworthy customers. For example, the treasurer of Chevron, a highly rated oil company that, as you can guess given energy prices, has a very strong profit outlook, recently complained to me that banks were reluctant to extend even its credit line. Such reluctance is also evident for lending to students, consumers, and other businesses. The risk of a deepening credit crunch remains as a weak economy—especially with further sharp declines in housing prices—escalates credit losses, harms financial institution balance sheets, and causes them to scale back lending even further. My sense from our business contacts is that their perception of reduced access to credit is causing them to manage their firm’s liquidity more carefully and is leading to some deferrals in capital spending projects as a precautionary measure. Certainly the mood is decidedly more pessimistic and cautious. Amid the gloom of the credit crunch, I do see a possible silver lining in that it may amplify the effects of the fiscal stimulus package, and this is part of the reason that my forecasted downturn is a little milder than the Greenbook’s. In particular, because of the credit and liquidity considerations, the latest fiscal package could well provide a bigger bang for the buck than the tax rebates in 2001. First, the current tax rebates are more directly targeted at lower-income households, which are more likely to be credit constrained and to spend the cash once it’s in hand. Second, given the current tightening of credit availability, households will likely spend an even April 29–30, 2008 49 of 266 greater fraction of the tax rebates than they did in 2001. Of course, there is considerable uncertainty about assessing the potential size of these effects. But over the next few months as the checks go out and the retail sales reports come in, we should get a pretty quick preliminary read on how things are shaping up. Regarding inflation, the most worrying developments since we met in March have been the price surges for a wide variety of raw materials and commodities, especially the jump in the price of crude oil. From the U.S. perspective, this run-up in prices represents mainly a classic supply shock, which could threaten both parts of our dual mandate, although the decline in the dollar has slightly exacerbated the severity of the impact. Like the Greenbook, my forecast for inflation does take commodity price futures at face value and foresees a leveling-out of prices going forward. Although I must say, after four years of being wrong, I am beginning to feel like Charlie Brown trying to kick that football. The most recent core consumer price data have shown some improvement, and like the Greenbook, I’m optimistic that core inflation will subside to around 1¾ percent over the forecast period, assuming that the commodity prices do finally level off and compensation remains well behaved. An interesting analysis by Bart Hobijn of the New York Fed as well as my own staff implies that, in an accounting sense, pass-through from the run-up in oil and crop prices may have boosted core inflation as much as 0.3 percentage point over the past two years. So a leveling-off of these prices could lower not only headline but also core inflation. My core PCE inflation forecast is a tenth or two lower than the Greenbook this year and next also because we assume lower passthrough of the dollar depreciation to non-oil import prices. We have been reexamining the data on this issue and find the evidence quite convincing that pass-through has been quite low recently— lower, for example, than embodied in the FRB/US model. April 29–30, 2008 50 of 266 With respect to inflation expectations, market-based measures have now edged down. We took little comfort from this fact, however, because we had viewed the uptick in inflation compensation in recent months mainly as a reflection of a higher inflation risk premium and not a reflection of higher inflation expectations. I am also somewhat concerned that the median expectation for inflation over the next five to ten years in the Michigan survey has ticked up. CHAIRMAN BERNANKE. President Fisher. MR. FISHER. Mr. Chairman, I want to focus my comments today on what I have heard from my CEO contacts. With regard to my District, it continues to do well relative to the rest of the country, but it is not immune to the pathology that is afflicting the overall economy. Although still positive, economic growth and employment creation are slowing, and our manufacturers in the survey we just took are experiencing substantial price pressures. Seventy-one percent of our manufacturers in the survey report higher prices, and 65 percent are expecting input prices to be even higher six months from now. Setting aside the 11th District, I spoke in depth to 31 CEOs nationwide. You have that list, Mr. Chairman, and I would like to speak to what I deduced from triangulating those conversations with what I read in the Bluebook and the Greenbook. Let me note that the focus of my conversations with these CEOs and CFOs was not what they have seen or what they are seeing now but how their behavior is likely to be affected going forward and how they are budgeting going forward. Distilling the inputs to their essence, it’s clear that activity is likely to weaken further. Those 21 miles of 89-foot flat cars that haul lumber, Mr. Chairman, are now up to 22.6 miles. Inventories of unsold homes are clearly building, and that is important against the background that March is almost always a good month in the housing or home sales business. The CEO of Centex reports that this is the first down March he has seen, and he has been in the business since 1974. It April 29–30, 2008 51 of 266 came down hard—20 percent. Consumer confidence is weak. Job insecurity is spreading. Companies are tightening their head counts. Banks are tightening credit standards, as we have discussed. According to the CEO of MasterCard, year-over-year retail sales to date in April—that is, ex-autos and ex-gas—were 2.2 percent, the lowest he has ever seen. Citibank, Chase, Bank of America, and the other credit card purveyors are experiencing high delinquency rates and a significant slowdown in their revenues from credit cards, and Wal-Mart reports the “cascading” use of credit as a form of payment, as their CEO for U.S. operations put it. In short, the consumer-driven corrective credit cycle is prolonging the economic slowdown and vice versa. Consistent with this sustained headwind, we have revised downward the Dallas forecast and continued for longer our projection of economic “anemia” (we are not among the four that included the word “recession”) not only for ’08 but also for ’09, and we have revised upward, to the upper end, our sense of projected unemployment. Thus, from what I am hearing, from what I am reading, and from what we are getting from our analysis, I acknowledge the thesis of the presence of a negative feedback loop among GDP growth, employment growth, and credit market conditions. I find more worrisome the reports I am receiving on expected price developments and behavior, and I see a feedback loop of another kind at work. Page 30 of the Bluebook notes, as I think President Plosser pointed out and President Evans referred to, that core PCE inflation has averaged more than 2 percent in every year since 2004 and is forecasted, as per David’s earlier comments, as doing so again in 2008. What concerns me more is the left-hand panel in chart 1 on page 4 of the Bluebook that indicates that the staff’s index of inflation expectations and uncertainty is now at the top of its range over the last decade. This is confirmed by my corporate contacts. April 29–30, 2008 52 of 266 Something persistent and pernicious, Mr. Chairman, has been occurring on the inflation front and calling into question the credibility of our continued reliance on core measures. Here is what I am hearing from my corporate contacts. I’m going to just mention a few because it is fairly consistent across the board. From the CEO of the largest retailer in the country, not to be named but located in Arkansas, [laughter] I reported last time that they are budgeting price increases on 10,000 items of a little over 5 percent in 2008. Yet his comment to me was, “Inflation is our number 1 concern, and it’s escalating significantly.” He added, “All the information we have points to an intermediate- and longer-term supply–demand problem, especially for food and any energy-dependent articles.” By the way, that was verified by the CEO of Frito-Lay, who tells me that they are offsetting their input price escalation of 11 percent in 2008 by raising prices 9 percent effective last Sunday. He added that—and this is interesting in terms of the mindset—“We have to—otherwise we’ll disappoint the Street, and in these markets no one can afford at this fragile time to do so.” The price pressures are less for clothing and nonfood items, but they are still there. I would like to use the example of JCPenney. JCPenney sells clothing to one-half of all the families in America, and 60 percent of their sales are apparel. The average price point for an apparel sale at that retailer is $15. The leading source of apparel is China. According to Penney’s CEO, increases in China’s labor costs, changes in their labor rules, and the cost of fuel and of cotton fibers have led to significantly escalating price pressures. He says that they can eat some of those costs and drive them down through other offsets and tighter controls, but they are planning a 4 percent increase in apparel costs in 2009. Here is his punch line, and it is not funny—this is a first-rate CEO, one of the best in the country: “We think the customer can take a little more price. After all, what’s 40 to 60 cents on $15? It won’t even be noticed.” April 29–30, 2008 53 of 266 This is the essence of the accommodation of inflationary expectations, and you are beginning to see this mentality set in in several industries. For example, the airlines. We talked about the increase in the price of crude. If you take what is called the crack spread and figure out what has happened in terms of jet fuel, year over year through mid-April jet fuel was up 70 percent. That’s an industry average, mitigated somewhat by the hedging of Southwest Airlines, which has been successful. According to the CEO of American Airlines, “This oil is a tsunami. We will have to get some pricing power, or we’ll be left with only one airline, Southwest.” Kimberly-Clark, a paper producer, notices that the weaker dollar and oil are driving realized costs increasingly up from, in their case, $250 million in ’07 to an estimated $600 million in ’08. They have raised prices, as I have previously mentioned, but the CEO feels that—and this is a winner—“We are having to learn how to run a business in an inflationary environment. We got used to productivity as the driver, but we can’t drive productivity any harder than we can. We will need more pricing.” It even affects semiconductor producers. Texas Instruments reports that the weakness of the dollar and the prices of energy, gold, and copper offset by their hedges added 2½ percent nonannualized to their costs in the first quarter. Asked what he envisions going forward, the CFO said, “Well, that just means we can’t spend it elsewhere. We have to take it out of our employees’ backs or out of cap-ex.” One CEO of a company that is expecting soon to lay off between 12,000 and 15,000 people and is, therefore, carefully surveying the attitudes of their employees because they have a morale problem, is finding out that employees are tapping into their 401(k) plans or not funding them. In their surveys they find the leading complaint is that “the price of gasoline and food is eating into my living standards. I can’t afford them.” Last but not least, just to bring this home, the Eagle Scout who mows my lawn in Dallas sent me a very nice, beautiful letter. It is clear that he and his mother had prepared it on a printer and put a fancy title on it, but the rest of the letter April 29–30, 2008 54 of 266 was, “Dear Mr. Fisher, I have to levy a 7 percent fuel surcharge.” [Laughter] We gave into it—he is a nice boy. In summary, Mr. Chairman, while there are many who have voiced concern with the adverse feedback loop that runs from the economy to tighter credit conditions and back to the economy, I am very troubled by a different adverse feedback loop—namely, the inflation dynamic whereby reductions in fed funds rates lead to a weaker dollar and upward pressures on global commodity prices, which feed through to higher U.S. inflation. That higher U.S. inflation not only has a price impact but also leads to cutbacks by consumers and by employers so as to offset the effects of inflation. I am worried that, if we do not respond to higher inflation, the whole cycle will intensify. When economic growth and activity return to normal, inflation is likely to have notched up considerably, according to our sense. I know my respected colleagues say that we are willing to be equally aggressive in raising rates once the outlook for real activity improves, but the practicability of that notion I find in talking to my interlocutors is met with some skepticism and doubt. With that, Mr. Chairman, I see a tail risk on the downside of growth. I acknowledge the argument of President Yellen and others. I think I’m sympathetic, but I see a fatter tail, perhaps an otter’s tail, on inflation. I am hearing this loud and clear from my corporate contacts. I believe that the risk posed by inflation is more significant than the extension of further anemia in the economy, especially now that we have put in place innovative liquidity bridging mechanisms, which we are amplifying upon today. Mr. Chairman, the other day Governor Kohn reminded me that reasonable people can disagree, and he quipped that he hoped that we could agree on the following—that we are at least reasonable people. [Laughter] I’m doing my very best, I hope, to provide reasonable alternative perspectives, and I hope you will judge me on that basis. Thank you, Mr. Chairman. April 29–30, 2008 55 of 266 CHAIRMAN BERNANKE. That made me dizzy. [Laughter] President Rosengren. MR. ROSENGREN. Thank you, Mr. Chairman. Without judgmental adjustments, the Boston Fed forecast is somewhat more optimistic than the Greenbook. As in the Greenbook, our GDP is weak in the first half of this year, though neither of the first two quarters actually turns negative. Our slightly more optimistic forecast assumes that consumption and business fixed investment are weak, but not as weak as in the Greenbook, and then the fiscal and monetary stimuli are sufficient for the economy to pick up in the second half of this year. In a sense, the Greenbook represents another mode in the forecast distribution with probability roughly equal to our forecast. The big risk to our forecast is that the financial turmoil and housing price declines, which are not fully reflected in the Boston model, result in a greater drag on the economy. Such an outcome would largely close the gap between the Greenbook and our forecast. In short, the downside risks to our forecast are appreciable. With a monetary policy assumption similar to the Greenbook’s, we have core PCE below 2 percent in 2009, but the unemployment rate remains well above the NAIRU even at the end of 2010. If we sought to keep inflation below 2 percent but did not want an extended period in which the unemployment rate was above the NAIRU, our model would require more easing than currently assumed in the Greenbook. Since the last meeting, the economic data have remained weak. Private payroll employment declined by approximately 100,000 jobs on average over the past three months, and the unemployment rate increased 0.3 percentage point. In addition, the labor market weakness was widespread across industries. Such labor market weakness is likely to aggravate an already troubling housing story. To date, falling housing prices have disproportionately affected subprime borrowers and those who purchased securitized products. However, if housing prices continue to decline rapidly, that will begin to affect more prime borrowers and a wide array of financial April 29–30, 2008 56 of 266 institutions. Smaller financial institutions that were largely unaffected by the financial turmoil last August are beginning to see increases in delinquencies, and those with outsized exposures in construction loans are now experiencing significant duress. Commercial real estate loans are also now experiencing increased delinquencies. Like the Greenbook, I am concerned that commercial real estate may be the next sector to experience problems. However, the biggest concern remains that rising delinquencies and falling housing prices cause a much higher rate of mortgage defaults than we have experienced historically. Should these mounting problems become more pronounced, we are likely to see credit availability for small- and medium-sized businesses affected. That sector has not to date been significantly affected by the financial turmoil. Many financial indicators have improved since the last meeting, as was highlighted in Bill’s report. The stock market has moved up. Many credit spreads have narrowed. Treasury securities and repurchase agreements are trading in more-normal ranges, and credit default swaps for many financial firms have improved. Nonetheless, several ominous trends remain in financial markets. The LIBOR–OIS spread has widened, so borrowers tied to LIBOR rates have seen those rates rise more than 25 basis points since the last meeting. Similarly, the TAF stop-out rate in the last three auctions was higher than the primary credit rate, providing another indicator that banks remain in need of dollar term funds. Finally, the asset-backed commercial paper market is once again experiencing difficulties. Rates on asset-backed commercial paper have been rising, and there is a risk that more of the paper will end up on bank balance sheets. Higher food and energy prices are both a drag on the economy and a cause for concern with inflation. But despite the extended sequence of supply shocks, I do not see evidence that inflation expectations are no longer anchored. Labor markets do not indicate that the commodity price increases are causing wage pressures, and such pressures are even less likely if the unemployment rate continues to increase. Many of the April 29–30, 2008 57 of 266 financial indicators of inflation, such as the five-year-forward rate, have fallen significantly from their peaks earlier this year. Finally, core PCE over the past year has been 2 percent, and most econometric-based forecasts expect that the weakness we are experiencing should result in core and total PCE inflation at or below 2 percent next year. Overall, the downside risks to demand that I listed in the outset seem the more compelling cause for concern. Thank you. CHAIRMAN BERNANKE. Thank you. President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. Our high-level view of current circumstances is that the real economy is quite weak, with weakness widespread. The financial markets are turning optimistic, and elevated prices and inflation remain a serious concern. Reports from our directors and District business contacts were broadly similar to the incoming national data and information from other Districts reported in the Beige Book. Observations from such District input support themes in the national data—for example, employment growth is quite weak. In this round of director reports and conversations, I heard an increasing number of reports of holds on hiring and expansion plans. One representative of a major retailer of home improvement goods reported that hiring for seasonal employees will be down 40 percent this spring. This translates to approximately 45,000 jobs. Nonresidential real estate development continues to slow in the District, especially in Florida and Georgia. Of the 18 commercial contractors contacted in April, 15 expect that commercial construction will be weaker for the rest of 2008 than for the same period in 2007, with several predicting even more pronounced weakness in 2009. On the brighter side, Florida Realtors are anticipating that sales over the next few months will exceed year-ago levels, and builders are signaling less weakness than in recent reports. This is a level of optimism we have not heard from Florida for some time. However, housing markets in the rest of the District continue to weaken. We heard several complaints that obtaining financing is a serious problem for April 29–30, 2008 58 of 266 commercial and residential developers and consumer homebuyers. In sum, the information from the Sixth District seems to confirm what I believe is the continuing story of the national real economy captured in the Greenbook—that is, shrinking net job creation, developing weakness in nonresidential construction, and a bottom in the housing market still not in sight. In contrast, conditions in the financial markets appear to have improved substantially. As has been my practice, I had several conversations with contacts in a variety of financial firms. There was a consistent tone suggesting that financial markets are likely to have seen the worst. This does not mean that no concerns were expressed. Some contacts had concerns about European banks and credit markets, and concern about the value of the dollar, notwithstanding the recent rally, is coming up in more contexts. Concern was expressed about the dollar’s disruptive effect on commodity markets, in turn affecting the general price level—in particular, the effect of high energy prices on a wide spectrum of businesses’ consumer products and even on crime rates in rural and far suburban areas related to the theft of copper wiring and piping from vacant homes and air conditioning units. I worry that a narrative is developing along the lines that the ECB is concerned about inflation and the Fed not so much. This narrative encourages a dollar carry trade mentioned, again, by some financial contacts that puts downside pressure on the dollar that potentially undermines both growth and inflation objectives. I remain concerned about the vulnerability of financial markets to a shock or surprise, but overall, my contacts express the belief that conditions are improving. The Atlanta forecast submission sees flat real GDP growth in the first half of 2008, with gradual improvement in the second half. We continue to believe that the drag on economic activity from the problems in the housing and credit markets will persist into 2009. On the inflation front, I am still projecting a decline in the rate of inflation over this year. I’ve submitted forecasts of declining headline inflation in 2009 and 2010, but I should note that my April 29–30, 2008 59 of 266 staff’s current projections suggest that improvement to the degree I would like to see may require some rises in the federal funds rate. It is my current judgment that, with an additional 25 basis point reduction in the fed funds rate target, policy will be appropriately calibrated to the gradual recovery of growth and the lowering of the inflation level envisioned in our forecast. This judgment is based on the view that, with a negative real funds rate by some measures, policy is in stimulative territory; that a lower cost of borrowing in support of growth depends more on market-driven tightening of credit spreads than a lower policy rate; that further cuts may contribute to unhelpful movements in the dollar exchange rate; and that extension of the four liquidity facilities may allow us to decouple liquidity actions from the fed funds rate target. In my view, we are in a zone of diminishing returns from further funds rate cuts beyond a possible quarter in this meeting. That said, as stated in the Greenbook, uncertainty surrounding the outlook for the real economy is very high, and the Committee needs, in my view, to preserve flexibility to deal with unanticipated developments. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Bullard. MR. BULLARD. Thank you, Mr. Chairman. The economy of the Eighth District continues to show signs of weakness. The services sector has continued to soften, and sales of both general and big box retailers are down from the same period last year. The residential real estate sector has continued to decline throughout the District. Across major metro areas, sales were about 15 percent below the level from last year, and single-family permits were down about 30 percent. Employment growth has slowed and is estimated to have turned negative in March for many areas. Typically, however, employment growth in the District has been stronger than that for the United States as a whole. Manufacturing has remained roughly flat, despite temporary shutdowns that have affected domestic automobile production. Also, commercial real estate construction remains strong, and April 29–30, 2008 60 of 266 vacancy rates are low; however, there are increases in the number of delayed projects. Banks in the District are still in good shape, generally speaking. There have been modest increases in total loans in all categories, including real estate. Contacts in the shipping and trucking industries reported a mixed bag. In some instances, business seems to be holding up, whereas in others it is down substantially. These businesses are being critically affected by increases in energy prices. Similarly, a contact in the fast food industry painted a picture of a business struggling with substantial increases in commodity prices. On the other hand, a contact in a large technology firm indicated that business is holding up quite well, in part because a large fraction of this firm’s business is overseas. Contacts in the energy sector reported robust business prospects, as expected. A contact at a large financial firm suggested that the discovery process concerning asset-backed securities, which has been ongoing for many months, has effectively come to a close. The idea that the discovery process—and the considerable macroeconomic uncertainty that attended that process—is over is an important consideration at this juncture. My sense is that expectations of future economic performance are changing rapidly. The probability that the U.S. economy will enter into a debilitating depression-like state has fallen dramatically. In the meantime, other risks have increased markedly—in particular, that the FOMC will lose credibility with respect to its inflation goals. The U.S. economy has certainly encountered a large shock. Monetary policy can mitigate the effects of a large shock but cannot be expected to completely offset exceptional disturbances. Attempts to do too much may create more and moredangerous problems in the future. Best-practice monetary policy would do well, it seems to me, to avoid setting the stage for future problems. April 29–30, 2008 61 of 266 The problems with the rate structure, which is too low, are threefold. First, there is the risk of setting up a new bubble. The exceptionally low rates of a few years ago are sometimes cited as providing fuel for today’s problems. Some have argued that today’s commodity price increases are exactly that new bubble. Second, continued unabated reductions in interest rates will bring the zero bound issue into play with unknown consequences. Third, still lower rates will push the envelope further on inflationary expectations. Those expectations may appear to be reasonably well anchored today, but that is because the private sector expects us to take actions to keep inflation low and stable. Should those expectations become unmoored, it will be too late, and an era of higher and more volatile inflation would be very costly for American households. Much has been done already. A low rate environment has been created and has been in place only for a short time. Marginal moves at this juncture are minor compared with the general thrust of policy over the last nine months. The Committee would do much better at this meeting by taking steps to address eroding credibility. Thank you. CHAIRMAN BERNANKE. Thank you. Why don’t we take a break for coffee and return at 4:45. Thank you. [Recess] CHAIRMAN BERNANKE. Why don’t we reconvene. President Pianalto, whenever you are ready. MS. PIANALTO. Thank you, Mr. Chairman. Regardless to whom I talk with these days, the conversation quickly turns to both the fragile condition of financial markets and the spectacular rise in energy and commodity prices. I had hoped that one of these problems would have gone away by now, but clearly that is not how conditions have unfolded since our last meeting. The bankers with whom I talked are paying close attention to their capital and liquidity positions. They April 29–30, 2008 62 of 266 remain concerned about wide bid–asked spreads and low trading volumes in a broad array of securities markets. Indeed, the repercussions of financial turmoil appear to have touched every channel of credit intermediation. It appears that a rewiring of credit channels is simply going to take some time to work out. The most significant financial news coming out of the Fourth District is the $7 billion investment of new capital into National City Bank. National City is the country’s tenth largest commercial bank, and its problems with mortgage-related credits are now well known. National City still has much work to do to clean up its balance sheet, just as many other financial institutions with impaired capital positions must do before they can stand on solid ground again. Although the fragile state of the financial sector represents a pretty sizable risk to my economic outlook, the National City situation, along with other stories I’m hearing, suggests that modest progress is being made. With regard to District business conditions, the stories I hear remain downbeat. Commercial builders are reporting mixed though generally positive first-quarter numbers. But their expectations for retail sales in the stores that they lease out across the country have deteriorated, and they are fairly pessimistic about 2008 growth prospects. One large national commercial developer whom I talked with told me that, for the first time in his 45-year career, his company has seen sales declines in March in every retail center that they own across the country. The manufacturers I talked with indicated moderate first-quarter revenue growth as export markets, especially in Asia and Eastern Europe, are still helping to sustain production despite weak domestic demand. At the same time, manufacturers report intense commodity price pressures, and they report little resistance as they attempt to pass along the rising cost of commodities to their customers. April 29–30, 2008 63 of 266 The projection I submitted for this meeting shows real GDP growth under 1 percent in 2008, with virtually all of that growth coming in the second half of the year. This is a decidedly more pessimistic projection than the one I submitted in January but not materially different from the outlook when we met just six weeks ago. I have, however, boosted my headline inflation projection for 2008 compared with what I submitted in January, and it is somewhat higher than what I was estimating when we met in mid-March. Although I am still projecting that the slack in the economy will be sufficient to bring the core inflation number under the 2 percent threshold sometime next year, I am now anticipating a little more pass-through of commodity prices into core measures than I thought probable six weeks ago. Indeed, every time I see commodity prices ratcheting up, I become less confident that slack alone will be able to prevent an upward drift in the inflation trend. To be clear, I think the downside risks that we face in the real economy remain substantial, and I am inclined to believe that some insurance against those risks is probably warranted. But in taking such a step, I am inclined to judge that the downside risks we face in the real economy will be roughly in balance with the upside risks that we face from a rising inflation trend. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Hoenig. MR. HOENIG. Thank you, Mr. Chairman. Economic activity continues to be slow in the Tenth District with a soft tone in our residential and nonresidential construction and certainly in our retail sales. Mitigating this weakness, however, to some extent is continued strength in energy and agriculture exports and, to a lesser degree, manufacturing. With regard to exports, one interesting development is a shortage of shipping containers domestically and internationally that is limiting the volume of exports of both our agricultural and some of our manufacturing products. On balance though, the District activity continues to be stronger than the national economy, and this is reflected in better employment growth and firm labor markets in many parts of our region. April 29–30, 2008 64 of 266 In my recent discussions with directors at our Bank and in our Branches and the Economic Advisory Council members, several themes have been prominent. Concern about inflation has escalated to the highest level I’ve been involved with in the last decade. Businesses across the board are experiencing the largest input cost pressures in recent memory for them. Many businesses have not been able to absorb these cost pressures and have raised prices to both retail and business customers, and generally speaking, businesses are finding much less resistance to price increases than in the past. Businesses also report that suppliers are increasingly reluctant to make contractual price quotes very far in the future. We have also been monitoring the effects of credit availability on business capital spending in our area. Although businesses report some tightening of credit conditions, credit costs and availability are not the primary factors behind reduced capital spending plans. Bank loans have actually continued to grow. Instead, businesses cite uncertainty about the economic outlook as the main impediment to investment. They are in a wait-and-see mode. So spending is being held back not for financial reasons but just caution. Indeed, they suggest that uncertainty about whether monetary policy will be eased further is a factor currently inhibiting their capital spending plans. They want to see when we’re done. Turning to the broader economic output and the national economy, I have revised down my growth estimate for the first half of 2008 but have had few changes to my longer-term outlook. Compared with the Greenbook, I see somewhat stronger growth this year and somewhat weaker growth next year. Weaker growth in the first half of this year is coming largely from the effects of higher energy prices on consumer and business spending coupled with the continued weakness in residential construction. I would say that the effect of high energy prices is now about as large as or even larger than the contraction in residential construction, and I think that the energy outlook April 29–30, 2008 65 of 266 constitutes a main downside risk to growth in the period ahead. In contrast—and contrary to the Greenbook and the views of some—I think that energy and housing perhaps now more than credit problems are holding back economic growth. Certainly credit conditions have continued to tighten as reflected in the April Senior Loan Officer Opinion Survey, and markets for many asset-backed securities, of course, have shut down. But the availability of credit for good business and household borrowers does not appear to have really been restricted that much. They are pricing more wisely for risk, and that is probably a positive. Consequently, the downside economic risks from a pronounced credit contraction appear to have diminished considerably over the past few months. I want to turn to inflation. In my view, the inflation outlook has worsened considerably. For the first time in many years, we are seeing significant inflation pressure from goods prices, especially imported goods prices. Moreover, the recent moderation in monthly inflation numbers is coming mainly from some softness in service prices, which in my opinion, is unlikely to continue. More optimistic views of inflation, including those in the Greenbook, rely heavily on economic slack and a turnaround in food and energy prices to improve the outlook. I am skeptical on both counts. I do not think that there will be as much slack generated in the current slowdown as does the Greenbook, and there is evidence that the effects of output and employment gaps on inflation have fallen, well, actually more than a little over the past two decades. Furthermore, I have not seen any indication that elevated energy and food price inflation is likely to dissipate soon, as many of these pressures are reflective of international economic developments that we have talked about here, including the weakness in the dollar. I believe that we are entering a dangerous period, if I can use that word, in which inflation expectations are beginning to move higher and inflation psychology is becoming more prominent in business decisions. In this regard, I also do not take much comfort from favorable readings of labor April 29–30, 2008 66 of 266 costs as wages tend to follow prices in my experience. In these circumstances, I am concerned that maintaining a highly accommodative policy stance for an extended period would greatly increase the likelihood that inflation exceeds our long-run objectives. Thank you. CHAIRMAN BERNANKE. President Lacker. MR. LACKER. Thank you, Mr. Chairman. Fifth District economic conditions softened further in recent weeks. Following a pop-up in March, our manufacturing contacts said that factory activity lost momentum in April. Services firms that we surveyed again reported tepid growth in their revenues, and retail sales continued to be very weak. In real estate, the story is mixed. Our housing markets continue to post generally slow sales, but recent anecdotes suggest some scattered firming. Realtors and others indicate that Northern Virginia and Maryland have seen a spring bounce in sales in recent weeks. One Realtor said that a factor supporting sales is that sellers now seem more willing to come off 2006 prices. The Charlotte market has also seen a spring bounce. Coastal areas in the Carolinas, hard hit until recently, are said to be more active lately. Of course, it is hard to know what these anecdotes mean on a seasonally adjusted basis, and contacts caution that it is too soon to call the bottom. In contrast, home sales are weakening in many other areas of the Carolinas, where markets had posted sales and price gains well after the national market had turned down. Residential construction in nearly all areas continues to weaken. On the commercial real estate front, conditions have softened somewhat, although in D.C. proper, commercial rents are firm and vacancies are low. Commercial construction activity is broadly softening. My reading of the national report since the last FOMC meeting is that the real outlook has not changed much. In particular, we still appear to be in a recession. Payroll employment has continued to decline, falling an average of 77,000 per month in the first quarter. Unemployment is rising, although it is still relatively low. Nonresidential construction is weakening, and the falloff in April 29–30, 2008 67 of 266 architectural billings is particularly discouraging. Other business investment has been soft as well. Consumer spending, like business spending, appears to have slowed to a crawl. The length and depth of the recession are likely to depend on stabilization in the housing market. The sharp decline in home construction has continued unabated, and outside of the one-month tick-up in the brand new, as yet untested, monthly home-price index from OFHEO, there’s no sign of any bottoming in any of the national data on housing. Having said that, I noted earlier some scattered reports of a seasonable pickup in home sales. So there’s a chance, perhaps only a slim one, that we’ll see some stability in markets this summer. Concerns are often voiced about the possibility of broad spillovers from financial market conditions in the form of sharply tightening credit conditions for households and businesses. But if we look past the drama in wholesale markets and the end-user credit markets that gave rise to it (in housing and buyout financing), evidence of such spillover is hard to come by, at least so far. It is true that delinquencies have risen across a broad class of credits—commercial real estate, C&I loans, and auto and credit card portfolios, for example—and lenders are reporting tightening terms across many of these borrower classes. But that is generally what happens in recessions: Spreads widen and credit flows fall because many consumers and firms become genuinely riskier. So far, delinquency rates and credit spreads faced by consumers and firms appear to be well within the bounds of what happened in past credit cycles. More broadly, recent experiences have revealed important new information about the efficacy of some prominent financial market mechanisms—information that is, in turn, affecting the current behavior of financial market participants. Auction-rate securities, for example, seem to have worked well for decades because investors attached relatively low probability to contractual clauses that reset their rates and prevented their exit. Reaching those clauses has naturally caused investors April 29–30, 2008 68 of 266 to update their estimates of the probability of reaching those clauses, and the result has been much less—in fact, virtually nil—demand for those securities. Similarly, recent experience has brought dramatic revelations about the informativeness or lack thereof of credit agencies’ ratings of assetbacked securities. Its revelations would seem to warrant fairly dramatic shifts in investor portfolios, just as a matter of Bayesian updating. These changing expectations in light of recent information revelation are just as much a change in fundamentals as the invention of the light bulb. Spreads in interbank markets certainly are elevated, of course, but one fundamental factor here is the continuing uncertainty about the severity of looming losses on mortgage-backed securities. Another fundamental factor is the demand for term funding by European banks about which uncertainty remains regarding mortgage-related losses that may be imminent. Those sources of uncertainty will persist as long as uncertainty about the bottom of the housing cycle persists. At our March meeting I had strong concerns about inflation, particularly the increase in fiveyear, five-year-ahead inflation compensation and the rising trend in overall inflation. Since then we received more-moderate inflation numbers for February, and five-year, five-year-ahead inflation compensation has backed off as well. Although I still believe that these TIPS spreads are too high to be consistent with stable, long-run inflation below 2 percent, it’s heartening to see them come down following our March meeting. It seems reasonable to infer that the improvement in inflation expectations occurred because of the unanticipated emphasis on inflation risks in our statement and the 25 basis point surprise on the funds rate. That response, however, confirms for me the hypothesis that the previous erosion in expectations was caused largely by the aggressiveness of our January policy actions. I believe that substantial risks for inflation and our credibility remain. The Michigan survey number for 12-month-ahead inflation expectations popped up to 4.8 percent, a relatively large number. The March CPI was again too high, and further increases in food and April 29–30, 2008 69 of 266 energy prices in recent weeks will continue to press headline inflation upward. Persistently high headline numbers could become ingrained in household and business decisionmaking. I believe the risk remains that cutting the funds rate again will have undesirable effects on inflation expectations. The real federal funds rate using the Greenbook’s forecast of overall PCE inflation is now between minus ½ and minus ¾ percent. That seems like plenty of stimulus for now. Thank you. CHAIRMAN BERNANKE. President Stern. MR. STERN. Thank you, Mr. Chairman. Well, for some time I have been using the headwinds period of the early 1990s as a frame of reference for thinking about credit conditions, economic growth, and inflation prospects for the next several years. I won’t belabor that comparison much this afternoon, except to say that I continue to find it helpful. With that, and given that the information we have received since our March meeting hasn’t caused me to change my views about financial conditions or about growth, let me just say that I continue to expect financial headwinds of some intensity to persist well into next year. I think that the economy will decline—contract in this quarter and in the next quarter—before growth resumes, and that the resumption will initially be fairly mild. So my outlook for economic growth next year is below that of the Greenbook. It is a pretty modest outlook. Recent anecdotes from business contacts and from people in financial services firms have not been what I would call overly negative. If I were to give those anecdotes more weight, I would probably be somewhat more optimistic about the economic outlook than I am. But I am guessing that those anecdotes are underestimating the weight of the credit constraints that are in train, and people—at least people that I have talked to—don’t fully appreciate that yet. Turning to inflation, on average it seems to me that the inflation situation and its prospects are no better, and possibly worse, than I had been anticipating. To be sure, the core April 29–30, 2008 70 of 266 measures of inflation have not accelerated recently and look to be what I might call close to acceptable, looking at their recent performance. But we have been warned that some of that better performance is likely to prove transitory. Meanwhile, headline inflation has been elevated and has tended to surprise on the upside. Moreover, I worry that the persistence of sizable increases in energy and general commodity prices will have a more pronounced effect on core inflation going forward than they have in the recent past. Further, I have the sense, both from some estimates of inflation expectations and from the comments and questions I have been getting about inflation and the foreign exchange value of the dollar, that the public’s conviction about monetary policy’s willingness and ability to maintain low inflation is starting to waver. Thank you. CHAIRMAN BERNANKE. Thank you. Vice Chairman Geithner. VICE CHAIRMAN GEITHNER. Thank you, Mr. Chairman. In terms of markets, Fed credibility, and negative surprises on the data relative to our forecasts, I think this has been the best intermeeting period in a long time. The markets reflect increased confidence that policy will be effective in mitigating the risks both of a systemic financial crisis and of a very deep, protracted recession. We have seen a substantial upward movement in the expected path of the fed funds rate and in real forward rates, significant diminution in the negative skewness in fed funds rate expectations, and a significant move down in a range of different measures of credit risk premiums, and markets have been pretty robust despite bad news over the past few weeks or so. Medium- and long-term expectations in TIPS have moved down, and we have had a very important and substantial additional wave of inflow of equity into the financial system. Our forecast, though, is roughly the same as it was in March, and it is broadly similar to the path outlined in the Greenbook. We expect economic activity to follow a path somewhere April 29–30, 2008 71 of 266 between the last downturn—a relatively mild downturn—and that of 1990. We expect underlying inflation to moderate somewhat over the forecast period to something below 2 percent. We see the risks to the growth forecast still skewed to the downside, though somewhat less so than in March, and we see the risks to the inflation outlook as broadly balanced. Uncertainty around both paths, though, is unusually high. I want to make four points. First, on economic growth, again, I still think we face substantial risk in this adverse self-reinforcing interaction among falling house prices, slower spending, and financial headwinds. Even with the very substantial adjustment in housing construction that has already occurred and even if demand for housing stays stable at these levels, we still have several quarters ahead of us before the decline in housing prices starts to moderate. A further falloff in aggregate demand during this period would raise the prospect of a much larger peak-to-trough decline in housing prices, with higher risk of larger collateral damage to confidence, spending, credit supply, et cetera. Weakness, as the Chairman has reminded us several times over the past few years, tends to cumulate and spread in these conditions, and weakness may only just be beginning outside of housing. The saving rate here may have to rise substantially further. The world is behind us in this cycle, and it is likely to slow further, diminishing potential help from net exports going forward. Second, financial conditions are, I think, still very fragile. The financial system as a whole still looks as though it is short of the capital necessary to support growth in lending to creditworthy households and borrowers. Parts of the system still need to bring leverage down significantly. Liquidity conditions in some markets are still impaired; securitization markets are still essentially shut. I think the markets now reflect too much confidence in our willingness and ability to prevent large and small financial failures. We are going to disappoint them on the April 29–30, 2008 72 of 266 small ones, which may increase the probability they attach to the large. At least I hope we disappoint them on the small ones. Third, I think the inflation outlook, as many of you have said, still has this very uncomfortable feel to it—very high headline inflation, very high readings on the Michigan survey, and the dollar occasionally showing the spiral of feeding energy and commodity prices and vice versa. I sat next to Paul Volcker when he gave his speech in New York the other day, and he said that the world today feels as it did in the 1970s. I was alive in the 1970s, but only just. [Laughter] But I think it is better than that. It has to be better than that. Core has come in below expectations. David is not going to explain all of that away by these temporary, reversible factors. You have all acknowledged that there is somewhat of an improvement in inflation expectations at medium-term horizon. It is very important that you have not seen any material pressure in broad measures of labor compensation. Profit margins are coming down, but they are still unusually high. The path of output relative to potential, both here and around the rest of the world, is going to significantly diminish pressure on resource utilization going forward even if you have other forces that push up demand for energy and food secularly. I think it is worth remembering that we had a very, very large sustained relative price shock in the years preceding this downturn, with very little pass-through to core inflation. In fact, in many ways, core inflation moderated over that period with output to potential much tighter. Fourth, on monetary policy, it seems to me that we are very close to a level that should put us in a good position to navigate these conflicting pressures ahead. What matters for the outlook is the relationship between the real fed funds rate and our estimates of equilibrium. Although we can’t measure the latter with any precision, those estimates of equilibrium have to be substantially lower than normal because of what is happening in financial markets. The April 29–30, 2008 73 of 266 Greenbook and Bluebook presentations suggest that the real fed funds rate now is about at equilibrium. You can look at it through a number of prisms and see some accommodation—see the real fed funds rate somewhat below equilibrium now. We won’t know the answer until this is long over. I think that we are probably now within the zone where we are providing some insurance against the risk of a very bad macroeconomic financial outcome without creating too much risk of an inflation spiral. We should try for an outcome tomorrow in our action and in our statement that is pretty close to market neutral. One final point about the future. What strikes me as most implausible in our forecast in New York, and I think in the average of our submissions, is the speed with which we expect to return to growth rates that are close to estimates of long-term potential. A more prudent assumption might be for a more protracted period of below-trend growth for a bunch of familiar reasons. I don’t know if that is the most likely outcome, but it is a plausible and realistic outcome. I don’t think we should be directing policy at trying to induce an unrealistically quick return to what might be considered more-normal growth rates over time. Thank you. CHAIRMAN BERNANKE. Thank you. Governor Kohn. MR. KOHN. Thank you, Mr. Chairman. My forecasts of output and inflation for this and the next two years are in the central tendencies of the Committee forecasts. My Okun’s law machine went haywire under the pressure of Debbie’s deadline, [laughter] so my unemployment forecasts need to be revised. But I hit the 5:00 deadline, I think. I have stronger growth in 2008 than the Greenbook because I was hesitant to adopt the staff’s assumption about persistent, serially correlated downside misses relative to fundamentals in consumption and investment implied by entering a recessionary period when we haven’t seen those misses yet. But I didn’t discount this possibility entirely, reasoning that the extraordinarily depressed business and April 29–30, 2008 74 of 266 household sentiment was significant. I came out between the Greenbook baseline and the “nearterm upside risk” alternative scenario. Despite slightly stronger growth than in the Greenbook, I have roughly the same headline and core inflation paths that are declining gradually through the next few years. I took some slight encouragement from recent better readings on core. I reasoned that flat commodity prices would reverse any recent tendency for inflation expectations to rise, and I anticipate that vacant housing units will continue to put downward pressure on rent increases. I have a couple of observations on the outlook. First, I think the expectation of improving financial conditions is critical to the favorable medium-term outcome for the economy that President Geithner was just talking about. We don’t really know what the current state of overall financial conditions is and how spending is likely to respond to them. Directionally, I think we can say that the severe deterioration that was much in evidence around the time of the last meeting has stopped, as concerns about an even more generalized set of failures—the seizing up of markets and lending—have abated with our actions and with successful capital-raising by intermediaries. We have seen improvements in many segments of the markets, but continued deterioration in term funding suggests to me that there are continued worries about and pressures on credit availability, and credit availability and the cost of credit will be under some pressure as credit is re-intermediated through the banks. Even with some of the recent gains, markets are still fragile and impaired. Spreads have retraced only a small portion of the run-up since last summer. I noticed in Bill’s charts that most of those spreads are back down to, say, those in January; and in January, we thought the markets were pretty impaired. So they are still very, very high by historical standards. Mortgage securitization markets away from GSEs remain broken. There are problems in some other securitization markets, including CMBS. A number April 29–30, 2008 75 of 266 of intermediate- and longer-term interest rates are still higher than they were before the crisis hit in August. Baa corporate bonds, which is about the median borrower rating for a corporation, long-term muni bonds, and prime jumbo mortgages are all higher than before we did any easing. Nonprice terms and standards are being tightened considerably, judging in part from the Senior Loan Officer Opinion Survey, and I think that process is likely to continue for a while. To be sure, short-term interest rates are a lot lower than they were in August. But I suspect that a continuation of current conditions would not be consistent with much of a pickup in growth and an eventual return toward full employment. This is a circumstance in which relationships between the federal funds rate and other measures of financial conditions have changed very, very substantially, and characterizing the stance of policy and financial conditions by looking at some measure of the real federal funds rate can be quite misleading in these circumstances. I think we need to be careful about how we characterize and think about the stance of policy. The sense that it is neutral right now, much less accommodative, depends very much on our expectations of substantial increases in risk-taking in financial markets. Now, I do think that the most likely path is improving financial market conditions, lower spreads, reopened securitization markets, and stabilization and maybe partial reversal of some of the tighter terms that have evolved. But this process is going to be slow. Until the housing market shows more signs of stabilizing, it is more likely to be subject to backsliding than to sudden unexpected improvements. A corollary to this line of thinking is that there isn’t a lot of ease in the pipeline in the conventional sense. Our reductions in the fed funds rate have not eased financial conditions. They have kept them from tightening even more than they would have done otherwise. The lagged effects of policy easing come from improvements in financial markets. That is, as we April 29–30, 2008 76 of 266 look forward, the lagged effects of policy easing come from the improvements in financial markets that allow the reductions in the actual and expected paths of short-term rates to show through to the cost of capital more broadly defined. This is a longer and more nuanced process than the usual rules of thumb about seeing the effects of ease on output after X quarters and inflation after Y quarters. My second point about the outlook is that the risks around my forecast for growth are still to the downside. Uncertainty is huge. We are sailing in a fog in uncharted waters, and the depth finder is on the fritz. So much for sailing analogies. [Laughter] Too bad Bill Poole is not here, though I am glad Jim is here. Let me note that for the record. [Laughter] Downside risks from financial market meltdown have been reduced, though not eliminated. But I think an important source of downside risk now is the economy itself—the threat of recessionary tendencies taking hold. I am told we have never had three months of substantial employment declines and business and household sentiment as depressed as they are right now without sliding into a recession. Businesses and households have been unusually cautious in how they invest their savings, moving into government-only money funds and bank deposits, boosting M2, and demanding much larger compensation for taking risks. They are facing much tighter terms for their credit and uncertainty about its availability. It seems to me there is a reasonable possibility that this extraordinary caution in managing their financial portfolios and uncertainty about credit availability will carry over into their spending decisions. That is not my projection or apparently the central tendency of the Committee, but it must be a significant downside risk. In contrast, the risk to total inflation seems skewed to the upside by the potential behavior of commodity prices. I don’t understand why these prices have risen so much over the last six months or so. To be sure, over the last several years the rise in prices must have reflected April 29–30, 2008 77 of 266 increasing demand in emerging-market economies, but over the past half-year the prospects for global growth have weakened. In those circumstances, I would expect the effects of lower interest rates—say, in the United States—to be offset by weaker demand. Still, prices have risen. The possibility that those types of surprises will continue poses an upside risk to headline inflation and, along with that, a risk to inflation expectations. Nonetheless, I saw the risk around a gradual downtrend in core inflation as about balanced, with the possibility of greater slack offsetting the possibility of higher commodity prices. I take some comfort in my projection for core inflation and implicitly for the more persistent aspects of overall inflation from the continued moderate increases in labor compensation. Those increases have been moderate for some time despite very high headline inflation for several years along with still-elevated markups for nonfinancial businesses. Outside of commodities, cost pressures appear to be muted, and businesses are able to absorb increases. Still, I agree that commodity price increases, like any supply shock, have complicated our choices. We are facing a sluggish economy with downside risks as well as uncomfortably high total inflation that is feeding through to some limited extent into core inflation and, by some measures, into inflation expectations, especially near-term expectations. I do think, however, that we need to keep in mind that the higher inflation is largely a function of these commodity prices rather than a broad acceleration in overall prices. Core inflation has come in less than we anticipated it would. I also take some comfort, relative to some of the tone I have heard around the table, in what has happened in markets over the intermeeting period. Markets have built in another ¼ point decline in the fed funds rate but then an increase further out. So somehow they are taking this promise of an increase seriously. At the same time they did that, the dollar rose—it didn’t fall—and the long-term inflation compensation built into April 29–30, 2008 78 of 266 markets came down. So I don’t see the evidence in financial markets that we are on the cusp of the broad decline in our credibility that I have sensed that some others see around the table. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. As has been described by most around the table, official data on the real economy suggest weakness but haven’t materially changed since we met in mid-March. Others have talked in more detail about weakening labor markets, poor consumer sentiment, and worrying trends in consumer spending. Certainly the reports through March that I have received are that consumer spending in March was as bad as anyone who was in the business of retail or credit card spending could have envisioned. That is certainly disappointing. Oddly, there are at least some preliminary data through the first few weeks of April of some improvement, but I don’t take much signal from them. Also, obviously, as others around the table have said, the tone, trading, and expectations of financial market participants have improved markedly. If only I were as confident. Whereas market participants only some weeks ago saw fear, they now perceive promise. Whether that is the triumph of hope over experience only time will tell, but I am skeptical. Let me talk for a few moments about a couple of positive factors that should be helping and four or so negative factors. First, on the positive side, I want to give voice to the capitalraising that a couple of others around the table have referred to. We and the Treasury have been calling for some months for capital-raising across all types of financial institutions. The questions then were whether financial institutions were willing to take the dilution and go raise capital. At least equally as important was whether there would be sufficient investor demand. I think the answer to both of those questions appears to be “yes.” Investor demand from nearly all April 29–30, 2008 79 of 266 sources—including sovereign wealth funds, hedge funds, and traditional long-only managers— has funded virtually all classes of financial institutions—that is, investment banks, money center banks, regional banks, and community banks—across the capital structure—equities, convertibles, and preferred debt—in a huge range of distressed and more-stable situations. I think that is invariably a very encouraging sign, and we should only be so lucky that those markets remain wide open. Is this improvement likely to be enduring? This strikes me as pretty consequential as to whether or not we see the economy respond as favorably in the second half of this year as the Greenbook suggests. Is the improvement in equity markets, in leveraged loans, and in high-yield markets and the narrowing of CDS spreads sustainable, or is there more bad news to come that is not priced into the market? My own view is that balance sheets are on the road to repair but that income statements for these financial institutions remain highly challenged. March was a terrible month for financial institutions’ profitability, which should make it harder for credit to expand, as would be hoped for with any sort of V-shaped or Ushaped recovery. The second positive factor, building on the increase in capital, is really what is going on among the Fortune 2000, particularly the nonfinancial Fortune 2000. Earnings look pretty stubborn and solid. Though they have come off their peaks, corporate profit levels are quite remarkable for all of the things that are wrong in this economy, and they look to me to be anachronistic with previous periods of recession. The balance sheets of those Fortune 2000 companies look excellent. The investment-grade markets remain wide open. I think the question is whether those Fortune 2000 will be hiring workers during the next two or three years in the United States, and on that front, I am probably reasonably skeptical. April 29–30, 2008 80 of 266 So if those are the positive factors, let me turn to the negative. First, consumer weakness seems to be spreading. The largest credit card providers report that credit card spend is deteriorating—again, absent a couple of odd noises in April—and that the strains showing up as delinquency, which were once only in states where housing issues were predominant, now seem to be in other states as well. Second, credit availability for small business seems under remarkable pressure. Not only has the Senior Loan Officer Opinion Survey continued to be disappointing, large money center banks appear to be pulling back from some segments of the small business markets entirely. Third, interbank funding market problems, as others have discussed, seem inconsistent with the broader improvement in credit markets. It is a troubling sign that all might not be as well as it appears in this curative process. A fourth and final negative factor is inflation. The Greenbook, which has a much more benign forecast for inflation than I do, revised up the forecast for core and headline inflation in the second half of 2008, as David said. I am still more worried about inflation prospects. As for inflation expectations and possible second- and third-order effects of these changes in prices, trading and anecdotes over the last several weeks and months continued to be troubling. I have spent less time in my remarks on inflation than on growth but only because I suppose there is less to say. The trends are troubling. The relationships among our policy actions, the foreign exchange value of the dollar, and commodity prices are worth further scrutiny. In summary, although we should be pleased with the official data on the economy as not deteriorating in the intermeeting period and with financial markets that have certainly exceeded my own expectations for improvement, I remain quite concerned about pressures on both sides of the dual mandate—a discussion that we will take up more in the next round. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. April 29–30, 2008 81 of 266 MR. KROSZNER. Thank you very much. As I have talked about many times before, I see what is happening as a continuing slow burn after the fires really heated up for a little while back in March. Things have cooled off again. But exactly as Governor Kohn said, we now seem to be comforted at levels that caused us extreme distress last fall and in January. So I think it is important to put it into that context. There certainly has been improvement, but it is a little early to declare victory—not that anyone has, but I think we just have to be very mindful of that. Some of the discussion reminds me a little of the discussions that we had at the end of October, when we thought that things were improving and then they deteriorated in a way that had us very concerned. But my central tendency scenario has always been not for a financial cataclysm, although that is certainly a real downside risk, but for a sort of slow burn that is just going to continue to weigh heavily on consumption. I think it is negative feedback between housing and finance, but not necessarily a broader cataclysm. I very much agree with President Evans that the chance of a significant nonlinear break to the downside is not gone but lower than it has been. But the tightening credit conditions are going to make it very difficult for the markets to repair and recover as rapidly as perhaps they do in the Greenbook. On housing, we know there are direct and indirect effects. We have all the signs that the contraction is continuing. Even after housing starts have fallen more than 60 percent, we are still seeing them in near free fall. But that hasn’t helped to alleviate the inventories of unsold homes, which remain at extremely elevated levels—although not moving up dramatically. Part of the concern is that some of the sales may be due to forced sales related to foreclosures because we know that foreclosures are up quite a bit. So we have to be a bit cautious there. Almost all the measures suggest that expectations of future housing prices are lower, which is causing people to be very cautious about buying. The anecdotal evidence that I have is that walk-throughs are fine April 29–30, 2008 82 of 266 but that actually closing the deal is much more difficult, both because of difficulty in finding credit and because people are unwilling to make a commitment now. They think that prices may be 10 percent lower in 6, 9, or 12 months. For many people, this is the largest investment that they will make, and trying to explain to a loved one that they just lost 10 percent of their nest egg is not an easy thing to do. So people are being more cautious. We also see some of this in the ABX measures that Bill put forward. Those numbers have come off their extreme lows, but they are still much lower than they were before. It is hard to believe that the actual default and delinquency performance will be as bad as those measures are suggesting, but they are still suggesting that things are going to be pretty tough, and so we still need to be very wary there. We are still seeing a difference in consumer behavior—people being willing to walk away from their houses before they walk away from their credit cards or from their cars. That is suggesting that people are just operating somewhat differently from the way they did before. The jumbo spreads are still extremely wide, as the charts showed. We may be getting some offset from the new FHA programs and from Freddie Mac and Fannie Mae, but I am still not optimistic that much of this can come in before the end of the year. That suggests that we have tightness on that part. We also have tightness in the credit card market, exactly as Governor Warsh said. The credit card companies I have spoken to see continuing deterioration. We didn’t see any sort of nonlinear changes but just a continuing downward trend of real challenges and increasing roll rates of people going 30, 60, 90, and more days delinquent. Spending is up a bit, but they usually say that’s mostly because of increases for gasoline and groceries due to the high commodity prices. Also, as President Yellen mentioned, there is more tightening in the HELOC market. More challenges are there, so the banks are pulling back, and more people are getting into trouble. April 29–30, 2008 83 of 266 I have an anecdote from one of the large companies. A number of large investment-grade firms have drawn down significant parts of their revolvers, not because they actually needed them but because they thought that they better do it now before they are pulled back. Even these large institutions seem to be hoarding liquidity, much as the banks are doing. I think the banks are doing that because we still see CDS spreads that are very high even though they are lower than their peaks. The LIBOR–OIS spread that a number of people have mentioned still is high and is continuing to increase. That is the most troubling for me—that we are moving back to the extreme highs we saw when we had the end-of-the-year problem. But then we had an explanation for its going away. Now we don’t have an end-of-the-year problem, so unfortunately, it is difficult for me to understand what is going to make this go away. I think we can provide more liquidity through some of our various facilities, but I am not sure that that, in and of itself, will be the cure. We have seen more capital come in and help out some of the institutions. But a lot of fragility is still there, as President Pianalto well knows. The issues with respect to National City were liquidity issues, not necessarily short-term concerns about solvency, although I think there are longer-term concerns about solvency. Liquidity and solvency issues are ultimately related, but there is a real concern that many of the money market mutual funds that hold between $3 trillion and $4 trillion will just walk away. We saw this with Bear Stearns. We can see this with other institutions. I think that it’s fragility that accounts for some of these very high levels. We used to worry primarily about deposit runs, but deposit runs are extremely slow. Deposit runs are leisurely strolls compared with what could happen in these liquidity markets. So I do think that issues are there precisely because still more challenges are coming with commercial real estate construction, as a number of other people have mentioned. There will still be a lot of April 29–30, 2008 84 of 266 provisioning that will have to come up, putting more pressure on the balance sheets and making it more difficult for people to borrow. I also very much agree with Vice Chairman Geithner that the rest of the world is a little behind us and that the boost that we are getting right now from exports isn’t going to persist. Turning to inflation, as I think a number of people have mentioned, we haven’t seen a lot of pressure on the labor side. As labor markets soften, it is unlikely that we are going to see more pressure there. So that seems to be a positive. But we do see these very elevated commodity price levels, which don’t seem to have fed through to core. But exactly as Governor Kohn said, it is a bit of a puzzle how they continue to increase, and that certainly puts some risks ahead of us. It is a particularly difficult time to get a good reading on inflation expectations because there have been lots of changes in liquidity issues and in other particular factors. Some of the survey-based measures are up, but they tend to be very closely related to gasoline prices, and we know that those are at extremely high levels. So I think it is extremely difficult for us now to make a solid determination about where inflation expectations are. Certainly that raises a caution because we don’t want to have inflation expectations become unmoored. But I think it is more difficult for us to identify right now exactly how they are evolving, and obviously, this will be important for us in our decisions tomorrow. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Mishkin. MR. MISHKIN. Thank you, Mr. Chairman. My modal forecast is for a mild recession in the first half of 2008 and is very much in line with the Greenbook forecast. I am more pessimistic, however, than the Greenbook on the issue of recovery. Again, the issue is that we have had a major disruption to our financial markets and there is a mess, and I think it is going to take a long time to clean up the mess. The parallel that President Stern made to the episode in April 29–30, 2008 85 of 266 the early ’90s is very apt. I suspect that there will be substantial headwinds coming from the problems in the financial sector for quite a while, and that means that the recovery we would see would be more L-shaped than V-shaped. When I look at where I was at the last FOMC meeting, there has really been a big change for me. I re-read the transcripts, because you always want to see what things sounded like, and I sounded so depressed then, as though I might take out a gun and blow my head off. That is the way it read. But my sunny, optimistic disposition is coming back. [Laughter] I think it is very possible that we will look back and say, particularly after the Bear Stearns episode, that we have turned the corner in terms of the financial disruption that we have just experienced. I should mention, however, that it doesn’t mean that we should be complacent. I am not sure that is the case. We have been disappointed before. But I think there is a very strong possibility that the worst is over. You can see this in that there is less concern about credit risks in financial institutions. That is because we had a major institution get into trouble, but because of our actions, it didn’t blow up the world. There is an issue, of course, of potential cost and moral hazard going forward, but I think it has had the effect of calming down the markets in a very substantial way. Very important in this regard is that we are seeing that our large financial institutions are able to raise capital now at not too high a cost. In fact, they are doing so in a major way. When we think about the long-term solution to the problems in the financial markets, cleaning up the mess and raising capital is going to be absolutely critical, particularly because in the long run the securitization market will come back. But it is going to very much involve the large financial institutions, which will have to solve the agency problems that were not solved in this recent bout of securitization, which created all of the problems. So their having enough capital is April 29–30, 2008 86 of 266 critical. I think it is very possible that we are on the path to their sorting out their problems, which in the long run will help sort out the problems in the credit markets. I should mention, by the way, that I still don’t want us to be complacent about this because things could go in the other direction. There is still the puzzle about what is going on in the money markets. In particular, we see these very large and actually widening spreads between LIBOR and OIS. So even though I am starting to become optimistic, I don’t want to be Panglossian in my view. From my perspective the key issue is that, although my modal forecast hasn’t changed much from March, I see that the tail risks have decreased substantially, and I think that the probability that we will have a severe adverse feedback loop, which really scared me just a little while ago, is going to be much lower. I still see some downside risks. Particularly, I am concerned about the issue of housing prices. They could fall more than we and the Greenbook expect, and that could trigger some problems. But I do think that the downside risk is much, much lower. Another thing I should mention is that I think there is very high uncertainty right now. So I could get depressed again, but we will have to see. I hope not. On the inflation front, I see that long-run inflation expectations are still reasonably well anchored around 2 percent. The information in the financial markets on this score is that there has not been a big blowout in that case. There have been problems regarding some of the surveys, but I am a little less worried about the surveys in terms of households. I am very skeptical of them because they tend to react very much to current conditions. Also, if you ask people what TV shows they are watching, they will tell you that they are watching PBS and something classy, but you know they are watching “Desperate Housewives.” [Laughter] CHAIRMAN BERNANKE. What is wrong with “Desperate Housewives”? [Laughter] April 29–30, 2008 87 of 266 MR. MISHKIN. But I do have a concern about the risk to inflation expectations because of the high commodity prices that we see. This is coming from the very adverse supply shock and the fact that we have had headline inflation so high for so long. The good news, by the way, is that it is actually quite remarkable, given how high headline inflation has been, how anchored inflation expectations have been. I think that has to do with confidence in this institution’s doing the right thing. It is very important that we retain that confidence. We have to think about that when we decide what we are going to do regarding policy. About where I think inflation is going to be—I have been a 2 percent guy for a long time. I am not changing that. I think that inflation expectations are around 2 percent and that there is no expectation that we will have excess demand in the economy. If anything, it is the opposite of that. I see the risks as balanced—there are some risks on the upside, particularly because of what is happening with commodity prices. On the other hand, there are risks on the downside because of the expected slack and because there is some downside risk in the economy. So on that ground, I basically have the same story that I had before. Thank you. CHAIRMAN BERNANKE. Thank you, and thank you all for very helpful comments. As usual, let me briefly summarize what I heard today and then make a few comments of my own. Again, in summary, data since the March meeting have been soft, and economic activity is weak. But the recent news has not generally been worse than expected. There was disagreement over whether we are technically in a recession. Most saw improved economic growth in the second half of 2008 with further improvement in 2009, although some saw more-protracted weakness. The housing sector remains weak, though there were reports of improvement. Starts and the demand for new houses continue to decline. Prices are falling. Inventories of unsold homes remain very high. Housing demand is affected by restrictive conditions in mortgage April 29–30, 2008 88 of 266 markets, fears that house prices have much further to fall, and weakening economic conditions. Retail sales, sentiment, and consumer spending have generally been soft, reflecting a long list of headwinds, including tightening credit, weaker house prices, and higher energy prices. Payrolls are falling, although there are some pockets of strength. Unemployment is likely to keep rising. It may remain somewhat high into 2010. We will soon see whether the fiscal stimulus package affects either the consumer or business investment plans. Possibly, liquidity-constrained consumers may respond more strongly than normally. Business sentiment is also relatively weak, reflecting in part credit conditions but also the uncertain prospects for the economy and continued cost pressures. Investment has softened somewhat, including declines in commercial real estate investment. Strength in foreign markets is helping support U.S. production and profits, especially manufacturing, although foreign economies may slow in the coming quarters. The energy and agricultural sectors are strong. Financial conditions have improved in the past month, with financing conditions better, credit risk spreads coming in a bit, and both equities and real interest rates up since the last meeting. Decent earnings, a sense on the part of some that the bulk of the write-downs in the banking sector have been taken, the ability of financial institutions to raise capital, and possibly Fed actions, including liquidity provision and the actions regarding Bear Stearns, have contributed to the improvement. On the other hand, many markets remain fragile, including the key interbank market and other short-term funding markets. Some expressed the view that moresignificant write-downs and financial stress lie ahead, as house prices continue to fall and the slowing economy weakens credit quality, and that the full impact of tighter credit has not yet been felt in the nonfinancial economy. Others, however, were less concerned about the real April 29–30, 2008 89 of 266 effects of the financial conditions. Financial conditions and the housing market probably remained the most important downside risks to growth, although energy prices were also cited. Readings on core inflation were moderate in the intermeeting period, although some of the reasons for improvement may be transitory. Oil prices have continued to move up, contributing to higher headline inflation. Other commodity prices have also begun to rise again. Many firms noted these strong cost pressures and indicated some ability to pass those costs along to consumers. Inflation breakevens showed improvement at some horizons since the March meeting, possibly reflecting lower risk premiums, though survey inflation expectations were higher. The dollar appreciated during the intermeeting period, but longer-term depreciation and rising import prices remain another source of pressure on inflation. Nominal wage gains remain moderate, however, and markups are high. Uncertainty about the course of oil and other commodity prices adds to overall inflation uncertainty and perhaps to inflation risks that are now somewhat more to the upside. Many participants expressed concerns about these upside risks, about inflation expectations, and about the maintenance of the Fed’s inflation-fighting credibility. Any comments? Let me just add a few thoughts to what has already been said. On the real side, I think that I am probably somewhat more pessimistic than the median view that I heard around the table. First of all, I am reasonably confident that we are in a recession. We don’t see these dynamic patterns of employment, sentiment, and so on without a recession being eventually called by the NBER. That fact, I believe, raises the risks of more-rapid declines in employment and consumer spending in the months ahead because there seem to be somewhat more-adverse dynamics in a recession scenario. Second, I remain concerned about housing, which is not showing really any significant signs of stabilization. Mortgage markets are still dysfunctional, April 29–30, 2008 90 of 266 and the only source of mortgage credit essentially is the GSEs, which are doing their best to raise fees and profit from the situation. Sales of new homes remain weak. Inventories of unsold homes are down in absolute terms, but they still are very high relative to sales. We heard this morning of yet even faster price declines for housing. As I’ve said several times at this table, until there is some sense of a bottoming in the housing market and in housing prices, I think that we are not going to see really broad stabilization, either in the economy or in financial markets. Now, there are some positives—exports, for example—which have kept manufacturing and other industries from declining as much as usual during a recession. Interestingly, this could be a mirror image of the 2001 recession. In 2001, the business sector was weak, and consumption and housing were strong. We could have the mirror image this time. In financial markets, there certainly have been improvements, and that is certainly encouraging. I agree with people about that. But we have heard a few people in the market say that credit losses and write-downs are in the ninth inning. As a baseball fan, I think we are probably closer to the third inning. Let me explain why I think that. The IMF recently projected aggregate credit losses on U.S.-based assets of about $945 billion worldwide, with about a quarter of those coming in the U.S. banks and thrifts. The Board staff has a somewhat lower number, around $700 billion to $800 billion, but they have a higher fraction in U.S. banks and thrifts. So the basic numbers are pretty similar in that respect. The staff projection for credit losses for U.S. commercial banks and thrifts, excluding investment banks, is about $215 billion for this year and next year and $300 billion if the recession is more severe. In addition, the staff projects about $60 billion in write-downs of CDOs and other types of traded assets. Now, most of those $60 billion write-downs have been taken. They are mostly held by the top banks, and they have mostly been already written off. However, of the $215 billion to $300 billion in April 29–30, 2008 91 of 266 projected credit losses, so far U.S. banks and thrifts have acknowledged only about $60 billion. So if you put together those numbers, you find that we are about one-third of the way through total losses. Now, there are, in fact, obviously some countervailing factors. Banks and thrifts have already raised about $115 billion in capital since the middle of last year, which essentially covers the losses announced so far. But that said, there is still a lot of deleveraging to go. There is going to be a long process of selling assets, reducing extensions of credit, and building capital ratios. This may not yet be fully felt in the real economy, but it will eventually be there. So I do think that we are going to see continued pressure from financial markets and credit markets, even if we don’t have any serious relapses into financial stress. So, again, I am somewhat more skeptical about a near-term improvement in economic growth, although I do acknowledge that the fiscal package and other factors that the Greenbook mentions will be helpful. The question has been raised about whether monetary policy is helpful and what the stance of monetary policy is. I agree with the comment that the real federal funds rate is not necessarily the best measure of the stance of monetary policy right now. Let me take an example that was given in the New York Fed’s daily financial report a couple of days ago, which was about the all-in cost of asset-backed securities backed by auto loans. According to this report, in February of ’07, the three-year swap rate was about 5 percent, and the spread on AAA tranches of auto-backed ABS was about 10 basis points. The all-in cost was 5.07 percent for this particular asset. In February of ’08, the three-year swap rate was 3.15 percent, almost 2 percentage points lower, but the spread on AAA tranches was 195 basis points. Therefore, the overall all-in cost of auto loan ABS was 5.36 percent. So the net effect is—well, is monetary policy doing anything? Absolutely. We have reduced the safe rate. We have brought down the April 29–30, 2008 92 of 266 cost of funds. But the spreads have obviously offset that. So what we have really done is essentially offset the effects of the credit crisis. Obviously, if we had not responded to the situation, those costs would be much higher, and the extent of restriction would be a lot greater. For these reasons, I really do believe that we need to take a much more sophisticated look at what the appropriate interest rate is. The Taylor rules, in particular, are just not appropriate for the current situation because the equilibrium real interest rate of 2 percent that is built into them is not necessarily appropriate. Let me turn to inflation, which a lot of people talked about today. First, let me just say that I certainly have significant concerns on the nominal side. In particular, I have a lot of anxiety about the dollar. Foreign exchange rates in general are not well tied down, and they are very subject to sentiment and swings in views. Therefore, although I think that the depreciation of the dollar so far is a mixed bag—obviously, it has effects on different parts of the economy—I do think that there is a risk of a sharper fall with possibly adverse implications, in the short run, for U.S. assets and, in the long run, perhaps implications for our position as a reserve currency and so on. So I think that is an issue to be concerned about. For that reason and for other reasons as well, I am very sympathetic to the view I hear around the table that we are now very, very close to where we ought to be, that it is time to take a rest, to see the effects of our work, and to pay equal attention to the nominal side of our mandate. I agree with all of that. So I am hopeful that in our policy discussion tomorrow we will be fairly close around the table. That being said, I do want to take a little exception to some of the discussion about inflation. There is an obvious and very elementary distinction between relative price changes and overall inflation. Let me ask you to do the following thought experiment. Imagine you are speaking to your board. Last year, as a first approximation, headline inflation was 4 percent, April 29–30, 2008 93 of 266 labor compensation grew at 4 percent, and oil prices rose 60 percent. Let’s imagine that we had been so farsighted and so effective that we managed to keep headline inflation last year at 2 percent. The implications would have been, assuming that relative price changes were the same, that wages would have grown at 2 percent and that oil prices would have risen at 57 percent. In the conversation with your board, your board would say, “This inflation is killing us. These costs are killing us. We have to pass them through.” They would, and they would be right. When there are big changes in relative prices, that is a real phenomenon, and it has to be accommodated somehow by nominal price shifts. So to the extent that the changes in food and oil prices reflect real supply-and-demand conditions, obviously they are very distressing and bad for the economy and create a lot of pain, but they are not in themselves necessarily under the control of monetary policy. If we give the impression that gasoline prices are the Fed’s responsibility, we are looking for trouble because we cannot control gasoline prices. That said, of course we need to address the overall inflation rate. We need to address inflation expectations. All of that is very important. But, again, we need to make a distinction between relative price changes and overall inflation. Now, a more sophisticated response to that is, “Well, maybe monetary policy is contributing to these relative price changes as well”; and I think that is a very serious issue. Certainly the dollar has some effects on oil prices. But keep in mind that a lot of the depreciation of the dollar is a decline in real exchange rates, which is essential in any case for balancing our external accounts. So, yes, the depreciation of the dollar, through our policies, has contributed somewhat to commodity prices. But compared with the overall shifts in relative prices that we have seen, I think it is not that large. There are other hypotheses suggesting that we have been stimulating speculation in a bubble, suggesting that low real interest rates contribute to April 29–30, 2008 94 of 266 commodity price booms. I don’t want to take more time, but the evidence for those things is very limited. In particular, the fact that we have not seen any buildups in hoarding or inventories is a very strong argument against the idea that inflation expectations, hoarding, or speculation is a major factor in energy price increases. So, yes, the nominal side is very important. We need to address that. I agree with that. But we should try to help our audiences understand the very important distinction between real and nominal changes. I think I will stop there. If I can ask for your patience, we could do the briefing on the alternatives today and give ourselves more time tomorrow. Around the table, does that seem okay? I’ll call on Bill English. VICE CHAIRMAN GEITHNER. Mr. Chairman, I was wondering if Brian or Bill wanted to talk President Plosser out of his concern about MZM at some point. MR. MADIGAN. If you like, I could try to address that tomorrow. CHAIRMAN BERNANKE. We’ll have a special session on MZM. [Laughter] MR. ENGLISH. 3 I will be referring to the revised version of table 1, which is included in the package labeled “Material for the FOMC Briefing on Monetary Policy Alternatives.” The revised table presents the same range of options regarding the target federal funds rate as the version discussed in the Bluebook, but we have proposed some changes to the statement language for alternatives B and C. New language introduced in the draft distributed on Monday is shown in blue, with language reintroduced from the March 18 statement shown in black and underlined. An additional adjustment made since Monday is shown in purple. [Laughter] We have about used up the color palette in Word. I will discuss these changes as I go along. Your policy decision at this meeting would seem to depend on three judgments: Where do you think you are; where do you want to be; and what path do you want to follow to get there? The staff’s assessment of where you are—at least in terms of the stance of monetary policy—is summarized in the r* chart that was included in the Bluebook. That chart showed that the current real federal funds rate is about 50 basis points above the Greenbook-consistent measure of r*, suggesting that the rapid easing of policy this year has left the real funds rate fairly close to the level required to bring the economy back to its potential over the medium term. The low level of the 3 The materials used by Mr. English are appended to this transcript (appendix 3). April 29–30, 2008 95 of 266 equilibrium funds rate reflects the staff’s judgment that the housing correction and financial market stresses—with their associated effects on consumer and business confidence—have been sufficient to shift the economy into a recession regime in which spending by both households and businesses is likely to be weak. As for where you want to be, the Greenbook projection assumes that the real funds rate is moved down to its equilibrium level—that is, the federal funds rate is trimmed 50 basis points further—and then remains unchanged over the rest of the projection period. Finally, as for the path you want to follow to get there, the staff projection assumes that you move the federal funds rate to the staff’s estimate of the rate’s equilibrium level relatively quickly by trimming the fed funds target 25 basis points at this meeting and another 25 basis points at the June meeting. However, there is no overshoot below the equilibrium level in order to provide insurance against a further unexpected slide in spending. If you agree with the staff that about 50 basis points of additional easing is needed to bring the real federal funds rate into alignment with its equilibrium level and you are at least moderately confident of that assessment, then you might be inclined to ease policy by 50 basis points at this meeting and issue a statement suggesting fairly balanced risks to the outlook, as in alternative A. A relatively large adjustment to policy at this meeting would be particularly attractive if the Committee wanted a somewhat faster recovery in output or was concerned about downside risks to growth and wished to move the funds rate back to its equilibrium value quickly in order to help head them off. Members might also select a larger rate cut if they were willing to live with somewhat higher inflation over time, as in the optimal control simulation in the Bluebook with an inflation goal of 2 percent. The rationale language proposed for alternative A sticks fairly closely to the language used in March, making modest adjustments that are intended to avoid leaving the impression that the weakness in economic activity or the concerns about inflation had worsened appreciably over the intermeeting period. The assessment-ofrisk language would continue to indicate that the easier stance of policy should “foster moderate growth over time and . . . mitigate the risks to economic activity,” but it would move toward balance by dropping the explicit reference to downside risks. As in March, it would end by promising timely action to “promote sustainable economic growth and price stability.” Investors would be surprised by the adoption of alternative A. Market participants generally expect a 25 basis point rate cut at this meeting and put very low odds on a 50 basis point cut. However, the effect of the relatively large easing would be damped somewhat by the shift to a more balanced risk assessment. The result would likely be lower short- and intermediate-term interest rates, a rise in equity prices, and a softening of the dollar. If the Committee viewed the target federal funds rate as probably close to the level that would appropriately balance the risks to its dual objectives but saw considerable uncertainty regarding that level, then it might be inclined to reduce the April 29–30, 2008 96 of 266 funds rate another 25 basis points at this meeting and suggest a more gradual pace of policy easing, or even a pause, after this meeting, as in alternative B. Policy has been eased very rapidly, and it is difficult at this point to assess the extent to which that easing has been transmitted to households and firms and so to spending. That assessment is complicated by the ongoing turbulence in financial markets as well as the usual difficulty in extracting signals from noisy data on economic activity. Against this backdrop, the Committee may be inclined to take a relatively small policy step at this meeting and then move to a more incremental policy approach under which policy will be guided by incoming information on economic and financial developments. Moreover, with some measures of long-term inflation expectations having moved higher in recent months, members may be concerned that a larger policy move at this meeting would encourage the view that the Committee is more willing to tolerate inflation than had been thought. By taking a smaller policy step at this meeting and suggesting reduced odds of additional near-term policy action, the Committee could limit the extent to which investors extrapolate the recent large policy moves and so build into asset prices more easing than is warranted. Such a brake on expectations may be seen as particularly useful since the incoming data on employment and economic activity are likely to be pretty soft in the near term, and the data releases could well spur expectations of further rate cuts even though the Committee anticipated the weakness when setting policy. Communication on this point will presumably be enhanced by the release of the “Summary of Economic Projections” in three weeks, which should clarify the Committee’s views on the appropriate path for policy and the expected trajectory for economic growth over coming quarters. In the Bluebook, the rationale portion of the statement associated with alternative B was identical to that under alternative A. However, in the revised version of table 1, the first sentence on inflation has been changed to acknowledge the recent improvement in readings on core inflation but point to the continued run-up in energy and other commodity prices. Rather than simply noting the Committee’s judgment that a further easing move is appropriate, as in alternative A, the assessment-of-risk paragraph begins by stating that “[t]he substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity.” The explicit, time-dependent pause that was suggested in the Bluebook formulation for this alternative has been replaced by wording that is intended to suggest that policy will be more data-dependent, with the final sentence now reading, “The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.” The addition of the phrase on monitoring developments coupled with the deletion of the indication in the March statement that the Committee will act “in a timely manner” will likely be read by investors as suggesting a slowing in the pace of easing and possibly a pause after this meeting if the economy develops as the Committee anticipates. Investors appear to expect that the Committee will trim the federal funds rate 25 basis points at this meeting and then leave the federal funds target at 2 percent for April 29–30, 2008 97 of 266 some time. The 25 basis point policy easing and the associated statement under alternative B would seem to be about in line with these expectations, implying little response in financial markets. If the Committee thinks that the substantial easing of policy already put in place, along with the coming fiscal stimulus, is likely to foster outcomes that appropriately balance its inflation and growth objectives, then it may want to stay its hand at this meeting and issue a statement suggesting that policy is likely to change gradually going forward and could even be on hold for a time, as in alternative C. The Committee may expect the ongoing weakness in spending to be relatively mild and brief. The real federal funds rate is already very low, and the incoming data may not be seen as sufficiently weak to confirm the staff’s view that the economy has shifted to a recessionary footing and therefore that spending is likely to come in weaker than one would otherwise expect. With financial markets most recently improving, on balance, and investors apparently less concerned about tail events, the Committee may see smaller downside risks to the outlook for growth. At the same time, members may think that the inflation outlook remains worrisome. Prices of oil and some other commodities touched new highs over the intermeeting period, and members may anticipate that firms will be able to pass a larger share of the increase in these costs through to their customers than the staff anticipates. Longer-term inflation expectations may have increased in recent months, and the Committee might be concerned that failing to push back, at least modestly, against that rise could allow for a more significant increase in expectations that could be very costly to reverse. Moreover, some members may worry that additional policy easing could trigger declines in the foreign exchange value of the dollar and increases in commodity prices that would give a further boost to inflationary pressures. Taken together, these arguments might suggest that, if a further easing step were taken at this meeting, it might have to be reversed fairly soon—an outcome that some members may wish to avoid. The discussion of economic activity in the statement under alternative C is identical to that under the other two alternatives. The inflation paragraph is similar to that under alternative A, but it does not list the reasons for the anticipated moderation in inflation. The exclusion of this list is intended to suggest less confidence in the judgment that inflation will moderate as expected. Some members may also be uncomfortable repeating the reference to “a projected leveling-out of energy and other commodity prices” when those prices have surprised to the upside yet again. The assessment-of-risk portion of the statement starts by pointing to downside risks, but then proceeds as in alternative B. The reference to downside risks might counter to some degree the suggestion of a possible pause in the easing process, but the lack of policy action combined with this statement language would presumably limit expectations for easing at coming meetings. Market participants put only about one-quarter odds on unchanged policy at this meeting, and so the combination of unchanged policy and a statement suggesting that the Committee could remain on hold for a time would surprise investors, even with April 29–30, 2008 98 of 266 the retention of downside risks to growth. Short- and intermediate-term rates would rise, stock prices would likely fall, and the dollar could rally. Effects on longer-term rates, and also on inflation compensation, would depend on whether investors interpreted the statement as indicating that the Committee desired a lower level of inflation than had been thought. The unexpectedly firm policy decision could boost pressures in short-term funding markets, either immediately, as a result of higher funding costs for leveraged firms and a weaker outlook for the real economy, or over time, in the event that economic data came in weaker than anticipated and the FOMC was seen as less likely to ease policy in response. That concludes my prepared remarks. CHAIRMAN BERNANKE. Thank you. Are there questions for Bill? MR. FISHER. Mr. Chairman? CHAIRMAN BERNANKE. President Fisher. MR. FISHER. You emphasized the phrase “reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization.” Can you just refresh my memory? For how long have we been using that phrase—just in the March statement, or have we used it before? MR. ENGLISH. I’m afraid I’m not sure. MR. MADIGAN. We must have used that just in March. It was not here in January. VICE CHAIRMAN GEITHNER. Definitely March. January was minimalist. MR. FISHER. So not in January—it was just in March that we used that. Second, let’s say we were to have a rally in the dollar. If we voted for no change, might that positively affect equity prices or the credit markets in the United States? Is it possible? MR. ENGLISH. I suppose it’s possible, but I guess I would expect that, if monetary policy came out tighter than people had expected, it would lead to at least a modest markingdown of the outlook for the economy. MR. FISHER. For how long? This is a personal view, but it’s not clear to me that things are that clear-cut on a sustainable basis. One of the things that seems to be undercutting April 29–30, 2008 99 of 266 confidence is the weakness in the dollar, even though in the past few days the dollar has rallied. I’m just wondering if it’s clear-cut that we would necessarily have a sustained selloff. I can see an immediate reaction, particularly on the announcement. But it’s conceivable, is it not, that if we had a dollar rally that we could have a positive effect on equity prices or on the credit markets? MR. ENGLISH. I think it’s hard to know how people would read the news. But as was emphasized earlier, a weaker dollar supports exports and supports the outlook for the real economy. CHAIRMAN BERNANKE. Bill Dudley. MR. DUDLEY. I think you could get your result if people took the action as that the Federal Reserve’s view was that the economy wasn’t as great a risk. So risk premiums would come down, the dollar would rally, and the stock market would do better. I mean, it’s possible. VICE CHAIRMAN GEITHNER. This speculation is perilous. MR. FISHER. Yes. I just wanted to ask a question. VICE CHAIRMAN GEITHNER. But I think it goes exactly to what both Bills just said, in that it depends fundamentally on whether the disappointment is reassuring or troubling. We have had two examples of disappointment that have been troubling, and we have had one example of disappointment being reassuring—the most recent one being the latter. So I think what matters most is what happens to the expected path of the fed funds rate going forward, and that is how you would know. If you disappoint significantly and the markets lower the expected path going forward, as they did in October and December, you could have the dollar weaken as a result just as easily as strengthen. We are not very good at speculating about the effect on the fed funds rate expectations of our statements, and it is much harder to speculate about the effect on April 29–30, 2008 100 of 266 the dollar in this context. You can tell a compelling story on both sides. It sort of depends how plausible it is, particularly if you have language saying that downside risks to growth remain even without moving, that we are signaling greater confidence in the strength of the economy going forward with an action that implies not moving. MR. DUDLEY. It is also being significantly driven by the subsequent data. MR. FISHER. Well, this just illustrates the point. It’s not as clear-cut as one might guess. Thank you. CHAIRMAN BERNANKE. President Evans. MR. EVANS. Thank you, Mr. Chairman. I have a couple of questions, unfortunately. I am very sympathetic to your point about how difficult it is to understand what the relationship is between the equilibrium fed funds rate and where we are with respect to financial stress. Actually, my question is for the Greenbook team—if you could remind me again, within the Greenbook-consistent measure, how do you deal with these? You have add factors in your forecast. Presumably, they’re related to the financial stress. I know that they are acting as if there is a higher interest rate at work. We also have the role of the lending facilities, which perhaps have relieved a bit of that stress. I am not quite sure how that plays out here, so if you could, please clarify that as best you can. Again, in chart 6 there is no role for the inflation preference, right? This is all about how long it takes to get back to potential over three years with this interest rate. The Board staff was very helpful over the weekend, when I asked a question about chart 7 and the fact that the funds rate took off from a higher level. If you add that type of analysis in there, it seems as if it comes down a little to what your inflation preference is. For the 1½ percent inflation rate, you might want to stick where you are; if it’s April 29–30, 2008 101 of 266 2 percent, you would move down a bit. Again, that is taking it as given that you can interpret these at face value, if you will. I have another question about the fed funds futures market and Bill Dudley’s chart about how the dealers seem to have slightly different expectations and whether or not that teases out anything about what Governor Kohn was talking about, because that’s a very interesting observation. You know, there is much more weight below the market. MR. DUDLEY. Yes, it’s hard to know what to read into that. It could be that the forecasts have more inertia to them. MR. EVANS. Oh. I thought these were the smart guys who really were on top of it. MR. DUDLEY. But forecasts don’t change that fast, so it is hard to know; but that could be one factor. CHAIRMAN BERNANKE. Dave, did you want to respond? MR. STOCKTON. Yes. First, you are absolutely right. The equilibrium funds rate calculation has no reference to inflation. It shouldn’t be viewed as a policy recommendation or where the fed funds rate should be. In essence, it is one transformation of the IS curve interacting with the supply side of the economy—set the real funds rate at that level, and it is designed to deliver the return of the economy to potential in 12 quarters. Now, as for the way that we have treated financial stress and its effect on the equilibrium funds rate, we have marked down our estimate of the equilibrium funds rate a huge amount since last August. A couple of those big steps really were putting in add factors for our sense of the extent to which financial turbulence and stress were going to depress aggregate spending going forward. How do we get that? We have taken some of these principal component measures of financial stress—in some cases, principal components of the Senior Loan Officer Opinion April 29–30, 2008 102 of 266 Survey—and regressed those on the errors in the spending equations, and observed that there is a pretty high correlation between those measures and our spending errors. We’ve tried, as best we could, to build that correlation into our spending forecast, so that when we calculate the equilibrium funds rate, it reflects a much weaker level of spending for any given funds rate than you otherwise would have observed. The adjustments show up as a lower equilibrium funds rate. The second factor that is currently depressing our estimate of the equilibrium funds rate is indirectly related to financial stress. But in the last forecast, when we shifted to this recessionlike scenario, we incorporated additional negative add factors on spending to reflect the observation that, when we are in a cyclical downturn, there tend to be correlated errors across these equations that are related to the cyclical event. That was a second factor that was leading to the very low estimate of the funds rate. So those are, as best as we could, incorporated in those measures. Thank you. CHAIRMAN BERNANKE. Governor Mishkin first, and then President Bullard. MR. MISHKIN. Is yours on this point? MR. BULLARD. It’s related to this. MR. MISHKIN. Then why don’t you take my slot, and I’ll come in after. MR. BULLARD. Is it a regime-switching kind of model in which you enter the recession state—you call it the recession state—and then add-factor down further? MR. STOCKTON. Yes, though that may be putting it too scientifically. In essence, we were looking at a configuration of data that, at the time of the March meeting, appeared to indicate recession. Even though we did not have the spending data in hand—and, as Governor Kohn indicated, we still haven’t seen these correlated negative errors on spending yet—we had April 29–30, 2008 103 of 266 seen enough other signals in terms of the business and consumer sentiment surveys, the rise in the initial claims for unemployment insurance, and the jump in the unemployment rate that, taken together, suggested to us that there was a likelihood that we were or would be in a recession scenario. We then added in more negative add factors to account for that. MR. BULLARD. Then, is that calibrated against the 1990–91 recession or the 2001 recession? MR. STOCKTON. Basically, we did an average of the residuals in recessions since 1970. MR. BULLARD. Oh, is 1980–82 in there? MR. STOCKTON. Yes, 1980–82 is in there. Again, the composition of where these residuals are is obviously heavily tilted in this case to housing, some of which is already behind us. So it isn’t quite as though all of this weakness is prospective. Some of this weakness we have already had, and so there are very big negative residuals now on housing relative to where you would otherwise have been. CHAIRMAN BERNANKE. Governor Mishkin. MR. MISHKIN. Just to ask Bill a question—first the tall Bill, but the shorter Bill can answer afterward. [Laughter] On alternative B, you indicated that this would be very much in line with market expectations and, therefore, shouldn’t have much impact. I was wondering about the statement aspect, in particular the assessment-of-risk part, because this is not just saying that we are doing 25 basis points; it is also saying that we are now in a different mode of operation regarding the cycle. So where do you think the markets are concerning where the statement would be in this regard? April 29–30, 2008 104 of 266 MR. ENGLISH. In recent days the stories we have been hearing from market participants and observers are that they think there may well be something—maybe not signaling strongly that we’re done but talking about slowing down or possibly a pause. So I think this really is pretty close to what is built in. MR. DUDLEY. Yes, a soft pause rather than a hard pause is the way I would think about what the market is looking for. MR. MISHKIN. Okay. Good. Thank you. CHAIRMAN BERNANKE. Other questions for Bill? All right. Well, we have overnight to reflect. We will also have the GDP data in the morning. I’m sure that they will be informative. We will reconvene tomorrow at 9:00 a.m. There is a dinner and reception, for those of you who would like to attend, and we’ll see you there. [Meeting recessed] April 29–30, 2008 105 of 266 April 30, 2008—Morning Session CHAIRMAN BERNANKE. Good morning, everybody. Why don’t we start with the report from Dave Stockton on the data. MR. STOCKTON. 4 We left at your place, and I hope you have found, a GDP advance release for the first quarter. It came in at plus 0.6 percent versus our Greenbook forecast of 0.4. It was really very close to our expectations, both for the total and for the individual components. There were a few small differences. Nonresidential structures, as you can see about halfway down that sheet, are estimated to have been weaker than we were forecasting. I think that additional weakness certainly reinforces the story I was telling yesterday about this being an area in which we are now seeing more convincing signs of softness. Residential investment was not quite as weak as we thought, but I don’t think the difference between a minus 27 and a minus 31 changes the basic tenor of that particular story. Two small areas for which we had some upside surprises were federal spending and inventory investment, but those surprises were really quite small. I don’t see anything in this report, quite frankly, on the real GDP side that would cause us to change our basic outlook. Obviously, when we get the detail, we might make some minor adjustments to the second-quarter forecast. As for prices, the final two lines of that table, total PCE came in right as we had expected. Core PCE was estimated by the BEA to be a tenth higher than we had projected, but that is still ½ percentage point below what we were projecting back in the March Greenbook. So, again, I don’t think that the report that I gave yesterday would be altered by this release. We also received the employment cost index. In the release, we get those figures only to one decimal place. To one decimal place, we are right on for total compensation—wages and salaries and benefits; in terms of the 12-month change, it was 3.2 percent, and that was what we 4 The materials used by Mr. Stockton are appended to this transcript (appendix 4). April 29–30, 2008 106 of 266 were forecasting. Wages were a bit higher than we thought—3.2 versus the 3.1 we projected— but benefits came in a little lower than we were projecting. There again, I think the data just basically confirm the story that we are not really yet seeing any signs of pressure on the labor cost side. CHAIRMAN BERNANKE. Any questions for Dave? All right. If not, yesterday we had an introductory presentation by Bill English on the alternatives. You will be pleased to know that there have been no further changes in the proposed statements. So why don’t we take comments now from the participants. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. What I would like to do—it will probably come as no surprise—is to make the case for why we should stand pat today and make no change. My case is built on a number of points, and I’d like to articulate those as best I can. First, as we all know, the economic outlook has weakened since the start of the year, but that deterioration occurred largely between January and March. Since the March meeting, there has been little change in the Greenbook forecast or in my own outlook for the economy. Incoming data over the intermeeting period are consistent with a weak first half but not appreciably weaker than we earlier anticipated. I believe that easing policy is appropriate in a weaker economy, but continuing to cut rates for as long as the economy remains weak is not appropriate. Although it is a difficult task, we must try to calibrate the appropriate level of the fed funds rate with the economic prospects and our policy goals. I will just note that, since last September, we have lowered the funds rate 300 basis points. This year alone, in a period of less than 60 days, we have cut 200 basis points. This is a very aggressive policy of easing. Not enough time has passed, in my view, to see the full effect on the economy of those cuts, and a April 29–30, 2008 107 of 266 further 25 basis point cut in the funds rate at this point will do nothing to change the near-term outlook of the economy. Second, we are currently running a very accommodative monetary policy, no matter how you look at it. The real funds rate is negative or very negative, depending on which measures of inflation you use to construct it. The nominal funds rate is below the level of most versions of the Taylor rule, even when adjusting for some interest rate and real rate effects, given our objectives. As I noted yesterday, monetary aggregates as measured by M2 and, to some extent, MZM have expanded very rapidly, especially since our rate cuts in late January. Now, although none of these measures of monetary accommodation or monetary ease is perfect—each has its drawbacks—I am concerned that all the measures of monetary accommodation suggest that we are very accommodative at the current time. Third, inflation is high, unacceptably high in my view, and has been that way for a sustained period, as I talked about yesterday. Some would argue that the weakened economy will bring the inflation rate down. But theory and experience both say that such will occur only if expectations of inflation remain anchored. But since the end of last year, most measures of expected inflation have moved up. The instability in the measures of expected inflation is a cause for concern. It suggests to me that markets may be less convinced of our willingness to take the necessary actions that are consistent with sustaining a credible commitment to price stability. I certainly understand the difference between a relative price shock and inflation. Clearly, oil prices and other commodity prices are in part a relative price shock. There is no question about that. But it is also true that in the 1970s one of our mistakes was that we accommodated relative price shocks with very accommodative monetary policy, and in so doing helped convert a relative price shock into sustained inflation. I think we should be careful not to April 29–30, 2008 108 of 266 fall into the same trap. Besides, I think that in most monetary models today we worry particularly about stabilizing core inflation because it represents the sticky prices in our stickyprice models. So if relative price shocks begin to seep into the core, or into the sticky-price elements, monetary theory would suggest that we need to respond to those. If we are going to achieve something close to optimal monetary policy, we should be concerned about that seepage because it may affect expectations and it is part of what monetary policy should be doing, at least in that class of models. Although it is true that we have not seen much in the way of wage inflation to date and that is encouraging, I would also reiterate, as some people noted yesterday, that wage inflation tends to be a lagging, not a leading, indicator of overall inflation. Contrary to the Greenbook forecast, which has us maintaining a negative real funds rate for two years and inflation coming down, I think that, if we continue easing or maintain the real funds rate well below zero for a period of time despite inflation well above our goal, it is reasonable to assume that expectations will not remain anchored. The FOMC’s stated goal of price stability cannot remain credible independent of our actions. If we want expectations to remain well anchored, we have to act in a way that is consistent with that. Fourth, I believe that we are in the fortunate position today of being able to pause. Market participants have reacted to the incoming data by appreciably tightening their expectations of future funds rate moves—at least as measured by the futures markets, as we have seen. Participants seem to be getting less comfortable with the idea of very easy monetary policy over a sustained period, given the outlook for inflation. I note that the markets’ reassessment of their policy expectations over the intermeeting period doesn’t appear to have had any significant negative effect on the markets, or the economy more broadly, during this period. I think this April 29–30, 2008 109 of 266 reassessment by the markets presents us with an opportunity to reinforce our stated commitment to price stability, not just with words but with action or, in this case, inaction. I think a pause today would send a strong signal of our commitment to price stability, which could further help anchor inflation expectations, which I consider to be very fragile. A pause, it seems to me, balances the risks of the two parts of our mandate. Some might argue that, in the midst of the financial market disruptions that we have seen this year, it is important for the Fed not to add to market turmoil by taking policy actions not anticipated by the markets. The mean expectation for the markets is for 25 basis points of easing today. But market participants are placing odds of somewhere between 25 percent and 30 percent on our pausing, so I don’t think a pause would be very disruptive to the markets. The magnitude of the surprise would be about the same as the surprise we had last time when we cut 75 basis points. That surprise, in my view, did not really cause much turmoil in the marketplace. Finally, when I say that cutting 25 basis points won’t help the outlook for the economy very much, others might respond that cutting 25 basis points won’t hurt it very much either, so why not. I disagree. I think a cut today will not be a disaster but will contribute to a further eroding of our credibility in the eyes of the public. At past meetings this Committee has spoken a lot about the need for rapid reversals of our rate cuts that we took out for insurance. I think we should not be overly confident of our ability to implement such rapid reversals. In fact, the lower the rates go, the further we will need to come back when we start taking the accommodation back. I am dubious of our ability because we will be so much further from what might be a more neutral rate. In summary, to my mind the gain in credibility from pausing today substantially outweighs any negative effects from slightly disappointing the markets. It doesn’t preclude us April 29–30, 2008 110 of 266 from choosing to resume cuts at a later date should economic conditions warrant them. After all, I think this Committee has demonstrated its ability to act aggressively in response to economic conditions, and we can do so again. But that is the future. For today, I think we should take the opportunity that the economy and the markets have afforded us to pause. As the old Latin expression says, “Carpe diem.” With regard to language, I am happy with alternative C. Rather than the language in paragraph 4 of alternative C, I would prefer the language of paragraph 4 of alternative B. I would just make that the language for paragraph 4 in alternative C—that is the only change that I think would be necessary. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Evans. MR. EVANS. Thank you, Mr. Chairman. I, too, favor maintaining the federal funds rate at 2¼ percent today. The current real interest rate provides accommodative monetary conditions for an economy that is struggling near recession or is in mild recession. Our lending facilities are probably doing as much as can be expected to mitigate the serious and necessary financial adjustments that must be accomplished by the private markets. If the economy takes another serious leg down, our current funds rate setting is well positioned for us to respond promptly, appropriately, and aggressively, if circumstances warrant. A pause today affords us a unique opportunity to wait and see how our recent aggressive actions are influencing the trajectory of real activity. Since markets are putting substantial weight on a 25 basis point easing today, a pause will be a relatively small disappointment. As President Plosser pointed out, that was similar to our March disappointment, which seemed to be all right. I think it is important for us to understand how the economy will respond to a pause in rate-cutting when it does occur. With high food, energy, and commodity prices, the extended positive differential of headline inflation April 29–30, 2008 111 of 266 over core measures risks an increase in the public’s inflation expectations. I agree with President Plosser’s discussion of relative prices on that front. From a longer-term perspective, which we don’t really talk about very often, I worry about the asymmetric response of policy to high inflation as opposed to when it is low. When headline inflation is above core inflation, we take on board the relative price adjustment, and then we are content, I would guess, to bring inflation down to our perceived inflation targets. But on the downside, when inflation gets low, we become uncomfortable with certain low inflation settings, and so I fear that we would respond more aggressively, as we did in 2003, which really was a positive productivity environment. If you have an asymmetric type of response, you are going to take on board increases in the price level because of that asymmetry. That’s one reason that I am concerned about these types of behaviors. Although I expect emerging resource slack to temper any adverse inflation developments, the risk is simply growing in importance with every additional policy easing, compared with the economic risks, which presumably are abating as we respond to them with such easings. Calibrating the current policy stance against these divergent economic and inflation risks is important and challenging, as you pointed out yesterday, Mr. Chairman. I think that comparisons to the rate troughs in the previous cycles of recession policy are instructive. The current real fed funds rate is somewhere in the neighborhood of zero, or it could be lower if you choose a different way to deflate the funds rate by total inflation. I was very impressed with Dave Stockton’s response to my question about what types of factors from financial market stress are embodied in the Greenbook-consistent real interest rate. It seems as though a tremendous amount of care has been taken to introduce some of these special factors in innovative ways, and while they may not capture all facets of that, I thought that they did quite a April 29–30, 2008 112 of 266 good job. So I feel a bit more comfortable in making those comparisons, but I do recognize that it is a treacherous period. That said, this is about the same place the real funds rate bottomed out during the jobless recovery with financial headwinds in the 1990–91 recession, and with the data we had in hand at the time during the disinflation concerns in 2003. Both periods were unique in suggesting a high degree of accommodation, and the factors that were at work in each of those episodes were unique. Our attempt to incorporate these factors has been quite useful, and so it’s a reasonable, if not definitive, comparison. With our current lending facilities addressing financial stress, I think our current policy accommodation, now at 2¼ percent, is appropriately similar to those episodes. My final observation has to do with these end-of-cycle expectations and what they might mean for long-term interest rates. If 25 basis points is viewed as additional insurance against downside risks, I just don’t think this action is significant enough to have much of an effect. We expect to take back some portion of the aggressive cuts, especially the ones that have been an attempt to respond to the financial stress. If the financial stress is mitigated to some extent, we should be expected to take that back. Expectations, as in the fed funds futures market, should limit the effect of those actions on long-term interest rates. After all, by the expectations hypothesis, you are going to be averaging these short-term paths into long-term rates. That is one reason that the Committee injected the language “considerable period” back in 2003, to try to convince people that we would do this for a longer period of time and affect long-term rates. So if there is an expectation of some type of rebound, these last insurance cuts might not have that large an effect. Again, I think our lending facilities are better geared for the financial stress. I think we have clearly demonstrated our willingness to provide appropriately accommodative policies in a timely fashion when the economic situation demanded it. For me, April 29–30, 2008 113 of 266 the public’s expectation of these actions in that event argues against one further small insurance move. Because we are concerned about inflation risks and have indicated that we must flexibly move toward more-neutral policy stances once the economy and financial markets improve, a pause today is a small down payment on those difficult future actions. In terms of language, if it came to that, I would be comfortable with the language of alternative B with this particular rate action. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. I must say that I am sympathetic to the “hold” advocates and the view that we are already accommodative. I think an apt anecdote is a conversation I had in the past six weeks with a cruise line CEO who doesn’t know how to drive his ships but who has in fact been at the helm a couple of times. He said, “When you turn the wheel and nothing happens for several miles, the temptation to keep turning the wheel is overwhelming.” [Laughter] So I do have some sympathy. That said, I am going to support a reduction in the target rate of ¼ percent, effectively alternative B, as I indicated yesterday. I think it is pretty clear that we have a tradeoff between “a little more help to the economy” and “enough for now” and really some shift in our focus to combating inflation. So let me lay out my rationale for not holding. I think there is still substantial downside risk to the general economy, and it may take quite some time for recovery to materialize. A quarter would help slightly to effect a lower cost of borrowing and, therefore, would stimulate activity, although much of that is really beyond our control. It will be dictated by market forces. I think that halting today versus conceivably halting at the next meeting risks some interpretation as a lack of recognition of the real state of weakness in the economy. April 29–30, 2008 114 of 266 Regarding inflation, I think the core numbers in the first quarter were not overly discouraging, and I have to believe my own forecasts—in many respects, the forecasts I heard— that inflation will soften in the coming months and be consistent with our working view of expectations. I would say, however, that I am concerned that, in the minds of the general public, high prices actually translate into inflation, whether or not the rate of inflation has flattened. As I have suggested, I am inclined to pause after this move, provided that the incoming data are not too adverse and too divergent from expectations, but with the caveat that I think a lot of shock risk is still out there and we have to remain flexible to deal with surprises. Holding or signaling a pause may help the housing market a bit by starting to construct a bottom, as borrowers or buyers begin to perceive that they shouldn’t expect any further rate cuts from us. Regarding the statement, I think the rationale section in alternative B is appropriate to the situation that we face. Section 3 is a realistic acknowledgement of inflation trends and risk. I gather that, with the changes in section 4, the question was whether or not to signal a pause or an inclination to pause, and I tend to agree with a more cautious, less committal approach of the proposed language—what yesterday was called a “soft” pause. So I am, on balance, quite happy with the language in alternative B. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Stern. MR. STERN. Thank you, Mr. Chairman. Well, I have given serious consideration to both alternatives B and C, and I think a credible case can be made for either one. There are, of course, risks associated with adopting either one as well. On balance, I come out in favor of alternative B, for the following reasons. First, we are certainly not yet out of the economic woods. Although my forecast is for a relatively mild recession, I would not be particularly surprised if it turned out to be both deeper and more prolonged, given, among other things, the April 29–30, 2008 115 of 266 persistent overhang of unoccupied, unsold homes and the severity of the financial dislocations of the past nine months. As I have tried to emphasize, I think it could be dangerous to underestimate the effects of the financial headwinds now in train and likely, in my judgment, to get more severe. Second, and closely related to those observations, financial conditions remain quite sensitive. Even if improvement is now under way in some markets, I think it will be some time, as I said yesterday, before credit conditions are fully supportive of economic growth. To amplify a bit, I think we need to be a bit careful about the weight we put on the low level of the real federal funds rate per se for, as Governor Kohn pointed out yesterday, the credit situation is a good deal more complicated than that. My principal reservation about supporting alternative B has to do with the inflation outlook. The news here has not been uniformly bad, especially with regard to core inflation, but I am not convinced that inflation will abate in a timely way without policy action. On the other hand, I take some comfort from the fact that apparently financial market participants do not anticipate further reductions in the federal funds rate target beyond this meeting. I think the language associated with alternative B should help to reinforce the view that, at a minimum, a pause in the reductions in the target is not that far off, given what we know today. I think it important that we find opportunities to bolster that view when we can. Thank you. CHAIRMAN BERNANKE. Thank you. President Rosengren. MR. ROSENGREN. Thank you, Mr. Chairman. There seems to be a groundswell of opinion in financial markets, and perhaps around this table, that given the easing to date we are at or close to a point where we should pause and assess the impact of both fiscal and monetary stimulus already provided. Should we pause at a fed funds rate below 2 percent, at 2 percent, or over 2 percent? The Greenbook forecast assumes that we pause at 1¾ percent. With this degree April 29–30, 2008 116 of 266 of stimulus, core and total PCE inflation is at or below 2 percent in 2009, but the unemployment rate remains well above the NAIRU, even at the end of 2010. The Boston forecast generates similar outcomes. The Greenbook and the Boston forecasts suggest that 25 basis points at this meeting may not be enough. Both forecasts imply that a significant degree of slack remains in the economy, even with a 25 basis point reduction at both this and the following meeting. In addition, there are significant downside risks to the outlook. Falling asset prices in other countries have frequently been accompanied by prolonged periods of weakness. Finally, given the rise we have seen in the LIBOR rate, for many borrowers a 25 basis point decrease leaves policy no more accommodative than at our last meeting. The consensus seems to be that we should be moving in smaller increments. But if we choose option B, it is not at all clear to me that we should pause after this meeting. In that regard, I was happy to see the revised language in the Bluebook table 1, which does not imply that our easing cycle has definitely ended. While I hope that the economy recovers sufficiently that further easing is not necessary, we need to remain flexible, particularly given that our models indicate that even with further easing we are likely to experience several years of elevated unemployment rates. Thank you. CHAIRMAN BERNANKE. Thank you. Governor Kohn. MR. KOHN. Thank you, Mr. Chairman. I think I can be brief by just associating myself with the comments of President Stern. This is a difficult decision. You could make a case for either of these. But on balance, I think we should be lowering interest rates 25 basis points, as under alternative B. As President Stern said, I don’t think just subtracting past inflation from the nominal federal funds rate is a good metric for where the stance of policy is today. It would be if financial conditions were consistent with historical relationships, but they’re not. We have very April 29–30, 2008 117 of 266 tight credit conditions in many sectors of the market, and a zero or negative federal funds rate means a very different thing today than it did even in the early 1990s, Gary, because then you had the banking system broken but the securities markets working. Now you have the banking system broken and the securities markets not working very well. So I think we have stronger—I guess Greenspan called them “50 mile an hour”—headwinds. I would say they are 60 or 70 today, at least for now. We expect the headwinds to abate; and as they abate, policy will look a lot more accommodative. But I don’t think we really have insurance right now against the contingency that the headwinds don’t abate very quickly or even get worse, or against the contingency that the staff is right and we are entering a recessionary period in which consumption and investment fall short of what the fundamentals would suggest. I think that 25 basis points probably won’t buy us much, if any, insurance, but it will get policy calibrated a little better to the situation that we are facing today. I expect a small decrease in the funds rate to be consistent with further increases in the unemployment rate—and everybody does, I think, judging from the central tendencies of the forecast—which will put downward pressure and help to contain inflation. I agree that there is an upside risk from continued increases in commodity prices that feed through, as President Plosser noted, into core inflation. I think that this is a very different situation from the 1970s. I looked this morning at the Economic Report of the President, at those tables in the back. The stage for the 1970s was set in the 1960s. Core inflation rose from 1½ percent in the mid-1960s to 6¼ percent in 1969. That’s a situation, obviously, in which inflation expectations can become unanchored, and then these relative price shocks feed through much more into inflation expectations. Looking in the Greenbook, Part 2, page II-32, every measure of core inflation for 2007 was lower than the April 29–30, 2008 118 of 266 measure of core inflation for 2006, and half of them—these are Q4-to-Q4 measures of core inflation—are lower than for 2005. So we are not in a situation of a gradual upcreep in core inflation, which I think was what set the stage for the 1970s. I don’t expect a small decrease in interest rates to result in higher inflation through this dollar–commodity price–inflation expectations channel either. The decrease in interest rates is already in the markets. If anything, a statement like alternative B might firm rates a bit; and taking out “downside risks” and “act in a timely manner” reinforces the notion that the Federal Reserve is not poised to ease any more. I wouldn’t expect interest rates to go down; therefore, I wouldn’t expect the dollar to go down, and I wouldn’t expect commodity prices to go up from this. I think the markets reacted very well over the intermeeting period to incoming data. They saw the tail risk decrease. They raised interest rates. The dollar firmed. They put a U shape in our interest rate path. It seems to me that path is very close to what many of us said we expected and thought was appropriate, give or take ¼ point, for the federal funds rate over the coming couple of years. I don’t see any reason to act in a way that changes those expectations; I think the market expectations are fine. I wouldn’t lower interest rates ¼ point just to confirm market expectations. I think it is the right thing to do, and I don’t see any reason to lean against it to change expectations. I think that expectations are lined up pretty well with our objectives. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Fisher. MR. FISHER. Well, Mr. Chairman, I was listening very carefully to Governor Kohn, as I do the rest of my colleagues. I noted your comment that it doesn’t buy us much. I’m worried that it may cost us much. Had I gone first, I would have made arguments similar to those of April 29–30, 2008 119 of 266 President Plosser and President Evans. I am in favor of a pause. I think that is pretty clear. I want to stress a couple of things I mentioned yesterday because I think they’re important. I am concerned about our costs regarding what I call a different kind of adverse feedback loop, which is the inflation dynamic whereby reductions in the fed funds rate lead to a weaker dollar and upward pressure on global commodity prices, which feed through to higher U.S. inflation and to cutbacks in consumption by consumers and actions by employers to offset the effects of inflation. I quoted a CEO, whom I consider to be very highly regarded, regarding his company’s behavioral patterns. This is someone, by the way, who was in the business in the 1970s. He said, “We’re learning to run a business, once again, in an inflationary environment.” That quote bothers me because it shows a behavioral response. This goes beyond the issue, but I thought that comment you made yesterday about relative prices, Mr. Chairman, was very interesting. But it shows a behavioral response, and behaviors eventually become habits, and habits become trends, and I’m worried about that. There was a period when I felt that we were at risk of a repetition of the 1930s. I think the liquidity measures that we have taken—which I have fully supported, and I applaud you, Mr. Chairman, and the New York group for thinking these through with the staff—have provided the bridge that we spoke of yesterday. Don, you mentioned the 1970s. I am no longer worried about the 1930s, although I think there are tripwires out there that are very, very serious. You pointed to them in your intervention. You are right; under Bill Martin these pressures were put in place. But somebody mentioned yesterday—it may have been Vice Chairman Geithner—that he wasn’t around in the 1970s. I actually sat by President Carter’s side when he got lectures from a leftwing socialist named Helmut Schmidt and by a right winger named Margaret Thatcher. Their points were that you cannot risk appearing to be complacent about inflation. I worry that we risk April 29–30, 2008 120 of 266 appearing to be complacent about inflation. I am speaking within the family here, but I sense that we are giving that appearance on the outside. The question really is, Is it worth ¼ point? What is the risk–return tradeoff here? I don’t think it’s worth cutting ¼ point. I think it is worth staying where we are. I know that the markets anticipate X or Y. We had a conversation about that yesterday. I made my living in the markets. The markets come and go, and I am happy to hear Governor Kohn say that we are not influenced by the markets. I don’t think we should be. Their reactions are momentary. But I just don’t feel the risk–return tradeoff makes it worthwhile for a ¼ point cut here unless we saw evidence of substantial downside slippage beyond what we are all discounting for housing, which is very negative. I have spoken about a price correction of 35 percent from peak to trough, and we’re not there yet. It would have to be more negative than that to convince me to cut rates further. So, Mr. Chairman, I respectfully submit that we should pause, and that’s how I plan to vote. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Yellen. MS. YELLEN. Thank you, Mr. Chairman. I favor alternative B with the wording that has been proposed. But I do appreciate that there is a case for alternative C as well, and I understand and appreciate the arguments that have been made in favor of it. On the pure economic merits, I definitely support a 25 basis point cut. As I noted in my comments on the economic situation, it appears that the economy has stalled and may have fallen into a recession. I share the same concerns as Governor Kohn and President Stern. My forecast is close to the Greenbook. I think a further easing in financial conditions is needed to counter the credit crunch, and I believe that a cut in the federal funds rate will be efficacious in easing financial conditions. April 29–30, 2008 121 of 266 Although the real federal funds rate is accommodative by any usual measure of it, I completely agree with Governor Kohn’s discussion of this topic. This is a situation in which spreads have increased so much and credit availability has diminished so much that looking at the real federal funds rate is just a very misleading way of assessing the overall tightness of financial conditions. I consider them, on balance, to be notably tighter than they were in the beginning of August. I don’t agree that further cuts in the federal funds rate will be ineffective in helping us achieve our employment goal or counterproductive to the attainment of price stability over the medium term. Given that a 25 basis point cut is what the markets are now anticipating—it is built in—I would not expect this action, coupled with the language in alternative B, to touch off further declines in the dollar or to exacerbate inflationary expectations. That said, I did see arguments in favor of alternative C as well. I can see some advantage in doing a little less today than markets are expecting as long as we reaffirm that we do retain the flexibility to respond quickly to further negative news with additional cuts. A case that could be made for pausing is that we will soon get information relating to GDP in the second quarter and get a better read on just how serious the downturn is. With respect to market and inflationary psychology, I also can see a case for doing less than markets expect. It is true that some measures of inflation expectations have edged up a bit, and I would agree with President Fisher that perhaps a pause would counter any impression that we have become more tolerant of inflation in the long run. But I don’t think we have become more tolerant of inflation in the long run, and I did see today’s reading on the employment cost index as further confirmation that at this point nothing is built into labor markets that suggests that we are developing a wage–price spiral of the type that was of such concern and really propelling the problems in the 1970s. On the other hand, I agree with President Plosser, too. Wages aren’t a leading indicator. We have to April 29–30, 2008 122 of 266 watch inflationary expectations. So I don’t think that is definitive. Nevertheless, I do find it quite reassuring that nothing is going on there at this point. I think doing nothing today might mitigate the risk of a flight from dollar assets, which could exacerbate financial turmoil. So there are arguments in favor of alternative C, and I recognize them. But, on balance, I believe that the stronger case is for B. CHAIRMAN BERNANKE. Thank you. President Bullard. MR. BULLARD. Thank you, Mr. Chairman. The FOMC is badly in need of a stopping rule on the federal funds rate. Continued reaction to bad economic news—and there is likely to be bad news in the coming months—is going to set up serious future problems for this Committee. The fragile credibility of the Committee is being eroded as we speak, and we will do well to take steps to reassert inflation-fighting resolve at this meeting. The intuition in dealing with the current crisis is that we can use new lending facilities to help return financial markets to more normal operation and that interest rate policy is not that likely to help on this dimension. But exceptionally low rates can create new problems. Since lower rates are not really helping directly with the smooth operation of financial markets, I suggest that we put that on hold for the time being and let our past, stunningly aggressive, interest rate moves have an effect through the summer and into the second half of the year. This would be consistent with alternative C in the policy alternatives. Many participants have emphasized that there will be a long unwinding process. The Chairman described us as being in the third inning on this, similar to the late 1980s and early 1990s. During that episode, the Fed went on hold at 3 percent, considered an exceptionally low rate at the time. That gave financial markets a chance to heal following the S&L problems without creating other problems for the mid to late 1990s. In retrospect, this policy worked quite well during that April 29–30, 2008 123 of 266 era, and it seems to me that something similar could be done today at the current level of the federal funds rate. Thank you. CHAIRMAN BERNANKE. Thank you. President Hoenig. MR. HOENIG. Mr. Chairman, I’m glad that reasonable people can differ. I do continue to hold the view that easing policy today is a mistake. If I were voting on it, I would vote to hold where we are. With the fed funds rate at the level it currently is, I think that continuing to ease policy in an environment of rising inflationary pressures gives serious erosion to our long-run credibility. We are seeing increasing signs that inflation expectations are rising. I see it constantly, as the public’s inflation psychology is changing as well. This change reflects the large, sustained now, increases in food, energy, and other commodities and accelerating import prices. I am concerned that maintaining at this highly accommodative policy level for an extended period, while it may bring some short-run stimulus into the economy, increases inflationary risk to an unacceptable level, which will, over the not-too-distant future, begin to distort long-run investment decisions and continue to increase the risk of financial instability and imbalances in the longer-run. Finally, on the psychology of the markets, holding rates constant, although it might disappoint some on Wall Street, will please many, many on Main Street. I judge that it will confirm to the world that we are turning our attention to these longer-run issues, and I’m disappointed that we’re not seizing the opportunity to make that statement. Thank you CHAIRMAN BERNANKE. Thank you. President Pianalto. MS. PIANALTO. Thank you, Mr. Chairman. My concerns about the real economy are similar to those that I had in March. I continue to believe that residential real estate markets could deteriorate even further than what I have in my baseline projection and could exert even greater downward pressure on business activity. Financial markets in my view are still fragile, and larger or April 29–30, 2008 124 of 266 more-widespread liquidity pressures could quickly present us with an even weaker set of economic fundamentals. At the same time, I can’t easily dismiss the ongoing escalation of energy and commodity prices. Although many of us, as we talked about yesterday, have expected these price pressures to abate for some time, they have not; and as I indicated yesterday, I do believe there is a risk that core inflation will not follow the downward path that I submitted as my projection for this meeting. So like others, I can see a case being made for alternative C. However, I think a modest reduction to our policy rate today as a precaution against further slippage in the real economy is prudent. But I also strongly support the language that indicates we’re very close to, if not at, a pausing point in our easing cycle. So I support the policy recommendation and the language in alternative B. Thank you. CHAIRMAN BERNANKE. Thank you. President Lacker. MR. LACKER. Thank you, Mr. Chairman. I find myself agreeing with my colleagues who have advocated alternative C. One way to think about our approach to the policy decision today is to look ahead and think about the probabilities associated with two bad outcomes. Will the economy go into a substantially deeper recession than we expect? Or coming out of this recession, will the trailing inflation rate be higher than it was when we went in? Although I hope neither of these occurs, my sense right now is that the chance of an increase in trend inflation is more likely than a much deeper recession, and I think we should alter our policy path accordingly. The incoming data since the beginning of the year have resulted in a more adverse outlook, and that change in the outlook is already, in my view, reflected in the current stance of policy. I noted yesterday that the real federal funds rate using the Greenbook’s inflation forecast rather than four-quarter lagged core inflation is now between minus ½ and minus ¾ percent. I think it makes sense to take advantage of information about foreseeable gaps between overall inflation and core, April 29–30, 2008 125 of 266 and the stance of policy strikes me as very stimulative, certainly plenty for the recession we now expect, when we look at back historical recessions. As I noted yesterday, at the retail level for firms and consumers, spreads aren’t out of line with where they’ve been in past recessions. It is true that jumbo mortgage rates and some other rates have not come down as much as they’ve come down in past recessions, but I just remind people of the secular technology shift. There’s a sort of level shift in intermediation technology that we’re going through right now that really constitutes a change in the relative prices of different financial assets. Now, I can’t think clearly about the stance of policy without talking first about the risk-free rate and then thinking about various spreads as really having to do with the relative prices of different financial claims. So in looking at and through retail rates, that’s informative. But the riskfree rate is the risk-free rate, and an array of factors affects how those relative financial prices evolve. The securitization channel that seemed to work very well for a while is now exposed as more costly and less efficacious than once was thought. Some of these securitization vehicles didn’t exist in past recessions or expansions, and only a couple of decades ago these spreads were as high as or higher than they are now. So I stick to thinking about the stance of monetary policy in terms of the real risk-free rate. I think our experience between the January and the March meetings with inflation expectations is pretty good evidence of their fragility in the current environment without our having articulated what our long-run objective is for inflation. I don’t think that the level of inflation expectations is aligned with our objectives; I think it is too high relative to our objectives. Market participants see a good chance of our dropping the rate ¼ point today and reversing field later in this year and raising rates again. I suspect they don’t fully grasp how difficult it’s going to be to reverse course while we negotiate the murky waters of the recovering economy later this year. Indeed, I April 29–30, 2008 126 of 266 think that the fiscal stimulus that we’re going to get will make those waters even murkier. It will be even harder to divine the underlying, ex-fiscal-policy strength of the economy. So for these reasons, I believe that we should leave the fed funds rate alone today. The upward surprise at our last meeting did not appear to affect financial markets adversely. Coupled with that statement’s emphasis on inflation risks, it did seem to have the beneficial effect of reversing the run-up in inflation expectations. I would expect that leaving the funds rate alone today would have a similar beneficial effect in stabilizing inflation expectations. So I favor alternative C, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. I can support alternative B, but I must admit I can’t do it with the conviction that I would prefer to have. I think market participants will look at our decision today and at the data over the next few weeks and try to measure whether we can hold up to the pause language that accompanies alternative B. Taking action with a 25 basis point move today, we have to then be prepared to stomach the continued weakness in the real economy that is in many of our projections. Speaking for myself, I’d say we also have to be prepared when we next meet to hold the line even if we see a retracing of some of the improvements in financial markets. So in my own base case, the judgment when we next meet will be a harder one. The economy might look weak; financial markets might look weaker than they are; and trying to signal to the markets in alternative B that we are serious about holding the line at what would then be 2 percent is putting a pretty hard task on us. I think we’re capable of holding the line there, but we have to hold ourselves to that standard. The 25 basis point move, in and of itself, doesn’t strike me as that consequential. What strikes me as consequential is the symbolism. Given the uncertainties that Dave and the team have April 29–30, 2008 127 of 266 spoken about, it strikes me that the 25 basis points is not nearly as consequential in effect as what might well happen to the transmission mechanism and the efficacy of this change in federal funds rates on the real economy. Put differently, if the financial markets can get back to business, they will be helping the real economy, in effect lowering the cost of capital far more than our actions would today. As I said, I think the symbolism here does matter. By moving 25 basis points today, we’re taking some risks with the dollar. I think that the dollar improvement we have seen over the past several days and weeks has occurred because there’s an expectation that we are closer to a pause and that this Committee is going to have a tougher decision about whether or not to move than they had anticipated some weeks ago. Even though the language in alternative B is useful in trying to lay the factual predicate for a pause when we next meet, there will be a lot of folks who will be wondering about our convictions there, and when they do, I think we are assuming some dollar risks. We are also assuming incremental risks on the inflation front. Continued easing could well encourage the perception that the FOMC has a greater tolerance for inflation than is prudent, with potential adverse effects on inflation expectations, a further run-up in commodity prices, and a continued decline in the foreign exchange value of the dollar. So this is a tough judgment that we’re making, with significant uncertainty. I take comfort in believing that the language in the minutes and the remarks that we all offer between now and the next time we meet will suggest not that this is a cut with a dovish pause but that this is a cut with an expectation of holding after our actions today. We are not barring all events because we can certainly imagine the world turning yet again and we can certainly imagine another let-down, particularly in the global economy. But this is a statement that we want to hold after our action April 29–30, 2008 128 of 266 today and that we are prepared to stomach some additional bad news with respect both to the economy and to financial markets. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. MR. KROSZNER. Thank you, Mr. Chairman. As many speakers before me have said, this is a pretty close call, and reasonable cases can be made for both alternative B and alternative C. If you look at financial market conditions, you can see your favorite indicator and say whether things have eased or not eased. One indicator that I look at when thinking about the transmission of monetary policy is the LIBOR–OIS spread, which has gone up very significantly. A lot of shortterm borrowing is priced off of that. If we wanted just to keep policy where it was six weeks ago, we would actually have to cut more—not that I’m suggesting that we should. But if you use that spread as the relevant indicator, it would suggest that, if one were to keep the same stance, or potentially the same stance, of monetary policy, you’d have to cut a lot. It doesn’t seem as though our liquidity facilities have been effective on this particular dimension. We had been hopeful that they would be, but they don’t seem to be. Even with some of the things that we voted on yesterday, we’re still going to see very elevated spreads in some of these markets, still making borrowing costs relatively high and so disrupting the traditional monetary transmission mechanism. So that’s where I would argue for alternative B. Another argument for alternative B is the potentially protracted slowdown. I agree very much with President Stern. As I’ve talked about a lot before, this sort of slow burn is related to the housing market. The repair and recovery of those markets is going to take a long time. The spreads are still quite elevated in a number of these markets. So providing more cushion against the downside risk there for those markets and then thinking about how that risk affects the potential for April 29–30, 2008 129 of 266 broader downside risks, in which the housing market seems to be a potential trigger point for negative nonlinear dynamics, again suggests that moving down 25 basis points now is prudent. The key, of course, that people have been talking about is inflation pressures going forward—inflation expectations. Here a case can be made on either side with some cogency. One challenge we have right now is that we have a lot of differences in the way to read inflation expectations. Looking at the five-year-ahead versus the five-to-ten-year-ahead, we’ve seen them spread apart quite a bit and now start to come back together, with the next five years starting to move up but the five-to-ten-year-ahead moving down. We have a number of other measures of expectations, some of which have moved up quite significantly but maybe primarily because of some relative price movements rather than underlying inflation trends. One thing that is comforting for me on the alternative B side is that during the last year to 18 months, when we have had very low—below 5 percent—unemployment rates, we have seen very little evidence of high wage pressure. I find it unlikely that it is going to increase as the unemployment rate goes above 5 percent, and I think, as many people around the table do, that unemployment may sustain itself above 5 percent for quite some time. We also haven’t seen some of the real shocks to energy and commodity prices feed through to core. Now, that still could be coming. But we’ve seen very elevated prices in these areas for quite some time—six to nine months—and the most recent readings from the PCE index suggest that they haven’t fed through. Maybe that is still to come, and I think to be worried about that is reasonable. It is also reasonable to be worried about implications for the dollar if we were to go for alternative B rather than alternative C. But the language in alternative B can provide some comfort to the markets that we are unlikely to be pushing much further, given what we see and what we expect, but that we are open to April 29–30, 2008 130 of 266 that possibility. We certainly have a very long time between this meeting and the next meeting. We’re going to be getting two employment reports, GDP, and a lot of other information, so we may need to revisit some of these issues. But at this point I would come down for alternative B with the language that we have. I think it gives us the appropriate flexibility, and I don’t see sufficient evidence of an unhinging of inflation expectations or actual inflationary pressures, at least with respect to core, to say that we need to take a pause now. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Mishkin. MR. MISHKIN. Thank you, Mr. Chairman. Well, I’m in a very uncomfortable position here because I usually like to be very decisive, and I think in all past cases I’ve had a strong view before going into the meeting in terms of what is the appropriate alternative that the Committee should take, at least that I should take. I’m in a very uncomfortable position because I’m actually sitting exactly on the fence between alternative B and alternative C. As you know, sitting on the fence and having a fence right in that anatomically uncomfortable position is not a good place to be. [Laughter] So let me go through the current situation and argue why I’m in this uncomfortable position. The first point to make is that inflation expectations are actually reasonably well contained. It is true that I have a concern that high headline inflation could make containing inflation expectations and preserving the nominal anchor more difficult. But it is important to note that we have been in a situation in which we’ve had very high headline inflation and, in fact, core inflation and inflation expectations have behaved very well. So it’s very important to emphasize that this is not the 1970s, and I really get disturbed when people point to that as a problem. We do have to worry about inflation expectations possibly going up, but it’s not a situation that, if we make a April 29–30, 2008 131 of 266 mistake, they go up a whole lot. They could go up, and it might be costly to get them down, but it would not be a disaster. The second issue is that, although we may have turned the corner, we are still in a situation of very fragile financial markets, and we have been disappointed before. I am getting more optimistic. I’m hopeful and think it’s very possible that we’ll look back at the middle of March and say that was the worst of it. But there is a possibility, and it’s not a small possibility, that things could go south again, and that would argue for the need for aggressive cuts in the future. The third thing that I point out about the situation is that the modal forecast given by the Greenbook—and consistent with my modal forecast and with the modal forecasts of most of the participants—suggests that we may have to cut a bit further in the future. So the problem is that, given the conditions that we face, we need a lot of flexibility to deal with potential downside risks. I think the downside risks have diminished, but they could go back up again. So there could be a situation in which we need to ease aggressively in the future. Of course, we’ve convinced the markets that we are non-gradualists, but so far we’ve been non-gradualists in only one direction, which is to ease. In fact, we’d like to be in a situation where we could aggressively ease in the future if we had to but not risk having inflation expectations go up. That’s a very serious problem that many participants have pointed out. So how would I like the markets to perceive us? Well, I’d like the markets to perceive us as being willing to be very aggressive in terms of easing, if necessary; but I’d also like them to perceive us as having the Volcker characteristics of being six feet, six inches, tall and having a big baseball bat and, if inflation and inflation expectations are starting to unhinge, being willing to take out the baseball bat and do whatever is necessary. You really would like to position yourself to have those characteristics. April 29–30, 2008 132 of 266 So let me first talk about the case for alternative C of not changing and then go to the case for alternative B. In the case for C, the advantage of pausing at this point is that it would actually indicate to the markets by our actions that we’re serious about keeping inflation under control and that it’s more likely that we would bring out the baseball bat. In that sense, it could enhance credibility, and a very important, positive element of that is that it would be easier for us to be flexibly aggressive if we needed to be so in the future. That is one reason that I think there is a strong case for alternative C. But I also think there is a strong case for B. First, the evidence that inflation expectations are unhinged or are likely to get unhinged is not very strong. I do not put a lot of stock in consumer surveys. But I tend to look at financial markets as being the canary in the coal mine. Though being a New Yorker, I actually have been in a coal mine [laughter] – at the Museum of Science and Industry in Chicago. It’s really cool. All of you should go there someday when you go visit Charlie. MR. KROSZNER. But he has never seen a canary. [Laughter] MR. MISHKIN. I have seen a canary. But the key is that the canary has not keeled over. In fact, if you look at what’s going on in the financial markets, the concerns in terms of inflation compensation have dissipated somewhat. I think the fact that they were moving up is an indication of greater inflation risk. They’ve come back down again. I don’t think that should make us complacent, but I do think it tells us that we haven’t seen anything really bad happen at this stage. So the question is why we should cut now and go with alternative B rather than C. Well, first, I think the modal forecast suggested that a cut is in line with optimal monetary policy, and I think that’s an important argument. It is particularly so because there is a very strong likelihood that, even though I’m a little more confident that the recession that we’re probably in now will be very mild, if it’s even a recession at all—I think it is likely that we’re in a recession but a mild April 29–30, 2008 133 of 266 one—the recovery actually is going to have a lot of the characteristics of the recovery that we had in the 1990s because it’s just going to take a long time to clean up this mess. That again argues for a cut. The other issue that I think is important is that there is a very long period between now and the next FOMC meeting. Given that the modal forecasts indicate that things are likely to get worse in the economy in this quarter, there is an issue that, if we get bad news, then we might regret not having cut now, and I’m not a big fan of intermeeting cuts. That would be another argument for cutting now. I guess the bottom line is that I’m just in a very uncomfortable position in that I dislike being not very decisive here. One thing that has helped me a lot in being comfortable with alternative B is that the language has changed quite significantly from the initial wording. I was not happy with the idea that, if we suggest that there will be a pause in the future, it would be time dependent. It should be clearly data-dependent. If it were time-dependent, we would get into exactly the problem that Charlie Evans talked about: We want the flexibility of saying that what we’re doing is dependent on data, not time, because if people know that you’re going to reverse things later on, it doesn’t have the impact. I think that is an important change here. So I’m quite comfortable with the language of alternative B. I’m willing to support B. It looks as though that is the consensus, and my view today is that I’m going to go with whatever the consensus is. Thank you very much. CHAIRMAN BERNANKE. Vice Chairman. VICE CHAIRMAN GEITHNER. Thank you, Mr. Chairman. The transcript says, “Mishkin says canary wheezing but hasn’t keeled over.” [Laughter] I support alternative B. I think you could frame this as a modest recalibration of policy with a hawkish soft pause. CHAIRMAN BERNANKE. And a wheezing canary. [Laughter] April 29–30, 2008 134 of 266 VICE CHAIRMAN GEITHNER. I don’t think the canary is wheezing. Look, I think there are lots of good arguments on both sides of this. I think all the good ones have been made. The markets have been giving us a pretty good test against the concern, which I think we all share, that if we move today we risk some significant erosion of our inflation credibility or inflation expectations feeding through the dollar into a commodity price spiral. We have had a pretty good test of it. Over the past several weeks, there has been a very substantial shift in expectations for the path of the fed funds rate, which embody substantial expectations around a near-term cut and very little beyond that and some modest retracing as we go forward. Expectations have come down despite what has happened to oil prices. Inflation has come down. The dollar is stronger on net over that period. This is pretty good validation that the path that is represented in alternative B does not come with excessive risk that we will be eroding our credibility. We can’t know for sure. It’s good to be worried about that risk, but the protection against that risk is fairly good. What strikes me about this discussion is the extent of the gap in this Committee in how we think about the way to measure the stance of monetary policy. What we could do is use a seminar and a bit of history on this. It would be nice to run monetary policy back over the past four decades to see, if it had been set with a basic policy regime in which we looked only at the real fed funds rate deflated by headline inflation today, what the outcomes would have been for the economy at that time. That’s essentially what you guys are saying. It seems to me that you are basically saying that equilibrium doesn’t vary and that deflating the nominal fed funds rate with some mix of headline and core today is the best way to judge the stance of policy. But I think it’s worth having a little exercise in it. It is hard to look back. MR. PLOSSER. Excuse me. Make sure that you say you’re speaking for yourself, not for me, in terms of how I think about policy. April 29–30, 2008 135 of 266 VICE CHAIRMAN GEITHNER. Okay, but it is a surprising gap. So I think it would be worth some time to think through that. Obviously we also disagree about how inflation works in the United States, how relative price shocks take effect, and what we should respond to in that sense. That would be worth a little time, too. Again, it is a surprise to me. We sit here to make monetary policy, and we haven’t talked much about this basic core question: How should we judge the stance of policy? It would be worth some attention. I just want to end by saying something about the dollar. My basic sense about the dollar— and I’m very worried about this dynamic now—is that it has been trading more on concern about tail risk in the economy and in the financial system than anything else. As I said yesterday, if you look back to when there has been an increase in perceived tail risk, however you want to measure it—credit default swaps on financials or something like that—and the two-year has fallen sharply or we have had a big flight to quality, those have been the periods that have been most adverse to the dollar. Now, it is not a consistent pattern, but I think it’s basically right; and I think it gives an important illustration that what goes into a judgment about whether people hold dollars and U.S. financial assets has to do with a lot of things. It has a lot to do with confidence that this Committee will reduce the tail risk in the financial system and the economy to tolerable levels. It also has a lot to do with confidence in our willingness to keep inflation stable over a long period, but it’s not only that. Again, we have had a pretty good experiment in that proposition over the past year or so. My sense is that the biggest risk to the dollar, since I’m pretty confident that this Committee is going to make good judgments about inflation going forward, is in the monetary policy of other countries. The real problem for us now is that we have a large part of the world economy—in nonChina, non-Japan Asia and the major energy exporters—still running a monetary policy that is based on the dollar as nominal anchor. That has left them with remarkably easy monetary policy April 29–30, 2008 136 of 266 and a pretty significant rise in asset-price inflation. The transition ahead for them as they try to get more independence for monetary policy and soften the link to the dollar is going to carry a lot of risk for us because the market is going to infer from that a big shift in preferences for the currencies that both governments and private actors in those countries hold. As that evolution takes place in their exchange rate and monetary policy regimes the risk for us is that the market expects a destabilizing shift in portfolio preferences, which people might infer is also a loss of confidence in U.S. financial assets. I think that’s a big problem for us. It’s not clear to me that it means that we should run a tighter monetary policy against that risk than would otherwise be appropriate because I don’t think it buys much protection against that risk. I just want to associate myself with all the concerns said about the dollar in this context. The judgment that goes into confidence and people’s willingness to hold U.S. financial assets is deeply textured and complex, and it has a lot to do with confidence in this Committee’s capacity to navigate the perilous path between getting and keeping down that tail risk and preserving the confidence that inflation expectations over time will stay stable. So I support alternative B and its language. CHAIRMAN BERNANKE. Thank you all. The discussion was very good as usual, and let me just assure you that I listened very, very carefully. So I’m certainly hearing what you’re saying, and I understand the concerns that people have expressed. I play Jekyll and Hyde quite a bit and argue with myself in the shower and other places. [Laughter] Let me first say that I think we ought to at least modestly congratulate ourselves that we have made some progress. Our policy actions, including both rate cuts and the liquidity measures, have seemed to have had some benefit. I think the fear has moderated. The markets have improved somewhat. As I said yesterday, I am cautious about this. There’s a good chance that we will see further problems and further relapses, but we have made progress in reducing some of the uncertainties in the current environment. April 29–30, 2008 137 of 266 I also think that there’s a lot of agreement around the table—and I certainly agree—that we have reached the point where further aggressive rate-cutting is not going to be productive and that we should now be signaling a willingness to sit, watch, and listen for a time, for two reasons. First, risks are now more balanced. That is, there is more attention to inflation risks and dollar risks, and although our output risks remain quite significant, the balance is closer than it has been for some time. Second, given that we have done a lot in a short time and moved aggressively and that we’re seeing fiscal actions coming in and perhaps other policy effects as well—lagged effects of our own actions— it seems to be a reasonable time for us to pause, to watch carefully, and to presume that we’re not going to move unless conditions strongly warrant it. So I think that, at least in that broad respect, there’s a lot of agreement around the table. The two alternatives that have been discussed by most people are B, which is to move 25 basis points today but to send a fairly strong signal of a preference to pause after this meeting, and C, which is not to move but to keep some elements of the downside risk alive in our risk assessment. Like a number of people, I think both are plausible. Both have appeal. Alternative C, in particular, has the appeal of pushing back against some critics on the inflation side who have criticized us for not being sufficiently attentive to the dollar, to commodity prices, and so on. As I said yesterday, I think that inflation is an important problem. It’s a tremendous complication, given what is happening now in the other parts of the economy. In no way do I disagree with the points made by many participants that inflation is a critical issue for us and that we have to pay very close attention to it. As I said yesterday, I do think that some of the criticism that we are getting is just simply misinformed. I don’t think there’s any plausible interest rate policy that we can follow that would eliminate the bulk of the changes in commodity prices that we’re seeing. I think they are due mostly to global supply-and-demand conditions. A small piece of evidence for that is that yesterday April 29–30, 2008 138 of 266 the ECB was mentioned favorably as having the appropriate inflation attitudes compared with our attitudes. I would just note that headline inflation in the euro zone is about the same as it is here, despite their stronger currency, because they are being driven by the same global commodity prices that we are. I would also say that, although the inflation situation is a very important concern, I don’t see any particular deterioration in the near term. Since the last meeting, oil prices have gone up, which is very high profile, but gold, for example, has dropped about 12 or 13 percent. Other precious metals are down. Some other commodities are down. The dollar is stronger. TIPS breakevens have moved in the right direction. Wages, as we saw this morning, are stable, and I would urge you to compare wage behavior over the past five years with wage behavior during the 1970s. Wage growth then was not only high but also very unstable and responsive to short-term movements in headline inflation. So I think the canary is still getting decent breath here. [Laughter] I want us to be careful not to overpromise. We cannot do anything about the relative price of gasoline, and I don’t think that we’re on the edge of an abyss of the 1970s type. I do think it’s an important issue, and I do think that there is benefit to pushing against the perceptions. In this business, perceptions have an element of reality to them, and we understand that. That’s an important part of central banking, and I fully appreciate that point. So again, I see a lot of merit in the alternative C approach. As I think you can conjecture, I’m going to recommend alternative B—25 basis points but with a stronger indication of a pause. Let me discuss why in the end I come down on that side. First is the substance, the fundamentals. I don’t think that 25 basis points is irrelevant. For example, one-month LIBOR is up about 35 basis points since our last meeting. These short-run financing costs do matter, particularly in a situation of financial fragility. So it is not just an issue, April 29–30, 2008 139 of 266 as President Evans mentioned, of long-term interest rate expectations. Overnight and short-term financing costs do matter for the financial markets, and a lower rate will help the markets to heal. It will affect other rates. To take an obvious example, it affects the adjustable rate that mortgages move to in the economy. So I think there’s a case to be made on the substance. I will not add much to the discussion about how we define “accommodative.” But one way to do it, I guess, is to look at the Greenbook’s very thorough analysis, which rather than using rules of thumb attempts to look at a broad forecast conditional on what the staff can ascertain about the financial drags that we’re seeing. Their analysis suggests that something around where we are or a little lower is consistent with slow economic growth but also price stability within a relatively short time. That is one way of trying to calibrate. Obviously, there are other ways as well. The second point I’d make, besides just the substance, is the consistency with our own projections. Virtually everybody around the table still thinks that the downside risks to growth are significant, and we’ve mentioned the same factors—financial conditions, housing, and a few other things. Those remain very serious downside risks. I don’t think anybody thinks they are under control at this point. Yes, we also see an increased number of people with upside risks to inflation. But again, in terms of the numbers we’ll publish, I think the downside risks are still held by more people than the inflation assessment. That, by the way, suggests why we can’t really do what President Plosser suggests—hold and move to the alternative B, paragraph 4, language. Not to move and to say that the risks are balanced would, I think, be clearly inconsistent with the risk assessments that are in the projections. The other issues have to do with communications. We are at an important transition point in our communication strategy. One of the risks that we took when we made the very rapid cuts in interest rates earlier this year was the problem of coming to this exact point, when we would have to April 29–30, 2008 140 of 266 communicate to the markets that we were done, that we were going to flatten out, and that we were going to a mode of waiting. It was always difficult to figure out how that was going to work in a smooth way. Whether through luck or design, market expectations have set up perfectly. I mean, basically they’re now assuming a flat path going forward, with some increase later; and that appears to be consistent, as Vice Chairman Geithner noted, in the last few days with significant dollar appreciation, declines in commodity prices, and declines in inflation expectations—all the things that we want to see. It appears that we’re in a position that had seemed really problematic some time ago, so we are now able to make the transition in a way that will be relatively clear and, I hope, not too disruptive. Now, I want to come back to the issue of disappointing markets. I agree with President Fisher and many others that disappointing markets can be a good thing. It is certainly not always a bad thing, by any means. I think the issue is a little more subtle than that. The issue here is the clarity of what we’re trying to say and the way our message is going to be read. Let me make two points about that. If we were to do alternative C, I think there would be essentially two issues. One is that, although we would not be moving, which would be a surprise, we would also not be declaring a pause because of downside risk, which would be another surprise. We’d have a surprise both in the action and in the statement. The risk there is that we confuse the markets about what our intentions are and what would cause us to respond. For example, the Greenbook’s projections of Friday’s employment numbers are somewhat more pessimistic than those being held in the market. If we took action C today and Friday’s numbers were consistent with the Greenbook forecast and with our own projections but worse, significantly worse, than the market expectation, would statement C then lead to the building in of additional ease? I think there would be a lot of confusion April 29–30, 2008 141 of 266 there—a lot of uncertainty about what exactly we are saying about when we’d be willing to respond. The other communication issue that I have with alternative C—and this, again, is something President Fisher said yesterday—is that if we don’t move and we put C out there, the stock market could go up because it might be read as saying that the Fed has increased confidence, is seeing things looking better, and is feeling stronger about the economy. I’m not sure that really is the assessment we have, and if we then have bad data on the labor markets and the financial markets weaken somewhat, will we be seen as having made a wrong call, as being blindsided by circumstances? This is more discussion than it’s worth, but what I’m trying to convey is that it’s not just a question of disappointing or not disappointing markets. It’s a question of whether or not we’re sending a clear message. I think alternative B, while it’s consistent with our risk assessments, is also a pretty strong statement. Let me, just for what it is worth, assure you now that data that come in within the general, broad ranges of what we’re expecting, even though they will be weak, should not cause us to ease further, given this statement. I believe that this statement will provide us with plenty of cover. No matter what the markets expect, we have said that we have come to a point at which we need to take a pause, we need to see what’s happening, and we are going to be watchful and waiting. With respect to the language, I just want to point out how much the language in alternative B has moved from March. It really is a very significant change. First of all, we are acknowledging explicitly how much we have already done—the substantial easing of monetary policy to date plus the measures to foster market liquidity—and expressing a general confidence implicit in that first sentence that we have done a lot; that it is likely to help; and therefore, that we should wait and see what happens. Second, we removed any reference to downside risk to growth, April 29–30, 2008 142 of 266 which has been in there for a long time. That’s a very strong statement. That says a lot about our inclinations going further. Third, we’ve added the phrase “continue to monitor,” which to me suggests very much a watchful waiting rather than an active approach to developments in the economy. Finally, we have made it clear that we are going to be data dependent and, in particular, though we have done a lot, we are expecting continued weakness, and we’ll act as needed. But we have taken out the “timely manner,” so the presumption that we’ll be responding in a very rapid and aggressive way, I think, has been moderated. I think of alternative B as being a compromise in the sense that it takes a step that is consistent with the fundamentals in terms of the underlying tightness of the financial system and the risks that most of us see to economic growth as well as inflation. At the same time, I think it is a rather strong step in expressing a shift in our strategy—that we are moving from the phase of rapid declines and aggressiveness to a phase of waiting and observing how this economy is going to evolve. Again, with full respect to everyone’s comments, I understand. Unlike Governor Mishkin, I wasn’t sitting on the fence; I thought that was a little uncomfortable. But I understand the concerns and the arguments. The communication issues did concern me, and largely on that basis, I would advocate B today. Are there any comments? If not, could you please take a roll call? MS. DANKER. This vote encompasses the language of alternative B in the table that was handed out as part of Bill’s briefing yesterday, as well as the directive from 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 reducing the federal funds rate to an average of around 2 percent.” Chairman Bernanke Vice Chairman Geithner Yes Yes April 29–30, 2008 President Fisher Governor Kohn Governor Kroszner Governor Mishkin President Pianalto President Plosser President Stern Governor Warsh 143 of 266 No Yes Yes Yes Yes No Yes Yes CHAIRMAN BERNANKE. Thank you. I will ask the Governors to join me in the office for the discount rate decision. Everyone else, why don’t you take a 20-minute coffee break. [Coffee break] CHAIRMAN BERNANKE. Okay. Why don’t we recommence. The meeting that we are about to begin is a joint meeting of the FOMC and the Board, so I need a motion to close the meeting. MR. KOHN. So move. CHAIRMAN BERNANKE. Without objection. The discussion is about interest on reserves. Let me turn to Brian. MR. MADIGAN. 5 Thank you, Mr. Chairman. We will be referring to the package of material labeled “Implications of Interest on Reserves for Monetary Policy Implementation.” Today, the staff will report on work prompted by two changes the Congress made to the Federal Reserve Act in October 2006 and will seek your guidance on further work. Both changes become effective in October 2011. As shown on page 2, the first change allows the Board to authorize the Reserve Banks to pay interest on balances maintained by depository institutions at an interest rate or rates not to exceed the general level of short-term interest rates. The second allows the Board to set required reserve ratios on transaction deposits within a range of 0 to 14 percent rather than the currently mandated range of 8 to 14 percent, permitting the Fed effectively to eliminate reserve requirements if it chooses. These two changes will allow the Federal Reserve to make significant improvements in its approach to monetary policy implementation. They give us an opportunity to reduce distortions and deadweight losses resulting from our current complex system of reserve requirements. They also give us an opportunity to improve the effectiveness of monetary policy implementation in routine circumstances as well as in conditions of financial stress. 5 The materials used by Messrs. Madigan, Meyer, Clouse, Hilton, and Dudley are appended to this transcript (appendix 5). April 29–30, 2008 144 of 266 While the Congress made important changes in the law, it also left some key statutory constraints in place. As discussed on page 3, if the Board chooses to retain reserve requirements, the law continues to allow them to be imposed only on transaction deposits, nonpersonal time deposits, and Eurodollar liabilities and only on depository institutions. In effect, the law continues to enshrine a system of reserve requirements that was designed to facilitate control of M1—an objective that has had little relevance to the conduct of U.S. monetary policy for a quarter-century. Second, the prohibition against paying interest on demand deposits remains in force and is a significant continuing distortion in the U.S financial system. We continue to work with congressional committees and staff to seek opportunities for the repeal of this prohibition. Third, the law retains significant constraints on the assets that the Federal Reserve can purchase in the open market. Fourth, interest on reserves has potential implications for priced services and for Reserve Bank operations more generally. Finally, the Federal Reserve remains unable to pay explicit interest on balances held at the Federal Reserve by the Treasury and by foreign central banks. Page 4 summarizes the steps we have taken to date in our work on interest on reserves. Shortly after the legislation was passed, the Chairman asked the staff to begin background work. Last year, a System workgroup undertook a preliminary study of a range of options for implementing monetary policy given the new authorities. I’d like to recognize the participants in that workgroup, who made remarkable progress during a period in which some of these individuals were experiencing considerable pressures relating to the implementation of monetary policy that day, not just in five years. These individuals included Jim Clouse, Seth Carpenter, John Driscoll, Sherry Edwards, David Mills, and Travis Nesmith from the Board; Spence Hilton, Leo Bartolini, Chris Burke, Todd Keister, Antoine Martin, and Jamie McAndrews from the New York Fed; Ron Feldman from Minneapolis; Steve Meyer from the Philadelphia Fed; and Huberto Ennis and John Weinberg from Richmond. Separately, a System workgroup co-headed by Don Hammond here at the Board and Ron Mitchell at the Boston Fed has begun work on the implications for priced services of paying explicit interest on balances. In February, the Board hosted a workshop on monetary policy implementation; five foreign central banks and the Federal Reserve participated. As shown on page 5, our briefing today is in four parts. After this introduction, Steve Meyer will present a summary of the Federal Reserve’s current approach to implementing monetary policy. Next, Jim Clouse and Spence Hilton will discuss five options for implementing the new legislative authorities. Finally, Bill Dudley will make a number of concluding comments and present our recommendations. As shown on page 6, we will be seeking your comments on the criteria that we have tentatively adopted for evaluating the options; on the options themselves; and on the process and timeline that we are tentatively proposing for this project. One of the key issues is whether you would be prepared to see reserve requirements reduced to zero. Steve will now continue our presentation. April 29–30, 2008 145 of 266 MR. MEYER. As Brian noted, I will summarize our current approach. As indicated on page 7, I will discuss depository institutions’ demand for central bank balances, how the Desk manages the supply of balances, and outcomes in the federal funds market. There are three components of demand. Some depository institutions (DIs) hold balances to satisfy the reserve requirements shown on page 8. Many more hold contractual clearing balances, and some routinely hold excess reserves. Page 9 notes that DIs can meet their reserve requirements by holding currency, by holding balances at a Reserve Bank, and by holding deposits at a correspondent that holds an equal amount at a Reserve Bank. These assets earn no interest, so DIs have an incentive to reduce their required reserves to the level of vault cash and reserve balances they would choose to hold if there were no requirements. In practice, DIs cut required reserves by using sweep programs that shift deposits out of transaction accounts into linked nonreservable accounts. This stratagem works because the Fed applies reserve requirements to end-of-day, post-sweep, deposits. About half of the DIs have no reserve requirement. A large majority of the remainder meet their requirements entirely with vault cash. Only 1,500 DIs hold balances to meet reserve requirements, so last year required reserve balances averaged less than $7 billion, an amount equal to 0.1 percent of total deposits in the U.S. banking system. Economists claim that central banks impose reserve requirements to ensure a sizable demand for central bank balances. Imposing a high required reserve ratio on a narrow deposit base and then allowing DIs to run sweep programs and use vault cash to meet reserve requirements does not achieve that goal. More than 7,000 DIs have accounts at Reserve Banks. On an average day, they use their accounts to make and receive more than 0.5 million interbank payments with a value of roughly $2.5 trillion. As noted on page 10, many of those DIs need a larger balance to avoid frequent overnight overdrafts than to satisfy reserve requirements. About 5,700 choose to hold a contractual clearing balance. The incentive to maintain a contractual balance is that such balances earn implicit interest that offsets the fees a DI incurs when it uses our priced services. But these “earnings credits” cannot be paid in cash, so DIs that do not use our services have no incentive to hold a contractual balance. Page 11 shows that DIs hold a bit less than $7 billion of contractual clearing balances. The rough equality with required reserve balances is coincidence. Required and contractual balances, though small, facilitate the implementation of U.S. monetary policy in two ways, as indicated on page 12. First, required and contractual balances are set before the start of each reserve maintenance period, so they establish a predictable lower bound on the period-average demand for balances. Second, DIs are allowed to meet reserve requirements and contractual balance commitments on average over multi-day reserve maintenance periods. This averaging feature helps make the demand for balances interest elastic. DIs reduce the opportunity cost of meeting requirements by holding smaller balances on days when the fed funds rate is above target and larger balances on days when the funds rate is April 29–30, 2008 146 of 266 below target. Carryover provisions and clearing bands, which give DIs some flexibility to hold too many or too few balances in one maintenance period and the opposite in the next period, also help make the demand for balances interest elastic. Page 13 summarizes the third component of demand for balances: desired excess reserves. Large DIs usually aim to hold zero excess reserves on average. Small DIs as a group generally hold positive excess reserves. The left half of the graph on page 14 illustrates that the daily sum of required, contractual, and excess reserve balances averaged about $15 billion from January through July of last year but varied between $10 billion and $25 billion. The day-to-day variation largely reflects big banks’ behavior: Big banks want much larger balances on days when an unusually large volume of payments flows through their Federal Reserve accounts than on other days. This strategy lowers their risk of incurring overnight overdrafts on high-paymentflow days while reducing their opportunity cost of holding non-interest-bearing balances on other days. The right half of the graph shows that demand for balances has oscillated even more widely since August. Even at $25 billion or more, DIs’ balances are not big enough to clear $2.5 trillion of Fedwire payments per day without incurring overdrafts. Indeed, DIs make heavy use of daylight credit. At least in theory, ready availability of inexpensive daylight credit reduces DIs’ demand for central bank balances. A proposed reduction in the cost of collateralized daylight credit—the proposal is now out for public comment—may further reduce demand for balances. We turn next to the supply of balances, beginning on page 16. You’ve told the Desk to keep the federal funds rate close to target on average. The Desk does so by trying to make each day’s supply of balances equal to the quantity that DIs would demand that day if the funds rate were at target. The Desk’s strategy is to use outright purchases or sales of Treasury securities, plus 14-day and 28-day repurchase agreements, to supply a level of balances somewhat lower than the minimum amount the banking system is likely to demand going forward. The Desk then uses one- to seven-day repo to supply the remainder. The Desk structures its operations so that maturing repo almost always leave the supply of balances short of the quantity demanded and then undertakes a new repo to fill in the gap. But as indicated on page 17, the Desk does not completely control the supply. Unanticipated changes in autonomous factors can make the supply of balances larger or smaller than projected. The staffs at the Board and in New York do a very good job, but not a perfect job, of predicting changes in these factors. Variations in borrowing from the primary dealer credit facility also affect the supply of balances. For example, Citigroup Global Markets borrowed on 20 of the first 25 business days that the PDCF was in operation, in amounts that varied from $0.5 billion to $2.7 billion. Barclays Capital borrowed on 21 days, in amounts that ranged from $1 billion to $7 billion. Four other primary dealers were frequent borrowers; another six borrowed less often. Changes in PDCF credit are not always captured in the staff’s daily projections, so they can, and do, cause the supply of balances to deviate from the intended level. In any case, if the day’s projected supply April 29–30, 2008 147 of 266 is not close to the forecast of quantity demanded, the Desk conducts an open market operation to make the two roughly equal. As noted on page 18, the Desk was in the market almost every business day—indeed, all but six business days—from January 2006 through July 2007, replacing maturing repo with larger or smaller repo as projections showed a need to add or to drain balances. How well does this approach to implementing monetary policy work? If the key criterion is keeping the funds rate close to target, our current approach works well in normal times and not so well when interbank markets are under stress. But our current approach imposes substantial and unnecessary burdens. As the graph on page 20 indicates, the effective fed funds rate is almost always within a few basis points of target during normal times, as it was from January through July of last year. But there have been many larger-than-usual deviations from target since last August, for two primary reasons. First, daily variations in demand for balances have become larger and more difficult to forecast. Second, demand apparently has become less responsive to temporary deviations of the funds rate from target—that is, demand has become less elastic. Even so, the average of daily deviations from target has been close to zero since mid-September. Pages 21 and 22 summarize equilibrium in the federal funds market and the reasons for large deviations from target. Fed funds typically trade near the target early in the morning because buyers and sellers usually expect the Desk to supply enough balances to get the funds rate to target in the afternoon. But the funds rate sometimes is firm or soft in early trading, signaling a likely shortage or surplus of balances and leading the Desk to aim for a somewhat larger or smaller supply than otherwise. After the Desk conducts the day’s operation, three things happen concurrently: The supply of balances responds to changes in autonomous factors and PDCF credit; the demand for balances is realized as DIs make and receive payments; and DIs trade federal funds, determining the day’s average or “effective” funds rate. If the supply of balances is close to the actual quantity demanded and if the payment system and the federal funds market work normally, the funds rate will be close to target. Any excess demand or supply generally does not become apparent until late in the day, when the Desk is unable to adjust the supply of balances because primary dealers no longer have uncommitted collateral. DIs that end up with larger balances than they want late in the afternoon seek to sell fed funds. When the banking system as a whole has sizable excess balances, DIs that try to sell fed funds late in the day find few buyers. Because balances earn no interest, the funds rate can fall to zero in that situation. On the other hand, an excess demand for balances makes the funds rate rise relative to target. If the funds rate climbs sufficiently above the primary credit rate, some DIs overcome their reluctance to borrow, raising the supply of balances and helping limit the increase in the funds rate. Last August provides an interesting case study. The demand for balances rose as DIs sought greater liquidity. The Desk increased the supply. Even so, the funds rate traded firm relative to target almost every morning as European banks bid aggressively for fed funds to lock in dollar funding before the end of their business April 29–30, 2008 148 of 266 day in Europe. The firm morning rate suggested a shortage of balances. But late in the day in New York, the funds rate often fell well below target as domestic banks that held larger-than-normal balances during the day tried to sell fed funds rather than hold big non-interest-bearing balances overnight. While our current regime keeps the funds rate close to target on average, it imposes sizable and unnecessary burdens. As noted on page 23, DIs use real resources to run sweep programs and to carefully manage each day’s balance in their Federal Reserve accounts. While those efforts generate private gains, they are a waste from a social perspective. Even with sweep programs, the opportunity cost of holding unremunerated reserve balances averaged about $360 million per year during the past two years. In addition, the banking system and the Federal Reserve spend many millions of dollars each year to ensure and monitor compliance with complex reserve requirement rules. As indicated on page 24, our current approach to implementing monetary policy has strengths: It usually keeps the funds rate close to target, and it supports an active interbank market. But our current approach also has shortcomings: It allows occasional large deviations of the funds rate from target even in normal times and more-frequent large deviations when interbank markets are disrupted. Our approach is less than transparent; even well-informed market participants sometimes are surprised by the Desk’s daily operations, and there was widespread misunderstanding of the Desk’s actions last August. Finally, our current approach imposes burdens that simply are not necessary to enable the Desk to keep the funds rate close to target. Theory and foreign experience suggest that it is possible to reduce the shortcomings of the current U.S. approach to implementing monetary policy without sacrificing its strengths. Jim Clouse and Spence Hilton will now discuss a range of options for improving the U.S. approach. MR. CLOUSE. Thanks, Steve. As noted on page 25, the Interest on Reserves Workgroup developed a set of options for monetary policy implementation in the United States based on alternative settings for a small set of core structural elements. The first core element—so-called balance targets—is a central feature of many systems. In the United States, Japan, Switzerland, and the euro area, balance targets are established through mandatory reserve requirements. In the United Kingdom, balance targets are established through voluntary contractual arrangements. Other countries, such as Canada and Australia, operate with no formal balance targets. Target bands are a second structural element incorporated in many systems to afford banks some flexibility in meeting their targets. The carryover provisions for required reserves and the clearing band for required clearing balances play this role in the United States. The structure of the maintenance period is another core structural element. As Steve noted, the U.S. system operates with a mixture of one-week and two-week maintenance periods. The United Kingdom and the euro area operate with maintenance periods that correspond to the interval between monetary policy meetings. Central banks like the Bank of Canada and Reserve Bank of Australia that operate without balance targets implicitly operate with a one-day maintenance period. April 29–30, 2008 149 of 266 Finally, most systems involve some form of interest rate corridor with the upper bound of the corridor established by a standing lending facility and the lower bound set by the rate of remuneration on excess reserves or a redeposit facility. As noted on page 26, market developments may, at times, impair the efficacy of one or more of these core structural elements. For example, the standing lending facility should, in theory, establish a cap on interbank rates. However, the presence of stigma in using the standing lending facility can impair the effectiveness of the cap. That certainly seems to have been the case in the United States over recent months. We have observed depository institutions regularly bidding for funds in the market at rates above the primary credit rate. The table at the bottom reports some evidence on this score culled from data on Fedwire transactions. Over recent weeks, many of the largest banks in the country have executed numerous trades for sizable amounts at rates well above the primary credit rate. It may be possible to redesign the discount window to mitigate stigma to some extent, but it appears likely that stigma will continue to be an issue for the discount window, especially during periods of financial distress. As a result, systems that rely heavily on a standing lending facility to establish an upper bound on the federal funds rate implicitly disadvantage those institutions that are most wary about using the discount window. As you can see in the table, that set of institutions in the United States includes many that are critical providers of liquidity across a range of markets. It is noteworthy in this regard that Citibank in the past has been willing to provide liquidity in the funds market by borrowing primary credit and relending the proceeds in the funds market. However, in recent weeks, Citi has seemed reluctant to pursue this strategy and has, in fact, executed more than 100 trades from late March through last week in sizable amounts at rates above the primary credit rate. Indeed, the three largest banks in the country— shown in the first three rows—all appear to be quite wary about using the discount window. As noted on page 27, it is helpful, broadly speaking, to think about the five options discussed in the paper as falling into two basic categories—systems that incorporate a multiple-day maintenance period and systems in which depositories manage their reserves to meet a daily reserve objective. The multiple-day systems— options 1 and 2 in the paper—rely on arbitrage across days of a maintenance period as an important factor contributing to day-to-day funds rate stability. Single-day systems tend to rely more heavily on standing facilities and the structure of remuneration rate(s) on reserves to stabilize the funds rate. The next few slides focus on multiple-day systems. Option 1. As noted on page 28, option 1 considers a straightforward modification of our current system of monetary policy implementation. Required reserve balances would be remunerated at a rate close to the target funds rate. The primary credit facility, in theory anyway, would establish the upper bound of an interest rate corridor. The lower bound of the corridor would be established by paying interest on excess reserves at a rate appreciably below the target funds rate. The solid line in the picture displays what the demand for reserves might look like on the last day of the April 29–30, 2008 150 of 266 reserve maintenance period. The curve would be downward sloping and might entail some precautionary demand for excess reserves. The reserve demand curve on previous days in the maintenance period—the dotted line—would be much flatter at the target rate over a wide range, reflecting the ability of banks to substitute balances across days of the maintenance period in meeting reserve requirements. Eventually, though, at very low levels of balances, the increased risk of an overnight overdraft would push the intraperiod demand curve up to the primary credit rate. At high levels of balances, the intraperiod demand curve would eventually fall to the remuneration rate on excess reserves as banks recognized that they held excess balances that could not be worked off by the end of the maintenance period. The width of the “flat portion” of the intraperiod demand curve tends to narrow over the maintenance period as the scope for substitution diminishes across the remaining days of the period. In this structure, the Desk would operate much as it does today, supplying an aggregate quantity of reserve balances each day to address both daily demands and maintenance-period average needs. Option 2. As noted on page 29, option 2 in the paper is a multiple-day system based on voluntary balance targets rather than mandatory reserve requirements. This system would share many of the key structural elements of the system for monetary policy implementation employed in the United Kingdom. Depository institutions would establish a voluntary balance target that they would agree to meet, on average, over a maintenance period. The maintenance period could be set equal to the interval between FOMC meetings. The system could include a target balance “band” to afford banks some flexibility in meeting their voluntary target balance. As shown on the right, the demand for reserves on the last day of the period would again be downward sloping, and the Desk would supply an aggregate quantity of reserves equal to the quantity demanded at the target funds rate. Reserve management and the funds market under this option probably would be similar to that for option 1. The longer maintenance period might allow depository institutions more scope for substitution of balances across days of the maintenance period. That could imply less need for daily fine-tuning of balances and greater funds rate stability. A key issue, however, is whether the aggregate quantity of voluntary balance targets would be large enough to provide adequate leeway for effective arbitrage across days of the maintenance period. Many banks might choose not to establish a voluntary balance target in this system, and those that do may not choose to establish a large balance target. In this case, the funds rate could be fairly volatile within the interest rate corridor. Option 3. As noted on page 30, option 3 in the paper—the simple corridor—is similar to the systems employed by the Bank of Canada and the Reserve Bank of Australia. Banks would not need to establish a balance target of any sort and would simply manage their accounts each day to balance the opportunity cost of holding reserves against the risk of overnight overdrafts. The system would involve a fairly narrow symmetric funds rate corridor. As noted in the figure, the Desk would supply reserves each day equal to the quantity demanded along the downward sloping portion of the demand curve. Because the demand curve is likely to be fairly steep, April 29–30, 2008 151 of 266 shocks to reserve supply are likely to result in significant volatility in the funds rate within the corridor. As noted earlier, the heavy reliance on the primary credit facility to establish an upper bound on the funds rate may be suspect, especially during periods of financial distress. Option 4. As noted on page 31, option 4 in the paper is a system similar in many respects to that employed by the Reserve Bank of New Zealand. Key structural features of this system include an asymmetric interest rate corridor and a relatively high level of balances to ensure that the funds rate trades near the floor of the interest rate corridor. As in option 3, depositories would not need to establish a balance target of any sort. The reserve demand curve for this system might look like that shown to the right. At low levels of balances, the demand curve would be downward sloping reflecting precautionary demands for balances to avoid overnight overdrafts. But at sufficiently high levels of balances, the risk of overnight overdrafts should become very low, and the demand curve would asymptote near the floor of the funds rate corridor. It is difficult to estimate the level of balances that would be necessary to reach this point, but an aggregate level of balances on the order of $50 billion would probably be sufficient in most cases. In principle, fluctuations in various factors affecting reserves would not have much effect on the funds rate, and the generally high level of balances could reduce daylight overdrafts. Partly because of the experience in New Zealand, there are questions about incentives for strategic behavior in this structure. Option 5. As noted on page 32, option 5 is a hybrid single-day system that would involve a voluntary daily balance target and a relatively wide target band. Depositories would receive full remuneration on balances maintained up to the upper bound of the target band and would be penalized for any shortfall in balances below the lower bound of the target band. With these structural elements, the reserve demand curve should be fairly flat at the target rate over a wide range, but the curve would be downward sloping near the upper and lower bounds of the target balance band. The Desk would presumably operate by targeting a quantity of balances each day near the middle of the target band. As with option 2, a significant issue with option 5 would be whether depositories would choose a high enough level of voluntary balance targets to allow the target band to play the desired role in stabilizing the federal funds rate. As noted on page 33, the paper also identifies a number of general issues that cut across all the options. First, depository institutions will still be subject to statutory limitations on their ability to pay interest on demand deposits. As a result, the Federal Reserve’s initiative to pay interest on reserves may be seen by correspondent banks as unfair competition. There are also technical issues associated with the setting of the remuneration rates on reserve balances that appropriately account for the essentially risk-free nature of balances held with the central bank. The Federal Reserve would need to work through governance issues associated with all the options. In particular, the Board is responsible for setting all remuneration rates on balances, and this would need to be closely coordinated with the FOMC’s April 29–30, 2008 152 of 266 determination of the target federal funds rate. Finally, many if not all the options discussed would likely require some transition period that would need to be carefully managed. Spence will now discuss some of the pros and cons of each option in more detail and how they stack up relative to key objectives. MR. HILTON. Thank you, Jim. We have identified four critical objectives for a new operating framework, which are listed on page 34 of your handout. These are (1) to reduce burdens and deadweight loss associated with the current regime, (2) to enhance monetary policy implementation, (3) to promote efficient and resilient money markets, and (4) to promote an efficient payment system. For each of the five options that Jim has just presented, I am going to describe what we see as the major advantages and disadvantages of each vis à vis these objectives. I will also highlight some important sources of uncertainty that we have about how some of these options might function in practice. Then I will close with a broad assessment of how the five options measure up against each of these four objectives. The key advantages and disadvantages of option 1—remunerate required and excess reserve balances—are listed on page 35. This option would have the advantage of being relatively easy to implement given that it would build largely on elements of the current operating framework and would simply pay interest on reserve requirements and, at a lower rate, on excess reserves. The basic framework, which consists of an interest rate corridor with reserve requirements and maintenance periods, is widely used by other central banks, and we’re pretty certain how it would function in practice. For central banks that have adopted this basic framework, it has proven to be reasonably effective for controlling short-term interbank rates under a variety of circumstances. However, this option would do little to reduce the administrative burdens associated with our current regime. This framework is also somewhat rigid, particularly in the flexibility it would provide to us and to banks themselves to adjust the level of requirements in ways that would facilitate monetary policy implementation. A particular shortcoming is that many depositories active in the interbank market have a very small base of deposits against which requirements of any level could be assessed. An important source of uncertainty with this option is whether it would lead to a significant increase in total required operating balances, which would be helpful for damping interest rate fluctuations that can arise when requirements are very low. However, the Fed would have some power to influence the aggregate level of requirements by raising requirement ratios. Option 2—voluntary balance targets—(shown on page 36) would lead to some reduction of administrative costs and burdens compared with the current framework (option 1), as relative simplicity would be one of the principal design objectives for a new system of voluntary reserve targets. The basic framework is similar to that of option 1. It consists of an interest rate corridor with maintenance periods but substitutes voluntary targets for reserve requirements. As already noted, this basic framework has proven to be reasonably effective for controlling overnight interbank rates where it has been adopted. Furthermore, a new system of voluntary targets could provide all DIs with considerable flexibility for setting their own level of April 29–30, 2008 153 of 266 targets and for adjusting the size of these targets, a feature that banks might find useful during periods of heightened uncertainty or stress. With this option, there would also be the opportunity to review and totally revamp the length and mechanics of the maintenance period to make them more supportive of monetary policy implementation. However, almost any system of voluntary targets for reserves is bound to impose some administrative costs on both depositories and the Fed, and there may be some tradeoff between administrative simplicity and design flexibility. An important source of uncertainty with this option is that we have yet to identify with precision a system of voluntary reserve targets that would be workable, in the sense of being easy to administer across a large number of DIs with disparate structures, and that would be effective in yielding a total level and distribution of voluntary targets across DIs that would enhance our ability to achieve our operating objectives. Unfortunately, experiences of other central banks offer little guidance in how to design voluntary targets. A particular risk that concerned the Bank of England when it designed its voluntary target scheme was the potential for market manipulation that a new system might offer individual banks if they were entirely free to choose their level. Option 3—simple corridor—(on page 37) would go about as far as possible toward eliminating administrative burdens by doing away with all requirements and maintenance period accounting rules. This option should also keep the overnight interbank rate within a narrower range than the other options, assuming that we adopt a narrower spread between the discount rate and the interest rate paid on excess reserves. Experiences of other central banks that have adopted this kind of operating system support that belief. However, there is also reason to believe that, with removal of the ability of banks to average reserve holdings over a maintenance period, interest rate volatility within the interest rate corridor could be high. We could respond to high volatility within a corridor by further narrowing that corridor. But there is the risk that, at some point as you go in that direction, market participants could use our discount window or interest on excess reserves as a first recourse rather than as a last resort and thus affect the Fed’s role as intermediary and impair normal market functioning. There are some important questions about how effectively a simple corridor system would function in our particular environment. All the options we are considering propose to use the primary credit facility to limit upward movements in market rates. To the extent that this facility might not serve as an effective brake on upward rate movements, the consequences would be greatest for this option because there are no other mechanisms for smoothing interest rates. Some central banks that have a simple corridor framework have also developed arrangements to adjust reserve levels late in the day to prevent exogenous reserve shocks from pushing market rates to either the upper or the lower end of the corridor. Option 4—floor with high balances—is shown on page 38. It would also do away with all requirements and maintenance period accounting rules and, like option 3, would go a long way toward eliminating administrative burdens. Moreover, because the rate effects of even a large aggregate reserve shock or a payment shock at an individual DI are likely to be relatively small, the need for depositories or for the April 29–30, 2008 154 of 266 Desk to manage daily reserve positions intensively is likely to be reduced, which should translate to further resource savings. Better insulation of market rates from exogeneous reserve shocks is a design objective, and it is a particularly distinctive feature of this framework. However, completely severing the link between daily reserve levels and interest rate movements can be a double-edged sword. While we may wish to better insulate market rates from reserve shocks, we may also wish to preserve some ability to influence market rates by manipulating reserve supply when other factors are distorting rates. One risk associated with this option is that it would represent a radical departure from the basic elements of our own current framework and from those of almost every other central bank, preventing us from learning from the experiences of other central banks. A particular unknown with this option is the possible implication for the functioning of the interbank market. Offering to compensate DIs for all the reserves they might choose to hold at a rate that is in line with market rates could have profound effects on their willingness to lend in the market, under both normal circumstances and during periods of market stress. The Reserve Bank of New Zealand, one central bank that has experimented with a system similar to option 4, did run into some difficulties with the hoarding of reserves by individual banks to the detriment of the interbank market. As a result, they adjusted their framework to cap holdings of excess reserves by individual banks. Option 5—voluntary daily target with clearing band—is on page 39. It has many of the same advantages and disadvantages as option 2, stemming from the fact that both feature voluntary reserve targets. Because simplicity would be one of the design principles, it should reduce current administrative burdens. It would also provide DIs with the same kind of flexibility that option 2 does for setting and adjusting their own reserve targets. On the other hand, a system of voluntary targets for reserves would still leave some administrative costs, and we have yet to specify a system of voluntary reserve targets that would be workable and effective. An additional advantage of this option is that it could allow the Fed to adjust the width of the daily clearing band around the reserve target. The final choice of clearing band width could be made after some experimentation based on what works best. Moreover, being able to make temporary adjustments to the width of this daily clearing band could be a powerful tool for dealing with exigent circumstances. Experiences of other central banks provide little guidance about how this flexibility might be best employed. But the Bank of England did widen its maintenance period clearing band during the recent financial market turmoil, and they have been happy with the results. Interestingly, the ECB, quite independently, has been examining the possibility of a new system centered on a one-day clearing band rather than a multi-day maintenance period. Let me sum up by outlining how these five options stack up against the four objectives that we have established for a new operating framework, which are summarized on pages 40 and 41. First, all the options would eliminate most of the current “reserve tax” associated with the nonpayment of interest on reserves, and perhaps with the exception of option 1, they would reduce the administrative burdens associated with our current framework. Option 3 (simple corridor) and option 4 (floor with high balances) would do the most to eliminate these administrative costs. April 29–30, 2008 155 of 266 Second, all the options would improve monetary policy implementation by helping set a floor on the fed funds rate. Most have additional features that could help control rate volatility, although these differ from one another in terms of their mechanics. But some of the options offer greater potential to adjust parameters in ways that could be helpful amid changing circumstances—say, during periods of market stress or heightened uncertainty about developments that could affect our balance sheet. An adjustable clearing band in option 5 could offer considerable flexibility. Adjustable reserve targets, a feature of both options 2 and 5, are another possibility. Third, all the options would rely on efficient money markets for distributing reserves between DIs. There is more uncertainty, however, about how some of the options might influence the incentive structure for trading and the allocation of liquidity in short-term financing markets and the role of the central bank in that process. This is the case with option 3 (simple corridor), should that corridor be too narrow, and with option 4 (floor with high balances), where the choices of lending excess liquidity in the market versus holding excess reserves would be nearly equivalent. Fourth, all the options are compatible with the proposed changes in payment system policies. However, there are differences among the options in the levels of reserves that would likely be in place and that could serve as a substitute for the provision of central bank daylight credit. Option 4 (floor with high balances) would provide the most reserves in the system, and option 3 (simple corridor) would provide the fewest, perhaps even lower than current levels. A system of voluntary reserve targets, a feature of both options 2 and 5, could be deliberately designed to encourage a relatively high level of reserves. MR. DUDLEY. Building on the earlier presentations, I am going to focus briefly on four areas. First, I’d like to put the interest on reserves project in the broader context of monetary policy implementation. Second, I will discuss briefly the implications of our experience during the recent market turmoil in terms of how it might influence our choices in this project. Third, I’ll suggest some next steps and a potential timeline. Fourth, I’ll focus on the criteria for evaluating the different options and those areas where your guidance will likely be particularly important. Turning to page 42 of the handout, the issue of paying interest on reserves should be placed in a broader context. In particular, this project should be considered as part of the process of improving the overall monetary policy framework. Put bluntly, although the current system works very well during normal times, we have found it recently to be less robust during times of stress. As a result, we should use this opportunity to strengthen the robustness of the framework. So what are the weaknesses of the current monetary policy framework? As shown on page 43 of the handout, four come immediately to mind. (1) In times of April 29–30, 2008 156 of 266 stress, the federal funds rate can be very volatile—both day-to-day and intraday. (2) On the upside, the primary credit facility rate is not a binding ceiling on rates. (3) When there is a large reserve adding miss, the Desk can temporarily lose control of the federal funds rate target to the downside. (4) Stability in the federal funds rate may not limit upward pressure in term funding rates. Today I’ll focus on the volatility issue and the failure of the PCF rate to be a binding cap. Two issues are worth noting regarding volatility. First, the federal funds rate has become more volatile on a day-to-day basis since last August. This can be seen on page 44. Second, the federal funds rate has become very volatile intraday. The exhibit on page 45 shows how wide the range of federal funds rate trading has been recently. The vertical dashed lines indicate the daily range. Note that the primary credit facility rate has not acted as a firm cap on the upper end of the daily range. As shown on page 46, these shortcomings suggest that paying interest on reserves should be considered in tandem with other changes to the overall monetary policy framework. We should be willing to make significant adjustments to our monetary policy framework so that it is more robust during times of stress. In this context, although option 1 (paying interest on required and excess reserves) and option 2 (eliminating reserve requirements) are attractive because both would eliminate the reserve tax distortion, they do not do much in terms of making the monetary policy framework more robust. That said, option 2 has a number of favorable features. It is voluntary and would lessen the regulatory burden. We have considerable experience with this type of framework, so the risks of unintended consequences might be lower than for some of the other options. The Bank of England has been using this framework successfully, and it has proven to be reasonably robust through this period of market turmoil. Nevertheless, we may wish to be more ambitious. Turning to page 47, option 5 (voluntary daily target with clearing band) is potentially more robust than option 3 or option 4. In part, this is because it is very flexible. This proposal has a number of parameters that can be adjusted—for example, the width of the corridor and the size of the voluntary reserve band. Thus, this option has the advantage that it could be modified relatively easily in light of experience or in response to changing market conditions. The biggest shortcoming of option 5 is that no other central bank has adopted such a model. Thus, experience and empirical evidence are lacking compared with the other proposals. So what is our recommendation in terms of pushing this forward (see page 48)? As Jim noted in his presentation, the five options can be broken down into two classes. Options 1 and 2 operate in a framework of a multiple-day reserve maintenance period. Options 3, 4, and 5 are single-day systems. Reserve maintenance periods have both advantages and disadvantages. Reserve maintenance periods reduce volatility by averaging—which can be a good thing. But there is a cost. The shocks can persist. In contrast, in single-day systems, each day is a new start, so one avoids the problem of a large shock contaminating an entire reserve maintenance period. This suggests that a reasonable next step might be to develop the best proposal within each of these two broad classes. We recommend focusing on April 29–30, 2008 157 of 266 option 2 as the best proposal within a reserve maintenance framework and option 5 as the best proposal in a single-day system. What would be the next steps (see page 49)? First, we would need to identify workable systems of voluntary targets for reserves needed for either option 2 or option 5. This would include setting clear objectives for the aggregate size and the distribution across depository institutions and how such a system would be applied to a heterogeneous banking system. Second, we would need to critically assess the relative merits of maintenance periods versus daily clearing bands. In this context, we would need to determine the optimal length of a reserve maintenance period and the width of a clearing band. Third, we would have to define the optimal width of a rate corridor under both options. Here we would have to understand the implications for rate dynamics and the functioning of the market during normal conditions and during times of stress. Finally, we would need to assess whether the options were compatible or could be made compatible with other changes that we might implement, such as changes in our counterparties or in the types of collateral we accept as part of our central bank operations. So what would be a possible timeline between now and implementation in October 2011? The timeline that I will discuss should be viewed as tentative and subject to revision in light of your comments and further discussion within the Federal Reserve System. Turning to page 50, we would propose that most of the remainder of 2008 be used for an extensive study of the options. In May 2008, the staff would publish a white paper on possible approaches for public comment. In December, the staff would propose a specific approach to the Board and to the FOMC. Continuing on page 51, the first half of 2009 would be spent filling in the details, with the final proposal published for public comment in August 2009. The rules implementing the proposal would be published by the Board in October 2009. The final two years would be spent preparing for October 2011 implementation. On the last page, we outline areas in which we particularly seek your guidance. These include the following questions. Do you agree with our metrics for evaluation of the policy options? In particular, what are the appropriate weights to place on the reduction in burden and distortions versus the other criteria? Which options should be studied further? Are you comfortable with our proposed timeline? Finally, how do you view the interaction of the interest on reserves project with other issues—for example, collateralized daylight overdrafts? We would now like to open the floor for questions and comments. CHAIRMAN BERNANKE. Well, let me first congratulate and compliment the staff for a really thorough piece of work, both the presenters and all the other people whom Brian mentioned. It is excellent work, particularly under very trying circumstances. I mentioned that in February a workshop was held here at the Board on monetary policy implementation, which brought together April 29–30, 2008 158 of 266 people from major central banks around the world. So there has been a very, very serious attempt to evaluate others’ experience. Thank you very much for all of that. Why don’t we take some questions first, if there are any. Then anyone who would like to make comments can do so. Any questions? President Hoenig, do you have a question, sir? MR. HOENIG. Yes. Option 1 doesn’t seem to be one of your recommendations, and yet it is something that basically people know how to do. The idea is to eliminate the pack so that you have the system already in place. It’s simple; you can learn from it. Why wouldn’t that be one of the options you’d pursue? I don’t have any real opposition to option 2, but I was just curious because the transition seemed so simple with option 1. That is the question. MR. MADIGAN. President Hoenig, I would say that we believe we already have a fairly good sense as to how paying interest on the required reserve balances and on excess reserves would work, at least qualitatively. We do think it would be an acceptable means of implementing monetary policy. As Jim noted, it probably wouldn’t be all that different in terms of monetary policy effectiveness from the way things work now. Of course, as we also emphasized, the current system of reserve requirements has a lot of problems. Admittedly, paying interest on required reserve balances in some sense solves the first-order problem, but there are lots of costs associated with the system of reserve requirements that we’ve discussed, and we think that those may warrant serious consideration of eliminating reserve requirements. But to be clear, we’re not suggesting that we rule out option 1 at this stage. We could certainly view it as a fallback position, for instance. CHAIRMAN BERNANKE. Governor Mishkin. MR. MISHKIN. I’d like to understand this issue in terms of the voluntary targets. How are they deciding on these? Clearly a big part of the issue is whether or not they choose you. I was just completely confused about what their considerations in choosing these numbers would be and what April 29–30, 2008 159 of 266 implications that would have. Now, there is experience for that one case. I’m sure you have views on this, but it’s sort of the black box in this proposal, and it’s a really important part of it. The second question regards the corridor approach. I do not think it is a good model for us because the countries that use it have very few banks. The issue of using the central bank as a financial intermediary is less of a problem for them because there are fewer guys that they have to look at, and we have to look at a zillion people. But is it true that they have high volatility? I’m not sure. I just would like to know the facts, but as I say, I don’t think it’s critical. I don’t think the experience there, even if it worked well, really does tell us that we should do something here. MR. MADIGAN. Maybe I could just take the second question, and Spence or Jim may want to take the first. On the corridor approach, for other countries that are using it—I’m thinking of the Bank of Canada in particular here—their institutional set-up allows them extremely precise control over the supply of reserves. Also the demand for reserves—I’m talking about reserve balances—is considerably less uncertain than in the United States. Part of it comes from the fact that they have only a handful of large banks. MR. MISHKIN. It is five or six banks, right. MR. MADIGAN. So the communication with banks regarding their reserve management is extremely simple compared with what we could expect here in the United States. MR. CLOUSE. The determination of voluntary targets, as Spence mentioned, is a really big issue that we’d have to study much further. At least in the context of the simple models, banks will face some probability of an overdraft charge if they are operating with very low balances, so they might have an incentive to set up a voluntary requirement on which they receive remuneration. On the other hand, they may not view even fully remunerated balances as an especially attractive asset, so there might be some balancing between the desire to hold large enough requirements to stay April 29–30, 2008 160 of 266 away from overdrafts and the idea of having balances or assets booked that aren’t particularly high earning. But this is a major uncertainty for these types of models. MR. MISHKIN. The Bank of England has used a procedure like this. What has been their experience? Again, it may not be completely comparable. MR. HILTON. Well, for the Bank of England, the way the voluntary target rules are set is really very simple. The bank chooses its own voluntary target. It can’t be below zero, of course, but they have a cap. It can’t be any higher than a certain amount, and I think it’s 2 percent of some measure of their liabilities on their balance sheet. They were extremely worried. They had no idea what they were going to get. Their experience was encouraging in that they got an aggregate level and a distribution that have brilliantly facilitated their control over their interbank market. But it is sort of taking a leap to go into that system, although we have some experience with our clearing balance program. We do see how banks adjust their participation with reserve-management objectives in mind. In our case, because there are practical limits—ceilings on the size of a clearing balance that makes sense for any bank to have—we don’t really have a direct observation of what we would get if it were entirely voluntary. The evidence that I see from our experience of clearing balances and from the Bank of England is encouraging that we would get, even with a very simply designed set of voluntary targets, a good aggregate level and distribution of voluntary targets. But right now, based on what we know, it is an uncertainty. MR. DUDLEY. The big risk would be if the voluntary balances were really low. MR. MISHKIN. So let’s say that actually happened, that they were zero. Then what? Let’s say we implemented this and they came out at zero. What are our options? MR. DUDLEY. You’d have to change the incentives somehow. MR. MISHKIN. Right, and that would be the answer. April 29–30, 2008 161 of 266 MR. DUDLEY. But you could. You could raise the cost of daylight overdrafts. MR. MISHKIN. Right. You could raise the cost of daylight overdrafts, or you could adjust the interest rate that you pay on reserves to get it right. That could solve the problem. MR. DUDLEY. As long as you have enough parameters that you can adjust to change the incentives, you’re probably going to be okay in that environment. But if you have a system in which there aren’t any parameters that you can actually move, then you have a real problem. MR. MISHKIN. But in the context of the law, we would have the ability to adjust these parameters. MR. MADIGAN. Governor Mishkin, to state the obvious, we’d want to avoid that situation completely. We want preparation and consultation with banks ex ante as to how they would react under various subparameterizations. MR. MISHKIN. Okay. Thank you. MR. CLOUSE. As Steve noted, we already have $7 billion in required clearing balances with a rate of remuneration that’s only 80 percent of the T-bill rate. So in all likelihood, we would have a positive number. How large that number would be is the question mark. CHAIRMAN BERNANKE. President Yellen. MS. YELLEN. I have a comment, not a question. CHAIRMAN BERNANKE. President Lacker. MR. LACKER. Thank you. This represents a once-in-a-generation opportunity to reengineer our monetary policy operational framework, and I think it’s important that we do our best to get it right. I want to start by applauding the staff for taking a very deliberate, very thoughtful approach to this project. I was able to attend the workshop on foreign central banks’ operations. I found it very illuminating, instructive, well organized, and well thought out. So far April 29–30, 2008 162 of 266 the work has been well organized, and the broad-based involvement has been very good. I want to compliment you on sifting down. The combinatorics must have been mind-boggling given the number of free parameters in the design of one of these schemes. I want to applaud you for boiling it down to a good, representative set that spans everything that I think we’d want to consider. What you produced—with one slight exception that I’ll talk about in a bit—is a very thorough and careful analysis. In Richmond, we have thought about the issue of interest on reserves for many, many years—even before the Congress considered it. Toward the end, I’m going to argue that option 4 deserves serious consideration, and I’d like to see you focus on that as well as the other options going forward. Before I do, though, I want to comment briefly on the objectives. You asked for feedback on this. In particular, I think objective 3 needs to be interpreted very carefully. The report often seems to interpret objective 3 as implying that anything that reduces the amount of lending in the fed funds market must reduce financial market efficiency. I just don’t think that’s right. The prohibition of interest on reserves is obviously a tax on reserve holdings. You have focused on the tax that it implies on reservable liabilities, but the fact that we also don’t pay interest on excess reserves is a tax on excess reserve holdings. If we eliminate reserve requirements and we still don’t pay interest on reserves, we’ll still be taxing reserve holdings. That gives rise to inefficiencies for the same reason that the lack of interest on currency gives rise to inefficiencies, and so in this setting, obviously banks do a lot of things to avoid the reserve tax. Some of the measures involve a lot of monitoring of the reserve account, monitoring of the prospective payment flow, and making sure that they can predict where they’re going to be at the end of the day. But some of the measures undoubtedly involve some transactions—such as fed funds loans, purchases of Treasury securities, repo lending, and the like—that are aimed at minimizing their non- April 29–30, 2008 163 of 266 interest-earning balances. Such transactions are exactly analogous to the classic shoe-leather costs of inflation. Additional transactions that are induced by the tax on currency are a waste. Reducing the inflation tax results in fewer trips to the bank or to the ATM to get money out, and that reduction is a good thing, not a bad thing. It would be a benefit, and that is exactly what it means to reduce the dead weight burden of inflation. Similarly, I think that paying interest on excess reserves will reduce transaction volumes in the fed funds market, but we should count that as a benefit, not a cost. Put more generally, the effectiveness of a market isn’t the same as the quantity of transactions. I bring this up because one of the main objections to option 4, at least in the report—it didn’t appear in the slides—is that it could reduce fed funds market lending. I think it should be obvious at this point why that wouldn’t necessarily be a bad thing. It’s sort of like saying that reducing inflation would be a bad thing because people would make fewer trips to the bank. I don’t think you’d say that. Even if we believed that fed funds volume is important, I think a quick look at the numbers would suggest that it’s not likely to be that big a problem. The staff estimates that the fed funds market is about $225 billion, on average. So how much by way of reserves will we need to add to ensure a negligible chance that our autonomous reserve factor drains reserves enough to drive the funds rate up? You showed a graph, and there was a flat spot, and you had supply way, way, way out on the curve. But it doesn’t need to go out that far. It just needs to go out so that you’d know that you’re not going to accidentally go in on the upward part. My reading of your intermeeting report is that reserve misses are typically on the order of $1 billion or $2 billion. I think the average absolute value is about $990 million. Two is pretty rare. It happens every now and then. So it seems as though $5 billion would do plenty. The report says that $35 billion would be how much reserves you’d need to add. I’m a little curious about where that number came from. It’s hard for April 29–30, 2008 164 of 266 me to believe we’d need that much. But certainly more broadly than that, if you think about the market, is that right now $225 billion in lending is going on. If you do the thought experiments about current equilibriums and you are a bank that just walks into the market and needs some reserves, will it be hard to get reserves? Well, you’re going to run into $225 billion worth from banks that are already lending their reserves with interest. So if you’re going to get your loan, you’re going to have to pay a competitive rate and shake loose some money from one of them. If we are paying interest on $35 billion in reserves, will that change that calculus much? I don’t think so. I think that your markets are still going to work the same way. If you want reserves, you’re going to have to pay a competitive rate for them. If you’re not getting reserves at that rate, you’re going to bid up until you get them. So I just don’t quite get this concern about the volume of transactions in the funds market. A related objection is the issue of hoarding—the idea that one bank might decide to hold a whole bunch of reserves. The staff cited the example of New Zealand. I thought that was a really interesting discussion at the workshop. One bank accumulated $8 billion or $9 billion in reserves, I think it was, which was large for them, and they had to add a large amount of reserves to accommodate that demand plus the demand of other banks in the system. Now, the problem for the Bank of New Zealand is, as I understand it, that the government doesn’t issue debt. When they have to issue deposits, they have to acquire foreign exchange reserves, and that involves a fiscal risk that they’re reluctant to take on. My sense of the conversation is that they don’t like to accumulate foreign exchange reserves. We seem to be quite willing to expand our balance sheet. Plus, there are plenty of government securities around. So I just don’t see why it would be a problem for us if reserve demand was unexpectedly high or some bank decided to hold $50 billion in reserves. April 29–30, 2008 165 of 266 I want to talk about one more thing, which is the issue of the rate. The way you have written it up is that what we target now is the average rate of brokered deposits. You said it was $80 billion to $100 billion out of $225 billion, on average—so less than half the market—just the weighted average of trades during the day that go through brokered channels. That doesn’t include direct credit funds. The approach you envisioned is that we try to set a remuneration rate so that the effective rate, that average, comes out at the target rate that the Committee sets. A very natural alternative, it seems to me—and I think this is the way the Bank of England does it—is that our policy rate is now the deposit rate. When we issue a press release, we say we’re changing the policy rate—I don’t know whether or not we would rename it. Now, you folks estimate that the risk premium that would, on average, be the gap between this deposit rate and this effective fed funds rate you measure might be 10 basis points. We now set the funds rate target in ¼ point increments. In theory, we could set our policy rate 10 basis points below ¼ point increments. That seems a little bizarre. I’m not sure that we have such precise confidence in the optimal funds rate that we’d know that it should be on the ¼ point and not 10 basis points below or above. It strikes me that a natural version of option 4 or any of these options would be to set the remuneration rate at ¼ point increments and have that be the policy rate, and just make that the reference point for how we do. Admittedly, econometricians would have to do a lot of work in the future to splice these series together, but I think that’s a workable alternative we ought to think about. I think that option 4 has some obvious benefits over the other options. Intuitively, if you were given a limited budget and were asked to peg the price of a commodity—minimize the variance of a commodity price around a given target—your natural inclination would be to stand ready to buy and sell that commodity at the target price. That would be, right out of the box, the April 29–30, 2008 166 of 266 first thing every economist would say. Option 4 is the closest practical analogue to that. It’s clean. It’s simple. I think it’s eminently workable. I just don’t see the force of the objections. In comparison, option 5, which is the one that comes closest to option 4, involves the monitoring of voluntary targets. You have to monitor these bands. You have to check the balances every night against the bands. It just seems like a lot of superfluous machinery. Option 4 would go furthest toward reducing our dependence on forecasting uncertain autonomous factors. It would also go furthest toward solving the problem that the primary dealer credit facility has given rise to, which has been particularly acute in the last intermeeting period, which is that rates are firm. You’ve done a pretty good job with the average daily rate, but it crashes at the end of every day. More than half the time you look at the low for the day and it’s under 1 percent. It’s like ½ percent. So we have a chronic intraday problem of rates being firm and then crashing because you don’t know. Primary dealers come in, that stuff goes on the market, and the rate crashes. I think option 4 would also be the most transparent approach. It would be the easiest to explain to people. It would go furthest toward eliminating the risk of the downside target misses and concerns about stealth easing. Option 4 would also facilitate long-run moves toward lesser lines of daylight central bank credit, and I think that’s an important consideration. It shouldn’t be the deciding consideration, but it is important. In terms of the timeline, you have yourselves focusing on two options before the results of the public comment come in. To some extent that’s prejudging where the public comment is going to come in. So, in short, option 4 strikes me as the most straightforward and practical way to do it, and I’d urge that we direct the group, which has done great work so far, to focus on option 4 and to keep it as a live option. Thank you, Mr. Chairman. April 29–30, 2008 167 of 266 CHAIRMAN BERNANKE. Thank you. Just a procedural question. You kind of segued into the positions. Does anyone have a short question of fact? Governor Kohn. MR. KOHN. I actually have a couple of questions rather than positions. One is a bit more about what we’ve learned in this period of stress. For example, on page 26, you list a bunch of banks that don’t seem to have taken advantage of primary credit. I assume that you have talked to them, and I wonder how they had rationalized their concerns about stigma and what they said about that. Along similar lines about stress, and following up on Governor Mishkin’s question, how did the U.K. system work in this period of stress? My impression is that they had problems. Initially the banks wanted to increase their voluntary targets and that required the Bank of England to be a little more flexible than it started out to be. I’d be interested in how option 2 behaved under stress and then any new insights you have about bank behavior in this period that produced the oscillations that we saw. A second point is that Brian, Scott, and I have been talking about asking the Congress to allow us to pay interest on reserves sooner rather than later. Are we pursuing that? If we got that authority, I assume that it would not involve implementing this over four years but that we could implement something in one or two weeks, in the maintenance period after we got that authority. How would you go about that? What are you thinking in that regard? I think I’ll stop there. MR. MADIGAN. If I may start with the last question, we can work our way up or around the list. On pursuing legislative authority, the Federal Reserve is interested in accelerating that authority. We have had some conversations with congressional staff about this. For instance, the staff of Senate Minority Leader McConnell has asked us recently whether we’d be interested in legislation to accelerate the authority. Of course, we responded enthusiastically. We did say to them that it would be helpful if it were clear that we could use that authority in such a way as to be April 29–30, 2008 168 of 266 able to pay interest on excess reserves or, rather, to buy federal funds as a way of paying interest on excess reserves, in effect. Buying federal funds when the rate is falling would help us put a floor under the funds rate. So we would want to be sure—perhaps Scott wants to comment on this—that the legislation clearly permitted that. Presumably we would be able to use that authority fairly quickly at an operational level—Bill or Spence may want to comment on this. Paying interest on required reserve balances is, of course, a whole other matter. That involves complicated systems, and we would simply want to be sure that we made this clear to the congressional staffs, that it would take a longer time before we could implement that. MR. DUDLEY. We think we could implement it pretty quickly. Another benefit would be not just addressing the crashes of the funds rate late in the day but also enabling us to actually expand our balance sheet if needed. CHAIRMAN BERNANKE. Vice Chairman. VICE CHAIRMAN GEITHNER. Just to clarify, what are the implications for scoring? MR. DUDLEY. It’s pretty small if you just confine it to excess. MR. MADIGAN. My impression is, as Bill said, that it is small and there may not even be positive costs if you confine it to excess. The issues of paying interest on required reserves are possibly a little more troublesome, but that may be viewed as a worthwhile cost to undertake at this point. CHAIRMAN BERNANKE. Let me interject. If there’s a sense of the Committee that this is something we should escalate, let’s move it up the ladder and do that. But anyone who wants to comment on that during the go-around, please feel free. There was a second part about the United Kingdom, I believe. April 29–30, 2008 169 of 266 MR. MEYER. With respect to the U.K. system during the period of turmoil, banks’ initial reaction was to lower their reserve deposits, their contractual commitments. But they came to their senses and realized that holding more rather than less was a more sensible approach, and the Bank of England accommodated the banks’ desire both to increase their targets and to widen the bands. MR. DUDLEY. Pretty dramatically, in fact. MR. MEYER. Quite dramatically, to avoid the end-of-period spike in rates. In terms of rate volatility, the Bank of England, the ECB, and the Fed all achieved about the same rate volatility during the period of market turmoil. For the Bank of England, the spikes just tended to be more on the upside than the downside, but that had to do with their implementation procedures and not getting to the end of the period and being willing to accommodate. MR. KOHN. I assume it was the stigma problem as well. MR. MEYER. Though they had a few trades above their lending rate, in fact that was not much of a problem. Their system worked quite well. Interestingly, the country with the smallest rate volatility during the whole period of market turmoil was Canada, and that’s because they knew the demand for balances at the end of every day and could adjust the supply by adjusting the government balance at the end of every day. So they hit it basically every day. CHAIRMAN BERNANKE. Other short questions? President Fisher. MR. FISHER. A very short question having nothing to do with what everybody else has asked about—but going back to page 33, what are the governance issues, and how do you resolve them, in 30 seconds or less? [Laughter] MR. MADIGAN. Well, the governance issues are that the FOMC is in charge of open market operations and setting the target for the federal funds rate, at least under current approaches to policy. The legislation specifies that the Board is in charge of setting the rates paid on balances to April 29–30, 2008 170 of 266 institutions. For instance, there may be differential rates as in option 1 on required reserve balances and excess reserve balances. Presumably, if we went with option 1, for instance, one approach would be to simply set them by formula relative to the target federal funds rate. We don’t mean to say that this is likely to be an enormously large issue, at least in some of the options, but it ought to be handled carefully. CHAIRMAN BERNANKE. President Stern. MR. STERN. My question is about intraday and day-to-day volatility in the funds rate. I would think that as long as we hit the target on average, that kind of volatility wouldn’t have any significant macroeconomic consequences. So why would we care? MR. HILTON. That’s our impression, that it doesn’t have macro consequences. Maybe it’s a tempest in a teapot, but for the participants in that market, the uncertainty and the costs that are borne by borrowers and lenders are an important issue. But the macro fallout, the effect on longerterm rates, doesn’t seem to be significant. MR. DUDLEY. What we don’t know is whether that volatility somehow has consequences for term funding. How do you know the linkage between the two because they’re happening sort of simultaneously? But I agree with Spence that we don’t think there’s any significant macro effect. There may be some marginal effect of volatility creating a greater risk premium in the market, but it’s hard to say. CHAIRMAN BERNANKE. There is an effect on swaps, like foreign exchange swaps, right? MR. HILTON. Well, for a lot of what we seem to get—like the Eurodollar rates and LIBOR and foreign exchange swaps and the way they relate to what goes on in our overnight funds market—the typical intraday pattern is firm in the morning and coming off late in the day. Those April 29–30, 2008 171 of 266 higher morning rates are the ones that are linked to the other rates—Eurodollars, swaps—and so it’s not the average rate over time that seems to get priced into these other vehicles. MR. DUDLEY. The high morning rate could conceivably affect other rates in a way that’s— MR. STERN. It sounds like an obvious arbitrage opportunity. MR. DUDLEY. Well, we’re not seeing much arbitrage. MR. HILTON. We are finding a great reluctance to do intraday arbitrage. We’re hearing this from the banks that in the past would do that from time to time. Coming back to one of the other questions that Don had about what we are hearing about stigma from some of the banks, one of our better contacts, Citibank, as Jim mentioned, used to do a lot of arbitraging and using the discount window, the primary credit facility. On occasion, after they borrowed to re-lend in the market at a higher rate last year or so ago, they would call us in the morning to let us know how it was that they were helping us out with the funds rate. That has pretty much stopped cold, and they have decided on sort of classic stigma. They routinely point to the publication of borrowing data in the H.4.1 release, and they are just not interested in the small gain from that kind of activity while taking the risk in the market of being seen as in dire need of liquidity. MR. DUDLEY. The TAF auction results underscored the idea of stigma at the primary credit facility. It’s possible that we have actually a bit more stigma now than we did before because you can just see very clearly that there would have to be stigma for people to be bidding that much in the TAF auction. CHAIRMAN BERNANKE. President Evans had a two-hander. MR. EVANS. My primary comment in all of this is related to what President Stern, I think, said. The way the objectives are worded here is “enhanced monetary policy implementation,” and April 29–30, 2008 172 of 266 the memo is worded more like, “How do we get our federal funds rate target effectively?” or something like that. But there is really no discussion that I could find about the transmission of our policy actions to the economy and to inflation. Under our current regime, we think, quite confidently, that the short-term federal funds rate prices short-term risk-free assets along the yield curve all the way up to the Treasuries and then corporates are priced off all of that. I associate that with Marvin Goodfriend, who taught me that quite some time ago. It’s not money; it’s not liquidity; it’s not the reserves per se. It would be nice if, for each alternative, there were some discussion that we are preserving our understanding of the policy transmission mechanism or that we are enhancing it or whatever. President Lacker mentioned the Bank of England—maybe we could set the policy rate as they do. The question is, What will the markets do in terms of actively arbitraging something that helps price these securities? This may not be an issue for many of these systems, but until there’s some kind of analysis, I’m not so sure. It’s not just averaging over the maintenance period, and I think that analysis would be useful. CHAIRMAN BERNANKE. Governor Warsh. MR. WARSH. Governor Kohn shamelessly stole my question. [Laughter] CHAIRMAN BERNANKE. Governor Kroszner, do you have a question? MR. KROSZNER. Yes. In a lot of the discussion you just take as given the stigma associated with the primary credit facility, and you were just discussing that related to the publication of information about the facility. Is that something that could also be on the table? That seems to be potentially an instrument for which we might have to consider how much information to provide or about making it less or more attractive, which then would affect which options are more or less attractive. Is there some reason not to do that? April 29–30, 2008 173 of 266 MR. MADIGAN. I think that’s worth some further thought, Governor Kroszner. One issue though, as I’m sure you know, is that the Board is required by law to publish weekly information on the individual Banks’ balance sheets as well as the consolidated balance sheet with a certain amount of detail. I don’t remember the exact legal wording, but at least within the current law, to back away from that might be difficult. Of course, you could conceivably pursue a change in the law, but I think we would want to think about the pros and cons of that before you went in that direction. MR. KROSZNER. For sure, but just thinking about whether there are other things that we could do related to stigma might be worthwhile in this context. MR. MADIGAN. Absolutely, we agree. Of course, when the Board adopted the primary credit program in 2003, we gave a lot of thought before that and did considerable work after that to try to minimize the amount of stigma by trying to make very clear to banks that in our view use of the window didn’t entail stigma. But the fundamental problem still is that banks are concerned that their use of the window may be detected in the market one way or another, especially in a period of financial stress, and that is just not a cost worth incurring. CHAIRMAN BERNANKE. President Plosser, did you have a question? MR. PLOSSER. Yes, just an implementation question. One thing you talked about was in periods of stress, the way we’ve conducted policy intraday, you have had firmness in the funds rate in the morning and then weakness in the afternoon causing some intraday volatility. The difficulty of hitting the target was partly the fact that we were entering the market only once a day, in the morning, and you had to see through that. With all these other strategies, as they are implemented in other countries, are the central banks doing the same thing? Are they entering the market only once a day, or do they come in several times a day? I just wondered if there are differences in their approaches as to how often they interact in the marketplace. April 29–30, 2008 174 of 266 MR. HILTON. I would say, as a general characterization, that the common practice is to intervene only once a day, in the morning—not unlike what we do. Where there’s an exception, it’s like with the Bank of Canada. They have access to information that would allow them to know with precision late in the day what the supply of reserves is in the absence of any further open market operations, and then they make an adjustment accordingly. The fact is that, even if we were to operate late in the day but still before the close—let’s say, 5:30 or 6:00—we really have no more information than we had at 9:30 in the morning upon which to make an estimate of that day’s reserve supply. We can observe rates, but we don’t know what amount of a reserve adjustment would be needed to bring supply in line with demand. The risk of just opening up and offering to be one side or the other of the market in that situation late in the day is that we could get the entirety of one side of the market and actually create a reserve imbalance in the other direction between that time and the close of the day. So simply being willing to operate late in the day isn’t really enough. You do need reserve information as well upon which to size those operations. VICE CHAIRMAN GEITHNER. Just to make this clear, Spence, is it the number of banks that make that information more accessible in Canada, or is it something else? Is it fundamentally that they have just five banks? MR. HILTON. No, it is that they know the balance sheet. They know it by late in the day with certainty. They have few sources of uncertainty to begin with, and their major source of uncertainty, government balances, is something that perhaps the small number of banks they’re dealing with facilitates. But it is that they know by late in the day what the supply of reserves will be with real precision. April 29–30, 2008 175 of 266 MR. MEYER. Basically everything clears through their equivalent of Fedwire, so they know in real time what the balances are. CHAIRMAN BERNANKE. Okay. Did you have a question? MR. LACKER. A comment about stigma. Every financial transaction that a substantive firm engages in that becomes known is relied upon by market participants to make inferences. There’s a huge literature on the effect on equity values of the announcement of a bank line of credit; and like through this last crisis, if you talk to funding-desk guys, they’re very aware at the tactical level about what counterparties are revealing by their actions in funding markets. They take that on board, and they’re very strategic about what they reveal with their market transactions. We can try to keep it secret, but there’s a broad ability in the market to infer when somebody goes to the window by their behavior before that. I’m saying that I don’t think we should get our hopes up about ever eliminating stigma. CHAIRMAN BERNANKE. Okay. Let’s take positions and comments, keeping in mind that lunch is being held hostage. [Laughter] President Rosengren. MR. ROSENGREN. Okay. Just a quick question, which doesn’t have to be answered now—given all of the financial turmoil, it would be interesting to see whether in other countries that have these different arrangements there was a decrease in either overnight or term lending with counterparties. Given the extent to which you can just work with a central bank rather than counterparties, is there any evidence in these other regimes that interbank lending transaction volume disappeared in some of these countries? I would be interested in seeing that. Regarding Governor Kroszner’s comment on the H.4.1 release, it does seem that we could probably have a materiality requirement in our balance sheet. Under most circumstances, what we are doing at the discount window would seem not to hit that materiality criterion. I think we could be a little April 29–30, 2008 176 of 266 more innovative—I agree with President Lacker’s point—but I think that the H.4.1 does seem to have an effect; and if we will be doing all these other things, taking another look at the H.4.1 and making sure that we don’t have more untapped flexibilities probably makes a lot of sense. I would like a little more discussion of “promote efficient and resilient money markets and government securities markets” as a criterion. I’m not sure I would weight those criteria equally. It seems that all these criteria, for the most part, take care of most of the dead weight loss; and given that the banks still have to administrate for daylight credit, I am not sure that the burden is all that different across these various regimes. But I can imagine that that one might be different, and given we just had financial turmoil—I know this is a bit different from what President Lacker said—I would put a little more attention to that. Overall, I like option 2 and option 5. I’m comfortable with those two. I’m attracted to the voluntary balance program. On net, I would probably prefer a longer maintenance period to a one-day maintenance period, but I don’t have a strong preference and could easily be convinced otherwise. CHAIRMAN BERNANKE. Thank you. President Evans. MR. EVANS. Thank you, Mr. Chairman. As I mentioned earlier, I would find some discussion about the transmission mechanism useful—at what rate we think the markets would be picking up the price of risk-free yield curves. I think that would help. To the extent that we can align this with other foreign central bank experiences, we might be able to draw on how they view that and what the financial market data look like. So I am comfortable with focusing primarily on options 2 and 5. I was thinking along the lines of President Hoenig, which is that the Federal Reserve tends to go slowly. Vince isn’t here, but he often reminded us of that. April 29–30, 2008 177 of 266 Option 1 is the easiest one. If we have enough information about it, then that’s fine. I think that’s all I have. CHAIRMAN BERNANKE. President Stern. MR. STERN. I have only two comments. I would drop option 1. I just think it doesn’t do enough to reduce the burdens and dead weight losses. As long as it’s there, there will be a tendency to fall back to it for all sorts of reasons, given bureaucratic tendencies. So I would just discard it. I would not discard option 4, so I would include options 2, 4, and 5. I was originally attracted to 4. I read the reservations in the report and thought, okay, it’s not worth pursuing. But I listened to President Lacker, and he reconvinced me that there are some significant merits there. CHAIRMAN BERNANKE. President Yellen. MS. YELLEN. Thank you. First, I do really appreciate all the excellent work the staff has done on this topic. I really learned a lot from these papers. I thought they were very clear and very comprehensive. I have just a couple of comments on the questions that Bill and Brian raised in the memo. The first one has to do with whether or not we agree with the objectives, and I do have a couple of issues. First, I think that the stated objective of reducing the burdens and dead weight losses associated with the current reserve tax is too narrowly framed in the paper. My starting point is, about burden, that to cover a given program of government spending, the Treasury has to obtain revenue from some source, and nondistortionary lump-sum taxes are not one of the available options. So the real question from the public finance standpoint is what to tax and how much. That means, to my mind, that the issue here is how the magnitude of the welfare gains that would come from lowering the dead weight loss due to the implicit tax on reserves compares with April 29–30, 2008 178 of 266 additional dead weight losses that would result from the alternative taxes that would have to be raised to make up for this lost revenue. Now the answer depends in part on the interest elasticity of demand for reserves, I believe. I think it is the case that, if the interest elasticity is relatively small, the dead weight loss from the reserve tax is relatively small, and the net welfare gain, taking into account the burdens of raising other taxes to make up for the lost seigniorage, in effect, could easily turn out to be negative. Let me give you an example of where this comes into play. There is a well-known paper by Martin Feldstein in which he looks at the benefits of moving to price stability, zero inflation, which he favors. He looks at this issue in that context, and he concludes that there would be net social losses, not gains, from the reduction in seigniorage that would be associated with a move to zero inflation from positive inflation because the dead weight loss due to the shoe-leather cost, also known as the Bailey effect, is smaller than the dead weight losses that would be associated with alternative taxes. In his analysis they are taxes on labor supply and saving. I actually think that this is a serious problem with the framing of the objectives in this paper. It is, in effect, saying, “We think we should give a tax cut. We think we should give it to banks, and we think that, because there is a welfare loss—a Harberger triangle—associated with that, this is clear welfare gain.” Now, I am not pretending to know exactly how this would come out, but I do think that’s the issue. If it were to come out that this is a net loss, not a gain, a possible implication is that if there were a fallback to option 1—I’m not saying that I favor option 1— there could be a case for paying no interest on required reserves rather than paying interest at the federal funds rate but paying interest on excess reserves at some rate that we would determine. April 29–30, 2008 179 of 266 There are administrative costs with having voluntary target balances, and it seems to me that the paper, as we come out with it, ought to try to at least estimate what the administrative burdens associated with options 2 and 5 would be. Another comment on the issue of objectives: If we are coming out with a white paper, it seems to me that the objective that everybody is now discussing and that was just discussed— namely, that paying interest on reserves would enable us to expand the size of our balance sheet in times of financial crisis, like now, and perhaps greatly enhance the scope for liquidity-altering interventions that would be possible without having to push the federal funds rate to zero—is a real improvement in the tool kit that is available to us to address market disruptions. I would see it as an advantage of paying interest on reserves. If you are discussing this right now with the Congress and it is much discussed in the press, I think it is kind of odd to come out with a paper that doesn’t even mention it. Maybe there are disadvantages and not just advantages. But it seems to me it should be there. Also, I would just say on the question of options 2 and 5 versus options 3 and 4, an advantage that the paper attaches to having voluntary targets is the ability to moderate the volatility in the federal funds rate. So it does seem to me that—I understand it may be difficult—the possibility of intervening multiple times during the day as an alternative, if it were possible to change the procedures so that there could be multiple interventions to reduce volatility, would mean that 3 and 4 could be on the table, and there might be less burden associated with those. So I think that possibility deserves at least careful consideration. CHAIRMAN BERNANKE. Thank you. President Bullard. MR. BULLARD. Thank you, Mr. Chairman. This is a proposal for study. The timeline seems fine to me. The study period is pretty important in this case because it is not clear to me April 29–30, 2008 180 of 266 which option is best, and so I think maybe we should keep more of the options on the table. One question that I have is, To what extent are current reserve requirements actually binding for depository institutions? There is a past study by the St. Louis staff—Dick Anderson and Bob Rasche—suggesting that, by and large, existing reserve requirements are not binding. To me that calls into question whether objective 1 for this study group is really appropriate. Dead weight losses make sense to me only if there is a binding reserve requirement. In that regard, I’d like to endorse President Yellen’s comment, which I thought was right on target, about whether you are going to make up for lost revenue from somewhere else and how distortionary that would be. There is a bit of political risk here that, if this starts to get painted as a handout to banks, maybe it wouldn’t serve us well. I would like to see more emphasis on option 3, which based on the discussion seems to be not too bad a system. That is the Canadian system. That is a tested system in an economy that is not too different from our own—certainly, an economy that is closely integrated with this one. The corridor would be narrow. There might be more volatility within that corridor, but you still seem to get pretty good results. I know they have a small number of banks, but it seems to me with today’s technology you might be able to get a good read even for a large economy. I would like to see it kept in the mix here. They have had lots of success and very low administrative burden, if that is what you are worried about. I am perhaps not so familiar with options 2 and 5, which are the favored options in this discussion. But I am concerned about the language of voluntary balance targets, which seem to be maybe not that voluntary. It seems to me to create a risk that the systems are really not as market-oriented as I would like to see or that they could be manipulated by market participants, particularly in a time of stress. Those are some of the concerns I had about this. April 29–30, 2008 181 of 266 CHAIRMAN BERNANKE. On the public finance question, of course, the Congress has acted and they score it to cost. So in some sense that is moot from our perspective. President Pianalto. MS. PIANALTO. Thank you, Mr. Chairman. Let me also start by commending the authors of the papers that were prepared on this topic. I found the material very informative and helpful. I agree with the objectives established by the staff to evaluate the set of proposals, and I also support the process and the proposed timeline for moving the proposals forward. I think it is good that the timeline provides for comments from banks so early in the process. It will be important for us to receive their input at an early stage. I found option 2 to be preferable to option 1 because option 2, as we have discussed, clearly reduces the administrative burdens relative to option 1. I think that option 3 leaves too much potential for fed funds rate volatility in its corridor. I was also intrigued by option 4 with caps. However, I ultimately rejected option 4 out of the concern that it might lead to a less robust interbank lending market. But given the comments of President Lacker and others, perhaps it makes sense to keep option 4 on the table. In the end, however, I am comfortable with moving forward with our focus on options 2 and 5. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. Just to answer the questions that were posed, I am comfortable with options 2 and 5, but I thought President Lacker’s presentation made the case that option 4 deserves to remain in the mix. I think the objectives are appropriate. The only comment I have—and this is a bit vague, I realize—is to ensure that we are thinking far enough ahead to ensure that we have a durable system that can operate in different mixes of private and public in the payment system. Certainly, I think it is conceivable that in some years April 29–30, 2008 182 of 266 we will be out of the business of retail payments, so I think we have to address different mixes of private and public payment systems. Regarding the timeline, Governor Kohn already asked the question about approaching the Congress to accelerate. Assuming that we do not approach the Congress to accelerate this, then this timeline seems to me quite comfortable and gives plenty of time for very careful consideration. In the room here is Will Roberds from our research staff, who by chance was at the Bank of England talking about their experiences recently. I thought I would share a couple of things that are apropos. They tried maintenance periods other than the intermeeting period, and they found them to be not so effective, apparently because of ambiguity around the target rate. That is a useful way of thinking—that the maintenance periods would be designed around the intermeeting period. They apparently tried option 3, and it didn’t work because of too much volatility within the corridor. Those two tidbits are feedback from the visit of a member of my staff to the Bank of England. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Hoenig. MR. HOENIG. Thank you, Mr. Chairman. I would look at this meeting as an introduction to this topic, given the breadth of the discussion here, which I found extremely interesting and useful. I think we will need to come back to another discussion of it—not necessarily with another 100-page study. I wouldn’t want to put that burden on you—it might negate any savings we get from this project. [Laughter] To the point of the options, the one that was most attractive to me was option 2. It is a good transition. We have some familiarity with it, given the way we do clearing balances now, and I think we can work on it. The reason that I was a little questioning about option 1 is that in April 29–30, 2008 183 of 266 option 2 you are not quite sure what you are going to end up with, given how the banks may choose to target the amount of reserves and so forth. But with any choice we make, we are going to have to go up that learning curve. So of those, I prefer option 2. I am fascinated, though, with President Lacker’s comments on option 4 and will look at it again with that in mind because I thought he made some good points. But at the moment, I think option 2 is a pretty good path to go down. CHAIRMAN BERNANKE. Thank you. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. This will be very brief. Option 2 looks very attractive to me. I think option 1 may be a fallback position, but like President Stern, given our tendency to move slow too quickly, if that makes sense, I would rather take the opportunity to make a larger step. So I think option 2 is fine. Option 5 is interesting, but its distinction is that nobody else is really doing that. So it would be a little more of a wild card in terms of how we might implement it and how it might work. But I think it has some merit. I had asked Bill Dudley back in the fall, when we were having trouble meeting the endof-day targets, about why we didn’t set the price. The answer I got was, “Well, this was a good time to think about that option in the context of paying interest on reserves.” I was probably a little disappointed that we didn’t see more of what such a strategy might look like and how it would behave. Thanks to President Lacker, his interpretation of option 4 is pushing us more in that direction. I hadn’t really thought of option 4 in that context that way, but I like it. I still have the view that essentially looking at everything as a quantity-based view of how we go about doing this restricts the way we think about what our options might be. So I would like to see a little more explanation of what a price target, where we buy and sell, might actually do. How that might interact with option 4 would be an interesting way to enrich the set of options. April 29–30, 2008 184 of 266 Another question I had—and I don’t know the answer to this—is that we have instituted a number of new facilities. There is the TAF, there is the TSLF, and so forth. I wasn’t quite clear how those facilities would interact or be appropriate or inappropriate within the context of these things, or whether this would substitute for all of those in some sense. If we wanted to pull those off the shelf again at some future time, how would they interact with these systems? I think it would be useful to have a little discussion about what those interactions might be. The last observation is related to President Lockhart’s comment. How we go about paying interest on reserves has implications for other parts of what the Federal Reserve System does—in particular the retail payment system and the way we calculate cost recoveries and our revenues under the Monetary Control Act. There are some separate study groups that are thinking about this, but we ought to make sure that we tie these pieces together as we go forward so that we know what the domino effects of going this direction might be. Maybe there will not be a concern, if we get out of retail payments, how it affects the Monetary Control Act requirements on fees for services and things like that. I would like to see that loop closed somehow before the end of the discussion. Otherwise, I want to congratulate the staff on a very thorough report. I was at the conference as well in February. I thought it was very interesting, and I applaud the staff on some good work. Thank you. CHAIRMAN BERNANKE. Thank you. President Fisher. MR. FISHER. Mr. Chairman, we have been in favor of paying interest on reserves for some time. This is an excellent paper. Like everybody else, I learned a great deal from all the papers that were sent and this superb summary that was just presented. I personally tend toward option 2, but I think it is worthwhile considering options 4 and 5 as well in terms of vetting this under the timetable. I think that Charlie asked a good question about how this relates to the other April 29–30, 2008 185 of 266 facilities, but generally, the optics on this are favorable. Again, we are moving forward. The public doesn’t really understand the background of this—where the Congress has stood and what we have achieved so far. I think it would be just one other good thing for us to be modernizing the Federal Reserve. I asked the question on governance just because I understand that the current plan calls for rates to adjust automatically to changes in target set by the FOMC. I would want to make sure that was the case. In other words, I don’t like the potential for vesting all the power in the Board; and, of course, that potential is there. I think it is worth preserving the federal system of the Federal Reserve. That is the only reservation I have. Those are my comments. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. We don’t want it. [Laughter] Governor Kohn. MR. KOHN. Thank you, Mr. Chairman. I thought this was a great piece of work by the staff, and I thank them all. You did a good job of organizing it and laying out the general principles in a way that people can understand. Despite President Yellen’s comments, I have no regrets about my testimony in favor of paying interest, perhaps because I bore so much of the administrative costs over the years [laughter]—along with Stephanie Martin and her predecessors in the Legal Division. Those costs that were borne were considerable, in addition to the dead weight losses. I think we should consider options 2 and 5 for sure. On option 4, I think we need to understand a bit—other people have said this—what the third objective, “promoting efficient and resilient money markets,” means exactly, what is entailed, and how that would intersect with option 4. So I think that needs to be fleshed out a little more. Because you have planned to get a white paper out soon, I think perhaps including option 4 would be easier than not including it, April 29–30, 2008 186 of 266 just to get people’s comments. Perhaps because of my administrative burden experience, I would like to see reserve requirements at zero, ruling out option 1. On option 3, I just don’t think, at least with our system and in periods of crisis, that the top of the band would hold, so I don’t think that option would really work very well. Thank you all for your work. CHAIRMAN BERNANKE. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. Let me add my plaudits to those already expressed on the quality of this work, and then let me confine my comments to the timing and sequencing. First, with respect to the rollout of the white paper, it strikes me that, given that questions have been raised about what our flexibility is around our balance sheet and tools in the event of continued problems in the financial markets, we just need to be cognizant in that paper of how this discussion might be read, not in the context of a long Fed effort to get interest on reserves but perhaps as being solely responsive to what are perceived to be burdens on our balance sheet flexibility. I am just sensitive to how that white paper will be read and rolled out. More broadly, on timing—come fall, in the event that we decide collectively to go to the Congress seeking other authority with respect to the PDCF, investment banks, and other things that might or might not be concluded, even though this timeline makes a lot of sense, we might be in good stead to have a fairly good sense of the conclusions to which we will ultimately come, even if our exhaustive Fed rigor isn’t complete by that time. If there is real benefit to accelerating our new authority from late 2011 to some earlier period, we could put that in the context of some of broader asks from us with an expectation that we might get some traction there. So as a sort of secondary timeline, having that option value come fall strikes me as useful. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. April 29–30, 2008 187 of 266 MR. KROSZNER. Thanks. Great work, great presentation. It is impressive to get through fifty-two pages in less than fifty-two minutes, and so I applaud you on that. Basically I agree with a lot of the stuff that has been said before. The trick may be thinking a bit creatively about stigma issues, if there is any way to deal with those. I am not quite sure what you are suggesting putting out in a white paper for comment—options 2, 5, and possibly 4? Or were you thinking of putting all five out? MR. MADIGAN. Well, I certainly think at this point the three that you mentioned first. At this stage, if we are going to go to with three, we might want to think about putting all five out, just to flesh out all parts of the spectrum and acknowledge that option 1 could be a fallback. We have to think about the pros and cons of that, but certainly the three at this point is where the consensus seems to be. MR. KROSZNER. Doing three of them seems perfectly reasonable. Thank you. CHAIRMAN BERNANKE. Governor Mishkin. MR. MISHKIN. I am very comfortable with the analysis and the approach, so I don’t have any major comments there. Although in the white paper you might mention them, I would like to take options 1 and 3 off the table. Option 1 has just too much administrative burden. We have enough tsuris already. Although option 3 may work well in countries with very different structures of the banking system, I don’t think it is a feasible alternative for us. So I think that we should look at options 2 and 5, and I am certainly comfortable with another look at option 4. One issue that I worry about a bit is that these markets do sort out some interbank credit risk issues. We don’t want to lose that, so we have to be very aware of it. I also worry a bit about setting a price when there is a credit risk element to it. When there is no credit risk April 29–30, 2008 188 of 266 element—if you want to set the Treasury bill rate—it is no big deal. But there may be an issue there, I am not sure, and it should be one of the considerations in this context. Thank you. CHAIRMAN BERNANKE. Vice Chairman. Oh, sorry. President Lacker. MR. LACKER. Presumably, the rate we pay would be viewed as a risk-free rate. Presumably, any market rate would be priced relative to that to include a credit premium in the usual way. If any other dynamics are anticipated by the staff, it would be useful to know that. But the usual presumption we have is that observed market rates would have our rate plus a credit premium booked into it, or transaction costs, or whatever. I’d just make that comment. CHAIRMAN BERNANKE. Vice Chairman. VICE CHAIRMAN GEITHNER. Thank you, Mr. Chairman. I don’t have a conviction yet on the options, but I agree that we should narrow our focus to options 2 and 4-5. I think we should design a process that tries to force us to get conviction more quickly on which option we would prefer. I think it is possible. You have made a huge investment already. You know the alternatives. I think it is worth, again, a goal that gets us conviction more quickly, in part because we do have a brief window now in which we might be able to get the Congress to accelerate and we could implement more quickly. I would get the Congress to accelerate if I could be totally confident that it would be free, that we would pay no price, and that there would be no risk that anything else would be on the table or that it would compromise any other objective. It is very hard to have confidence on that. But if you get confidence on that, then I would go do it. But I would certainly run a process by which we get conviction early. I would want us to have conviction before we go out for public comment. The general rule is to figure out what you want to do and design a process that maximizes the chance that you get there quickly. It also strikes me that a process this drawn out will take much more staff time. April 29–30, 2008 189 of 266 You guys are busy. We don’t have a lot of time. We don’t have a lot of excess capital in the Federal Reserve System now relative to the challenges we face. The longer it is drawn out, maybe the smaller the tax day by day, week by week, but it is just a huge tax. I would not want to go out for public comment on a white paper in this time frame until I knew two things. One is, Are we going to get the Congress to accelerate? If so, on what? What is the probability? Are we going to ask for it? The other is I wouldn’t do it until I knew that we were closer to saying, “If we got it, we would do this in this time frame.” Finally, I think it is hard to have this discussion in public with the Congress now without an answer to what they will perceive to be the larger questions. What are the larger questions? I think that you can reduce some of the larger questions simply to, What are we going to do with our role as lender of last resort going forward? This is a version of President Plosser’s and Governor Warsh’s questions—what the future of our facilities is, in some sense. The staff has assured me that these options all preserve optionality on any future facility framework. They don’t prejudice those options, which is very important. But I think there is a demand now and interest in what our answer is to those broader questions. It is hard to see the architecture of our role as lender of last resort without having the answer to what the framework will be for restraints on risk-taking by institutions that have access in normal times and in extremis to those lender of last resort facilities. We can’t get conviction on that in the same time frame that we need to accelerate legislation on this stuff, but—and probably because—I think those things are fundamentally more important than whether we end up with 2 or 4.5 or 5 on the way to 4.5. I would try to shorten the amount of time and effort we put into this, and I would increase the amount of time and effort we put into that broader set of policy questions, which are going to be essentially April 29–30, 2008 190 of 266 about the intersection among the lender of last resort role, our monetary policy regime, the moral hazard consequences of all the stuff we have done, and how we deal with those in the future. I think that is going to take a lot of time, effort, and care. I don’t know how to reconcile all of what I just said in the context of a practical path forward, except just to repeat it. Why not try to run a process in which you get conviction more quickly on this relatively small set of adjustments as to how we operate? Try to get a judgment quickly about whether we can get the Congress to accelerate without any meaningful political cost, then design a process whereby we put ourselves in the position to implement early next year, if the Congress were to accelerate. And try to have the resources saved by attenuating that process devoted to these deeper questions about our future facilities and the associated constraints we are going to have to put on a broader set of institutions. CHAIRMAN BERNANKE. Thank you. On those broader questions, Vice Chairman, we are going to talk at lunch about some initiatives by which we will address some of the broader regulatory and bank supervision issues. That process will be parallel to this. What I would say about this issue is that, as you go forward, you should keep in mind the possibility we might want to go to the Congress for some kind of interim power. Obviously, there are things that we can do that are not the full panoply of things you described today. They would be interim steps, and I think that the most important thing is to make sure that whatever we ask for would not be inconsistent with or contradictory to some of the longer-term plans. We obviously don’t anticipate implementing option 5 next year, but we could take some interim steps that potentially might be useful in the current circumstances. Very briefly, I agree with President Fisher and President Lacker. This is a once-in-ageneration chance to modernize our system. It is a relic that we use a quantity-based April 29–30, 2008 191 of 266 management of the federal funds rate. So I think option 1 should be a fallback if we can’t make something else work, but we should try very hard to see if we can find a system that will let us manage the funds rate tightly, even as our balance sheet expands and contracts, and so on. I have the same concerns about option 3, that it might not tie down the fed funds rate very much. Options 2 and 5 are interesting. I agree with President Lacker that option 4 is worth exploring. I broached this with the staff before the meeting. Option 4 seems a lot like Friedman’s optimum quantity of money: You just throw out money until the transaction cost on margin is zero. That’s basically what it is. I don’t, frankly, fully understand what the implications would be for the federal funds market—whether the federal funds market is just a shoe-leather cost or whether it actually has some useful functions, including price discovery, credit risk management, and counterparty discipline. There may be some functions of that market that are important, and even if it still existed, if its liquidity were greatly reduced so that it wasn’t functioning in a normal way, it could be a question. To my mind, that is the main question we have to understand as we think about option 4. Once again, terrific work, and this is really exciting, interesting stuff. So thank you all very much. Are there any other comments on interest on reserves? Okay. If not, let’s see. First, again, the projections are due Thursday at 5:00 p.m. If anyone has changes, please make the effort to do that. We will be circulating information on the 2009 FOMC schedule to try to come to closure on that. The next meeting is Tuesday and Wednesday, June 24 and 25. In a moment, we will adjourn and get lunch, but please come back to the table so that we can have some discussion about some of our longer-term issues on supervision and regulation. Thank you very much. The meeting is adjourned. END OF MEETING June 24–25, 2008 1 of 253 Meeting of the Federal Open Market Committee on June 24–25, 2008 A joint meeting of the Federal Open Market Committee and Board of Governors of the Federal Reserve System was held in the offices of the Board of Governors in Washington, D.C., on Tuesday, June 24, 2008, at 2:00 p.m., and continued on Wednesday, June 25, 2008, at 9:00 a.m. Those present were the following: Mr. Bernanke, Chairman Mr. Geithner, Vice Chairman Mr. Fisher Mr. Kohn Mr. Kroszner Mr. Mishkin Ms. Pianalto Mr. Plosser Mr. Stern Mr. Warsh Ms. Cumming, Messrs. Evans, Lacker, and Lockhart, and Ms. Yellen, Alternate Members of the Federal Open Market Committee Messrs. Bullard, Hoenig, and Rosengren, Presidents of the Federal Reserve Banks of St. Louis, Kansas City, and Boston, respectively Mr. Madigan, Secretary and Economist Ms. Danker, Deputy Secretary Mr. Skidmore, Assistant Secretary Ms. Smith, Assistant Secretary Mr. Alvarez, General Counsel Mr. Baxter, Deputy General Counsel Mr. Sheets, Economist Mr. Stockton, Economist Messrs. Connors, English, and Kamin, Ms. Mester, Messrs. Rolnick, Rosenblum, Slifman, Tracy, and Wilcox, Associate Economists Mr. Dudley, Manager, System Open Market Account Ms. J. Johnson,¹ Secretary, Office of the Secretary, Board of Governors Mr. Cole, Director, Division of Banking Supervision and Regulation, Board of Governors Mr. Frierson,¹ Deputy Secretary, Office of the Secretary, Board of Governors _______________ ¹ Attended portion of the meeting relating to the supervisory report concerning investment banks and related policy issues. June 24–25, 2008 2 of 253 Ms. Bailey,¹ Deputy Director, Division of Banking Supervision and Regulation, Board of Governors Mr. Clouse, Deputy Director, Division of Monetary Affairs, Board of Governors Mr. Parkinson,¹ Deputy Director, Division of Research and Statistics, Board of Governors Ms. Barger,¹ Deputy Director, Division of Banking Supervision and Regulation, Board of Governors Mr. Blanchard, Assistant to the Board, Office of Board Members, Board of Governors Mr. Struckmeyer, Deputy Staff Director, Office of Staff Director for Management, Board of Governors Mr. Stehm,¹ Associate Director, Division of Reserve Bank Operations and Payment Systems, Board of Governors Messrs. Reifschneider and Wascher, Associate Directors, Division of Research and Statistics, Board of Governors Mr. Gagnon,² Visiting Associate Director, Division of Monetary Affairs, Board of Governors Mr. Wright, Deputy Associate Director, Division of Monetary Affairs, Board of Governors Mr. Zakrajšek, Assistant Director, Division of Monetary Affairs, Board of Governors Mr. Erceg,² Assistant Director, Division of International Finance, Board of Governors Mr. Oliner, Senior Adviser, Division of Research and Statistics, Board of Governors Mr. Gross,¹ Special Assistant to the Board, Office of Board Members, Board of Governors Ms. Tevlin,² Senior Economist, Division of Research and Statistics, Board of Governors Mr. Ammer,² Senior Economist, Division of International Finance, Board of Governors Ms. Beechey, Economist, Division of Monetary Affairs, Board of Governors _______________ ¹ Attended portion of the meeting relating to the supervisory report concerning investment banks and related policy issues. ² Attended portions of the meeting through the policy vote. June 24–25, 2008 3 of 253 Ms. Dykes, Project Manager, Division of Monetary Affairs, Board of Governors Mr. Luecke, Section Chief, Division of Monetary Affairs, Board of Governors Ms. Beattie,¹ Assistant to the Secretary, Office of the Secretary, Board of Governors Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of Governors Ms. Hughes,¹ Staff Assistant, Office of the Secretary, Board of Governors Mr. Barron, First Vice President, Federal Reserve Bank of Atlanta Mr. Fuhrer, Executive Vice President, Federal Reserve Bank of Boston Messrs. Altig, Angulo,¹ Rasche, Schweitzer, Sellon, and Weinberg, Senior Vice Presidents, Federal Reserve Banks of Atlanta, New York, St. Louis, Cleveland, Kansas City, and Richmond, respectively Messrs. Fernald and Fisher, and Ms. McLaughlin, Vice Presidents, Federal Reserve Banks of San Francisco, Chicago, and New York, respectively _______________ ¹ Attended portion of the meeting relating to the supervisory report concerning investment banks and related policy issues. June 24–25, 2008 4 of 253 Transcript of the Federal Open Market Committee Meeting of June 24-25, 2008 June 24, 2008—Afternoon Session CHAIRMAN BERNANKE. Good afternoon, everybody. Why don’t we begin, as usual, with the Desk report and Bill Dudley. Bill. MR. DUDLEY. 1 Thank you, Mr. Chairman. I’m going to be referring to the handout that you should have in front of you. Financial markets have become more resilient to bad news in recent weeks. Although the news associated with several important groups of financial intermediaries—including investment banks, commercial banks, and the monoline insurers—has not been favorable, contagion has been limited compared with some of our earlier experiences during the past year. Moreover, the types of vicious feedback loops that were evident, for example, in early March have been largely absent more recently. Despite this, much of the news has not been good. Looking first at the U.S. equity and credit markets, a good portion of the improvement that occurred in the run-up to the April FOMC meeting has been unwound recently. The broad U.S. equity indexes are only marginally above their low points reached in mid-March and the price of the Standard & Poor’s 500 financial sub-index has fallen to a new trough (exhibit 1). In contrast, corporate credit spreads have held on to much of the gains achieved after mid-March. As shown in exhibit 2, the spreads on both investmentgrade and high-yield corporate debt have been quite stable recently. However, as shown in exhibit 3, corporate credit default swap spreads have widened over the past few weeks. Most of the major investment banks have continued to struggle. As shown in exhibit 4, the share prices of the four remaining independent U.S. investment banks remain depressed. Further write-offs, capital-raising (which is increasing the number of common share equivalents outstanding), and investors’ concerns about the consequences of deleveraging on long-term profitability have all been important factors weighing on share prices. In contrast to this poor equity-price performance, credit default swap (CDS) spreads remain much narrower than at the time of Bear Stearns’s demise in mid-March (exhibit 5). The establishment of the Primary Dealer Credit Facility and the Federal Reserve’s role in the acquisition of Bear Stearns by JPMorgan Chase are undoubtedly both important factors behind the divergence of equity prices and credit default swap spreads. Lehman Brothers, which reported a second-quarter loss that was considerably larger than expected, has been under the most stress. However, in contrast to Bear Stearns’s experience in mid-March, Lehman’s short-term financing counterparties have generally proved to be patient. The financing backstop provided by the Primary Dealer Credit Facility has been cited by many counterparties as a critical element that has encouraged them to keep their 1 The materials used by Mr. Dudley are appended to this transcript (appendix 1). June 24–25, 2008 5 of 253 financing lines to Lehman in place. The investment banks have begun to rapidly deleverage their balance sheets. As shown in exhibit 6, the gross leverage ratios for Lehman Brothers, Goldman Sachs, and Morgan Stanley all fell sharply in the second quarter. This stands in marked contrast to the rise in leverage ratios that persisted through the first quarter of this year. Regional banks have also come under considerable strain recently. Deterioration in their construction lending, commercial real estate, and residential mortgage books has caused many banks to raise their loan-loss provisions sharply. Potential acquirers of troubled regional banks have been discouraged by the accounting requirement that these banks must mark down the assets of the bank that they’re acquiring to the current market value at the time of the acquisition. The financial guarantors have also been under stress. Both Standard & Poor’s and Moody’s recently downgraded Ambac and MBIA. The Moody’s downgrade of MBIA was particularly sharp—five notches to A2 from AAA. These downgrades of the monoline guarantors have a number of important implications. First, the firms that have purchased protection from Ambac and MBIA will have to take significant write-downs. Citigroup, Merrill Lynch, and UBS appear to have the largest exposures to these two firms. Second, the ability of Ambac and MBIA to establish new AAA-rated subsidiaries that would enable them to write new municipal bond insurance is increasingly in doubt. Most likely, these firms will be forced to go into runoff mode in which they can no longer write new business. Third, the financial resources of these firms will be strained by the downgrades. For example, MBIA said that, as a result of the downgrades, it may have to pay out $2.9 billion to satisfy certain contracts and post up to $4.5 billion of additional collateral. Fourth, the risk of a default or a restructuring event by a major monoline guarantor could potentially unsettle the CDS market. As shown in exhibits 7 and 8, the share prices of the monolines have continued to slide, and their credit default swap spreads have risen further. As has been the case for some time, there remains—even after the credit rating downgrades—a big disconnect between the CDS spreads of these firms and their credit ratings. Despite these rating downgrades, the effect on the municipal securities market has been muted compared with the turmoil evident in the first quarter. Put simply, much of the adjustment in the short-term municipal market—for example, the demise of the muni auction rate securities market and the restructuring of many variable rate demand notes (VRDN) and tender option bond (TOB) securities, has already taken place. Although the yields on the VRDNs wrapped by Ambac and MBIA have increased sharply, up to now much of this paper has been remarketed rather than put back to the liquidity providers. The effect on the municipal bond market has been even more subdued. As shown in exhibit 9, the ratios of 10-year and 30-year municipal yields to comparable Treasury yields have risen only slightly recently and remain well below the peaks reached in mid-March. Investors have already been looking through the credit ratings of the monoline insurers to the quality of the underlying tax-exempt issuer. June 24–25, 2008 6 of 253 The performance of term funding markets also suggests a greater resilience to bad news. Subsequent to the May expansion of the TAF auction sizes and the increase in the foreign exchange swap lines with the European Central Bank and the Swiss National Bank, one-month and three-month LIBOR–OIS spreads have narrowed significantly (exhibits 10 and 11). The decline in term funding spreads is particularly noteworthy because it stands in contrast to the widening that occurred in the last month of the three preceding quarters—September, December, and March. The increase in the size of the TAF auctions has also been associated with a decline in bid-to-cover ratios. Also, as shown in exhibit 12, the spread between the stop-out rate and the minimum bid rate has been relatively low. In contrast to the U.S. auctions, the bid-to-cover ratios in the ECB and SNB auctions have risen sharply over the last three auctions (exhibit 13). This likely reflects several factors including (1) a reduction in the willingness of U.S. banks to lend at term to European banks—due mostly to balance sheet constraints and (2) strategic bidding behavior. As you recall, the ECB auction is a noncompetitive auction with the stop-out rate determined by the TAF auction. As a consequence, increasing the bid size in the ECB auction will not raise the price that the banks will have to pay, and that encourages more bidding in the ECB auctions. This strategic bidding explanation, however, is undercut by the fact that European banks have also been strong bidders in both the TAF and the SNB auctions. The introduction by ICAP of a competing measure of bank funding costs— the New York Funding Rate (NYFR)—has mostly bolstered the credibility of LIBOR. The NYFR rates have consistently been within 1 or 2 basis points of LIBOR. However, it is unclear how much this conformity reflects the accuracy of LIBOR. It is possible that the NYFR respondents use LIBOR as a benchmark for their own responses, since LIBOR comes out earlier in the day than when they have to respond. Demand for the term securities lending facility (TSLF) auctions has also generally been subdued. Only one of the last nine auctions has been fully subscribed. This mainly reflects the convergence in Treasury and non-Treasury repo financing rates. Following the first TSLF auction, Treasury repo rates rose sharply. Given the minimum bid rates for the schedule 1 and schedule 2 auctions of 10 and 25 basis points respectively, the convergence in repo rates has eroded the economic appeal of the TSLF auctions as a funding vehicle. The $80 billion of the single-tranche repo program has been more attractive as a source of funding. Moreover, the PDCF backstop has made investors more willing to finance the non-Treasury collateral held by the investment banks and other primary dealers, and this has also reduced the demand for TSLF borrowing. The continued rise in commodity prices has been another important market development. As shown in exhibit 14, both energy and agricultural prices have been rising sharply. Although the weakness of the dollar has often been cited by analysts as a causal factor behind the surge in commodity prices, the recent rise in energy and food prices has been accompanied by a slightly stronger, rather than weaker, dollar (exhibit 15). Nevertheless, short-term movements in the dollar and oil prices do June 24–25, 2008 7 of 253 appear to have become more closely linked over the past few years. Exhibit 16 plots the six-month rolling correlation between the weekly change in the spot price of West Texas intermediate crude oil and the weekly change in the value of the tradeweighted dollar. As can be seen, these price changes have become increasingly negatively correlated in recent years. Of course, correlation does not imply causality. Even if there is causality, it is unclear in what direction the causality runs—from commodities to the dollar or from the dollar to commodities. Although many factors are undoubtedly at play, a couple of possible explanations that have made the rounds may be worth considering. First, higher oil prices swell the dollar reserves held by the oil-producing countries. Because these countries may respond to this dollar influx by selling dollars to diversify their foreign exchange reserve holdings, traders may sell dollars in anticipation. Second, trade data suggest that the composition of import demand from the oil-exporting nations is skewed away from the United States, and this may also weigh on the dollar. The rise in commodity prices has fanned anxieties about inflation. As shown in exhibit 17, the University of Michigan consumer sentiment survey measures of oneyear and five-to-ten-year inflation expectations have increased recently. In contrast, both Barclays’ and the Board’s five-year, five-year-forward measures of breakeven inflation have moderated a bit since the last meeting. These measures remain well inside the ranges evident over the past year (exhibit 18). The anxiety about higher commodity prices and inflation has been an important factor behind the sharp shift in monetary policy expectations. As shown in exhibits 19 and 20, the federal funds rate and Eurodollar futures curves have continued to shift upward since the April FOMC meeting. As shown in exhibits 21 and 22, our survey of primary dealer expectations also shows an upward shift in the expected path of the federal funds rate target. However, compared with the expectations embodied in futures prices, the rise has been more modest. As a result, the gap between the average of the dealers’ forecasts and the market’s forecast has continued to increase and is now unusually wide. The divergence between the dealers’ forecasts and market expectations and the wide range of the dealers’ forecasts one year ahead indicate that there is considerable uncertainty about the future path of short-term rates. This uncertainty is also evident in the fact that the implied volatility of short-term interest rates is unusually high currently. The tightening expected over the next year is not anticipated to begin soon. As shown in exhibits 23 and 24, options on federal funds rate futures contracts currently imply that market participants expect that the FOMC will stand pat at both this and the August FOMC meetings. Although considerable tightening is priced in over the next year, this is not unusual at this stage of the monetary policy cycle. Assuming that we are at the trough of the current rate cycle, the magnitude of tightening expected over the next year is not significantly greater than what has been priced in following other troughs in the federal funds rate target. Tomorrow we will be eight weeks beyond what may turn out to be the onset of the trough in the target rate. As shown in exhibit 25, the roughly 125 basis points of tightening that is currently priced in over the next year is comparable to what was anticipated at the same point after the federal funds rate trough in 1992. June 24–25, 2008 8 of 253 Finally, a few words about the Primary Dealer Credit Facility. (Art Angulo will talk about this in more detail tomorrow.) We have been actively managing our counterparty risk in this facility and have made it clear to market participants that this should be viewed as a backstop facility rather than as a core source of funding. By the end of next week, borrowing from this facility is likely to drop sharply because of two events. The first is this week’s closing of the Bear Stearns–JPMorgan Chase transaction, which will result in the elimination of Bear Stearns’s PDCF borrowing. The second is the anticipated closing next week of the Bank of America acquisition of Countrywide, which is expected to eliminate Countrywide’s PDCF borrowing. In the absence of new financial shocks that could provoke renewed funding difficulties, we would anticipate little persistent PDCF borrowing after these mergers are completed. Last week I sent you a memo informing you of our plans to initiate a euro time deposit with the Netherlands Central Bank, subject to Regulation N approval by the Board. There were no foreign operations during this period. I request a vote to ratify the operations conducted by the System Open Market Account since the April FOMC meeting. As always, I am very happy to take any questions. CHAIRMAN BERNANKE. Thank you, Bill. The quarter-end premium seems less this time, but am I correct that the dollar premium is higher than the euro and pound premiums? MR. DUDLEY. It is a bit higher, yes. CHAIRMAN BERNANKE. Is there anything to be inferred from that? MR. DUDLEY. About 225 basis points are priced in for our dollar turn—maybe 150 basis points or 175 basis points elsewhere—but those are pretty small differences measured over just a couple of days. So I wouldn’t read too much into it. The reality is that the European banks are structurally short of dollar funding, and so that may be why there is a little more upward pressure on dollar rates over the quarter-end. CHAIRMAN BERNANKE. Other questions for Bill? President Lacker. MR. LACKER. Yes. I notice that in chart 18, in your TIPS-implied average inflationary plot to the ten-year horizon, you omit the Markets Group’s estimate. Is that because of skepticism on your part that leads you to judge it as inferior or an overabundance of humility? [Laughter] June 24–25, 2008 9 of 253 MR. DUDLEY. The latter, of course. [Laughter] MR. LACKER. It does, of course, show a slightly different trend, right? MR. DUDLEY. It actually has increased a bit. But I have consistently shown just the Barclays and Board measures over the past few months, so this is not “pick and choose.” CHAIRMAN BERNANKE. President Fisher. MR. FISHER. Bill, by inference, talking about the Primary Dealer Credit Facility, two of the limited number of borrowers have been the two institutions you mentioned. Have there been many more or just one or two? MR. DUDLEY. There have been more borrowers than just them. Some have done it because they wanted to test the facility. Some have done it because they viewed it as a fairly advantageous cost of funding. You know, there have been quite a few different borrowers, but those two borrowers mentioned are the ones that I would view as more persistent than desired. MR. FISHER. Thank you for discreetly answering the question. CHAIRMAN BERNANKE. Other questions? President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. Just to follow up on that question, I was at a meeting in New York not too long ago and was talking with some people on Wall Street. They suggested that for the primary dealers there was stigma attached to borrowing from the PDCF. I wasn’t quite sure what to make of that, and I just wondered if you had any observations or comments about whether you thought that was real or perceived, or is there an interpretation I should give to that? MR. DUDLEY. I think there is some stigma attached to the Primary Dealer Credit Facility. It is hard to know exactly how much. One thing I thought was interesting: The first week the facility was outstanding, a number of institutions went to the Primary Dealer Credit June 24–25, 2008 10 of 253 Facility and then announced that they were doing it as a test. Now, presumably you wouldn’t announce that you were doing it as a test if there were no stigma associated with the facility. But I would judge that it is clearly less stigmatized than the Primary Credit Facility, probably because it doesn’t have the history that the Primary Credit Facility has. The fact is that it is an advantageous rate or was an advantageous rate several weeks ago, and there were some institutions that were borrowing from the facility just on the basis of rate—so that suggests less stigma than the discount window. MR. PLOSSER. Thank you. CHAIRMAN BERNANKE. President Stern. MR. STERN. Yes. Bill, on chart 6, just a quick question on the leverage ratio: Do we know how good those data are? I mean, to the best of our knowledge, is that reliable stuff? MR. DUDLEY. This is just assets divided by equity, so I think it is pretty good. When the investment banks start proposing their adjusted leverage ratios, then I think you have a problem—you know, apples and oranges—because the different investment banks calculate those kinds of adjusted leverage ratios a bit differently. Usually you see two leverage ratios— one that is gross and another one that excludes the matched book—and the leverage ratio falls pretty significantly when you exclude the matched book. VICE CHAIRMAN GEITHNER. Mr. Chairman? President Stern, I have just one thing to add. For the first time with the three investment banks that reported for the quarter that ended in May, the SEC allowed them to disclose their risk-weighted ratio on the SEC’s version of Basel II. That’s the ratio for which your question is more germane in some sense because it shows a pretty significant cushion of capital against risk-weighted assets. The question is, How good are those measures of risk-weighted assets? This is a subject for discussion tomorrow, but June 24–25, 2008 11 of 253 part of our problem is that we have much less confidence in judging the integrity of what goes into those measures of risk—not to mention whether the risk weights are any good, which is a harder thing for the market to judge. But for the first time the market can see what their riskweighted measures are, at least on an SEC basis, which is pretty close to Basel II, and those ratios were, if I recall correctly, north of 10, tier 1, for the three that reported—significantly higher than they were on March 1, by their own measures. MR. STERN. Thanks. CHAIRMAN BERNANKE. Other questions? If not, would someone move the ratification. MR. KOHN. So move. CHAIRMAN BERNANKE. Without objection. Thank you. Okay. Let’s turn now to the economic situation. Nathan, I’ll start with you. MR. SHEETS. 2 Thank you, Mr. Chairman. Given that developments in global commodities markets have continued to have influential effects on our forecast for domestic activity and prices, we felt that it would be useful for me to lead off with the international portion of the chart show, which will include a discussion of these markets. Following my remarks, Larry and Bill will present our outlook for the U.S. economy. As shown in the top panel of your first exhibit, total foreign real GDP growth (line 1) stepped down from an average pace of 4½ percent in the first three quarters of 2007 to around 3 percent in the fourth quarter of last year and the first quarter of this year. We see growth abroad as likely to decline to 2.2 percent in the current quarter and to pick up only slightly in the second half of the year. Next year, with the expected firming of U.S. activity and diminishing headwinds from the financial turmoil, foreign growth should rise back to a 3½ percent pace. Growth abroad was just a bit stronger in the first quarter than we had anticipated, but the composition of that growth came as more of a surprise. Canadian GDP (line 3) posted a slight contraction, reflecting a continuing downturn in exports and stagnant investment. In contrast, the pace of activity in Japan (line 4) and the euro area (line 5) was much more vigorous than we had expected, including a 6¼ percent surge in Germany. Nevertheless, recent data for these economies point to much weaker growth in the second quarter. As shown in the middle left panel, Japanese manufacturing output 2 The materials used by Messrs. Sheets, Slifman, and Wascher are appended to this transcript (appendix 2). June 24–25, 2008 12 of 253 has declined recently, and labor market conditions have softened. For the euro area (the middle right), various indicators are showing weakness, including retail sales and the purchasing managers’ index. As highlighted in the bottom panel, growth in the emerging market economies is expected to step down over the next few quarters but should remain relatively resilient, especially compared with the weak performance of these economies during the U.S. recession earlier this decade. Many of the EMEs were particularly vulnerable to the high-tech- and manufacturing-led downturn that occurred at that time, and fundamentals in the EMEs are now stronger than was then the case. In addition, Chinese domestic demand has remained quite robust of late, and this has likely helped to support growth in emerging Asia. As shown in the top left panel of exhibit 2, oil prices have continued to soar with the spot price of WTI closing yesterday at $136 per barrel. The far-dated futures price has climbed to about the same level. Our forecast for the path of oil prices is now roughly $50 a barrel higher than at the time of the January chart show. Divining the causes of this staggering rise in oil prices is no doubt ground on which angels fear to tread, but we continue to assert bravely that the primary driver of higher oil prices is constrained (and price inelastic) oil supply coupled with relatively strong (and price inelastic) oil demand. These deep features of the oil market—along with stressed geopolitical conditions in many oil-producing countries, rising production costs, and concern about the reliability of medium- to long-run supply—have sent oil prices spiraling upward. As shown in the last column of the middle table, the increase in oil prices appears to have contributed to modest declines in oil consumption in the advanced economies, including the United States (line 3). But oil consumption has continued to move up in the emerging market economies, especially in China (line 5) and the Middle East (line 6). Consumers in many EMEs have been shielded from rising prices by government fuel subsidies. The economic and fiscal costs of such subsidies are becoming increasingly burdensome, however, prompting some countries (including China late last week) to allow domestic fuel prices to move toward world levels. As seen on the top right, oil inventories in OECD countries have declined over the past year and a half. Unfortunately, little information is available about the behavior of inventories outside of OECD countries. The bottom left panel shows that the rise in global oil production since 2004 has significantly lagged the expansion of world GDP (weighted by oil consumption); indeed, production has remained relatively flat during most of that period. Notably, however, the lack of oil production is not due to geological constraints. Data on years of proved reserves (shown on the bottom right) are at roughly the same level as a decade ago. But those reserves are now concentrated in areas where production is constrained by acute geopolitical risks, uncertainty about property rights, inadequate investment, and high production costs. Turning to your next exhibit, nonfuel commodity prices have also risen significantly on average since your last chart show, with most of the increase coming June 24–25, 2008 13 of 253 in the first few months of the year. Here, too, we believe that the elevated level of prices is a result mainly of strong and sustained global demand, lagging supply responses, and rising production costs. Consistent with this observation, inventories of key commodities, shown in the middle left panel, have trended down in recent years. It bears emphasizing, however, that nonfuel commodity prices certainly have not moved in lockstep with each other. As seen in the bottom left panel, the price of corn has surged to new highs, supported by ethanol demand and, more recently, as adverse weather in the Midwest has endangered a substantial fraction of this year’s crop. In contrast, the price of wheat has fallen back from its recent peak, as improved growing conditions in Australia seem likely to boost supply. For metals, the price of zinc has moved down significantly since its peak in late 2006, as new smelters have come on line. The price of copper has moved sideways—but at a high level—over the past two years, as prospective increases in supply have not yet materialized. A number of other explanations for the recent run-up in oil and other commodity prices have also been advanced, including the possibility that increased purchases by “speculators” in commodity futures markets may be playing an important role. Given the magnitude of the financial flows into these markets, we are hesitant to slam the door completely on this explanation, but our work finds little supporting evidence. As noted on the top right, prices of a number of commodities that are not traded in futures markets have also risen substantially. Second, a sustained increase in demand by investors would suggest that inventories should be rising; instead, as I have noted, inventories are now relatively tight. Finally, we see no evidence that the positions taken by noncommercial traders in futures markets actually predict commodity prices; for example, such positions for light sweet crude oil on the New York Mercantile Exchange have been roughly flat since mid-2007. Two other frequently cited explanations for the rise in commodity prices are the depreciation of the dollar and declines in interest rates. The middle-right panel shows the correlation of the broad nominal dollar with oil prices and with an index of nonfuel commodity prices. Both correlations are negative over most of the sample, implying that depreciations of the dollar have tended to happen at the same time as rises in commodity prices. While these correlations have become more negative since mid-2007, they remain within the ranges seen in recent years, and interpreting the direction of causality for this relationship is difficult. Also, as Bill noted, the dollar has been relatively stable over the past several months, but oil prices have continued their upward climb. Similar plots of correlations of interest rates with commodity prices (shown on the bottom right) are quite noisy and fail to point to any clear conclusions. As shown in exhibit 4, the run-up in commodity prices has continued to lift headline consumer price inflation in both the advanced foreign economies and the emerging markets. We expect that inflation abroad will remain elevated in the near term but eventually move back down as slower global growth reduces pressures on resources and as commodity prices flatten out (consistent with quotes from futures markets). Of course, one clear risk to these projections is that commodity prices may, yet again, confound our expectations and continue rising. Another risk is that the high rates of inflation now being recorded may become embedded in inflation June 24–25, 2008 14 of 253 expectations. As shown in the top right panels, measures of long-term inflation compensation have recently edged up in the euro area and increased more markedly in Canada. In recent weeks, major foreign central banks have intensified their inflation-fighting rhetoric. Notably, the ECB has warned that it may raise rates at its next meeting; and in the United Kingdom, Mervyn King—in his letter to the Chancellor—underscored his determination to ensure that inflation remains contained. As shown on the bottom left, we now assume that both the ECB and the Bank of England will raise rates in the second half of this year, compared with the near-term cuts we had anticipated in the April Greenbook. In addition, we now see the Bank of Canada keeping policy on hold. In the emerging market economies, including Mexico and China (the bottom right panel), increases in inflation have largely been driven by rising food prices, which account for a substantial share of consumer expenditures. Policymakers in the EMEs have taken steps to slow the rise in food prices, with some countries introducing price controls and export bans on agricultural goods. But officials have also relied on more-orthodox policies to combat inflation, including raising policy rates and hiking reserve requirements. Indeed, over the intermeeting period, monetary policy was tightened in a range of emerging market economies, including Mexico, Brazil, China, India, Russia, and Hungary. As shown in the top left panel of exhibit 5, the path of the broad real dollar is now just a little weaker than we anticipated at the time of the January chart show. We continue to expect the dollar to depreciate at an annual rate of 3 percent through the forecast period, reflecting persisting downward pressures associated with the current account deficit. This depreciation is projected to come largely against emerging market currencies (including the Chinese renminbi), which have moved less since the dollar’s peak in early 2002. It’s safe to say that core import price inflation (on the right) has come in substantially higher than we projected in January. Incorporating the BLS monthly data for April and May, we now see core import prices in the second quarter surging at an annual rate of 10½ percent, the fastest rise in two decades. This increase, which comes on the heels of an 8 percent jump in the first quarter, was heavily concentrated in material-intensive goods and suggests a much more rapid and, perhaps, stronger effect from the run-up in commodity prices than we saw in the past. Conditional on nonfuel commodity prices flattening out, core import price inflation should decline to less than 2 percent next year. Finally, summing up what these developments mean for U.S. activity, we now see the contribution from net exports to U.S. real GDP growth (line 3 in the table) as likely to exceed 2 percentage points in the second quarter, as exports expand at a smart pace (supported by the lower dollar) and imports contract sharply. This marked weakness in imports reflects both a steep drop in real oil imports and a continued decline in imports of core goods (reflecting sluggish U.S. GDP growth and rising prices of imported commodities). The positive contribution from net exports moderates to ¾ percentage point in the second half of this year and to ½ percentage point in 2009. While the pace of export growth is projected to remain strong, at June 24–25, 2008 15 of 253 above 7 percent, imports should gradually accelerate as the U.S. economy recovers. Larry will now continue our presentation. MR. SLIFMAN. Last week, the Washington Post ran a front page story with the headline, “Why We’re Gloomier than the Economy.” Like the author of the Post article, we too have noticed the difference between what people are saying about the economy in surveys and what they apparently are producing and spending. Starting first with the survey indicators, the top left panel of exhibit 6 plots the plunge in the Michigan index of consumer sentiment, which is far deeper than can be explained by its usual predictors such as labor market conditions, inflation, and the stock market. The panel to the right plots two of the most timely surveys of business attitudes, which continue to suggest that the respondents are pessimistic about overall business conditions. Meanwhile, as shown in the middle left panel, although private payrolls continue to shrink, the declines have been much smaller than we were expecting and, as you can see from the shaded area (if you look very closely), [laughter] much smaller than the ones that occurred during the last recession. In terms of spending data, the most striking piece of news was the upward revision to earlier retail sales figures. At the time of the April Greenbook, real outlays for consumer goods other than motor vehicles appeared to be moving sideways (the red line in the middle right panel). However, the black line shows that according to the latest estimates—which, of course, are still subject to additional revisions—spending rose rapidly in March and April and climbed further in May. With these numbers, we revised up appreciably our near-term estimates of the growth rate of real PCE goods other than motor vehicles (the inset box). On the business side, the bottom left table, shipments of nondefense capital goods, excluding transportation, rose further in April, and new orders jumped. In addition, outlays for construction of nonresidential buildings, the bottom line of the table, continued to climb in April. All told, these indicators suggest stronger business spending than we had anticipated in our April forecast. A potentially important downside development may be emerging in the motor vehicles sector—the bottom right panel—where, according to our industry contacts, sales of light vehicles appear to be plummeting in June. Whether this is just a reaction to the surge in oil prices that will be contained within the auto sector or whether it’s a canary in the coal mine pointing to something far more serious for the entire economy remains to be seen. But it certainly has grabbed our attention and highlights a downside risk to our projection. Exhibit 7 focuses on the overall GDP forecast through 2009 and some of the key factors that informed our thinking about the outlook. We had a lot of moving parts to deal with this round, and the upper panel summarizes how we put them together. First, in light of the incoming information, we revised up our forecast for the first two quarters of this year, especially the second quarter. We now think that real GDP growth came in at an annual rate of 1.1 percent in the first quarter and picked up to a 1.7 percent pace in the second quarter. As you know, earlier this year we put in some June 24–25, 2008 16 of 253 judgmental adjustments to the forecast, which reflected a combination of the tendency for negative model residuals to be correlated during cyclical downturns as well as the macro effects of financial turmoil and uncertainty that are not well captured by our models. We have interpreted some of the recent spending surprise as suggesting that we went too heavy on such effects in the April Greenbook, and so we have tempered them in this projection. That said, we still anticipate that some of these influences will show through to spending, especially in the household sector, and we expect the economy to be on a very subdued growth path for the next few quarters. As I will discuss shortly, residential investment is still projected to be a drag on economic growth well into next year. Moreover, with house prices expected to fall through the end of next year, the ratio of household net worth to income remains on a downward trajectory, reducing some of the wherewithal for consumer spending. Household purchasing power also is being held down by the surge in oil prices that Nathan discussed (the middle left panel). As shown in the inset box, by our reckoning the increases in the spot and futures prices of WTI since the April Greenbook subtract about ¼ percentage point from real GDP growth in both 2008 and 2009, with much of the effect working through PCE. Despite these negative influences, if the story ended here, the economy still would be operating with a somewhat higher utilization rate—that is, a smaller GDP gap—than in the April Greenbook. In light of this consideration, as well as the less favorable outlook for inflation that Bill will discuss, we have conditioned this forecast on a tighter path for monetary policy than the one in the previous Greenbook. As you can see in the middle right panel, by the end of next year the federal funds rate is 100 basis points higher than in the April Greenbook. I should note here that we also have raised our estimate of the growth rate of potential GDP, which Bill will discuss shortly. Because we view our revised estimate of potential as merely the staff’s catching up with what individuals and firms were already expecting, these revisions result in corresponding adjustments to the growth rate of real GDP going forward. All told, as illustrated in the bottom left panel, after increasing substantially faster in the first half of the year, real GDP is now projected to grow at an annual rate of ¾ percent in the second half of 2008, a bit less than in our previous projection. In 2009, real GDP is expected to increase 2.4 percent, about ½ percentage point less than in the April Greenbook. The bottom line of the forecast is perhaps most easily seen by the path of the GDP gap. As shown in the bottom right panel, the gap starts out the projection period being much narrower than in the April forecast. By the fourth quarter of 2009, however, the gap is essentially the same as in the April Greenbook. After that high-altitude flyover of the projection, the next two exhibits swoop down for a closer look at some of the details. Exhibit 8 focuses on the housing sector. With demand weak, the overhang of unsold new and existing single-family homes— the vacancy rate—has soared, putting downward pressure on prices. As shown to the right, the OFHEO purchase-only index of house prices fell at an annual of 6.7 June 24–25, 2008 17 of 253 percent in the first quarter of 2008, and we expect home prices to continue declining around this pace into next year. Anecdotes and common sense suggest that many prospective homebuyers, leery of purchasing an asset whose value is falling, are waiting for house prices to bottom out before entering the market. This behavior further saps already sagging housing demand. We don’t have direct survey evidence for this supposition; however, the middle panels present some suggestive numbers taken from the Michigan survey. First, as shown by the black line in the panel to the left, the share of current homeowners who think the price of their home fell over the past 12 months jumped dramatically through early this year and remains elevated. In addition, the share that thinks the price will fall over the next 12 months also has drifted up. The panel on the right, which is based on work by my colleague Claudia Sahm, looks at the views of renters. Here the blue bars show the percentage of renters in the Michigan survey who say that now is a bad time to buy a house. The red line plots an estimate of house price overvaluation derived from a price–rent model that we follow. As you can see, as houses became increasingly overvalued, more and more renters became pessimistic about homebuying—apparently for affordability reasons. Of course, relative prices are not the only influence on affordability. General macroeconomic and credit market conditions also are important. Thus, even though the extent of overvaluation has diminished so far this year, renters, at least thus far, remain quite pessimistic about homebuying conditions. So what brings us out of this seeming death spiral? If house prices follow the expected trajectory, we estimate that they will move into rough alignment with their long-run relationship with rents early next year and then, as typically happens, overshoot somewhat. As the market returns to something closer to equilibrium, prospective homebuyers who had been waiting out the price bubble in rental quarters should begin to see housing as more affordable and be more willing to buy into owner-occupied housing. As that happens, the rate of decline in house prices should slow, and sales of single-family homes (the bottom left panel) should start to improve. With demand improving and the inventory overhang being worked off, we expect housing starts to level out and then begin to gain altitude slowly in 2009. Exhibit 9 presents the medium-term outlook for consumer spending and business investment. Starting with PCE, real spending is projected to fall, on balance, in the second half of this year. Tax rebates push up the third quarter and create a pothole in the fourth quarter as rebate-related spending drops off. More fundamentally, spending is held back by the effects of higher oil prices on household purchasing power, the ongoing hit to household wealth from falling home prices and earlier declines in equity prices, and the restraining effects of financial turmoil and unusually pessimistic consumer sentiment. In 2009, spending picks up as many of these factors begin to improve; but at 1½ percent, the increase is still rather tepid. The middle panels focus on business outlays for equipment and software. Real spending on the high-tech component (the green bars) has slowed sharply this year June 24–25, 2008 18 of 253 and is expected to remain relatively soft throughout the projection period. The major U.S. computer manufacturers—such as HP, Dell, and Sun—have expressed caution about the outlook for sales. Meanwhile, capital spending guidance from telecommunications service providers points to a slowing in their outlays for communications equipment. As shown by the blue bars, investment outside the hightech segment has been declining at a modest pace since late last year, and we expect it to contract further over the next year and a half. Spending is held back by normal accelerator effects, tight lending standards, and gloomy business sentiment. For nonresidential structures, the lower panels, the BEA reported that outlays in the drilling and mining component (the green bars) dipped in the first quarter. Anecdotal reports suggest that this may have reflected bottlenecks stemming from shortages of skilled labor and supplies. However, recent data on footage drilled and the number of drilling rigs in operation have picked up, signaling a near-term rise in spending. Looking forward, escalating energy prices are likely to spur continued increases in investment. In contrast, as shown by the blue bars, real construction spending for buildings is projected to be very weak following sizable increases in 2006 and 2007. The evolving supply-and-demand factors for this sector are almost uniformly downbeat: Vacancy rates are moving up; sales and prices of existing properties are sagging; and financing conditions are tight for new projects. Because of these developments, we expect outlays in this category to fall throughout the projection period. Bill will now continue our presentation. MR. WASCHER. Exhibit 10 reviews our assumptions about aggregate supply. As you can see from the first two rows of the table at the top, we now assume that potential output growth will hold steady at about 2½ percent per year over the forecast period, about ¼ percentage point per year higher from 2007 to 2009 than we had assumed in the April Greenbook. This upward revision is split roughly equally between structural productivity growth (lines 3 and 4) and trend hours (lines 5 and 6). The middle two panels provide the reasoning for our change. The left panel shows the difference between actual productivity growth (the black line) and a simulation from our standard model (the green line) using the pace of structural productivity growth that we had assumed in April. As you can see, labor productivity growth in recent quarters has been stronger than the model would have expected given the deceleration in economic activity. As shown in the inset box, a purely statistical model based on a Kalman filter would have responded to the recent data by raising its estimate of structural productivity growth 0.2 percentage point. Because we place less weight on data that have not yet been through an annual revision, we generally tend to revise our own estimate by less than the amount suggested by such models; moreover, the Kalman filter model does not take into account the steep rise in energy prices, which we think might subtract a bit from structural productivity growth in coming years. Nevertheless, we did think it appropriate to nudge up our productivity growth trend a little. The green line in the middle right panel shows a similar model simulation for the labor force participation rate, again using our previously estimated trend. Here, too, the incoming data have been a little higher June 24–25, 2008 19 of 253 than the model would have expected. One can think of potential explanations for this—for example, it may be that strains on household budgets associated with rising costs of food and energy have increased labor force participation among secondary earners, an influence not captured by the model. We are not ready to back away from our basic story that demographics will continue to put downward pressure on the participation rate over time, but we did slightly raise our assumed trend in response to the recent data. The key elements of the labor market forecast are shown in the bottom panels. As indicated to the left, nonfarm payroll employment (the black line) is projected to decline about 40,000 per month through the rest of this year. As the economy improves in 2009, we expect payrolls to start rising again, although at a pace below our estimate of trend employment growth (the green line) for most of the year. As shown in the inset box in the bottom right panel, we expect the unemployment rate to drop back in June from its suspiciously high May reading, which would leave the average jobless rate in the second quarter at 5.3 percent. However, with employment declines projected to continue for a while longer, we expect the unemployment rate to drift up to 5.7 percent by early next year and remain near that level through the end of 2009. Exhibit 11 presents the near-term inflation outlook. As you can see in the top left panel, the recent data on consumer prices have come in a little lower than we had expected at the time of the April Greenbook. As shown on line 3, core PCE prices rose only 0.1 percent in April, and based on the latest CPI and PPI readings, we expect an increase of 0.2 percent in May. As a result, we have marked down our estimate of core PCE inflation in the second quarter by 0.3 percentage point, to an annual rate of 2 percent. Total PCE prices (line 1) have risen at a substantially faster pace than core prices; but here, too, the current-quarter forecast is a little lower than in our previous projection, both because of the lower core inflation and because the sharp increases in oil prices have been slow to feed through to finished energy prices. Despite this recent news, we expect inflation to rise sharply over the next few months. In part, this reflects our judgment that core prices were held down in the first half by some factors that will not persist into the second half. In addition, as shown to the right, we expect increases in food and energy prices to push up the twelve-month change in the total PCE price index more than 1 percentage point over the next several months, to about 4½ percent. The remaining panels of the exhibit focus on the projection for energy and food prices. As shown by the black line in the middle left panel, rising crude oil prices have pushed up retail gasoline prices sharply so far this year. Even so, margins are still relatively low, and we expect further sizable increases in pump prices in coming months. Spot prices for natural gas (the red line) have also risen noticeably, reflecting its substitutability with crude oil. Meanwhile, prices for crops, plotted in black at the right, have moved well above the levels at the time of the April Greenbook, mainly in response to the severe flooding in the Midwest. The higher prices for grains have also pushed up livestock prices (the blue line), although recent June 24–25, 2008 20 of 253 increases in supply have tempered this rise somewhat. In both cases, futures prices indicate that market participants expect these prices to flatten out at about their current levels. The bottom two panels show our forecast for overall consumer food and energy prices. Based on current futures prices, we expect energy price inflation to move yet higher next quarter before slowing to a pace close to zero in 2009. We expect food prices to show a similar—albeit less pronounced—pattern, with the fourquarter change peaking at about 5 percent this quarter and then decelerating to a pace of 2½ percent next year. The upper panels of your next exhibit examine the implications of the recent increases in energy and other commodity prices for core inflation. The first thing to note is that these increases are showing through to producers’ costs. As indicated in the top left panel, the producer price index for core intermediate materials (the black line) has accelerated yet again and was up more than 7 percent over the past twelve months, with especially large increases for metal products and energy-intensive materials. Likewise, the diffusion index for prices paid from the Institute for Supply Management’s manufacturing survey (the red line) has climbed steadily since late last year. As Nathan noted, rising commodity prices have been an important source of the sizable increases in import prices shown to the right. In addition, higher energy prices have boosted the costs of shipping goods from manufacturers to wholesalers and retailers. As you can see in the middle left panel, the PPIs for both trucking and rail transport have accelerated sharply over the past year or so. Obviously, a key question is the extent to which these higher costs will be passed through to core consumer prices. The panel to the right provides rough estimates of the size of these pass-throughs from our suite of econometric models, with the effect of energy prices on core PCE inflation shown by the blue bars and the combined effects of import prices and other commodity prices indicated by the red bars. As you can see, these effects add more than 0.6 percentage point to our forecast of core inflation this year. With energy and import prices expected to decelerate, the contribution of these factors to core inflation steps down to ¼ percentage point next year. In contrast to the evidence of greater cost pressures from commodity prices, we’ve seen no signs of acceleration in labor costs. The bottom left panel plots the three main measures of labor compensation that we follow. None of them suggests that employers have experienced a step-up in the pace of compensation growth; and given the weaker labor market in our projection, we don’t think that workers will do much better over the next year and a half either. Accordingly, we expect the rise in trend unit labor costs, shown in the table to the right, to hold steady at about 2 percent per year over the projection period. In putting together our forecast, we’ve also had to make some decisions about how to interpret the recent data on inflation expectations—the subject of your final exhibit. As shown in the top left panel, some measures of short-run inflation expectations have jumped sharply in response to the run-up in energy and food prices this year. In particular, the Reuters-Michigan measure of one-year-ahead expectations (the blue line) rose above 5 percent in May and remained high in the June 24–25, 2008 21 of 253 preliminary June survey. Meanwhile, as shown to the right, indicators of long-run inflation expectations have ranged from roughly unchanged to higher since late April. As I already noted, the recent compensation data do not suggest that higher inflation expectations have started to push up wage increases. However, on balance, we view the data as consistent with a slight updrift in the underlying long-run inflation expectations that drive actual inflation, and we have carried this updrift into the projection period. All told, we expect core PCE inflation (line 3 of the middle left table) to step up to a 2½ percent annual rate in the second half of this year, pushed up by the effects of higher input costs and the increase in inflation expectations. In 2009, core inflation is projected to step back down to 2¼ percent, as the effects of decelerating energy and import prices and a wider unemployment gap offset a small further updrift in expected inflation. We have taken only a small signal from the apparent deterioration in expected inflation, but we view the possibility that inflation expectations will become unmoored in response to the persistently high rate of headline inflation as a risk to our forecast. Accordingly, as indicated in the box to the right, we included in the Greenbook an alternative simulation that assumes that long-run inflation expectations move up ¾ percentage point relative to baseline in the third quarter. Consistent with our usual practice, monetary policy in this simulation is assumed to respond according to the estimated Taylor rule. Both wages and prices are affected by these higher inflation expectations, and as you can see by the green line in the middle panel at the bottom, core inflation rises to 2.6 percent in 2009, almost ½ percentage point higher than baseline. Monetary policy responds in this simulation by raising the federal funds rate more than in the baseline forecast. As a result of this additional tightening, the unemployment rate declines a bit more slowly, and core inflation moderates to about 2¼ percent in 2012. Brian will now continue the presentation. MR. MADIGAN. 3 I will be referring to the separate package labeled “Material for Briefing on FOMC Participants’ Economic Projections.” The top two sections of table 1 show the central tendencies and ranges of your current forecasts for the first and second halves of 2008; central tendencies and ranges of the projections published by the Committee this past April are shown in italics. To facilitate comparisons, the Greenbook projections are shown in the bottom section. In your forecast submissions, most of you indicated that you saw appropriate monetary policy as entailing a path for the federal funds rate that lies above that assumed in the Greenbook. As shown in the first row, first column, of table 1, the central tendency of your real growth forecasts for the first half of 2008 has been marked up substantially since April. However, a number of you noted that recent upside surprises to consumer and business spending are likely to prove transitory and that falling house prices, tight credit conditions, and elevated energy prices will probably restrain growth over the remainder of 2008. Accordingly, some of you revised down a touch your growth expectations for the second half of this year (the second column) especially those of you who had previously anticipated the briskest 3 The materials used by Mr. Madigan are appended to this transcript (appendix 3). June 24–25, 2008 22 of 253 growth rates, as indicated by the downward revision to the upper end of the range shown in the middle section. Most of you think the economy will skirt recession. Nonetheless, your projections for the speed of recovery over the second half exhibit considerable dispersion: Four participants are projecting growth rates of real GDP between 2 and 2¼ percent, whereas an equal number are calling for growth at an annual rate of only around ½ percent, a pace similar to the one projected in the Greenbook, with many of you attributing the tepid growth partly to financial headwinds. The tendency for some clustering of your second-half growth forecasts at the extremes can be seen by noting the similarity between the central tendency and the range. As shown in the second set of rows in the top panel, your projections for headline PCE inflation in the second half of 2008 have been revised up more than 1 percentage point, to around 3½ to 4¾ percent, largely as a result of the surge in prices of energy and agricultural commodities. However, in view of better-thanexpected news on core PCE inflation, the central tendency of your projections for core inflation during the second half (shown in the third set of rows) revised up only 0.1 percentage point. Looking ahead to 2009 (table 2, the middle column), you continue to expect growth to pick up as the drag from the housing sector dissipates and credit conditions ease. The midpoint of the central tendency of your forecast for real GDP growth next year is 2.4 percent, the same as in April and the same as the staff’s current forecast. Your growth forecasts for 2010 (the third column) are a shade lower than in April, and the central tendency of your forecasts for the unemployment rate is a touch higher, perhaps because a number of you assumed more policy tightening over the forecast period in order to counter heightened inflation pressures. The midpoint of the central tendency of your projections for the unemployment rate edges down from about 5½ percent in 2009 to about 5¼ percent in 2010. Your commentaries suggest that many, albeit not all, of you view those rates as a quarter-point to a half-point above your estimates of the NAIRU. The third and fourth sets of rows indicate that most of you see overall and core inflation staying above 2 percent next year; but by 2010, the extended period of economic slack and the assumed leveling-out of energy prices push down overall and core inflation to around 1¾ to 2 percent; for core inflation, the central tendency and range are a touch higher than you forecasted in April. For the first time since you started these projections last October, the upper end of the range of your projection of total inflation in 2010 exceeds 2 percent, albeit marginally. Thus, many of you project that, at the end of the forecast period, the economy will still be operating with some slack and real output growth will be slightly above the growth rate of potential. The continued presence of slack suggests that you anticipate that inflation will continue to edge lower in 2011 and, given the assumption of appropriate monetary policy, implies that you typically anticipate that inflation will still be a bit higher in 2010 than you see as consistent with price stability. Exhibit 3 presents your views on the risks and uncertainties in the outlook. As shown by the green bars in the top two panels, a large majority of you continue to perceive the risks to growth as weighted to the downside (the left panel), and many June 24–25, 2008 23 of 253 judge that the degree of uncertainty regarding prospects for economic activity is unusually high (the right panel), although the number of you seeing uncertainty about growth as elevated has declined slightly over the first half of the year. In your narratives, you attributed the downside risks primarily to the potential for steeper declines in house prices and persisting financial strains, which through a further tightening of credit conditions could exert an unexpectedly large restraint on household and business spending. Although your views of the risks regarding growth have shifted only modestly, the distribution of your perceptions of the risks regarding inflation (shown in the bottom two panels) has changed significantly so far this year. As shown in the lower left panel, about three-quarters of you now see the risks to the outlook for overall inflation as skewed to the upside. In your commentaries, you typically pointed to continued increases in energy and food prices and an upward drift in inflation expectations as the main reasons for the upside risks to inflation. In addition, as shown to the right, the number of participants who perceive the degree of uncertainty regarding the inflation outlook as larger than usual has risen considerably. Turning to exhibit 4, as I noted, your projections suggest that you do not see the economy as having fully settled into a steady state by 2010. The dynamics of the economy evidently are such that, following moderately large shocks, it can take quite a few years to converge back to steady state, a view that is captured by many econometric models such as FRB/US and is also reflected in the current Greenbook forecast. Thus, the three-year forecast horizon currently used by the Committee does not necessarily allow your forecasts to reveal fully your views of the steady-state characteristics of the economy and your views of the rate of inflation consistent with the dual mandate. Recognizing this, the Subcommittee on Communications recently sent the Committee a memo outlining several possible approaches to providing longer-term projections. The approaches are summarized in the lower panel. One option would be for participants to extend their entire set of projections out to, say, five years. Under this option, participants would be asked to submit projections for economic variables in year 4 as well as in year 5. You would also expand your individual forecast narratives to explain the trajectory of the economy and inflation over the five-year projection period. This approach would have the advantage of providing the basis for a complete presentation of the Committee’s medium-term and long-term views. The principal disadvantage of this option is the relatively heavy burden it places on Committee participants to make projections covering five years. Another disadvantage is that in some circumstances—that is, following a very large shock—the economy still may not be in a steady state after five years. A second option is for participants to continue to submit economic projections and narratives out to three years as now but also to provide estimates of the values of output growth, unemployment, and inflation in year 5 under the assumption of appropriate monetary policy. Under this approach, you might wish to collect and publish long-term projections only for output growth, unemployment, and total inflation, and not for core inflation, in order to emphasize that total inflation rather June 24–25, 2008 24 of 253 than core inflation is the appropriate metric for the longer-run goal of price stability. This second approach presumably places less demand on your time than the first but it would make for a less integrated presentation. It would also suffer from the same defect as the first approach, in that the figures you submit might not reveal the steadystate characteristics of the economy after a large shock. In a third approach, you would augment your three-year projections with projections of the average values for output growth, unemployment, and total inflation over the period five to ten years ahead. This approach would have the advantage of more directly revealing your estimates of the key operating characteristics of the economy—that is, the parameters related to productive capacity and your inflation objective. It might also be less demanding of your time in the sense that you would need to project fewer time periods than in the first option. On the other hand, it might be more difficult in that you would need to consider likely trends in demographic variables and productivity further ahead than is ordinarily necessary for monetary policy making. Moreover, it is possible that some of the parameters you would be supplying for the period five to ten years ahead might take on different values than would apply to the medium term that is relevant for monetary policy. In your comments in the upcoming economic go-round, you may wish to express your views on whether you support publication of longer-run projections and, if so, which of the approaches you prefer. You might also wish to comment on the desirability of conducting a trial run with long-term projections—say, in October— before going live with long-term projections, perhaps in January. That concludes our prepared remarks. CHAIRMAN BERNANKE. Thank you, Brian. Are there questions for our colleagues? President Fisher. MR. FISHER. If I may, I would like to ask Nathan, Mr. Chairman, about exhibit 4 and exhibit 5. Particularly noteworthy is that exhibit 4 is the forecast period showing a significant decline in inflation in the emerging market economies. I am wondering what that is based on. Do we have a sense of capacity utilization or slack, if it is all reliable, or is it based on a sense of commodity prices? What is that noticeable down-swoop? MR. SHEETS. You are asking particularly with respect to the emerging market economies? MR. FISHER. Yes, sir. In the top left-hand panel. June 24–25, 2008 25 of 253 MR. SHEETS. In the process of preparing our forecast, we do come up with estimates of slack for the emerging market economies, but we are not inclined to put a whole lot of weight on them. The concept of an output gap is not really a well-defined construct for, say, China. Nevertheless, these economies will be growing a little more slowly than they have in the past, and some of the pressures on resources associated with that growth may abate a bit. I think that is at least a piece of the story of what you see here as the decline. But at the end of the day, it has to be a story about commodity prices. Food prices and energy prices have pushed this up. Depending on exactly which emerging market economy you’re in, food prices will range anywhere from 25 percent to 33 percent of their basket. As long as those food prices and energy prices are moving up dramatically, you are going to see rapid increases in inflation. So the decline that you are seeing in this chart really is conditioned first and foremost on commodity prices flattening out. I wish I had a better story. MR. FISHER. You don’t know how happy I am to see global things come first. But are you saying that a great deal of uncertainty is attached to that forecast? MR. SHEETS. Oh, absolutely. MR. FISHER. Then, in exhibit 5 on core import prices, I guess it is pretty much the same answer. One would expect that these would fall of their own weight after a while. MR. SHEETS. Yes. The spike that we have seen is driven particularly by commodity prices. The depreciation of the dollar has played a secondary role, so the decline in core import price inflation to below 2 percent next year is conditioned crucially on commodity prices flattening out and the dollar not depreciating as rapidly as it has over the past few years. MR. FISHER. Mr. Chairman, if I could ask just one other question—of Larry, I think it was—on the housing exhibits. I am wondering if we are not in the eye of the storm here. We June 24–25, 2008 26 of 253 have had the first wave of buckling at the knees—or worse, cascading. If you talk to the homebuilders, they are, of course, the most depressed group imaginable. But they are waiting for another shoe to drop, which is the foreclosures on alt-As. I’m wondering what our opinion is on that. Things have calmed down a bit, but we still have another phase of the storm coming through, which is what I just described. What are our assumptions about that? MR. SLIFMAN. We expect foreclosures to rise—and to rise appreciably. One thing we have done in thinking about house prices is, in effect, to build in some extra house-price depreciation, above and beyond what our price–rent model would want to say, to reflect the kinds of factors that you are talking about—the foreclosures, what that means then for the vacancy rate, and what that does to house prices, particularly in certain parts of the country. I see President Yellen nodding her head because California, for sure, is one place where that could clearly be an important factor. MR. FISHER. Thank you. CHAIRMAN BERNANKE. President Evans. MR. EVANS. Thank you, Mr. Chairman. I’d like to ask a question about inflation and labor compensation. At the last meeting, many of us, myself included, mentioned that labor compensation had not been growing very strongly, and we took that as a possible comforting comment about inflationary pressures not being too strong. That comment was in this presentation and yesterday’s, too. Now, statistically, isn’t it the case that labor compensation is not really a good predictor of inflation? It really tends to lag more. So how should we think about interpreting that lack of acceleration for inflation expectations and pressures? Feel free to dispute that. MR. WASCHER. No, I agree with you. I think our models have been surprised by the low rates of compensation growth. One way to think about it is that in the past we might have seen June 24–25, 2008 27 of 253 higher headline inflation passed through more quickly to compensation growth—as in the ’70s, when those wage–price spirals were really led by prices, but then wages contributed by following. So far we haven’t seen any sign that higher headline inflation has been putting upward pressure on compensation costs. I think there’s a risk. We obviously included the simulation because we think there’s a risk that could happen in the future, but to date we have not seen evidence that that’s been the case. There are a number of reasons to think that things now might be different than they used to be. For example, just a structural reason, unions are less powerful than they used to be; a much smaller share of the work force is unionized. In the 1970s there were all sorts of automatic cost-ofliving adjustment clauses. Even when there weren’t, there were big catch-ups for past inflation. Another structural reason might be that the minimum wage was higher in the 1970s, and it is lower in real terms now. I think more generally this fits in with the general notion that inflation expectations are less responsive to immediate shocks in headline inflation than perhaps they used to be. MR. STOCKTON. From a forecasting perspective, President Evans, I think you’re right. I don’t think models that rely simply on labor costs to predict prices are very sound in terms of their forecasting ability versus just a plain old price–price type of Phillips curve or a price type of Phillips curve augmented with price expectations. Part of the reason may be that the compensation data themselves are just so poor that, in fact, it’s really a measurement problem. It’s not that you would argue that labor costs, which are a very significant chunk of overall business costs, don’t matter. I do think you can probably take, and we certainly have taken, some limited comfort from the fact that we have not yet seen an acceleration of labor costs. That likely indicates that you are not seriously behind the curve already or that something is baked in the cake. I don’t think you can necessarily take comfort from the well-behaved compensation thus far that you are not going to June 24–25, 2008 28 of 253 confront some inflation problems going forward. It’s more that the compensation data don’t suggest that you’ve fallen seriously behind the curve. In some sense we see the higher inflation expectations readings themselves, or at least some of the mixed-to-slightly-higher inflation expectations data, as suggesting that you’re facing a bit more of an inflationary difficulty over the next two years than we thought two months ago would be the case. CHAIRMAN BERNANKE. President Fisher. MR. FISHER. Just a quick follow-up, Mr. Chairman. To what extent do you impute the kind of insecurity that comes from competition and broader outsourcing? If you impute anything there in terms of wage behavior here, to what extent are you assuming going forward that the increase in wages being paid elsewhere might bleed into our wage behavior here? MR. WASCHER. Well, we don’t account for that in our compensation model. That said, as I mentioned, the models have been surprised about how low compensation has been. That would be one possible explanation for that residual. If that factor were to diminish, it would imply that that residual would diminish, but we haven’t built such an effect into our forecast. MR. FISHER. Thank you. CHAIRMAN BERNANKE. Other questions? President Bullard. MR. BULLARD. I want to ask a question about exhibit 7, which talks about factors affecting the GDP forecast. The second bullet point mentions judgmental adjustments, which were tempered this time relative to last time. Last time I described this as a regime-switching model, and you said that was perhaps too much. The economy sort of switches into this recession-like behavior, and we know that the economy might behave differently in that environment. But do we now think the probability of switching into that behavior is smaller? What is the forecast? Is the forecast some kind of average between this high state and this low state? That’s what you said June 24–25, 2008 29 of 253 here—it has tempered our judgmental adjustments. It sounds as though there is less probability of switching into that state. MR. SLIFMAN. It’s hard for me to think of it in these probabilistic terms. I would say that we still think that the economy is going to have these negative effects that are associated with periods of low growth. Now, whether that is precisely a recession or simply just a low-growth period, it’s hard for me to distinguish. MR. BULLARD. But the rationale is that you switch into the recession and you get the correlations from— MR. SLIFMAN. Yes. The way to think about it is that we switched into a low-growth period. Whether it is precisely a recession or just simply a low-growth period shouldn’t be the demarcation point. We still think that the economy is operating in a low-growth period. There is probably not as much severity to that low-growth period, but we still think that is where it’s operating. MR. BULLARD. But then you’re switching into the low-growth period, and then we take the correlations for low-growth periods, which I guess are maybe not as severe as in recession periods. MR. SLIFMAN. Just as a factoid to throw out here, one of my colleagues on the Board staff, Jeremy Nalewaik, has estimated some of these models looking at switching between highgrowth periods and low-growth periods, where a low-growth period does not necessarily have to be a recession. Using the GDP data through the first quarter plus our forecast for second-quarter GDP, which is now at an annual rate of 1.7 percent, his model still would suggest that there’s an 84 percent probability that the economy is operating in a low-growth state. So I think that it was a fair thing for us to continue to have the judgmental adjustments, which by the way aren’t just June 24–25, 2008 30 of 253 recession-like effects. They also include financial turmoil effects and some uncertainty things. I think it’s a fair thing for us to have included those, but as I say, we’ve tempered them. CHAIRMAN BERNANKE. President Lacker. MR. LACKER. I want to make sure I understand what you just said. Your response suggests that there’s a third state that’s even worse than we are in now, that one could possibly go into, and that what you’ve tempered is the probability that we’re in that worst state? MR. STOCKTON. Again, we want to step back a bit from taking this regime-switching too seriously as implying that there are just two states of the world or maybe three states of the world. There are lots of different states of the world. What we are trying to do is look at the residuals in our spending equations and ask how they behave in various kinds of periods. In periods with substantial increases in the unemployment rate, weak payroll employment, and big declines in consumer sentiment, there also are substantial negative residuals in our spending equations, particularly on the consumer spending side. That is still built into this forecast. So we have not interpreted the last six weeks of data as suggesting that recession concerns are all behind us, that we were just completely wrong, and that we are now on a much stronger growth path than we previously thought. If, in fact, you’re worried that the incoming data might be signaling a stronger growth path, then I would take a look at the “upside risk” scenario that we show in the Greenbook. There we take out all of our spending residuals—those that are incorporated because we thought we might be in this low-growth or recessionary-like state and the ones that are associated with financial turmoil—and you get growth in that case that is a little above potential growth and a path for the fed funds rate that is even steeper than the current market expectations. Now, although we kept these negative residuals in our forecast, we did have to acknowledge the fact that underlying aggregate demand appeared stronger than we thought it was going to be at June 24–25, 2008 31 of 253 the time of the last FOMC meeting. There is an underlying strengthening of aggregate demand in this forecast that shows up as an increase in the equilibrium funds rate of roughly ½ percentage point. So we’re trying to acknowledge the strength of the incoming data, but we want to be clear that this forecast still embeds some significant negative add-factors on spending going forward. That could be wrong. Maybe the incoming data are signaling that we are just fundamentally wrong about that aspect of the forecast. As Larry showed, given the stunning decline in consumer sentiment, the continued weak business sentiment, and the fact that the unemployment rate has risen as much as it has and has done this in the past only in periods of recession, we felt comfortable still presenting you with a forecast that anticipates that aggregate demand is going to be very weak over the next several quarters. MR. LACKER. I don’t want to belabor this too much. I was curious about what you tempered. I think President Bullard was looking for whether you tempered the probability on state 2. I’m with you in not wanting to place a lot of probability on n states, but it sounds as though the growth trajectory—you know, the magnitude of the add-factors you were thinking of—has been drawn back a little. Is that a fair characterization? MR. STOCKTON. That’s correct—and the timing. So there are two aspects. One is that we have interpreted some of the surprise as a persistent strengthening in aggregate demand that we had not anticipated. The other is that the economy is not as weak now, and therefore the bounceback in activity next year won’t be as strong. As Larry said, there are a lot of moving parts, but both of those considerations are built into this forecast. MR. LACKER. Thank you. CHAIRMAN BERNANKE. Thank you. Any other questions? Okay. We are about ready for our go-round. Let me remind you about the proposal to add a long-term line to our June 24–25, 2008 32 of 253 projections. The rationale for doing so is that the current system doesn’t necessarily let the public know what our views on the steady state of the economy are. To show my own hand, I think it would be helpful to add maybe one line that said in five to seven years out what we think the economy would do. But I think it is important for those of us who want to express an opinion to do so. If there is interest, as Brian mentioned, we can do a trial run in October, and we won’t have to make a final decision about whether to go forward until October or December or perhaps later depending on how things go. But if you have a view on that, please add that to your commentary. So let’s begin with the economic go-round, and we’ll start with President Hoenig. MR. HOENIG. Mr. Chairman, I will begin my remarks this afternoon with a brief update on the conditions in our District. Overall, District economic activity continues to expand moderately, with strengthened energy, agriculture, and export manufacturing more than offsetting the softness in our housing, retail sales, and other types of manufacturing activity. District labor markets continue to perform reasonably well. While job growth has slowed over the past few months, unemployment remains very low, and many sectors continue to have difficulty finding workers, especially skilled ones. Evidence on wage pressures is mixed. Although wage pressures have moderated somewhat in our Beige Book survey, some recent labor union contracts have built in rising profiles for hourly wage increases over the term of the contract. Rising energy and commodity input prices are continuing to negatively affect our District economic activity. Reports from businesses suggest that higher energy and food prices are being quickly passed on to the customer now. However, businesses are having mixed success in passing on other cost increases, resulting in some severe erosion in margins and profitability in some of the June 24–25, 2008 33 of 253 firms. To illustrate some of the cost–price dynamics, I would like to take just a minute and relate the recent experience of one of our Branch directors, who operates a multi-line manufacturing firm. I mention this because I am hearing it more and more. In addition to rising fuel prices, his business has seen a doubling in steel costs since January, with July quotes on steel tubing up an additional 25 percent. In response, his company recently announced a price increase of 16 to 18 percent across a range of products. Competitors immediately matched or exceeded his price increases. Notably, he made these price increases despite a decline in new orders in May. He also noted that import prices from China that he has seen have risen 28 percent this year and that ocean freight prices have risen about 20 percent. As a result, customers who previously bought Chinese products are now purchasing U.S.-manufactured goods. It is interesting—I talked with some of the folks at Union Pacific, and their shipments into the Midwest have dropped slightly, but their shipments out have increased about 3 to 4 percent. So that is what is going on in the region. More broadly, turning to the national economy, I have revised up my growth estimate for the first half of 2008, but it has made little change in my longer-run outlook. Compared with the Greenbook, I see somewhat stronger growth in the second half of this year and somewhat weaker growth next year and in 2010. Most of the difference from the Greenbook in 2009 and 2010 comes from the policy path assumptions. I assume that policy accommodation is removed at a more rapid pace than does the Greenbook. Recent economic data suggest that, although downside risks to growth remain, they have diminished. I continue to judge that the potential spillover effects from the financial distress have understandably been overestimated in this Committee’s recent decisions and in Greenbook forecasts in recent months. In my view, the greater risks to the outlook come from rising energy and commodity prices and less from the June 24–25, 2008 34 of 253 financial distress as we go forward. In my view, current policy accommodation is greater than needed to address these risks. As I indicated at the last meeting, I believe that the upside risks to inflation have increased considerably over the past several months. Like the Greenbook, I expect both overall and core PCE inflation to move higher in the second half of this year. If this happens and we maintain the current level of the funds rate, I believe we are likely to see further erosion in inflation expectations, which will undermine our credibility with financial markets and the public. In this event, I judge we will greatly increase the likelihood that we will need to raise rates more aggressively, taking rates above neutral, in order to achieve our longer-run inflation objectives; and that is of significant concern to me, Mr. Chairman. Turning to the issue of long-term projections, let me comment that I have felt somewhat constrained by the current three-year horizon for our quarterly projections. Of the options presented by the subcommittee, I am most comfortable with providing estimates of the values for total inflation, output growth, and unemployment at which the economy is likely to converge. I am not sure, however, how we want to label these estimates, if they are included in the table. I understand that putting these estimates out might be interpreted as a move closer to inflation targeting, but I think that this is a bridge we are ready to cross since we adopted the enhanced projections process. The other options seem less desirable. Given the resources required, by my staff at least, I doubt that we could provide a meaningful forecast at a four-year or five-year horizon, and I am not sure how projections for average values over a period of five to ten years ahead would be interpreted by the public. In my view, appropriate policy should be expected to return the economy to its long-run equilibrium over a three-to-five-year period, with the length of the period depending on the nature of the shock. Setting out a five-to-ten-year horizon could June 24–25, 2008 35 of 253 be construed as a weakening in our commitment to achieve our mandate in a timely manner. Thank you. CHAIRMAN BERNANKE. Thank you. President Yellen. MS. YELLEN. Thank you, Mr. Chairman. The intermeeting period has been full of surprises. Real-side data came in considerably stronger than I anticipated, so like the Greenbook I have adjusted up my forecast for growth in the current quarter. At the same time, the adverse fundamentals that will weigh on household and business spending going forward have grown somewhat heavier overall, and that has prompted me to revise down my growth forecast for the second half. On the inflation front, readings on core inflation surprised to the downside. Nonetheless, given that the prices of many commodities have continued to rise more rapidly than I anticipated and that some measures of inflation expectations have turned up, I have adjusted up my inflation forecast for 2008, considerably up for headline inflation and modestly up for core inflation. The strong incoming data on spending eased my fears that we are in or are approaching a recession regime of the sort embedded in the last two Greenbooks. However, given the numerous large and worsening drags on spending, a couple of months of data aren’t enough to convince me that we are on a solid trajectory. Moreover, the spending data may well fail to reflect the real underlying strength of consumer demand because of the effects of the tax rebates. Spending patterns could easily be distorted by small differences between what we projected that households would spend each month out of rebate checks and what they actually spent. In monthly spending data, a swing of just a few billion dollars looks enormous. Perhaps households who were already paying through the nose for food and gas and are increasingly credit constrained have put their rebate checks to work a bit early this time. After all, households June 24–25, 2008 36 of 253 knew in advance that the checks were going out. For example, Google searches related to tax rebates peaked in April. We actually kept track of the data on that. So I will be closely watching the data over the next few months, hoping to get a cleaner read on the underlying state of consumer demand. As I said, the adverse fundamentals are still with us and in some part are worsening. Evidence that the credit crunch is ongoing is all too clear. Bank asset quality continues to deteriorate. Banks continue to deleverage, and they are tightening lending standards as they do so. The market for private-label securitized mortgages of even the highest quality remains moribund. Spreads on agency-backed mortgage-backed securities have risen during the intermeeting period, which are likely to spill over to the primary mortgage market with a lag. Anecdotal reports suggest that the constraints on household borrowing continue to tighten. For example, two of my most senior bank supervisors—both with FICO scores in the stratosphere— have had their home equity lines slashed. One has deferred a planned home renovation project as a consequence. If that is happening to them, I can only imagine how hard it must be to get a loan if you have a merely average credit rating. Housing prices have also fallen at a somewhat faster rate than the Greenbook previously anticipated. Given the overhang of homes for sale, the recent rise in mortgage rates, and the fact that the homeownership rate is likely to continue trending lower, I think the downward pressure on home prices and construction will persist, as the Greenbook suggests. The Greenbook is actually at the conservative end in its estimates of the wealth effect. It assumes a marginal propensity to consume out of housing wealth of about 3½ cents on the dollar. In contrast, a number of recent estimates in the literature are in the 6 cent to 9 cent range. There is a clear risk, June 24–25, 2008 37 of 253 then, that the combination of declining housing wealth and tightening credit could lead households to restrict spending more, and more persistently, than anticipated. But the big adverse shock since the last meeting is oil prices, which are up $25 a barrel from the already elevated April levels. Empirically, since the mid-1980s, the estimated responses to relatively exogenous increases in the relative price of oil have tended to look qualitatively like the simulations in the Bluebook and the Board staff’s special memo on oil prices, in which we are credible in our commitment to long-term price stability. Most notably, the empirical estimates suggest at most a modest effect on core inflation. Nominal wages barely respond; by some estimates they even fall slightly. The model results suggest that the outcomes we have seen in the actual data are crucially dependent on our having credibility. With substantial target drift, workers demand higher wages, which firms pay and then pass on. Fortunately, the anecdotes I hear are more consistent with credibility than with an upward wage–price spiral. In particular, my contacts uniformly report that they see no signs of wage pressure. There also is no evidence of real wage rigidity in response to energy prices. When energy prices have risen, real wages—in product as well as consumption terms—have generally fallen. In other words, real wages have been depressed in the 2000s, at least in part reflecting rising energy prices. But there is no sign that workers have over a number of years tried to recoup these losses at the bargaining table. Given the importance of credibility, the substantial increase in expected inflation in the Michigan survey is concerning but not yet alarming. I discount these readings somewhat because of analysis by my staff that suggests that, at either the one-year or the five-to-ten-year horizon, consumers have always tended to react strongly to contemporaneous inflation data. June 24–25, 2008 38 of 253 Changes in credibility are fundamentally about changes in the process by which people form expectations. But as far as consumer expectations are concerned, that process appears remarkably stable. For example, if you use data through the early 2000s to estimate equations that link inflation expectations to contemporaneous inflation, you will find that those relationships fit remarkably well out of sample. They don’t show the systematic underprediction of inflation expectations one might expect if the Fed had suffered a significant loss of credibility at this point. The dependence of consumer inflation expectations on recent data also leads me to believe that they will fall if, in fact, headline inflation comes down as we are predicting as commodity prices level off. Furthermore, I don’t think that households’ elevated expectations will make it harder to achieve our projections. Earlier research suggested that surveys did, in fact, provide useful information about future inflation. But during the past 15 or 20 years, the actual inflation process has become much less persistent even though households appear to assume otherwise. There is, thus, a notable divergence between the actual inflation process and the one that is embodied in consumers’ inflation forecasts. As a result, inflation forecasts incorporating consumer expectations have been a lot less than stellar over this recent period. So it does not appear unreasonable to believe that the effects of recent commodity price shocks will wear off faster than consumers are expecting. An unresolved question is, Whose expectations matter for the dynamics of inflation? I take some solace from the fact that 10-year inflation expectations in the Survey of Professional Forecasters have been relatively stable since the late 1990s and from the fact that five-to-ten-year breakeven rates on TIPS are below their peaks from earlier in the year. June 24–25, 2008 39 of 253 Taken all together, I think inflation expectations remain reasonably well anchored. The oil price increases have led me to raise my projections for overall PCE inflation sharply. Cost pressures are likely to push core inflation up a bit, though I see less pass-through than the Greenbook does. Higher oil prices and interest rates and lower housing prices have led me to modestly reduce my forecast of growth in the second half of this year and next year. My forecast is predicated on fed funds rate increases that begin in December of this year, gradually bringing the funds rate to 4¼ percent in 2010. Briefly, on the issue of long-term economic projections, I welcome greater transparency about our long-term objectives. I think that would be beneficial, and there is a good reason, as you have articulated, to try to do that now, given that for many of us—certainly for me—2010 is not long enough for me to project that the economy will have converged to a steady state. My preference is to provide projections of the average values for output growth, unemployment, and total inflation that are expected, say, five to ten years out. I think that these values can communicate the necessary steady-state information without burdening us with forecasting every year of the transition to the steady state. Also, I would favor conducting a trial in October. CHAIRMAN BERNANKE. Thank you. President Fisher. MR. FISHER. Mr. Chairman, you are going to get a contrapuntal tune here. That is the beauty of this table and the different perspectives around it. I am going to take a different approach today than I have in the past. I am going to talk a bit about the Eleventh District first, which I don’t often do. The reason for that is, because of its nature and size, because of its being the leading exporting state in the country now, and because of its job creation, it is in a slightly different position—or significantly different position, depending on which District it is compared with—from the rest of the country. June 24–25, 2008 40 of 253 Our job growth through March is running about 3.8 percent. Unemployment in April was 4.1 percent, despite a sizable influx of immigrants, which we see from new license plate registrations from California and particularly from Florida as well as from people still coming across the border. Sales of existing homes rose in May, while inventories and prices held steady. Apartment demand is robust, and rents in the major cities, such as Dallas and Houston, are rising. The real export growth of Texas was 7.2 percent in April after 3.9 percent in the first quarter. That is telling you that our chemicals are now being priced aggressively but also that everything else is being priced aggressively worldwide. That’s a significant export sector for us. Importantly, on the price front, the Dallas Fed’s own Texas manufacturing outlook survey and the regional CPI data indicate continuing price increases and substantial evidence of passthrough to higher final goods prices. Thirty-nine percent of the respondents report the ability to realize higher prices of finished goods currently; another 45 percent expect to be able to realize higher prices in the next six months. Despite these strong numbers, our soundings and our instinct project a slowdown in the future. We have been projecting a slowdown—we haven’t seen it. Discretionary income has been bolstered by employment, but squeezed by rising food and energy prices and credit constriction. So we are looking for the District to slow and yet to continue to outperform relatively speaking. I would like to devote the rest of my comments to the U.S. economy and to the global economy, particularly to the contrapuntal insights I have gained from my soundings. First, on the global economy, Nathan, our own research at our little globalization institute in Dallas indicates that the projections of real economic growth of most of the advanced countries are being revised downward whereas expected inflation is being revised upward. For the major emerging market economies, growth realization, at least as it appears in their forecasts, for the June 24–25, 2008 41 of 253 most part holds up, but inflation expectations are being steadily revised upward. In other words, the two types of economies share on the inflation front, whereas there is disparity and a little cacophony as far as growth is concerned. We are working on it, but we have yet to develop a reliable measure of global slack. JPMorgan, with whom we have been working, has a slack index that purports to be global. But as you pointed out, Nathan, it excludes China. Minor oversight. It also excludes India. One would think that the growing slack in the advanced countries would be mitigating price pressures. Yet those countries with numerical price objectives or inflation targets—from Mexico to Turkey to New Zealand to the European Central Bank to the Brits—are now contending with inflation in excess of their target or comfort range. I was thinking the other day of Mervyn King’s comment that, once they had to write to the Chancellor of the Exchequer, it would lead to a lot of letter-writing. It took 15 years for the first letter to be written after inflation targeting was embraced. Of course, two years ago this was resurrected, and now they seem to be doing so with a great deal more frequency. Now there is a risk of acquiring writer’s cramp. I would say that, if we were under the same strictures as the Bank of England, we might be subject to the same concerns. In our last meeting, I posited that something persistent and pernicious was occurring on the inflation front. Mr. Chairman, the one thing that is even clearer now—particularly after my soundings, which I’ll report in just a second—than it was in May is that inflationary pressures, inflation expectations, and anticipatory behavioral responses among consumers and businesses have intensified, whereas our confidence about economic growth has improved. I don’t believe that we are out of the woods yet on the risk of a credit-induced slowdown, though I believe our liquidity initiatives are a proper and good palliative, as you know. But if June 24–25, 2008 42 of 253 Robert Frost will forgive me, the woods are not lovely, and they are indeed deep and dark on the price front. Although the tail risk of economic recession has diminished, I think it still exists; certainly the anemia—just to use another word that you referred to—does. But the risk of inflation, in my view, has assumed greater depth and breadth since we last met. Stated differently, I don’t believe that inflation expectations are presently well anchored, here or elsewhere. I believe they are being—just to kill the sea analogy, Don—torn from their moorings and are at risk of going adrift. Now, I took a different approach this time with the 30-odd interlocutors with whom I discussed the outlook. I simply asked them one question: What is different in this cycle from what you have seen before? Most of these people have been in business for 30 years plus. Here are some sample testimonials as to what they are seeing. The CEO of Fluor, which has a $38 billion backlog currently, said, “When I started here in 1974, we put inflation contingencies into every contract. In the 1990s, that had not only gone away, but we were confident we could negotiate cost down to below what we were bidding. Now it is just the opposite.” The CFO of Frito-Lay, which just pushed through a 9 percent price increase (which, parenthetically, WalMart accommodated at 7 percent), said, “Most of our executives are in their late 30s or early-tomid 40s. They have never seen these kinds of numbers. This is reminiscent of the aftershock to Nixon’s wage and price controls, and we are currently having to hold seminars to teach management how to manage inflation.” From the CEO of Wal-Mart USA: “We see increased”—and this is his word—“pervasive price pressures. I am telling you that we have an economy where the real people are being trampled by inflation, and for the first time in memory, we are getting noise from employees about the cost of living.” Wal-Mart raised the pay of 60 percent of their associates between single and double digits in the last quarter, and my contact June 24–25, 2008 43 of 253 said, “We are now contemplating a series of measures such as providing discounts to employees to counter considerable employee angst about the cost of living.” From the CEO of KimberlyClarke, who just notified the retailers of a 7 percent price increase to come in August after the 7 percent they pushed through in February, in addition to which they are going to add a shipping surcharge: “Customers are no longer asking if, but when, we will increase prices, so they can move in anticipation.” I can give you other testimonials, Mr. Chairman. One of my favorites, by the way, has to do with a very small operation, a three-store dry cleaning operation, Faulkner’s Fine Dry Cleaning in Dallas. They approached me the other day to say that they would have to increase the price of cleaning our shirts because the price of 18-inch white hangers, which are steel-based, has increased 65 percent. They showed me the circular that had been sent around by the fabric cleaning supply company that is the last remaining manufacturer of hangers in the United States. All of that manufacturing has gone to China. The circular that they are sending their customers, the cleaners, says “What should cleaners do? Raise your prices. You’re worth it.” Then—and this strikes at the heart of every son of every Australian—Budweiser, which raised its prices 3½ percent in February, according to our local distributor, plans to raise 3½ percent again in September. And the Bud distributor in North Texas, who has had that distributorship for 43 years, said that never before in his lifetime had he seen two price increases in one year. Finally, the CEO of JCPenney’s just returned from an around-the-world buying trip. After 11 years of apparel price deflation, Chinese manufacturers are seeking 8 to 9 percent price increases in ’09, 11 to 12 percent for footwear, and for small kitchen appliances in the mid-20s. The CFO of the company told me that they are running at minimum staffing levels. If anybody begins to break the wage barrier, then, “Katie, bar the door!” June 24–25, 2008 44 of 253 So, Mr. Chairman, I would say that currently our patient—the economy—is indeed a sick puppy. Some of its vital organs—geographic regions such as the one I am fortunate to live in, or a strong export sector of the United States, or entrepreneurs and business leaders who have learned to wring unanticipated efficiency and profits out of globalization or from within cyberspace—are very strong. Yet others—states like California and Florida, the housing sector, and overall consumer confidence—are bleeding, if not hemorrhaging. This is not to mention the still precarious state, despite the very good report that Bill gave, of our financial system as it recovers, I hope with our help, from years of its recklessness and excess. I think we have, like loyal practitioners and with the equivalent of the Hippocratic oath, done the job that we are expected to do in terms of resuscitating the victim. That is the good news. The real bad news is that our patient appears to be acquiring a staph infection in this hospital that we have created, and that staph infection is inflation. I believe inflation is upon us. I believe expectations are discounting more inflation. Very importantly—and this is tough to get from the models—I believe that behavioral changes are beginning to manifest themselves. Now, some would argue that this infection is temporary and may well go away. Others will argue that it will be stayed by strong rhetoric. Still others say that it will require—I don’t know if it’s an antibiotic or an antidote—further tightening, lest the infection spread and counteract the good that we have done with our liquidity facilities and by previous policy decisions. That seems to me to be the problem that we will have to deal with at this meeting, and I look forward to hearing my other colleagues’ opinions. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Lockhart. June 24–25, 2008 45 of 253 MR. LOCKHART. Thank you, Mr. Chairman. I would like to start with some anecdotal feedback from the region. As you know, we have a lot of Branches, so we have a lot of directors, and we ask our directors a lot of questions. The anecdotal feedback from our 44 directors about the second half can be characterized as subdued. Almost all reported that they expect economic activity to be flat or slower, and I took special note that these expectations deteriorated in June after having actually improved a bit in May. The residential housing situation in the District resembles the national picture. Both sales and new construction are weak. High levels of inventories are being exacerbated by foreclosures, which are adding to downward pressure on prices. However, there are tentative signs of a bottom forming. Our survey of Realtors across the District indicates that the pace of decline of single-family home sales may be abating. Industry contacts tell us that foot traffic and buyer interest are picking up, particularly in Florida, although I would say that what constitutes progress in Florida would not be considered very encouraging elsewhere. Nevertheless, our view is that the beginning of an adjustment process is under way, but the end of the process looks to be a long way off. Some further home-price deterioration is likely to accompany this bottoming process. Credit conditions in the District continue to tighten because of perceived risk and also liquidity pressure on our banks. Our banks indicate that the process of deleveraging continues, which is affecting lending for residential real estate and, to some extent, commercial real estate. We are also hearing from several sources that funding of community banks is becoming an increasing problem because of their previous dependence on wholesale and correspondent bank sources. Higher energy prices are, not surprisingly, affecting our outlook. Hospitality industry June 24–25, 2008 46 of 253 contacts, for instance, expressed concern about low summer bookings. Although most tourist destinations have reported solid activity to date, few expect this to continue. The reacceleration of energy and commodity price inflation has businesses focused on cost pressures. Several business contacts indicated that price increases had been relatively easy to pass through and make stick in this environment. I wouldn’t say that it’s widespread yet, but I do hear some reports that businesses are expecting wage increases to eventually reflect the recent increases in the cost of living. This could be a significant factor, particularly in service price inflation. This and other anecdotal input has colored my outlook for the national economy for the balance of the year and into 2009. I have revised up my forecast for headline inflation in 2008 and 2009 by 50 and 25 basis points, respectively. I am also assuming that the recent inflationary pressures from elevated energy and food prices will unwind more slowly than I previously projected—a view reinforced by expectations expressed by my District contacts. Like everyone else, I am deeply concerned that inflation expectations seem to be rising and that expectations of general price inflation, reflecting second-, third-, and fourth-order effects of recent oil and commodity price rises, risk becoming institutionalized. I am prepared in the near term to think tactically regarding the conflict between growth and employment policy objectives and inflation objectives; but sustained inflationary pressures that extend well into the fourth quarter and rising expectation readings may force, at least on my part, a more strategic look at the tradeoff. I would like to talk for a moment about financial markets. I made a number of calls during the intermeeting period, and the growth-versus-inflation tactical dilemma is complicated further by a very mixed picture in financial markets. My contacts all acknowledge improved conditions since mid-March, but discussion of the current market circumstances and the outlook June 24–25, 2008 47 of 253 had a sort of half-full/half-empty quality. My contacts, taken together, pointed to several positives, including the health of the corporate loan market, improved CDO pricing, the readiness of forming distressed funds to buy asset-backed securities, alt-A mortgage demand, the growing perception that subprime loss estimates have been overstated, and some comment on Goldman’s Cheyne deal, which they believe will help create price determination for certain securities. At the same time, these contacts cited areas of continuing or worsening weakness, including: HELOCs and second mortgages; option ARMs and alt-A hybrids; indirect auto, given the collateral value of SUVs in current circumstances; in contrast to CDO pricing, CDO squared pricing is very weak and deteriorating; the obvious concern about the growing liquidity issues of regional banks; and the view that the auction rate securities market valuations, given illiquidity, are suggesting that this market has little probability of returning to normalcy. Overall, my contacts in financial markets were encouraged but expressed worries over still-substantial downside potential. Let me turn now to my national forecast compared with the Greenbook forecast. The Atlanta projections for the national economy are broadly similar to those of the Greenbook. We have the same general narrative of slow growth for the balance of the year followed by a gradual pickup through 2009 and 2010. My projections for headline and core inflation are virtually identical to the baseline Greenbook projections. However, I believe that there may be less disinflationary pressure than seems implicit in the Board staff’s forecast. As a consequence, the fed funds rate path that supports my inflation outlook is well above the Greenbook’s at the end of 2009 and 2010. We are 75 basis points higher at year-end 2009 and 100 basis points higher at year-end 2010. Notwithstanding the upward revision of the first-quarter GDP number and the better expectations for this quarter, I still believe the near-term risks to growth are weighted to June 24–25, 2008 48 of 253 the downside. At the same time, as suggested by my revised forecast, I see the risks to our inflation objective as weighted to the upside. On the subject of the long-term projections, I favor the third approach, which is three years plus long-term averages, and certainly would be comfortable with approach number 2. I’m generally dubious about the ability to do actual forecasting for the outyears, even as near-term as the third year. So I really don’t favor approach number 1. My experience, in the brief time I have been with the Fed, has at least personally been, shall I say, challenging from the point of view of forecasting. I tend to think of the long-term projections as being roughly equivalent to our targets or policy goals. In fact, the approach we have generally taken with our three-year forecasts is making the outyear approaching at least what we would consider to be the trend rate for growth and the employment and inflation objective. So I think long-term projections really do amount to more-explicit targeting, and very likely the first question we get when we come out of the blocks—if we have this kind of approach—will be, Is this your target? I am comfortable saying “yes” to that question and, therefore, would support the third approach. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Rosengren. MR. ROSENGREN. Thank you, Mr. Chairman. Despite some encouraging data recently, the Boston Fed economic outlook continues to see the economy growing below potential over the next several quarters, further weakening in labor markets, and core PCE trending down in response to excess capacity. Overall, our forecast has not changed significantly since our April meeting. I view recent strength in consumer spending indicators as largely borrowing from the second half of this year. This view is supported by the assessment that, apart June 24–25, 2008 49 of 253 from the fiscal stimulus, consumption fundamentals—income, wealth, and employment—remain on the weak side. Taking on board some of the increase in the May unemployment rate, our forecast has the unemployment rate peaking at a slightly higher rate than at the last meeting. In this respect, we are similar to many other forecasters. The May Blue Chip forecast had unemployment peaking at 5.6 percent. The June Blue Chip forecast for unemployment peaks at 5.7 percent. While the Greenbook has the unemployment rate peaking at 5.7 percent, as it did in April, it has the unemployment rate at 5.6 percent at the end of 2009—0.1 percent higher than the April Greenbook. So at least as measured by the unemployment rate, there seems little improvement in the outlook since the April meeting. As in the Greenbook, residential investment in our forecast continues to be a drag on the economy in 2009, and consumption holds up primarily as a result of the fiscal stimulus package, which is in part offsetting the negative impact of significantly higher oil prices on consumption. A major uncertainty remains whether further home-price declines will have a more negative effect on residential investment and consumption than we currently have in our forecast. Similarly, I would view financial market conditions as not having changed significantly since our April meeting. The three-month LIBOR–OIS spread remains quite high by historical standards at roughly 70 basis points, where it has been trading since the April FOMC. The Dow Jones, S&P 500, and Nasdaq indexes have all declined since our April meeting. Investment banks, such as Merrill Lynch and Lehman Brothers, are now trading substantially below where they were trading at our April meeting and below where they traded during the middle of March when Bear Stearns experienced difficulties. Stock prices for large regional banks have declined as they have needed to increase loan-loss reserves, raise new capital, and reduce dividend June 24–25, 2008 50 of 253 payments. I continue to be concerned that we have more, significant difficulties ahead for many financial institutions. First and second mortgages and home equity lines of credit are deteriorating at many banks as falling home prices and job losses create problems that have now spread to some prime residential products. I would characterize financial markets as remaining fragile. The past two TAF auctions still produced stop-out rates above the primary credit rate, and financial markets remain susceptible to event risk. The recent flurry of articles on Lehman before their announcement of their capital infusion highlights continued concerns about investment banks, despite our new liquidity facilities. As a result, I continue to view the downside risk of further financial shocks as being significant. Core PCE inflation has trended lower during this quarter, bringing the four-quarter change for the past year to 2.1 percent. Given that the Boston Fed forecast expects significant excess capacity over this year, we forecast that core PCE inflation will be slightly below 2 percent in 2009. If food and energy prices stabilize, we expect total PCE to converge to core PCE. We have experienced significant food and energy shocks, and oil prices continue to be higher than our expectations. I would be quite concerned should the serially correlated surprises in food and energy become embedded in inflation expectations and wages and salaries. But a critical element to my forecast is that total PCE inflation converges to core PCE as wage and salary increases remain largely unaffected by the supply shocks. In the data to date, wage and salary increases have not trended up in response to the supply shocks, and my expectation is that excess capacity in labor markets and continued competition from abroad make it unlikely that the relative change in food and energy prices will become embedded in labor contracts. For the intermediate term, I remain focused on core PCE rather than total PCE for several reasons. First, monetary policy is unlikely to have much effect on food and energy prices, which June 24–25, 2008 51 of 253 are responding, among other developments, to the impact of natural disasters such as flooding in the Midwest and manmade disasters such as ongoing political difficulties in Nigeria and the Middle East. Second, statistical evidence provided by our research department seems to indicate that over the past 20 years, when total and core inflation diverge, total has tended to converge to core and not the opposite. Third, while inflation expectations are difficult to model, the lack of an upward trend in wages and salaries seems consistent with worker expectations being driven by core rather than total inflation. While the supply shocks may have increased the upside inflation risks, the downside risks to the economy and financial markets remain quite elevated. In my view, we need more time and data to determine with greater confidence which of these risks poses the greatest danger to the economy. In terms of the options, I am comfortable with either 1 or 3. I have a slight preference for option 1. It is not that difficult for us to extend our forecast out five years. I actually think it would be easier to explain to the public than option 3, and I think explaining to the public is one of the main goals of expanding the forecast. But I could be happy with either option. CHAIRMAN BERNANKE. Thank you. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. In the Third District, as anticipated, manufacturing activity, residential construction, and employment have remained weak. Nonresidential construction has now softened, although vacancy rates in Philadelphia and around the District remain relatively low. Retail sales remain sluggish. Bank lending has been restrained. The outlook among our business contacts, however, varies significantly by sector. Manufacturers expect a rebound in activity over the coming six months, and residential real estate contacts report that they believe market conditions may be near bottom, although they expect any recovery to be slow. Interestingly enough, it is the same sort of anecdotal evidence June 24–25, 2008 52 of 253 that President Lockhart referred to. Now, it is hard to know whether it is just mostly wishful thinking or whether there is something real there—although his saying it and my saying it sort of reinforces it a little. But it is the first time that I have heard such news in a very, very long time. Retailers are quite pessimistic, however, because they are expecting the increase in energy prices to limit sales, especially among lower-income customers, despite the tax rebates. Despite the soft economic conditions, the most prominent concern that we have heard from our business contacts across a variety of industries is the run-up in commodity prices and other prices. Thus far, firms have resisted passing along their rising costs to customers, to the extent that they could, but many firms tell us that they have gone as far as they can on holding the line on their own prices and plan to raise prices further in the next few months. Some firms are including general cost-increase clauses in their new contracts. Earlier we saw various sorts of fuel surcharges added onto prices, but now contracts are being written in a way that includes broad cost-adjustment increases. This is still only anecdotal evidence although it has been referred to—I think President Fisher made a couple of comments in this regard. But it may be yet another early warning sign that inflation expectations cannot remain in check indefinitely in this current environment. In June, the prices-paid index in our business outlook survey of manufacturers rose to the highest level it has been since 1980. Manufacturers and firm contacts across a wide range of industries say that they expect their input prices and the prices of their own goods to increase further over the next six months. They see no abatement of price pressures in the near term or medium term and are very pessimistic about inflation. The national economic situation is similar to what I see in my own District, and it is an uncomfortable situation for all of us. The data we have received on economic activity over the intermeeting period have come in slightly better than I expected, but the continued price June 24–25, 2008 53 of 253 increases, particularly in oil and commodities, have been a very unpleasant development. Certainly, economic conditions remain weak, and the recent positive news may prove to be transitory. From the financial side, credit spreads have fallen, bond issuance has risen, and it appears that financial market functioning has at least improved. In my view, although downside risks to growth remain, the tail risk of a very bad outcome has clearly been diminished. I expect GDP growth to come in around 1.7 percent this year—only marginally higher than my April projection—before picking back up to trend of around 2.7 percent in 2009-10. Despite the upward revisions in the Greenbook baseline, my forecast remains somewhat more optimistic for growth in 2008 and 2009 than the Greenbook. In fact, my forecast is similar to the Board staff’s “upside risk” alternative scenario, which essentially removed the downward adjustment factors the staff added to build in more recession-like features caused by the financial turmoil and other factors not captured in their baseline model, which is what Dave was mentioning earlier. My concerns about the inflation outlook have increased since our last meeting. I am not alone. Inflation has become a predominant concern for many businesses and consumers, and you only have to read the newspapers to see that. Obviously, monetary policy cannot control the price of energy, but we do have a responsibility to act to keep broad-based inflation under control. Contributing to the increase in inflation risk is not only the surge in energy and other commodity prices; it is supported also by our own accommodative stance of monetary policy. Short-term inflation expectations and headline inflation measures are up significantly since our last meeting. So far, core inflation increases have been modest, and long-term inflation expectations remain, although volatile, within a tolerable range. But if we continue to maintain the real funds rate well below zero, despite inflation that is well above acceptable levels, can we June 24–25, 2008 54 of 253 really expect inflation expectations to remain anchored? We must remember that longer-term inflation expectations tend to lag inflation not to lead it. If we wait until these measures rise, we will be too late. Apropos of President Evans’s question about wages, I have been troubled by stories in the press suggesting that we can be less concerned about inflation than we were in the 1970s because wages haven’t risen and labor unions are less prominent. These stories suggest that the wage–price spiral caused the unanchoring of inflation expectations in the ’70s. But I think this gets the direction of causation backwards. In my view, the story of the ’70s was that the public lacked confidence in the central bank’s commitment to price stability—it didn’t believe the central bank would take the necessary steps to bring inflation under control. As a consequence, inflation expectations rose and wages rose. It was the higher inflation and the lack of credibility that led to higher wage demands. The key to avoiding such a situation, in my view, is maintaining the credibility that the Fed has worked so hard to achieve. The Board staff memo on optimal monetary policy in the context of higher oil prices illustrates the importance of maintaining credibility, and I want to thank the staff for their efforts in this regard. I think it was an excellent piece of work. As they clearly say, the critical factor in containing inflation through an expectations channel is the belief that policymakers will always adhere to a full-commitment rule. When the central bank is unable or unwilling to commit in a credible manner to future policy actions or to a long-run inflation goal, the result is both higher inflation and lower output. In the real world, of course, full commitment can never absolutely be achieved. But beliefs about which regime better approximates reality are informed by the actions taken by the central bank to maintain its commitment to price stability. June 24–25, 2008 55 of 253 I believe that the FOMC has done a good job with our words—including FOMC statements, minutes, and speeches—in helping to anchor longer-term expectations. I believe the Chairman’s speech at the Boston Fed conference earlier this month delivered a well-articulated and important message about the importance of keeping longer-term inflation expectations anchored. But our credibility rests on more than just words. We must act in a way that is consistent with our hard-earned reputation, or our credibility could soon vanish. To underscore our words, we should take actions and take back some of the insurance we have put on in the context of elevated downside tail risks. Given recent economic developments and the improvement in financial market functioning, coupled with our accommodative stance of policy, it seems pretty clear to me that, if the economy continues to evolve as it has over the past couple of months, we should move to raise the funds rate. This is also the view of market participants, whose expectations for policy have steepened considerably over the intermeeting period. My forecast, therefore, incorporates a monetary policy path that is steeper than the one in the Greenbook. I assume that the funds rate will reach 2.75 percent by the end of 2008 and move up to 4.5 percent by the end of 2009. This steeper funds rate path is necessary, in my view, to deliver inflation that is declining back toward our goal. Regarding the suggestion by the Subcommittee on Communications on lengthening the forecast period, I think it can be a very useful device, and I support it. My preference, however, is for option 2, although I think option 1 could work just as well. I’m for option 2 partly because I, too, am less confident about forecasting whatever the dynamic adjustment process happens to be, and so just going to year 5 I think would be useful. Omitting year 4 is not omitting any information that is terribly informative, as far as I am concerned. I am a little reluctant to go to June 24–25, 2008 56 of 253 some longer-term average like five-to-ten years because I think that muddles the communication picture and may signal a weakening of our commitment about the timeframe over which we think we can really achieve some objective. So I am most comfortable with option 2, or I could be happy with option 1 as well. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Lacker. MR. LACKER. Thank you, Mr. Chairman. Economic activity in the Fifth District has remained soft in recent weeks. Our retailers report declining activity in June, especially in autos. We are still hearing scattered reports of delayed or canceled new construction projects, either because of a lack of financing or because demand is expected to decline. Our survey measure of manufacturing activity, which by the way covers a manufacturing sector bigger than the Philadelphia and the Empire indexes combined, [laughter] has edged lower in the last two months; but exports continue to be a bright spot with reports of robust outbound activity at area ports. Manufacturing contacts report some success in passing on rising energy and transportation costs to their customers, and their indexes of expected six-month-ahead manufacturing price trends, both for prices paid and prices received, reached new record highs for the 14-year history of those series. I, too, have heard scattered reports in the last couple of weeks of employers contemplating providing extra compensation boosts to their employees to make up for rising energy costs. On the whole, I think the risk of the national economy sinking into a serious recession has receded, and the growth outlook has edged up a bit. I was relieved by the strength in retail sales in May as well as the upward revisions for April and March. The ISM indexes have steadied at right around 50 over the past four months; and although the labor market has been weak, it has not yet shown the accelerating declines that I feared. The Greenbook projection for June 24–25, 2008 57 of 253 Q2 real GDP has been revised from minus 1.4 to plus 1.7, and we have made a similar adjustment in our own projection. There remain plenty of reasons for concern on the real side of the economy, of course. Real disposable income has suffered with the fall in employment over the last half-year, and the rising cost of gasoline is taking its toll as well. The continued fall in housing prices has cut into household net worth and could contribute to a rise in consumer saving. Stimulus checks might be playing an important role in supporting consumer spending right now; it is not clear how much. But I am concerned that, when the stimulus effects wear off later this year, we may find that the underlying trend in consumer spending is fairly soft. Commercial construction also remains a potential risk, I believe. There is a bit of a disconnect between the surprisingly strong data on nonresidential construction and the reports of slowing that we keep hearing from regional contacts. This suggests that the numbers reflect projects initiated before the beginning of the year and that commercial construction is likely to soften later this year and to be a drag next year. Despite all of these elements that could depress growth, I think the economic situation has undoubtedly turned out better than we expected at the April meeting because of the better-thanexpected consumer and business-investment numbers. Greenbook now forecasts a period of low but positive real growth, significantly better than the experiences of the last two fairly mild recessions, and I think that is about right. Inflation is a growing problem, though. CPI came in at an annual rate of 8 percent in May and has averaged 4.9 percent over the last three months. The core intermediate goods PPI is increasing at double-digit rates. Oil prices have risen 16 percent by my calculation since the last meeting. Retail gas prices are up 13 percent. Changes in inflation expectations since the last meeting vary with the measure that you choose. But my reading is that they continue to June 24–25, 2008 58 of 253 deteriorate. In any event, they are above levels consistent with price stability. The Michigan survey numbers for inflation expectations have risen notably, especially for the one-year horizon. The TIPS-based measure of expected one-year inflation five years forward has increased 30 basis points since the April meeting, and although the five-year, five-year-forward figure has been stable since then, it is still quite close to the highest value it reached at any point last year. It is popular, as many have noted around the table, to cite the stability of compensation gains as evidence that we are not seeing a wage–price spiral. I have done it myself recently. But I share the concerns expressed by President Evans and others around the table about that being a lagging indicator. I am concerned that, if we wait until we see rising inflation expectations showing up as wage pressures, we will have waited too long. I noted in just a casual glance at the data from the 1970s that, although wage acceleration was a prominent component of the acceleration of inflation in the late 1960s, it was largely absent in the accelerations that occurred in ’74 and ’79. I think monetary policy is quite stimulative right now. Using the Bluebook’s standard approach of subtracting four-quarter lagged core inflation, the real funds rate now stands just below zero, about where it bottomed out in the ’91 recession and a good deal above its trough in 2004. But I don’t think lagged core inflation is the best estimate of overall inflation now. I am drawn to the Bluebook’s real rate estimate, new in this edition, that uses the Greenbook’s projection for headline inflation. Using that measure and going back and reconstructing it for the past, the real funds rate is now minus 1.3 percent, and that is substantially lower than its troughs in the last two recessions, which were right around zero. This is a lot of stimulus, arguably way too much given the improvement in the growth outlook, the reduction in downside risks, and the continuation of inflation pressures. I think withdrawing the stimulus is going to be challenging, however. June 24–25, 2008 59 of 253 About the extended projections, I am not convinced that the benefits exceed the cost. I don’t think it is going to provide much help on communicating an inflation objective. I think it will show about as much dispersion as our third-year forecasts show now. In any event, I haven’t noticed much of a decline in the volatility of inflation expectations since we began releasing projections on an accelerated calendar late last year. Moreover, I think those steadystate or longer-run projections are just going to tempt people to think that we have an unemployment rate target and a growth target. That some politicians have suggested that we actually adopt such makes it dangerous to engage in any exercise that seems to comply with that suggestion. Besides, I am not sure who cares about our steady-state growth forecasts besides maybe some business-cycle-model calibrators. But we are likely to get our steady-state growth forecasts from those people in any event, so I am not sure that is going to be very helpful. I don’t think we should bother with these extended forecasts. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Why don’t we take a break until 4:45 and have some coffee. Thank you. [Coffee break] CHAIRMAN BERNANKE. Why don’t we reconvene. President Bullard, whenever you are ready. MR. BULLARD. Thank you, Mr. Chairman. The District economy continues to be sluggish. Severe weather, combined with a very wet spring, is hampering agriculture in some areas. Major flooding has caused significant damage already, and the situation continues to develop. Many business contacts in the District emphasize energy costs along with some other high commodity prices as an overriding concern. Most of the descriptions I have encountered concern businesses and consumers scrambling to adjust to new pricing realities. Many contacts June 24–25, 2008 60 of 253 are reporting skittishness over the inflation outlook, fueled by dramatic increases in key commodity prices. Many contacts with deep experience in the commodities markets remain convinced that market manipulation or speculation is behind the run-up in commodity prices across the board over the past several years. This belief is widespread and deeply held. Many predict a crash in market prices of these commodities once the bubble bursts. My assessment is that this very strong belief may, by itself, have important macroeconomic implications. Businesses and households may be reacting very differently to price increases that they see as temporary, as opposed to their reaction if they view price increases as permanent and unlikely to reverse. Reports on the level of economic activity are decidedly mixed. The housing sector remains in a deep slump and subject to a widespread shakeup. Business in the energy sector continues to boom. High energy prices are affecting the logistics business, which has to try to be profitable at higher prices with reduced demand. Still, a very large retailer reports brisk activity, and a large technology firm is essentially unaffected by the macroeconomic slowdown. Recent data on the U.S. economy have been stronger than forecast, keeping economic performance weak but avoiding a particularly sharp contraction. The worst outcomes stemming from financial market turmoil have failed to materialize thus far. There is, to be sure, still some potential for additional upheaval, depending in part on the managerial agility among key financial firms. However, the U.S. economy is now much better positioned to handle financial market turmoil than it was six months ago. This is due to the lending facilities now in place and to the environment of low interest rates that has been created. Renewed financial market turmoil, should it occur during the summer or fall, would not now be as worrisome from a systemic risk perspective. In addition to this lessened risk from financial markets, I see the drag from housing June 24–25, 2008 61 of 253 dissipating during the second half of the year. Most likely we will also see a moderation in energy price increases. Output growth is, therefore, likely to be moderately stronger going forward. Policy was very aggressive during January and March of this year. This was, in part, a preemptive action, insurance against a particularly severe downturn brought on by financial contagion. This was a very real possibility, but it did not materialize. This has created a situation with more stimulus in train than would have been intended had we known the outcome in advance. This is putting upward pressure on inflation and inflation expectations in the second half of this year. Policy has to turn now to face this situation. On the long-term projections, I think it is a good idea to put down long-term projections. I am happy with any of the options. I have a slight preference for option 3. I think a trial run would be good. If the objective is to name these numbers, such as an inflation target or the potential growth of the economy, another way to do it would just be to name those numbers and not have it tied to any projection or any particular year. We could just say, “This is what I think the inflation objectives should be. This is how fast I think the economy could grow in the absence of shocks. And this is what I think the unemployment rate would be if output were growing at potential and inflation were at target.” You could just name those numbers. You wouldn’t have to say five years away or ten years away, which kind of brings in new long-run factors that you might not want to get into. Thank you. CHAIRMAN BERNANKE. Thank you. President Pianalto. MS. PIANALTO. Thank you, Mr. Chairman. The last two months have brought an interesting shift in my conversations with my business contacts. Their concerns have shifted from problems in financial markets to the rapid increase in input prices. Energy prices are the June 24–25, 2008 62 of 253 focus nationwide, but steel prices are also capturing the attention of the business people in my District. Several manufacturers and builders noted that the price they pay for steel has almost doubled since the beginning of this year. Clearly, businesses are worried about signs of growing price pressures, but their reactions to these price shocks tell a more complicated story. Many manufacturers have not been able to pass on price increases, resulting in a clear loss to profit margins. These businesses often report cost-containment or efficiency programs that will affect their hiring and capital decisions for months to come. Interestingly, the consumer price data show a similar dichotomy. My staff noted that our primary measures of core inflation are not providing a consistent story about the path of underlying inflation. In the May CPI report, roughly one-third of the weighted price changes increased at rates above 5 percent, and roughly one-third of prices changed by rates less than 1 percent. For example, while energy costs were up strongly and prices for a number of general service components have been drifting higher, large declines in apparel and vehicle expenses are imparting significant offsets. The 16 percent trimmed mean indicator showed an alarming 4 percent rise in prices, while the median rose just at 2.2 percent. The weight of price changes in the 1 percent to 5 percent range was unusually small, making it difficult to estimate the central tendency of the price change distribution with much confidence. So this makes it difficult to get a good read on where future prices are headed. My District business contacts remain pessimistic about growth prospects. District retail reports focused extensively on the likely effects of gasoline and food prices on the purchasing decisions of consumers. Many manufacturers, builders, and distributors are facing complicated output and investment decisions in the context of input price growth and weaker markets. Overall, most of the business people that I talk with are still quite cautious about their business June 24–25, 2008 63 of 253 plans, despite the fact that most of them have found sources of credit and terms that are not too elevated from what they have seen in previous years. In the economic projections that I submitted for this meeting, I raised my near-term forecast for output growth slightly and for headline inflation slightly more. Over the medium term, my outlook continues to be for modest growth because the housing market, in my forecast, recovers slowly, actually more slowly than in the Greenbook. My staff estimated a model for national housing starts that takes into account what has happened in the past in states that have seen major increases in foreclosures. The real estate difficulties that these states faced were much more persistent than anything that we have yet seen in the national data. The bottom line of this analysis is that, if the patterns of past housing cycles from the states that experienced the boom–bust cycles are repeated at the national level, then housing starts should remain relatively weak over the next couple of years. Supporting this analysis, three of the large regional banking organizations in my District are increasing their loan-loss provisions significantly in the second quarter based on the continued deterioration in the housing sector. Based on current projections, these institutions are projecting housing sector credit losses to accelerate in the second half of 2008 and to continue into 2009. Currently, the weak output growth contributes to my forecast of declining inflation rates, especially the core rate, but I also see evidence supporting that view in the “less worker bargaining power” scenario that is in the Greenbook. My contacts see very little price pressures coming from labor costs now or in the near future. Finally, implicit in my forecast for output growth and inflation is a fed funds rate path that includes increases later this year and into next year. Although additional risks to growth remain, the primary risk to my forecast concerns input prices and inflation expectations. If commodity prices continue to accelerate, they are going to put upward pressure on both headline June 24–25, 2008 64 of 253 and core inflation and downward pressure on output. That environment could lead to a highly undesirable increase in inflation expectations. On the positive side of risk to the outlook, I think that the fed funds rate actions that we have taken, in conjunction with the actions that we took in August to bolster market liquidity, have improved confidence, and I have substantially lowered the odds I had placed on financial market meltdown and on a severe recession. In that sense, since our meeting in April the downside risks to my outlook for economic growth have lessened somewhat, and the risks to my inflation outlook have moved up somewhat. Regarding the issue of providing longer-term forecasts, I have long supported efforts to clarify the underlying objectives of FOMC participants by providing our longer-term economic projections. Of the proposals that were offered by the Subcommittee on Communications, I favor reporting the average values for output growth, unemployment, and total inflation expected over a five-to-ten-year period—option 3. The features of these five-to-ten-year projections that I find attractive are that they indicate where the economy might converge and don’t imply too much knowledge of the path to the long run. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Evans. MR. EVANS. Thank you, Mr. Chairman. Most of my contacts continued to report sluggish domestic demand, and they are not currently seeing any improvement in activity. In addition, their comments often focused on the substantially higher costs that they are facing for a wide range of nonlabor inputs. With regard to business activity, much of what we heard about the District and the national economy was a rehashing of preexisting developments. At our last meeting, we felt that there was substantial risk of a further softening in second-quarter growth, so the absence of new news is a positive development. With regard to specific sectors, exporters I have talked with continue to thrive, and steel producers are doing quite well. But any business June 24–25, 2008 65 of 253 associated with housing markets is very weak, and the motor vehicle outlook continues to worsen. All Detroit Three CEOs are expecting light vehicle sales to be less than 15 million units in 2008. The Seventh District has experienced substantial flooding in recent weeks, particularly in Iowa. We have been in contact with state officials and numerous businesses. The corn and soybean crops have experienced significant losses, though the range of estimates is wide. Higher estimates for lost corn output in Iowa are about 10 percent. That substantial loss would represent a national crop loss of just about 2 percent. In addition, although there have been transportation disruptions, especially on the Mississippi, our contacts expect these to be short-lived. So overall, our sense is that the economic damage seems to be relatively contained, especially in comparison with the floods in 1993, which hit a much wider geographic area and affected activity for a longer period of time. Turning to the national picture, the incoming data regarding growth generally have been positive. Indeed, the string of upward quarterly forecast revisions continues. In particular, I have been impressed by how much second-quarter GDP growth forecasts have moved up. This is not to say that we are out of the woods. Clearly, the continued difficulties in the housing and credit markets as well as the unrelenting increases in energy prices pose important downside risks to activity. Our Chicago Fed national activity index continues to be in territory I would characterize as a recession—the three-month moving average is minus 1.08 this past month. Still, the risk of the adverse feedback loop that concerned us so much clearly seems less likely today. Importantly, the financial situation seems better. Though conditions are still far from normal, institutions have had time to cope with bad portfolios, much as President Bullard mentioned. They have made significant progress in raising capital and have increased provisions June 24–25, 2008 66 of 253 against losses. I think our lending facilities have helped financial institutions gain time to facilitate the adjustment process. It seems well beyond our abilities, however, to engineer a return to “normal financial conditions,” given the extent of financial losses and overbuilding in housing. With regard to our economic projections, we expect growth this quarter to be similar to the Greenbook; but unlike the Greenbook, we are looking for the momentum to carry forward to a better second half of the year. Beyond this year, we think growth will run near potential. This is based on a fed funds rate path close to that in the futures markets. We are assuming a fed funds rate of 2½ percent by the fourth quarter and 3¾ percent by the end of 2009. Turning to inflation, a number of factors present a concern for inflation expectations and our ability to bring inflation down. As I mentioned, my contacts spent a good deal of time talking about materials cost pressures, and many around the table have talked about those as well. Many manufacturers were citing large increases in energy and most commodity prices, and everyone was passing along some portion of these cost increases. I have one anecdote on this: In retail, Crate&Barrel reported on recent buyers’ trips to Asia, saying that prices for items purchased there would be 15 to 20 percent higher for next year. Finally, wage pressures have been subdued thus far. Still, econometric analysis by my staff reminded me that wage inflation tends to follow price inflation not the other way around. So by the time we see wage pressures, either we are not behind the curve now, or it is “Katie, bar the door!” It is probably one or the other. [Laughter] Indeed, I am concerned that large and persistent changes in costs and in relative prices of high-profile items, such as energy, could change the inflationary mindset of businesses and households. The resulting increase in inflation expectations would pose a difficult challenge for monetary policy. Maybe it will end up being okay; maybe surveys will be right. But it is a big risk, and that risk is a bit large for my comfort. June 24–25, 2008 67 of 253 Looking ahead, we all see the substantial upside risk to price stability posed by the passthrough of higher costs and any possible increase in inflation expectations. While I hope I am wrong, I feel that we may need to accept a somewhat longer period of resource slack than we would like in order to address these risks and put inflation more firmly on a downward trajectory. Under our projection for GDP growth, the economy does not close the modest resource gaps we project will be in place at the end of 2008 until beyond the forecast horizon. Along with a flattening in energy and other commodity prices, such gaps should be sufficient to contain inflation expectations and bring overall PCE inflation near 2 percent in 2009 and 2010. That is our expectation. But my base case does not have inflation moving below 2 percent until after 2010, and that is even with more aggressive policy tightening than the Greenbook path. Now, turning to the long-term projections, I think that our forecasts for 2010—or at least the way that I think about it—do suffer from some difficulties. We would like to mention in the write-up that, at the end of the period, the range is between 1½ percent and 2 percent, and we can infer policymakers’ preferences from that. That is one interpretation. Given the inflationary pressures, that is harder and harder for many people to come up with. I think in some cases it requires a monetary policy response that is beyond what most people would expect that we could actually do. So I don’t try to force my inflation forecast into my preferred range if it is too hard. Based upon monetary policy, it is more medium term. So I do tend to favor a longer period. I am somewhat indifferent between the first and the second options. I don’t really see a lot of difference, but something that has a five-year forecast I think is useful. Whether or not it has the fourth year and whether or not it is core PCE or total are less important issues. One argument for this is an interesting body of research, which I have been exposed to only at conferences—and Jim probably knows it better than most—on learning and whether June 24–25, 2008 68 of 253 individuals in the economy can learn these rules without a variety of information. Some of the better papers that I have seen on that remind us that you need more pieces of information than just what the target is, whether it be 1½ percent or 2 percent. You need some type of contour when people are learning with simplistic learning rules, like least squares learning. So I think a bit more contour on the forecast would be helpful. In my mind, that pushes you toward the five years of forecasting as opposed to a steady state or a five-to-ten-year forecast. I think that’s an important element. On the trial run, I think we could do it sooner than that, but I know a lot of staff resources are involved. So I favor sooner rather than later. Thank you. CHAIRMAN BERNANKE. Thank you. President Stern. MR. STERN. Thank you, Mr. Chairman. Well, like some others—maybe many others—I, too, have raised my forecast for growth for this year, basically just extending what’s happening in the first half of the year, and I’ve raised my projection for growth next year marginally as well. Still, I must admit to some significant reservations about doing that. As I look at the outlook and as Larry Slifman pointed out, there are a number of weaknesses, concerns, or downsides that you can pretty readily identify—tight or tightening credit conditions, a still significant decline in housing activity, a decline in housing values and the negative wealth effects associated with that, the run-up in energy prices, and so forth. Many of those will adversely affect the consumer, it seems to me. When we have that high a number of what I would call identifiable negatives, I wouldn’t be surprised if we had one or more quarters of significant economic contraction still ahead of us despite the recent relatively good news on the growth side. At the same time, the news on inflation hasn’t been particularly positive from my perspective, and that’s particularly true if the Greenbook is right and some of the relatively favorable recent readings on core inflation are likely to prove transitory. I’m struck by the volume June 24–25, 2008 69 of 253 of questions I get and concerns expressed about inflation when I’m out talking with business groups or giving a speech to a more general audience. Now, a lot of this, of course, is focused on or stems from what’s happening to energy prices and food prices, which are highly visible and which people experience directly and frequently. Nevertheless, I’m concerned that all of that makes inflation expectations a bit more vulnerable, maybe more than a bit more vulnerable, than they have been to this point. My reading of inflation expectations per se is that they, at least the longer-term expectations—and I’m relying mostly on the TIPS data here—have been remarkably well anchored so far. Perhaps a partial explanation for that is that core inflation really hasn’t moved much since 2003–04. That’s a bit of a double-edged sword because it has locked in a bit higher than I might have preferred. Nevertheless, stability that has been maintained is there. Perhaps it goes some distance to explain our continuing, or what appears to be our continuing, credibility on that issue. Now, the Greenbook does have some inching up of core inflation from here. If they’re right and that’s all we get, then I would be surprised if that led to a real deterioration in inflation expectations. But that may prove to be a big “if.” As far as extending the projections goes, I’m in favor of doing that. I don’t think there will be a huge payoff, but I think it will provide some additional information to us internally and to the public. I don’t have a strong preference about which alternative we go with. Maybe the trial run will point out some advantages or disadvantages that we didn’t anticipate. At the moment, if I had to vote, I’d probably vote for the second alternative, which would be to split the difference, put down the fifth year, and let it go at that. CHAIRMAN BERNANKE. Thank you. Vice Chairman. June 24–25, 2008 70 of 253 VICE CHAIRMAN GEITHNER. Thank you, Mr. Chairman. I think we face an extended period of relatively weak economic growth, quite weak domestic demand growth, and overall growth significantly below trend. I think this is both likely and necessary. It’s likely because we have more weakness ahead as the housing drag continues, financial headwinds remain acute, the economy adjusts to the very large and sustained energy price shock, the saving rate increases, and global demand moderates. It’s necessary to achieve a reasonable inflation outcome over the forecast period. Our central projection has the U.S. economy growing, though at a rate significantly below potential, and then recovering gradually toward trend over the next year. This is our modal forecast; and in this forecast, the economy just skirts a recession. The output gap begins to narrow over the forecast period. Housing prices begin to stabilize only late in ’09, after a cumulative peak-to-trough drop of roughly 12 percent, using the OFHEO repeat sales purchase-only index. Net exports provide a significant, though fading, boost to GDP growth this year and next. We project a very gradual, very modest moderation in core inflation over the forecast period. Of course, this forecast depends on a lot of things happening. It depends on expectations remaining reasonably well contained, energy and commodity prices following the futures curve, the dollar only modestly weaker, somewhat diminished pressure on resource utilization here and around the world, and continued moderate growth in compensation and unit labor costs. Our policy assumption builds in significant tightening—a significant move up in the fed funds rate over the forecast period—though not as soon as the market now expects. The uncertainty around and risks to this central projection are substantial. On the growth front, although we believe the risks of a very deep, prolonged economic downturn have diminished—not on their own but because of the force of the policy response so far—we still think June 24–25, 2008 71 of 253 the risks are weighted significantly to the downside. The main risks remain: the ongoing stress on financial markets; the risk that this further restricts the supply of credit, exacerbates financial conditions, pushes home prices and other equity prices down more further tightening credit conditions, et cetera; a steeper-than-expected rise in the saving rate; and the adjustment to the ongoing drag from energy prices. On the inflation front, we—I think like the rest of you—see the risks ahead tilted somewhat to the upside for many obvious reasons. I think it’s true that, looked at together, the mix of measures of inflation expectations suggests that private agents may have less confidence in the FOMC’s commitment to price stability than they did in previous periods when total inflation was running significantly above core. So this is going to be a very challenging period for policy. It’s not all terrible. Productivity growth is a little higher than we thought. Underlying inflation and long-term inflation expectations certainly could already have been showing signs of a more compelling, immediate danger. Spending has been somewhat stronger than confidence measures would have suggested. The current account balance has narrowed significantly. We are seeing very substantial changes in behavior across the U.S. economy in the consumption of energy. So there are good things to point to. But in the two dangerous areas—in the financial sector and in the global inflation environment—I think things are materially worse than at our last meeting. Again, the risk of inflation is readily apparent. Apart from the numbers, I agree with many of you who said that the alarm and concern is materially higher and materially different today across a broad range of firms in different industries than it was even as recently as two months ago. We have to be worried about intensified pressure on compensation growth even with the degree of slack that we now see in the labor market. Although firms are absorbing in margins a significant part of the increase in unit costs—and a lot of the complaining that we hear is about margins that are June 24–25, 2008 72 of 253 coming down and those that are expected to come down—I do think that firms are demonstrably able to pass on more than they would have been before. Of course, what makes it very hard for us is that the pressure on resources is coming largely from outside the United States and the other major economies, from countries that are growing significantly above trend with central banks that are not independent and are running very expansionary monetary policies. I think we are really seeing an alarming acceleration in inflation rates in large parts of the world for the first time in a couple of decades. If these countries do not tighten monetary policy sufficiently and reduce energy price subsidies materially, then we will have to be tighter than we otherwise would have to be. In the financial world, although I think it’s true that the market believes there has been some significant reduction in the risk of an acute systemic financial crisis, I think we have a long period of acute fragility ahead. We’re in the midst right now of more material erosion in sentiment, spreads, asset prices, balance sheet pressures, and liquidity in some markets. Overall financial conditions are probably somewhat tighter than when we last met. The financial headwinds have intensified again, and they are likely to remain intense for some time. Again, I think this is going to be a very challenging road ahead. It is important to recognize that the current stance of policy embodies not just the fed funds rate today, relative to our best measure of equilibrium, but also the expectations about policy that are now built into the Treasury curve. That policy today does not look that accommodative. If you look at the Bluebook charts and at a range of measures of real fed funds rates today relative to different measures of equilibrium, policy is less accommodative just on that simple measure than it was at the most accommodative point of the last two downturns. That said, we’re going to have to tighten monetary policy, and the question is when. My sense is soon but not yet. Right now we still face a very delicate, very fine balance and have to be careful not to declare victory prematurely on the growth front or on the June 24–25, 2008 73 of 253 financial front. I think it’s going to be hard for us to do that until we see that we are closer to the point at which we can confidently say that we start to see the bottom in housing prices. Also, we have to be careful not to raise expectations too much that we’re on the verge of an imminent, significant tightening in policy. It is a difficult balance. We should take some comfort from the fact that the market believes we will do enough soon enough to keep those expectations down. On the projections front, I have a complicated view, Mr. Chairman. I apologize. If we are going to change, we should focus on stuff that will change things significantly. I don’t see huge gains from the changes in these options to our current communication regime. If we’re going to change, a trial run in the fall is fine. But I think the fall is too soon to change. We need to get through this thing. We have a very challenging period with a lot of stuff going on, and I think we need to use every molecule of oxygen in the System to get through this mess. I don’t think this projections change materially helps the communication challenge in getting through this mess and may complicate it in some ways. If we are going to do something beyond our current regime, I would favor doing something slightly different from this. I would favor at least considering publishing the average of our individual views on what the desirable long-run rate of inflation is, an average of our judgments of what trend growth is today, and maybe what the natural rate of unemployment is today. We know very little about what those latter variables—trend growth and the natural rate of unemployment— are five to ten years ahead. It is very hard for us individually to put much confidence on whatever the path is toward that point. Our current regime for aggregating our forecasts the way we do, tossing out the individuals, makes our basic forecast not particularly useful as a prism. So I would focus on doing something slightly different to change the regime, and I wouldn’t do it this soon. If we’re going to change, let’s debate the big things and not spend too much time on things at the June 24–25, 2008 74 of 253 margin, which fundamentally aren’t going to offer too much promise relative to the level of ignorance we have or relative to the complexity that people face in reading any particular meaningful value in the aggregation of our forecasts the way we now do them. CHAIRMAN BERNANKE. Thank you. Governor Kohn. MR. KOHN. Thank you, Mr. Chairman. My forecasts for both economic growth and inflation are within the central tendency of the rest of you and a little stronger than the staff’s outlook. In fact, my 2008 projections for economic activity for the second half of the year were revised very little from two months ago. Growth turned out to be stronger than I expected in the first half, and that carries some weight going forward; but financial conditions are tighter with higher bond rates and lower equity prices, and of course oil prices are a lot higher and that will damp demand going forward. So I expect slow growth in the second half followed by expansion around, maybe a little above, the rate of growth of potential in ’09 and ’10, with the same basic story that everybody else has: drags on activity from declining housing activity, decreasing wealth, tight credit conditions, and higher petroleum prices. All of those drags will abate over time, allowing the natural resilience, with slightly accommodative financial conditions, to show through, and I assume a gradual tightening of monetary policy beginning next year. Incoming information on prices and costs has been mixed. Oil and food price increases will raise headline inflation, but core has been stable and has come in a little to the soft side of expectations, and labor costs as yet show no signs of accelerating. Going forward, I see a sharp decline in headline inflation later this year with the assumed leveling-out in oil prices and a gradual decrease in core as economic slack inhibits wage and price increases, offsetting the pass-through from oil prices. Now, that’s my central tendency. I consider the odds on that being realized to be even lower than usual, and the usual odds are disappearingly small. It seems to me that the defining June 24–25, 2008 75 of 253 characteristics of the current situation are uncertainty and risk. We’re facing multiple shocks, many of them unprecedented in size and persistence, in the housing market, financial markets, and commodities. The outlook is full of puzzles, and in my mind anyone who thinks he or she understands what’s going on is either a lot smarter than I am or delusional—or both. [Laughter] I class the risks for both output and headline inflation as greater than usual, and let me tell you about some of the things I wrestled with. Financial conditions, are they accommodative? I continue to believe that the 2 percent nominal funds rate is not indicative of a highly accommodative financial condition, given the current state of financial markets. That is, in my view we have limited insurance. Spreads have widened sufficiently over the past 10 months both for long-term and short-term credit, and bank terms and conditions for loans and lines of credit have tightened enough that only a small part of the drop in the fed funds rate is showing through to the cost of capital for median households and firms. The staff’s flow of funds estimates show a marked deceleration in the growth of both household and business debt in the first half of this year, from 10 percent for households last year to 3 percent in the first half of the year and from 12 percent for businesses to 7 percent in the first half of the year. A 2 percent fed funds rate will become accommodative as spreads narrow and financial functioning returns more toward normal, and that’s one reason I assumed a gradually rising federal funds rate over 2009 and forward. The evidence about improving financial markets over the intermeeting period was decidedly mixed. Some spreads did come in from late April. Investment-grade businesses tapped bond markets in size, but almost all spreads remain unusually wide. We were reminded of the fragility of the evolving situation, especially in the financial sector, with the worries about continuing credit problems resulting in sharp declines in equity prices on financials and an uptick in their CDS spreads, which had narrowed the previous month or two; the downgrading of monolines and June 24–25, 2008 76 of 253 investment banks; and the increasing attention to the problems of regional banks. It would be surprising if these were not reflected in even greater caution by banks and other lenders in their lending practices. Also the securitization markets, especially for non-agency mortgages, are not functioning in a way to replace bank intermediation. This is going to be a prolonged process of reintermediation, deleveraging, and building liquidity with an uncertain endpoint. Like the staff, I assume that the conditions return to something approaching normal over the next 18 months, but the risks are skewed toward an even longer recovery period. The second topic is household spending. Households are facing a huge number of adverse shocks: higher oil prices, tighter credit, declining house prices, and rising unemployment. It’s not surprising that confidence is at recessionary levels. It is surprising that spending is so resilient. I assumed that the saving rate would rise very gradually once the tax rebate effects wore off, but I think a more abrupt and sizable increase in household saving is a distinct downside risk. What about housing? Some sales measures have shown a few tentative indications of leveling off. I was encouraged by President Lockhart’s report from Florida, but I’m also struck by renewed pessimism about housing in the financial markets. Equities of construction firms and builders have declined after stabilizing, actually rising, earlier this year. ABX indexes have turned down, reversing earlier improvements; and perhaps underlying the previous two developments, the Case-Shiller futures indexes remain in steep decline, though today’s information was less weak than expected. The view of the financial markets, anyhow, is that the light at the end of the housing tunnel is receding, and declines in expected house prices must be an important reason for the erosion in market confidence in financial intermediaries. In sum, although the incoming data may have reduced the threat of a sharp drop in spending, in my view there remains a very pronounced downward skew around my outlook for modest growth June 24–25, 2008 77 of 253 in H2 and a strengthening next year. However, that downward skew around output did not translate into a downward skew around my forecast for headline inflation. In fact, I saw the risks on headline inflation as tilted to the upside, though roughly balanced around the gradual decrease in core. I think the upside risks result from two additional areas of uncertainty. One area is commodity prices, though the trend increases in commodity prices over the past few years can be attributed to rising demands from emerging market economies relative to sluggishly responding supplies. Despite Nathan’s best efforts, I really don’t think we have much of a clue about the cause of the spike in oil prices this year. It has been especially striking to me over the intermeeting period, when the prices of industrial commodities have been falling on balance. Presumably prices in these markets already incorporate expectations of reasonably strong global growth outside the United States as in the Greenbook. Absent any surprises, futures market quotes ought to be the best guide, but what we don’t understand can fool us, especially when so much of the relevant information involves emerging market economies, where data are sparse and of questionable value. Given our experience over the past few years, I think continued increases in commodity prices would seem to be an upside risk. The other area is inflation expectations. I assume that as headline inflation comes down, both short- and long-term inflation expectations, especially in the survey data, will reverse their recent increases based a lot on the kind of information that President Yellen was observing about how the household survey has tended to follow contemporaneous inflation. I’m encouraged by the relatively flat readings on core inflation and labor compensation increases. Higher expectations have not so far become embedded in prices and costs, despite all the talk of passing along cost increases. But headline inflation is going to rise before it falls. Real wages will be further eroded by higher energy costs. Although this is a necessary part of an adjustment to an adverse terms-of- June 24–25, 2008 78 of 253 trade shock, it will be resisted. Hence, a further rise in inflation expectations and a stronger determination by households and businesses to act on those expectations will be a risk over coming months. With that further rise in oil prices, it’s a bigger risk than it was a couple of months ago. In terms of the long-term projections, Mr. Chairman, I think I’m fine with something like your proposal. Our objective for adding a year was to give the public a better sense of where we’re going over the long term. Given the shock to the economy, that’s not as informative as it was before. I think we’re close to where most people would say their inflation objective was, but not for the growth rate of potential or the NAIRU. I could live with option 3 or President Bullard’s alternative to that—to state exactly what our long-term expectations are instead of talking about five to seven years or five to ten years. I don’t think we’ll gain a lot. I don’t think the costs or benefits are very large on either side of this. Our problems now are not that people don’t understand where we’re going in the end. I think they have a pretty good idea that we want inflation to be a lot lower than it has been. But I think they don’t really understand how we’re going to get either to full employment or to price stability, given where we’re starting. So I think the uncertainty about our objectives is a very small problem relative to the other problems now. But if we can reinforce what those objectives are, it might help a little around the edges. I do worry, as President Lacker said, that what we say about output and employment not be interpreted as goals but rather as a judgment about the state and the structure of the economy. I am hopeful that we could take care of that in what we say about what we’re publishing. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. At this point everything has been said, but everybody hasn’t said it. So let me try. [Laughter] Let me make three summary points, and then I will talk about three issues that I think are harder. First, on the economy, through late May, as the June 24–25, 2008 79 of 253 Greenbook suggests, the real economy proved more resilient and more dynamic than the consensus had anticipated. Consumer spending was moderate but positive, and the labor markets were soft, but neither was necessarily indicative of a recession through late May. Business fixed investment and corporate profits ex financials look all right. Productivity growth looks, frankly, impressive, and corporations, unlike consumers, still appear okay through the month of June—but I’m going to return to June in just a short while. In sum, my assessment of the economy reasonably approximates the average GDP from the Greenbook for 2008, but I remain considerably more cautious on the catalyst for return-to-trend growth in the forecast period of 2009 and beyond. I suspect that this is a long, slow climb with the credit channels needing to be rebuilt and that the process is still in its very early stages. Second, let me talk about the financial markets. Financial markets continue to show tenuous but real improvements in market functioning—which, as Bill Dudley suggested, is remarkable given the weakness among financial institutions themselves. Leveraged loans and high-yield markets continue to trend toward improved market functioning. Credit spreads are well off their March highs. Credit markets, in particular, are holding up well, despite the broad weakness across equities. Third, let me turn to inflation risks. Inflation risks, in my view, continue to predominate as the greater risk to the economy. There is more evidence of a global secular reversal of inflation trends, making the jobs of central bankers worldwide considerably more difficult. I remain worried about energy and food pass-through and the effect of a weakening dollar if our policy rates and those of our major trading partners are perceived to diverge. I would expect import prices, core inflation, and expectations to move up in the coming months even more than in the Greenbook, likely causing a policy response by our foreign peers. Commodity prices, again, with the exception June 24–25, 2008 80 of 253 of metals, have been moving up while global demand is falling, and markets have come to see this rise of some, if not most, commodities as essentially permanent. So at the end of the day, we have to be concerned about this period of above-acceptable inflation. It’s crucial that broader prices do not start to rise at still-faster rates, and that could well happen if those making decisions about prices and pay expect higher inflation in the future. Anecdotes are not comforting, particularly on the price front. As a result, I think the trajectory of inflation is less favorable than in the Greenbook, thereby necessitating a policy response more significant than the Greenbook would suggest. Let me turn to three even harder issues. One is consumer spending. We’re not done with the second quarter, and my sense of what’s happened in the first three weeks of June is pretty miserable. I hate to extrapolate based on three weeks of data to the trajectory of the economy. But from a discussion with contacts from three credit card companies that constitute a little more than half of the credit card spend, I would say that the views from these guys were shocking in how bad things looked in the past three to four weeks, particularly in comparison to reasonably positive news from the previous two months. It is suggestive that June will be much weaker than May, and if I add that to the figures on autos that are coming out of the Detroit Three, those are a couple of anecdotes that make me a little hesitant to declare with an exclamation mark what an enviable second quarter we’ve had. I also look at equity market prices sometimes as maybe telling us something. I would say that consumer companies and retailers over the last three weeks have gotten killed. So I’m a little hesitant to suggest that the second quarter is going to be strong. Delinquencies and charge-offs have also moved meaningfully to the downside in the last three or four weeks among these credit card companies, and this weakness appears to be much more focused on the coasts than it is in the center of the country. I heard that from three of three. My own view June 24–25, 2008 81 of 253 may be influenced by my take on the fiscal stimulus—it sure doesn’t appear to be helping very much. The second issue that I continue to struggle with is financial institutions. Financial institution equity prices showed significant underperformance, and some people say that is the Federal Reserve’s fault. We’re talking up our concerns about inflation. We’re changing the Treasury curve going forward. I think that is a total red herring. The reason that financials are getting killed is an equity story. They have business models that are having a hard time delivering profits in this environment. They have had to show a very tough quarterly set of losses. I think the problems on financials have to do with financials and not with the Fed, though there is a disturbing amount of chatter in the markets that somehow we’re the cause of that. I am comforted, again as Bill Dudley reminded us, that the broader market functioning has been able to withstand this dramatic financial institution weakness. Whether at some point that will give out I don’t know, but I’d say that’s extremely encouraging. In addition, we have to recognize that massive amounts of new capital are going to be needed for financial institutions of all sizes. Given the weak performance of virtually every financial investment from November till now, I think it is very easy to see a supply–demand problem. It is very easy to see that, with the number of banks that come to these markets, some of them at some point might not be able to find capital even at dramatically lower prices than their expectations. It is prudent for us at the Fed to think about alternative sources of more-patient institutional funding during this period. The third issue for discussion is credit availability, especially for small businesses. This strikes me as being key to the labor market situation. Credit availability for small businesses has held up better than I would have expected four or five months ago, but pockets of weakness remain, particularly among the regional banks, which are a source of concern. I guess I’ve become June 24–25, 2008 82 of 253 convinced that credit lines have not been tapped out. There was a theory, one that I even had some sympathy toward, that increases in C&I lending in the last few quarters were involuntary, reflecting existing credit lines that were called upon. That strikes me as being somewhat overstated. According to anecdotes and our own survey of the terms of business lending, it does suggest that capital is still available for these small businesses to provide some strength to the economy; but again, continued weakness among the regionals could call that into question. Let me turn finally, Mr. Chairman, to the projections. I have some sympathy for the view that Vice Chairman Geithner put forth. It strikes me that at this time the markets will see the benefits of changing our communication strategy as, yet again, pretty small. The costs are harder for me to be certain about. So if anyone is proposing to do this during the next six months, I would have real hesitancy about introducing this variable into our communication strategy amid our assessment of all the other challenges that we have. So I favor having a trial run come October, but I think we should revisit where we stand on the inflation front, the financial institution front, and the growth front before adding this to the mix. To the extent that we find the appropriate time to go down this path, I would favor option 3. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. MR. KROSZNER. Thanks a lot. Well, as I’ve mentioned many times before, I have thought about this as sort of a long, slow burn scenario; and as we well know, the embers are still smoldering. It seems to be less of a risk that they could re-ignite, causing a major conflagration; but there is still some chance of re-ignition, and I think there’s still a fair amount of heat. Consistent with that, my central tendency view is probably closer to the Greenbook’s “delayed credit recovery” alternative scenario than to the main Greenbook forecast. In looking at the alternative scenario, there’s not much of a real effect on growth, but that response is due to a lower fed funds path. June 24–25, 2008 83 of 253 Given the discussions that we’ve had, I think it may be very difficult to pursue something like that in this environment, particularly given higher uncertainty about inflation and inflation expectations, even if, as a number of people have mentioned, inflation expectations haven’t moved up that much or you pick your favorite measure and some have moved up more than others. Given that it’s likely that we had some transitory factors keeping core and headline inflation down a little lower than they otherwise might have been and they probably are going to go up, I think that dealing with the “delayed credit recovery” alternative scenario in the way that’s discussed in the Greenbook makes our policy choices particularly difficult. So let me focus briefly on why I think the delayed credit recovery or slow burn scenario is a reasonable central tendency one. I think it relates largely to our continuing challenges on banks’ balance sheets, liquidity, and capital. Banks are facing very high short-term financing costs. Those LIBOR–OIS spreads are still at extremely elevated levels compared with what they’re used to in funding themselves, and this is true whether they are commercial banks or investment banks. The forwards suggest that this ain’t going away anytime soon. So one thing that this does is simply to cut into profitability and the ability to earn your way out of the challenges. An easy way to do it— of just allowing the machine to go forward—is going to produce less than it otherwise would. A lot of institutions rely on the Federal Home Loan Banks, but those are largely tapped out as another source of financing. We know that the monoline issue has sort of come back, and the challenges there are great. It is undoubtedly going to be leading to a lot more write-downs over the next couple of quarters. On the other hand, as President Lockhart, Governor Warsh, and some others have mentioned, there have been a few areas that seem to have opened up. The leveraged-loan market seems to have opened up a bit. People seem to be getting those leveraged loans off their books— and not even at effectively subsidized financing rates. They were proud of getting these off their June 24–25, 2008 84 of 253 books before, but they were doing it by basically just making another loan, which effectively doesn’t get them off the books. Now it seems as though they are legitimately able to move this, and obviously that book is not growing. That book is shrinking. Of course, one of the biggest challenges is in housing, and I see the shocks of some of the resets from the nontraditional mortgages continuing through ’09. We’re seeing very significant increases in delinquencies and foreclosures, not only in the subprime space but also in the adjustable rate space generally—that’s both subprime and prime, although the levels for prime are dramatically lower. The increases are quite significant for prime ARMs, and that starts to raise some challenges for the institutions that didn’t do subprime but may still have a reasonable amount of prime ARMs on their books. HELOCs have been mentioned and the inability to securitize anything that’s nonconforming. We’ve seen very little benefit yet from the changes that allow Freddie Mac and Fannie Mae to raise those limits. Also, as many of you know, from my visits around the country to your Districts, I see that conditions in different areas are dramatically different, but in general a lot of markets remain in very difficult circumstances. One of the largest mortgage lenders in the country said that, over the last couple of months, their average FICO score on what they’ve been originating outside the conforming market has been 800. That’s astonishingly high—so that gets back to President Yellen’s comment about even with FICO scores in the stratosphere—and they claim that’s an average FICO score, and they have been pulling back on the HELOCs et cetera. On rising delinquency rates for credit cards, I didn’t hear quite as bleak a view as Governor Warsh described. I wouldn’t want to say a positive view. They seemed to say that it is where they would have expected it to be in this part of a cycle with increasing delinquencies. One thing that they were seeing was a little increase in payments, and so that may be one of the consequences of the stimulus check coming—that people are using it to pay down some of their credit card debt. But June 24–25, 2008 85 of 253 a big challenge that they have been seeing is the so-called roll rates—that once someone begins to go delinquent, they tend to roll right to full loss rather than getting some recovery. It suggests that, when people get into trouble, they are in fairly deep trouble. All of this means that the demand for capital is going to be very high going forward at these institutions as provisioning has to go up. You know, we’ve tapped sovereign wealth funds, institutional investors, and a lot of others. As Governor Warsh said, tapping other sources, encouraging perhaps private equity to come in, is something that’s important. But how long are these guys willing to invest when over the past nine months every single investment has seen a reduction rather than an increase in value? I’m borrowing a prop from President Fisher—we have been going around and saying, “Raise capital. You’re worth it.” [Laughter] I hope the investment banks are going around to their shareholders and saying that also. So far there’s not a lot of evidence that they have been. I think in the long run they will, but we have to worry about that. This slow burn scenario is even more problematic in the context of what Vice Chairman Geithner mentioned about some slowing of foreign demand that I think may be coming and in the context of a fair amount of increases in interest rates that may be coming in a lot of these countries. You’re going to be seeing some credit tightening globally, as I think a number of people have mentioned. It is more likely, unless there’s a major shock, to be more on the tightening side going forward. This makes it more difficult to deal with some of the issues in the “higher inflation expectations” alternative scenario that was in the Greenbook because, when you have this financial fragility, it’s harder perhaps to raise interest rates as quickly or as much as you would like because of the concerns about what might happen in the financial markets. On inflation, I think much like President Stern and a number of others—it depends on which particular series you look at. It is hard to say that things have really become unmoored, but I think June 24–25, 2008 86 of 253 there’s a lot more uncertainty in the minds of both the public and the market participants about where inflation may go. That’s particularly problematic when you have the likely increase in the actual numbers coming that the Greenbook is forecasting for the next quarter or so; and in that context, dealing with some of the challenges is more difficult. But we’ll talk about that more tomorrow. On the projections, I think it is important that we continue to increase transparency over time. We structured what we did last time to make it part of a process, and I think it makes sense to periodically revisit whether we want to continue on that road. I very much prefer a gradualist approach, in principle, to add year 5 or so—as the Chairman said—but I think there’s a bit of a problem in doing that because too much meaning may be attributed to it. It may be too difficult to avoid saying, “Well, we’re just doing a target.” If we add year 4 and year 5, even though there’s not a lot of information content in year 4, I think it helps to reduce the kind of shock value of seeing that fifth year out there. Now, that’s potentially a negative because, in some sense, we want to provide more information that way. But given the fragile conditions, as Vice Chairman Geithner mentioned, I don’t think that we want to generate a debate on inflation targets, employment targets, and other things like that particularly right now. So maybe having a gradualist approach, by which we just extend things to year 4 and year 5, which is seen as a natural outgrowth, wouldn’t be as much of a shock. Not that I think it would be shocking, but I think it might raise as many concerns and as much of a debate and distract us from the key issues that we have before us. Thank you. CHAIRMAN BERNANKE. Thank you. Governor Mishkin. MR. MISHKIN. Thank you, Mr. Chairman. Well, we have seen recent data that actually have been stronger than expected. Also as time goes on, there seems to be a lower probability of financial meltdown and these adverse feedback loops that we’ve all been discussing. But I don’t June 24–25, 2008 87 of 253 think we want to become too sanguine about the current data because some very negative things are going on that might tell us that this is just very temporary stuff. In particular, it’s really remarkable how weak consumer sentiment is. There is also a huge hit from energy prices, and it’s going to get worse. One thing in the Greenbook is that the very low margins that we’ve had in refining are going to increase, so we’re going to see gasoline prices that are well over $5.00 a gallon, according to the kind of numbers you’re coming out with, and that is going to be a major contractionary hit to household spending. Luckily I don’t drive much anymore—I’m down to less than 600 miles a year right now—so maybe that is okay, but unfortunately I’ll get back to driving more in the future. In any case, I do think that what the Greenbook has done is reasonable in terms of changing the forecast. They have a stronger first half, but the longer-run forecast, particularly regarding the output gap, is really not very different, and I think that’s a reasonable forecast. My baseline is somewhat less optimistic because I feel that the “delayed credit recovery” alternative scenario was actually a nice one to put in this Greenbook, and I was glad to see it because it is very close to the way I am thinking about the situation right now. I think there’s going to be a much slower recovery of financial markets than was in the Greenbook baseline because two things have to occur for us to get back to normal underwriting. This, of course, doesn’t mean what we had before, which did not have serious enough underwriting standards, but something we think is realistic given the kinds of risks in the economy. Financial institutions have to have enough capital just to make loans—so there’s the direct effect that we think about. But also the securitization market is clearly very impaired. Eventually it will come back, but it will need new business models to solve the agency issues that have led to all of the heartache that we’ve seen recently. When I think about how that is going to happen, I think the large financial institutions have to play a key role because you need somebody who will originate these loans and then will have the incentives to make sure that the June 24–25, 2008 88 of 253 agency problems are not severe. Only when that’s done can they be sold off, and that requires that there is recourse, which requires that they have plenty of capital. Of course, it is a very slow process for them to build up capital in the current environment. So given that situation, I think the idea that the financial markets will be back to normal over the next year or two is a little optimistic. It’s going to take a long time for this to get worked out. So the bottom-line scenario is one in which we’re going to have strong headwinds for quite a time, and that’s going to be important in terms of our monetary policy stance. When I think about inflation, as you know, I put a lot of emphasis on long-run inflation expectations and on expectations about future economic slack in the economy. At this point, I do not see a major change and deterioration in long-run inflation expectations. I’ll explain that in a second. I should emphasize that I say that is true so far. But an issue is whether that will change, and that’s going to be very important in terms of how we manage monetary policy. The first things I look at when I think about long-run inflation expectations are, of course, the surveys of consumers. As you know, I’ve always been a little skeptical of them, but I think that my views are very similar to the ones that President Yellen mentioned. I have a slightly different explanation using behavioral economics. Behavioral economics tells you that surveys will rise a lot with what happens currently and overreact and that’s exactly what should happen because it’s a framing issue. You see very high headline inflation. You’re going to raise expectations of inflation one year out. But it’s very natural that you’re going to raise them for the longer term, and they’ll come back down when headline inflation comes down. So I really am not as concerned about the survey expectations being a long-run problem as long as inflation comes back down. I think there are good indications that it will, given that headline is so much higher than core and that core has actually stayed very stable. June 24–25, 2008 89 of 253 The other things that I look at, and look at much more seriously, are the Surveys of Professional Forecasters (which have basically moved up a bit but not very much and have not gotten much out of the range in which they have been in the past) and then information from financial markets, that is, inflation compensation. Again, that has not risen recently, and actually it’s better than it was at its peak. So I don’t see a huge problem there. What this tells me about the inflation forecast is—you know, I’m a 2 percent kind of guy on PCE, and I’m still a 2 percent guy—that even though headline inflation is very elevated, we’re going to see over the forecast period that inflation will come back down to around the 2 percent level both on the headline and on the core. However, though my baseline on this is that inflation will return to a level that, by the way, I am comfortable with as an inflation objective, I do very much worry that inflation expectations could be more fragile in the current environment. So it’s not that I think we have to do something now. But we do have to be extremely vigilant to see whether inflation expectations are actually starting to move in an undesirable direction, and if so, we will have to take action. The challenge may be that we have to take action when unemployment is still rising, but what is key is that we have to be aware of that. My modal forecast is that it isn’t going to happen, but I think we have to be ready to deal with it and deal with it quickly. As you know, I’m not a believer in gradualism in circumstances such as we are in currently, and I think this applies to dealing not only with financial disruptions but also currently with inflation expectations. We have to be willing to move very quickly in that context. Let me turn to the issue of long-term projections. You will not be very surprised to know that, in fact, I’m a supporter of this. This Committee has actually been well served. Even though it is not my normal personality—as you know, I like to move fast on things—we have moved in an evolutionary process in terms of communications, and I think that has worked quite well for us. June 24–25, 2008 90 of 253 This is just an obvious next step. Our communication strategy in terms of the long-run projections now has an important flaw in that we are not providing the information that we intended to provide, and it needs a fix. We now realize that that’s the case. It’s particularly relevant concerning information about potential output growth and the NAIRU. I do share the concerns that President Lacker mentioned on these, and I have talked about this in many speeches. I think this can be handled by speeches—in particular, by the Chairman emphasizing these issues going forward. So I don’t see it as a huge problem, but it is something that we have to deal with. In any case, we need to clarify what our projections mean. We’re not providing information that we should. We have to fix it, and there’s no reason not to. I think it’s a minor change. I do not think that there will be much reaction by the markets or in the political sphere on this. I agree completely with Governor Kohn that, relative to the other problems that we are dealing with, this is very small potatoes; but I think it is good to show that we’re still sticking to the basic things that we need to stick to and that, in this very complex environment, we can do the things that need to be done on communication strategy. That argues that we should be doing this and even doing it right now. Regarding the issues that you raised about going more to the full Monty on this kind of stuff, I do agree with Vice Chairman Geithner that now is not the time to do that. I should mention that I will be giving a speech in which I will be advocating going to an explicit inflation objective, but that’s because I’m leaving the Board, and I have to say what I think. But there’s an issue in terms of what this Committee should be doing, and I am sympathetic to Vice Chairman Geithner’s view that this is not what we should be doing for the Committee right now. On the other hand, I’m a free individual now. In going back to be a civilian, I can say what I want. In terms of my preferences, I really don’t feel strongly. There are a lot of issues here. When I first thought about it, I preferred an option like 3 because I didn’t want to give the impression that June 24–25, 2008 91 of 253 we’re great at forecasting five years out, and I think that’s really the strongest argument for it. But I do understand how we articulate that is a little tricky, and I think that’s something that we have to think about. It might be clearer to do something along the lines that President Bullard discussed, as arguing it that way, but maybe we can do it in some other way. I think that’s exactly why the staff can have some extra work for themselves to think about the best way to describe this, but I think something along the lines of providing information that we actually are putting in our projections right now, where we have a little section that says, “What are your long-term assumptions?” and we put them down. Somehow we need to convey that information to the public. Then the question is, What’s the best way to do that? You can have all the wonderful arguments that we have over the statement each period. We’ll get something like that going, and I think we’ll figure it out. Thank you. CHAIRMAN BERNANKE. Thank you, and thank you all. First, on the long-term projections, I think there’s consensus that we should just go ahead and have a trial run. The staff should review the transcript and make gold out of straw there. We should consult with the subcommittee, and we should think about maybe even a couple of alternatives. Maybe we could try a couple of alternative ways of doing it in October. So let’s go ahead and do something along those lines and keep thinking about how best to do it. Let me first, as I usually do, try to summarize the discussion around the table, and I’ll add some comments of my own. Beginning with the summary, the incoming data were stronger than expected, notably for consumer spending but for some other components as well. As a result, economic growth in the second quarter, though not robust, was likely positive, continuing the pattern of weak but positive growth since the fourth quarter of 2007. However, to the extent that strength in consumption was transitory or due primarily to fiscal stimulus, some of the growth in the June 24–25, 2008 92 of 253 second quarter may have been borrowed from the second half. Participants generally saw growth continuing at a slow pace the rest of the year and improving in 2009. There was, however, some divergence of views, with some expecting a longer period of slow growth. Recent numbers on retail sales suggest that the consumer is holding up better than expected. Consumer finances may be better than feared, and the fiscal stimulus may already be having an effect. However, as many have noted, there are substantial drags on consumption going forward, including falling wealth and income, credit constraints, and the recent rise in energy prices. Sentiment has also fallen noticeably further. Weaker consumption may, thus, restrain growth later this year, particularly after the effect of the stimulus wanes. Labor markets continue to soften but at a relatively moderate pace. The peak in unemployment is projected to be between 5½ percent and 6 percent. That’s what I generally heard around the table. Prospects for housing continue weak, with falling prices, high inventories, and weak demand. Some saw a possible bottom forming but noted that the recovery of this sector is still some way off. As has been the case for a while, businesses are quite cautious, noting economic uncertainties and surging input costs, with one or two mentions of tighter credit, although that was not a dominant theme today. Real exports continue to grow and are partially offsetting weaker domestic demand, especially in the case of manufacturing. Financial conditions have been mixed since the last meeting, although the improvements from March have largely been maintained and the risk of systemic crisis may have receded to some degree. Funding markets are generally doing better. The concerns about credit losses have led the stock prices of banks, including regional banks and investment banks, to fall sharply. Capital raising continues, though at less favorable terms and with perhaps declining availability. As the economy continues weak and housing contracts further, more credit losses for banks may well be in store, adding to financial market stress and reducing the availability of new credit. Progress in the June 24–25, 2008 93 of 253 financial markets is likely to be slow as the deleveraging process will take a while. Stock prices in general are also lower. Financial conditions in the housing market remain important downside risks to growth, with the spurt in oil prices adding to those risks. Uncertainties about the growth prospects are great. However, tail risks may have moderated somewhat. Readings on core inflation have remained relatively moderate. However, the sharp rise in oil prices and some other commodity prices, in part reflecting flooding in the Midwest, is likely to lead to very high levels of headline inflation over the next few months. Gas and food prices have become perhaps the most important economic issue for consumers, and firms are feeling everincreasing cost pressures. Moreover, inflation pressures are global. There are increasing reports of firms being able to pass through these costs, which could lead to an increase in core inflation. On the other hand, slack may restrain core inflation increases. Measures of longer-term inflation expectations have been up a bit on net since April, depending to some extent on the measure chosen. Nominal wage growth is still slowing. Participants debated how much comfort to take from slow wage growth, some arguing that, by the time wages reflected higher inflation expectations, it would be too late. Most saw inflation risks as now to the upside, with the primary concern being the possibility that inflation expectations could rise further as headline inflation rises and more costs are passed through. That’s my very, very quick summary. If anyone has any comments, I’d be happy to hear them. If not, let me just say a couple of words on my own views here. This may come as a surprise to some of you, but I am not a fine-tuner. I think that the objective of the Federal Reserve ought to be to avoid a very bad outcome, and so my concerns are primarily with tail risks on both sides of our mandate. I think that the evidence of the last month or so provides a bit of reassurance, on both the real side and the financial side, that the tail risks on the growth side of the mandate have June 24–25, 2008 94 of 253 moderated somewhat. That being said, I think they remain and are still significant. In particular, as I mentioned in the summary, I am at this point still suspicious of the strength that we saw in the second quarter. If we look at the fundamentals for consumption—including wealth, income, employment, and energy prices—and look at the plunge in sentiment, which is at remarkably low levels, I think there’s a very good chance that consumers will weaken going forward and bring the rest of the economy along with them. In addition, of course, housing remains extremely uncertain. We are at best some distance from stabilization in that market. Even when residential construction begins to stabilize, we’ll still see continuing declines in house prices, which will affect consumer spending and, importantly, will affect financial markets as well as the value of mortgages. With respect to financial markets, I agree certainly that the crisis atmosphere that we saw in March has receded markedly, but I do not yet rule out the possibility of a systemic event. We saw in the intermeeting period that we have considerable concerns about Lehman Brothers, for example. We watched with some concern the consummation of the Bank of America–Countrywide merger. We worried about a bank in the Midwest. Other regional banks are under various kinds of stress. We’re seeing problems with the financial guarantors, with the mortgage insurers. So I think that those kinds of risk are still there, and we need to be very careful in observing them. Moreover, even if systemic risks have faded, we still have the eye-of-the-storm phenomenon—we may now be between the period of the write-downs of the subprime loans and the period in which the credit loss associated with the slowdown in the economy begins to hit in a big way and we see severe problems at banks, particularly contractions in credit extension. So I’m not yet persuaded that the tail risks are gone. I think it would be very valuable to have some more data, some more observations, to see how the financial markets and the economy are proceeding. But I want to say that I do agree that the developments in financial markets and the June 24–25, 2008 95 of 253 surprisingly strong data in the second quarter should lead us to feel somewhat better. I think we should take a little credit for our various efforts to support both the financial system and the economy. Now, what about tail risks on the other side—on inflation? The increase in oil prices that we’ve seen in the past six weeks is obviously very, very bad news. I think that the combination of the commodity price increases and what we’re going to see as very ugly headline inflation numbers is beginning to generate a tail risk on that side of the mandate as well, and I am becoming concerned about that. Indeed, I think that it’s now appropriate that we begin, as some of us already have, to move rhetorically toward acknowledging that risk and agreeing that it may be at the point where it even exceeds the risk that we see on the growth side, although I think we’re very uncertain about that. Now, the concern I have is the following, which is that there has been a lot of talk about policy action. I don’t think that a 25 basis point or even a 50 basis point move, if it’s not viewed as being the start of a continued increase, is going to do very much on the inflation side, frankly. We had a good test of that over the intermeeting period. Partly because of our rhetoric and for other reasons, the dollar strengthened. The two-year rate rose 50 or 60 basis points, and oil prices went up $25. I do not think that with a small change in our stance we can do anything about commodity prices, and frankly, it’s commodity prices that you’re hearing about from your Board members and from people you talk to. It’s the real change in the relative price of those commodities that is painful and the real change in the terms of trade coming through the dollar which is painful, and I don’t think we can do very much about those in the short term. Our objective, of course, as everyone has noted, is to prevent that from becoming a sustained and persistent source of inflation. June 24–25, 2008 96 of 253 So the problem then is that a small amount of movement will not solve the problem. A small to moderate movement, however, might create some serious financial strains given the fragility of the system. I think what we need to do is to decide when we reach that tipping point. There will be a tipping point at which we’re sufficiently confident that the system is stabilizing and that we can begin to turn in a serious way to the inflation concern. A partial one step, unless it signals a longer-term tightening program, could give us the worst of both worlds. We will just have to make the judgment about when we have reached the point of having to switch from our previous approach of supporting the economy and financial system to an approach that is aimed more at containing inflation. It’s going to be a very difficult and delicate situation, but I want to express again my agreement with those of you who are worried about inflation and my belief that the time might be relatively soon. But it’s going to be a very, very delicate decision and one that we have to make with great concern and consideration. A little anticlimactically, I would like to say just a couple of words about the 1970s because they keep coming up and I do think that these comparisons are a bit misleading. First, in the current episode, commodity prices—particularly oil prices—are basically most or almost all the inflation that we’re seeing. That was not the case in the ’70s. In particular, inflation rose considerably before the first oil price shock in 1973. PCE inflation was 5 percent in 1970, which prompted the wage– price controls, of course, which is an episode we’re all familiar with; and in 1972, before the oil shock, average hourly earnings were growing between 7 and 8 percent. There was already a serious inflation problem before the oil price shocks came. Hence, credibility was already damaged at the time of the oil price shocks. That is not the case here. Second, the movement in wages and core inflation following the oil price shocks in the 1970s was very striking. From the time of the oil price shock right before the second quarter of June 24–25, 2008 97 of 253 1973 until the first quarter of 1975, total inflation rose a little over 5 percentage points, reflecting the quadrupling of oil prices. During the same period, core inflation rose more than 6 percentage points. In other words, core inflation responded almost one for one to total inflation. Moreover, average hourly earnings rose more than 2 percentage points, and productivity and cost compensation rose 3½ percentage points in that year and a half. So there was a very strong sensitivity of expectations and pass-through to these commodity price shocks. Obviously, we’ve been seeing oil price increases since 2003, and they have not yet shown anything like that effect on core inflation or on wages. The final observation I’d make about the 1970s is that we shouldn’t forget that, even in that very bad situation with very poorly anchored inflation expectations, the slowing of the economy did do something to reduce inflation. In particular, core inflation fell 3½ percentage points during 1975 following the 1973–75 recession. So while we cannot do much about oil prices, I do think that there is some hope that weakness in the economy is going to provide some restraint on core inflation, which of course will generate a more stable total inflation rate if and when commodity prices stabilize. So I’ve been very all over the map here. I apologize. I tried to organize my thoughts in the meeting. My bottom line is that I think the tail risks on the growth and financial side have moderated. I do think, however, that they remain significant. We cannot ignore them. I’m also becoming concerned about the inflation side, and I think our rhetoric, our statement, and our body language at this point need to reflect that concern. We need to begin to prepare ourselves to respond through policy to the inflation risk; but we need to pick our moment, and we cannot be halfhearted. When the time comes, we need to make that decision and move that way because a halfhearted approach is going to give us the worst of both worlds. It’s going to give us financial stress without any benefits June 24–25, 2008 98 of 253 on inflation. So we have a very difficult problem here, and we are going to have to work together cooperatively to achieve what we want to achieve. The last thing I’d like to say is on communications. Just talking about communications following this meeting, I’d like to advise everyone, including myself, to lean, not to lurch. That is, we are moving toward more concern about inflation, but we still have concerns about economic growth and financial markets. We should show that shift in emphasis as we talk to the public, but we should not give the impression that inflation is the entire story or that we have somehow decided that growth and financial problems are behind us, because they are not. So if we can convey that in a sufficiently subtle way, I think we will prepare the markets for the ultimate movements that we’re going to have to make. Again, I very much appreciate your insights and your attention today. We have a dinner at 7:30, and for that reason I think we should probably bring this to a close. We’ll start tomorrow morning with Brian’s presentation of the policy options. The statement is essentially the same as the Bluebook’s. There won’t be any surprises there. So we’ll begin with that first thing in the morning. Thank you. [Meeting recessed] June 24–25, 2008 99 of 253 June 25, 2008—Morning Session CHAIRMAN BERNANKE. Good morning, everybody. PARTICIPANTS. Good morning. CHAIRMAN BERNANKE. We have two major items this morning. We’ll first complete the discussion of policy action and the statement; and in the second part of the meeting, we’ll discuss supervision of investment banks and some related policy issues. Over lunch, if time permits, we’d like to hear Laricke Blanchard talk about congressional developments, and we’ll have a chance to ask questions there as well. So without further ado, let me turn to Brian to introduce the policy discussion. MR. MADIGAN. 4 Thank you, Mr. Chairman. I will begin by referring to the draft announcement language in table 1, included in the package labeled “Material for FOMC Briefing on Monetary Policy Alternatives.” As Chairman Bernanke noted yesterday, this version is only slightly revised from the version discussed in the Bluebook. Rather than keep you in suspense, I will note now that the revision is simply to strike the phrase “near-term” from alternative B, paragraph 4. Turning first to alternative A, the Committee would ease policy 25 basis points at this meeting and would issue a statement similar to the one published after the April FOMC meeting. The second paragraph would indicate that economic activity has remained weak in recent months. It would recognize that consumer spending appears to have firmed but would go on to mention other aspects of economic performance that remain weak. The paragraph on inflation would cite the recent further increase in energy prices but would also note the stability of core inflation. It would again express the Committee’s expectation for inflation to moderate, partly reflecting a leveling-off of energy prices, but would acknowledge that uncertainty about the inflation outlook remains high. As in April, the final paragraph would be silent on the balance of risks and on the likely path of policy. For most of you, your baseline outlook would seem to provide little support for selection of alternative A at this meeting. As was noted yesterday, most of you conditioned your projections on a path for policy that begins to tilt up either immediately or sometime in the next few quarters. With such a policy path, the central tendency of your projections points to a gradual pickup in economic growth and a fairly prompt drop in total inflation as energy and other commodity prices level out but only a gradual decline in core inflation, which reflects the moderate amount of economic slack that you foresee over the next few years. As was illustrated in one of 4 The materials used by Mr. Madigan are appended to this transcript (appendix 4). June 24–25, 2008 100 of 253 the optimal control simulations presented in the Bluebook, a case can be made for alternative A if you agree with the staff baseline outlook and favor aiming for 2 percent inflation over the longer term. One of the estimated policy rules presented in the Bluebook also suggests modest further easing, but again that prescription relies on the staff’s forecast rather than on your generally stronger near-term outlook. But given the modal outlooks of most members of the Committee, any case for easing at this meeting would seem to be best motivated by persisting concern about the downside risks to growth that many of you again cited in your forecast submissions. The “recession” simulation in the Greenbook provided one plausible scenario for the realization of such risks and suggested that the funds rate might need to be lowered to 1½ percent. Under alternative B, the Committee would leave the stance of policy unchanged at this meeting. The statement would note that economic activity continues to expand and, as in alternative A, would mention the firming of consumer spending. It would cite the same factors that could restrain economic growth that were referenced in April and would add the rise in energy prices to the list. The inflation paragraph would again convey the Committee’s anticipation that inflation will moderate but would elide the explanation for that expectation and would reference high uncertainty about inflation prospects. The final paragraph would indicate that the downside risks to growth appear to have diminished somewhat and that the upside risks to inflation and inflation expectations have increased. As I noted previously, we have suggested that the phrase “near-term” be struck as the Committee’s focus presumably is on longer-term inflation. The references to risks to both growth and inflation would be consistent with the concerns that you expressed in your forecast submissions. The statement proposed for alternative B seems generally in line with market expectations, and an announcement along these lines is unlikely to provoke much market reaction. By pointing to reduced risks to growth and increased risks to inflation while not explicitly stating that the inflation risks predominate, the Committee would likely be seen as suggesting that its next policy move could be toward firming but also that such a move probably was not imminent. A policy approach along the lines of alternative B seems generally consistent with the projections that many of you provided for this round. Although most participants conditioned their projections on a steeper policy path than the one in the Greenbook, many also appeared to assume that the firming process would not commence until later this year or in 2009. A decision to stand pat at this meeting might be motivated importantly by your sense that the risks in both directions around your baseline projections are substantial. While staying your hand today might risk a further upcreep in inflation expectations, you might also be concerned that a policy firming now, given that financial markets are still fragile, would risk having outsized market effects with adverse implications for an economy that remains weak. As a result, you may see benefits to allowing more time for financial markets to recuperate and more time for information on the outlook to accumulate before taking policy action. Holding the funds rate at 2 percent at this meeting would be consistent with the June 24–25, 2008 101 of 253 Committee’s past behavior as captured by the estimated outcome-based rule presented in the Bluebook. Under alternative C, the final column, the Committee would firm policy 25 basis points at this meeting. In the statement, the paragraph on real activity would be identical to that for alternative B. However, the third paragraph would provide the motivation for the action by emphasizing that overall inflation has been elevated, that energy prices have risen further, and that inflation expectations have risen further. No assessment of the balance of risks would be provided in the final paragraph, thus avoiding a suggestion that the firming signaled a sequence of further rate increases. Nonetheless, with market participants currently seeing only a small chance of a rate increase at this meeting, an announcement along the lines of alternative C would likely prompt a considerable jump in short- and intermediate-term market interest rates. Although most of your forecasts appeared to assume that policy firming would begin later this year or early next year, some of you explicitly assumed an earlier start to policy tightening. Members might believe that firming at this meeting is warranted partly by evidence of some reduction in downside risks to growth. Recent spending data suggest that economic activity has a bit more forward momentum than previously perceived, reducing the odds on recession; the modest improvement in financial market conditions points to some reduction in downside risks; and the Federal Reserve’s special liquidity facilities appear to have been successful in reducing the odds of negative tail events and severe adverse feedback loops. Thus members might see it as appropriate now to begin to reverse some of the Committee’s past policy actions to the extent that those actions were seen as motivated by downside risks that have now diminished. Also, near-term firming might be motivated by the further increases in inflation pressures and risks resulting from the continued upward march of energy and some other commodity prices. Finally, with inflation expectations continuing to show some signs of moving up, a firming of policy at this time might be viewed as a timely shot across the bow that could be helpful in restraining such expectations. I thought that it might be helpful to conclude by reviewing two exhibits from the medium-term strategies section of the Bluebook, starting with the optimal policy simulations that are reproduced in exhibit 2. The simulations underlying these exhibits are based on the FRB/US model after adjusting it to line up with the Greenbook forecast and extension. As usual, these simulations assume that you aim to minimize the sum of squared deviations of inflation from target, squared deviations of the unemployment rate from the NAIRU, and squared changes in the nominal funds rate. Two key points can be drawn from these simulations. First, whether policy firming should begin sooner or later may depend partly on your longer-run inflation objective. As shown by the black line in the top right-hand panel, if your objective for the longer run is to get back to a 2 percent inflation rate, these simulations suggest that you can hold the funds rate steady or even ease slightly June 24–25, 2008 102 of 253 further before beginning to firm in 2010. This policy path produces a somewhat faster decline in the output gap and thus somewhat slower disinflation than in the Greenbook and extension. In contrast, the simulations shown in the left-hand column suggest that pursuit of a 1½ percent inflation objective would involve policy firming beginning quite soon. In general, the policy paths described by many of you in your forecast submissions seem to fall between these two scenarios, apparently reflecting your sense that aggregate demand growth could be a bit stronger and inflation pressures a bit more intense than projected by the staff as well as your dissatisfaction with a path for inflation that is as shallow as that for the scenario with a 2 percent inflation objective. The second point underscored by these simulations is that, even though the nearterm path for the unemployment rate is a bit lower than in April, reflecting the recent indications of somewhat greater strength in aggregate demand, the medium-term outlook involves larger and more persistent slack than foreseen in April under either inflation goal. Despite that greater slack, as shown in the bottom two panels, core inflation under both inflation objectives runs 0.1 to 0.3 percentage point higher over the next four years than in the April simulations. That, of course, is the fundamental nature of a negative supply shock: Policymakers are forced to accept some combination of greater economic slack and higher inflation during a period of transition to a lower output path and, presumably, to an unchanged long-run inflation rate. That same point was made in a Bluebook box and in a staff paper on this subject. Turning to your final exhibit, I would like to note that, in response to the comments of some members at recent FOMC meetings, the r* exhibit in the Bluebook has been augmented to include two additional measures of the real federal funds rate. Line 11 in the table at the bottom shows a measure of the real federal funds rate that uses lagged headline inflation as a proxy for expected inflation. By contrast, our standard measure, shown on line 10, employs lagged core inflation as the proxy. Line 12 shows a measure based on the staff’s projection of headline inflation. Both of these new measures, at minus 1.3 percent, are considerably lower than the current value of the standard measure, minus 0.2 percent. I want to emphasize, first, that these additional measures should not be compared directly with the r* measures shown in lines 1 through 9 of the table because the values of those measures are in part a function of the proxy used for expected inflation. For example, the r* value that would be consistent with the Greenbook projection and the actual real funds rate based on the lagged four-quarter average of headline inflation is minus 0.7 percent. Moreover, even if we redefined the Greenbook-consistent measure of r* to use lagged headline inflation, the implied 0.6 percentage point gap between the actual and the estimated equilibrium real rates would not necessarily imply that you should quickly raise the nominal funds rate by more than ½ percentage point. If, like the staff, you think it likely that headline inflation will moderate substantially later this year, then it follows that a gradual firming of policy in nominal terms would be consistent with a substantial rise in the June 24–25, 2008 103 of 253 real funds rate on this measure over time. Indeed, in the staff’s view, the average value of the real federal funds rate over the next few years on any measure is a bit above the corresponding value of r*, and consequently the trajectory of the real funds rate on any measure would be consistent with protracted slack and declining inflation over the next several years. Of course, you may not agree with the staff about underlying trends for prices and real activity and, hence, about the value of r*. Even if you do agree, you may be dissatisfied with the projected trajectories for key variables such as output, employment, and inflation. Such considerations illustrate why no estimate of r* can be a complete guide to policy. That completes my prepared remarks. CHAIRMAN BERNANKE. Thank you. Are there questions for Brian? President Lacker. MR. LACKER. Thanks, Brian, for including these two new lines of the real federal funds rate. As I remarked yesterday, one use of the figures is to look back and judge the degree of accommodation relative to other historical episodes. My understanding is that the Greenbook forecast of headline inflation four quarters ahead is higher now than it was in 2004, when the black line in your exhibit 3 last hit its lowest point. My understanding is that, if you drew that black line using the equivalent of line 12, the Greenbook’s forecast for overall inflation, the trough in 2004 would lie around zero, and we would now be at minus 1.3. MR. MADIGAN. Unfortunately, President Lacker, I haven’t made that computation, so I can’t confirm that. MR. LACKER. Okay. Just a comment then. CHAIRMAN BERNANKE. Governor Mishkin. MR. MISHKIN. Just a quick question: When you do this based on the Greenbook projection for headline inflation, how far forward are you going with headline inflation? MR. MADIGAN. Well, in any given quarter, it’s four quarters ahead. MR. MISHKIN. Four quarters ahead. MR. MADIGAN. Yes. CHAIRMAN BERNANKE. Any other questions? June 24–25, 2008 104 of 253 VICE CHAIRMAN GEITHNER. May I? CHAIRMAN BERNANKE. Vice Chairman. VICE CHAIRMAN GEITHNER. Brian, it might be helpful if you would circulate your remarks about the new exhibit 3 and its implications after the meeting. That was very helpful. But I just want to clarify one thing. Could you just repeat what you said—looking forward under any of these basic measures, where do you expect the real fed funds rate to be in relation to r*? MR. MADIGAN. The actual real federal funds rate is above r* under any measures—so in other words, our outlook is the same. These are just different yardsticks for assessing our basic view of the stance of policy. CHAIRMAN BERNANKE. If there are no further questions, why don’t we begin our goround? President Evans. MR. EVANS. Thank you, Mr. Chairman. I’d like to start by saying that I agree with your comments yesterday about how we should proceed with the Committee approach and think very collaboratively about the policies and delicate strategies that we’re facing. Although we disagree on a number of the elements of the outlook, I think that bringing everything together is a very important part of this. I have fully endorsed funds rate cuts that we have taken so far in large part as insurance against tail risks to growth. I think that policy last summer was much too restrictive given what we were facing and that, along the way, a lot of these cuts have been motivated by tail risks to growth. The funds rate at 2 percent is pretty ample insurance to my mind—more so given the improvement in the outlook for growth that we’ve seen as second-quarter growth has been marked up so much and even more so given the inflation risks that we’re facing, the risks to inflation expectations, and the potentially very low real interest rates that we might be looking at, depending on the measure. If June 24–25, 2008 105 of 253 we had the opportunity to recalibrate things a bit, I probably would prefer something more like a 2½ percent fed funds rate to be positioned against the different risks that we’re facing, but I understand that we’re at 2 percent, and no change seems like the right move for today. I do have a few concerns about the way we’re thinking about this, more in the line of risks. One is that, as we take insurance against tail risk, we’re positioning the funds rate against an event that we think is not the most likely and is negative compared with where we are. Unless and until that event happens, policy is somewhat accommodative because it hasn’t happened, and we’re thinking that it is closer to where it ought to be if that should happen. Unless you think that we haven’t taken out insurance, then I think that we have more accommodation than we might like. The second concern is whether it is possible to be more precise about what we mean by this tail risk. I mean, it’s really a catch-all. Nobody is very comfortable with all of this. What are the markers that we could look at for improvement if we could quantify this somehow? Is it that financial markets should be functioning better? I think surely that is the case. Is there a way that we could describe that? I’m sure we’ll disagree on many elements of this. Labor market improvement—we should expect that, if the labor market does better than we were thinking, then that would tend to bolster consumption spending a bit better in the face of all the shocks that we’re looking at. So the extent to which the labor market doesn’t continue to deteriorate, at least in line with some of the recession scenarios and the tail risk scenarios that we were thinking about, is a potential marker. As we keep pushing out our expectation that the economy is going to weaken—and we’ve done this a number of times—and if we’re looking at the third quarter being revised up—and I agree that we’re facing a lot of risks there—but if we start marking that one up, I think that’s a marker that we have to be concerned about. Obviously, if oil prices and commodity prices were to June 24–25, 2008 106 of 253 decline and free up purchasing power for consumers, that would help out, too. So these are just some of the things that come to mind. Is there a way to think about the details a little better, with a bit less of a SWAG? Another risk relates to financial markets. Here I’m thinking about the really influential work of yours, in 1983, on nonmonetary influences on the Great Depression. A lot of the actions that we have taken are defenses against those types of issues, right? In the 1930s, when the economy was doing very badly and banks were failing—I’m telling this to you, and you’ve described it to everyone—then the knock-on effect was that the banks weren’t there anymore and important resources for evaluating credit were lost, and so it was more expensive and very difficult to do. We have some of that going on now, right? We’ve moved from the banks making mortgages and holding them to the “originate to distribute” model. Those resources have been dispersed, and now that securitization market is closed. I heard that very clearly yesterday. Those important resources aren’t there to originate mortgages, so if we get to the point that buyers are willing to purchase these houses, that could be a concern. What happens if there’s a true impairment to the financial capital stock, and real resources aren’t there anymore to help out with this? We’re probably looking at a reallocation of resources from that sector of the financial market either back to banks or to somewhere else. But as we see those resources reallocated and as we think about unemployment being higher, we can talk ourselves into thinking that a lot of slack is in the economy when, in fact, there may not be so much slack. At some point it may be slack, and at other times it won’t be, until those resources are reallocated most efficiently. I think this could reduce potential growth rates and have structural elements to it, not just cyclical elements. So there’s not a slam-dunk for this. There is just a risk that an element of that is playing out throughout this, and other factors are superimposed on that. June 24–25, 2008 107 of 253 But it’s something that I worry about. In a robust type of policy development, I think we should be considering things like that. It’s just the case that, in the current situation that we’re looking at, there might be a limited role for monetary policy to repair real capital stocks. Another concern is that anytime we’ve engaged in substantial risk-management policies, there has always been difficulty in taking them back. That’s part of the delicate strategy that you are referring to, I think. That’s how I heard it. So we have to be very careful. There’s a lot of art to this clearly, but it would be good if we could offer a few more bright lines about how we’ll approach that. Still, I certainly agree. I think we need to seek consensus. It’s our role to raise these issues and then come to the best judgment. So I’m quite comfortable with no change today. I’m quite comfortable with the language in alternative B, although in the third paragraph we say, “However, in light of the continued increases in the prices of energy,” and I think it would be better if we didn’t say “continued.” I think it’s enough to say “the increases.” In part, I don’t know if this is a marker that, if prices level out, we’d still be comfortable with the inflation risk. I think that there will be a lagged effect of all the very large increases that we’ve seen for oil as they work their way through. If prices just level out, we still have risks to inflation expectations. So I prefer taking that out. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. MR. KOHN. A two-hander, Mr. Chairman. CHAIRMAN BERNANKE. Governor Kohn. MR. KOHN. President Evans, so you are arguing that the re-intermediation process is going to raise the NAIRU. I thought that the NAIRU depended on the structure of the labor markets, job matching, and stuff like that, so I didn’t quite understand the connection. June 24–25, 2008 108 of 253 MR. EVANS. I’m alluding, without understanding or working out, to a sectoral-shifts model of unemployment and how that search process could be more difficult. You’re just taking resources that over some period took a while to allocate to the financial sector and now they have to be reallocated somewhere else. CHAIRMAN BERNANKE. President Hoenig. MR. HOENIG. Thank you, Mr. Chairman. Recognizing, as I do, where we’re coming from and its dangers, I think more-recent data suggest that the downside risks to growth have diminished, and in my judgment the current stance of policy is much more accommodative than necessary to address these risks. I continue to believe that the two most recent policy actions of this Committee were more than sufficient, and we really need to think about reversing them sooner rather than later. Inflation risks have risen, and we have seen erosion in longer-term inflation expectations. As I noted in my previous remarks on the outlook, if we do not begin to remove policy accommodation soon, I think we risk having to tighten policy more aggressively in the future to reestablish our credibility. A couple of things. It struck me in looking at some of the major economies besides the United States—the European Union, Japan, and China—if you look at the real interest rates, they’re low. I mean, they are 1 percent or less or negative. So this is a lot of stimulus coming into the world economy. And to make my point again, I don’t think you can have a sustained recovery with a sustained inflationary environment, which we’re in danger of encountering if we continue on this path. Over the past several weeks, markets have significantly altered their expected funds rate path to remove policy accommodation, and therefore, I don’t know that doing something today would be that big a surprise. The current funds rate path built into the market rates is closer to what June 24–25, 2008 109 of 253 I believe is desirable to maintain price stability over the long run, but I would prefer moving somewhat faster—3 percent by the end of this year and perhaps 4¼ percent by the end of ’09. Thus, in my view, we should begin the process of removing monetary policy accommodation by increasing the fed funds rate target by 25 basis points at this meeting. I think this action would perhaps be somewhat unexpected, and I recognize that there is some risk that markets would react by moving the funds rate path up more dramatically than some might desire. However, taking this action would move us beyond merely talking about inflationary risk and would help us contain inflation expectations by reaffirming our commitment to maintaining price stability. I think it would quickly have a positive effect on the economy as these expectations begin to shift. Now, assuming that’s not the majority view today, I would then encourage us to set the stage in our language for stronger actions coming in the future. That is an important issue especially, as you mentioned yesterday, in terms of remarks that we might make following this meeting, in speeches and so forth. Finally, let me just say that I think policy is currently accommodative, perhaps very accommodative. The insurance policy taken out earlier this year to guard against the tail risk of spillovers of the financial distress to activity is less necessary, perhaps far less necessary, and it is potentially even harmful to the efforts of maintaining price stability. Therefore, I encourage action sooner rather than later. Thank you. CHAIRMAN BERNANKE. Thank you. President Lacker. MR. LACKER. Thank you, Mr. Chairman. The growth outlook has improved over the last two months, but the inflation picture has not. If anything, it has deteriorated. I think it’s clear, as President Hoenig argued, that we should be tightening policy soon. The extent to which we brought the funds rate down was predicated on downside risks and the notion that we could reverse course June 24–25, 2008 110 of 253 rapidly. As downside risks now look much less likely, I just don’t see how an argument that 2 percent was the appropriate funds rate in April does not also imply that a higher funds rate would be appropriate now. Taking back some of that stimulus at this meeting, however, is probably inconsistent with the commitment implied by the Committee’s traditional interest rate smoothing behavior. So I’m willing to stand pat today with the funds rate. The timing of such moves is going to present us with some trouble going forward, though. Even if we avoid outright recession, as now seems probable, the unemployment rate is likely to keep rising for a time. But waiting isn’t going to make it easier for us, in any event, because there’s a likelihood of the fourth quarter’s showing a slowdown when the stimulus wears off. But inflation is going to increase in the near term as well. At least that seems likely, and holding rates down while that happens and while inflation expectations are already fairly elevated seems awfully risky to me. I can understand the need for some conviction when we raise rates. When we began cutting rates aggressively in January, there were some significant uncertainties in the inflation outlook, though. I hope we don’t set any higher a threshold of conviction for rate increases than we set for rate cuts. Looking back at 2003-04, and this is strictly in hindsight, one can argue that we erred by waiting too long to reverse course, and I’ve heard you yourself make that argument, Mr. Chairman. So the logic of risk management works in both directions. I think we need to keep that in mind. CHAIRMAN BERNANKE. Thank you. President Yellen. MS. YELLEN. Thank you, Mr. Chairman. I favor alternative B with the proposed wording. Given the forecast and the risks around it, our next move on the funds rate is likely to be up, and the question is when. Assuming that the data on growth and inflation come in roughly as I and the Greenbook expect, I would envision beginning to remove policy accommodation toward the June 24–25, 2008 111 of 253 end of this year, similar to the assumption in the Greenbook. As I mentioned, I’m not very confident that the outlook for growth and employment has improved as much as the Greenbook assumes. I’m concerned that households and firms are in a python squeeze of an intensifying credit crunch and a continuing decline in housing wealth as well as pressures from surging food and energy prices. I think the economy has shown resilience so far, and that’s reassuring, but I don’t think it’s assured for the future. The aggressive policy actions that we have put in place since January are actually working to cushion the blow, and that’s part of the reason that we haven’t seen a greater unraveling so far. I mentioned yesterday that, with respect to inflation, the behavior of both core inflation and wages thus far makes me optimistic that headline inflation will come down if commodity prices finally level off. But I think there’s no doubt that the risks with respect to inflation are not symmetrical at this point, and they have definitely increased. I still see inflation expectations as reasonably well anchored, but there’s no doubt that a wage–price spiral could develop, and dealing with it would be a very difficult and very painful problem for the Committee. So while I feel that we are essentially credible now, I wouldn’t want to take absolutely for granted that this is something that we can count on going forward. At this point, the federal funds rate remains well below the recommendations of most versions of the Taylor rule. I have viewed this as appropriate, not largely as insurance against downside risk but simply in refection of the unusually severe pressures from collapsing wealth and tight credit and financial constraints. But it does seem to me to be appropriate going forward to at least take out some insurance against the development of a wage–price spiral mentality, and that could take the form of gradually removing that discrepancy from what, for example, a Taylor rule June 24–25, 2008 112 of 253 recommends. But before we begin to do that, it does seem to me that we should wait to get a somewhat clearer picture of where the real side is going. CHAIRMAN BERNANKE. Thank you. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. In my view the economy is evolving in a way that suggests that we need to take back sooner rather than later some of the insurance we put in place against downside tail risk. I base this view on several points. First, economic activity remains weak. I don’t dispute that. The data since our last meeting have been better than expected. The Greenbook forecasts as well as most private-sector forecasts have been revised up. So although downside risks remain, the tail risk of a significant recession-like outcome for the economy, though it has not vanished, has certainly diminished. Second, financial market indicators suggest that market functioning, though not back to normal, has certainly improved somewhat in recent months. Demand for Fed liquidity from the primary dealers has fallen. Primary credit borrowing generally is down. Now, although we may wish to keep our liquidity facilities for now as a backstop, the extra accommodation that we have built into monetary policy may no longer be needed or even appropriate at this point. The real economy and financial functioning have improved since our last meeting, but the inflation outlook has worsened, as we have been hearing. Headline inflation is up. Expectations of various kinds are elevated. Upside risk to core inflation has increased, as the Greenbook has said. As I said yesterday, these upside risks stem not only from the potential passthrough of energy prices but also, in my view, from the fact that we’re running a very accommodative policy despite rising inflation. In fact, I believe that policy has actually become more accommodative since the meeting at the end of April. First, the nominal funds rate has been at a constant level, but expectations of inflation have risen. So, in fact, the real funds rate has actually declined since our last meeting as June 24–25, 2008 113 of 253 inflation has risen. Second, real rates of interest more broadly have been gradually drifting up since late March or early April. The TIPS rates, the real interest rates, have been drifting up by, depending on which term you look at, anywhere from 25 basis points to 35 basis points. So as the real rates on risk-free securities have risen, which may be appropriate given the fact that prospects for the real economy have improved modestly, the real funds rate has been declining. As a consequence, whatever you think about the level of the fed funds rate, we have become more accommodative since the last meeting. As I’ve argued before in this Committee, optimal monetary policy in a broad class of models suggests that you get Taylor-rule-like rules but that the funds rate follows the real interest rate as it moves around. Optimal policy calls for following the real rates. I argued that was the case and appropriate as real rates fell in the context of a weakening economy. It was important that policy match those declines in the real rates, which I think it did. It’s a coherent policy, but it also means that as real rates begin to rise, as we have been seeing, policy needs to adjust to those real rates rising. Now, of course, a lot of judgment is required in this type of policy. There are smoothing issues. Real rates could be quite volatile. There’s debate about which real rate you want to be looking at. I understand that. But I don’t think there’s any question that the objective should be to match those movements in the real rates, and we should be thinking about it in those terms. Long-term inflation expectations have been volatile but have moved within a reasonably defined range over the last period, and I’m comforted somewhat by that. But as I have said, I believe that inflation expectations are fragile. At the very least, the anchor is dragging, and if we continue to maintain a real funds rate well below zero with rising inflation well above our goal, I do not think we can continue to assume and trust that expectations will remain well anchored. June 24–25, 2008 114 of 253 We’ve done a good job with our words so far, but with the shift from downside risk to growth to upside risk to inflation, we need to take action to ensure that price stability remains a credible objective of this Committee. If the economy and financial markets continue to evolve as they have over the last couple of months, that time may be soon. We must take back some of the insurance we put on. Not doing so soon risks having to respond more aggressively later on, which I believe will be much more difficult for the Committee to do. In fact, smaller moves sooner will help with our credibility in the marketplace and will help anchor those expectations as we wait for more data and for the economy to strengthen. In this regard, I think we are fortunate that market participants reacted to the incoming data by appreciably tightening their policy expectations. Thus, a move to raise rates is unlikely to catch them off guard. Moreover, I don’t think that we should disabuse them of such policy expectations. Some might argue that an increase in policy expectations is a negative development. I would disagree. I think that it reflects rising expectations of a somewhat stronger economy and concerns about inflation. As the Chairman said, we should resist any erosion, any rise in longer-term inflation expectations. Now, as I said, the timing of such a move is a judgment call, and I expect that my views will differ from those of some of my colleagues, particularly since I had my fed funds rate path rising to 2¾ percent by the end of ’08. So let me turn to language. In the rationale in paragraph 2, I have only one suggestion. I think that we should acknowledge that the functioning of financial markets, while not back to normal, has improved. So instead of saying “financial markets remain under considerable stress,” which we have said for some time, perhaps it might be easy to say just that the financial markets remain under stress, leaving out “considerable.” That acknowledges the fact that there’s some improvement but that stress is still there. Finally, in paragraph 4, I am pleased that the revisions make more explicit that June 24–25, 2008 115 of 253 the upside risks to inflation and inflation expectations have increased and that the downside risks to growth remain but are diminished. I was going to suggest that we strike “near-term,” but Brian beat me to the punch there. So I approve of that change. I think that’s very good. In alternative B, I would prefer that we add some of the language from the Chairman’s recent speech to paragraph 4. I think it would be a stronger message that the Committee will take actions to ensure that inflation expectations do not become unhinged, and it would also convey that both parts of our dual mandate, price stability and economic growth, are at risk should inflation expectations become unhinged. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kohn. MR. KOHN. Thank you, Mr. Chairman. I support the action and language of alternative B; Brian’s striking of “near-term” is fine with me. This is a tough situation, as we all remarked yesterday. Commodity prices are at the center of the problem that we find ourselves in. In my view, we didn’t cause the rise in commodity prices. We may have contributed a little around the edges, but whatever we contributed was a necessary byproduct of what we needed to do to cope with what was happening to the U.S. economy, and we can’t reverse the rise in relative prices without tremendous cost to the U.S. economy. Or even the rise in headline inflation, we couldn’t undo that without putting a huge amount of slack in the economy to force down wages, sticky prices, et cetera, and that would not be appropriate. I think the classic response that we’ve all been talking about is to take a temporary increase in inflation and in unemployment that facilitates the relative price changes that need to happen, concentrate on second-round effects, and make sure those increases are temporary. I think that’s inadvertently what we’ve fallen into here. Given the housing and financial shocks, the 2 percent fed funds rate of alternative B is consistent for now with continuing along the path of the temporary June 24–25, 2008 116 of 253 increases in inflation and unemployment. Unlike many of you, I don’t see the current rate as extraordinarily accommodative, given what else has happened in financial markets. There is no insurance in the staff forecast, right? The Greenbook forecast has zero insurance in it. My own forecast was a little stronger than the Greenbook’s. I think all of ours were a little stronger than the Greenbook’s, but even if I marked up r* by ½ point or 1 point, that’s not a huge amount of insurance in the circumstances that we’re facing. I note that no one sitting around this table predicted a decline in the unemployment rate over the balance of the year; so everybody has 5½ percent or higher unemployment rates predicted by the end of the year. The staff thinks that the current 5½ percent is a little too high. So they are expecting the unemployment rate to come down in the next month or two. Given this, we’re all expecting the unemployment rate to rise over the balance of the year. I would think, given the lags in policy, that if you thought policy was hugely accommodative, you’d see some decline in the unemployment rate over the next six, seven, or eight months. I think our own forecasts suggest that some insurance might be here, but not the amount that I’m hearing some of you talk about. I don’t see the consistency there. My own view is that there’s probably a little insurance in it, and it’s appropriate for now. I agree that the next move in interest rates is more likely to be up than down. I assumed, like President Yellen, that it would be at the end of this year or at the beginning of next year. The rising unemployment that we all expect should help damp inflation and inflation expectations and make it very hard to pass through all these cost increases that we’re hearing from businesses that they want to pass through and certainly make it hard for wages and cost pressures to rise. So I agree with everyone else that the weight in the two tails has shifted. There’s less weight in the downside risk tail for output and more weight in the upside risk tail for inflation. The statement does a very nice job of saying that explicitly, and I think that we just need to await June 24–25, 2008 117 of 253 incoming data and information about inflation expectations, costs, and whatnot to see when the appropriate time to move will be. Because I don’t think there’s a tremendous amount of insurance in there, I think we can afford to be a little patient and data dependent here. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. President Pianalto. Oh sorry, President Plosser. MR. PLOSSER. Governor Kohn, a question, or a comment, about interest rates. A lot of our discussion has been centered on how accommodative we think policy is and how we interpret it in the current environment. If I want to quantify the magnitude a bit, at least the way I think about it, even if I believe that the economy is weak enough so that the appropriate equilibrium real rate of interest is zero, we have inflation running somewhere north of 3 percent. That would suggest a nominal funds rate of about 3 percent as opposed to 2 percent. So roughly speaking, I would interpret that to say that we have roughly 100 basis points of extra accommodation built into our fed funds rate relative to what—and that’s assuming an equilibrium real rate of zero, which might even be low. So if I’m thinking about it that way, could you clarify how we should quantify it in some way? MR. KOHN. It’s very difficult. We don’t know what inflation expectations are. We’re all using proxies, as came forth very strongly at the Cape Cod conference where we both were, President Plosser. We don’t even understand very well how expectations are formed, and I think what we’re looking for is how people perceive the cost of capital to finance purchases. So we’re wondering whether this low interest rate is causing them to bring purchases forward from the future to the present to induce them to buy things, capital goods, right? That’s the interest rate we’re really looking at—the perceived cost of credit to folks—and I’m not sure that subtracting any rate of inflation is the way to get that. Obviously, the cost of credit for housing is perceived as hugely high June 24–25, 2008 118 of 253 right now. The cost of credit for automobiles is perceived as hugely high for reasons that perhaps aren’t related to monetary policy. I don’t think we see a surge in purchases of capital equipment that would suggest that businesses perceive the cost of credit to be very negative. So I think, because we don’t understand inflation expectations and can’t measure them, you have to look for a lot of different things around the edges to confirm what people perceive the real rate to be. I just don’t see a lot of information that suggests that people perceive the real rate to be very negative and that it is influencing how they manage their purchases of goods and services over time. CHAIRMAN BERNANKE. Thank you. I guess just to say it more simply, all the rates that have determined behavior—for example, mortgage rates, auto rates, or corporate bond rates—are higher than a year ago. Now, unless there has been a major change in long-term inflation expectations, which the TIPS data don’t suggest, there don’t seem to be indications, as far as interest rates that are relevant to people’s spending decisions, that there has been a significant reduction. Someone else had a comment. Governor Kroszner. MR. KROSZNER. It’s directly on this point. It seems that in the situation we’re in, with very elevated spreads in LIBOR, there are almost no contracts in the real markets that are related directly to fed funds. It’s usually through three-month LIBOR, and we know that the spread is now roughly 70 or 75 basis points higher than it used to be. It used to be about 10 basis points, and now it’s around 80. For me that’s one rough proxy in how I think about this—that the way in which our actions are being translated into market prices is somewhat different from the way it was when the spreads were lower. CHAIRMAN BERNANKE. President Lacker will back President Plosser up though. VICE CHAIRMAN GEITHNER. This is like pro wrestling. [Laughter] June 24–25, 2008 119 of 253 MR. LACKER. Just a brief observation. Spreads always rise in recessions. We always lower real rates in recessions. So to say that the fact that spreads have risen by itself doesn’t make this an exceptional circumstance. CHAIRMAN BERNANKE. The magnitude is somewhat greater, though. MR. LACKER. For some; not for others. Corporate bond spreads aren’t as high. CHAIRMAN BERNANKE. President Pianalto, we apologize. MR. PLOSSER. I apologize. MS. PIANALTO. Thank you, Mr. Chairman. I support keeping the fed funds rate target at its current level and the language in alternative B. I see some hopeful signs that stress in financial markets has diminished as has the threat of a sharp recession. Despite these recent signs, I expect that the growth momentum in the economy will build only slowly. Moreover, I continue to worry that the residential real estate market could deteriorate even more than I had put in my baseline projection. Nevertheless, I am somewhat more comfortable with the prospects for economic activity than I was in April. At the same time, I can’t easily dismiss the recent behavior of energy and some other commodity prices. I found the Bluebook’s supplemental analysis on oil prices, inflation expectations, and monetary policy to be very useful in thinking about the dilemma that we face. The fact that oil prices have risen so sharply and have been so persistent highlights the risks surrounding the downward projection that I have for core inflation. Without some evidence of less inflationary pressure I don’t believe that the fed funds rate can be kept at its current level for very long. But while I do believe that the next policy action will be a rate hike, the potential for the recovery to sputter makes me cautious about embarking on an upward trajectory for the fed funds June 24–25, 2008 120 of 253 rate just yet. I believe that the language in alternative B conveys the right sense of direction for the fed funds rate path, with the right amount of caution. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Bullard. MR. BULLARD. Thank you, Mr. Chairman. U.S. economic data have been stronger than expected during the intermeeting period. The earlier, very aggressive moves in January and March taken by the FOMC were viewed in part as insurance against the possibility of a very serious downturn brought on by financial market turmoil. That very serious downturn has not materialized. Tail risk has diminished significantly. This means that this Committee has put too much economic stimulus on the table and must think about ways to remove it going forward. Failure to do so will create a significant inflation problem on top of problems in housing and financial markets. Slack might be helpful, as mentioned by Governor Kohn, but those effects are small compared with expectations effects. I think it is too early to tighten at this meeting. Therefore, I am supporting alternative B with the language proposed by President Plosser. But the Committee has to think carefully about how and when to embark on a path for interest rates that will set us up to achieve price stability in a reasonable time frame. My sense is that this will require more-aggressive tightening of policy than currently envisioned in staff simulations. Financial market problems have been described here as a slow burn, and I think that may well be an apt description. Many firms in this sector took on too much risk and, in retrospect, had poor business models. I expect that this will take a long time to unwind. Despite this, the systemic risk component of the situation has diminished considerably. Systemic risk is in part a function of the degree of surprise in the failure of a financial institution that was perceived to be in good health. Surely by now few market participants would be surprised to encounter the failure of certain institutions. Failures, should they occur, can be handled in an orderly way. June 24–25, 2008 121 of 253 Certain investors would lose out in such an event, to be sure, but my sense is that the panic element that would be associated with systemic risk would not be present. I believe that we should start to downweight systemic risk concerns substantially going forward because it is no longer credible to say that market participants are surprised to learn of problems at certain financial institutions. Thank you. CHAIRMAN BERNANKE. Thank you. President Stern. MR. STERN. Thank you, Mr. Chairman. Well, first of all, I believe that policy is well positioned for now from a couple of perspectives. For the next quarter or two, I think there is still some potential for significant disappointment in terms of economic growth—but only for a quarter or two. Beyond that, a pickup in real activity appears pretty likely. That is, based on what I know now, further reductions in the federal funds rate shouldn’t be required for the economy to improve next year and beyond, and we do have the liquidity facilities available should strains in financial markets threaten to intensify. Policy is also well positioned for now from a second perspective—namely, that the fed funds futures curves have priced in an increase in the funds rate beginning in the late summer or the fall. I think that this is appropriate because I think we are going to find that we will want to and have to start moving to contain inflation expectations. Precisely when to move may turn out to be a difficult call, but I would like to see futures priced to anticipate such action on our part—as indeed they are at the moment. That brings me to the recommendation and the language. I think the strategy expressed in the Bluebook associated with alternative B is fine for now, and so I favor alternative B. The language in alternative B is okay as well, although I would endorse President Plosser’s recommendation to drop “considerable” from the description of financial strains. The other thing I would point out is that the Bluebook says that, at least in the staff’s judgment, the language June 24–25, 2008 122 of 253 associated with B might push back expectations for the onset of policy tightening. I am reading from page 33. It is not that I am anxious to tighten necessarily as early as possible, but I would rather not push those expectations back at this point. So if that assessment is correct, it might be advisable to find a way to address that issue. I don’t feel all that strongly about it, but I think we could, if we wanted, take the sentence in paragraph 4 that’s in red, drop three words—the first word “although,” a word at the end of the phrase “remain,” and then “they.” So you would just say, “Downside risks to growth appear to have diminished somewhat,” which I think is true. It doesn’t suggest that we are sanguine about growth, although I suppose it could be read that way. But I am a little concerned about the way we might change expectations based on the Bluebook commentary. CHAIRMAN BERNANKE. You have your Strunk and White style manual with you, I can see. [Laughter] Thank you, President Stern. President Rosengren. MR. ROSENGREN. I support alternative B. At this time, there are significant downside risks to the economy and financial markets, as the collateral damage from the housing problems works through the economy and financial institutions. At the same time, continued increases in oil and food prices raise the risk that some part of these supply shocks will be incorporated into inflation expectations. In the absence of more-compelling evidence about which of these two risks will dominate, I would favor remaining on hold at this meeting. I hope that the economy picks up in the second half of this year and that the financial markets stabilize so policy can become less accommodative, but it is not clear that this will be the outcome. While the inflation outlook has been affected by continued energy shocks, the future path of oil prices remains uncertain, and recent history has many instances in which oil shocks are short-lived and have little effect on longer-run inflation expectations. Until we have more clarity on the path of the June 24–25, 2008 123 of 253 economy and inflation, policy should remain on hold, and our language should be consistent with that. CHAIRMAN BERNANKE. Thank you. President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. I also prefer the fed funds rate recommendation and language of alternative B. It captures the delicacy—I think that word was used yesterday—of the current tradeoffs and leans fairly heavily rhetorically against inflation and inflation expectations. I note that inflation and inflation expectations are mentioned in both paragraphs 3 and 4 using the language, “Uncertainty . . . remains high” and “risks . . . have increased.” I think this constitutes considerable stress on the seriousness of our commitment to address inflation and expectations, and it is a complete statement and will serve to condition the market. As Brian said, it suggests that firming later in the year could occur, and I believe that is appropriate. I would like to give the medicine that we have applied to resolve the situation and the financial markets a little more time to work. I am in accord with Governor Kohn’s thinking of stimulus or accommodation in terms of the cost of borrowing to real borrowers—individuals and businesses—and, therefore, we really have not seen a proportionate improvement in the cost of capital, notwithstanding such a strong reduction in the fed funds rate. So as of now, I would expect to support a reversal a little later in the year. I also think there is enough ambiguity currently that giving the situation a little more time to clarify would be helpful. Core inflation has not risen dramatically, whereas headline has, and it is headline that the public is reacting to. Measures of expectations, such as they are, seem to suggest that shortterm expectations have risen more than long-term, so there really hasn’t been a clear breakout of long term. It may be true that it would be too late if we saw that breakout, but I think we can afford to wait for a greater preponderance of evidence to accumulate over the next few weeks June 24–25, 2008 124 of 253 before considering a reversal. So I support, as I said, alternative B and the language of alternative B. CHAIRMAN BERNANKE. Thank you. President Fisher. MR. FISHER. Mr. Chairman, I listened very carefully to what was said around the table yesterday, and I especially listened very carefully to you. You made a very good and interesting point about the differences from the 1970s. I would add that there are significant differences from the 1970s. We didn’t have the Internet in the 1970s. We were not globalized in the 1970s. If you were selling oil into the market, you sold to three buyers—the ten countries known as Western Europe, the United States, and Japan—whereas now you have several billion people more to sell to. Another difference is that the transmission mechanisms were not as fluid, which gets me to a question, really, with which I am wrestling constantly. Before, a cyclical slowdown would lead to a lessening in price pressures. I am not so sure that’s correct if we are talking about a cyclical slowdown in the United States. We already have wages going up significantly in the largest factory in the world, which is China, where we source a great deal. So there is wage–price inflation, but there are enormous demand-pull forces that are quite different from what we had before. I am a little concerned—and I say this with not only respect but humility at having less training—Governor Kohn, when you say that we might tolerate a “temporary increase in inflation.” If you opened the New York Times this morning, you would have seen that Dow Chemical raised prices 25 percent after just raising them 20 percent—in one month. By the way, I notice that these little bottles of water have gotten smaller—this will be a Visine bottle at the next meeting. [Laughter] What goes into this—the plastic? Here’s the point. Many micros make a macro. Micro business operators are not going to tolerate temporary increases in June 24–25, 2008 125 of 253 inflation. They are going to act on them. I worry about that enormously, particularly given the fact that they are globalized and they sell to a globalized market. We can be victimized by that. Now, I may have over-analogized yesterday. You teased me after the meeting. Although I like Janet’s analogy of the python—one of my tutors at St. John’s had a python named Julius Squeezer, by the way. [Laughter] Just to kill that reference, I feel a bit squeezed here at the table. You mentioned yesterday, Mr. Chairman, three things that caught my ear. Obviously, we need to strive to avoid bad outcomes. Second, we need to decide when we’re at the tipping point. We need to pick our moment, as you said. Third, you also said that we need to lean and not lurch. I listened very carefully just now to President Evans, who was most eloquent in his presentation. I happen to agree with him in terms of where I think we should be. Yesterday I said I thought there were three ways to deal with our current predicament now that the tail risks have shifted. One is to hope it will cure itself. I don’t believe that is going to happen because of the way micro operators operate. The second is to treat it rhetorically, and I think that the language in alternative B is quite good, if that is the way you wish to go. But I don’t think it is going to get any easier, as was mentioned earlier at this table. I am not sure that things will get easier by August. We then get into an election season, which I think still conditions somewhat our thinking. I think it is important to take a shot across the bow. I think we have to put some substance behind our words. As I said before, and I know you know, I like to be liked. I don’t like to be alone. But I am going to vote for alternative C. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Warsh. June 24–25, 2008 126 of 253 MR. WARSH. Thank you, Mr. Chairman. Let me say just a few things. First, to state the obvious—there are risks on all sides of these decisions. Second, I will try to wade into the debate briefly on this accommodation point. My own view is that policy is accommodative—the degree of that is why we are having this debate. I think about our degree of accommodation as a function both of our target fed funds rate and what the financial markets do with it, by which I don’t mean just what the expected fed funds targets are out in the future but the transmission mechanism. The degree of accommodation, as we think about our decision now and in the next several months, will depend more on financial market developments than, frankly, the decisions that we end up making on the target; and it is very hard for us to judge the direction of these markets. As much as we have talked about tail risks on the financial market side and the real economy side being diminished, I think all of us would say that there is a real chance that this will be a long, hot summer. It is hard to know what the credit channels are going to do with our target federal funds rate. It is not obvious to me that we should try to perfectly offset the changes in financial market developments by contemplating changes in the federal funds rate now. What I think most likely is that we won’t be as certain as we would like to be regarding growth risks and we won’t be as certain as we would like to be regarding financial market developments before we have to begin a posture of removing policy accommodation. So with all those caveats and a view that policy remains more accommodative than we can allow it to be for too long, I will support alternative B and think that we have to remain very open-minded, very nimble, in our task of removing policy accommodation. In terms of President Plosser’s suggestion on “considerable,” I think the reason for the debate over using that word is in my own view that these markets are still under considerable stress, but the trend from the last statement to this statement is that they are under less June 24–25, 2008 127 of 253 considerable stress. Therein lies the difficulty in wording this in the statement. If we do remove “considerable,” it wouldn’t surprise me that when we next meet we will say, “Boy, it seems as though stress is up. Wonder if we should put it back in?” I don’t feel strongly, other than I don’t like the idea of removing it now if we think that there’s a chance that the trends, which are very tenuous, turn around. So I think I would favor the language that you have written. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. MR. KROSZNER. Thank you very much. Obviously, as we have all discussed, we are facing enormous challenges from the continuing strength in prices and price changes in energy and raw materials. Now, some of those are relative price changes that we don’t have the tools to address directly. Recently, we have seen wheat come down as Australia has been able to replant, and it seems that things are going to come back. Corn has gone up, as we heard from a number of people around the table, because of the challenges there. We don’t have the tools to address that directly, but obviously, when so many of these commodity prices and energy prices are going up, that leads to concerns about where both headline inflation and core inflation are going. So we definitely do have to be very mindful of that. I think the type of approach that we are taking in alternative B is a reasonable one. Given the challenges that we are facing right now with the fragility in the financial markets—the continuing smoldering of those embers, with still chances that they could reignite and cause us a great deal of difficulty—it seems sensible to me to be roughly where we are now in terms of policy but to be signaling that we understand that challenges are coming from various sources that could lead to inflation pressures and that we need to be ready to offset those. June 24–25, 2008 128 of 253 In terms of how accommodative monetary policy is, I think actually it would be worthwhile—and maybe at the end of this I might pose a question to Brian—to look at LIBOR– OIS spreads and how much they typically go up during recessionary periods. I know that other risk spreads typically go up, but my understanding is that those typically don’t go up as much. Since so many contracts are based off the one-month and three-month LIBOR, that 75 basis points suggests that at least now we might want to take that into account in thinking about where monetary policy stands relative to other times when we would have had a funds rate at roughly this level. In terms of the language, I share Governor Warsh’s view on the use or lack of use of the word “considerable.” I think President Stern’s suggestion—this is always a very dangerous and difficult game—would actually push the markets further than they are because I agree that broadly the path that they are seeing in the future is a reasonable one for them to see. This language would roughly keep it there. Taking out the acknowledgement of downside risks to growth remaining would make me concerned because (1) I certainly see those as still being there and (2) I think that would push the markets further to think that this is a signal that next time we are going to do it, and I don’t think we are quite there yet. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Mishkin. MR. MISHKIN. Thank you, Mr. Chairman. I do support alternative B and the current language in the statement. I have no problem with that. I think it conveys what we need to convey. Although I think that the next move is very likely to be up and it maybe should be done quite soon, I would argue that we still need to have a lot of flexibility and to think in terms of having a lot of flexibility in where we may have to head in the future. I want to argue along those lines and outline why I think that is the case. June 24–25, 2008 129 of 253 The first issue is something that the Chairman mentioned yesterday, about which I felt very strongly—in fact, I meant to say it, but as always the Chairman says things better than I could in this context—that there really is still a very serious possibility that the shoe could drop in the financial markets. The Chairman mentioned a set of institutions that we have to be concerned about, and although there has been some improvement in terms of the stress that the financial markets are under, I don’t think we are out of the woods yet. We are likely to be, but we have to be ready to recognize that things could go south. So that’s one issue. The second issue is that the recent positive data we have seen are, again, very tenuous to me. I’m hoping that they indicate that things are going in the right direction. But a bunch of things make me very nervous, which I mentioned yesterday—how consumers react in housing crises, consumer sentiment, and the big problem that is going to occur when people have to face very high prices of food and energy, which hit their pocketbook very directly. So, again, that could be quite contractionary. The good news that we have seen recently might reverse very quickly. The third issue is that I think the headwinds could be very substantial in the future, that this cleanup will take a long time, and in that case we could have very slow and subpar growth that could widen output gaps more than the Greenbook and most participants here are expecting. So I do not consider the current stance of monetary policy to be overly stimulative. For me it is just about right and very much along the lines of what I think would be optimal policy. Of course, my view relates not only to the real economy. I also think that inflation expectations, as far as I can tell so far, are reasonably well contained. There is very little movement in the measures of inflation expectations that I pay most attention to. That argues that our stance is about right. I would also very strongly argue that I do not think that we have taken out a lot of insurance. I have argued that before. We have moved less gradually, which I think is very June 24–25, 2008 130 of 253 beneficial, and I would commend the Committee in that regard. But we moved in line with what the forecasts have been telling us optimal policy would be, and I think that is quite important. However, here is why I think we need to have flexibility in the other direction. If you think about a risk-management approach, it should not be focused just on tail risk to economic growth, which has been our most major concern because of the financial disruption. It equally implies that, symmetrically, we should be just as worried about tail risk to inflation, particularly to long-run inflation expectations, which I think are the key driver of underlying inflation, which is what monetary policy can particularly deal with. Here we have a situation in which we have hit the perfect storm of shocks because of the huge supply shock and there are much more serious upside risks and tail risks in terms of long-run inflation expectations. So I really do worry that with long-run inflation expectations and, therefore, underlying inflation we are in a more fragile situation and that we have to be very cognizant of that in terms of what we do in the future. The bottom line is that we may have to move very quickly to raise rates if any of several things happens. One is that headwinds are not as serious as I think they are likely to be. There is certainly a very serious possibility that things could be better than I expect. I would not be unhappy, so I would not get depressed, about that. Really more depressing would be if inflation expectations started to look as though they were getting more unanchored. Particularly, I would worry much more about what happens in terms of inflation compensation and the Survey of Professional Forecasters, paying some attention to consumer surveys but putting a lot less weight on them. If the canary starts to look as though it is keeling over, we have to move very quickly, and so I am going to watch that canary very, very carefully. MR. FISHER. Before the python gets it. [Laughter] June 24–25, 2008 131 of 253 MR. MISHKIN. Before the python gets it. I think another consideration is very important. I have to commend you on the Bluebook this time—it just had some great boxes. [Laughter] It would be nicer if they had a little color to them. As a textbook author, I think they could have been a little ritzier and have had a little color, but they were great boxes. In particular, a very important box was the one on the optimal reaction to oil price shocks. One thing that comes out very strongly from that box is that if your credibility is weak on commitment to price stability and containing inflation expectations, you would have to tighten more to restore that credibility and get to a policy that would produce better outcomes. So here is an issue that, with these supply shocks potentially causing a problem for long-run inflation expectations, we actually may have to react more quickly and more aggressively than we otherwise would. This is an issue that I have been concerned about in terms of communication strategy—about how we better anchor long-run inflation expectations. So my bottom line is that I support alternative B. I would like to keep the language the way it is currently, which I think works quite well. But I do think that, going forward, we should not lock ourselves into what our policy is going to be, in either direction. We need to preserve flexibility because we could be very surprised, although I think that the signal we have made that we are more concerned about inflation risks is absolutely appropriate. We have to make clear that we will do whatever it takes, including raising interest rates when unemployment is rising, if we feel that long-run inflation expectations and inflation are not remaining under control. CHAIRMAN BERNANKE. Thank you. Vice Chairman. VICE CHAIRMAN GEITHNER. Thank you, Mr. Chairman. I just want to say at the beginning that I think the way you framed your remarks yesterday had perfect pitch and balance, and it is really important that we not get ahead of ourselves in taking too much comfort from the June 24–25, 2008 132 of 253 fact that the first half was not as bad as we thought and think that the risks on the growth front are definitively behind us. The improvement in financial markets that many of you spoke of is not as significant as we think or hope; we have had a lot of false dawns over this period. A lot of what you see as improvement is the simple result of the existence of our facilities in the implied sense that people infer from our actions that we are going to protect people from a level of distress that we probably have no desire, will, or ability to actually do. It is sort of like waking up in the hospital and having them say, “You are not dead yet, but we are not sure you’re going to live.” It is not as good an improvement, and there has been a material erosion over the past four weeks. It is very unlikely that you will have a substantial improvement in overall confidence in markets, a durable improvement in market functioning, and a substantial reduction in those spreads until there is more clarity about the likely path of the economy going forward, house prices in particular, and therefore the cash flows associated with the huge amount of credit that was extended over the past five years. Again, it is going to be very hard for us to have a better feel for the balance of risks on growth front and the financial sector until we think we see signs ahead of some significant deceleration in the rate of decline of housing prices, if not some actual bottom. On the basis of everything we know, that is still several quarters ahead. Maybe it is going to surprise us on the upside and maybe we are going to see a big improvement in housing demand, but I think that the sense of a bottom looks to be several quarters ahead of us still. I would say that the risks are still acute. Sure, the markets are a little more confident that we are going to successfully avoid a systemic financial crisis, but I wouldn’t take too much comfort from that. I think it is also plausible that oil will be at $150 or $200 over the next six months or so. There is some material probability that the set of challenges on that front is going June 24–25, 2008 133 of 253 to get worse. So all that is just in favor of a fair amount of care and caution now, given the scale of the uncertainty out there and how fat the tail risks are on both sides of our mandate going forward. I like, and fully support, the language in alternative B. I would not—as you might sense from my comments—take out the word “considerable” from the characterization of stress. I am pretty comfortable with the framework laid out here, and, more important, Mr. Chairman, with the broad balance and strategy that you outlined yesterday. CHAIRMAN BERNANKE. Thank you very much. In April, we signaled that, following our aggressive rate actions and our other efforts to support financial markets, it was going to be a time to pause and to assess the effects of our actions. That was not that long ago, and I think it is appropriate to continue our watchful waiting for just a bit longer. I talked yesterday about the balance of tail risks as opposed to the balance of risks. I think that, although the tail risks on the growth and financial side have moderated somewhat, they are still quite substantial. I agree with the Vice Chairman on that point. They arise from two separate but related sources. The first is that, notwithstanding the stronger-than-expected performance in the second quarter, I think there is an excellent chance that we will still see a recessionary dynamic with the associated strong movements in employment and production. Second—again as the Vice Chairman mentioned—I do not agree that systemic risk has gone away. I think it is in abeyance. There is perhaps, if anything, excessive confidence in the ability of the Fed to prevent a crisis situation from metastasizing. Even if we don’t have a failure of a major firm, we still have the possibility of a significant adverse feedback loop as credit conditions worsen and banks come under additional pressure. So if I could try to think about this—I don’t want to say “mathematically”—a lot of our discussion has implicitly suggested that June 24–25, 2008 134 of 253 there has been a linear model, which is that we are just trying to balance on the scales this risk against that risk. Again, if you are worried about preventing bad outcomes, you have to worry more about nonlinear or discontinuous changes. I think that, at this point, we still have significant risk of a nonlinear, discontinuous change in the financial markets or in the real economy. Tail risks have risen for inflation. There is no question about it. I take what has been said around the table extremely seriously, and I am quite anxious about it, I have to concede. If I were making a comparison of tail risks to tail risks, I still think that the inflation tail risks have not yet reached the level of the concerns I have about the financial crisis. In particular, some important indicators—such as wages, inflation expectations, and core inflation—have not yet signaled a major shift. That being said, I do think we need to acknowledge the relative change in those risks, and we need to begin to prepare the market for the normalization that is going to have to come. Both President Fisher and President Stern talked about the rhetorical aspects of our policy and the effects on policy expectations, and I think we are all in agreement that words mean nothing unless they are eventually backed up by actions. On the other hand, actions may be better if they are preceded by words, if you will. We do need to begin to prepare the markets and to communicate clearly so that people will know what’s coming and that the system will be better able to deal with that. If I thought for sure that we were going to begin renormalizing very soon, I would propose doing it today. Why wait? But I think enough uncertainty and enough risks are on both sides that there is some benefit from waiting just a bit longer to see, first, how the financial markets evolve and, second, whether we continue this stronger-than-expected growth pattern or June 24–25, 2008 135 of 253 whether we begin to see a more recessionary-type of pattern. In particular, between now and the next meeting, we have two employment reports, a lot of other relevant information, and a lot of insight from the financial markets. At the same time, on the inflation side, we will see how commodity prices evolve, whether we have any kind of relief from what we saw in the last intermeeting period, how the dollar behaves, and how inflation expectations behave. All those things will give us a better sense of where we are and how we should proceed. So I think we should try to be nimble. We should try to respond to the information as it comes in. We should be focused particularly on tail risks. I think we should begin to move, or should maintain, market expectations toward tightening. President Fisher, I think I have to note for the record that I don’t think we should let political considerations affect our decisions in any way, and I am not concerned about that. I think we are all prepared to do what is necessary. I don’t know what we are going to do in the next meeting or the meeting after that. But my expectation now is that, as others have mentioned, we will begin normalizing interest rates relatively soon, and we should, if possible, begin to prepare the markets for that. For today, as I have indicated, I recommend no change in the federal funds rate target and alternative B for the statement. I think alternative B captures the facts pretty well on the whole. I won’t go into it, but I think the inflation paragraph is a little more hawkish. It drops the discussion of a leveling-out of commodity prices. It doesn’t refer to core inflation, which we have taken before as sort of a reassuring element. I’m disappointed that President Fisher is going to vote against his own language in alternative B, paragraph 4, which we have adopted and which I think is a very good expression of the risks. MR. FISHER. I appreciate the adoption of the language. I think it is much better. June 24–25, 2008 136 of 253 CHAIRMAN BERNANKE. I think President Stern’s suggestion is interesting. I am a little worried that it might go just a bit too far in suggesting that we have discounted the downside risks. I am struggling with the “considerable” in alternative B, paragraph 2. I have sort of heard two for and two against. I don’t know if others have a view. It is a bit risky to change, given how quickly things can move. But if others would like to express a view, I think yet a third thing that we could do would be to say, “Financial markets, though somewhat improved recently, remain under considerable stress.” That might be a way to address it. Does anyone have any thoughts on that word? Any concerns? President Lacker? MR. LACKER. I thought Vice Chairman Geithner’s characterization of markets was pretty good, but it is compatible with your suggestion. CHAIRMAN BERNANKE. Vice Chairman. VICE CHAIRMAN GEITHNER. If we look back and try to recalibrate at each meeting whether things are getting better or things are getting worse, we would regret each zig and each zag. So I would just say that we have a suite of facilities in place. They are in place today. They are exceptionally significant in terms of a change in policy. They are there because we think they are playing an important role in helping facilitate the necessary process of repairing markets et cetera. If we were going to take them back tomorrow or dial them back substantially, then I would be willing to rationalize and explain that part of the judgment is that we think things are improving materially. I just feel as though the risk is too high. CHAIRMAN BERNANKE. I think the Vice Chairman raises an interaction that I hadn’t thought of, which is that our facilities are existing under the premise of unusual and exigent circumstances, and we don’t really want to undercut that. President Fisher. June 24–25, 2008 137 of 253 MR. FISHER. I would support what Vice Chairman Geithner mentioned because I think we may be faced with a situation of having to raise rates even though there is considerable risk in the financial market. So I think showing sensitivity to that is very, very important. On a second point, Mr. Chairman, I do appreciate the change in the language. I also suggested some changes to alternative C, but I won’t go into them. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Yes. President Plosser. MR. PLOSSER. Given that I suggested removing the word “considerable,” my purpose there was merely to indicate, as many people around the table have said, that things are somewhat better. I don’t think that we should suggest that problems are solved, because things are still under stress. I agree with Vice Chairman Geithner in that regard. I am willing to withdraw that suggestion. I don’t feel that strongly about it. I thought it would have been useful to convey a direction that we saw. But I don’t disagree with Vice Chairman Geithner’s suggestion that these things can reverse themselves and maybe a little more stability might save us some zigging and zagging down the road. So I withdraw that suggestion. I can live with the language as it is, if that simplifies things. MR. MISHKIN. And it will come out in the minutes. CHAIRMAN BERNANKE. Of course, all of these subtleties will. MR. PLOSSER. As they always do. CHAIRMAN BERNANKE. I would like to propose no change in alternative B as given in exhibit 1. Any further comment? If not, could you please take the roll? MS. DANKER. Yes. This vote applies to the directive as well as the language of the statement in alternative B of exhibit 1. “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. June 24–25, 2008 138 of 253 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 2 percent.” Chairman Bernanke Vice Chairman Geithner President Fisher Governor Kohn Governor Kroszner Governor Mishkin President Pianalto President Plosser President Stern Governor Warsh Yes Yes No Yes Yes Yes Yes Yes Yes Yes CHAIRMAN BERNANKE. Thank you. Why don’t we take a fifteen-minute coffee break, and we will come back and discuss investment banks. [Coffee break] CHAIRMAN BERNANKE. Why don’t we commence, then. This is a joint FOMC and Board meeting, and so I need a motion to close the Board meeting. MR. KOHN. So move. CHAIRMAN BERNANKE. Without objection. Okay. Our topic for this morning is investment banks, their supervision, and related policy issues. Let me turn it over to Art Angulo of the New York Fed, who will introduce the topic. Art. MR. ANGULO. 5 Thank you, Mr. Chairman. We’re now in the handout. Why don’t we start on page 2, and I’ll give you an overview of where we are headed this morning, at least from my section. First I’ll talk a bit about the objectives and the approach of our monitoring program. Then I’ll talk about how we’re focusing primarily, but not exclusively, on four investment banks and where our focus is there. I’ll say a few words about the extent of usage of our section 13 facilities. Again, the PDCF is primarily our focus, but for the sake of completeness, I’ll also discuss and provide some highlights on TSLF usage by the primary dealers. Then I’ll close by just highlighting near-term issues that we’re addressing or dealing with. 5 The materials used by Messrs. Angulo, Alvarez, and Parkinson are appended to this transcript (appendix 5). June 24–25, 2008 139 of 253 On page 3, in terms of the objectives of our monitoring program, we’re very cognizant that our efforts are tied closely to our section 13(3) authority in the establishment of the Primary Dealer Credit Facility. Our effort does not stem from our general supervisory examination authority. We’re very clear on that. We have two key objectives. The first is the ability to exercise informed judgment about the capital and liquidity positions of the primary dealers that have access to the PDCF. Second and just as important, we’re aiming to, in shorthand, mitigate the moral hazard that accompanies the creation of the PDCF in particular. So we will make sure that the PDCF does not undermine the incentives for the primary dealers and the firms that own them to manage capital and liquidity more conservatively. On page 4, in terms of our approach, our focus is on the firms that own primary dealers that are not affiliated with financial holding companies. That’s primarily, but not exclusively, the four largest investment banks. I’ll touch at the end of my presentation on several other primary dealers with which we’ve had interactions of late. Our effort does include an on-site presence, but that is limited to examiners at each of the four largest investment banks. We also have a small off-site staff, which includes staff members from our Research Group, our Markets Group, our Legal Group, and Bank Supervision. We are in direct contact with the management of these firms. We are obtaining information directly from the firms as well as from the SEC, and of course, we are communicating and coordinating closely with the SEC. It’s important to point out, however, that we’re not engaged in traditional bank supervision. Our scope is fairly narrow. We’re not conducting examinations, and we’re not providing or issuing examination reports back to the firms. Therefore, we are making assessments, I would say, without the normal range or normal complement of supervisory protections that we’re accustomed to. To be frank, that carries with it some risk and some vulnerability for us. I’ll touch on that at the end of my presentation as well. Our current focus is limited or narrowly focused on capital, as well as liquidity, which I’ll get into in a moment. So let’s turn to page 5. Page 5 gives us a view of the leverage of the four investment banks. I should note that it may be a bit confusing at first glance. Leverage is typically expressed as a multiple. We’ve converted that into ratios because bank supervisors tend to look at ratios. So bear that in mind. Investment bank leverage does tend to be cyclical. This graph picks up really the latter half of the last cycle, so I can orally give you some perspective. If this graph had moved back to the left, in approximately 1999 to 2001 you would have seen the investment banks deleveraging in response to the Russian default and the LTCM crisis in the third quarter of 1998. So we would see leverage coming down between then and 2001. In 2001-02, leverage was essentially flat, and then this graph picks up the increasing leverage from 2004 to the end of 2007. As you can see, 2007 marked the cyclical low point in the ratio, or high point in leverage as a multiple. Since then, the firms have been deleveraging. Right now they are clustering around 4 percent, with the trajectory, I hope, still up, and we may have something to say about that. CHAIRMAN BERNANKE. Art, could you define “leverage” in this picture. June 24–25, 2008 140 of 253 MR. ANGULO. This is gross leverage, so it is just equity—in this case, a ratio of equity over total assets—a very blunt measure. Page 6 gives us a more current view. In the left-hand panel is the tier 1 capital ratio for the four largest securities firms. As I think you know, the SEC has made a decision to use and hold investment banks to a Basel II ratio that’s consistent with how the bank supervisors apply it. To date, the firms have not disclosed those ratios. That begins this quarter, the second quarter. For Goldman, Lehman, and Morgan Stanley, that quarter ended May 31, 2008, so we show the estimated ratios there. These were not in their earnings releases, although they were picked up by some of the analysts in their conference calls—so these numbers are seeping out there. Merrill reports on a bank cycle, June 30, so they have not yet released their tier 1 capital ratio. A couple of takeaways from the left side of this page: First, the quarter has not ended, but Merrill was obviously low compared with its peers. They do have the benefit of seeing and being aware of where their peers have come out, so we shall see if Merrill takes some action in the near term to bolster capital. The second point is that the investment bank ratios look fairly high compared with where the commercial bank tier 1 capital ratio would be. There are a couple of reasons for that. First, the assets of the investment banks are concentrated in the trading book, so there are two issues there. Those assets tend to have a lower credit charge. The other issue, which we have to do more work on, is that we need to understand better the modeling methodologies and the model approvals that the SEC has given these firms to compute tier 1 capital. That could be a significant factor as well. So at first blush they look very healthy, very high; but I think it will take more analysis to get beneath those. The right-hand side of page 6 gives another way of looking at capital—what we call an “FRBNY-adjusted leverage ratio.” What we’re trying to do here is to have another way of putting investment banks and commercial banks on a somewhat similar footing. So in terms of the numerator, we use tangible equity for two reasons. First, it’s a higher form of equity capital, perhaps the highest form. Second and just as important, it avoids current differences between how investment banks and commercial banks calculate tier 1 capital. Right now there’s a grandfathering period in which the securities firms are allowed to carry a higher portion of subordinated debt in tier 1 capital. It does not apply to bank holding companies. This puts them on more of an equivalent basis in terms of the numerator. The deal is the same with the denominator. Again, we’re trying to make allowances for the differences in business models. So here we subtract from the denominator secured financing assets. These are reverse repos and securities borrowings. Of course, these are collateralized by cash and thus are relatively low-risk assets. So by making those two adjustments, we have a somewhat comparable view. The takeaway here is that they don’t look too far apart—they are not dissimilar—at least at this point in the cycle. June 24–25, 2008 141 of 253 Why don’t we move now to page 7, to liquidity? I have a picture of liquidity, but not a full picture. This shows the trend in parent company liquidity pools. This is unencumbered cash or high-quality securities at the parent company of the four investment banks. As you can see, the trend has been increasing since the middle of March. The general trend has been to increase. This, of course, tells us only half the story because one wants to know what that pool is held against. So, let’s turn to page 8, and I can talk a bit about how we’re trying to look at and assess this. We’ve been engaged with the SEC and have entered into an approach in trying to assess liquidity at the four investment banks. When we first started this endeavor back in late March, the first thing we did was to go back to the firms and to say, “Show us what would happen to liquidity if you experienced a Bear Stearns, full-run kind of scenario? For that exercise we want to know what assets you have eligible for the PDCF. We want to know how bad and how dark it would get.” That exercise was pretty demanding. No one would have passed the test. We looked at that and asked whether a full run on the institution was an appropriate way to look at it or an appropriate standard to hold them to. So we came up with another scenario that we put back to the firms. We basically said, “Listen, we want you to do a stress analysis for us. Look at something that’s pretty severe but short of a full Bear Stearns scenario. Look out over thirty days. By the way, you have no access to the PDCF. Let’s see how that looks.” We’re in the process of doing that right now. The table on the left gives you an idea of some of the things that we’re looking at and how we’ve asked the firms to provide the information to us. Basically there are several buckets: (1) their unsecured and secured funding; (2) what comes on the balance sheet under stress, either general market stress or firm-specific stress; and (3) the impact from operating cash flows toward the bottom. Those are the combination of liquidity claims that they would face under stress. The last piece is the additional funding from affiliated or unaffiliated bank lines along with, obviously, the liquidity pool, which we have separately. Basically, we’re engaged in an exercise in which we compare and converge assumptions. We’ve had multiple discussions with each of the four firms, trying to understand where their assumption differed and trying to converge those. We then constructed, or are in the process of constructing, a cash flow analysis. Again, we are relating their cash needs under stress, given these assumptions, to their available liquidity pool plus the unaffiliated or affiliated bank lines that can be drawn. The drivers here, obviously, are going to be the mix and term of secured funding, which is going to be a big driver in terms of the liquidity needs, as well as some of the operating cash flow assumptions that firms make in looking at a stress scenario. We are fairly close to pulling together information with which we can construct an analysis, go back to the firms, share with them our assessments of where they are, and give them a chance to explain to us how we were spot on or where we may have missed certain things. But those conversations will happen in the near future. So that’s basically what we’re doing in terms of liquidity. It has been an interesting exercise. I think that there is no simple way to look at liquidity but that this is the best way to do so. June 24–25, 2008 142 of 253 Let’s turn to page 9. I have just a few words about the use of both the PDCF and the TSLF. I have graphs later on the TSLF. A graph of the PDCF usage would be kind of boring. It would show Bear Stearns as far and away the dominant borrower. Actually I think Bill Dudley conveyed to you yesterday that Monday was their last night of borrowing under the PDCF. So Bear Stearns is now out. Until very recently there were three others that I’ll call chronic users of the PDCF. First, we had Cantor. I’ll say a few words about that. They started borrowing in late March, initially $600 million to $700 million. They stabilized in mid-April at about $500 million. We saw that borrowing coming in every night. Members of the team here spent one afternoon at Cantor at the end of April. We asked them for some information in advance. We spent a good chunk of time with them. We came away not being comfortable with the number or the size of their borrowings in relation to the firm’s capital. We then consulted with our colleagues in both the Legal and Markets Groups. We asked Cantor to submit a plan to wean itself from the PDCF and to submit that to us in writing. We then followed up with a friendly letter from Mr. Dudley and Mr. Baxter asking for a little more information and a little more specificity. They got the point. They started to bring that down in accordance with the schedule they gave to us. In fact, they ended up winding down to zero in their borrowing last week, ahead of schedule, and they obtained third-party financing. So that was the Cantor story. Countrywide was a somewhat similar situation. They had been borrowing from day 1 of the PDCF. Initially they would ask us for $1 billion. They had borrowed and stabilized at about $900 million. Our Markets Group initiated a conversation with Countrywide Securities at the end of May. In short, we were uncomfortable with, in essence, providing bridge financing to the close of the acquisition by Bank of America. We felt some vulnerability there. So our initial salvo or proposal back to Countrywide Securities was that they needed to wind down the use of section 13(3) facilities by the end of June—both the PDCF and the TSLF. They came back to us and in essence said, “Well, couldn’t you just let us go into July a bit because our merger is supposed to be approved today actually by the Bank of America board? Our legal Day 1, our closing is July 1. We can transfer positions July 2. What’s a couple of days among friends?” We had a little negotiation back and forth. We reached, I think, an agreement that was amenable to all. They agreed to wind down their use of the TSLF—no new borrowings. They could swing some of that into the PDCF. We would allow them to go until the closing, July 2, when they could transfer those positions. In return we got a little extra margin. So, in effect, those borrowings were being collateralized at a margin of roughly 7 percent. We got an additional 13 percent, bringing us to 20 percent, which will bring us through until July 2. So I think all sides are reasonably comfortable there, and with friendly persuasion, Dudley and Baxter sealed the deal there. Let me say a few words about Barclays Capital. We handled this a bit more informally. They started using the PDCF more in late March, at around $5 billion. They got to a peak of about $7 billion. Both Bank Supervision and Markets had June 24–25, 2008 143 of 253 conversations with Barclays, asking them to tell us a little more about why they were using this. What’s the rationale? They had a consistent story. They would tell us that it was economically advantageous for them to use that. They thought it was good. In one conversation with our colleagues in the Markets Group, one of the traders conveyed that Barclays thought they needed to support the TSLF in much the same way that they supported open market operations. Our colleagues in Markets very quickly disabused them of that notion. After a couple of conversations, they got the message. They eventually ceased borrowing from the PDCF around the beginning of June. So as of now, the only outstanding we have is with Countrywide Securities, and that should come to a close next week, knock on wood. Again just for the sake of completeness, on page 10 I’ll talk about the TSLF usage. First, schedule 1, which is OMO-eligible collateral—as you can see among the primary dealers, Merrill has had the highest amount outstanding. Merrill is, I guess, the tan line. The biggest users have been the commercial banks—Deutsche Bank is up top, a pretty consistent user. Then Citigroup (the green line), which has also been a fairly consistent and heavy user. Let’s turn to schedule 2 (page 11), which is the less liquid collateral. Here among the primary dealers, Lehman (the blue line) has been the most consistent user, followed by Merrill Lynch. As you can see, UBS among the banks was clearly far and away the biggest user, although within the past two weeks they have reduced their TSLF borrowings. So that’s, very briefly, the top five. There’s again a bit of a mix here. But as you can see, the investment banks are not the biggest users of the TSLF. Let’s turn to page 12, and I’ll finish up here. I’ll just highlight a very near-term challenge that we face, and I think it will provide a nice transition to Scott’s and Pat’s portions of the briefing. I don’t want to get too much into their sections. But I think generally we have an issue. I think that, the longer we stay on site with this effort, the reputational risk to the Federal Reserve increases. As Governor Kohn testified last week, we’re not examining; we are just very narrowly focused. I think that message was well received. At this time, it’s not too problematic. But if someone is up on the Hill six months or a year from now, I think it’s going to be very difficult to say that we’re just doing this liquidity and capital thing. People are going to want to know a little more about our judgments and how we made those judgments. As I said early on, I think there’s some risk to making those judgments without having a little more information. So I think the trick for us is, if we have our traditional bank supervision model on the left and what we’re doing right now on the right, we have to move this way, more to the left. By no means should we be way over here. But I think we have to figure out how to get this way a little more. With that, I will end my remarks and pass to Scott and then to Pat. MR. ALVAREZ. Well, as you can tell from Art’s presentation, there’s been a significant amount of information-sharing and collaboration already between the Federal Reserve and the SEC. So we’ve taken this opportunity simultaneously with what’s going on with the primary dealers to fashion a document that will lay out a framework for how this information-sharing and collaboration will go forward. June 24–25, 2008 144 of 253 We’ve made some pretty good progress on a document, but we’re still negotiating. In fact, the Chairman is negotiating this afternoon with Chairman Cox. This is one in which the principals have been intimately involved. The agreement as it is currently structured really has two parts. The first part outlines plans for sharing information between the two agencies. Here I would divide the world into two pieces. There are the consolidated supervised entities (CSEs), which are the four large investment banks—Goldman Sachs, Morgan Stanley, Lehman Brothers, and Merrill Lynch. We have agreed to share information and analysis of the financial condition, risk management, internal controls, capital, liquidity, and funding resources of those firms. The agreement is focused primarily on those areas—so the financial condition, liquidity, and risk management of the firms. As you know, we have accessed information from these companies in connection with our providing liquidity through the PDCF and the TSLF, so we’ll share that with the SEC. Similarly, the SEC, which is the primary regulator for those and has access to much more information, will share their information with us. We’ve also agreed to share information and analysis on various financial markets that these companies are intimately involved in—in particular, the tri-party repo market and the interbank lending market. Now, two bank holding companies participate in the SEC’s CSE program— Citigroup and JPMorgan Chase. We have agreed to share with the SEC the same type of financial and risk-management information regarding those two firms but only to the extent that that information affects the broker-dealers that are controlled by those two firms. So we are not expecting, nor is the SEC expecting us, to share information that relates to the condition of the bank or the condition of the other nonbank portions of either of those two firms—just the part related to their broker-dealer. We have an interest here in the Federal Reserve in the financial condition of broker-dealers that are not in the CSE program. That would be any broker-dealer that’s in a bank holding company regulated by the Federal Reserve. Our plan is to include an information-sharing arrangement regarding those institutions as well. More broadly, the SEC would provide us with information on an ongoing basis about the financial condition and risk management, internal controls, capital, liquidity, and funding resources of all broker-dealers that are controlled by a bank holding company. This would allow us access beyond what we’re currently getting. Right now we’re getting primarily FOCUS reports on the broker-dealers, which are not always the most informative documents. So we’ll get more access. We also are expecting to agree to provide similar kinds of financial and risk-management information to the SEC, again to the extent that the information affects the brokerdealer. So we would not be routinely providing information about bank holding companies related to the bank or related to the nonbanking operations that are not broker-dealers. We also are expecting to include a provision that outlines several existing agreements that we have for sharing information regarding some of the clearing companies—DTC in particular—transfer agents, municipal securities June 24–25, 2008 145 of 253 dealers, and investment advisers. This would simply incorporate, without changing, the arrangements we already have. An essential part of all this sharing of information is that both agencies would agree to keep the information confidential. In addition, the SEC is agreeing not to use our exam or supervisory information, in particular any opinions that we might have, in their enforcement actions or investigations without the permission of the Federal Reserve. The second part of the agreement, as we’re working through it, relates to supervisory expectations for the four large investment banks and for the primary dealers that have access to the PDCF and the TSLF. There the current proposal is that the two agencies would agree to collaborate and coordinate with each other in obtaining access to the information on the financial condition of these organizations and in setting supervisory expectations concerning the capital, liquidity, risk management, and funding for the CSEs and the primary dealers. We’d also collaborate and coordinate our communications to those entities about supervisory expectations, something that’s already begun with Art and his group. The memorandum of understanding (MOU) is intended to serve as a bridge from the existing world to whatever brave new world the Congress may put together. But it is not tied specifically to the PDCF or the TSLF and is intended to last beyond access to those facilities. It also does not change the legal authority that either of the two agencies has. We continue to have full, unfettered legal authority over bank holding companies. They continue to have full, unfettered authority over the brokerdealers. But we do agree to talk more, collaborate more, and coordinate more. As I mentioned, the MOU is substantially worked out. We are still, though, in negotiation over a couple of key points. Our goal is to have it done this week, we hope with an announcement at the end of the week or sometime next week. We expect that the terms of the MOU will be made public. As soon as we have something that’s concrete enough, we’ll also send that around to you. MR. PARKINSON. Thanks. I’m just going to go over the last few pages of the handout you have, pages 13 through 15. Page 13 is just a table reminding you who the primary dealers are and providing some basic information about their size, borrowing activity, and regulatory status. As you probably know, there are currently 20 primary dealers, although as Art mentioned we’re about to lose two of them—Bear Stearns and Countrywide. An important point to note, which ran through Scott’s presentation, is that although the investment banks—the four firms that are subject to consolidated supervision by the SEC under their CSE program—are among the largest primary dealers, there are some very large bank-affiliated dealers, including not only affiliates of U.S. banks but also affiliates of German, Swiss, British, and French banks. Also, if you look at column 3, you’ll see—and these are data that we get from the two government securities clearing banks that facilitate tri-party repo, JPMorgan Chase and Bank of New York—that it shows that the investment banks are not, in fact, the largest borrowers in the tri-party repo markets. Rather that distinction belongs to Deutsche Bank, Banc of America, and Barclays. I think that’s significant because arguably the biggest threat from Bear’s bankruptcy was the impact on the June 24–25, 2008 146 of 253 availability of secured financing, especially from money funds and other highly riskadverse investors that provide tri-party financing to the dealers. So we have some very large borrowings by those non–investment bank firms. Columns 4 and 5 provide some information about how these firms are regulated. Essentially the legal entity itself in every case but one is a broker-dealer regulated by the SEC, and in that case it’s a government securities dealer regulated by the Treasury but the SEC really does the enforcement of those Treasury regulations. Finally, all of these firms except one, Cantor Fitzgerald, which is an inter-dealer broker, are subject to some form of consolidated supervision by one or another consolidated regulator, although the regimes can differ appreciably. The OTS has a regime for Countrywide, I guess being a notable example itself, quite different from the one that we would apply. So with those facts in mind, turn to the next two pages. I don’t intend to go through all these questions, but what we’ve done here is set out some issues for discussion. Basically there are two sets, one relating to the future of our liquidity facilities for the primary dealers and the other relating to the supervisory arrangements through which we’re seeking to mitigate the moral hazard that those liquidity facilities create. In each case, there are questions about what to do under current laws, until such time as the Congress may change those laws. Then there are questions about what legislative changes we might seek, particularly if the Congress shows an inclination to legislate in this area. Our purpose for this list of questions is to stimulate a discussion among you about these important issues and to provide you with an opportunity to express any preliminary views you may have. With that, I think we’d be pleased to answer questions on any of the three staff presentations. Thanks. CHAIRMAN BERNANKE. Questions for our colleagues? President Lacker. MR. LACKER. Thank you. Thank you, Art, Scott, and Patrick, for a very forthcoming presentation. Two things for you, Art: First, on page 8 you presented some information about the details of the stress test that you’re applying, and the table lists various unsecured funding and secured funding from other sources, and you have numerical assumptions for the severity of stress. I take it that you apply those to the balance sheet numbers and do some calculations to calculate the stress test. MR. ANGULO. Correct. We went back to the firms and asked them to give us the information cut this way because it’s not readily available from any public information that we have. We also asked them to give us, under a severe test scenario, what their assumption was. June 24–25, 2008 147 of 253 Based on the submissions that we got from the four, which we converged and massaged, we came out pretty close to these assumptions. We didn’t make these up. MR. LACKER. I was going to say that you essentially asked the question, What does “severe” mean in your stress system? MR. ANGULO. We left it somewhat in their hands, saying that it’s going to be short of a full run. MR. LACKER. Then you had some iteration to get to an agreed-upon set of numbers for these. MR. ANGULO. Yes. MR. LACKER. Okay. Now, you also said that you started your first iteration by asking them to give you the results of a Bear Stearns failure scenario. What numbers does that correspond to on this table? MR. ANGULO. You would have a lot higher numbers on secured funding. You would have the numbers coming much closer to the illiquid, 100 percent, and you would have a— MR. LACKER. Well, wait. I’m sorry. I lost you there. MR. ANGULO. Under fixed-income finance, for example, under the secured funding, there’s liquid and less liquid. Those are 20 percent and 50 percent. Those would have been approaching 100 percent. MR. LACKER. So the severity, that’s how much of the money goes away. MR. ANGULO. How much runs—exactly. MR. LACKER. Okay. So do you have those numbers for Bear—what they actually experienced? June 24–25, 2008 148 of 253 MR. ANGULO. The SEC is working on a post mortem. They have promised to share it with us when they’re done. They have folks—I wouldn’t say forensic accountants—in there looking at that, trying to piece together what happened. So we did not have the exact numbers. MR. LACKER. You didn’t have the exact numbers. MR. ANGULO. No. MR. LACKER. But you knew roughly what they were. MR. ANGULO. Things moved pretty quickly at the end. MR. LACKER. I see. Well, I was just interested in information on exactly how that transpired. If there’s a chance that you could share with us that information when you get it, that would be very useful. A second question for you: You noted reputational risk from being in on the supervisory basis, and I want just to probe as to how you think about that. What eventualities would be risky for us? MR. ANGULO. I guess a couple. We’re saying that we’re looking at the capital position. I think Governor Kohn was careful to say in his testimony that we’re looking at capital in relation to near-term earnings prospects. That gives us kind of a short window, but we know from examining banks that a capital number that’s reported to you depends on how you’re carrying your assets. We have not done any work in trying to get behind, for example, the evaluations on Lehman’s commercial real estate portfolio. That’s a potential vulnerability there. Also, we have not really looked to a consolidated assessment of risk management at these firms, something we do in the bank supervision process. So we’re basically taking the inputs, for lack of a better word, at face value and not doing our own work to try to validate those. That’s what I was referring to in terms of the risk to us. I think as long as we’re there, people expect us to be doing a little more than what we’ve been doing to date. June 24–25, 2008 149 of 253 MR. LACKER. So it’s essentially the risk that, after the fact, marks are questioned, and they ask, “You guys were in there—why didn’t you . . .?” I understand that. Thanks. The third question is for Pat. You talked about the repo market. My understanding is that some supervisory work under the LFI (large financial institution) umbrella is aimed at conditions in the repo market and mitigating some risk there. You mentioned that it was obviously an important factor in Bear. To what extent do you think paying interest on demand deposits would obviate the need for the huge volume of transactions in the repo market and the extent to which that legislative prohibition could have contributed to the market structures and fragility that gave rise to what happened in Bear. MR. PARKINSON. I can’t answer that, but that’s a good question. I mean, the basic problem here is that you have a tremendous demand for investments that have essentially the characteristics of Treasury bills, but the supply of Treasury bills isn’t nearly as large as that demand coming from money market mutual funds and from investment of cash collateral on securities lending and other kinds of secured financing. Over time, the marketplace has come up with synthetic Treasury bills of various sorts, but those short-term investments have been created outside the banking system by and large because the inability to pay interest on demand deposits doesn’t allow them to be provided by the banking system. Now, if that prohibition were removed, I think you would see banks offering things that would be competing with overnight repos, overnight commercial paper, and other sorts of things that are outside the banking system that are meeting these needs. In terms of the effects on stability, whether that leaves us in a better place obviously would depend on how good a job we do of regulating maturity transformation by the commercial banking system. An interesting question there is—whenever I hear Art give his presentation and look at June 24–25, 2008 150 of 253 these stress tests we’re applying to the investment banks, even under current conditions, when they’re not offering overnight interest-bearing deposits—how well our banks would fare if we tested them against these standards. But I think your observation and your question are good ones. MR. LACKER. I mention that because it sounds as though it would be worthwhile knowing if it’s important. Since we’ve asked the Congress twice now for permission to pay interest and they’ve declined, and if this was a factor in the recent crisis, we might want to point that out to them as part of our legislative dialogue with them over the next couple of months to try to get them to do something. CHAIRMAN BERNANKE. Governor Kohn. MR. KOHN. Thank you, Mr. Chairman. Just a comment on President Lacker’s question: I guess in the end it would depend on how big Bear Stearns’s balance sheet would have been and whether paying interest on demand deposits at commercial banks would have somehow shrunk Bear Stearns’s balance sheet and the secured funding that could then run. So it’s pretty complicated. It’s not obvious to me whether it would have made Bear Stearns a smaller player and a less significant part of the market, but it’s interesting. Tim looks as though he wants to say, “Yes, it would.” VICE CHAIRMAN GEITHNER. No. May I? You know, we think that the money funds finance about a quarter or a third of the stuff in tri-party. Money funds have a unique type of liquidity risk. So it is possible, if the same set of assets were financed by banks, that because banks have a different liquidity risk the system would be more stable. So you can maybe say, even with the same balance sheets as investment banks and the same mix of illiquid stuff financed through that mechanism, if the banks were the dominant providers of liquidity or it was provided through banks, that the system would be more stable, and the broader protections that we designed over the last June 24–25, 2008 151 of 253 century to limit the risk of runs on banks because of the risk to the system might have more power, insulating us from a system where nonbanks are large. I think that’s the argument. It would be interesting to know a bit about the politics on the Hill of thinking about that legislative change. It would probably look a little like the Middle East, I suspect. [Laughter] That would be a huge change in the relative return on different types of financial businesses that now would come with that. But it would be worth knowing a bit about the history of that debate in the past and what the probability is that we could get something like that through. MR. KOHN. I also had a question, Mr. Chairman, and it’s on the PDCF. I find some tension in my own attitudes here. Your leaning all over these people not to borrow helps protect the Board’s decision that this is unusual and exigent, credit couldn’t otherwise be available, and all of that. So it’s supportive of that. On the other hand, it sounds really like what we used to do with commercial banks all the time and thought it created stigma in the process. We don’t want you to borrow. If you come in and borrow, given that we don’t want you to borrow, you must really be hurting to overcome Art Angulo’s or Bill Dudley’s frown. So I think the more we do this, the less useful this thing is as a backstop in some sense. I don’t know. I don’t have an easy answer as to how to resolve this tension. VICE CHAIRMAN GEITHNER. Mr. Chairman, may I—not to preempt Art and Scott—in this case? I completely agree. It is very important not to undermine the value of these liquidity backstops by introducing stigma in their use until we get to the point at which we want to dial people back. But the decisions or the actions we took in the context of Cantor and Countrywide had a very compelling rationale. It would have been irresponsible for us, given the facts that over Cantor we have no comparable framework of supervision and that their exposure was very large relative to capital. In that context, we could do it without any risk that we were going to stigmatize June 24–25, 2008 152 of 253 the use of the PDCF because it’s a unique thing. Countrywide, as you know, had a slightly different but similar rationale. It would have been imprudent for us to have had a substantial amount of securities outstanding, insufficiently collateralized, in the event that the deal didn’t go through, because they were not viable on their own without Bank of America’s buying them. That was a necessary and prudent thing to do. I think also that the risk was very limited that we introduced stigma to the facilities. The Barclays thing was more delicate. We would not say to them, “You can’t use the facility.” We just asked some careful questions about what they were doing and why, because their pattern of use was so different from everybody else’s in that context. But I completely agree with your concern about that stuff. I think we must be very careful going forward that we don’t do things that will alter this balance. CHAIRMAN BERNANKE. President Lacker, you had something? MR. LACKER. Yes. About the general topic of stigma and lending at our facilities, I think it would be a useful agenda item for future research, and it would be useful for us to work at thinking carefully about this. Stigma represents some information revelation to market participants attending on some act, whether it’s borrowing from us or from someone else. The usual presumption is that more information is better. We talk as if stigma is a bad thing. So I’d want to see a model that lays out how the sense in which it’s a bad thing counteracts the sense in which information is usually a good thing. I’m really curious about that. I think it’s something we ought to think more carefully about. CHAIRMAN BERNANKE. President Plosser, did you have a comment? MR. PLOSSER. Yes. I asked Bill Dudley yesterday a question about what I had heard from the Street—that they perceived that stigma was attached to it. With this conversation, it certainly appears to me that I was hearing them say that, at least from the investment banks’ point of June 24–25, 2008 153 of 253 view, they do feel that some stigma is already attached to it, good or bad. Now that I’ve heard this discussion, it is consistent with what I was hearing from those Wall Street firms. MR. DUDLEY. May I just interject one thing on this? Vice Chairman Geithner makes the important point that one issue is counterparty risk for Cantor and Countrywide, which was sort of separate. The other issue is, since this is permissible only under section 13(3), that it can’t be a chronic source of funding and it can’t be part of their core funding plan. We want to make it clear to them that this is going to go away, and we want to be confident that they’re not dependent on the PDCF as a source of funding. So I would distinguish between Barclays coming in occasionally with Barclays coming in every day, and that’s really the point we were trying to make to them. MR. ANGULO. It may be too fine a distinction, but we didn’t say “no” to anyone when they came in. When they came in and stayed for a month and a half or two months, then we started to say “no.” VICE CHAIRMAN GEITHNER. But these are very different. I’m sorry— CHAIRMAN BERNANKE. Go ahead. Finish your sentence. VICE CHAIRMAN GEITHNER. I was just going to say that it’s a very delicate balance. We want this set of firms to get themselves to the point where, in the eyes of the market, they have a more conservative mix of leverage (appropriately measured) and funding risk so that they are less likely, even in a pretty adverse shock, to need to finance illiquid stuff with their central bank as a defense against that liquidity pressure. We’re trying to do that without forcing a level of deleveraging that would be adverse to our broader objectives of trying to get markets back to some point where they’re functioning more normally. We’re not going to get that perfect. By definition, our facilities by design should allow them to run with a mix of leverage and liquidity risk that is above what the market probably now would permit. In the absence of our facilities, leverage and June 24–25, 2008 154 of 253 liquidity risk, if you measured it on a scale, would have to be lower in some sense. But that’s the purpose and the necessary complement of the facility, and it is a delicate balance. But just to come back to President Plosser’s point, I don’t think that the stigma is the result of how we’re applying the discretion we preserved for ourselves around use. It is really the result of the fact that, particularly if you’re at a point when you perceive escalating concern about your viability, people don’t want to risk that their pattern of use, if disclosed, would magnify the concern. That’s really what accounts for the care in use, particularly as concern about viability has been intensified these last few weeks or so. MR. DUDLEY. If I could add just one more thing, I also think that the stigma doesn’t really undercut the benefit of the PDCF as a backstop to these firms’ financing. If the stigma really undercut the benefit, then the stigma would be quite important. But I think that the PDCF is still a very viable backstop even with some stigma associated with it in the current environment. CHAIRMAN BERNANKE. President Hoenig, did you have an intervention? MR. HOENIG. Yes. To follow up on Governor Kohn’s point, I think it’s important to our discussion going forward in terms of how we view these firms, from commercial banks to investment banks and primary dealers, because we are lending under exigent circumstances to these institutions under the primary dealer facility. Therefore, they almost by necessity should be concerned about stigma if they were to continue to borrow through there. On the other hand, it’s important because the TAF is a different instrument and has different implications going forward in how we think about it and whether we want stigma with that. I think about how and how broadly we view different financial institutions, that is, investment banks. Are they blending into commercial banks? What about beyond that? We are going to have discussions about other types of financial institutions—should they not continue to be lent to only under exigent circumstances June 24–25, 2008 155 of 253 versus an ongoing TAF type of arrangement? So I think there is stigma and probably should be unless we are concluding that they’re more like banks than not like banks. CHAIRMAN BERNANKE. We’re going to have a chance, of course, for everybody to give their views. President Fisher, did you have a question? MR. FISHER. I just wanted to get in on this point that Governor Kohn raised. I’m not uncomfortable with our being parsimonious with the Primary Dealer Credit Facility. It is under unusual and exigent circumstances, and I think we need to be sure that they are unusual and exigent circumstances. That’s the reason it was created, and I think we have to respect that. I’m just wondering, judging from the decline in the extent of the outstandings and given what you described, can we assume that there’s a lessening of unusual and exigent circumstances? That’s my question. MR. ANGULO. I would defer to my colleagues in Markets, but I would just give one anecdote. Over the past few weeks, in particular, when Lehman announced its second-quarter results, some observers in the market stated that Lehman might not have come through this period if the PDCF had not been there. They never drew on it. I think it’s an interesting point. I think there may be some relevance, some truth, to that. Bill, you would have a better sense as to whether the markets are back to normal or not. MR. DUDLEY. I don’t think they’re back to normal, and I also think very strongly that the amount of use of the Primary Dealer Credit Facility is not a guide to how important it is as a backstop for financial firms. MR. FISHER. That’s my point. That’s important. MR. DUDLEY. There were a number of people to whom we talked who said that the reason they stayed with Lehman during this period of stress was that they knew that the Primary June 24–25, 2008 156 of 253 Dealer Credit Facility was there as a backstop. So I have a high degree of confidence that Lehman would have been in great difficulty without it. VICE CHAIRMAN GEITHNER. Just to make sure—it isn’t quite as awkward as it sounds. I mean, it’s not clear. The test for us about whether or not these make sense is not fundamentally about whether the PDCF would save Lehman from itself. I would just make the observation that we thought originally that you could look at the bid to cover and at the clearing price in the auction facilities as a measure of stress in markets, and they would be a test by which you could see conditions. I think it’s important to recognize that that’s not itself a particularly useful prism on stress today. Independent of the specific circumstance around Lehman, the people who are funding tri-party balance sheets, for better or worse, tell anybody who listens that they’re doing so significantly because of the existence of this facility as a backstop. So the use is not a very good measure of stress probably because of the stigma around it and because we’re affecting prices anyway by the existence of these facilities. We’re doing as much as we can to improve the odds that these firms get to the point at which, in the eyes of their short-term secured or unsecured creditors, they look as though they can withstand a pretty large shock in the future without recourse to our facilities. But I don’t think we’re at the point yet where we can say that confidently, not because they haven’t deleveraged sufficiently or bought enough liquidity—though there’s a bit of that still left—but because there’s so much uncertainty left still about the scale of pressure on balance sheets, what that might do to the losses, what that might do to asset prices going forward or to behavior. So this is just one man’s view, but I think a very good, substantive case based on what you can observe and what people say about behavior suggests that circumstances are still so fragile that we could justify the provision of these facilities as a responsible, sensible act given our broader objectives. June 24–25, 2008 157 of 253 CHAIRMAN BERNANKE. Did you complete your questions? MR. KOHN. Yes, I did. CHAIRMAN BERNANKE. President Rosengren. MR. ROSENGREN. I just have a couple of questions of fact. How big was Bear Stearns’s tri-party repo on the Thursday that they started getting into trouble—just to give a rough sense of scale? I know it’s not exact. MR. ANGULO. About $150 billion. MR. ROSENGREN. About $150 billion? MR. LACKER. That Thursday? MR. DUDLEY. It was a little over $100 billion. MR. LACKER. It hadn’t run off that week? MR. DUDLEY. It was starting to run off. MR. ROSENGREN. Okay. So roughly $100 billion. The numbers seemed to be in that range. Now, one of the reasons that we’re worried about the tri-party repo was that the securities in that tri-party repo were very illiquid. Was Bear Stearns unusual in the amount of illiquid securities that were being financed? As we look down this list, is the nature of the tri-party repo across these different parties similar or different? You could have a tri-party repo with collateral that would be easy to liquidate, or you could have a tri-party repo with something very difficult so that the counterparty would have a difficult time actually selling it into a distressed market. From the work you all have been doing, are there big differences or not? MR. ANGULO. There are definite differences among dealers. I don’t have the Bear Stearns cut, but we did a cut recently, and there are very clearly differences among dealers. As we know, the share of less liquid assets being financed by tri-party has been growing over the last— June 24–25, 2008 158 of 253 pick a number—five, seven years. The trend line is going like that, clearly at a steeper or more pronounced rate than the growth in more liquid or more eligible collateral. MR. PLOSSER. So—I’m sorry—what percentage would that be? When you say it’s growing, is it now 10, 20, 50, or 80 percent? MR. ANGULO. Pat, do you have that? MR. PARKINSON. I have in front of me data from Bank of New York, which facilitates about two-thirds of the repos. At Bank of New York, 18 percent of the collateral is debt that’s settled through DTC—so that would be non-government, non-agency debt—and another 6 percent is equity. So about 25 percent is non-OMO things. The biggest chunk by far is agency MBS. Of course, I think in extremis Bear was having trouble financing even agency debt, importantly given the illiquidity that had developed in even the agency debt markets at that time, which was the critical thing that made investors no longer willing to provide financing for that kind of collateral with a shaky counterparty. MR. ROSENGREN. For Bear Stearns, we have one side of the transaction looking at the investment banks. On the other side of that transaction, you have companies like Fidelity, Schwab, and Federated. So as we think about who poses systemic risk, we probably want to think about both sides. In terms of a distress scenario, you have tri-party repos that are very illiquid. The clearing bank does not want to provide the cash. As a result they have to liquidate, and you have companies like Fidelity, Schwab, and Federated having to break the buck, and they don’t have much capital to infuse. So just as we think about systemic risk, as you’re looking at these other organizations, are there other people that you would add to that? I know for Bear Stearns that Fidelity, Schwab, and Federated played a very large role. Were there other organizations that we ought to be thinking about that would have the same kind of nature? June 24–25, 2008 159 of 253 MR. PARKINSON. Well, the other big category that we have been able to identify of entities that are providing tri-party financing is the custodian banks that act as agents for securities lenders. When someone lends out securities, they often take in cash collateral. Then they want to reinvest that collateral, and the big bank custodians do that on their behalf and invest a portion of that cash in tri-party. Interestingly, JPMorgan Chase and Bank of New York Mellon are two of the big banks involved in that particular business. So that’s another category. I think maybe what you’re getting at is about dealing with the issues of the tri-party market per se. We have to be very careful in our approach to these issues because the situation is still very fragile, and until we get out of this period of turmoil, we first want to do no harm there. But any solution can’t be focused solely or even primarily on the clearing banks and the way they process these transactions, although that’s part of it. It also has to focus on the behavior of the borrowers and the lenders, and the borrowers are basically all of these primary dealers and certain other big broker-dealers. The lenders are more diverse, which makes them more difficult to deal with. But I think there are certainly questions about whether they’re managing their risks effectively. If you’re a money fund and you’re treating an overnight repo secured by illiquid collateral as the equivalent of an overnight Treasury bill, there’s something problematic about that in terms of your own thinking about the situation you’d be in if, in fact, the borrower were unable to repay. MR. ROSENGREN. One last question. Sorry for so many questions. The situation of Lehman was kind of interesting because you saw their stock price go down. Talking to financial institutions, both regulated and unregulated, in Boston, a lot of people were evaluating counterparty risk and deciding whether or not they were going to start running before the capital issue. Did your measures of liquidity pick up the amount of stress that was going on in the counterparty analysis being done, I assume, all over the country? One of the conditions for an institution’s access to the June 24–25, 2008 160 of 253 discount window at a primary credit rate is that it not be rated a 4 or a 5. I know we’re not doing bank exams, and I know we’re not looking at all the elements of the bank exam. How confident are we, if we were to do something like that for Lehman or for Merrill Lynch, that we wouldn’t rate them a 4 or a 5? MR. ANGULO. On the first question, yes, we were picking up the pressures on liquidity. We saw some cracking, but it never broke. There were some counterparties that were skittish, but we never saw the type of accelerated withdrawals or running that came to mark Bear Stearns. We were watching it very closely, and so were they. But basically it hung together. The second question is a very difficult one. It goes back to the point I finished on, that we are somewhat vulnerable in making these assessments without having a more robust process. One way to look at it in the near term, though—again, as best we can, looking at capital—is the chart on page 6. If you look at Lehman—with its capital raise, their tier 1 risk-based capital would be 12.5 percent. There may be some range around that. There are certainly questions about how accurately Bear’s capital was stated. But as a rough measure, I think it would be difficult to say that Lehman would be a 4 or a 5, looking at it from a solvency perspective. They’ve bolstered liquidity. As I said, it started to crack, but it never really shattered. CHAIRMAN BERNANKE. Governor Warsh, did you have a question? MR. WARSH. Not a question, just for the go-round. CHAIRMAN BERNANKE. Why don’t we then have an opportunity for general comments on these issues. Let me just give a bit of context. When we instituted the PDCF and the TSLF in March, about the time of the Bear Stearns event, we stipulated that they would be available for up to six months. That date, mid-September, is coming closer. It’s my view, and I think others share it, that markets remain fragile, and in the case of Lehman, for example, the existence of the backup June 24–25, 2008 161 of 253 was an important support in maintaining the stability of that institution. Therefore, given the state of the markets and given that I think we still face some systemic risks, I am quite inclined at this point to ask the Board to extend the PDCF and the FOMC to extend the TSLF over year-end, which is a difficult period—subject, of course, to the continued finding of unusual and exigent circumstances. If we do that, I would ask the Board to consider that in a Board meeting, and depending on the comments today, if there’s sufficient support, I would ask the FOMC to do that in a notation vote later this month. Now, if we make the announcements that we’re going to at least provisionally extend these facilities, I think it’s important that we do so in the context of explaining that we have an exit strategy. In particular, we are working to strengthen supervisory oversight, market resilience, and the overall regulatory structure so that there is understanding and confidence that we’re moving forward in a way that will over time make this unnecessary not only in the short term but in the long term as well. There are several parts to the plan here. One, as Scott already described, is the memorandum of understanding with the SEC, which will provide the basis for cooperation and collaboration in the medium term for our oversight of the investment banks. Two, working with the SEC, we’d like to push forward along the lines that Art was describing, go beyond where we are now, and begin to establish a set of supervisory expectations regarding what we expect to see for the investment banks and to make sure that we have greater confidence in what we’re doing and what they’re doing. A third element that I think is important as we go forward is to try to improve the financial infrastructure in a number of dimensions. A lot of this work is already taking place at the Federal Reserve Bank of New York, working with other regulators and with the private sector. It includes things like improving the clearing and settlement process for various kinds of derivatives June 24–25, 2008 162 of 253 and improving risk management of derivative positions and counterparty positions, for example. It would be important for us going forward to make sure that major institutions can identify their exposure to a given counterparty through derivatives and other instruments and be able to close out that counterparty in an efficient and effective way. In addition, work is going on here at the Board and in conjunction with New York on the tri-party repo market, trying to think of ways that we can strengthen that—perhaps, for example, by narrowing the range of collateral that is normally accepted and through other steps. So the way I would envision this proceeding would be—again, with your assent and subject to your comments—that we will announce within the next few days the MOU agreement with the SEC, which I would reemphasize is not tied to the PDCF. That is, we would anticipate that this relationship would continue even should we close those facilities, on the grounds that the moral hazard issue is still there, until such time that there is further resolution by the Congress. Second, I’ll be giving a speech at the FDIC on July 8, followed by testimony on regulatory reform on July 10, when Secretary Paulson and I and others will be laying out some broad principles, including some of the issues of infrastructure, and will be discussing some of the longer-term legislative issues—for example, the issue of how we should perhaps normalize or regularize the resolution of a failing systemically important firm and, in so doing, maybe define more strictly what the parameters are for Fed lending and what our responsibility is in this kind of situation. So to summarize, the MOU is this week. There will be testimony coming up. Presumably after the monetary policy testimony later this month, we would like, conditional on your approval, to announce the extension of these facilities conditional on continuing unusual and exigent circumstances. We would like to package that with a series of announcements concerning investment bank expectations, infrastructure, and as part of this environment as we talk about this in June 24–25, 2008 163 of 253 testimony and so on, some of our thoughts about how we might go forward in terms of statutory change in the future. What I’m trying to convey is that, although I think we need to extend these facilities, we should do it in a context of increasing clarity about how we are working to make them less and less necessary in the future. So with that as context, let me just open the floor for any comments that people might have. I have first President Lacker. MR. LACKER. Thank you, Mr. Chairman. The issues around the liquidity facility and what supervisory apparatus we have wrapped around primary dealers have to do with our having extended our lending reach. I think there’s now a substantial gap between our implied lending commitment and the scope of our supervisory authority. Vice Chairman Geithner spoke very eloquently about that earlier this month. I think it’s paramount that we close that gap in order to keep borrowers from exploiting the obvious lending commitment and choosing to leave themselves vulnerable to runs and run-like behavior. But this leaves open the question of the extent of our lending reach and how we close that gap, and I think that that’s the most critical challenge for us in the year ahead, particularly as we approach negotiations with the Congress. I’d like to share a couple of thoughts on that broader question because the questions posed to us sort of get at those. It’s important to start this from a peacetime perspective, sort of a timeless perspective, and ask the question as if you were choosing afresh a lending and regulatory policy that was going to last a long time. If you imagine for the moment that whatever we announce and adopt would be perfectly credible and immediately viewed as credible, I think you’d obviously choose to not have this gap. You’d obviously choose to have lending and regulatory policies that are mutually incentive compatible. So you’d want an adequate supervisory regime in place for any institution that market participants believe we’ll lend to. Conversely, it means that you would want market June 24–25, 2008 164 of 253 participants to believe that we will constrain our lending to those institutions for which we have an adequate supervisory regime in place. So then the question comes up: How do you choose the boundaries of our lending commitment? I take it as self-evident that our lending commitment shouldn’t be open-ended and unlimited. We don’t want to supervise every financial intermediary in the world or in the United States, much less all individuals, partnerships, and corporations. But even limiting ourselves to what’s called systemically important financial institutions is going to be problematic as well. I take that phrase to mean any institution whose failure could be costly or disruptive to many other market participants. Any institution that chooses to engage in maturity transformation to some extent faces the potential for run-like behavior by the creditors. Unless we impose draconian regulations, market participants will always have a virtually unlimited capacity for creating financial arrangements that run the risk of disruptive failures. So extending our lending reach to whatever institution that makes itself systemically important just leads us down a path of ever more financial regulation of an ever larger portion of the financial system. I think we’re going to have to set some boundaries. I’d like to see them tighter rather than looser, and making them credible is going to be the hard problem for us going forward. In doing that, we’re going to face a classic time-consistency problem. I take that as given. I’m not sure everyone else shares that view, but I take it as obvious. Inevitably the exigencies of crisis management are excruciating, but I think there are times when they conflict with our long-run interest in the type of financial system that we would design from a peacetime, timeless perspective, just the way short-run concerns about growth sometimes conflict with our long-run interest in price stability. But just as sustaining monetary policy credibility sometimes requires resisting the temptation to ease policy to stimulate growth, sustaining credible lending limits is going to June 24–25, 2008 165 of 253 sometimes require not preventing a disruptive failure of an institution and not ameliorating the cost of financial distress. To put it another way, I think it would be a mistake to adapt our supervisory reach to a purely discretionary lending policy. We’re going to have to choose a policy and commit to it and then take hard actions to make that credible. From this point of view, I have a deep question about the questions posed by the staff. They focus entirely on primary dealers, and it doesn’t strike me that the fact that Bear Stearns was a primary dealer was what made us lend. It was the fact that it was more disruptive. I think it’s likely that any other institution that presents the same threat of a disorderly resolution is going to be perceived as benefiting from our implicit lending support, whether or not they’re a primary dealer, unless we say something otherwise, unless we draw a boundary, and unless we make that credible. So, for example, other large broker-dealers, hedge funds, private equity firms, or insurance companies could easily fail in a disruptive way. We need to think through whether we’re going to let that happen or whether we’re going to be forced to step in. At some point we’re going to have to choose to let something disruptive happen. I think that ambiguity about our lending limits would be a bad choice. Market participants are going to form their own views about the likelihood of us lending. Any lack of clarity about the boundaries is just going to lead some firms to test the boundaries, and it’s not going to help us resist the temptation to lend beyond the boundaries we want to establish. Besides, Mr. Chairman, you’ve emphasized the value of de-personalizing and institutionalizing the conduct of monetary policy. It’s important that we strive for lending policy that isn’t critically dependent on particular officeholders. As I said, I’d favor fairly tight limits on our lending commitments, and you are probably not surprised about that. I think we really ought to maintain this section 13(3) hurdle at a fairly high level, but the exit strategy makes me nervous. Crafting this MOU, a permanent shift in our visibility June 24–25, 2008 166 of 253 into and in our ability to protect the system from primary dealers, is just going to sustain the expectations that have arisen since Bear—which have been described and referenced a couple of times and which you see in the fall in CDS spreads for those institutions—and it is just really hard to see how to put that genie back in the bottle and limit the extent to which we’re viewed as backstopping them. But I think we ought to strive to make that somehow be viewed as unusual as possible. More broadly, my reading of the history of economics and financial intermediation is just my reading. But I’m motivated broadly by the sense that we’d be better served in the long run with as small an extent of central bank lending commitment as possible. Central bank credit is fiscal policy. It entangles us in politics. It risks compromising the independence of our monetary policy. You’ve heard me say this before. Expanding our lending forces us to extend our regulatory reach, and that can’t be good for the financial system even though I trust our staff to do a very good job of being as efficient and effective as they can be. I’ve argued this before. It’s not obvious on the evidence that our financial system is terribly fragile apart from the volatility induced by uncertainties about government and central bank policies. Besides, I think that we should take seriously the notion that some amount of financial instability is undoubtedly optimal, as work by economists such as Allen and Gale has demonstrated. Those are the kinds of considerations that I think ought to guide our policy. Finally, Mr. Chairman, a word about process. At our last meeting we discussed interest on reserves, a historic and consequential decision for us. We had a briefing package of 100-plus pages reflecting substantial staff work. The Committee very much benefited from that. At an upcoming meeting we’re going to talk about inflation dynamics, another consequential topic. We’ve received somewhat less material, even going back several months, about financial markets, their character, June 24–25, 2008 167 of 253 and the welfare economics of our interventions. I’d urge you to consider a special topic at some future meeting at which we explore the economics of financial stability, since it is becoming such a consequential part of what we do. Related to that, I was happy to learn from Art that an after-action review by the SEC was under way. Because our role is different from the SEC’s, I’d like to suggest that maybe building on that or maybe in parallel to that we conduct our own after-action review of the factors that went into how that event played out. Thank you very much, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. I agree with you that we need to define limits, but I think we have stronger tools than just our declarations of piety. I would just note that there are models. One good model is the FDICIA model, for example, which lays out a whole set of criteria under which intervention can be taken and, if intervention is taken, has a set of rules. There are ways through the legal structure to solve some of these problems without our necessarily having to make time-inconsistent promises. MR. LACKER. I agree, and those are mechanisms for legislatively tying our hands, and that ought to be high on the agenda. CHAIRMAN BERNANKE. We’ll discuss those. Yes, President Plosser. MR. PLOSSER. On that point, I have been reading a bit recently. It might be useful in thinking about some of these issues about how we tie our hands and the mechanism for doing that. The IMF went through an extraordinary study effort during the sovereign debt crisis and came up with some very important mechanisms for how to change the contracts that were being written by sovereign countries so as to avoid the IMF’s having to step in and look for other solutions, which is, I think, along the same lines. I don’t know whether or not there are things from which to learn in parallel with that to think about how we approach that issue. CHAIRMAN BERNANKE. President Rosengren. June 24–25, 2008 168 of 253 MR. ROSENGREN. I have three comments for the long term and three comments for the short term. For the long term, in the tradeoff between focusing on markets versus institutions, to the extent that we can have standardized products traded on exchanges, we don’t need to spend as much time with institutions, and that takes care of a lot of the counterparty risk. To the extent that the products have to be customized and done in dealer markets, then we have counterparty risk and that becomes an issue. So I applaud what the New York Fed is doing with the credit default swap market in thinking about a way to more systematically reduce counterparty risk. I wonder if we should more forcefully be trying to push it not only to a clearinghouse but also maybe to exchange traded. I know there is a tradeoff between standardized products and nonstandardized products. But if we can get things to be more standard so that they can trade on an exchange, we won’t have to spend as much time talking about some of the issues that we’ve been talking about. Not just a credit default swap market has that characteristic. So if we can push a number of areas in which there’s counterparty risk into an exchange, then we can get out of the business of focusing on all the institutions. The second point is that there’s a broader role for us as a holding company supervisor. When I look at this list and look at Countrywide, it’s not because they’re a primary dealer that I would be focused on them. It’s because they were 20 to 25 percent of the residential mortgage market; they were a very large player. The OTS has holding company supervision over them. We ought to ask ourselves whether now is the time to think about what organizations we ought to have holding company responsibility for. The OTS has WaMu and had Countrywide. We ought to give some thought to that. Now is the time to think about whether or not that’s appropriate and push for it if there are going to be legislative recommendations. In terms of broker-dealers, I think the same thing applies. I don’t think that we should be the primary regulator for these organizations. But if June 24–25, 2008 169 of 253 we’re going to be lending to them in exigent circumstances, having holding company regulatory authority does become important. The third point is that, when you look at this list, there are a lot of foreign institutions. One insight that we’ve gotten is that an organization as big as UBS could potentially fail. That may not be something that we thought was very likely nine months ago, but it is obviously more likely now than we would have anticipated. Foreign organizations can either establish themselves as a branch or have a domestic holding company. To the extent that foreign supervisors decide to wall off their organizations around their geographic borders and say that, if there is a problem, we’re not going to support institutions that are in the United States and you’re on your own, I think we need to revisit some of our rules on how much capital we expect foreign holding companies that are intermediary holding companies to hold. We might also want to think about, if there’s a lot of activity being done through a branch that has no capital supporting it, how concerned we should be about that. Should we be taking actions to make sure that, if the foreign parent decides that they are going to abandon the branch, we feel very comfortable with that outcome? Given the list of the primary dealers, I think the numbers are fairly large, larger than they were for Bear Stearns, and that’s something that we probably should give a bit more thought to. On the short-term issues, I certainly think that we should extend the facilities past the end of the year. That makes perfect sense. A number of us have made the point that the markets are still fragile. Just the announcements about Lehman Brothers over the last month highlight that we’re not yet safe, and I think that it makes perfect sense to extend through the end of the year because there could be an end-of-the-year financing problem this year. Second, narrowing tri-party repo collateral also makes sense. But it has implications for what securities people hold, and some of those markets may become much more distressed if we announce that they no longer can be part of a tri- June 24–25, 2008 170 of 253 party repo. So we need to give some thought to whether there will be collateral damage and to the unintended consequences from that. Third, I agree with President Lacker that primary dealers wouldn’t be where I’d focus. I’d focus on systemically important. That would be key players and key markets whose failure might cause a cascading of counterparty failures. I think we ought to start with that premise and which organizations fit into that category. Some of them will be on the primary dealer list, but they are on the primary dealer list for a reason very different from the reason they are systemically important. So maybe distinguishing between those two would be useful. CHAIRMAN BERNANKE. Thank you. President Hoenig. MR. HOENIG. Mr. Chairman, on the short term, I think extending through the end of the year is prudent and would support that. I would say that the possibility of its naturally dying off would be ideal. I would support that because it is “exigent circumstances.” We should make that clear and work these people out of it as quickly as possible. On the longer-term issues, I share the view of a lot of what President Lacker said. A couple of things: I’m very uneasy about extending our lending and supervisory authority to these institutions on the basis of systemic risk. The banking industry has been under our umbrella, importantly around transactions activities—that is, payments—and how important they are systemically. It’s clear, and a line is there. Beyond that, it is size that’s systemically important. If we extend this and institutionalize it because we’ve had this emergency and we’ve used section 13(3), then I have to ask what will happen when the next Long-Term Capital occurs that’s larger, more complicated, with a lot more interaction that will affect the markets globally. What will we do? To what then will we extend ourselves in terms of supervisory oversight, memos of understanding, agreements for the group of hedge funds that aren’t regulated, and so forth. So I think it’s important that we focus on the fact that this is an emergency and that we go back to June 24–25, 2008 171 of 253 “exigent circumstances” in the future for these institutions so that we have clear boundaries on that. I think it has served us well and will continue to serve us well. Then we use our best judgment in exigent circumstances and very sparingly. I think that’s a lot of what President Lacker said, so I won’t repeat everything else, but those are the concerns that I really do have going forward. CHAIRMAN BERNANKE. Thank you. VICE CHAIRMAN GEITHNER. May I make a suggestion? CHAIRMAN BERNANKE. A suggestion? VICE CHAIRMAN GEITHNER. Yes. You know, these are deep, consequential questions we face. This is a question on the economy, and we’re not going to resolve it today. I think it’s important that we recognize that we’re going to have to build some time into our agenda—later this year probably, certainly early next year—and get deeper into the basic question about what we are for in the future. What amendments to the Federal Reserve Act, if any, would we support? What would we resist? What mix of these things? That’s important because we’re not going to do an adequate job of getting ourselves on the table on those actions today. We are going to need to be very careful that the stuff we’re doing in the here and now doesn’t prejudice those decisions long term. Again, I think the package that the Chairman laid out and the strategy we have are pretty carefully designed to mitigate that risk. We’re trying to be very careful that we’re preserving full optionality, once we get through this particular period, to go on any of the paths that are ahead in this context. Of course, this short-term stuff is vulnerable to the risk. It looks as though we’re prejudicing some of those choices, but I think we’re trying to be careful not to do that. I just wanted to make the point that we’re all going to need a little time to think through this stuff, and we’re going to need some time to come back and talk about the deeper policy questions that we face in June 24–25, 2008 172 of 253 this because they are very consequential. I have a lot of sympathy for all the concerns that are on the other side of where we are today. MR. HOENIG. I would very much like to see us make that happen sooner rather than later just because of the force of events taking us forward. CHAIRMAN BERNANKE. That’s right. Because of testimonies and so on, we are going to have to at least enunciate some broad principles, and that is why this discussion is very useful. Obviously, details will be worked out over a longer period. President Bullard. MR. BULLARD. Yes, I just have a few comments. In reading through this memo and hearing the presentation this morning, I think that these are fantastic questions. They deserve a lot of research and analysis. Just to echo Vice Chairman Geithner, they cannot easily be answered in a forum like this one. What is happening is that we start out looking at these questions, which just spawn more and more questions; so we end up with an even longer list of questions. The short-term strategy seems perfectly reasonable, somehow tied to an exit strategy maybe next year. So I didn’t have any problems with that as outlined by the Chairman. When we get down to approaching a more detailed analysis of what we want to do overall, it brings up very difficult questions of what the optimal regulatory environment is. I think that we all think the regulatory environment in the United States is not optimal right now. Also, in a world of increasing globalization, it is not so clear how you should set up your regulatory structure. This is a once-in-a-generation chance to possibly reformulate the regulatory structure. I wouldn’t hold my breath on that. I think the Congress does not have a great record of dealing with issues like this. These issues are complicated, and it is very hard to get agreement on them. But you would like to have a benchmark. I think that one is out there in the June 24–25, 2008 173 of 253 economics literature about what that environment should look like. That is what we could possibly work on over the next nine months or so. Then I have another comment. When we are evaluating these programs, we have to think about whether these programs have been effective and to what extent. How do we measure success? One of the comments earlier was that the mere existence of the programs might be success in some sense. In a model, that is going to work. Even if you take it out of existence, because the market knows it’s there and you can put it back into existence in the future, it will have exactly the same effect. Whether or not you have the program in place, the equilibrium is going to be the same in a lot of models, so the effects would still be there. If it is just the potential of putting the program in place that is considered successful, then maybe it is not critical whether it is in place but priced not to be used or whether it is actually taken out of existence temporarily. CHAIRMAN BERNANKE. President Fisher. MR. FISHER. Mr. Chairman, I am in favor of keeping these facilities open through yearend as you have suggested. I think that just the existence of the PDCF is important, which we talked about earlier, and your overall outline of an approach, the topography of that approach, is attractive. The question I have is about—and you used the term—“supervisory expectations.” I have a question for Scott, and then a thought to follow up on. Since, Scott, no one asked you a question, I want to ask you a question. MR. ALVAREZ. I was perfectly content to get through this without any questions. [Laughter] But I am happy to answer anything. June 24–25, 2008 174 of 253 MR. FISHER. In working up this MOU, have you had any interaction with Chairman Frank or any of his staff, getting a sense of how they might react or what it does in terms of their own expectations? MR. ALVAREZ. Well, we have had a bit of interaction on the Senate side. The Senate folks are very interested in what we are doing and whether this would preempt a congressional action. Chairman Frank has been more sanguine about our doing what is appropriate to deal with the situation now—Laricke may speak to this more at the lunchtime conversation. But we are building on existing authority. We are not expanding beyond the existing framework. We are agreeing to collaborate more, work together more, but we don’t gain any legal or statutory authority through this MOU. We gain some admission because we are standing next to the SEC. We expect that the primary dealers and CSEs will be more willing to talk with us because we are with the SEC. But in the end, it depends on voluntary cooperation by all. MR. FISHER. Are you picking up any signals in return, in this interaction with the Senate or elsewhere, about what they might be thinking? Are we picking up any other signals that might be of concern? MR. ALVAREZ. On the House side, Chairman Frank is thinking of a model that is similar to what the Treasury blueprint outlined, where the Federal Reserve would be a systemic regulator and have some authorities that go along with that. I think that on the Senate side they are very much in disarray. They want to visit this issue, but they haven’t figured out exactly what point of view they want to have. MR. FISHER. I am a little confused. You testify in July and then have a speech. You said that you and Paulson will be speaking. I think that is a very important point. It is going to be a tough act because you don’t want to take anything off the table, but you want to keep a lot June 24–25, 2008 175 of 253 open and not show your hand. Well, we don’t know what our hand is yet. You may, but I don’t think we have it as a group. So we can’t really show our hand. Anyway, I don’t know how this is going to be prepared, but I’m sure there are lots of feelings around this table. This is the substance that Vice Chairman Geithner referred to earlier—these very, very important questions. But you are going to have to show some leg during that speech. Obviously, this is a Board issue, but with regard to the FOMC, I would just ask that it be fairly carefully vetted. CHAIRMAN BERNANKE. I was planning to do that. MR. FISHER. Yes, sir. Just for some suggestions, for whatever they’re worth. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. President Stern. MR. STERN. Thank you, Mr. Chairman. Just a few points. With regard to the shortterm plan of extending the facilities over the turn of the year and so forth—that is, the MOU and the testimony that goes with it—that is all fine with me. I don’t have any problem with that. That sounds sensible under the circumstances. A number of important points have already been raised. I won’t reiterate all of them. Maybe the one that caught my attention most completely was President Lacker’s point about credibility. Whatever we go forward with obviously has to be seen as credible, and as he pointed out, it is important that at some point, to limit our involvement in supporting institutions and markets going forward, we may have to be prepared to let one large institution fail. The reason, of course, that we are very concerned about protecting them over time is the spillover effect. As I have said many times before, where we need to concentrate our efforts—not necessarily exclusively, but certainly in part—is in devising ways to limit spillovers. That is all about June 24–25, 2008 176 of 253 preparation—the analysis and so forth that goes with it—and it is all about communication—that is, putting uninsured creditors on notice that the regime is in fact in the process of changing. Now, having said that, I don’t mean to suggest that it is easy. I don’t mean to suggest that we will get it 100 percent correct. But if we don’t do those kinds of things, then statements about boundaries aren’t likely to be credible. They are just going to be, well, you guys wish it were this way, but you have section 13(3), and we know it’s there, and we are going to act accordingly. So I think it is very important, as we go forward with this, that we focus some attention exactly on those areas. CHAIRMAN BERNANKE. Thank you. President Yellen. MS. YELLEN. I will be very brief, Mr. Chairman. I do want to say, with respect to the short-term issues, that I fully support the plan that you laid out. I certainly favor keeping these facilities in place beyond September. Even if their use diminishes, I agree with the point that it doesn’t necessarily indicate that they are not playing a tremendously important role. The ramping up of our oversight of these institutions in the agreement with the SEC is a very important part of continuing these facilities. On the long-run issues, it is a wonderful list of questions. I don’t know the answers to the questions. I think we really need to dig in very rapidly and do serious work on them. They are fundamental. President Rosengren raised a list of issues about this, the same ones that have been very much in my mind. What institutions? It is not obvious to me that the right list of systemically important institutions is the primary dealers. I think someone—maybe President Rosengren—raised the issue of Countrywide, a huge mortgage company. I certainly worried last summer that it had created systemic risk, and it is not just the primary dealer there. I also think there is an issue with respect to hedge funds, similar to those that arose with Long-Term Capital June 24–25, 2008 177 of 253 Management. This raises very troubling issues to me about our trying to identify and take on supervision of all systemically important institutions. This is a very tough issue that I don’t know the answer to. But also, what is going on raises fundamental issues about how we conduct consolidated supervision. Even if all the systemically important institutions were primary dealers or mortgage companies within bank holding companies that currently we do have umbrella supervision over, I am not at all convinced that the way we are carrying out supervision now would have prevented a Bear Stearns-type of episode within an institution that is currently solidly under our supervision. Last summer I was pleased in some ways that we had lost direct supervision of Countrywide to the OTS. But it might well have been in our domain—six months earlier it would have been—and it could have created a systemically important problem if it had failed. So just the nature of how we carry out this Fed-lite approach, is that really the right way? I see us as very focused on process in our supervision of holding companies. We don’t do a lot of transaction testing. Obviously, this raises very fundamental issues, even within our existing domain, about how we carry out comprehensive umbrella supervision. I don’t have any answers, but we clearly need to get on it quickly. CHAIRMAN BERNANKE. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. I will be very brief. A lot of my views have been shared already. Just to expand on President Rosengren’s comment—how we define the right institutions, the scope of this, I think that some of the questions here are really hard. It is my understanding that the workgroups we talked about last time are going to be working on some of these things, and we need to get those well under way to help us define these problems. On the longer-term problem—Vice Chairman Geithner made this point, and I just want to June 24–25, 2008 178 of 253 reiterate it—it is really important in the short run that we not do things that constrain our longerterm options. It is a very slippery slope that the long run ends up being transformed into a series of short-term steps, and by that almost inevitably you end up in places you don’t want to be. So I just want to make sure that we stay abreast of that and not let that happen to us—that we find ourselves six months from now in a position where, gee, we wish we hadn’t done that. So I just wanted to stress that again. I’m fine with extending the facilities through the end of the year. I don’t have any tremendous problem with that, although I have always been a little puzzled by “unusual and exigent circumstances.” What does that really mean? How do we define that? It would be a lot easier for me to think about when to take it off if I knew what the criteria were for putting it on. It would be helpful to me, anyway, if we could work on defining those criteria a little more rigorously. I know there will be judgment involved in that at the end of the day. I don’t disagree with that. But it would help us to define what we mean by that because it is going to be really hard to define what we mean by a “systemically important institution.” I am not sure I know the answer to that. I think it is a very difficult question. So I am okay on the short run. I will just reiterate the other point that President Stern made about the issue of credibility and commitment. You know, I have talked a lot about this over the last couple of years regarding monetary policy. It applies equally well in this framework. Figuring out ways to implement our policies, whatever they may be, in both a time-consistent and committed way, and defining those boundaries and how we live up to them, is a really hard problem. But I don’t think we can avoid dealing with it, and it is going to be a critical piece of how we think about the longer term. I will just leave it at that. CHAIRMAN BERNANKE. Thank you. President Pianalto. June 24–25, 2008 179 of 253 MS. PIANALTO. Thank you, Mr. Chairman. I also support extending our lending facilities to get through the year-end funding problems. As many others have already said, I agree that we should undertake an evaluation of the changes to our emergency liquidity facilities. I think it is important that we do it more broadly and that we don’t do it in a piecemeal fashion. How the pieces fit together matters greatly. Any extension of Fed authority to provide routine liquidity support beyond insured banks should be something that we consider as part of a comprehensive regulatory and financial safety net reform. My own view may be that I prefer a narrower lending facility than I think was envisioned in some of the documents that we received, but I do think that the top priority is to have a well-thought-out, documented plan for how we move forward. That will help us address some of the moral hazard issues that we have been concerned about. I think it will avoid our having to create any new institutions or new facilities to respond to future crises. I also think it will help better define some of the boundaries. Thank you. CHAIRMAN BERNANKE. Thank you. President Lockhart. MR. LOCKHART. Thanks, Mr. Chairman. I have maybe a variation on Governor Warsh’s comment of yesterday: Much has been said by many, so I will try not to take too much time here. I think Vice Chairman Geithner’s admonitions are correct, and I certainly support them. I am quite supportive of extending through the year-end, and the short-term plan that the Chairman laid out seems quite sensible to me. I don’t have well-informed or well-thought-out answers to the more detailed questions that were posed in advance of the meeting. I didn’t devote the time to study them in any depth. So let me take refuge in some sort of high-level comments. A number of people around the table have been expressing overview types of comments. I see the touchstone of all of this to be our June 24–25, 2008 180 of 253 perceived accountability for systemic risk and financial stability. There may be, in the context of legislation, regulation, and so forth, limits to that; but I think that we are largely perceived as the most accountable party. I have to ask myself, Do we have a system today that is aligned with the reality of the financial markets? Or, put in more vernacular terms, do we have the right stuff to do what we need to do to take responsibility as best we can for financial stability? My answer to that is “no.” I don’t think we have the right stuff. I think the answer to that lies in working out the details of what the right stuff is. But the reality is that financial markets are not bank-centric any longer, with the widely discussed shadow banking system, including hedge funds, a complexity that is not going to go away; international integration that is not going to go away; very, let’s just say, compelling economic and financial reasons for off-balance-sheet treatment of various kinds of things; and on and on. We could make a long list of what that reality is. To me, and I have been kind of dwelling on this for some time, that is a reality that is likely to continue. It may take a couple of steps back, but it will continue to develop along certain lines. Do we have a system that is aligned with it? The answer to that is “no.” So if we can take care of the short-term plan and then buy the time over the next several months to hammer out what we think is the best possible thinking opposite that reality, then that is what I believe we need to be doing. So thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Evans. MR. EVANS. Thank you, Mr. Chairman. I will also try to be brief, in spite of the large number of questions that were handed out. The short term should be quite easy. On the tactical issues, I agree with the suggestion of extending the facilities through year-end. They seem to have worked well. Also, a number of very interesting and important initiatives are ongoing as well on the CDS over-the-counter market and tri-party repo, and those should help out as well. June 24–25, 2008 181 of 253 On the longer-term issues, I am very happy to hear that you will be giving a speech and testimony on this, and I will be looking forward to how you lay out those issues. Obviously, there are large-scale changes in our regulatory environment that are being contemplated. These happen only every now and then. It is an opportunity to improve or to make a tremendous mistake if we are not very careful. So I think it, obviously, requires a tremendous amount of time. People have talked about the various issues, so I won’t dwell on them. I think there have been a lot of very good comments around the table and speeches that have laid out the important issues that we are facing. One that I am sure we will have to talk a bit more about is that we can’t think about this in a static environment. Obviously, the markets are very dynamic. As soon as we lay out a structure that will help out certain types of institutions, then there is going to be an opportunity to arbitrage that. We are presumably talking about reducing earnings of a number of institutions, and so they will be seeking those out. Another way to characterize the big question—it is nothing new—is how we maintain the incentives for market discipline. Many of the comments that President Stern and others made about how we think about preparing for possible resolutions will be very important. So I am looking forward to many more discussions about this. Thank you. CHAIRMAN BERNANKE. Thank you. Governor Kohn. MR. KOHN. Thank you, Mr. Chairman. I think I would just like to dig into some of the comments that President Lockhart and President Evans just made, just for a second, take a step back, and ask why we are here having this conversation. I know the timing is because we have this PDCF, but what happened was that the financial markets evolved in such a way that simply having a liquidity backstop for commercial banks was not sufficient to protect the economy from June 24–25, 2008 182 of 253 systemic risk. I myself have been very surprised—I will be very open about this—at the persistence, the extent, the depth, and the spread of this crisis and how long it went and what it covered. Every couple of months, I thought it was about to be over, and then another wave would come. I think that we have learned something about the financial system in the process, and we have learned that the regulatory structure and the liquidity provision structure were not sufficient to give the economy the protection it needed from the new style of financial system. That is really the background of why we are here, not just because we made the loan or we set up the facilities because we thought we needed to do so to protect the system under the circumstances. I completely support, Mr. Chairman, your suggested path forward for the near-tointermediate term. I think that is the right way to go. I would say, relative to the two senators that I testified in front of last week, that they were very supportive of the memorandum of understanding between the Fed and the SEC and particularly supportive of the efforts that the Federal Reserve Bank of New York and the other regulators are leading to strengthen the infrastructure of the OTC derivatives markets. We didn’t get into tri-party repos, fortunately. But I’m sure they would have been supportive of that, too. I think everybody has raised very good questions about where, in this new financial system, you draw the boundaries. What do you need to do? There are no easy answers here, and I look forward to coming back to this. My going-in position is that our liquidity facilities outside of commercial banks ought to be available in systemic circumstances, not in just any circumstances, and they ought to be available at this point to just broker-dealers or investment banks. I would hesitate to get outside that realm. Those guys are already regulated, and so what we’re talking about is strengthening the regulation. I think that we can strengthen the core of the June 24–25, 2008 183 of 253 system to make it resilient to things happening outside, but I am not totally dug in on that. So I look forward to more discussion. It is going to be very hard to draw the line and make it credible. I agree, partly this will be defining what we mean by “systemic,” but I don’t think we will ever really get to the point of having a bright line around that. It will always need a great amount of judgment, combined with—as you said, Mr. Chairman—a process by which you make that decision, to help limit the moral hazard. Crises are always difficult. You get into a crisis, and the near-term costs are much more palpable than the long-term costs that might be there. So it is always hard to say “no.” We have said “no” in the past on certain circumstances. Drexel is the obvious example. Markets were a little stressed. There was a little disorder. It was fine, but it was a very different circumstance. I think that completes my remarks. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. Let me make a few prefatory comments, and then try to answer a couple of the key questions in the memo. First, a crisis is a terrible thing to waste. My sense is that we have an opportunity here to do the right thing over the period to try to get market discipline—to Charlie’s point—back and vibrant and working countercyclically with regulatory discipline and capital standards. So this is an opportunity. As we contemplate our six-months-and-a-day problem, what do we do between September and year-end? I agree with Vice Chairman Geithner’s comment that we need to keep options open, and I will make a proposal in a moment for how to do that. Second, the memo from the staff said that improvements in financial markets have resulted, importantly, from the availability of the special liquidity facilities, and I agree with that. But I wouldn’t give short shrift to the other things that have been going on in the markets that June 24–25, 2008 184 of 253 have improved market functioning. I don’t think it is fair to say that we deserve a disproportionate amount of credit for what has happened. We have seen a ton of capital-raising. We have seen a lot of diversification of funding sources. We have seen changes in duration by financial institutions. We have seen improved disclosure and transparency. We have seen big write-downs. We have seen brutal changes in management teams. We have seen pairing of business lines and improved risk management. So it strikes me that market discipline is alive and well. It was necessary for us to do what we did, but I think it hangs way too much on our facilities if we suggest that we are the only thing that is keeping the system together. As a final prefatory comment, the memo says that some investors have indicated their willingness to lend to primary dealers in recent months, and that has been conditioned on dealers’ access to the PDCF. It strikes me that proves too much. I am not sure that is a good thing. The concerns we have late in the cycle, when we look back, include that market discipline broke down. In the short term, obviously, we want to see some of the money market mutual funds from President Rosengren’s neck of the woods hang in there with these institutions so we don’t have a sort of panic coming. But over the short to medium term, we want the guys in money market mutual funds to recognize that, when they are providing funding overnight, they are making an investment decision that has a risk. So I hesitate to suggest that we want to do things over the period that let them be complacent. We want to do things that make them very focused on the decisions they are making. Now a bit to the key questions that were asked in the memo. First, on liquidity facilities, on the question of the PDCF and its symmetry with the TSLF, I like that notion of the balance of having an auction and having one that is available more regularly. But we have to recognize that the PDCF, whether intended or not, has been stigmatized. If Lehman Brothers, when they were June 24–25, 2008 185 of 253 on their darkest day, had answered the question differently, I dare say they might not be in existence. They were asked, “Have you accessed the PDCF?” The answer was, “Absolutely not.” If their answer to that had been “yes,” I suspect that they and we could have been in a very different circumstance. So what does that prove? I think that proves that the existence of these facilities matters. It keeps institutions in the game. The particular terms matter less. But also, in extremis, accessing that facility, unlike the securities lending facility, causes losing a considerable amount of control over one’s own fate. So I think we have to take that into consideration. We have considerable leverage over these institutions at this time. No matter what they and their lobbyists say, they want us to be their regulator more than they can possibly contain themselves—mostly for our credibility and mostly for our balance sheet. I worry that if we extend the PDCF as is by just punting it down the road some months, we will lose some of that leverage. So one idea, which I must say I haven’t explored as much as I probably should, is extending the PDCF, not as is but by modifying it in a way that would make Bagehot proud—by making it more expensive, by widening the spread. Now, there are other things we could do in this short-term extension that modify its terms—changing collateral or changing haircuts. But it strikes me that price might be an interesting way to say, “Listen, we aren’t pre-judging outcomes, but you can see from this move that we aren’t comfortable with the status quo, and we are asking ourselves these very hard questions that we brought to bear.” That could send an important signal, which I don’t think would be overly disruptive to the markets if we explained some of the rationale for doing it. Let me turn, finally, to the prudential supervision questions. I have a note here in answer to the first question, “How do we limit moral hazard if we continue the facilities?” My bold June 24–25, 2008 186 of 253 answer is “carefully,” so I guess not much is there. On what principles should supervisory expectations be based? I think Art talked rightly about these different regulatory frameworks for the big money center commercial banks and the investment banks. We’d be doing ourselves a disservice over the period, Mr. Chairman, to take the regulatory regime that we have now had for a long time for these big complex commercial banks and try to put it on the investment banks. I’ll answer this the way I began. We have an opportunity to start with a blank sheet of paper, with four institutions over the period, and figure out how to be really, really good regulators, building on the lessons that we have learned from our traditional supervision and regulation function. I think that we would be making a mistake by saying, “We have a model, and let’s throw it on these guys.” If we regulate these four institutions the way we have long been regulating commercial banks with the OCC and others, I think we won’t have maximized the best of regulation. The goal would be to figure out how to regulate these four right and then, frankly, to export those lessons to what we have long been doing to make regulation better and stronger across this group. If it turns out that we do to Goldman Sachs and Morgan Stanley what we have been doing to Citi and JPMorgan, as was suggested, we will find other people will be in the business of investment banking, so we won’t have done terribly much to mitigate systemic risk. Finally, on the question about the role for the Congress. Both in the medium term, Mr. Chairman, in the context of your speeches and as we get toward the end of July, when you announce some modification—if the FOMC agrees—about these facilities and the PDCF, it is very important that the Congress be given serious responsibility for this. It has been very easy for them to criticize, on the one hand, and to whisper to us all their support, on the other. I think they need to be given very important homework assignments in terms of what they can do. June 24–25, 2008 187 of 253 Some form of FDICIA with investment banks might be one example. Wrestling about these issues in terms of regulatory organizations strikes me as very consequential. Even if we could convince ourselves that we have all the regulatory authority to figure this out with our regulators, we would be better off, when we are ready and we have the right answer in our own view, to bring it to the Congress for final clarity and to get their imprimatur. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. MR. KROSZNER. Thank you very much. I agree with a lot of what Governor Warsh said and a lot of what has been said before. Let me just take a slightly different tack answering the question that Governor Kohn raised: Why are we here? Part of that is, because of the GlassSteagall Act, we have this unusual structure in the United States. Other central banks can provide credit much more easily to a wide variety of institutions. We have a legacy that created this separation, which isn’t as strong in most other countries. In continental Europe, for example, you just don’t really see this. Then, we have built a regulatory regime that helped to promote that. Remember, the discussions have been about markets and the challenges in the markets. Well, I think our regulatory regime, not just in the United States but throughout the world, helped promote the disintermediation to promote greater reliance on the markets. In certain ways this is a very good thing, but it creates exactly the kinds of problems and challenges that we are facing now. I think we need to be mindful of that and take that into account when we are thinking about what to do next in dealing with these issues. Thinking about market resiliency and market infrastructure is crucial, but we also have to be mindful that, if we try to get things to migrate to the exchanges, to clearinghouses, et cetera, it is great for us as regulators, and it is also useful because the information is much more centralized. But it also could create market dynamics, as June 24–25, 2008 188 of 253 President Evans said, that could lead to trying to get around that. Then the risky stuff goes OTC. The risky stuff is in new institutions that we haven’t thought of yet. President Yellen mentioned some other institutions. We can mention hedge funds and money market mutual funds, but in five years there may be institutions that we haven’t even thought about. No matter what structure we set up, there would be ways to try to get around it. So we need to think about a regulatory regime that gets the costs and benefits right to make the different relevant institutions not bridle too much at being part of it and so to rethink the financial holding company structure. If the investment banks had found the financial holding company structure an amenable one, then we wouldn’t be here either because we would have solved the Glass-Steagall legacy problem. But we haven’t quite done that. So actually exactly as Governor Warsh was saying—and believe it or not, we didn’t coordinate beforehand—I think that we should think about how to revise our general regulatory structure to get more institutions under this umbrella, not have them find it scary, upsetting, or disturbing but to see that we are doing it in a reasonable cost–benefit way. I can see just in all the issues that we have been facing regarding some capital relief in particular circumstances— so-called 23.80 relief on particular types of transactions, issues of what’s included in the definition of a leverage ratio. I think it gives us an opportunity to rethink why so many institutions find it onerous and are so lacking in desire to be part of this regime. Obviously, there is some regulatory competition—President Rosengren, I think, brought that up—so we need to think of that as a whole. This is part of the homework assignment that the Congress needs to think about—setting up a reasonable FDICIA-like regime for a broader set of institutions that would choose to come and be regulated by the Fed. June 24–25, 2008 189 of 253 We have been talking about where the bright lines are. But if we okay someone to be a financial holding company, then they become part of our regime in the existing structure. So the lines aren’t completely carefully drawn. It really is sort of a cost–benefit analysis if someone chooses to apply. So we need to think about that carefully and about the costs and benefits of getting people in because the long-term dynamics will be that people always try to get away from regulation unless they see that there is some sufficient benefit. Being very mindful of that, both from the institution context and the broader context of the markets, is very important. Thank you. CHAIRMAN BERNANKE. Thank you. MR. KROSZNER. Oh, and I apologize—I fully support going ahead with extending the facility past the year-end. I would make sure that it’s a bit more than just immediately past yearend and go some time into February so there are no questions about year-end. CHAIRMAN BERNANKE. Thank you. Governor Mishkin. MR. MISHKIN. Thank you, Mr. Chairman. I also strongly support the short-term strategy that was laid out by the Chairman. I don’t see that we really have an alternative in that context. There are a lot of issues here. The reality is that this is super complex, and we have a lot of work over the next year to be ready for the next Administration, when all these issues are going to become extremely relevant. In general terms, regarding the long-term issues, although we got here under exigent circumstances, in a financial disruption, we might have gotten here anyway. The reality is that there was a fundamental change in the way the financial system works. When banks are not so dominant, the distinction between investment banks and commercial banks in terms of the way the financial system works is really much less. It would be nice to think that we could limit the June 24–25, 2008 190 of 253 kinds of lending facilities that we have so that we didn’t have to worry about regulating or supervising other institutions, but I don’t think that is realistic. The nature of the changes in the financial system means that we extended the government safety net but it probably would have been extended anyway. It was just unfortunate that it had to happen in such a crisis atmosphere. So I think we have to think very hard about the issue of limiting moral hazard in terms of a much wider range of institutions. I am very sympathetic to the issues that President Stern raised, which is that we have to think about the kind of things that we have thought about more in terms of the banking industry: How do we actually set things up so that it is easier for firms to fail and not be systemic? There are a smaller number of firms that we actually have to supervise and regulate, and the reality is that we have to think very hard about how we’re going to extend regulation and supervision to a wider range of firms. We just can’t escape that. It would be nice to say that we could limit it, but we are not going to be able to limit it except to the extent that we can think about some of these issues. But it is going to be a huge issue going forward, and we really have to be ready to deal with the political process. The way we are proceeding makes a lot of sense. It is not committing us in a way that creates a problem, but we have to be ready when this issue is dealt with. It will be one of the hottest issues that the next Administration and the next Congress will have to deal with. We have to be really on point and to have positions very carefully thought out, not just by the Board but by the entire FOMC and the entire System, so that we can have a unified position to make sure that crazy stuff doesn’t happen and that sensible stuff does. Thank you. CHAIRMAN BERNANKE. Thank you. Vice Chairman. June 24–25, 2008 191 of 253 VICE CHAIRMAN GEITHNER. I obviously support the strategy laid out. I just want to underscore, particularly in response to Governor Warsh’s comments, that this is in effect a conditional extension, in the sense that we are being careful to get ourselves more comfortable with where these four firms in particular are on capital and liquidity before we announce an extension. We are trying to get clarity on the ongoing supervisory relationship with the SEC before we announce an extension. We have already gotten the 18 major dealers in the world to commit themselves to a path to improve the capacity of the OTC derivatives infrastructure to withstand failure before announcing. We have already begun to get the resources held against default risk in the existing central counterparties higher, in satisfaction of President Stern’s general admonition that we want the system better able to withstand failure. I think we are just beginning the delicate process of taking some of the air out of the vulnerable tri-party repos before the extension is announced. So, in that sense, we have left ourselves in this strategy that the Chairman laid out with a little less vulnerability to the possible impression that we would just willy-nilly extend with no effort to make the system safer. We are not going to get far enough. We are not going to know what’s far enough. But I think we have a credible plan to say, “We took the initiative, even in a moment of incredible delicacy for dealing with the system, to try to get these institutions and the system in a better capacity to withstand the possibility of failure.” In that sense it’s a defensible and sensible strategy. I really don’t know what the right mix of boundaries is on access to liquidity in normal times and in extremis and what mix of supervisory authority conditions with what type of resolution regime is optimal. I just don’t have a sense. I feel as though I know the broad tradeoffs in it, but I don’t know what really looks ideal in terms of the mix of those things. You can make a pretty reasonable case for a whole bunch of variance in that mix of things. The June 24–25, 2008 192 of 253 complication for us is that we won’t be able to fully control the outcome because it is going to require legislation. Part of the consequence of the system that we live with and part of the reason that we live with the system we have today is that policymakers and regulators don’t fully control the outcome in terms of the incentives created in the legislation for these kinds of things. So it will be difficult for us, but all we can do is focus on the merits, think through those ahead of everybody else, and try to have the best package of suggestions that we can. But just to come back to what we spent most of the last two days talking about, let’s not lose sight of the fact that we are in the middle of this still. It likely has a long way to go. It is very hard for us to know now what we are going to decide at the end was the most critical source of vulnerability and, therefore, what to do to fix it. We don’t know what the market is going to think the new equilibrium should be in terms of the return on equity across different types of financial institutions and models. Another reason to be careful as we try to contain the risks in this crisis and make the system stronger in the near term is so that we don’t prejudge some of those longer-term questions. Thank you. CHAIRMAN BERNANKE. Thank you. President Plosser. MR. PLOSSER. I want to come back to one of Governor Warsh’s comments, just probe it a little further, because I was intrigued by his notion that in some way trying to wean ourselves from this he suggested that we raise the price. It occurred to me in that same context, if we thought that had value in some sense, another way we could do the transition is to cut back either the frequency or the size of the TSLF, as we sort of wean the markets off access. Announcing both those things in advance might have some value to us moving forward. I wanted to hear other people’s thoughts and reactions. CHAIRMAN BERNANKE. Vice Chairman. June 24–25, 2008 193 of 253 VICE CHAIRMAN GEITHNER. First, I completely agree that, once we get to the point at which we believe the best policy is to dial this stuff back and transition to a world in which they don’t exist, we are going to want to look at a whole bunch of things—changing terms, changing the relative attractiveness across the auction facilities, thinking about size, and thinking about price. I think that will be very important to do. It is very unlikely that the optimal path is going to be that there is a cliff—one day they are there, and the next day they aren’t. So I completely agree with that. My own judgment is—but it may not be right, and it could change over time—that for the moment we want to have a clean, crisp signal. Better to say that we are going to extend in the context of these broader initiatives to strengthen the system and not at the same moment alter their terms and relative attractiveness. But we are going to have to think very carefully over the fall, conditions permitting, and well ahead of whatever the new date is, what the desirable exit strategy is in changing incentives around use. However, my basic sense is not now, not yet, partly because of the complexity of the signal you are sending and the difficulty of how it will be interpreted. We have done all this stuff in part because we are trying to address a complicated mix of things around incentives, stigma, and that kind of thing. It is hard for us to predict what the effect would be. Its purpose is to wean, but to do it now would make the message a bit more complicated. If the world is strong enough that you can wean them now, why are you extending? So my basic sense is, absolutely, we are going to have to figure it out by the transition, not quite yet but well ahead of February 15 or whenever it is going to be. CHAIRMAN BERNANKE. President Lacker. June 24–25, 2008 194 of 253 MR. LACKER. Yes. I support Governor Warsh’s suggestion for raising the price. It is hard for me to believe that confidence in any of these institutions depends materially on 100 basis points of the price. It is the access, the funding, that they would be able to use to fund withdrawal or flight by somebody. I think it sends the right signal that we view this as exceptional. Conditions are certainly different than they were in March, when we designed and implemented it, and I think they are unlikely in the fall to be anywhere close to where they were on March 16. You might disagree, and we could always change things between now and then. But I like the signal of withdrawing the generosity just a tad. CHAIRMAN BERNANKE. Remember that we are doing moral suasion as well. I mean, we are not really allowing investment banks to use this as a profit center. So I’m not quite sure what the marginal effect would be on incentives. MR. LACKER. But this would also place less weight on moral suasion to discourage and would use the price system a bit. CHAIRMAN BERNANKE. It also might increase the stigma. It is a very complicated calculation. VICE CHAIRMAN GEITHNER. There are many things that I would love to do. I would like to make them pay for it and say that we are not going to extend it unless they pay for it. I would like to say that we are not going to extend it unless they pre-fund some liquidation facility for one of their little counterparties. There are a million things that I think would be good to do from an incentive angle—but not at the same time that we are trying to maximize the chance that we get through this and have the flexibility to let monetary policy adjust to the changing amounts of risk on the other side of the tail. So there are a million things I think it would be cool to do, and we will have to do them. We will design them really in a clever way June 24–25, 2008 195 of 253 once we are at the point where that is optimal, but I just don’t think that’s now. The risk is that it will undermine what we are trying to achieve with a fleeting “make us feel better” benefit. CHAIRMAN BERNANKE. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. So just on behalf of the troublemaker caucus, [laughter] let me make a suggestion. It doesn’t strike me as though the deltas between Vice Chairman Geithner’s formulation and what I proffered are that large. That is, I think we collectively agree that we need, as part of an extension of the facility, to ensure that there is a suite of facilities and self-help efforts—tri-party repos, OTC derivatives, principles by you, and clarity on what the horizon looks like. I guess the only question is, At the time that you solicit the notation vote and announce this—let’s say that is the second half of July—how comfortable are we at how that package looks to suggest that we are keeping options open and that the signal we are sending is not that this is a business that we want to stay in forever? Maybe in that context we will see what kind of progress we are making in truth on some of those infrastructure improvements and in the narrative, so that we can revisit—I think maybe with some guidance from Brian, Bill, and the staff—what the incremental benefits are of a modest change to the PDCF in that context. By the second half of July, we might find that we are much more informed so as to weigh the benefits and costs of it. CHAIRMAN BERNANKE. Bill Dudley, did you have a comment? MR. DUDLEY. The real issue may be that the PDCF borrowing may be de minimis. In that environment, it’s not really clear what raising the price really means. It might even be confusing to people if you raise the price at the time the borrowing was de minimis. So I think that is just one consideration. June 24–25, 2008 196 of 253 CHAIRMAN BERNANKE. Okay. If there are no other pressing comments, thank you very much for this discussion. I heard general support for the short-term strategy, which means, I hope, that if we do come to ask you for an extension of the TSLF we can do it by notation vote without a videoconference meeting, unless things change. There clearly is a lot of dissatisfaction among all of us about the ad hoc nature of the way we had to deal with the crisis in March. We would all like much more clarity about our authorities, the limit of those authorities, and the match between our responsibilities and our authorities; and, as we go forward, we will try to get clarification on that. At the same time, we also want to take steps to try to increase the resilience of the system and reduce the risk that we will be in the same situation again in the future. I will try to vet my speech. I don’t want to overpromise. It has to be done over the Fourth of July weekend, so I expect everyone to be available 24/7 for commentary. [Laughter] But I will generally be talking about things that we are doing. I will talk only in general terms about some of the principles that we have discussed today about the need for clarification about how to resolve a troubled institution, how to set those limits, and so on. But I will try to circulate that, to the extent that it is feasible. Let’s see, our next meeting is Tuesday, August 5. You are invited to get lunch and come back to the table to hear Laricke Blanchard’s update on congressional matters. If you have any revisions to your economic projections, you have until 5:00 p.m. tomorrow to send those in. And I want to thank—I haven’t done this—Art, Scott, Pat, and all of their colleagues, who have been working very hard on these issues, for their presentation and their hard work. The meeting is adjourned. END OF MEETING July 24, 2008 1 of 50 Conference Call of the Federal Open Market Committee on July 24, 2008 A joint conference call of the Federal Open Market Committee and Board of Governors of the Federal Reserve System was held on Thursday, July 24, 2008, at 4:30 p.m. Those present were the following: Mr. Bernanke, Chairman Mr. Geithner, Vice Chairman Mr. Kohn Mr. Kroszner Mr. Mishkin Ms. Pianalto Mr. Plosser Mr. Stern Mr. Warsh Ms. Cumming, Messrs. Evans, Lacker, and Lockhart, and Ms. Yellen, Alternate Members of the Federal Open Market Committee Messrs. Bullard, Hoenig, and Rosengren, Presidents of the Federal Reserve Banks of St. Louis, Kansas City, and Boston, respectively Mr. Madigan, Secretary and Economist Ms. Danker, Deputy Secretary Mr. Skidmore, Assistant Secretary Ms. Smith, Assistant Secretary Mr. Alvarez, General Counsel Mr. Baxter, Deputy General Counsel Mr. Stockton, Economist Messrs. Connors, English, and Kamin, Ms. Mester, Messrs. Rolnick, Rosenblum, Sniderman, and Wilcox, Associate Economists Mr. Dudley, Manager, System Open Market Account Ms. J. Johnson, Secretary, Office of the Secretary, Board of Governors Mr. Cole, Director, Division of Banking Supervision and Regulation, Board of Governors Ms. Roseman, Director, Division of Reserve Bank Operations and Payment Systems, Board of Governors Mr. Frierson, Deputy Secretary, Office of the Secretary, Board of Governors Mr. Clouse, Deputy Director, Division of Monetary Affairs, Board of Governors July 24, 2008 2 of 50 Mr. Blanchard, Assistant to the Board, Office of Board Members, Board of Governors Ms. Edwards, Associate Director, Division of Monetary Affairs, Board of Governors Messrs. Carpenter and Perli, Assistant Directors, Division of Monetary Affairs Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of Governors Ms. Beattie, Assistant to the Secretary, Office of the Secretary, Board of Governors Messrs. Fuhrer and Judd, and Ms. Krieger, Executive Vice Presidents, Federal Reserve Banks of Boston, San Francisco, and New York, respectively Messrs. Hankins and McAndrews, Ms. Perelmuter, Messrs. Rasche, Sellon, Sullivan, and Weinberg, Senior Vice Presidents, Federal Reserve Banks of Dallas, New York, New York, St. Louis, Kansas City, Chicago, and Richmond, respectively Ms. McLaughlin, Vice President, Federal Reserve Banks of New York July 24, 2008 3 of 50 Transcript of the Federal Open Market Committee Conference Call on July 24, 2008 MR. KOHN. I move that we close the meeting. CHAIRMAN BERNANKE. Without objection. This is a joint Board–FOMC meeting because the issues on liquidity provision that we are going to be discussing today require both Board and FOMC actions. At the last FOMC meeting, the one in June, we discussed briefly some of the facilities— the TAF, the PDCF, and the TSLF—and I think there was an agreement that we would be announcing an extension of those beyond year-end. At that time, I suggested that we might take a notation vote on those issues. However, the staff has proposed a couple of additional wrinkles, which would make sense to announce at the same time that we announce an extension. Because we want to get your views on these, I thank you for taking the time to join this meeting. Two additional suggestions have been made. The first is to add an auction of options to the TSLF to allow dealers to bid for the option to have access to the TSLF over critical short periods such as over year-end. We will get more explanation of that. The second proposal is to extend the maturity of the Term Auction Facility from the current 28 days to 84 days. As you know, the Swiss National Bank and the European Central Bank have been conducting auctions pursuant to our TAF auctions. We have contacted them and told them that we are considering the extension in time. If we do that, they have both indicated that they would want to follow and do three-month auctions with us. To make that work out, we are going to propose a small increase in the ECB swap line—well, not small, but from $50 billion to $60 billion. I guess $10 billion is large money anywhere. The purpose is that they can divide that by six and have a more even number for auctions. July 24, 2008 4 of 50 The reasons I thought that we should discuss this now instead of waiting for the meeting in a couple of weeks are, first, that there is considerable interest in what we are going to do with these various facilities and already some reporting about them, and I think it is better for us to get this out sooner rather than later. If we decide today to take these steps—in particular, if we decide to lengthen the TAF—for purposes of coordinating with ECB, they would have to get approval from their governors as well. The bottom line is that our announcement would be next Wednesday morning, so we would not be quite ready to announce for a few more days. In addition, because I do want everyone to have a chance to give their views and we have only a one-day meeting coming up, I thought it would be better to get this done before the FOMC meeting. Again, the issue at hand is whether to make these two additional modifications to our liquidity program. I am going to turn to New York and ask Bill Dudley to brief us on these proposals. He will be assisted by Debby Perelmuter and Sandy Krieger. After that, there will be time for Q&A with them; with Brian, who is here; with Scott Alvarez; or with anyone on the staff. Following that, we will have an opportunity for discussion. The votes are actually kind of complicated because the responsibilities for these programs are divided in various ways between the Board and the FOMC. But we will get to that, I guess, at the appropriate time. So let me now turn over the meeting to Bill Dudley. Bill. MR. DUDLEY. Thank you, Mr. Chairman. As outlined in the memo circulated earlier to the Committee from Brian and myself, the staff is proposing two innovations to our suite of liquidity facilities. First, we are proposing to add a $50 billion options program to the TSLF. There is a precedent for this. We auctioned options in advance of Y2K. This proposal calls for selling options to primary dealers in a series of auctions beginning several weeks before each quarter-end. The options would be for the right to borrow Treasuries from the SOMA portfolio in exchange for schedule 2 collateral for a short period of time (a week or so) over the quarter-end period. If the option is exercised, the dealer would pay a fixed rate for the borrowing (we have currently penciled in this rate at 25 basis points, annualized—the same as July 24, 2008 the minimum bid rate on 28-day TSLF borrowing). The fine points of the program, such as the rate and the precise timing and tenor of the borrowing that the options would reference, would be determined after consultation with the primary dealer community. As you recall, in the rollout of the original TSLF program, we consulted with the dealer community after the program was announced. The dealer comments did result in changes in the program that we believe made it more effective, and the dealers certainly did appreciate the opportunity to have their views heard before the program was implemented. We anticipate that an options facility would be helpful in providing a means for dealers to purchase insurance that could be used to secure funding over stress periods such as quarter-end and year-end. Because the options would be auctioned well in advance of quarter-end, dealers should be able to better plan their funding needs over that period. The options program should help reassure dealers that they will be able to finance their less liquid collateral over these highstress balance sheet periods. Greater comfort on the part of the dealers is likely to reduce the risk of a margin spiral in which forced liquidation of illiquid collateral leads to lower prices, higher volatility, and higher haircuts, which, in turn, provoke further liquidation. Debby Perelmuter will discuss the TSLF options proposal in greater detail in a few minutes. Second, we are proposing to extend the maturity of Term Auction Facility loans to 84 days from 28 days. The size of the total program would remain unchanged at $150 billion. The auction cycle would remain biweekly, with the size of each auction cut proportionately to the rise in maturity—to $25 billion per auction in six biweekly cycles covering 12 weeks from the current program of $75 billion in two biweekly cycles covering four weeks. We also are proposing to change our overcollateralization rules. In the current program, we require that TAF bids must not exceed 50 percent of pledged collateral. But the overcollateralization can be withdrawn after the loans are made. Under the new rules, we would change this standard so that the sum of all outstanding term TAF and term PCF loans could not exceed 75 percent of available collateral, both initially and throughout the term of the loans. As the Chairman noted, the ECB and the SNB have indicated that they will modify their programs accordingly. The ECB is seeking to raise its swap line authority to $60 billion from $50 billion. They are seeking to do this because the current swap line of $50 billion is not easily divisible into a six biweekly auction cycle. We anticipate that they will decide to raise their biweekly auction size to either $9 billion or $10 billion—so the total swap draw is likely to rise to either $54 billion or $60 billion. The motivation for the maturity extension is provide greater support to term funding markets. For some time, banks have asked for longer-term maturity TAF loans. This is attractive to them for two reasons: (1) almost all of these loans will extend over quarter-ends—periods in which balance sheet stress is likely to be greatest—and (2) the longer maturity would also help banks extend the average maturity of their borrowings. This change will also put the maturity of TAF loans more on par with the ninety-day limit of the primary credit facility. Sandy Krieger will discuss our TAF maturity extension proposal in more detail shortly. 5 of 50 July 24, 2008 So what will these two programs do? My own view is that these new proposals are evolutionary rather than revolutionary. They are unlikely to result in a dramatic improvement in term funding conditions. However, they are likely to be helpful at the margin. In particular, I think they will help reduce the risk of the type of margin spiral that could potentially turn a period of balance sheet stress into something systemic. In my view, this is a worthwhile goal. Better to take steps now to reduce the risks of bad outcomes than wait to respond only after the bad outcomes occur. Introduction of these program innovations also will demonstrate that the Federal Reserve is actively on the case, refining its liquidity suite in order to make its tools more effective. Will introduction of these changes be alarming to the market? I don’t think so. Because they would be announced simultaneously with the extension of the PDCF and the TSLF programs, the changes are likely to be perceived as an ongoing refinement of the existing programs rolled out as a package with the PDCF and TSLF extension rather than as a program that signals great concern about problems known to the Federal Reserve but not to market participants. Should we worry that the $50 billion TSLF options program further commits the Fed’s balance sheet, making it more difficult to respond to large, unanticipated PCF or PDCF borrowing? Although this is a legitimate issue, it should be emphasized that the Federal Reserve has other means of easing its balance sheet constraints, which the staff has been actively pursuing. Also, the regular TSLF program has been undersubscribed—currently only $113.5 billion of TSLF loans are outstanding. This will climb to $123.1 billion tomorrow, when today’s auction settles. This means that there is a bit more headroom than suggested by the $175 billion size of the TSLF auction program and the $200 billion that was authorized. Moreover, in the worstcase scenario of massive PCF or PDCF borrowing, I wonder whether the $50 billion claim on the Fed’s balance sheet represented by the options would indeed be significant at the margin. Debby Perelmuter will now explain how we anticipate that such a TSLF options program would work. MS. PERELMUTER. Thanks, Bill. We will propose auctioning the options in two $25 billion offerings. This will allow dealers to adjust their bidding behavior in response to the first auction results. The first TSLF options program (TOP) auction is currently anticipated during the week of September 1 for the option to lock in TSLF financing over the September quarter-end. We expect to hold the second auction two weeks later. These auctions will be in addition to our ongoing TSLF auction cycle. Thus, there will be two TSLF schedule 2 auctions totaling $125 billion and another two TSLF schedule 1 auctions totaling $50 billion that will also span quarter-end. The plan is to hold TOP auctions against schedule 2 collateral in weeks on either side of the two regular TSLF schedule 2 auctions during the months ahead of quarter-ends or year-ends. The first of these auctions would be for $25 billion. If that auction is undersubscribed, we intend to add the unused option authorization to the second auction two weeks later. 6 of 50 July 24, 2008 Each auction will offer the option for dealers to borrow general collateral Treasury securities against pledges of TSLF schedule 2 collateral, which includes AAA-rated private-label residential and commercial MBS and ABS, agency CMOs, and the basket of collateral already eligible for our regular open market operations. Our initial recommendation is for the options to have a one-week duration spanning the month-end and a strike price of 25 basis points, annualized. The strike price represents the lending fee that the dealer is willing to pay to borrow general collateral Treasury securities against pledges of their choice of schedule 2 collateral. This fee concept is very familiar to the dealers participating in both the TSLF auction program and the Desk’s regular daily securities lending auction. The 25 basis point strike price for the TOP correlates to the minimum fee already in force that dealers can bid in the regular 28-day TSLF schedule 2 auctions. Dealers will bid for these options by specifying the quantity of TSLF options they demand and the price or premium they are willing to pay for the set maturity loan at the set lending fee. As with the TAF and the TSLF, a minimum bidding premium level will be set. We are recommending a minimum bid of 1 basis point with bidding increments of 0.1 basis point. Volume parameters will be similar to those of the TSLF—a $10 million minimum with a maximum of 20 percent of the auction size for any one dealer. We expect that auctions will be held in the afternoons with results posted very shortly after the auctions close. The premium that each dealer will pay will be determined by the competitive single-price auction process, in which the accepted dealer bids will be awarded at the same premium, which shall be the price at which the last bid was accepted. The options will not be transferable between dealers. Dealers who have received awards in the auction will have to notify the New York Fed at least one day before the exercise date if they wish to enter into the TSLF loan. Dealers may also let the options expire unexercised at no cost beyond the premium paid at auction. All haircuts, collateral eligibility, and settlement conventions will be the same for the TOP as they are for the TSLF. As Bill noted earlier, and consistent with how the program parameters were developed for the TSLF program, we expect to develop more precisely the terms and conditions of the TOP after consultation with the primary dealers. Should the Committee approve the proposal this afternoon, we expect these conversations to begin shortly after the announcement next week. Thank you. Please let me turn the floor over to Sandy Krieger to discuss the TAF maturity extension proposal. MS. KRIEGER. Thank you, Debby. Regarding the longer-term TAF, a transition from the current biweekly schedule of 28-day auctions, $75 billion each, to a schedule of biweekly 84-day auctions, $25 billion each, will require four additional biweekly auctions of 28-day credit for an eight-week period. We need to do this to keep the amount of TAF credit outstanding at $150 billion. We contemplate a schedule that permits us to auction the 84-day credit of $25 billion on the now-typical Monday “cycle,” announce these results Tuesday morning, and then auction 28-day credit Tuesday afternoon. The two auctions will settle Thursday of that week, the day other TAF credit matures. 7 of 50 July 24, 2008 8 of 50 We are also requesting that we enhance the collateral protection for the Reserve Banks against term loans. Specifically, we are seeking a collateral cushion on term loans. The cushion is meant to provide protection to Reserve Banks if there are unanticipated needs for overnight credit during the term of the loan as well as serve as a collateral buffer that provides for deterioration in the value of the collateral or the creditworthiness of the depository institution (DI). This would apply to both TAF loans and term primary credit loans. Currently, there is a requirement that a TAF auction bid, plus other term credit that will be concurrently outstanding, not exceed 50 percent of available collateral. However, this requirement is only for the time when the bid is submitted. We imposed this as a modest measure of comfort that DIs would have adequate access to collateral to cover unanticipated needs for additional credit during the term of the TAF loan. This collateral cushion has not been an element of the term primary credit borrowing program, first introduced in August 2007. Under the current collateral policy for the TAF bids, we observe that some DIs add collateral just before an auction and withdraw the excess amount after the auction. That is, they do not maintain the cushion during the actual term of the loan. Particularly for the longer-term TAF and also for the term primary credit loans, we feel that Reserve Banks should have access to additional collateral. As I noted above, this would provide a cushion for unanticipated needs for additional credit during the term of the loan and for deterioration in the value of the collateral or the creditworthiness of the DI. An alternative would be to alter the haircuts themselves, but that could have other negative market consequences. In fact, for that reason, the Federal Reserve stated publicly in August that it was not changing its haircuts amid the uncertain market conditions. Specifically, the requirement we are proposing is that a DI’s aggregate term borrowings not exceed 75 percent of available collateral. Most current holders of term credit have sufficient collateral to meet this requirement. We do not feel that this will restrict participation in any significant way. As is the case currently, the terms for TAF bidding and outstanding extensions of credit will require that Reserve Banks be collateralized to their satisfaction and that they take additional measures, including the right to ask for more collateral or to call a loan, if they feel insecure. Other terms of the auctions will remain as they are today: maximum bids and awards of 10 percent of the auction size, minimum bid size of $10 million, maximum of two bid rates, minimum bid rate based on the OIS rate, et cetera. These seem to have been working well, and we see no need to request any changes. We would be happy to answer your questions. Thank you. CHAIRMAN BERNANKE. Thank you very much. Are there any questions for Bill or other staff members? President Evans. MR. EVANS. Thank you, Mr. Chairman. I have a question for Bill Dudley and Sandy Krieger. I am a bit confused about the discussion of the overcollateralization withdrawal. I guess I am not sure what the purpose is of the TAF collateral restriction of 50 percent only being July 24, 2008 9 of 50 for the day of the auction. I don’t recall a robust discussion of that particular detail, and frankly—maybe this is my fault—that wasn’t my interpretation. When we discussed this with our directors, who are quite concerned about the safeguards on these loans, we had indicated that there was a term cushion, which Sandy is now mentioning we need to impose. I guess my question is, Was this anticipated? Any discussion of that would be helpful. MS. KRIEGER. Well, as I said before, we imposed it to provide us with some comfort that DIs could stretch toward extra collateral, should they need it during the term of a loan. It came against the background of a term primary credit program that didn’t have any such requirements or expectations. So I think we were a little cautious about the measures that we were taking at that time. It is spelled out in the terms and conditions. I think the Reserve Banks have been comfortable administering it on auction day, and the DIs seem to understand it. Maybe they understand it too well because some of them have figured out that they can bring in collateral and withdraw it. MR. EVANS. Thanks, I appreciate that. I do wonder why we didn’t have more of a robust discussion about that at the time because it seems more than just a detail, given that it was part of the representations that at least some of us—or at least I—made to our directors. But thanks. CHAIRMAN BERNANKE. President Lacker. MR. LACKER. With the way that we currently operate the Term Securities Lending Facility now in place, is there any upper limit on the fee that some participant can bid? MR. DUDLEY. No. MR. LACKER. So they can wait and virtually guarantee themselves a vanishing probability of not getting their bid hit by just bidding an arbitrarily large amount, right? July 24, 2008 10 of 50 MR. DUDLEY. Correct. Although if a number of institutions did that, they would not know what the price would be for that loan. MR. LACKER. No. But this is what single-price auction theory is about, figuring out what the equilibrium bid function is. Presumably they make some inference and act on it, and presumably they are doing that calculation now in deciding how much to bid to guarantee them a certain probability. Right? So this auction would provide insurance, as I interpret it, against the TSLF fee being higher than they would otherwise think it would be or being unanticipatedly high—equivalently, the spread between agency MBS and Treasury GC (general collateral) repo rates being unanticipatedly high. Is that a good interpretation of what this option would provide in economic terms to the participants? MR. DUDLEY. If you won an option, you would lock in with certainty the ability to borrow at the TSLF for a fixed price—so you would be locking in your place in the queue, and you would also be locking in your price. MS. PERELMUTER. You will also be bidding at a premium, so it will cost you to lock that in. MR. LACKER. Right. So you’re paying for insurance. MR. DUDLEY. You are reducing your uncertainty. MR. LACKER. Right. It is reducing the upper tail. So what sort of evidence or reports have you had from the dealer community that the upper tail of the probability distribution of TSLF bids is causing financial strain for them? MR. DUDLEY. I think they would have trouble characterizing it that way, to be frank about it. We have certainly heard that there is a lot of uncertainty about what is going to happen going forward in terms of balance sheet stress. We certainly have heard that that stress tends to July 24, 2008 11 of 50 be greatest around quarter-ends and year-ends. I don’t think that we have heard the dealers characterize it in terms of tail risk. I don’t think that is how they would frame the question. MR. LACKER. Let me ask you about the margin spiral you talked about, that this could help prevent. I would be interested in hearing your comparison of this option proposal with simply expanding the size of the TSLF offer by an equivalent amount. In just my simple, basic sort of thinking through this, I can’t see any difference in the degree to which those two alternatives would prevent the kind of margin spiral you are talking about. Presumably you’d have a margin spiral under this option plan if some big demand for dumping securities occurs, once they tap out both the regular TSLF and draws on these options. That’s the extra securities that we are absorbing off the market. If the TSLF is the same amount, we’d provide the same amount of insurance against a margin spiral. Is there some reason to prefer this as a way of ensuring against margin spiral versus just expanding the TSLF amount? MR. DUDLEY. Well, I think one advantage of it is that you are buying an option today for an auction that is going to take place several weeks in the future. That allows you to plan a little better what you need to do to actually be able to finance yourself over year-end. If you win the option, you know you have locked in that financing. Then you may behave differently in terms of how you manage your portfolio and how you manage your willingness to extend credit to other counterparties. I would say that is the major difference. MS. PERELMUTER. The options also are for a shorter maturity, so you can lock in for the days surrounding the stress date rather than need to have it outstanding for 28 days. So this is another opportunity to manage your risk just around those dates. MR. LACKER. Has that risk been a particular problem for dealers? July 24, 2008 12 of 50 MR. DUDLEY. I think we have seen a couple of quarter-ends over the last year that have been problematic and more difficult. Certainly, the September quarter-end was difficult, and the year-end was difficult. March somewhat less so, but that was a little colored by the fact that the Bear Stearns resolution happened just before the March quarter-end. June was actually pretty manageable. But we have definitely seen more stress over those periods. MR. LACKER. Was it unpredictable? It seems pretty predictable at this point that we’re going to get stress over the quarter-ends. I mean, this is addressed at the uncertainty around that not at the stress per se. MR. DUDLEY. Well, I think the stress during those periods means that there is more risk that a small shock could actually build into something bigger because people are all in balance sheet reduction mode at the same time. That is why you care about those periods. You already know that they are likely to be more stressful, but the fact that they are more stressful means that a shock of a given magnitude could have more-damaging consequences. So you are really trying to lean against that. MR. LACKER. There also isn’t any maximum bid in the Term Auction Facility, right? MS. KRIEGER. Yes, there is—10 percent of the auction. MR. LACKER. So there is no maximum on the rate— MS. KRIEGER. Of bid—correct. MR. LACKER. Now, if I want funds from six to nine months from now, I can just wait and virtually guarantee that I am going to get those funds by planning to bid just exorbitant amounts for them, right? July 24, 2008 13 of 50 MR. DUDLEY. Right. But that is not tenable in the large. If a whole group of institutions had that same strategy, we could have a very interesting auction result. It would be profitable for us. MR. LACKER. Right. So? MR. DUDLEY. Well, I don’t think that is the result we are going for. MR. LACKER. We would flood the market with reserves. We wouldn’t let it get to that, would we? We would have other tools for addressing a huge spike in the demand for funds at that point. Presumably it wouldn’t go far above the primary credit facility rate. I am just probing here about the amount of insurance we are providing. This seems like a very specific piece of insurance that we are providing in both of these cases, and I am having trouble seeing the link between these and the overall financial strains you are characterizing or seeing in the market. That is what all of this is about. That is why I am asking this. CHAIRMAN BERNANKE. Okay. Other questions? President Hoenig. MR. HOENIG. I have a question that is somewhat different from that. When you brought this up, I thought that we were asking to extend this into next year but that the idea was to eventually back away from this. We are setting up this new procedure that suggests to me that it might end up needing to go longer since we are talking quarter-ends and so forth. I am not there, but I know there are other strains. Are the liquidity strains suggesting not only that we want to extend this into next year but also that there is a tightening, a worsening, of conditions that means we need to change the approach here and provide even more assurances to the market, so that we are committed to this? This seems to take us away from rather than toward backing out, and I really am a bit concerned about that. July 24, 2008 14 of 50 The second question I have on this is about going from 28 days to 84 days on the TAF. We in Kansas City don’t have a lot of this going on, but we have some; and we haven’t had a lot of concern about the fact that it’s 28 days and not a longer maturity. Are things happening in the markets such that we would want to do this to help settle things out, or is it merely an administrative change to ease our burden and perhaps theirs as well? I don’t have a lot of problems with 125 percent coverage ratios, but I am interested in why we are looking to change the maturity. So I have those two questions for you. MR. DUDLEY. Okay. To answer your first question—Does this commit us for longer?—I don’t really think so. I think the options could be granted only for periods over which the Federal Reserve determines that unusual and exigent conditions exist. So today if we extend that time table to January 30, 2009, then we are opening up the possibility of having options over the September quarter-end and year-end but no longer. In terms of the maturity, the banks have been pushing for this for a long time. If you ask people, “What is your single most popular recommendation that you would like the Fed to do in terms of its suite of liquidity tools?” this is the one that is always at the top of the list. Now, to your question, “Have things deteriorated?” I would say “yes and no.” They haven’t deteriorated in terms of term funding pressures by looking at the LIBOR–OIS spread being worse. But what has deteriorated is that the markets think these strains are going to last a lot longer—if you look at the one-year-to-two-year-forward LIBOR–OIS spread on a forward basis—and that deterioration has occurred over the last couple of months. MR. HOENIG. On your first answer, okay, you are suggesting that this doesn’t mean we are going to extend it further. But what we have now is not fully utilized, and yet we are July 24, 2008 15 of 50 extending it and adding to it. That it just seems contradictory to our ultimate goal bothers me a little. That is a comment, not a question. CHAIRMAN BERNANKE. Tom, let me say just a word about that. The “unusual and exigent” is a determination that the Board makes. I personally feel comfortable with that determination at this time, given a lot of indicators of stresses in the markets. In addition, I think that, in the absence of our facilities, the risks of systemic problems would be much higher. I think it is useful for us to give a time frame, to provide some sense of assurance to market participants that, if conditions remain stressed, there will be these backups. I would note, for example, with respect to your point about underutilization, that the PDCF is now at zero and has been at zero; but I do think that its presence has actually provided some assurance. Finally, I would also mention that—as you will see, if you have not already seen in our official resolution on this—if at any point going forward the Board determines that unusual and exigent circumstances do not prevail—and Scott is nodding—we would not be committed to going six months. At that point we would no longer have a basis for maintaining these programs. So we do have to make that determination, and at this point I would say it is a reasonable determination. MR. HOENIG. All right. Thank you. CHAIRMAN BERNANKE. Other questions? President Plosser. MR. PLOSSER. I want to go back to the collateral issue for a minute. I share some of the concerns about the options on the TSLF that President Lacker and President Hoenig were discussing. I assume we will come back and talk more about some of those things, but I do have a question about the collateral. My understanding in the discussion about the larger collateral on term lending is that it would also apply to the primary credit lending, which means that if somebody came into the primary credit facility and asked for primary credit of two or three days, July 24, 2008 16 of 50 they would have to have this 125 percent or this extra collateral. Is that the way we are interpreting this thing, and is that really what we want to be doing by raising the collateral on term loans at the primary credit facility? I am just confused about that and whether—particularly on things less than 30 days, the primary credit facility—we want to be applying the same standard to that lending as we are on the longer TAF stuff. Just a question. MR. DUDLEY. Sandy, do you want to take this? MS. KRIEGER. So, yes, what we have proposed is that the additional cushion be taken against all loans more than one business day—primary credit and TAF, not seasonal credit. Clearly one could make a decision about where that point should be, and unless you can do it in a trend line, which our systems don’t make operationally easy or comfortable for us, there will be a discrete point. An alternative would be to do it at some particular point in time, and there would be costs and benefits. On the one hand, it would make some more comfortable with the collateralization at very short terms. On the other hand, you also want to be comfortable with the incentives that we will create for DIs, if they are collateral constrained, to take loans of the short term that go just up to that point and continue to roll them. For example, let’s say that your point was one week. Banks that are not collateral constrained probably would take the longer-term loan. Banks that are collateral constrained, the ones that you probably want to follow most closely, are likely to take the loan for six or seven days and then roll it and roll it and roll it again. MR. DUDLEY. You could get a bit of an adverse selection problem. MR. PLOSSER. Yes. But if they really want a week-long loan, do we really want to be encouraging our depository institutions coming in to just roll it over one day after one day after one day after one day. It seems to me, that really changes the nature of the way most of our July 24, 2008 17 of 50 primary credit has been made. For us, in particular, the collateral that most banks use for primary credit is not the sort of securities that they can pull in and pull out very easily—a lot of it is loan collateral and securities of that type. If you really want more collateral on these longerterm loans, making it more than just one day, it seems to me, is too short. I am just wondering if it makes more sense, so that we don’t drastically change the nature of the primary credit window, to say it is longer than 30 days or some other time frame. I realize it is going to be a discrete point at which it turns over. But I just think it would be very awkward, and I don’t think it is really necessary for the very short term end. MR. DUDLEY. I think we would concede that point, that one could have a break point at 28 days or 30 days, where beyond 30 days you had this overcollateralization requirement, and less than 30 days—it could be zero—that is really for you to decide. But to us it is not really compelling one way over the other. CHAIRMAN BERNANKE. Bill, if our goal is not to take away something that the banks already have, wouldn’t it make sense to make the 28 days or more the loan that needs to be overcollateralized? Would that be the right way to think about it? MR. DUDLEY. I think we would be comfortable with that as an alternative. I mean, it does have the advantage of not taking something away that we have already given. CHAIRMAN BERNANKE. All right. President Plosser. MR. PLOSSER. That would make a little more sense. You know, anything in excess of 30 days or somewhere in that range would make a little more sense to me anyway. MR. DUDLEY. We are picking 28 days because that is the length of the current TAF loan. If you are going to make a cut, that would seem to be a logical place to make that change. July 24, 2008 18 of 50 CHAIRMAN BERNANKE. President Evans, did you have a two-handed intervention on this? MR. EVANS. Yes, I did. Thank you. I guess my basic question is, Do we feel comfortable with the level of collateralization that we are imposing on these programs for the TAF? I thought that we were expecting double collateral, and I had thought it was for a longer period of time, but it was only on the one day. I still don’t understand why it would be important on one day and not longer than that. But is 25 percent the right number? I just don’t know how to think about it. If the people who are the experts at this could offer some discussion and the appropriate assurances on that, I could certainly feel more comfortable about some of these exotic proposals. My concern is really that we seem to be doing this very quickly. The rationale for the choices that we are making is not exactly clear, and if we had a little more clarity, that would be better. CHAIRMAN BERNANKE. Let me turn to President Pianalto, who has been very patient, and then, Bill, you can respond to both, as you wish. President Pianalto. MS. PIANALTO. Thank you. During the presentation, it was mentioned that many banks were asking for this longer-term TAF. I am not getting that request here in my District, but I wonder whether any thought was given to keeping the 28-day TAF and then adding the longer 84-day TAF. Is that even an option? The reason I raise this question is that I am concerned about the credit risk. We have had situations in which it has been difficult to assess whether an institution was going to stay in sound financial condition over a 28-day period. Obviously, it would be even more challenging over an 84-day period. So I just wondered if it 1s even an option to keep the 28-day TAF and add the 84-day TAF. July 24, 2008 19 of 50 MR. DUDLEY. Of course it is an option. I think the reason that we preferred moving completely to an 84-day was that we thought it was much clearer. In other words, the users would know what they were doing and wouldn’t be faced with a multitude of choices in terms of keeping straight what week this is and what auction they are bidding for today. So we felt at the end of the day, because we had repeatedly been asked for a longer maturity, that we would be diluting it if we split it 50-50 between 28 days and 84 days. We also thought it would be more confusing in terms of if 84 days is good, why are you moving only halfway? MS. KRIEGER. In terms of the size of the cushion, we did speak with SCRM (Subcommittee on Credit Risk Management) a bit about this, and, of course, there is a variety of views there; and across the System, as we look at the loans that are outstanding, there is a range of collateral that is used. A good portion of the collateral that is used is not priced securities; it is loans, many of which we do not have the details on, so it is very difficult to establish a good value. Then, even behind that in quality are nonpriced securities, and we have increasingly seen more of those pledged to us in these times. So we felt, because it is difficult for us to feel really comfortable with the values of some of these pledged instruments, that taking the cushion did seem appropriate. For what it is worth, of the more than $150 billion of loans that we have outstanding, they fall short of being collateralized by this extra margin by only about $200 million. So virtually all the value can be overcollateralized. Now, it is not quite so pleasing a picture if you look at it by the number of borrowers outstanding. Of the 140 or some borrowers outstanding, maybe 25 of them are short some margin of collateral, if you would impose the 25 percent overcollateralization. But, again, the values are quite small, even in percentage terms, for institutions. So as we try to balance, on the one hand, our comfort with some of the collateral we are taking and our ability to value it with, July 24, 2008 20 of 50 on the other, the longer term, we look to the preference of many in the reserve community who have dealt with institutions whose quality has deteriorated. We felt we might be doing best by the vast majority of Reserve Banks if we were to introduce the cushion. MR. DUDLEY. I also want to point out that for the banks that don’t have enough collateral today, that doesn’t mean that they don’t have collateral available. It is just that the collateral hasn’t been pledged at the window. So the bottom line is that we don’t think that the overcollateralization requirement is very constraining—to use economics terms, the shadow price of collateral is pretty close to zero as far as we can tell. CHAIRMAN BERNANKE. Thank you. Other questions? Well, if there are not any other questions, let me first say that I do want to thank the staff. These innovations did come from the staff members who are on the front lines. President Evans, we really have talked about these, and I know the staff has thought these through. I think that these are constructive ideas. The option idea essentially will allow for a better targeted use of our balance sheet to some short periods that have been particularly stressful, and I think it will give us overall more flexibility to use our balance sheet in the most effective way. So it seems like an innovative way to deal with a particular problem, which is this end-of-quarter issue. On the 84-day TAF, I know for sure that banks have been asking for a longer term. I have heard it directly myself and have heard a lot about this from the Desk. It is frequently pointed out by the banks that the ECB and the Bank of England have been making effective use of longer-term loans, and in their view that has made the liquidity pressures less severe in those jurisdictions. So I do think it is certainly worth considering the three-month TAF loan. Obviously, as Reserve Bank presidents, you have to administer these; and the first question that comes to your mind is, of course, the greater credit risk. In that respect, I think that taking the July 24, 2008 21 of 50 existing haircuts plus 33 percent should provide some comfort. Of course, you retain the right always to demand collateral to your satisfaction or to convert the loan to a primary or secondary or overnight loan or to call the loan. So you have always the same protections that you currently have. I suppose it would be, in some sense, a de facto tightening of standards, if you were looking at institutions that would be eligible on a three-month basis. At the same time, to go back to my earlier comment, we don’t have to make a final decision today, but it might be worth considering not putting the overcollateralization requirement on any loan less than, say, 14 or 28 days on the grounds, as President Plosser pointed out, that we don’t want to be seen as taking away something or increasing the cost of funding at a time when we still want to provide these liquidity benefits. So I guess that one option I would raise for consideration is that, if we do the three-month maturity, we use the overcollateralization for loans greater than 28 days. This means that, as a loan maturity comes down—as it comes close to payoff—some collateral could be withdrawn if desired. I do think these are reasonable extensions. They seem to me to be quite consistent with our earlier practice. I take President Hoenig’s point that we are not in this business indefinitely. We need to be thinking about cutting back. But at the moment, conditions do not seem considerably better, and I don’t think that at this moment we really should be reducing our support to the market. Are there others who would like to comment on any aspect of these proposals—about collateral or about any of the other issues? President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. There are just two other observations I want to share. They aren’t direct questions, just sort of my thoughts on this. In general, I am okay with the extension to the 84 days—I don’t think that is problematic. As I mentioned before in our meetings, I really would like to see some more clarification and standards applied to what the July 24, 2008 22 of 50 Board and the staff mean by “unusual and exigent circumstances,” how we define that term and how we know when it is time to take it off. I understand that there is stress in the marketplace. I am not disputing that. But I think as we go forward—and following up on President Hoenig’s point—it would be useful if we had a way of discussing more explicitly the criteria that we use to put this on or take it off. So at some point I would like to have some discussion about that. The other point I would make is that I am just not persuaded by the staff’s arguments about the options. The TSLF is undersubscribed. If we wanted to make loans available, we could offer more-frequent auctions. We aren’t tied to any particular two-week schedule. We could offer auctions near the end of the quarter. I am just not convinced that this is going to provide much to the marketplace. Even the staff suggested that it might be marginal. The more we tweak and change these things and try to provide things that we don’t know whether they are needed, I am not persuaded that they are adding anything. I think the 84 days runs over quarterend. There are auctions as much as one week or two weeks before quarter-end every quarter. There are funds available. So I am just not sure that this is necessary. Thank you. CHAIRMAN BERNANKE. Okay. Thank you. Anyone else? President Yellen. MS. YELLEN. Thank you, Mr. Chairman. I support extending the TSLF along with the PDCF, and I am also supportive of the proposal to auction options on TSLF draws. I think we do continue to have money market stress, particularly at quarter-end, and it strikes me as a welltargeted program that might have some success in addressing the strains. On the proposal to extend the term of the TAF loans to 84 days, I do have some qualms, and they have been heightened by our own recent experience with a failing bank and my sense that the most recent bank failure is not going to be our last. I definitely understand the motivation for extending the term of the loans, and I am not saying that I am, on balance, July 24, 2008 23 of 50 opposed to it. But I do think that the program entails credit risk for Reserve Banks and may actually create complications in facilitating least-cost resolution of troubled banks. My anxiety about this has been heightened by our own recent experience with IndyMac. If you will indulge me for a second, I will tell you the story of what happened there and why I am concerned. IndyMac was closed on July 11. On June 26, just two weeks earlier, the information provided to us by the OTS indicated that IndyMac was a CAMELS 2–rated institution. We monitored Call Report data that showed it to be well capitalized. On the morning of June 26, we approved a loan for $1 billion under primary credit. IndyMac didn’t participate in TAF auctions, but it was eligible to do so. If the new 84-day facility had been in operation, it would hypothetically have been eligible to be covered under that. It could have had an 84-day TAF loan. My staff consulted with me on the IndyMac request on that morning of June 26 because it represented a significant escalation in borrowing, and our own monitoring suggested that the institution had been deteriorating. We had informal hints of some concerns at the OTS. It was unknown to us, but in point of fact the OTS had already informed the institution that it had actually been downgraded to a 3. Even so, even if we had known that, it still would have been eligible for primary credit and participation in a TAF auction. Now, the memo we got points out that we can disqualify an institution from participation in a TAF auction on the grounds that we judge it to be in unsound financial condition or that we can on such a judgment move an institution to secondary credit. But we thought that would be a drastic action, and it probably would have been seen as arbitrary. It would have entailed a supervisory judgment that was in conflict with that of the institution’s supervisor. We didn’t think we had an adequate database to make such a judgment, and we couldn’t have done it July 24, 2008 24 of 50 without making a formal communication to the institution that we had made such a judgment, which we would have been concerned about. Now, with respect to collateral, we thought we were very much overcollateralized. The institution had pledged collateral with us amounting to around $4 billion. We applied standard haircuts and assigned a lendable value of $3.2 billion, so our credit risk appeared to be very well covered by the collateral, and we approved the loan. On that very afternoon of June 26, it became public that Senator Schumer had written a letter to the FDIC and the OTS expressing concern about the institution, and that very evening we learned that the OTS had downgraded the institution to a 5, and that, as of June 30, the OTS expected to declare it to be significantly undercapitalized. We also learned that the FDIC was planning to close the institution within a few weeks. We moved it to secondary credit. We took an additional 10 percent haircut on the collateral. That brought IndyMac’s borrowing capacity down to $2.8 billion. But we took the precaution of sending our most senior mortgage specialist from Banking Supervision and Regulation (BS&R) down to the bank to gather information to refine our assessment of the true market value of the collateral, based on that institution’s profile and more detail about the collateral than we had had from applying the standard haircuts. He concluded that the haircuts we were taking were drastically too low and advised us to reduce the lendable value of the collateral down to $1.1 billion. We reserved $100 million for non-Fedwire payment system exposure, leaving us with a $1 billion loan and $1 billion of now-assigned, lendable value of the collateral. So, in retrospect, it turns out that we actually did make a $1 billion loan under primary credit to a troubled institution that was undercapitalized under FDICIA guidelines and on the verge of closure. And we did it based on collateral we should have valued at $1.1 billion rather than $3.2 billion. July 24, 2008 25 of 50 So we did have significant credit exposure, and I think we are lucky we lent only overnight and were paid the next day rather than having an 84-day loan. With the TAF, if we had an 84-day loan outstanding on June 26, we would have had no further capacity to assist in the bank’s final days in moving toward what we deemed an FDIC-led least-cost resolution. The bank had lost all access to brokered deposits and also to Federal Home Loan Bank loans after it was downgraded, and our inability to lend any further would almost surely have precipitated a liquidity crisis and a failure well before the FDIC finally closed that institution on July 11. So let me draw a few morals from this shaggy dog tale. First, troubled banks can be downgraded and fail very rapidly. They may be deemed eligible to borrow under primary credit and participate in TAF auctions when in reality they are near failure. Second, it is true we have discretion to judge whether or not to allow an institution to participate in auctions and can exclude an institution that we don’t consider in sound financial condition. But, in reality, we deal with hundreds and potentially thousands of banks at the discount window and can’t monitor and make independent judgments on the health of all those institutions on an ongoing basis. We do have to rely on primary supervisors for assessments. If we act on our own hunches, we are substituting our judgment for that of primary supervisors. If we decided we wanted to do so, we would be truly taxing the resources of our colleagues in BS&R beyond their capacity to deal with these institutions. Third, we may think that we are overcollateralized, but that judgment can be highly flawed in the case of a troubled institution. Finally, while we may, in principle, demand immediate repayment of any discount window loan, including a TAF term credit, in a failingbank situation such an action can cause the institution’s immediate failure, making an orderly least-cost resolution impossible. Now, I know that this applies, we hope, to a handful of institutions and not to most of them; but I don’t think that IndyMac is going to be the last failing July 24, 2008 26 of 50 bank. I do think that this would have worked very badly in that case, and so it does give me qualms about the proposal. CHAIRMAN BERNANKE. President Yellen, San Francisco did a really good job in a difficult situation. We were following that very carefully. Just a footnote, did the FDIC not give you some assurances as well—protections for lending—because they asked you explicitly to assist them in winding down the bank? MS. YELLEN. They initially told us that they would take up to the face value of the collateral, and we quickly determined that that is not consistent with Federal Reserve policy. In point of fact, it is not consistent with the written agreement that the Reserve Banks have with the FDIC, which actually states that the FDIC will compensate us for the market value of the collateral. So I think that the FDIC here faces a sequence of failures and wants our cooperation. They did compensate us—we had $500 million outstanding to IndyMac at the moment it failed, and we were immediately compensated. But our agreement with the FDIC is that they compensate us only up to the market value of the collateral, which we deemed to be close to $1 billion, rather than our haircutted value based on a standard haircut, which was over $3 billion. CHAIRMAN BERNANKE. My main point, though, is that if you had allowed this bank—and you probably had some suspicions about it—to participate in the three-month TAF, you would have had all the same protections: the ability to convert to overnight, to primary credit, or to secondary credit; to call the loan; or to ask for more collateral. Am I mistaken? Sandy? Anyone? Why would you have been unable to do the same? MS. YELLEN. Well, I guess we would have had that. Had they taken the loan out earlier, when they were still rated 2 or 3, I think it would have substituted for borrowings that July 24, 2008 27 of 50 they could have had at that time from the Federal Home Loan Bank. They might have had a motive to take out a long-term loan from us rather than to tap their Federal Home Loan Bank access. They would have pledged a huge amount of collateral to the Federal Home Loan Bank, which was not accessible to us, had we wanted to lend more because the Federal Home Loan Bank has blanket authority over a large class of collateral. So if we had, in fact, extended that loan, we could have called it in; but that would have precipitated a failure. And we wouldn’t have had the ability to augment the collateral. So our hands would have been tied when the FDIC came to us and said, “Please assist us in lending. This institution is experiencing deposit outruns. We want to get it through to a close that we think will be least-cost, and it is going to take us another week and a half.” There would have been no more collateral to be had. We would have been, then, up against the limit of what we could lend. CHAIRMAN BERNANKE. Okay. Governor Kroszner had a two-hander on this one. Governor Kroszner. MR. KROSZNER. I just want to underscore the points that President Yellen made because extending the term or even just having the term with the TAF really creates a bit more of a burden for us to think about not just primary versus secondary credit but effectively three modes. One is sort of a superprimary credit, where you can borrow at term and now term of 84 days rather than 28 days. This issue came up not only in the San Francisco District but also, as Sandy Pianalto well knows, in the Cleveland District. Then there are the overnight primary credit and the secondary credit. We have to think about how we will apply this in a consistent way throughout the System. Also, although in principle we can pull back exactly as you described, as Janet argued, that can be very dangerous to do. Also, if we do that, sometimes it may have to be revealed publicly on a form 8-K. If there is a significant change in an July 24, 2008 28 of 50 institution’s liquidity situation and if an institution is in a difficult circumstance, the institution has often made reports publicly about how much liquidity it has. If there is a significant change in our willingness to provide institutions with credit, they may have to report that, and that could be a precipitating event, which puts us in a difficult situation. So I think we just need to think very carefully about the criteria that we will use for eligibility for long-term borrowing versus overnight borrowing and primary versus secondary borrowing and then not kid ourselves that we may have more options than we think to pull back because it may be very, very difficult to pull back. Obviously, we also have pressure from the FDIC and other regulators not to be the precipitating event. CHAIRMAN BERNANKE. President Lacker, you had a two-hander? MR. LACKER. Yes. I want to, first, just express appreciation to President Yellen for the full account of their experience. I think it is useful for us to share notes on experiences like that. We had an experience with the OTS, and we found that their rating plus 1 was the rating we usually came to. We had the luxury of having someone on our staff who had experience with Countrywide, and we essentially treated them like an institution that we supervised and insisted on the full panoply of information, such as reports and financial reporting, to be able to make our own independent assessment. Our guys did a great job. I have to commend them—they did a lot of work. But it was a strain on our staff. I do think, if lending is going to play such a large role for us going forward, that we should build up the capability of developing our own independent assessment of institutions whose primary regulator is not us. In this instance, I think it is outrageous that the OTS downgraded them and didn’t inform the San Francisco Fed. I hope, Mr. Chairman, that the unacceptability of that sort of behavior is communicated at the highest levels to the OTS. This instance demonstrates the principle that July 24, 2008 29 of 50 lending on which we incur no loss doesn’t necessarily equal lending that is appropriate. I think it is a good thing, President Yellen, that you folks insisted on comfort from the FDIC that they were pursuing a least-cost strategy. But it will not necessarily be the case that lending to allow the chartering institution to delay closure will be the least-cost resolution. I am curious, President Yellen, whether there were uninsured claimants that were able to withdraw funds in the interim during your lending. MS. YELLEN. There was about $1 billion of uninsured deposits out of roughly $30 billion of total liabilities, and some fled. I don’t know exactly what proportion fled. Maybe at the end there was something like $700 million of uninsured deposits, and we certainly worried about that in thinking about whether the FDIC’s approach was consistent with least-cost resolution. I guess we came to be convinced that, in the absence of our lending, there would have had to be a fire sale of assets and that great losses would have been taken in selling assets on that time frame to cover withdrawals. On balance we accepted the idea that the FDIC was going to close it within a twoweek time frame, and we’re reasonably satisfied that it was consistent with least-cost resolution. MR. LACKER. So you don’t think refusing to lend would have forced the FDIC to accelerate closure? MS. YELLEN. If we had not lent, they would have been unable to meet withdrawals, and I think that there would have had to be an earlier closure. It would have been a midweek closure. The firm probably would have had fire sales of the assets. The closure would probably have been very disorderly. CHAIRMAN BERNANKE. President Lacker—I’m sorry, Janet. Go ahead. MS. YELLEN. No, that’s fine. July 24, 2008 30 of 50 CHAIRMAN BERNANKE. I just wanted to assure President Lacker that we did, in fact, communicate our concerns to the OTS about this episode. President Stern. MR. STERN. Thank you, Mr. Chairman. I have just two brief comments. The first one is that I share the concerns that are highlighted by President Yellen’s story with regard to IndyMac. Second, with regard to the TOP, the TSLF options program, I’m not opposed to it, but I must say the case for it seems to me to be distinctly underwhelming. As a factual matter, Bill Dudley said, well, there were quarter-end and year-end pressures in September and December but March and June went better. But, of course, in September and December we did not have the PDCF and the TSLF facilities in place, which we now have in place. So I would have to say that it’s not clear to me what we’re expecting to get from this additional option. Thank you. CHAIRMAN BERNANKE. Anyone else? President Evans. MR. EVANS. Thank you, Mr. Chairman. I am concerned about the credit risk associated with the term lending here, and I suppose if everybody feels comfortable with it, then that would be all right. It does seem, though, that the value of these new programs, much as President Stern just mentioned, seems small. These are temporary facilities exercised under unusual and exigent circumstances. They are currently anticipated to go away. I would think that we should be having big value added from additions to these programs. I wonder a bit about how confident we are about what the market reaction to the introduction of these pretty complicated programs is going to be. Are they going to wonder about what we’re looking at versus what they’re looking at? These are supposed to be temporary; but the way we add more to it, it seems as if it’s going to be more difficult to take this away, at least in terms of the expectations of our borrowers and the markets. We have been doing this as we make comparisons to the ECB and the Bank of England, and they have been doing this for some time. It sort of suggests that this is something that we’re going to do July 24, 2008 31 of 50 for a longer period of time. I am not saying that that might not be the right decision ultimately under the right risk management, but it does seem to be prejudging that a little. Thank you. CHAIRMAN BERNANKE. I would just note that the TAF is not contingent on any unusual and exigent circumstances because that is just the regular discount window. President Rosengren. MR. ROSENGREN. I am supportive of the overall recommendations. I would say, along with President Evans, that I am a little worried about how the markets may react to these new additions and whether they may view it as the Federal Reserve viewing things as deteriorating rather than improving. We have to think a bit about what the market expectations may be with the announcement of these additions. I would just like to comment on President Yellen’s comments. I think they highlight that we probably need to spend a little more time thinking about the link between supervisory ratings and our running of the discount window as we do some of the other work streams we are doing. Both our own supervisory ratings and the ratings of the primary regulators in some cases seem to have lagged. That is particularly true for the OTS. There are a number of other OTS institutions that the market seems quite concerned about and where the ratings seem inconsistent with the market’s concerns. So it is not just looking backward but also looking forward. As we extend the term for things like the TAF, I think the concerns do get raised if the primary supervisor is not being very quick to make an evaluation of deteriorating circumstances. So as we do our work streams, I would just encourage us to spend a little time thinking about how the supervisory ratings and our operations of the discount window could be melded a bit better. CHAIRMAN BERNANKE. Okay. Thank you. Mr. Rosenblum. MR. ROSENBLUM. I want to thank President Yellen for the detailed discussion of the role of the Federal Reserve in supporting IndyMac in its final weeks. It reiterates some of the fears I July 24, 2008 32 of 50 have of what we may face going forward. Extending the term of the TAF to 84 days may compound the adverse selection process whereby those banks that anticipate difficulties may be those most likely to want to go for the 84-day period and bid up the rate that they are willing to pay because they would be anticipating some of the difficulties that we just heard recited. More than that, we in Dallas are worried about the reputation of the Federal Reserve if there is a series of such follow-up events to IndyMac and how it is going to look for you, Mr. Chairman, if you have to testify before the Congress, which has the benefit of 20/20 hindsight and will criticize us for making loans for which foresight is far from perfect: “How could you have made such a loan to a bank that everybody who reads the Wall Street Journal and the New York Times and looks at the Internet knows was in trouble, and how could you do it on such preferential terms?” Such questions damage the reputation of the Fed. In addition to the credit risk aspects, we have the problem of the Fed’s reputational risk, particularly in the halls of the Congress, during a particularly troubled time going forward. On balance, I think the TOP program does no harm. We in Dallas are willing to support it, but we still have some reservations. One of my concerns is that, in the document that was sent out yesterday for the FOMC vote on the TSLF options authorization, there is no mention in the first paragraph on page 3 about this being a special, short-term, end-of-month, end-of-quarter option. It is just left there in general terms that we are going to offer up to $50 billion in additional draws on the facility, and there seems to be a lack of clarification. One question I have is, Is the System going to put out a list of frequently asked questions or something of that nature to add clarity? Another concern that I have is Bill Dudley’s earlier statement that the Fed has other means of easing its balance sheet constraints should the new facilities tie up more funds or encumber more funds on our balance sheet. We didn’t really have any follow-up on that point. What are the plans to ease our July 24, 2008 33 of 50 balance sheet constraints should it become necessary, and does this conflict with the fed funds targets that the FOMC is trying to hit? We need some explicit discussion of that or at least to raise the questions as we go forward, perhaps at the next FOMC meeting. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. President Bullard. MR. BULLARD. Mr. Chairman, I am going to have to leave the call, and I just want to say before I go that I think a lot of good questions have been raised here, and I just wouldn’t rush into this. I think the 84-day term seems to be long in this environment of troubled banks; and frankly, it is not very clear that either of these proposals is really going to buy us a lot. I am also sensitive to the announcement effects, and I am not quite sure what the announcement effects would be. So I would prefer to think about it longer before we go ahead and approve this. Thanks. CHAIRMAN BERNANKE. President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. I apologize. I was a couple of minutes late—caught in traffic here in Miami actually—and I missed Bill Dudley’s briefing at the beginning. So I don’t really know all that he covered in terms of market stress. But my question really relates to an impression I have that a high proportion of the TAF usage is actually foreign banking organizations, where the primary regulatory would, in effect, be a foreign regulator. Listening to President Yellen’s discussion of coordination and communication among domestic regulators leaves me with the question of what the state of our communication with foreign regulators is, if they would be in possession of information that we might not have while we are exposed on this longer-term basis to a foreign banking organization. CHAIRMAN BERNANKE. President Lacker. MR. LACKER. Thank you, Mr. Chairman. I share President Stern’s intuition that the value of these at the margin, given what we already have in place, seems questionable. Even with some July 24, 2008 34 of 50 generosity to the theories of financial strain that seem to motivate the mechanisms we have in place, the additional contribution to alleviating stress seems just trivial, just incredibly minor, to me. I also very deeply share President Hoenig’s concern. There is an endless stream of improvements we could potentially make to our intermediation efforts here, our lending facilities. Continuing to invest in more and more improvements just sends the signal, it seems to me, that we’re settling in for the long haul and envision and expect to be offering these for quite some time. As you all know, I have deep reservations about all of these facilities. But I would think that the broad consensus of the Committee was that these are temporary, transitory facilities, and in that light I think we ought to be thinking of ways that we are going to wean the banking system off these. Adding features like this is just going to further entwine the institutions with us and develop further dependency on us and these facilities. I also think Mr. Dudley said that this was the number 1 desired improvement articulated by dealers. I think that cannot possibly be a standalone rationale for something like this. Market participants are bound to think of stuff that they would like us to do, and we can’t let that guide us. We have to have a sense that we are actually doing something of broader significance. Finally, I will say that I do strongly support the collateral policy change of making the overcollateralization apply every day that the credit is outstanding. I questioned the one-day-only part when we first brought it up with the TAF, and I think that would be a step in the right direction. Thank you. CHAIRMAN BERNANKE. There is a kind of embarrassing situation that this is, in fact, a Board decision. What I would like to do is ask President Geithner and President Plosser to make a couple of final comments, and then I would like to turn to Board members. Governor Kroszner, I am going to give you warning. In that you are the head of Supervisory and Regulatory Affairs, I would like to know what your view is. In particular, can you offer any kinds of steps, assurances, or July 24, 2008 35 of 50 anything that might persuade our colleagues particularly on the credit issues with respect to the three-month TAF? If not, we would like to know that. But let me first turn to President Geithner. President Geithner. VICE CHAIRMAN GEITHNER. Thank you, Mr. Chairman. Let me make just a few quick points. There is no way you can state these things with perfect clarity and conviction, but my sense is that we are in a period in which the sets of basic pressures we’ve been living with now for 12 months are intensifying again and that the scale of the balance-sheet pressures is in some ways greater now than it has ever been. That poses to us the same set of risks that we have been facing and debating but, in some sense, with greater consequence. I just want to underscore that, because I do not believe it is right to look at the constellation of things that we can observe and the use of our facilities and conclude that we are now at a point where we can start to say that we have materially reduced the scale of risks to the financial system and what those risks pose to the economy and our objectives. That is my judgment. I can’t prove that, but I think it’s important for you to hear that from me. Second, as Bill said and the Chairman said, I think these proposals together offer only modest benefits relative to the risks. They slightly change the mix of forms of assurance that we’re offering. It is very hard to know whether that balance would be more compelling on net than what we have today, but these alternatives would not be before you today if there had not been a fair amount of thought put into that basic judgment. Neither the Chairman nor Bill Dudley oversold or overclaimed what these would produce. I do not agree with the concern, although I understand it, that any refinements to our existing tools, themselves, increase the expected duration of our commitment to these exceptional things. In fact, I would take the opposite view. If we have things we could do that would materially reduce July 24, 2008 36 of 50 the risk that intensification of these dynamics would make our problems worse, we’re more likely to be able to exit earlier and more likely to get out of this without having to do other things that we think will be much more consequential and worse from a broad moral hazard and risk perspective. Now, I do not think that anybody could look at this mix of things—what we have done to date or what we propose to do—without deep reservations. The basic business we are in entails risk; and if we are not prepared to take any risk, then we are going to be limiting our ability to mitigate materially the range of basic things that we exist to help mitigate. I agree with you about the reservations, and I worry about all the things you guys raised and don’t feel that comfortable about them, but I think it is worth recognizing again that there is risk in everything we are doing. I am very, very worried about the concerns that Janet raised and those echoed by your colleagues. I do not believe at this point that we have a viable framework of interaction with other primary supervisors that leaves us in a comfortable position with our existing 28-day facilities. If we are not prepared individually to deny access to 28-day loans for institutions at the margin, to scale back access, to scale back the maturity of those things, or to call those loans, then we have a big problem, and we have to figure out how to fix that problem. If we fix the 28-day problem, we will fix the 84-day problem, although at the margin it does add a bit to that stuff, but that can be mitigated with other things. But if we don’t fix it for 28 days to our basic mutual comfort, we have a real problem. I was going to make one process suggestion, Mr. Chairman, because we cannot resolve those things today. I think that Tom Hoenig, as chair of the Committee on Regulations and Bank Supervision; Governor Kroszner; and I—I will nominate myself since I’m chairman of the Credit and Risk Management Committee—should get on the phone together and enter into a conversation and see if we can come up with a better set of choices and principles for how we individually deal July 24, 2008 37 of 50 with a question that is going to get much worse for us, which is marginal institutions slipping toward the point of nonviability, where ratings lag and so ratings just have no value in making these judgments. I also agree with and want to echo the point that Jim Bullard made before he left, which is that we do need to talk more about our balance-sheet-sterilization, reserve-management kinds of options because none of us should be fully comfortable that we now have an adequate set of contingency planning measures in the context of potentially huge increases in demand at open facilities. But the Chairman, of course, recognizes this better than anybody else, and it is very important for us to walk everyone through the range of choices and their limits. I just want to end by saying, Mr. Chairman, that I think we have to defer to you on this. It’s worth reflecting on whether we think we have the balance right in this context, but this is going to be a matter of judgment, and it is going to be hard to give anyone a high degree of reassurance that we know exactly how this will be received and whether, as I said at the beginning, we are right in suggesting that the benefits are modest but significant relative to the risks. The basic choice we face, of course, is whether it’s better to take advantage of those benefits now or to withhold them knowing that we may face a point down the road when things get materially worse. We may face worse choices then that would raise even deeper reservations for all of us. CHAIRMAN BERNANKE. President Plosser, did you want to add something? MR. PLOSSER. I’ll pass, except for just a brief comment. I agree with what President Lacker was saying about the options. If we are going to create new specialized facilities, the hurdle for the problem we think we will be solving ought to be a little higher than just, well, we think it might help a little. That’s all. Thank you. CHAIRMAN BERNANKE. Okay. Governor Kohn. July 24, 2008 38 of 50 MR. KOHN. Thank you, Mr. Chairman. I think this has been a really good discussion that has raised a lot of interesting points. I agree with President Geithner that these are adjustments around the edges that were intended to make the facilities a little more useful in potential periods of stress. I, myself, was favorably disposed toward the options for the reasons you said, Mr. Chairman, of focusing our balance sheet. If we’re a little worried about our balance sheet, let’s focus on putting it to work where the stress points in the system are likely to be, which is quarterend and year-end. I didn’t see it as promising a further extension. We would be voting on one through the end of January—that’s what it says, and that’s what it would be. On the TAF extension, I do think that the financial system and the depository system, regional banks in particular, are coming under increasing pressure. I think we ought to keep the maximum flexibility to deal with these liquidity pressures. I would hesitate to go to just 84 days if I thought that meant there was going to be a material tightening of the standards that the Reserve Banks use to grant these loans because of nervousness about the shifting of a bank’s rating over the 84 days. So I would ask Bill to think again about whether we could run 28-day and 84-day auctions at the same time. I don’t think it’s that confusing, to tell the truth. We run schedule 1 and schedule 2 auctions for the dealers, so I think we ought to give that a little thought so that we’re not forcing the Reserve Banks to make even more difficult judgments about long-term viability than they do now. So on balance, I’m favorably disposed, but I think we need to take on board the discussion we’ve heard here today and think carefully about whether we have these proposals adjusted in the right way. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. July 24, 2008 39 of 50 MR. KROSZNER. Thank you very much. I am supportive of these initiatives; and with respect to the options, I do think it is very important for us to be thinking about the perceptions of how we are using our balance sheet. Whether or not the reality is there about how much we can expand and deal with, there are a lot of questions and concerns. I think a better focus does make sense. Options were used successfully with respect to Y2K, so there is a precedent for them. They’re not as unusual as some of the other ones, or at least not as new as some of the others. Just being careful about the way we will articulate how we are using our balance sheet and trying to respond practically to questions about the balance sheet stresses make sense. On the extension of the TAF, we have had some very important and valuable discussions. I had ongoing discussions with President Yellen and certainly President Pianalto, both facing very difficult decisions that highlight some of the issues with the longer-term funding. As I said, one thing that I think will be necessary for us going forward, particularly in extending the TAF, is to think about whether this is adding something. I do support the extension, although I agree with Governor Kohn that it makes sense to think about both the 28-day and the 84-day terms. Private market participants deal with a lot of complexities—one-month, three-month, and six-month LIBOR, and I think they may be able to deal with this. I think it may add something to have both the 28-day and 84-day terms; but there may be operational issues, and I defer to the Desk on that. I think it raises questions about consistency in thinking about how to deal with now really a third level of comfort that we would need to have in providing credit to institutions. It’s not just secondary versus primary but also primary overnight versus primary term. To that end, I think the proposal that President Rosengren mentioned is important—that we really do need to be thinking about the relationship between these liquidity facilities and our supervisory judgments. To that end I have already asked Brian Madigan and Roger Cole to canvass the heads of supervision and July 24, 2008 40 of 50 regulation to get a feeling for, and to get a list of institutions, where at least at this stage there may be some differences in our view as an umbrella supervisor from the view of the primary regulator as to the challenges that the institutions are facing. Then either I will or we will have a process by which we will ask each regulator, institution by institution, why there may be differences in assessments and try to understand them. We will also put those regulators on notice that we may be taking a different view and that we, as the lender of last resort, can go in and do our own assessments. We take into account what they provide us, but we are not in any way obligated to follow their particular ratings in making our decisions. If we feel that an institution has more difficulty, we do not have to provide credit to that institution. Similarly, I have talked with some of the presidents about being proactive in thinking about collateral rather than at the last minute, as was described with respect to IndyMac, having to think about what the value is of the collateral that is provided. We should be doing that proactively, both because we need to know that from our lending point of view and because we can provide that information to the institutions so that they can better manage their liquidity, decide where they wish to pledge their collateral, and understand how they are going to go forward. Also, the other regulators will know more in advance what type of lending may be available. I do think that we can manage this and that there is potentially some value to extending the term of the TAF. But it raises a number of challenges. Working with President Geithner and President Hoenig on some of these issues, in some sense I have already taken some actions on what President Rosengren has suggested, and I am very happy to hear any other actions that we may need to be taking. I think that we need to be taking those independently of the particular issues here. We can deal with these issues because, of course, it will be up to the individual Reserve Banks to judge July 24, 2008 41 of 50 whether they want to make the term lending available. If there is concern about that, the Reserve Bank will ultimately make that judgment if it does not wish to provide that credit. Thank you. CHAIRMAN BERNANKE. Thank you. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. A couple of things briefly. First, Mr. Chairman, the most important decision that needs to be made—and, again, I defer like others to your judgment—is on the extension of the facilities, given market expectations about what you and others have said about them in recent weeks. While many very serious, legitimate issues have been raised about the nature of our supervisory framework and about our comfort with the collateral we’ve received, I would suggest that we won’t be able to wait until we’ve gotten comfort around those questions before you decide that we should take a vote either today or by notation vote on the broad facilities that we’ve already put in place. So I would suggest that maybe we’d want to separate that from the broader discussion. As for the most optimal mix of liquidity facilities, I’m convinced that what we have is imperfect. It has had some beneficial effect, but it can be improved upon. Exactly how we judge those improvements—the standards by which we come to a determination, which will necessarily be imperfect in these markets—is worth further consideration; and I would not object to separating that question from the extension question that you raised at the outset. Thank you. CHAIRMAN BERNANKE. Thank you. Is there anyone who hasn’t spoken who would like to speak? Governor Mishkin. MR. MISHKIN. Yes. Thank you, Mr. Chairman. I agree with the basic point that it’s very important to recognize that we do not want a lot of these facilities to be permanent and that at some point we will need to remove them. I do worry about the issue of creating the kind of moral hazard from an idiosyncratic viewpoint, and that’s very different. There are two aspects to moral hazard. July 24, 2008 42 of 50 One is moral hazard that is created by providing a backstop when there’s a systemic problem. But you expand this tremendously if you have a backstop for an idiosyncratic episode or for idiosyncratic episodes for individual institutions. So we have to think very seriously about the temporary nature of many of these measures. On the other hand, I just don’t see the stress dissipating. I’m getting ready to go back to academia, and it’s going to be a much quieter life for me. I really am extremely nervous about the current situation. We’ve been in this now for a year; but boy, this is deviating from most financial disruptions or crisis episodes in terms of the length and the fact that it really hasn’t gotten better. We keep on having shoes dropping. So although there’s an issue that we’re going to need to get out of many of these facilities, the reality is that we’re in this, and I’m not anticipating that this is going to go away quickly. I hope that it will. I just don’t understand the argument that actually thinking of more ways to be on top of this and being creative about it will indicate that we want to do something permanent. I just don’t see that. I am also a bit puzzled by the objection to these options. I think that they worked quite well during the Y2K episode. I think they are more targeted. I don’t think they are a major deal. On the other hand, I just don’t see where the problems are. I do recognize that there is a lot of work that we have to do to basically make sure that we’re managing credit risks better, particularly with an extension of the maturity of the TAF loans, but I do not think that this is a situation in which we can just sit back and get everything perfect before we put in these facilities. So there are a lot of issues here. Maybe just because I’m having a bit more trouble sleeping at night, I am supportive of going in this direction. I think that we have to keep on pushing, and I don’t think that this in any way encumbers us or hinders us from removing these when we need to July 24, 2008 43 of 50 do so. I hope that happens soon, but I think the reality is that we’re still in very difficult times. Thank you. CHAIRMAN BERNANKE. Thanks. I may not be the only one who thinks that maybe we should come to some kind of conclusion here. So let me suggest a way to go forward. First of all, as Governor Warsh mentioned, I think we were in agreement at the last meeting that we would extend the TSLF and the PDCF beyond September. The TSLF extension requires approval both by the Board and by the FOMC. So let me make a list here. The first thing I’d like to do—and I hope this is okay with everyone—would be to have Scott read those two resolutions. I would then like to ask the Board to extend the PDCF. Again, I believe we have discussed these and are okay with them. With respect to the extension of the TAF terms, my sense is that this would be a productive thing to do from the perspective of markets. I agree with President Geithner that the markets are still quite stressed and that this would be helpful. It has the additional sort of multiplier effect that, if we extend to three months, the ECB will auction $60 billion to three months as well, to give some additional impetus in Europe. That said, I do not feel comfortable doing this unless we have at least a reasonable sense that the presidents are okay with it. So after we finish the first three votes, I’ll take a straw vote of the presidents and ask you to answer the following question: Given the efforts, to which President Geithner and Governor Kroszner alluded, to address the credit issues that we already face in our 28-day program, do you feel comfortable in doing the 84 days? If you do not, then my suggestion would be just not to go forward with it. Finally, the TSLF options program is an FOMC vote. I would propose that we take a vote on it and see how it comes out. Okay? Any comments, questions, or concerns? If not, Scott, could you start us off with the TSLF extension and take us through what we have to do? July 24, 2008 44 of 50 MR. ALVAREZ. The TSLF authorization needs to be voted on by both the FOMC and the Board. Shall we begin with the FOMC? CHAIRMAN BERNANKE. Sure. MR. ALVAREZ. I think you have all received the resolution. It is the second resolution on the third page. “The FOMC extends until January 30, 2009, its authorizations for the Federal Reserve Bank of New York to engage in transactions with primary dealers through the Term Securities Lending Facility, subject to the same collateral, interest rate, and other conditions previously established by the Committee.” CHAIRMAN BERNANKE. This is an FOMC vote. Debbie, if you would take the roll, please. MS. DANKER. Chairman Bernanke Vice Chairman Geithner Governor Kohn Governor Kroszner President Lockhart Governor Mishkin President Pianalto President Plosser President Stern Governor Warsh Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Thank you. CHAIRMAN BERNANKE. You got President Lockhart. Okay, good. Thank you. Now the Board has also to make a determination. Scott. MR. ALVAREZ. Yes. The Board also votes on the TSLF. This is on the second page, the third resolution. “The Board finds that conditions in the credit markets in which primary dealers obtain funding continue to be fragile and subject to unusual strain and uncertainties. This fragility continues to threaten the satisfactory functioning of broader financial markets and thus poses July 24, 2008 45 of 50 significant risks to the economy. In view of these unusual and exigent circumstances, the Board authorizes the Federal Reserve Bank of New York to continue to make credit available to primary dealers through the Term Securities Lending Facility, subject to the same collateral, interest rate, and other conditions previously established, until January 30, 2009, unless the Board finds that the unusual and exigent circumstances no longer prevail. The Reserve Bank may extend credit where it has evidence that reasonable credit accommodations are not available to a borrower from other banking institutions.” CHAIRMAN BERNANKE. All right. Unless there is an objection, since we had a unanimous vote on the first one, I am going to assume, if no objection, that we will pass that resolution. Okay. Let’s turn to the Board’s determination on the PDCF. MR. ALVAREZ. The second resolution on the second page: “The Board finds that conditions in the credit markets in which primary dealers obtain funding continue to be fragile and subject to unusual strain and uncertainties. This fragility continues to threaten the satisfactory functioning of broader financial markets and thus poses significant risks to the economy. In view of these unusual and exigent circumstances, the Board authorizes the Federal Reserve Bank of New York to continue to make credit available to primary dealers through the Primary Dealer Credit Facility, subject to the same collateral, interest rate, and other conditions previously established, until January 30, 2009, unless the Board finds that the unusual and exigent circumstances no longer prevail. The Reserve Bank may extend credit where it has evidence that reasonable credit accommodations are not available to a borrower from other banking institutions.” CHAIRMAN BERNANKE. All right. Why don’t you call the roll on this one, Debbie. MS. DANKER. This is a Board resolution. So— Chairman Bernanke Vice Chairman Kohn Yes Yes July 24, 2008 46 of 50 Governor Kroszner Governor Warsh Governor Mishkin Yes Yes Yes CHAIRMAN BERNANKE. Okay. Thank you. Now, I’d like to poll the presidents on the following question. Assuming that we do take the measures that were described by Governor Kroszner and President Geithner to work with President Hoenig on improving our collateral and surveillance procedures, are you more comfortable with the extension in terms of the ability to manage credit risk? I might add, if you are a negative, would your view be changed if we broke this into a 28-day and an 84-day so that you would have the option of directing a bank to the 28-day if that were your decision? Let me ask people just to get a quick response. President Rosengren. MR. ROSENGREN. I support this recommendation. MR. HOENIG. Mr. Chairman, this is President Hoenig. May I ask just one clarifying question? CHAIRMAN BERNANKE. Certainly. MR. HOENIG. It doesn’t affect how I come out on this, but if I understand the conversations, if we made an 84-day loan and if during the period we found the institution’s condition deteriorating, we could in the Reserve Bank’s judgment change that to a primary credit loan, call that loan if we felt it necessary, have conversations with the primary supervisor, and deal with that loan whether it was 84 days or 28 days. That is my understanding. Is that correct? CHAIRMAN BERNANKE. That is correct. MR. HOENIG. Thank you. CHAIRMAN BERNANKE. President Rosengren, did you say you support the proposal? MR. ROSENGREN. I support the 84-day extension. CHAIRMAN BERNANKE. Thank you. President Geithner. July 24, 2008 47 of 50 VICE CHAIRMAN GEITHNER. I am comfortable supporting the 84-day extension, and I would be supportive of splitting it. But I’d like to think a little more about both operational issues and how that would work. In principle, since I would be comfortable with 84, I would be comfortable with two tranches or two windows. CHAIRMAN BERNANKE. Okay. President Plosser. MR. PLOSSER. Yes. I’m comfortable with 84, but I also have some sympathy for the view of having two tranches, and 28 and 84 would be fine with me as well. CHAIRMAN BERNANKE. Thank you. President Pianalto. MS. PIANALTO. My preference is to have the two options, the 28-day and the 84-day. As I expressed earlier, I am concerned that, even with improving the collateral and surveillance aspects, the 84-day still presents some challenges. So if it is operationally feasible, I would prefer having the two options of 28 and 84 days. CHAIRMAN BERNANKE. Thank you. President Lacker. MR. LACKER. Yes. I don’t think we should do the 84. If we have to, I’d rather have the 28-day option. I have a procedural question. The original Term Auction Facility authorizations required action by all the Reserve Bank boards of directors. Would this modification also require their consent? MR. ALVAREZ. The only action by the Reserve Bank board of directors on the original TAF was to set the formula for the rate. That has been set, and no further action would be required for this modification to the TAF. CHAIRMAN BERNANKE. President Lockhart. MR. LOCKHART. I’m comfortable with the 84, Mr. Chairman. Thank you. CHAIRMAN BERNANKE. President Bullard has left. President Evans. July 24, 2008 48 of 50 MR. EVANS. I would prefer not to be involved in term funding generally without greater study than we have done so far. But I am confident, with the additional measures that you’re talking about and the conversations, that we would end up being able to do it appropriately. I would prefer the 28-day and 84-day separation if that’s operationally possible, but I’m not sure if any potential adverse signals would somehow be conveyed that way. Frankly, I just don’t understand it well enough, and this is being done very quickly. Thank you. CHAIRMAN BERNANKE. President Stern. MR. STERN. Yes, I’m comfortable with going to 84 days. If it’s workable, I think there would be merit in both 28 and 84. CHAIRMAN BERNANKE. President Hoenig. MR. HOENIG. I’m comfortable with 84. I’d be interested in thinking about the 28-day as well, but I’m comfortable with 84 as long as we have the conditions that I talked about. Thank you. CHAIRMAN BERNANKE. President Yellen. MS. YELLEN. Yes. Well, while I expressed some qualms, I’m comfortable with the proposal and can support it. I think I prefer having the two options of 28 and 84, but I’m comfortable with the proposal. CHAIRMAN BERNANKE. Bill, are you having any issues with the feasibility of splitting it? MR. DUDLEY. Well, the big problem would be how we would make the transition, because I think we cannot do two auctions simultaneously on 84 days and 28 days and it’s not clear how one would actually transition then to steady state. We would have to spend some time working on that to see if it is possible to make this happen without having a lot of reserve-management issues July 24, 2008 49 of 50 because we really don’t want the outstanding amounts to go up or down violently as we’re transitioning. So we’re just going to have to see if that’s feasible or not. VICE CHAIRMAN GEITHNER. Just to underscore, Mr. Chairman, what I said, I think President Evans is right—I would not be prepared to make a recommendation today on 28 alongside 84. I think it just needs a little more time, not a lot more time, but we have to think through it to make sure we can do it. We have to come back to you and explain how we think we would manage through those issues, if we think they’re manageable. One thing we might do is use the SCRM process that exists to expose them in a little more depth to whatever our thinking collectively here is on the operational issues and the signal issues, and we can probably do something quickly on that tomorrow. But I think we need to reflect a bit and come back to you. CHAIRMAN BERNANKE. So let’s do this. Let’s have Bill and his team look at the feasibility of a split auction. Let’s have any discussions we might have about how we might improve our monitoring of the credit risks and of the institutions. We will then have the staff communicate with everyone in the FOMC. Then depending on the reaction, we’ll have notation votes. Will that be a reasonable way to go? All right. We will not take any further votes on this issue, but we will have the staff contact you and discuss with you both the issue of 28 versus 84 and the issue, going forward, of how to improve our surveillance. There will have to be notation votes if we decide to go forward. The extension of the TAF would be a Board vote, but we also would need the FOMC to approve an increase in the swap line so that the ECB could follow us. All right. So we’re leaving those notation votes, and you will all be contacted by the staff. I appreciate your feedback on that. The last item on the agenda is the options program for the TSLF. Scott Alvarez advises me that we can July 24, 2008 50 of 50 take a straw vote. I’m okay with a regular vote. Let’s go ahead and take a vote. This is a vote by the FOMC. Could you read the resolution, Scott? MR. ALVAREZ. Sure. This is the first resolution on the third page. “In addition to the current authorizations granted to the Federal Reserve Bank of New York to engage in term securities lending transactions, the Federal Open Market Committee authorizes the Federal Reserve Bank of New York to offer options on up to $50 billion in additional draws on the facility, subject to the other terms and conditions previously established for the facility.” MS. DANKER. Chairman Bernanke Vice Chairman Geithner Governor Kohn Governor Kroszner President Lockhart Governor Mishkin President Pianalto President Plosser President Stern Governor Warsh Yes Yes Yes Yes Yes Yes Yes No Yes Yes CHAIRMAN BERNANKE. Thank you. We had a very long meeting but a very productive discussion. I thank you for that. We will be in touch with you about both of the issues relating to the TAF. Thank you very much. Without other issues, the meeting is adjourned. END OF MEETING August 5, 2008 1 of 145 Meeting of the Federal Open Market Committee on August 5, 2008 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, August 5, 2008, at 8:30 a.m. Those present were the following: Mr. Bernanke, Chairman Mr. Geithner, Vice Chairman Ms. Duke Mr. Fisher Mr. Kohn Mr. Kroszner Mr. Mishkin Ms. Pianalto Mr. Plosser Mr. Stern Mr. Warsh Messrs. Evans, Lacker, and Lockhart, and Ms. Yellen, Alternate Members of the Federal Open Market Committee Messrs. Bullard, Hoenig, and Rosengren, Presidents of the Federal Reserve Banks of St. Louis, Kansas City, and Boston, respectively Mr. Madigan, Secretary and Economist Ms. Danker, Deputy Secretary Mr. Skidmore, Assistant Secretary Ms. Smith, Assistant Secretary Mr. Alvarez, General Counsel Mr. Ashton, Assistant General Counsel Mr. Sheets, Economist Messrs. Connors, English, Kamin, Sniderman, and Wilcox, Associate Economists Mr. Dudley, Manager, System Open Market Account Ms. Bailey, Deputy Director, Division of Banking Supervision and Regulation, Board of Governors Mr. Blanchard, Assistant to the Board, Office of Board Members, Board of Governors Mr. Struckmeyer, Deputy Staff Director, Office of Staff Director for Management, Board of Governors August 5, 2008 2 of 145 Ms. Liang, Messrs. Reifschneider and Wascher, Associate Directors, Division of Research and Statistics, Board of Governors Mr. Levin, Deputy Associate Director, Division of Monetary Affairs, Board of Governors Mr. Small, Project Manager, Division of Monetary Affairs, Board of Governors Mr. Luecke, Section Chief, Division of Monetary Affairs, Board of Governors Ms. Wei, Economist, Division of Monetary Affairs, Board of Governors Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of Governors Mr. Connolly, First Vice President, Federal Reserve Bank of Boston Messrs. Fuhrer and Judd, Executive Vice Presidents, Federal Reserve Banks of Boston and San Francisco, respectively Messrs. Altig, Hakkio, Rasche, and Sullivan, Senior Vice Presidents, Federal Reserve Banks of Atlanta, Kansas City, St. Louis, and Chicago, respectively Messrs. Danzig and Duca, Vice Presidents, Federal Reserve Banks of New York and Dallas, respectively Mr. Weber, Senior Research Officer, Federal Reserve Bank of Minneapolis Mr. Hetzel, Senior Economist, Federal Reserve Bank of Richmond Mr. Sill, Economic Advisor, Federal Reserve Bank of Philadelphia Mr. Del Negro, Officer, Federal Reserve Bank of New York August 5, 2008 3 of 145 Transcript of the Federal Open Market Committee Meeting of August 5, 2008 CHAIRMAN BERNANKE. Good morning, everybody. Today is the last meeting for our colleague, Governor Mishkin. Rick has attended 16 FOMC meetings as a Committee member and 23 additional meetings, I assume mostly as the research director for New York. We are certainly going to miss your singular interventions—[laughter] as well as your insights and your collegiality. There will be a lunch today in honor of Rick, and we will have a chance then to express our appreciation for your time here and for your contributions. There are comings and goings. Today is also the first meeting for Governor Duke, whom I was pleased to swear in about 15 minutes ago in my office. [Laughter] It took an unconscionably long time for this qualified person to be confirmed by the U.S. Senate. We are very glad that she had the patience to stick it out and that she is finally here. She brings a great deal to the table, including a lot of experience in banking, which obviously is something of great interest to us these days. So, welcome. We look forward to a long and productive association. Turning to Desk operations, before Bill begins, a couple of issues were raised in our last videoconference. One had to do with the concern about whether we have a sufficient balance sheet to address liquidity needs going forward. Bill, I believe you are going to talk a bit about that—give an interim report on where we are on balance sheet issues and what we might do in case those constraints start to bind. The second concern that was raised had to do with what we mean by “unusual and exigent” and how we determine whether those conditions are still prevailing. I have asked Brian and the staff to put together a memo giving us some thoughts on that issue, and that will come to you before the next meeting and give us a chance to think about it and, as time permits, discuss it at the next meeting. Without further ado, Bill. August 5, 2008 4 of 145 MR. DUDLEY. 1 Thank you, Mr. Chairman. I am going to be referring to the handout in front of you. It seems to be getting thicker at every meeting. Since the June FOMC meeting, financial markets have been characterized by two distinct phases. Until the middle of July, share prices weakened substantially, and credit spreads widened. The financial sector’s difficulties were at the forefront as housingprice declines continued to pressure this sector. The IndyMac failure led to uninsured depositors taking losses, and this roiled the regional banking sector. The equity prices of Fannie Mae and Freddie Mac plummeted, and their ongoing viability was called into question. The passage of housing legislation that provided support to the GSEs then led to an improvement in investor sentiment and a modest recovery in share prices. As shown in exhibit 1, financial sector shares led the recovery. However, the overall improvement in the broad market indexes was very modest, both in the United States and abroad (exhibit 2). Moreover, no meaningful improvement was evident in the corporate debt or CDS markets. CDS spreads have not changed much, and spreads of asset-backed securities have begun to widen again (exhibits 3 and 4). Despite intermeeting news that I would characterize on balance as more bad than good, this news did not trigger the type of risk-reduction spasms by investors that have sporadically plagued financial markets over the past year. Exhibits 5 and 6 compare the correlation of daily asset price changes across a broad array of asset classes in July to the corresponding period in March. The blue boxes denote correlations with absolute values of more than 0.5. As can be seen, asset price movements have become much less correlated. Although the mood is slightly improved today compared with a few weeks ago, the underlying news, especially from the financial sector, remains quite bleak in most respects. In particular, there is little conviction that financial shares have reached a bottom. This can be seen in the unusually high volatility of financial share prices (exhibit 7) and the positive skew in options prices for financial firms, in which the price of a put has been much higher than an equivalent out-of-the money call (exhibit 8). Financial market participants are paying more to protect the downside than to participate on the upside. Merrill Lynch’s recent experience is reflective of the challenging environment faced by financial firms. Merrill Lynch raised new equity capital and announced that it had sharply reduced its net ABS CDO exposure. Investors were initially pleased that the company had bitten the bullet, and the share price rallied in response. But further consideration tempered the initial enthusiasm—and there are more articles on this in the Wall Street Journal today. A closer look revealed some troubling aspects of the transactions. First, Merrill Lynch took an additional $4.4 billion of CDO writedowns from the June quarter-end valuation date. Merrill Lynch sold CDO exposures with a par value of $30.6 billion to Lone Star for $6.7 billion. At quarter-end, these positions had been carried on the books for $11.1 billion. Second, this transaction resulted in a drop in net CDO exposure of only $1.7 billion because Merrill Lynch 1 The materials used by Mr. Dudley are appended to this transcript (appendix 1). August 5, 2008 5 of 145 provided 75 percent nonrecourse financing to Lone Star. Merrill Lynch gave away all the upside on these assets in exchange for a payment equal to 6 percent of their par value. Third, Merrill Lynch’s equity issuance reportedly resulted in 38 percent dilution to existing shareholders. The dilution was exacerbated by the terms of an earlier share issuance agreement with Temasek, a Singapore sovereign wealth fund. This agreement granted Temasek a “make whole” provision if, within 12 months, common stock was issued at a price below Temasek’s $48 per share investment. This resulted in Merrill Lynch’s paying $2.5 billion to Temasek, which Temasek then rolled into a new $3.4 billion share investment. Over the past month, the troubles of Fannie Mae and Freddie Mac have taken center stage. Rising loan delinquencies for prime single-family mortgages caused share prices to plunge. This eroded confidence that the firms would be able to raise new equity capital and raised concerns about the viability of these firms. This, in turn, intensified the downward pressure on share prices. As a result, investors began to lose their enthusiasm for the firms’ debt. Investors in short-term discount notes were uninterested in taking on any potential credit risk. As a result, issuance volumes fell, and discount note rates climbed (exhibits 9 and 10). Some investors in the firms’ longer-term debt obligations—including some major foreign central banks—became unwilling to add to their long-term agency debt and agency MBS positions, and one or two of the central banks actually cut their positions somewhat. However, longerterm debt spreads did not change much because the loss of central bank demand was offset by buying from U.S. fixed-income asset managers, who believed that the implicit Treasury support of GSE debt was likely to be hardened (exhibit 11). Fannie and Freddie responded by issuing less debt. To husband their liquidity, the two firms have backed away from purchasing agency mortgage-backed securities for their own portfolios. The removal of this bid was one factor that caused the mortgage basis— the spreads between the option-adjusted yield on agency MBS and other benchmark yields, such as Treasuries and interest rate swaps—to widen significantly (exhibit 12). The Congress responded by enacting housing legislation that included provisions that hardened the implicit government guarantee and, thus, reduced debt rollover risk. The Treasury now has authority to lend the GSEs an unlimited amount of funds, the magnitude being constrained only by the debt-limit ceiling. In response, discount note issuance costs have fallen in the most recent auctions. However, enactment of the legislation has not generated any comparable narrowing in the mortgage basis or resolved the longer-term outlook for the GSEs. The mortgage basis remains wide in part because Fannie Mae and Freddie Mac have few incentives to expand their balance sheets. Although their regulatory capital is still well above minimum levels, these capital standards are under review. Moreover, because further losses are likely in coming quarters, it is unclear how long this excess capital will be available to support portfolio growth. Of course, the two firms could respond by issuing new equity. However, the low level of these companies’ share prices makes this option unattractive. To raise sufficient funds to ensure long-term viability would cause massive dilution for existing shareholders. To put this in perspective, the current market capitalization of Freddie Mac is only about $5 billion. This compares with a August 5, 2008 6 of 145 book of business in terms of its portfolio and guaranteed book of $2.2 trillion. Because the GSEs will likely remain reluctant to expand their balance sheets in the near term, the mortgage basis will probably remain elevated, keeping mortgage rates high. This will intensify the downward pressure on housing activity and prices, which in turn will lead to greater loan delinquencies and losses. The consequence will likely put further pressure on Fannie’s and Freddie’s capital positions. So what’s the bottom line? In my view, the legislation has helped to avert—at least for now—a meltdown in the agency debt and agency MBS markets. But the passage is no panacea for ensuring the viability of Fannie Mae and Freddie Mac or in enabling the two firms to provide significant support to the U.S. housing market. One consequence of the GSE-related turbulence was a temporary pickup in demand in the most recent schedule 1 TSLF auction, on July 25 (exhibit 13). As term mortgage agency repo spreads widened relative to term Treasury repo rates, the cost of borrowing via the TSLF became more attractive. This illustrates how the TSLF program can act as a shock absorber and reduce volatility in term repo rates. With the exception of the July 25 auction, the TSLF auctions continue to be undersubscribed with relatively stable bid-to-cover ratios. In contrast to the turbulence evident in the financial sector, the bank term funding markets have been relatively stable since the June FOMC meeting. As shown in exhibits 14 and 15, the spreads of one-month LIBOR and three-month LIBOR to OIS remain elevated in the United States, Europe, and the United Kingdom. However, this masks the fact that forward funding rates appear to have risen significantly. As shown in exhibit 16, the forward three-month LIBOR–OIS spread has risen about 20 basis points over the past three months. This spread is now anticipated to remain elevated at around 50 basis points on a one-to-two-year time horizon, indicating that market participants expect term funding pressures to persist for the foreseeable future. Before the crisis, the spread was about 10 basis points. The U.S. TAF auctions also show a stable trend. As shown in exhibit 17, the bidto-cover ratio remains around 1.2 to 1, and the stop-out rate has been quite steady over the past five auctions. In contrast, as shown in exhibit 18, the bid-to-cover ratio for the ECB dollar auction continues to climb. As I noted in an earlier briefing, part of this rise reflects the fact that the ECB auction is noncompetitive. The bids are prorated, and the banks pay the U.S stop-out rate. Larger bids by European banks in the ECB auction do not affect the interest rate they pay for such funding, and that encourages more-aggressive bidding. Conversations with the ECB staff indicate that they are concerned that the outcome could be a bidding spiral. Individual banks could keep raising the size of their bid submissions to ensure a stable amount of dollar funding. It is possible that these pressures could eventually encourage the ECB to switch to a Swiss National Bank type of multiple-price auction. This would eliminate the incentives to bid more and more aggressively on the part of the European banks. However, such a change probably would result in a higher stop-out rate in the ECB auctions compared with the United States or Switzerland. ECB officials might not be fully comfortable with such an outcome. August 5, 2008 7 of 145 Early reactions by primary dealers and depository institutions to the two refinements to our liquidity facilities—the $50 billion program of options on the TSLF and the introduction of the longer, 84-day, maturity TAF auctions—have been favorable. We recently—last Friday and this Monday—completed an extensive set of interviews with the primary dealer community about the TSLF options program and will be proposing final terms, within the set of parameters approved by the FOMC on July 24, by the end of this week. Of course, we will keep you fully apprised as we go forward on this. As you know, our liquidity facilities have placed significant demands on the Federal Reserve’s balance sheet, as the Chairman mentioned. As the liquidity facilities have been expanded, we have reduced the size of our Treasury portfolio. We do this to drain the reserves added by our liquidity programs. The use of our balance sheet to sterilize these reserve additions has raised questions about whether sufficient capacity is still available to meet prospective demand—especially a large unanticipated rise in PDCF or PCF borrowing. Exhibit 19 illustrates the transformation of the Federal Reserve System’s balance sheet over the past year, out of Treasuries into non-Treasury lending. As shown in exhibit 20, the non-Treasury portion consists mainly of $150 billion of TAF loans, the $62 billion (in steady state) of foreign exchange swaps executed with the ECB and the SNB, and our $80 billion 28-day maturity, single-tranche repo program. Although the amount of Treasuries held in the SOMA portfolio still totals $479 billion, a majority of these securities are encumbered in one way or another. As shown in exhibit 21, from that $479 billion we need to allocate $45 billion of Treasuries to collateralize the foreign central bank repo pool, retain $35 billion of on-the-run Treasury securities to keep available for our traditional Treasury securities lending program, and set aside $175 billion for the TSLF program and now an additional $50 billion for the TSLF options program (TOP). When the options program is included, we have about $174 billion of unencumbered Treasuries available to offset additional PCF and PDCF borrowing or to fund further expansion of our liquidity programs. Obviously, further expansion of our TAF or TSLF auctions or single-tranche repo operations would be at our discretion and, thus, does not pose a meaningful problem in terms of reserve management. We wouldn’t expand these programs if we didn’t have the ability to conduct offsetting reserve draining operations. However, what would we do if faced with a huge rise in PCF or PDCF borrowing? An inability to drain the reserves added by such lending would cause the federal funds rate to collapse below the target. Fortunately, we have a number of alternatives that would enable us to offset very large demands for PCF or PDCF borrowing. First, we could sell our remaining unencumbered Treasury holdings or use them to engage in reverse repo operations with the primary dealer community. This could be augmented by the $35 billion of on-the-run Treasury securities currently set aside for securities lending. Together, these two sources could be used to drain more than $200 billion of reserves. Second, we have made arrangements with the Treasury so that, if the need arises, the Treasury would issue special Treasury bills into the market on our behalf and take the proceeds August 5, 2008 8 of 145 and deposit them at the Federal Reserve. Putting the proceeds of such T-bill sales on the Fed’s balance sheet would drain reserves from the banking system. The potential scope here is large. The housing legislation raised the debt limit substantially. There is now about $1.2 trillion of headroom under the debt limit compared with only about $400 billion previously. Third, we continue to press for legislation that would accelerate the timing of the Federal Reserve’s authority to pay interest on reserves. Being able to pay interest on reserves would put a floor under the federal funds rate. In this case, an inability to drain additional reserves from the banking system would not result in the federal funds rate collapsing toward zero. Finally, we continue to explore the legal and operational feasibility of expanding our balance sheet in other ways. For example, could we engage in reverse repurchase transactions using the collateral obtained from our single-tranche repo and from our TSLF operations? I wouldn’t say I am confident that we can handle any eventuality—after all, the triparty repo system provides trillions of dollars of funding to the primary dealers. In the unlikely event that it all came to us, we wouldn’t have the capacity to fully offset it at present. But we could accommodate hundreds of billions of dollars of demand if that proved to be necessary. That said, I want to go on record that any very large unanticipated demand for funding from the Federal Reserve by dealers or depository institutions might take a few days or more to offset by reserve-draining operations. Thus, in such a circumstance, the federal funds rate could temporarily trade below its target. Turning now to interest rate expectations, monetary policy expectations have reverted back to the very slow path toward tightening that was evident before the April FOMC meeting. As shown in exhibits 22 and 23, the federal funds rate and Eurodollar futures curves have shifted down sharply since the June FOMC meeting. Our current survey of the primary dealers shows an even slower anticipated pace of tightening. As shown in exhibit 24, the average of the dealer forecasts in our most recent survey anticipates no tightening until the second quarter of 2009. But the change in the dealers’ forecasts since the June FOMC meeting is more modest than the shift in market expectations (compare exhibits 24 and 25). Looking at the probabilities of different rate outcomes implied by options on federal funds rate futures in exhibits 26 and 27, one sees that there has been a steady trend upward in the probability that the FOMC will keep its policy target rate unchanged at both the August and the September FOMC meetings. Note also that the probability assigned by market participants to further easing is lower than the probability assigned to tightening. The past month has been marked by a significant decline in commodity prices. As shown in exhibit 28, although the energy complex has led the way down, agriculture and industrial metals prices have also declined significantly. These declines have spurred a large decline in breakeven rates of inflation measured by the spread of nominal Treasury and TIPS yields (exhibit 29). As shown in exhibit 30, longer-term market-based indicators of inflation expectations have increased a bit. Both the Barclays’ and the Board staff’s measures of five-year, five-year-forward August 5, 2008 9 of 145 inflation implied by nominal Treasury versus TIPS yields have drifted upward since the June FOMC meeting. However, both measures remain well below the peaks reached in early March. There were no foreign operations during this period. I request a vote to ratify the operations conducted by the System Open Market Account since the June FOMC meeting. As always, I am very happy to take any questions. CHAIRMAN BERNANKE. Thank you very much, Bill. Any questions for Bill? President Evans. MR. EVANS. Thank you, Mr. Chairman. Bill, at our recent intermeeting call, I wasn’t expecting the characterization of the financial stresses to sort of backtrack to the point that it feels like March. Maybe somebody said it was as scary as March. I have noticed in a lot of our speeches that many have noted that financial conditions have not returned to normal, and I have always kind of wondered what “normal” would be. With hundreds of billions of dollars of losses at major financial institutions, I guess I am wondering whether we can reasonably expect that this distress and adjustment will be alleviated over some reasonably short period of time. We are 12 months in. Isn’t this likely to take 12 more months or longer? Financial institutions have a lot to digest. What do you think financial institutions and markets have to do to signal a return to acceptable functionality? What are we looking for, and what changes in fundamentals are likely to occur that would deliver sustainable liquidity improvements? MR. DUDLEY. Okay. That is a big question. [Laughter] MR. EVANS. I think this is a good time to revisit our strategy and what we are thinking about accomplishing here. It is my understanding that the Chairman has asked you to look at unusual and exigent circumstances. MR. DUDLEY. I think the first thing we can say is that market participants expect this to last a long time. The fact that the forward LIBOR–OIS spreads are elevated, looking out a August 5, 2008 10 of 145 year or two years, suggests that the market views the balance sheet adjustment process as taking quite a long time. Second, I would say that how long is really going to depend in part on how the macroeconomy evolves. If the macroeconomy evolves in a favorable way, then the losses that will be borne by the financial sector will be discretely smaller, and so you can get through this process sooner. In contrast, if the economy has a bad macroeconomic outcome, then obviously this is going to be a lot worse. We don’t really know the answer to that yet. Part of that is also going to be very sensitive to what happens in terms of individual institutions over the next 6 to 12 months because we are putting a tremendous amount of strain on the financial sector. If there is little breakage, then the chance of our getting through relatively quickly, say in 12 months, is pretty high. But if that stress creates failures and systemic contagion because of those failures, then this could last quite a long time. So the answer is that we don’t really know yet. I think there is a long way to go. We are about one year in, by my measure. I date this back to August 9, when the ECB did their massive reserve intervention. So I wouldn’t want to make a bet on what inning this is, but it is definitely not the ninth inning. MR. FISHER. Please, no baseball analogies. [Laughter] MR. EVANS. Thank you. CHAIRMAN BERNANKE. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. I want to follow up on that a little because it seems to me that, over a year ago now, there was a lot of discussion by various parties that had to do with risk premiums being very low. People were worried that the economy and the financial markets were underpricing risk. Now, all of a sudden, these spreads have increased. If you look at the OIS spread that you referred to, the one-to-two years out, is there a possibility that this is permanent—that in some sense the level of spreads in the pricing of the risk is just now higher August 5, 2008 11 of 145 and it is going to stay higher, maybe not as high as the peak but at some higher level? If that is true, then using those spreads as a measure of how distressed the market is could be very misleading. As a consequence, it would seem as though you would want to be asking questions not just about the prices and the spreads but also about volumes in these markets. Maybe, Bill, you can elaborate on what volumes are doing—certainly in the near-term, the overnight, and the one-month interbank funding markets? Are volumes back to their levels even though the spreads are higher? I think we have to be a little careful that, if this really is a permanent shift in risk premiums, looking at these things may be the wrong metric for assessing what is going on. If you have any observations about that, I would like to hear them. MR. DUDLEY. I think it is a fair point that we shouldn’t assume that “normal” is returning to the LIBOR–OIS spreads that applied before August 2007, so we have to look at a broader set of indicators. For example, I think that it would be worthwhile looking at the spread between jumbo mortgage rates and conforming mortgage rates as evidence of the degree of the shadow price of balance sheet capacity. I think that, once financial institutions either raise sufficient capital or stop taking loan-loss provisions or writing down assets so that they have enough capacity to expand their balance sheets, we will be getting to the end of this process. Another thing I would say to add to the answer I gave earlier to President Evans is that the trajectory of housing in all of this is going to be hugely important. One thing that may signal the next phase, maybe the beginning of the end, is when people really do get a sign that the housing sector is starting to bottom, probably first in activity and then in price. Once that happens, the huge risk premium embedded in some of these mortgage-related assets will then collapse. That means that the mark-to-market losses in a lot of institutions will start to fall. So I think that is going to be a very, very important metric once housing starts to really bottom and August 5, 2008 12 of 145 people get some visibility about how much home prices will go down. You know, when the argument is about whether home prices are going to go down 15 percent or 20 percent, that will be a very different argument from the argument now, which is whether home prices are going to go down 15 percent or 30 percent. MR. PLOSSER. How about volumes? MR. DUDLEY. I think that the market function has varied, frankly. In the middle of the GSE turmoil, the agency market was basically shut down. With the passage of the legislation, it has improved. Haircuts are still quite elevated. Liquidity is certainly not as good as it was back before this crisis. The cost of funding through the FX swap market is still very elevated relative to LIBOR. I think things are improving, though, in the sense that shocks are not as broadly contagious as they were before. The reason is that people now are pretty cognizant of what the problems are; and so when there are new, bad pieces of information, people aren’t quite as shocked, and they don’t revise their outlook to the same degree about a whole variety of asset classes. But I think that is why the correlation slide that I showed you in the exhibits showed less of a correlation between different asset classes. We are still getting tremendous amounts of movement in asset prices, but it doesn’t seem as though, if something happens in one sector, it necessarily ripples through to other sectors. CHAIRMAN BERNANKE. President Bullard. MR. BULLARD. Thank you, Mr. Chairman. I’m just following up here. I mean, as much as I love exhibits 14, 15, and 16—and I have used a lot of them myself when I talk about the economy—it is not really appropriate to look at these as measures of stress. You could just say that these are the equilibrium prices in an economy that is adjusting to a big shock. You could have a completely flat line here that would indicate stress in markets because these prices August 5, 2008 13 of 145 aren’t moving around appropriately to the risks that have developed and opened up. So a lot of the concern around the table has been exactly that, when markets freeze up, you can’t do any trade at any price; and for that the volume data would seem to be a much better indicator of the kinds of things that we are worried about. I think that this is conditioning a lot of our thinking about the economy—you look at this picture, and you naturally think it has to go back to 10 basis points before the crisis is over. That probably is not going to happen anytime soon and maybe never. Thanks. CHAIRMAN BERNANKE. President Lacker. MR. LACKER. I thought that part of President Evans’s question was whether markets are back to normal for a period in which they are adjusting to hundreds of billions of dollars of losses on mortgage loans. So I would be interested in your characterization of how markets are working relative to how well they ought to work in that circumstance. MR. DUDLEY. I guess we don’t have a lot of observations to know what normal is in that environment. I think that the markets are generally doing somewhat better, as I said, relative to the flow of new information. I don’t think the information flow has improved, but I think the markets are responding a little better to the bad information. That is how I would characterize it. MR. LACKER. If I could follow up, the reactions you described sound warranted by the information coming in. The market is digesting information about the location and magnitude of losses and the extent to which housing is going to recover. MR. DUDLEY. I think the market is reacting pretty appropriately to the information it is seeing, although I would say that the risk premiums are still high in a pretty broad array of assets relative to what one would think would be normal. Haircuts are high, and market liquidity is still August 5, 2008 14 of 145 impaired. We are definitely not back to normal market function in a pretty broad array of asset classes. MR. LACKER. But when you use “normal” in that sentence, you mean a time period without hundreds of millions of dollars of losses that we don’t know quite the magnitude of, right? MR. DUDLEY. Yes. It is hard to benchmark how markets are supposed to behave in a period with hundreds of billions of dollars of losses—because how many times have we actually gone through this experience? MR. LACKER. So if I could just follow up—in these graphs, what would you point to as the effects of our actions or our lending? MR. DUDLEY. The effects of our actions have been to mitigate the rise in term funding pressures and to somewhat mitigate the forced liquidation of collateral because of the inability to obtain funding. Because of that, our actions have helped prevent the kind of pernicious margin spiral that we saw in March, when volatility was going up and haircuts were going up, which was then causing mark-to-market losses, which were causing forced selling. So I think our actions have mitigated those to some degree. Now, obviously, we don’t know what the counterfactual would have been in the absence of our actions, but I believe—and most market participants believe—that our actions have been helpful in those respects. CHAIRMAN BERNANKE. Thank you. I guess I would comment that there is an asymmetry here, which is the possibility of systemic risk. There are situations in which failures—major collapses of certain markets—can have discontinuous and large effects on the economy. We have seen that in many contexts across a large number of countries. These stresses do reflect the working out of equilibriums given fundamental losses, which we can’t do August 5, 2008 15 of 145 very much or anything about. But they do create machinery that is less flexible and less able to respond to new shocks, and that raises systemic risk. That is the risk that we want to try to minimize, even as we allow the markets to work their way through and to price the changes we have seen. MR. DUDLEY. We have never argued that the role of our facilities is to prevent the adjustment. We have always argued that the role of the facilities is to allow the adjustment to be orderly rather than disorderly. That is what we have been going for. MR. LACKER. I would be interested in seeing a model, Mr. Chairman. Thank you. CHAIRMAN BERNANKE. Certainly. Any other questions for Bill? If not, let me turn to David Wilcox for the economic situation. MR. WILCOX. Thank you, Mr. Chairman. In putting together the economic outlook for the current Greenbook, we confronted three main changes in circumstances relative to the situation as it stood in June. First, the labor market looked distinctly weaker than we had anticipated. In the employment report that was released in early July, payroll employment declined by more in June than we had been expecting, and the unemployment rate held at 5½ percent rather than dropping back as we had anticipated, following the increase of 0.5 percentage point in the previous month. The fraction of the labor force working part time for economic reasons had moved up sharply, and claims for unemployment insurance were trending up. The second major change in circumstance that we confronted was a secondquarter increase in real GDP that apparently continued to outpace our expectations. In last Wednesday’s Greenbook, we projected growth at an annual rate of 2.7 percent in the second quarter, 1 percentage point stronger than in the June Greenbook. At that pace, GDP growth would have slightly exceeded our estimate of the rate of growth of potential output. The third major change was a financial sector that looked more hostile to economic activity, on balance, than at the time of the last meeting despite the improvement during the second half of the intermeeting period that Bill Dudley has just described. When we put the Greenbook to bed, the stock market was about 7 percent lower than we had expected as of June, a variety of spreads remained wide or had widened further since the previous Greenbook, and concerns had been heightened about some key institutions. In addition, the latest reading from the Senior Loan Officer Opinion Survey pointed to a remarkably widespread continued tightening of terms and standards for both households and businesses. These three factors—a weaker labor market, apparently stronger aggregate demand, and a more hostile financial environment—did not easily fit together. To August 5, 2008 16 of 145 resolve the situation, we began by ruling in favor of the profile presented by the labor market and heavily discounting the greater vigor being signaled by the spending indicators. In our judgment, the story being told by the labor market seemed by far the more credible one, what with housing prices continuing to decline at a rapid pace, consumer sentiment dropping into sub-basement levels, energy prices remaining high even after their recent partial reversal, loan officers reporting a pervasive tightening of credit terms and standards, and other measures of financial stress flashing at least amber. Moreover, while quarter-to-quarter discrepancies between GDP and IP are commonplace, the nearly 4 percent drop in manufacturing IP during the second quarter fueled our skepticism that the economy was on a fundamentally sound footing. As you know, for several Greenbooks our GDP projection has been substantially weaker than it would have been if we had kept in line with the advice from our forecasting models. We were motivated to impose this judgmental weakness partly in recognition of the possibility that we might be entering a recession, and recessions are times when spending tends to fall short of the level that would be indicated by the fundamentals. We also were motivated by the restraint that we think financial markets are imposing on real activity and which our models are ill-equipped to capture. In the current projection, we had to modify these assumptions in light of the changed circumstances. In effect, we interpreted the greater-than-expected strength of real GDP during the second quarter as reflecting an error of timing with respect to the judgmental weakness that we had built into the forecast but not a misjudgment about the overall magnitude of that weakness. Implementing that interpretation involved three steps. First, we responded to the unexpected strength in first-half GDP growth by shifting some judgmental weakness into the second half. Second, we deepened the overall amount of restraint that we imposed in light of the less favorable financial climate. Third, we stretched out the period of financial recuperation: Whereas previously we had financial market conditions essentially returning to normal by the middle of next year, in this projection we have the period of recuperation extending into 2010. These adjustments left our projection for real GDP growth 0.1 percentage point lower over the second half of this year and 0.2 lower next year, despite the offsets from lower oil prices and a slightly greater dose of fiscal stimulus, reflecting the introduction of extended unemployment insurance benefits. For the most part, the avalanche of information that we received since putting out the Greenbook last Wednesday has corroborated our projection. This year’s revision of the national income and product accounts threw us no real curve balls. (Sorry for the baseball analogy.) [Laughter] The growth of real GDP was revised down by an average of 0.2 percentage point per year. The revisions to the PCE price indexes, both core and total, were very slight. While the BEA has given us some homework to do between now and the September meeting in folding these data into our thinking, any adjustments that we might be prompted to make, including to the supply side of our forecast, are likely to be slight. August 5, 2008 17 of 145 On the face of it, the advance estimate of real GDP growth in the second quarter of this year seemed to hold a bigger surprise. The BEA’s estimate, at 1.9 percent, came in ¾ percentage point below our estimate in the Greenbook. However, as best as we can tell—based on still-incomplete information—the miss was attributable to lower estimates by the BEA of farm inventory investment and of value added in the trading of used motor vehicles. Our preliminary reading is that neither of these errors carries any signal for the forward momentum of the economy moving into the second half of the year. Friday’s employment report was likewise mercifully well behaved— at least in the narrow sense of conforming to our expectation. Private payroll employment declined an estimated 76,000 in July; together with small downward revisions to May and June, that left the level of employment in July very close to our forecast. In addition, the unemployment rate came in only a few basis points higher than we had expected. The only real news since Greenbook publication came from the motor vehicle manufacturers. On Friday, they reported that sales of light vehicles in July were at an annual pace of 12.5 million units, much weaker than our already weak forecast of 13.3 million units. Moreover, they knocked their assembly schedules for the third quarter down from 9.4 million units to 8.9 million units. Taking their schedules on board would slice another ½ percentage point from our estimate of GDP growth in the third quarter. The manufacturers have already announced increases in incentives, but it remains to be seen how vigorously consumers will respond in the current environment and how great the financial wherewithal of the manufacturers will prove to be to sustain such moves. In any event, the drop in sales and production is certainly large enough to give renewed urgency to the question as to whether a broader retrenchment in spending might be in train. Turning to the inflation side of the projection, our forecast for core PCE prices over the remainder of this year is nearly unchanged from the June Greenbook. We still have core inflation stepping up from a little more than 2 percent during the first half of this year to a little more than 2½ percent in the second half, as the surge in prices for imports, energy, and other commodities passes through to retail prices and as some components that saw unusually low readings earlier in the year accelerate to a more normal rate of increase. Next year, with the pressures from import, energy, and commodity prices diminishing and with slack in resource utilization becoming a little greater, we have core inflation dropping back to 2¼ percent. The projection for next year is also the same as in the June Greenbook, as the influences from lower energy prices and slightly greater economic slack are roughly offset by the passthrough of higher import prices. The more dramatic changes in our inflation outlook came in the noncore pieces. Not surprisingly, the plunge in oil prices since the June meeting caused us to whack our forecast for retail energy price inflation over the second half of this year. For next year, however, we marked up PCE energy price inflation a little, partly because natural gas futures prices have a more positive tilt than they did before and partly August 5, 2008 18 of 145 because gasoline margins will still have some recovering to do. At the same time, we have become more pessimistic about the outlook for food price inflation. The CPI for food in June came in at 0.8 percent, much higher than our forecast of 0.3 percent. Because we have mostly been surprised to the upside thus far this year, we decided to move closer to our food price model, which has been calling for larger increases than we were previously willing to write down. The net result, as you saw in the Greenbook, is an outlook with faster food price inflation despite the fact that futures curves for both livestock and crops have moved down since the last meeting. All told, we now have headline PCE inflation running at an average annual pace of 3½ percent over the second half of this year, nearly 1 percentage point slower than in the June Greenbook. For next year, we have marked up total PCE inflation by a few tenths in light of our reassessment of the food price situation and the slightly greater rise in energy prices that we now see next year. With regard to the risks in the outlook, my sense is that the downside risks to economic activity have increased since the time of the June Greenbook. That view is informed by two main factors: First, while we have factored the more unsettled nature of the financial environment into our baseline outlook, the situation seems more fragile than before, and the implications for real activity of a sharp deterioration in financial conditions could be quite large. The first alternative scenario that we presented in the Greenbook—entitled “severe financial stress”—updates our periodic attempt to assemble an integrated macroeconomic and financial scenario. Second, the deterioration in the motor vehicles sector now, to my eye, more convincingly takes on the profile of what we usually see in the course of a typical recession. During the intermeeting period, we will be on high alert for evidence suggesting that the weakness in vehicle sales is a harbinger of a broader shortfall in consumer spending. As for inflation, the upside risks have, in my view, diminished somewhat. Again, two factors inform this assessment. First, the downtick in the long-term inflation expectations measured in the Reuters/Michigan survey is somewhat reassuring. Second, the drop in oil prices is a welcome relief from the steady drumbeat of bad news from that sector and suggests a somewhat diminished probability that persistently high topline inflation will be reflected in a more serious erosion of household expectations, with all the adverse implications for monetary policy that would entail. To be sure, even with those favorable developments, upside risks remain. We illustrated one such risk in the scenario entitled “inflationary spiral,” in which we posited an initial shock to inflation expectations of 50 basis points followed by an adverse feedback loop that causes actual and expected inflation to chase each other up nearly 1 percentage point above baseline. Monetary policy eventually brings the process under control but only over a lengthy period of time, partly because the rule that we use in the simulations has policy responding to actual but not to expected inflation. Steve Kamin will now continue our presentation. MR. KAMIN. For the next couple of weeks, millions of people around the world will be watching the Olympic games in Beijing. For those of us charged with forecasting the global economy, of course, China-watching is a year-round task. But August 5, 2008 19 of 145 notably, the most salient developments since your last meeting have arisen outside of China. Chief among them, of course, have been the precipitous fluctuations in the price of oil. When the last FOMC meeting concluded on June 25, the spot price of WTI crude oil was running at $134 per barrel. It soared to over $145 by mid-July before plunging to about $119 as of this morning. The $26 per barrel drop over a three-week period was the largest on record in nominal dollar terms, although in percent terms, the 18 percent decline we’ve seen has been exceeded on a couple of occasions in recent years. Notably, many other commodity prices, especially those for natural gas and many food crops, also declined sharply. It has been heartening, and a welcome change, to see oil prices undershoot rather than overshoot our previous forecast. But it would be premature to pop open the champagne. We’ve seen several other steep declines in oil prices in recent years that gave way to renewed upward surges, and it remains to be seen whether an important shift in the supply–demand balance has occurred. Saudi Arabia added a total of 400,000 barrels a day to its production of oil in May and June, and there are indications that its production rose in July, too. However, these increases bring total OPEC production up only to their level in early 2006, and the world economy has grown considerably larger since then. Analysts have cited gloomier forecasts of global economic growth, and thus global oil demand, as contributing to the weaker oil prices; but those forecasts have been coming down for the past year with little apparent effect. Although oil consumption in the industrial economies clearly has slowed over the past year, we have yet to see either a concerted buildup in U.S. oil inventories or any indications that oil demand among developing countries is slowing. Therefore, a further lurch upward in oil prices is a distinct possibility. Moreover, with spot and futures prices having first soared and then plunged since your last meeting, the relatively flat path of oil prices that we are projecting is only about $12 per barrel lower, on balance, than in the previous forecast. In the meantime, indicators of foreign growth have come in a bit weaker than we expected, and inflation readings have been on the high side. These gloomier aspects of the international outlook counterbalance, to some extent, the improved tone of oil and other commodity markets. Clearly, prospects appear weakest in the advanced economies. Consistent with our earlier forecasts of a sharp deceleration in activity, we estimate that growth in all four of our largest industrial country trading partners—Canada, the euro area, the United Kingdom, and Japan—came in below 1 percent in the second quarter. In the United Kingdom, a sharp contraction in the housing sector appears set to drag the economy into a mild recession in the second half of this year. The remaining major economies should skirt recession but remain quite weak in the near term amid slackening export performance, continued stresses in financial markets, tightening credit standards, and very sharp erosions in business and consumer confidence. Why are the foreign industrial economies slowing about as much as in the United States, when the subprime crisis originated in this country and the major drag on the U.S. economy is the slump in a nontradables sector, housing? Clearly, part of the August 5, 2008 20 of 145 story involves the international financial linkages that have led foreign markets and institutions to share in the stresses and losses induced by the U.S. subprime crisis. Another part of the story involves a common shock—the global boom in oil and food prices—that has cut into real household income and spending around the globe. Third, even as the persistent decline in the dollar since 2002 has buoyed U.S. exports and growth, this has come at the cost of trade performance and economic activity in our trading partners. Finally, the foreign industrial countries have enjoyed little or none of the substantial monetary and fiscal stimulus we’ve seen in the United States over the past year. We estimate that growth in the emerging market economies also slowed further in the second quarter, to a pace of roughly 4 percent, where we have it staying for the remainder of the year. Obviously, this is well above the growth rate of roughly 1 percent that we’ve penciled in for the industrial economies, but it is still below their likely potential rate as many developing countries struggle with softening export demand and rising food and energy prices. Notably, however, even after slowing in the second quarter, estimated Chinese growth powered on at about 10 percent. By 2009, we see both foreign advanced and emerging market economies accelerating as financial stresses ease, the U.S. economy picks up, and commodity prices stop restraining the growth of real household incomes. This recovery scenario depends crucially on our projection that headline inflation starts moving down within the next quarter or two, so that substantial monetary tightening is not needed. The recent decline in oil and other commodities prices provides some comfort that this scenario will materialize. However, we saw some surprisingly sharp increases in consumer prices in June, bringing 12-month headline inflation to around 4 percent in the euro area and the United Kingdom, 5¼ percent in Mexico, and 6 percent in Brazil. In most of our major trading partners, inflation excluding energy and food prices has remained better contained; and in China, headline inflation has actually moved down from its February peak of 8.7 percent, registering 7.1 percent in June. Even so, until we see several quarters in a row of declines in aggregate measures of inflation, we will not be out of the woods. So far, the imprint of slowing foreign growth and rising foreign inflation on the U.S. external sector has been limited but not negligible. Turning first to prices, core import price inflation has moved up sharply, from about 3 percent last year to 11 percent in the second quarter; this was the fastest quarterly increase since 1987. Most of this acceleration was concentrated in material-intensive goods, such as food and industrial supplies, and was likely due to rising commodity prices rather than to more-generalized pricing pressures abroad. However, inflation in imported finished goods also increased this year. As we noted in a special box in the Greenbook, prices of imports from China have been moving up briskly as a result of increases in domestic costs and in the value of the renminbi. This step-up in the so-called China price explains less than one-fifth of the overall acceleration of core import prices but about one-third of the run-up in inflation for finished goods imports. Even so, August 5, 2008 21 of 145 assuming commodity prices stabilize going forward, we expect changes in overall core import prices to slow quite substantially in coming quarters. So far, U.S. external sector performance has held up well in spite of the slowing global economy. Net exports added 2¼ percentage points to real GDP growth in the second quarter, the largest quarterly positive contribution since 1980. Admittedly, much of this reflected a 6 percent decline in imports, which were dragged down both by weak U.S. demand and the quirky seasonal pattern in the data on oil imports. Even so, exports expanded at a very healthy 9½ percent, supported both by the depreciation of the dollar and by continued robust demand for commodities. Going forward, we anticipate export growth holding up at a still healthy 7 percent or so, as foreign economic growth picks up right around the time that the boost from previous dollar depreciation starts wearing off. The contribution of net exports to U.S. GDP growth should move down, but this will chiefly reflect a recovery in imports as the U.S. economy picks up. Thank you. David and I will now be happy to address your questions. CHAIRMAN BERNANKE. Thank you. Questions for our colleagues? President Fisher. MR. FISHER. David, in terms of the relatively benign outlook for core inflation now and for headline inflation, I’m wondering what your assumptions are about margin compression and for the ability of corporations to pass through price increases. By the way, I found the core revisions somewhat alarming because they’re well above 2 percent, but less alarming than what I think I heard you say about headline inflation projections. If my memory is correct, over the past two years there has been a wider spread between core and headline, and part of that has been due to the ability of firms at least to restrain or not to exploit any perceived pricing power. If you’re assuming that core will be relatively well behaved over time, some assumptions must be in there about margins and margin management, and I wonder what they are. Then I have a question for Steve on the international side to follow up on that. MR. WILCOX. By our highly imperfect measure of margins, which we see through the filter of the national income and product accounts, margins at this point are somewhat above the average over the past 30 years, and we have them coming down for the nonfarm business sector. We have them coming down a little, but not very much. So we have some slight erosion in August 5, 2008 22 of 145 margins, but they remain above average. In the corporate sector, which is measured a little differently from the overall nonfarm business sector, margins are about average at the moment. So I would not say that a big move in the markup of price over cost is a material driving factor in our inflation outlook. MR. FISHER. Obviously the implication of this more dire outlook for economic growth is that movement of the top line will be very, very difficult, so again, more pressure comes into the margin side to see that one can satisfy shareholders that things aren’t as bad as they might be. That’s really the nature of my concern. I don’t know if we’re surveying or getting a sense as to the pressures that people feel. I’m going to talk about some of that, but you may be doing this more formally than I’m able to do to get a sense of what kinds of pressures are occurring on margins. On the international side, Mr. Chairman, if I may—Steve, I’m curious about these Chinese inflation numbers. As I understand from the Chinese Ministry of Human Resources, the average wage of urban workers rose 18 percent year over year in the first half of ’08, and yet they report an official inflation number that I believe you say is 4 or 5 percent of something. How do you square that corner? MR. KAMIN. Well, the short answer is that we don’t have enough consistent sources of data to square it. But you certainly point to a factor that many people have talked about—the rapidly increasing wages, particularly in those industrial areas on the seaboard that are responsible for most of the manufacturing. It’s hard to square the relatively limited data that we have on those wages with movements in overall CPI. But there, too, is a limitation—those CPI numbers that are cited from China are mainly for urban areas, so it’s hard to know how comparable those are with the others. As you know, there’s also an extremely large food component in the Chinese CPI. So because basically food is probably less labor-intensive than the types of manufacturing in which August 5, 2008 23 of 145 most of the workers are working, that’s part of the way to square that. In some sense, the food prices aren’t reflecting those high wages as much. Then a final wild card is that there are different views on what’s happening on both the level of profit margins in China and what they’ve been doing. A lot of anecdotal reports suggest that profit margins are razor thin and that they are being squeezed. Other analyses, including some of the World Bank’s, suggest that those profit margins are still pretty ample. So I think you correctly allude to an important phenomenon—the rising wages because of high demand for workers—but we’re still busy sorting out the data to figure out exactly how that maps into prices. MR. FISHER. Thank you. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. I have two questions. First, on the Greenbook forecast, one thing that struck me is that there was a fairly large revision in your forecast for nonresidential structures going forward. In fact, after a pretty good showing in the first half of this year, you marked down the second half of this year for that and marked down substantially 2009. In the last Greenbook, you had structures actually growing positively in 2009; now it’s minus 4 percent, something like that. Is that driven by something in the model, or is that some adjustment factor that was added in? If so, what was the rationale for that, or why might it be coming out? Why do we have that change? Then I’ll follow up with another question. MR. WILCOX. We don’t quite understand why this sector seems to have resembled the cartoon character that keeps running along when we think there shouldn’t be any support underneath it. [Laughter] We are staunchly negative about the second half for this sector, and that view is informed by the precipitous drop in the architectural billings index. That’s one of the relatively few indicators that gives us any purchase on what’s going to happen in this sector. It’s a August 5, 2008 24 of 145 helpful indicator of spending about six months ahead. We think that financial conditions are pretty tough in this area. We’re getting a lot of anecdotal evidence that people are having greater difficulty financing projects than was the case before, and we’ve seen some uptick in vacancy rates as well. So we think all of those are factors. I guess I would say that we’ve heard very persistently negative reports from our supervision colleagues as well about what’s going on in that area. MR. PLOSSER. But the change is not just in the second half of this year. You’ve got a big change for ’09, too. MR. WILCOX. Yes. MR. PLOSSER. If we think about the phrase that people use—“financial headwinds”—and the credit problems that we see, my interpretation of how the staff has modeled that is on the demand side—of restrained credit limiting demand. But I can also think of the financial sector as having been hit by a very significant productivity shock, if you will, where the production function for intermediation has taken a huge productivity shock to it. So in thinking about a model in which that has happened, you might find yourself thinking about the consequences of that, particularly how that affects the path of potential output over the near term. If you think that type of shock is driving potential output down over the near term, depending on the magnitude of that, it is going to affect your estimates of the gaps and therefore your estimates of inflation and what the economy looks like going forward. So I guess my second question is, Have you thought much about this, or is much of this incorporated in the evolution of your output gaps or your potential output measures, working through that channel? If so, what might be the ramifications for inflation and policy going forward? August 5, 2008 25 of 145 MR. REIFSCHNEIDER. I’ll take that because we did have a bit of an internal debate on that issue awhile back. In particular, Spencer Dale, who was visiting us from the Bank of England, was basically making exactly the same point you’re making and raising that issue. MR. PLOSSER. So maybe I’m not so kooky after all. [Laughter] MR. REIFSCHNEIDER. No. MR. KROSZNER. But we sent him out of the country. [Laughter] MR. REIFSCHNEIDER. One test is whether in previous periods of financial stress like this, we saw what might be more upward inflation pressure than we otherwise could explain or productivity performance that we had trouble explaining. After looking at the experience during the early 1990s in the headwinds period and trying to think about the likely magnitude of the effects of such a productivity shock coming out of the financial system, we decided that you could see a negative productivity shock of that sort going on but that its effects are overwhelmed by the fallout from its effect on demand. So although there might be some negative productivity shock, on net it turns out to be more of a disinflationary effect. But we also had difficulty seeing it show up in productivity data. That said, that would be extremely hard for us to find. You know, it could be there, and we just couldn’t find it. MR. PLOSSER. So in the way you’ve modeled this in your forecast, are you thinking of yourselves as modeling that net effect, or do you think of yourselves as modeling and forecasting just one side? Have you made any effort to incorporate both sides of this potential effect? Even though it may be small, the question is how small it is. MR. REIFSCHNEIDER. We’ve made no explicit adjustment for that in the potential output assumptions we have going in. Looking back, it was hard to see that there was much, if any, effect, but that’s a risk knowing that there could be some productivity effect and it’s just hard to find. August 5, 2008 26 of 145 MR. PLOSSER. Thank you. MR. WILCOX. May I just augment my earlier answer? I spoke about the nonresidential building sector. Another factor taking down overall nonresidential spending is that the lower energy price trajectory reduces our expectation for drilling and mining expenditures, which have also fallen. CHAIRMAN BERNANKE. President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. A question for Steve. Could you review your thought process on core import prices and comment on how sensitive our inflation projections are to the assumption of, I believe, moderation in core import prices in 2009? MR. KAMIN. Sure. As I mentioned, core import price inflation shot up very rapidly to over 10 percent in the second quarter, and our approach toward modeling and predicting core import price inflation focuses on three main sources of increase. First are increases in foreign cost pressures, which we proxy by CPIs, which have not been a particularly important driver of core import prices as of late, though they are not negligible. Then the other two, which are more important, are declines in the dollar, which push up our prices, and finally increases in commodity prices because a lot of our imports, even core imports, which exclude oil and high-tech products, still have a lot of commodity input into them. For the past few years, our experience has been that the pass-through of declines in the dollar into core import prices has been relatively moderate. It has definitely contributed materially to the increase in core import prices but not as much, we feel, as the run-up in commodity prices, which has had a pretty substantial effect. One way that we can sort of confirm that impression is that we know that the prices of imported material-intensive products that have the most commodity input have gone up much more rapidly than prices of finished goods, and that has been true over the past year as well. So for all of those reasons, we feel August 5, 2008 27 of 145 that commodity prices have been the prime impetus for the run-up in core import price inflation. Going forward, we take our guidance from the futures markets, which indicate that oil prices and other commodity prices will flatten out. As a result, we anticipate that, relatively shortly, core import price inflation also should start to decline. At the same time, our anticipation is that, compared with the past few years, the dollar will fall less rapidly going forward than in the past, and that should be another factor supporting our view that core import price inflation should diminish. CHAIRMAN BERNANKE. Steve, you might want to define “core import price inflation.” It’s not analogous to the other core. MR. KAMIN. Right. So, yes, thank you. In the case of core imports, we exclude oil, which is very important, as well as computers and semiconductors. CHAIRMAN BERNANKE. Vice Chairman. VICE CHAIRMAN GEITHNER. I have a question similar to President Plosser’s. Both the financial shock—the housing adjustment—and the big relative price shock you could say all in different forms could hurt the rate of growth of the economy’s productive potential. You could say that they all might, in some dimension, reduce the near-term expected path of potential growth. I guess my question is that you have this “costly sectoral reallocation” alternative scenario—do you attribute any effect on potential growth over the forecast period in your baseline to the combined effect of the housing adjustment and the big relative price shock from energy? MR. WILCOX. No. One of the facts that we learn from microeconomic data about, for example, job flows is that there is always a huge, astonishing amount of churn—job destruction and job creation—just astonishing; and that’s true even in normal macroeconomic times. So the background radiation level is not zero. But we haven’t incorporated in our baseline any allowance for greater cost, and that’s what this alternative scenario was intended to illustrate, making a pretty August 5, 2008 28 of 145 generous allowance for the potential effect of that sectoral reallocation on the productive capacity of the economy. But it’s a serious question. MR. REIFSCHNEIDER. There’s one minor qualification to what David just said. We do keep track of rough estimates of what we think that the rise in energy prices over the past few years is possibly doing to trend productivity, and we’ve come up with estimates that maybe it’s 0.1. We think that effect has been ongoing, and it is built into the data. In some sense it’s occurring, and so in some sense it’s in our trend estimates. It is not as though our trends aren’t implicitly taking in the fact that there’s an ongoing loss in productivity associated with rising energy prices. VICE CHAIRMAN GEITHNER. I was just going to say that I thought the interesting thing about that scenario was that it doesn’t really change your view about the appropriate path of monetary policy going forward. It’s basically at the baseline. So even if you were to build in a material change in potential growth, because of the effects on demand going forward it doesn’t affect your view about the appropriate path of policy. MR. WILCOX. The reason is that it operates like a classic supply shock, which presents monetary policy with just simply a less pleasant policy menu to choose from; and in the context of that costly sectoral reallocation, the economy is running closer to its productive capacity. Let’s see. I lost my train of thought here. MR. REIFSCHNEIDER. Well, basically you can just stop there. [Laughter] It’s the tradeoff between the two. Obviously, if you were more concerned about inflation outcomes than real activity outcomes, you might tilt it a different way. CHAIRMAN BERNANKE. Isn’t it true, though, that changes in potential growth also have demand effects as well—to some extent offsetting? MR. REIFSCHNEIDER. Yes. August 5, 2008 29 of 145 VICE CHAIRMAN GEITHNER. Yes. It means that it’s another way of saying that you wouldn’t expect the estimates of the now-prevailing equilibrium real fed funds rate to be higher. Not to stretch this too far, but another way of saying why the likely expected path or the appropriate path of policy doesn’t change in terms of the nominal fed funds rate is that we have these offsetting effects on demand. MR. REIFSCHNEIDER. Yes. CHAIRMAN BERNANKE. President Evans. MR. EVANS. Thank you, Mr. Chairman. Regarding a comment that Bill Dudley made about housing prices, for financial institutions, it’s going to matter a lot whether we’re looking at a decline from 15 percent to 20 percent or from 15 percent to 30 percent. Housing inventories, unsold homes, are very high, and I guess I’m wondering again—we have gone over this a few times—what factors are likely to get housing advancing if it’s not a sharp decline in housing prices? I’m having a hard time understanding why the expectation would not be for a relatively sharp decline. I’m translating the Greenbook/OFHEO numbers to Bill’s numbers, and I’m not sure, but it seems to me that financial institutions ought to be thinking that a significant adjustment must still be in train if we’re not expecting demand to pick up all of a sudden. The mortgage origination challenges are there. Or is this disequilibrium just going to sit there for an extended period of time? MR. WILCOX. I guess I would push back on the premise that we don’t have a pretty significant adjustment in house prices built into our baseline. We have house prices as measured by OFHEO declining 7 percent this year and another 5 percent in 2009, and I wouldn’t anticipate any rebound in 2010. You know, our ability to measure where that would leave house prices relative to some notion of fair valuation is incredibly imprecise. But one regression-based indicator that we follow suggests that it would have house prices relative to rents swinging from a relatively high August 5, 2008 30 of 145 valuation to a noticeably low valuation. Charles Fleischman illustrated this yesterday in his preFOMC briefing. The major factor that provides some reason for optimism is that construction starts are now low enough that builders are making progress in chipping away their inventory of unsold homes. The months’ supply figures remain extraordinarily high because the denominator is very low; but in terms of units of unsold homes, my recollection is that we’ve chipped away about half the run-up in terms of absolute number of units in inventory. We also have starts continuing to come down materially from their current level. So we think that the process will begin to get inventories into a more normal alignment. MR. EVANS. The staff has been way out front in projecting the housing decline, and that has been very helpful. Is there any dissonance between what Bill said and your pretty substantial expectation of housing-price declines? MR. WILCOX. I don’t think so. MR. EVANS. Was it 15 to 20 or 15 to 30? MR. DUDLEY. I think what makes it complicated, though, is that there’s a nonlinearity. If the housing-price declines do turn out to be on the higher side, it then puts more stress on the financial system and on credit availability, which then leads to a weaker economy, which then puts more stress on the housing sector. So small differences in the path get amplified. MR. EVANS. I agree with that chain and those risks, but what I thought I was hearing from David was that the staff estimate has in it quite a substantial adjustment process in housing, and then I would expect financial players to share that assessment. MR. DUDLEY. I wasn’t really addressing the point estimate of where housing was going as opposed to the uncertainty around that estimate. I would argue that the uncertainty around that August 5, 2008 31 of 145 estimate is still quite wide. At some point it will be resolved. When it is resolved, that will be a favorable development, but I don’t think we’re there yet. MR. WILCOX. I would just augment Bill’s comment with two other observations. There’s plenty of probability mass out in the tail. I think it actually is two-sided risk. We illustrated one side of that risk in our “severe financial stress” scenario. The other point I would make is that our projection for national house-price declines of 12 percent cumulative in 2008 and 2009 makes plenty of room for a very much more severe decline in Florida, California, and other highly stressed areas, and we have attempted to take that regional diversity into account. It’s a rough exercise, to be sure, but we’re not oblivious to the fact that some areas are doing much worse than the average. That is the nature of averages. MR. EVANS. Thank you. CHAIRMAN BERNANKE. Vice Chairman, did you have an intervention? VICE CHAIRMAN GEITHNER. I was just going to say this. I think that you can do crude estimates of likely total losses across the U.S. economy and credit markets in a scenario like the baseline scenario in the Greenbook, and if you use Nellie Liang’s study or the stuff done in New York, there’s a huge amount ahead still. Even though financial market prices now reflect an expectation for house-price declines that are not significantly more optimistic than David’s baseline scenario, I don’t think you can say with confidence now that financial institutions have already provisioned for or written down losses to accommodate that. Because the trajectory of house prices will depend in part on financial behavior—the availability of credit—as financial institutions catch up and adjust to that and adjust capital and asset growth, et cetera, there is some risk that you’ll push that expected path of house prices down further from where it is. So if institutions have to prepare for the possibility that you’re going to have a much weaker economic outcome because there’s August 5, 2008 32 of 145 some probability around that, then there’s a risk that they will produce that outcome through the combined effects of their behavior, which is why we’re living with such a delicate balance. MR. EVANS. They do seem to be taking out a lot of insurance on the downside, right— like your Merrill Lynch put option? MR. DUDLEY. They’ve had to pay a lot for not very much insurance in the case of Merrill Lynch. CHAIRMAN BERNANKE. President Rosengren—sorry. President Lacker, an intervention? MR. LACKER. Thank you, Mr. Chairman. Just to point out that it must be the case that lower house prices have a positive effect on the homeownership rate. So there must be some mitigation, some good effect. We’re obviously getting to where we need to get eventually. The question I have for the staff about this is, Have you thought about the sequence? I mean, it strikes me that we’re likely to get to a point of stability in prices and construction activity before we get months’ supply back down to some historical norm. Because it’s sort of a stop variable, are you guys expecting it to converge smoothly, and have you thought about what measures of activity you expect to see stabilize first? MR. WILCOX. We expect starts to stabilize next year, and that will be followed by a pretty considerable period of several quarters with house prices finally stabilizing. But we think that builders will look ahead and see that they’ve cut their additions to supply by enough to make even more rapid progress against their inventory of unsold homes. The question of the dynamics of house prices is a tricky one because it depends on what model of expectations one assumes that homebuyers will have. If every homeowner were a rational economic being, then it’s pretty unambiguous that a lower level of home prices would elicit greater optimism on the part of home August 5, 2008 33 of 145 shoppers that, gee, the valuation is better compared with yesterday; I should be more enthusiastic about getting into the housing market; I should be happier today than I was yesterday. I think it’s at least an open question as to whether expectations aren’t more extrapolative than that. We haven’t seen any diminution in, for example, the Michigan survey in response to what homeowners expect to happen over the coming 12 months, and I think it’s a serious possibility that they look at their recent experience and extrapolate that forward and conclude that over the next 12 months the user cost of owning a home is going to be really high. We just don’t have a very good grip on exactly what the dynamics of prices and housing demand will be. CHAIRMAN BERNANKE. President Lockhart. MR. LOCKHART. I just want to point out that we hear a fair amount of anecdotal feedback suggesting that just determining what is the net real price for a house is not so easy because of incentives, particularly in multifamily but also new homes in general. You pay list, but you get a Mercedes and a year’s worth of gasoline and your lawn mowed and a lot of things thrown in for the seller to hold the price close to what the list is. So I don’t know how these things are actually measured to take into account those kinds of incentives. MR. WILCOX. I don’t know what the OFHEO does to capture the quality of automobile that comes in the driveway. [Laughter] I suspect that there’s no adjustment for that. CHAIRMAN BERNANKE. President Plosser. MR. PLOSSER. On the inventories and the sequencing, which I think is very interesting because of how it plays out, I learned recently—and you can correct me if this is wrong—that, in the inventory of new homes for sale, the way that’s counted includes permits that have been issued even though there’s no home that’s been built. So a developer may get permits but may not have started the home yet. It may just be sitting on a pile of permits. So if that’s correct, and I think it is, August 5, 2008 34 of 145 it means that, if you think about the sequencing of what’s going to happen as demand begins to turn around, those permits don’t have to get bought, but they may start building on permits that they’ve already been issued and they haven’t started building yet. Is that a correct way of looking at the data? MR. WILCOX. I don’t know what the story is with regard to permits that you’re mentioning. I do know that the cancellation rate of new home sales has declined a bit. Previously we were emphasizing that the high level of cancellations that the builders were experiencing was actually causing the supply situation to be even worse than one would infer from the Census Bureau data. Now the cancellation rates have come down, and so that situation is not as severe as it was six or nine months ago, I believe. CHAIRMAN BERNANKE. President Rosengren, you have been patient. MR. ROSENGREN. My question is for Steve. There have been judgmental adjustments to the domestic forecast reflecting financial headwinds in the United States. I’m wondering if we made the same adjustments for financial headwinds in Europe. You highlighted that residential investment looks a bit different in Europe, but they do have a lot of capital losses in their banking system. Their LIBOR–OIS spread is quite elevated, and at least in some European countries— Ireland and Spain as well as the United Kingdom, which you mentioned—housing has been quite soft. Are you doing judgmental forecasts to reflect those headwinds, or do we do it on the domestic side but not for the European outlook? MR. KAMIN. As you correctly point out, Europe, in particular, does indeed have a lot of financial stresses; and some parts of Europe, particularly the United Kingdom as well as Ireland and Spain, are looking at some very serious weaknesses on the housing side. So we are, indeed, kind of in parallel but not exactly the same as our domestic colleagues building financial stresses into our August 5, 2008 35 of 145 outlook. We don’t necessarily increase or decrease the amount of financial stress in our forecast in lockstep with the domestic side. In particular, the European financial situation has probably gotten a bit worse over the intermeeting period, but some indicators haven’t deteriorated to quite the extent that they have in the United States. Nonetheless, we have built in a fair amount of financial stress. One factor that’s worth keeping in mind is that we built it into our outlook fairly early on. So we haven’t adjusted downward the outlook for Europe by that much compared with the last couple of Greenbooks, but we had already built in quite a bit of weakening of activity, and a lot of that does reflect both the direct effects of financial stresses as well as their knock-on effects on tightening credit standards for banks. CHAIRMAN BERNANKE. I have President Fisher, and then if it’s okay with everybody, we should probably start our go-round. President Fisher. MR. FISHER. Very quickly, I want to come back to the housing issue. You know, I’ve been more pessimistic than I think anybody around the table from the standpoint of peak-to-trough correction, and I find the numbers you mentioned very benign relative to my expectations. One issue that I’m trying to understand a little better in terms of its likely effect is that the real bulge in resets comes in 2009 to 2012 because that’s when the alt-A resets kick in. We talked about this many, many moons ago, the ultra-poor documentation on those types of loans, in particular, and I’m wondering to what degree you’re factoring this into your outlook going forward, particularly for those out-years. MR. WILCOX. We’re certainly aware of that. To my eye the numbers look astonishingly negative. For foreclosures, we have 2.5 million foreclosures this year and another 2 million foreclosures next year. We have a very bleak landscape built into the projection. MR. FISHER. On that happy note, Mr. Chairman, thank you. August 5, 2008 36 of 145 CHAIRMAN BERNANKE. Thank you, President Fisher. The go-round. President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. The contours and basic outcomes of Atlanta’s forecast are similar to the baseline of the Greenbook forecast. So I want to focus my remarks this morning on the underlying assumptions in both forecasts—assumptions that I view as pivotal and if we miscalculate could result in a longer-term policy error. It seems that at every meeting there’s great uncertainty around the outlook, and this juncture is no different. I perceive considerable uncertainty and debatable assumptions in the base-case scenario. As I see it, the key assumptions broadly are that housing stabilizes, perhaps as indicated by housing prices, in the second half of ’09. Inflation pressures intensify in the near term but then abate because of economic slack and lower commodity prices and, as discussed, core import prices. Recent declines in oil prices stick, and prices remain more or less flat. Certainly since the Greenbook was published, we note the fluctuations just in the past few days that were referred to earlier, and I also can’t dismiss geopolitical risks and the potential of a severe shock. Finally, financial market stress will persist for some months but diminish next year. These assumptions, using the respectable term “assumptions,” have the feeling to me of “bets,” not so respectable a term. The policy assumption integral to both the Greenbook and the Atlanta forecasts could be added to this, and that is that rate rises starting in 2009 won’t choke off improving growth and will be enough to blunt remaining inflation pressures. So I’ll devote my comments to input from regional and other contacts that either serve to confirm or cast doubt on these assumptions. We oriented this cycle’s questions to our Atlanta and Branch directors to, first, evidence of wage pressures and pass-through of higher costs. In interpreting the feedback, we noted some confusion between a business’s management of its labor August 5, 2008 37 of 145 costs versus general wage pressures. We heard that businesses are working to keep their total wage bills in check by raising wages for key talent but letting less critical employees go or cutting their work hours as an offset. The reduction in hours is attributed to some combination of weaker product demand and increased average productivity. Rising unemployment appears to be keeping wage demands in check. There are exceptions, such as the oil field services industry, for which qualified staff are in short supply, and certain skilled industrial and business trades in which local bottlenecks exist. In businesses enjoying strong export demand, some employers are utilizing bonuses rather than commitment to permanent wage increases. So our regional contacts did not indicate the development of broad-based underlying pressures on labor costs reflecting wage demands. As for inflation pass-through, our contacts reported widespread and growing efforts to pass through higher input costs. Pass-through efforts appear to be the rule rather than the exception. As one Branch director put it, people are passing through costs like crazy using high energy costs as cover. The reports of my supervision staff regarding banking conditions indicate a continuing decline in asset quality and a very nervous interbank funding market. Foreclosed properties, both single-family and condo, are making up the majority of house sales and slowing the absorption of the oversupply of new homes. Some contacts are very concerned about the prospect of a second wave of foreclosures as option ARM mortgage borrowers, mostly concentrated in large states like Florida and California—these are borrowers who are currently paying less than the accrued interest—run up against maximum loan-to-value ceilings. New, higher GSE standards are resulting in fewer borrowers being qualified, putting downward pressure on house prices and bringing more foreclosures. Virtually all comparables for Florida residential valuation are based on forced sales and foreclosures, we are told. Beyond the deterioration in real estate portfolios, banks are reporting August 5, 2008 38 of 145 growing problems in credits to food distributors, restaurants, trucking, and other petroleum fuel or input-intensive industries. Based on my calls with financial market contacts, it seems that—no surprise—much of the attention in financial markets has shifted from private fixed-income markets to Fannie and Freddie. Fixed-income markets for private securities appeared to have improved relative to their lows since the current financial turmoil began. Although significant concerns remain, it appears that leveraged-loan deals are getting done. Volume is down, spreads are up, and the deals are very conservative, but deals are getting done. That said, one of the patterns in my calls over the past year has been that, every time one concern abates, another seems to jump up and take its place. Although the recent legislation appears to have alleviated concerns about the Fannie and Freddie senior debt, my contacts indicate that there is widespread uncertainty about what will happen to junior securities if the Treasury injects funds. Furthermore, more than once I heard the view that foreign holders of GSE debt are concerned that their positions are not as safe as they believed. One contact mentioned that the 18-month term of the guarantee is reportedly affecting some holders’ maturity choices. In response to my question about the relative weakness of European banks, one contact suggested that they have booked much of their troubled assets in the “hold to maturity” account, suggesting slower recognition of losses and difficulties ahead. We confirmed with one large regional bank CFO significant deterioration of HELOCs in their portfolio and, by implication, broadly among regional banks. The option ARM problem, by contrast, is perceived to be possibly the next shoe to drop but, as I said earlier, not uniformly distributed across the country. Finally, we heard the view that markets perceive banks as facing protracted difficulty raising capital. To conclude, the downside risks to growth have not diminished in my opinion. On the flip side, I agree that the upside risks to inflation are obviously a serious concern. In particular, I put a August 5, 2008 39 of 145 fair amount of weight on the possibility that inflation will not moderate sufficiently without a more substantial tightening of monetary policy than that projected in the Greenbook baseline. My intermeeting internal and external discussions make it difficult for me to dismiss some of the alternative scenarios in the Greenbook, specifically the “severe financial stress” scenario, the “typical recession” scenario, and the “inflationary spiral” scenario; and in a high-uncertainty environment, I don’t view any of these scenarios as exclusive of another. That said, I see the risks to both the inflation and the growth objectives as very roughly in balance at this time. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Evans. MR. EVANS. Thank you, Mr. Chairman. Overall there has been little change in the sentiment of my business contacts since our last meeting. Most are still reporting sluggish domestic demand with little evidence of any improvement over the near term. On the price front, everyone continued to cite cost pressures. Manufacturers have long lists of materials cost increases, while retailers note large increases in wholesale prices of imported consumer goods. Everyone discusses how they are planning to continue passing these costs along to customers in second-round effects. Undoubtedly weak market conditions will limit their efforts, but I suspect that many will be successful in raising prices significantly. Turning to the financial situation, to start I should note that I did hear some good reports with regard to liquidity in Chicago financial markets. A contact at the Chicago Mercantile Exchange told us that they conducted extensive liquidity reviews for their largest clearing members, with special scrutiny of firms that had substantial volumes of hard-to-value assets on their books. The clearinghouse was very pleased with the results, finding that these firms had good access to liquidity. August 5, 2008 40 of 145 Overall, however, my financial conversations this round were relatively downbeat. I did hear some interesting details, though, about the dynamics of the restructuring of credit intermediation. With commercial-mortgage-backed securities markets effectively shut down, a highly rated owner-developer of high-end shopping malls described his increasingly difficult attempts to find funding for his regular flow of balloon payments on mortgage properties. He has gone from restrictive loans from life insurance companies to attempting to put together his own structured-debt securitization. They want to issue bonds backed by the revenues generated from a pool of their high-quality properties and sell them to major fixed-income investment funds. This is one example of what economists like Kashyap and Shin estimate will be a reduction of at least $1 trillion in lending to nonfinancial institutions due to mortgage-related losses at U.S. financial institutions. It is also an example of how firms are trying to find workarounds for the functions that intermediaries used to do for them. But such restructuring must be raising the cost of financing in ways that are not obviously amenable to mitigation through liquidity policies. Turning to the national outlook, the information we have received over the past several weeks has contained many crosscurrents, but overall our forecast for output growth is little changed from our June projections. With regard to prices, I am concerned that inflation risks continue to grow. The most recent news on core prices has not been good. Oil prices may be coming off the boil, but they are still scalding. Prices are still down only to where they were in May. My impression from my contact calls is that the ultimate pass-through to final product prices of earlier increases could take a disconcertingly long period of time. Furthermore, I continue to think that the current funds rate in conjunction with our enhanced lending facilities represents a quite accommodative monetary policy stance, even given the disruptions in financial markets. If the policy path remains as accommodative as futures markets expect, then improvement in inflation will August 5, 2008 41 of 145 most likely require fortuitous favorable developments in inflation expectations and more restraint from resource slack than we might have otherwise expected. This brings me to three considerations that I would like to highlight as we evaluate the riskmanagement positions underlying our views on appropriate policy and our economic projections. The first factor is that, according to many econometric estimates, the 5¾ to 6 percent unemployment rate envisioned in the projections would provide only very modest restraint on inflation. In addition, costly reallocation could lead to less resource slack, perhaps temporarily driving the NAIRU above 5 percent. You know, when I talk to my staff, they assure me that there are very good reasons, demographically based, to believe a NAIRU under 5 percent. But I tend to think I’ve read a few too many papers on policy and policy mistakes where that’s exactly the issue—when you think the sustainable unemployment rate is lower than it actually is. So that’s a risk, I think. The second factor is that many individuals and businesses see the large relative price changes in oil, food, and commodities as precursors to more-persistent inflation. Whether or not their assessments are analytically correct depends on their expectations of our policy response. A substantive response may be necessary to prevent self-fulfilling price increases and keep inflation under control. Words can take us only so far. The third consideration is the potential diminishing returns through our efforts to mitigate distressed financial market conditions. It is my interpretation that our current accommodative monetary policy and suite of lending facilities are set to mitigate severe downside risks and the systemic risks that you mentioned earlier, Mr. Chairman. This is helpful under the assumption that reducing liquidity strains will assist financial markets to return to normal operations and prevent a permanent impairment of our financial infrastructure. But financial conditions seem unlikely to return to our previous perceptions of normal, at least for some time. Thus, I see a risk that extra August 5, 2008 42 of 145 accommodation intended to grease the financial wheels could be left in place too long and prove counterproductive for price stability. Indeed, the old perception of “normal” likely is not the correct benchmark for us to use in looking for whether we are experiencing structural changes in the intermediation process in which new liquidity providers are playing enhanced roles in the lending process and in which risk standards are changing. So when thinking about market functioning, it would be useful to discuss this within a longer-term framework of what we can feasibly expect from market functioning and what central bank liquidity has the ability to usefully and appropriately influence. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Fisher. MR. FISHER. Mr. Chairman, I may have to leave the lunch early. So before I start, I do want to bid Rick adieu. Rick, I remember describing you as charming in one of our early meetings. You have charmed me by your intellect and devotion. Anyway, I’m going to miss you. So I wanted to say that in case I do have to leave early. Mr. Chairman, in the intermeeting period, I spent almost as much time in President Rosengren’s District as I did in my own—part as vacation but the rest consulting with some advisers and mentors in the People’s Republic of Cambridge at my alma mater. [Laughter] I mention this because I want to underscore that, in arguing a perspective, I tend to move away from the rather felicitous circumstances that prevail in my District. Even though things are slowing, we still expect employment growth to come in a little short of 2 percent a year, and our banking situation thus far is holding up rather well. In terms of my national soundings, and you know the list and the group is familiar with it, the anecdotal evidence from everyone—from the bankers to the credit card companies to retailers to fuel producers, food producers, energy companies, shippers, equipment manufacturers, August 5, 2008 43 of 145 homebuilders, and entertainment companies—confirms reports of progressively higher obstacles to growing their top lines and continued efforts to drive down their cost of goods sold through reducing their head counts, running very tight inventory cycles, tightening their operating expenses, and reexamining and in many cases cutting back significantly on cap-ex. Nationally I expect continued anemia on the growth side. We are, as you know, not at the extreme but at the low end of expectations for economic growth. I would expect zero growth as we approach year-end. As I said earlier, from our perspective we’re only about two-thirds through the peak-to-trough correction on housing, and I view that as a continued weak influence. So the summary is that most of my contacts are planning around expectations of a prolonged U.S. and advanced-country slowdown and have a rather woeful outlook as to the growth side. At the same time, there is also a woeful concern with regard to price pressures—intensifying cost pressures affecting their margins at a time when the stock market is most unforgiving of people who miss their mark. Even in the First District, I might note. I want to quote the Beige Book report from Boston: “Almost all contacted manufacturers voiced concerns about elevated . . . costs. . . . Respondents generally have raised their selling prices in recent months. . . . Over one-half of contacts expect to increase their selling prices further in the second half of 2008 and/or early 2009.” It went on to say that, while some contacts express worry that price increases have led or will lead to loss of market shares, others indicate that—and these are the key operative words—“customers have become more receptive to price increases because they see them as a consequence of generalized cost pressures.” Mr. Chairman, that passage captures the message that I’m receiving from my CEO and CFO contacts around the country. By and large, we appear to be transitioning from vigilance on the price front to acquiescence. Inflation expectations are, I think, becoming unmoored, and I believe they are, if not already adrift, at risk of drifting. August 5, 2008 44 of 145 On the small business front, I do like to look at Bill Dunkelberg’s recent reports from the National Federation of Independent Business. His most recent report indicates that the percentage of small business owners citing inflation as “the number one problem they face,” rose to 20 percent in June, the highest rating since 1982, and that 41 percent of his respondents report raising selling prices. At the other extreme of size, to put this in perspective, Wal-Mart’s CEO for the United States reported last week—and I quote this: “My biggest concern is inflation. This month we had an experience that Wal-Mart has never ever”—that’s literally what he said—“had before, which is that a major supplier told us we need a 9 percent increase or we will not supply you at all.” Now, he did not mention the name of that supplier. It could have been Unilever, which saw the volume of goods it ships slip 0.5 percent year over year in the second quarter. Yet according to our conversations but also quoted in the Wall Street Journal on August 1, Unilever’s CEO reported that he “raised average prices on his thousands of products 7.4 percent,” and then added that he “doesn’t plan to reverse any price increases.” Or it could have been one of the largest snack food companies, whose CFO has informed us that, after taking and having stick a 9 percent increase in price in March—I reported this at our last meeting—they will effect another 9½ percent increase in October. Here’s the pithy quote he gave me: “Thus far we’ve been bleeding out price increases to our customers. Now our strategy is to bludgeon them—to broadcast our increases in the expectation that competitors will do the same.” I doubt the supplier to Wal-Mart was Kodak. Last week the New York Times reported that “hurt by higher manufacturing and materials costs, the company said it will combat these cost pressures by passing on to consumers and raising prices on some products by as much as 20 percent.” I have lots of examples of similar responses. President Evans indicated similar pressures. President Lockhart did too. I’m not going to go through them. I will add, by the way, the one thing August 5, 2008 45 of 145 that surprised me. Despite Disney’s brilliant annual report of record earnings, they, too, plan to raise their single day prices by 5 percent, to $60, in the next quarter. There is also a growing feeling, which I haven’t heard before, among semiconductor manufacturers that, after years and years of constant price deflation, they expect that there may—and the operative word is “may”—be a bottoming out because of the raw materials prices they face and the wage prices and pressures they are receiving in China, which has become a major semiconductor manufacturer. One might take heart from the recent correction in commodity prices. I agree with Steve that we have to be very careful about that. My smartest energy contacts have been expecting a correction in prices. Markets were overshooting. Natural gas prices have reacted to recent developments like the Barnett Shale and, even more important, the so-called Haynesville Play in Louisiana. The “oilies” note that increased Saudi supply hit our shores with the normal six-week lag. They were talking about production increases in May and June, and those have just hit our shores recently. So they’re not surprised at the price reaction at the pump. But none feels that the basic demand–supply situation has been dramatically altered—much as you argued, Steve—and most expect structural prices to obtain at or near current levels. Now, what does “at or near current levels” mean in terms of price impact? I had a long conversation with the CEO of Burlington Northern, and just for data purposes, in terms of what they call their RCAF—an automatic costadjustment contract that covers 25 percent of the goods shipped by their rail—their third-quarter RCAF is 17 percent. The 75 percent of products that are not covered by that automatic contract are subject to a fuel surcharge. That fuel surcharge at $120 a barrel is a 30 percent increase for the third quarter. One might also take comfort in the purported calmness in compensation growth seen so far, along the lines of what I read in the Financial Times by Mark Gertler on July 29. I don’t hear August 5, 2008 46 of 145 confirmation of that benign argument among business operators. First, as President Evans and Mr. Stockton pointed out in our last meeting, labor compensation is not a good predictor of inflation. I remember Dave said that it’s not that labor costs, which are a significant chunk of business costs, don’t matter but that you can’t necessarily take comfort from the well-behaved compensation thus far that you are not going to confront some inflation problems going forward. Now, the last anecdote I want to give you illustrates that point. Yesterday I had a lengthy visit with the CFO of General Mills. Until their fiscal year ’08, which ended in May, they priced over many years an average increase of 0 percent. They took 2½ percent as the year ended, and they’re taking another 5 percent this year. They are having to reexamine their elasticity models, he said. Here is what he said that worried me the most: They are finding those models less predictive because (a) “everybody is raising prices,” and (b) consumer perception is that inflation is back. So, again, vigilance is giving way to acquiescence. Mr. Chairman, I do want to comment very briefly on something I mentioned last time, which regards calculating the cost of goods sold. I am hearing more and more from companies that have shifted production to China a verification of the 18 percent number that the ministry gave us. Whether it’s a hospital producer whom I talked to in California or a Black & Decker tool assembler in China, they’re complaining not only about cost increases of 15 to 20 percent, depending on whether you’re operating in the north or south, but also about the employee contract law that was just put into place, which in essence allows for almost an old-fashioned scala mobile Italian/French model, which feeds a wage–price spiral, and it is beginning to infect their wage cost and inject rigidities into their ability to operate in China. So overall, Mr. Chairman, I am concerned, obviously, about economic growth. I think we, as President Lockhart mentioned, are in a very difficult spot. We have three enormously worrisome August 5, 2008 47 of 145 scenarios facing us. I think we have to be very careful how we word ourselves on inflation. Last night at 6:00 National Public Radio opened their Marketplace report with this headline: “The Fed Fuels Your Pain.” We have a perception issue that we must address, and there are two ways to do it. One is by being strong in terms of how we argue the case of inflation. The other is to act by raising rates. I’m going to listen very, very carefully because, frankly, I’m undecided here as to what the right approach is. But I think we have to be careful when we state a balance of risks, which are enormous, that we don’t understate the fact that inflation is now being accommodated in the minds of the marketplace. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. President Fisher, I’m going to ask you a very innocent question. You’ve given many chilling anecdotes over the last few meetings about increases in prices, but the official statistics just don’t show anything like that outside of oil, gas, gasoline, and the direct commodity price increases. Do you believe that the CPI is not an accurate measure? MR. FISHER. Well, I do see the CPI rising. The monthly report was not encouraging. The last 12 months have not been encouraging, and I think what worries me is the spread between core and headline. Core is rising as well, by the way. Even our own estimates indicate that. I do see it in headline numbers. The numbers I saw that were just reported I thought were quite alarming. You are seeing the pass-through. You’re hearing evidence of this in the anecdotal reports. I do believe, Mr. Chairman, that it’s visible in the data. I’m just trying to report what I’m hearing from the field against the background of much more sophisticated analysis, which I respect enormously. What I’m worried about is the perception. I do believe that the data are very imperfect on inflation expectations—I noticed that David said that about the further-out expectations in the Michigan survey. If you look at the reliability of the data, the one-year survey, which has risen significantly, has been quite reliable over time. The August 5, 2008 48 of 145 five-to-ten-year—I don’t know if they’re talking about ten years, five years, or somewhere between the two, and I don’t think statistically that’s been a very accurate indicator historically, but I’m not sure about that. So we have very imperfect hard data on inflation expectations, and I think that’s when anecdotal evidence may be helpful. All I’m trying to do, Mr. Chairman, is report to you what I’m hearing from the field, and not from my District, and I hope it is useful in the deliberations. CHAIRMAN BERNANKE. Governor Mishkin. MR. MISHKIN. I think there’s no question that headline inflation is very high right now. Clearly, when you get these kinds of increases in energy prices and food costs, you’re going to have to reflect them in current prices. In fact, that’s exactly what you need to have happen so that relative prices shift. The reality is that high oil prices have to mean that real wages fall. People have to conserve and not drive as much and so forth. So this is a normal process, and monetary policy does not control these relative price shifts. What I think is more critical is that, although there are some problems in terms of core, the effect has actually been quite limited given the incredible rise in energy prices. While it’s important to think about headline in the long run, the information from core is very useful in terms of thinking about policy because it tells you whether this is spilling over into underlying inflation. One of my concerns about going to anecdotal information and why I think we need to use an analytic framework in thinking about what is really driving the inflation process is that we do need to focus on the longer-run because that’s what monetary policy can control. I get a bit nervous about these anecdotal concerns, which I think can tell us something about headline. Then we have to ask what they tell us about the longer-run context but not put too much weight on them. That’s one reason that I think some of the analytic frameworks that we’ve developed here are very useful for thinking about these things. Thank you. August 5, 2008 49 of 145 MR. FISHER. Well, in terms of the weight, again, I’m just one of 17 or 18, and I would weigh it accordingly. But I am worried that we’ve had a spread between headline and core for a long period now. I am worried that we’re seeing core expectations pick up—modestly but they are beginning to pick up. I am worried that core expectations are above 2 percent. And I am particularly worried about developments on the global wage front in terms of how it affects the cost of goods sold here in the United States. One last thing that I just started to detect—and again, it’s all just hearsay—but I’m increasingly hearing reports of concerns of people who operate companies about the welfare of their employees and about their ability to pay transportation costs, pay food costs, and maintain the value of their 401(k) plans and, as President Lockhart reported, some way to try to manage, if not through formal demands on wages, at least to try to cushion their welfare. These are marginal influences, and I don’t disrespect the analytical side. I do worry that data capture history, and I’m trying to give myself a sense for what is happening at the margin in terms of microeconomic behavior, and the report is only what it’s worth. It’s just one input in the many. Thank you. CHAIRMAN BERNANKE. Thank you. President Bullard. MR. BULLARD. Thank you, Mr. Chairman. Economic activity in the Eighth District has remained roughly stable during the summer. Activity in the services sector has increased slightly, and except for the auto industry, manufacturing activity is also stable to slightly higher. Automotive contacts reported a variety of plans to lay off workers or to idle production, and at least three automotive parts suppliers will close plants in the District. Contacts in the auto industry are not optimistic that production will increase in the short term. Retail and auto sales have softened in recent weeks, and some District retail contacts have expressed concerns about summer sales. Many contacts continue to emphasize commodity price levels as a key factor in business decisions. They August 5, 2008 50 of 145 are concerned both about the necessary business adjustments, given the new pricing structure, and about the implications for the overall level of inflation going forward. The residential real estate sector continues to decline. Across four of the main metropolitan areas in the District, home sales through May declined about 18 percent compared with 2007, whereas single-family construction permits declined about 40 percent. The number of foreclosures in the St. Louis area in the second quarter increased to about 6,300 filings, up about 77 percent from last year. I am impressed, however, with the regionalism in the foreclosure situation, as some areas of the nation continue to have far higher foreclosure rates than others. In contrast with the generally positive reports in commercial real estate activity for the earlier part of 2008, recent reports have indicated more uneven conditions in the nonresidential real estate sector across the District. Turning to the national outlook, I was encouraged by the recent GDP report for the second quarter, which showed growth at an annual rate of 1.9 percent. Real final sales increased at an annual rate of 3.9 percent. It now appears that the worst quarter associated with the current episode of financial turmoil was probably the fourth quarter of 2007, when the economy abruptly stalled. The slow- or no-growth period was through the winter, with the economy gradually regaining footing through the spring and summer. If there were no further shocks, I would expect the economy to grow at a more rapid rate in the second half of this year. But there has been another shock—namely, substantial increases in commodity and energy prices. I think it’s important to be careful not to confuse the effects of this latter shock with the effects of the housing-sector shock. My sense is that the level of systemic risk associated with financial turmoil has fallen dramatically. For this reason, I think the FOMC should begin to de-emphasize systemic risk worries. My reasoning is as follows. Systemic risk means that the sudden failure of a particular financial firm would so shock other ostensibly healthy firms in the industry that it would put them August 5, 2008 51 of 145 out of business at the same time. The simultaneous departure of many firms would badly damage the financial services industry, causing a substantial decline in economic activity for the entire economy. This story depends critically on the idea that the initial failure is sudden and unexpected by the healthy firms in the industry. But why should this be, once the crisis has been ongoing for some time? Are the firms asleep? Did they not realize that they may be doing business with a firm that may be about to default on its obligations? Are they not demanding risk premiums to compensate them for exactly this possibility? My sense is that, because the turmoil has been ongoing for some time, all of the major players have made adjustments as best they can to contain the fallout from the failure of another firm in the industry. They have done this not out of benevolence but out of their own instincts for self-preservation. As one of my contacts at a large bank described it, the discovery process is clearly over. I say that the level of systemic risk has dropped dramatically and possibly to zero. Let me stress that, to be sure, there are some financial firms that are in trouble and that may fail in the coming months or weeks depending on how nimble their managements are at keeping them afloat. This is why many interest rate spreads remain elevated and may be expected to remain elevated for some time. These spreads are entirely appropriate for a financial system reacting to a large shock. But at this point, failures of certain financial firms should not be regarded as so surprising that they will cause ostensibly healthy firms to fail along with them. The period of substantial systemic risk has passed. Of course, we have also endured a bout of systemic risk worries stemming from the operations of the GSEs. However, my view is that the recent legislation has addressed the systemic risk component of that situation as well. Because of these considerations, my assessment is that the chances of unchecked systemic risk pushing the U.S. economy into a severe downturn at this point are small, no larger than in ordinary times. August 5, 2008 52 of 145 Unfortunately, while the threat from this source is retreating, another threat is upon us— namely, a substantial shock from increased energy and certain commodities prices, which is leading many to forecast slower growth during the fall. Real automotive output subtracted 1.1 percentage points from real GDP growth in the second quarter. Many contacts seem to attribute this largely to consumer reaction to increased gasoline prices. If this is true, then it seems to me that some of the most visible reaction to this shock may have already occurred, being pulled forward into the second quarter. Labor markets have been weak, but I am not as pessimistic as most on this dimension. So far this year, the U.S. economy has shed about 387,000 nonfarm payroll jobs as compared with a drop in employment of 402,000 jobs during the first seven months of 2003 or 315,000 during the first seven months of 2002. Neither of these latter two episodes is associated with the recession label. These two years might provide better historical guides to the behavior of today’s economy than those associated with the recession label, such as 2001, 1990–91 or 1980–82. This is one reason that I think the labeling game can mislead us in our thinking about the economy. The main contribution that the FOMC can make to the economy is to keep inflation low and stable. The headline CPI inflation rate is running close to 5 percent measured from one year earlier. The University of Michigan survey of inflation expectations one year ahead reflects this reality with the most recent reading at 5¼ percent. The June CPI annualized inflation rate was a 1970ssounding 13.4 percent. Of course, much of this is due to energy prices. Still, with these kinds of numbers we’re going to have to do more than talk about inflation risks. Thank you. CHAIRMAN BERNANKE. Thank you. President Yellen. MS. YELLEN. Thank you, Mr. Chairman. Developments during the intermeeting period have heightened my concern about downside risks to economic growth and slightly August 5, 2008 53 of 145 allayed my concern about upside risks to inflation. Let me begin with growth. The moderate growth rate registered in the second quarter was disappointing, especially because it benefited from the temporary effects of the fiscal stimulus package. Moreover, the pattern of consumer spending during the quarter, with weakness in June, is worrisome. With all the publicity surrounding the rebate checks, households may have put them to work earlier than usual, especially since they were facing significantly higher prices for food and gasoline. This interpretation does not bode well for activity in the current quarter. Assuming no change in the funds rate this year, we have lowered our forecast for real GDP growth for the second half of the year about ⅓ percentage point, to just ¾ percent, and project a correspondingly higher unemployment rate. Our forecast for weak second-half growth reflects not only the unwinding of fiscal stimulus but also adverse financial sector developments. The credit crunch appears to have intensified since we last met. Evidence of tighter financial conditions abound. Risk spreads and the interest rates charged on a variety of private loans, including mortgages, are up noticeably, and lending standards have tightened further. Credit losses have risen not only on mortgages but also on auto loans, credit cards, and home equity lines of credit. As a consequence, the list of troubled depository institutions is growing longer. IndyMac and First National will not be the last banks in our region to fail. Indeed, the decline in broad stock market indexes is partly a reflection of the market’s concerns about the health of the financial sector. Many financial institutions are deleveraging their balance sheets and reducing loan originations. For example, a large bank in my District has begun now in earnest to cancel or cap outstanding home equity loans and lines of credit, despite an ongoing concern about alienating consumers. Tighter credit is affecting demand. Anecdotal reports suggest that the plunge in July car sales partly reflects a August 5, 2008 54 of 145 tightening of credit standards for auto loans and leases. A large bank reports a substantial drop in demand for mortgage credit in response to the recent rise in mortgage interest rates, and the anecdotal reports that we hear support the Greenbook’s negative view of the effect of credit conditions on investment in nonresidential structures. The housing sector is of considerable concern. House prices have continued to fall at a rapid rate, and futures prices suggest a further decline of around 10 percent over the next 12 months. This forecast seems reasonable given the overhang of homes for sale, the recent rise in mortgage rates, and the tightening of credit. Unfortunately, the risk of an adverse feedback loop from tighter credit to higher unemployment, to rising foreclosures, to escalating financial sector losses, to yet tighter credit remains alive and well, in my opinion. Indeed, stress tests conducted by some of the large financial institutions in our District reveal an exceptionally high sensitivity of credit losses to both home-price movements and unemployment. The “severe financial stress” simulation in the Greenbook illustrates my concern. It is not my modal forecast, but it certainly seems well within a reasonable range of outcomes. The probability of such a scenario has risen, in my view, since we met in June. One partially mitigating factor that should help to support consumer spending is the drop in the price of oil since our last meeting. But to the extent that the decline in oil prices partly reflects reduced expectations for global growth, the net impetus from stronger domestic spending will be offset by weaker export growth. Continued declines or even stabilization in oil prices will, however, be good for inflation. We have revised down slightly our forecast for core inflation as a consequence. Moreover, the fact that we were not once again surprised on the upside by oil prices has had a small favorable effect on my perception of inflation risks going forward. That said, inflation risks obviously remain. Even with the recent decline, energy prices August 5, 2008 55 of 145 are well above year-ago levels and are not only pushing up headline inflation but also spilling, to some extent, into core. Higher headline inflation could undermine our credibility and raise inflation expectations. If the public concludes that our implicit inflation objective has drifted up, workers may demand higher compensation, setting off a wage–price dynamic that would be costly to unwind. Fortunately, the reports I hear are consistent with the view that no such dynamic has taken hold. My contacts uniformly report that they see no signs of wage pressures. They note that high unemployment is suppressing wage gains. Growth in our two broad measures of labor compensation are low and stable; and taking productivity growth into account, unit labor costs have risen only modestly. I tend to think of the chain of causation in a wage–price spiral running from wages to prices, but it is certainly possible that the causation also, or instead, runs in the opposite direction. Either way, though, faster wage growth is an inherent part of the process by which underlying inflation drifts up, and at present we see not the slightest inkling of emerging wage pressures. Growth in unit labor costs also remains at exceptionally low levels. I would also note that I have looked for evidence of some increase in the NAIRU due to sectoral reallocation by examining the Beveridge curve, thinking that if there were sectoral reallocation we might see an outward shift in the Beveridge curve. I have detected no evidence of such an outward shift. These facts provide me with some comfort. Moreover, various measures of longer-term inflation expectations suggest that they remain relatively well contained. When we met in June, the Michigan survey of inflation expectations five to ten years ahead had recently jumped a couple tenths of a percentage point. I argued then that the respondents to that survey typically overrespond to contemporaneous headline inflation. Since that meeting, oil prices have come August 5, 2008 56 of 145 down a bit, and so have the Michigan survey measures. Assuming that the funds rate is raised from 2 percent to 3 percent in 2009, my forecast shows both headline and core PCE inflation falling to about 2 percent in that year. So, in summary, during the intermeeting period, my forecast for economic growth has weakened, and that for inflation has edged down slightly. I consider the risks to our two policy objectives pretty evenly balanced at the present time. CHAIRMAN BERNANKE. Thank you. President Pianalto. MS. PIANALTO. Thank you, Mr. Chairman. My outlook for economic growth and inflation over the next few years is broadly similar to the one that I held last meeting, although I think that the prospects for both inflation and economic growth in the near term have deteriorated since June. To a close approximation, my outlook ends up looking very similar to the Greenbook’s baseline scenario. The most significant change I am making to my outlook is to mark down the prospects for business fixed investment this year and next, based on the reports that I am hearing from the manufacturers in my District. There is an interesting short-term/long-term dynamic taking place in the manufacturing sector. The manufacturing CEOs with whom I have spoken say that over the long term they are very bullish on America. The dollar depreciation, increased transport costs, and rising wages in China all favor more U.S.-based production. A senior executive from Alcoa told me that, in his 35 years of working in the manufacturing sector, he has never seen the fundamentals point so strongly toward the United States as a profitable location for manufacturing. The short term, however, presents a more mixed picture for manufacturers. Although some industries, such as power generation equipment and aerospace, are running flat out and expect to continue doing so, companies in other manufacturing industries have received or expect to receive order cancellations. In particular, the manufacturers that supply the August 5, 2008 57 of 145 automotive and commercial construction sectors are reporting a worsening outlook. Perhaps the best way to summarize the sentiments that I am hearing from manufacturers is to say that they see a bright future but they see challenging conditions over the next 12 months. We all know that housing markets are extremely weak. Housing prices began their decline earlier in Cleveland than in the rest of the country, and we are now seeing some stability in housing prices. Despite that hopeful glimmer, we have not seen any pickup in home sales. Based on this experience, it seems that we still have a long way to go nationally before we see any pickup in residential construction. In regard to financial markets, my chief concern is that lending is going to be constrained by lenders needing to maintain sound capital ratios in the face of asset write-downs and loan charge-offs. Balance sheet constraints and a declining risk appetite on the part of bankers mean that some worthy borrowers are going to be rationed out of credit markets, further restraining economic activity. Turning to inflation, I anticipate that price pressures will intensify further before we see some relief, just as the Greenbook baseline scenario depicts. Manufacturers are still raising their prices in response to rising prices for raw materials that they purchase. Some companies have had fixed-price contracts in place for five and ten years, and as these contracts mature, the companies are passing on huge price increases to their customers. Consequently, I think that even after a point at which energy and commodity prices flatten out, prices at the wholesale and retail levels are likely to adjust upward for a while longer. I just said that manufacturers are expecting some challenging times ahead. One reason is that many of them are caught between weakening demand conditions and soaring input costs. Sherwin-Williams represents an extreme case, but I think it illustrates the situation pretty starkly. August 5, 2008 58 of 145 The CEO of Sherwin-Williams told me last week that their business is down more than 20 percent in sales channels both to new construction and to existing homes. They have been in business for 126 years, and the last time this occurred was during the Great Depression. Despite these dismal sales, they are having to raise prices. The CEO told me that the company typically raises prices once a year, but in July they announced their third price increase this year. In the entire history of the company, they have never before had three price increases in one year. So I continue to see the risk to my projection for output as being to the downside for the reasons that we have been discussing for some time—high energy prices, severe financial stress, and a depression in the housing markets. The risk to my inflation outlook is weighted to the upside because I am concerned that inflation could remain elevated for too long, potentially destabilizing inflation expectations. The Greenbook baseline scenario expects the near-term inflation picture to worsen in the second half of this year before improving gradually over the entire forecast period. This pattern is a concern to me. In that environment, I worry that inaction on our part before next year could be seen as complacency on our part. So when I stack up the two risks against one another, I regard them as fairly equal right now. But my outlook is conditioned on a federal funds rate path that begins to increase about a quarter earlier than called for in the Greenbook baseline. I will speak to the relevance of this factor when we discuss monetary policy in the next go-round. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. Economic conditions in the Third District remain relatively weak, but they are not materially different from what we and our business contacts have been expecting for the past several months. Manufacturing and residential construction sectors continue to show a slow decline. Payroll employment in our three states fell August 5, 2008 59 of 145 in June, but it is still above the levels of where it was three months ago and so has been performing somewhat better than in the nation as a whole. The pace of retail sales seems to have been softening, and commercial real estate firms indicate that most office and industrial markets have weakened slightly since the spring. My business contacts generally expect weak growth for a while. Manufacturers do expect a rebound during the next six months; but most other sectors, particularly retail sales, anticipate only soft or slightly improving conditions in the near term. Residential real estate is not expected to strengthen appreciably in the second half of the year. Banks expect somewhat sluggish growth in overall lending for the rest of the year, although compared with some regions, banks in our District are in pretty good shape. There are stresses, but they seem to be manageable. Credit, however, is generally available to businesses, and we hear only sporadic information from businesses that they are unable to obtain needed loans. For some time my business contacts have expressed concern about rising energy and commodity and transport prices. Our business outlook survey’s prices-paid index rose yet again in July, and it is now at its highest level since March 1980. Although the prices-received index edged down slightly, it remains at a very, very high level relative to historical standards. The BOS’s future prices-received index rose to 49.6 percent, which is the highest level it has been since January 1989. This indicates that roughly half the manufacturing firms that responded to our survey expect the prices they receive for their products to be increased over the next six months. To gauge the extent to which manufacturing firms have been able to pass on rising costs to their customers, we asked several special questions about product pricing in our July survey. More than 60 percent of our respondents indicated that, since the beginning of the year, they have been able to raise prices and pass along increased costs to their customers. About August 5, 2008 60 of 145 26 percent said this took the form of increases in base prices. Almost half of them had increased base prices. The rest said they have used either surcharges or escalator clauses and, in some cases, combined those with base price increases as well. Surcharges and escalation clauses are not likely to go away anytime soon and may even become more widespread. About 56 percent of our respondents indicated that price escalation clauses and surcharges are likely to be a part of their pricing in the future. Further, since a large number of firms have already built cost increases into their base prices, it is not clear at all that prices will come down quickly, even if oil prices stabilize at a lower level. On the national level, the incoming data since our June meeting have been mixed but largely in line with my expectations for the near-term path of the economy. Real GDP growth for the second quarter came in somewhat weaker than many expected, although I will note that as recently as April many people were expecting negative growth in the second quarter and it is now almost 2 percent. But I think that the strength is a remarkable testament to the ability of this economy to weather shocks from financial market disruptions, a severe housing correction, and surges in energy and commodity prices. Nonfarm payroll employment has fallen an average of 66,000 jobs per month over the last seven months—a weak number to be sure but not nearly as severe as the job losses over the last three recessions, which averaged nearly 180,000 jobs a month. Since our June meeting, we have taken further steps to address fragile financial markets that were manifested by the difficulties surrounding the GSEs and the IndyMac takeover. On balance, my outlook for the economy is little changed, although the financial market developments since our last meeting have marginally increased the uncertainty surrounding my forecast. I do see near-term weak growth for the economy, but I continue to expect an improvement in output and employment growth next year as the economy rebounds closer to August 5, 2008 61 of 145 trend. Unfortunately, there has been a resurgence in financial market volatility, especially on the part of the banking sector and mortgage markets related to the problems of the GSEs. The liquidity in the interbank and primary dealer markets appears to have improved somewhat relative to the first quarter of this year. I read the conditions in the financial markets and the wide spreads on selected assets as having improved somewhat on net and the spreads we are seeing increasingly reflecting real credit risk as opposed to dysfunctional markets. As I indicated in my questions earlier, we should not use such spreads as the primary criteria for assessing the fragility of the financial markets. Moreover, we must be cautious in using monetary policy or other tools at our disposal as a form of forbearance that delays the necessary adjustments in the pricing of various financial claims. I think we need a high hurdle—that there are real market failures—before we intervene to stem liquidity desires on the part of traders or attempt to influence the price of specific asset classes. To agree with President Bullard’s comments, we should begin to deemphasize and destress the importance of systemic risk because I think it is gradually dissipating as firms adjust to the more volatile and risky environment. The current state of the financial markets seems to me to bear some resemblance to the financial headwinds analogy that many people referred to during the early 1990s. Indeed, spreads on many forms of business and consumer loans are behaving now much in the way as they typically behave during recessionary times as credit risks rise. In the early ’90s, monetary policy was less accommodative than it is now—at least the funds rate reached a low point of 3 percent from October 1992 to February 1994—and during that time headline PCE inflation ran about 2 to 3 percent. The real funds rate, measured by a one-quarter-ahead forecast of the CPI from the professional forecasters, was minus 0.1 percent over the six quarters from 1993:Q3 to August 5, 2008 62 of 145 1994:Q4. Currently, the real funds rate using the same measure of one-quarter-ahead professional forecasters’ CPI stands at minus 1.1 percent. The inflation outlook remains a cause of concern. Headline inflation is higher, and there is evidence of modest pass-through to core inflation measures. Inflation compensation on the six-to-ten-year horizon has risen modestly. Inflation compensation at the near term has fallen with recent declines in oil prices, but it remains volatile. The staff has suggested that a portion of the increase in the longer-dated inflation compensation measures may reflect an increase in inflation risk premiums. That is, markets are uncertain about the long-run path of inflation. This is not terribly comforting. It suggests that our credibility may be waning. Despite the recent drop in oil prices, I remain uncomfortable with the longer-term inflation outlook. Indeed, the focus of monetary policy must be on the intermediate to longer term, and we must resist the temptation to act as if our funds rate decisions can manage the outcomes over the very near term. Year-over-year inflation, headline CPI and PCE inflation, have now been consistently above 3 percent since October 1987. Year-over-year core PCE inflation has exceeded 2 percent every month but one since April 2004. That is four years. Businesses are reporting an increased willingness to pass on cost increases. Near term, we might get some moderation in headline inflation, if the recent drop in oil prices holds. This might result in less upward pressure on inflation expectations, at least in the near term. Of course, as has been pointed out, oil prices are notoriously hard to predict, and we may well see a resurgence in oil prices before the year’s end; but we don’t know. More important, a drop in oil prices will only temporarily mask what I view as the underlying inflationary pressures. Oil prices have clearly exacerbated the recent numbers and may mitigate them in the near term going forward. August 5, 2008 63 of 145 But my concern is that the real source of intermediate-term to longer-term inflationary pressures comes from our own accommodative policy, whose consequences for inflation will be felt only over time. We are unable to control the rise in oil prices and its consequences for inflation in the short term, but we must hold ourselves accountable for the longer-term consequences of our choices. Should we maintain our accommodative stance for too much longer, my view is that we are likely to see higher trend inflation in the intermediate term and a ratcheting up of inflation expectations. If that scenario unfolds, it will take a much more costly policy action to re-anchor those expectations than the cost of a preemptive move to raise the funds rate in the near term. To be sure, shifting policy to a less accommodative stance will be a difficult decision to make, given the continued volatility in financial markets and the projected near-term weakness in employment and output growth. However, what has been referred to as the tail risk of a very negative growth outcome has decreased since the start of the year, whereas inflation risks have increased. I think the enhancements we have made to our liquidity facilities should be sufficient to address any remaining dysfunctions in the financial markets, but they will not address the credit or solvency issues, nor should we expect them or desire them to do so. The markets will have to do that admittedly heavy lifting. I do not believe that we can wait until employment growth and the financial markets have completely turned around to begin to reverse course. But by our aggressive attention to short-term risk to growth and financial turmoil, we do put at some risk our ability to deliver on our intermediate- and longer-term goals of both price stability and sustainable growth. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Why don’t we take a coffee break until 11:20. [Coffee break] August 5, 2008 64 of 145 CHAIRMAN BERNANKE. Okay. President Rosengren. MR. ROSENGREN. Thank you, Mr. Chairman. The Boston forecast used for the June meeting expected that the unemployment rate would peak at approximately 5.7 percent. Unfortunately, with the July employment report, the unemployment rate has already reached 5.7 percent, and we expect the economy is likely to grow less than potential for the next several quarters. With the unemployment rate rising in the past three months by 0.7 percentage point and payroll employment declining for the past six months, I am concerned that there remains a significant risk that the second half of this year would look a lot like the “severe financial stress” or “typical recession” scenarios. My concern reflects the potential impact of further deterioration among financial institutions and financial markets that may create a significant headwind for the economy and the likelihood that economic problems are growing in other countries, which would slow one of the few bright spots in the economy—exports. Since our last meeting, much has been written about the problems at the GSEs. Concern with the viability of the GSEs and potential future losses has contributed to mortgage rates rising despite our past easing, the weak economy, and diminished demand for mortgages. With financial institutions showing little interest in lending to subprime or jumbo borrowers, the increased cost for individuals that qualify for conforming loans is likely to weaken the one part of the housing market that had been relatively resilient to financial problems to date. For potential buyers, higher interest rates and the likelihood that housing prices will continue to fall provide little current incentive to purchase a home, while the job losses are providing an immediate need for some owners to sell their homes. We need the housing market and housing prices to stabilize, which I had hoped would occur in the second half of this year, but now it looks as though it will be deferred until next year. August 5, 2008 65 of 145 Falling housing prices have created significant collateral damage. Liquidity problems that began one year ago remain in play. The capital-constrained financial institutions that are forced to shrink their balance sheets may pose a significant additional problem in the second half of this year. While many of the largest banks that suffered significant losses last year were able to raise additional capital fairly readily, the capital losses on newly issued bank equity may have reduced many investors’ appetite for providing new capital for banks until it is clear that the economy is recovering. The falling national housing prices and problems in commercial real estate in some sectors of the economy are now affecting regional and community banking institutions, many of which are unlikely to get equity infusions and thus will be forced to shrink. A reduction in the willingness to lend, as represented by the Senior Loan Officer Opinion Survey, has often portended a reduction in credit to bank-dependent borrowers. As we get a more traditional credit crunch compounding the liquidity problems, I am concerned that credit will be less available to consumers and businesses and further slow consumption and business investment. Since the June meeting, the stock market has fallen 7 percent; and with the number of large financial institutions experiencing very elevated CDS spreads and stock prices in the single digits, the failure of one or more relatively large domestic or foreign financial institutions is a real possibility. In such an environment, the assumption of annual equity prices rising 7 percent in the rest of this year and 12 percent in 2009 as assumed in the Greenbook would seem to have some significant downside risk. Elevated unemployment rates and a flat or slightly falling trend in wage and salary inflation suggest an absence of the inflationary pressures in labor markets that would lead to rising inflation once energy and food prices stabilize. These factors give me some confidence that we will see core and total inflation in 2009 close to 2 percent. Since our last meeting, labor markets have been weaker than expected, and oil August 5, 2008 66 of 145 prices and many other commodity prices have fallen, in part as a result of the concern with a slowing global economy. Although total inflation measures are clearly higher than any of us would want, these readings appear to be transitory responses to supply shocks that are not flowing through to labor markets. In fact, evidence from the labor market would seem to indicate that the downside risks to the economy are affecting labor markets through job losses but are not creating an environment in which labor tries to offset supply shocks with higher wage demands. Thank you. CHAIRMAN BERNANKE. Thank you. President Lacker. MR. LACKER. Thank you, Mr. Chairman. Before I begin, let me add my words of welcome to Betsy Duke, welcoming Governor Duke back to the Federal Reserve System. I say “back” because she has served excellently on our board of directors beginning almost 1 years ago. She’s a fast friend and strong supporter of the Federal Reserve System. I’m delighted that the long wait for her installation is over, and I look forward to working with her; but I don’t want any of my compliments to her to be detrimental to her effectiveness. [Laughter] The Fifth District economy has remained weak in recent weeks. Manufacturing and service sector activity fell. Real estate conditions remain sluggish. Labor markets remain soft. Export activity remains the bright spot, with reports of sustained growth in outbound cargo at District ports. In a new development, however, manufacturers’ expectations for the very near future turned negative in our most recent survey. This is very unusual. Respondents are typically relatively optimistic about things six months from now. Retail contacts indicate that the decline in sales broadened in July in our survey, and there aren’t many reports mentioning the effect of tax stimulus checks. Price expectations for both raw materials and final goods rose in our July survey, and some of those measures are at record highs. August 5, 2008 67 of 145 At the national level, my outlook for real growth is broadly consistent with the Greenbook’s this time. I expect sluggish growth to continue through the remainder of the year, with a pickup beginning sometime next year. Housing is likely to continue to be a drag, though a diminishing one, until then. Consumer spending is likely to remain subdued, and business investment is likely to moderate somewhat. I expect payroll employment to continue to decline for a while at about the current pace—a pace that, as others have noted, is quite modest relative to what we typically see in a recession. I think the most likely outcome is for us to continue to skirt an outright recession. I think there is some risk of a broader and sharper contraction. I believe the magnitude of that risk is modest, but it’s not negligible to me. Business investment could deteriorate, a risk that’s most prominent in the nonresidential construction sector that we discussed earlier. But this is a small component of aggregate demand, smaller than housing; and given the nature of gestation lags in this sector, I think a downturn is likely to be gradual rather than abrupt. Household spending probably poses the greatest risk to growth at this point. Consumer spending has flattened out in real terms, although that’s what one would expect given the increase in food and energy prices that we’ve seen. Given the difficulty of assessing the extent to which tax rebates are propping up consumer spending right now, we do not know how much Q4 consumption is going to be affected by the stimulus rolling off. Potential growth effects of credit constraints or financial headwinds have gotten a lot of attention these days. I remain skeptical about the magnitude of the drag on consumption and investment spending that credit market conditions are likely to create. We have, of course, seen reports in the Senior Loan Officer Opinion Survey of tightened credit terms, but through June both C&I and consumer loans have continued to grow. I would note that we are hearing in the Fifth District concerns from some of our smaller institutions that some large banks are bidding August 5, 2008 68 of 145 aggressively for deposits—this has been going on for several months now, of course—and as a result, the smaller banks are paying more to fund their loans. We’re also hearing now—and this is a new report—of larger banks cutting back on fed funds lending to smaller institutions, no doubt out of a concern about possible bank failures. What I think we’re seeing in banking markets is more of a reallocation of activity among banks. Different institutions have been affected very differently by recent events depending on the strategies they chose to pursue in the years preceding this episode. As a consequence, intermediation is just shifting from some institutions to others. In fact, we’ve heard of banks picking up business that other banks are shedding. Anecdotes about particular banks cutting back on lending thus need to be taken with a grain of salt, and I don’t think they’re necessarily representative of the banking sector as a whole. In fact, there was a really egregious case in the New York Times of people not getting credit from banks because of this credit crunch. In paragraph 6, one is introduced to their lead anecdote: a borrower at Wachovia who was denied credit. In paragraph 22, we find out that he actually got credit two weeks later at this same institution. So I’m a little skeptical about all of this anecdotal evidence about credit constraints. It’s undoubtedly the case that credit standards have tightened, but the environment is such that a lot of borrowers have gotten genuinely weaker. I mention all of this just because it influences how I feel about arguments that credit market conditions make the current level of the real funds rate any less meaningful as an indicator of the stance of monetary policy. I just don’t find those arguments convincing right now. The real funds rate using the Greenbook’s forecast of overall inflation four quarters ahead is lower than it has been at any time since the 1970s. In fact, this measure is about 1½ percentage points lower than the lows August 5, 2008 69 of 145 it reached in 2003 or 1994, and I think this is to my mind a better way to measure the actual real federal funds rate than what’s plotted in the Bluebook. The Greenbook forecast is that core PCE inflation will rise to 2.6 percent for the second half of this year and then gradually subside to 1¾ percent a year or so after that. This forecast is a very risky path, I believe, because at any point along that hump, higher inflation could well become embedded in expectations. I think getting back to price stability after this episode is going to depend critically on the stability of inflation expectations, as many of you have noted. It is true that TIPS compensation measures have been reasonably steady for a few months and that wage rates show no sign of accelerating as yet. But if we wait to raise rates until wage rates accelerate or TIPS measures spike, we will have waited too long. I think that’s very clear, and it will cost us too much to recover our credibility. Accordingly, I believe that the biggest policy risk we’re going to be facing in the months ahead is the risk of waiting too long. In past episodes of economic or financial weakness, we’ve been unwilling at times to raise the funds rate until we were almost completely certain that economic recovery would be sustained. I do not think that we can afford that luxury at the present time. The risk is too great that inflation expectations will ratchet up again. We need to be prepared to raise rates even if growth is not back to potential and even if financial markets are not yet tranquil, and we need to be prepared to raise rates even if we think that we might have to reverse course. After all, we cut rates aggressively even though we were not certain that a recession was in store for us and, in part, on the grounds that we could reverse course if it proved that we cut too far. To insist on more certainty to raise rates than to reduce them would introduce a fatal asymmetry in our reaction function. August 5, 2008 70 of 145 Let me add a comment or two inspired by some of the discussion around the table. I want to commend President Bullard’s discussion of systemic risk. You mentioned this earlier in your Q&A session, Mr. Chairman. This is a notoriously slippery concept. In popular usage, it seems to mean an episode in which one bad thing happens followed by a lot of other seemingly related bad things happening, and as such, it’s a purely empirical notion without any content or usefulness by itself as a guide to policy. It doesn’t say whether those other bad things are efficient—things that ought to happen—or inefficient and preventable by suitable policy intervention. To invoke the notion of systemic risk to support a particular policy course requires theory. I spoke about theory last night, but it requires some theory, some coherent understanding of the way you think the world works. The theoretical literature related to systemic risk is relatively young, and this isn’t the place to go into it. I’ve said before that I think it would be useful for this Committee to learn more about this. The Committee might be surprised that the literature provides only relatively tenuous rationales—I think is a fair judgment—for policy intervention. I hope, Mr. Chairman, that the group you’ve commissioned to study the meaning of unusual and exigent circumstances can explore this terrain in a little more depth. Going forward, I think our deliberations would be aided if we were to strive to put our theoretical frameworks on the table when discussing how financial markets work and what we ought to do about them. In case there’s any suspense, for my own money—and this is just one man’s view—I haven’t seen a convincing case for the existence of policy-relevant market failures in the financial markets in which we’ve intervened, apart from the usual distortions owing to the federal financial safety net. We systematically expanded that safety net. I believe what we’ve done has been to subsidize selected borrower classes and prop up prices of various financial assets, and I think the August 5, 2008 71 of 145 problem we face now is the tremendous dependency of financial institutions and markets on our credit. Thank you. CHAIRMAN BERNANKE. Thank you. President Stern. MR. STERN. Thank you, Mr. Chairman. Let me make just a few comments about the Greenbook forecast at this point, which I found quite useful for thinking about policy going forward only in part because it is quite close, at least in broad overview, to the forecast I submitted before the June meeting on the economic outlook, inflation, and so forth. In any event, given the alignment in these forecasts, I think there are several characteristics worth emphasizing. First, financial headwinds persist—we have talked about this for quite a while—and the Greenbook now assumes more stress and more persistence than it assumed earlier. Second, the inventory overhang in housing persists with negative implications for activity and for prices in that sector. Third, real growth is subdued over the next several quarters at least. Against the background of the Greenbook forecast, growth over the balance of this year in excess of 1 percent in real terms would have to be considered a positive surprise. Growth in excess of trend next year would have to be considered a positive surprise. Finally, with regard to inflation, headline inflation abates after the current quarter, although overall both headline inflation and core inflation remain above 2 percent through 2009. I realize that there’s considerable uncertainty surrounding all of that and that not everybody shares that assessment, but I think it’s worth emphasizing those features because we need to try to think several months and several quarters ahead in terms of the environment in which we will be making policy decisions. If these forecasts are at least in the ballpark—at the risk of perhaps belaboring the obvious—it seems to me that a major message of those forecasts is that the policy environment is likely to remain significantly challenging for several more quarters at least. I could put that another way. It seems that evolving readings on the economy and inflation are not likely to August 5, 2008 72 of 145 line up appreciably at all with either aspect of the dual mandate over the next several quarters. Thank you. CHAIRMAN BERNANKE. Thank you. President Hoenig. MR. HOENIG. Mr. Chairman, let me say that the Tenth District probably, on the whole, performed a little better than the national average in the industries that we have; but in terms of job growth, it has slowed. At the same time, we’re still adding jobs in the region, and our unemployment rate remains relatively low compared with national measures. Although wage pressures actually do show some elevation relative to our Beige Book survey, they have obviously eased a bit in recent months. But it’s interesting that, as we talk and monitor the labor conditions and we talk to some of the labor unions, there is a great understanding that they’re losing ground. They are going to begin entering contracts at the end of this year and in the next year, and how they approach that is extremely important because, again, they are looking and talking now about costof-living adjustments and those sorts of things, which gives me some pause. According to our manufacturing survey, our activity actually strengthened in July, although the expectations for future activity have diminished somewhat. Not surprisingly, manufacturers producing energy and agriculture and in export-related markets continue to operate at relatively high levels whereas the other areas within the District are showing some slowdown. Let me talk just a second about oil. Although oil prices have declined, as was noted, they are still high enough that capital spending and production remain elevated and look to remain so in the foreseeable future. In fact, some of our industry contacts suggest that, as long as expected prices for oil remain in the $70 to $80 range, there should continue to be a fair amount of investment in that particular sector. As you well know from reading the Wall Street Journal, we did have the SemGroup go bankrupt in the Tulsa area. It has had, I think, fairly confined effects. One of our August 5, 2008 73 of 145 regional banks took some pretty heavy losses. They’re very well capitalized and did recapitalize some of it, so they’ve not been dramatically affected by it. Local producers are in the worst bind because they haven’t been paid for some of the oil delivered and there’s no other party to contract with for future deliveries. So that has brought a lot of uncertainty in the local area about where to provide some of this oil that they’re producing. In my discussions with businesses around the District, it’s interesting that there’s a lot more conversation about and focus on managing your price strategy in this environment. As has been true for a while, fuel surcharges are prevalent, and firms are able to pass those along with a fair amount of ease. In addition, businesses are reporting that materials suppliers are placing 10-day to 30-day time limits on their price quotes. Finally, most price indexes in our manufacturing survey remain near historically high levels, and plans for future pass-throughs have actually intensified. Turning to the national outlook, my outlook for growth has not changed materially since the last meeting. I expect that growth will slow in the second half because of these higher energy prices, some weakness in the labor market, and sluggish activity in some of the manufacturing sectors. The fact is that the uncertainty regarding the economic outlook is considerable, and downside risk to growth in the near-term future is there. These risks are being addressed, from our perspective, by our current stance of accommodative monetary policy. So we are addressing that uncertainty. The point I would like to make is that I’m less uncertain about the outlook for core inflation. We have seen erosion in longer-term inflation expectations, and I believe inflation risks have actually risen. If core inflation rises in the second half as expected, there is a real possibility that inflation expectations will become unanchored, especially if we maintain our current accommodative stance of policy. An expected leveling-off of food and energy prices and slack in the economy could help moderate upward pressure on inflation, but I do not think they will be August 5, 2008 74 of 145 enough to actually bring inflation down to an acceptable level. In fact, if we maintain the funds rate at 2 percent, I think inflation is more likely to move higher than lower over the medium term, and that concerns me. Thank you. CHAIRMAN BERNANKE. Thank you. Vice Chairman. VICE CHAIRMAN GEITHNER. Thank you, Mr. Chairman. Like the Greenbook, our modal forecast shows weaker real activity and slightly higher core inflation over the forecast period. Downside risks to growth remain substantial, in my view, and have probably increased relative to what we thought in June. Risks on the inflation front remain weighted to the upside, perhaps somewhat less than in June, but this is hard to know with confidence. The adverse growth risks are worse for several reasons. The labor market and labor income are weakening more quickly than expected. Although there were some tentative signs of stabilization of housing demand in the spring, demand seems to have fallen further since. Credit conditions are tighter and are expected to be tighter longer, and this seems likely to produce a further deterioration in overall demand—note, of course, the reduction in credit for autos, the rise in mortgage rates, and the more conservative lending standards for consumer and corporate credit. Growth outside the United States seems likely to slow further. Of course, fundamental to this dynamic, as has been true for 12 months, each shift in perceptions that the bottom in overall economic growth is further away produces additional stress for financial institutions and markets, adding to the intensity of prospective financial headwinds and to concerns about downside risks to growth. Now, the adverse tail on the inflation front remains significant. Many measures of underlying inflation suggest a broad-based, if limited to date, acceleration in the rate of underlying inflation. Market- and survey-based measures of long-term expectations are high. Surveys suggest that firms are able to pass on some part of the acceleration in energy and materials costs. On the August 5, 2008 75 of 145 more positive side, energy, commodity, and materials prices have declined significantly, principally it seems because of expectations of slower growth in global demand. Growth is moderating significantly around the world, and it’s going to have to moderate further in the most populous parts of the world as central banks there get monetary policy tighter. The growth of unit labor costs has been and is expected to be very moderate here. Profit margins still show plenty of room to absorb cost increases, and as David reminded us, you can have a relatively benign outlook for the path of core inflation without margins narrowing very dramatically. Inflation expectations have not deteriorated meaningfully here, even with the flatter expected path of monetary policy in the United States. Of course, it’s very important that inflation expectations and pricing power moderate from current levels. If some of the downside risks to growth materialize, this will happen, and inflation risks will moderate. If, however, the economy continues to prove to be resilient to these downside risks, then we will face higher inflation. On balance, the rate of growth in underlying inflation suggests that growth in demand in the United States will have to be below potential for a longer period of time if inflation expectations are to come down sufficiently. This means that we will have to tighten monetary policy relatively soon compared with our previous behavior in recoveries—perhaps before we see the actual bottom in house prices and the actual peak in unemployment. However, at this point, the risks to real growth remain critical. In my view, we need to have more confidence that we have substantially reduced the risks of a much sharper, more protracted decline in growth before we begin to tighten. I think it is unlikely that we will be able or will need to move before early next year. Short-term market expectations for monetary policy in the United States seem about right at present. I don’t see a strong case for trying to alter those expectations in either direction at this point. To try to pull forward the expected tightening would risk adding to the August 5, 2008 76 of 145 downside risk to growth and magnifying the risk of a much more severe financial crisis. On the other hand, if we avoid some of these downside risks to growth, then policy will need to tighten more quickly, perhaps, than the expected path now priced in the markets. The evolution of monetary policy expectations and of inflation expectations since May illustrates how uncertain the markets are about what path of policy will be appropriate. But the pattern of changes in both of these measures of expectations suggests that the markets believe we will get this balance right—that we will do enough soon enough to keep underlying inflation expectations from eroding materially. Thank you. CHAIRMAN BERNANKE. Thank you. Governor Kohn. MR. KOHN. Thank you, Mr. Chairman. Like others around the table, I made only small revisions to the central tendency of my forecast going forward as a result of the developments of the intermeeting period, maybe a slight reduction in the path of output and a quicker decline in headline inflation owing to the oil prices. But I think more important than any shift in central tendencies is the sense that the information tends to reinforce—to reduce the uncertainties around—the basic contours of a projection in which the economy operates with a wider output gap and a lower inflation rate on balance over the next 18 months or so than it has over recent quarters. About the output gap, the incoming information strongly suggests that we are on a trajectory that at least for some time will have the economy growing appreciably below the growth rate of its potential. The most obvious evidence is the persistence of a soft labor market—continuing declines in employment and no sign of near-term strengthening in the initial claims data. I agree that the declines in employment, as several of you have pointed out, are not consistent with a recession, but they’re certainly not consistent with the economy growing close to its potential. You need another August 5, 2008 77 of 145 150,000 or 200,000 jobs rather than minus 60,000, which is where we are now. So I think the economy is likely to grow below potential for some time. Even on the spending side, the decline in consumption in June, when rebate checks were continuing to hit bank accounts, and a further sharp drop in auto sales in July might be early signs that households are beginning to pull back under pressure from higher energy prices, job worries, declining house values, and reduced credit availability. To be sure, one month’s consumption data along with auto sales, which are subject to all kinds of idiosyncratic influences, are not enough to justify a major change in outlook. But as President Lacker noted, household spending has for some time been a source of downside risk to the forecast. At some point, household spending could begin to reflect attitudes, and this information at a minimum seems to underline those risks as well as to point to sluggish growth of spending in the third quarter. Soggy economic news has extended to our trading partners, where actual activity and expected activity also have been marked down. The tone of news from abroad has been decidedly downbeat, as those economies feel the effect of weaker purchases from the United States, continuing financial strain, softening housing markets, and higher energy prices. Much as in the United States, attitudes abroad seem weaker than the data; but the euro area did report a record decline in retail sales in June this morning, and my sense is that our trading partners are facing larger downside risks to growth as well as a markdown of central tendencies. The dollar hasn’t changed much on balance for four or five months now. With a stable dollar and weaker demand abroad, production in the United States will be getting a lot less cushion from net exports over the next few quarters than it did in the first half of the year. Finally, despite the downward movement in Treasury interest rates and in the expected federal funds rate path, financial conditions for households and businesses have tightened since the August 5, 2008 78 of 145 last FOMC meeting. Savers and intermediaries have become even more cautious amid concerns about deepening losses spreading beyond subprime mortgages, about the safety of uninsured deposits at regional banks, high volatility in markets, and the possible weakening of the underlying macro situation. Lenders are hunkering down to endure a long period of rising credit problems and great uncertainty. I don’t think we need to rely on anecdotes here. Mortgage interest rates have actually risen on balance, as have corporate bond yields across many risk categories; and in many of these cases, the nominal interest rates are at least as high as or in some cases much higher than they were last August when the federal funds rate was at 5¼. Banks continue to tighten terms and standards for nearly all categories of loans. Equity prices have fallen, adding to the downward pressure on wealth from declining house prices, and I think these developments underscore the very slow recovery likely in financial markets and the possible downside risks relative to even that very gradual improvement that many of us were expecting. The tightening of conditions is damping credit growth broadly defined and will constrain, at least to some extent, spending going forward, delaying the return to trend or above-trend growth. Thus although uncertainties remain quite elevated, I think we can be a little more confident that the economy will be subject to further quarters of below-trend growth and declining resource utilization. Furthermore, with housing prices still falling fast, inventories of homes still high, and financial markets quite skittish, the downside risks even to a slightly lower central tendency forecast remain high. Greater confidence that output will grow below potential for a time contributes to a little more optimism on my part that inflation will, indeed, come down substantially over the coming quarters. An environment of rising unemployment and declining capacity utilization is not one in which businesses or labor will find it easy to restore real incomes or raise profit margins after the increase in energy prices. August 5, 2008 79 of 145 With regard to that increase in energy and other commodity prices and how it affects headline inflation, I like to differentiate pass-through from spillover. I think we can expect passthrough. Pass-through to consumer prices of the higher energy and commodity prices is part of the adjustment process by which demand gets damped and by which consumers realize, unfortunately, the lower real income that they get from the adverse terms of trade. So the fact that businesses are able to pass through higher commodity prices and higher petroleum prices I don’t find all that worrisome, provided that they’re passing through a one-time increase in prices rather than a continuing rise. I think we have some further evidence that at least to date—things could change, I admit—what we are seeing is a pass-through of a one-time rise rather than some continuing increases. For one thing, commodity prices, as shown in Bill’s chart, have flattened out or actually declined in the past few months. So presumably that pass-through is a one-time jump, if that’s what they’re doing, passing through those prices. Second, I think we saw in the GDP chain-type price indexes that the price of domestic value added increased at an annual rate of only 1.1 percent in the second quarter—which suggests to me that, at least through the second quarter, there was very little spillover from these higher commodity and energy prices to the stuff we produce here at home. Also, labor compensation growth, which could be a lagging indicator, at least to date hasn’t increased. If anything, it has slowed a little further, which along with relatively robust productivity growth is holding down unit labor costs. Headline inflation—the goods and services that people purchase—has been high. Energy prices are being passed through, but I think to date there’s no evidence or very little evidence that it’s spilling over into other prices in the economy. So this is about the adjustment to relative prices. Obviously the decline in oil prices, if it holds, will be helpful on the inflation front, both in its direct effect on headline inflation and its indirect effect on inflation expectations. We finally have evidence of two-way risk in oil prices, and that should make August 5, 2008 80 of 145 us more comfortable with an assumption of stable prices as a reasonable basis for forecasting. Other recent contributors to higher price levels have also become less averse. As I mentioned, other industrial commodity prices have leveled out or declined, and the dollar has been relatively stable in recent months. Although I feel a little more confident about the expectation of lower inflation going forward, I agree that upside risks still prevail. Core inflation has ticked up. Headline inflation will be high for some time and could threaten to spill over through increases in inflation expectations. Oil and commodity price declines are largely an endogenous response to perceptions of weak growth, and if those perceptions turn around, so will those prices. Longer-term inflation expectations remain elevated by some measures and are probably less well anchored than they were a couple of years ago, before oil and commodity prices rose so much. In sum, I see upside risks to both the inflation gaps and the output gaps as having diminished over the intermeeting period, and we’ll get to the implications of that for policy in the next part of the meeting. CHAIRMAN BERNANKE. Thank you. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. I have no material changes to report in my view on the overall state of financial stability, growth, or inflation; but as I talked about at the last meeting, it still is likely to be a long, hot summer, and we’re only about half over with it. I’ll talk first about financial institutions—make maybe four or five points—and then turn quickly to the economy and inflation. First, on financial institutions, I think the body blow that the financial markets and the real economy have taken because of the turmoil at the GSEs is not complete. It is easy for those of us in Washington to forget that bill signings don’t always solve problems. I’d say, if the last thing that happens on GSEs is that the bill was signed two weeks ago and action isn’t taken in the coming August 5, 2008 81 of 145 weeks and months, then I would be surprised if we could get through this period without more GSE turmoil finding its way onto the front pages. Second, in terms of financial market conditions, the fall in oil prices and the rest of the energy complex is, indeed, good news, but it strikes me that it has camouflaged an even tougher period for financial institutions than would otherwise be the case. That is, financial institutions somehow look a little more resilient, but I think part of that is only because of the negative correlation that’s developed in recent times between equity prices of financials and oil prices. The financial institutions themselves strike me as being in worse condition than market prices would suggest. Third, capital raising, as we have long talked about, is essential to the fix among financial institutions. The way I best describe capital raising over maybe the last nine months is that the first round of capital raising, which was in November and December, was really the vanity round. This consisted of very limited due diligence, sovereign wealth funds signing up, issuers relying upon their vaunted global brands, and capital being raised in a matter of days. The second round probably took us to the spring, a round that I’d call the confessional round. [Laughter] In this round, financial institutions said, “Oh my, look at these real write-downs that I have. Look at the need for this real capital raising, and here I’m telling you, the investors, all that I know.” But the second and third confessions usually have less credibility than the first. The third round is the round that we’re in the middle of, which I think of as the liquidation and recap round, likely to be the hardest round to pull off. It is likely to force issuers of new shares or of new forms of preferred stock to be asking of themselves and their investors the toughest choices. They have to assess the strength and durability of their core franchises. I think that this will be happening in very real time. So the circumstance of an investment bank that Bill mentioned at the outset I don’t think will be the sole case of this. This liquidation and recap round is later than would be ideal from the perspective August 5, 2008 82 of 145 of the broader economy, but it is absolutely needed. Until we see how it occurs, it’s hard for me to be much more sanguine that the capital markets or the credit markets will be returning to anything like normal anytime soon. Let me make a fourth broad point about financial institutions. Because of these different phases of capital raise, I think management credibility among financial institutions is at least as suspect as it has ever been during this period. Even new management teams that have come in have in some ways used up a lot of their credibility. It would be nice to believe that they have taken all actions necessary to protect their franchises and their businesses, but most stakeholders are skeptical that they’ve taken significant or sufficient action. At the end of the day, no matter where policy comes out in terms of regulatory policy from the Fed and other bank regulators or accounting policy from the SEC or FASB, it strikes me that those changes in policy are less determinative of how things shake out. That is, management credibility is so in question that the cure is not likely to come from accounting rules or regulators but from the markets’ believing that what management says is what management believes and will act on it. As a result, I think that many of these financial institutions are operating in a zero-defect world, which is posing risks to the real economy. Fifth, let me make a final point about financials. We’ve all talked a lot about the effect of different curves for housing prices on the financial institutions themselves. I don’t mean to give short shrift to any of that, but I would say that the level of uncertainty and associated risks of their non-housing-related assets are now very much a focus. According to July 2008 data, of credit currently being extended by banks, only about 20 percent is for residential real estate. Only about 9 percent is for consumer credit. So that leaves the balance in areas where these financial institutions and their management teams have to be asking themselves whether the weaknesses that are emerging in the real economy will place uncertainty over assets that have nothing to do with August 5, 2008 83 of 145 housing. That’s a major downside risk for financial institutions and has not been much of a focus of shareholder and stakeholder concerns. There are two open issues that will guide some of our thinking, at least with respect to these credit markets. First, as we talked about a little last night with the presidents, are the embedded losses so great at such a critical mass of institutions with management credibility so low that many more than currently expected might be unable to survive? This is a question that I’m not sure I know the answer to. Second, despite the concerns about the effect of the credit markets on the broader economy that I talked about, our monetary policy may not be terribly well suited to be fixing those problems, and financial institutions may not be terribly sensitive to the extent we decide that we should change the stance of policy. Taking all that into account, let me say a couple of words about growth and inflation. First, on the economic growth front, given my views of what’s happening in the credit markets, it’s very hard for me to believe that the economy will get back to potential anytime soon. There are continued financial stresses that could last through year-end, and in there could be an upside surprise. Still, all things considered, my base case has second-half growth still above staff estimates owing in part to the productivity we’ve seen in recent months and the remarkable resiliency of this economy. If we look beyond that horizon, though, toward the Greenbook forecast in 2009 and beyond, I must say I don’t really see the inflection point to take us back to economic growth of 2.2 percent or whatever the Greenbook suggests. I think we’re going to be in this period of belowtrend growth for quite some time. My own view is that, when the Congress comes back after its August recess, we will be in the middle of a big debate on “Son of Stimulus” and that the stimulus probabilities have moved up quite materially. However, it is not at all obvious to me that it will do much in terms of helping the real economy. Outside the United States, I share the view of Governor August 5, 2008 84 of 145 Kohn, which is that I’d expect global GDP, particularly GDP among advanced foreign economies, our major trading partners, to continue to disappoint, making the remarkable addition of net export growth to our own GDP likely to dissipate. Turning finally to inflation, my view is that inflation risks are very real, and I believe that these risks are higher than growth risks. I don’t take that much comfort from the move in commodity prices since we last met. If that trend continues, then that would certainly be good news; but I must say I don’t feel as though inflation risks have moved down noticeably since we last had this discussion. The staff expects food prices to continue to be challenging; that is certainly my view. The staff also expects core import prices to fall rather precipitously. I’m a little skeptical of that view. I think it’s possible, but I don’t really see the catalyst for that given what we see about changes in input prices overseas and given expectations of the dollar in foreign exchange markets. So with that, I think that the inflation risks are real, and I’ll save the balance of my remarks for the next round. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. MR. KROSZNER. Thank you very much. We have now had the first anniversary of all the financial turmoil, and how have the markets celebrated? Well, we have had Freddie and Fannie go down and need one of the largest bailouts. We have had IndyMac go down—the second largest bank failure in U.S. history and perhaps the most costly bank failure in U.S. history. I am talking just in nominal terms; I haven’t actually done the real adjustments. Also, we’ve seen a variety of widening risk spreads. At the last meeting I went on with my standard metaphor of the slow burn and said that things could reignite, and I think we certainly have seen a few things reignite. I very much agree with Governor Warsh with respect to Freddie Mac and Fannie Mae that, although legislation has been passed, the devil will be in the implementation August 5, 2008 85 of 145 details. Simply because the Treasury has the capacity to do something, it is not quite clear what it will do or be able to do or how the markets will respond to that. Obviously, Freddie and Fannie have been really the only game in town for mortgage securitization. The jumbo markets have not been working. The subprime market is not there right now. So until and unless we can be assured that they will operate properly, they still have a lot of potential for more flames coming out. There are also a number of other reasons that I am still concerned about financial markets being very far from normal. One, reference was made to a study that we have done here at the Board that Nellie Liang is taking the lead on. New York has also done a study; I think they used very different methods but came out with similar numbers. The studies say that large losses are still to come and that total losses associated with the challenges that we have been seeing will be on the order of $900 billion. U.S. and European financial institutions have taken about $400 billion of write-downs. Not all of those losses will be on financial institutions’ balance sheets, but there certainly are potentially more losses to come—not only in mortgages, in leveraged loans, and in commercial real estate but also in the consumer parts of the portfolio and potentially other parts of the portfolio. A fragility is there, which has to be taken into account when we look at capital ratios. If you simply look at reported capital ratios, they are off their peaks of a few years ago. However, if you were to do a more-thorough mark-to-market on a lot of different pieces of the portfolio or if you did have to liquidate—even assuming it wasn’t a broad fire sale but just one institution that had to liquidate now and it had no further consequences for anyone else’s expectations, which I don’t think is accurate—you would see those capital ratios be in fact much, much thinner than they appear in an accounting sense. August 5, 2008 86 of 145 A number of people talked about the OIS spreads and said that things seem to be at 50 basis points rather than at 10 basis points. Well, that is true not only in the U.S. dollar but also in the euro and in sterling. If you look to the forward market, that number is increasing. It is not staying the same. It is going up quite a bit, to about 75 basis points over a year period for the dollar to 130 to 150 basis points in sterling and in euro. That suggests a lot more challenges to come. So even if 50 is the new 10, it is still a major challenge going forward. That puts a lot of pressure on banks to generate earnings to make up for the write-downs and other challenges. In the old days, when you could finance yourself at 10 basis points, the institutions were undertaking a lot of activities that would allow them to generate a lot of revenue, even if they kept taking hits in certain parts of their portfolio. But when funding is at 5 times that, or 10 times that, or 15 times that, a lot of activities that once were profitable are not profitable. The margins are much lower, and their ability to earn their way out of this is much, much more of a challenge. I think that is going to be even truer for the European institutions. That is actually one area in which I see it as more likely that an important shoe might drop, not just in the United States but in a major European institution. European institutions haven’t been as active in raising capital, and there are more constraints on their ability to raise capital, given the way rights issues work. I think that greater challenges are going to come in the European economies and that the ECB faces greater challenges in dealing with the increasing inflation threat that they have there and worldwide, while being able to provide some policy accommodation. Third, securitization markets have certainly not recovered. We have talked about that. The infrastructure investment that will be needed for these to come back in terms of data, contract certainty, et cetera is going to take a long, long time. It is not clear exactly how long, but it is clear that recovery will not be right around the corner. That means continuing pressure August 5, 2008 87 of 145 on banks’ balance sheets independent of all the other capital issues. If they just want to continue on, they have to keep a lot of things on their balance sheets. One bright light, just in case you see nothing positive, is that we were able to put off some very significant changes in accounting— FAS 140 and FIN 46(R). They were on a very fast track to make changes that could have brought literally trillions of dollars of assets back onto balance sheets and would have made it extremely difficult for securitization markets to work. That has been significantly delayed, and I think they will take a more balanced and measured approach. Not only has that been put off, but also the institutions will have more time to deal with it. But this pressure is real. The Senior Loan Officer Opinion Survey couldn’t be more crystal clear on the challenges that are there and that are likely to continue to be there. Why is that? Well, as a number of people have mentioned, it is because of challenges on the HELOC portfolios and on the option ARM portfolios and uncertainty about a lot of other pieces of the portfolios. So given my views, I am really glad that the Greenbook baseline has taken on board much more of what was previously a “delayed recovery” alternative simulation scenario, much in line with what President Stern mentioned. But I continue to see that the situation is quite brittle and that small pressures potentially can lead to large and rapid responses. The “severe financial stress” alternative simulation in the Greenbook is certainly not my central tendency one, but I think that we can’t dismiss it too easily because there still could be another—what I have now taken to calling, since I chair the supervision and regulation committee—flare-up with one of my problem children. Many of you know the problems in your Districts, but there are a lot of problems, unfortunately, in all the Districts and around the world. I hope no one will ever hear about the problems that my children are having, but sometimes they do come out. As Governor Warsh said, one way to try to deal August 5, 2008 88 of 145 with those is through capital. It is becoming increasingly difficult to do that. In the old days the accounting rules were such that you could take over an institution through so-called pooling accounting methods, so you would not face an immediate write-down of everything to current market values. One challenge we have with the institutions that are likely to be failing over time is that these accounting standards are no longer available, so it is very, very difficult to use the kinds of methods that have been used in the past by the FDIC and other regulators to avoid the IndyMac type of problems. It is quite possible that we will be seeing more people queuing up, and more people pulling money out of accounts, even though they are insured accounts. There has certainly not been a generalized drain from the banking system. There has been a recent shuffling, as President Lacker said. But it also makes a lot of institutions much, much more vulnerable than they have been in the past. If you look at the “severe financial stress” scenario in the Greenbook, what is interesting about it is that it is relatively benign. For something that is severe stress, the macroeconomic outcomes in terms of GDP and unemployment aren’t that severe because of the policy response—taking the federal funds rate down to ¾ percent. I don’t think we can possibly do that in the current environment. It is not that I think that inflation expectations have become unanchored or are not contained, but I do think that our policy responses are contained precisely because we can’t quite go there. If you look at the “inflationary spiral” scenario, it says that by 2009 the fed funds rate would have to go up to 3½ percent. I don’t think we are in that or anywhere close to that. But if we had to respond as the Greenbook said to bring the fed funds rate down below 1 percent, I think we would get close to that, and we would be in a very, very difficult position. August 5, 2008 89 of 145 We have to be very careful about inflation expectations. I think we have mixed evidence on inflation expectations and inflation, although I am heartened that things do not seem to have become unanchored. Some of both the market-based measures and the survey-based measures have come down a bit, although I think, as Governor Kohn said, that the situation is much more fragile. I don’t want to take on board too much comfort from the change in commodity prices because we have seen temporary movements up and we have seen temporary movements down. It is heartening, but I think we have to still be very, very careful on this issue. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Mishkin, your swan song. [Laughter] MR. MISHKIN. Well, I get one more chance in the policy round. That is the one I am going to really go for. I am sure that people are waiting for it. [Laughter] My modal forecast has not changed appreciably. Clearly, I am very concerned about the headwinds as a result of the difficulty in recapitalizing financial institutions, which Governor Warsh talked a lot about. As a result, I think that we are going to have subpotential growth for quite a period of time. However, the bigger concern is that I see downside risks as having risen substantially. So let me first talk about the things that are the less worrisome downside risks. I think there are increased downside risks just on the real side of the economy. In particular, the consumer has been very resilient, but I am not as sure that that will be true in the future. We just saw terrible auto sales. It could be just one month, and it could bounce back up. But it could be a precursor to much bigger problems, which would not be completely surprising given some of the other things going on with housing prices and credit restrictions. That is one downside risk. The second is that European growth may have shifted down, and so the kind of problems that we are August 5, 2008 90 of 145 experiencing here perhaps are being experienced there, particularly in terms of lower housing prices in some parts of the euro zone. That could mean less demand for our exports, and it would be another negative for economic activity. The third is that we have actually seen a backup in mortgage rates, and that can have a direct effect on housing demand. It is pretty grim when you look at what is going on in terms of housing starts, but it could get worse. It can’t go below zero, but it could get worse. So if that were all there was, I would say that there may be a little increase in downside risk, but it wouldn’t frighten me. But I really am very worried about the potential downside risks in the financial sector. I have to disagree very strenuously with the view that, because you have been in a “financial stress” situation for a period of time, there is no potential for systemic risk. In fact, I would argue that the opposite can be the case. Just as a reminder, remember that in the Great Depression, when—I can’t use the expression because it would be in the transcripts, but you know what I’m thinking—something hit the fan, [laughter] it actually occurred close to a year after the initial negative shock. In this particular environment, we have to think about where we started. We were very lucky that this financial disruption occurred when bank balance sheets actually were in very good shape initially. You know, thank our lucky stars that it happened at that point. We are now a year into this. Bank balance sheets do not look very good, for all the reasons that we have been discussing. In fact, they look pretty grim. We have had some failures, and we are concerned about other failures. So we have a very different environment. In that situation, if a shoe drops—and we have had big shoes dropping; we had Bear Stearns, we had the GSEs, and we had smaller cases like IndyMac—and if financial systems are in a very weakened state, really bad things could happen. I think that there really is a serious danger here. In August 5, 2008 91 of 145 particular, we could have a dynamic through a decline in demand for housing because of the backup in mortgage rates or other reasons lowering housing prices and that spilling over into the financial system in terms of raising credit spreads, which then lowers demand, and we could get a nasty, vicious spiral. It is exactly one of these adverse feedback loops that we are all concerned about. So this is not off the table, and it very much worries me. I will talk about the implications of that for policy later. On the inflation front, although I definitely see upside risks, I think they may have diminished just a smidgen. There is a question about how large those upside risks are. In terms of my thinking about what drives the inflation process, it is expectations about future output gaps and expectations about inflation over a long period, not a short-term period. I see absolutely no evidence that, in the last couple of months, we have had deterioration in long-term inflation expectations. If anything, they have gotten a little better since March. If you look at the numbers—and Bill had it in his picture—basically there was some ratcheting up when the crisis first hit. I would argue a lot of that had to do with inflation risk, because there really was increasing inflation risk. There has been a slight movement up—maybe a tenth, maybe you could say two-tenths—in expectations when you look at forecasters. I am very skeptical of consumer surveys because, exactly what behavioral economics tells us, there is framing. If headline inflation is high, short-term inflation expectations go up, which should happen, but long-term inflation expectations also go up. When headline goes down, then they will come down. There was a nice little article from the San Francisco Fed in one of those little letter deals on exactly this issue, which came up with exactly this conclusion. I recommend that you read it; and the good news is that it takes only four minutes to read because the articles are meant to be very short. So I really do not see that there has been deterioration, August 5, 2008 92 of 145 and—I think that this is very important—it is why I stressed the issue of the analytic framework for thinking about the inflation process and what monetary policy can do. We can’t control relative prices, but we can do something about long-run inflation expectations and expectations about future output gaps. So I haven’t seen a problem lately that there has been deterioration in long-run expectations. What about output gaps? Well, if anything, they look as though they are expected to widen maybe a smidgen, not that much. We don’t have any indication to expect that we will be overshooting in terms of having output greater than potential. Again, that should not be raising inflation. It should, if anything, maybe lower it a bit. Finally, of course, oil prices are lower. I don’t think that means that they will stay low because the volatility is huge; but at least the fear that they are going to keep on going up and up and up—so it would not be a one-shot change but would be put into long-run inflation—has, I think, diminished somewhat. So where do I stand in terms of the upside risk? There still is upside risk because having high headline inflation does have the potential to spill over into inflation expectations. All of us have that concern. But I want to emphasize very strongly that it has not happened yet; I think that is very important. I also think it is very important to monitor this. One concern that members of the Committee have is that we wouldn’t react fast enough because we have sometimes been inertial in the past. That is a serious concern. But I think there is a strong argument that, when you have very big downside risks to economic activity, you want to deal with inflation expectations when they actually indicate that there is some problem. And I just do not see that at this juncture. Thank you very much. CHAIRMAN BERNANKE. Thank you. Governor Duke. August 5, 2008 93 of 145 MS. DUKE. Thank you, Mr. Chairman. I was advised to speak of things I know, so all of my comments will have to do with commercial banks and the traditional banking operations within those banks. Also, they are limited to the market area that I operated in. I was in a large community bank. The primary competitors were 2 of the top 5 banks and 4 of the top 20 banks. I hope to expand that on the supervision committee. I guess the major observation I would have is that I can’t see lending growth ever resuming until the market for financial stocks improves. That market is not going to improve until it is clear that the credit risk is manageable. I haven’t seen the confidence in banking and banking institutions this low since we were well into the S&L crisis back in the early 1990s. At the same time, the credit numbers—or at least the commercial banks’ part of the credit numbers—don’t look all that bad. At this point, we are sharing those credit losses with a number of other types of institutions, and I think the banks got the better slice of that pie. So I do believe that the banks will be able to manage through this. On the equity side of things, you have had equity destroyed through credit losses, and so those banks are certainly reducing their lending. I don’t think there is enough capital in the system. I don’t think earnings are strong enough. There is certainly no external capital available to pick up that slack. So while you hear smaller banks say, “We are getting great business now because the larger banks have cut back on their lending,” they just don’t have the capacity to take in that business. No matter why they are trying to raise capital, capital issuance is viewed as a sign of weakness. It is scarce. It is expensive. The short selling has been just amazing. It has really driven down the prices. For some of the larger banks, it is running anywhere from 10 to 15 percent of total float. It has even gotten down into banks smaller than $5 billion. I was looking at one, and the short interest on July 15 was 10 times that of April 15. It was running August 5, 2008 94 of 145 about 7 percent of float on a very thinly traded stock. I can’t believe that it has anything to do with the fundamentals of the institution. It is just all being painted with the same brush. For institutions that must raise capital or fail, my concern is that the capital that is being raised or being offered comes with an exit strategy. I don’t think that the capital is going to have the patience to wait for a longer-term resumption of lending. Those that do have capital cushions seem to be spending them on small buybacks or dividend increases in an effort to demonstrate some confidence in the future. On the liquidity side, central core funding is very tight and incredibly uncertain. CD rates do remain high, and as one institution after another desperately needs money, they raise the rates. As one falls out of that situation, somebody else picks it up again. After the full weekend of IndyMac coverage in the press, the phones just lit up everywhere asking about FDIC insurance. Now there is a renewed interest in the CDARS program. I didn’t realize that these deposits are classified as brokered deposits. It will be interesting to see if we have a big jump in brokered deposits in the next couple of quarters. The Home Loan Banks are tightening their collateral requirements. They are introducing risk rating systems, so that source of funding is not as available as it was. Nonconforming mortgages are impossible to place. On the asset side, I talked to several correspondent bankers, and they have been told to cut their overall fed funds lines sometimes in half. It doesn’t matter who it is, just cut them in half. A number of the banks are cutting home equity lines across the board and freezing those lines. The full-relationship lending is prized, but even in that it is only to the extent that lending is in some ways self funding. Transaction deals are like hot potatoes; nobody wants to touch them. August 5, 2008 95 of 145 We had some calls from other bankers who were asking what liquidity premium we were adding to our pricing, so there is clearly a change in the pricing, which may actually improve profitability. However, I think a lot of it is in order not to turn down the credit but simply to price out the credit, so that the borrower makes the decision not to borrow rather than the bank making the decision not to lend. On the credit side, the reserve additions have been incredibly dramatic, but a lot of that is because reserve levels were so low going into this. Capital was strong, earnings were strong, but reserve levels were down at 70 or 80 basis points. I had not ever seen them below 1 percent until two or three years ago. That is because of the change in the accounting for reserves as well as 10 years of no demonstrable losses. Oddly enough, the charge-off and delinquency rates really don’t look all that bad. When I looked at first-quarter rates, they didn’t look a whole lot different from what used to be the norm, at least in terms of commercial loans. Then, on the consumer side, in this case it was mortgage loans versus consumer loans, but still a 75 basis point loss on consumer loans historically was actually normal. It is really difficult to follow any discussion of what is going on in terms of credit losses because you get confused between what is mark-to-market loss, what is actual credit loss, what are charge-offs, what are reserves, and then who owns those losses. I am not quite sure what the rate of deterioration or the rate of resolution is. In terms of collection, it takes an awful lot of time to ramp up collection and recovery efforts, and I don’t know where we are in that cycle, but I think we have a long way to go. The last cycle was all about commercial real estate, and nobody could work up much sympathy for commercial real estate developers. [Laughter] In this situation, there is so much political sensitivity around foreclosures that I think it is going to be much elongated. When a August 5, 2008 96 of 145 borrower cannot or will not pay and you can’t restructure it to create capacity or willingness to pay, then some form of forced sale is the only thing that gets you off go. I think that has been pushed out and pushed out. It is also the only way to clear any junior liens. This process is expensive and time-consuming, and owning the property is even more expensive. So as the lender-owned properties become a larger and larger segment of the properties for sale, I do think price declines are going to accelerate significantly. I will be watching the IndyMac resolution particularly closely. In the last cycle, if you will remember, the properties that were sold by the RTC brought the biggest discounts of all. So it will be interesting to see what this theory of holding off on foreclosures and then at some later point having to move the assets actually does to prices. The good news is that once lenders start selling, they do tend to move units at whatever price it takes. Lenders are going to have to do that. There is no justification for wasting precious capital or liquidity on dead assets. But there is also no justification for selling the portfolios at fire sale prices if the net realizable value of collecting them is higher, and I think it definitely is for the banks. Finally, if I could take one more minute, I did do some very in-depth personal research on the housing decisions of a relocating worker. [Laughter] I purchased a residence in January ’06 for a May ’06 closing and hit the peak. The current value, I am told, is 80 to 85 percent of the purchase price, marketing time 6 to 12 months. The purchase in the new location—I did do the calculation—it was 15 to 20 times annual rent, but that didn’t matter. I had already had all the thrill of ownership that I could stand and will be renting. [Laughter] The second thing is that, if I had financed this property at 80 percent, I would have had no equity to roll into a new purchase anyway, so there would have been no decision involved. The good news is that as long as there is no need to sell, the price doesn’t matter, and I could have waited it out very easily. So the August 5, 2008 97 of 145 conclusion that I came to is that this current elevated inventory we have of housing includes only those who absolutely have to sell because nobody in this market would choose to sell. So once that begins to turn around, again, there just have to be a whole lot of pent-up houses for sale. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Michelle, what time is our hard cutoff here? MS. SMITH. We can be pretty flexible. We’re okay. CHAIRMAN BERNANKE. You want it before 2:15, though. All right. Well, I spent a lot of time through the meeting and during the break working up a crystalline summary of the discussion. [Laughter] But I am a bit concerned about getting to lunch and avoiding the 2:15 hard deadline; so if you would excuse me, this time I will just go directly to a few comments of my own, and then we can go to the policy round. We saw growth of about 2 percent in the second quarter, which suggests a campaign slogan for the Republicans, “The Economy: It Could Be Worse.” [Laughter] The question, though, is whether this higher-than-expected growth rate in the second quarter implies that we are actually looking forward to a better-than-expected remainder of the year or whether this was in some sense a last hurrah of borrowing from the future. I feel that I am very strongly in the latter camp, unfortunately. I do think that, for reasons people have talked about, the remainder of the year and into next year are likely to be quite weak. I don’t know how weak, but if you look at each component of spending or component of production, you see mostly very negative indicators. We have talked about consumption. We know about all the fundamental issues that are affecting consumers, and we have seen recently, I think both anecdotally and in terms of the data, some softness, particularly in the auto area. In the labor market, several people have noted August 5, 2008 98 of 145 that the loss of payroll jobs has not been as rapid as, for example, in 2001. The unemployment rate, though, has risen as quickly as in previous episodes, and any look at the unemployment rate would suggest that this is something close to a normal recession dynamic. Housing, of course, remains very uncertain. We don’t really know when the bottom will be, although I would add, a point that I think Bill Dudley made, that there seems to be a growing confidence that when we have reached the bottom in housing, whenever that may be, we will see a very quick improvement, both in the financial markets and then, presumably, in the economy as well. In other areas, such as nonresidential construction, architectural billings and other factors suggest slowing there. We see slowing in the other industrial countries, although some strength is still in the emerging markets. So just looking at the traditional indicators of growth and production, I think the best guess is for a slow second half, a slow beginning of 2009, and an unemployment rate that continues to rise from here. I do believe that the financial stress and its implications for credit availability are important in this whole dynamic. I guess President Lacker and I keep talking past each other, but I don’t think that the federal funds rate is an adequate description of the stance of monetary policy. To give another example, in the past we have used money growth as an indicator of monetary policy. If we used that indicator, it would look quite different. I think the appropriate indicators are the rates and terms that are being faced by the people making decisions to spend in the economy. You can go through the entire list, and in every case, as Governor Kohn suggested, the actual rates being faced in the data by borrowers are as high as or higher than they were last summer. Mortgages, which are a particularly sensitive area, are of course critical here. Despite the decline in the federal funds rate, the spread between mortgage-backed securities and duration-matched Treasuries is now about 260 basis points compared with 120 basis points last August 5, 2008 99 of 145 summer. In addition, for the spread between jumbo loans and conforming loans, which in the past has normally been between 25 and 50 basis points, the offer rate is about 120 basis points. So there seems little doubt—and we can check with Governor Duke about this—that, despite the lower rate on overnight bank lending, the rates that matter for economic activity are largely higher than they were a year ago. Therefore, I don’t think it is evident at all that we are in a financial situation that is conducive to rapid, excessive growth and inflationary increases a priori. Now, going forward, of course, a lot of what happens in the economy is going to depend on bank balance sheets. I won’t spend much time. In April, I talked about the staff’s estimates of losses going forward. That has been updated. Nellie Liang is working with people in New York. The numbers are not too encouraging under the baseline scenario, forgetting about the more severe scenarios. The staff now projects about $228 billion in losses for U.S. banks and thrifts in ’08 and ’09. That excludes investment banks. That excludes write-downs. If that occurs, it would be about a 2 percent loss rate over the next two years, which would be above the peak of 1991 and 1992. Of course, if the economy does worse, it would be even higher. Relative to that $228 billion in losses, there are so far loan-loss provisions of about $68 billion. So it looks as though we still have a long way to go in terms of bank losses and write-downs. In addition, some of the biggest banks will take very significant hits. This is very preliminary, and I don’t want to make too much of it, but the preliminary analysis shows that for five of the very biggest banks, under a baseline scenario and looking at the composition of their asset holdings, their current tier 1 capital ratios will be reduced between 30 percent and 50 percent over the next two years. So there is a real concern about the availability of credit and about the cost of credit. I could go on and talk about a variety of other areas, including the Senior Loan Officer Opinion Survey, which suggests that credit will be a concern going forward. August 5, 2008 100 of 145 President Lacker and I have, I hope, respect—I respect him, and I hope he respects me. But we disagree also about President Bullard on systemic risk. I take his criticism to be that it works in practice, but can it work in theory? Systemic risk is an old phenomenon. There are literally dozens and dozens of historical episodes that are suggestive of that phenomenon. There is also an enormous theoretical literature. Maybe it is not entirely satisfactory, but certainly many people have thought about that issue. I, myself, have obviously worked in this area. Clearly, it is not something that we can tightly explain in all aspects, but I do think it is a concern. We need to remain concerned about it. Although it is true, as President Bullard points out, that there is an accommodation and a basis for anticipating crises as we go forward, it is also the case, as I think Governor Mishkin noted, that after a year we are also facing a situation of greater fragility, of much lower capital, and fewer shock absorbers. Those things will make any crisis that much more severe, should it occur. So overall I think there is still significant downside risk to growth. I think the baseline of slow growth is right. I am hopeful that we will see growth restored early next year, but I think it is very uncertain at this point. On inflation, I do have concerns, as everyone else does. I think that the commodity price movements we have seen are good news. They have been quite significant. Besides oil prices down about 10 percent and natural gas prices down about 32 percent, since the last meeting corn is off 27 percent; soybeans, 17 percent; and wheat, 16 percent. Those are not small changes. Now, obviously, the level of prices is still very high. It has risen considerably over the past year. We will continue to see that high level of prices being passed through into the core, as Governor Kohn noted, but I would argue that if—and this is a very big “if”—commodity prices do begin to stabilize within the general range of what we see now, I think that the inflation concerns will moderate over time because they will have lost essentially their driving force. We don’t really August 5, 2008 101 of 145 have the conditions to turn the commodity price increases into persistent inflation, absent continued pressure on that front and absent changes in inflation expectations, of which there is only limited evidence at this point. So I want to be very clear: I think that containing inflation is enormously important, and I think it is our first responsibility. We need to watch this very carefully. I think there will be continued pressures even if commodity prices don’t rise, but I do think there is also a chance that we will see a moderation of this problem going forward. What else? I guess there has been a lot of discussion about the appropriate withdrawal of stimulus. Again, I don’t think I accept the idea that we are currently in an extremely stimulative situation. However, if financial markets were to normalize, for example, that would lead to a more stimulative situation. I would like to say just a word about that. That is to say that the speed at which we remove the accommodation—and I think it is clear we do have to do that relatively soon—should depend to some extent on how inflation evolves. Under the more benign scenario that I have just described—if inflation does decline significantly because of commodity prices—I think that we obviously have more time. I would just note for comparison past episodes. In 1994, for example, the pause lasted 17 months, and the first increase in rates came two years after payrolls began growing again. In 2001, again, it was more than a year after unemployment rates started coming down, and payrolls began growing before the rates started going up. Now, I think there is a view, which is a reasonable one, that maybe in at least the second of those two episodes we waited too long to begin to normalize. That is entirely possible. But, again, it would be extraordinary if we were to begin raising rates without an immediate inflation problem with the economy still in a declining or extremely weakened situation. If inflation does in fact become the problem that many around the table think it is, particularly if commodity August 5, 2008 102 of 145 prices begin to go up again or if the dollar begins to weaken, then I will be the first here to support responding to that. I do think it is incredibly important to keep inflation expectations well anchored, particularly to the extent that movements of commodity prices and the dollar seem to be derived from monetary policy as opposed to things like geopolitical risk. Then, I think we can’t treat them as truly exogenous. We would have to respond to those things. So I welcome the ongoing discussion we should have about the pace of withdrawal of accommodation. I do think it depends very much on how things evolve, and I do think that our strategy should be to watch carefully and to make the right decisions as we see the data come in. Let me stop there and turn to the last round and ask Brian, please, to introduce the policy discussion. MR. MADIGAN. 2 Thank you, Mr. Chairman. If you prefer, in the interest of time, I can cut back my remarks to focus just on the policy statement and not the general background. I will be referring to the version of table 1 included in the package labeled “Material for FOMC Briefing on Monetary Policy Alternatives.” This version incorporates some small revisions from the draft that was included in the August Bluebook. The table presents two policy alternatives. Under alternative B, the Committee would maintain its current policy stance at this meeting but in its statement would underscore its concerns about inflation. Under alternative C, the Committee would firm policy 25 basis points today and issue a statement indicating that the action was taken to better balance the risks to growth and inflation; the statement would be noncommittal about whether further rate increases were imminent. The language proposed for paragraph 2 of alternative B has been modified a little from that proposed in the Bluebook. Most important, the first clause is now in the past tense, referring to economic growth in the second quarter, thus avoiding an implication that the economy is continuing to expand in the current quarter. In a change relative to the June statement, exports as well as consumer spending are cited as factors that supported growth. Also, the sentence beginning with “over time” has been moved up from the risk assessment paragraph. That shift is likely to be seen as underscoring a view that policy is currently positioned to foster a gradual resumption of moderate economic growth, suggesting that further easing is not likely to be forthcoming. That sense may also be reinforced by the omission of the phrase “to date” after “easing of monetary policy.” In paragraph 3, the inflation discussion for alternative B gives slightly greater emphasis than in June to the Committee’s inflation 2 The materials used by Mr. Madigan are appended to this transcript (appendix 2). August 5, 2008 103 of 145 concerns, partly by starting with the flat statement that “inflation has been high” and by giving less prominence to the expectation that inflation will moderate. The slight change to the final clause in paragraph 3 is proposed for purely stylistic reasons. In paragraph 4, the first sentence of the risk assessment states that “although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee.” While this sentence does not provide any explicit weighting of the two risks and does not suggest that policy firming is imminent, the statement as a whole probably would be read as giving a bit more emphasis to inflation concerns and a bit less to growth concerns than market participants now expect. Thus, even though the absence of a rate action today would be consistent with market expectations, the statement would likely be viewed by market participants as a bit more hawkish than they anticipated, and market rates could rise modestly in response. Turning to alternative C, concerns about upside risks to inflation could motivate the Committee to begin firming the stance of monetary policy at this meeting. The first three sentences of alternative C, paragraph 2, are identical to those of alternative B. However, the final sentence differs, partly by indicating explicitly that the Committee sees the current stance of monetary policy as accommodative. Also, by dropping the phrase “over time,” which appeared in paragraph 4 of the June version, the Committee would suggest that it sees moderate economic growth as resuming sooner rather than later. In paragraph 3, the Committee would still note that inflation is expected to moderate but, in the last sentence of the paragraph, it would explicitly cite the risk—and note its concern—that inflation might not fall as expected. Finally, the risk assessment, paragraph 4, would indicate that the Committee firmed policy today in order to better balance the upside risks to inflation and the downside risks to growth. However, the statement would avoid an explicit judgment about whether the risks were now balanced and would provide little information about whether further tightening was imminent. Even though the wording of the statement for alternative C would not indicate that policy was now on a steady firming march, market participants would likely conclude that the firming process had been accelerated considerably relative to their expectations. With the Committee having tightened amid bad news about financial institutions and in the immediate wake of the implementation of a number of additional Federal Reserve liquidity initiatives, investors would likely conclude that the Committee did not see financial stability considerations as raising a barrier to further policy tightening. They would view the Committee as adopting a more aggressive posture toward inflation. Because it has been historically rare for the Federal Reserve to implement a one-off tightening, investors would likely see fairly steady rate hikes over the course of future meetings, and thus short- and intermediateterm interest rates would, in all likelihood, move up sharply after this action. Yields on longer-term fixed-rate mortgages might rise particularly substantially, as premiums for interest rate and prepayment uncertainty increased and as mortgage investors hedged the increase in mortgage durations. Such a development could adversely affect the prices of financial assets that are closely tied to housing markets and mortgage performance. However, yields on long-term Treasuries could decline, August 5, 2008 104 of 145 particularly if market participants marked down their expectations for economic growth and inflation. CHAIRMAN BERNANKE. Thank you. Any questions for Brian? President Fisher. MR. FISHER. In terms of the wording in paragraph 3, if we do not raise rates, I am wondering why the second sentence that is now in alternative C wouldn’t be more appropriate for alternative B, and I am wondering what your thinking is about that. In other words, if we don’t take action, that seems to be a more emphatic statement than what you have currently, assuming no change in rate—“The Committee expects inflation to moderate later this year and next year,” et cetera—whereas if we are trying to send a signal that we are really concerned and we do not change rates, why wouldn’t we have used, “Although the Committee expects inflation to moderate . . . the possibility that inflation may fail to decline as anticipated is of significant concern”? Then, maybe take the word “also” out of the fourth paragraph. It just seems to me odd that if we act and describe the risk after acting, the language is even stronger. Whereas if we don’t act and we want to emphasize that we are remaining vigilant, why wouldn’t we use that stronger language? I am curious as to why you chose the two or what you feel the tradeoff is there. MR. MADIGAN. I would say, President Fisher, that the substitution that you are suggesting seems plausible to me, but I would also say that the first sentence of alternative B already does suggest some pretty significant concerns about inflation. CHAIRMAN BERNANKE. All right. Any other questions? Let me start, then, with President Yellen. MS. YELLEN. Thank you, Mr. Chairman. I favor alternative A—no change in the funds rate and a balanced assessment of risks designed to leave market expectations concerning the path of the funds rate roughly unchanged. Oops, I made a mistake, there is no A. [Laughter] So August 5, 2008 105 of 145 I propose to create it by changing the wording of the first sentence of alternative B, paragraph 4, to read, “Both downside risks to growth and upside risks to inflation are of significant concern to the Committee.” As it is currently worded, B(4) downplays the downside risks to growth, which have intensified since our last meeting as the credit crunch has worsened and emphasizes inflation risks, which have moderated slightly as oil prices have fallen. The assessment of risks in alternative B, as it stands, is unbalanced and—as Brian just pointed out and the Bluebook does also—is more hawkish than the primary dealers and most market participants generally expect. So it is likely to shift the fed funds futures path and other interest rates upward. I see no case, at this juncture, for signaling that we are likely to adjust policy upward before the end of the year. Indeed, there is a non-negligible probability, to my mind, that the next move will be down and not up. There is already significant slack in the labor market, and with the economy expected to grow at a near-recessionary pace in the latter half of this year, the unemployment rate is poised to rise further. This growing slack is working to contain inflationary pressures as evidenced by the stability and low level of wage growth. I expect that growing slack will continue holding down wage inflation going forward. Long-term inflation expectations seem relatively well contained, and core inflation has been stable for the past several years. Finally, a major component of the surge in headline inflation—oil price increases—has finally started to show some sign of reversing direction. Although the real funds rate remains quite accommodative by the usual metrics, we are clearly not in a business-as-usual situation. We are in the midst of a serious credit crunch that has, again, worsened during the intermeeting period, as exemplified by the developments at Freddie and Fannie and the other things that many of you have pointed to in our last round. We are likely seeing only the start of what will be a series of bank failures that could make matters much worse. Given these financial August 5, 2008 106 of 145 headwinds, it is not clear to me that we are accommodative at all; I agree, Mr. Chairman, with the comments you just made on this matter. Given my preference for an inflation target of around 1¾ percent and equal welfare weights on the inflation and unemployment gaps, I view the Greenbook policy path and forecast as a roughly optimal trajectory to the attainment of our goals. Although core inflation exceeds the level I consider consistent with price stability, unemployment also exceeds the level consistent with full employment. Given our dual mandate and a forecast that envisions a growing unemployment gap, coupled with declining inflation under the Greenbook funds rate path, I see no case for jolting expectations in such a way as to, in effect, tighten policy now. I feel especially strongly about this in view of the major downside risks to the economy from an intensifying credit crunch. CHAIRMAN BERNANKE. Thank you. President Evans. MR. EVANS. Thank you, Mr. Chairman. A funny thing happened at my board meeting the other week. I was all set to prepare them not for a rate change recommendation this time but for one in the not-too-distant future. By the time I was done, they were asking what the procedure was for dissenting from my recommendation. So, in fact, they forwarded a recommendation for an increase this time around. You know, we can disagree over the inflationary consequences of a lot of this, but I think there is a message from around the table and the public, our directors, and whatnot, that they do feel that there is a concern about inflation. So I favor alternative C, although I recognize the reality of today. I am struggling with the fact that we lowered the funds rate rather aggressively, and things have worked out much better than we expected against the risks that we thought that we were facing. We could disagree over that as well. I do take the point that uncertainty is very August 5, 2008 107 of 145 high at the moment. But I think that we will need to increase rates sooner than currently expected by markets. We are counting on a modest degree of slack and our credibility with the public to keep inflation and inflation expectations contained while we leave rates on hold. But I am concerned that there will be only modest inflationary restraint from the slack that we see and that we may not be able to convince the public that they shouldn’t worry about high headline inflation. I certainly agree that bank balance sheets were pretty good in 2007, but I am concerned that headline inflation has been above core inflation for quite a long time. I am not sure our own balance sheets would reflect that. So by following a wait-and-see strategy, we are accepting a large baseline inflation risk. In addition, there is an enormous tail risk—that is, a return to much higher underlying inflation. Also, I was a little concerned to see in the dealer feedback to the TAF extensions that some market participants think that we will not increase the policy rate as long as we keep the “unusual and exigent” determination in place. I am not sure that is a good expectation for them to have. Fundamentally, it is my opinion that there has been a change in the balance of the economic rationale and risk-management calculus that we used to lower the funds rate to 2 percent. It is not a huge change, but I think there has been a change. One year on, the economy has withstood the financial shock in a resilient fashion, especially given the add-on shock from oil. I don’t know what more we could have hoped for from the vantage point of the fall of 2007 and the losses that have been taken. I think the odds of preventable negative feedback loops that we took out the last 75 basis points of insurance against are somewhat smaller than they were five to six months ago. Part of our earlier logic to appropriately lower rates to a decidedly accommodative policy stance was to guard against disorderly market conditions that might permanently damage our financial market August 5, 2008 108 of 145 infrastructure and destroy the financial capital stock in a real, productive sense the way that I think President Plosser was alluding to. But real forces have unmasked dramatic weaknesses and faults in our financial system, and markets will be evolving to a new intermediation structure. Our policy can ease transitions only to a degree, but it cannot restore the previous financial status quo, nor should it be aimed at doing so. During the transition, I would not be surprised if we revisit periods of market volatility as the disadvantaged players are repeatedly challenged to restructure to the new environment. Counterparties are shying away from previous financial partners, in part because of uncertainty over the risk–return profiles and the transitioning industry structure. These profiles involve both liquidity risk and credit risk. I think our lending facilities allow a modest decoupling of the fed funds rate setting to deal with this. In my view, the balancing of current risks calls for increasing the funds rate in the range of 50, maybe 75, basis points within some reasonably short period of time. If events change importantly, I would certainly advocate further adjustments in either direction, depending on how those risks adjust. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. I would just note on the “unusual and exigent” issue that there are two schools of thought. The other school is the one you said, which is that having done this, we would have the freedom to raise rates; so I think it sort of cuts both directions. President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. In the interest of time, I will be very brief. I support alternative B in substance and concur with its wording. I think we are in a delicate rhetorical balancing act at this stage, and as Brian described, the slightly greater emphasis on inflation is appropriate at this time. I think alternative B has substantially captured the current situations and concerns of the majority of the Committee, so I support alternative B. August 5, 2008 109 of 145 CHAIRMAN BERNANKE. Thank you. President Hoenig. MR. HOENIG. Thank you, Mr. Chairman. I appreciate the fact that reasonable people may differ, and I do differ. In saying that, I am not advocating a tight monetary policy. I am advocating a less accommodative monetary policy. I recognize Governor Kohn’s point that relative prices are adjusting, and others have made that point. I think around that context is the fact that we are seeing a systematic increase in the price indexes, both total and core, and I don’t think we should ignore that. Now, the core is creeping up, but up nevertheless, and it is systematic in my view. I would feel more comfortable that it was transitory if policy were not so accommodative, which affirms the likelihood of further increases in inflation going forward. That is really where I am focused, I guess is the way to say it. We introduced the policy that we have, as I think others mentioned, as an insurance policy early on, when we were more in an immediate crisis. I don’t negate or minimize the tension that we are under, but I do think we have become very accommodative in our policy with negative real rates. So here we are with this insurance. We have this subpar growth. The subpar growth is not going to go away soon, so we are delaying removing the insurance policy. I worry about that. I think in the long run that does increase the risk of an inflationary problem of a sizable magnitude later on. I know we have this immediate problem, but our role also is to take a long-run view, and I think we would be wise to raise the rate now modestly. It would still be an easy policy. The effects of that increase might be disturbing to the markets. On the other hand, it might actually give more confidence to the markets that inflation is going to come down because we are going to insist that it does. I think there would be some good effects from that. So that is where I am coming from on preferring that we move rates up slightly at this point. Thank you. August 5, 2008 110 of 145 CHAIRMAN BERNANKE. Thank you. President Bullard. MR. BULLARD. Thank you, Mr. Chairman. I am going to make my remarks a little shorter here. My judgment is that the current situation is a difficult one for the Committee. Because of the very appropriate focus on financial market turmoil over the past year, our attention has naturally turned away from keeping the level of interest rates consistent with longer-term inflation objectives. This was done to avert particularly extreme, but low probability, outcomes in which the economy would experience an especially severe downturn. As it turned out, the bad state did not materialize, which I think will go down in history as a successful element of the Committee’s policy over the past year. The ability to take on financial market turmoil of this magnitude and prevent it from doing substantial damage to the economy— a recession of the magnitude of 1980-82, let’s say—has been a real achievement. In that sense, all has gone according to plan. At the same time, we have moved interest rates to a very low level in the context of rising inflation and rising inflation expectations. A severe downturn was unwelcome, to be sure, but it was also projected to keep inflation in check. Since that did not materialize, we are left with low rates and an environment of CPI inflation running at 5 percent headline, measured from one year earlier, and long-term inflation expectations creeping higher. We face more risk now of creating a serious inflation problem than we have in a generation. To make progress, I think we should keep rates steady today but with the plan of preparing markets for an increase in rates at the September meeting, conditional of course on incoming data. This would be consistent with alternative B today; and with intermeeting statements, it would move probability mass toward higher rates through the fall and through the first half of 2009. I have several remarks on a fall tightening campaign. First of all, moving 25 basis points is by itself not likely to have a large effect on economic activity, nor does it bring the August 5, 2008 111 of 145 level of the federal funds rate high enough to have a meaningful effect on inflation. The FOMC started tightening in mid-2004 but achieved a core CPI inflation rate below 2 percent in only one month during the entire three-year period of 2005, 2006, and 2007. What the move would do is get the Committee started on returning interest rates to a more normal level, a level more consistent with our inflation objectives. The Committee could pause or even reverse course should particularly adverse data suggest that economic activity was weakening substantially. Preparing for an increase in rates means that we would be signaling that financial market turmoil is no longer the paramount concern. On that, I think we can reasonably stress that we have provided accommodation over the past year in the form of lower interest rates and innovative liquidity facilities. We have bought time for financial firms to repair and adjust. While all is not as it was, we do not want to create an inflation problem in the aftermath of a shock of this magnitude, which may actually compound the situation and make it worse. Longer-term inflation expectations have been creeping higher, a fact that has been widely cited in commentary on monetary policy. I would like to stress that, in my view of a wellfunctioning inflation-targeting regime, these inflation expectations would not be moving at all. Short-term interest rates would be moving higher and lower in response to shocks to the economy, and inflation expectations would never move. This would reflect the confidence that the central bank’s short-term interest rate adjustments were being accomplished in just the right way to offset disturbances buffeting the economy. Because of this, I prefer not to interpret observed movements in inflation expectations as evidence of what we should or should not do with respect to interest rates. The short-term interest rate would have to move to offset the shocks to the economy even if longer-term inflation expectations never moved. Thank you. CHAIRMAN BERNANKE. Thank you. Governor Kohn. August 5, 2008 112 of 145 MR. KOHN. Thank you, Mr. Chairman. I support keeping the federal funds rate at 2 percent for now. I think that is consistent with bringing inflation down over time. I agree that we’re going to have to tighten at some point. I agree with your analysis, Mr. Chairman—I don’t think we have a highly accommodative policy right now. Not only would I cite the interest rates that you cited, but I would cite the behavior of households and businesses, which aren’t acting as if they’re looking at very low real interest rates by making purchases of durable goods, capital equipment, et cetera. The cost of capital is not perceived to be low right now, and I think it’s for the reasons you cited. In my view, over the intermeeting period the inflation risks have narrowed just a bit. The damper on inflation risk comes from the decline in oil and commodity prices, the steadiness of the dollar, and my perception that we can count on a more negative output gap going forward, which will provide some discipline on prices and wages. This is a difficult situation. There are no ideal outcomes when you have this change in relative prices. We will have to live with higher inflation and higher unemployment temporarily. We have to keep our eye on the second-round effects, not just the pass-throughs but the spillovers, and I think so far so good. That’s a tenuous situation, I agree, but my read of the incoming information is that we can be a little more patient than we thought we could be six or seven weeks ago. As for the wording of the statement, I could live with President Yellen’s rewording, but I think that this language Brian suggested is okay as well. I’m actually not sure how the markets will react to this. Some of the commentary I read over the last couple of weeks thought that we were tilted toward inflation last time because of the way we worded things. I don’t think that the market reaction will be large to this, and I agree that the first choice would be not to change market August 5, 2008 113 of 145 expectations substantially. I think they’re aligned pretty well right now, but I think the reactions will be small, and I can live with the alternative B wording. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Pianalto. MS. PIANALTO. Thank you, Mr. Chairman. As I indicated in the earlier go-round, I found the balance of risks to economic growth and inflation to be essentially the same. So other things being equal, I might prefer to have risk assessment language that is even more balanced than the risk assessment language that is presented in alternative B. But I have a tactical reason for wanting to see words that express a stronger concern about inflation risk. I do, as I said earlier, expect inflation to worsen before it improves. In particular, as we have been discussing, the core statistics are likely to worsen notably during the next several months, and I could just shrug those worse numbers off because I have a projection that calls for those numbers to improve by early next year. But I’m not confident that the public will shrug them off. As we have been talking about, the cost of longer-term inflation expectations drifting up is large. I believe that we can influence those expectations, and I think it is important that we do let the public know that we are serious about opening the doors to a rate increase if that becomes necessary. We need the flexibility to move nimbly, and I think the language that is contained in alternative B puts the markets on notice. I think alternative B enables us to hold our present strategy of watchful waiting, but it does call somewhat greater attention to inflation risks than we expressed at the conclusion of our last meeting. So I find both the strategy and the language of alternative B to be quite appropriate for the circumstances we face today. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Stern. MR. STERN. Thank you, Mr. Chairman. I favor alternative B and the language as displayed here. Let me say a few words about the issue of withdrawal of accommodation, which August 5, 2008 114 of 145 I’ve been giving thought to and will want to give more thought to over time. Earlier today I talked about the Greenbook forecast and indicated that I found it credible. But another virtue of it, even if you don’t find it that credible, is that the cards are on the table. I mean, it has a path for the federal funds rate. It has a path for the foreign exchange value of the dollar and so on and so forth. Two of the key elements, as I indicated earlier, are, at least over the near-term to intermediate-term, that real growth is subdued and that headline inflation abates after the current quarter, and I think that’s relevant. Given the current stance of policy, I think we are well positioned for that subdued pace of real growth. Indeed, even if we get contraction for a quarter or two, I would argue that we have maybe not entirely but largely already addressed that. On the inflation side, it seems to me that the key part of that forecast is the diminution of headline inflation starting in the fourth quarter. What that means as a practical matter is that in November, December, and January, when we get those data, we’ll get confirmation that it is either happening or it’s not. Now, assuming that there are no major, decisive surprises between now and then—and that may be heroic—we’ll get confirmation of whether that inflation outlook was the accurate one. If we do, then it seems that the path of the funds rate inherent in the Greenbook looks as though it could be acceptable. If we get disappointments on headline inflation for whatever combination of reasons, it calls into question, at least in my mind, that path for the funds rate. Thank you. CHAIRMAN BERNANKE. President Lacker. MR. LACKER. Thank you, Mr. Chairman. For my part, our exchanges have in the past been predicated on nothing but the utmost respect. I expect that to continue. If I have done anything or said anything to contribute to any other impression, I regret it, and I apologize. CHAIRMAN BERNANKE. That wasn’t my intention, President Lacker. August 5, 2008 115 of 145 MR. LACKER. In the interest of avoiding talking past each other, let me say a bit about why I view real rates as low. I recognize what you and Governor Kohn said about other interest rates. But when I look at the low real rate now and at times in the past when it has been low and I look at things like corporate borrowing rates then, they didn’t fall nearly as much as the fed funds rate. If you plot them by lining up the NBER dates, it doesn’t look as though what’s happened now with those borrowing rates is out of line with past experiences. So if we think now that real rates were low in ’03, I’m led to conclude that I ought to think that they are low currently. Another way of saying this is that spreads always go up in recessions. We drive real rates down in recessions. If consumers and businesses were spending with frenzy now because of low rates, to me that would be a reason that we have to raise them, get them up right away. You know, my sense of the economics of why we push real rates low in recessions is that the state of aggregate demand needs it. It’s exactly when consumer and business spending is sort of moribund that we have real rates low. I’m not sure that the fact that it’s moribund tells me whether they’re low or not relative to where they ought to be. That’s how I think about that evidence, but I look forward to being enlightened further in the future on this. CHAIRMAN BERNANKE. You raise a good point—that we ought to look empirically at the relationship between borrowing rates and the federal funds rate in this episode and other episodes, which we really haven’t done. So we need to do that. Thank you. MR. LACKER. I’ll dispense with the rest of my prepared remarks and just say that I recognize the real risks ahead of us. We’ve experienced sluggish growth, and all the downside risks to growth that have been enumerated are very tangible and very plausible right now. I think we should hold off raising rates at this meeting, but I’m very concerned about the inflation risks. I find myself leaning toward a tightening campaign earlier rather than later, and I’d like to see the August 5, 2008 116 of 145 statement do what it can to prepare markets for that. I liked the first version of alternative B, the one without the word “also.” I think “also” damps the concern about inflation. It kind of makes it a little too balanced for my taste. I’m also concerned—I should say “broadly”— that we seem to have left the impression over the past several months, since the beginning of the year, that our concerns about inflation fluctuate. I agree with President Bullard. What we ought to view as ideal is an equilibrium where inflation expectations are rock solid and don’t change and, moreover, that people don’t perceive our concerns and worry about inflation or the weight we’re giving in policy deliberations as shifting from time to time. So that’s an aspect of our communications that concerns me. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. President Rosengren. MR. ROSENGREN. I support alternative B. I would actually prefer President Yellen’s language but definitely believe that we should have the word “also” in there. Tightening at this time would sap more strength from an already weak economy, and should the forecast look like the “severe financial stress” scenario or the “typical recession” scenario, it would be extremely poorly timed. If the data indicate that inflation is not ebbing as I expect and the economy is on a surer footing than I fear, then it would be appropriate to begin what is likely to be a series of increases in the federal funds target. But the data to date don’t indicate that, so I support alternative B. CHAIRMAN BERNANKE. Thank you. President Fisher. MR. FISHER. Well, Mr. Chairman, I’m already out of the closet in terms of my economic proclivities. I realize it’s awkward for some folks, but I haven’t heard enough today that would change my view that we are running an over-accommodative monetary policy. I agree with your point very much that the rates and the terms being faced by those who drive the economy count. As to Governor Kohn’s point that some of these key rates have not come down, I think that has more to August 5, 2008 117 of 145 do with risk premiums, and I hate to see it migrate toward inflation premiums, which I believe is a significant risk. I’m obviously driven by what I hear from my contacts, although I respect the analytics you mentioned, Governor Mishkin. My long-run thinking is as conditioned by globalization as it is by domestic policy, and I just still have a great concern about the wage–price spiral that’s taking place in some of our manufacturing centers in the developing countries. I think it would be wise, just to shift my analogy here and think in canine terms, to take a newspaper across the snout and call for a 25 basis point increase. We’re always talking about tightening at some point. I think it just becomes increasingly difficult to take that first step. I grant you that the economy is weak. The financial situation is brittle. That hasn’t changed in my view, but the inflationary behavioral patterns that I’m beginning to hear about reinforce my concern about an updrift in the core and the headline data. So I apologize, it perhaps is being a little too strong to say that we’ve become unmoored or that maybe we are no longer anchored. I think that is nonetheless a real perception. I’m going to vote against alternative B and for alternative C. I may be a minority of one, but perhaps I’ll be a sea anchor, if you understand the sailing analogy here, and assist the process of our commitment to be focused on inflation as a risk just as we focused on downside risk to growth. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. As you can imagine, as we’ve discussed, this meeting presents a difficult policy position for us—and for me in particular. I think we must pay careful attention to the financial market volatility; and to the extent that it has consequences for the real economy, I’m certainly sensitive to that concern. I had a similar experience with my board of directors that President Evans did. I went into my board recommending no change and got considerable push-back in discussion about how we dissent and what the consequences of doing August 5, 2008 118 of 145 that are. They are concerned about inflation, and I’m concerned about our mandate to keep longerterm and intermediate-term inflation in check. We’re unlikely, in my view, to get confirming or convincing evidence about whether expectations have become unanchored until well after the fact. I agree there has been very little wage–price pressure to date. But that will be the last shoe to drop in this sequence of raising expectations, and by the time we get to that, I’m afraid it will be too late. I think in the near term we might see some relief in headline inflation; but as has been discussed, whether that will persist is highly dubious. My real concern is that I believe that monetary policy is accommodative, and with all due respect, Mr. Chairman, when I look at the data comparing the levels of borrowing rates of consumers and businesses, both the levels in real and nominal terms and the spreads, what we see in this period looks remarkably similar to what we’ve seen in lots of other recessionary, slow growth periods. So, again, following the analogy that President Lacker was using, I see this period as less atypical and more typical of what we see in slow-growth periods. I think it’s important that we begin to prepare the markets for an impending shift to a tighter policy. I agree with President Hoenig. The request here is not for tight policy but somewhat less accommodative policy; and if we choose to go with no funds rate increase today, I think the language must help prepare the markets going forward. I’m pleased with a lot of the discussion around the table. We are actually beginning to talk, I think, about what our exit strategy is going to be from this. I think it’s very important to have those conversations, and I appreciate them. I, too, share the observations that President Evans had about talking with people who say, “Well, we can’t possibly remove accommodation until we get August 5, 2008 119 of 145 rid of the facilities.” I think that is wrong. As you said, Mr. Chairman, actually having the facilities might make it easier for us to correct monetary policy, and I think that’s very, very important. I guess my bottom line is that I can accept leaving the funds rate unchanged today as long as our language is sufficiently strong about inflation. To that end, I was actually a little more comfortable with the draft table 1. I didn’t like the addition of the word “also.” I thought that weakened the statement. I would prefer paragraph 4 without the “also.” I also have one other, minor observation about paragraph 3, and that’s the first sentence, which says that “inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities.” Well, I think that’s partly true, but I’m concerned that somehow it conveys the impression that the problem with inflation is oil and commodities, when in fact more correctly my concern about inflation is not just oil. My concern is about the stance of policy. So I would put on the table the possibility of saying that “inflation has been high, partly spurred by high oil and commodity prices” to say that it’s more than just the short-term behavior of commodity prices. I think the word “also” means that inflation concerns there are added as an afterthought, which is my reading of the change from the draft table 1 to paragraph 4. So I prefer that “also” be eliminated. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. I’ll be brief. I favor alternative B as written and presented. I think it strikes the right balance by highlighting the risks that we see on the inflation front, and I agree with Brian’s characterization that the capital markets’ reaction might be a little surprise. It is hard for us in a time like this to predict exactly how the capital markets are going to interpret this, but it wouldn’t surprise me to see some initial market reaction that is ostensibly negative. That doesn’t trouble me too much. Ideally, the removal of policy accommodation, which August 5, 2008 120 of 145 we talked about today, would be from a position of strength not weakness, but we may or may not have the luxury of waiting for that opportunity. Finally, I think it’s important over this period that we not be perceived to be lurching. I think alternative B strikes the right balance of explaining our concerns and provides us reasonable optionality—that is, as you’ve described previously, statedetermined rather than time-determined. Thank you. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. MR. KROSZNER. Thank you. I support no change, alternative B. As I mentioned before, I don’t want to put the commodity price decreases and energy price decreases in the bank and say we don’t have any problems going forward. But we also can’t ignore them, and I think that does take off a bit of the pressure. It also manifests itself in some of the survey numbers and some of the market-based numbers in terms of expectations. So I think it allows a little more time, as someone said earlier, to be patient, to make the determination, given that I still think there are some very real downside risks, as I’ve mentioned. I think this type of statement will be largely consistent with market expectations, although I do think, and Brian can correct me, that this is one of the first times that we have made a very clear statement such as “inflation has been high.” I think that’s a bit of a change from where we have been. That’s a much stronger acknowledgement of the inflation situation, which I think is appropriate to be acknowledging. But I do think that it may send a relatively strong signal to the market, and it makes me feel more comfortable about no change today with the statement because it shows a lot of concern about the level of inflation in actually characterizing it as high. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Mishkin. August 5, 2008 121 of 145 MR. MISHKIN. Thank you, Mr. Chairman. Just let me talk a little about monetary policy, and I’ll be brief there. But then I have to use my opportunity to raise some issues for the Committee when I’m not here. I do support alternative B. As is obvious from my earlier discussion, I believe that the risks are balanced. I have one modification to Janet’s language because I think it is just simpler to say that “the downside risks to growth and upside risks to inflation are of concern to the Committee.” I don’t see the need for “both,” but we’re actually on the same wavelength in terms of this issue. What I’d like to spend some time on—because I feel this is sort of my swan song, but maybe because I’m a classy guy, I’ll call this my “valedictory remarks”—are three concerns that I have for this Committee going forward. I’m not going to be able to participate, but I have a chance now to lay them out. The first is the real danger of focusing too much on the federal funds rate as reflecting the stance of monetary policy. This is very dangerous. I want to talk about that. Second is that I think it’s absolutely critical that we keep our options open in the current circumstances, and so I want to talk about that. The third is on the communication issue, but it’s not going to be on inflation objectives. I’ve already talked about that enough in public, so it’s clear to you one way or the other. I hope you consider it, but that’s something that I don’t need to go into here. First of all, let me talk about the issue of focusing too much on the federal funds rate as indicating the stance of monetary policy. This is something that’s very dear to my heart. I have a chapter in my textbook that deals with this whole issue and talks about the very deep mistakes that have been made in monetary policy because of exactly that focus on the short-term interest rate as indicating the stance of monetary policy. In particular, when you think about the stance of monetary policy, you should look at all asset prices, which means look at all interest rates. All asset prices have a very important effect on aggregate demand. Also you should look at credit market August 5, 2008 122 of 145 conditions because some things are actually not reflected in market prices but are still very important. If you don’t do that, you can make horrendous mistakes. The Great Depression is a classic example of when they made two mistakes in looking at the policy interest rate. One is that they didn’t understand the difference between real and nominal interest rates. That mistake I’m not worried about here. People fully understand that. But it is an example when nominal rates went down, but only on default-free Treasury securities; in fact, they skyrocketed on other ones. The stance of monetary policy was incredibly tight during the Great Depression, and we had a disaster. The Japanese made the same mistake, and I just very much hope that this Committee does not make this mistake because I have to tell you that the situation is scary to me. I’m holding two houses right now. I’m very nervous. [Laughter] The second issue is that it’s absolutely critical that we keep our options open. This relates to the points that I already made in my discussion—I argued that we don’t know where this situation of financial stress is actually going to head and that the potential for shoes dropping and bad things happening out there is real. I think it’s likely that it won’t happen, but it’s a significant probability with very serious negative consequences. In that situation, we don’t know exactly the direction of where we have to go. I was actually very pleased with President Evans’s comments. Charlie has been a good friend for a long time, and he is one of the people I have tremendous respect for as an economist. Although we had a disagreement in our view of monetary policy today, on the issue going forward I was pleased to see that you actually indicated that there is a possibility—we hope it doesn’t happen, by the way—that things go south and that we actually have to be much more aggressive on monetary policy and on liquidity issues. I know that there have been some concerns on the Committee about that as well, but no option should be taken off the table if bad things happen, and we cannot get boxed in. I feel very, very strongly about that. August 5, 2008 123 of 145 I would also say that the same issue comes up in terms of inflation. I have argued very strenuously for nongradualism in a situation like the one we’re in. We are in a different world when we are in a situation of financial stress, and it’s very possible that we might have to raise rates very quickly. There’s a good news case and a bad news case. The good news case is that housing prices stabilize. That could actually turn things around very quickly. I think, Bill, if I’m not incorrect, you mentioned that possibility, and I think you’re absolutely right. In that kind of situation, our policy would become very accommodative. I do not think it’s too accommodative at all right now. I think it’s balanced; it’s appropriate. But if the financial markets improve, it will become much too accommodative very quickly, and we then have to respond very quickly in order not to have inflationary consequences. I’d like to see that happen, by the way. The other case, which I would not like to see happen, is that inflation expectations get unhinged. I have seen no evidence that long-run inflation expectations have gotten unhinged, but there is substantial risk. If that happened, we would also have to move up very quickly. So I really implore this Committee to keep your options open. Do not get boxed in. Let’s hope and pray— let’s all get around in a circle and hold hands—that oil prices fall, which will also help us not get boxed in. Don, I told you I was going to be a little colorful. He was waiting for this one. I should mention that Don was actually at a conference where he talked about constraints on people’s behavior as a result of the transcripts being recorded, and he said, “But not Rick.” [Laughter] The third issue is something about which I am less constrained, which is communications. I would not have talked about this earlier, but it really does worry me. We have a complicated governance structure in this Committee, which I actually think is the right governance structure. We have two types of groups that vote on this Committee. We have the people who are Presidential appointees and then confirmed by the Senate, who are Board members, and I will soon not be one of August 5, 2008 124 of 145 them. I’ll be a civilian again. Then we have Bank presidents, who are much more tied into the private sector because your boards of directors, which are composed of private-sector people, recommend you. Then we do have some role, but they’re the primary people who decide who becomes a Bank president. I think that’s a very good framework. It actually serves us very well. I’ve been on both sides. I’ve been on the other side of the fence, not as a president but as an executive vice president. It serves us very well because we have a link to the private sector that we normally would not have; importantly, it keeps us real in terms of information; and there’s a group of people out there who are not in Washington or New York (because people also have a hard time about New York) but who tend to be very important supporters for us politically. So this is a system that I would very much like to see preserved. It does have a problem because of the different roles here. What I have been very concerned about—and I have had people in the markets speak to me about this—is that recently I had a very prominent central bank governor say to me, “What in the hell are you guys doing?” The issue here is that we need to have a situation where Bank presidents and also members of the Board can speak their views. They may have different views, and I very much encourage that in terms of discussion, of where they think the economy is going, which is what we do inside; and I think that does need to be done outside the Committee because it shows that there are different views, that we’re thinking about it, that we’re trying to learn from each other, and so forth and so on. What is very problematic from my viewpoint are the speeches, discussions, and interviews outside, when people talk about where they think interest rates should head and where the policy rate should head. That’s where the criticism has been coming from. I have to tell you that a lot of people whom I respect tremendously are saying to me that it’s making us look like the gang that can’t shoot straight. I think it’s a really serious problem. I understand that we want to keep the August 5, 2008 125 of 145 priority of speaking our minds, but we have to work as a team, and I think that we’re having a problem in this regard. Let me talk about why I think this is dangerous. It’s dangerous in terms of policy setting. You can see this is very blunt. Clearly, if you were in a multi-period game, you wouldn’t be this blunt. But now I’m not going to be here anymore, so you can hate me—I don’t care. [Laughter] But this kind of cacophony on this issue has the potential to damage us in two very serious ways. One is that it weakens the confidence in our institution, and I have to tell you that I love this institution. It’s very hard for me to leave this place, but it’s something I have to do. If the institution is damaged in terms of the confidence that the public and the politicians have in us, it will hurt us deeply. It will hurt us in terms of policy because it will weaken our credibility, which actually will make it harder to control inflation. So I consider this a very serious cost. The second issue is on the political front. It is very possible that we’re going to have a reopening of the Federal Reserve Act with the next Administration and the next Congress. The reason I think it is possible is that we have to restructure our regulatory structure. There’s no way to get around it—we are in a brave new world on this. That could lead to an opening of this issue. The problem here is, in that opening, there are a lot of people in the Congress who are very uncomfortable having policymakers who are not Presidential appointees and confirmed by the Senate. Two outcomes could come out of that. One is that they could take the vote away from the presidents, which I think would be a disaster because then you’re not going to have good people going into the System. We won’t have boards of directors that will be good. We won’t have all of the benefits that we think we have from the current system. The other alternative is that we then have presidents who are actually appointed by the President and then confirmed by the Senate. I think, again, that hurts the private linkage. August 5, 2008 126 of 145 So I feel very strongly about all three of these issues, but I think that you’re going to come up with serious challenges in the future that could be very damaging to the System. So I hope you think about this and still like me for being blunt, and also miss me because there will be a little less amusement. Who else would have brought Monty Python into the FOMC? Thank you very much. CHAIRMAN BERNANKE. Thank you, Governor Mishkin. Governor Duke. MS. DUKE. Thank you. I support alternative B. I don’t think that the “severe financial stress” scenario is out of the question right now. CHAIRMAN BERNANKE. Thank you. Vice Chairman. VICE CHAIRMAN GEITHNER. Thank you, Mr. Chairman. I support alternative B for the reasons that you and many others have already stated. CHAIRMAN BERNANKE. Thank you. I want to thank everyone for your comments today. I know we don’t have agreement around the table, but as somebody once said, if everybody agrees, then everybody except one is redundant. [Laughter] I listened very carefully to what has been said. I understand your concerns. I think hard about them—I do every day. As we go forward, we will obviously continue to have these fruitful discussions. I do think that we need to continue to clarify this exit strategy issue. One point I would make, and Governor Warsh alluded to it, is that we need to think of this as a state-dependent rather than a time-dependent strategy. We need to be clear not so much as to whether we are or are not going to raise rates but under what circumstances and why and what our objectives are. On that basis, I reiterate that my greater attention recently to financial and real conditions has to do with my view of the risks rather than my objective function. I recommend no action today and alternative B. There were a number of suggestions for changes. I think I will avoid them just to avoid further controversy. My reasons for suggesting August 5, 2008 127 of 145 alternative B were well stated by President Pianalto. It’s hard to judge. I don’t know what the markets will make of this, but my intention is for it to be slightly hawkish—to indicate a slight upward tilt in policy—which has several functions. First, if we don’t move, it emphasizes our ongoing concern with inflation and perhaps provides some prophylactic protection with respect to expectations and so on. On the other hand, if conditions do warrant action, and it could be quick action, at least we will have provided the markets with some warning and some indication of our concern about this issue. So that’s my recommendation. Any comments? Would you call the roll? MS. DANKER. Yes. This vote includes the alternative B language from the table distributed this morning and the directive from 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 2 percent.” Chairman Bernanke Vice Chairman Geithner Governor Duke President Fisher Governor Kohn Governor Kroszner Governor Mishkin President Pianalto President Plosser President Stern Governor Warsh Yes Yes Yes No Yes Yes Yes Yes Yes Yes Yes CHAIRMAN BERNANKE. Thank you very much. The next meeting is September 16, and we will adjourn now to the Terrace Level of the Martin Building to pay honor to Governor Mishkin. Thank you very much. END OF MEETING September 16, 2008 1 of 108 Meeting of the Federal Open Market Committee on September 16, 2008 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, September 16, 2008, at 8:30 a.m. Those present were the following: Mr. Bernanke, Chairman Ms. Duke Mr. Fisher Mr. Kohn Mr. Kroszner Ms. Pianalto Mr. Plosser Mr. Stern Mr. Warsh Ms. Cumming, Messrs. Evans, Lacker, and Lockhart, and Ms. Yellen, Alternate Members of the Federal Open Market Committee Messrs. Bullard, Hoenig, and Rosengren, Presidents of the Federal Reserve Banks of St. Louis, Kansas City, and Boston, respectively Mr. Madigan, Secretary and Economist Ms. Danker, Deputy Secretary Mr. Skidmore, Assistant Secretary Ms. Smith, Assistant Secretary Mr. Alvarez, General Counsel Mr. Sheets, Economist Mr. Stockton, Economist Messrs. Connors, English, Kamin, Rolnick, Rosenblum, Slifman, Tracy, and Wilcox, Associate Economists Mr. Dudley, Manager, System Open Market Account Mr. Cole, Director, Division of Banking Supervision and Regulation, Board of Governors Mr. Clouse, Deputy Director, Division of Monetary Affairs, Board of Governors Mr. Parkinson, Deputy Director, Division of Research and Statistics, Board of Governors Mr. Blanchard, Assistant to the Board, Office of Board Members, Board of Governors Mr. Struckmeyer, Deputy Staff Director, Office of Staff Director for Management, Board of Governors September 16, 2008 2 of 108 Mr. Gagnon, Visiting Associate Director, Division of Monetary Affairs, Board of Governors Messrs. Reifschneider and Wascher, Associate Directors, Division of Research and Statistics, Board of Governors Mr. Oliner, Senior Adviser, Division of Research and Statistics, Board of Governors Mr. Small, Project Manager, Division of Monetary Affairs, Board of Governors Mr. Luecke, Section Chief, Division of Monetary Affairs, Board of Governors Mr. Carlson, Economist, Division of Monetary Affairs, Board of Governors Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of Governors Mr. Moore, First Vice President, Federal Reserve Bank of San Francisco Mr. Judd, Executive Vice President, Federal Reserve Bank of San Francisco Mr. Altig, Ms. Baum, Messrs. Rasche, Schweitzer, Sellon, and Tootell, Senior Vice Presidents, Federal Reserve Banks of Atlanta, New York, St. Louis, Cleveland, Kansas City, and Boston, respectively Mr. Krane, Vice President, Federal Reserve Bank of Chicago Mr. Chatterjee, Senior Economic Adviser, Federal Reserve Bank of Philadelphia Mr. Wolman, Senior Economist, Federal Reserve Bank of Richmond September 16, 2008 3 of 108 Transcript of the Federal Open Market Committee Meeting on September 16, 2008 CHAIRMAN BERNANKE. Good morning, everybody. Sorry for the late beginning. The markets are continuing to experience very significant stresses this morning, and there are increasing concerns about the insurance company AIG. That is the reason that Vice Chairman Geithner is not attending, and Chris Cumming will sit in his place. I want to turn in a minute to Bill Dudley for his usual report, and he will be able to give you more information about the situation. There is another action item I would like to add, given what is happening, which is that there are very significant problems with dollar funding in other jurisdictions—in Europe and elsewhere. After Bill makes his presentation and we have our discussion, I would like to put on the table a request for authorization for swap lines. I prefer not to put a limit on it, so I know I’ve got my own bazooka here. [Laughter] There is a Foreign Currency Subcommittee that consists of myself, the Vice Chairman of the FOMC, and the Vice Chairman of the Board. Again, after Bill’s discussion, I would like to discuss the possibility of giving us a temporary authority to use swap lines as needed. Before I turn to Bill, let me say one other thing. Obviously, we started late. We have a lot to talk about. I would like—just for today, if you would indulge me—to condense our discussion to one round. In your discussion, please include your tentative views on the policy decision. Obviously, that is not ideal because you will not have heard everyone else’s views, but we will have an opportunity afterward for people to amend, revise, and give additional thoughts. But in the interest of time, I think it would be more efficient at this time just to do it that way. Without further ado, let me turn to Bill and ask for a report. MR. DUDLEY. Thank you, Mr. Chairman. I am not going to go through this in great detail. You can look at these charts at your leisure. 1 I am going to focus on 1 The materials to which Mr. Dudley refers are appended to this transcript (appendix 1). September 16, 2008 4 of 108 what is going on right now, how we have responded to it, and what I think the issues are. Just to give you a snapshot of what has happened since Sunday evening, stocks are down worldwide—4 percent plus everywhere. Yesterday, the U.S. stock market was down about 4½ percent, and S&P futures indicate a lower opening today. As you might expect, there has been a big flight to quality, especially into the Treasury bill market. Ten-year Treasury note yields fell about 30 basis points yesterday, and there has been a big rally throughout the Treasury curve. The big thing, where there has probably been the most severe stress in the market, is in dollar liquidity for foreign banks. As you remember, foreign banks, especially in Europe, have a structural dollar funding shortfall, and they look to execute foreign exchange swaps or borrow in the dollar LIBOR market to fund that. There was significant upward pressure in that market—overnight LIBOR rates today were 6.44 percent—and that pressure in Europe is leaking over into our market. Yesterday the federal funds rate opened at 3 to 3½ percent. Despite our doing a $20 billion repo at our normal 9:30 a.m. time, the upward pressure on the funds rate yesterday continued. It rose to as high as 6 percent in the late morning, and that is why we came in with a second operation of $50 billion around noon yesterday. To try to have more effect on this issue, this morning we came in much earlier than we normally do—around 8:00 a.m. We did a $50 billion overnight repo. The funds rate at the time was trading at 3¼ percent. I think this means that we are obviously adding way too many reserves for the current maintenance period; but the good news is that, when this maintenance period is over a week from tomorrow, we get a fresh start. So at the current time I think we will see essentially a lot of firmness in the funds rate in the morning and then the funds rate trading down to zero late in the day. Where the funds rate averages relative to the target is going to be somewhat difficult to say. Yesterday, despite the collapse in the funds rate to essentially zero at the end of the day, the funds rate was quite firm relative to the target. I don’t remember the numbers, but it was in the 2½ percent range. We are going to try to hit the target on average, but it is going to be very difficult. In the current circumstances, it probably is more sensible—at least my advice would be—to err on the side of providing enough liquidity to the market rather than trying to be cute and worrying just about the target federal funds rate. Now, the Lehman filing has also intensified the pressure on Morgan Stanley and Goldman Sachs in a number of respects. The Lehman failure means that investors now view the debt of Morgan Stanley and Goldman Sachs as having much more risk than it did on Sunday. This means that these firms need bigger liquidity buffers than they had before, and it does have implications for long-term profitability. As a consequence, their share prices fell very sharply yesterday. Morgan Stanley was down about $5 a share, to $32, and Goldman Sachs’s stock was off 18 points, to $135. Morgan Stanley experienced a modest, but not insignificant, pulling back of their counterparties and ate into their liquidity buffer by a measurable degree. The Lehman problems also were evident in some other areas. This is very incomplete, but the ones that came to my attention were money market funds—especially, the Reserve Fund that had large withdrawals, and they encountered a significant liquidity September 16, 2008 5 of 108 problem. I am actually not sure how that was resolved, but I think that State Street was in the situation of having to cover a very large shortfall of the Reserve Fund last night. The risk here, of course, is that, if AIG were to fail, money funds have even a broader exposure to them than to Lehman, and so breaking the buck on the money market funds is a real risk. The capital resources of the entities that are associated with the money market funds often are quite modest, so their ability to top up the money funds and keep them whole is quite limited. Thus the money market funds are definitely one important issue in how this contagion could be broader. The second issue is the people who are dealing with Lehman and who have positions with Lehman as their counterparty and how they wind up those positions. As you know, the parent filed for bankruptcy, but the U.S. broker-dealer is still in operation. But being in operation doesn’t mean that they are necessarily conducting business in a normal way. One issue that has received a lot of attention is from some of the asset managers on their mortgage TBA positions with Lehman. Apparently, the sell side can net these up pretty easily through the FICC (Fixed Income Clearing Corporation), but the asset managers have positions with Lehman to either take on mortgage-backed securities or to sell mortgage-backed securities on a forward basis, and they are not really sure what those positions are going to be when we get to that date. Lehman was not executing those trades yesterday, and so these asset managers are in the very unfortunate position of not knowing what to do. Do they offset their Lehman position with a trade elsewhere or not? So that has been another very openended issue for the market. In terms of market function yesterday, it was manageable in the sense that markets did trade. But I think it is much too soon to think that we are going to make it through just based on yesterday’s move because that move, even though it wasn’t particularly severe in terms of, for example, the share price movement, did cause quite a bit of damage, and people are still pulling away. Of course, we also have the issue of AIG. The AIG problem is at least starting as a liquidity crisis. The problem with AIG is that the parent company doesn’t have a lot of liquidity resources and doesn’t have easy ability to funnel liquidity up from their subsidiaries because most of the subsidiaries are regulated entities. So AIG is running into two problems: One, they are unable to roll their commercial paper and, two, as their ratings are downgraded—they were downgraded by Moody’s yesterday, I think from AA minus to A minus, but don’t quote me on that—they have to post a lot more collateral against their derivatives exposures and also with respect to their GIC (guaranteed investment contract) business. So AIG is in a situation in which the parent is basically going to run out of money—today, tomorrow, Thursday, or very, very soon. Now we say it’s a liquidity thing, but a lot of times when people look closer at the books they find out that the liquidity crisis may also be a solvency issue. I think it is still a little unclear whether AIG’s problems are confined just to liquidity. It also may be an issue of how much this company is really worth. Finally, let me talk a bit about the facilities that we introduced over the weekend. Basically, we did two things. We broadened the Primary Dealer Credit Facility (PDCF) significantly in terms of collateral eligibility. Whereas, before, the PDCF September 16, 2008 6 of 108 took investment-grade securities only, we broadened it to include basically everything that is in the tri-party repo system. We felt that, by backstopping the tri-party repo system completely, we would reassure tri-party investors that they didn’t face rollover risk, and so we would keep tri-party investors investing with the banks. That seems to be mostly what happened, at least yesterday. We did get quite a bit of PDCF borrowing yesterday evening, but it was predominantly Lehman. It was about $28 billion of Lehman borrowing. I think the total borrowing was something on the order of $42 billion. That is telling you that most of the borrowing we had was associated with Lehman’s not being able to roll over their tri-party repo positions with their investors. We don’t really know the reasons for the other borrowing, but it probably was mostly to test the facility as opposed to actual need. So broadening the PDCF collateral eligibility does seem to be working, so far at least, in keeping tri-party investors in the game and continuing to provide funds to the other primary dealers. The second thing we did was to the Term Securities Lending Facility (TSLF). In terms of the collateral requirements, that had been AAA-rated RMBS, CMBS, and asset-backed securities. We broadened that collateral, so the terms are now the same as the old Primary Dealer Credit Facility. We think that there is quite a bit of collateral that the primary dealers have in those AA, A, and BBB classes of assetbacked securities, CMBS, and RMBS. So we think that is going to provide more support to the primary dealers in terms of funding their liquid collateral in this environment. We also increased the size. The original authorization was for $200 billion. Our auction schedule had been $175 billion, and we put that $25 billion increase into schedule 2. Remember, there are schedules 1 and 2. Schedule 1 is Treasuries and agencies. Schedule 2 is Treasuries, agencies, and this other stuff. So the schedule 2 auctions are going to go up in size, and we frontloaded that increase because the TSLF has not been fully subscribed. We are actually going to be able to do two TSLF schedule 2 auctions this week of $35 billion, so we are going to get quite a bit of TSLF liquidity into the market this week, which we think will also be helpful. So that is where things stand. Otherwise, I think things in the market are doing what you would expect. There is a flight to quality. The Japanese yen and the Swiss franc are outperforming. The dollar is sort of in the middle, and the high-yielding currencies continue to be under pressure. But that is just what we have seen for the last year underlying these risk trades. I have a lot more material, so if you ask questions I can get into that. But I think I will just leave it there. CHAIRMAN BERNANKE. Questions for Bill? President Rosengren. MR. ROSENGREN. Just an amplification on the State Street situation. My understanding is that no money actually went out. There was $20 billion in withdrawals that came in late in the day. They had a $7½ billion credit line. State Street had enough collateral to September 16, 2008 7 of 108 do $7½ billion. They were unwilling to do $20 billion. They asked us what our position was, and we told them that they needed to make their own business decision in this case. I haven’t heard what has happened this morning. I assume that they are scrambling for funds. But I would emphasize that a real concern is that there will be a run this week on money market funds because they may have to freeze the funds. It is possible that they will break the buck, and this will be at organizations that don’t have sufficient capital to make people whole. So I think that is a real concern. CHAIRMAN BERNANKE. President Plosser. MR. PLOSSER. Just a question on the PDCF, about the expansion of the collateral base. You said there was $42 billion, $28 billion of it was Lehman. Do we know what kind of collateral Lehman posted? Did they actually make use of the expanded options or not? What was the nature of it, do you know? MR. DUDLEY. That was not actually even known until late yesterday evening. It takes a while for us to get the reports from the clearing bank to be able to go through and tell you what the collateral is. In terms of the Lehman collateral, they are not allowed to broaden the PDCF— they are basically bringing us the stuff they had on Friday. It is also important to recognize that for Lehman we are demanding a lot higher collateral requirements on the non-Treasury and nonagency securities. Their collateral haircut for those is 20 percent. So the Fed is taking some credit exposure there, but we put in place on Friday—and we are continuing that—a 20 percent collateral haircut on the non-Treasury and non-agency stuff that is in the PDCF for that exposure to Lehman. We think that’s about roughly three times the market level that investors had been charging previously, so I think that gives us a fair degree of protection. CHAIRMAN BERNANKE. President Lacker. September 16, 2008 8 of 108 MR. LACKER. Thank you, Mr. Chairman. The higher collateral requirement, is that just Lehman? MR. DUDLEY. At this time, I believe that is right. MR. LACKER. Okay. I know there was a lot of concern going in yesterday about the tri-party repo market, and I envisioned two scenarios and anything in between them. One is triparty lenders pulling away from particular names and moving their funds to other names. Another, at the other extreme, would be tri-party repo lenders pulling away from the market as a whole. If you look at the tri-party repo market from the point of view of the borrowers, that is a frightening scenario. Then the lenders are going to do something with that money. I have been curious about what they would do. My understanding is that cash balances, in essentially deposit accounts, piled up at State Street and BONY yesterday and that they were able to do tri-party repos with some institutions that had been pulled away from. Is that a valid observation? What are the prospects for that providing some kind of resilience for the tri-party market? MR. DUDLEY. Well, I guess the first thing I would say is that you are absolutely right. If investors pull away, they have to take their money somewhere. It doesn’t disappear. I think that the Primary Dealer Credit Facility has been shown to be pretty significant in providing support to this market. If you look at what happened to Lehman, for example, even though Lehman was under extreme pressure on Friday, the tri-party repo investors stayed with Lehman on Friday night, which actually surprised me. I think the reason that they stayed is that they knew they didn’t really have a lot of rollover risk. As long as the broker-dealer didn’t file for bankruptcy over the weekend—and that was the risk they really were taking—the Federal Reserve and the PDCF would be there as the tri-party repo investor of last resort. Lehman’s experience suggests to me that, if we can contain the broad parameters of this crisis so that it September 16, 2008 9 of 108 doesn’t spread much further, then we can keep the tri-party repo investors from bolting because they don’t really have a huge amount of risk as long as we are there behind them to take them out when their overnight obligation comes due the next day. MR. LACKER. So, if I can just follow up, my understanding is that tri-party repos are exempt from the automatic stay, so it is not filing per se that is the risk. It’s the risk that they don’t have the cash, right? MR. DUDLEY. Well, I’m not sure about that. I thought that there was an issue about broker-dealer filing. I know that the clearing banks are certainly quite nervous about that eventuality, but I’m not a lawyer. MR. PARKINSON. The repos are exempt from the automatic stay provisions of the bankruptcy code. But if Lehman had gone into SIPA liquidation, they could have been subject to a SIPA stay. MR. LACKER. All right. Then a question about the TSLF. Is it this program in which we provide Treasuries? MR. DUDLEY. We give them Treasuries, and they give us other stuff. You know, this will also probably be helpful this week in providing more Treasuries to the market. There was a tremendous amount of Treasury fails yesterday. So this mechanism does two things. It takes illiquid collateral from the dealers, and it also supplies a lot of Treasuries to the market, which should help improve the market function in Treasuries. CHAIRMAN BERNANKE. Other questions? Bill, would you be able to talk a bit about the need for swaps? MR. DUDLEY. I have just sketchy details based on a phone call, so this may not be quite right. But my understanding is that this morning Norway put in place a facility by which September 16, 2008 10 of 108 they are going to offer their banks dollars, up to $5 billion, on a one-week term—sort of an open facility. The fact that Norway is doing this suggests that the situation has broadened quite a bit further because this is the first time that we have heard about Norway in this story, except for maybe some exposures to the Icelandic banks. I have had some conversations with my counterparts at the ECB this morning—this is at a staff level, so I can’t really say what would happen if you were to take this up the chain of command. But certainly, at least on a preliminary basis, there is quite a bit of interest in having a similar facility for the ECB, which would not be a TAF loan type of facility but more of an open facility where European banks could come and get dollars. This would reassure people that dollar liquidity was available in Europe throughout the European day. My advice to you is that this is probably a good idea in this environment because we are seeing that the lack of dollar liquidity in Europe is really having a feedback effect on people’s willingness to do business with one other in the broader markets. I think we should be open to doing this with the ECB and perhaps with the Bank of England and the Bank of Japan as well—at least have the ability to do it should it prove necessary. CHAIRMAN BERNANKE. You had a two-hander, Governor Kohn? MR. KOHN. Just to note that we did have a discussion of foreign exchange swaps in the Committee on the Global Financial System a week and a half ago, and the general consensus was that these had been very handy in damping pressures in money markets—dollar funding markets in particular—when the foreign exchange swap market isn’t working very well in Europe and in Switzerland. The central banks around the table, which are all the major central banks, are quite supportive of expanding the facility. We were talking about putting something on a standby September 16, 2008 11 of 108 basis for use in situations just like this. So the other central banks view this as very helpful to them in containing pressures in their own markets. MR. DUDLEY. The Bank of Japan has requested at the staff level to set up a facility that would be on the shelf for year-end because the Japanese are quite worried that their banks are going to face a dollar funding problem at year-end. Now, this preceded the recent crisis, so even before this last week they were concerned that the Japanese banks could potentially have problems, and they were interested in exploring with us having a facility in place. We were actually going to pursue this, and I hope we will have more at the October FOMC meeting if not sooner. CHAIRMAN BERNANKE. Bill, if we were going to take action today, what would you recommend in terms of counterparties? Should we say an unlimited amount? Should we specify an amount? Can we leave the time open? What are your recommendations on all those dimensions? MR. DUDLEY. Certainly you want to make it pretty broad. You want to make it to the Bank of England, Switzerland, the ECB, the Bank of Japan, potentially Canada. I would leave it to their discretion if they would like to participate. I would make the offer to them; and if they want to participate, then we should be willing to do that. In terms of size, I think it is really important that you don’t create notions of capacity limits because the market then can always try to test those. Either the numbers have to be very, very large, or it should be open ended. I would suggest that open ended is better because then you really do provide a backstop for the entire market. As we’ve seen with the PDCF, if you provide a suitably broad backstop, oftentimes you don’t even actually need to use it to any great degree. So I think that should be the strategy here. CHAIRMAN BERNANKE. President Lacker. September 16, 2008 12 of 108 MR. LACKER. Remind me again how big the European system of central banks’ own outright holdings of dollar balances are. MR. DUDLEY. European banks? MR. LACKER. Yes. MR. DUDLEY. I don’t know. MR. LACKER. Central banks. MR. DUDLEY. Do you mean in terms of their dollar foreign exchange reserves? MR. LACKER. Right. The ECB—they all have their own dollar reserves. MR. DUDLEY. I don’t have the numbers. MR. SHEETS. I believe that number is about $180 billion of dollar reserves in the euro system. The ECB itself has control of only a fraction of that. MR. LACKER. These are held at individual national central banks, so our swap lines to them aren’t approaching that level yet, right? MR. DUDLEY. No. MR. LACKER. Note here a sense of discomfort with our lending them dollars that they already have and so our serving as a substitute for their mobilizing their own dollar reserves for this purpose. Obviously, the demand could swamp their own reserves, and at that point I would feel differently about this. But my understanding is that the distribution within the European system of central banks is uneven, and in some sense this just provides them with a way to circumvent negotiating how those dollars would be distributed from different central banks to different private-sector banks within their own system. Broadly, I’m uncomfortable with our playing that role. September 16, 2008 13 of 108 CHAIRMAN BERNANKE. Whether it’s sensible or not, the ECB has made a pretty strong distinction with us between their foreign exchange reserves and their dollars that they use in these operations. They really want to keep those segregated. They want, to some extent, to represent this as being a collaborative effort with the United States as opposed to something they are taking on their own behalf. From their perspective—actually President Poole raised the same issue earlier on, and we had this discussion—they seem to put a lot of value on having a distinct swap line, which symbolizes the cooperation and coordination of the two central banks as opposed simply to using their own reserves. President Fisher. MR. FISHER. Mr. Chairman, I was going to say that we had this discussion before. We did approve the swap lines. I wonder if you could just summarize for us what you view as the downside risk to our doing this. CHAIRMAN BERNANKE. Well, I don’t think there are any significant downside risks. There are operational issues that Bill Dudley and his team have to worry about. If we extend funds to the Europeans, which they then relay to their banks, it affects our reserve positions and affects the management of the federal funds rate and requires sterilization. That’s an operational issue. I suppose, if there were really very large draws, it would begin to affect some of these balance sheet constraint concerns that we have. I think that is not an entirely separate issue, but it is certainly one that we are looking at in terms of trying to get interest on reserves and those other kinds of measures. Again, my expectation is that having the facility would in part provide some confidence over and above how much we actually extend. So I guess the operational issues and the further draw on the balance sheet would be the downside, but to me, it seems to be a relatively September 16, 2008 14 of 108 straightforward step—one we’ve done in the past and one that has the additional benefit of indicating global cooperation on these issues. MR. DUDLEY. In principle, we could talk to the ECB and other central banks about having the rate on these swap lines be at a slight penalty relative to normal times to try to mitigate the potential reserve impact. I mean, it doesn’t have to be at 2 percent or 2¼ percent for overnight funds—it could be somewhat north of that. But if we have a credible backstop, then it should calm the markets, and then the backstop should not be used. If we have a backstop and it actually is used, that is presumably because market conditions are horrific. So in that environment, you could argue that the reserve-management things are very second order concerns in some sense. CHAIRMAN BERNANKE. Other comments? All right. Then I’d like to propose that the FOMC delegate to the Foreign Currency Subcommittee an unspecified authority, in terms of amount, to offer swaps to foreign central banks as needed to address liquidity pressures in those other jurisdictions. Those decisions will be made, again, by the Foreign Currency Subcommittee in consultation with the Open Market Desk. We would keep the FOMC closely informed, and we would revisit and discuss this issue again in October. Is that an acceptable resolution? Any amendments to that? Further discussion, comments, or concerns? President Stern. MR. STERN. Yes. I am in favor of this. I just wonder how the marketplace will look at the open-ended nature of this because typically we have dollar magnitudes associated with swaps. It may all go relatively smoothly; on the other hand, it may raise questions about exactly what we think the issues are here. September 16, 2008 15 of 108 MR. DUDLEY. Well, I think we are going to have discussions with our foreign counterparts to decide what the right strategy is. I think right now it is better to have it open ended. MR. STERN. That’s fine. CHAIRMAN BERNANKE. Why don’t we have discussions with our counterparties— we won’t announce anything today, I would assume? MR. DUDLEY. No, I think they have to take it up the chain of command, just as we do here. So it’s going to take probably a day. MR. KOHN. This would come out in the minutes for this meeting. CHAIRMAN BERNANKE. Right. We’ll announce something. MR. STERN. But I assume there will be an announcement at some point. CHAIRMAN BERNANKE. Of course. When would we announce this measure? MR. DUDLEY. I think it would be after we’ve had a chance—I mean, I think we have a lot of work to do with our foreign counterparties. This was basically raised to me this morning. CHAIRMAN BERNANKE. All right. So this is all conditional on agreements and discussions with other counterparties. We will come up with a joint communication announcement strategy. President Plosser. MR. PLOSSER. I just have one clarification. I have no basic objection to this. I wonder whether or not, if the FOMC is going to delegate the decision to this group, it is sort of an openended delegation to do this on an ongoing basis. Does it make sense to define a period of time for which this open-ended delegation is appropriate—that it would expire and would have to be renewed? September 16, 2008 16 of 108 MR. DUDLEY. Yes. We have authorities extending right now to January 30 for a lot of these facilities, so that would certainly be a reasonable time frame, I think. CHAIRMAN BERNANKE. Existing facilities go to January 31, is that right? MR. MADIGAN. January 30. CHAIRMAN BERNANKE. January 30. Would that be acceptable? MR. PLOSSER. Yes. I think it ought to have a termination point so that, if we wanted to renew it, we would be free to do so, but it wouldn’t last forever. CHAIRMAN BERNANKE. Of course. MR. KOHN. One more clarification, Mr. Chairman—this is intended for G-10 central banks, to include the ECB. Just to be clear, if somebody asks, this is not to give to central banks of emerging-market economies. MR. DUDLEY. I presume so. MR. KOHN. I think we should presume so. If the other were to happen, we would come back to the Committee. MR. DUDLEY. Yes, this is about the major financial centers and the ability of large banks that operate globally to obtain dollar funding. CHAIRMAN BERNANKE. Okay. So I amend the proposal to terminate on January 30. President Lacker. MR. LACKER. Could I hear a little more about the benefits of an open-ended commitment? All of our programs have been capped at a certain size. You said something about “test the limits,” and it makes me think of foreign exchange regimes. What kind of scenario do you have in mind? September 16, 2008 17 of 108 MR. DUDLEY. I think a lot of the programs that we have are actually open ended. The discount window is open ended in the sense that it’s limited only by the amount of collateral that the banks post there. The Primary Dealer Credit Facility is open ended in that it is limited only by the size of the tri-party repo system. My point here is that, if foreign banks worry about capacity limits, even having a large program could in principle not be sufficient in extremis. But if the program is open ended, the rollover risk problem goes away. If I lend you more dollars today, I don’t have to worry about getting those dollars back because I always know that the facility is there. So it’s really the elimination of the ability to flatten out your position if you need to in terms of your dollar exposures. CHAIRMAN BERNANKE. It’s not open ended in the sense that it is not an open window that anybody can come to and take. It just gives us the authority to adjust the amount. MR. LACKER. So you will set a definite amount? CHAIRMAN BERNANKE. We will certainly negotiate with the other central banks and tell them what we’re doing now. But we want to have the flexibility in case of an emergency to respond, and we also don’t want to communicate to the markets somehow that we have a hard limit that is not going to be changed. That would be potentially bad for confidence. MR. LACKER. But we will communicate a program size? MR. DUDLEY. I think that remains to be discussed with our counterparties. I think we need to have discussions about what would be most effective. Would a big size that’s fixed in quantity be most effective? Would an open limit be most effective? I think we have to have those discussions. I think the important thing here—and what we’re going for—is credibility. In a crisis you need enough force—more force than the market thinks is necessary to solve the problem—and we’re going to have to have discussions to determine how much is enough force. September 16, 2008 18 of 108 CHAIRMAN BERNANKE. I think it is mostly a communication issue. Anything else? All right. Do you want to call the roll on this one? MR. KOHN. So move. CHAIRMAN BERNANKE. We need a second. MR. FISHER. Second. CHAIRMAN BERNANKE. All right. Thank you. MR. PLOSSER. Can we read the resolution? CHAIRMAN BERNANKE. The resolution is to provide to the Foreign Currency Subcommittee the authority to enter into swap agreements with the foreign central banks as needed to address strains in money markets in other jurisdictions. This will be done in cooperation with the Open Market Desk and in consultation with those other central banks. The amounts are unlimited in principle, but the decisions will be made by the Foreign Currency Subcommittee as needed and as appropriate for the particular circumstances. The FOMC is providing this authority through January 30. It will, of course, be open to discussion at any meeting. MR. PLOSSER. As actions are taken, presumably you’ll circulate the outcomes of these decisions to this Committee in advance of any announcements?. CHAIRMAN BERNANKE. Of course. All right. Let’s take a vote. MS. DANKER. Chairman Bernanke First Vice President Cumming Governor Duke President Fisher Governor Kohn Governor Kroszner President Pianalto President Plosser President Stern Governor Warsh Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes September 16, 2008 19 of 108 CHAIRMAN BERNANKE. Thank you. Brian, have you circulated the statement? MR. MADIGAN. Yes, Mr. Chairman. Everybody should have it. CHAIRMAN BERNANKE. Has everyone a copy of that? Good. Before we get started on that, I just want to comment that we may want to say something in the statement about financial conditions, but we’ll come back to that later. We need also now a vote to ratify the domestic open market operations. MR. KOHN. So move. CHAIRMAN BERNANKE. Any objections? Okay. Thank you. Let’s turn now to the economic situation. Dave Stockton and Nathan Sheets. MR. STOCKTON. Thank you, Mr. Chairman. In response to your request for some economy in our remarks this morning, I’m going to set aside my prepared remarks and just hit some of the highlights here. We did receive a great deal of macroeconomic data since we closed the Greenbook last Wednesday. We didn’t seem to get any of it right, but it all netted out to just about nothing. [Laughter] Retail sales came in considerably weaker than we had anticipated, enough by themselves to have knocked about ½ percentage point off third-quarter GDP growth. But some of that was offset in higher retail inventories, and the rest was offset by a stronger-than-expected merchandise trade report for July. It all left us still feeling very comfortable with our forecast because it looks to us as though economic growth is going to drop below 1 percent on average in the second half of the year. In terms of the things that really have stood out over the intermeeting period, at least to my mind, one has been the weakness in consumption. As I indicated, the retail sales report was weak; and now with that report in hand, we’d probably mark down our current-quarter consumption forecast to a decline of 1½ percent at an annual rate. What I think is really remarkable about that is that this weakness is occurring even though we still think spending is probably receiving some boost from the rebates. So excluding that effect, we’d be looking at something even weaker. Now, as you know, we’ve been head-faked a number of times by the retail sales data, which are subject to some pretty substantial revisions. So I wouldn’t necessarily take that report at face value. But the drop we’ve seen in motor vehicle purchases pretty much mirrors in size and timing the kind of falloff that we’ve seen in overall consumption spending. So it looks like a very weak picture for consumption. The other notable development over the intermeeting period has been the weakness in the labor markets—now not principally in the payroll employment figures. Private payroll employment has been falling pretty sharply but not any faster than we would September 16, 2008 20 of 108 have thought. But the rise in the unemployment rate is remarkable. Now, some of the 0.4 percentage point increase in the unemployment rate last month could be statistical noise. It wouldn’t be entirely surprising to see it fall back some. But the more than 1 percentage point rise that we’ve had since April is not going to be statistical noise. Some of that increase probably reflects a bigger response to the emergency unemployment compensation program than we previously thought, and we’ve upped our estimates for that to a little less than 0.3 percentage point on the level of the unemployment rate. But even putting that aside, we have experienced a more significant rise in the unemployment rate, and I think that’s consistent with other things that we’re seeing in terms of the labor market data. We’ve seen another appreciable jump in initial claims. Announced job cuts are up. Job openings are down. Survey hiring plans have softened. Now, this sharp rise in the unemployment rate is a bit difficult to square with a GDP figure that looks as though it was running above 3 percent in the second quarter and even 2 percent if you want to average the first and second quarters together. There are occasionally large errors in Okun’s law, as I think I’ve noted in the past. It seems as though Okun’s law gets obeyed about as frequently as the 55 mile an hour speed limit on I-95. [Laughter] But still, one of the things that we should probably be considering is that perhaps the economy has not been as strong as suggested by the real GDP figures. Real gross domestic income, which is output measured on the income side of the accounts, has risen about 2 percentage points less than GDP over the past year. And if we look at industrial production and compare that with the components of GDP that are, in essence, goods production, there’s about a 1 percentage point discrepancy there, with industrial production suggesting weaker figures than GDP. We see no reason to discount the rise in the unemployment rate as suggesting that we’re entering the second half with more labor market slack than we had previously thought. Furthermore, on net, we’ve revised down our projected growth in GDP over the next two years—admittedly just a bit—and that was in response to two pretty strong crosscurrents. One was the significantly lower oil prices that we have in this forecast. We do think they’re going to provide some support to underlying disposable income and spending. But the positive effect of that on our forecast going forward was more than offset by a significant marking down in our forecast for net exports—which Nathan will be discussing—in response to an appreciation of the dollar and a further downward revision to our outlook for foreign activity. On net, that left us with a little lower growth rate and carrying forward a noticeably higher unemployment rate over the forecast period. Now, those were pretty small adjustments. I don’t think we’ve seen a significant change in the basic outlook, and certainly the story behind our forecast is very similar to the one that we had last time, which is that we’re still expecting a very gradual pickup in GDP growth over the next year and a little more rapid pickup in 2010. The three things that are absolutely central to producing that outcome are our projection that we’re going to get a stabilization in housing in 2009—and early in 2009; that there will be some diminishment of the drag on growth from the financial turbulence; and that oil prices flatten out. Of those three, to my mind, the component September 16, 2008 21 of 108 that probably is most central and most important would be seeing some stabilization in the housing market, not only because this has been a big drag on growth and will also have consequences for household wealth but also because if there’s going to be some clarity and reassurance to financial market participants, it seems as though some end to the housing debacle has to be in sight. We think we are seeing a few glimmers of hope there—however, we thought that on occasion in the past and have been proven wrong. But sales of existing homes have been flat since the turn of the year. Sales of new homes have been flat for several months now. We’ve had a drop in mortgage interest rates that followed the takeover of Fannie and Freddie. Starts have fallen so much now that, in fact, builders are making significant progress in working down the inventory of unsold new homes and even months’ supply has tipped down of late. So we think that some things are looking a little better for us there. As a consequence, we’re expecting to see some bottoming-out near the end of this year or the beginning of next year—but not a sharp recovery. Overall residential investment actually is still a negative for 2009 but less of a negative than it has been this year. As you know from the Greenbook, our estimates suggest that the financial restraints on overall activity—actually on the level of GDP—will increase between 2008 and 2009, but their effects on the growth rate of GDP are diminishing somewhat. Finally, with regard to oil prices, by our assessment the rise in crude oil prices since the beginning of 2006 is probably knocking about ½ percentage point off growth in 2008; and with a flattening out of oil prices, we expect that to be more of a neutral factor over the next two years. That’s providing some impetus. A lot of what’s going on in our forecast is bad things not worsening any more quickly next year than they did this year, rather than things actually getting better. I guess it’s a sad comment that we’re relying on second derivatives turning positive to be the main force generating some upward impetus to economic growth. But we are projecting a gradual pickup. Now, on the inflation side, this morning’s CPI report for August actually came in a little better than we were expecting. The CPI in August fell 0.1 percent. We had been expecting an increase of 0.1 percent. That surprise was all in the energy component, but we at least did see some moderation in the retail food price side that we were looking for, and the change in core CPI fell back to 0.2 percent after a string of 0.3 percent increases. I don’t think these data will do much to change our basic forecast, which is for total PCE prices to be up somewhere in the neighborhood of a 5 percent rate in the third quarter, and core prices up 3 percent. Still, if one looks back at the last few CPIs and PCEs, things have come in a little higher on the core side. The projected 3 percent increase is up about ¼ percentage point from where we were in our August forecast, and our interpretation of this is that we’re probably seeing more upward impetus and passthrough from the higher energy prices, other commodity prices, and imports than we had previously expected. That certainly squares with what we’re hearing from our business contacts. It also squares with what we saw last week in the PPI, which was another very sharp increase in prices of intermediate materials. At least going forward, for the first time since this process got under way, we are seeing more than just a futures price forecast flattening out. Some easing in the prices of both oil and other commodities and the appreciation of the dollar are giving us at least a little more confidence that some of these cost pressures are going to abate going forward and that we will get the disinflation September 16, 2008 22 of 108 that we have been forecasting. We continue to see reasonably encouraging signs on inflation expectations. The medium-term and long-term inflation expectations in the preliminary Michigan report last week dropped 0.3 percentage point, to 2.9 percent. TIPS haven’t really done very much, and hourly labor compensation continues to come in below our expectations. So based on our assessment, once these cost pressures work their way through the system—and we still think that the process will take place over the second half—we think that we’ll get some receding of core inflation from the 2.4 percent that we’re projecting for this year to 2.1 percent next year and 1.9 percent in 2010. Just a couple of final remarks on current events. Hurricanes Gustav and Ike obviously created an enormous amount of devastation for a whole lot of people, but they don’t really appear to us to have significant macroeconomic consequences. There will be some temporary disruption to oil and gas extraction and refining, but it looks as though the basic infrastructure has largely been spared. I’ll be interested to hear President Fisher’s report. Retail gasoline prices have jumped in the last few days, but wholesale prices for delivery in October are actually lower than they were before the storms were on the horizon. I think that suggests that this is not going to be a major negative event. Undoubtedly, industrial production is going to fall like a stone in September, reflecting these two hurricanes as well as the Boeing strike, but we’re expecting that to bounce right back again. I don’t really have anything useful to say about the economic consequences of the financial developments of the past few days. I must say I’m not feeling very well about it at the present, but I’m not sure whether that reflects rational economic analysis or the fact that I’ve had too many meals out of the vending machines downstairs in the last few days. [Laughter] But in any event, we’re obviously going to need to wait a bit to see how the dust settles here, but I think the sign would be obviously in a bad direction. I’ll turn over the floor to Nathan. MR. SHEETS. I also will be very brief in summarizing economic developments abroad. Indeed, I would just like to make six very brief points. The first one is that the incoming data we’ve received since the last Greenbook for the foreign economies have been extraordinarily soft. Indeed, we’ve marked down our forecast or projection of the second quarter by a full percentage point. The data also suggest that we should carry forward a fair amount of that softness at least through the next year. So our foreign outlook is much softer than it was before. The second point is that this softening outlook in our view has been a key factor that has contributed to further sizable declines in oil and commodity prices. This morning, oil prices were trading around $92 a barrel, which was down another $25 a barrel from where we were at the time of the last meeting. The third point is that this deteriorating foreign outlook also seems to have triggered something of a reassessment in currency markets. Since your last meeting, the dollar has strengthened nearly 5 percent in broad nominal terms. In our view, what happened in currency markets was that the markets had priced in the expectation that the foreign economies would remain quite resilient in the face of a slowing in the United States. September 16, 2008 23 of 108 Now with the incoming data over the past couple of months, it is becoming clearer and clearer that the U.S. slowing is going to have a marked effect on these foreign economies, and this has shifted the relative attractiveness of the dollar and supported the appreciation that we’ve seen over the last couple of months. The fourth point is that, in a number of emerging market economies, we’ve seen a resurgence of certain sorts of financial vulnerabilities. We’ve seen across really a broad array of these economies rising external debt spreads and rising CDS spreads. We’ve seen falling equity prices and, for a number of these economies, downward pressures on their currencies. On that last point, a number of the Asians have been intervening in the foreign exchange market over the intermeeting period but have actually been intervening to try to prevent their currencies from depreciating, which is a marked change from what we’ve seen in the last couple of years. The fifth point is that the surprisingly strong performance of U.S. exports that we’ve seen appears to have continued through July. After the Greenbook went to bed, we got the July trade data, and they continue to point to a fair amount of strength in the export sector. It was particularly strong in the auto sector, but it was a broad-based strength through July. Nevertheless, our view is that, given the rise in the dollar and the softening outlook for foreign growth, we’re very likely to see some slowing in export growth going forward. The final point I’d like to mention is that, also late last week after the Greenbook went to bed, we received data on import prices. These data, really for the first time in a long time, showed a marked deceleration in both material-intensive goods import prices and finished goods import prices. Our forecast for a long time has called for a deceleration in import prices in line with the projected flattening out of commodity prices and a projected flattening out of the dollar. Now it seems that we’re at a point at which all those things that have been incorporated into our forecast but we haven’t had a lot of evidence for are starting to materialize. We have the dollar flattened out and, indeed, somewhat stronger than in the last Greenbook. We have lower paths for commodity prices, and then the data that we recently received showed an actual deceleration in core import prices, which gives us some confidence that perhaps the rise in those import prices has peaked. I’ll stop there. CHAIRMAN BERNANKE. Thank you. Are there questions for Dave and Nathan? MR. FISHER. Could I ask just one question, Mr. Chairman? CHAIRMAN BERNANKE. President Fisher. MR. FISHER. Could you interpret for us the Bank of China’s cut in the bank lending rate? September 16, 2008 24 of 108 MR. SHEETS. Yes. Yesterday the PBOC cut its main policy rate 27 basis points. I guess they felt that 26 would not have been enough and 28 would have been too much. [Laughter] And 27 was just the right number. I’d say a couple of thoughts were there. One important point is that inflation in China has decelerated significantly. In the spring they were looking at twelve-month inflation rates of around 8.3 percent. The latest reading for August was 4.9 percent. So it’s clearly on a decelerating trajectory. That has been driven by a marked decline in food prices. Earlier this year, food prices were moving up at over a 20 percent rate, and now it is about 10 percent. So the deceleration in prices; some concerns about where activity is going, particularly in the aftermath of the Olympics; and signs of slowing external demand have given them the scope they need to cut policy rates. Besides the cut in monetary policy, we’re also hearing reports that the authorities are poised to implement fiscal stimulus if that’s necessary. MR. FISHER. Thank you. CHAIRMAN BERNANKE. Three is a lucky number in China. Don was going to tell you that 3 cubed is 27. [Laughter]. MR. KOHN. He was also going to wonder, Mr. Chairman, whether we needed to harness the mystical powers. [Laughter] CHAIRMAN BERNANKE. I think we have good feng shui here. MR. SHEETS. The science of monetary policy. CHAIRMAN BERNANKE. Any other deep questions for our colleagues? I’m a little surprised. MR. PLOSSER. We’re all trying to be brief, Mr. Chairman. CHAIRMAN BERNANKE. Everyone has been very brief. I’m shocked. [Laughter] My proposal, which I can be argued out of, is to do one round, if that’s acceptable. Please indicate your September 16, 2008 25 of 108 preliminary view on policy, and you will have another opportunity to refine and extend your views. Is that acceptable with everybody? MR. KROSZNER. Should we have Brian’s presentation? CHAIRMAN BERNANKE. Yes, of course. I was about to turn to that. If that’s acceptable, let’s turn to Brian and have your discussion. MR. MADIGAN. 2 I will be referring to the package labeled “Material for FOMC Briefing on Monetary Policy Alternatives and Trial Run Survey Results.” The results of the survey are shown in exhibit 2. In the interest of time, I will not cover them this morning. The Subcommittee on Communications plans to be in touch with the Committee on this issue over the upcoming intermeeting period. The first page of the package reproduces the version of table 1 that you received yesterday afternoon. This version includes three policy alternatives. As in the Bluebook, alternative B would leave the stance of policy unchanged at this meeting, and alternative C would involve a 25 basis point firming today. However, alternative A now entails a 25 basis point policy easing rather than the unchanged funds rate that was specified in the Bluebook version of this alternative. I will begin by discussing alternative C. The discussion at your last meeting suggested that you generally saw the next move in policy as likely to be a firming, a point that was explicit in the minutes of the meeting. Even though market volatility and financial strains have increased notably in recent weeks, you might view those developments as having only limited implications for the economic outlook and hence see economic fundamentals as continuing to suggest that policy should soon be firmed. Inflation has been well above the rates that Committee members judge as appropriate for the longer run, and despite lower oil prices and greater slack in labor markets, there remains considerable uncertainty about how soon and how much core inflation will slow. In these circumstances, you may believe that a firming of policy is appropriate. Under the version of alternative B distributed yesterday evening, the Committee would hold the target funds rate constant at this meeting, and the statement would suggest that the Committee sees the risks to growth and inflation as roughly balanced. You may believe that this combination is appropriate for this meeting if your modal outlook for the economy has not changed much since the last meeting and if you judge that the upside risks to inflation have diminished, given the sharp drop in energy prices, the decline in indicators of inflation expectations, and the greater economic slack implied by the recent unexpectedly sharp jump in the unemployment rate. You might also believe that the downside risks to growth have increased as a result of the recent increase in financial strains. But at the same time, you may want 2 The materials used by Mr. Madigan are appended to this transcript (appendix 2). September 16, 2008 26 of 108 to let the dust settle a bit before concluding that these developments warrant an adjustment in your policy stance. In particular, you may think there is a good chance that the latest enhancements to the Federal Reserve’s special liquidity facilities will help keep markets functioning and mitigate the risks to growth. Relative to the Bluebook version, the language of alternative B has been revised in three material ways. First, B2 now notes that “strains in financial markets have intensified.” Second, the clause “some indicators of inflation expectations have been elevated” has been dropped from B3 in view of the recent declines in inflation compensation and survey measures of inflation expectations. Finally, the first sentence of B4 has been revised to suggest that the Committee now sees the significant risks to growth and inflation as roughly balanced. Given market participants’ expectation that the funds rate could trade soft to the target for a time in light of recent developments, gauging exactly what is built into markets for the outcome of today’s meeting is difficult. But earlier this morning, market prices appeared to incorporate high odds of at least a 25 basis point easing today or possibly more. Thus markets might well see a decision to keep the funds rate constant and to make no appreciable change to the language of the statement as signaling less concern about financial developments than they anticipated. If you saw recent developments as significantly boosting the downside risks to growth or noticeably lowering the modal outlook, you might consider easing the federal funds rate 25 basis points at this meeting, as in alternative A. The rationale language for this action would begin by noting that strains in financial markets have increased significantly and would go on to indicate that the policy action should help to promote moderate growth over time. The Committee would cite the recent decline in energy and other commodity prices and the increased slack in resource utilization as factors that are expected to foster a moderation of inflation. The risk assessment would indicate that “the downside risks to growth have intensified, but the upside risks to inflation remain a concern to the Committee.” With a policy easing largely built into markets, shorter-term interest rates would likely decline modestly in response to such an action, depending on how much is built in, or they might be little changed. As the Chairman indicated earlier in the meeting, adjustments to the statement could be considered in light of the further volatility in markets over the past day. Thank you, Mr. Chairman. MR. DUDLEY. If I could add a few thoughts on market expectations about this meeting—I think it looks as though easing is priced in for two reasons. One, dealers do expect the federal funds rate to trade soft as we add excess reserves, so I would not take the softness in the September federal funds futures contract as indicative of necessarily expecting an easing. Two, I think it is important to recognize that the rates embodied in those fed fund futures contracts are means not modes. So I September 16, 2008 27 of 108 would characterize the market expectation as either that things get very, very bad and the FOMC cuts rates significantly or that the FOMC does nothing. I think that actually a 25 basis point cut is probably the least likely outcome that the market anticipates. As evidence of this, a couple of dealers yesterday did change their forecast to a 50 basis point rate cut. I’m not aware of anybody who has changed to 25. Probably people like that are out there. I know that my colleagues at Goldman Sachs, where I used to work, are saying that they think the FOMC is going to keep rates unchanged today but, if they were to move, it would be 50. That gives you a sense that it’s really a bimodal kind of view and that putting different probabilities on 50 and zero gives you some easing priced into the federal funds rate futures market. So I think the consensus view still in the marketplace is that the Fed probably will not cut rates today. That would be a disappointment to a degree because there’s some probability placed on the idea that the Fed might do 50, but that’s how I would interpret what’s priced into the markets today. CHAIRMAN BERNANKE. President Fisher. MR. FISHER. Could I ask for a little clarification here? The indication of sentiment is important, is it not, in terms of expectations from the population that you’re talking about? The signaling of our direction would be important here? MR. DUDLEY. Well, I think the market participants would gain some comfort to the extent that the Federal Reserve as an institution indicates concern about what’s going on in the financial markets. But in some ways the Desk has already signaled that concern by its intervention, so I’m not sure that additional indications are needed. But in the language you might want to indicate to market participants that, if things were to materially worsen in the financial markets, the Committee might revisit the issue of where the federal funds rate should be. September 16, 2008 28 of 108 CHAIRMAN BERNANKE. Just on the issue of trading soft, though, the OctoberDecember has also come down, and there is certainly some shift in the actual policy expectation. MR. DUDLEY. That is true. I think on Friday the mood was basically that the funds rate was going to be flat for a long time. Probabilities placed on either easing or tightening were quite low, and since then the probability of easing has gone up fairly significantly. But I think it’s hard to interpret because it’s really not about 25 versus zero. It’s really about zero versus 50 or maybe even 100 as you look out longer term. Either the financial system is going to implode in a major way, which will lead to a significant further easing, or it is not. CHAIRMAN BERNANKE. Other questions? All right. If not, let’s begin with President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. I finalized the thinking that went into my prepared remarks late last week, which seemed like a good idea at the time. But I should follow the philosophy of Charlie Brown, who I think said, “Never do today what you can put off until tomorrow.” [Laughter] Obviously, we can’t ignore the events of the weekend and yesterday’s financial markets. So late yesterday I reviewed the views that I shaped last week and tried to ground them in an assessment of whether the outlook for the real economy has changed materially, whether the balance of risks has been altered, and whether, in my opinion, we must reintroduce a risk-management approach and consider taking out more insurance. With that as prologue, let me make just a couple of comments on regional soundings from the last couple of weeks. Anecdotal reports from the Sixth District support the view that the economy is quite weak but not deteriorating markedly. The CFO of a large retailer of housing-related goods said that they think they see a bottom forming. I am also starting to hear some reports that housing markets feel as though they are beginning to stabilize; but, really, it is September 16, 2008 29 of 108 a little too early to say that a bottom has formed in any of our housing markets. My overall sense from District contacts and our surveys is of an economy that is quite weak, with no clear trend evident. Turning to the national outlook, like most forecasts, my view on the likely path for the economy has not changed materially since our August meeting. I see nothing in the data and hear nothing from District reports that alters my views that the second half will be very weak. I expect this weak period to be followed by a slow recovery gathering in 2009, but the foundation of a recovery starting around year-end or early 2009 may be far from solid. The contraction of credit availability that is confirmed by both surveys and anecdotal evidence could deepen as financial institutions face tight liquidity and difficulty recapitalizing. A protracted credit crunch would likely operate as a substantial drag on the economy. Consistent with the Greenbook, I expect some near-term improvement in headline inflation, as we saw this morning, some near-term deterioration of core inflation measures, and inflation moving in the right direction later this year and into next year. That said, one director said that he and his particular industry had seen no moderation of price increases up to this date. I am comforted somewhat that the upward drift in some inflation expectation measures appears to have been reversed. In addition, my staff has been monitoring revisions to inflation forecasts of professional forecasters, which also seem to suggest that concerns about accelerating inflation have abated somewhat. Regarding the balance of risks in the economy, I am concerned that the downside risks to growth may be gathering force, as evidenced by the weakening personal consumption and retail sales data, the weakening economies of export partners, and the delicate state of the financial markets. At the same time, I perceive that there is significant risk that the current disinflationary September 16, 2008 30 of 108 environment may fail to bring core inflation down to anything resembling acceptable levels for the longer term. Adding up all of this, I perceive a very rough balance of risks that could break either way in coming months. My view of the appropriate policy path is consistent with the Greenbook—that the fed funds rate target will remain stable at or close to the current level for several months going into 2009. My preference is to hold the fed funds rate at the current level of 2 percent. Among the reasons is that a ¼ percentage point drop, as suggested by alternative A, is really not clearly called for by a changed outlook for the real economy. Inflation risks are still in play, and I think we should give credit markets more time to digest events and sort out rate relationships. As regards the statement, my preference is alternative B. However, I am concerned that the reference to the recent financial turbulence is not quite strong enough, so I took a shot at rephrasing just the beginning of the rationale section to read as such: “Economic growth appears to have slowed recently, and labor markets have weakened further. In addition, strains in financial markets have increased significantly”—basically taking the slightly stronger expression in the alternative A rationale and putting it in alternative B. So my position, Mr. Chairman, is to hold at this meeting. Thank you very much. CHAIRMAN BERNANKE. Thank you. President Rosengren. MR. ROSENGREN. Thank you, Mr. Chairman. I will be brief. This is already a historic week, and the week has just begun. The labor market is weak and getting weaker. The unemployment rate has risen 1.1 percentage points since April and is likely to rise further. I am not convinced that the unemployment rate will level off where the Greenbook is assuming currently. The failure of a major investment bank, the forced merger of another, the largest thrift and insurer teetering, and the failure of Freddie and Fannie are likely to have a significant impact September 16, 2008 31 of 108 on the real economy. Individuals and firms will become risk averse, with reluctance to consume or to invest. Even if firms were inclined to invest, credit spreads are rising, and the cost and availability of financing is becoming more difficult. Many securitization vehicles are frozen. The degree of financial distress has risen markedly. Deleveraging is likely to occur with a vengeance as firms seek to survive this period of significant upheaval. Given that many borrowers will face higher interest rates as a result of financial problems, we can help offset this additional drag by reducing the federal funds rate. I support alternative A to reduce the fed funds rate 25 basis points. Thank you. CHAIRMAN BERNANKE. President Hoenig. MR. HOENIG. Mr. Chairman, I see no reason to focus on the details of the forecast. Clearly, the economy is under stress, both as we look at the economic growth forecast and as we look at the inflation forecast. So I recognize the amount of stress we are under here. I would say to you, in dealing with that stress, I am fully supportive of the actions that we take in terms of liquidity—the TAF and the other efforts to provide liquidity into the market. These are tools that we can and should use for these kinds of shocks in a short-term context. On the other hand, I would encourage the Committee to resist the impulse to ease policy in a sense of doing something. The issue is not the level of our policy rate at this time. It is the dysfunctioning of the markets that we hope our liquidity efforts will help address. To begin to talk about easing or even to put language in there that suggests easing is to cause people, on the expectation that we might ease at some point even if we hold off now, to delay decisions that they would otherwise make that would benefit the economy. I also encourage us to look beyond the immediate crisis, which I recognize is serious. But as pointed out here, we also have an inflation issue. Our core inflation is still above where it September 16, 2008 32 of 108 should be. Headline inflation has been up, even though there are some signs that commodities and energy are backing off. But the businesses themselves are saying, “How do I recover my margin?” So there is no impulse to pass along those reductions. We talk about wages and labor backing off. But they are holding off, they are not backing off, and in negotiations they are much more antagonistic. Those kinds of pressures will emerge at some point. Those are the longer-run issues that I think we need to keep in mind as we deal with this immediate crisis. So I would strongly encourage us to leave rates where they are, to be very careful with our language, not to encourage the expectation of further rate decreases, and to continue to be aggressive in our liquidity provisions as we have been the last several weeks and months. Thank you. CHAIRMAN BERNANKE. Thank you. President Yellen. MS. YELLEN. Thank you, Mr. Chairman. During the past several weeks, my head office and Branch directors have become decidedly more pessimistic about the economic outlook. My own assessment of incoming data coincides with theirs. My contacts also report that their businesses are still raising prices in response to past increases in commodity and import prices that boosted their costs. I expect as a consequence that core inflation will remain uncomfortably high for a while longer, but the marked decline in commodity prices since June reinforces my conviction that there is light at the end of this inflation tunnel. With respect to growth, our forecast is similar to the Greenbook’s, with a little more weakness in the second half of this year and a little more strength in 2009. I think the risks to this forecast are decidedly skewed to the downside. I agree with the Greenbook’s assessment that the strength we saw in the upwardly revised real GDP growth in the second quarter will not hold up. Despite the tax rebates, real personal consumption expenditures declined in both June and July, and retail sales were down in August. My contacts report that cutbacks in spending are September 16, 2008 33 of 108 widespread, especially for discretionary items. For example, East Bay plastic surgeons and dentists note that patients are deferring elective procedures. [Laughter] Reservations are no longer necessary at many high-end restaurants. And the Silicon Valley Country Club, with a $250,000 entrance fee and seven-to-eight-year waiting list, has seen the number of would-be new members shrink to a mere thirteen. [Laughter] Exports were a huge source of strength in the second quarter, but I am concerned that we cannot count on very large contributions to growth from exports going forward, now that the dollar has begun to rise and economic growth abroad has slowed, even turning negative in some important trade partners. Indeed, the growing weakness of the global outlook appears to be an important explanation for the reversion in commodity prices, and this adds a dimension of gloom to what would otherwise be a decided plus for both inflation and demand. Recent data also suggest that labor markets are weakening across the board—a development that will cast a pall on household income and spending. The interaction of higher unemployment with the housing and financial markets raises the potential for even worse news—namely, an intensification of the adverse feedback loop we have long worried about and are now experiencing. Indeed, delinquencies have risen substantially across the spectrum of consumer loans, and credit availability continues to decline. One ray of hope is that the changes at Fannie and Freddie have caused a notable drop in mortgage rates. Another is that the decline in home prices has become somewhat less steep, and we have seen an outright improvement in home inventories relative to sales. But my contacts are very pessimistic about the prospects for nonresidential construction. They note that construction is continuing on projects in the pipeline with committed funding, but new projects are all but impossible to finance. September 16, 2008 34 of 108 Turning to inflation, I have long anticipated and still expect that inflation will fall to more-reasonable levels in 2009. However, developments since our August meeting diminish the upside risks to this projection. The drop in oil and other commodity prices, along with the appreciation of the dollar, should work to moderate the current inflation bulge and diminish the potential for a wage–price spiral to develop. Import inflation has already begun to ease. Furthermore, we have seen a remarkable decline in inflation compensation for the next five years in the TIPS market. I would not rely heavily on this decline to support my view, but I do have to say that the decline is a lot more reassuring than the alternative. I was also encouraged by the 30 basis point drop in long-term inflation expectations in the most recent Michigan survey. I anticipate that the recent jump in the unemployment rate will place some additional downward pressure on growth in labor compensation, which has been quite low, and in core inflation. Although the jump in the unemployment rate probably partly reflects the extension of unemployment insurance coverage, a back-of-the-envelope calculation suggests that the upper bound on this effect is just a few tenths of a percent. I would agree with the Greenbook estimates. We have also examined the possibility that the increase in unemployment reflects a rise in the NAIRU due to sectoral employment shifts out of construction and finance and into other industries. Ned Phelps has argued that the sectoral shift story implies a sizable dispersion of employment growth across industries and states. But we looked at these data and found no significant increase, so I don’t find this Phelps argument particularly convincing. Considering all of these factors, I expect both headline and core PCE price inflation to fall to about 2 percent for 2009 as a whole, and I see the risks to this projection as roughly balanced. With respect to policy, I would be inclined to keep the funds rate target at 2 percent today. For now, it seems to me that the additional liquidity measures that have been put in place September 16, 2008 35 of 108 are an appropriate response to the turmoil. I am fine with the wording of alternative B and would support President Lockhart’s suggestion for change. That would seem fine to me, too. In view of the intensified financial stress and the potential for more turmoil, obviously I think we will need to be flexible in setting policy going forward, and I am very concerned about downside risks to the real economy and think that inflation risk is diminished. CHAIRMAN BERNANKE. Thank you. President Bullard. MR. BULLARD. Thank you, Mr. Chairman. I am going to start with the national economy in the interest of brevity here. Concerning the national outlook, it is difficult and probably unwise to try to assess growth and inflation prospects in the immediate aftermath of an event like the Lehman bankruptcy. I expect to see more failures among financial firms, and I expect those failures to continue to contribute to market volatility. This is part of an ongoing shakeout among financial market firms, following some of the worst risk management in a generation. I expect sluggish growth in the second half of 2008, in part due to labor markets that are somewhat weaker than expected. Financial market turmoil is certainly a key concern, but the U.S. economy still outperformed expectations in the first half of 2008, despite the demise of Bear Stearns—an event not too different in some respects from the current episode. My sense is that three large uncertainties looming over the economy have now been resolved—the GSEs and the fates of Lehman and Merrill Lynch. Of these, the resolution of GSE uncertainty seems to be the most pivotal, even though it is not the one leading the news today. Normally, the elimination of key uncertainties is a plus for the economy. As is typical in this type of situation, safe interest rates have fallen dramatically across the board. A second macroeconomic shock stemming from the dramatic rise in oil and other commodities prices has been an unwelcome development during the past six months. The retreat September 16, 2008 36 of 108 of West Texas intermediate prices to $94 a barrel, and today down to $92 a barrel, should improve second-half growth prospects. Meanwhile, an inflation problem is brewing. The headline CPI inflation rate, the one consumers actually face, is about 6¼ percent year-to-date. That does not include today’s report. This is against the federal funds target of 2 percent. While it makes sense to focus on financial markets for the time being, it is essential that we keep in position to put downward pressure on inflation going forward. The financial crisis threatens to roll on for such a long time and to demand so much attention that the private sector may rationally conclude that we have lost all sight of our inflation objective. In such a case of unmoored expectations, outcomes could be far more severe than those envisioned in the Greenbook. My policy preference is to maintain the federal funds rate target at the current level and to wait for some time to assess the impact of the Lehman bankruptcy filing, if any, on the national economy. In uncertain circumstances like these, I think it would be unwise to react too hastily to a fluid situation. Any immediate effects may not be the ones that are intended, and further down the line—that is, once more data have accumulated—a hasty action may leave the Committee out of position relative to the incoming data. By denying funding to Lehman suitors, the Fed has begun to reestablish the idea that markets should not expect help at each difficult juncture. Changing rates today would confuse that important signal and take out much of the positive part out of the previous decision. In addition, a rate move would be poorly targeted toward mitigation of difficulties at particular financial firms. The FOMC has already done a great deal to create a low interest rate environment in order to shepherd the economy through a substantial shock to the financial and housing sectors. The Committee now needs to allow the financial September 16, 2008 37 of 108 sector shakeout to occur using liquidity facilities to the extent possible to help navigate the resulting turbulence. Thank you. CHAIRMAN BERNANKE. Thank you. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. New data and survey and anecdotal information in the Third District suggest that the economy in our District continues to be weak. There have been further declines in some industries and deceleration of growth in others, but generally data are coming in as expected. Employment growth was flat over the three-month period ending in July, and I expect that unemployment rates in our three states will tick up in August, when the regional data come out, much as it did in the national data. Overall, the activity in our region, as I said, has remained weak since the last meeting. Housing construction continues to be weak. Sales of existing homes remain sluggish, and inventories remain high. One builder said, “Things don’t feel very good. I feel as though I am in a tar pit. My feet are maybe now on the bottom; my nose is still above the level of the tar; and while I may feel the bottom, it still doesn’t feel very good.” On the commercial real estate side, we saw a slight uptick in the value of July contracts, but they are not very high. In fact, they really remained at the average level of the last seven years. Retailers remain pessimistic in the latest Beige Book. District banks saw loans rise slowly but steadily in August. The Beige Book reports from them see slight gains in consumer and real estate lending and C&I loans essentially flat. The good news is from our business outlook survey for September, which will be released to the public on Thursday at 10:00 a.m., but the results are in. The survey is from the first two weeks of September. The general activity index has been negative, if you recall, for the last nine months—since December 2007. The last value was minus 12.7. The September September 16, 2008 38 of 108 number, not to be released until Thursday, is a positive 3.4, so that’s a swing of 15 points to the good. This is clearly somewhat encouraging, although we don’t want to get too excited about one month—but it is good news. Furthermore, both the new orders and shipment indexes in the survey improved in September. Price pressures have abated somewhat with the fall in commodities and oil, but they remain. The six-month-ahead outlook indexes also improved substantially in the new survey. This is the best picture that the survey has painted in certainly quite a while—about the last six or eight months. In summary, the economic conditions of the Third District remain weak and sluggish but are not materially different from what we and our business contacts had been expecting over the near term. While a lot of attention in the short run is being paid to financial markets’ turmoil, our decision today must look beyond today’s financial markets to the real economy and its prospects in the future. In this regard, things have not changed very much, at least not yet. Indeed, the Greenbook forecast has changed only modestly since the last Greenbook. The economy remains weak but not appreciably different from what I anticipated or even what the Greenbook anticipated at the last meeting. I agree that the recent financial turmoil may ultimately affect the outlook in a significant way, but that is far from obvious at this point. We also need to acknowledge the long lag times associated with the effect of monetary policy actions on the real economy. Actions today will not help us very much in the very, very near term where the real economy is concerned. On the inflation front, there has been some good news. The decline in the retail price of gas has contributed to a decline in headline inflation in August. In my view, the price declines in commodities and oil have mitigated somewhat the upward pressure on expectations and have reduced the likelihood that inflation expectations will become unanchored, at least in the near September 16, 2008 39 of 108 term. Nevertheless, I remain concerned about the inflation outlook going forward. In part, my concern stems from the fact that I do not see that the ongoing expected slowdown in economic activity is entirely demand driven. As I noted before, the impact of financial shocks and high commodity prices can plausibly lead to a decline in the growth rate of potential output. If so, there will be less offset to inflation going forward than incorporated in the baseline Greenbook forecast, which relies heavily on slack variables to control inflation. The Greenbook simulation entitled “costly reallocation” provides some welcome effort from the staff in this regard, and I appreciate that. Yet the details of that experiment were a bit sketchy for me, and at some point I would be interested in a little more detail as to how that actually plays out. In my view, the main driver for the outlook of future inflation over the next two years is not, nor has it been, oil prices per se, but the path of monetary policy that the Committee will adopt over the next several months and quarters. I appreciate the memo that the staff produced regarding the stance of monetary policy. According to the memo, the current stance of policy is not unusually accommodative. However, I would like to note that that conclusion depends critically on the specific forecast and the nature of the FRB/US model. A different model, one that says that inflation expectations are more forward looking, may well lead to a very different conclusion. But I take the message of the memo to be that the assessment of the stance of monetary policy is dependent, at a point in time, on a model, and I very much agree with that assessment. Given that my model is somewhat different from the staff’s model, I continue to believe that monetary policy at its current level is accommodative and that, if this current stance is sustained, the economy will experience faster inflation in the medium term. Clearly, we must pay attention to the adverse effects of the financial disruptions. But we also must recognize that our policy actions today and over the next several months will affect the outcomes of inflation September 16, 2008 40 of 108 over the medium term. As I said, it is my view that the current stance of policy is inconsistent with price stability in the intermediate term and so rates ultimately will have to rise. Now, I acknowledge that there are risks to economic growth going forward. The slowdown and the financial market turmoil could turn out to be worse than I expect. I also recognize that, given the events over the weekend, now is probably not the time to shock markets by raising rates. But neither is it a time to panic and lower rates. A cut today may be reassuring to some in the financial markets, but it also may serve to scare markets by sending a signal that we are much more worried than perhaps they are. There is just way too much volatility and dust blowing around to make such snap judgments on monetary policy. We have been aggressive with our liquidity provisions, and we will continue to be so, and I support that. Stability coming from monetary policy is an important attribute, and I think we have an opportunity to provide some stability here. However, I am uncomfortable with the current Greenbook baseline path that has the funds rate remaining unchanged well into the second half of next year. In my view, that will not deliver an acceptable path of inflation outcome over the medium term. At the same time, I do not perceive an immediate threat to the unanchoring of expectations, so I can accept keeping the funds rate at an unchanged level at this meeting. But at some point, before the unemployment rate begins to improve substantially, I believe this Committee will need to raise rates in order to deliver on our inflation objectives. Regarding language, I can live with the language in alternative B. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Stern. MR. STERN. Thank you, Mr. Chairman. Well, even before the events of the last several days, I thought that this was the most severe financial crisis, certainly, that I have seen in my September 16, 2008 41 of 108 career. And the last several days—as well as some of Bill’s comments about possible contagion spreading from breaking the buck and so on and so forth—have only heightened that conviction and my concern about where we are. So I think it is fair to say that the headwinds confronting the economy have intensified even further. It is difficult to comment on the degree or the duration, but I think we know the direction. As far as the near-term economic outlook is concerned, I wasn’t terribly optimistic about the next two or three quarters to begin with. If I were going to prepare a new forecast at this point—or even had I prepared one last week—I probably would mark it down a bit. But, of course, there is not much we can do about that at this stage. As far as the inflation outlook is concerned, I have thought that, late in this year and into next year, inflation would start to abate, and recent developments perhaps heighten my conviction about that. But I will agree that it is still an open issue. So it seems to me that all of this suggests that the outlook, at least in terms of financial conditions and the economy in the near term, has clearly deteriorated. The inflation outlook, if anything, has perhaps improved a notch, or at least the outlook that I had earlier is a little more solid. Given the lags in policy, it doesn’t seem that there is a heck of a lot we can do about current circumstances, and we have already tried to address the financial turmoil. So I would favor alternative B as a policy matter. As far as language is concerned with regard to B, I would be inclined to give more prominence to financial issues. I think you could do that maybe by reversing the first two sentences in paragraph 2. You would have to change the transitions, of course. I would say that if we wanted to change policy at this meeting—and that is not my preference—I would do it by ½ percentage point, and I would think that the rationale would be September 16, 2008 42 of 108 psychological reasons. Again, I don’t think we are going to have a big effect on the near-term performance of the economy. But if we think psychology in the marketplace is sufficiently bad or that there is sufficient concern that the Federal Reserve somehow doesn’t quite get it—I would think that all our actions cumulatively, including the actions over the weekend, should not make that a grave concern—then I think we would want to do more than ¼ percentage point. Thank you. CHAIRMAN BERNANKE. President Evans. MR. EVANS. Thank you, Mr. Chairman. The unfolding financial situation is injecting enormous uncertainty into the economic outlook and policy picture. Although this analogy is imperfect, today’s uncertainty reminds me of March 2003. Then, on the eve of the invasion of Iraq, the FOMC decided that geopolitical uncertainty was so great that the Committee could not characterize the balance of risks at all in the policy statement. Today, the downside risks to output are almost too dispersed to characterize. In one or two weeks, we may know better that either the economy will somehow muddle through or we’re likely to be facing the mother of all credit crunches. I think that the first outcome would be quite an accomplishment under the circumstances, but at the moment it’s very hard to say how this will turn out. Nevertheless, we have to offer an opinion. With respect to the economic landscape before the developments of last weekend, one thing that I kept hearing was that uncertainty and caution in the business community had increased in recent weeks and that they were causing many firms to hold back on spending and committing to financial investments. But a number of my contacts indicated that the weakness was not out of line with their earlier expectations. On the plus side, I got the impression that, with the exception of housing, there are not many excesses on the real side of the economy that needed to be worked off. Notably, I did not hear of inventory overhangs or September 16, 2008 43 of 108 unused capacity, and Manpower even indicated that their clients had been careful not to go overboard earlier in the hiring cycle, and so we’re not left with bloated workforces. Still, this sentiment and the incoming data did not paint a pleasant picture with regard to the national outlook. As one of my directors said, turning the common phrase against me, the economic problems that we are facing appear to be remarkably resilient. Even before last weekend’s events, the economic risks had increased somewhat. We had the large rise in the unemployment rate, the recent weak consumption data, and heightened caution by firms. Now, of course, the financial risks have increased substantially and further threaten the growth outlook. At a minimum, credit standards are likely to tighten further and crimp spending. I’m not looking forward to putting a forecast together in October. Dave and the Board staff have my sympathy and respect for doing this each meeting. It’s unfortunate, Dave, that we haven’t had the time to spend talking about the excellent special memo that you and your staff put together on gauging the effective stance of policy. I thought that was very helpful. I had on previous occasions mentioned that it would be nice to have some markers that we could look at, and at least for me, that was quite helpful. Now, it’s not a large stretch to expect that inflationary pressures will recede, given what we’re facing. We could see enough weakening in the economic outlook that the projected slack in the economy will point inflation more clearly down and below 2 percent over the medium term. Just last week I was still a bit skeptical that these forces would be large enough to achieve this disinflation. But we need to be forward looking, and that would be how I would mark my inflation forecast down today. So what does this mean for policy today? I favor alternative B. In my view, we’ve kept the policy rate low so that we would not be far from appropriate policies if and when the risks to growth intensified enough relative to the risks to inflation. So we are well positioned to act if we need to. I September 16, 2008 44 of 108 agree with President Stern that, if we were to act, we should do something significant on the order of 50 basis points. But I think we should be seen as making well-calculated moves with the funds rate, and the current uncertainty is so large that I don’t feel as though we have enough information to make such calculations today. We will know much more in a couple of weeks, I hope at least about the changes in underlying financial conditions, and will thus have a better sense of the risks to both elements of the dual mandate and the associated policy actions. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Pianalto. MS. PIANALTO. Thank you, Mr. Chairman. The recent financial market news is shaking people’s confidence dramatically. But even before recent events, the evidence was already pointing to more effects of the financial crisis on the real economy than I had built into my projection at our last meeting. The reports from my District contacts and the incoming data caused me to revise down my near-term output projection even before the latest round of financial market troubles. The improvement in net exports that was reflected in the second-quarter GDP growth has not encouraged manufacturers in my District to revise up their export projections. They are still holding firmly to the opinion that the global economy is slowing and that export growth will slow with it for several quarters. Of course, manufacturers are concerned about weakness spreading further within their domestic customer base. The ongoing turmoil in financial markets continues to affect businesses in my District. Some of the banks in my District are finding it very, very difficult to attract new capital and to manage their way out of trouble. I am hearing that credit is harder to come by for many borrowers who in the recent past would not have thought twice about their creditworthiness. Last week I met with a business contact with a very long and successful track record of buying and operating private companies. He reported that he had reached a deal with a bank to finance a project at a 7 percent September 16, 2008 45 of 108 interest rate with the loan amortized over a fifteen-year term. On the morning of the close just three days later, the bank faxed him the paperwork, which reflected a 12 percent interest rate on a nonamortizing loan with a 10-year term. So the deal obviously is not going forward. One of my directors, who heads a very large regional banking organization, reported at our board meeting last week that many banks are shedding assets and that in some cases they are walking away from longstanding customer relationships in order to do so. He said that investors are very skeptical about putting new equity into banking deals and that those who have done so in the past vow not to be burned twice, let alone a third time. Of course, inflation remains an important issue as well. My contacts, as Dave mentioned in his report, are not so confident that a broad array of intermediate and retail prices are actually going to move back down as a result of the recent decline in energy and other commodity prices. Several of my contacts report that major suppliers are trying to maintain their prices despite the decline in raw material costs just to make up for a long period of absorbing price increases. Nevertheless, most of my contacts agree that the commodity price environment has stabilized considerably, making me more confident that core inflation will gradually slow over the next couple of years. At our last meeting, my forecast was broadly consistent with the Greenbook baseline. Today my forecasts for output and prices are broadly similar to the Greenbook’s for 2009 and 2010, although I am expecting more weakness in economic activity in the second half of this year than the Greenbook is forecasting. My contacts in the manufacturing sector have persuaded me that exports are going to be weaker in the short term than I had previously thought, and I have also revised down my consumption path on the basis of the credit constraints on households. Although I am more encouraged about the recent decline in energy and commodity prices, I would like to see further evidence of price stability in these markets and also continued stability in inflation expectations for September 16, 2008 46 of 108 a while longer before I reduce the upside risk that I place on my inflation outlook. However, a growing risk to my outlook is that the short-term weakness that I have now built into my outlook extends further out into the forecast period. I worry that my outlook doesn’t fully capture all of the many ways in which financial forces at work in the economy are actually going to restrain spending. On Friday, I was convinced that the best course of action was to keep an even keel in these rough seas—to be flexible, of course, but to look beyond the latest wave crashing over the bow. Only six weeks ago, inflation risks were on the verge of being unacceptable, and today the troubles of Wall Street are the focus. I was sure that we were going to be in for many more surprises; I just didn’t know when and from where they would be coming. So I supported not only keeping our policy unchanged but also keeping our language changes to a minimum even if that language missed some nuances of the outlook. Given the events of the weekend, I still think it is appropriate for us to keep our policy rate unchanged. I would like more time to assess how the recent events are going to affect the real economy. I have a small preference for the assessment-of-risk language under alternative A. I think it captures my concern that the downside risks have intensified. However, I can support some of the comments and changes to highlight the financial market strains that were made by President Lockhart and President Stern. So I can support the language under alternative B with some additional comments about the financial strains that we are facing. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Lacker. MR. LACKER. Thank you, Mr. Chairman. I’ll be brief. The Fifth District hasn’t changed much; it pretty well aligns with the national outlook. On the national outlook, I find myself, all except for the policy path, aligned well with the staff. There have been a lot of economic reports since the last meeting about particular categories of spending or particular sectors of the economy, September 16, 2008 47 of 108 but they net out to only a small change, if any, in the broad contour of the outlook for me for overall growth. I expect it to be sluggish for the remainder of the year with recovery beginning at some point in the first half of next year. I’ll commit the sin of saying that uncertainty is especially high now. There seem to be reasonably plausible risks in the outlook in virtually every spending category and, in many cases, on both sides of the outlook. About inflation, so far our credibility has helped to prevent a pickup in compensation growth. In fact, it’s heartening that compensation growth is coming in a little below expected in response to the energy price shock this year. This has allowed us to accomplish the inevitable decline in real wages without setting off an inflationary acceleration in wage rates. But we’re still in the midst of an upsurge in core inflation, which the Greenbook expects is going to tick up near 3 percent this quarter. As I said before, I think it’s critically important for us to emerge from this episode without trend inflation ratcheting upward, and I’m not sure we can take the forecasted moderation for granted. Inflation compensation has been well contained, and that has been heartening. But I have also said this before—I think the current level of five-year, five-yearforward inflation compensation seems more consistent with a trend above 2½ percent than it does with a 2 percent trend. So I’m not convinced that there’s going to be much gravitational pull down from an elevated rate once core rises. At the very least, I think there’s some uncertainty about that. For financial markets, this is yet another historic week, as President Rosengren remarked. I think the questions facing financial market participants, the uncertainty they face, can be usefully partitioned into three broad categories. One is the aggregate magnitude of fundamental losses that the financial sector faces. Another is the location of those losses—where they are going to pop up within financial intermediary sectors. The third is the likelihood and the magnitude of fiscal transfers in the form of governmental support for particular firms. I think the weekend’s events September 16, 2008 48 of 108 have caused financial market participants to revise their assessments of the future. It seems to me at this early date in the process that the revision in the outlook has had more to do with the latter two categories than with the aggregate size of fundamental losses we have coming down the pipeline. That is to say, it’s about where they’re popping up, which firms are affected and are going to be hit, and about the likelihood of government support. What we did with Lehman I obviously think is good. It has had an effect on market participants’ assessment of the likelihood of other firms getting support, and I think you would have to attribute at least some of changes in equity prices to that. We’re likely to see a lot more disruption this week and in the days going forward than we’ve seen so far. I don’t want to be sanguine about it, but the silver lining to all the disruption that’s ahead of us is that it will enhance the credibility of any commitment that we make in the future to be willing to let an institution fail and to risk such disruption again. On the other hand, if the disruption proves less severe than we expect, the silver lining is that that will strengthen our hand in the future as well. However, I would note that I don’t think that what we did with Lehman has set a clear and firm boundary on the circumstances under which government support is likely to be forthcoming. All the language around not supporting Lehman was of a one-off nature. So I’m not sure about the extent to which we’ve diminished uncertainty about the likelihood of support going forward, and I think that such uncertainty is likely to exacerbate financial volatility in the months ahead until we can make more progress on articulating a reasonably principled policy on when we’re going to intervene and when we’re not, or at least enhancing clarity about that. Overall, I don’t take what’s happened in the last few days as changing much. It’s not obvious to me what the implications are for the outlook for inflation and growth, at least at this point. So I don’t see a reason to deflect from our policy path at this point. I can support standing September 16, 2008 49 of 108 pat with the funds rate today. I think that’s a good idea. I think, looking forward, that we will want to raise rates sooner rather than later if core inflation doesn’t moderate. I think we’re more likely to require a path more like the August Greenbook than the current one. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. President Lacker, I have a question. I really would like your advice on this. Historically, if we look at situations like Japan and Scandinavia, ultimately there comes a point at which the banking system is decapitalized and dysfunctional and the government intervenes on a large scale. Those interventions have been very expensive, but in those cases I mentioned, they have generally restored the banking system to health and have helped the economy recover. What’s your view on the right sequencing? Do you think that we should remain very tough until such time as it becomes inevitable that fiscal intervention is needed? Do you think that we should avoid fiscal intervention at all stages? I’m seriously interested in knowing what you, or anyone else who would like to comment, think is the appropriate stage, if any, at which fiscal intervention becomes necessary. MR. LACKER. We have a legislated program of fiscal intervention—deposit insurance— and the boundaries around that are very clear. Which liabilities are insured and which ones are not are very clear. Around the edges there’s some lack of clarity about what least-cost resolution means and the extent to which deviations from that can be verified, and that provides some room for the Federal Deposit Insurance Corporation to deviate from that and implicitly to forbear to some extent. But even that is sort of a well-contained and well-defined government support. That’s what the Congress has enacted, and it’s not clear to me whether we should go beyond that. Japan got down to deposit insurance. Scandinavia did, too. That seems like a natural benchmark. CHAIRMAN BERNANKE. But I think this is a historical fact—that, once the banks became decapitalized, there were also capital injections into the banks in both of those cases. September 16, 2008 50 of 108 MR. LACKER. Sure. Those were fiscal actions. CHAIRMAN BERNANKE. Right. MR. LACKER. And the FDIC does exactly that when it resolves a failed institution. CHAIRMAN BERNANKE. President Hoenig. MR. HOENIG. Mr. Chairman, I have thought about this considerably because I think we have come to a time in our history when we have institutions that clearly ought to be and may in fact be too big to fail. I think we tend to react ad hoc during the crisis, and we have no choice at this point. But as you look at the situation, we ought, instead of having a decade of denying too big to fail, to acknowledge it and have a receivership and intervention program that extends some of the concepts of the FDIC but goes beyond that. That is, if you are insolvent, it is not a central bank issue—we are a liquidity provider—and therefore the government comes in. But unlike the GSEs, everyone has to take some hit—the equity holders, certainly the preferred stockholders, also the subordinated-debt holders, and perhaps the senior ones—by assuming a certain amount of loss. They would have immediate access to—pick a number—80 percent. The research would help us pick that number, and they can have access, but the rest becomes a subordinate-subordinate position after the liquidation so that you have still a sense of market discipline in play and you don’t get the system gaming it in that, if you know there’s a bailout coming, you buy the debt and sell the equity short to make a bundle. I think therein lie the distortions that are absolutely detrimental to the longrun health of the economy. Regarding how we go forward, I think we are going to have many lessons from this. Part of the problem has been very lax lending and, obviously now, weaknesses in some of the oversight. Also a history of our reacting from a monetary policy point of view to ease quickly to try to take care of the problem and, therefore, to create a sense in the market of our support has raised some September 16, 2008 51 of 108 real moral hazard issues that we now need to begin to remedy as we look forward in dealing with future receiverships. We are in a world of too big to fail, and as things have become more concentrated in this episode, it will become even more so. CHAIRMAN BERNANKE. I certainly agree—and the Treasury Secretary and I have said publicly—that we need a strong, well-defined, ex ante, clear regime. But we have the problem now that we don’t have such a regime, and we’re dealing on a daily basis with these very severe consequences. So it is a difficult problem. MR. HOENIG. I think what we did with Lehman was the right thing because we did have a market beginning to play the Treasury and us, and that has some pretty negative consequences as well, which we are now coming to grips with. CHAIRMAN BERNANKE. President Rosengren. MR. ROSENGREN. I think it’s too soon to know whether what we did with Lehman is right. Given that the Treasury didn’t want to put money in, what happened was that we had no choice. But we took a calculated bet. If we have a run on the money market funds or if the nongovernment tri-party repo market shuts down, that bet may not look nearly so good. I think we did the right thing given the constraints that we had. I hope we get through this week. But I think it’s far from clear, and we were taking a bet, and I hope in the future we don’t have to be in situations where we’re taking bets. It does highlight the need to look at the tri-party repo market, look at the money market fund industry, and look at how they’re financing. There are a lot of lessons learned, but we shouldn’t be in a position where we’re betting the economy on one or two institutions. That is the situation we were in last weekend. We had no choice. We did what we had to do, but I hope we will find a way to not get into this position again. CHAIRMAN BERNANKE. Okay. President Fisher. September 16, 2008 52 of 108 MR. FISHER. Mr. Chairman, it may surprise you that President Yellen and I agree, [laughter] at least with the recommendation, as I do with the majority. I also agree firmly with President Hoenig. David wanted to know a little more about Houston, so I will start out with that, and then I’ll quickly go to the policy matter. The storm devastated Galveston and Beaumont. Their combined population is 650,000. The population of the greater Houston area is 6.5 million. The damage to Houston was moderate. The overall effect on the Texas economy should be relatively mild. We still expect employment growth this year of 1½ percent or so, plus or minus, even though the storm really hit hard an area that accounts for 26 percent of our employment and 30 percent of our output. In terms of the national impact, I think it’s important to understand that the energy infrastructure took minor losses. The short-term functioning of that infrastructure is hampered by power losses and water problems. Gasoline prices have gone up because 3.9 million barrels a day, or roughly 22 percent of the U.S. refining capacity, has been shut down. By the way, that affects the spot market—I think that’s some of the reason you’ve seen this weakness recently—and maybe the near-term futures market. If you look at the gasoline price market, the gasoline price went up another 13 cents yesterday, but the near futures market is down 19 cents. I think it reflects expectations that, once power is restored, the refineries will come back on line about a week later. So we will likely have a temporary bump-up in inflation due to the gas prices. But I think it is important to realize that this, unlike Katrina, didn’t shut down the Mississippi, and the effect on other commodity prices is likely not to be significant, with one exception. If you look, you’ll see that prices of soybeans and soybean oil have spiked recently. Clearly, the weather has an impact, but I think that’s more supply–demand imbalance— something that I’m watching carefully. September 16, 2008 53 of 108 The silver lining, if there is a silver lining to human tragedy, is probably twofold. One is, if you notice, that lumber prices are actually up this year, which is kind of odd in terms of lumber trading. Of course, lumber producers are probably pretty happy with the devastation in our state. Second, Mexican laborers will be very happy if we let them into the country because the Hispanics build most of our buildings in the United States. But I would say that the storm should not have any effect on nor should it alter our preferred policy direction, and I would like to talk about that very quickly. I have been affected in my thinking about economic growth and inflation by what I’m seeing overseas. I’m globally oriented. I do expect that we’re going to have less impetus from exports, which were significant in carrying our growth. Our numbers show that, and your numbers, David, show that, and all of our conversations have revolved around that. We were surprised on the upside by it. Now I think weakening economic growth elsewhere is likely to subdue that effect. We have also had an appreciation of the dollar. Oil prices have declined. I dove deep in my anecdotal explorations with the majors and also with all supply companies. For whatever it’s worth, they are convinced that OPEC now has $100 rather than $70 as their benchmark. Most of them expect prices to slide down to somewhere in the $80 range. But over the longer term, whatever that term may be, we’re going to talk about $100-plus oil. Then, of course, many commodity prices are off their peaks. They have retraced significantly—some entirely. That said, in my anecdotal interchanges, I am still hearing about the likelihood, as I think President Pianalto mentioned, that people are seeking to preserve their margins. They’ve been stung for many years, and I’ll just give you one case because I think it tells us something. If you talk to the CEO of Wal-Mart USA, what they are pricing to be on their shelf six to eight months from now has an average price increase of 10 percent. Now, of course, you might have this September 16, 2008 54 of 108 reversed as we go through time. My biggest disappointment, incidentally, was that the one bakery that I’ve gone to for thirty years, Stein’s Bakery in Dallas, Texas, the best maker of not only bagels but also anything that has Crisco in it, [laughter] has just announced a price increase due to cost pressures. But I do think we have a mitigation of inflation, and we also have a mitigation of the impetus to economic growth. As to the current financial predicament, I want to go back to a comment I made a long time ago. This is not the first for me. I like to tease President Stern about his maturity—I don’t go back to the Panic of 1890, but to Herstatt, 1974; New York City’s failure, 1975; 1987; and what happened in Japan. Incidentally, you see the same pictures repeated in every newspaper. It’s always the trader holding his head or looking up at the board. Now it’s in color; it used to be black and white. I think it comes from the same archive, and it is repeated throughout time. [Laughter] All of that reminds me—forgive me for quoting Bob Dylan—but money doesn’t talk; it swears. When you swear, you get emotional. If you blaspheme, you lose control. I think the main thing we must do in this policy decision today is not to lose control, to show a steady hand. I would recommend, Mr. Chairman, that we embrace unanimously—and I think it’s important for us to be unanimous at this moment—alternative B. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you very much. Coffee is ready. Why don’t we take about thirty minutes? I have a couple of calls to make. See you at about 11:20. [Coffee break] CHAIRMAN BERNANKE. Okay. If we’re ready, we can reconvene. First Vice President Cumming. MS. CUMMING. Thank you, Mr. Chairman. In our forecast, we do show a downgrade in real activity in the near term since the August meeting. Downside risks to the economy we see as September 16, 2008 55 of 108 still very considerable, and I would probably say that they really have increased quite a bit. I’ll say a few more words about that. I’ll also talk about the inflation front. We have long thought that inflation in the medium term will moderate, and we’ve been taking some comfort from recent developments that have been cited already. On the weaker economic outlook, we see the intensification of adverse growth coming from many things mentioned already: the unemployment rate increase and the likelihood that consumer spending is going to be negative. I would put great stress also on indications that world demand is slowing abruptly, as Nathan mentioned. I think that all three of these things are occurring in an environment in which we have massive correction, adjustment, structural change in autos, housing, and financial intermediation. That adjustment is really interconnected—one has effects on the others. As part of this—particularly in the financial sector, I would say—in our senior loan officer survey we’ve seen indications that, even as rates in, say, the mortgage markets start to ease a bit, nonprice terms may still be tightening. President Pianalto talked about other areas in which borrowers are facing much tougher terms. As financial institutions feel their capital is constrained—and there’s plenty of evidence that balance sheets are constrained across much of the financial sector—those kinds of nonprice rationing measures probably will become more evident. Second, as we discussed earlier, we’ve seen that credit losses, which thus far have been largely confined to the financial sector and increasingly their shareholders, run some risk of spilling over to other kinds of investors, who to date really have not felt that impact, such as money market fund investors, as mentioned earlier. In addition, the three big corrections that we have seen in autos, housing, and financial intermediation are not limited to the United States. In particular, as you know, several G-10 countries are facing very difficult situations in their housing markets, not much different from us; and the financial intermediation adjustment is truly a global correction. September 16, 2008 56 of 108 On the inflation side, as I mentioned, we have acknowledged that we’ve seen elevated rates of inflation. But the recent developments—as we’ve seen in inflation expectations discussed earlier, in energy and other commodity prices, the unit labor cost developments that President Yellen discussed, and the year-over-year changes in import prices—are all pointing in the direction of some moderation of inflation and moderation of inflation expectations. In particular, we have looked at inflation expectations as measured by financial markets and feel that the decline that we see in those expectations cannot be explained simply by the drop in energy prices and technical factors but look larger than that. We would attribute that to indications, again, that global demand is slowing. Coming into this meeting today, we favor alternative B. I would associate myself with the comments of President Stern and President Evans, that if we were, in fact, going to make a move today, it would be better to make a large move of 50 basis points. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kohn. MR. KOHN. Thank you, Mr. Chairman. I think that, even before the recent intensification of financial market turmoil, there were trends becoming increasingly evident over the summer, since late June, that suggested that the economy was on a substantially slower path than it had been before. Resource utilization was falling appreciably, and the expected downward path of inflation in the future had much better odds of occurring. Indeed, I think that the expected weakness in the economy and the financial markets are interacting. We have one of these feedback loops in play. There has been a lot of concern not only in the United States but in other countries as well, as I heard in Basel last weekend, about a spillover—that the problems were not confined to the mortgage markets but were spilling into the loan books of the banks. That was related to the weakening in economic activity and was tightening up credit conditions, which would, in turn, September 16, 2008 57 of 108 further weaken economic activity. So this feedback loop was at work certainly in the United States and was beginning to be felt a little more in other countries as well. Since late June we have come to know a couple of things a little better. One is that consumption is not immune to soft labor markets, increases in energy prices, declining housing wealth, and tighter borrowing conditions. Even if we can’t parse out the effects of each of these factors, consumption has weakened substantially. We have had three months in a row of declines in the retail control component and very weak auto sales. Although recent declines in oil prices will support disposable incomes and consumption, I think the other sources of restraint on households— declining house prices and tighter credit conditions—are more likely to intensify than to abate in coming quarters. Another thing we know is that businesses have not gotten ahead of their need to shed labor, and they continue to trim staff in response to actual and expected weakness in demand. The decline in employment shows no signs of abating. Initial claims are running more than 50,000 higher than they were at the end of June, and they have remained elevated past the time that the introduction of the temporary extended benefits should have been felt. The unemployment rate is already ¼ percentage point higher than anyone around this table predicted for the end of the year. The household survey, along with national income statistics, could be signaling greater softness in activity and higher output gaps than is evident in the GDP and spending data. Another thing we have learned, as Nathan emphasized, is that foreign economies have not decoupled from the United States, and their prospects have been revised down substantially. They’re absorbing the effects of weaker U.S. domestic demand on their exports, and growing risk aversion in financial markets is spreading abroad. The latter, the growing risk aversion, is beginning to have, as Chris Cumming was noting, effects on a number of emerging-market September 16, 2008 58 of 108 economies, where capital inflows show signs of abating or even reversing; and indicators of financial stress have risen as a consequence of all this. Because of the stronger dollar, we will be able to rely less on exports going forward than we did before. We never expected a rapid return to more normal financial market functioning, but the adjustment in the financial sector now looks to be more severe and to take longer than we thought before. Financial firms need to bolster profits to offset losses and track capital. They need to delever by reducing debt relative to equity. They need to consolidate, and above all, they need to protect themselves against the possibility of a run. All of this implies a prolonged period of very cautious lending and a high cost of capital for borrowers relative to benchmark interest rates. If the current severe financial situation persists, I think the flight to safety and liquidity could dry up credit to a broad array of all but the very safest borrowers and reduce asset prices with feedbacks on spending, and that feedback loop could intensify if these market conditions pertain. I think that’s a substantial downside risk to the growth outlook. Not all news affecting spending has been negative. Capital goods orders have held up. The decline in interest rates and commodity prices that respond to the markdown in global growth will help support domestic demand, and actions to stabilize the GSEs are helping the mortgage market. Activity is more likely to stagnate than to decline. But I think that we can be more certain than we were, say, at the end of June that the economy will move substantially away from our high employment objective over the next several quarters and that the downside risks to that are larger. On the inflation side, incoming data have been disappointing, a little worse than anticipated, perhaps suggesting greater pass-through. The rise in import prices at the beginning of the third quarter was higher than anticipated. But we’ve also learned over the last couple of months that oil and other commodity prices can go down as well as up. The drop in retail energy prices helped to September 16, 2008 59 of 108 reverse much of the run-up in inflation expectations at the household level and reduced inflation compensation in financial markets at least over the next five years. Weaker economies, along with lower commodity prices, are expected to reduce inflation in our trading partners, and that along with the dollar should lower import price inflation. The broadest measures of labor compensation available through the second quarter continue to suggest no upward pressure on the pace of increases in nominal labor costs. Despite elevated headline inflation, surprisingly good growth of productivity is holding down unit labor costs. Taking all of this together, I think that, despite the incoming inflation data, we can have greater confidence in our forecast that inflation will decline late this year and run much lower in the next few years than in the past year or so, though the risks to that still lie on the upside until we actually see the decline in headline inflation persist. On policy, Mr. Chairman, I support alternative B, keeping the funds rate at 2 percent. I think that, at least for now, is consistent with lower inflation and a slow return to full employment in the future over time. We need to assess the effects of the financial turmoil. If asset price declines accelerate and the tightening of financial conditions is large and likely to be sustained, I would be open at some point in the future to a lowering of interest rates. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. Let me do three things. I’ll talk first about a modal forecast but probably give it short shrift; second, about financial market conditions; and third, about policy. Working under the assumption that our modal forecast doesn’t look quaint a week from now, if the world were somehow to hew to a reasonably moderate view of how financial market conditions work going forward, personally I’d be a bit more optimistic than the Greenbook for the second half of ’08. I think that the net export growth is likely to prove stickier than embedded in that forecast in spite of a stronger dollar and weaker global demand. But as we get to September 16, 2008 60 of 108 2009 and 2010, I would actually be less rosy than the Greenbook. I don’t see real catalysts for the economy to normalize and to approach trendlike growth. Key uncertainties around financial markets, labor markets, and housing and, I think, broader macroeconomic uncertainties that I’ve discussed before in terms of trade policy, tax policy, and regulatory policy, would make the creepback to potential slower than embedded in those forecasts. On the inflation front, I continue to be encouraged by the strength in the exchange value of the dollar and the work that is doing for us on import price inflation. I’m encouraged by the move down across a breadth of commodities—not just energy, metals, and food but really across the entire basket—but I’m still not ready to relinquish my concerns on the inflation front. Let me turn now to financial market conditions. I have talked before about the financial architecture. I guess what we can say today with more confidence than I’ve been able to say before is that the dismemberment of the existing financial architecture has accelerated in the last few days and weeks, and we will very quickly look at business models, and industry will find new business models, we hope, to provide credit to the real economy. Financial markets have been testing financial institutions with weaker capital structures, uncertain management teams, and unsustainable business models. I think the question before us today that’s hard to judge is whether financial markets are now to the point at which they are acting indiscriminately, testing all financial institutions regardless of capital structure or business model. I’d say that the evidence of the past twenty-four or forty-eight hours is still unclear. I think we’ll have a greater clarity several days from now about whether markets are able to make the distinguishing judgments that we would count on. Look at the CDS spreads for the two remaining independent broker-dealers, Goldman Sachs and Morgan Stanley, which Bill referenced. Goldman Sachs’s CDS moved up another 190 or so September 16, 2008 61 of 108 this morning. They are up 340 in the last two days. Morgan Stanley’s are up 690. I wouldn’t want to say whether those numbers are right or wrong. It may be that the business model is a failing one—that is, wholesale funding is no longer practicable in the world that we’re now in. If the problems were confined to that part of the financial services industry, it would be tough and it would be ugly and, if you were a resident of New York, particularly painful. But I don’t think it would rise to the level that would force us to recalibrate monetary policy. But if, in fact, those losses end up being endemic to all financial institutions, even those with strong deposit bases and higher capital ratios, then we certainly would have to take that into consideration. The few that are trying to swim against this tide are flailing; and without extraordinary actions either by a consortium of their competitors or by the official sector, they’re likely to continue to fail. I think our efforts to date to protect the broader financial markets and the economy from knock-on effects in particular financial services sectors do seem to be helping to cushion the blow. But the prospect of some meaningful discontinuity and of some systemic risk remains real, and it’s hard for me to judge today whether that prospect is as low as we might have thought even some weeks ago. Ultimately, the question for the real economy is whether the emergence of this new financial architecture can come quickly enough to get credit markets to normalize. Is the suddenness of events in the last week going to accelerate the move toward a new financial architecture? Will the forces of creative destruction make that faster but ultimately bring credit back to these markets sooner? Are these forces so strong and overwhelming that all financial institutions will be hunkering down, clinging to an architecture that no longer works? That’s a question to which I don’t know the answer. A couple of more points on markets. I think the work that was done over the past few days on Lehman Brothers should make us feel good in one respect. Market functioning seems to be September 16, 2008 62 of 108 working okay—by which I mean that the plumbing around their role in the tri-party repo business, due in part to the Fed’s actions, seems to be working. It’s ugly. The backroom offices of these places are going crazy. There’s a lot of manual work being done. So they wouldn’t give it high marks. But it looks as though positions are being sorted out in a tough workmanlike way, and so that’s encouraging. Other than the CDS moves and the equity moves on the other broker-dealers, Goldman Sachs and Morgan Stanley, I don’t think that that is the real specter that’s casting some question over broader financial institutions. I think the Lehman situation, no matter what judgment we made this past weekend about whether or not to provide official-sector money, is not what is driving markets broadly outside of the investment banks. What’s driving the broader uncertainty are questions about institutions like AIG that were rated AAA, that were so strong that counterparties didn’t need collateral, and that were a certain bet to be a guarantor around stable value funds and all sorts of other products. If in a matter of weeks that AAA rating and that security could turn out to be worthless, then that would force institutions to evaluate two things. First, narrowly, how much AIG exposure do I have? Second, more broadly, if that’s AIG, what about the rest of the insurance companies? What about the rest of the financial institutions, which aren’t investment banks but are really representing the foundations of the U.S. financial system? So it is both those direct and indirect aspects that we have to try to understand as best we can. My own view is that the AIG question would be more financial devastation if these institutions turn out to be meaningfully insolvent but actually, in some ways, less market dislocation among intermediaries. That is, Lehman Brothers, Merrill Lynch, and Bear Stearns are touching and are in the middle of many more flows of data, and there are real losses being felt. But if an AAA company like AIG were really fundamentally insolvent, the direct losses to a range of institutions, particularly those that are not September 16, 2008 63 of 108 just wholesale institutions but are retail institutions, could be very significant. I don’t think we know the answer yet to the question of whether AIG speaks to a broader loss of confidence that could affect the foundations of the U.S. financial system. Let me turn finally to policy, Mr. Chairman. I support alternative B and, based on some of the discussion from Presidents Lockhart and Stern, I’d make some simple suggestions that may strike a balance that acknowledges the concerns we have about financial markets but doesn’t put us in the position where we are inclined to lurch in one direction, which as some people suggested could create more uncertainty than we intend. My suggestion, Mr. Chairman, would be to take the first sentence from alternative A, paragraph 2—“strains in financial markets have increased significantly and labor markets have weakened further”—and make that the first sentence of alternative B. Then strike the second sentence of alternative B, because I think we’ve largely covered that. That order gives proper attention, it strikes me, to the financial market developments. Finally, in the assessment of risk, Mr. Chairman, if you look at the last sentence, I would suggest modifying that ever so slightly by inserting the word “closely” and making one other modification. So that last sentence would read, “The Committee will continue to monitor economic and financial developments closely and will act as needed to promote sustainable economic growth and price stability.” Also, if you think it’s acceptable, rather than saying “financial developments” maybe there we would say, “The Committee will continue to monitor economic and financial market developments closely.” Those would be my suggestions to try to strike that balance—that we are keenly focused on what’s going on, but until we have a better view of its implications, we are not going to act. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. September 16, 2008 64 of 108 MR. KROSZNER. Thank you very much. Since the last meeting, there have obviously been a number of flare-ups in the fires that have been burning in the financial markets—the GSEs and then certainly what’s come this past weekend and what’s likely to come over this week and into the future. A number of people have mentioned things ranging from AIG to pressures on money market funds to some large financial institutions. There are some very large regional banks and a very large thrift that will be facing a lot of challenges as the uncertainties in the markets continue. I won’t repeat what Governor Kohn said about the continuing pressures on the bank balance sheets. I think it is important to take into account that those pressures will be there going forward not only on U.S. institutions but also increasingly on international institutions. No one has mentioned UBS yet, but that’s another institution about which there’s a lot of concern, and if you look at CDS quotes there, they are skyrocketing also. Much as Governor Warsh said, I think that people are worried about what the next shoe to drop will be and whom we have to challenge. Whom do we have to get more information about to make us feel comfortable? If that suddenly becomes everyone, then of course the markets don’t function. I just want to focus quickly on consumption and consumer credit markets and then on inflation, and then I’ll conclude. We have made some references to how consumers have acted in the past and whether they will continue to act this way. In some sense the consumer has been on a marathon since the early 2000s, facing an incredible amount of shocks—a lot of contraction in 2001, significant declines in stock market wealth, September 11, corporate governance scandals, sustained job losses, and low real income growth. Nonetheless, the consumer continued to consume. But now the consumer seems to be flagging. We have perhaps a very modest effect of the stimulus, which obviously can lead to negative payback for the rest of the year—so a drag going forward as well as drags from housing and stock market wealth, continuing job losses, rising September 16, 2008 65 of 108 unemployment, and pressures on income. Although many of these shocks were similar to ones that happened earlier in the decade, it seems that consumers do not have the same resilience now that they did at one point. It’s not surprising that, after having run this marathon, they’re going to be a bit tired. Part of it could also be the credit conditions that are putting much more pressure on them. Just to give you an anecdotal report, but it’s from one of the largest providers of consumer credit in the economy. After stabilization basically through our FOMC meeting in August, we’ve seen some significant deterioration in delinquencies and in the performance of those who get into delinquencies—they roll right to full chargeoff much more rapidly. So we have seen not exactly a qualitative change but a significant deterioration. Also, the ability to securitize credit cards has changed dramatically. After our having opened the window and the markets having opened up in the second quarter, they basically haven’t been able to do anything in the third quarter, and that’s before this weekend. Obviously that’s not going to be helping them. Of course, there are some offsetting factors that can help the consumer. The very significant decline in mortgage rates has led to quite a response, according to this very large provider of consumer credit in the United States. The number of applications for mortgages, particularly for refis, has doubled over the last couple of weeks. So people do respond to prices, and that can help to ease some of their income burdens. Obviously, the reduction in energy prices and many food prices is helpful on that. But of course, what has been good news for U.S. consumers may not be good news for international consumers. As a lot of people have mentioned, the rest of the world is seeing a very significant slowdown. I think the elevated commodity prices had helped to mask a lot of the underlying fiscal and structural problems in these economies, actually much like rising housing September 16, 2008 66 of 108 prices in the United States had masked the problems in underwriting standards and what was going on in the mortgage market. So I think there are going to be significant challenges in a lot of countries around the world. The boost that we had earlier this year from the international sector is something we can’t rely on. On inflation, we’re heartened by some of the lower energy prices. But I want to relate one anecdote. In a meeting at the OECD, the CEO of one of the largest private oil producers in the world was asked what reference price he used because obviously he has to make tens of billions of dollars of decisions on investment and so they thought here’s someone who would really have a good notion of what the price of oil would be going forward. Without hesitation the person responded, “$100, plus or minus $50.” [Laughter] That kind of uncertainty from someone who is really in the markets and making those kinds of decisions shows us that we have a reasonable degree of uncertainty in inflation pressures going forward. That said, I think the Greenbook forecast is where I would be also, although we’re at uncomfortably elevated levels now. There are a lot of reasons to believe that, although they may be even a bit more elevated in the coming quarter, there are likely forces to bring things back down. This is particularly credible in the context of both survey-based and market-based expectations being quite contained, the market-based expectations being at the low of the year or even over the last couple of years. So this brings me to support alternative B for no change today. On the statement, I do believe that some greater recognition of the stress would be valuable. I think it would be valuable to have something in the first sentence of paragraph 2 that focuses on the strains—perhaps just a single sentence about the strains—and then we can put the other pieces on consumption and housing into the next sentence. It is important in the final paragraph to leave our options open if we do see significant negative feedback effects so that we can make a move that wouldn’t be a shock to the September 16, 2008 67 of 108 markets but it also wouldn’t be something that the markets could bank on. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Duke. MS. DUKE. Thank you, Mr. Chairman. I continue to focus on the traditional commercial bank structure. I looked at two large retail banks, three regional banks, and three community banks, and two things came out of this. First, capital is driving everything, and the amount of capital that the banks need is now being driven more by the analysts and the rating agencies than it is anything that the regulators are doing. The banks feel as though they have done everything they can do in terms of capital management. They’ve quit buying back stock. They’ve cut their dividends. They’ve reduced expenses. There is no more capital available in external markets—not common stock, not preferred, not anything. One bank did issue some preferred stock through its own networks and a common stock issue—interestingly sort of snuck it into the market. They dribbled it out in small amounts because they found that, as soon as the markets determined that they were going to need to issue capital, they started to short the stock, figuring they could buy it back. So they did almost a reverse stock buyback. The markets are fragile to dead. So what are they going to do? The only thing they can do is contract the balance sheet and not lend. Before I get to that, there was again discussion in several of the conversations about naked short selling. One bank reportedly had 103 percent of total outstandings in short interest, and that seemed odd to me. So I went and checked it this morning, and it turns out that it was not 103 percent. It was only 93 percent. But if you subtract out the stock that was owned by the officers and the directors, then it was over 100 percent. Another bank said that the rules in the disclosure that surround long positions have to be replicated somehow in short September 16, 2008 68 of 108 positions because they’re having just as much control over what happens in the fate and the management of the firm. So what are they doing in terms of credit? Any heavy uses of credit or predominant uses of credit are just not being done. This eliminates all commercial real estate. They’re actively trying to move that off their books. Participation loans, in which the participants get only the credit piece, are drying up. Those aren’t available. No bank has any interest in going back into residential construction lending. One large bank said they were approving only one-third of the consumer credit that they would have approved a year ago. The secondary market for jumbos for takeouts on commercial are nonexistent, and one bank told me that, with the current cost of capital and cost of funding, the breakeven spread for a loan was 400 basis points over LIBOR. That’s the new lending market, and I don’t see it getting any better until some capital is available. The credit quality side is actually a better story. First, except for residential real estate, it’s really still pretty good. C&I lending is holding up extremely well. In commercial real estate, again, outside of residential development, things are really looking pretty good. Some small retail centers are showing softness with the small storefronts; and in areas like Michigan, they’re worried about losing the anchor tenants. Other than that, everything is okay. The other consumer credit feels like a mild recession but, again, is normally cyclical. Home equity is awful. The bank-originated loans range from good—one institution had 39,000 loans with 44 past due—to performing similar to unsecured credit. The broker-originated loans, especially the later vintages, are 100 percent loss. Within the mortgages, the rate of acceleration in new past-dues has slowed down. About rejections, I asked them to project when the new delinquencies would be offset by the resolution of existing delinquencies, and they said somewhere between year-end 2008 and mid-2009. So we are moving through that process. The severity, however, continues to grow as housing prices decline. It does September 16, 2008 69 of 108 appear that the portfolio lenders are getting their arms around the collection and the loss-mitigation effort. They’re assigning resources, accountability, and priority. It looks as though they are finally set up to do a pretty good job on that, managing it on several fronts—the analysis of the issue, the early stage collection, contact, and loss mitigation—and actually assigning a permitted spend, if you will, to resolve the loan. Foreclosures are going to take a lot longer and are particularly affected by state law. Apparently in Florida it takes a year to get a property in foreclosure. So those foreclosures are going to happen over a fairly long period of time. I asked about a bottom, and they said they do feel as though they’re seeing bottoms in some markets—Ohio and coastal areas in California, although not inland. Las Vegas and Atlanta are overbuilding, but the in-migration will absorb it. Florida is a bottomless hole—speculation combined with insurance problems. In Arizona so much land was available that they can’t find a bottom there. Regarding lot inventory, a community banker in Omaha said they had seven years of inventory in terms of lots, which I thought was pretty startling until I read in the American Banker the same story in Atlanta and the same story in Orlando. So I think when residential development does resume, it will be to work out the lot inventory. Also, the phantom inventory is at least as large as the current inventory—phantom inventory being defined as people who want to sell but don’t want to sell in the current market. Asked to compare current credit metrics with those in the 1980s and 1990s, one contact said they peaked in 1988 at 5.8 percent nonperforming. Now they are at 1.66. I found a chart, and for the entire industry, nonperformers were 4 percent in 1991. They’re 1.2 percent right now. So the credit metrics are just nowhere near what they were in the S&L crisis for the industry. I came out of that really believing that, if we are going to do something, we need to address the availability of capital to commercial banks but we should leave the bad loans in the banks September 16, 2008 70 of 108 because they’re getting to the point where the portfolio lenders are doing a good job of working through these loans. To try to take them out and put them into another structure, we would just have to replicate that whole gearing-up process. I don’t necessarily think that’s the case with the servicers, particularly the servicers of private-label mortgages. That’s something on which I know we’ve done some research here, and I want to investigate that a bit more to see if there’s something to be known there. In terms of the policy, I, too, would favor alternative B with some change in the language to paragraph 2. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you very much, and thanks, everyone, for very helpful comments. Let me try to summarize, and I will just make some comments, and then we can turn to the statement and policy. The group indicated, of course, that economic growth has slowed and looks to be quite sluggish in the second half. I didn’t hear a great deal of change in the general profile, with most people still viewing growth as being slow in the near term but perhaps recovering somewhat in 2009. But obviously there is a lot of uncertainty surrounding that judgment. The ongoing problems in housing and the financial system are, of course, the downside risks to growth. Another factor, which is becoming more relevant, is the slowing global economy, which together with the stronger dollar may mean that U.S. export growth will be somewhat less. Despite the tax rebate, consumer spending seems likely to be weak in the near term, reflecting a variety of factors that we noted before, including housing and equity wealth, credit conditions, and particularly perhaps the ongoing weakness in the labor market. The labor market is deteriorating, with unemployment up, although UI programs may play some role in the unemployment rate. It is somewhat difficult to predict the peak of the unemployment rate, given September 16, 2008 71 of 108 the upward momentum we are seeing. Declines in energy prices, however, will improve real incomes and help consumer sentiment—so that is a potentially positive factor. The housing sector continues to be the central concern in the economy, in both the real and the financial sides. There are no clear signs of stabilization, although obviously regional conditions vary considerably. The government action regarding the GSEs has lowered mortgage rates and may be of some assistance. Credit conditions have tightened, though, in other areas as well, including nonresidential construction. Firms are continuing to struggle with weaker demand, higher uncertainty, and high costs. Manufacturing has been relatively stable to weaker, but we had at least one report of a survey that in the medium term the outlook is looking a little better. Inventories appear to be relatively well managed. Credit conditions for business vary, but there are indications that some firms are finding it very difficult to attract capital. Financial markets received a lot of attention around the table. Conditions clearly have worsened recently, despite the rescue of the GSEs, the latest stressor being the bankruptcy of Lehman Brothers and other factors such as AIG. Almost all major financial institutions are facing significant stress, particularly difficulties in raising capital, and credit quality is problematic, particularly in residential-related areas. One member noted that it is not evident that markets are clearly differentiating between weaker and stronger firms at this point. Deleveraging is continuing, and securitization markets are moribund. Credit terms and conditions are quite tight and may be a significant drag on the economy. However, the mediumterm implications of the recent increases in financial stress for the economy are difficult to assess. We may have to wait for some time to get greater clarity on the implications of the last week or so. September 16, 2008 72 of 108 On the inflation front, recent core and headline numbers have been high, reflecting earlier increases in the prices of energy and raw materials. There are positive factors, including the significant intermeeting declines in the prices of oil and other commodities, which, if maintained, would bring headline inflation down rather notably by the end of the year or next year. The dollar has also strengthened. Generally speaking, inflation expectations, though noisy, have improved. We have seen a decline in TIPS breakevens and some decline in survey expectations as well. But it was noted that the five-by-five TIPS breakeven remains above a level consistent with long-term price stability. Nominal wage growth has remained subdued so far, slack is increasing, productivity has been strong, and therefore, unit labor costs are well controlled. Again, all of these factors are positive in terms of a better inflation picture going forward. On the other hand, recent declines notwithstanding, the cumulative increases in commodity prices over the past year or so do remain large, and there is some evidence that these cost increases are being passed through into core prices. Commodity prices are extremely volatile, which makes inflation very difficult to forecast and makes the inflation outlook, therefore, quite uncertain. Wages could also begin to rise more quickly as the economy strengthens. For all these reasons, inflation risks are still in play and remain a concern for the Committee. Some participants reiterated their concern that maintaining rates too low for too long risks compromising our credibility and stimulating inflation over the medium run. That is a very quick survey of the comments. Are there any comments or questions? If not, let me just make a few comments. Personally, I see the prospects for economic growth in the foreseeable future as quite weak, notwithstanding the second quarter’s strength. I think what we saw in the recent labor reports removes any real doubt that we are in a period that will be designated as an official NBER recession. Unemployment rose 1.1 percentage points in September 16, 2008 73 of 108 four months, which is a relatively rapid rate of increase. The significance of that for our deliberations is, again, that there does seem to be some evidence that, in recession regimes, the dynamics are somewhat more powerful and we tend to see more negative and correlated innovations in spending equations. So I think that we are in for a period of quite slow growth. That is confirmed by what we are seeing in consumption, which probably would be quite negative if it weren’t for the remainder of the fiscal stimulus package. Other components of demand are, likewise, quite weak. We are all familiar with the housing situation. Some other factors that were supportive in Q2 are weakening—a number of people have noted the export growth. Actually, it is net exports—which is important—not just exports, and we are seeing both slowing growth in exports and some forecast of increased growth in imports. A factor that we haven’t talked about much is the fiscal side. That has been supportive and may be less supportive going forward. Generally speaking, though, I do think—and I have said this for a long time—that the credit effects will be important. They operate with a lag. It is very difficult to judge the lag. But my strong sense is that they are still some distance from their peak; that they will begin to be felt outside of housing, in nonresidential construction, for example, in consumer spending, and in investment; and that this is going to be independent of last week’s financial developments. I think that is going to be a major drag, probably well into next year. There are a few positives, which give some hope of some improvement next year. We have talked about energy and commodity prices as they relate to inflation, but of course, the decline in energy and commodity prices is also a plus for consumers and raises real incomes and would be supportive of sentiment, as we have already seen. There are a few positive indications here and there on the housing market, a few glimmers of stability, particularly in some regions. I September 16, 2008 74 of 108 think that the GSE stabilization is going to be very important. It has already lowered mortgage rates. It suggests that there will be a market for securitized mortgages, and I think that is positive. So if I wanted to outline an optimistic scenario, it would involve stronger indications of stabilization in housing, which in turn would feed into more confidence in the financial sector and would lead over time to improvement in the broader economy. I do think that financial conditions are a major concern. The situation right now is very uncertain, and we are not by any means away from significant systemic risk. Even if we avoid a major systemic event, the increase in risk aversion, the pullback from all counterparties, the deleveraging, the sale of assets—all of these things are going to continue for some time and are going to make the financial sector very stressed, which obviously will have effects on the economy. I have been grappling with the question I raised for President Lacker, and I would be very interested in hearing other views either now or some other time. The ideal way to deal with moral hazard is to have in place before the crisis begins a well-developed structure that gives clear indications in what circumstances and on what terms the government will intervene with respect to a systemically important institution. We have found ourselves, though, in this episode in a situation in which events are happening quickly, and we don’t have those things in place. We don’t have a set of criteria, we don’t have fiscal backstops, and we don’t have clear congressional intent. So in each event, in each instance, even though there is this sort of unavoidable ad hoc character to it, we are trying to make a judgment about the costs—from a fiscal perspective, from a moral hazard perspective, and so on—of taking action versus the real possibility in some cases that you might have very severe consequences for the financial system and, therefore, for the economy of not taking action. Frankly, I am decidedly confused and very September 16, 2008 75 of 108 muddled about this. I think it is very difficult to make strong, bright lines given that we don’t have a structure that has been well communicated and well established for how to deal with these conditions. I do think there is some chance—it is not yet large, but still some chance—that we will in fact see a much bigger intervention at the fiscal level. One is tempted to argue that by doing more earlier you can avoid even more later, but of course that is all contingent and uncertain. So we will collectively do our best to deal with these very stressful financial conditions, which I don’t think will be calm for some time. With respect to inflation, I accept the many caveats around the table. I have to say that I think, on net, inflation pressures are less worrisome now. The last two meetings have been very positive in that respect. The declines in energy and commodity prices are quite substantial. Natural gas, for example, has reversed all of its gains of the year. Steel scrap is down 40 percent in two months. We are seeing many other indications that commodity prices really have come down quite a bit. The dollar’s increase is also quite striking, and we have talked about wages, TIPS, and other factors. So I think overall I see at least the near-term inflation risk as considerably reduced. I do agree, though, with the points that were made that we may well see pressure on core inflation for a while longer, despite this morning’s reasonably benign number. The increases in commodity costs, although they have been partially reversed, have not been entirely reversed. Certainly over the last year to year and a half there is still a net substantial increase, which will show up as firms begin to pass through those costs. It is also the case, of course, that we have seen a very, very sharp movement in commodity prices and the dollar. Therefore, there is no logical reason why that couldn’t be reversed. Clearly, one problem we face is that the uncertainty about forecasting commodity prices is so large that it makes our forecasting exercises extraordinarily uncertain and means that September 16, 2008 76 of 108 we need to be somewhat more careful than we otherwise would be if we were back in the days of the Texas Railroad Commission, when we knew the price of oil six months in advance. We don’t have that privilege anymore. So I think core inflation may be elevated for a while. It may take a while for inflation to moderate. Everything I say is contingent on the dollar and commodity trends not being strongly reversed. But if those things are not reversed, I think we will see some improvement in inflation in the near term. I also agree with those who say that, when the time comes, we do need to be prompt at removing accommodation. It is just as much a mistake to move too late and allow inflation, and perhaps even financial imbalances, to grow as it is to move too early and be premature in terms of assuming a recovery. I think that is a very difficult challenge for us going forward, and I acknowledge the importance of that, which a number of people have noted. So that is a quick summary of my views. Let me just turn briefly, then, to policy. Do we have the statement? Let me just preview. I talked with Governor Warsh, and he gave me now during the break some of those suggestions he made. As they fit closely with other things that people said around the table, we have made a version here that incorporates them. I’ll discuss that in just a minute. 3 First, as a number of people have said, let me just say that I thought the memo that the staff prepared over the intermeeting period was extraordinarily helpful. We have been debating around the table for quite a while what the right indicator of monetary policy is. Is it the federal funds rate? Is it some measure of financial stress? Or what is it? I think the only answer is that the right measure is contingent on a model. As President Lacker and President Plosser pointed out, you have to have a model and a forecasting mechanism to think about where the interest rate is that best achieves your objectives. It was a very useful exercise to find out, at least to some 3 The statement referred to here is appended to this transcript (appendix 3). September 16, 2008 77 of 108 extent, how the decline in the funds rate that we have put into place is motivated. In particular, the financial conditions do appear to be important both directly and indirectly—directly via the spreads and other observables that were put into the model and indirectly in terms of negative residuals in spending equations and the like. The recession dynamics were also a big part of the story. I hope that what this memo does for us—again, I think it’s extraordinarily helpful—is to focus our debate better. As President Plosser pointed out, we really shouldn’t argue about the level of the funds rate or the level of the spreads. We should think about the forecast and whether our policy path is consistent with achieving our objectives over the forecast period. I am sympathetic to the general view taken by the staff, which argues that those recession dynamics and financial restraints are important, that we are looking at slow growth going forward, and that inflation is likely to moderate. Based on those assumptions, I think that our policy is looking actually pretty good. To my mind, our quick move early this year, which was obviously very controversial and uncertain, was appropriate. Their analysis also suggests that the amount of insurance that we have is perhaps limited, given that they take a risk-neutral kind of modeling approach. Having said that, I think they have also clearly set out the conditions and the framework in which we can debate going forward exactly where we should be going. To the extent that those around the table disagree with the model or with the projection, then that is the appropriate way, it seems to me, to address our policy situation. So, again, I do very much appreciate that. It helped me think about the policy situation. As I said, I think our aggressive approach earlier in the year is looking pretty good, particularly as inflation pressures have seemed to moderate. Overall I believe that our current funds rate setting is appropriate, and I don’t really see any reason to change. On the one hand, I think it would be inappropriate to increase rates at this September 16, 2008 78 of 108 point. It is simply premature. We don’t have enough information. There is not enough pressure on inflation at this juncture to do that. On the other hand, cutting rates would be a very big step that would send a very strong signal about our views on the economy and about our intentions going forward, and I think we should view that step as a very discrete thing rather than as a 25 basis point kind of thing. We should be very certain about that change before we undertake it because I would be concerned, for example, about the implications for the dollar, commodity prices, and the like. So it is a step we should take only if we are very confident that that is the direction in which we want to go. Therefore my recommendation to the Committee—and I will open it up for comment in a moment—is to keep the funds rate at its current level. I listened very carefully to the conversation around the table in terms of the statement. I think it was President Lockhart, President Stern, and Governor Warsh, among others, who talked about strengthening the language on financial markets. So the draft statement that you have in front of you is an attempt to make that change. It has two changes relative to existing alternative B. First, as Governor Warsh suggested, it reverses the first two sentences and so focuses in the first sentence on “Strains in financial markets have increased significantly and labor markets have weakened further,” and then the rest of it is basically the same as it was. The other change, which is in the last paragraph in the risk assessment, is pretty small, but it is probably worth considering. The word “closely” has been added to suggest, obviously, that we understand that the situation is changing rapidly and that we are carefully following conditions as they evolve. Kevin, we took your word “market” there—what was the rationale for it? MR. WARSH. My sense is—and this is certainly open for discussion—that we want the focus to be that we are really watching market developments closely. We are not trying to September 16, 2008 79 of 108 monitor the broader economy, which we might not be able to measure too much. I will admit that we have “economic and financial markets,” with “closely” modifying both of them, but the idea was to put the focus on the market side to a slightly greater extent than we normally do. CHAIRMAN BERNANKE. Okay. So I think that’s useful, although I do note that, all else being equal, there’s a slight barrier for making any change, and that one word is a change. President Fisher. MR. FISHER. I am sort of indifferent about this, but I don’t want to forget what Governor Duke was talking about. It’s not just financial markets; it’s financial developments. We are also talking about the internal dynamics of what is happening in the banking system and the credit contraction you spoke of. So we lead off with financial markets. I don’t want people to think we are focusing only on markets—Governor Warsh, I would disagree on that point. It’s a minor disagreement, but I think it is overkill. CHAIRMAN BERNANKE. All right. Let me open it up for any other comments on the statement or the policy action. President Evans. MR. EVANS. Thank you, Mr. Chairman. It is really just a question. What type of reaction do we think will be engendered by inserting “closely”? Everybody understands that we monitor financial developments very carefully. So we are bringing attention to this. Will there be a presumption that we are likely to do something intermeeting or something like that? I am not saying that is wrong, but it is a question. MR. DUDLEY. I would say that the markets will take it as a statement that is conditional on what happens in markets. If markets get sufficiently bad, if there is some threshold of deterioration, that can potentially provoke an intermeeting move is the way I think they would take it. Brian, would you agree with that? September 16, 2008 80 of 108 MR. MADIGAN. I agree. The fact that the first sentence of the risk assessment has a parallel treatment of the upside and downside risks may communicate a bit the sense that you are not ready to ease immediately. CHAIRMAN BERNANKE. Okay. We will decide. We will take a vote on it, if necessary. President Lacker. MR. LACKER. Yes. I echo President Evans’s concern. My recollection is—and I haven’t consulted the record recently—under your predecessor there was some phrasing like “watch market developments closely” that came to be widely understood as a signal of an intermeeting move. CHAIRMAN BERNANKE. I think it was “monitor closely.” Is that what it was? MR. LACKER. “Monitor closely” or some language like that. CHAIRMAN BERNANKE. Yes, “monitor closely.” Maybe you’re right. MR. LACKER. Yes, and that gives me pause. Then, about “market”—like a lot of economists, I am willing to construe the word “market” very broadly to include intermediation mechanisms of all types and the market for commercial credit in, you know, Dillon, South Carolina. [Laughter] But I am not sure that market participants are going to take it that broadly. They are going to take it in the sense of markets in traded financial instruments and organized exchanges and such. I just wonder if they are going to interpret it too closely as Wall Street. CHAIRMAN BERNANKE. Okay. So the sentiment over here on this side is that nobody thinks “market” is important. Let’s get rid of “market.” We’ll discuss “closely.” President Plosser. MR. PLOSSER. I think “market” may be construed too narrowly. We don’t really mean it that way, I don’t think. September 16, 2008 81 of 108 CHAIRMAN BERNANKE. “Market” is already gone. All right. Other comments, suggestions, or thoughts? Governor Kroszner. MR. KROSZNER. But I do think it is the delta, so it is the change. By including “closely,” I think the markets are going to look very closely at that change, and they are going to think that we are clearly trying to convey something with that. I just think we have to make sure that we feel comfortable in doing so. Certainly some people have suggested that they would be happy to move 50 basis points if they saw the markets moving, but I do think that that one particular word will get a lot of attention. Not that it should, but I think it is going to be focused on. Just as at one point we used the word “yet,” and that got an enormous amount of attention. And this has two syllables. [Laughter] MR. FISHER. Unless you are from the south. [Laughter] CHAIRMAN BERNANKE. The sad thing is that Governor Kroszner is right. We have seventeen people debating over this word, and it actually does matter. Does anyone else want to weigh in? Okay. I think my sense is that there should be a barrier, a bit of a hurdle, to changing; so I am leaning toward sticking with what we have. Would that be okay, Governor Warsh, do you think? MR. WARSH. On “closely”? CHAIRMAN BERNANKE. Getting rid of “closely.” MR. WARSH. Let me ask Brian and Bill. Brian, without “closely,” how do you think the markets will react to that? MR. MADIGAN. That you are not particularly ready to change your stance of policy. September 16, 2008 82 of 108 MR. DUDLEY. I think the expectation going in is, for most people, that you are not prepared to ease today, but if things got really dark from here you would. So the question is, How do you convey that with the right word? You need something in between “closely” and— MR. WARSH. I think the sentiment we are trying to suggest is watchful waiting. We are not indifferent, we are not clueless, we are paying attention, but we are not predisposed. Hence, Governor Kohn’s suggestion. MR. KOHN. My suggestion was to substitute “carefully” for “closely.” I agree that “monitor closely” had this other connotation, but I think we should be seen as paying more attention than usual. There might be another alternative. MR. DUDLEY. “The Committee will carefully evaluate economic and financial market developments.” That means you are on the case. CHAIRMAN BERNANKE. Well, it is not an analytical thing we are doing. We are just watching closely. MR. WARSH. Keenly? Carefully? MR. LACKER. Mr. Chairman? CHAIRMAN BERNANKE. Yes. President Lacker. MR. LACKER. Including “closely,” what does that imply about the opposite? I mean, are we going to be able to take that out? MR. WARSH. Well, we have done things like “in a timely manner” and other kinds of phraseology. MR. LACKER. Yes, but this is an adjective. CHAIRMAN BERNANKE. No, it’s an adverb. September 16, 2008 83 of 108 MR. LACKER. There goes my credibility. [Laughter] If we take it out, can we use the phrase without it? CHAIRMAN BERNANKE. What we have done in the past is basically just use a new phrase. MR. LACKER. So that means we have to throw this phrase out. MR. WARSH. Mr. Chairman, I would support “carefully.” CHAIRMAN BERNANKE. Is that better? President Evans. MR. EVANS. Just to be clear, we have gone a long way just now from its being a semantic discussion to whether or not the Committee wants to hint at the possibility of a nearterm action. I do not have a problem with that. In fact, in my comments I suggested that the resolution of uncertainty might improve in the next couple of weeks, but that seems to be the principal issue here, which I don’t really recall us discussing in as much detail as we just have. CHAIRMAN BERNANKE. No, you’re right. But there is another issue, which I think is the thing we’re concerned about and which motivates the change in alternative B, paragraph 2. We don’t want the world to feel that we are not awake, that we are not paying attention. We know that very unusual things are going on in the financial markets; and we are prepared, maybe not through monetary policy but through whatever mechanism is necessary, to address that. MR. EVANS. Right. So I fully support that sentiment, and if you find the right wording that captures it, that’s fine with me. CHAIRMAN BERNANKE. Other comments? President Plosser. MR. PLOSSER. As long as we are throwing monkey wrenches into the language, I think we do signal our concern. In paragraph 2, we put the very first sentence, which says, “Strains in financial markets have increased significantly.” So we have acknowledged that at the very top of September 16, 2008 84 of 108 this statement. So there is no going back on that. I am a little concerned about what moving back “closely” means. Another alternative that I’ll throw out would be, rather than use “closely,” to say that “the Committee will continue to monitor economic and financial developments.” SEVERAL. That’s what it said last time. MR. PLOSSER. Well, that seems fine. We are monitoring these things. Is this the FOMC statement dictionary we are going to? Is this the code book? [Laughter] CHAIRMAN BERNANKE. Any other comments? All right. Let me just ask for a straw vote: “closely,” no “closely,” or “carefully.” Do we want “carefully”? All right. Is “carefully” more acceptable to those who are concerned? MR.KOHN. It’s less of a code word. The intention was to loosen it up a bit but not revert to those code words that nearly promise intermeeting action. MR. PLOSSER. We make note of this in the lexicon of FOMC terminology. CHAIRMAN BERNANKE. The semiotics class will begin as soon as the—[Laughter] All right. “Carefully”—is that okay? I’m seeing nodding. All right? Governor Warsh? MR. WARSH. Yes, sir. MR. KOHN. I’m closing the dictionary. CHAIRMAN BERNANKE. All right. So we are changing the last part of that sentence. We are striking the word “market” and changing “closely” to “carefully.” Any other comments or thoughts on the substance, sizzle, or marketing? Or as Rick would say, “moychandising”— but he’s not here. [Laughter] All right. If not, Ms. Danker. MS. DANKER. I will be reading the directive from the Bluebook and the statement that was just circulated. “The Federal Open Market Committee seeks monetary and financial September 16, 2008 85 of 108 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 2 percent.” Then the statement is as it was handed out, except the last sentence reads, “The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.” Chairman Bernanke First Vice President Cumming Governor Duke President Fisher Governor Kohn Governor Kroszner President Pianalto President Plosser President Stern Governor Warsh Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes CHAIRMAN BERNANKE. Thank you. The next meeting is October 28 and 29. Lunch will be available in the anteroom. While we have lunch, Laricke Blanchard will provide us with an update on congressional developments. Thank you all very much. The meeting is adjourned. END OF MEETING September 29, 2008 1 of 16 Conference Call of the Federal Open Market Committee on September 29, 2008 A conference call of the Federal Open Market Committee was held on Monday, September 29, 2008, at 9:00 a.m. Those present were the following: Mr. Bernanke, Chairman Mr. Geithner, Vice Chairman Ms. Duke Mr. Fisher Mr. Kohn Mr. Kroszner Ms. Pianalto Mr. Plosser Mr. Stern Mr. Warsh Messrs. Evans, Lacker, and Lockhart, and Ms. Yellen, Alternate Members of the Federal Open Market Committee Messrs. Bullard and Rosengren, Presidents of the Federal Reserve Banks of St. Louis and Boston, respectively Mr. Madigan, Secretary and Economist Ms. Danker, Deputy Secretary Mr. Skidmore, Assistant Secretary Ms. Smith, Assistant Secretary Mr. Alvarez, General Counsel Mr. Sheets, Economist Mr. Stockton, Economist Messrs. Connors, English, and Kamin, Ms. Mester, Messrs. Rosenblum, Sniderman, and Wilcox, Associate Economists Mr. Dudley, Manager, System Open Market Account Mr. Clouse, Deputy Director, Division of Monetary Affairs, Board of Governors Mr. Blanchard, Assistant to the Board, Office of Board Members, Board of Governors Ms. Edwards, Senior Associate Director, Division of Monetary Affairs, Board of Governors Mr. Leahy, Associate Director, Division of International Finance, Board of Governors September 29, 2008 2 of 16 Mr. Carpenter, Deputy Associate Director, Division of Monetary Affairs, Board of Governors Mr. Luecke, Section Chief, Division of Monetary Affairs, Board of Governors Mr. Barron, First Vice President, Federal Reserve Bank of Atlanta Messrs. Fuhrer and Judd, Executive Vice Presidents, Federal Reserve Banks of Boston and San Francisco, respectively Ms. George, Messrs. Sellon, Sullivan, and Weinberg, Senior Vice Presidents, Federal Reserve Banks of Kansas City, Kansas City, Chicago, and Richmond, respectively September 29, 2008 3 of 16 Transcript of the Federal Open Market Committee Conference Call on September 29, 2008 CHAIRMAN BERNANKE. Thank you. Good morning, everybody. Thank you as always for your flexibility and meeting on short notice—particularly to Janet. How are you feeling today, Janet? MS. YELLEN. Fine, thank you. CHAIRMAN BERNANKE. I have three topics to raise with you today. First, financial market conditions, as you know, remain quite strained, and in response to that we are proposing some additional liquidity measures. Mostly this is informational. However, we are proposing to increase the swap lines fairly significantly, and although you have authorized the Foreign Currency Subcommittee to take those actions, we thought that, given the size of the change, it would be worthwhile to bring this back to you for your attention and your vote just to get the Committee’s agreement on this issue. The second issue is Wachovia. As you may have heard, Wachovia was purchased, or there’s a plan to purchase, by Citigroup this morning. To facilitate that purchase, the Board invoked the systemic risk exception, which has not been done before. So we want to give you a chance to catch up on what’s going on there. Then third, we want to talk a bit about interest on reserves, which will be provided in the Paulson financial rescue bill, which is supposed to be up for a vote on Wednesday. I just want to brief you on what we’re planning in that regard. So let me start by turning to Bill Dudley in New York. Bill, if you could give us a brief overview of the financial conditions that motivate these actions, review the actions we’re proposing, and take Q&A, that would be very helpful. MR. DUDLEY. Okay. Thank you, Mr. Chairman. Let me start with the foreign exchange swap lines, and then I’ll talk a bit about the TAF increases and about the balance sheet. I think Brian later is going to talk about interest on reserves in more detail. September 29, 2008 All of the foreign central banks that have obtained dollar swap lines in response to dollar funding pressures in their home markets have decided, with some encouragement on our part, to seek an increase in the size of these swap line authorizations. We just have to hear from the Bank of Japan—I think that’s the only one that’s outstanding—but we expect to hear that shortly. The actual draws on these lines may turn out to be considerably less, and the amounts that are actually drawn are likely to depend on market conditions. The large increase in authorization should be considered as insurance in case market conditions continue to deteriorate and as reassurance to market participants that the world’s major central banks are determined to respond in force to mitigate dollar funding pressures. By foreign central banks, the current lines are being doubled for the larger participants and tripled for the smaller participants. The increases are as follows, very quickly: the Bank of Canada, $30 billion from $10 billion; the Bank of England, $80 billion from $40 billion; the Bank of Japan, $120 billion from $60 billion; the National Bank of Denmark, $15 billion from $5 billion; the ECB, $240 billion from $120 billion; the Bank of Norway, $15 billion from $5 billion; the Reserve Bank of Australia, $30 billion from $10 billion; the Swedish Riksbank, $30 billion from $10 billion; and the Swiss National Bank, $60 billion from $30 billion. Adding up all of this would result in an increase in our swap line authorization to $620 billion from $290 billion previously. I think that these decisions have been made in response to the increasing turmoil evident in interbank markets, especially for dollar funding; and by increasing the size of the authorization significantly, the intention is to reassure market participants that sufficient dollar funding will be available well into 2009. The staff believes that these large increases are appropriate to reassure market participants that the world’s central banks are prepared to take extraordinary steps as needed to address ongoing strains in financial markets. These strains are evident in a number of ways. First, we’ve seen a sharp rise in overnight dollar funding rates and in term LIBOR–OIS spreads. For example, on Friday, the three-month LIBOR–OIS spread was over 200 basis points, and in fact, LIBOR may actually understate the degree of funding pressure. The NYFR index, which is the U.S.-based alternative to LIBOR, has actually been much higher than LIBOR over the past week or two. So LIBOR actually may be understated. Second, there have been many anecdotal reports of a withdrawal of counterparties’ willingness to engage in term funding activity. So the tenor of almost all activity in the market now is overnight. Third, there are growing liquidity strains at major financial institutions. Obviously, Wachovia is part of that story. Fourth, we’ve seen a significant rise in the demand for our TSLF and TAF credit. For example, the stop-out rate for the most recent TAF auction, which was a 28-day maturity auction, was 3.75 percent, significantly above the one-month LIBOR rate at the time. Fifth, we’ve seen a sharp rise in PCF and PDCF borrowings. For example, on the week ending last Wednesday, PCF credit was $39.4 billion, an increase of about $18 billion from the previous week, and PDCF borrowing was $88 billion in the latest week, up $68 billion from the previous week. Last, European banking strains have been increasingly evident in recent days, especially this weekend following the announcement of the Fortis rescue and the nationalization of B&B in the United Kingdom. The European banking news has led to a sharp drop in the European equity markets—this 4 of 16 September 29, 2008 5 of 16 morning they’re down 2 to 3 percent—and the euro and sterling exchange rates have dropped quite sharply against the dollar, down about 2 percent. Now, along with this increase in authorized swap lines, Chairman Bernanke has approved the staff recommendation for a large increase in our term auction facility (TAF) program. We are proposing two changes in the TAF program. First, we’re proposing to increase the 84-day TAF auction sizes to $75 billion per auction, from $25 billion. That will start with the next 84-day auction that was scheduled for October 6. The second change is that the Chairman has approved two forward TAF auctions totaling $150 billion. These auctions would take place in November, and they would auction short-dated TAF funds for one-week or two-week terms over year-end. Together, these two changes to the TAF program would increase the supply of TAF credit to $450 billion, from $150 billion currently. The notion is that a larger commitment to TAF funding should help ameliorate market concerns about the availability of term funding and about the availability of such funding over year-end. The effective dates for the swap lines and all the programs will be extended, I think, to April 30, 2009. This would enable the foreign central banks to extend 84-day TAF credit through year-end under their swap agreements. Obviously, these commitments are likely to put considerable further strain on the Federal Reserve’s balance sheet. In recent days we have been offsetting the large reserve additions with the Treasury SFP (supplementary financing program) cashmanagement bill issuance. After this week’s scheduled bill issuance, the total amount of outstanding SFP obligations will reach $400 billion. However, we cannot rely on this program indefinitely because the Treasury’s room under the debt limit ceiling is about $900 billion as of early last week and is shrinking rapidly because of the SFP and other ongoing funding commitments. PARTICIPANT. It’s impossible to hear. MR. FISHER. Someone has had a BlackBerry on during the last two or three sentences. MS. DANKER. New York, in particular, could you make sure you have no cell phones or BlackBerrys near the microphones. MR. DUDLEY. I’ll make sure everything is off. Probably I’m the culprit. Poetic justice. Let me just repeat the last stuff on the SFP. After this week’s scheduled bill issuance, the total amount of SFP obligations will be $400 billion. We can’t keep relying on that program indefinitely, though, because the Treasury’s room under the debt limit ceiling, which was $900 billion as of early last week, is shrinking rapidly because of that program and other ongoing funding commitments. So that’s where the interest on reserves legislation comes in. Assuming that the Congress enacts that legislation this week, we will be able to pay interest on reserves. I’ll leave that to Brian to talk about in more detail. Thank you. I’m happy to take any questions. September 29, 2008 6 of 16 CHAIRMAN BERNANKE. Okay. So just to clarify, we’ll be asking you for the following two actions after the question-and-answer period. One is, again, that although the Foreign Currency Subcommittee was authorized to increase swaps, because we are essentially doubling the outstanding swap lines, we would like to go back to the Committee for a vote, or to hear your views, to get approval for those swap lines, which pending approval, we plan to announce shortly, right? MR. DUDLEY. At 10 a.m. CHAIRMAN BERNANKE. Yes, very shortly. The other thing, which also requires a vote, is that, in order to do three-month swaps over year-end, some of the three-month swaps would go beyond January 30. So we’re asking for the extension not for all programs but only for the swap lines to April 30. Is that right? MR. DUDLEY. Yes. CHAIRMAN BERNANKE. So that’s the second request—to extend the swap line authorizations to April 30 of next year. With those two points in mind, are there any questions for Bill? President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. I was confused about April 30. I thought I heard Bill Dudley say that he’s requesting the TAF be extended to April 30. Is it just the swap lines, or is it both? Can I get some clarification? MR. DUDLEY. Just the swap lines. The TAF program doesn’t need an authorization because it is just within the discount window program. CHAIRMAN BERNANKE. The issue of unusual and exigent is not coming up here because we’re not dealing with any section 13(3) lending today. President Evans. MR. EVANS. Thank you, Mr. Chairman. I’d just like to review by asking a question. The swap lines are very large now. Could we review what could go wrong for our balance sheet in a September 29, 2008 7 of 16 not-so-pleasant scenario? Are these actions consistent—and I think they are—with the substantial deleveraging of the financial system that we’re trying to make take place in an orderly fashion but we can’t resist the natural forces that have to take place? Thank you. MR. DUDLEY. I think that’s correct. Our strategy all along has been not to prevent the deleveraging or the unwinding that developed earlier but to stretch it out a little so fewer things break. The swap lines are just one more tool to help that process unfold without severe systemic consequences occurring. Obviously, things are breaking, even with all the tools that we’ve rolled out. So I think that just suggests that more force needs to be applied. Clearly, confidence in the markets is extraordinarily poor and fragile, and that’s another reason that an escalation in the authorizations is important—to reassure people that the central banks are prepared to be there, if necessary. CHAIRMAN BERNANKE. Of course, for the balance sheet—and we’ll discuss that also with interest on reserves—it has the benefit of having zero credit risk because the other central banks are our counterparties. President Evans, did you have another comment? MR. EVANS. Well, I suppose you answered my question there. It just seems that, in looking at the TAF auctions, there are a number of foreign institutions that, because I don’t follow it, I’m not familiar with, and these are the types of institutions that are borrowing under these agreements. But I suppose that the foreign central banks are careful with their counterparties. CHAIRMAN BERNANKE. Other questions for Bill? If there are no questions, since Bill has to go and get ready for the announcement—sorry, President Plosser. MR. PLOSSER. It’s not pertinent to this particular decision, but I was going to ask Bill whether there are any other sorts of measures or tools that the Desk in New York is considering— that are being explored or thought about going forward? September 29, 2008 8 of 16 MR. DUDLEY. We’re looking at a lot of different things to potentially make the management of reserves more effective and to provide more support for the market. But we don’t have anything that is close to being put forward at this time. We’re always looking at contingencies, what other tools are available, and what other options might be available, but there’s nothing that I would say is imminent. VICE CHAIRMAN GEITHNER. Mr. Chairman, could I just add one thing? Maybe Eric could speak to this. I think the only other thing at the moment that deserves some quick reflection is whether the Federal Reserve should be modifying the facilities it put in place for money market funds last week. A team of people across the System is looking at a range of options there and is likely to give a recommendation to the Chairman sometime later today. My own sense is that it is the only area in which there is an immediate, compelling need and there’s active exploration of some escalation options. CHAIRMAN BERNANKE. With the anticipated passage of the fiscal plan, a lot of our intellectual talents are going to be harnessed trying to support the Treasury in thinking about their auctions and other strategies that they’re going to use. The Board, New York, and others have been working very closely with the Treasury staff. Other questions? President Lacker, do you have a question? MR. LACKER. Yes. What do we know about the time line for the implementation of the Treasury’s program of insuring money market mutual funds and how that would work? CHAIRMAN BERNANKE. They have already put in place a program that insures deposits that were there before a fixed date. In other words, new deposits are not protected. They made that change because they were generating runs from banks into money market mutual funds and the banks were complaining. September 29, 2008 9 of 16 MR. LACKER. Now, Vice Chairman Geithner, does the recommendation likely to come forward involve expanding or contracting the coverage? VICE CHAIRMAN GEITHNER. It is obviously not my decision, but they are looking at options that go in the direction of expanding the liquidity support provided both to the agent banks and perhaps directly to the funds themselves. MR. LACKER. But any change in the space of qualified commercial paper? VICE CHAIRMAN GEITHNER. Eric may be a little closer to this than I am at the moment. Again, they’re looking at it broadly, conceptually. The options fall into expanding the scope of the types of funds covered by the—what’s it called, Eric?—the AMLF. MR. ROSENGREN. That’s right. VICE CHAIRMAN GEITHNER. Second would be some expanded section 23A approvals to facilitate what the clearing banks need to do to provide liquidity. Another option would be to expand the scope of instruments that might be supported through that program. Another option might be to lend directly to money funds against a broader class of assets, and of course, it’s possible that the Treasury may rejigger, change, expand, or add to their guaranty. CHAIRMAN BERNANKE. Other questions, comments? Let me ask: Scott, are you prepared to state the resolutions we would like? Brian? Anyone? I’d like to note for the record that all three of the staff briefers today—Bill, Brian, and Scott—worked all night last night. So we have dedicated employees here in the System. Brian. MR. MADIGAN. Thanks, Mr. Chairman. I’ll read a resolution regarding the swap lines: “The Federal Open Market Committee authorizes the Federal Reserve Bank of New York to take the following actions to amend the existing temporary swap arrangements with foreign central banks as follows: with the Bank of Canada, to increase the aggregate amount to $30 billion; with September 29, 2008 10 of 16 the Bank of England to increase the aggregate amount to $80 billion; with the Bank of Japan to increase the aggregate amount to $120 billion; with the Danish National Bank to increase the aggregate amount to $15 billion; with the European Central Bank to increase the aggregate amount to $240 billion; with the Norges Bank to increase the aggregate amount to $15 billion; with the Reserve Bank of Australia to increase the aggregate amount to $30 billion; with the Swedish Riksbank to increase the aggregate amount to $30 billion; with the Swiss National Bank to increase the aggregate amount to $60 billion. In each case the System Open Market Account Manager would be authorized to determine appropriate liquidity buffers. The FOMC also extends the current delegation of authority to the Foreign Currency Subcommittee until April 30, 2009.” MS. DANKER. And it extends the expiration dates. CHAIRMAN BERNANKE. He has that. Okay. So there’s a motion. Any further questions or comments? If there’s no objection, may I take a vote now? Debbie. MS. DANKER. Chairman Bernanke Vice Chairman Geithner Governor Duke President Fisher Governor Kohn Governor Kroszner President Pianalto President Plosser President Stern Governor Warsh Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes CHAIRMAN BERNANKE. Thank you very much. I’m going to excuse Bill if he wants to go. There he goes. [Laughter] All right. Let me turn now to the second item, which is a briefing by Scott Alvarez, who as I said worked all night on the Wachovia situation. If President Lacker would like to add anything, he is certainly welcome to do so. Scott. September 29, 2008 11 of 16 MR. ALVAREZ. Thank you, Mr. Chairman. On Friday, Wachovia experienced significant liquidity pressures, and its management concluded that it would have difficulty funding itself this week. So the board of directors of Wachovia authorized the management to begin entertaining merger offers. Wells Fargo and Citi quickly emerged as the leading candidates among a group of candidates, but by Sunday it became clear that those two, which were the only remaining candidates by Sunday, could accomplish the merger only with government assistance. For a variety of reasons, the Board believed that it was appropriate to implement the systemic risk exception to give the FDIC the widest flexibility to resolve Wachovia in order to maintain confidence in the banking system. Among the reasons was the concern about liquidity pressures that would be felt by similarly situated banking institutions if there was a disorderly or very focused failure of Wachovia. Also, there was concern that, because Wachovia looked so strong on a capital basis and it would be somewhat surprising to some in the market when it closed, it would send a bad signal about similarly situated institutions. There was also concern about the large amount of foreign deposits that would be left behind in a least-cost resolution; the potential for money market mutual funds, which are already in a fragile state, to have further disruption from a least-cost resolution; and that the current financial turmoil and weakened economy would be further weakened if the leastcost solution was pursued and that might undermine business and household confidence. The FDIC and the Treasury both agreed with that analysis, and the Secretary consulted with the President, and the systemic risk exception was invoked on Sunday late afternoon. After a bidding process that was run by the FDIC between Citi and Wells Fargo, Citi emerged as the better bid for Wachovia. You may have seen this morning a report about that bid. Citi offered slightly more than $2 billion to the existing shareholders. Plus it would buy out all of the banks from underneath Wachovia and leave A.G. Edwards and Evergreen, the two investment banking firms of Wachovia, with the existing shareholders. Citi identified a portfolio of largely real estate–related assets that was about $312 billion in size that it felt it could not handle without some loss-sharing with the FDIC. It proposed to the FDIC that Citi would take a $54 billion first loss position, and then it asked the FDIC to share losses—actually to take losses on the portfolio—above the $54 billion mark. The FDIC’s analysis of that was that the $54 billion cushion was sufficient to allow the FDIC on its average basis to emerge with little or no loss, and so the FDIC accepted that bid. The Board was asked to give some capital relief to Citi in connection with this and did agree to give relief at the holding company level from the tier 1 regulatory ratio and the leverage ratio for approximately $270 billion worth of assets that would come over from Wachovia to Citi. That capital relief will be amortized over time and is similar in many ways to the relief that was granted in the Bear Stearns transaction. An application will be filed shortly for the merger. The two parties are still working out the details of the merger agreement, but they expect to have it done in the next day or so. That’s all. CHAIRMAN BERNANKE. Are there questions for Scott? President Lacker, would you like to add anything? September 29, 2008 12 of 16 MR. LACKER. Yes. Wachovia was losing about $1 billion in deposits a day on average over the past couple of weeks. They have liquidity to last under a calm scenario this week only until maybe Thursday or Friday. They probably would have needed discount window borrowing in the middle of the week; but given the news, they were affected by the WaMu closure because of what that did to senior debt holders, and they began experiencing companies pulling away from them in the middle of the day on Friday. So they were sort of caught up in the wake after WaMu. They didn’t think they could survive without a lot of support today. So they were very committed to doing something over the weekend. They have $64 billion plus in collateral, lendable value pledged at the discount window. They have $12.5 billion outstanding at the TAF, some of that 28-day, some of that in the two 84-day auctions, and we will leave them on primary credit, and they’ll retain that TAF credit. We intend issuing an announcement later this morning that says something like, “In support of this transition, the Federal Reserve Bank of Richmond stands ready to provide liquidity as needed.” So they have $52 billion in lendable value net of the TAF money. They have $150 billion in uninsured deposits, and as for other numbers, the market cap at the end of the day Friday was a little over $21 billion. Evergreen Investments, Wachovia Securities, and A.G. Edwards have a value of about $12 billion. This leaves shareholders of the holding company with about $14 billion in value. Wachovia was trading at about $1 this morning after trading at about $10 per share last Friday. I’m not sure people understand the Edwards and Evergreen part, but we’re monitoring the situation very closely and have people on their desk right now. CHAIRMAN BERNANKE. Thank you very much. We’ll take questions for either Scott or Jeff. President Plosser, I think you were first. September 29, 2008 13 of 16 MR. PLOSSER. Thank you, Mr. Chairman. I have a question about the $300 billion of mortgage assets referred to that were segregated out, and the FDIC said that Citi will take the first $54 billion. Does anybody know whether that is current market value? What is the $300 billion? Is it market price, or was it face value? How was that valued—do we know? MR. ALVAREZ. The $312 billion was the value on the books of Wachovia, and so Citi is providing the cushion in several ways. One is marking them down $30 billion to begin with, to be more in line with what Citi’s own marks are and to add to reserves to supplement the potential losses there. Then the rest is a loss-sharing. MR. PLOSSER. Does the first $30 billion markdown come out of the $54 billion? MR. ALVAREZ. Yes. MR. PLOSSER. So they have already taken roughly $30 billion of the $54 billion losses they’ve promised they’d take? MR. ALVAREZ. That’s correct. MR. PLOSSER. Thank you. CHAIRMAN BERNANKE. President Fisher. MR. FISHER. Mr. Chairman, this may be a conversation for another day, but it seems to me that we’re ending up with more and more concentration—Bank of America, Citicorp, Morgan— and I’m curious as to what we plan longer term so as not to displace the ability of other institutions to play their role in the financial markets and grow their businesses—the super-regionals that are healthy and so on. But I guess just philosophically what concerns me longer term is that, in response to these actions, there are no other people to take these steps, but we’re creating larger and larger concentrations and bigger and bigger situations where we have too big to fail. I’d just like at some point to have a conversation on that matter. I’m not objecting to the move taken, obviously, September 29, 2008 14 of 16 but it is going to present a bigger problem as we go down the path because we’re getting increasing concentration in fewer and fewer institutions. Just a comment. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Well, let me just add that I share your concern. There is an increasing concentration. On the other hand, you could also view it as part of a process of consolidation as well, as we have reduced the number of independent investment banks, for example. But I agree with that. We have been very constrained throughout this entire crisis, as you know, by the existing facilities for dealing with failing institutions and mergers being one of the only tools we have. Going forward, I think there is some hope in the near term under the new TARP, which would allow resolutions using capital injections basically without necessarily doing a merger. Then subsequently, I think it’s very important, as we look toward restructuring our financial regulatory system, to develop good resolution mechanisms and to think about the issues of concentration and too big to fail. So I take your point, basically. MR. FISHER. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Any other questions for Scott or for Jeff? All right. If not, let me turn to our last item on the agenda, which is interest on reserves. The TARP legislation provides for that, and Brian will talk a bit about how we might use that. MR. MADIGAN. Thanks, Mr. Chairman. As the Chairman indicated, the TARP legislation includes a provision that accelerates the effective date of the authority to pay interest on reserves from October 1, 2011, to October 1, 2008. The Federal Reserve staff believes that we’re ready to start paying interest on reserve balances beginning with the reserve maintenance period that starts on October 9. Assuming that the legislation is passed by the Congress and signed by the President later this week, we plan to recommend shortly thereafter to the Board that the Board direct the Reserve Banks to begin paying interest on reserves on October 9. Specifically, we plan to suggest that required reserve balances be remunerated at a rate of the target federal funds rate less 10 basis points, and more significantly in current circumstances, that excess reserve balances be remunerated initially at a rate of the target federal funds rate less 50 basis points. We anticipate that the spread between the excess reserves rate and the target federal funds rate may well need to be adjusted over time, but we’re suggesting a 50 basis point spread initially. We’re proposing no other significant changes to the September 29, 2008 15 of 16 reserve maintenance framework at this time, although we’ll be recommending a few relatively technical changes that are motivated by the ability to pay interest on reserves. In more normal circumstances, we’d think of the system that we’re recommending at this time as being a type of a corridor system but with required reserves. The primary credit rate should set the ceiling for the federal funds rate; the excess reserves rate should set the floor. In the current circumstances, though, it may turn out that the system will operate more like what we have been calling a floor system in which the gap between the target federal funds rate and the excess reserves rate is narrow. This is because, as was discussed earlier, our tools to absorb reserves provided by, again, various lending operations could be constrained given the limited remaining capacity to sell securities and possibly reluctance on the part of Treasury to expand further the supplementary financing program. In any case, the interest rate on excess reserves should put a floor— possibly a soft floor, but a floor—under the funds rate and thereby allow the Federal Reserve to conduct monetary policy appropriately while providing liquidity consistent with financial stability. I would note that the overall reserve maintenance framework will remain very complex, possibly overly complex. The staff plans to continue the study that we presented to the Reserve Bank presidents and the Board members earlier this year, and at some point, we expect to bring significant further changes to the policymakers for consideration. But for now, we think that the changes that we’re proposing will make effective use of the authority that we expect we’ll have beginning on October 1. Thanks, Mr. Chairman. CHAIRMAN BERNANKE. Thanks, Brian. Are there questions for Brian? President Lacker. MR. LACKER. Yes, Brian. So at 50 basis points under the target rate for excess, it sounds as though your philosophy here is just to limit the tails of the intraday funds rate distribution rather than to attract a lot of funds and replace the Treasury program. Is that accurate? I mean, how do you intend to approach that question? MR. MADIGAN. President Lacker, I think we’re going to need to proceed somewhat adaptively. We’ll be going from one type of system, in which there has been no remuneration on excess reserves, to one with a rate that’s fairly close to—50 basis points under—the federal funds rate. My guess is that it could attract a substantial increase in banks’ interest in holding excess reserves, especially under current circumstances, when there’s a lot of concern about counterparty September 29, 2008 16 of 16 credit risk. It may well be the case, as I mentioned, that we’ll be proposing a further narrowing of the excess reserves rate as we get experience, and we may, indeed, have to do that if our ability to drain reserves is otherwise constrained. We may need to use the excess reserves rate as the way to effectively set the federal funds rate. But I think we’ll need to see how it goes and get some experience. CHAIRMAN BERNANKE. Other questions for Brian? Jeff, did you have another question? No. Okay. Any other comments or issues? If not, thank you very much, again, for the short notice, and we’ll obviously keep you well briefed, and we hope you’ll do the same for us. Good morning. END OF MEETING October 7, 2008 1 of 30 Conference Call of the Federal Open Market Committee on October 7, 2008 A conference call of the Federal Open Market Committee was held on Tuesday, October 7, 2008, at 5:30 p.m. Those present were the following: Mr. Bernanke, Chairman Mr. Geithner, Vice Chairman Ms. Duke Mr. Fisher Mr. Kohn Mr. Kroszner Ms. Pianalto Mr. Plosser Mr. Stern Mr. Warsh Ms. Cumming, Messrs. Evans, Lacker, and Lockhart, and Ms. Yellen, Alternate Members of the Federal Open Market Committee Mr. Rosengren, President of the Federal Reserve Bank of Boston Mr. Rasdall, First Vice President, Federal Reserve Bank of Kansas City Mr. Madigan, Secretary and Economist Ms. Danker, Deputy Secretary Mr. Skidmore, Assistant Secretary Ms. Smith, Assistant Secretary Mr. Alvarez, General Counsel Mr. Baxter, Deputy General Counsel Mr. Sheets, Economist Messrs. Connors, English, and Kamin, Ms. Mester, Messrs. Rolnick, Rosenblum, Slifman, Sniderman, Tracy, and Wilcox, Associate Economists Mr. Dudley, Manager, System Open Market Account Mr. Cole, Director, Division of Banking Supervision and Regulation, Board of Governors Mr. Parkinson, Deputy Director, Division of Research and Statistics, Board of Governors Mr. Blanchard, Assistant to the Board, Office of Board Members, Board of Governors Ms. Liang and Mr. Reifschneider, Associate Directors, Division of Research and Statistics, Board of Governors October 7, 2008 2 of 30 Mr. Nelson, Associate Director, Division of Monetary Affairs, Board of Governors Mr. Gagnon, Visiting Associate Director, Division of Monetary Affairs, Board of Governors Mr. Luecke, Section Chief, Division of Monetary Affairs, Board of Governors Mr. Fuhrer, Executive Vice President, Federal Reserve Bank of Boston Messrs. Rasche, Sellon, Sullivan, and Williams, Senior Vice Presidents, Federal Reserve Banks of St. Louis, Kansas City, Chicago, and San Francisco, respectively Mr. Bryan, Vice President, Federal Reserve Bank of Atlanta Mr. Schetzel, Assistant Vice President, Federal Reserve Bank of New York October 7, 2008 3 of 30 Transcript of the Federal Open Market Committee Conference Call on October 7, 2008 CHAIRMAN BERNANKE. All right. Let’s begin. Thank you all for joining this meeting. We’re having a lot of meetings off the regular cycle. I think it’s just a sign of the extraordinary times that we’re currently living through. The only agenda item for this meeting is the discussion of a proposed coordinated action with five other major central banks. It will be a six-bank coordinated action. Besides ourselves, the other banks involved are the European Central Bank, the Bank of England, and the Bank of Canada, and since I spoke to you, the Swiss National Bank and the Bank of Sweden have joined in this collective action. Japan has its own issues and will not be cutting but will be expressing support and has been consulted. The plan, conditional on our approval, would be for all six major central banks to cut policy rates by 50 basis points jointly and announce tomorrow at 7:00 a.m. Eastern time before the U.S. markets open. There are two statements. There’s a short joint statement by all of the central banks, which has been negotiated. I don’t know if you have access to it. I will read it to you shortly, if necessary. Then it is proposed that we have our own short statement, which I know has been circulated and which you should have in front of you. So that’s the issue we’re here to discuss. My proposal would be, first, to begin with some short briefings by the staff. Bill Dudley in New York, Larry Slifman here at the Board, and Nathan Sheets here at the Board would just give us a short update on what’s transpiring in the financial markets and the broader economy. We will have an opportunity for Q&A with the staff. I’d then like to introduce the subject briefly and just talk about the rationale, and the floor will be open for your comments on the action, on the economy, and on the statement, as you see fit. So without further ado, let me turn to Bill Dudley. Bill, are you there? MR. DUDLEY. Yes. Thank you, Mr. Chairman. Despite our massive escalation on the liquidity provision front and passage of legislation granting the Treasury authority October 7, 2008 to set up a $700 billion troubled asset relief program, or TARP, market conditions continue to deteriorate. This is occurring in three broad respects. First, market participants continue to pull back in their willingness to engage with one another. This pullback is evident in elevated interbank lending rates and elevated foreign exchange swap bases and market liquidity more generally. The one-month and three-month LIBOR–OIS spreads have widened to 271 and 296 basis points, respectively. That is up more than 175 basis points in the past three weeks since the September 16 FOMC meeting. The all-in cost of dollar funding via the foreign exchange swap market, although bouncing around day to day, has actually been even higher than LIBOR, often by 100 basis points or more. In addition to the interbank market, the commercial paper market has come under stress. The breaking of the buck by the Reserve Fund led to a wholesale flight out of prime institutional money market funds. This forced the liquidation of assets, which has led to impairment of the commercial paper market. Term commercial paper rates are elevated, and the average tenor of commercial paper has shortened considerably. Second, financial conditions continue to tighten, and in recent weeks, the tightening has been substantial. Equity prices have plunged both in the United States and abroad. Corporate bond yields, especially for non-investment-grade debt, have increased substantially. Short- and long-term tax-exempt rates have climbed, and credit availability has been even further impaired. On the equity market side, for example, the S&P 500 index has fallen about 18 percent since the September 16 FOMC meeting. Although there is considerable uncertainty about the appropriate metrics and weights to use in examining the evolution of financial conditions over time, most data are consistent with the judgment that conditions have tightened significantly since the onset of the crisis, despite the 325 basis point reduction in the federal funds rate target. Compared with the previous two monetary policy easing cycles, there have been four important divergences. First, corporate bond yields have climbed. In previous cycles, the widening credit spreads were more than offset by the decline in Treasury note and bond yields, causing corporate bond yields to fall. Second, credit availability has declined greatly in this cycle. In the two previous cycles, the proportion of banks tightening credit standards actually fell through the easing cycle. That stands in sharp contrast to what has been happening in this cycle. Third, housing price declines have been far larger than in previous cycles, in real and in nominal terms. Fourth, the dollar has weakened actually much less than in the previous two easing cycles. The third aspect of the market that I think warrants noting is that the U.S. financial sector in particular remains under pressure, especially with respect to share prices and banks’ ability to obtain funding, especially term funding. Today was a particularly bad day for financial shares, with double-digit declines common for many banks. The only good news was that credit default swaps actually narrowed a bit, maybe helped by the introduction of our commercial paper backstop facility or the fact that we’ve escalated so massively in terms of the term auction facility and the foreign exchange swaps with our foreign central bank counterparts. 4 of 30 October 7, 2008 5 of 30 On the inflation side of the ledger, pressures continue to abate. Since the last FOMC meeting, both industrial and agricultural commodity price indexes have fallen about 15 percent. At the same time, the dollar has strengthened. The fall in the commodity prices and the strength in the dollar are two factors that have contributed to a fall in breakeven measures of inflation on both the spot and the five-year, five-year-forward basis. For example, the Barclays measure of five-year, five-year-forward breakeven inflation has declined more than 60 basis points since the September FOMC meeting. Today it was around 1.5 percent. The interbank, money market, and capital market dysfunction, the tightening of financial conditions, and the apparent easing in inflation risks have caused investors to conclude that the FOMC is likely to lower its federal funds rate target in the near future. Late today, the November federal funds futures contract implied an effective rate for the coming month of about 1.4 percent. That’s more than 50 basis points below the current target. Interestingly, the failure of the FOMC to ease today actually led to a rise in October and November federal funds futures contracts. Market participants presumably interpreted the introduction of the commercial paper funding facility as potentially a substitute for further monetary policy accommodation at this time. Obviously, this is an extremely fragile and dangerous environment. I am struck by the feeble market response to the substantial escalations implemented over the past ten days. These include expanding standing foreign exchange swap facilities’ capacity to $620 billion from $290 billion; expanding the TAF auction cycles to $900 billion from $150 billion; and proposing a major backstop for the commercial paper market. With respect to the commercial paper market backstop facility, the market reaction today was generally positive, but market participants clearly want to know more in terms of the specifics, especially when the program will be up and operational. Of course, I’m happy to take any questions. CHAIRMAN BERNANKE. We’ll take any questions or comments at this point. Since Bill has covered the financial area, are there any questions for him? President Lacker. MR. LACKER. Bill, you said you were struck by the feeble reaction of markets to expanding our credit programs? MR. DUDLEY. Yes. The markets didn’t take as much solace as I would have hoped, given the degree of escalation of those provisions. MR. LACKER. So what would it have looked like for them to have taken much solace? I mean, what prices and quantities would change? October 7, 2008 6 of 30 MR. DUDLEY. Well, for example, I would expect that LIBOR–OIS spreads might narrow rather than widen. I might expect that equity prices would have taken some comfort from our efforts. So generally I think the reaction was somewhat disappointing, frankly. MR. LACKER. Could it be that some fundamentals are going on there that market participants don’t view it as addressing? MR. DUDLEY. Well, a fair point is that the Federal Reserve cannot by its actions solve the balance sheet constraints of the U.S. banking system. The Federal Reserve by its actions cannot create capital for banks, and that’s obviously one of the problems at the core of what is going on in the financial system. MR. LACKER. I want to ask you about the LIBOR spread. It’s pretty striking, but I’m wondering, Do you have data on the quantity of borrowing that’s going on in that market and what that LIBOR figure really represents? We have a bank in our District that reports on the LIBOR panel but reports borrowing at 100 to 150 basis points below it. MR. DUDLEY. The LIBOR panel may understate the pressure on funding costs for some banks. But if you remember, the way the LIBOR is calculated, it actually is a truncated sample size. They throw out the highs, and they throw out the lows. They get the median of people in that market. Also, other measures, such as the New York NYFR, have actually tended to be elevated relative to LIBOR, and the FX swap rate—the all-in basis for dollar funding in the FX swap market—has actually been elevated relative to LIBOR. So I think that what we’re seeing in the LIBOR market is a pretty fair indication of the strains in term funding markets. MR. LACKER. In that LIBOR panel, there are places where you can get individual banks’ reports. I haven’t looked in a week, but the last time I looked, the spread between the bottom bank and the top bank was over 150 basis points. October 7, 2008 7 of 30 MR. DUDLEY. I think the reality right now is that LIBOR does not mean very much because there’s very little term funding going on at all. So I think that there are rates that are posted in LIBOR, and they pull them off. But you could argue that in some ways it’s even worse than the rate that is posted because, according to the reports that we’ve gotten, there’s just very little activity at term not just in the interbank market but in the broad array of markets. MR. LACKER. Okay. So the LIBOR–OIS spread may be misleading—not that sensitive an indicator. If it goes up or down 50 basis points, we maybe shouldn’t read a lot into that. MR. DUDLEY. Well, I wouldn’t go quite that far. Where it is today tells you that there’s significant strain. I wouldn’t say that, if it goes up 10 basis points tomorrow or down 10 basis points tomorrow, I would conclude that the strains had lessened. MR. LACKER. That is what I was getting at. CHAIRMAN BERNANKE. Other questions for Bill? President Lockhart. MR. LOCKHART. Bill, how would you interpret yesterday’s size of the TAF auction? MR. DUDLEY. Well, the escalation in the size of the TAF auction was obviously quite significant, and I think that it tells you two things: Maybe there are limits to the demand for term funding, and maybe it represents a constraint in terms of collateral pledged at the discount window, especially given the fact that we announced the auction on Monday morning and the auction happened Monday afternoon. So it is very possible that there was a bit of a lag in terms of the ability to mobilize collateral or take advantage of that auction capacity. I thought it was actually pretty well subscribed. I think it was $130-something billion in bids for $150 billion of available credit. So in retrospect, I think that it was sized about right. CHAIRMAN BERNANKE. All right. Let’s go on now and hear from Larry Slifman and Nathan Sheets. October 7, 2008 MR. SLIFMAN. Let me first talk a bit about the near-term outlook. Most of the economic data that we’ve gotten since the September Greenbook have come in to the soft side of our expectations. The PCE number for August was surprisingly weak. Auto sales dropped sharply in September. Shipments and orders for nondefense capital goods fell in August, and in the labor market, as you know, private payrolls fell about 168,000 in September. In addition, the Boeing strike is going to last longer than we thought at the time of the September Greenbook, and the hurricane effects from Hurricanes Gustaf and Ike appear to be more substantial in terms of the production adjustments than we had been thinking at the time of the September Greenbook. So all told, we now expect GDP to be about unchanged in the second half of the year, and that’s down about ¾ percentage point since the last Greenbook. In terms of the medium-term outlook, 2009-10, we’ve had important changes in some of the conditioning assumptions that we see as working through so-called conventional channels. As of this afternoon’s close, the stock market is down about 20 percent since the September Greenbook. Corporate bond rates are up about 90 basis points, and the dollar is up about 3 percent since the last Greenbook. One good bit of news is that oil prices are down about $13 per barrel since we put the September Greenbook to bed. Of course, financial stress has greatly intensified. Using our usual method, which we described in the box in Part 1 of the Greenbook, we now think that the intensification of financial stress since the September Greenbook would subtract nearly 1 percentage point from real GDP growth in 2009. The stock market has clearly been a moving target for us as we’ve been trying to put this all together and assess the outlook for next year and 2010. But using this afternoon’s close as the starting point, real GDP now is projected to rise only about ½ percent over the four quarters of 2009 and then to pick up to an increase of about 2½ percent in 2010. With that growth rate, we would have the unemployment rate rising to about 7¼ percent by the end of 2009, and we would expect it to remain at about that level through 2010. In terms of inflation, the recent data on core inflation pushed up our estimate of core PCE price inflation in the third quarter to more than 3 percent. That’s about 0.2 percentage point higher than in the September Greenbook, but we expect that to ease back off in the fourth quarter and come down to a rate of about 2½ percent. For the medium term, core inflation is expected to slow over the remainder of the forecast period. We think that the pass-through from import and energy prices will abate, and of course, the additional slack that we now have in the forecast also could relieve some pressure on inflation. In terms of the overall inflation rate, we expect energy and food price increases to taper off, and so we would see PCE price inflation slowing to about the same rate as core inflation. Specifically, we would see inflation at about 2 percent in 2009 and about 1.7 percent in 2010. Nathan now has a few comments he wants to add. MR. SHEETS. Since the last Greenbook, the economic indicators for the foreign economies have generally surprised us on the downside, notwithstanding the fact that our expectations in the Greenbook for foreign growth were already pretty grim. In the euro area, measures of consumer and business sentiment have continued to retreat. Industrial production has moved down, and retail sales have been soft. Recent data for 8 of 30 October 7, 2008 the United Kingdom have continued to point to a mild contraction during the second half of this year, and notably house prices there continue to fall. In Japan, industrial production plummeted in August, recording its biggest monthly decline in more than five years, and survey data point to further declines in business and consumer confidence. Finally, in the emerging market economies, industrial production has fallen in a broad set of countries, and exports have softened significantly. In light of these data, we now see foreign growth in the second half of this year as likely to come in at a little less than 1½ percent, down ½ percentage point from our last forecast, with these markdowns spread about evenly between the advanced economies and the emerging market economies. We have reduced our projections for growth in 2009 almost as much. This weakening outlook for global activity has been largely driven, as Bill has described, by a marked deterioration in financial conditions in both the advanced and the emerging market economies. Since the last FOMC meeting, equity markets have fallen sharply in numerous countries. Risk premiums on many types of assets have risen, and conditions in short-term funding markets have worsened further. These difficult financial conditions threaten the outlook for foreign growth going forward both by weighing on sentiment in financial markets and by potentially limiting the flow of credit to the economy. If there is any good news for me to report, it’s that the softening outlook for global growth has continued to put downward pressure on the price of oil and other commodities. Oil prices have been extraordinarily volatile over the last month, lurching up and down in response to a number of factors, including the effects of the two hurricanes, shifting expectations regarding global growth, and financial turbulence. On net, as Larry mentioned, the price of WTI is down about $13 a barrel since the Greenbook and down over $55 per barrel from its peak in mid-July. Prices for many nonfuel commodities have fallen sharply since the FOMC meeting, including price declines of more than 10 percent for copper, nickel, and rubber, and more than 20 percent for corn and soybeans. Headline inflation remains elevated in the advanced foreign economies. Notably, U.K. inflation in August reached 4¾ percent, a 15-year high. In contrast, the most recent CPI data for the euro area hint at some deceleration, with inflation moving down from over 4 percent in July to 3.6 percent in September. Going forward, there are good reasons to expect inflation in these economies to abate, given the recent sharp decline in commodity prices and emerging slack in their economies. Inflation rates in the emerging market economies appear to be cresting for similar reasons. In the midst of these events, the dollar has remained quite resilient, rising about 3 percent since the last FOMC meeting. In our view the currency markets earlier this year had priced in expectations that the major foreign economies would remain largely resilient despite U.S. slowing. As the growth prospects for the foreign economies have deteriorated, the relative attractiveness of the dollar has increased. This, along with the sustained demand for dollar funding in global financial markets, seems to have buoyed the dollar of late. 9 of 30 October 7, 2008 10 of 30 Finally, given the weaker path of foreign activity and the stronger dollar, we now expect export growth to be somewhat less robust than was the case in our previous forecast and, consequently, net exports to be less supportive of U.S. economic growth over the next two years. Nevertheless, net exports are still expected to contribute a positive 0.5 percentage point to growth in the second half of this year and about 0.3 percentage point in 2009. We are happy to take your questions now. CHAIRMAN BERNANKE. Are there questions for Larry or for Nathan? Governor Kohn. MR. KOHN. Larry, what were the policy assumptions under your forecast? MR. SLIFMAN. We maintained the same path as in the September Greenbook. CHAIRMAN BERNANKE. President Fisher. MR. FISHER. Mr. Chairman, I just want to add to Nathan’s discussion but join it with the credit road. I spent this afternoon with the National Retail Federation. These are CEOs of Home Depot to JCPenney’s to Ann Taylor, et cetera. One thing that I’ve been concerned about has been Chinese pressures in terms of their selling prices. As you know, these were being elevated—for example, in women’s wear, 8 percent across the board. What is interesting is that, in the past two weeks, it has completely changed. They will deal only with those they consider to be creditworthy buyers, and they’ve now negotiated that price all the way back to last year’s levels, as long as you are creditworthy. If you’re not creditworthy in their opinion, they won’t sell to you, period. So these two things are beginning to join, and I think this adds to the points that Nathan made. It’s not just a matter of slack. It’s a matter of unwillingness to deal with certain opposite parties—a counterparty risk of its own kind, so to speak—and it at least mitigates the concern I’ve had about the pass-through risk that we’ve talked about quite a bit. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Other questions for Nathan or Larry? President Evans. MR. EVANS. Thank you, Mr. Chairman. I was jotting down some of the figures on the lending facilities and the magnitudes just to see if I had the right ballpark. You know, from the TAF October 7, 2008 11 of 30 to the TSLF, the primary dealer credit facility, and on down to today’s facility on commercial paper, and then if you throw in the Treasury program, which is not exactly ours, and the swaps as well, I get to something like over $3 trillion that is being put out against collateral and to be lent. Is that the right order of magnitude? I guess the question I have is whether we have any sense that this is likely to get to the point of unlocking the lending capacity that’s so important to get the economy going? CHAIRMAN BERNANKE. Bill, do you want to tackle that? MR. DUDLEY. Sure. I think those figures are the right order of magnitude. I looked at some figures today that, based on reasonable assumptions, you might expect the balance sheet to grow to a high of $2.5 trillion to $3 trillion by the end of the year. Obviously, it depends on what assumptions you make about the amount of TAF credit that is actually drawn down and the amount of swaps that are actually drawn down. But it could be that order of magnitude, and that would be exceptional. That’s why getting interest-on-reserves authority was very, very important. As Brian has said in earlier briefings, interest on reserves is going to start on Thursday, and that’s going to place a floor on the federal funds rate. So we think we’re in a situation where we have a very important tool that will allow us to expand the balance sheet but maintain control of the federal funds rate. So we’re not going to be compromising monetary policy. CHAIRMAN BERNANKE. Other questions? Vice Chairman Geithner. VICE CHAIRMAN GEITHNER. Could I just add something, Mr. Chairman, to what Bill said? CHAIRMAN BERNANKE. Certainly. VICE CHAIRMAN GEITHNER. I’m not sure this is the right way to think about it, but you could think about the use of our balance sheet as a necessary but not sufficient condition to October 7, 2008 12 of 30 achieve Charlie’s objective, which is to help stabilize the financial system and make sure that intermediation begins again and that people are willing to start lending again on a scale necessary to support some reasonable outcome for the economy going forward. Our basic judgment—and I think everybody’s judgment—is that it is going to require capital from the government in some mix of forms for that to happen. I don’t think that any of us believes that the expansion of our balance sheet alone is going to be sufficient to achieve that outcome. That’s why—and I think you all know this—the Chairman has been working so closely with the Secretary of the Treasury to make sure that the authority that the Congress passes is used in a way that has the maximum possible benefit in things that are about capital so that the probability of default of the financial system goes down and people feel more comfortable lending at term to financials. CHAIRMAN BERNANKE. Thank you. Other questions? All right. If not, let me just say a few words. I will be brief. It’s more than obvious that we have an extraordinary situation. It is not a single market. It’s not like the 1987 stock market crash or the 1970 commercial paper crisis. Virtually all the markets—particularly the credit markets—are not functioning or are in extreme stress. It’s really an extraordinary situation, and I think everyone can agree that it’s creating enormous risks for the global economy. What to do about it? The exchange we just had suggests that we may have disagreements about the benefits of liquidity provision. I personally think that it has been helpful. But I think we can agree that it is obviously not a panacea because, as the Vice Chairman points out, it doesn’t address the underlying capital issues. That suggests that the right solutions probably have a significant fiscal element to them. However, one feature of the last few days is how striking, how uncoordinated, and how erratic some of the fiscal approaches have been—particularly in Europe, where there has been a remarkable lack of coordination in the European Union. So the fiscal October 7, 2008 13 of 30 solutions are coming, but they’re not there yet, and it is going to be a while. We need greater clarity on those issues. We had a meeting today on the Treasury’s authority, and they are hoping in the next few weeks to begin to provide greater clarity, which will be very helpful. But I think that, if we can find some kind of bridge, it would be helpful, and that’s what this meeting is about. Although the financial markets are the dramatic element of the situation, I think we can make a case for easing policy today on the macro outlook, as given by Larry and Nathan. I won’t go into detail. I think it’s fairly clear. You look first at inflation, and you see the remarkable decline in commodity prices, the appreciation of the dollar, and the decline in breakevens. The 10-year breakeven this morning was about 1.35. Of course, that could be a noisy indicator, but certainly it’s quite low. I would say that, in terms of activity and the relation to inflation, we don’t have to rely on any flat Phillips curves here. We have a global slowdown, and the implications for commodity prices are first order for our inflation forecast. It is never safe to declare inflation under complete control, and I certainly don’t claim that no risks are there; but clearly the outlook for inflation is not looking nearly so threatening as it may have in the past. On the economic growth side, what is particularly worrisome to me is that, before this latest upsurge in financial stress, we had already seen deceleration in growth, including the declines, for example, in consumer spending. Everyone I know who has looked at it—outside forecasters and the Greenbook producers here at the Board—believes that the financial stress we are seeing now is going to have a significant additional effect on growth. Larry gave some estimates of unemployment above 7 percent for a couple of years. So even putting aside the extraordinary conditions in financial markets, I think the macro outlook has shifted decisively toward output risks and away from inflation risks, and on that basis, I think that a policy move is justified. October 7, 2008 14 of 30 I should say that this comes as a surprise to me. I very much expected that we could stay at 2 percent for a long time, and then when the economy began to recover, we could begin to normalize interest rates. But clearly things have gone off in a direction that is quite worrisome. One could legitimately ask questions about the transmission mechanism under these conditions, and I think those are good questions. But first it seems to me that we can, to some extent, offset costs of credit through our actions, even if spreads are wide. Second, to the extent that the global coordination creates some more optimism about the future of the global economy, we may see some improvements in credit spreads. We may not, but it seems to me that this is the right direction in which to go. Despite everything that’s happening, I might not be bringing this to you at this point, except that we have the opportunity to move jointly with five other major central banks, and I think the coordination and cooperation is a very important element of this proposal. First of all, again, I mentioned before the lurching and the lack of coordination among fiscal authorities and other governments. I think it would be extraordinarily helpful to confidence to show that the world central banks are working closely together, have a similar view of global economic conditions, and are willing to take strong actions to address those conditions. I think that there is a multiplier effect, if you will. Our move, along with these other moves, will have a stronger effect on the global economy and on the U.S. economy than our acting alone. Moving together has other benefits. Just to note one, we can have less concern about the dollar if we’re all moving together and less concern about inflation expectations given that all the banks are moving and all see the same problem. There is a tactical issue. I think the real key to this is actually the European Central Bank. They have had some difficulty coming to the realization that Europe would be under a great deal of stress and was not going to be decoupled from the United States. They made an important October 7, 2008 15 of 30 rhetorical step at their last meeting to open the way for a potential cut, but I think that this coordinated action gives them an opportunity to get out of the corner into which they are somewhat painted and their move will have a big impact on global expectations about policy responsiveness. So, again, I think the coordination is a very important part of this. I want to say once again that I don’t think that monetary policy is going to solve this problem. I don’t think liquidity policy is going to solve this problem. I think the only way out of this is fiscal and perhaps some regulatory and other related policies. But we don’t have that yet. We’re working toward that. We are in a very serious situation. So it seems to me that there is a case for moving now in an attempt to provide some reassurance—it may or may not do so—but in any case, to try to do what we can to make a bridge toward the broader approach to the crisis. So that’s my recommendation, that we join the other central banks in a 50 basis point move before markets open tomorrow morning. If we proceed in that direction, there are, as I mentioned, two statements. Brian, do the Presidents have the joint statement? MR. MADIGAN. They do not. CHAIRMAN BERNANKE. All right. I’m going to read the joint statement by central banks, which has been negotiated with the other central banks. So we really can’t edit this one because of the negotiations that have already taken place. However, you should already have the FOMC statement. So here’s the joint statement by central banks: “Throughout the current financial crisis, central banks have engaged in continuous close consultation and have cooperated in unprecedented joint actions such as the provision of liquidity to reduce strains in financial markets. Inflationary pressures have started to moderate in a number of countries, partly reflecting a marked decline in energy and other commodity prices. Inflation expectations are diminishing and remain anchored to price stability. The recent intensification of October 7, 2008 16 of 30 the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability. Some easing of global monetary conditions is therefore warranted. Accordingly, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, Sveriges Riksbank, and the Swiss National Bank are today announcing reductions in policy interest rates. The Bank of Japan expresses its strong support of these policy actions.” So that would be the joint statement. Then we would issue separately on our website the FOMC statement. Let me stop there and open the floor for comments on the action, on the general situation, on the statement, or whatever you would like to talk about. Would anyone like to speak? President Yellen. MS. YELLEN. Thank you, Mr. Chairman. I strongly support your proposal to cut the federal funds rate by 50 basis points today and the wording of the statement. I’m pleased that the FOMC will take this step as part of a coordinated program with other central banks. In my opinion, a larger action could easily be justified and is ultimately likely to prove necessary. We’re witnessing a complete breakdown in the functioning of credit markets, and it is affecting every class of borrowers. The financial developments are dangerous and are having a pronounced impact on the economic outlook. The outlook has deteriorated very sharply, and even so, I still see the risks to the downside. Moreover, recent data on consumer and capital spending and on housing confirm that a sharp contraction in domestic demand is under way. As far as I’m concerned, for the reasons you gave, inflation risks have diminished markedly. Indeed, in a contraction as severe as that which is now on the horizon, I anticipate that inflation will decline noticeably below my own estimate of price stability. I think the Board has taken a wide array of creative and massive actions to provide liquidity to the credit markets. I think these are very appropriate and necessary. I hope we will do October 7, 2008 17 of 30 more, but they are not completely a substitute for cutting the federal funds rate. I think that’s an important complement to the liquidity actions. CHAIRMAN BERNANKE. Thank you. Vice Chairman Geithner, you had a two-hander? VICE CHAIRMAN GEITHNER. I just wanted to point out that I have assembled a historic coalition in New York of hawks on both sides of me today in support of your proposal. They have agreed to join me here in New York as a gesture of support for your proposal. CHAIRMAN BERNANKE. Somebody send me a photograph. MR. FISHER. Mr. Chairman, we enjoy visiting Third World countries. [Laughter] MR. PLOSSER. We just thought we would outflank him, but we haven’t succeeded. CHAIRMAN BERNANKE. I don’t know where to go from there. [Laughter] Are there any other comments? President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. I’d just like to make a couple of observations and perhaps ask a question and make maybe one observation about language. As a general proposition, I do not like intermeeting cuts. I think they signal more panic than they do stability. On the other hand, I think this is an opportunity, given what the other central banks are doing, that might prove to be an exception to that. So I am reluctantly or modestly comfortable with this, however you want to characterize it, because I don’t think that anything that we do today—cutting the funds rate 50 basis points or whatever—is going to make the next couple of months in terms of the overall economy any less painful. They won’t be felt in the real economy for some time to come. They may provide some solace to the markets. I hope that they will. I wouldn’t bet the ranch on that, but I do think that the coordinated effort might be helpful. I like in the statement the stressing of the point that, as you put it, this is based on a deteriorating economic outlook, and I October 7, 2008 18 of 30 think it is very important that we continue to emphasize that point as opposed to just volatility in the financial markets. So I feel that’s very helpful. I have one question. President Yellen alluded to this, and I would like your thoughts on this, Mr. Chairman. Obviously, as we have been experiencing over the last year, things have seemed to change very rapidly at times, sometimes in surprising ways and in ways that we couldn’t anticipate. But I have stressed in past meetings the importance for us of thinking not just about a funds rate decision on any given day or at any given meeting but about what we think the path should look like. So rather than just considering our action today, we obviously have a scheduled meeting coming up in a few weeks. Do you think that this is the precursor, as President Yellen suggested, to perhaps additional cuts, and where do you think a likely path might take us going forward, given that this is an intermeeting cut? My last comment has to do with the language, and I’d just like to make an observation about the sentence on inflation. It reads, “Inflation has been high, but the Committee believes that the decline in energy and other commodity prices and the weaker prospects for economic activity have materially reduced the upside risks to inflation.” I guess I would make two observations, Mr. Chairman. One, that seems to be a much stronger statement about the reduction in the prospects for inflation than actually you gave in your speech today, where you emphasized that it had been reduced but that there continues to be lots of uncertainty and inflation continues to need monitoring. I would put on the table for discussion that we change the phrase “materially reduced” to these things have “mitigated near-term upside risks to inflation.” Clearly commodity and oil prices have both mitigated the expectational channel for inflation in the near term. But I’m not necessarily convinced—and it’s very model dependent—as to what inflation might do in the latter part of ’09 October 7, 2008 19 of 30 and so forth. So I think that we should emphasize that the inflation risks for the near term have been mitigated as our rationale there. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. To respond to your question, I am not planning any particular action at the regular meeting at this point or any particular recommendation. Obviously, given how quickly things are changing, the world could be very different then from the way it is now. I think this is a good opportunity to move with the other central banks, as you mentioned. Thinking about funds rate paths, we all have to be aware that we are, in fact, now at a very low level, and there are serious questions about the functioning of markets and the economy at extraordinary low levels of interest rates. So that constraint is going to be an issue, and it will affect our decision as we think about it. But I feel rather unconfident about predicting the path of rates six months in the future because I’m not quite sure what is going to happen tomorrow at this point. Let me turn to President Stern. MR. STERN. Thank you, Mr. Chairman. I support reducing the funds rate target 50 basis points and doing it now. I think we ought to take advantage of the situation that has arisen with regard to coordinated action with other central banks. That seems to me to be important and appropriate at this point, given the extraordinary circumstances that we confront. I’d just make a couple of other comments. Larry Slifman marked down the economic outlook for the next several quarters for sure and I guess longer than that. If I were doing my forecast today, I would mark down the near-term outlook even more. It seems to me that the restraints on the economy together with the nature of the incoming evidence suggest that the nearterm outlook at least is not terribly promising—not that we can do very much about that, of course. But I think maybe more important, I have been one who for some time thought that it was likely that inflation would diminish relatively quickly. That apparently isn’t going to happen or didn’t happen October 7, 2008 20 of 30 in the third quarter as measured by core, but the incoming evidence both nationally and globally suggests to me that inflation risks have diminished. I’ve expected that to be the case. It seems to be unwinding in that fashion. Obviously I didn’t anticipate the path of commodity prices and the stress in the financial markets to the degree that it has occurred, but they only reinforce my confidence that inflation, in fact, will run lower from here. Thank you. CHAIRMAN BERNANKE. Thank you. President Evans. MR. EVANS. Thank you, Mr. Chairman. I’d like to say that your own commentary touched on almost all the issues that I had in front of me. I can support this action. I’m not sure it’s the ideal time, but I can certainly support this. I agree with you that I think inflationary pressures will be coming down. I think that we’re looking at significant resource slack. Commodity prices are coming down, and the prospects for growth are not good at all. I think the only thing keeping us from calling this a recession is the official people who are in charge of doing that. I don’t want you to misinterpret my question about our balance sheet and the size of what we’re extending to the markets when I asked about $3 trillion when I added in the Treasury proposal. Clearly there is a lot of financial stress out there, and I think that we’re facing a very substantial credit crunch of unusual proportions. I agree that these facilities are attempting to unlock the lending capacity, as Vice Chairman Geithner mentioned. I think that’s extremely helpful. I just have concerns—these are very, very large, unprecedented actions—and I’m sure that everybody else shares them as well. I’m reasonably confident that there’s adequate risk management in terms of the collateral, but this is certainly something that we all should be concerned about. You also mentioned the transmission mechanism. I normally don’t think that timing issues are that important. But when we cut the funds rate tomorrow morning and when the headwinds are October 7, 2008 21 of 30 still the predominant factor, I just wonder whether or not the economy will notice. I think that ultimately the liquidity will continue to flow out, and it will have some effect, but I don’t know how large it will be, and that is a risk. Nevertheless, the opportunity to take a coordinated action with the foreign central banks that you mentioned is very important, and as President Plosser and you already mentioned, I’m not sure what this means for future actions, but we’re not very good at being able to say how the economy is going to go from here. So I can support this action. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kohn. MR. KOHN. Thank you, Mr. Chairman. I support the proposal for all the reasons that others have given. I think the incoming data and the events of the last month or so suggest a major downward revision to expected income and a substantial revision to expected inflation. On the income side, we still have very substantial downside risk. This is a credit crunch. Banks won’t lend to each other. It’s hard to imagine that they will lend much to households and businesses unless they perceive those households and businesses to be super-safe borrowers. I think there’s a real risk of a very sharp downturn in the economy here. It’s not my modal forecast, but I think that tail has gotten very fat. So even on a mechanical basis, a Taylor rule or something like that on a forecast basis would justify a 50 basis point cut in the funds rate. But this isn’t about mechanics. We’re in the middle of a crisis of confidence, really, in the financial markets, and I think part of the dynamic that we’re seeing out there is concern about how the financial markets and the economy will interact. I agree with everyone else that a cut in the federal funds rate is certainly not a panacea. It’s not going to restore confidence instantaneously. But I do think the coordinated action by the central banks will have an effect around the edges on interest rates and on the cost of capital, but even more October 7, 2008 22 of 30 in confidence that at least some functions here are operating—people are consulting internationally and are willing to take decisive action. It’s not going to be sufficient to get us out of where we are, but I think it’s a necessary step. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Rosengren. MR. ROSENGREN. Economic and financial conditions have deteriorated significantly. I strongly support a 50 basis point reduction, and I would not change the language. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Fisher. MR. FISHER. Mr. Chairman, I find especially attractive the global coordination that you and others have engineered here. I think it’s important that we act in concert with our colleagues. I don’t have any problem with the statement. I do worry about whether or not we have any bullets left in our holster on this front, and I think we need to be mindful of that as we go forward. I’m sympathetic to President Plosser’s comment about inflation, but I think in this case that the inference is pretty clear—that is, we’re accepting the fact that this economic weakness that is driven or exacerbated by the intensification of the financial market turmoil does reduce the risk to inflation—and I think the implication is “for the foreseeable future.” I trust, however, going back to a point that Governor Mishkin made before his departure—it may surprise you that I agree with Governor Mishkin—that we do have to be resolute in our understanding that we will not repeat the mistakes that have been made in the past. Once this condition is under control and the economy begins to repair—and I expect it will be quite a while before that occurs—I hope that we will not be the least bit hesitant to tighten monetary policy if it’s required and not make the mistake of the past of waiting too long. Incidentally, markets are rarely October 7, 2008 23 of 30 satisfied even with an action such as the one that’s about to be taken, and they’ll ask for more, and they’ll want to take more. But I support the cut, Mr. Chairman. Thank you. CHAIRMAN BERNANKE. Thank you. President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. I also support the policy action and really have nothing to add in terms of its rationale. But in the statement there is really no reference to the coordinated and global nature of the action. I’m sure that’s purposeful. It does seem to me that we have an opportunity perhaps to reinforce the psychological power of this by referencing it. So my question is, Why not include some nod to that aspect, which in the minds of so many people seems to be the real power behind this decision? Thank you, Mr. Chairman. CHAIRMAN BERNANKE. President Lockhart, just again the structure of the announcement. There will be two parts. The first part is joint from all of the central banks and, of course, will focus on the coordinated aspects of this. The second part is specific to each central bank reflecting on its own national situation. So, in fact, the common announcement will begin with an emphasis on the coordination aspects of this move. President Lacker. MR. LACKER. Thank you, Mr. Chairman. Economic growth has undoubtedly weakened in the past two months, and that was getting me comfortable with a 2 percent funds rate. I don’t have any objection to the cut in interest rates at this time. I am sympathetic to President Plosser’s suggestion about the language about inflation. It is quite a swing from our previous language to what we have in the draft here, although actually part of me likes the joint statement better. But I can see the need for our own statement. About use of our balance sheet, it’s hard for me to see why it’s absolutely necessary for a recovery. A lot of what we’ve done has been sold to us as insurance against the possibility of runs, fire sales, margin spirals, or various theoretical possibilities that involve some inefficient devolution October 7, 2008 24 of 30 of activity separate from fundamentals. If the fundamentals improve, it seems to me likely that lending is going to return whether or not these facilities are in place. More broadly, I’m worried about unwinding these. I’m afraid that it might be as difficult as it would be for the FDIC to reduce their deposit insurance premium back from $250,000 to $100,000 after this. I think it would be worthwhile, as we go on with financial markets in such turmoil, to reflect on whether what we’re seeing is genuine fundamental uncertainty about counterparties and whether our lending is the equivalent of pushing on a string, to use another metaphor from the Great Depression. CHAIRMAN BERNANKE. Quoting Keynes, I see, Jeff. All right. President Pianalto. MS. PIANALTO. Thank you, Mr. Chairman. I also support your recommendation to reduce our target fed funds rate by 50 basis points. Clearly, as has been noted, economic activity has weakened substantially since our last meeting, and inflation concerns have lessened. For all the reasons you articulated, especially the opportunity to participate in a coordinated effort with other central banks, I think a 50 basis point cut in our fed funds rate target is appropriate today. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Actually, going back to President Lacker and President Plosser, President Lacker made the point about the joint statement. The joint statement with respect to inflation says “the recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability.” I would be content if the preference of others is to take out the word “materially” and just say “have reduced the upside risks to inflation.” That would be perhaps more consistent, but I’m happy either way. So that’s just a suggestion. Let me go on now to Bob Rasche. October 7, 2008 25 of 30 MR. RASCHE. Thank you, Mr. Chairman. President Bullard has a prior commitment and was unable to participate in the discussion. He’s asked me to present some comments to reflect his views, and with your permission, I’d like to proceed. CHAIRMAN BERNANKE. Go ahead. MR. RASCHE. It is not desirable to implement a reduction in the intended funds rate at this time. First, intermeeting actions should be reserved for those few instances in which significant unforeseen developments with predictable consequences for the economy occur. The current situation is highly volatile and unsettled. Clearly financial markets are experiencing great turmoil. However, we have established new risk facilities to address liquidity issues, including new facilities in the past two days. The outlook for economic activity in the second half of 2008 has deteriorated. It is likely that this period eventually will be labeled a recession. Probably the extent of the weakness is not apparent at this time. The revised forecast from the Board’s staff as of last Friday is for real GDP to be essentially flat for the current and final quarter of 2008. The Macro Advisers forecast from last weekend has flat GDP for the third quarter and a 2 percent annual rate of decline in the fourth quarter followed by weak but positive real growth in the first half of 2009. While the uncertainty surrounding these forecasts may be greater than in a typical environment and while a good case can be made that the risk to the forecast is weighted to the downside, there’s still a significant probability that any recession will be quite mild. We have acted preemptively, aggressively, and unilaterally since the beginning of the year against the risk of an economic slowdown. We can afford to be patient until we have more information and can better assess the impact of recent financial market events on the real economy. October 7, 2008 26 of 30 Second, a rate cut at this time carries downside reputational risk. After the decline in equity prices over the past ten days, an action today could be perceived as an effort to shore up those markets. Whether we like it or believe it, a significant population is convinced that we set policy to provide a “Greenspan put” for the markets. A rate action under current conditions could reinforce that perception. If there is a dramatic market rally before the next scheduled meeting, would we entertain a reversal of any actions taken today? Worse, if equity markets continue to slump between now and the end of the month, would we entertain additional rate cuts solely for that reason? At this point it’s too soon to realize any impact of the TARP. The idea of a “Wall Street bailout” is not universally popular, and commentators and pundits are already questioning whether it will succeed. A rate action today carries the risk that the Committee will be perceived as questioning whether the TARP can achieve the desired results. Finally, an action today could be interpreted as a lack of confidence on the part of the Committee in the efficacy of various liquidity facilities that have been announced or enhanced in the recent past. Thank you. CHAIRMAN BERNANKE. Thank you. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. Let me make three brief points. First, on financial markets, I think Bill described them accurately as a mess. I guess to amplify that comment I’d say that what appears now in financial markets is that the thesis we’ve been talking about—that this is significantly about housing—seems to some extent overcome by events. I think the best way to view financial markets is to say that what’s fundamentally going on is a reassessment of the value of every asset everywhere in the world, and what might have been triggered by housing has certainly gone beyond that. That forces us and market participants alike to think about the mix of policy responses, not principally or not just from the Federal Reserve. October 7, 2008 27 of 30 Second, on the economy, I suspect that it will be increasingly hard to find decouplers, and I suspect that the real economic problems in Europe and among the advanced foreign economies are likely to be more real, deeper, and harder for them and their economies to respond to than ours. So as Nathan suggests, that makes the policy decisions they have over the coming months and our ability to count on a global recovery even more suspect. Third, on the policy front, in thinking about this as a global, synchronized rate cut it strikes me that the first two words of that phrase are far more important than the last two and that the focus on global, synchronized action is an important symbol to markets not just here but abroad—that the world’s central banks and policy action are very focused and that all of us will do whatever it takes to try to make sure that the real economy and financial markets respond more positively. So I take your judgment, Mr. Chairman, that this is the right time—to take advantage of the action of a host of central banks; and I’ll join the realistic expectations crowd in thinking that we shouldn’t oversell what’s the likely policy response. In terms of the statement itself, I would be comfortable with the statement as written but would have a preference to dropping “materially” as you suggest. Thank you. CHAIRMAN BERNANKE. Governor Kroszner. MR. KROSZNER. Thank you very much. With the intermeeting move that we had back in January—10 months ago, which now of course seems like 10 years ago—we spoke a lot about the possibility of a regime shift—that there’s a growth state and a contraction state and there could be a nonlinear movement between the two. Unfortunately, over the past few weeks we’ve seen some evidence of that nonlinear shift, both in the real economy and in financial markets. In particular, we’re seeing that globally—we are seeing a very, very sharp change internationally in growth prospects, and that’s being reflected in the financial markets. One reason that we’re seeing some of October 7, 2008 28 of 30 the problems in the financial markets, as mentioned by a number of participants, is the concern about insufficient capital. Well, one reason for the concerns about insufficient capital and the heightening of those concerns is what losses are going to be faced. Obviously the real economy has to do with how the housing market is going to evolve, which has to do with wealth, which has to do with unemployment, and I think that’s part of what’s feeding what’s going on. That’s why I think a significant move now, especially coordinated internationally, could be helpful in trying to reduce some of that macroeconomic tail risk. We are seeing reasonable evidence that we’re shifting into a contraction regime, if you will, rather than a growth regime. I think we were fighting hard against that with our earlier rate cuts and with our liquidity facilities. I think we were able to hold that shift at bay for a while. But now we have some evidence that we’ve moved into this other regime, and I think that is partly what is feeding the problems in the financial markets. That’s why it’s extremely important that we make this move and make it in a coordinated, international way. As others have also mentioned, we’re starting to come close to running out of ammunition. So if we are going to take a shot, we had better make it as powerful as possible. Doing it in an internationally coordinated way is to make it as powerful as possible. So I very much support the actions. CHAIRMAN BERNANKE. Thank you. Governor Duke. MS. DUKE. Thank you, Mr. Chairman. I don’t have an awful lot to add to what has already been said. I’m not optimistic that this will necessarily increase financial institutions’ confidence in lending to each other, but I think the coordinated action at least will be something that maybe helps to give some confidence in the certainty of future actions. I think a lot of it has been the unpredictability of what government is going to do. So that may help on that score, and I support the action. October 7, 2008 29 of 30 CHAIRMAN BERNANKE. Thank you. Vice Chairman. VICE CHAIRMAN GEITHNER. Mr. Chairman, I support your recommendation and the statement as drafted and commend you for taking this initiative and bringing together the central banks of the major economies at this time. I would just say that there is substantial risk that this will get substantially worse before it gets better, and we may have to do further escalation on a range of fronts. I’m not saying monetary policy necessarily, but it’s good to prepare for that possibility. CHAIRMAN BERNANKE. Okay. Anyone else? First Vice President Rasdall from Kansas City. MR. RASDALL. Thank you, Mr. Chairman. Briefly, we support the recommendation and the statement and recognize the significance of the opportunity to move with the other five central banks. Thank you. CHAIRMAN BERNANKE. Thank you. I didn’t hear a clear sense on the word “materially,” but if there’s not a strong view one way or the other, I guess I would suggest striking it on the grounds that it’s a little more continuous with our previous communication and similar to the common statement. Is there anyone who is concerned about that change? President Plosser, did you have a comment? MR. PLOSSER. I would prefer that. I think it is more consistent with both your speech today and our previous statements and it still conveys the correct message. So I support and would be happy with just leaving out “materially.” CHAIRMAN BERNANKE. Okay. Thank you. Anyone else? If not, Ms. Danker, can you call the roll please? MS. DANKER. Yes. The vote will encompass both the directive and the policy statement that were distributed earlier today, with the exception of the final sentence in the second paragraph October 7, 2008 30 of 30 of the draft policy statement, which says, “Inflation has been high, but the Committee believes that the decline in energy and other commodity prices and the weaker prospects for economic activity have reduced the upside risks to inflation.” Chairman Bernanke Vice Chairman Geithner Governor Duke President Fisher Governor Kohn Governor Kroszner President Pianalto President Plosser President Stern Governor Warsh Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes CHAIRMAN BERNANKE. Thank you. Thank you for a constructive discussion. Again, I believe it is 7:00 a.m. tomorrow for the release of the information. Brian has handed me a note here. We’re going to be considering the request of Boston to reduce the discount rate by 50 basis points. That’s the request that we have. All right. Thank you very much. END OF MEETING October 28–29, 2008 1 of 206 Meeting of the Federal Open Market Committee on October 28–29, 2008 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, October 28, 2008, at 2:00 p.m., and continued on Wednesday, October 29, 2008, at 9:00 a.m. Those present were the following: Mr. Bernanke, Chairman Mr. Geithner, Vice Chairman Ms. Duke Mr. Fisher Mr. Kohn Mr. Kroszner Ms. Pianalto Mr. Plosser Mr. Stern Mr. Warsh Ms. Cumming, Messrs. Evans, Lacker, and Lockhart, and Ms. Yellen, Alternate Members of the Federal Open Market Committee Messrs. Bullard, Hoenig, and Rosengren, Presidents of the Federal Reserve Banks of St. Louis, Kansas City, and Boston, respectively Mr. Madigan, Secretary and Economist Ms. Danker, Deputy Secretary Mr. Skidmore, Assistant Secretary Ms. Smith, Assistant Secretary Mr. Alvarez, General Counsel Mr. Baxter, Deputy General Counsel Mr. Sheets, Economist Mr. Stockton, Economist Messrs. Connors, English, and Kamin, Ms. Mester, Messrs. Rosenblum, Slifman, Sniderman, and Wilcox, Associate Economists Mr. Dudley, Manager, System Open Market Account Ms. Bailey, Deputy Director, Division of Banking Supervision and Regulation, Board of Governors Mr. Clouse, Deputy Director, Division of Monetary Affairs, Board of Governors Mr. Blanchard, Assistant to the Board, Office of Board Members, Board of Governors October 28–29, 2008 2 of 206 Mr. Struckmeyer,¹ Deputy Staff Director, Office of Staff Director for Management, Board of Governors Messrs. Reifschneider and Wascher, Associate Directors, Division of Research and Statistics, Board of Governors Messrs. Levin and Nelson, Associate Directors, Division of Monetary Affairs, Board of Governors Ms. Kole, Assistant Director, Division of International Finance, Board of Governors Mr. McCarthy, Visiting Reserve Bank Officer, Division of Monetary Affairs, Board of Governors Mr. Oliner, Senior Adviser, Division of Research and Statistics, Board of Governors Mr. Small, Project Manager, Division of Monetary Affairs, Board of Governors Messrs. Bassett and Luecke, Section Chiefs, Division of Monetary Affairs, Board of Governors Mr. Morin, Senior Economist, Division of Research and Statistics, Board of Governors Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of Governors Mr. Moore, First Vice President, Federal Reserve Bank of Cleveland Mr. Fuhrer, Executive Vice President, Federal Reserve Bank of Boston Messrs. Altig and McAndrews, Ms. Mosser, Messrs. Rasche, Sullivan, and Williams, Senior Vice Presidents, Federal Reserve Banks of Atlanta, New York, New York, St. Louis, Chicago, and San Francisco, respectively Messrs. Clark and Hornstein, Vice Presidents, Federal Reserve Banks of Kansas City and Richmond, respectively Mr. Weber, Senior Research Officer, Federal Reserve Bank of Minneapolis _______________ ¹ Attended Wednesday’s session only. October 28–29, 2008 3 of 206 Transcript of the Federal Open Market Committee Meeting on October 28-29, 2008 October 28, 2008—Afternoon Session CHAIRMAN BERNANKE. Good afternoon, everybody. We received requests from members for more time at this meeting to discuss the economic situation and our policy response. So as you know, we postponed the special presentations on inflation—my apologies to the presenters. We will come back to that at the appropriate time. What we are going to do instead is to have three rounds of briefings today and tomorrow. We are going to start in the first round with Bill Dudley and his usual presentation on open market operations, followed by Nathan Sheets on the swaps proposals that you have been informed about, and then Bill Bassett will give a supplementary briefing on financial markets to complete that round. Then we’ll have Q&A at that point. We will then turn to the economic situation and hear from Norm Morin on the nonfinancial economy and Linda Kole on the international economy and from Brian Madigan on our projections. Then we will have another round of questions. Tomorrow at lunch, after the close of the formal meeting, we will have some additional briefings on the TARP (troubled asset relief program), on the FDIC program, and on the supervisory and regulatory implications of that. So we hope to make this a very informative two days, and we hope to have plenty of interaction and conversation about our broad policy response to these very difficult times. So let me start, then, by turning to Bill Dudley. Bill. MR. DUDLEY. 1 Thank you, Mr. Chairman. Today my attention will be narrower than usual, given the briefings by Bill Bassett and Linda Kole that will follow covering the broader developments in the equity, fixed income, and foreign exchange markets in the United States and abroad, which have been considerable over the past six weeks. I will focus on three topics: (1) the impact of our new facilities and other government initiatives on market function, (2) the consequences of the expansion of these facilities on our balance sheet and our ability to hit the federal funds rate target over time, and (3) the travails of the hedge fund community and how 1 The materials used by Mr. Dudley are appended to this transcript (appendix 1). October 28–29, 2008 4 of 206 this could potentially add to market dysfunction. I will be referring to the chart package that should be in front of you. As you all know, the Lehman bankruptcy led to sharp outflows from prime money market mutual funds into Treasury-only funds (exhibit 1). The result was a collapse in Treasury bill yields (exhibit 2). At the same time, the cost of financing Treasury securities via repo fell sharply—this is illustrated in exhibit 3 by the drop in the overnight general collateral (GC) repo rate. This increased the incentive for Treasury traders to short Treasury securities that were already hard to obtain because the effective cost of borrowing such securities is determined by the level of the GC repo rate. As a result, Treasury fails, which represent Treasury securities that are not delivered as promised to their buyers, soared. Treasury fails were also exacerbated by the withdrawal from the securities lending market of some large holders of Treasuries, including some major foreign central banks. Although Treasury yields fell sharply and Treasury bills were in great demand, the rise in fails resulted in a sharp diminution of trading and liquidity in the Treasury securities market. The fact that there are severe market-functioning problems in the asset class that is in greatest demand—Treasuries—underscores the scope and severity of the markets’ broader dysfunction. At the same time, the outflows from prime money market funds led to a sharp drop in the demand for commercial paper, a significant rise in commercial paper rates, and a shortening of commercial paper maturities (exhibits 4 and 5). Term bank funding spreads rose sharply, with the one-month and three-month LIBOR–OIS spreads increasing to levels that make the earlier peaks look like modest speed bumps (exhibits 6 and 7). The Lehman bankruptcy caused counterparty risk concerns to intensify. Moreover, the Lehman bankruptcy disrupted a number of markets because participants in these markets were uncertain how to adjust their long- and shortposition exposures that offset their open positions with Lehman. The result was a sharp drop in the willingness of counterparties to engage with one another, especially at term. Essentially, the result was a massive coordination problem that has led to a very unattractive equilibrium. I would put it this way: “I won’t lend to you even though I think you’re okay because I am not sure others will lend to you either. I need some assurance that others will lend to you in order to have some assurance I can get my money back if I need it.” Even though it has been in the interest of all parties to engage, no party has been willing to go first. In response, the Federal Reserve dramatically expanded its programs of liquidity support. The size of each TAF auction has been raised to $150 billion—the same size as the entire TAF program just six weeks ago. Fixed-rate tender dollar auctions were implemented by the BoE, the BoJ, the ECB, and the SNB. The asset-backed commercial paper money market mutual fund liquidity facility (AMLF) and the commercial paper funding facility (CPFF) were implemented, and plans for a money market investor funding facility (MMIFF) were announced. The Federal Reserve and other central banks stepped forward to engage in transactions with a broad range of bank and, in the case of the Fed, nonbank counterparties. The hope, of course, is that October 28–29, 2008 5 of 206 this willingness to engage will reduce rollover risk and therefore encourage others to re-engage with their counterparties. At least for now, the escalation in the size of the TAF auctions appears to have been sufficient to satisfy the demand for dollar funds in the United States. As shown in exhibit 8, the first two auctions of $150 billion have been slightly undersubscribed. Currently, about $300 billion of TAF credit is outstanding. Demand for dollar funding in Europe has increased sharply even though the cost is much higher than in our TAF auctions. Whereas the two most recent TAF auctions were stopped out at the OIS rate, which is the minimum bid rate, the foreign fixed-rate tender operations have been conducted at a rate of OIS plus 100 basis points. As shown in exhibits 9 and 10, swap outstandings have grown to nearly $500 billion currently. The ECB swap size is currently about $280 billion, more than half the total amount of swaps outstanding. The amount of outstanding swaps is likely to climb sharply when the first 84-day fixed-rate tender operations are conducted in Europe next week. The CPFF facility is another important element in the Fed’s program of liquidity escalation. As you know, this facility provides a backstop for domestic issuers of A1/P1-rated commercial paper. Issuers can sell commercial paper to the facility at three-month term for an effective cost of OIS plus 200 basis points for nonfinancial and financial issuers and OIS plus 300 basis points for asset-backed commercial paper (ABCP). This facility complements the AMLF, which lends funds to banks at the primary credit facility rate against the ABCP purchased from money market mutual funds. Yesterday was the first day that the CPFF was open for business, and a number of borrowers issued commercial paper to the facility totaling more than $50 billion. At the close of business last week, 79 issuers had registered to use the facility, paying 10 basis points, or $580 million, to cover the potential issuance of commercial paper. The 10 basis point fee provides a little equity to get the program off and running. Finally, the most recent facility, the money market investor funding facility, was announced last week. This facility will provide liquidity to five conduits that will purchase commercial paper and certificates of deposit of designated issuers from 2a-7 money market mutual funds. It will likely be several more weeks before this facility is operational. The escalation in the provision of liquidity and some of the other initiatives I will discuss shortly have led to a grudging improvement in the interbank funding markets and in the commercial paper market. Reviewing the earlier exhibits, most term funding spreads have narrowed, but the improvement is modest relative to the earlier deterioration. It is unclear at this stage whether the modest extent of improvement reflects the limited ability of additional capacity and breadth in terms of liquidity provision to restore confidence, especially at a time that the macroeconomic outlook has deteriorated globally, or whether it will just take time for these liquidity facilities to restore confidence and some semblance of normality to the money markets. October 28–29, 2008 6 of 206 The expansion of the Fed’s liquidity provisions has been accompanied by escalations on two other fronts. First, the FDIC announced a bank funding guarantee program. Although the terms and conditions of this program have not yet been finalized, the program is likely to guarantee most of the new senior debt obligations of participating depository institutions and their associated holding companies up to a cap of 125 percent of the maturing obligations through June 30, 2009. Importantly, new interbank funding will be covered. How this affects the federal funds market remains to be seen. Second, the Treasury has committed $250 billion of funds from the TARP program to inject as preferred stock into the banking system. Nine large banks announced two weeks ago that they will accept $125 billion of preferred stock investment from the Treasury. Over the past few days, the Treasury announced that an additional $35 billion of capital has been committed. The FDIC guarantee announcement and the TARP capital infusion have been effective in shoring up confidence in the major U.S. banks. As shown in exhibits 11 and 12, credit default swap spreads for most major U.S. financial institutions have narrowed sharply. But the guarantee of the senior debt of depository institutions and their associated holding companies has generated some unintended consequences for those firms not covered by these guarantees. In particular, the credit default swap spreads for major nonbank financials have narrowed less than those for the banks (exhibit 13). Moreover, the funding costs for the GSEs have climbed, especially for short-term discount note issuance. The funding costs for Fannie and Freddie for both long-term and short-term debt are shown in exhibits 14, 15, and 16. However, the fear that funds would flow out of prime money market funds back into bank assets guaranteed by the FDIC has not been realized—at least not yet. The expansion of the Fed’s facilities and the open-ended nature of the fixed-rate tender dollar operations by the foreign central banks that we are funding by swaps have led to rapid expansion of our balance sheet. Exhibit 17 provides a snapshot of the Federal Reserve’s balance sheet at different times before and during the crisis. During the first 13 months, the size of our balance sheet was little changed. We accommodated our liquidity programs mainly by selling Treasury securities. During the next stage, which began around the time of the Lehman bankruptcy filing, we expanded our balance sheet but drained the reserve additions primarily by having the Treasury issue supplemental financing program bills and placing the proceeds on our balance sheet. However, the capacity to continue to drain reserves via SFP bills was unlikely to be a long-term solution because the Treasury would ultimately be constrained by the debt limit ceiling. The passage of the Emergency Economic Stabilization Act of 2008 granted the Federal Reserve the authority to pay interest on reserves immediately. This was very important because it meant that we could expand our balance sheet size by unsterilized reserve additions but at the same time keep the federal funds rate from crashing to zero by paying a positive interest rate on holdings of excess reserves. Further rapid balance sheet expansion appears inevitable as the takedown from the TAF auctions and the fixed-rate tenders expands further and as our new facilities, October 28–29, 2008 7 of 206 such as the CPFF and MMIFF, begin operation. Although the estimates shown for year-end in exhibit 17 are indicative—the actual size will be driven by the use of our various liquidity facilities—it does seem likely that the Federal Reserve System’s balance sheet will grow very rapidly through year-end. We are now nearly three weeks into the new interest-on-reserves regime, which was implemented on October 9. As you know, the Board of Governors initially set the spread between the target federal funds rate and the rate paid on excess reserves at 75 basis points. Policymakers erred on the size of a wide margin given unsettled market conditions and the lack of experience with the new regime, recognizing that the spread could be reduced if the federal funds rate traded soft relative to the target. As shown in exhibit 18, despite the payment of interest on reserves, the federal funds rate has continued to trade soft relative to the target. As a result, the Board narrowed the spread to 35 basis points with the start last Thursday of the second reserve maintenance period under the interest-on-reserves regime. It is too soon to assess the effect of the narrower spread on our ability to push the federal funds rate back up to the target because the interest rate paid on reserves is based upon the lowest target federal funds rate during the reserve maintenance period. So currently it is hard to separate the impact of the narrower spread on the effective federal funds rate from the expectations for further cuts in the target federal funds rate that might occur at this meeting. There are two complications in fixing the interest-on-reserves spread at a level consistent with the target. First, some of the GSEs, which hold balances at the Fed, are not allowed to earn interest on their balances. Thus they have to sell federal funds to banks that, in turn, hold the funds and are paid the interest-onreserves rate. Second, some banks have also been selling federal funds below the interest-on-reserves rate. We expect this to diminish over time as they gain more experience with the new regime. However, other factors, such as concern with their overall leverage ratios, could cause this phenomenon to persist. As a result, there has been a significant amount of federal funds rate trading below the interest-on-reserves rate. This is illustrated in exhibit 19, in which the circles are sized to reflect the amount of trading at a particular rate level. This trading of fed funds below the interest-on-reserves rate has two consequences. First, it blurs the meaning of the effective federal funds rate with respect to its relationship to the stance of monetary policy. Conceptually, the intereston-reserves rate, rather than the effective federal funds rate, could be viewed as representing the default risk-free investment rate for banks. Second, it implies that we may have to narrow considerably further the spread between the target federal funds rate and the interest rate paid on excess reserves in order to push the effective federal funds rate up to the target. In principle, if fed funds sales were to continue in large volume below the interest-on-reserves rate, the interest-on-reserves rate might need to be set right at the federal funds rate target in order to support the federal funds rate close to that level. Before turning to a discussion of monetary policy and inflation expectations, I want to make a few comments about the hedge fund industry. Before this crisis October 28–29, 2008 8 of 206 began, most of the fears about a market meltdown were focused on hedge funds. Until now, these fears have been mostly misplaced. However, the risks that hedge fund problems will now exacerbate the crisis have increased substantially recently. The underlying problem is that the recent performance of the hedge fund industry has been very poor and hedge fund viability is not very robust when net asset values slip considerably below their high-water marks in individual funds. September was the poorest month in the past 10 years, and so far October returns are on pace to be even worse. Net asset value for the entire hedge fund industry is down more than 10 percent year-to-date. The average performance, shown in exhibit 20, masks substantial dispersion in returns and particularly poor performance for certain strategies. In particular, convertible arbitrage, emerging market arbitrage, and fixedincome arbitrage strategies suffered double-digit losses in the month of September, and further losses are likely in October. Poor hedge fund performance has been exacerbated by several factors. First, policy shifts such as the short sales ban have caused big problems for convertible arbitrage, statistical arbitrage, and long/short equity strategies. This has been an important factor behind Citadel’s travails. Second, prime brokers continue to pull back in their willingness to provide financing by raising their haircuts assessed against hedge fund assets as market volatility rises (exhibit 21). Third, investors are pulling funds out of hedge funds because of their poor performance and a generalized increase in risk aversion. As a result, hedge funds are raising cash to meet actual and potential redemptions, and many hedge funds are either hitting or approaching their net asset value trigger points. Let me say a few words about net asset value triggers. Hedge funds often negotiate agreements with each of their prime brokers that set the terms for their access to financing. These contracts give the prime brokers the option to seize and liquidate collateral if the hedge fund net asset value falls by more than a certain magnitude—say, a 30 percent decline in assets under management over a three-month period; that’s a very common trigger. Obviously, if only a few hedge funds are close to these triggers, there is little problem as there is no potential flood of asset sales into the market. But when so many hedge funds are under pressure at the same time, the risk of broader asset liquidation increases. The prime broker may have a lessened incentive to waive its right to liquidate collateral when a greater proportion of the industry is troubled because the first-mover advantage of selling collateral likely becomes more important under such circumstances. I anticipate that the pressure from the liquidation of hedge fund assets will continue to weigh on financial markets over the next few months. Some major fund of fund managers anticipate redemptions between now and early 2009 of at least 25 percent of the total industry, or about $500 billion based upon the estimated $2 trillion size of the global hedge fund business. Market participants continue to price in additional cuts in the federal funds rate target. Of course, it is a little harder than usual to tell what they are expecting based October 28–29, 2008 9 of 206 on futures prices because the federal funds rate has traded soft relative to the target and those expectations are also embedded in the near-term rates for fed funds futures contracts. Regardless of the cause, if you look at exhibits 22 and 23, there has been a fairly sharp downward shift in the federal funds rate curve and the Eurodollar futures curve—they have shifted downward about 100 basis points. Moreover, the curves are considerably flatter than they were a few months ago, indicating that market participants expect that the FOMC will be slow to raise the federal funds target in 2009. Our primary dealer survey indicates that most survey respondents expect the Committee to lower the target federal funds rate over the next two meetings to around 1 percent and keep it there through most of 2009. This also represents a downward shift of about 100 basis points from the survey conducted before the September 16 meeting (exhibits 24 and 25). When the survey was conducted more than a week ago, the majority of respondents anticipated a 25 basis point cut. Since then, the consensus has flipped, with most now anticipating a 50 basis point rate cut at this meeting. On the inflation expectations front, normal relationships between TIPS and nominal Treasuries have been distorted by the illiquidity of TIPS relative to nominal Treasuries and the high level of chronic fails in the five-year sector of the nominal Treasury market. As a result, TIPS yields have climbed sharply relatively to nominal Treasuries, leading to a sharp fall in breakeven inflation measures (exhibit 26). The fact that breakeven inflation rates have fallen more sharply in the five-year sector than in the ten-year sector has generated a rise in five-year, five-year-forward measures of inflation (exhibit 27). The distortions in the U.S. Treasury market suggest considerable caution in interpreting the rise in these measures. Interestingly, our Desk survey of primary dealers shows a slight drop in long-term inflation expectations since the September survey (exhibit 28). Before concluding, let me note that the staff recommends approval of a $15 billion foreign exchange swap line with the Reserve Bank of New Zealand to help satisfy the dollar funding needs of banks that operate in New Zealand. As noted in the memo to the Committee from Nathan Sheets and myself that was distributed on Friday, this would complement the swap agreements that we have already enacted with other advanced economies and would have the same technical features as those with the smaller advanced countries (that is, Australia, Denmark, Norway, and Sweden) with fixed swap line limits. Nathan will be discussing the potential for additional swap line authorizations for four emerging market countries recommended by the staff that were discussed in a second memo to the Committee on Friday. There were no foreign operations during this period. I request a vote to ratify the operations of the System Open Market Account that have been undertaken since the September 16 FOMC meeting. Nathan will continue our presentation. CHAIRMAN BERNANKE. Thank you, Bill. Nathan. October 28–29, 2008 10 of 206 MR. SHEETS. In response to intensified global financial stresses, the central banks of four major emerging market economies—Mexico, Brazil, Korea, and Singapore—have recently expressed interest in temporary liquidity swap lines with the Federal Reserve. For the reasons outlined in our background memo, which was circulated on Friday, the staff recommends that the Committee approve these requests. We propose that the lines be sized at $30 billion for each of these four countries, similar to our existing lines with Canada, Sweden, and Australia. We envision that these lines would expire on April 30, 2009, as is the case with our other swap lines. We also recommend that these lines have several safeguards relative to our lines with central banks in the advanced economies. Notably, even following initial FOMC approval, the proposed lines could not be drawn on without further authorization, and individual drawings would be limited to $5 billion. We recommend that the FOMC delegate to its Foreign Currency Subcommittee the authority to approve these drawings. The subcommittee would ensure that the dollars drawn would be used in a manner consistent with the purposes of the swap agreement. The central banks in these countries would also agree to publicly announce the fact that they had drawn on their lines and the mechanisms that they had used to allocate the dollar liquidity. These safeguards are designed to provide protections for Federal Reserve resources and to ensure that the swap lines are used in a manner consistent with our envisioned objectives. These safeguards, however, are not intended to be so onerous as to discourage the use of the lines if the situation warrants. We see the case for these swap lines as resting on three important observations. First, each of these economies has significant economic and financial mass. Mexico, Brazil, and Korea are all large economies with GDP of around $1 trillion, and Singapore is a major financial center. Given the structural interconnectedness of the global economy and the financial fragilities that now prevail, a further intensification of stresses in one or more of these countries could trigger unwelcome spillovers for both the U.S. economy and the international economy more generally. Our interdependencies with Mexico are particularly pronounced. Second, these economies have generally pursued prudent policies in recent years, resulting in low inflation and roughly balanced current account and fiscal positions or, in the case of Singapore, sizable surpluses. Accordingly, the stresses that these countries are feeling seem largely to reflect financial contagion effects from the advanced economies, including sharp reductions in risk appetite, rapid deleveraging by global investors, and a drying up of liquidity in dollar funding markets. Third, there is good reason to believe that swap lines with the Federal Reserve would be helpful in defusing the economic and financial pressures that they now face. These lines would promote financial stability by helping to ensure that financial institutions and corporations in these countries have access to dollar liquidity. Dollar funding pressures in Brazil and Korea appear to have intensified significantly. Such pressures remain less acute in Mexico and Singapore, but the authorities there view these lines as valuable protection should such pressures intensify, particularly over year-end. In October 28–29, 2008 11 of 206 addition, the authorities in these countries have expressed the view that these lines could provide a significant boost to confidence, although such outcomes are admittedly hard to predict. I turn now to two questions that have been the focus of energetic deliberations among the staff as we have formulated these proposals. First, is there some better approach that we could recommend? Second, what are the risks associated with initiating swap facilities with these emerging market economies, or EMEs? As for the first question, we could ask these countries to rely on their sizable stocks of foreign exchange reserves. Across many contingencies, we believe that these countries do have sufficient resources to address financial pressures on their own. Consistent with this observation, they don’t have any immediate plans to draw on their swap lines. In this sense, the lines serve as a backstop. However, in the event of intensified stresses, we believe that it would be desirable for these countries to able to meet the dollar funding needs of their institutions by drawing on the swaps rather than by going into the Treasury or agency markets to liquefy their foreign exchange reserves. Alternatively, we could ask these countries to go to the IMF. Tomorrow, the Fund is likely to approve a large, rapidly disbursing facility that might be appropriate. That said, we see the IMF’s efforts in this area as broadly complementary to those of the Federal Reserve. Meeting the potential liquidity needs of these large countries would strain the available resources of the Fund. Conversely, the Fund is much better placed than we are to judge the liquidity needs of smaller, less systemically important countries. As an additional consideration, these top-tier EMEs that we are recommending for swap lines are very reluctant to return to the IMF. Given the strength of their policies, they no longer view themselves as clients of the Fund and would prefer to go it alone rather than seek IMF financial support. We note that there are indeed risks associated with our recommendation. One obvious concern is that the swaps might not be repaid. However, given the large reserve holdings of these countries, their prudent policies, the weight they place on good relations with us, and the safeguards built into the swap agreements, we judge the risk to Federal Reserve resources to be very low. More notable is the risk that approving these lines might cause us to be flooded with requests from many additional EMEs. Nevertheless, in proposing lines with these four countries, we feel that we have set the bar quite high. Their importance to the global economy and the quality of their policies set a standard that few, if any, other EMEs can match. In addition, the potential IMF liquidity swap facility might be helpful to us in limiting the risk of a slippery slope, as additional countries that request lines with us could be asked to go to the IMF. Similarly, European EMEs seeking swap lines could be encouraged to approach the ECB. In assessing these issues, the staff has conferred with senior officials at the U.S. Treasury and the State Department. In both instances, these agencies emphasized the global economic significance of Brazil, Mexico, Korea, and Singapore. However, they also cautioned that expanding the swap lines beyond this group could leave us October 28–29, 2008 12 of 206 increasingly vulnerable to a “pile on” effect, which might manifest itself either in a large number of additional swap line requests or in political pressure. Given these considerations, the staff would benefit from some signal from the FOMC regarding its willingness to consider swap lines with other emerging market economies. We see two broad options in this regard. First, the FOMC could indicate that it is not inclined to establish swap lines with other EMEs. Inquiries from additional countries could be forwarded to the IMF. Alternatively, the FOMC could emphasize that the bar for any additional EME facilities is high and that swap lines would be extended only if the case is seen as being comparable to that of the four countries that are being voted on today. Under this second approach, the FOMC might consider granting the Foreign Currency Subcommittee the authority to establish swap lines with the central banks of other large and systemically important EMEs. Bill Bassett will now continue our presentation. MR. BASSETT. 2 Thank you, Nathan. I will be referring to the exhibits labeled in red, “Staff Presentation on Financial Developments.” The intermeeting period was characterized by persistent strains in financial markets and a sharp drop in asset prices. Although some markets have improved in recent days, the ongoing disruptions have generated intense pressures on financial institutions and have contributed to a significant further tightening of credit conditions for households and businesses. As Bill Dudley noted, spreads on credit default swaps (CDS) for financial institutions have been quite volatile. As shown by the top left panel of your first exhibit, median spreads for large bank holding companies (the black line) and regional commercial banks (the red line) declined substantially after the announcement of the Treasury’s capital purchase program and the FDIC’s temporary liquidity guarantee program on October 14; they ended the period almost 70 basis points lower, on balance. The median CDS spread for insurance companies (the blue line) increased substantially over the latter part of the intermeeting period amid concerns about the financial condition of these firms. Judging from the wide range of dealers’ price quotes on CDS for the same firms (shown in the top right panel), liquidity and price discovery in the CDS market remain strained. The functioning of markets for corporate debt is also impaired. As shown by the blue line in the middle left panel, the staff’s proxy for the bid-asked spread on highyield bonds spiked to more than 4 percent before partially reversing course over the past week. This spread is also unusually elevated for investment-grade bonds (the black line). As shown to the right, the average bid-asked spread on syndicated loans traded in the secondary market (the black line) jumped up over the intermeeting period. Secondary market prices for syndicated loans (the blue line) dropped to unprecedented levels, reportedly reflecting heavy sales by hedge funds that were forced to meet investor redemptions as well as the unwinding of some types of structured investments. Municipal finance, the subject of the bottom two panels, was significantly disrupted by dislocations in money market mutual funds in September and record 2 The materials used by Mr. Bassett are appended to this transcript (appendix 2). October 28–29, 2008 13 of 206 withdrawals from long-term municipal bond funds in early October. Markets for structured products, such as tender-option bonds, that issued short-term variable-rate debt backed by longer-term municipal bonds were particularly affected. Yields on those short-term instruments (shown by the black line in the bottom left panel) jumped for a time, and the sales of the underlying long-term bonds as the structures unwound boosted long-term municipal bond yields (the blue line). As shown to the right, issuance slowed substantially until mid-October, when a few states—notably California—placed a sizable amount of new debt, though they paid fairly elevated interest rates to do so. In recent days, however, liquidity conditions have shown signs of improvement, yields have decreased somewhat, and issuance has moved back up from the extremely slow pace seen in the second half of September and the first half of this month. Please turn to exhibit 2. As noted by Bill Dudley, prime money market funds suffered a wave of redemptions in mid-September, shown by the red bars in the top left panel. Although the flows diminished after the Federal Reserve and the Treasury announced steps to support money funds on September 19, prime funds lost about one-fifth of their assets, on net, over the intermeeting period. As a result, prime funds have dramatically reduced their holdings of commercial paper, generating significant disruptions in that market. As shown by the black line in the top right panel, unsecured financial commercial paper outstanding has declined sharply since midSeptember, and the ongoing contraction in ABCP (the blue line) has continued. In contrast, the amount of unsecured commercial paper placed by nonfinancial firms (the yellow line) was little changed, on net, over the period. As shown in the middle left panel, broad equity prices (the black line) dropped about 30 percent over the intermeeting period as the outlook for both economic growth and earnings dimmed, and implied volatility increased to record levels. As depicted by the red bars to the right, those developments were accompanied by record outflows of about $60 billion from equity mutual funds in September. Weekly data indicate that, over the first half of October, investors withdrew more than $100 billion from long-term mutual funds, including about $70 billion from equity funds, but outflows have slowed in recent days. As shown in line 1 in the bottom left panel, M2 expanded rapidly in September and early October as some firms and households shifted toward safer assets. Liquid deposits (line 2) increased significantly in September and stayed about flat in October. In contrast, retail money funds (line 3) were little changed in September but have grown briskly this month. The sizable increases in small time deposits in both months (line 4) were widespread, in contrast to the more concentrated gains seen over the summer in response to elevated yields at a few financial institutions. Currency (line 5) began increasing rapidly in recent weeks, apparently supported by higher demand from both foreign and domestic holders. As a result of the disruptions in short-term funding markets, a range of borrowers turned to banks for funding. The “other loans” category (the blue line in the bottom right panel) rose sharply beginning in mid-September as a result of both unplanned October 28–29, 2008 14 of 206 overdrafts and draws on existing credit lines by nonfinancial businesses, money market mutual fund complexes, foreign banks, nonbank financial institutions, and municipalities. C&I loans at banks (the black line) have also increased significantly in recent weeks, as a broad spectrum of nonfinancial firms tapped existing credit lines. According to the October Senior Loan Officer Opinion Survey, however, about 25 percent of the largest banks and 35 percent of other banks surveyed indicated that C&I loans not made under previous commitment accounted for some of the recent increase. Additional results from the survey are the subject of your next exhibit. Large net fractions of institutions reported having continued to tighten their lending standards and terms on all major loan categories over the previous three months, with some banks reporting that they had tightened lending policies considerably. As shown by the black line in the top left panel, about 80 percent of domestic respondents tightened their lending standards on C&I loans since July, and all but one of the 54 banks surveyed reported charging higher spreads over their cost of funds on such loans (the red line). As noted to the right, nearly all the banks that tightened standards or terms did so in response to a more uncertain or less favorable economic outlook and a reduced tolerance for risk. Almost 40 percent of domestic banks tightened in part because of concerns about their capital or liquidity position, somewhat more than had cited those pressures in July. As indicated in the middle left panel, a large fraction of domestic banks again reported tightening standards on commercial real estate loans over the past three months. Moving to loans to households, almost 70 percent of respondents tightened standards on residential mortgages to prime borrowers (the red line in the middle right panel). As shown by the blue line, nearly 90 percent of the institutions that originated nontraditional mortgages tightened standards on such loans. As shown by the short black line in the bottom left panel, about 75 percent of the respondents tightened lending standards on home equity lines of credit, and about 60 percent tightened standards on both credit cards (the blue line) and other consumer loans (the red line). As noted to the right, almost 25 percent of banks, on net, reported reducing the credit limits on existing credit card accounts of some prime customers over the past three months, and about 60 percent of banks reported cutting existing lines of some of their nonprime borrowers. Banks that had trimmed the limits on existing credit card accounts most often cited the more uncertain economic outlook as a very important reason followed, in turn, by a reduced tolerance for risk and deterioration in the credit quality of individual customers. Business finance is the subject of your next exhibit. The spread on BBB-rated bonds issued by nonfinancial corporations (the blue line in the top left panel) rose about 275 basis points over the intermeeting period, to more than 600 basis points, whereas that on bonds of financial firms (the black line) reached nearly 1,000 basis points before easing some in recent days. As spreads spiked and volatility increased, bond issuance by both nonfinancial and financial corporations (shown in the table to the right) dropped appreciably in the third quarter (row 3) relative to the pace seen in October 28–29, 2008 15 of 206 the first half of the year (row 2). As shown in the last row, there has been no highyield issuance by nonfinancial firms so far this month, and bond issuance by financial firms has come to a near halt. In commercial mortgage markets, secondary market spreads on AAA-rated commercial mortgage-backed securities (CMBS), shown in the middle left panel, continued to increase on net, and no new CMBS have been issued for several months. As noted to the right, using announced earnings for about 200 firms and analysts’ estimates for the rest, the staff expects third-quarter S&P 500 earnings to come in about 10 percent below the level posted in the third quarter of last year. Losses at financial companies account for the drop. Bank holding companies reported further substantial write-downs on mortgage-related and other securities as well as higher loan-loss provisions necessitated by widespread deterioration in credit quality. In contrast, earnings of nonfinancial companies are projected to have risen about 12 percent from a year earlier, but increased profits of energy companies account for virtually all of those gains. As indicated in the bottom left panel, analysts have revised down significantly their expectations for earnings of nonfinancial firms (the red line) over the next year, likely in response to the worsening economic outlook. Expected earnings for financial firms (the black line) also have been cut further this month. A rough estimate of the equity premium (shown in the bottom right panel) stands at an extremely high level. The household sector is the subject of your last exhibit. As shown by the top left panel, interest rates on conforming residential mortgages have been volatile—partly in response to the renewed pressures on GSE debt noted by Bill Dudley—but ended the period only slightly higher at around 6 percent. The staff expects home prices (the black line to the right) to decline significantly further through the end of 2010 and mortgage debt (the red line) to be about flat over that period. Both paths have been marked down from the September forecast to reflect a weaker economic outlook and tighter credit conditions. Spreads on asset-backed securities backed by credit card loans (the black line in the middle left panel) and auto loans (the red line) have risen more than 150 basis points since mid-September, moving well above their spring peaks. The cumulative increase in spreads since midyear has hindered issuance of such securities, and the volume of new deals, shown to the right, dropped more than 50 percent in the third quarter. The latest data, available through October 17, suggest that very little issuance has occurred this month. As shown in the bottom left panel, consumer credit has decelerated recently. With lending conditions likely to remain tight and with spending on durables expected to be soft, the staff sees significant further weakness in consumer credit in coming quarters. Summing up, although there has been modest improvement in several financial markets recently, the worsening of the global financial crisis sharply increased pressures on financial firms and markets over the intermeeting period as a whole. Those pressures have led to further deleveraging, diminished liquidity, increased concerns among investors about the economic outlook, and a reduced tolerance for risk-taking. The resulting sharp fall in asset prices and the further tightening of credit October 28–29, 2008 16 of 206 conditions have had substantial adverse effects on nonfinancial businesses and households. That concludes my prepared remarks. CHAIRMAN BERNANKE. Thank you. I’m going to open up in a minute to questions for Bill, Nathan, and Bill. I want to say just three brief things about the emerging market swaps. First, we have been talking with these countries for some time, and I think when the conversations began it was more of a preventive measure than a response to conditions. But the EMEs are now at a flashpoint in the financial crisis, and as I think Linda Kole will probably discuss, the urgency has increased, and the risks to the broader global economy are probably higher than they were a few weeks ago. Second, with respect to the choice of four countries that Nathan proposed—as he mentioned, we have talked to the Treasury and the State Department. I spoke to Secretaries Paulson and Rice about this. There was an interesting confluence of agreement that, if you are going to do this, these are the right four countries and we probably shouldn’t do more, both from an economic perspective and a diplomatic perspective in the sense that these are the countries that among the emerging markets are the most important from a financial and economic point of view. Third, as I think Nathan also mentioned, the IMF is planning to create a liquidity facility, which will be a low-conditionality facility available to a broad range of countries. So there has been some discussion back and forth about the relationship between this, if we do it, and the IMF facility. I had a conversation this morning with Dominique Strauss-Kahn, the head of the IMF, and we agreed that the two facilities are complementary—that ours would provide important additional resources to the total availability of liquid resources for these countries. If we decide to take this step, we have agreed that tomorrow, after the IMF board approves their facility, we would jointly announce these two actions so that it would create an impression of cooperation and coordination between the Federal Reserve and the IMF. October 28–29, 2008 17 of 206 So those are just a few additional pieces of information. I’m sure that you have plenty of questions. Who is first? No one? Ah, President Fisher. MR. FISHER. Just to follow up on your note, Mr. Chairman, I spent four years as the senior trade negotiator with all four of these countries, and I’d just like to comment on their importance to us. Mexico is obvious. It’s a national security risk. We’re interlinked economically. They have a sophisticated central bank and a very good central bank governor, and I think that would be number one on the list. Singapore is unique. I doubt that Singapore would ever go to the IMF. It would be beneath Lee Kuan Yew’s dignity. It is a vital link in terms of that sphere of the world. You made the case earlier, or at least Nathan made a case, as to the uniqueness of Singapore. In terms of Brazil, I’d say that is the dodgiest of the lot. However, we should remember that 40 percent of the GDP of Latin America south of the Yucatan is produced by that one country and roughly 60 percent of the population is represented by that one country. It has made significant progress since Cardoso was president, and it is a robust economy relatively speaking. Every economy in Latin America borders upon it. It does have a unique negotiating history—and Tim knows this as well as I do, having spent a lot of time negotiating with them—but I would say that it is a critical part of our hemisphere and that is the justification for including them in the package. Finally, we have been trying to negotiate a free trade agreement with Korea for some time. Korea is an underrepresented country in terms of discussions about developments in that part of the globe, and yet it is inordinately successful. I would argue that it is also a strong case to make. The only other country that I would include under the rubric that we might ever consider is Chile. Even though it is tiny, its representation is important and its nature unique. I think you could justify doing this by virtue of their immediate impact on our economy, their unique role in our hemisphere, and the fact that I doubt that they October 28–29, 2008 18 of 206 would want to go to the IMF in the first place. Therefore, it is complementary to the package you announced earlier. My only discomfort in the discussion would be the idea of allocating to the Foreign Currency Subcommittee the authority to approve additional countries. As to the supplement for these four countries that has been proposed, I would be in favor of that. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Evans. MR. EVANS. Thank you, Mr. Chairman. I thought there was some pretty good risk management described in the memo, but I didn’t really follow or don’t understand exactly the process by which we would generate a loss through these swap lines. Could you take us through the state of the world in which we would actually generate a loss? I raised this question before with the industrialized countries, and the answer was that because those are very high quality countries, we don’t really have to worry about that. I understand that they follow pretty reasonable economic policies during normal times. But what are the safeguards, and what would be the process by which we would generate a loss? MR. SHEETS. I very much agree with the thrust of the question—it would take a very severe state of nature for us to sustain losses on these. We are protected by the full faith and credit of our central bank counterparty. In addition to that, when we give them dollars, we take their domestic currency. So I suppose, in some very extreme state of the world, one could imagine that the loan that was made in dollars defaulted on the central banks, the central bank chose not to make us whole, and the currency that was escrowed for us had depreciated significantly in value. But I’d say that you are multiplying three very small possibilities, particularly the last two, that the central bank would choose to default on us, and there would October 28–29, 2008 19 of 206 have to be such a substantial fall in their currency that it would reduce the value of that effective assurance or collateral or whatever you want to call it. MR. EVANS. Okay. But it would be that we have their currency and presumably that would be a state in which it had depreciated. MR. SHEETS. Absolutely. These would function very similarly to the swap lines that we have with the advanced economies. In addition, we are going to allow them to draw only $5 billion at a time at the discretion of the Foreign Currency Subcommittee. When the Foreign Currency Subcommittee makes the determination as to whether or not a drawing should occur, it has the scope and the mandate to look broadly at what is happening in the economy and make sure that the resources are going to be used in a manner that is consistent with the terms and the expectations of the swap agreement. CHAIRMAN BERNANKE. Vice Chairman? VICE CHAIRMAN GEITHNER. A clarifying question, Mr. Chairman. Nathan, on page 4 of the memo, at the last bullet, you say, “FRBNY would have broad ‘set-off rights.’” MR. SHEETS. Yes, indeed. Maybe Trish and Bill want to jump in here as well. What this means is that, in extinguishing any obligation that arises from the swap agreement, if the central bank for some reason doesn’t pay us, we can take other assets on the books that are being held by the Federal Reserve Bank of New York to extinguish those liabilities. Does that make sense? So if the Brazilians are holding some additional assets at the New York Fed that are unrelated to the swap and they are not making good on the swap, we can draw on those other assets to extinguish the obligations from the swap. October 28–29, 2008 20 of 206 MR. ROSENGREN. But there is nothing that prevents them from withdrawing those assets before that, right? Presumably, if they’re in a situation of default, they would withdraw any Treasury securities held here first. MR. SHEETS. They could do that. But any drawing under the swap agreement would be no longer than three months, and some drawings would be much shorter. So they would have to move very quickly, given the short nature of these transactions. But there are certain states of nature that are so severe that we couldn’t rule it out. CHAIRMAN BERNANKE. Vice Chairman. VICE CHAIRMAN GEITHNER. Let me just state my understanding of this so that I can be corrected by Nathan or by Bill. These countries hold substantial amounts of their reserves in dollars. They hold a substantial fraction of those dollars in accounts at the New York Fed. If they defaulted on their piece of the swap and the falling value of their currency left us with some exposure, we would have the ability to take assets from their accounts to cover any loss. So it’s better than the fact that this is a sovereign credit and it is better than the fact that we have an asset on the other side of the swap, because they hold substantial foreign exchange reserves with us. The way to think about this is just as a mechanism to help them transform the composition of their dollar reserves in a way that might be more effective in responding to lender-of-last-resort needs in dollars, rather than having to sell Treasuries or agencies into the market in a period of panic or distress to meet that cash need. I meant it as a confirming question. MR. SHEETS. I agree. MR. STERN. But I thought we were concerned about a shortage of Treasury collateral in the market. So why wouldn’t we want them to sell, and in fact, what are reserves for if they don’t use them in these circumstances? October 28–29, 2008 21 of 206 VICE CHAIRMAN GEITHNER. I have never stood in their shoes, so I’m not sure I fully understand it. You are right that the world is a little short of the risk-free asset now, and so a greater supply would be terrific in some sense. But they have a general view, which I think our people share, that to meet the kind of lumpy, unpredictable, potentially large needs for lender-oflast-resort purposes you may face in our currency, you have to manage reserves in a way that you can meet those needs without selling Treasuries or agencies. It would not be so terrific for the world. I have never stood on the other side, but that’s my basic sense. Another way to think about this is that the privilege of being the reserve currency of the world comes with some burdens. Not that we have an obligation in this sense, but we have an interest in helping these guys mitigate the problems they face in dealing with currency mismatches in their financial systems. We have an interest in helping them meet that in some sense. It’s not our obligation. We have the same basic interest that led us to be responsive to the European need in some cases. These guys are different in that they actually have managed the countries’ balance sheets better because they at least have a huge amount of their assets in dollars. That should make us in some ways as comfortable as—maybe more comfortable than—doing it with the Europeans because they ran a banking system that was allowed to get very, very big relative to GDP with huge currency mismatches and with no plans to meet the liquidity needs of their banks in dollars in the event that we face a storm like this. CHAIRMAN BERNANKE. President Lacker, you had a two-hander? MR. LACKER. Yes. President Geithner, you described the EMEs as motivated by a desire to transform their reserves from illiquid Treasuries or from Treasuries to some more fungible and more convenient form of dollars. That strongly suggests collateralizing their swap October 28–29, 2008 22 of 206 line with the Treasuries rather than their own currency. What would be the disadvantage of doing that? VICE CHAIRMAN GEITHNER. I think effectively we have done that by the way in which the thing is structured. MR. LACKER. But the point that President Evans made is that we’re not constraining them to not withdraw the reserves. VICE CHAIRMAN GEITHNER. Do you mean that you want to put a reserve floor on them, too? CHAIRMAN BERNANKE. The question is whether, in an unlikely but possible state of the world in which they don’t want to pay us back, they could withdraw their Treasuries in advance of defaulting. MR. LACKER. Or we could lend to them, collateralized by the Treasuries rather than by their own currency. VICE CHAIRMAN GEITHNER. Well, lots of things are possible. I think this is a pretty good conservative balance. CHAIRMAN BERNANKE. That would basically be a repo agreement, I guess. MR. SHEETS. For what it’s worth, the ECB has entered into something similar to that with the Hungarians, in which the Hungarians are able to repo to them long-term eurodenominated stuff and get euros back. CHAIRMAN BERNANKE. Governor Kohn. MR. KOHN. Thanks. I think I’d be a little concerned about stigmatizing the swaps by saying that we have enough doubts about these other countries that we need to take collateral— we don’t have confidence that their central banks will meet the obligations that they have taken October 28–29, 2008 23 of 206 on. So my preference would be to stick with the extension of our current swap agreements to these countries. I think they all are using their reserves to some extent already, so this is not a case of them not touching their reserves and instead taking the swaps. They say they don’t intend to use them, but they could very well use them. They’re already using them. The other market that the Treasury has expressed some concern about is the agency market. If they were just meeting a huge demand for Treasuries by selling Treasuries, that might be one thing—although intermediate- and longer-term Treasury yields themselves have moved up presumably because of supply pressures there. But the agency spreads have widened quite a bit, and I think forcing them to sell agencies in a kind of lumpy way would feed back on our mortgage markets. It would not be in our interest. CHAIRMAN BERNANKE. President Fisher, a two-hander? MR. FISHER. Just responding to President Lacker. I think it would be an insult to these four parties, particularly given the fact that we appear to have negotiated, again, the ability to attach other assets. I am, frankly, surprised that Singaporeans would go along with that. If we got that, I’d use it and pocket it. But I would argue, especially for the case of Mexico, that I don’t see any reason that we should differentiate between them and Canada, for example. It would stigmatize them in a way, and it would be an insult to these people. At the same time, as I think I understand the explanation from Vice Chairman Geithner and from Nathan, we do have some ramped-up security here—so it’s a special arrangement. I think going further than that would not be appropriate. CHAIRMAN BERNANKE. Let me say just a couple of quick things. One is that this would require renegotiating the whole thing from the beginning, and we would like, if possible, to do this tomorrow with the IMF. The second point I would make is that we do have October 28–29, 2008 24 of 206 considerable security, and we will be dispensing this—under strict conditions—in limited tranches. I think we could monitor pretty well what was going on. But the point is well taken. President Plosser. MR. PLOSSER. I have just a clarification. This is a question. Don’t we already have a swap line, a standing facility, with Mexico as a part of NAFTA? So we don’t have to add it. MR. SHEETS. We do have a swap line with Mexico. It’s a standing swap line. It’s $3 billion under the North American Framework Agreement. It’s the counterpart to NAFTA. Under that agreement, we also have a $2 billion swap line with Canada. Here we would be adding a new temporary liquidity swap line, so it would be a new legal construct. MR. PLOSSER. I guess my question is why we can’t use the swap line that is already in existence. MR. SHEETS. In principle, if you were so inclined, you could probably just raise the size of the existing swap line to $30 billion. However, we built in a variety of mechanisms and safeguards in this proposal. In addition, the structure of what we’re putting forward is tailored particularly to meet the kinds of challenges and liquidity pressures that exist right now. So in some sense this one is structured to meet the challenges that the Mexicans are most likely to face in the current episode rather than the more generic one that already exists on the books. CHAIRMAN BERNANKE. Let me go to President Rosengren, who has been waiting patiently. MR. ROSENGREN. I have two unrelated questions. One follows up on this, but the other one is on the term auction facility. First, given how much we have expanded the term auction facility, is there any consideration to having a minimum stop-out rate, given that the last two have had fairly low stop-out rates? I wonder if that was being considered at all, given how October 28–29, 2008 25 of 206 much we expanded the size. Then the second question gets to the stigma issue related to the swap lines. There was quite a lot of discussion about how to differentiate the countries. I had the same thought that President Lacker had—if we could have set-off rights that enable them to collateralize the swaps. I do think going to the IMF will attach a fair amount of stigma to the organization. So I am worried that the spillover benefits to other countries will be negative, not positive, because of that stigma. One option would be to say that either you could go to the IMF or we would provide collateralized loans for other than these four, since it sounds as though these four are a done deal. But rather than trying to draw the line and figure out whether Chile or some other country is appropriate, we could collateralize it. If they held enough Treasury securities at the New York Fed, then it would seem that we would have no reason not to do it. If they didn’t have Treasury securities, which would probably partly reflect some of their own mismanagement in their countries, then they wouldn’t be able to use the facility and would have to use the IMF. But it would seem to be a way to get around some of the stigma issues, if someone chose to come to us and fully collateralize it. That might be an alternative way to draw the line rather than trying to come up with criteria that seemed a little difficult to understand, as I went through the memo. MR. DUDLEY. Under the term auction facility, there is a minimum bid rate, the OIS rate. So when we have a $150 billion auction and let’s say there are propositions of $120 billion, the winning bid rate is the OIS rate for everybody. MR. ROSENGREN. But I’m just wondering, as the OIS rate has come down, when you think of the band that we have for excess reserves, it does seem that the OIS provides a much bigger band, for example, than what we have even for excess reserves. I wonder whether, during October 28–29, 2008 26 of 206 periods in which people are considering a reduction of as much as 50 or more basis points, the OIS ends up being a very low lower bound. MR. DUDLEY. Yes, right now it is a very low rate because the market is building in future rate cuts. So I think the OIS rate is now below 1 percent on a three-month basis. MR. ROSENGREN. But as we narrow the target for excess reserves and have a narrow band there, you wonder whether the stop-out rate, having a lower band that is a little higher than the OIS, might be an alternative way to think about it, now that we have the excess reserves option as to the lower bound. MR. DUDLEY. I think that is something worth considering. The emphasis right now has been getting term funding out in as much size as possible and not worrying so much about whether the cost of the funds is or is not at a penalty. So I think the emphasis of the program did shift a bit over the past six weeks. Obviously, if things settle down and the demand at the TAF auctions subsides, then you can have the option of cutting the size of the auctions or increasing the minimum bid rate or some combination of the two. VICE CHAIRMAN GEITHNER. Mr. Chairman, may I make an amendment to Eric’s question or suggestion? I think that, when we have a chance to breathe and we feel as though we have achieved some durable stability in the panic, then we will want to reassess not just the basic complement of our facilities and how we think about the future but the relative economics of what we’ve done with the dollar swaps and our existing open-end auction facilities for institutions. Ideally, we want a situation in which it is more attractive for them to borrow from their foreign central banks—the dollars we provided through the swaps—than to come to us in our auctions and other areas through their U.S. affiliates. October 28–29, 2008 27 of 206 I am a bit less troubled by the point you made than I am by the fact that we have set up a regime in which the incentives for them to come to our facilities are still substantial when they have now the ability they didn’t have before to go to their foreign central banks for dollars in large scale. As we think about consolidation and not just exit—about how we prepare the ground for a shift over time—I think we want to come back to looking at the relative economics between our dollar facilities for U.S. banks and U.S. affiliates of foreign banks and what is open to them from their home country central banks now. As part of that, we could think about size, reserve price, and price in our auction. MR. DUDLEY. The awkward thing right now is that we are trying to add liquidity as powerfully as we can. So to raise the minimum bid rate or do anything that somehow suggests a pulling back would be a bit inconsistent with the LIBOR–OIS spread widening that we have seen and the fact that it still remains very, very elevated. You might want to do exactly what you suggested, President Rosengren, at some future date, but I think that doing it now would send a very mixed message to the market. I think people would be confused about what we are doing. CHAIRMAN BERNANKE. President Hoenig. I’m sorry, Nathan had an answer. MR. SHEETS. Could I just respond to President Rosengren’s second question? CHAIRMAN BERNANKE. Go ahead. MR. SHEETS. I think you put your finger on two very difficult judgments that we made when structuring this facility. I don’t see the risk of creating stigma for emerging market economies that are not in our swap network as being a first-order concern. It is broadly recognized that the folks that we are recommending are larger, more systemically important, and as well managed as anybody else. If you were sitting down to make a list—and the Fund has recently done this—the economies that we’re recommending would be at the top of the list, and I October 28–29, 2008 28 of 206 think that is recognized by essentially all observers. So I see what we’re doing here as really ratifying perceptions rather than creating new ones. On the second point, the choice between the swaps versus the repos, that one is particularly tricky. I very much agree that the repos would give us a little more security. On the other hand, the swap framework gives the emerging market economies a little more flexibility. As to how they are going to proceed, as President Fisher mentioned, it also creates symmetry between the industrial countries and the way we’re treating them and the emerging markets and the way we’re treating them. Given the successes of many of these economies over the past ten years, I see this as being an appropriate step. Nevertheless, I admit that the choice between the swaps and the repos is a difficult one. Another thought is that the repo structure might provide a bit more security, but we have tried to get that security through other ways—through tranching, careful reviews, and so on. CHAIRMAN BERNANKE. President Hoenig, I’m sorry. Go ahead. MR. HOENIG. No, no. In fact, it follows right on with what Nathan was just answering. That is, for the moment we are creating kind of a broader in-list for these four countries and stigma with the non-accepted group at this point. What will happen, then, if we do have an issue that involves—pick a country—Chile? Are we going to send them to the IMF? Are we going to have our subcommittee make a decision as to whether to give them a swap? If we do that, will that then create uncertainties about others? Are you really not concerned about the stigma and the implications of this, especially—I guess they are asking this in anticipation of the possibility, even though they think it’s fairly remote—would we not be increasing the probabilities of a problem by doing this now? I know these are tough questions; but in this environment, I am anticipating a bad event. So what do we do in the case of that bad event? October 28–29, 2008 29 of 206 MR. SHEETS. I would hope that initiating these swaps would reduce the probability of bad outcomes in the emerging market economies. Certainly, if Brazil, Mexico, and Korea are up against the ropes and experiencing significant financial stresses, my sense is that it would be an environment in which many other EMEs would be experiencing negative spillovers. So to the extent that we can backstop these major linchpins in the emerging market world, I see that as having very positive effects for others. That would be one point. Second, the decision as to how to handle Chile, if Chile comes to us for a swap line, I think is very much a policy decision for the Committee to determine. As I said in the remarks, we as staff members would very much appreciate some sort of signal from you as to whether you want to say four and that’s all we’re willing to do, and everyone else—Chile, India, and South Africa—goes to the Fund? Or is the Committee open to having potentially a few other large, important emerging market economies have swap lines with the Federal Reserve? I see that as being a policy decision. MR. HOENIG. But it’s something that we ought to think about sooner rather than later because the likelihood is that, if you take care of these four and you get another request, you are going to get three others and not one other. MR. SHEETS. Wherever you draw the line, there is going to be somebody who is just a bit away from the line that says, “I am very similar to those folks.” I am reasonably comfortable with where we draw the line. Here there is as much gap as you’re going to find. In my mind, the next one for which you could make a case would be India. However, India’s financial system isn’t as developed as is the case with these folks. They are not as integrated into the global financial system as is the case with these, so there is a bit of space there. But these are admittedly hard judgments, which we tried to flesh out regarding some of these issues in our memo. October 28–29, 2008 30 of 206 MR. FISHER. Have we been approached by any other countries? MR. SHEETS. Yes, indeed, we have. We have been approached by 552 U.S.C. (b)(4) , and we have had very informal inquiries from a couple of other countries, including 552 U.S.C. (b)(4) . CHAIRMAN BERNANKE. But we have not encouraged that. MR. SHEETS. We have done everything we possibly can to discourage it. CHAIRMAN BERNANKE. Just to be clear. MR. SHEETS. That’s right. We’re not advertising. CHAIRMAN BERNANKE. President Lockhart. MR. LOCKHART. Another question for Nathan on swap lines is how this works exactly. If the pattern holds and Mexico, for example, supports its banking system—in the case of Mexico it is a little different from others, in that all of the large banks are foreign-owned (Citibank owns Banamex, and the Spanish banks own the other two or three large banks)— where does our responsibility stop and theirs begin? Is it possible for the subsidiary of a U.S. bank or a Spanish bank to draw dollar liquidity in Mexico and with fungible dollars move that around the world? Or does it in one manner or another stay in Mexico? MR. SHEETS. A couple of thoughts. Certainly these home-versus-host issues bedevil many, many discussions of banking issues right now. They are true in Mexico, as you suggested, and they are true in spades in Central and Eastern Europe, where instead of U.S. banks there are European banks in the tension between the home and host. So these considerations are very relevant and also exceedingly complicated. If the Bank of Mexico or the Mexican authorities move to address tensions in their financial system, the standard that has been set by several Federal Reserve actions, the Brits in October 28–29, 2008 31 of 206 the things they have done, and I believe a number of the other countries is to include subsidiaries of foreign firms that are operating in that country. So, for instance, for the United States, Deutsche Bank’s U.S. subsidiary has had access to our various facilities, and that has been the coin of the realm in the announcements today. So my feeling is that Banamex, which is owned by Citi, would have the same access to these kinds of facilities as other Mexican institutions. Now, there is no guarantee of that, but that would be my feeling. Regarding the question of, once a Mexican institution gets its hands on dollars, what happens to those dollars, my understanding is that they can move around. In fact, in a discussion, Guillermo Ortiz indicated that to date Mexican institutions were net suppliers of dollars to the United States rather than the other way around. MR. LOCKHART. So in the case of a foreign bank—they lend to a foreign bank in their country, in Mexico in this case—defaulting, whose problem is it? Is it the home country supervisor’s problem, or is it Mexico’s problem vis-à-vis us? MR. SHEETS. I would guess that it is a joint problem. CHAIRMAN BERNANKE. Vice Chair. VICE CHAIRMAN GEITHNER. I’m not sure that this is helpful, but maybe I can give a slightly different example from another perspective. We have a bunch of U.S. affiliates of some of the weakest European institutions that have faced very substantial dollar funding needs and have come to us and asked for substantial ongoing access to liquidity. When they have a substantial amount of lendable collateral, collateral with substantial market value relative to the needs, we have been comfortable meeting those needs. When their needs have substantially exceeded or might potentially exceed the market value of their eligible collateral, then we have talked to the home central bank. We have said that, in effect, if you want us to be able to meet those needs and they October 28–29, 2008 32 of 206 have collateral in your market that is substantial relative to those needs, then the better way for us to do this is for the home country central bank to meet their dollar liquidity needs against the collateral there or meet the liquidity needs and we provide the dollar’s worth of guarantees from the central bank. So this home–host thing is a delicate balance, and as Nathan said, it shouldn’t all fall on the host central bank. The best thing possible is for the home country central bank to take most of the responsibility for meeting the liquidity needs and for us to help them facilitate that where necessary. But when those needs exceed what we would normally give in terms of access, then you have to have a conversation with the foreign central bank. So, for example, if a weak U.S. institution in Mexico faces substantial needs in Mexico well in excess of their eligible collateral in Mexico, I suspect they would call us and say, “We want you to meet those needs.” We would have to consider at that point where they are in the liquidity-solvency spectrum and how comfortable we are in meeting those needs. CHAIRMAN BERNANKE. Very good. President Lacker. MR. LACKER. I have a question for the staff. You noted that the countries believed that this would help market confidence. So the choice of extending a line is potentially consequential here. I have a two-part question. First, what do you think the risk is of the uncertainty surrounding whether particular other countries will or will not in the future be able to obtain a swap line from the Federal Reserve? Second, what would you suggest that we say if asked by the public or if the Chairman is asked in the Congress about what criteria or principles we used to draw the line between the countries that have swap lines and those that don’t? I know that you posed the question to us, but what would you suggest that we say? October 28–29, 2008 33 of 206 MR. SHEETS. As outlined in the memo and then also my remarks, the first is that we are looking for economies that are large and systemically important. The second is that we are looking for economies in which their policies have been strong and it appears that they are largely being influenced by contagion. The third piece is countries for which we believe that the swap line might actually make a difference. Now, let me just give you a concrete case of the third criterion because that’s a little more abstract than the first two. Iceland came to us and requested a swap line of approximately $1 billion to $2 billion, which would have been 5 to 10 percent of Iceland’s GDP—so it was fairly large relative to the size of the country. But the liabilities of the banking system were on the order of $170 billion, and the underlying problem was really that there was a loss of confidence in its banks. We came to the conclusion that a $1 billion to $2 billion swap line was very little ammunition to use against a potential loss in confidence in this $170 billion financial system. For that reason, we as the staff recommended against a swap line for Iceland. Those are the three conditions that we’d emphasize. Sort of subsidiary to that is that I think it is very appropriate for all the European EMEs to report to the ECB for their liquidity needs. That would further constrain the list of countries that we’d look at. As we work down the list of countries, I think it gets easier to say “no” in that fewer and fewer of the countries can make a case that they are large and systemically important. With the risk of creating stigma, some countries are big, and some aren’t, and that’s pretty darn objective. Now, you can debate about, well, what’s big and what isn’t and where you draw the line, but it just so happens that these three major economies that we’re putting forward all have GDP of around $1 trillion. That seems like a reasonable line to draw. Again, there’s an element of arbitrariness here, but any line you draw will have an element of arbitrariness to it. October 28–29, 2008 34 of 206 MR. LACKER. And the first part of my question? MR. SHEETS. Oh, I thought I got it. What was the first part? MR. LACKER. What sort of uncertainty might this engender about the likelihood of other countries qualifying? My recollection is that many economists have claimed that the IMF had this trouble in the 1990s, when interventions would give rise to uncertainty about subsequent interventions in other cases. MR. SHEETS. Well, I guess I’m not sure I know exactly what you’re driving at. Are you concerned that, by moving on these, we’re sending a negative message about the ones we’re not moving on? MR. LACKER. I’m just wondering about the uncertainty that might be created about the lack of clarity about who’s in, whether this is the final list, and so on. MR. SHEETS. Our press release that we are negotiating lists, as clearly as one can in a press release, the criteria that we were looking at—that they are large, well-managed, fundamentally sound, systemically important countries. So we are trying to communicate that. In addition, in conversations when these folks come to us—and especially if we get some direction from the FOMC as to how you’d like to proceed on this issue—we can be very, very blunt with them in telling them why the answer is “no” or “yes,” depending on which way the FOMC goes. CHAIRMAN BERNANKE. Vice Chair, did you have a two-hander? VICE CHAIRMAN GEITHNER. Well, I just want to point out that I think these are absolutely the right kinds of questions about this. But I think these concerns are substantially mitigated by the fact that the IMF is putting in place a facility at basically the same time, which will be there with relatively little stigma for a range of other countries that need it. There will be a universe of other countries that would not meet the test for eligibility for this swap type of facility, October 28–29, 2008 35 of 206 for the IMF or us, that will have to go through a program with conditionality and a bunch of adjustments such as Iceland is going through or Hungary will go through. So it is right to raise these questions. But the boundary problems around our swap lines are substantially mitigated by the fact that there is a new facility coming out that’s going to the same place. Raising the question of why we need to do our swaps is good, too, but you’ve heard lots of good arguments for that, and I think that realistically there’s a natural division of labor between what central banks have classically done with each other in the swap context and what the IMF does. What we’re doing is a natural extension of what central banks do. The IMF is moving a little further in from where they are in this case, and I think that will mitigate some of the signaling problems and uncertainty created by having this evolution in the scope of swap lines. CHAIRMAN BERNANKE. President Plosser. MR. PLOSSER. I guess I’m worried about this for all of the considerations that President Hoenig and President Lacker have just been talking about. I don’t know where we draw the lines, and when we have to go to the State Department and start asking what countries we can or can’t develop swap lines with, I’m not sure those are the criteria we want to be using. We mentioned the countries already. What happens when 552 U.S.C. (b)(4) ? You can just go down the list. MR. SHEETS. We have already said “no” to some of those. MR. PLOSSER. I understand, but if you really follow the logic of the argument about being large and systemically important, if we draw a line somewhere, we start expanding this now bit by bit and we draw a line somewhere, and the question then becomes, Will markets begin to question other countries on the periphery and create problems? It’s not that any one of them— 552 U.S.C. (b)(4) , I don’t know, pick one—is large and systemically important, but by doing what we’re October 28–29, 2008 36 of 206 doing and creating the uncertainty that President Lacker was referring to, maybe we are forced to go and do it collectively because they all band together and as a group say, “We’re all facing this problem. Why can’t we have the same access?” Partly I like President Rosengren’s suggestion about using repos with securities, which we have here as a mechanism. Alternatively, if the IMF is creating a largely unconditional or low conditionality type of program, why not just say that everybody else goes to them first? If they tap out of the IMF access, maybe then we might consider being a backstop rather than their coming to us in the first place. I just don’t know where this ends. I think that, with all of the questions you raised and tried to answer, you hit it right on the head. On all of them that you said were kind of marginal, you went one way, and I’m leaning the other way on the same criteria. CHAIRMAN BERNANKE. President Plosser, a couple of things. The IMF has very limited resources. They’re not remotely able to meet the needs of— MR. PLOSSER. We don’t know what the needs are yet, do we? CHAIRMAN BERNANKE. Well, the resources are very limited. The other thing is that the staff asked for guidance on the limits here. I’d like to propose that, when we get to that point, to ask the voters to suggest how they stand and what qualifications they might have. One thing that you could do, for example, would be to say, “I do or do not support this, but if I do, I think a very sharp line should be drawn at this point and be communicated that way.” The legislative history can be part of this, and we can communicate to the staff how we feel about potential extensions. MR. SHEETS. Just to put some numbers on IMF lending capacity—total IMF lending capacity is about $250 billion. To get even that high they have to call in some special arrangements that they have with a variety of countries. The maximum capacity is $250 billion. So the $120 billion that we’re proposing today would be essentially half of what the IMF could do. In that October 28–29, 2008 37 of 206 sense I really see what we’re proposing as our taking off the IMF’s hands some of the largest potential liquidity needs, which then allows them to focus on a whole range of additional countries. A related point is that I understand that, in an IMF executive board meeting today, the managing director indicated that they are getting a fair amount of interest in this new facility. It really is a different kind of facility, and frankly, even a week ago if you told me that the IMF was going to be able to put this facility together in this quick a time, I would have said, “No way. There’s no way that the IMF can move this quickly.” So it is about as good as we could expect and maybe even better than what we could have expected from the Fund. I think that they are doing what they can to minimize stigma. On the other hand, they don’t have enough lending capacity to really handle these folks that we’re talking about today. CHAIRMAN BERNANKE. President Bullard. MR. BULLARD. Thank you, Mr. Chairman. In the Bluebook here, it says, “Additionally, the Swiss National Bank announced plans to draw on its swap line to help finance up to $60 billion in purchases of assets from a major Swiss bank.” So is that really what you have in mind here for a country like Brazil—that they’ll draw on their swap line to purchase assets from banks? MR. SHEETS. No, and maybe the folks in New York want to talk a bit more about this. The transaction with the Swiss National Bank was a very special transaction that occurred outside the typical constraints of the swap lines that we’d be agreeing to with these folks. In the swap lines with these folks, they would have to tell us up front how they’re going to allocate the resources. We would envision that it would be done in something similar to an auction, in a very transparent, on-market sort of way. But it would not be that kind of a transaction, which was a special case in order to help a particular financial institution. October 28–29, 2008 38 of 206 MR. BULLARD. Well, if you think that there are systemically important institutions in these countries, why not? MR. SHEETS. Again, we’re drawing lines here. I am not prepared to give these folks carte blanche. That’s why we’ve added additional safeguards and additional governance structures to these facilities. Maybe the Committee has a different view on that, but I wouldn’t be prepared to let them do whatever they wanted with these resources. CHAIRMAN BERNANKE. President Lockhart. MR. LOCKHART. To continue to grill you, Nathan— MR. SHEETS. I’m earning my pay today. MR. LOCKHART. You know, the atmosphere right now is largely precautionary on their part—they are well capitalized with foreign currency reserves. But if we want to deal with hypotheticals, let’s assume that some of these recipients of the swap lines get into a liquidity crisis. Is the European Central Bank being approached for swap lines? I recognize that they need dollar liquidity, but in a general liquidity crisis, the euro would do as well to help. Do we have any sense of whether the ECB is considering swap lines for some of these emerging markets? MR. SHEETS. I don’t have details on that. As I’ve mentioned, I know that they have created a facility with the Hungarians, a €5 billion facility. They were also approached by Iceland at the same time that we were. I would speculate, but I don’t have any basis for that speculation, that given the emerging tensions in Central and Eastern Europe and Northern Europe that they probably are being approached, but I don’t have any details on that. MS. MOSSER. My understanding is that they have been approached. I don’t know what decisions have been made other than the ones that may have been mentioned. In addition, they have opened a swap line with the Danish Central Bank in euros, which was virtually identical to the October 28–29, 2008 39 of 206 dollar arrangement that we have with the Danish Central Bank. So they definitely have been approached for swap lines. On how many of them they’ll put into place, we don’t have any particular information at this point. MR. LOCKHART. Thank you. CHAIRMAN BERNANKE. President Plosser. MR. PLOSSER. I just want to clear up the question. I think Tim and Nathan may have both answered this, but it’s a question that President Lockhart raised earlier. In Mexico’s case, for example, where almost all the major banks are foreign owned—EU banks, Spanish banks—those banks clearly have access to dollars through the ECB swap line. There’s no reason that the dollar funding needs of those banks, to the extent that they can move these things around, can’t be satisfied by access to dollars from the ECB. Is that a correct or an incorrect assumption? MR. DUDLEY. The collateral isn’t always in the right place. You are absolutely right if the collateral could be easily moved; but the collateral oftentimes isn’t in the right place. MR. FISHER. Let me ask Nathan a question to follow up, if I may. Obviously you’ve been approached by the governor of the Central Bank of Mexico—Ortiz has been here to visit. MR. SHEETS. Indeed. MR. FISHER. So what’s his argument? I would assume that you asked these questions. MR. SHEETS. Yes, absolutely. MR. FISHER. So inform us as to what his justification is. MR. SHEETS. Mexico is experiencing increased financial stresses, particularly in its corporate sector, where recently some bad bets on structured finance products have emerged, and Ortiz was very concerned about continued confidence in the Mexican economy. Now, that said, from what he had to say, dollar funding pressures had not yet emerged, and he was emphatic that October 28–29, 2008 40 of 206 they would not draw on these until the time that those funding pressures emerged or until the time that they saw a significant further deterioration in conditions in their economy. He was very specific about the fact that they would use their own reserves as their first, second, and third lines of defense. MR. KOHN. Just to add to that, he said that, to deal with the issue that Nathan raised about the problem with their businesses and the kind of dollar needs they had, they were meeting those needs out of their own foreign exchange reserves. So they were not going to engage in a swap with us in order to meet that particular problem, but they were concerned about the dollar pressures more generally on their financial segment, particularly as year-end approaches. CHAIRMAN BERNANKE. If it’s okay, maybe we could just go ahead with the votes on this. I’d like first to do the open market operations, which I hope are not too controversial. There was no discussion of the New Zealand swap line. I’ll ask to see if there is any comment on that. Then on this issue, I’ll take a set of positions from the voters, if that’s okay. So let’s go back to domestic open market operations. MR. KOHN. I move that we approve. CHAIRMAN BERNANKE. Without objection. The New Zealand swap. MR. KOHN. I move we approve that, too. CHAIRMAN BERNANKE. Is there any discussion or concern? All right. Without objection. Now, turning to the resolution on the EME swaps, in the interest of time I propose—and I hope it is okay—to go through the voters and ask each one to state whether you are in favor or opposed. You can say what you want and, if you want, whether you have some argument to make or if you’re conditionally in favor—for example, I’m in favor if X or if we do Y—but just to get a October 28–29, 2008 41 of 206 sense of where everybody is, and then we’ll decide what to do. Okay? So let’s go down the roll here. I’m in favor. MR. FISHER. Any conditionality? CHAIRMAN BERNANKE. I think we should be fairly tough at this point. Vice Chairman. VICE CHAIRMAN GEITHNER. I’m in favor. On the basic question of how you would deal with other requests beyond the four, Nathan gave two options. One is that you delegate to the subcommittee discretion to make those judgments. The second option was to say, “No, not without coming back to the Committee.” I do think it makes sense to see how the IMF thing works and how it is received, how much participation they get, and how these boundary problems and the signaling problem play out, and it is probably a good idea for the Committee to have at least a briefing about how that is playing out so that there is some context going forward. I would be in favor of your delegating that authority to the subcommittee, as you would expect me to be, just because sometimes these judgments need to be made quickly. But I certainly understand why people would want to have a better sense of how this is unfolding and how we deal with it. The boundary problems are going to get worse if we have to go broader than this. CHAIRMAN BERNANKE. Governor Duke. MS. DUKE. I’m in favor. CHAIRMAN BERNANKE. President Fisher. MR. FISHER. I’m in favor Mr. Chairman, and I would also favor, in terms of the screening device for future requests, that you come back to the full Committee. Thank you. CHAIRMAN BERNANKE. Okay. That’s understood. Governor Kohn. October 28–29, 2008 42 of 206 MR. KOHN. I’m in favor, Mr. Chairman. I think these boundary problems are difficult. I agree with the Vice Chairman that our having the IMF there mitigates them. I was encouraged by Nathan’s sense that there are some people interested in the IMF, so there might not be much stigma there. I would be in favor of very strongly encouraging other countries to go to the IMF. CHAIRMAN BERNANKE. Governor Kroszner. MR. KROSZNER. I, too, favor the facility. I think it’s very important that we are tranching this and using somewhat different ways of providing the money to these countries than we have with other countries because, as President Bullard and others mentioned, if we’re not careful, this could be used for purposes with which we are not comfortable. It could be used for supporting a currency, and I don’t think we’d be particularly comfortable with that. Obviously, we have to be realistic. Money is fungible. They have very large reserves. They could be using the reserves for these other purposes and using the swaps for purposes that we find acceptable. But I think, given the circumstances, it makes sense to be coming up with something that’s complementary to the IMF facility and make sure that the IMF facility and our facility together are sufficient to deal with the pressures in this environment. I would be satisfied to delegate the authority to the subcommittee. CHAIRMAN BERNANKE. President Pianalto. MS. PIANALTO. I’m also in favor of the program, and I agree with Vice Chairman Geithner’s comments that this announcement along with the IMF program should be sufficient. But if there are other requests, I think it is important to bring them back to the Committee. CHAIRMAN BERNANKE. Understood. President Plosser. MR. PLOSSER. I guess I’ll approve, but with reluctance. I think this is a very slippery slope. I’m worried about other central banks ganging up on us as a group, saying that they have to have this. I would prefer that even these large countries use some combination of the IMF facility October 28–29, 2008 43 of 206 plus their own reserves to meet these needs. I think that would be a better outcome and better for us in that regard. So that’s a very reluctant “yea” vote. I’d also insist that any further expansion come back before this Committee. CHAIRMAN BERNANKE. President Stern. MR. STERN. I’m reluctantly in favor of this. I won’t elaborate very much. I’m just not persuaded that this is a very valuable contribution, as best as I can judge it. I would be in favor of limiting it to these four countries. I don’t know if that’s credible, though. Certainly I would be in favor of any additional considerations coming back to the full Committee. CHAIRMAN BERNANKE. Governor Warsh. MR. WARSH. Mr. Chairman, I support the proposal on the floor. I think the safeguards are meaningful and real and should help. I think the bar for further consideration, as Nathan described, should be high, but we shouldn’t overstate what that bar is, given how circumstances can change quickly. I wouldn’t want to have to change that rule in the middle of the game, but I think the highbar language works. On the question of delegating to the subcommittee, I think in the interest of speed it would be appropriate; but given the sense around the table, certainly making sure that the folks around the table were at the very least briefed as to the thought process might be a prudent path forward. CHAIRMAN BERNANKE. Okay. Thank you. So the sense I hear is that people are willing to accept it, but the bar for additional countries should be high. We should bring any country that we propose to add back to the FOMC for approval, and we will keep you well briefed on the conditionality, the draws, and anything else that happens. Okay? May I have a motion? MR. KOHN. So moved. October 28–29, 2008 44 of 206 CHAIRMAN BERNANKE. I am going to say without objection because we had a unanimous view. Okay. Thank you. Let me go on next to the economic situation. MR. LACKER. Mr. Chairman. CHAIRMAN BERNANKE. Yes. MR. LACKER. Do we have time for a brief question for the Manager about the funds market? It has behaved a little unusually in the last period. CHAIRMAN BERNANKE. Go ahead. MR. LACKER. Thank you, Mr. Chairman—I appreciate this. I have a three-part question. As you said in your presentation, the effective funds rate (the average of brokered transactions) has been below the interest rate on reserves, and there are all of these institutions that apparently aren’t eligible to earn interest on reserves. One, what’s the policy reason for excluding them from eligibility for interest on reserves? I understand the policy reason for excluding them from credit, but this is the opposite, and so I’m not quite sure why we screen them out. Second, as I read the data on your operations, it seems to me as though we have added enough reserves to drive the funds rate virtually down to the interest rate on reserves. I want to know if that’s a fair characterization of the state of open market operations and the funds rate. Third, I’m interested in knowing, especially if that’s true, why don’t we just give up and say that the interest rate on reserves is our target rate? MR. DUDLEY. Okay. Let me take them in reverse order. I don’t like to give up, but if I could just exclude that portion of it, it’s possible that you might want to consider the interest rate on reserves or some reasonable facsimile thereof as your target because that is essentially the risk-free rate that banks face. That may be the purer measure of what you’re really trying to accomplish in terms of its link to monetary policy than the federal funds rate. It’s possible. There are obviously important governance issues that surround that choice, though, in terms of what’s the Board’s October 28–29, 2008 45 of 206 prerogative and what’s the FOMC’s prerogative. But that’s a completely reasonable thing to think about, just as long as we don’t characterize that as giving up. Have we added enough reserves to drive the federal funds rate down to the interest on reserves? Well, I think not. I wouldn’t look at it quite that way because the gap in principle, if other things are not going on, should be the difference between us as a counterparty and a bank as a counterparty. One is an unsecured loan between one bank and another bank, and the other is us as the counterparty. So normally there should be a spread between the interest on reserves and the federal funds rate. Now, obviously what complicates that in the current environment is the Federal Deposit Insurance Corporation’s guarantee on interbank funds going forward. So federal funds may be covered—in fact, they look as though they could be covered by that guarantee. In that circumstance, one might argue that the federal funds rate and interest on reserves should probably be the same rate because there’s no difference in credit risk. MR. LACKER. Excuse me. Without interest rates on reserves, there’s that spread plus a scarcity factor, and we’ve essentially driven that scarcity factor down to zero—that’s how I meant the question. MR. DUDLEY. Right, but I still think that generally a bank faced with a choice of having risk with the Fed or selling fed funds to another bank would want to be compensated for that risk of selling, so they are going to get some positive spread. MR. LACKER. I understand that. MR. MADIGAN. I would say that we may well be in a situation where the interest rate on excess reserves is the effective tool for controlling the federal funds rate, and there may be a spread. As Bill said, we are in the process of learning how this works, and it may well be the case that we need to push that interest rate on excess reserves very close to the federal funds rate. October 28–29, 2008 46 of 206 MR. DUDLEY. It would not surprise me at all if, when we are finished with this process—I hope over the next six weeks as we go through a couple more reserve maintenance period rounds— that that margin might be zero and we might see the federal funds rate trading right on top of the interest rate on reserves. But we are going to have to see. I think our presumption at the current time would be to recommend to the Board next round to narrow that spread further—it is 35 basis points today. Another thing that we don’t know is how much learning is going to go on by banks. So the selling of fed funds below the interest rate on reserves is not just the GSEs; it is also banks, and so it’s a little hard to understand exactly why they’re doing that unless the leverage ratio is what’s driving that behavior. Maybe they are just not very well informed or they haven’t gotten their first check for the interest rate compensation, so I think it’s a little too soon to be certain about how they’re going to behave going forward. You had one other question about the policy reason for excluding the GSEs. MR. MADIGAN. There’s not really a policy reason. I would say there’s a legal reason. The statute allows us to pay interest only on balances held by depository institutions. My own view is that it would be a good thing if we were able to pay interest to the GSEs exactly for the reasons that we’ve been discussing. It might be something we could seek authority for at some point in the future. CHAIRMAN BERNANKE. President Plosser. MR. PLOSSER. Just a clarification. If we were to take that step, are there any other institutions that participate, other than the GSEs? VICE CHAIRMAN GEITHNER. Chile, Mexico— October 28–29, 2008 47 of 206 MR. MADIGAN. We would have to look at that. I think there are more than just the three GSEs that we usually think of. But they’re the biggest institutions that participate in the federal funds market. MR. DUDLEY. It is not at all clear that their behavior is going to persist necessarily, because they may decide to manage their short-term liquidity in a different way than selling at a very low federal funds rate to banks. MS. DUKE. Mr. Chairman, if I could. CHAIRMAN BERNANKE. Oh, yes. MS. DUKE. As part of my preparation when I talked to the banks, I asked them specifically this question about interest on reserves, and every single one of them said, “We haven’t had time to even focus on it. We don’t even know what’s going on with that. We’re not changing anything.” There’s so much going on right now. So I think we’re really going to have to wait until some of the other decisionmaking has worked through before we can draw any conclusions as to what behavior this might drive. CHAIRMAN BERNANKE. Learning theory in practice. Thank you very much. Very helpful. All right. Mr. Morin. MR. MORIN. 3 Thank you, Mr. Chairman. I’ll be using the packet with the green lettering on the cover entitled “Staff Presentation on Nonfinancial Developments.” Over the intermeeting period, the data we received on real activity were considerably weaker than we had been expecting. That, combined with the intensification of financial turmoil since mid-September, led us to significantly mark down our nearterm and medium-term projections for economic activity. Your first exhibit focuses on the near-term outlook. As shown by the blue bars in the top left panel, we currently expect real GDP to fall at an annual rate of slightly more than 1 percent, on average, in the second half of 2008—a reduction of about 2 percentage points from our projection in the September Greenbook (the red bars). One factor that has informed our thinking about the near-term forecast is the labor market, which looks weaker than at the time of the last FOMC meeting. As you 3 The materials used by Mr. Morin are appended to this transcript (appendix 3). October 28–29, 2008 48 of 206 know, payrolls fell steeply in September. Since then, initial claims for unemployment insurance (the black line in the top right panel) have been quite elevated, even after adjusting for factors that are temporarily boosting claims (the red line). As shown in the inset box, the latest claims data point to another sizable drop in employment this month. Turning to spending, sales of light motor vehicles (plotted in the middle left panel) have been dismal of late and are expected to stay that way at least through the end of the year. Motor vehicle sales have been depressed, in part, by financing constraints, limited sales incentives, a retreat by the automakers from leasing, and worsening consumer assessments of car-buying conditions. More broadly, as you can see by comparing the black and red lines in the panel to the right, consumer spending excluding motor vehicles has been significantly softer in recent months than we were expecting. In addition, the conditions influencing consumer outlays have worsened considerably, including a sharp drop in household wealth, tepid real income gains, a weakening labor market picture, historically low levels of sentiment, and reduced credit availability. Consequently, as reported in the inset box, we substantially revised down the projection for overall real PCE in the second half of the year. In the housing sector, single-family starts, shown in the bottom left panel, fell to about 550,000 units in September—6 percent below our expectation. Even with the ongoing cutbacks in production, the weak demand has left the months’ supply of unsold new homes (not plotted) very elevated, and we expect starts to decline well into next year. In the business sector, the spending data in hand are somewhat stale— tomorrow morning we receive the advance reading on durable goods shipments and orders in September—but the information we do have points to softening business investment in the third quarter. Moreover, as shown on the right, the first available surveys on business activity in October plunged to very low levels. Exhibit 2 summarizes the enormous changes to the key conditioning factors that we confronted in putting together the staff forecast. As shown in the top left panel, reflecting the recent plunge in equity prices, the stock market path in this projection is markedly below the path anticipated in our September forecast. This downward revision, together with the projected declines in house prices that Bill Bassett presented in his briefing, leaves the level of the wealth-to-income ratio, plotted to the right, substantially lower than in the September Greenbook. As a result, over the next two years, household wealth exerts a much greater drag on consumer spending than we assumed earlier. Yields and spreads on corporate bonds, illustrated by the Baa rate in the middle left panel, soared over the intermeeting period. We expect the higher cost of capital in this forecast to weigh on business capital spending over the projection period. A further drag on economic activity in the medium term is the recent jump in the exchange value of the dollar, shown to the right. While we expect the dollar to decline a touch more quickly than in the September Greenbook, by the end of 2010 it remains more than 4 percent above the level assumed in our previous forecast. In addition, as Linda Kole will discuss shortly, the outlook for foreign activity has deteriorated. A partial cushion to these factors depressing activity is the plunge in oil prices over the past few weeks; the bottom left panel shows the spot October 28–29, 2008 49 of 206 price of West Texas intermediate crude oil. The path for oil prices over the projection period, based on futures quotes, averages nearly $30 per barrel below the September Greenbook path and should provide some countervailing support to household purchasing power and consumer spending. As noted to the right, according to our standard forecasting models, the lower level of equity prices, the higher bond rates, and the higher exchange value of the dollar—all of which are intertwined with the intensification of financial turmoil—exert a considerable drag on real activity over the next two years. Through conventional wealth, cost-of-capital, and terms-of-trade channels alone, these developments would lead us to revise down real GDP growth about 1¼ percentage points, on average, in 2009 and 2010. But these effects likely understate the full extent of the fallout on real activity from financial turmoil. This is because our standard models do not explicitly account for the additional effects of such factors as tighter lending standards and heightened uncertainty. Consequently, for some time we have been using supplementary analyses to try to account for these credit-channel effects in our judgmental projection. Your next exhibit provides some detail on how we updated these adjustments in light of the intensification of financial stress during the intermeeting period. Two measures that we have found useful for measuring the extent of financial turmoil are plotted in the top row of your third exhibit. On the left is an index of financial market stress, and on the right is an index of bank credit standards derived from the Senior Loan Officer Opinion Survey. Both indexes have skyrocketed lately, reflecting the sharp deterioration of financial conditions. As discussed in the past two Greenbooks, we use two basic empirical approaches to try to quantify the effects of financial turmoil on real activity that are not captured by our standard models: One is based on the historical correlations between these financial turmoil measures and errors in FRB/US spending equations, and the second method incorporates these indicators of turmoil into small-scale vector autoregressions. The middle left panel shows estimates of the cumulative effect of our judgmental adjustments for financial turmoil, outside the conventional channels noted earlier. The effects are shown relative to the level of real GDP in the fourth quarter of each year. The solid black line is the judgmental estimate built into the current Greenbook forecast, whereas the red dashed line plots the estimates used in the September projection. The shaded area shows the range of results from the model-based estimates detailed in Part 1 of the October Greenbook. As you can see by comparing the black and red lines, we now expect that financial turmoil, outside the usual channels, will impose a markedly greater drag on real activity than we projected in the last Greenbook. For 2008, we think that much of the unexpected weakness observed recently in the spending data reflects financial turmoil effects, which puts our judgmental adjustment near the bottom of the model-based range. In contrast, our adjustment for 2009 is in the middle of the range of model-based results, whereas for 2010 our adjustment is near the top end of the range. We are more optimistic than the models for 2010 in part because none of the model-based estimates fully accounts for what we assume will be the likely restorative effects over time of the actions taken by governments to mitigate the problems afflicting the financial system. As shown in October 28–29, 2008 50 of 206 the middle right panel, these restraining influences, taken together, led us to mark down our assumed path for the federal funds rate. We now assume that the funds rate is lowered to ½ percent by early next year and is held at that level until mid-2010. Although the path for the funds rate is appreciably lower than we had assumed in the September Greenbook, the additional monetary easing only partially offsets the greater restraint on activity from the other factors shaping the projection. All told, as shown in the first line of the table at the bottom of the page, we project that real GDP will fall at an annual rate of nearly 1 percent in the first half of 2009 and then turn up modestly in the second half. In 2010—with the drag on activity from the strains in financial markets beginning to ease, housing market conditions stabilizing, and an accommodative monetary policy in place—activity accelerates further, and real GDP increases 2.3 percent over the four quarters of the year. The contributions of selected domestic spending categories to changes in real GDP are shown in lines 3 to 5. As you can see, we think that consumption will begin to recover next year and that the drag from housing will diminish over time. In contrast, we expect business fixed investment to remain quite weak next year, reflecting in part the lagged effects on investment of declining business output, the high cost of capital, and heightened uncertainty. Although each of the major components of private domestic demand contributes to the acceleration in economic activity in 2010, the contribution to growth from net exports (line 6) is expected to turn slightly negative late next year. As shown in the top panels of exhibit 4, the margin of slack both in labor markets (the panel to the left) and in the industrial sector (the panel to the right) is expected to remain substantial through the end of the projection period. We expect this persistent slack to be a source of downward pressure on inflation. Other influences are also likely to hold down inflation over the projection period. As shown in the middle panels, energy prices and core goods import prices decelerate sharply from their recent elevated paces. The projected path for consumer energy prices (the left panel) largely reflects the effect of the intermeeting plunge in oil prices, and the forecast for core import prices (the right panel) reflects both the sharp drop in commodity prices and the stronger dollar. As shown in the bottom left panel, while the Michigan survey readings on near-term inflation expectations have remained elevated (the black line), those on longer-term inflation (the red line) have more than retraced the run-up observed earlier this year. Taken together, as shown in line 7 of the bottom right panel, we now expect core PCE inflation to move down to 1½ percent in 2009 and to slow further to 1¼ percent in 2010, roughly ½ percentage point less in each year than projected previously. Total PCE inflation (line 1) is projected to run at about the same rate as core PCE inflation in both years. Turning to exhibit 5, a critical feature of the staff forecast is our assumption that the strains in financial markets will ease gradually over the next two years. However, the current situation is so extraordinary, in terms of both the financial disruptions and the policy responses to those disruptions, that an extremely wide band of uncertainty surrounds this assumption: Matters could easily turn out much worse or much better. October 28–29, 2008 51 of 206 To give some sense of possible magnitudes, this exhibit reviews two alternative scenarios from the Greenbook. In the first scenario, outlined in the top left panel, financial turmoil intensifies further over the projection period rather than gradually abating, and the accompanying economic fallout turns out to be more severe than in the baseline projection. Specifically, risk premiums on loans, corporate bonds, and equity jump a further 50 basis points and are slower to fall back over time; in addition, the level of house prices falls an additional 10 percent relative to the baseline. We also assume that credit-channel and other nonconventional effects are even more restrictive in 2009 and 2010 than those built into the staff forecast—to a degree more in line with the bottom end of the range of empirical estimates I presented earlier. As shown by the red line in the middle left panel, with the intensification of the financial turmoil and the larger judgmental adjustments for the impact of financial stress on economic activity, real GDP is significantly weaker than in the baseline (the black line). As a result, the unemployment rate (plotted to the right) rises faster and farther, peaking at nearly 8½ percent at the end of 2010, more than 1 percentage point above the baseline. Reflecting the greater accompanying slack, core PCE inflation (shown in the bottom left panel) moves down appreciably faster than in the baseline, reaching just ¾ percent at the end of 2010. With substantial slack and a low and falling inflation rate, the funds rate remains pinned through 2010 at ½ percent and continues at that level through 2012 in the extended simulation presented in the Greenbook. In the second scenario, outlined in the top right panel, the stress weighing on financial institutions and markets lifts much more quickly than in the baseline, perhaps in response to the extraordinary recent government actions. Here, we assume that risk spreads recede by early next year to the levels that were projected in the September Greenbook, and as a result, equities reverse most of their recent losses by the middle of next year. In addition, we cut back the size of the judgmental adjustments for financial turmoil to their September Greenbook levels. As shown by the blue lines in the middle panels, economic activity responds fairly vigorously to the improvement in financial conditions, with GDP growth reaching about 4½ percent by the end of 2010 and the unemployment rate moving down to 5¾ percent. As shown in the bottom left panel, the narrower margin of slack in the alternative scenario tempers the decline in core PCE inflation relative to baseline. Finally, as shown to the right, the federal funds rate, under an optimal control monetary policy, declines briefly to 1 percent early next year but then moves up steadily as it becomes clear that the financial strains are lifting rapidly. Linda Kole will now continue our presentation. MS. KOLE. 4 I’m referring to the next exhibits that are attached to the material you are already looking at. Since the September FOMC meeting, financial market distress has intensified and has spread around the world, threatening many emerging market economies that previously had been less affected by the U.S. and European credit crisis. As shown in the top left panel, equity prices have fallen sharply in Europe, 4 The materials used by Ms. Kole are appended to this transcript (appendix 4). October 28–29, 2008 52 of 206 Japan, and the United Kingdom. Indeed, the Nikkei is at a 26-year low today. The carnage has been just as pronounced in emerging markets, shown on the right. Credit spreads between industrial countries’ risky corporates and government bonds (plotted in the middle left panel) soared, especially in the euro area; and as shown in the right panel, credit default swap premiums on sovereign debt in many emerging market economies have skyrocketed. The widespread pullback from risk led to safe-haven flows into dollar assets; as shown in the bottom left panel, the dollar appreciated nearly 11 percent against the major currencies (the black line) despite a 9 percent depreciation against the yen (the red line) as carry trades were unwound. The dollar strengthened 9 percent against the currencies of our other important trading partners. As shown on the right, effective exchange values of the currencies of Brazil, Mexico, and Korea were particularly hard hit. In your next exhibit, the top left panel shows the extent to which investors fleeing risk have been liquidating emerging market equity funds. Several foreign governments, notably Russia’s, have fought related currency pressures by drawing down their reserves (the top right panel). For instance, since the peso fell sharply against the dollar in early October, the Bank of Mexico has deployed 15 percent of its reserves to shore up its value. China and Russia have even intervened to stem the fall in their equity prices. Following the collapse of Lehman Brothers, credit markets seized up, and dollar funding needs intensified. Since then, governments around the world have taken several steps to support their banking systems (the middle panel). Some central banks have injected massive amounts of liquidity, and many have cut policy rates or reserve requirements or both. In addition to the countries joining the Fed in a coordinated 50 basis point rate cut on October 8, a wide range of other economies have eased policy lately. Note that there have been a few exceptions: Hungary, Iceland, and Denmark increased rates to counter currency pressures. Governments have also expanded bank deposit insurance and guaranteed new bank lending in order to improve confidence and liquidity. Following a similar initiative in the United Kingdom, euro-area governments announced plans to guarantee the issuance of new medium-term senior debt by banks and to directly assist their recapitalization if necessary. In recent weeks, authorities have announced capital injections into a number of banks whose financial soundness was in question. The swap lines extended by the Federal Reserve to foreign central banks have been expanded. The ECB approved a €5 billion swap line for Hungary and a €12 billion one for Denmark, and several Asian countries are currently negotiating swap lines with each other as well. Private firms in several emerging market economies have confronted pressures in rolling over foreign currency funding, and authorities there have also raised deposit guarantees, guaranteed bank lending, and injected capital into vulnerable banks. Finally, several countries have applied to the IMF for assistance. The bottom left panel shows median credit default swap premiums for banks in Europe, the United Kingdom, and the United States. The declines since the beginning of this month suggest that the announcement of these plans has improved confidence in banks’ safety, even if they have not restored confidence in broader economic prospects. As shown by the implied OIS forward rates in the bottom middle panel, October 28–29, 2008 53 of 206 market participants expect considerably more monetary policy easing in Europe than they did at the time of the last FOMC meeting. We assume that further cuts in official rates (shown on the right) will be forthcoming as output falls short of potential and inflation recedes. As can be seen in exhibit 3, highly stressed global financial conditions and the weaker U.S. outlook have led us to take a whack out of our outlook for foreign growth. Comparing lines 1 and 2, we have marked down our estimate of total foreign growth for the third quarter more than 1 percentage point, and we have slashed our forecast even more for Q4 and 2009. We project outright recessions in the advanced foreign economies (lines 3 through 7) and in Mexico (line 12). In other emerging economies, we foresee growth rates well below potential. Chinese real GDP growth (line 10) is estimated to have slowed considerably in the third quarter. We expect some payback in Q4, but beyond that we have revised down our outlook. As can be seen in the middle left panel, exports fell in August in many of our largest trading partners, though they still chugged along in China through September. The black line in the middle panel shows that the volume of exports from Canada has been falling for some time, but exports had held up in Japan and Germany until the third quarter, when they fell. Industrial production in Japan (the red line in the middle right panel) has fallen nearly 5 percent below its year-ago level, and IP has also fallen over the past year in the United Kingdom and the euro area. As global demand has slumped, oil prices (the black line in the bottom left panel) have plummeted, and nonfuel commodity prices have fallen as well. The decline in commodity prices along with slackening economic activity is projected to help bring down inflation in all of the regions shown (on the right). Exhibit 4 focuses on the outlook for Europe. Banks remain leery of lending to each other, as evidenced by the growing amount of funds parked at the ECB’s deposit facility. The latest BoE bank lending survey (the top right panel) pointed to further tightening of U.K. lending standards in the third quarter and suggested that banks expected to tighten them somewhat further in the fourth quarter (the striped bars). Notably, this survey was taken before Lehman failed. A confidential conversation with a contact at the BoE who had talked with a few bankers more recently suggested that the latest survey considerably underestimated the recent tightening of standards. The quarterly growth of U.K. loans to nonfinancial corporations (the red line in the middle left panel) fell from double-digit paces for the past two years to 5 percent in the third quarter. Credit expansion to households (the dashed line) declined as well. Loan growth in the euro area (the middle panel) also slowed. Europe has clearly moved into recession. The middle right panel shows that house prices have fallen over the past year in the United Kingdom and Ireland and have also slowed in other European locales. But it is not just the property sector that has slumped. Business confidence (the bottom left) has disintegrated. Total economy purchasing managers’ indexes (the middle panel) are in the downturn range in both the United Kingdom and the euro area. Unemployment rates have increased, especially in France and Spain, where construction activity has slowed sharply. October 28–29, 2008 54 of 206 Your next exhibit takes a quick tour through the rest of the world. In Japan, business confidence (the red line) has plunged, partly because lending terms faced by firms, particularly small and medium-sized enterprises, have become more restrictive. Investment intentions (not shown) have deteriorated as shipments (the black line) and exports have declined. The labor market has deteriorated, with the ratio of job offers to applicants (in blue) falling to its lowest level in the past four years. The Bank of Japan recently downgraded its outlook and stepped up measures to deal with financial market stresses. In China, investment spending (the black dashed line in the top right panel) continued to be strong through September, and retail sales accelerated. However, industrial production (middle left panel) slowed this summer partly because of efforts to reduce pollution in Beijing during the August Olympics but also because of declining steel production, suggesting further slowing. Industrial production has also slowed in Korea and Taiwan, and export orders (shown on the right) are falling in China, Brazil, and Singapore. As shown in the bottom left panel, Mexico has suffered a steep fall in remittances, flattening industrial production, and declining auto exports. Oil revenues (not shown) are down as well. Finally, global PMI and new orders indexes, which aggregate data for 26 major countries, are both in contractionary territory but have not yet reached their depths at the trough of the 2001 recession. Exhibit 6 reviews the main elements of the U.S. external outlook. As shown in line 1 of the top panel, net exports contributed 1.8 percentage points to growth in the first half of this year, but we expect this contribution to drop off considerably in coming quarters as exports (line 3) slow with foreign growth and imports (line 5) remain flat. Total foreign growth (the black line in the middle left panel) is now projected to dip down about as much as U.S. growth, while the dollar (shown on the right) is well above the level we projected in the September Greenbook. As shown in line 3 of the table, we now expect export growth to move down sharply starting in the current quarter and to remain well below what we’d written down in our last forecast. Although lower U.S. demand caused us to lower import growth (line 5), the projected contribution of net exports to GDP growth has, on net, been revised down a bit over the forecast period. The bottom panel gives a longer perspective on U.S. external deficits. The non-oil trade deficit (the dashed orange line) and current account deficit (the red line) have continued to narrow over the past year and a half although oil imports have remained large. The current account deficit to GDP ratio is forecast to fall below 3 percent in 2010, a level last reached in 1998. Brian Madigan will continue with our presentation. MR. MADIGAN. 5 I will be referring to the separate package labeled “Material for Briefing on FOMC Participants’ Economic Projections.” Exhibit 1 shows the central tendencies and ranges of your current forecasts for 2008; corresponding information about the Committee’s most recent projections, those from June, is shown in italics, and Greenbook projections are included as a memo item. Your June projections regarding GDP growth and inflation for the first half of 2008 turned out to be quite close to subsequent BEA data releases; therefore, the revisions in your 5 The materials used by Mr. Madigan are appended to this transcript (appendix 5). October 28–29, 2008 55 of 206 projections for the year as a whole are almost entirely due to the changes in your implicit projections for the second half of 2008. As shown in the right column of the top panel, your GDP growth forecasts for 2008:H2 now range from minus 2½ percent to minus ¾ percent; compared with June, each of you has marked down your projection for second-half growth by at least 2 percentage points. As shown in the second panel, your forecasts of the fourthquarter average unemployment rate fall in a range of 6.3 to 6.6 percent, more than ½ percentage point higher than in June. In accounting for the sharp deterioration in the near-term outlook for activity, your narratives point to the intensification of the financial crisis and its impact on credit conditions and stock market wealth as well as the weakness of incoming data on consumer spending and labor market conditions. Your assessments of inflation in 2008 have also shifted significantly since June. The central tendency of your forecasts for overall PCE inflation during 2008:H2 (the right column of the third panel) is now about 1½ to 2¼ percent, a drop of about 2 percentage points from June. In this regard, a number of you noted the implications of recent sharp declines in energy and commodity prices that were apparently triggered by the worldwide slowdown in economic activity. In contrast, your projections for core PCE inflation in 2008:H2 (the right column of the bottom panel) are a notch higher than in June. Exhibit 2 reports your projections for the next three calendar years. Most of you anticipate little or no GDP growth during 2009; as with your implicit forecasts for the second half of 2008, these projections are about 2 percentage points lower than in June. A few of you are projecting even weaker outcomes, with output declining about 1 percent, whereas a few others are projecting stronger economic growth of about 1½ to 1¾ percent. The width of both the ranges and the central tendencies of your projections for real GDP growth for 2009 and 2010 has increased noticeably. Still, all of you anticipate that economic expansion will resume by 2010, and most of you expect a further pickup in growth during 2011. In the narratives accompanying these projections, a number of you said that you expect the pace of recovery to be damped by persistent credit market strains, ongoing adjustment in the housing market, and economic weakness abroad. Apparently, only a few of you assumed that additional fiscal stimulus would be enacted. Most of you project that the unemployment rate will peak at around 7 to 7½ percent in 2009 and decline gradually over the subsequent two years. However, you generally expect that, even by the end of 2011, the unemployment rate will still be at or above 5½ percent. Moreover, most of you anticipate that the unemployment rate in 2011 will remain well above your own projections of the longer-run unemployment rate that were provided in your trial-run submissions. The central tendency of your projections for overall PCE inflation is about 1¼ to 2 percent for 2009 and about 1½ to 1¾ percent for 2010 and 2011—roughly the same as for your forecasts of core PCE inflation. About half of you projected inflation October 28–29, 2008 56 of 206 rates in 2011 close or identical to your own individual assessments of the rate of inflation consistent with Federal Reserve’s dual mandate for promoting price stability and maximum employment, where we have again judged the latter from your longerterm trial-run submissions. But half of you are projecting that inflation in 2011 will be below your own individual assessments of the mandate-consistent inflation rate by about ¼ to ½ percentage point, and in one case, by more than 1 percentage point, mainly reflecting the lagged effects of weak economic activity and the relatively sluggish pace of recovery. In your forecast submissions, several of you indicated that the appropriate path of monetary policy would involve less near-term easing than assumed in the Greenbook, and more than half of you expressed the view that policy tightening would need to occur several quarters earlier and at a substantially more rapid pace than in the Greenbook. Exhibit 3 presents your views on the risks and uncertainties in the outlook. As shown in the top left-hand panel, all of you now see uncertainty about growth as elevated relative to historical norms. As shown to the right, most of you continue to perceive the risks to growth as weighted to the downside even with the downward revision in your modal projections. Several of you pointed to the possibility that financial market turmoil might not subside as quickly as anticipated and to significant risks of an increasingly negative feedback loop between credit markets and economic activity. As shown in the bottom left-hand panel, most of you also continue to see an elevated degree of uncertainty about inflation. In June, most of you judged the risks to the inflation outlook as skewed to the upside, but as shown to the right, nearly all of you now see the risks to the inflation outlook as either balanced or tilted to the downside. Exhibit 4 summarizes the results of the trial run on longer-term projections. These projections were intended to represent values to which variables would converge over time, say five to six years ahead, under the assumption of appropriate monetary policy and in the absence of any further shocks. For real GDP growth, your longer-term projections have a central tendency of 2½ to 2¾ percent and a range of about 2 to 3 percent. For the unemployment rate, your longer-run projections have a central tendency of 4¾ to 5 percent and a range of about 4½ to 5¾ percent. For both variables, the central tendencies are very similar to those of the projections for 2010 that you made in October 2007, shown in the bottom panel, a point at which many of you viewed the modal outlook for 2010 as being fairly close to the balanced growth path of the economy. For PCE inflation, your longer-run projections have a central tendency of about 1¾ percent and a range of 1½ to 2 percent. The range of these projections is identical to the range of two-year-ahead inflation projections that you made last October; the minutes from that meeting indicated that those projections were influenced importantly by your judgments about the measured rates of inflation consistent with the Federal Reserve’s dual mandate of promoting price stability and maximum employment. October 28–29, 2008 57 of 206 The request for the trial-run projections suggested that convergence might typically occur over a period of five to six years. One of you noted that the convergence process this time will likely occur over an even longer period because of the severity of the economic crisis. However, apparently most of you thought that convergence would occur sooner than that, suggesting that the configuration of this trial run produces a good representation of FOMC participants’ views of the steady state values of GDP growth, unemployment, and inflation. As usual, the staff will be preparing a summary of economic projections (SEP) and will be circulating drafts to you over the next few weeks along with drafts of the minutes. The published SEP, and hence the drafts, will not incorporate the longerterm projections from the trial run. The staff will provide to you separately a version of the SEP that has been modified to incorporate the longer-term projections generated by the trial run. The subcommittee will consult with the Chairman about next steps. One possibility would be for the Committee to discuss experience with the trial run at its December meeting and make a provisional decision at that time as to whether to proceed in January with regular longer-term projections; a final decision could be made in January. Thank you. That concludes our presentation. CHAIRMAN BERNANKE. Thank you. Before we go too long, we’ll take a coffee break, but now let’s take some questions. President Lacker. MR. LACKER. In the forecast, the federal funds rate goes to 50 basis points, and I take it that’s essentially as low as you think it can go. You treat that as sort of the lower bound on nominal interest rates. Is that right? MR. STOCKTON. That’s how we were thinking of it. The 50 basis points, however, was not done on the basis of any deep analytical analysis of whether that, in fact, is the zero bound, and I think that’s an issue that the staff will need to address pronto. But the message in the forecast with that funds rate path was that we think this shock is large enough that you will need to lower the funds rate as low as you think it can feasibly go. MR. LACKER. Well, whatever that lower bound is, I have a question that’s kind of hypothetical. I wasn’t a member of the Committee five years ago. My understanding, though, is that much thought was given to how we would conduct monetary policy if we needed to reduce the nominal federal funds rate to zero or its effective equivalent. My understanding is that the general October 28–29, 2008 58 of 206 conclusion—and my understanding is that this is mainstream economists’ general view as well—is that the way we would do that would be to expand the monetary base, perhaps by buying assets outside the normal range of assets that we would buy. Now, the first question is, Is that correct? Then I have a follow-up. CHAIRMAN BERNANKE. May I? You can answer, but let me just make a suggestion, which is that there were a number of memos and studies done in 2003. I think we ought to look at them, update them, and circulate them fairly soon. So we’ll do this in some detail; but by all means, let’s hear the answer. MR. MADIGAN. President Lacker, I would say that there are a number of strategies that the Committee could think about if it were at the point that it felt it couldn’t lower the federal funds rate any further, be that zero or some higher level. One would be communications that suggest to market participants a willingness to hold short-term rates at very low levels for a very long period of time. Of course, one could view the 2003 experience as implementing that strategy with the “considerable period” language. But obviously the idea is to try to hold down the longer-term rates that matter for spending to a larger degree than might be implied by market participants’ views that you might instead begin to firm monetary policy sooner. There are a number of other possibilities. As you suggest, one would be simply to expand the Federal Reserve’s balance sheet further—engage in a sort of quantitative easing. The effectiveness of that could be debated. Another possibility that was discussed, at least in the period in which the studies were done, would be to change the composition of the Federal Reserve’s balance sheet. Of course, we’ve already done a lot of that with the various lending facilities, and so the scope for additional expansion there would need to be thought through. October 28–29, 2008 59 of 206 MR. LACKER. The reason I ask is that my understanding is that the strategy of expanding the monetary base would work through increasing inflation or reducing deflation. MR. MADIGAN. That’s not how I would think about it. I would think about it as giving, if it works, depository institutions increased incentives to expand their lending by providing them with a great deal more funding than they actually need and thereby increasing spending propensities. I would see this more as part of a package of various ways to stimulate spending by reducing real interest rates but not as something that would feed through directly to inflation. Rather this would more properly be viewed, at least in the way I think about things, as fighting deflation rather than trying to cause a higher positive rate of inflation. MR. LACKER. My understanding is that economists such as Woodford and others who have studied this believe that, by using monetary assets to purchase other assets, we can make the price level and thus the inflation rate higher than it otherwise would be. Is that a fair understanding? CHAIRMAN BERNANKE. I don’t think that’s right. I think the thrust of the elementary approach to quantitative easing is the old Milton Friedman idea—that changing the composition of money and other assets changes relative returns. So it’s a way to bring down returns on other assets and create stimulus even if the policy rate is down to zero. MR. LACKER. The mechanism Friedman sketched ultimately produces a proportionate increase in the price level, doesn’t it? CHAIRMAN BERNANKE. Eventually, but through the aggregate demand mechanism. MR. LACKER. Right. CHAIRMAN BERNANKE. We should look at the Woodford thing, but I don’t think that’s quite the right characterization of his view. October 28–29, 2008 60 of 206 MR. LACKER. Well, the reason I ask all of this is that, with an interest rate on reserves above zero, that’s effectively equivalent to a zero lower bound on nominal interest rates. So we are effectively doing this quantitative easing. CHAIRMAN BERNANKE. We’re pretty close, yes. MR. LACKER. Right. So the thought that sparks is that, if the mechanism involves creating inflation, then I’d wonder what checks we have on the scale of open market operations now to ensure that we’re not, by expanding our balance sheet as much as we have, risking an increase in inflation. CHAIRMAN BERNANKE. I don’t think that’s the right characterization, but I’d be happy to talk about it off line. President Plosser. MR. PLOSSER. I have a question. As you characterized the forecast in the Greenbook, it is really the result of very large adjustments to the financial constraints piece—in fact, they’re about double what they were in the September Greenbook—and those adjustments or factors really account for a large portion, maybe not all, of the downward revision in the forecast. Now, one of the inputs in the financial factors are spreads of various kinds in the VARs that you used to estimate those. But those spreads we’ve learned are very, very volatile. They can rise very quickly, as we’ve seen. They also can fall very quickly sometimes. Spreads have actually come down a little in the last few days, which is the good news. If our facilities are successful, they actually may fall further—knock on wood; that would be very nice. But I get a little nervous making our forecast be driven so much by something that’s potentially very, very volatile. Now, we get a bit of a picture of this—and I want to applaud the staff—in I guess it was exhibit 5, where you were comparing the baseline forecast and the two alternative scenarios, particularly the one in which you get quicker recovery in the financial sector. I thought that was a October 28–29, 2008 61 of 206 very useful exercise, and I really appreciate it. My interpretation or intuition is that the “more rapid financial recovery” scenario is what the forecast would look like had we not done the additional add factors in October and instead held them to what they were in September. That suggests that the real data, whether on spending or other things, have driven the forecast down a little, but not a whole lot. In fact, in that scenario, you imply that the funds rate would actually be held constant at 1½ percent. So, in looking at those two scenarios and trying to parse out how much risk or how much probability to attach to them, what is the staff’s view? Obviously here’s what you thought the baseline would be, but if I ask you what you think the probabilities are on some of these different scenarios—in particular, I’m interested in this sort of faster recovery—do you have any sense of what the probabilities of these two different outcomes might be and how one might think about that? They imply very different paths for the funds rate and very different forecast profiles, but their differences depend on variables that are very, very volatile. So can you give me some probabilities of how you think about those two scenarios? MR. STOCKTON. I can give you some probabilities, but I don’t know how seriously you should take them. [Laughter] MR. PLOSSER. You can give me a distribution. MR. STOCKTON. What we wanted to convey in the alternative scenarios that we showed this time—and we reduced the number because we thought the possible little risks that you might be facing were being swamped by some really big ones—was our sense that the likelihood function is pretty flat around the baseline and the two alternative scenarios that we show here in exhibit 5. I share your discomfort. As I was telling President Evans at lunch today, I feel a bit as though the forecast is going to depend a lot on when the clock stopped, given how much volatility there has been in the stock market and in corporate spreads. When the clock October 28–29, 2008 62 of 206 stopped, we had close to a 25 percent weaker level on the stock market, 200 basis points higher on the Baa spread, and a 7 percent higher dollar. There were a whole lot of negative forces operating on this forecast. Indeed, both the conventional wealth effect and cost-of-capital channels account for about one-third of the downward revision we made. The special nonconventional credit channel effects account for a third, and a third of the downward revision really is a combination of the stronger dollar and the weaker foreign outlook. The part that I feel most comfortable with in this forecast is that there has been a very significant negative shock to the economy and that it is difficult to imagine that activity will not be affected importantly by that. The part that I feel most uncertain about—and, as you point out, is relevant to the policy decisions that you are going to make over the next several meetings—is that I have no idea about the timing or the manner in which this will fade away. So we have it fading away gradually over the next two years. I think that a more rapid recovery is certainly a possibility. As you noted, even that scenario doesn’t go back to where we were in September. One, the incoming data suggest that the underlying economy is starting out at a weaker place, and even if conditions were to improve very rapidly over the next quarter or two, you have still sustained a hit that is going to take some time to play out through the system. By the same token, I don’t think that you can discount the more extended and deeper financial fallout here. We have certainly been surprised over the past year in many ways by just how virulent and persistent this shock has been. Two, looking at the current state of aggregate demand and aggregate activity, I think we are probably still just at the front edge of the credit constraint effects on actual spending. So you could still be faced with some very substantial restraint on spending—and more than we have built into the baseline forecast. October 28–29, 2008 63 of 206 So, and as you noted, the difference in the policy prescriptions there—the worse scenario is that the funds rate stays as low as it can stay for several years. The other would be—putting too fine a point on it—that optimal control, even with the more rapid recovery, goes down to 1 percent on the funds rate and then starts recovering to 1½ percent. But that is obviously a very different policy picture. I just don’t think that, at this point, science is going to allow us to put a lot of probability mass on one of those scenarios versus the other two. MR. MORIN. One quick follow-on comment. In exhibit 3, in the middle left panel, if you look at our financial turmoil effects, with the gray shading, the bulk of the markdown in 2008 actually is what we’re labeling the financial turmoil. But those are data we pretty much already have in hand. We are calling much of the shortfall in consumption that we expect to see in the third quarter as “financial turmoil.” So much of the weakness in the second half of this year isn’t just taking a flyer on what we think turmoil is going to do; some of it is already in the data. MR. PLOSSER. I was looking at the table in the Greenbook, at the bottom. That’s where I was trying to back out some of this. Thank you very much. CHAIRMAN BERNANKE. President Fisher. MR. FISHER. I have a question and a statement disguised as a question. CHAIRMAN BERNANKE. Not anymore. [Laughter] MR. FISHER. A quick question on fiscal policy, both domestic and international. Being struck, Ms. Kole, by your verbs “whacked” and “disintegrated”—very forceful language—what are your assumptions about fiscal policy in terms of staff projections, first, for the domestic economy and, second, for other economies? That’s the question part. October 28–29, 2008 64 of 206 MR. MORIN. Right now, although the odds are that there will be a fiscal package next year, it is not a feature of the baseline forecast. We discussed two alternative simulations for different packages, but additional fiscal stimulus is not a feature of the baseline. MR. STOCKTON. We made a deliberate decision in constructing the forecast, given the enormous uncertainty about both the size and the composition of those fiscal packages. We had so many moving parts in our baseline forecast that we wanted to present you with that and then show you what the consequences might be, first, of a stimulus package that looks a lot like the one we had this year—which we think probably gave a shock, but a very short-lived shock, to aggregate demand and then faded away. That doesn’t really have many important consequences for the outlook. The second was a much larger package that delivered some stimulus over the next two years. That had a bit of an effect in terms of raising GDP growth and lowering the unemployment rate. But even that $300 billion fiscal package wasn’t enough, in our baseline forecast, to lift the funds rate assumption off the floor. So I think one of the messages would be that, to have a fiscal package that would actually influence your current policy discussion, you have to think both that it would be extremely large and that it would deliver stimulus over an extended period of time to be effective that way. MS. KOLE. I think that in many of the major foreign countries there is room for fiscal stimulus. That may be a bit of an upside risk to our forecast because, for example, China has already put some things in place. They have increased exporter rebates, and they are also putting more money into homebuilding and trying to prop up the construction industry. Japan just announced a bigger package. I’m not so sure if it will go through. Korea has announced—and even some of the oil producers are announcing—plans to put money into the system. I don’t October 28–29, 2008 65 of 206 think we have fully incorporated that. Maybe we have thought about it in China’s case because we think that they will do everything they need to do to keep that economy growing at a— MR. FISHER. So it’s possible that we might have marginally higher rates of growth than— MS. KOLE. Right. I think that the United Kingdom, too, is expanding fiscal policy. Europe hasn’t really announced much yet, but perhaps they will do more as well. MR. FISHER. The second thing goes back to this business of the judgmental effects of financial market turmoil. Do you have any concern that the financial turmoil may have reduced the marginal effectiveness of changes in the funds rate? In other words, if you think in my simple way of a patient on the operating table, we have an IV tube into them, we titrate the fed funds rate—we have been cutting rates—but the tube has been crimped. The flow, I would suggest may not be as full as it would have been before. Is it possible that we haven’t felt the full effects or, all things being equal, we haven’t felt the same effects that we would have felt if the pipes hadn’t been crimped? I’m curious as to your view on that. MR. STOCKTON. The answer to that is “yes”—it is certainly possible. Obviously, it is very difficult to separate things that might actually have changed the transmission channel of monetary policy from just big financial developments that have offset the beneficial effects of easing policy. We built an assumption into the baseline forecast that GDP responds close to the average response to a fed funds rate reduction, as would normally be the case. The one small technical area in which it seems as though the effect almost certainly would be smaller is that, with the equity premium so high right now, any given change in the funds rate is likely to result in a smaller change in the required return on equity and probably a smaller stock market response than you would normally get. So I think, basically, it is certainly possible, but in our forecast we October 28–29, 2008 66 of 206 have assumed that the additional reductions will have GDP consequences along the lines of the normal response. CHAIRMAN BERNANKE. Okay. Why don’t we take fifteen minutes for coffee, and then we’ll do part of the go-round. Thank you. [Coffee break] CHAIRMAN BERNANKE. Well, why don’t we turn part of our dinner period to the goround. Let’s start with President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. Most of the anecdotal information from the Sixth District is consistent with the downbeat picture that has been emerging in the national data. The sentiment of directors and their contacts has turned decidedly more pessimistic regarding current economic conditions and the near-term outlook. Banking contacts indicate a further tightening of credit standards, while stresses on household and small business finances have resulted in increased credit card usage. A state economic-development official noted that some banks have halted their 90/10 SBA lending. Bankers active in the VRDN (variable rate demand note) market noted that municipalities are under pressure with declining revenues and higher financing costs. Nonresidential building contractors noted a large increase in the number of canceled projects. Advisory council members described a substantial decline in domestic shipping and transport activity for most goods, other than energy products, and some slowing of export volumes through regional ports. Finally, retail contacts, in anticipation of the coming holiday season, noted that orders are down, and heavy price discounting has begun already. Thematically, Atlanta’s forecast is consistent with the Greenbook, but we are projecting a slightly more severe and protracted downturn in business activity than the Greenbook baseline. My assumption is that the cascading dynamic at work in the financial markets may take longer October 28–29, 2008 67 of 206 than projected in the Greenbook to come to an end. As a consequence, I view the Greenbook’s scenario entitled “more financial fallout” as the most plausible storyline among the likely range of outcomes. I should acknowledge that we’re in an interval between the announcement of the TARP and its full implementation. The encouraging improvement in credit spreads and term funding we have seen in recent days may accelerate once the TARP is operational. With inflation abating more or less as expected and with such uncertainty surrounding the playing out of continuing and recently worsening turmoil in the financial markets, I have to view the balance of risks as more negative for growth than upside for inflation. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Fisher. MR. FISHER. Mr. Chairman, I think it is clear that inflation has been rolled over by the steamroller of the credit crisis. I am not going to belabor what I have heard from the CEOs I have spoken to. Basically, the best summary is that things have gone from interesting to unbelievable. We have had an implosion of economic activity. Business women and men, not having any pricing power, are doing what you would expect them to do: They are cutting their costs of goods sold, which means they are shedding head count dramatically. They are stretching out their ROI assumptions, and they are cutting back on cap-ex and, basically, assuming pro-cyclical behavior on the downside. I doubt that any of us are going to report anything different, particularly since I think I am in a District that, relatively speaking, is still strong. I would hope that during our discussions today we would each take the time, or at least ask, for some response. I would like some response from you in particular. The situation is dire. There is no question about that. We are in dire straits. There is no inflationary tail, or if there is, October 28–29, 2008 68 of 206 it is completely flattened in terms of the foreseeable future. The risks are to the downside on economic growth. A question I have is, What do we do next? Actually, I should address the issue of what we do first. I don’t think doing dribbles and drabs is an answer. I think we just do nothing—and I could make that case because we’ve done an awful lot—or we do something that is a firm statement. But in response to that statement, the question has to be, What do we do as next steps? I’m particularly curious about whether or not we address during this meeting, and tonight and tomorrow, not only next steps but what the end game is. Where do we want to be? How long are we going to be there, and eventually, how do we exit? But that is, of course, the ultimate question that I think we can delay. So, Mr. Chairman, I’d like to suggest that we not go through our standard ritual of reading about our Districts and so on because I don’t think there is going to be a whole lot of difference. The real question is, What do we do about it, and what’s the cognitive road map from here? Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Well, I for one will certainly give my response to that at the appropriate time, and we need to hear from everybody. But everyone is obviously free to talk about whatever they want to talk about. President Yellen. MS. YELLEN. Thank you, Mr. Chairman. In the run-up to Halloween, we have had a witch’s brew of news. Sorry. [Laughter] The downward trajectory of economic data has been hair-raising—with employment, consumer sentiment, spending and orders for capital goods, and homebuilding all contracting—and conditions in financial and credit markets have taken a ghastly turn for the worse. It is becoming abundantly clear that we are in the midst of a serious global meltdown. Like the Board staff, I have slashed my forecast for economic activity and now foresee a recession with four straight quarters of negative growth starting last quarter. I October 28–29, 2008 69 of 206 wish that I could claim that I place a lot of confidence in the sobering forecast, but I am sorry to say I can’t. In fact, I think we will be lucky if the adverse feedback loop that is under way doesn’t wrench us into a much more pronounced and more protracted downturn. The outlook for inflation has shifted markedly, too, with the days of heightened upside inflation risks behind us. In fact, I am concerned that beyond next year we run the risk of inflation falling below the level consistent with price stability. Even before the extraordinary deterioration in financial market conditions over the past few weeks, there were numerous signs that the economy had weakened dramatically. I won’t recite the litany of disappointing data but instead try to touch upon some high, or I guess I should say low, notes based on what my contacts tell me. They are consistent with President Fisher’s observations. Consumer purchases of durable goods, especially motor vehicles, have been particularly hard hit by the one–two punch of tight credit and reeling consumer confidence. The mood on showroom floors is downright grim. One auto dealer in my District reports that he is now experiencing the worst period in his thirty-plus years in the business. A home appliance retailer adds that he has never seen more uncertainty and gloom from both the retailers and the vendors. This sentiment is echoed by a large retailer who says simply, “The holiday shopping season is going to stink.” Businesses are under siege from weak demand, high costs of borrowing, curtailed credit availability, and pervasive uncertainty about how long such conditions will last. Our contacts report that bank lines of credit are more difficult to negotiate. Many have become more cautious in managing liquidity and in committing to capital spending projects that can be deferred. They are even cutting back trade credit to customers. Even firms that are currently in good shape report that they are hunkering down, cutting back on all but essential spending, and preparing for October 28–29, 2008 70 of 206 the worst. Our venture capital and private equity contacts tell us that they are instructing their portfolio companies to cut costs, put expansion plans on hold, and draw down existing credit lines. The market for commercial mortgage-backed securities has all but dried up, and lenders have also become less willing to extend funding. With financing unavailable, I am hearing talk about substantial cutbacks on new projects and planned improvements on existing buildings, as well as the potential for distress sales of properties whose owners will be unable to roll over debt as it matures. The deterioration in overall financial conditions since the September FOMC meeting is truly shocking. Even with today’s 900-point increase in the Dow, broad indexes are still down about 20 percent, and the latest data suggest house prices in a freefall. Baa corporate bonds are up about 200 basis points since our last meeting, low-grade corporate bonds are up a staggering 700 basis points, and to top it all, the dollar has appreciated nearly 10 percent against the currencies of our trading partners. The sharp deterioration in financial and credit conditions will weigh heavily on economic activity for some time. In addition, prospects for the one remaining cylinder in the engine of growth—namely, net exports—are bleak owing to the slowdown in global demand and the appreciation of the dollar. We now expect real GDP to decline at an annual rate of 1¼ percent in the second half of this year and to register two more negative quarters in the first half of next year. That forecast is predicated on cutting the funds rate to ½ percent by January, as assumed in the Greenbook, and also is premised on another fiscal package. An absolutely critical pre-condition for the economy to recover next year is for the financial system to get back on its feet. In that regard, I have been greatly heartened by the important actions that the Treasury, the FDIC, the Fed, foreign governments, and other central banks have taken in recent weeks to improve liquidity and inject capital into the financial systems. But we are fighting an uphill battle against falling home October 28–29, 2008 71 of 206 prices, an economy in recession, and collapsing confidence. It is not clear whether these steps will reopen credit flows to households and businesses, especially those with less than sterling credit. Under the Greenbook forecast we will see further large declines in housing prices over the next two years. Banks and other financial institutions will likely suffer larger losses than many had anticipated, and that will mute the impact of recent capital injections. The interaction of higher unemployment and rising delinquencies raises the potential for even greater losses by banks and other financial institutions and for an intensification of the adverse feedback loop we have worried about and are now experiencing. Such a sequence of events plausibly could lead to outcomes described in the “more financial fallout” alternative scenario in the Greenbook. There are considerable downside risks to the near-term outlook as well. As I mentioned, the most recent economic data have consistently surprised on the downside, and I see a real risk that the data may continue to come in weaker in the near term than the Greenbook has assumed. For example, a dynamic factor model that my staff regularly uses is much more pessimistic in the near term than is the Greenbook. This model aggregates the information contained in more than 140 data series. Based on the most recent economic and financial data available, this model predicts that real GDP will fall 2½ percent in the fourth quarter. The model’s pessimism reflects the combination of the recent weak data releases for the month of September, followed by the abysmal data that we have available so far for October, including financial market prices, regional business surveys, and consumer sentiment. Turning to inflation, the most recent data have been encouraging. Looking forward, the sharp decline in commodity prices, especially oil prices, will bring headline inflation down relatively quickly. More fundamentally, the considerable slack in labor and product markets will put downward pressure on the underlying rate of inflation over the next few years. A number of October 28–29, 2008 72 of 206 my contacts already report that their businesses are working on lower margins in the more challenging economic environment. I expect headline PCE price inflation to decline to about 1½ percent in 2009 and core PCE price inflation to be 1¾ percent next year. I expect both inflation rates to edge down to 1¼ percent in 2010. Given the sizable downside risk to the forecast for growth, the risks to the inflation forecast are likewise weighted to the downside. In conclusion, I think the present situation obviously calls for an easing of policy, as I assumed in my forecast. Given the seriousness of the situation, I believe that we should put as much stimulus into the system as we can as soon as we can. CHAIRMAN BERNANKE. Thank you. President Evans. MR. EVANS. Thank you, Mr. Chairman. In spite of the fact that I am going to validate what President Fisher said in terms of content, I am reminded of what candidate Ronald Reagan said in 1980 against George Bush. To paraphrase, “I paid for the plane ticket down here. I’m going to tell you what I learned.” [Laughter] Pessimism is running deep, and no one I spoke with this round was immune to the current economic and financial turmoil. Even contacts who have sworn for months that their prudent financial management had insulated them from funding difficulties now report being stressed. The speed of the turnaround in sentiment has been breathtaking. Some of these new reports about changes in financing conditions came from large manufacturing firms that had been doing well this cycle. For example, John Deere noted that its financing subsidiary was having difficulty rolling medium-term notes that fund their customer leases. This seems symptomatic of financial stress because the subsidiary has a large capital cushion with high-value collateral backing the leases. Caterpillar did have better luck getting such funding but only because it went to the market during a very brief window when lenders were actively seeking customers with October 28–29, 2008 73 of 206 high credit quality. I also heard numerous reports of businesses having difficulty renewing longstanding lending arrangements with their banks; and for those who were able to get new loans, the terms were typically viewed as unattractive—at least they felt so. Several Chicago directors indicated that businesses were successfully tapping existing loan commitments and revolving credit, much along the lines that President Yellen just mentioned. However, this was not greeted enthusiastically by their bankers. In fact, I heard a very interesting story about a major New York bank CEO who spent some time in Chicago a couple of years ago. He was calling a large customer to assure him that their credit lines were good and that they didn’t need to be taken down preemptively. The customer, who is our chairman, listened politely and then tapped the line anyway. [Laughter] No wonder banks are worried about their liquidity position. With regard to nonfinancial developments, reports on both current and expected real activity have turned uniformly more negative. An abrupt change occurred in September. People are spooked—sorry—[laughter] and it is showing through to spending. Retail sales are weak. I have grown accustomed to the inherent pessimism of one of my retail contacts. He has often said that business has never been weaker in 40 years, but this time he said never in 46 years. I also heard many reports about how the slowing in demand is worldwide. In my District, the sharp slowdown is evident in the Chicago purchasing managers’ index. In October, it plunged nearly 20 points, to 37.8, the lowest level since the last recession in May 2001. This index will be publicly released on Friday. Businesses appear to be responding to the drop in demand by doing anything and everything they can to cut back spending. Labor demand is way off. My Manpower contact indicated that even companies that are doing well had turned cautious about hiring and are trying to squeeze out more productivity. He thought October 28–29, 2008 74 of 206 that the drop in sentiment could have some extra impact, given that it was occurring during the annual planning cycle for corporations. The idea was that a lot of harder-to-sell structural adjustments were being implemented anyway and that CEOs wanted to get these moves done quickly and have them behind them by early 2009. This is consistent with a range of reports we have heard that new capital spending is dead in the water or that planned expansions are being canceled. On a positive note, I think we are seeing the benefits of the structural improvement and inventory management that has occurred over the last 25 years. My contacts are reporting some increases in inventories, but they think that so far they have kept stocks under relatively good control. With prompt production cuts, we may not get the additional downside of a big inventory swing later in the cycle, perhaps when it is more painful. Turning to the national outlook, our forecast envisions a full-blown recession, roughly on the scale of the Greenbook. But like everyone else, I have a great deal of uncertainty about this projection. Things could turn out a lot worse. In contemplating the transmission from recent financial events to the real economy, there seem to be at least two channels to note. First, there is the dramatically reduced availability and higher cost of credit. Second, a recessionary psychology has emerged strongly in households and businesses. With regard to the psychology, I haven’t spoken with anyone this round who thought there was a good reason to undertake any kind of discretionary expenditure. Clearly, the self-reinforcing dynamics implied by these and other reports could generate a deeper downturn than I have written down in my forecast. That’s a big risk. With regard to the credit channel, the hit to the nonfinancial sector has intensified a good bit. We clearly are sailing in uncharted waters when it comes to quantifying these effects. The factors identified in the Greenbook highlight the unprecedented nature of the financial impulses to the economy. October 28–29, 2008 75 of 206 Looking ahead, I expect that the improvement in financial conditions will be somewhat faster than in the Greenbook. That is my cautious optimism. Still, in our forecast, financial headwinds weigh substantially on growth throughout 2009 and continue, to a degree, into 2010. Accordingly, substantial resource gaps remain open throughout the projection period. Also, I expect inflation expectations to decline in this depressed environment. With greater slack, lower inflation expectations, the reduction in energy and other commodity prices, and the higher value of the dollar, we are projecting core inflation to move under 2 percent by 2010. And I won’t be shocked if the Greenbook projection for this to happen in 2009 actually happens. So, on balance, I think that inflationary risks are low but the downside risks to the economy are very high. Much as President Fisher indicated, it is much in line with the reports so far. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Lacker. MR. LACKER. Thank you, Mr. Chairman. Business and consumer sentiment in the Fifth District has deteriorated markedly. Even though economic conditions were already decelerating heading into our September meeting, a discrete shift in outlook seems to have occurred. It seems to me to have originated during the week of September 15 or shortly thereafter. Our business contacts express anxiety about the national economy, and they express uncertainty about the meaning for their firms’ prospects of the astonishing sequence of events that began unfolding that week. Both consumers and firms have been increasingly unwilling to make long-term commitments and engage in discretionary expenditures. Consumers are delaying large and discretionary expenditures. Firms have adopted a wait-and-see attitude on investments. October 28–29, 2008 76 of 206 Our regional survey released this morning shows a substantial drop in business conditions as well. Our business survey respondents report that obtaining business loans is more difficult than three months ago, and there are widespread reports of lenders tightening credit terms and seeking to reduce exposures. Most respondents, however, also indicated that they would still be able to satisfy their borrowing needs. When you listen to bankers, they will tell you that they are tightening standards, but they also report that they are still extending credit to solid borrowers with high-quality deals. I find it difficult right now to pin down the real effects of the financial market turmoil of the last few weeks. As the Greenbook notes, assessing such effects “poses significant identification challenges.” Specifically, it is hard to disentangle the effects of the increased cost of bank capital from those of the deterioration in the economic environment facing borrowers. Personally, I suspect the latter are playing the more prominent role in the tightening of credit terms right now. Looking on the bright side, the near-term inflation picture has eased noticeably since our September meeting, mainly because of the decline in oil and other commodity prices. The Greenbook carries this moderation into its long-term forecast, where PCE inflation now converges to 1 percent in 2013. I did a double-take when I saw that—it had me wondering whether the Greenbook was ghost-written this month by President Plosser. [Laughter] Whoever’s forecast it is, the longer-term projected moderation in inflation relies heavily on the opening-up of a large and persistent output gap. In the current circumstances, I am not sure how plausible that story is. In particular, I have been struggling with how to think about the effect of credit market disruptions on the concept of potential output. To the extent that we think of these disruptions as analogous to shocks to intermediation technology—and that is what the models of October 28–29, 2008 77 of 206 these kinds of credit channel effects generally tell you to do—it seems to me that we should see them as pulling down potential as well as actual output. I believe this point has been made at previous meetings. We have also talked before about the tenuous nature of the Phillips curve relationship, and it is difficult to forecast. The slope is sort of flat. We had been scheduled to discuss inflation dynamics, and we postponed that, for good reasons I believe. I hope we can get back to it soon because I think it’s going to be relevant to how we see our way through this. In any event, I think we should be careful not to be overly optimistic about the forecast of an inflation decline driven by a large output gap. The shift in the Greenbook’s long-term inflation projection is noteworthy for another reason, I believe. We are getting closer to a 1 percent target federal funds rate, and we may actually reach 1 percent at some meeting soon. The last time this happened it sparked a widespread discussion of and concern about the zero lower bound on nominal interest rates. I want to make a couple of related observations. First, a key to conducting monetary policy at the zero bound is being able to keep inflation expectations from falling and thereby increasing real interest rates. From this perspective, the revision of the Greenbook’s forecast from 1.7 percent one meeting ago to 1.0 percent for five-year-ahead inflation implies that we run a monetary policy regime in which five-year-ahead expected inflation varies pretty significantly in response to contemporaneous shocks. I don’t think that variability in long-run inflation projections can help our ability to manage inflation expectations at the zero bound. We’d be better if we ran a policy in which long-run expected inflation was more anchored, more stable. You can tell where I’m going with this, I’m sure. This highlights the value of an explicit inflation objective as well as the value of being able to communicate clearly about how we view the functioning of monetary policy at the zero bound. Second, I will just note briefly that the October 28–29, 2008 78 of 206 economics of monetary policy at the zero bound are closely related to the economics of paying interest on reserves at close to the target rate. In fact, if I’m not mistaken, they are virtually identical. I think progress on both fronts would be useful right now. Finally, let me just comment on financial market conditions. My sense is that what the public has seen—the large failures, the variety of resolution techniques, the deliberations leading up to the Congress’s adoption of the bill it adopted—taken together have added up to significant pessimism on people’s parts and have altered optimal strategy for a lot of financial institutions. So I think that is altering how people allocate portfolios and has led to further volatility in certain markets. It has led some institutions to adopt a wait-and-see attitude, to see how particular programs are going to be implemented. I think that we are seeing at least some dead-weight loss associated with the burdens of shifting financial flows between things that are covered and things that aren’t and we are seeing a good deal of rent-seeking behavior as well. What we are seeing is going to have the effect of masking the evolution of underlying fundamentals. It is going to make it harder to see our way through this and understand just what is happening. I think that is going to be a thicket that we will need to cut through in the months ahead. That concludes my comments, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Rosengren. MR. ROSENGREN. Thank you, Mr. Chairman. While the LIBOR–OIS spread has narrowed somewhat, the mutual fund industry is no longer experiencing waves of redemptions, and commercial paper market conditions have improved, we’re still not back to the short-term credit conditions that prevailed before the failure of Lehman Brothers. This outcome is striking considering the historic interventions that have occurred in the past month. With all of the new October 28–29, 2008 79 of 206 government guarantees and equity infusions here and abroad, the limited improvement in short-term credit markets attests to the degree of concern and risk aversion prevailing in financial markets. These concerns are likely to become even more elevated if the economy slows to the degree expected in most forecasts. Like the Greenbook, our forecast anticipates a significant recession. The Boston forecast includes three consecutive quarters of negative GDP growth and results in an unemployment rate peaking above 7½ percent. The weakening labor market and the large losses in housing and stock wealth make it quite likely that consumption will shrink in the second half of this year. While we need housing to reach bottom, mortgage rates relative to federal funds rates remain quite high, and further job losses are likely to aggravate the upward trend in foreclosures and add to the downward pressure on housing prices. With limited new home purchases and demand for vehicles weak, consumption of consumer durables is unlikely to recover until next year. Commercial real estate, which has held up reasonably well, all things considered, is likely to be much weaker next year as new and rollover financing is difficult to obtain and staff cuts and hiring freezes affect the space needed by businesses. More generally, firms are likely to have little incentive to make new investments until the severity of the downturn becomes much clearer. Unfortunately, many of our trading partners are likely to face an even more severe downturn, aggravated by their slow fiscal and monetary response to deteriorating economic and financial conditions. While the Greenbook assumes the stock market will rise by 8 percent for the remainder of this year—it looks as though that happened today— CHAIRMAN BERNANKE. Nice job, Dave. [Laughter] MR. STOCKTON. I think that just offset the decline that had happened since the time we finished the Greenbook. [Laughter] MR. ROSENGREN. —I would say that I’d be surprised by that outcome. October 28–29, 2008 80 of 206 There are several looming financial problems that are likely to affect financial markets. Bill Dudley highlighted the one that I think is the biggest for me, which is that the NAV (net asset value) triggers for hedge funds will be a significant problem in the fourth quarter. Without comprehensive information on hedge funds, it’s difficult to know the extent of the problems they are facing. However, since the stock market remains one of the few markets available for the disposing of assets in bulk without a significant liquidity haircut, I’d expect significant selling in the fourth quarter. My second big concern is that rollover financing will become more problematic as financial problems persist. Particularly exposed are real estate developers and highly leveraged private equity firms. My third worry is that neither insurance companies nor commercial banks have reserved for the economic outcome in our baseline forecast. Under-reserving and high payout ratios are likely to limit the amount of additional lending that banks are willing to take on. These financial problems place additional downside risk to our forecast. Our forecast, like the Greenbook forecast, expects the rate of inflation to slow as a result of falling food and energy prices and significant excess capacity emerging in the economy. In fact, our equations indicate there is a non-negligible risk that deflation will be a problem in the outyears of our forecast. Unlike President Lacker, I was surprised that it stayed as high as 1 rather than as low as 1. The outlook for a weak real economy and falling inflation highlights the need for both monetary and fiscal policy to offset some of the financial and economic problems that we are likely to experience. Thank you. CHAIRMAN BERNANKE. Thank you. President Hoenig. MR. HOENIG. Thank you, Mr. Chairman. Let me just briefly say that, in our region, we have continued to do actually better than the national average, but that is beginning to wane. We are seeing, obviously, the energy effect show itself as rigs are being put out of production and you see a October 28–29, 2008 81 of 206 slowing there. We are seeing some concerns being raised about agricultural prices and the boom that has been going on in that part of the economy. That said, there’s still a reasonable amount of business going on that they haven’t frozen up. We asked our directors and our other advisers how they were seeing things, and it varies. There were some organizations that say that our non-investment-grade borrowers from the banks, if they had credit already, are still able to access those lines. If they lost some portion because of a bank problem or something like that, they cannot get new credit, so it is cut off in that way. I think that’s important to keep in mind. Businesses themselves are beginning to pull back on their capital plans. They’ve said that. Their balance sheets—obviously outside the auto industry—are still decent, but they’re saying, “We’re looking at this, and we’re pulling back until we see how it plays out.” You are beginning to hear more of that. They feel that they can get credit. Some of them are talking about actually trying to pull down their lines to make sure they have the money, and the only thing keeping them from doing that is they don’t know what to do with it once they get it. So that’s their dilemma. They’re afraid of losing their credit, but they also know that it costs if they pull it down. So the dynamics there are interesting. On the national outlook, I’ll be brief. I think that obviously the projections for recession are in place. Down is where we’re going. How much, though, is speculation right now. I don’t know. I don’t know that anyone does until we begin to see things settle out. Inflation should be down as well. Obviously, when you have a recession, you will back off from that, but how much? That’s not clear at this point. There is a lot in play, and that’s why we don’t know the answers to those questions. We have these liquidity facilities and an enormous amount of liquidity out. We have the TARP that is now in process but not completed. That’s going to have an impact, and I think those are very important. As we discuss our own policy, we are very close to the point of the quantitative October 28–29, 2008 82 of 206 easing discussion that we had, as you said, in 2003. Pulling that material out and taking a look at that is important as we decide what we’re going to put our money into as we try to stimulate this economy. Right now we’re subject to waiting and seeing. There’s been a lot done, and attitudes are a critical part of this now, and we just have to wait to see how those change over the next quarter or two. Thank you. CHAIRMAN BERNANKE. Thank you. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. I’m not going to say much about the District conditions. In the Third District, as many of you have noted, they’ve weakened considerably. I will make just a couple of observations that I think might be pertinent. Our last Business Outlook Survey, the one that was released a week ago, had actually gone into positive territory in September to 3.8, which was the first positive reading we had had since January—since, I guess, last December, actually. And it dropped from that plus 3.8 to minus 37.5 in one month. Now, it’s relevant to know the timing of this a bit. Our survey is done during the first 2 weeks or the first 10 or 12 days of each month—which meant that the September survey was closed on September 12, 4 days before that weekend. So what we see is a very precipitous, dramatic change in the tone that had as much to do with events and perhaps policy actions as with what was actually going on in the economy. I share a bit of President Lacker’s concern to try to disentangle a little the tone and feel of the economy, which really did feel as though it fell off a cliff in September, unlike any other month that I’ve seen during this episode. We have to think carefully about disentangling that effect not just because something fundamental happened to the economy but also to see to what extent policies, whether our policies or Treasury’s policies, have contributed to a change in tone and increased uncertainty and aggravated what might be the real fundamentals going on. I don’t know the answer October 28–29, 2008 83 of 206 to that question, but it suggests something that many of us have argued over time—that moreconsistent and more-predictable policies can help us avoid some of that. One special question that was asked in this survey in October was whether firms had trouble getting credit. Interestingly enough, only 14 percent of the respondents reported that they had trouble obtaining credit, but twice that number, almost 30 percent, reported that they believed that their customers were having trouble getting credit, which was an interesting dynamic going on that leads to a bit of uncertainty. I guess the best thing I can say about the Third District right now is “Go Phillies!” [Laughter] Maybe that will turn things around in the Third District. Anyway, let me turn briefly to the national outlook. It has deteriorated, certainly more than I expected, from what I thought in June. In our conference call on October 7, I indicated that I was revising my forecast downward. I expect the economy to contract during the second half of this year and perhaps in the first quarter of next year—but that’s less clear to me—and then gradually approach what I would consider trend growth over 2009, so that by the end of 2009 we’re getting back toward what might be considered trend growth, which I consider to be about 2.5 to 2.7 percent. In essence, for 2010-11, I pushed out my recovery of the economy by somewhere between six and nine months because of the current turmoil. I expect the unemployment rate to peak around mid’09 at about 7¼ and then to decline gradually to its long-run rate of about 5 percent by the end of 2010. Inflation pressures have subsided somewhat since June, and inflation expectations have remained contained. I expect core inflation to decline gradually from the current levels to my goal of about 1.7 percent by 2010. Now, my overall forecast is considerably better than the Greenbook baseline forecast. In fact, it’s similar to what we talked about as the “more rapid financial recovery” scenario, which makes some of the adjustment for the financial turmoil somewhat quicker and somewhat less October 28–29, 2008 84 of 206 dramatic than in the baseline. The fed funds rate path underlying my forecast is less accommodative than the Greenbook. I assume that the fed funds rate remains at 1½ percent through the spring of next year and then gradually begins to rise, reaching 4¼ percent by the end of 2010. Now, there are certainly risks around that forecast. Somebody at this table has to be a little more optimistic after all, and we have risks around all forecasts in this environment. Certainly mine is no exception. In particular, the effect of the financial markets, as we’ve all been talking about, remains highly uncertain and highly risky, and I am not trying to disregard that. Every day it seems as though there’s a new development, usually negative, although I guess 900 points on the Dow today should be considered good news. But in fact, I believe that the risks around the Greenbook baseline forecast are to the upside, as I have alluded to. First, the baseline entails a sizable downward adjustment based at least partly on the volatile financial data, especially spreads. Spreads can fall dramatically, although they don’t always do so. But they can rise and fall very quickly, and I think it’s very risky to base monetary policy, which ought to be taking a longer-term perspective, on week-to-week movements in such volatile variables. If spreads do continue to fall over the next quarter or two as they have in recent days and if the financial market tools we’ve put in place have the desired effect, we could see the economy becoming much stronger than the Greenbook’s baseline. Second, in the Greenbook, inflation falls and remains low despite a very low fed funds rate path. In fact, it’s reminiscent of the funds rate path in 2003-04. This apparently is due to the sizable output gaps that open up in the forecast period. Now, these output gaps arise in the forecast because the effects of the financial turmoil show up mainly in aggregate demand. However, as I’ve suggested in previous meetings and as President Lacker alluded to, I think a plausible alternative view is that the financial market disturbances we’ve experienced—resulting in a restructuring of the financial system and a lowering October 28–29, 2008 85 of 206 of the efficiency of financial intermediation—act on the supply side as well, much like a somewhat persistent productivity shock with an associated damping effect on measures of potential GDP for some period of time. If so, we’ll see much smaller output gaps opening up, and that means the risk of higher inflation than in the Greenbook, especially if the baseline funds rate path is followed as they lay out. In thinking about the appropriate monetary policy going forward, it’s important that we not let our policy be whipsawed by volatile market data. We have been lowering the funds rate since January, largely in anticipation of a recession or to mitigate the chances of one occurring. Now, it may finally have arrived. Does that mean we have to lower more? A difficult question. The level of the funds rate is always a difficult question. Clearly, if we experience a sustained slowdown in real economic activity, which suggests a lower equilibrium in the real rate of interest, policy needs to allow the funds rate to fall with the equilibrium rate, and I based my recommendations throughout the year on such a forecast. But I think it’s a mistake to overreact to volatile data, especially when it’s the stock market. Although there has always been the desire and much pressure from markets to do something when we see such swings in the market, in my view, the economy is better served if monetary policy is a steadying hand, taking appropriate action when the intermediate-term view dictates, but not overreacting to fluctuations in the market with an inappropriate tool. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. I have a question about the potential output view. So you would also have to argue that the natural rate of unemployment is higher because of this. MR. PLOSSER. Yes. CHAIRMAN BERNANKE. You think that’s plausible? I mean, I understand why productive capacity would be affected, but why do you— October 28–29, 2008 86 of 206 MR. PLOSSER. Well, I don’t like the NAIRU, but in my baseline forecast, my natural rate of unemployment is higher than what the Greenbook has. CHAIRMAN BERNANKE. But it rises because of the financial situation. I see. MR. PLOSSER. Yes, right. MR. LACKER. If I could, Mr. Chairman, in the dynamic stochastic general equilibrium models, one of which I understand has been adopted by the staff for use in forecasting, employment fluctuates with shocks to productivity, and it’s the natural correspondent to that. So in some sense the unemployment rate rises because the natural rate rises, but that’s a way of saying that the natural rate goes up in recessions. I’m not sure if proponents of the natural rate view that as consistent with that old model, but that’s what happens in these models. CHAIRMAN BERNANKE. Employment fluctuates, but to get unemployment you need a richer picture of matching, or something like that. MR. LACKER. Right. You need some matching model, and you get intersectoral flows. You get the same thing. MR. PLOSSER. But even in my steady state, if I view this as a permanent inefficiency in financial intermediation that changes things, the unemployment rate is a little higher. CHAIRMAN BERNANKE. President Stern. MR. STERN. Thank you, Mr. Chairman. I’ll start with a few comments about the District economy, which will sound pretty familiar by now. The preponderance of the anecdotes from business contacts that I’ve talked with since our last meeting have been distinctly negative. It’s not just a slowing of activity or some deterioration but a sharp contraction in activity, particularly with regard to discretionary spending or discretionary projects, beginning in the middle of September. The one exception to that is commercial construction, where there are enough things under way that October 28–29, 2008 87 of 206 business remains pretty good. But the backlogs are dropping, and so weakness certainly is anticipated next year. I thought another possible exception to the negative tone was the housing market in the Twin Cities—not that the housing market in the Twin Cities is in and of itself so important but that it might be representative of some middle-of-the-road markets across the country. Clearly, it’s not indicative of what’s going on in Florida, California, or places like those because sales volumes in the Twin Cities had been up distinctly. Some of that is no doubt due to short sales and foreclosures; nevertheless, there were some other signs that were favorable. The affordability index has really improved a lot. It is back to levels of 2002-03, which Realtors call very comfortable. The ratio of housing prices to rent has moved back to the levels of 2002-03, and that’s also encouraging. I already mentioned the higher sales volumes. Unfortunately, when you get beyond those statistics and look at other things, it’s too early to declare stability in the housing market or anything resembling underlying improvement. Part of the problem is something that we’ve talked about before. The inventory of unsold, unoccupied properties remains very substantial—by historical experience way above anything resembling normal. Second, even though the price-to-rent ratio has come down, it’s still elevated relative to the longer-term historical experience. So it looks to me as though, even in that market, there are some further price declines to come and it’s going to take some more time to get through all of this— probably well into next year. As far as the national economy is concerned, I, too, have marked down my outlook for real growth for the balance of this year, for all of next year, and into early 2010 as well. This reflects to some extent the nature of the incoming data but also the intensification of the financial problems and associated headwinds, the impact of the negative wealth effect, and so on. When I looked at my June forecast, back then the forecast obviously looked better, although there were a number of what October 28–29, 2008 88 of 206 I called “identifiable negatives.” They have proven, for worse rather than for better, to be relevant. I already talked about some of them. In addition, we still have the problem in housing with excess inventories. We have steady declines in employment, which obviously have negative implications for consumer spending, and the credit headwinds as well. So now I have the economy contracting through the middle of next year, modest growth resuming thereafter, and robust growth beginning with the second quarter of 2010—quite some distance off. On the inflation outlook, I have for some time been thinking that inflation would begin to slow this quarter. With the decline in commodity prices, the evolution of the economic outlook, and so forth, my confidence in that forecast has increased, and I do expect inflation to diminish over the forecast period. So I think I’ll conclude with that. CHAIRMAN BERNANKE. Okay. President Pianalto. MS. PIANALTO. Thank you, Mr. Chairman. I concur with the view that we face a very serious situation. In most respects I agree with the Greenbook baseline projection, with the reasoning that the Board staff used to arrive at the projection, and with their view that the risks to growth are to the downside. Like the Greenbook projection, my projection is heavily influenced by judgments that we are bringing to the projection from forces that are not captured by our models. The magnitude of the judgmental adjustment has become strikingly large, as we talked about earlier, and I realize that, if one wanted to be a skeptic about the Greenbook baseline, one would have to look no further than these assumptions and question their significant influence on the outlook. But I am not a skeptic. During the past few weeks, in our Bank we have stepped up our contacts with business people from large, medium, and smaller businesses, bankers, and local government officials. We have been asking them to tell us not so much what they think and feel but what has actually happened to their order books, production runs, and account receivables and what October 28–29, 2008 89 of 206 actions they are taking as a result. It suffices to say that the feedback about the environment was overwhelmingly negative. Respondents say that their situation has gone either from good to bad or from bad to worse, and I want to share just two anecdotes that I think capture the essence of what we are facing—one of them from a business perspective and the other from a consumer perspective. One of my directors is the CEO of a company that produces and sells forklift trucks all over the world. He reported last week that his sales are down and orders have fallen off dramatically, and he expects to be announcing some layoffs soon. But what was making a greater impression on him is the fact that orders for the forklift parts have fallen off as well, and this tells him that the warehouse operators have cut back on the use of trucks that they already own. My second story concerns the owner of a body shop that is located in a solid, middle class community. He told us that he was doing record business all year until last month, when business just went dead. He said it is not that people suddenly don’t need auto repairs, but in fact, they are collecting the insurance money and not fixing their cars. They want the cash and they don’t want to pay out the deductible. Stories like these convince me that the Greenbook baseline is on the right track. I do part company with the Greenbook in one respect—namely, the longer-term inflation outlook. I think it is quite likely that we are going to experience some costly reallocation of resources across some sectors of the economy. Finance and construction are two obvious examples. Going forward, I think there is reason to think that fewer workers and less capital are going to be employed in these sectors. The costly adjustment is going to be characterized by slower productivity growth, higher trend unit labor costs, and a smaller output gap than would otherwise occur, leading to somewhat less disinflation in the outyears in my projection. Nevertheless, with output and inflation expected to decline sharply over the coming quarters, I think it is essential for us to be thinking about the zero bound in conducting monetary policy in a low inflation environment, and I will address the October 28–29, 2008 90 of 206 magnitude, timing, and communication aspects of our monetary policy in tomorrow’s go-round. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Bullard. MR. BULLARD. Thank you, Mr. Chairman. Economic conditions in the Eighth District have deteriorated since the September Beige Book. Citing weak demand and higher input costs, a variety of manufacturing firms throughout the District reported job cuts and plant closings. The decline in manufacturing activity has been concentrated in firms producing durable goods. Service sector activity also continues to decline. In particular, recent layoffs have been reported in business, medical, and financial services. Two large auto dealers have closed and filed for bankruptcy. Retail sales are steady, but contacts have noticed that consumers are trading down to lower-priced products. The residential real estate sector continues to decline across the District. As lending standards have tightened for commercial building projects, industrial construction has slowed. Payroll employment numbers continue to vary across the Bank’s Branch cities. The most recent figures suggest that Memphis and St. Louis continue to lose jobs at a pace faster than at the national level. Louisville has moved from two consecutive months of positive year-over-year employment growth to negative growth in the most recent month. Little Rock continues to experience positive year-over-year employment growth. Unemployment rates in St. Louis and Memphis remain above 7 percent—that’s 7.2 percent and 7.1 percent, respectively. Louisville’s unemployment rate is 6.6 percent. In opposition to the national trend, Little Rock’s unemployment rate has fallen to just 4 percent. The national outlook is clouded by dramatically increased uncertainty fueled by the financial market turmoil. The explosion of uncertainty is driven in part by speculation about the nature of the government response to the turmoil, both in the United States and abroad. We know from past October 28–29, 2008 91 of 206 experience that, when economic actors—investors, businesses, and consumers—are faced with new and substantial uncertainty, they tend to adopt a “wait and see” approach, during which they make as few commitments as possible. This seems to be a reasonable expectation in the current environment, so we should expect to see many types of important economic decisions being deferred. Anecdotal evidence seems to support this idea. Most likely, this means we will experience an important deterioration in economic activity during the second half of 2008 and into 2009. In times of increased uncertainty, it can be useful to consider distinct alternative scenarios instead of considering a baseline scenario with many possible offshoots. The financial sector crisis that we are experiencing has some admittedly inexact parallels with the banking crises that occurred in Japan since 1990 and in the Nordic countries in the early 1990s. The general tenor of the literature on these events is that the Nordic countries dealt forthrightly with their financial sector problems, suffered through recessions, but were well positioned to grow once the crisis had been addressed. For Japan, real economic performance was subpar for a long time, and it is the Japanese outcome that is a looming risk for the U.S. economy. Part of the Japanese experience was the lowering of nominal interest rates to zero. This was done, no doubt, in the name of doing everything possible to help the economy recover. It was not very successful and, in fact, may have been counterproductive. Recent academic work—I’m thinking of Jess Benhabib here—has emphasized the possibility of a low nominal interest rate, low inflation rate, steady state equilibrium, and a trap at very low or zero nominal interest rates. This steady state coexists with the targeted steady state, the one we know and love, which has inflation at our specified target and relatively high nominal interest rates. So there are two possible focal points for the economy. Markets clear at both of these October 28–29, 2008 92 of 206 focal points. My main concern is that if we choose to continue to flirt with the trap steady state, we should think clearly about the possible implications given the current environment. The trap steady state is associated with very low inflation expectations, actually deflation. This is, in fact, what happened to Japan. They experienced deflation of about 1 percent for a number of years. Since our core problems are in the housing market, which is dominated by nominal contracting, deflation could sharply exacerbate our problems and lead to further difficulties. I am, frankly, not sure that this is a wise route for the Committee or for the nation. My preferred approach would be to maintain rates at the current low level and to use alternative fiscal policy actions to address the particular concerns in financial markets. Thank you. CHAIRMAN BERNANKE. Thank you. Well, it’s a little after 6:00 p.m., a long afternoon. Why don’t we recess the meeting until tomorrow morning? There’s a reception and a dinner up on the terrace, which is for your convenience. There’s no business being conducted, and we’ll see you in the morning. Thank you. [Meeting recessed] October 28–29, 2008 93 of 206 October 29, 2008—Morning Session CHAIRMAN BERNANKE. Good morning, everybody. PARTICIPANTS. Good morning. CHAIRMAN BERNANKE. We have some data this morning. Dave, would you like to discuss this? MR. STOCKTON.6 Yes. You have at your place a table on orders and shipments of durable goods, one of the more inscrutable releases to actually make sense of, but the bottom line is very little effect on our basic outlook here. As you can see in that second set of numbers, the shipments area excluding the aircraft line was up 2 percent in September. That was actually a little stronger than we had penciled in, but only enough to add a few basis points to GDP growth in the third quarter. Then you can see that it has basically been averaging flat for the last two months. This is a September figure, so it’s fairly dated at this point. The orders figures, the set of numbers above—again looking at the “excluding aircraft” line—have been coming down. I wouldn’t say that they’re collapsing, but they’re certainly weakening some. So this really has no appreciable effect on our outlook for a small decline in equipment spending in the third quarter and a more appreciable decline in the fourth. CHAIRMAN BERNANKE. Does the resolution of the Boeing strike have any macro implications? MR. STOCKTON. We actually predicted that the strike would end this week. It did. MR. PLOSSER. My, you’re good. MR. STOCKTON. It wasn’t looking too good last week. [Laughter] But we’re expecting that it would provide a small rebound effect on first-quarter GDP growth. It’s going to take a little while to get production back on track here. 6 The materials used by Mr. Stockton are appended to this transcript (appendix 6). October 28–29, 2008 94 of 206 CHAIRMAN BERNANKE. Other questions for Dave? Okay. If not, let’s continue with our go-round. Vice Chairman. VICE CHAIRMAN GEITHNER. Thank you, Mr. Chairman. We expect a recession at least as bad as the 1990–91 recession, with a significant risk of a deeper, more protracted downturn worse than the ’80s, and a very substantial rise in the unemployment rate. Inflation is decelerating quickly, and deflationary forces are ascendant around the globe. The huge decline in energy and commodity prices will add to a very substantial downward pressure on core inflation from increased economic slack around the world. We could see an abrupt change in inflation expectations into deflationary territory. We’ve seen a lot of policy action over the past few weeks. One question is whether policymakers should wait to measure the effects of these measures before going further, and I want to talk a little about that question. My view is that I don’t think so. The outlook has been deteriorating ahead of the policy response. This is true both here and around the world. The magnitude and speed of the tightening financial conditions, the erosion in business and consumer confidence, the fall in actual spending, and the shift in inflation risk together present very grave risks to growth and to the financial system. Mitigating these risks is going to require more monetary policy here but even more so in the other major economies. But in addition to the very substantial easing in the global stance of monetary policy ahead, the substantial damage that has already happened to financial intermediation globally suggests that a broad-based and quite large fiscal stimulus will be critical to prevent an excessive fall in aggregate demand. How quickly and how far should we reduce the federal funds rate in the United States? The Greenbook and the Bluebook present a very strong case for moving down another 100 basis points quickly. In fact, if I read the pictures in the Bluebook correctly, they might imply a need to get real October 28–29, 2008 95 of 206 rates to the negative 3 to negative 5 percent territory relatively quickly, if we could do that. If we don’t move another 50 today, we’ll be behind again. Monetary policy has effectively tightened substantially since the summer, of course, because of the intensification of financial pressures and because of the rise in forward real interest rates that have come with the rapid deceleration in expected future inflation. Beyond this meeting and this choice, our choices are harder. I think we need to get real rates lower and, to make sure we get them there, we need to keep them low enough long enough. This requires that we get the nominal fed funds rate as low as possible as soon as possible. I don’t see a good case for monetary policy gradualism in the current context. The risks are too great. If we’re too tentative, the damage to the financial system and to the real economy could be much greater and much harder to correct. If we end up doing too much, we can always adjust. That’s an easier problem to solve. It just requires will. With global financial markets placing progressively more weight on a very severe global recession, the “keep our powder dry” and “reserve our remaining ammunition” arguments don’t seem that compelling to me. We don’t have much ammunition left in the fed funds rate anyway. If we hold that back, it will likely be less effective when we ultimately use it. The more powerful escalation options we have left will probably involve communications, such as continued commitments to keep rates low enough long enough that we avert creeping expectations of deflation and can be confident that inflation will come in around our target level over the forecast period. I don’t have a strong view now about how low we can go with the nominal fed funds rate without causing too much risk of damage to the functioning of financial systems. We need to look at all possible options, though. I think the principal focus of our staff’s work in the coming weeks will be to put together a set of alternative policy options going forward along with the analysis of their benefits and risks so that we’re in a position to act quickly enough to be effective. Just a few October 28–29, 2008 96 of 206 final points. I think this basic risk-management choice really involves three dimensions of judgment. One is about the relative probability of alternative outcomes. The second is about the relative consequences of or the damage caused by those alternative scenarios. Importantly, it also involves a judgment about the ease of correcting, adjusting, or mitigating the consequences of being wrong. This is just a stylized presentation, but in the staff notes yesterday, there was a nice way to think about those choices. I just wanted to point out one thing about this stylized framework of those choices, which is the consequence. If you look at exhibit 5, the bottom left panel, which shows the inflation outcome associated with the “more rapid recovery” scenario, in this presentation you don’t have much risk of a very bad inflation outcome in the event that we end up doing too much with too much policy and have to take that back. Again, it’s important to recognize that it’s not just about the probability that we attach to the alternative scenarios. It’s not just about the relative impact of the consequences of those scenarios. It’s about the ease with which we can correct for a judgment that was wrong—in this case, a judgment that we did too much. This may understate the complications in correcting for that error and may make it look easier than it may ultimately be, but I think it’s a nice framework. Finally, I just want to point out, just to underscore the basic point: This is not going to be principally about monetary policy going forward. If you look at the broad framework of policies that are now in place, both here and globally, and the instruments we have to play with, along with the fiscal authorities: we have monetary policy; we have the liquidity arrangements and what we do with our balance sheet over time; we, the collectively integrated government, have the broad fiscal policy questions and the scope for either a broad-based substantial fiscal package or more-targeted fiscal measures, as the Chairman suggested, to focus on the credit markets; and we have the October 28–29, 2008 97 of 206 capacity to alter the framework of capital and guarantees that is now in place. Beyond that, the government here also has the ability to change what the GSEs, the FHA, and the FHLB can do. So when we think about escalating going forward, to go to President Fisher’s question from yesterday, we have the ability on all these fronts to do more if that’s necessary and prudent. But I think the mix has already changed substantially. It was probably mostly fiscal nine months ago. It is certainly mostly fiscal now in a broader sense, except that many of the major economies going forward will have to move monetary policy very substantially. Thank you. CHAIRMAN BERNANKE. Thank you. Governor Kohn. MR. KOHN. Thank you, Mr. Chairman. A number of the presentations yesterday talked about falling off a cliff in the middle of September. I think we need to remind ourselves that we were sliding downhill pretty fast before we hit that cliff. The third-quarter data, which aren’t really affected by what happened in the last two weeks of September, indicate that the economy was weaker than we thought at the time of the last FOMC meeting. I think Dave Stockton or Norm Morin noted that about a third of their downward revision reflected incoming data rather than the credit tightening. That was especially true for consumption, with real consumption spending falling through the summer, responding to lower employment and tighter credit. Private domestic final purchases were revised down to a decline of 3½ percent in the third quarter after being flat in the first half. Housing price declines picked up in August, and I think the deteriorating economy and concerns about the economy were reflected in increased nervousness in financial markets over the summer into the first half of September. It was really those worries about what the losses were going to be and how they would spread from mortgages to loan books generally—that deepening pessimism—that doomed the marginal institutions like AIG and Lehman and the GSEs. They just October 28–29, 2008 98 of 206 didn’t have a chance to recapitalize or stabilize themselves when so many of the other market participants were worried about what their own positions would be. The resulting flight to liquidity and safety, the loss of confidence that followed, the deepening gloom, and the failures and near failures and associated losses triggered a tremendous tightening of financial conditions over the intermeeting period—President Yellen and others discussed this—despite the 50 basis points of easing. Even after the 900 point increase yesterday, equity prices are down about 20 or 22 percent over the intermeeting period. The dollar is up 10 percent. Corporate borrowing rates are up for investment-grade corporations 200 to 250 basis points. Banks tell us that they’re tightening across every dimension of their lending; and other lenders, like finance companies, are also cutting back very, very sharply. You can see this in autos clearly, but the stress is much broader than just the auto finance companies. We have good programs in place to deal with many of these problems—the capital, the FDIC guarantees, and the Federal Reserve balance sheet facilities—and they are having some effects relative to the freezing up of markets that we had in mid-September. We can see that interbank spreads and LIBOR have come down some. Commercial paper rose, I guess, on Monday with the introduction of our facility. Declines in money market mutual funds have abated, though they’re still there, and there are some signs that maturities are beginning to lengthen in funding markets. As these programs are more fully implemented, we’ll see some greater effects—including, I hope, some greater willingness to extend credit. I also assume that the fiscal package is necessary, as in the Greenbook “fiscal stimulus” alternative. But we need to remember that the improvement we’ve seen over the last couple of days is relative to a situation in which funding markets were in effect frozen beyond a very short term, and although a sharp snapback is possible, as President Plosser was noting yesterday, I think further October 28–29, 2008 99 of 206 gains are more likely to be gradual. In the past few days, the declines in LIBOR have seemed very grudging and gradual, and LIBOR remains quite high—I think close to 75 basis points higher— relative to what it was in mid-August, before we even cut rates. This was three-month LIBOR that I looked at this morning. In an environment of economic weakness, spreading credit problems, falling house prices, a number of false dawns in this episode so far, and death and near-death experiences, lenders and investors are going to continue to be very cautious and conserve their liquidity and capital. So despite further improvements, financial conditions will remain quite tight. The effects of lower wealth, higher borrowing costs, the stronger dollar, and tighter nonprice terms of credit will play out over the next few quarters, putting downward pressure on an economy that was already in recession. At the same time, heightened uncertainty and fear of future problems caused a sharp deterioration in attitudes and spending even apart from the effects of credit. Judging from the Conference Board index, regional purchasing manager surveys, and anecdotes—including what we heard around the table yesterday—it feels like a recessionary psychology, as I think Charlie Evans called it. Others talked about pulling back and curtailment of discretionary spending in train, and this is not just caused by credit effects. This is just fear. So we’ve had a downward shift in aggregate demand as well as a movement along the aggregate demand curve, and this downward shift in aggregate demand will propagate through multiplier–accelerator effects even if attitudes begin to improve some. The global dimensions of the shock are important. As we talked about yesterday, heightened risk aversion has had a pronounced effect on emerging market economies as well as on industrial economies. Net exports cushioned domestic weakness in the first half of the year, but with the dollar strong, if anything we’ll be absorbing weakness from abroad, not exporting it, as the October 28–29, 2008 100 of 206 rest of the year goes on and we get into next year. Growing credit problems abroad will only add to pressures on many large global lenders who might have thought they were diversified geographically. But a little like our U.S. housing market, they will find that diversification doesn’t really work when there’s a global recession. The net effect of all of this is a much weaker growth path for the economy. In my forecast, I had a somewhat steeper near-term decline in economic activity and a slightly sharper bounceback than the staff, including my fiscal assumption, but I also have the unemployment rate peaking at over 7 percent, as the Greenbook did. With commodity prices plunging, the added slack maintained through several years, and declines in inflation expectations, inflation will be on a clear downward track. In the Greenbook, this downward track for inflation obtained even with the assumption of some rebound in commodity prices and the resumption of dollar weakness. In my forecast for inflation from next year on, inflation was at or below the 1½ to 2 percent rate I would like to see as a steady state consistent with avoiding the zero bound when adverse shocks hit. Critically, the downside risks around activity forecasts are huge and tilted to the downside. I think they’re huge because we’ve never seen a situation like this before, certainly not in my experience dating all the way back to 1970, and have only the vaguest notion of how it will play out in financial markets and spending. I think they’re tilted to the downside because I, like the staff, assumed a gradual improvement in financial markets. That could be delayed or even go in the wrong direction for a time, further tightening financial conditions. In addition, the effect on spending of the heightened concerns and tighter credit conditions could be larger and longer lasting than I assumed. For some time an important downside risk to the forecast has been a sharp upward revision to household saving as wealth, job availability, and borrowing capacity eroded. I assumed a moderate increase in the saving rate, but I can definitely see the possibility that adverse October 28–29, 2008 101 of 206 developments will galvanize a more thorough rethinking by the household sector of what saving is needed, and that will affect investment as well as consumption. We’ll get to the policy implications of all of this in the next round. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. The first sentence of the Greenbook said that “recent economic and financial news has been dismal”; and the last sentence on page 1 of the Bluebook said that “markets generally remain extremely illiquid and volatile.” I can’t do better than that, but I can certainly do worse; so let me give that a try. [Laughter] Market prices and official and corporate data confirm an additional leg down in midSeptember, which has been much discussed. I think it is going to become increasingly clear that October, particularly the first 20 days of the month, was materially worse. So if we fell off the cliff in the middle of September, I think that once the data come out and find their way into the marketplace in October, the Greenbook forecast might look a bit more positive than the facts on the ground would suggest. As a result, my own forecast is less optimistic than the Greenbook, but there is plenty of uncertainty, as I think Dave Stockton talked about yesterday. Let me make a few comments about financial markets before turning to the broader economy. I expect a prolonged period of significantly strained credit markets, and that strain is likely to be exacerbated between now and year-end and I suspect even well into 2009. The credit intermediation process that we’ve talked about is fundamentally broken. I talked six months ago about the financial architecture that was fundamentally being changed. I think that has all happened faster than I could have anticipated. Confidence, not just in counterparties but in basic rules of doing business across financial markets, has been lost, and my own sense is that loss of confidence is not easily fixed, even by well-intended government programs. We should all be quite patient in October 28–29, 2008 102 of 206 terms of seeing the benefits of the rather dramatic actions taken by the official sector, both here in the United States and overseas. Corporate bond rates and other risk spreads may well fall from their recent peaks, as suggested in the Greenbook, but spreads across asset classes are likely to stay far wider than historical norms throughout the forecast period. I think these new spread relationships are uncertain. So what we thought would be sort of normal spreads of LIBOR and normal spreads of corporate bonds, all have to be reassessed not just by us but also by market participants. Even if credit is now made more available to businesses through some of these new Treasury and other programs, I suspect the all-in cost of capital is likely to materially impede business investment, particularly given expectations by businesses for a weaker economy in the upcoming period. As Vice Chairman Geithner suggested, monetary policy might be able to do a bit about this, but it is not going to be able to change it very much. Let me turn to three points on the economy before closing. First, in the near term, given my sense of how October is tracking, it’s likely to be extraordinarily weak. I expect weaker fourthquarter consumption than the Greenbook, weaker labor markets going into 2009, and a materially weaker fourth-quarter GDP print. Some labor surveys—including some of my own preferred measures, like the JOLTS—seem to be holding up; but I’m not sure that that’s going to hold for another couple of months. So I’d expect the labor markets to trend more materially in the direction that I’ve discussed. Well, what about beyond the near term? What about 2009 and beyond? It strikes me that the catalysts for marked improvement are lacking. When I think about fiscal policy, regulatory policy, tax policy, and trade policy, which I talked about previously, it’s not obvious to me that any of those are going to provide some kind of catalyst for a marked change in the contour of the economy. On the fiscal front, I assume that the fiscal stimulus is likely to be larger, maybe even October 28–29, 2008 103 of 206 materially larger, than in the Greenbook alternative simulation, but my own conclusions are similar to the Greenbook’s, which is that I’m not sure it’s going to be terribly effective. I’m not sure it’s going to be constructed in that way, and I’m not sure it will do nearly as much as it will inevitably be advertised to do. A more disturbing trend probably even than the efficacy of a fiscal package— which in my own view is absolutely necessary, but again I query whether it’s going to be structured in a way to do what it needs to do—is that potential output in the forecast period is likely to fall. Trend growth rates are coming down, and I expect productivity to fall perhaps even more than in the Greenbook projection. The vaunted resilience of the U.S. economy, which I’ve talked about for a long time, is certainly going to be tested during this period. Business investment, it strikes me, will be a useful gauge as we get into the first quarter of 2009 to see how tough an economic period we have in front of us, and I worry about the decisions that business people will be making. Now, of course, against all of this, markets could snap back, as we saw a little yesterday—2009 could look better. We have to remain open minded about the possibility that the economy will continue, as it has over the past ten or fifteen years, to outperform model-based expectations. Let me turn to foreign growth. These decouplers, which were so prominent for so long, are somehow hard to find these days. Foreign growth strikes me as likely to fall faster and stay lower than in the Greenbook projection. The road back is not likely to begin as early as the first quarter of 2009 for our major trading partners. The “more financial fallout” alternative simulation strikes me as significantly more likely for foreign growth. In light of a growth trajectory that is better here in the United States than outside the United States, at least relative to current market expectations, I’d expect the foreign exchange value of the dollar on balance to strengthen against a basket of foreign currencies. October 28–29, 2008 104 of 206 So let me turn finally to inflation. The trend on import prices, the broad measures of commodity prices, and the expected dollar strength all suggest that inflation problems are abating markedly. I think an open question, which isn’t likely to be dispositive but is likely to be interesting, is how sticky prices are, particularly from the consumer product companies during this period—how long the various surcharges and increases in prices we’ve seen can stay high and the companies attempt to keep profit margins. My guess is that they can make profit margins look decent for another quarter or two; but beyond that, prices across a broad set of products and services are likely to retrace some of the gains in recent periods. I’ll save the balance of my remarks for the next round. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. MR. KROSZNER. Thank you. Well, the autumnal bonfires have really sort of heated up since the last FOMC meeting. I think we have evidence in the United States and now worldwide of what emerging market literature calls “sudden stops”—a sudden stopping of the flow of capital, the so-called flow of hot money, into Latin America or other countries and the devastating impact that could have when suddenly credit is no longer available. I’ve been talking about the slow burn of the problems in the credit markets, but I think we saw that move up to a different level globally over the past six weeks. This is the concern that we had earlier in the year about a regime shift. We seem to have moved from a growth regime to a sliding-by-with-some-growth regime and now to a contractionary one and the nonlinear effects that we had been concerned about. As we always say, it’s particularly difficult to predict where the economy is going to go. But there’s evidence of why it’s so difficult because almost any measure of volatility is up dramatically. That’s true on the financial market side, on the real side, as well as just in movements of consumer confidence. So I think that we can say with some confidence that it is particularly October 28–29, 2008 105 of 206 difficult to predict which way things are going to go. As many people have said before, a few spreads have come down, but given the extent of our actions and those of other governments around the world—central banks, fiscal authorities, et cetera—it is surprising that there has been so little effect. Now, maybe it’s just because so much is going on that there’s a fair amount of confusion and uncertainty about what the programs mean, how they will actually be implemented, and to whom they will be applied. I think that’s perhaps part of the reason for some of the spreads not coming down with respect to interbank borrowing—there is a lack of clarity about exactly how the FDIC program will operate and exactly how the TARP will operate. We’ll hear more about that in a bit, but I think it’s going to take time for people to feel confident about how that will work. Also, I think there is real uncertainty because after thirty days some banks may not get the guarantees or may have the guarantees pulled back. I think there is also a lot of uncertainty about who will get TARP funding and who is qualified for TARP funding. As information comes out about people not being qualified or markets being concerned that individual institutions are not going to be qualified, that could put on a lot of pressure. Unfortunately, that’s going to be coming in addition to the endof-the-year pressures. So I see a number of looming risks, particularly in the financial services sector, as we fully implement and clarify some of the programs that I think on balance can be helpful but that can actually cause some uncertainty at individual institutions. Others have also mentioned broader challenges in the emerging markets and the insurance companies and certainly we have the hedge fund redemptions that are looming. I’m very concerned about trying to get over the end of the year with so many different pieces putting additional pressure on. Even some of the pieces that we thought would be helpful potentially have a lot of downside risk to them. October 28–29, 2008 106 of 206 But even if we get through this—and the government guarantee programs, the special liquidity facilities, and the negative real rates that we have and potentially may make even more negative would provide some support—the fundamental uncertainty is not going to be resolved until we see what is going to work in the financial sector, what’s going to be the successful business model, and what are going to be the new sets of activities that can be undertaken. Will certain funding markets come back and at what spread once you take away all these special programs? Until that is worked out, I don’t see how the markets can figure out who will survive and who won’t, who is going to be there in three months and who isn’t. I think that the programs are very valuable in providing a time out—a time for people to reassess. But until there’s greater clarity in those financing markets going forward, I don’t think the markets will actually be able to recover. That why the alternative simulation that puts things off a bit more seems quite sensible to me. Some specifics on consumption. As I often do, I talked with some of the largest providers of consumer credit in the United States. They are reporting, exactly as Governor Kohn said, that consumption or spending growth was decelerating through the summer, but it did seem to get much more rapid in September and October. One of the large companies actually reported significant contraction on the consumer side of spending. On the small business side, it was still positive but down from double-digit growth in the second quarter to basically flat. They also looked across income categories. This is not a phenomenon of just the people at one or the other end of the spectrum. It seemed to be across the board for what they looked at. All of them have reported, just as the Senior Loan Officer Opinion Survey did, a significant reduction of credit lines. So even if we’re not seeing credit in and of itself having contracted yet, the ability to get credit down the line is going to be much, much more difficult. Also the funding markets for the credit card companies October 28–29, 2008 107 of 206 have effectively closed. They may reopen. Things may come back, but I think it’s going to take time for that to happen, and they were certainly not optimistic about that. As virtually everyone has mentioned, inflationary pressures for a variety of reasons are much lower, and I think that fits into what the Vice Chairman said about thinking about the costs of moving now and perhaps moving “too quickly.” There seem to be lower costs now in being a bit more aggressive than, let’s say, six months ago because much less inflationary pressure seems to be out there. I think a prudent risk-management point of view would certainly take into account those costs and benefits. We need to use our monetary policy tools as effectively as we can and then work with the other tools that a number of others have mentioned to try to get the markets to be more comfortable with where things will go and then be able to lend to each other—to have the unlocking of the credit markets without government guarantees, without negative interest rates, and without extraordinary liquidity facilities. Thank you. CHAIRMAN BERNANKE. Thank you. Governor Duke. MS. DUKE. Thank you, Mr. Chairman. I focused on the “more rapid financial recovery” scenario, not so much because I thought it was the most likely but just trying to think what it would take to bring that about. I’m not sure that the policy changes we have done recently will do that, but I am fairly certain that we are going to keep at it until we find something that restores confidence. I was shocked when I was looking at the Bluebook at how short a time has passed since the meltdown of all these major financial institutions—Fannie, Freddie, Lehman, AIG, WaMu, and Wachovia. There is a sense among those who were affected, who lost from it, that they just really didn’t see it coming, at least not at this speed, and that all of them had adequate regulatory capital, and the bankers at least were used to watching a sort of gradual burndown of that capital October 28–29, 2008 108 of 206 before institutions failed. They had a sense of being unable to predict who was going to be saved, who was going to get whacked, and who would be the winners and the losers. So subsequently both the banks and their customers froze, and there has been very little activity since then. All the banks I talked to reported having stopped doing business with one or more counterparties and that one or more counterparties had stopped doing business with them, and they were shocked by both of those things. So, first and foremost, it is clear that we need to restore confidence and predictability. In this sense, the recent moves to increase deposit insurance, to guarantee interbank short-term debt, and to provide capital on the same terms to banks of all sizes should be helpful—but only as long as we can do this without creating new uncertainty about who is going to benefit and who is not. Without being too subjective or too cute, we need at this point just to create confidence in our entire system. The demonstrable and preemptive support of the nine largest financial institutions; our public support of AIG; similar support of globally important banks by their home countries; and the resolution of Wachovia and National City, the two largest troubled institutions, without loss should help us avoid shocking surprises while everybody calms down. In this light, my conversation with the banks centered mostly on their reactions to the recent policy changes. All thought the deposit insurance increase was helpful. They varied in their estimates of the importance of the increase to $250,000, with a lot of them pointing out that for consumers they had already really restructured deposits to insure fairly large amounts, and several were using the CDARS (Certificate of Deposit Account Registry Service) program for larger depositors. They were even more enthusiastic about the coverage of transaction accounts, although one banker felt as though this coverage really hadn’t gotten as much visibility as it should, particularly with corporate treasurers, and many had already seen corporate and October 28–29, 2008 109 of 206 institutional deposits move into Treasuries and felt as though it was going to be difficult to get those back. There was even much more confusion about the guarantee of short-term debt. One banker questioned how they would know whether the fed funds sold to another bank actually fell inside the 125 percent cap. Another one thought that the all-or-nothing structure of the guarantee was a little difficult to work with. Interestingly, and as I pointed out yesterday when I asked about interest on reserves, nobody had even focused on it. They had bigger fish to fry. So I wouldn’t read anything into those early results. As for capital injections, most were taking a hard look at it. Two large community banks had just issued private capital to support growth that had been attracted from competitors, but they thought that they could profitably deploy the new capital. Other banks were interested in having the capital just in case they had the opportunity to buy weaker competitors, particularly deposits or branches in problem resolutions. None was really concerned about the announced restrictions, but a number of them were somewhat suspicious of the possible restrictions that might come later. Some small banks with already high levels of capital somehow felt pressured to apply anyway just to show that they would qualify, although they didn’t think it would give them much growth. In all cases, capital is only part of the story. They also need reliable funding if they are going to expand lending. This will have to come either from reliable deposit growth or from the reopening of secondary markets because all of them were reluctant to increase borrowing from any source. The loan-to-deposit ratio is growing new fans. In terms of lending, all reported that they were still lending to their relationship customers, and they were cutting back on credit to credit-only customers. As one defined it, if 90 percent of the revenue is coming from credit, then that was a customer relationship they wanted to exit. October 28–29, 2008 110 of 206 They still report no significant deterioration in the C&I book. I asked about drawdowns from companies, and across the board they said they had seen it in a couple of instances but really they had not seen an awful lot of that, so that might be some posturing rather than actual drawdowns on the credit. They are, however, exercising strong pricing discipline, and the pricing decisions, more than credit decisions, are being escalated up the approval chain, actively outreaching to customers that they want to keep and assuring them of credit availability. But because they have no pricing power on the funding side and pricing became very skinny on loans in recent years, there is a high level of sticker shock going on, which might explain some of the complaints about unreasonable terms. They also report very high levels of caution from their customers, with the descriptions ranging from “hunkering down” to “wait and see.” There were more anecdotal reports of companies riding trade credit by trying to accelerate receivables or extend payables. Now, whether this is due to the actual or to the perceived unavailability of credit from banks is not yet clear. Real pressure is on commercial real estate lending. They are very selective in new projects. They are processing renewals for only one year, using the opportunity to shore up pricing and underwriting, and no longer writing mini-perms. Nobody is doing those. So far, the performance is holding up on commercial properties, with strong performance on apartments and weakness showing up in retail. Residential construction and land development continues to be a problem. In visiting the San Francisco and the Kansas City Banks, I was shocked to hear the same story from large builders about land sales. One builder had a 300-acre parcel with a cost of $75,000 an acre, listed it for $15,000 an acre, and sold it for $10,700. Another reported a property with a cost basis of $120 million selling for $12 million. Apparently, the impetus for both of these transactions was a judgment that the cash received from tax refunds was more October 28–29, 2008 111 of 206 advantageous than holding out for better pricing. So the outlook for lending in residential construction or commercial real estate is dim far into the future, and I would say the same thing for syndicated or participated lending. However, to the extent that banks can exit those segments, it should free up funds for normal lending for businesses and consumers. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. President Fisher. MR. FISHER. Mr. Chairman, I would like to ask Governor Duke a question. Do you sense in this deep dive into the institutions that you talked to that they are benefiting from cuts in the fed funds rate? Are they enthusiastic or not about the prospect for a lower fed funds rate? MS. DUKE. Actually, I have heard a couple of reports that, when we did that last 50 basis point cut, banks did not lower their prime. A lot of banks still have prime-related credits. As we lower the rates, whether it makes a difference on anything else, it affects the prime, and there are still an awful lot of 5 percent CDs out there. So as we lower rates, we are cutting into those margins, and it is likely to turn some of them negative. MR. LACKER. Mr. Chairman? CHAIRMAN BERNANKE. President Lacker. MR. LACKER. I would just echo that. I have heard the same thing from bankers in our District—just vociferous complaints about lowering rates because their loan rates go down but their cost of funds doesn’t. MR. FISHER. Mr. Chairman, if I could just add one other thing. We are hearing more and more about people switching to LIBOR, trying to shift their lending contracts to LIBOR rather aggressively, obviously, because they are higher rates. But I’m wondering if you’re picking that up as well. October 28–29, 2008 112 of 206 MS. DUKE. Well, I don’t know. But just as soon as they get them switched over there, maybe we’ll be successful at bringing LIBOR down. CHAIRMAN BERNANKE. Okay. Thank you. Let me try to summarize all that I heard today and yesterday, and then I’ll try to add some new comments to that. The outlook for economic growth appears to have deteriorated quite significantly since the last meeting. Data on consumer spending, production, and employment had weakened more than expected even before the recent intensification of the financial crisis. Over the past six weeks or so, however, financial conditions have greatly worsened, and risk aversion has increased, despite actions here and abroad to stabilize the banking system. Equity values have declined sharply amid conditions of low liquidity and extraordinary volatility. Credit market conditions have improved modestly since the global actions to recapitalize banks and guarantee their deposits, assisted also by additional central bank liquidity actions. However, in almost all credit markets, spreads remain much wider, maturities shorter, and availability more constrained than was the case before the intensification of the crisis. Firms face continued funding risk and rollover risk. Banks have probably not reserved sufficiently for the credit losses to come, and hedge funds will be hitting their net asset value triggers in greater numbers, forcing them to liquidate assets. The duration of future financial turmoil is hard to judge, but it could be lengthy. The worst thing is that financial conditions appear already to have had a significant and remarkably quick effect on activity and consumer and business expectations and plans. Most Committee participants see us in or entering a recession and have marked down significantly their expectations for near-term growth or for the pace of the recovery. The difficulty of predicting the course of the crisis or its effects on the economy has also increased forecast October 28–29, 2008 113 of 206 uncertainty. In particular, the ultimate effects of some major policy actions, such as the creation of the TARP and the bank guarantee, are not yet known. Uncertainty about future policy actions, as well as uncertainty about the economy, has affected behavior in markets and the broader economy. Consumer spending has weakened considerably and probably fell sharply in the third quarter, reflecting in part a recessionary psychology. Consumer durables, such as automobiles and discretionary expenditures, have been particularly hard hit. This weakness reflects the same set of negative influences on consumption that we have been seeing for a while, now compounded by losses of equity wealth and confidence effects on prices, although lower oil prices may provide some relief. The labor market continues to decline, with many firms reporting that they are cutting back workers. The housing sector has not been noticeably worse than expected, and reports are somewhat mixed. But on a national basis, the contraction is continuing, and recent developments in the economy and credit markets are likely to have adverse effects. Inventories of unsold new homes remain high, putting pressure on prices. Nonresidential construction continues at a moderate pace; but backlogs are falling, and the sector is looking increasingly vulnerable to weakening fundamentals and tighter credit conditions. Whether a new fiscal stimulus package will be passed and to what extent such a package would be helpful remain open questions. Manufacturing production has weakened significantly as have expectations of demand, including export demand. Credit is becoming more of a problem for many firms and their customers. Spending on equipment and software appears to have slowed, reflecting greater pessimism and uncertainty. Falling commodity prices may reduce mining activity and cool the boom in agriculture. On the plus side, firms are reporting fewer cost pressures, and inventories do not appear excessive. October 28–29, 2008 114 of 206 Deterioration in global growth expectations has been marked. Industrial economies had already shown signs of slowing, and they have been hit hard by recent financial developments. Emerging market economies, until recently evidently not much affected by the U.S. slowdown, have in recent weeks also been hit hard by the spreading financial crisis. Together with the stronger dollar, these developments are likely to restrain future growth of U.S. exports. Inflation risks have declined materially, reflecting the fall in the prices of energy and other commodities, the stronger dollar, and the prospect of considerable economic slack. Firms report much reduced pricing power and lower markups. Inflation expectations have come down, both in the surveys and in the TIPS market, though it wasn’t noted—but I will note—that the TIPS market is distorted by illiquidity and other problems there. Most participants see both overall and core inflation moderating in the coming quarters toward levels consistent with price stability, with some seeing a risk of undesirably low rates of inflation. Some note, however, that financial dislocations affect aggregate supply as well as aggregate demand and may reduce the extent to which slower growth damps inflation. So that’s just my sense. Any comments? Additions? Let me make just a few additional comments, none of which will be radically different from what we have already discussed. I do think it is overwhelmingly clear that we are now in a recession and that it is going to be a severe one. To give some sense of perspective, the postwar record for duration is 16 months. If the NBER sets this experience as having begun early this year, I think we have a reasonable chance to break that record. The largest increase from peak to trough in unemployment rate was in 1981. It was 3.6 percentage points. Starting from 4.4 percent, I think we have a chance to come close to that number. Yesterday’s drop in consumer confidence in one month from 61 to 38 shattered the previous low of 43 in December October 28–29, 2008 115 of 206 1975. So I think we are talking about an episode here that could easily be among the largest postwar recessions. We don’t know how things would have evolved without the developments in September, but obviously we have to deal with that reality. It was just a few weeks ago that we were dealing with what might have been a true systemic crisis, in the week leading up to the G-7 and IMF meeting. I think it has been very fortunate that Europe, the United States, and other countries have adopted vigorous responses to that, including bank capitalization, bank guarantees, and other measures. That has been very important in calming the situation somewhat and reducing the systemic aspects of investor concerns. That being said, concern about counterparties remains very strong. Risk aversion is intense, spreads remain high, and I think that this has now become really pervasive. It isn’t just a question of junk bonds and weak borrowers or weak credit histories. The spreads on GSE debt, on high-grade corporate debt, and other areas have also widened, leading to a very broad based tightening in credit conditions. So I think that, overall, any reasonable reading of financial conditions suggests that the tightening of credit or financial conditions in the last six weeks or so has been quite substantial and overwhelms the effects of our coordinated rate cut. Now, normally you would expect to see a tightening of credit conditions affect the economy with some lag. It takes time for people to borrow money and to use the money they borrow to make expenditures. But compared with that prediction, we have instead seen a sudden stop—a remarkable and very rapid effect on economic activity. It is possible this is due less to the direct effects of credit availability and more to the psychological impact of these events. One possible analogy is the 1980 Carter credit controls, when the government announced what seemed to be a tightening of credit. There was a very sharp response in economic activity, October 28–29, 2008 116 of 206 probably based more on expectations than on actual credit availability. Unfortunately, the credit controls could be removed by government fiat; we are not able to do that today. One interesting development is that the labor market has not yet shown as much weakness as one would expect. Unemployment insurance claims and other indicators do not yet show a marked deterioration. I expect that we will see more deterioration of the labor market. Besides the intensification of the financial crisis that has markedly increased the restrictiveness of financial conditions, I think the other very important development since our last meeting has been the internationalization of the crisis. We had already seen weakening in Europe before the most recent intensification, but it has become much more severe. There is little doubt that the United Kingdom and Europe are in or about to enter recession. My sense is that their monetary policy responses will be stronger than what the Greenbook anticipates. I believe they will be very aggressive in responding to that. A new and particularly worrying development is the fact that the crisis has now spread beyond the industrial countries to the emerging markets. The G-7 weekend was quite an interesting one. It was a striking experience. I heard over and over again from the Indians, from the Brazilians, and from all over the world that, until the middle of September we were fine, we were not being much affected, we didn’t see much effect on our trade flows, and suddenly everything changed; and now we are under severe stress. We are seeing tremendous outflows. Our currencies are plummeting. Commodity price declines are hurting many countries. I think that is going to be a very significant development as we go forward. Just to give some data, in just a few weeks the EMBI spread, the emerging market sovereign debt spread, went from 280 basis points to 850 basis points; and the emerging market equity index has fallen about 40 percent since the last meeting. It is not obvious that these October 28–29, 2008 117 of 206 changes were justified by economic fundamentals. Many of these countries are very well run and had shown a lot of progress in their domestic policies and their domestic economies. Instead, I think they are suffering contagion from us mostly. Unfortunately, the implications of this will be not only the usual trade and commodity price type of implications but also, and even more important, financial implications. We are now seeing that the adverse feedback loop, which we’ve been talking about for a long time in the United States, is becoming a global phenomenon. In particular, European banks are very heavily exposed to emerging market debt. So we are going to see yet more of this interaction between the financial markets and the broader economy, except at a global rather than a national level. These developments, obviously, are very disturbing and don’t bode well for U.S. growth or now for global growth. Somewhat ironically, all of this deterioration in the global outlook has led the dollar to appreciate very sharply, which is interesting to say the least. For us that obviously also has important implications for inflation, and as Governor Kohn mentioned, it means that we will be less a recipient of foreign strength and more a supporter of foreign weakness than we have been until now. On inflation, I know there is some discomfort in talking about a 1 percent policy rate and promising to keep it low for a protracted period—and all those things. We have seen this movie before, and I think we all have to recognize the importance of watching the implications of that for our economy and for asset prices and to take quite seriously the responsibility for removing accommodation in a timely fashion once the crisis has begun to moderate. That being said, I don’t think that there is really any case in the near term to be worrying very much about inflation—or, perhaps even less so, the dollar—as we look at our policy. Pricing power is evaporating. And given what is happening in the global economy, I don’t see a commodity price October 28–29, 2008 118 of 206 boom any time soon, although I think as the economies do begin to recover in the next year or so that we might see some recovery in commodity prices. So I think that, as everyone has indicated, this is a very worrisome situation. I don’t think we have control of it. I don’t think we know what the bottom is, so we have to remain very flexible and very open to new initiatives as they become necessary. There has been some comparison of this to the Japanese situation. I’m beginning to wonder if that might not be a good outcome. The advantage of the Japanese was, first of all, that they were isolated. The rest of the world was doing okay, and they were able to draw strength from their exports and the rest of the global economy. Although they had very slow growth, they never really had a deep recession or big increases in unemployment. I think we are looking at perhaps a much sharper episode, and our challenge will be to make sure that it doesn’t persist longer. I do think that one lesson of both Japan and the 1930s as well as other experiences is that passivity is not a good answer. We do have to continue to be aggressive. We have to continue to look for solutions. Some of them are not going to work. Some of them are going to add to uncertainty. I recognize that critique. I realize it’s a valid critique. But I don’t think that this is going to be a self-correcting thing anytime soon. I think we are going to have to continue to provide support of all kinds to the economy. Let me stop there and, unless there is any question or comment, ask Brian to introduce the policy round. MR. MADIGAN. 7 Thank you, Mr. Chairman. I will be referring to the version of table 1 that was distributed to you on Monday. It is reproduced in the package before you labeled “Material for Briefing on Monetary Policy Alternatives.” Changes in the language relative to the Bluebook version are shown in blue. Starting on the right-hand side of the table, even though members saw the economic and financial information that became available over the intermeeting period as worse than expected, they might be inclined to leave the stance of policy unchanged at today’s meeting, as in alternative C. As noted yesterday, your 7 The materials used by Mr. Madigan are appended to this transcript (appendix 7). October 28–29, 2008 119 of 206 economic projections reveal that many of you anticipate that inflation pressures will diminish less quickly than the staff anticipates, and several of you noted explicitly that you thought less easing would be appropriate than was assumed in the Greenbook forecast. Also, the Committee already reduced rates in early October, responding to at least some of the adverse economic news. Moreover, the Federal Reserve has put in place additional facilities to support credit intermediation, and the Treasury and the FDIC are moving quickly with the implementation of other programs that should, with time, help stabilize financial institutions and markets and enhance the flow of credit to households and businesses. Finally, you might believe that the Congress is likely to enact a second fiscal stimulus package, possibly reducing the need for additional monetary policy accommodation. The rationale section of the statement suggested for alternative C would acknowledge the intensification of financial turmoil and the weakening of the economic outlook. However, it would also cite the range of policy actions taken in recent weeks as factors that should help over time to improve credit conditions and promote a return to moderate economic growth. The language on inflation would be essentially identical to that used in the Committee’s statement earlier this month, noting that the upside risks to inflation have been reduced. The risk assessment would state explicitly that the Committee’s primary concern is the downside risks to growth, suggesting a predilection for lowering rates. Nonetheless, with market participants anticipating an easing today—a 50 basis point move is seen as most likely—an announcement along the lines of alternative C would point to a much higher trajectory for the federal funds rate over the next few months than investors had expected. Short- and intermediate-term Treasury yields would likely jump, credit spreads probably would increase further, and equity prices might decline sharply. If the Committee is of the view that further policy accommodation is appropriate at this time but is also quite uncertain about the extent of rate reductions that will ultimately be required, it might be attracted to the 25 basis point easing of alternative B at this meeting. Members might have a less pessimistic outlook for the economy than that presented as the baseline in the Greenbook or might at least be quite uncertain as to the extent of the negative forces at work in the economy. At the same time, you may view the incoming information as suggesting that the 50 basis point easing earlier this month is unlikely to be sufficient to adequately balance the risks to economic activity and inflation. Given these considerations, you might see modest further easing today as appropriate and be prepared to cut rates again in coming months should developments warrant. The statement proposed for alternative B would note that the pace of economic activity appears to have slowed markedly, and it would repeat language from your early October statement indicating that the financial market turmoil is likely to exert additional restraint on spending. The announcement would also indicate that, in light of the decline in the prices of energy and other commodities, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability. As noted in a box in the Bluebook, we think that, in view of your previous policy October 28–29, 2008 120 of 206 communications, outside analysts would interpret such a statement on the inflation outlook as indicating that the Committee anticipates that overall inflation will drop to around 1½ percent to 1¾ percent before long, a indication that would be consistent with the central tendency of your inflation projections for 2009. The risk assessment in alternative B, paragraph 4, would cite the same broad range of policy actions that was proposed in alternative C, paragraph 2. It would indicate that the predominant concern of the Committee is the downside risks to economic growth. Market participants see a 25 basis point easing at this meeting as possible, but at this point they seem to place significantly higher odds on a 50 basis point reduction. The explicit citation of downside risks to growth would suggest that further easing could be forthcoming after this meeting, but this announcement still would suggest a higher path for the federal funds rate than they anticipate. Consequently, short- and intermediate-term rates might tend to edge up after such an announcement, credit spreads might widen somewhat further, and equity prices might decline. Under alternative A, the Committee would ease policy 50 basis points at this meeting. An economic outlook along the lines of the Greenbook forecast would provide one rationale for choosing this alternative. The Greenbook forecast for aggregate demand has been slashed dramatically, importantly reflecting a sharp decline in equity prices, a steep rise in credit risk premiums, and a considerable climb in the foreign exchange value of the dollar. One metric for this revision is the Greenbook-consistent measure of the short-run equilibrium real interest rate, r*, which has been cut nearly 3 percentage points since the September meeting to a level of about minus 3 percent. That level is about 2 percentage points below the actual real funds rate defined on a consistent basis. The staff outlook for a protracted period of substantial economic slack, together with the recent plunge in energy prices, points to a considerable diminution of inflation pressures, with overall inflation falling to 1½ percent next year in the Greenbook forecast—even with the Greenbook’s assumption of 100 basis points of further easing by early next year. But even those who are somewhat less pessimistic about the outlook than the Board staff might view the modal outlook as having deteriorated enough, or the downside risks as having increased enough, to warrant a 50 basis point rate cut today. The rationale language for alternative A in the revised version of table 1 is similar to that for alternative B, but alternative A, paragraph 2, notes additional factors that are restraining growth. The risk assessment, too, is similar to that for alternative B, but it references the rate reduction that would be implemented today under this alternative and notes that downside risks to growth remain, without saying that the downside risks are the Committee’s predominant concern. An announcement along these lines seems largely consistent with market participants’ expectations, and the market reaction would likely be relatively small. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Questions for Brian? All right. If there are no questions, why don’t we begin our go-round. President Lockhart. October 28–29, 2008 121 of 206 MR. LOCKHART. Thank you, Mr. Chairman. I think that this is a tough call. I support alternative B, with the statement wording as presented. In my thinking, a 25 basis point cut today is part of a total 75 basis point action, including the October 8 move. I believe the deterioration we have seen in September and October and the resulting downward revision of the outlook merit a cumulative response of this magnitude. That said, I am sympathetic to the view that we would be well advised to keep some powder dry to respond to shocks or developments ahead. I anticipate that, because a number of the dynamics in the markets have not really played out, we will have more shocks and they could come from further financial institution failures, corporate failures, a sovereign debt crisis, and market disarray; and in other markets, such as the municipal market, there is always a chance of a geopolitical event. In all likelihood these things come in combination or in rapid fire. So, as I said, I am sympathetic to the “powder dry” view, but I see the powder dry objective as being in conflict with responding to the recent deterioration. Therefore I come to 25 basis points or alternative B to some extent as a compromise, combined with the 50 basis points of October 8. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Yellen. MS. YELLEN. Thank you, Mr. Chairman. I favor alternative A, a 50 basis point cut in the funds rate. This action, and even more, is justified by the dramatic developments since our last meeting—a deepening of the recessionary outlook worldwide, the near meltdown of the global financial system, and the abatement of inflationary pressures. Frankly, it is time for all hands on deck when it comes to our policy tools, and the fed funds rate should be no exception. Although we cut the funds rate 50 basis points a few weeks ago, the Greenbook inflation projection was revised down more than that, so the ex ante real funds rate actually edged up over the intermeeting period. October 28–29, 2008 122 of 206 We need to do much more and the sooner, the better. One might argue against such a policy move in favor of a wait-and-see approach to better gauge if the recent flurry of policy initiatives will turn things around. In normal times, I would have some sympathy for this argument, but these are about as far from normal times as we can get. We are in the midst of a global economic and financial freefall, and the confidence of households, businesses, and investors is in shambles. The adverse feedback loop is playing out with a vengeance. Lenders continue to ratchet up terms and standards, sapping the ability of households and businesses to spend. As the economy weakens, further loan defaults will mushroom. I think strong, clear action is needed. Historical precedents, such as the case of Japan, teach us that it is a mistake to act cautiously as the economy unravels. I think the clear lesson from both economic theory and real-world experience is to lower rates as quickly as possible to avoid a deeper and more protracted recession, not to keep our powder dry or to wait to use tools until later if they are available to us now. The more medicine we give and the sooner we give it, the better. The Bluebook optimal policy simulations tell us that, absent the zero bound, the funds rate should be lowered well below zero next year. Since that is not an option, we should do the most with what we’ve got and cut the funds rate aggressively now. CHAIRMAN BERNANKE. Thank you. Governor Kohn. MR. KOHN. Thank you, Mr. Chairman. Like President Yellen, I support alternative A, the 50 basis point cut. I think it’s the right response to the very, very substantial change in the economic outlook since the last meeting. We would have cut the nominal federal funds rate by 1 percentage point and real federal funds rates by something less than 1 percentage point depending on what you think is happening to inflation expectations. But surely inflation expectations are coming down—and coming down substantially. October 28–29, 2008 123 of 206 I think the incoming information, the weakness before the shock hit in mid-September (which to me suggests that we didn’t have any insurance against that weakness at the time), the extraordinary tightening of financial conditions, and the downshift in spending that we’ve seen since mid-September all suggest that a 1 percentage point cut in the real rate, and even a little less than a 1 percentage point cut, would seem a very modest and moderate response to the shock. It’s probably a down payment. If the staff is right, we will need more. I built more into my own forecast. But even if the economy is not as weak as the staff has built into the Greenbook, I think a substantial cut in the federal funds rate is entirely appropriate. All of us—without exception, I think—said that there were downside risks to their forecasts, and a number of us have cited the possibility of a very deep recession here. So I think we need to take action. We are starting with a situation in which the economy is declining. We are in recession. The unemployment rate is rising. Inflation is falling. There is a global recession in train. It seems to me, from a risk-management perspective, that the costs of not doing enough—the costs of being reluctant to lower rates and making that situation worse—are far larger than the costs of going a little too far because things turn around faster. I think we are in a situation in which it is almost impossible at this point to go too far. Mr. Chairman, we may have to take it back at some point in the future, but right now I think the 50 basis points is absolutely justified by the conditions in which we find ourselves. I was drawn, as the Vice Chairman was, to the staff simulation having to do with a more rapid financial recovery. I myself think that’s a very small probability. But even if that’s what happens, we’ll know by December whether the financial markets are recovering faster. We can stop at 1 percent, if we’re getting that recovery; and the outcomes, as the Vice Chairman noted, really aren’t that bad in that recovery. So I think that even the small probability of a very sharp October 28–29, 2008 124 of 206 turnaround in the markets is still consistent with cutting rates another 50 basis points at this meeting. The fact that we are already low is not a reason to hold back. I don’t agree with the “keeping the powder dry” kind of argument. I think the lessons of history, including from Japan, are that the closer you get to the zero lower bound the more aggressive you should be. If you let weakness build, that weakness will overwhelm your policy tools. The most effective use of the limited scope for policy easing is to be preemptive and stop weaknesses from building. I think a 50 basis point easing will have beneficial effects. I don’t think that the markets will react very much. We won’t see those beneficial effects. But if I can compare it with doing 25 or nothing at all, I think doing 25 or nothing at all would have adverse effects. With 25 or nothing, you’ll get longer-term rates up, you’ll get stock prices down, and you’ll get an erosion of confidence at a time when we don’t need it—that the central bank doesn’t get how serious this situation is. I agree that the last easing was largely offset by the loss of confidence and the rise in uncertainty. I also agree that it might not feed through as directly and completely as it often does because banks are trying to rebuild and lenders are trying to rebuild profit margins. But I still think it will be effective. As I say, I convinced myself of that by asking about what would happen with the alternatives, and I think the alternatives would be far worse. We need to keep fine-tuning the TARP and the liquidity provision. We need fiscal stimulus. I agree with all of that. We need to move on lots of dimensions. But these things will not be sufficient in and of themselves to counter this. Monetary policy is a fairly blunt instrument, but we need to stimulate the spending wherever we can to do this. Some have expressed concern about circumstances forcing us to ease between meetings. We have done 50. Will that take us further? I think we need to make clear in our statement and October 28–29, 2008 125 of 206 our minutes—particularly in our minutes—that we do expect a weak economy going forward, at least a moderately softer economy, and that the process may call for further easing. I think it will call for further easing at the next FOMC meeting, but we can get to the next FOMC meeting and see. But it should take a substantial and unexpected deterioration relative to that path to justify an intermeeting action. So I think we are absolutely right to have a prejudice toward taking actions at meetings, when we can sit around and discuss things. The odds are high that we will need to go further, but we should do that at a meeting if we can. If we do have a very strong and substantial deterioration even relative to our weak outlook and we do end up moving between meetings, surely that move would not put us at a level that is unjustified by the circumstances. So I think we can deal with the intermeeting situation and not have the pressures of the market, the pressures of expectations, get us to a level at which we’re ultimately uncomfortable. In short, I think it’s a very serious situation. We need to do all we can to counter this situation. Now is not the time to hold back. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Rosengren. MR. ROSENGREN. Like the Greenbook forecast, our forecast predicts a significant recession. Further easing will likely help mitigate the severity of the recession. Coupled with improvements in short-term credit spreads, a reduction in the federal funds rate should lower rates on home equity lines of credit as well as business and consumer rates tied to LIBOR, easing cash flow for consumers and businesses. We are facing problems of historic proportions, both here and abroad. A 50 basis point easing, as in alternative A, is both necessary and appropriate. Even with the easing assumed in the Greenbook, the unemployment rate remains too high for too long. The inflation rate falls enough to be well below my target. To avoid a severe and October 28–29, 2008 126 of 206 prolonged recession, we will very likely need further monetary easing and a significant fiscal package, even after this 50 basis point reduction in the federal funds rate. I would just note in terms of the language that, although I am comfortable with the alternative A language, my actual views would be closer to saying “the predominant concern of the Committee is the downside risk to growth” rather than “nevertheless, downside risks to growth remain.” CHAIRMAN BERNANKE. Okay. Thank you. President Evans. MR. EVANS. Thank you, Mr. Chairman. After thinking about this for quite some time, I cannot convince myself that alternative A is not the right way to go. MR. KROSZNER. Let the transcript reflect that. [Laughter] MR. EVANS. You were very effective in listing a number of dire circumstances. The fact that we may challenge the maximum duration of a recession in the postwar period, any mention of the 1981-82 recession is very frightening, you even mentioned 1975 in terms of the reduction in confidence, and the 1980 credit crunch also—you were able to do that without any mention of the 1930s, and that’s quite compelling, I would say. So for the reasons that have been already discussed, the outlook is quite unfavorable, and I think that this will help improve matters. But as I thought about the concerns that I have, one concern is whether this will actually be viewed as effective today. I’m not sure about that. The last time we cut rates, financial stress intervened to swamp any beneficial interpretation of that. Whether that affects our credibility, I think that Don Kohn was very effective in mentioning that there will be credibility hits in the other direction if we don’t take some action like that. I do think that eventually things will subside and the beneficial effects of lower policy will be seen. About the dry powder argument, we are not going to have many more actions left after this, but I October 28–29, 2008 127 of 206 don’t see what the alternatives are other than to go ahead and put this in place. I don’t subscribe to the view that inflation is likely to be too low, although that is a risk. Inflation concerns, the financial stress, all of those issues, even taking into account the risk that President Bullard mentioned the other day, I think speak strongly to the fact that we’re running out of normal monetary policy options and that fiscal actions are going to be strongly important. So I do favor alternative A. Thank you. CHAIRMAN BERNANKE. President Hoenig. MR. HOENIG. Well, Mr. Chairman, I certainly understand how serious this matter is, and I guess I am of the view that alternative A is not going to solve much. There is a psychology, I understand, in the market that is going on, and I am not convinced that our continuing to take these actions and then having adverse outcomes is necessarily going to inspire confidence. I think we need to let our actions work their way through. Part of the problem is that the credit mechanism is stuck right now because of the tremendous uncertainties. Then I look at all of the things we have done over the last month, and the ramping up of the liquidity facilities has really exceeded even our ability to sterilize. So we have had, in effect, a funds rate that is well below our target. We have excess reserves in that period that were over $280 billion when they are normally $2 billion, and that was before we added more swap lines and more liquidity into the market. Frankly, I think we are at a point now where the liquidity mechanisms that we’re trying to use, not our interest rate targeting, are really our monetary policy. As we go forward, perhaps we need to think about how we are going to conduct monetary policy under a quantitative easing environment. That is what I think we will effectively be at if we move again today. So how we think about liquidity and about the credit mechanisms is really where more of our attention will have to be spent. Lowering the rate may have some positive effects, but I October 28–29, 2008 128 of 206 doubt it. So I would just stay where we are, let some of these past actions begin to work through, and see what the effects of those are before we then take another move because I think the market would just appreciate some stability over time in our actions so that they can see these things begin to work. It isn’t a problem of the interest rate level right now, in my opinion, so that’s why I would wait and see. Thank you. CHAIRMAN BERNANKE. Thank you. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. Clearly, forecasts have been marked down since our September meeting—mine included. This reflects the weaker data that we have obtained on the real side, especially consumer spending and manufacturing, but also worsening conditions in the financial markets. Accordingly, in an intermeeting move on October 8, we cut the funds rate 50 basis points. Yet the additional effect on the economy of financial turmoil during the last month remains highly uncertain. Spreads in many markets remain higher than at the time of our September meeting, but some have started to decline. If our new facilities have the desired impact, we may well see spreads continue to fall back to September or lower levels. It is very difficult to say at this time. Although I dislike intermeeting rate cuts, I supported the October 8 cut because it was part of a coordinated effort among central banks around the world and it seemed justified given that our growth outlook had deteriorated and inflation expectations had remained stable. We may well have to do more, but I think we are near the end of what we can do with monetary policy. Of course, it’s difficult to determine the appropriate level of the funds rate, and I want to draw your attention to the Greenbook, which showed that, whether we cut today or don’t cut today, the paths of GDP, employment, and inflation over the next year or two are not much different. In fact, in most models, cuts of that magnitude do not show up very heavily in October 28–29, 2008 129 of 206 real variables. I would also note that, according to the Greenbook, we could cut the rate to zero and have no effect on inflation, apparently, for the next four years. However, given the fact that rate cuts don’t have much effect, even in the Greenbook simulations, we have cut rates. It may not make much difference, as President Hoenig was saying. My preference at this meeting would be to stand pat and see how the data and financial markets improve. We are already engaged in extraordinary quantitative easing, even at this point, and we are hearing from bankers that the funds rate will do little to stimulate lending on their part or improve their balance sheets. Now, delaying necessary rate cuts is not desirable. But given the considerable uncertainty around our forecast, it is not clear that further cuts are either necessary or desirable or are going to be effective. And doing so for purely psychological reasons, from my standpoint, is a dubious way to conduct policy. A comparison of the baseline Greenbook forecast with the alternative scenario involving more-rapid improvement in financial conditions suggests that the appropriate policy path is very much dependent on knowing whether the increase in financial stress in September will be lasting. If conditions deteriorate further, which they might, we may want to cut in December. If conditions improve, this may not be necessary. Given the decline in confidence in our markets and institutions, I think the Fed can play a positive role by being a steadying hand. That’s another reason to wait a bit longer before moving again. I do not believe that we inspire confidence by appearing to react to market fluctuations. Even though that’s not what we’re doing, I fear that we often give that appearance. Moreover, although we have gotten positive reactions to the creativity of our liquidity programs, I think we have missed opportunities for raising confidence by rolling out our liquidity facilities in a piecemeal fashion. We had announcements made every day between Monday and Wednesday, October 28–29, 2008 130 of 206 on October 6, 7, and 8. I think it would have been far better to announce these actions as a wellthought-out package, explaining the intention of the individual pieces and how they related to one another. For example, we now have three different lending programs designed in whole or in part to support money market mutual funds. I have concern that we have been looking reactive rather than proactive, even though I know that some of these programs had been in the works for a while. I have argued that it is important that we think about our policy choices in terms of policy paths—that is, a dynamic path. The principles of dynamic programming suggest that we think about our policies in a backward-looking way. This, I believe, applies not only to monetary policy but to our liquidity programs as well. In this spirit, I believe that we must think hard about our exit strategies both from the liquidity programs and from our very low funds rate. I think we have dug ourselves a very deep hole in terms of the breadth and depth of our lending to the private sector. We seem, at times, to be the lender of first resort as well as the lender of last resort. We must make sure that we have a sturdy ladder that will enable us to climb our way out of this hole. This is especially important given the interaction between the programs and the differences across the programs in their current expiration dates. On the monetary policy side, we have added significantly to liquidity in the economy, as I alluded to earlier. Given the uncertainty surrounding our forecast, we may very well find ourselves in a position of having to reverse those injections sooner than expected. I am even more concerned with this planning process than I have been when I have raised this point before. The baseline funds path in the Greenbook is quite extraordinary from my perspective. It suggests that we can keep the funds rate low, below 1 and even close to zero, throughout most of the forecast period. Indeed, in 2011 the funds rate is still below 2 percent, even though the October 28–29, 2008 131 of 206 economy is growing at 4.4 percent. We may disagree somewhat on the magnitude of the contributions of our low interest rate policies in the 2003–05 period to the current problems, but I don’t think many of us want to repeat that episode. Yet looking at the baseline forecast and where the funds rate remains—below 1 percent or certainly below 2 percent for the next four years—it strikes me as a risky strategy at best and perhaps even a dangerous one. We have previously expressed views around this table that this Committee historically has been reluctant to raise rates in a timely fashion, and I believe that fear is reinforced by what I see in the baseline forecast in the Greenbook. That projection worries me a great deal. We must not act in a way that sows the seeds of the next crisis. Despite the pressure of the here and now, we cannot and should not ignore the consequences of our actions in the intermediate term. Managing our way from point to point, dealing with immediate problems, can very easily lead us to a place in which we do not wish to be—thus the importance of thinking in terms of a path. I think it would also serve us well to think about the process we will follow to unwind our liquidity programs in advance, so that we avoid unintended consequences across markets, and about the communication strategy that will ease the transition back to a more market based provision of liquidity. In sum, Mr. Chairman, although I would prefer not to move today, I recognize that my forecast is more optimistic than most. Moreover, I also accept the notion that there is a great deal of uncertainty about the outcomes and fragility in the marketplace, and your concerns are well noted. Thus, I will not dissent against a 50 basis point cut. But I would like to remind the Committee of our earlier discussions and the general agreement I thought I heard that, when the time comes, we will have to raise rates and we may have to do so aggressively. In all likelihood, October 28–29, 2008 132 of 206 that will occur before lagging indicators, such as the unemployment rate, are firmly on the decline. This is not the projection offered in the Greenbook baseline. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Bullard, you have a handout? MR. BULLARD. I do have a handout. CHAIRMAN BERNANKE. Everybody have a copy? President Bullard. MR. BULLARD. 8 Thank you, Mr. Chairman. I guess before I start, I just want to say that I generally agree with everything everyone is saying. This is a dire situation, and I am perfectly comfortable with that assessment. What I want to do with my comment here is just put on the table one idea about why a rate reduction might be counterproductive. That is what I’m trying to do here. The U.S. economy now appears to be in recession. Intensified financial market turmoil and very fluid expectations have created a very difficult situation. A key question for the Committee is what to do with the monetary policy piece of the policy response to the situation. We know that monetary policy is a blunt instrument that does not directly address fundamental problems in financial markets. We have other programs in place to try to address those problems more directly. We also have important fiscal actions, which are probably having the largest effect in trying to stabilize the current situation. Unlike the ECB, we already lowered nominal interest rates aggressively earlier this year in anticipation of the possibility of weak macroeconomic performance. We are now in the middle of a further round of easing, which is threatening to send nominal interest rates to zero, given the force of events. Is this the optimal policy, or could it backfire on the Committee? I want to at least lay out the possibility that a very low nominal interest rate policy may be counterproductive. My key worry is that housing markets remain at the core of the current turmoil. Mortgage markets— 8 The materials used by Mr. Bullard are attached to this transcript (appendix 8). October 28–29, 2008 133 of 206 $14 trillion or so, about one GDP—are based on nominal contracts. Deflation tends to be very destructive in an environment of nominal contracting. I want to stress that macroeconomic expectations are very important for the way the economy actually evolves and will evolve going forward and that those expectations are very fluid in the current environment. The Japanese experience, while it is not an exact parallel, represents an important reference point for the current situation. Japan’s problems were very real. Some have described the outcome as a lost decade. So let’s turn to the graph here for just a second. This is what I was talking about yesterday. This is an argument put forward by Jess Benhabib, Stephanie Schmitt-Grohé, and Martín Uribe. On the vertical axis is the nominal interest rate. On the horizontal axis are the inflation rate and inflation expectations, which in this graph are going to be the same thing. The diagonal line labeled “Fisher” is just a Fisher relationship. The nominal interest rate is the real interest rate, r, plus inflation expectations. Then policy is described by the line with the kink in it. The policy line means that, when medium-term inflation expectations are above target, we raise the nominal interest rate and, when medium-term inflation expectations are below target, we lower the nominal interest rate. That works beautifully around the targeted equilibrium, the π* in this environment, and all goes well. It’s just that, when you go to low nominal interest rates, strange things start to happen because you have to do something with policy as you come to very low nominal interest rates. You could just go to zero, and then you would have the horizontal line labeled “policy” that would go across all the way to the minus r there. Or you could stop at some earlier level. I chose something here to illustrate what the Greenbook seems to have in mind, say ½ percent. October 28–29, 2008 134 of 206 But any way you cut it, this is going to create another crossing of the Fisher relation and create a second steady state. This is the main point of the Benhabib analysis. You can layer on top all kinds of other stuff that you would like to include in your model, but most models are going to have a Fisher relationship, and most models are going to have the policymaker reacting by adjusting the nominal interest rate. So this other steady state, the steady state with low nominal interest rates, has deflation. If you get stuck there, in our current environment, this would exacerbate the housing problem a lot and make our problems much more severe. So this is just one caution about going to a very low nominal interest rate environment. When I saw this six or seven years ago, it had some influence on me. Before this, I was not worried about any of the zero bound issues. But then, this does make me a little nervous, given the core problem in our situation, which is the housing problem. That’s the argument. So let me set that aside then. One thing this line of research pointed out—and a whole bunch of papers have been written since this paper—is the existence of this second steady state and that the deflation associated with the trap steady state is a worrisome phenomenon. There are two steady states here. You can just argue that you don’t think the lower one is going to be the one the economy coordinates on and that eventually we are going to go back to the high one and that is perfectly fine. However, the Japanese case seemed to be zero nominal interest rates and a moderately low rate of deflation for quite some time. You could say that, if we coordinate on this low nominal interest rate steady state, we can somehow take fiscal policy actions to move off that to the other steady state. That is a more complicated issue. That has been addressed in the literature, and that is also a reasonable thing to say. I guess my main concern about this is, since it is a very dire situation and I think we are going to go very close to zero very soon, I want us to do it with October 28–29, 2008 135 of 206 our eyes open. It has some possibility of creating a worse environment. That is the only thing I wanted to say here. So my preference based on this would be to leave rates alone and say, “Let’s use fiscal policy.” I don’t think what we have now is an interest rate problem. What we have now are problems in credit markets, and I think they are being fairly well addressed by the most recent fiscal actions, including capital injections into the banking sector. So that would be my preference at this point. CHAIRMAN BERNANKE. Thank you. Let’s see, President Fisher. MR. FISHER. Mr. Chairman, if you had kicked around in the streets of Hong Kong in 1997, then you would have wandered into elementary schools and seen what we called at that time “Quotrons”—children trading stocks on the lunchroom floor. It was the surest indicator that the market was out of control. This morning I opened the Wall Street Journal, and on the front page they describe an exercise run by the Securities Industry and Financial Markets Association, which you know is Wall Street’s biggest trade group, with a similar program in American schools. It says that a 13-year old in Wilmington, Delaware—Michael Ashworth—is slumped by his computer, weary from another rough day in the stock market with all his favorite picks—Domino’s Pizza, the Hershey Company, and Gap—surprise! [Laughter] “I’ll be honest with you,” he confided, “before all this I asked my Mom to give me stocks for Christmas. But then, I told her not to do it. I asked for a parakeet instead.” [Laughter] Now, this is not as exotic or thoughtful a handout as the one from my colleague from St. Louis, but here’s the point. He may not get that parakeet because the pet store may not have access to credit. This is, to me, the fundamental issue that I think President Plosser—and I won’t repeat his arguments—and President Hoenig were referring to. The concern I have is not about the price of money. In fact, October 28–29, 2008 136 of 206 I think we are not seeing that kind of transmission mechanism—Governor Duke gave testimony to that earlier. All of us are aware that it is not moving as quickly through the IV tube as we would like it to because of the crimped nature of the tube. I have no problem with the language in alternative A, except for the first paragraph, and the phrase “including today’s rate reduction.” I have an open mind. I do think the issue in terms of restoring the system comes back to credibility and predictability. You cannot have a functioning capitalist system if you have total uncertainty. These are the issues that I believe President Plosser, President Hoenig, earlier President Lacker, and others were referring to in the first intervention. I thank President Geithner in particular for addressing the questions I asked yesterday, and there was reference to them earlier. We have done so much so quickly. We are in a quantitative easing period. The question is whether it actually makes a difference if we cut rates or not and whether the price of money is actually the issue or the fact that money is not flowing, that there are counterparty risks and rollover risks, and all the things we have talked about at this table and each of us has articulated in our public speeches. To be very honest with you, Mr. Chairman, I am open-minded about this because I could make that argument both ways. If it doesn’t matter, why not cut 50 basis points? Or why not hold? I am not convinced yet—and I’d like to listen to the rest of the arguments— that alternative A, in terms of the action, is the right way to go. I do think it’s very important that we be very clear and articulate in laying out how we see the world, and I do believe that the language in alternative A does the best job of all the columns that have been presented. But I come back to the question I asked before. What are the next steps? I’d like to know. What is the end game? I’d like to know before I cast my vote. I will conclude with actually once again agreeing with President Yellen, as I think I have done twice in history. October 28–29, 2008 137 of 206 [Laughter] The last time was at the last meeting. I think it’s very important that we have all hands on deck, that we have a unanimous decision. But, still, I would like answers to my questions. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. President Fisher, I promised you answers, and I will deliver them. President Pianalto. MS. PIANALTO. Thank you, Mr. Chairman. I strongly favor alternative A, a 50 basis point cut in our fed funds target rate today. I think it is important for us to move aggressively and quickly to offset the strong forces that are acting to depress economic activity. I know that some prefer a more measured response, especially as we move closer to the zero bound, but the lesson I take from history is that more and sooner is better than taking smaller steps over time. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Lacker. MR. LACKER. Thank you, Mr. Chairman. The economic outlook has definitely deteriorated. On top of the slowing at the beginning of the third quarter, a sequence of policy actions and statements has spread an inchoate fear. In response to that, a wide variety of economic agents have delayed outlays. The breathtaking credit market interventions that we have undertaken in the last several weeks are going to make it hard to judge whether those markets are stabilized. It is going to make it even harder to judge how and when to withdraw. Governor Duke asked rhetorically what it would take for recovery to begin. I think it is not going to be a very healthy recovery unless we have made substantial progress toward withdrawing these interventions. I know it’s probably premature in the midst of a crisis to be talking about the recovery, but a number of people did, and I think it makes sense on the grounds that President Plosser advanced for us to be thinking ahead. President Geithner talked about the October 28–29, 2008 138 of 206 will and the desire and that it amounts to a matter of will to reverse course later on. I think that in withdrawing these subsidies and these credit market interventions is where we are going to need the will. It is going to be really hard to disenfranchise somebody who now has access to one of these programs. The inflation outlook has improved. Expected inflation has come down. A couple of people have noted that. That brings the real rate where the interest rate is now—to about zero. So I can favor a 50 point reduction in the federal funds rate target at this meeting. I think a funds rate that is, in real terms as best as we can measure it, about minus 1 percent is how we should see our way through here, at least in the near term. Like President Evans, I will mention the 1930s. What I take from my reading of the Great Depression is that this is what central banks should do in times like this—keep real interest rates low. Let me make a couple of brief observations. As I mentioned yesterday, I think we are going to face a challenge communicating about our strategy. If we need to reduce interest rates to the lowest practical level to which we feel we can reduce them, I think yesterday’s discussion suggests that the Committee could use a refresher course on the monetary economics of the zero bound. I applaud President Bullard for his breaking new ground by providing a figure from the Journal of Economic Theory. [Laughter] I want to put something on the table about the federal funds rate. We are voting today on the target for the federal funds rate. The way our operations are conducted now, we are leaving so many excess reserves in the system that we are driving the federal funds rate down to the interest rate on reserves. The interbank risk premium is likely to become small as the FDIC guarantee becomes well understood and more broadly effective. The GSEs are likely to catch on that they deserve more on their funds. Small banks, as Governor Duke says, that haven’t really October 28–29, 2008 139 of 206 paid attention to what this new regime is about are going to find that brokers are going to be able to find them placements at closer to the interest rate on reserves. So I think that the sloppy trading below the interest rate on reserves is going to fade over time. As long as we have excess reserves at the scale that we do, as long as the Desk has added that many reserves, we are going to have the effective federal funds rate at the interest rate on reserves. Because we are voting on the federal funds target rate, I think that the Committee ought to have some understanding from the staff that either excess reserves are going to be drawn down to the point that the effective rate is lifted off the interest rate on the reserves floor or—and this would be my preferable course of action—we raise the interest rate on reserves to equal the target rate. Otherwise, we are voting on something, but we are actually doing something else. I can understand the desire to err on the side of soft rates. This is what we did in August 2007. But as rates go down, we need to be more and more careful about what the Committee is actually voting on. CHAIRMAN BERNANKE. Just to support what you said, we are obviously still trying to find our way in how to use this in the new regime with the excess reserves interest rate. It is possible that at some point we might decide to target that interest rate. That might be the most straightforward thing to do. But as I understand it—and, in fact, I’m quite confident—the intention of the staff and the Board is to try to figure out what the relationship is between the excess reserves interest rate and the federal funds rate as normally measured. If we can establish a reliable relationship, then we should try to—and we will—use that to hit the target. It’s coming close to it. We certainly are not trying intentionally to come under the target. If that fails, then we will go to what you are suggesting, which is effectively what I’m saying, and make them the same. Then, effectively, there is no difference between targeting the interest rate on excess reserves and targeting the federal funds rate. We are certainly open to that, and there is October 28–29, 2008 140 of 206 no intention to do anything other than to try to figure out a way to take the FOMC’s decision and put it into practice in the money markets. President Stern. MR. STERN. Thank you, Mr. Chairman. Well, financial headwinds continue to be a major part of my thinking about the economic outlook. Reasonable people can differ about that issue, but it seems to me that the headwinds are significant and they are likely to persist. Partially as a consequence and partially for other reasons, the economic outlook has deteriorated, and the inflation outlook, fortunately, has improved. So I favor alternative A, and I am satisfied with the language associated with it. Let me make just one additional comment. One way of thinking about lowering rates at this juncture and its potential effectiveness is that it is important to reduce the price of liquidity in this environment. I think that’s what lowering the target would do. That said, if I think about policy a bit beyond this meeting, I start with an observation that Governor Kohn made. We are probably going to receive a batch of pretty negative economic news over the next several months. At the same time, a lot of programs are in place, as everybody is aware; and perhaps my optimism is ill-conceived, but I actually think that they have the promise of being effective over time. So it’s not just a question in my mind of the nature of the news we get, but are we also seeing signs that all these programs are getting some traction and being effective? If they are, that ought to temper our desire to go further. Obviously, a lot of things are in play, and a great deal of uncertainty is present here and abroad. But we will simply have to assess all these developments as best we can as time passes. I think I’ll end my remarks there. CHAIRMAN BERNANKE. Thank you. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. Let me begin by agreeing with Don Kohn on two things. This is the toughest economic period I can remember in his lifetime, [laughter] and I October 28–29, 2008 141 of 206 support alternative A. I think the inflation trends and the trends in the global economy give us flexibility, which six months or so ago I did not think we would have. I think that gives us some degree of freedom that, given all of the negative tone, including my own, around the table, gives us at least some source of comfort. Next I would say that I agree with the consensus around the table, which is that these problems are not principally about monetary policy. But I also think that monetary policy isn’t irrelevant to this, and all agencies of governments around the world are making tough decisions, and the marginal benefits of further monetary policy changes strike me as not high but not irrelevant. I think President Plosser talked a bit about the alternative policy paths in the Greenbook that range from keeping the fed funds rate constant where it is to taking it to zero percent and the surprisingly small differences in output, employment, and core inflation there. In some ways, in the discussion that we’re having about 25 or 50 or moving or not, it would not be fair for any of us to overstate the importance in terms of directly affecting the economy in the short term. That goes to my final point, which is that the most valuable asset that we have isn’t what at the end of this meeting might be 100 basis points left of monetary policy. Frankly, it is the credibility of the institution and the credibility of the FOMC. If I compare our credibility now to virtually any other organization in the United States or maybe even globally, I think our credibility is holding up quite well, particularly relative to the degree of difficulty we have in front of us, relative to the trauma in financial markets and the weaknesses in the economy. So it is that asset, that credibility, that we need to continue to protect more than incremental basis point moves on the fed funds rate. I think that credibility will be tested over this period as it will for our counterparts. We don’t want to find ourselves in a corner come December or come a couple of brutal days in the markets where we feel compelled to continue to act and make 50 basis point moves unless and until October 28–29, 2008 142 of 206 we know where we want to end up on this. So I’m sympathetic to that point of view. We need to tell the story before the story is told for us of what our lower bound is, why it’s there, and what our diagnosis of the economy is. I think that the Chairman and the rest of us will have ample opportunity to do that between now and December and that it is quite important to make sure we come out of this as strong as we have been through this period so far. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. MR. KROSZNER. Thank you very much. Well, I’ve not been able to convince myself not to agree with President Evans. As everyone has said, we have this very significant global shift that has stepped down real activity and financial activity. The inflation environment has changed dramatically from a number of months ago with the change in commodity prices, the change in the value of the dollar, and the change in not just U.S. but also global resource utilization. I think we’ve seen just an enormous change there. Also, when you look at the expected federal funds rate path— we have to be careful in looking at anything in the markets these days because of liquidity, risk premiums, or term premiums that we’re not quite sure about—the markets are expecting significant cuts from us. They are not expecting any immediate or near-term significant increases in inflation, and I think all of the indications are that it will be going down. In a cost–benefit analysis, the costs seem relatively low in terms of the potential for inflation of doing this. Now, we have to think about it in terms of benefits, and a number of people have touched on the transmission mechanism. I do think that there are forces that mute the extent to which a 50 basis point cut translates into 50 basis points or lower on costs, but I don’t think they completely offset it. It still has the effect of reducing the cost of liquidity, reducing many people’s borrowing costs. I think it still does have an effect even if there’s an offsetting risk spread and even October 28–29, 2008 143 of 206 if there’s an offsetting bank action that affects that. So in terms of costs and benefits, at this time it seems that the costs are relatively low or muted, and the benefits are positive and potentially high. In particular, as I mentioned before, I’m concerned about the confluence of forces that may make things very difficult around the end of the year. If you look at a lot of these LIBOR or forward markets, they’re not coming down either in the United States or around the world. We have a lot of uncertainties with hedge funds, with the potential for other institutions getting into trouble, and with just the implementation of our policies—in particular, as I mentioned, the way the FDIC guarantee program and the TARP program work may end up singling out institutions and bringing them down more quickly than otherwise. So I think it makes sense in terms of cost–benefit analysis, even more so given the tail risk around the end of the year, to act now. We have another opportunity to act in December and obviously an opportunity to act at any point if we do see a dramatic change. We are getting near as much as we can do, but I don’t see the costs of acting more aggressively and more quickly here outweighing the benefits. So I support alternative A with the language as drafted. Thank you. CHAIRMAN BERNANKE. Thank you. Governor Duke. MS. DUKE. Thank you. I confess I find myself torn between the position of President Plosser and the equally compelling arguments of Governor Kohn, and that makes alternative B quite attractive as a way, not because of any optimism about the economic outcome, but I really do question the effectiveness of any move in the fed funds target given the actual trading of the fed funds rate right now. When we set the interest rate on reserves, at that point I was concerned that our interest on reserves would disrupt the market for fed funds between banks because of the risk premium. With the FDIC insurance, I think that goes away, and so probably President Lacker’s suggestion deserves some strong consideration. I am also painfully aware of the operational and October 28–29, 2008 144 of 206 financial difficulties that banks experience at a 1 percent fed funds rate and the likely difficulties of other intermediaries as the absolute level of rates falls further. As I stated in my earlier remarks, I’m also most concerned about the importance of predictability in returning confidence to the markets, and in that light, I am concerned about market expectations. But having recently been an expecter rather than a decider, I’m going to suggest that most of those doing the expecting don’t understand at all the issues that we’ve discussed here today. There’s a thought that, if the fed funds rate just comes down, it would maybe make this pain go away. So I agree with Governor Warsh that the public statements in the intermeeting period and as we approach the point where we simply can’t meet market expectations anymore are critically important to shape market expectations. So I do think it’s important that the markets focus on the other efforts, and with that I would support alternative A. CHAIRMAN BERNANKE. Thank you. Vice Chairman. VICE CHAIRMAN GEITHNER. Mr. Chairman, I support alternative A, both the action and the language for the reasons I said earlier. I just want to make a couple of other points. I think the only way to be predictable in a crisis like this is to be predictably inert or to be late. I don’t understand the basic argument that you add to confidence by being inert or by being late or, as the Chairman said, by being passive despite overwhelming evidence about changes in the outlook and risks to financial stability. The argument that makes me most uncomfortable here around the table today is the suggestion several of you have made—I’m not sure you meant it this way—which is that the actions by this Committee contributed to the erosion of confidence—a deeply unfair suggestion. Now, a lot of things happened over the last three months and the last year, and a lot of things happened in terms of policy over the last six weeks. There is no doubt that communication about October 28–29, 2008 145 of 206 policy by all the arms of the U.S. government and the uncertainty created by the actions by all the arms of the U.S. government contributed in ways to uncertainty about the policy response going forward. There is also no doubt that inevitably in a crisis like this, when policy moves forcefully, it is scary because a lot of people are not yet at the point of assessing or understanding the forces driving our decisions. But I think it’s just unfair to suggest that the actions by the Chairman and this Committee were a substantial contributor to the erosion in confidence and to uncertainty about further policy actions, even though it’s true that when we move with force and drama it has the risk of adding to uncertainty. I’d be very careful to look more broadly at the full range of other things that happened in that period of time, including, for example, the confusion established by the range of different choices for interventions in Lehman, AIG, the GSEs, WaMu in particular, and Wachovia and what that meant. Look particularly at the damage to confidence created by the Congress’s actions in the weeks after the legislation was first proposed. Compare that, for example, with the announcement effect of the initial thing. Look also at the uncertainty created around what the package was designed to do and how it was designed. But please be very careful, certainly outside this room, about adding to the perception that the actions by this body were a substantial contributor to the erosion in confidence. I think that Don Kohn said it best. The whole framing, which seems to have hardened now, that the world ended with the Lehman bankruptcy is just deeply unfair to the basic truth. Independent of whether there was an option available at the time, the erosion in underlying economic conditions and in confidence in the future outlook was powerful and substantial going into August and early September. So I just offer that. You know, everyone wants to quote FDR. FDR said at one point, “If I judge the mood of the country right, what this calls for is bold experimentation.” I do not believe that this Chairman October 28–29, 2008 146 of 206 and this Committee have been irresponsibly experimenting at the cost of predictability and confidence going forward. What we have done is a relatively well designed series of escalations in monetary policy and liquidity intended to be preemptive against what we knew was substantial risk of a very adverse economic and financial outcome. The risks were not broadly shared, not just in this room but outside. But I think the judgments by the Chairman were largely correct in weighing those risks appropriately at that time, and I think we all owe him a substantial amount of deference for the judgments he made and his wisdom. Both here in this room and in the effect he had on the policy choices that the fiscal authorities also ultimately made look very good now and will look even better over time as people understand how grave and substantial the risks were that we were facing in the economy and the financial system. One last point to President Fisher’s question. President Fisher asked the obvious question, which is, What next? I think a very good approach to decisionmaking is to say, “I don’t want to know so much about this. I want to know about the next three things.” I know the Chairman is going to give a nice, thoughtful, and complete answer to this. But I would just say the following: We don’t need to know today what is next on the monetary policy front. We know there may be some arguments for going lower than 1 percent. We have to think through very carefully the collateral damage consequence in terms of what that does to market functioning and behavior. We have to look at the alternatives to that, including in communication. A range of other policy options are within our capacity to influence and effect that will give us the ability to minimize downside risk going forward. But I don’t think that we need to know—and we cannot know with precision—what the optimal mix of those things is now before deciding what to do, although I’m very sympathetic to the basic judgment. The question really is, In moving today, are we going to do more harm than good to our ultimate objective? It’s very hard to make the case that we do damage to any of our October 28–29, 2008 147 of 206 basic fundamental objectives and mandate. I can see a much stronger case that we do a lot of damage to those if we don’t act today, even though we all recognize that ultimately this is going to require more than monetary policy to address the risk here. CHAIRMAN BERNANKE. Thank you. President Plosser. MR. PLOSSER. I’d just like to just take a moment to react. I’m not sure whom you heard saying that the result was primarily a result of this Committee’s actions or the Chairman’s actions or anyone else’s actions. If those were words you were putting in my mouth, that was not what I said, President Geithner. I do think I have been supportive of almost all the actions in terms of liquidity facilities; I supported the actions. I also was supportive of the Lehman Brothers decision. But I think it’s a far cry from saying that uncertainty about policies contributes to uncertainty—which you agreed to—it’s a far cry from that to saying we lay the blame at the feet of this Committee or the Chairman. So I don’t know what straw man you were setting up, but it certainly didn’t apply to this member of the Committee. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Okay. Thank you. Let me just offer some thoughts that may be somewhat more expansive than usual in response to the questions that have been raised. Some of this is extemporaneous, so you’ll have to bear with me. Let me first talk about the strategy we pursued thus far and where we are and then think about where we might go as a country as well as an institution going forward. Without going through all of the familiar discussion about how the crisis began, what the sources of it were, I think that the Federal Reserve’s responses are essentially three. First, we were relatively early and aggressive in our monetary policy easing, particularly compared with other countries. Second, we have been creative and expansive in our use of liquidity tools, including a October 28–29, 2008 148 of 206 wide variety of lending programs. Third, we have used our available, but not always adequate, tools to try to stabilize systemically critical failing institutions and to try to mitigate systemic risk. Without sounding too defensive, I will try to argue that I think on all three of these we have been more or less in the right direction. First, on the early and aggressive monetary policy easing, obviously there was a lot of concern—a lot expressed abroad that we were going to create a stagflationary 1970s type of situation and that we were going to destroy the dollar and its role as an international currency. Our response essentially was that we thought that the increases in commodity prices were mostly a relative price change induced by changes in real demand for commodities and in the supply of commodities across the globe and that, at some point, those commodity price increases would stabilize, which would lead to a moderation of the inflationary effects and concerns. It took longer than we had expected; but once it began, it was more pronounced than we had expected. Inflation has not become the problem that was anticipated by many early on, and the dollar, of course, is now stronger than it was before we began our cutting of interest rates. So in retrospect, I think our monetary policy, although not perfect certainly—and our communication was not always perfect—broadly speaking was appropriate given what has turned out to be a very severe economic situation. Liquidity expansion also received some criticism early on. There was a view that this was inducing moral hazard. There was also some question of whether this was an effective approach. We were helped in this respect by the fact that the ECB joined us very early in this type of aggressive policy. I don’t know the counterfactual. It has obviously not solved all of the problems. But I think there’s a strong perception in the markets and in the general public that these actions have been supportive, and they helped mitigate the effects of the crisis on the functioning of the financial system. So I feel comfortable also with that approach. October 28–29, 2008 149 of 206 The attempts to stabilize failing systemically critical institutions, beginning with Bear Stearns, have obviously been very controversial. There have been criticisms from the right and from the left. From the right, the initial criticism was that we have no business interfering with the market process. We should let them fail. The market will take care of it. What are we doing? We heard this as recently as Jackson Hole. I never took this seriously. I just don’t believe that you can allow systemically critical institutions to fail in the middle of financial crises and expect it to be not a problem. I don’t want to get into the issue about the inconsistency. It’s true that we treated senior debt differently between Fannie and Freddie and WaMu and Wachovia, but I don’t think that that is the reason we are having the financial crisis we’re having. I think there was a panic brought about by the underlying concerns about the solvency of our financial institutions. That panic essentially turned into a run. Companies like Wachovia that had adequate Basel capital faced a run on their deposits, which was self-fulfilling. The investment banks essentially faced runs. We did our best to stabilize them, but I think that it was that run, that panic, and then the impact the panic had on these major institutions that was the source of the intensification of financial crisis. So I don’t buy the argument that we should stay out of the business of protecting the financial system, and I think that the major factor was, in fact, the panic that was generated by the underlying uncertainties and the effect that had on critical institutions. Also more recently we have heard more of a critique from the left, which is, What in the heck were you guys doing letting Lehman fail? This is interesting given that the critique had been the other one for quite a while. I think that critique is unfair at a narrow level in that, first, Lehman was a symptom as well as a cause of the recent crisis and, second, the Fed and the Treasury simply had no tools to address both Lehman and the other companies that were under stress at that time. I think that criticism is appropriate, though, as directed toward the United States as a whole. We did October 28–29, 2008 150 of 206 not have—as the Europeans have or as we have FDICIA for banks—a system that was set up to allow a reasonable and responsible orderly resolution of nonbank systemically critical institutions. I think we now have made a lot of progress there. The TARP will provide a good interim solution. It is very important that in the future we address the too-big-to-fail problem that we have, that we find ways to reduce that problem, and that we find ways to deal systematically with firms that are in crisis. So given the fog of war—which has, of course, been intense going back for more than a year—I would defend what we’ve done in terms of the general direction, acknowledging that execution is not always perfect and that communication is not always perfect. Now, what about the future? History suggests that, whenever a financial crisis becomes sufficiently severe, ultimately the only solution is a fiscal solution, and we will have a fiscal solution. There are two possibilities. One is that the financial system will muddle through, in which case the fiscal solution will be of the sort we’ve already seen: injections of capital, support for critical firms, support for the credit markets in general; Keynesian-style demand support. That’s one possibility. I hope that’s where we’re going to be. In my own testimony, I argued that we should try to focus whatever stimulus we have in solving the underlying problems rather than simply handing out money and that we could do that, again, by addressing credit markets. I would add, foreclosure, homeownership, and some of those issues as well. So I hope that’s where the fiscal policy will be. I hope that will take the lead from us going forward. Obviously, we’ll have to continue to play a supporting role in a lot of different ways. The other possibility, of course, is that things get much worse and that we are in the same situation as Sweden or Japan, in which case a massive recapitalization of the banking system will be necessary. That will eventually happen, but I just note that, in all of these fiscal dynamics, there is a political economy overlay. You have to get to the point that it is not only the right policy to induce October 28–29, 2008 151 of 206 fiscal support but also that it is politically possible. That’s one reason that I think the TARP was not possible before the most recent period. In fact, it was barely possible recently. So, again, I believe that fiscal policy will have to be a critical part of the solution going forward. Another part that we should not forget about is the international response, which is now just beginning really to become serious. The responses after the G7 weekend on banks and bank guarantees were important and suggested a commitment by other countries to stabilize the system. That’s very important. I think we will see aggressive monetary policy going forward, and I think we’ll see increasingly aggressive fiscal policy in other countries because they recognize that the decoupling is no longer a realistic story. So that’s going to be important as well. With respect to the Federal Reserve, just generally speaking—and I’ll come back to the specific recommendation for today—again, I think that our liquidity provision has been constructive. It has allowed the use of our balance sheet to help push in the deleveraging process that’s been going on now for more than a year. My guess is it will probably expand some more, but I don’t see it expanding a lot more, if for no other reason than we are reaching the limits of our operational capacity as well as balance sheet capacity. I think we have been reasonably successful in staying on the side of liquidity provision and not straying into credit or taking credit risk. I want to stay on that side of the line both for legal reasons and because that’s the way monetary policy and lender-of-last-resort policy are supposed to work. Again, I hope that the fiscal interventions will now be able to take away some of these responsibilities from us, but we’ll have to see how they play out. I confess that I hear President Plosser’s concerns about reversing these programs. I recognize that it’s something we’ll have to do carefully. But I just don’t see it as being something that will be a huge problem if the economy begins to recover and credit markets begin to function October 28–29, 2008 152 of 206 more normally. I think we’ll be able to do it. Japan was able to get out the quantitative easing without too much difficulty. But I acknowledge the point that it is something we’re going to have to plan for and think about. On monetary policy, I think it is important for us to be responsive. Even if we stipulate for the moment that the interest rate changes we might make today have a minimal effect on the cost of capital—and I don’t necessarily agree with that, but let me stipulate it—there is still the importance of the signaling and what we’re trying to tell the markets about what we plan to do in the future. Frankly, I don’t think that we should try to signal that we are going to stand pat, that we are reluctant or refuse to move lower. We have to be prepared to move as low as makes sense. By that I mean in part that there are institutional factors that affect the efficacy of monetary policy at very low interest rates. We’re all aware of that. I asked yesterday, and I’ll ask again, for the staff to go back to the 2003 work, to update it, and to think it through and help us understand what I would call the effective zero. What is the real zero? Is it zero? Is it 50 basis points? Is it 75 basis points? We have to recognize that if we do go to literal zero, it would have very substantial effects on a number of financial markets, and we would have to ask ourselves whether the benefits from that are worth the dislocations. The Japanese thought they were, and for example, they did shut down the interbank market for a long time. Maybe doing it is worth that. Those are decisions that we need to make before the next meeting, and we will have opportunities to talk about this together and in public as well. But I do think that monetary policy needs to be proactive and to continue to be part of the solution here going forward. What about today’s action? I essentially accept the general change in outlook as proposed by the Greenbook. Since our last meeting there has been an effective tightening in financial conditions, which has overwhelmed the 50 basis point cut that we did with the other central banks. October 28–29, 2008 153 of 206 The outlook has become much worse. So it is important for us to act aggressively and to signal essentially that we’re willing to do whatever is necessary to support the recovery of this economy. There has been a lot of talk about confidence. I think the best thing we can do for confidence is to say that we’re going to do whatever it takes, even if it involves extraordinary actions, to get this economy back onto a path where it can begin to grow in a reasonable way again. Signaling coyness, being cute, is not a safe strategy right now. We just need to be straightforward and say that we’re going to do what it takes. In my view, just to be specific, 50 basis points is the right step today. Now, a number of concerns and objections have been raised. Let me address just a few of them. One is President Bullard’s very interesting presentation on the inflation trap, and intuitively it’s clear that, for a given real interest rate, you can have an equilibrium at which you have a high nominal rate and a high expected inflation rate or you can have a low nominal rate and deflation. Both of those things are possible. That was the trap that Japan got into. We obviously want to avoid the deflation trap. The question is, How do you avoid it? As far as I can see—obviously we can get further into this—the best two ways to avoid it are, first, as President Lacker suggested, reaffirm our commitment to price stability defined as 1½ to 2 percent or whatever our Committee’s general view is. We’re going to try to do that with our projections and potentially with the trial projection that we’re doing, and I think we can continue to strengthen our commitment to maintaining a positive inflation rate. The other thing, in terms of the dynamics, is to be aggressive in trying to avoid getting to a deflationary situation, where those expectations move in that direction. I don’t think deflation expectations will arise spontaneously because we’re cutting interest rates. I think they’ll arise because the economy is expected to be extremely weak, and anything we can do to eliminate that expectation in my view would be helpful. October 28–29, 2008 154 of 206 The second objection I’ve heard is the question of whether or not these actions are effective. I think they are effective. Maybe they’re not as effective as under normal circumstances, but let me put it to you this way. If we cut 50 basis points today and the LIBOR–OIS spread rises 50 basis points tomorrow, I will accept that there’s a problem. But if the LIBOR spread doesn’t move much and the overall LIBOR drops 50 basis points, then I think that we’re having an effect. If you look at LIBOR over the past year, you’ll see a dramatic decline even though the spreads have widened. I don’t think you can argue that we’re not having any effect. To the extent that we’re having a muted effect, you can just as well argue that we should be more aggressive because you need to do more to get the same impact. So I understand those concerns, and I reiterate, responding to Governor Duke and others, that as we get very low, there are side effects on certain institutions and financial markets. We need to understand those, and that’s part of our decision process. But I don’t think it’s the case that monetary policy has zero impact. The third argument I’ve heard is the “keep the power dry” argument. Unless you think that movements in the rate are entirely psychological in their effect, I don’t think that that’s a strong argument in this particular circumstance. Again, we analyzed this quite a bit in the 2003 episode, and the general outcome from the literature and from simulations done by our own staff—Dave Reifschneider, John Williams, and others have published research on this—is that the best way to avoid the zero bound is to be more aggressive than normal to try to avoid the accumulation of weakness and try to avoid getting into that trap. So more-preemptive strategies are, in fact, consistent with what we’ve done for the last year. My recommendation for today is 50 basis points and the language in alternative A. I do think that it will be at least moderately beneficial both in terms of psychology and in terms of reducing the cost of funding and giving some additional support to funding markets. I hope that in October 28–29, 2008 155 of 206 these remarks, which again are somewhat extemporaneous, I have addressed to some extent the future steps. We ought, again, to think very hard in the next six weeks about what the real zero is and what the implications are of going below, say, 75 basis points. Then we ought to make a determination, and it may be that we can sit still in December. It may be that things improve quite a bit in the markets, for example. It’s possible. One advantage of doing 50 today is that we almost certainly will not have to do anything intermeeting because we will have done this significant step today. So in December we’ll be able to look at the situation. We may be able to do little or nothing—it is possible. But if we decide that further action is needed, at that point we should be prepared to decide what the regime is going to be, how far we’re going to go, and what the effective zero is, and I think that we shouldn’t hesitate to do that if that’s what the situation calls for. So I think there is a way forward. I understand the need to withdraw all these policy actions at an appropriate time. But I don’t think that focusing on the near term for the moment is at all inconsistent with the fact that at some point these things will have to be reversed. So, any further questions or comments? President Fisher. MR. FISHER. First, I would like to thank you, Mr. Chairman, for that very thorough and clear elucidation. I meant to mention earlier that I actually agree with President Evans. It’s worthwhile now and then evoking Ronald Reagan. What I mean by that is not his “Where’s the pony?” comment, but more important, the reason he was so successful as a leader was that he had clear objectives, they were limited, and they were well articulated. It doesn’t matter if you’re a Democrat or a Republican. I think it’s very important for us to understand what our objectives are in order for us to be fully supportive. By the way, Tim, as Mr. Plosser has been, I have been fully supportive of all of these initiatives. Again, I want to thank you, Mr. Chairman, for helping us understand better the cognitive road map because it is critical for all of us to do what Janet October 28–29, 2008 156 of 206 suggested, which is have all hands on deck and make sure we’re all fully supportive. Against that background I would support alternative A. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Other questions? President Plosser. MR. PLOSSER. Just a question or thought. As the staff prepares the review of the 2003 studies and memos and thinks about what zero effectively means and how we might operate in those circumstances, one thing I think would be useful to include is a discussion of whether or not when that time comes we announce that publicly and say, “Okay. This is it. From now on we have to do X, Y, or Z,” and make it part of the communication strategy. Maybe they would anyway. But if we get to the point where we now as a group have some concerns that, well, effectively we really don’t want to go below X, we will have to do some other operational actions as a substitute for that. CHAIRMAN BERNANKE. I think there’s no problem doing that. I can do that. That is not a problem. President Lacker. MR. LACKER. Yes, I also strongly support your charge and direction to the staff to assemble with all due haste updated information for the Committee about what the effective lower bound on nominal interest rates is. But I’d urge you, along the lines of what President Plosser suggested, to include in that charge what we would do once we got there, what we could do, and what would be open to us. I emphasize again the relevance even if we don’t get there because analytically we’re effectively doing that right now with interest on reserves. The classic economics of this is that, when you get down to effective equivalence between a monetary asset and a government bond of one-day duration or whatever, to be effective monetary policy needs to be fiscal policy. It needs to acquire other assets that we wouldn’t normally otherwise acquire. We’re doing that right now. So I’d emphasize the importance and relevance of that. VICE CHAIRMAN GEITHNER. Mr. Chairman. October 28–29, 2008 157 of 206 CHAIRMAN BERNANKE. Vice Chairman. VICE CHAIRMAN GEITHNER. I also think it would be helpful, as the staff looks at the policy options going forward, that they do other parts of the communication options, too—not just those but also other ways to think about how to make policy for looking at and communicating a path that are different from what we did in 2003. It would be good to look at options for how we talk about policy going forward in that context along with just the operational choices and the policy choices. CHAIRMAN BERNANKE. President Plosser. MR. PLOSSER. Just to follow up on that—I think that’s a very excellent suggestion, President Geithner. To be very specific about that, in our trial run, one thing that we did was to look at what we thought was the steady state. One way to engender some communication about the longer run might be to include what the Committee thought the steady-state neutral level of the funds rate would be in that environment. I’d describe the path by which we got there; it would convey some sense to the marketplace of what we thought would be in some normal world a reasonable level of the funds rate consistent with those targets. I just throw that on the table as something to think about. CHAIRMAN BERNANKE. Okay. Other comments? Would you call the roll, please, Debbie? MS. DANKER. Yes. This vote encompasses the language of alternative A that was in the package passed out earlier today as well as the directive from the Bluebook, which states the following: “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, October 28–29, 2008 158 of 206 the Committee in the immediate future seeks conditions in reserve markets consistent with reducing the federal funds rate to an average of around 1 percent.” Chairman Bernanke Vice Chairman Geithner Governor Duke President Fisher Governor Kohn Governor Kroszner President Pianalto President Plosser President Stern Governor Warsh Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes CHAIRMAN BERNANKE. All right. I’ll need the governors to join me in my office for just a moment. Everyone else, let’s all take a twenty-minute coffee break. When we come back, maybe we can start at that point with your briefing, David, on the TARP, and around 12:15 we’ll break and get lunch and hear the end of the briefing, if that all works for everybody. VICE CHAIRMAN GEITHNER. The expected duration of the next part of our meeting is four hours, three hours? [Laughter] CHAIRMAN BERNANKE. We should be done by 1:00. MS. DANKER. It’s not part of the meeting. VICE CHAIRMAN GEITHNER. The nonmeeting part of the meeting? CHAIRMAN BERNANKE. It’s only a briefing, not a meeting, once we come back. Okay. A twenty-minute break now and then we’ll have a briefing and lunch. [Recess] CHAIRMAN BERNANKE. Well, let me officially get to the point of adjourning the FOMC meeting just by first noting that the next meeting is Tuesday, December 16. Put that on your calendar. VICE CHAIRMAN GEITHNER. That’s a long way away. [Laughter] October 28–29, 2008 159 of 206 MR. PLOSSER. Can’t we meet before then? [Laughter] CHAIRMAN BERNANKE. I’d like to remind you that you have until 5:00 p.m. on Thursday to submit revisions to your economic projections, in case the markets change your views. MS. DANKER. Only through today’s meeting. CHAIRMAN BERNANKE. Sorry—using information only through the end of today’s meeting. All right, the FOMC meeting is adjourned. Thank you. END OF MEETING December 15–16, 2008 1 of 284 Meeting of the Federal Open Market Committee on December 15–16, 2008 A joint meeting of the Federal Open Market Committee and Board of Governors of the Federal Reserve System was held in the offices of the Board of Governors in Washington, D.C., on Monday, December 15, 2008, at 2:00 p.m., and continued on Tuesday, December 16, 2008, at 9:00 a.m. Those present were the following: Mr. Bernanke, Chairman Ms. Duke Mr. Fisher Mr. Kohn Mr. Kroszner Ms. Pianalto Mr. Plosser Mr. Stern Mr. Warsh Ms. Cumming, Messrs. Evans, Lacker, and Lockhart, and Ms. Yellen, Alternate Members of the Federal Open Market Committee Messrs. Bullard, Hoenig, and Rosengren, Presidents of the Federal Reserve Banks of St. Louis, Kansas City, and Boston, respectively Mr. Madigan, Secretary and Economist Ms. Danker, Deputy Secretary Mr. Skidmore, Assistant Secretary Ms. Smith, Assistant Secretary Mr. Alvarez, General Counsel Mr. Ashton,¹ Assistant General Counsel Mr. Sheets, Economist Mr. Stockton, Economist Messrs. Connors, English, and Kamin, Ms. Mester, Messrs. Rolnick, Rosenblum, Slifman, and Wilcox, Associate Economists Mr. Dudley, Manager, System Open Market Account Ms. Johnson,² Secretary, Office of the Secretary, Board of Governors Mr. Cole, Director, Division of Banking Supervision and Regulation, Board of Governors Mr. Frierson,² Deputy Secretary, Office of the Secretary, Board of Governors _______________ ¹ Attended Tuesday’s session only. ² Attended the portion of the meeting relating to the zero lower bound on nominal interest rates. December 15–16, 2008 2 of 284 Mr. Blanchard, Assistant to the Board, Office of Board Members, Board of Governors Mr. Struckmeyer, Deputy Staff Director, Office of Staff Director for Management, Board of Governors Messrs. Clouse and Parkinson,¹ Deputy Directors, Divisions of Monetary Affairs and Research and Statistics, respectively, Board of Governors Messrs. Leahy,² Nelson,³ Reifschneider, and Wascher, Associate Directors, Divisions of International Finance, Monetary Affairs, Research and Statistics, and Research and Statistics, respectively, Board of Governors Mr. Gagnon,² Visiting Associate Director, Division of Monetary Affairs, Board of Governors Ms. Shanks,² Associate Secretary, Office of the Secretary, Board of Governors Messrs. Perli and Reeve, Deputy Associate Directors, Divisions of Monetary Affair and International Finance, respectively, Board of Governors Mr. Covitz, Assistant Director, Division of Research and Statistics, Board of Governors Ms. Goldberg,² Visiting Reserve Bank Officer, Division of International Finance, Board of Governors Mr. Zakrajšek,² Assistant Director, Division of Monetary Affairs, Board of Governors Messrs. Meyer² and Oliner, Senior Advisers, Divisions of Monetary Affairs and Research and Statistics, respectively, Board of Governors Mr. Small, Project Manager, Division of Monetary Affairs, Board of Governors Messrs. Ahmed and Luecke, Section Chiefs, Divisions of International Finance and Monetary Affairs, respectively, Board of Governors Ms. Aaronson, Senior Economist, Division of Research and Statistics, Board of Governors Messrs. Gapen and McCabe,² Economists, Divisions of Monetary Affairs and Research and Statistics, respectively, Board of Governors Ms. Beattie,² Assistant to the Secretary, Office of the Secretary, Board of Governors _______________ ¹ Attended Tuesday’s session only. ² Attended the portion of the meeting relating to the zero lower bound on nominal interest rates. ³ Attended the meeting through the discussion of the zero lower bound on nominal interest rates. December 15–16, 2008 3 of 284 Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of Governors Mr. Werkema, First Vice President, Federal Reserve Bank of Chicago Mr. Fuhrer, Executive Vice President, Federal Reserve Bank of Boston Messrs. Altig, Hilton, Potter, Rasche, Rudebusch, Schweitzer, Sellon, Sullivan, and Weinberg, Senior Vice Presidents, Federal Reserve Banks of Atlanta, New York, New York, St. Louis, San Francisco, Cleveland, Kansas City, Chicago, and Richmond, respectively Mr. Burke,² Assistant Vice President, Federal Reserve Bank of New York Mr. Eggertsson,² Senior Economist, Federal Reserve Bank of New York _______________ ² Attended the portion of the meeting relating to the zero lower bound on nominal interest rates. December 15–16, 2008 4 of 284 Transcript of the Federal Open Market Committee Meeting on December 15-16, 2008 December 15, 2008—Afternoon Session CHAIRMAN BERNANKE. Good afternoon, everybody. We welcome Chris Cumming, who is sitting in for New York. As you know, under the extraordinary circumstances we added an extra day to the meeting. The purpose of the meeting taking place today is to discuss the zero lower bound and related policy and governance issues, and I hope that the discussion today will set up our policy decision for tomorrow. Just for preview purposes, the program today will start with Bill Dudley and Q&A. We’ll then have a staff presentation on the zero lower bound and alternative policies. We’ll have a goround on those issues, including nontraditional policies and communications associated with it and so on. Let me just mention that on the agenda for tomorrow, after the policy decision, we have the subcommittee’s report on long-run projections and the quarterly projections. We put that there to save time and to make sure that we met our deadlines; but obviously there’s some linkage between that and the discussion today, and if anyone wants to bring that up today, please feel free to do so. Finally, if we’re very efficient—as I hope we will be—I’d like to get to the staff economic briefing at the end of today, if possible—if not, not—and then there’s dinner afterwards. So without further ado, let me turn to Bill Dudley. Bill. MR. DUDLEY.1 Thank you, Mr. Chairman. Unfortunately this package is a little thicker than usual, but that’s the way it goes, I guess. The stimulus provided by monetary policy to the real economy depends not only on the level of the federal funds rate but also on the health of the financial system. The ability of market participants to intermediate and act effectively as the transmission channel between the change in the federal funds rate target and financial asset prices is critical. When bank and dealer balance sheets are constrained as they are now, this transmission mechanism is impaired, and traditional monetary policy instruments become limited in their ability to support economic activity. 1 The materials used by Mr. Dudley are attached to this transcript (appendix 1). December 15–16, 2008 5 of 284 The recent sharp deterioration in the macroeconomic outlook and the forced deleveraging of the nonbank portion of the financial sector have led to sharp declines in asset values during the past few months. The consequence will be further big mark-to-market losses for investment and commercial bank trading books and a significant increase in loan-loss provisions on commercial bank loan books. These losses are likely to intensify the vise on financial firm balance sheets, and that is likely to further impede the Federal Reserve’s efforts to ease financial conditions. As a consequence, a broadening of our suite of liquidity facilities that bypass banks and dealers may prove to be necessary. Equities, corporate debt, and securitized assets—especially commercialmortgage-backed securities (CMBS)—have all been hard hit, and the commodity sector, the preferred asset class of choice earlier in the year, has been clobbered. As shown in exhibit 1 of the handout, U.S. equity prices fell sharply beginning in September. Although the aggregate indexes have bounced off their low points, the S&P 500 index had still fallen 30 percent between the end of August and the end of November. This is the relevant quarter for Goldman Sachs and Morgan Stanley, which report this week. In the current calendar quarter, despite the rebound, the S&P 500 index has declined about 25 percent. The carnage has also been evident abroad, especially in emerging markets. The corporate debt market has scarcely been more hospitable. The high-yield corporate bond yield for some broad indexes has climbed above 20 percent (exhibit 2). Assuming a 20 percent recovery rate on defaults, yield levels in this sector appear to fully discount a default experience consistent with the peak reached in the Great Depression. The securitization markets have performed little better. Not only are most securitized markets shut to new issuance, but also the yields on even the highest-rated outstanding tranches have climbed sharply. Exhibit 3 illustrates the current spreads for different types of AAA-rated consumer securitizations—credit cards, auto loans, and student loans. Exhibit 4 illustrates the sharp deterioration in valuations in the CMBS market. The left panel shows spreads on a basket of post-2003 vintages. The right panel shows the price performance of particular AAA-rated CMBS tranches. Most have fallen about 20 points in the past quarter. Commodity prices also continue to plummet. As shown in exhibit 5, the declines have been particularly pronounced in the energy and industrial metals sectors. In contrast, gold prices have held up quite well (exhibit 6), especially since the October FOMC meeting. Gold prices presumably have been supported by the drop in global short-term interest rates, which reduces the carrying cost of owning gold. It is also possible that gold is viewed as a hedge against the risk that central bank policy actions could ultimately prove inflationary. Presumably, the fear may be that the exit from these policies could be delayed or prove more difficult to engineer than generally anticipated. This poor performance of financial and real assets has a number of important implications. In particular, the earnings of most major financial intermediaries will be very poor this quarter. For example, the two investment banks that report this December 15–16, 2008 6 of 284 week are almost certainly likely to record large mark-to-market losses. The Wall Street Journal reported earlier that Goldman Sachs will report a loss of around $2 billion when it reports tomorrow morning. This may actually understate the carnage because compensation booked for previous quarters can be reversed and the reversal of income taxes paid will reduce the size of the loss. Commercial banks will also not be spared when they report next month. Not only will they have significant losses on their trading books, but also loan-loss provisions are likely to climb sharply. JPMorgan indicated last week that the current quarter has been terrible, and they have been one of the best-performing commercial banks. The sharp decline in asset prices is also likely to reinforce the deleveraging process that is occurring throughout the financial sector. Although hedge fund performance in November was better than in the previous months, preliminary figures show that the aggregate index continues to slide (exhibit 7). We’re down about 17 or 18 percent so far this year, and that’s the worst performance in hedge fund history in the aggregate by a significant margin. Although the redemption deadlines for yearend have generally passed, this pressure will persist into the first quarter and beyond for two reasons. First, many fund-of-funds managers will get another round of redemption requests before year-end, which will cause them to ask for monies from the hedge funds that are part of their fund-of-funds families in the first quarter. Second, some hedge funds restrict or “gate” the rate of withdrawals. For example, Citadel suspended all redemptions for their two biggest funds through March 31. This means that there will be a backlog in unfulfilled requests that will take time to satisfy. The Bernard Madoff scandal may also lead to additional redemption requests. The losses suffered by dealers and banks mean that their balance sheet constraints will continue to stymie the Federal Reserve’s efforts to supply liquidity to prospective borrowers. As shown in exhibit 8, recent TAF auctions have been undersubscribed, and as shown in exhibit 9, the amount of dollar liquidity supplied via our swap lines has stabilized even though term LIBOR remains elevated well above the minimum bid rate that we charge on those auctions and the fact that swaps are open-ended in size. The problem is no longer one of supplying sufficient liquidity to the banks and dealers. The problem is getting these intermediaries to pass the liquidity onward to their clients. Balance sheet constraints reveal themselves in many guises. Although LIBOROIS spreads have narrowed somewhat, they remain very elevated relative to historical levels (exhibits 10 and 11); jumbo mortgage rate spreads remain wide relative to conforming mortgage rates (exhibit 12); and cash instruments that take balance sheet room trade at significantly higher spreads than the corresponding derivatives that don’t. Exhibit 13 illustrates the spread between high-yield cash bonds and the corresponding CDX high-yield derivatives index. This widening in that basis is one reason that some banks have taken large losses in the fourth quarter. Evidence that balance sheet constraints are impeding the availability and cost of credit continues to proliferate. This is obviously important because, if credit is not available on reasonable terms, this is likely to exacerbate the downward pressure on the economy. December 15–16, 2008 7 of 284 A darker economic outlook, in turn, threatens to lead to more losses and balance sheet pressures, reinforcing the downward dynamic. In terms of credit availability, the commercial mortgage area appears to be particularly vulnerable. According to industry sources, about $400 billion of mortgage debt—most put on five to seven years ago—needs to be refinanced when it comes due in 2009. In recent years, commercial banks and the CMBS market provided the major source of funds for the commercial mortgage market. The owners of this commercial real estate are worried that, without new Federal Reserve and Treasury initiatives, funding will not be available to refinance this mortgage debt in 2009 on virtually any terms. Investment-grade and high-yield corporate debt will also have to be refinanced. Exhibit 14 illustrates that more than $600 billion of term investment-grade corporate debt will need to be refinanced in 2009. So far, this market still looks open for business, but it may become less so if the macroeconomic environment continues to deteriorate. Enough gloomy news. In the credit markets, are there any areas that have shown improvement? The answer, of course, is “yes.” In those areas in which the federal government, including the Federal Reserve, has applied the most force, the situation has generally stabilized or improved. Let me briefly give a few examples. First, the FDIC funding guarantee, the Citigroup intervention, and the $250 billion of TARP money allocated for bank capital seem to have stabilized the banking sector. As shown in exhibits 15 and 16, CDS spreads have been pretty stable recently despite the deterioration in the macroeconomic outlook. Second, the commercial paper funding facility (CPFF) has led to significant improvement in the commercial paper market. As shown in exhibit 17, the yields on highly rated commercial paper have declined. As this has occurred, the CPFF has become less attractive, and the number of issuers and the amount of commercial paper purchased each day by the CPFF have moderated sharply (exhibit 18). Just as important, after an initial surge in which the CPFF represented virtually all of the long-dated maturity issuance, the CPFF share of long-dated issuance has fallen significantly (exhibit 19). So far, the CPFF has worked pretty much as designed. Third, our announcement and purchases of agency debt have brought in agency debt spreads relative to Treasuries. For example, in the five-year sector, debt spreads for Fannie Mae and Freddie Mac have narrowed more than 50 basis points since the last FOMC meeting. Fourth, our announcement that the Federal Reserve would purchase up to $500 billion in GSE mortgage-backed securities has caused the spread between conforming mortgages and Treasuries to narrow sharply. Coupled with the fall in Treasury yields—encouraged somewhat by the Chairman’s suggestion in a speech that the Federal Reserve might buy long-dated Treasuries for the SOMA—this has caused conforming mortgage rates to drop sharply (exhibits 20, 21, and 22). As a result, mortgage refinancing activity has climbed sharply. Exhibit 23 illustrates the spike upward in the Mortgage Bankers Association mortgage applications to refinance index that has occurred in the past two weeks. December 15–16, 2008 8 of 284 Exhibits 24 and 25 contrast the performance in markets with federal government intervention to those markets without. Spreads have generally narrowed where there has been intervention and widened elsewhere. The contrast in the behavior of spreads suggests that one might wish to expand our existing facilities further. The TALF is an obvious potential candidate given that it could conceivably be extended in multiple dimensions—including the scope of asset classes, vintage, and credit quality. In my opinion, the liquidity facilities should be viewed as part of our suite of monetary policy tools. The impulse of monetary policy to the real economy depends not just on the level of the federal funds rate but, more important, also on the impact on financial conditions. In normal times, movements in the federal funds rate result in moves in financial conditions in the same direction. Markets do the work, and financial conditions ease as the federal funds rate is cut. But in extraordinary times such as the present, in which banks and dealers are unwilling to on-lend liquidity because of balance sheet constraints, federal funds rate reductions alone may be ineffective in easing financial conditions. In such an environment, special liquidity facilities that bypass the banks and dealers may prove necessary to ease financial conditions. However, expansion of our liquidity tools does blow up our balance sheet. Exhibit 26 shows the growth of the balance sheet and the changes in its composition over time. Since late September, the balance sheet has grown sharply mainly because of the expansion of our foreign-exchange swap program (shown in light blue), the CPFF (shown in brown), and the TAF program (shown in purple). As shown in exhibit 27, which is a snapshot of our balance sheet late last week, this has caused excess reserves to rise sharply. The growth in excess reserves has been exacerbated by the rolling off of the Treasury SFP (supplementary finance program) bills. We peaked at about $500 billion earlier, and now we have $364 billion of SFP bills on our balance sheet. The Treasury was unwilling to continue this program at its earlier level because of worries about reaching the debt limit ceiling in the first quarter and because they would have had to notify the Congress 60 days before that. Turning now to the Desk’s efforts to implement monetary policy and the FOMC’s directive, the effective federal funds rate has continued to trade soft relative to the target rate (exhibit 28). The interest rate paid on excess reserves (IOER rate) has not been a perfect substitute for the Treasury SFP program. Because the IOER rate for the two-week reserve maintenance period is set at the lowest level that occurred anytime during that period, the sharp drop last Thursday evident in the exhibit occurred because banks anticipate a substantial cut in the federal funds rate target and the IOER rate at this FOMC meeting. The drop in the effective rate has occurred even though we have increased the rate paid on excess reserves to equal the federal funds rate target. Although some of this softness in the effective rate relative to the target reflects the sales of federal funds by GSEs that are not eligible to be paid interest on excess reserves, this is by no means the whole story. The unwillingness of major banks to bid more aggressively for these funds is an important factor. This unwillingness to fully arbitrage the gap between the IOER rate and the effective federal funds rate is another consequence of the lack of balance sheet capacity in the banking sector. Although we are exploring ways to remove most of the GSE effect from the picture, even if we were to be successful in doing this, we expect that the December 15–16, 2008 9 of 284 balance sheet constraints would still be powerful enough to cause the effective federal funds rate to trade soft relative to the target. Also, if the GSE federal funds volumes were removed, it is not clear what the effective target would represent because trading volumes could then turn out to be very, very low. The drop in the effective federal funds rate has been accompanied by a corresponding drop in other short-term interest rates. In particular, general collateral repo rates have collapsed almost all the way to zero (exhibit 29). This is likely to lead to a rise in Treasury fails because, when general collateral repo rates are very low, the cost of shorting Treasury securities becomes negligible. As fails climb, in turn, this erodes market function in the Treasury market and reduces the usefulness of the Treasury market as a hedging vehicle for other fixed-income assets. The effect of fails on Treasury market function can be seen in exhibit 30, which shows how errors in our Treasury yield curve model have increased as short-term interest rates have fallen close to zero. In terms of monetary policy expectations, the federal funds rate futures curves (exhibit 31) and the Eurodollar futures curves (exhibit 32) continue to shift lower. However, with the effective federal funds rate persistently trading below the target rate, it is unclear how much of this shift represents a change in expectations about what the Committee will do with respect to the target. The primary dealer credit survey sheds considerably more light here. As shown in exhibits 33 and 34, rate expectations have shifted lower since the last FOMC meeting. All 16 respondents to our most recent survey expect the FOMC to reduce the target, with most (13 out of 16) calling for a 50 basis point reduction in the target rate. No dealer expects a 25 basis point cut at this meeting. Two are at a 75 basis point cut, and one anticipates a 100 basis point reduction in the target rate. A slim majority—9 out of 16—expect a 50 basis point target to be the trough for the target rate. Most expect that the FOMC will not cut the target at future meetings, and no rate hikes are expected by anyone until the second half of 2009 at the earliest. Comparing exhibits 33 and 34, the most recent survey shows considerably less dispersion in the four-quarters-ahead federal funds rate forecasts. Finally, for completeness, I include our standard chart on inflation expectations as measured by the Board’s and Barclays’ measures of the five-year, five-year-forward breakeven inflation rate (exhibit 35). I don’t think these breakeven rates provide much information right now because the TIPS market has been heavily influenced by the sharp fall in CPI inflation that will accrue to TIPS over the next few months and by the growing illiquidity of TIPS versus nominal Treasuries. Interestingly, the most recent primary dealer survey shows no change in five-year, five-year-forward expectations for CPI inflation, with the average of the group remaining at 2.4 percent. There is, however, somewhat greater dispersion on both sides indicating uncertainty about how successful the Federal Reserve will be in keeping core PCE inflation in the “comfort zone” of 1½ to 2 percent on a longer-term basis (exhibit 36). December 15–16, 2008 10 of 284 There were no foreign operations during this period. I request a vote as always to ratify the operations conducted by the System Open Market Account since the October FOMC meeting. Of course, I am very happy to take questions. CHAIRMAN BERNANKE. Thank you. There was a sharp decline in the spike in the fails recently? MR. DUDLEY. Yes. There are two potential explanations, and it’s really hard to sort out what’s driving it. One is just that trading volumes have come down, and as trading volumes have come down, fails have come down. So that’s part of it. It’s just tied to trading volume. The second explanation is that the Treasury Market Practices Group published a best practices report basically arguing that a penalty rate should be put on fails, and it is going to design a road map to show how that might be implemented in practice. It may be that, given that publication, people who before might have been more cavalier about shorting Treasury securities at very low interest rates are now somewhat less inclined to do so just because of the moral suasion of that report that it is not a good thing to do. So it is some combination of those two, I think. CHAIRMAN BERNANKE. Thank you. Questions for Bill? President Hoenig. MR. HOENIG. Bill, in your discussion on exhibit 13 and around the idea that a number of resets are coming for mortgages—the earlier seven-year ARMs and so forth—and as you also look forward to where mortgage rates are, why are you anticipating trouble with the ability to refinance, given the outlook for mortgages rates? MR. DUDLEY. I think you have to distinguish between conforming mortgage markets and everything else. The conforming mortgage market is doing fine. Some spreads are a little wider than they have been historically, but our actions seem to have been pretty successful in bringing those spreads in a bit. So the conforming mortgage market rate is fine. The problem is in December 15–16, 2008 11 of 284 commercial-mortgage-backed securities and nonconforming mortgages. The appetite to provide financing there is very, very much impaired, especially in the commercial mortgage market. MR. HOENIG. Right. Okay. That clarifies. Thank you. CHAIRMAN BERNANKE. President Fisher. MR. FISHER. Bill, has the FDIC’s temporary liquidity guarantee program interfered with or added to the confusion in the purchase and sales of fed funds, or has our excluding sales under one month changed the picture? MR. DUDLEY. I don’t think it has created much confusion. The biggest confusion is who is guaranteed and who is not and which instruments are guaranteed and which instruments are not. I think people will have trouble sorting that out. Most of the issuance has been long term—three years. People say, “Well, if I’m paying 75 basis points, let me get the most value for that.” So there hasn’t really been much channel conflict with the very short end, and I think that the fact that one month and in is not covered also has reduced that potential channel conflict. MR. FISHER. Is that pretty well understood in the marketplace? MR. DUDLEY. I think so. MR. FISHER. Then speaking of guarantees, I have just one more question, if I may, Mr. Chairman. In chart 14, are these net of credits that might have some kind of government guarantee? MR. DUDLEY. This is total. In fact, when you look at the issuance of investment-grade corporate debt recently, there’s quite a bit of it, but most of it is the guaranteed stuff. MR. FISHER. Yes. MR. DUDLEY. So excluding the guaranteed stuff, the issuance volumes do not look as robust as the aggregate number suggests because so much of that is the guaranteed stuff. MR. FISHER. So for 2009? December 15–16, 2008 12 of 284 MR. DUDLEY. I don’t have the number off the top of my head. MR. FISHER. It’s not this total? MR. DUDLEY. No. MR. FISHER. Thank you. CHAIRMAN BERNANKE. Any other questions? President Bullard. MR. BULLARD. At the beginning of your comments, you said that you expected further big mark-to-market losses. Do you mean over and above what markets anticipate now? MR. DUDLEY. No. I mean that in the fourth quarter they will reflect the decline that occurred from August 30 to November 30 for the investment banks. September 30 to December 30 just hasn’t been yet recorded on their balance sheet. They haven’t announced it yet. MR. BULLARD. You cited that Goldman number of $2 billion, but that’s been widely reported. MR. DUDLEY. That has been widely reported. Morgan Stanley is also going to report this week, and it is highly likely they will have similar losses. MR. BULLARD. Then I just want to understand—on exhibit 2 you said something about a fully discounted default rate last seen in the Great Depression. What did you mean by that? MR. DUDLEY. Well, if you basically take that 21 percent and compare it with the default rates in the Great Depression and write down some numbers for recoveries, if you had a default rate equal to the Great Depression default rate and you had a 20 percent recovery, you’d actually do pretty well owning high-yield debt at these levels right now. So the level of yields fully discounts horrific default rates. CHAIRMAN BERNANKE. In fairness, these are junk bonds. These are low-rated companies. December 15–16, 2008 13 of 284 MR. DUDLEY. Well, yes. It is possible that we could have default rates greater than those of the Great Depression. I’m just saying that these levels discount that kind of outcome. Obviously, the high-yield debt market today is different from general default rates. Yeah, I think that’s a fair point. MR. BULLARD. Do we know? Was there something like a junk market in the Great Depression that we can compare this with? MR. DUDLEY. Well, there were certain leveraged utility companies that you could argue were pretty junky. MR. FISHER. Corporate grade became junk in the Great Depression. CHAIRMAN BERNANKE. Michael Milken hadn’t been born yet. [Laughter] President Lacker. MR. LACKER. That’s a calculation that embeds risk neutrality into the extrapolation? MR. DUDLEY. Well, you could solve for the risk premium that was left over, and we did a back-of-the-envelope calculation in New York on that. It was an excess return of about 600 basis points. MR. LACKER. Doesn’t that depend on the assumption about the correlation between— MR. DUDLEY. Look. This is back of the envelope. Obviously, you’d have to dig down pretty deeply to try to separate what’s the default rate and what’s the risk premium. But the point here is that the market is discounting very adverse outcomes. MR. BULLARD. I just want to follow up on that. Would you say that that represents a tremendous amount of pessimism out there, or are you saying that you think we’re going to get default rates like the Great Depression? December 15–16, 2008 14 of 284 MR. DUDLEY. No, I think it’s some combination. I don’t think you can really separate how much of it is default rate versus how much of it is risk premium. The point is that there’s probably a considerable amount of both. Clearly the risk premiums are high because we see risk premiums on safe assets being very, very high. The classic example is the student loan, which is 97 percent guaranteed by the federal government, trading at LIBOR plus 350 or LIBOR plus 400. That’s probably a pretty good measure of risk premium—that’s your underlying risk premium on all assets, maybe a few hundred basis points. CHAIRMAN BERNANKE. President Lacker has a two-hander. MR. LACKER. First, about the risk premium, it’s either a lot of pessimism or a lot of correlation between defaults and bad states of the world and essentially low growth. The second thing, I took a look at the student-loan-asset-backed securities that you talked about—FFELP. I think you have a chart here. It turns out that the trusts are guaranteed a rate of return equal to the commercial paper rate, and any excess over that they have to return to the Department of Education. They get a payment if the return is below that. Your coupon is 200 points above LIBOR, and LIBOR is trading a bit above commercial paper rates, right? So there’s a negative spread built into the trust documents. They’re paying 300 basis points more than they’re earning on the trust. So a little extra premium seems pretty reasonable. Is my understanding of that security correct, Bill? MR. DUDLEY. I think what you’re describing is the perspective from the issuer of the obligation. The issuer of the obligation has a problem because on one side they get commercial paper and on the other side they get LIBOR, and so they have a mismatch. They have essentially a basis risk. But about where securities are trading in the market or what end-investors can invest in the securities—I think you’re referring more to the issuers of the securities, and the chart I showed is what investors in the AAA tranches get. So I think it’s a slightly different thing. December 15–16, 2008 15 of 284 MR. LACKER. Well, wouldn’t investors want to discount or take into account the fact that the trust, which is their only source of payment, is earning about 300 basis points less than the coupon? Wouldn’t that show up in a higher premium on what the investor is willing to pay? MR. DUDLEY. I don’t see it that way. MR. WILCOX. President Lacker, it’s a complicated security, but it’s wrapped by a guarantee that ultimately the Department of Education will make good on to the tune of 97 cents on the dollar. There’s one little detail that is causing another piece of friction in the market, and that is that, if the servicer doesn’t perform on the loan, then the Department of Education has the right to not make good on the guarantee. But other than that, it’s about 97 percent guaranteed. MR. DUDLEY. We think they’re pretty safe—not perfectly safe, but pretty safe. MR. LACKER. Okay. MR. WILCOX. Apparently the ability of the Department of Education not to make good on the guarantee is very rarely exercised. MR. LACKER. But the Department of Education doesn’t guarantee LIBOR plus a 200 basis point coupon. It guarantees the commercial paper rate. MR. WILCOX. I believe Bill’s point is that it guarantees a return to the investor. MR. LACKER. That still doesn’t seem that irrationally priced. Thank you. CHAIRMAN BERNANKE. Okay. Other questions for Bill? If not, we need a motion to ratify domestic open market operations. MR. KOHN. I so move. CHAIRMAN BERNANKE. Any objections? All right. Thank you. Let’s turn now to Brian, and we’ll have a staff presentation on the zero lower bound. I’m being reminded that this is a December 15–16, 2008 16 of 284 joint Board–FOMC meeting. I’m reconvening a Board meeting that began this morning. Thank you. MR. MADIGAN. Thank you, Mr. Chairman. As the Committee requested at your last meeting, the staff has provided background for your discussion today of issues related to the zero lower bound on nominal interest rates. Ten days ago, we sent you 21 notes covering lessons from the U.S. and Japanese experiences in disinflationary or deflationary environments; the possible costs to financial markets and institutions of very low interest rates; the potential benefits of further rate reductions; and the advantages and disadvantages of nonstandard approaches to providing macroeconomic stimulus that could be employed when the federal funds rate cannot be reduced further. Numerous staff members contributed to these notes—too many to recognize individually right now. But I would nevertheless like to thank them collectively for their intensive efforts on this project when many were already quite busy with other important assignments. Steve Meyer will now summarize the key conclusions from the staff work, and then I will review the suggested questions for discussion that we sent to you last week. Steve. MR. MEYER. Thank you, Brian. By way of background, the Greenbook and many private forecasters project a sizable drop in real GDP from mid-2008 to mid2009, followed by sluggish growth into 2010, even with short-term interest rates barely above zero and with substantial fiscal stimulus. The Board staff and the median forecaster in the December Blue Chip survey predict that unemployment will peak around 8.25 percent in 2010. The Greenbook forecast shows core PCE inflation dropping below 1 percent in 2010; many private forecasters envision similar disinflation. Moreover, responses to a special question in the latest Blue Chip survey indicate that private forecasters see a sizable risk of deflation, and stochastic simulations of FRB/US that take the Greenbook forecast as the baseline suggest a roughly 1-in-4 chance that the core PCE price index will decline over one or more of the next five years. In short, forecasts generally suggest that additional stimulus would be desirable. With the target federal funds rate at 1 percent and the effective rate significantly lower, the Committee has little scope for using conventional monetary policy to stimulate the economy. As a practical matter, the System’s large liquidity-providing operations and the Treasury’s decision to scale back the supplementary financing program make it likely that the effective federal funds rate will remain quite low into the new year. Even so, the Committee could choose to apply some additional stimulus by reducing its target federal funds rate and pushing the effective funds rate closer to zero. The research literature strongly suggests that a central bank should quickly cut its target rate to zero when it faces a substantial probability that conventional monetary policy will, in a few quarters, be constrained by the zero lower bound on nominal interest rates. But as discussed in several of the notes you received on December 5, December 15–16, 2008 17 of 284 driving short-term interest rates to zero would have costs as well as benefits. Zero or near-zero rates cause a high volume of fails in the Treasury securities market, leading to decreased liquidity in that market and potentially in other fixed-income markets. And if short-term rates remain very close to zero, some money market funds probably will close. Such costs may argue against cutting the target funds rate to zero and driving the effective rate closer to zero. Whether or not the Committee chooses to cut its target rate to zero, policymakers may find it helpful to expand the use of nonstandard monetary tools. In the current environment, using such tools has two potential benefits. First, they may help the Federal Reserve achieve better expected outcomes on both parts of the dual mandate. Second, nonstandard tools could help mitigate the risk of an even more negative outcome. It may prove useful to group nonstandard tools into four broad categories and treat each category in turn. The first category is simple quantitative easing. This approach uses conventional open market operations such as buying short-term government debt and conducting repurchase agreements to raise excess reserves in the banking system to a level well beyond that required to drive short-term interbank rates to zero. The objective is to spur bank lending by ensuring that banks have ample funding at very low cost. The Japanese experience suggests that greatly expanding excess reserves, per se, has limited success in spurring bank lending, and thus has modest macroeconomic effects, when banks and borrowers have weak balance sheets. The second category of nonstandard policy tools is targeted open-market purchases of longer-term securities. The objective here would be to reduce term spreads or credit spreads and thus reduce the longer-term interest rates that are relevant for many investment decisions. The Committee could, for example, direct the Desk to buy a large amount of longer-term Treasuries. The Bank of Japan bought sizable quantities of Japanese government bonds; its purchases are thought to have lowered yields. The available evidence for the United States suggests that adding $50 billion of longer-term Treasury securities to the SOMA portfolio (a bit less than 1 percent of publicly held Treasury debt) probably would lower yields on such securities somewhere between 2 and 10 basis points; a substantially bigger purchase could have a disproportionately larger effect as longer-term Treasuries became scarce. Of course, what matters for the macroeconomy is the effect on private agents’ borrowing costs and wealth. Those effects are difficult to predict. Corporate bond yields should decline with Treasury bond yields, though perhaps less if supply effects are the main reason Treasury yields fall. But corporate bond yields could decline more than yields on Treasuries if the Committee’s action reduces investors’ concerns about downside risks and thus reduces credit risk premiums. Such a boost to confidence could also lift stock prices and household wealth. Another possibility is to instruct the Desk to buy a large quantity of GSE debt and mortgage-backed securities to reduce their yields and thus drive down mortgage rates. As Bill noted, markets reacted positively to the November 25 announcement that the Federal Reserve will buy $100 billion of GSE debt and up to $500 billion of agency-backed MBS; yields December 15–16, 2008 18 of 284 on 10-year GSE debt and option-adjusted MBS yields fell about 60 basis points that day, and the spread over 10-year Treasury yields narrowed about 40 basis points. Quoted rates on conventional conforming mortgages declined a similar amount in subsequent days. The magnitude of the announcement effect, which is consistent with estimates from the research literature, suggests that additional targeted purchases of agency debt and MBS could provide further macroeconomic stimulus. The third major category of nonstandard tools encompasses special liquidity and lending facilities. The Board could choose to expand current facilities or create new ones. Special liquidity facilities for banks and other financial firms are intended to help them meet their customers’ needs for credit by providing a reliable source of funding even if the markets in which those lenders usually raise funds are disrupted or if their depositors withdraw funds. Indeed, these facilities seem to be meeting these needs effectively. The Term Auction Facility, or TAF, is one example; the AssetBacked Commercial Paper Money Market Mutual Fund Lending Facility, or AMLF, is another. Liquidity facilities may also support specific funding markets. The idea is that such markets are more likely to function if borrowers are confident that they will be able to issue and roll over debt and if lenders are assured that they will be able to fund purchases of debt instruments or reduce their holdings of such instruments when necessary. The Commercial Paper Funding Facility, or CPFF, is an example of this sort of program. Although the commercial paper market has not returned to normal, the CPFF has been helpful in supporting overall credit flows and reducing some credit spreads. Direct discount window lending to creditworthy nonfinancial firms is another potential tool for supporting economic activity. The Federal Reserve Act allows such lending, on a secured basis, if the borrower is unable to obtain adequate credit from banking institutions during unusual and exigent circumstances. Significant further expansion of the System’s lending programs would raise a host of issues. New facilities that lend directly to individuals, partnerships, or corporations would have to meet the requirements in section 13(3) of the Federal Reserve Act. The Reserve Banks would take on more credit risk unless the Treasury or other parties took substantial first-loss positions. Moral hazard would become a larger issue. The resulting increase in reserve balances would further complicate the implementation of monetary policy unless the FOMC were willing to accept a federal funds rate of essentially zero. Developing satisfactory exit strategies would be challenging. And the practical burdens of designing and operating a sizable number of new liquidity facilities would be substantial. Even so, some expansion might prove useful if credit conditions do not improve. Communication and commitment strategies are the fourth and final category of nonstandard policy tools. In current circumstances, the Committee might use such strategies in an effort to lower market expectations of future short-term interest rates and thus reduce long-term rates, or it might wish to prevent expectations of deflation from taking hold. I will mention three strategies that the Committee might pursue. December 15–16, 2008 19 of 284 First, research suggests that it would be helpful for the Committee to be explicit about its longer-term goals, particularly about its goal for inflation. Foreign experience supports the theoretical prediction that an explicit and credible inflation objective helps anchor longer-run inflation expectations and thus can help prevent a downward drift in expected inflation and an upward drift in real interest rates during a protracted period of high unemployment and slowing inflation. That is, an explicit longer-run inflation target can prevent the public from thinking that the Federal Reserve will allow inflation to remain persistently below rates that the Committee has previously said are desirable. The Committee has discussed the pros and cons of a numerical objective for inflation several times. You may wish to consider whether the significant risk of deflation and the near certainty that the zero lower bound will constrain conventional monetary policy have changed the cost–benefit calculus. Second, the Committee could announce that it will seek to run a somewhat higher rate of inflation for a number of years than it will seek in the long run. Such a promise, if deemed credible, would stimulate real activity by raising inflation expectations and reducing medium- and long-term real interest rates. Researchers have proposed several approaches for dealing with the zero lower bound that would operate in this fashion, including targeting a slowly rising price level. These approaches would be a significant departure from historical practice, and so their pros and cons would need to be evaluated carefully. Third, research suggests that it would be helpful for the Committee to provide more-explicit information about its views on the likely future path of the federal funds rate. Suppose, for example, that the Committee concludes that it most likely will need to keep the federal funds rate close to zero for some time to spur an economic recovery and to prevent a persistent decline in inflation. In the current environment, an announcement to that effect might lead market participants to expect the funds rate to remain near zero for a longer time than they now think likely; the announcement might also lead to an increase in expected inflation. Those changes in expectations would lower nominal and real bond yields, providing some stimulus to economic activity. Theory suggests that it would be important to make clear that the Committee’s current view about the likely future path of policy is conditional on current information and the current outlook and to spell out how the actual policy path would depend on a range of possible future outcomes. Communicating this conditionality could be difficult. The bottom line from the staff’s analysis is that unconventional monetary policy tools can be useful complements to well-designed fiscal stimulus and to steps to recapitalize and strengthen the financial system. Additional purchases of longer-term securities, expansion of targeted lending facilities, and explicit statements of policymakers’ goals and intentions all seem likely to be useful when conventional monetary policy is constrained by the zero lower bound on nominal interest rates. Our limited experience with these tools makes it difficult to estimate the amount of macroeconomic stimulus that would be generated by each and thus makes it difficult to calibrate their application. If the Committee and the Board choose to make greater December 15–16, 2008 20 of 284 use of nonstandard tools now or in the near future, it may be appropriate to deal with the uncertainty by using the tools in combination. Finally, the Bank of Japan's experience suggests that nonstandard tools are more likely to be effective if they are used aggressively. I’ll now turn back to Brian. MR. MADIGAN. 2 The staff provided eight questions to help frame your discussion, and those questions are included in the package we have placed before you—a single page with a blue cover sheet. I would like to comment briefly on each of them. The first question deals with the issue of whether policy adjustments should be accelerated when the zero bound looms, as the research literature indicates, or whether the Committee should “keep its powder dry”—for example, if it believes that the announcements of rate cuts have some special ability to buoy confidence. In present circumstances, a key practical consideration is that the System’s liquidity programs have already resulted in a very low effective federal funds rate. Absent a very substantial unwinding of those facilities, the effective funds rate will remain close to zero for the foreseeable future even if the Committee adopts a significantly positive target for the federal funds rate. Still, the announcement of cuts in the target rate probably would trigger further reductions in the prime rate and thus in rates paid by a sizable fraction of debtors. Alternatively, the Committee might set a target rate significantly above zero to convey its intentions for the stance of monetary policy over a period longer than the intermeeting period. The second question concerns your views of the costs of very low interest rates. In the financial markets, very low short-term rates are likely to erode liquidity; fails will increase, and the returns available on some short-term investments simply will not overcome the transaction costs. The staff research concluded that certain financial intermediaries, such as Treasury-only money market funds, will clearly be adversely affected by very low interest rates, and those adverse effects could have spillover effects into other markets, such as the repo market. But not all financial institutions will be hurt by low rates; there will be winners and losers, depending partly on their asset–liability mix. Moreover, our work suggested that financial institutions in the aggregate tend to benefit from the macroeconomic stimulus of monetary policy easing. Overall, judging the point at which the marginal costs of rate reductions exceed the marginal benefits is quite difficult. The third question asks whether you see a net benefit from communicating your intentions for inflation beyond the next few years or your views about the likely stance of monetary policy over some period longer than the intermeeting period. Specifically, we suggested that you comment on the desirability of stating (1) that you intend to hold the funds rate at very low levels until specified conditions prevail, (2) that the Committee is concerned about the risks of excessive disinflation and will act to mitigate that risk, or (3) that the Committee will be willing to temporarily accept higher rates of inflation in the next few years in order to limit the economic downturn 2 The materials used by Mr. Madigan are attached to this transcript (appendix 2). December 15–16, 2008 21 of 284 and encourage recovery. The draft statements presented in the “Policy Alternatives” section of the Bluebook include language that you might consider if you decide to pursue one or more of these possibilities. Questions 4 through 8 cover nonstandard policy tools. Question 4 asks your views about the benefits of large open market operations in agency debt, agency MBS, and Treasury securities. Such purchases are clearly within the authority of the FOMC, and the staff research suggests that they have definite potential to stimulate economic activity by lowering longer-term interest rates, although calibrating those effects is difficult. However, members could be troubled by the fact that purchases of agency debt and MBS could be regarded as steering funds to the GSEs and to particular economic sectors. In your responses to this question, you may want to comment on whether you are concerned by the credit-allocation aspects of such purchases. You may also want to provide your views on the channels through which purchases of Treasuries or agency securities would have a beneficial effect. In particular, do you see the power of such tools as arising from their effects in reducing long-term yields and spreads and supporting aggregate demand through those channels? Or would you emphasize the increase in excess reserves and the monetary base that would accompany such purchases and the possible effects on bank lending? Question 5 relates to liquidity facilities. As Steve noted, the creation of additional lending facilities is another potentially powerful policy tool for the Federal Reserve— particularly in current circumstances, in which credit flows in some markets are severely disrupted. Some of those facilities appear to have been successful in supporting credit flows and thus economic activity. But even though further additions or expansions could be helpful to credit intermediation, taking these steps would involve a number of substantive issues. Also, the design, implementation, and ongoing operation of such facilities pose real resource challenges to the System. Moreover, these programs raise governance issues. Because such programs generally rely on the section 13(3) lending authority, authorization of these programs is the responsibility of the Board, and the decision to lend is made by the Reserve Bank. At the same time, these programs create reserves and thus potentially affect the FOMC’s ability to influence the funds rate. Question 6 is open-ended: Do you see other nonstandard policy tools besides open market purchases and liquidity facilities as likely to be particularly helpful in current circumstances? If so, what are those tools? Question 7 returns to governance issues: Given that the Desk has begun to purchase agency debt and MBS, how should the FOMC specify its directive to the Desk? If the Committee instructed the Desk to undertake purchases in order to attain specific objectives for interest rate levels or rate spreads, serious practical issues could arise. Longer-term yields are heavily affected by expectations of future policy rates, which are in turn importantly driven by incoming economic news as well as by various risk premiums. Experience indicates that our operations have an effect on longer-term yields, but to have an effect that is economically significant, the December 15–16, 2008 22 of 284 operations may need to be very large. Even then, given the substantial effects of the other factors that affect yields, it might be very difficult or impossible to achieve specified rate levels or spreads. As an alternative, the Committee could instruct the Desk to purchase specific quantities of particular types of obligations. Such an approach is clearly feasible, but its potential benefits may be harder to communicate to the public except in qualitative terms. Another issue is whether the directive should be conditional on market developments. The Bluebook provided drafts of directives in which the basic approach is to specify quantities of purchases over specified periods of time but with some allowance for qualitative judgments about market conditions. Question 8 comes back to communication issues. If the Committee embarks on the use of unconventional policy tools, clearly communicating the nature of the policy and the intended objectives will be challenging. For example, once the Committee has formally brought its target for the federal funds rate to around zero or otherwise has signaled that further rate reductions will not be forthcoming, there will surely be press stories asserting that the Committee has “run out of ammunition,” potentially undermining the Committee’s message that monetary policy still can provide considerable stimulus. Overcoming these communication challenges will be somewhat easier if the Committee is able to agree on the substance of what it is trying to accomplish and a broad approach to explaining it to the public. But achieving such agreement is complicated by significant remaining uncertainties about the effectiveness of the various unconventional policy tools, a very uncertain economic outlook, and other factors. In your remarks, you may wish to provide your views of the best practical means for the Committee to address these communication challenges. Thank you. We would be happy to respond to your questions. CHAIRMAN BERNANKE. Thank you very much. I would like to give special thanks to the staff, some of whom are here and some of whom are not, for an extraordinary amount of work on these difficult topics over a short period of time. We very much appreciate those efforts. Are there questions for Brian or Steve or anyone else? If there are no questions, we’re ready for the go-round on this topic. I’d like to ask your indulgence. There’s an awful lot here, and I’d like to go first this time and try to clear out some underbrush and to lay down some issues in the hope that it will perhaps focus our discussion a bit more. As you know, we are at a historic juncture—both for the U.S. economy and for the Federal Reserve. The financial and economic crisis is severe despite extraordinary efforts not only by the Federal Reserve but also by other policymakers here and around the world. With respect to December 15–16, 2008 23 of 284 monetary policy, we are at this point moving away from the standard interest rate targeting approach and, of necessity, moving toward new approaches. Obviously, these are very deep and difficult issues that we are going to have to address collectively today and tomorrow. I want to say that, although we are certainly moving in a new direction and the outlines of that new direction are not yet clear, this is a work in progress. The discussion we’re having today is a beginning. It’s not a conclusion. Everyone can rest assured that this conversation is going to continue for additional meetings, and today we’re not going to be setting in stone an approach that will be used indefinitely. In fact, it would be hubristic to do so, given all the uncertainties and changes that we face. I’m not going to try to address all of these questions, but I thought it would be useful for me to talk a bit, first, about nontraditional policies and then, second, about the important issue of governance, which I know a lot of people are concerned about. So let me start, first, with nontraditional policies. I want to note that we are working and we should continue to work to improve our control of the effective funds rate. The interest rate paid on reserves is not currently sufficient to keep the rate at the target. That’s for a lot of reasons with which you are all familiar. I would just note that the staff is still working. We should not give up on that. The interest rate on reserves may be more effective as people get used to it, as balance sheet constraints ease, and as the rate gets higher if we decide to raise rates. So I think that is still a tool that we should keep and be aware of. There are other strategies—opening term accounts of various kinds, taking steps to encourage arbitrage, using Treasury bills, or perhaps issuing our own bills. In fact, we have had a lengthy discussion in this Committee of alternative structures for implementing monetary policy that involve different ways of setting up reserve requirements. So first of all, let’s just acknowledge that, although we are not keeping the effective funds rate at the target currently, we should not assume that that’s always going to be the case. We do December 15–16, 2008 24 of 284 have some optionality in that direction. That being said, it’s obvious that the effective funds rate now is quite low, and given the amount of excess reserves in the system, we’re going to have to find other ways at least in the near term to address the economic crisis. One approach, as was discussed by Steve and others, is communications. Here, in particular, I think, we are at early stages. I don’t think we’re going to come to any conclusions today. There is a lot of interest in terms of possibilities. The one thing I would say is that, if we do use communications as a way of providing information about future policy moves, we should be very careful to make those interest rate forecasts, if you will, conditional on the state of the economy. It should be very clear, if we give forward guidance of some kind, that the evolution of the policy rate will depend on how the economy evolves. The more clarity we can provide in that direction, the more effective our policy will be and the less problem we will have exiting from that strategy in the future. The statements that were circulated in the Bluebook gave two examples just for discussion, both of them in alternative A. In paragraph 2, there was some suggested language for using an inflation target as a way of managing expectations. Let me just read the sentence: “In support of its dual mandate, the Committee will seek to achieve a rate of inflation, as measured by the price index for personal consumption expenditures, of about 2 percent in the medium term.” The idea there would be to try to stabilize inflation expectations, avert deflationary expectations, and keep real rates lower than they otherwise would be. The 2 percent in that statement is a placeholder. Obviously if we do this, we would have to talk more about what 2 percent means. Is it a permanent level? Is it a temporary number? But that is one strategy. I would add that, of course, as we have discussed, adopting what might be a de facto inflation target is a pretty big deal, and if we decide to do that, I would like to have some opportunity to consult with the Congress appropriately. But if we decide to go in this direction, I do December 15–16, 2008 25 of 284 think that this might be a good time because it is certainly not a negative as far as employment growth is concerned in this context, and so it might be easier to explain. The other example of communication, also in alternative A, ties policy to economic forecasts. “The Committee anticipates that weak economic conditions are likely to warrant federal funds rates near zero for some time.” I note that this is a forecast of policy rather than a commitment to policy, but it does provide some information about the Committee’s expectations and should affect market rates. So, again, I think we’re at early stages of this particular approach, but it may be promising, and I hope today’s discussion will provide some insight. The second general approach to conducting nontraditional monetary policy is by use of the balance sheet. We have already begun to do this to some extent, as you know. In some respects our policies are similar to the quantitative easing of the Japanese, but I would argue that, when you look at it more carefully, what we’re doing is fundamentally different from the Japanese approach. Let me talk about that a bit. The Japanese approach, the quantitative easing approach, was focused on the liability side of the balance sheet—specifically the quantity of bank reserves, the monetary base, or however you want to put it, in the system. The theory behind quantitative easing was that providing enormous amounts of very cheap liquidity to banks, as Steve discussed, would encourage them to lend and that lending, in turn, would increase the broader measures of the money supply, which in turn would raise prices and stimulate asset prices, and so on, and that would suffice to stimulate the economy. Again, the focus of the quantitative easing was on the liability side, and indeed, there were targets, as you know, for the amount of excess reserves or reserves in the system. I think that the verdict on quantitative easing is fairly negative. It didn’t seem to have a great deal of effect, mostly because banks would not lend out the reserves that they were holding. The one thing that it did seem to do was affect expectations of policy rates because everyone understood it would December 15–16, 2008 26 of 284 take some time to unwind the quantitative easing. Therefore, that pushed out into the future the increase in the policy rate. So I would argue that what we are doing is different from quantitative easing because, unlike the Japanese focus on the liability side of the balance sheet, we are focused on the asset side of the balance sheet. In particular, we have adopted a series of programs, all of which involve some type of lending or asset purchase, which has brought onto our balance sheet securities other than the typical Treasuries that we usually transact in. You are all aware of the lending facilities for banks and dealers, the swaps with foreign central banks, the promised purchases of MBS, the various credit facilities for which even I do not know all the acronyms anymore. [Laughter] In this case, rather than being a target of policy, the quantity of excess reserves in the system is a byproduct of the decisions to make these various types of credit available. I think that’s a very different strategy, and Bill gave some evidence—we can debate it further—that these different policies have had some effects on the markets at which they’re aimed. Again, to distinguish between the balance-sheet, quantitative-easing, liability-side approach and the asset-side approach that we have been using, I do not think—and I feel this quite strongly— that it makes any sense for us to have or try to describe monetary policy with a single number, which is the size of the balance sheet or the size of our liabilities, as the Japanese did. There are a number of reasons for this, but the least important reason is probably just the fact that many of our programs don’t have fixed sizes. They are open-ended—like the swap programs, for example. Also, many of the programs have different timing, different durations, maturities, beginning points, ending points, and the like, and so in that respect I think it would be difficult to put in a single number. More important, the programs on the asset side of our balance sheet serve different purposes and have different structures, and aggregating a dollar of MBS purchase, a dollar of December 15–16, 2008 27 of 284 commercial paper purchase, and a dollar of swaps to make three dollars strikes me as being apples and oranges. I do not think that is the right way to think about it. Furthermore, and finally, these programs obviously have different operational costs and risks, different risks of losses, different maturities, and most important, they present different issues with respect to the exit strategy, which we will want to talk about. Rather than looking at this as a single number, as a measure of the liability side of the balance sheet, I think we ought to think about it as a portfolio of assets, a combination of things that we are doing on the asset side of our balance sheet, that have specific purposes and that may or may not be effective; but we can look at them individually. Let me turn now quickly to the governance issues. Before getting into them, let me just say that, whatever difficulties we may have finding appropriate governance, it is certainly the case that the Federal Reserve Act did not exactly contemplate the situation in which we find ourselves today. I think we all agree that getting the right policies for the U.S. economy is the top priority and, whatever we do, we need to find a way to get the right policies in place. Frankly, I think the best way to achieve that—I am going to talk about some details—is through operating in good faith. If we work together and keep each other apprised of developments and our views, we will be able to make this work. If we take too narrow an approach, too legalistic an approach, I think it will be much more difficult. So let me make a few comments. I think I can focus this best by simply answering the question: If the federal funds rate is at zero and the FOMC no longer sets the target, then what is the role of the FOMC in monetary policy? I have four answers to that question. The first is that the Federal Reserve’s outlook is the FOMC’s outlook. That is, the FOMC’s views about the evolution of the economy, of prices, and of financial conditions will govern our policy decisions. In particular, it is the FOMC’s outlook that appears in the minutes, it is the FOMC’s outlook that December 15–16, 2008 28 of 284 appears in the projections, and it is the FOMC’s outlook that appears in our communications. Therefore, if your board members ask you with respect to monetary policy, “Well, what are we doing now?” the answer is, “Keep telling us what you are seeing in the economy and financial markets. We will transmit that to the full FOMC because the FOMC’s outlook is the perspective that governs the policy actions that we take.” The second role of the FOMC, I believe, is in the communication policy, both in the narrow and in the large. In the narrow, if we decide to adopt a target, make a commitment about the length of time in which we hold rates low, or make any other kind of verbal promise in our statements or in other contexts, that is obviously the FOMC’s prerogative, and I think we understand that that’s how it would work. The third area is the most difficult one, and that has to do with the balance sheet. The law provides a kind of odd co-dependence, if you will, between the Board and the FOMC with respect to the balance sheet. Both the Board and the FOMC are enjoined by the Federal Reserve Act to pursue the dual mandate, and both the Board and the FOMC have powers that affect the size and composition of the balance sheet. In particular, the FOMC has authority over Treasuries, agency purchases, and swaps, whereas the Board has, in particular, the 13(3) authority, which has been utilized a lot lately for credit programs. So we have dual authority, and we have dual or joint responsibility. I think the only way to deal with that essentially is through close consultation and collaboration. My commitment to you is that we will work together even more closely, even more collegially, going forward to make sure that everyone is on board and understands what we are doing with respect to our various programs on the asset side of our balance sheet and that each person on this Committee is well informed and is able to give views and input into the discussions that we have. December 15–16, 2008 29 of 284 The legal authorities are what they are, but I do think that a collective and cooperative effort can help us solve this problem. In particular, I understand that the briefing sessions that I have provided have been useful. I am willing to commit to do those as frequently as necessary, and I am willing to make them into meetings if we need to have two-way discussions and input from the Committee with respect to policy actions. So it is a bit awkward, but I hope that cooperation will allow us to work together on the balance sheet. Now, there is a special issue here, though, which is the unwind issue. One way in which the balance sheet affects the responsibilities of the FOMC is that, if the FOMC is going to be raising interest rates at some point in the future, clearly, it needs to have information and understanding about the constraints being placed on policy by the size and composition of the balance sheet. So I think that keeping the FOMC as a whole informed about the balance sheet, about the programs, about the constraints that may be placed on the unwind, and about alternative strategies for raising rates once the time comes, is incumbent upon me and the rest of the Board to do. As a down payment on that, I have asked Bill Dudley, if there is time tomorrow, to give you a bit of an update on the TALF, the asset-backed securities loan facility, and talk to you about some issues that it raises for the unwind and for future interest rate policies. Fourth, and finally, with respect to the FOMC responsibilities, is communication to the public. The public doesn’t make the distinction between the Board of Governors and the FOMC. The public understands the Federal Reserve. What we need to do is to come together and decide what policies we want to pursue and then collectively take responsibility for those policies and communicate them in a coherent and consistent way to the broad public. That is the responsibility of all of us, and I hope we can work together to provide everybody with the information that they need to do that effectively. In particular, I am going to say that, given the December 15–16, 2008 30 of 284 state of confidence in the markets and in the economy, I hope whatever disagreements we may have that as much as possible we can keep them within these walls. With respect to the public, we need, as much as possible, to communicate a clear strategy going forward. So those are just some thoughts on governance. I recognize the problems. I am eager to hear your views about how to do it better. I am also interested in knowing how you think these governance issues should translate into the statements and into the directives. I think we have thrown out some suggestions there. We are not in any way wedded to them. If other people have other ideas, we are very open to adopting those ideas. But at least I want to say that I am fully aware of these issues, and I think that however many structures we may impose, nothing is going to substitute for a good faith, collaborative effort in making this work. Let me stop there and begin the go-round with President Lacker. MR. LACKER. Thank you, Mr. Chairman. Let me echo your comments about the staff’s work. They have provided us with a very comprehensive compendium of research and experiences relevant to the policy problems that we are facing now. And they have presented it in a surprisingly digestible form, all things considered. [Laughter] This was no small feat, as you and Brian noted, given the other demands on the staff’s time over the past few months. Clearly, as you said, Mr. Chairman, this is a critical moment for the Fed and the economy. Whatever we do and say at this meeting is going to mark a discrete change in the way we have conducted policy and communicated about it to the public in recent years. Some of this change, as has been noted, is already under way. We exhausted our ability to sterilize the additional reserves created through credit expansion at about the same time we implemented interest on excess reserves. Beginning with this meeting, we have to articulate how we would December 15–16, 2008 31 of 284 intend to conduct monetary policy and pursue the goals of our dual mandate with the funds rate at a very, very low level, perhaps zero, and perhaps for a very extended period of time. Before addressing specifically the questions that Brian has laid out for us, I want to make clear what I think is one of the central issues at hand, and that is the Committee’s control over the monetary base and its conduct of monetary policy. When we target the fed funds rate at any rate above zero, we instruct the Desk to manage reserves or, equivalently, the monetary base so as to keep the effective funds rate at our target. Monetary policy has always been about controlling the base, and this continues to be true at the zero lower bound on interest rates. In fact, the path of the monetary base is even more critical at the zero bound because that is how we prevent deflation. By managing the public’s expectations about future base growth and future inflation, we manage current real rates and influence real activity. In essence, we prevent deflation by convincing the public that future base growth will be inconsistent with a falling price level. Just as a thought experiment, imagine that we commit to keeping interest rates at the zero bound for an extremely long time period, say infinitely. If we do that—this is a clear result from the literature—it does not prevent a deflationary equilibrium. But if we can commit to keeping the monetary base at a finite level, not falling, then that does rule out a deflationary equilibrium. So it is key that expectations about the base, not just nominal interest rates, are vital for our ability to prevent a deflationary equilibrium. I think that focusing on the monetary base is going to help communication, and the reason is that a lot of people out there might not understand the relationship between credit spreads and growth or inflation or various other things that we are doing. But in almost everyone’s mind is the phrase “too much money chasing too few goods.” It provides, for a lot of December 15–16, 2008 32 of 284 people, an intuitive link between money and inflation, and I think we—for all the warts of our policy in the early 1980s under Chairman Volcker—exploited that well, to convey to the public that we were committed to bringing inflation down in a simple, intuitive way. I think that can help us now, analogously, in convincing the public that we are going to be able to prevent deflation because we control money. The Committee’s management of the base or bank reserves is distinct, in my view—as you noted, Mr. Chairman—from the initiatives that use our balance sheet to target specific financial market spreads. Credit market programs may have macroeconomic effects. Indeed, that is their intended effect—to have beneficial macroeconomic effects on growth and inflation. It is the same as other fiscal policy initiatives that also may have macroeconomic effects. But they are not monetary policy, and I think that is fairly clear. This Committee, I take it as given, is responsible for monetary policy. At the end of the day, monetary policy is about controlling the monetary base or bank reserves. From the point of view of FOMC policy, what is important about the nonstandard tools and credit market programs is their effect on the monetary base. Again, to make this contrast stark, a policymaker controlling spreads cannot prevent deflation. A monetary policy maker controlling the base can. I should note that the ability to pay interest on reserves means that we face this issue generically, whether or not the funds rate is zero, because now, with interest on reserves, we can vary the monetary base independently of how we vary the federal funds rate. This makes it even more important that we make this transition in a way that clarifies the Committee’s role. Turning now to Brian’s questions, I think the most important one is number 7, the one about the directive to the Desk. I believe that, if the directive is not going to specify a numerical target for the funds rate, then we need to find a way to specify some numerical target or range for December 15–16, 2008 33 of 284 the growth in the monetary base or the growth in bank reserves. Now, I realize that the directive is to the Desk, which has control over the SOMA account, and under a strict constructionist interpretation, that doesn’t necessarily equal the quantity of the monetary base. In fact, the discrepancy has gotten fairly large now with all of these credit programs. But if the Committee doesn’t provide direction about the interest rate, that is fixed at a floor, and if the Committee doesn’t provide direction about a monetary aggregate, the Committee really isn’t doing monetary policy, in my view. The Committee can also choose specific asset categories for the Desk to buy for the System Open Market Account, but that shouldn’t be confused with monetary policy as long as the monetary base is being determined at the margin by our credit programs. To put it slightly differently, individual Reserve Banks can propose their own credit programs, subject to the Board of Governors’ approval. But if they want to monetize those assets, then I would expect that the Committee’s prior approval would be required if an alteration in the base target were needed. That is what I would propose for the directives. Question 8 flows directly from question 7. What we should communicate is that we are targeting a quantity of the monetary base or bank reserves, and this communication should be made in a way that is broadly similar to the way we talk about interest rate policy, stating that our goals are for growth in the monetary base that supports the achievement of sustainable real growth and our medium-term goal for inflation. Question 3 also deals with communication, but more from the point of view of the funds rate path. I think in the present environment we should communicate that we anticipate that it will be near zero for some time—or something to that effect. Regarding part B of question 3, instead of citing the risk of deflation, I think we should presume some measure of success and communicate that we intend to use the growth of reserves to minimize the risk of inflation December 15–16, 2008 34 of 284 running below our medium-term inflation goal. Regarding part C, I think we should stick to communicating our goals for inflation. Questions 4 and 5 are about the means by which we grow our balance sheet and the monetary base, and I think the Committee should strive to maintain as much distance as possible from credit allocation. To me that means trying to have as little effect as possible on relative prices among nonmonetary assets, and I say that because I don’t think we really know enough to second-guess those outcomes. So I would like to see us focus on long-term Treasuries. Let me close with a few remarks about the Committee. In the 1920s, each individual Reserve Bank made open market operation decisions on its own, in an uncoordinated way. That proved ineffective, and at times we were operating at cross-purposes, one Reserve Bank selling while another was buying. In response, the Conference of Presidents formed the Open Market Investment Committee to coordinate our decisions and make all the purchases through the good offices of the Federal Reserve Bank of New York. But the role of the Board of Governors in that Committee was unclear. In fact, the Board at times tried to order the Open Market Investment Committee to do things that the presidents didn’t want it to do, and they came to an impasse. This was remedied with the legislation of the 1930s that created the Federal Open Market Committee. Now we do things that weren’t envisioned then, that’s for sure. But, surely, the guiding principle there was that they wanted one single governance body in the Federal Reserve System to be responsible for the monetary conditions in our country, and I take that to be the guiding spirit of the FOMC as well. This is the only body in the Federal Reserve System in which we all come together as one and subject ourselves to the discipline of listening to each other’s different views and forming a workable consensus on the way forward. I agree, Mr. Chairman, that we December 15–16, 2008 35 of 284 shouldn’t be splitting hairs about legal niceties about who is responsible for what. I agree wholeheartedly that we should work toward consensus for that, and that is why I think the Committee has to have a serious role in monetary policy. I don’t think that focusing the Committee’s decisions on just what the System Open Market Account does and leaving all these other programs to have whatever affect they might on the base is the right way forward. Thank you. CHAIRMAN BERNANKE. I won’t try to respond, but I do want to ask you what your interpretation of the Japanese experience is. They had enormous increases in the base, no increase in M1, and no inflation. MR. LACKER. First, let me say that there are models and sets of policy rules under which in the short run there is an irrelevance proposition, a kind of Modigliani–Miller theorem, about exchanges of monetary assets for short-term liquid securities that are virtually perfect substitutes and at the zero lower bound are definitely perfect substitutes. So that is definitely true. The point I made about the base in the long run is true as well. It has to do with eliminating certain possible conjectures that the public might make about our willingness to tolerate deflation. In the Japanese case, they were widely known to be quite eager to lift interest rates. It was known that they viewed the problems in the banking sector as exacerbated by low interest rates. They thought that raising real interest rates would provide more discipline and force more restructuring in the banking system. So they continually had to fight to keep the long end of the yield curve down. I don’t view that experience as providing the best evidence about what a firm commitment to preventing deflation could be. CHAIRMAN BERNANKE. President Fisher, you had a two-hander. December 15–16, 2008 36 of 284 MR. FISHER. Yes, sir. I just want to ask a question—again acknowledging that I am the least well educated on this subject matter and not as erudite in my understanding. So this is a tutorial question. What we have been doing is implicitly acknowledging that standard monetary tools are not as effective as they could be because of the financial frictions that we have encountered in the marketplace. So we have been targeting dealing with those financial frictions. My question, President Lacker, is just from an educational standpoint: Do we know how much monetary base or balance sheet expansion would be needed to bring credit spreads back into normal order or to deal with these financial frictions? If we are going to target the monetary base, I worry about the operational consequences of doing so, since it seems to me that is an open-ended question. That is my question. MR. LACKER. That is a very good question. We don’t have any models to draw on because we don’t have any data that would allow us to uncover a structural relationship between spreads and the quantity of the base. In any event, even were we to focus solely on our primary objectives for growth and inflation, I think we would have trouble there. I think we would have a great deal of difficulty figuring out a quantitative relationship between the monetary base at the zero bound and our objectives. But we started the way we usually do things—without a serious quantitative understanding of the relationship between the funds rate and growth and inflation, and we groped and groped and found our way. We are going to grope and try to find our way in this new regime, and we are going to have to think hard about it and make some guesses—by trial and error—just the way we learned how to do funds rate targeting. CHAIRMAN BERNANKE. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. I, too, want to add my praise to the staff. It was an extraordinary set of memos, as Jeff indicated, making reasonably clear very difficult December 15–16, 2008 37 of 284 literature on a complex topic. So I want to thank them. Reading through them was very helpful to me in trying to sort out some of my own views as well. As we know, the nominal funds rate has been trading well below our target. It is near zero. The real funds rate is about minus 2 percent. The outlook for growth is now even weaker than it was before. In that case, we would want our policy rates to decline with the equilibrium real rate. But the zero bound, of course, may constrain us, and our ability to do that is complicated by the prospect of declining inflation expectations, which make more difficult our ability to let the funds rate fall. Once we are in the situation in which our policy rate is effectively zero, it does become a constraint on monetary policy—as has been well explained. In that case, theory suggests that our policy strategy must focus on ways of raising expectations of inflation, so that, near the zero bound, real rates can decline while nominal rates remain close to zero. One way to implement such a strategy is to credibly commit to keeping policy accommodative for some period of time after the funds rate is no longer constrained by the zero bound and before moving policy back to more neutral rates, thereby raising expectations of inflation. Eventually, however, we would need to bring policy rates back up in line with economic conditions, to avoid a permanent increase in long-run inflation expectations. That will be a tricky task to be sure. What we promise to do with policy in the future is of overriding importance in this framework. Now, I am sympathetic to this theoretical analysis, but I have some concerns as well. The models that deliver these results are models of full commitment and thus presume that policymakers have already in some sense credibly committed to deliver on an inflation target and to deliver this strategy in the event that the near-zero bound becomes binding, which in these models amounts to having a price-level target as opposed to an inflation target. I would like to December 15–16, 2008 38 of 284 think that we are committed and credible policymakers as far as the public is concerned, but, frankly, I have my doubts. I would feel more comfortable if this Committee had agreed to a well-articulated inflation target. Had we done so, the current task before us might have had a greater chance of success. Unfortunately, we do not have that luxury. Consequently, I am somewhat less confident of how the public and the marketplace will react to our efforts. The trick we face now is how to make these promises understandable and credible. One difficulty is that the optimal policy for many models in these circumstances is very complicated and very difficult to understand, much less communicate. If we hope to affect expectations, we need to explain our policies in a way that the public can understand. Even approximation of optimal policy in these circumstances would involve price-level targeting, as I said, and it would be very difficult to explain, particularly since the FOMC has never formalized its inflation target, let alone a price-level target. I think we would be better off trying to communicate something simpler. First, we need to tell the public that we have lowered the funds rate as low as we think it is beneficial to go. I do have some concerns about lowering the target rate all the way to zero. We still do not understand why having interest rates on reserves isn’t working to keep the funds rate at its target, and there may well be unintended consequences of moving our target to zero, beyond those well articulated in the Board’s staff notes. Whether that lowest rate is 100 basis points, 75 basis points, 50 basis points, or 25 basis points is very hard to say. However, given the law of unintended consequences and our lack of experience at the lower bound in this country, I do not want to go all the way to zero. But I think we do need to communicate clearly to the public that, when we reach whatever that effective zero rate is, we are done. A way of communicating that might be by giving a funds rate target or range, say, between zero and some percent. December 15–16, 2008 39 of 284 There are two additional practical advantages I see that argue for bounding our target rate above zero. First, it will allow additional time for banks to become more proficient at managing their reserves, so that our interest-rate-on-reserves regime can become effective. By going to zero, we will effectively shut out that learning process. Second, I believe that when the time comes to raise rates, even by modest amounts, we will be in a better position to do so from a non-zero position than from a zero position. Next, we need to communicate that the FOMC desires inflation rates that are higher than perhaps our long-run target and communicate an inflation range we are aiming for. That is somewhat difficult because we have refused to communicate such a target in the past. We certainly need to communicate that we do not wish deflation in a very weak economy. We also may wish to convey that we are going to keep the nominal funds rate low for some period of time because we desire higher inflation, and that currently seems to be expected. Communicating this serves to increase commitment, and it also limits misunderstanding when inflation rates might temporarily be above a longer-run target. Thus, I think we need to say ex ante that we desire higher inflation rates than currently. As suggested earlier, this would be easier to communicate had we adopted a target earlier. Regarding the use of nonstandard policy tools—in my view, we are already there. With the funds rate trading below target, we are effectively conducting monetary policy through quantitative easing, which I define as increases in reserves either by open market operations or by any other means. Indeed, expansion of our balance sheet, including unsterilized lending, is monetary policy, as it is monetizing the debt, either public or private. As an aside, I find the description of such a policy as nonstandard a bit peculiar since using balance sheet quantities as instruments of policy has had a long tradition in monetary policy. Indeed, even the Federal Reserve has targeted nonborrowed reserves at various points in its history. In principle, I have December 15–16, 2008 40 of 284 no objections to quantitative easings of this form. But if that is how we view the new regime, then we need to publicly acknowledge that we have changed—that we have a new instrument— and communicate how monetary policy will be determined going forward. Internally, we also need to resolve, as has been pointed out, how decisions about our lending and liquidity facilities will be made, particularly now that these have become the main instrument of monetary policy as opposed to being the mechanism for providing liquidity to improve market functioning, which is then sterilized. The FOMC, and not only the Board of Governors, needs to be involved in decisions about the magnitude of such lending and the choice of assets. In effect, these are choices about the extent of the Fed’s balance sheet and its expansion or contraction. There are a number of ways in which one might proceed. First, I believe we need to publicly convey that we have entered a new regime. Otherwise, it may look as though we have lost control of monetary policy or that the FOMC, which sets the target funds rate, and the Board of Governors, which largely is controlling the liquidity provisioning, are at odds. One obvious step would be to change the directive to the Desk, which is released in the minutes, in a way that clearly indicates that the new regime is now operative and that the FOMC has deliberately chosen to be in that regime. We would then have to communicate something about the size of the balance sheet going forward in terms of limits, ranges, or maximums of some form, such as President Lacker was suggesting. My preference is for the directive to specify objectives in terms of asset quantities rather than the level of non-funds-rate interest rates or interest rate spreads. That is question 7 of the staff memo. These latter two are not under our control and, even more so than before, reflect counterparty risk not liquidity impairments. Moreover, the December 15–16, 2008 41 of 284 transmission mechanism from reserve quantities to rates and spreads is not precise enough for these to be operational objectives. Setting a quantity limit on the size of the balance sheet is more familiar—similar to our experience with operating a reserves-based target. In this quantitative regime, it means that the Board of Governors wishes to implement new lending programs that expand the balance sheet— that is, that are not sterilized. The Board of Governors would have to seek approval of the FOMC to get such an expansion but not necessarily for the composition of the assets. As I have articulated before, I believe we need to remain cognizant of the line between monetary policy and fiscal policy. I would prefer to see us purchasing Treasuries rather than riskier assets, as I would favor the purchases of long-term Treasuries over new 13(3) facilities. This refers to questions 4 and 5. To the extent that some of our lending programs are targeted at aiding specific markets, my preference would be to shift those assets from the Fed’s balance sheet to the Treasury and substitute Treasury securities. This would help distinguish monetary policy from credit policy and preserve our ability to conduct independent monetary policy. We also need to recognize that, as the economy begins to recover, these programs will need to be unwound, and this may occur before all financial institutions are fully recovered. Some of our facilities have termination dates and will shrink naturally as those dates are reached; but others, like the agency MBS programs or the TALF, will complicate the problem. Under a well-functioning corridor system, should we get there, the target rate will be somewhere between the upper and lower bounds, and we will have to shrink the balance sheet if we expect to hit our target. The reduction may be quite significant if it is accompanied by a general fall in the demand for reserves by banks. December 15–16, 2008 42 of 284 Even if we imagine going to a floor system in which, in principle, we can raise the target rate without shrinking the balance sheet, we need to be concerned about the health of our balance sheet so that we can ensure that we can finance the interest rates on reserves and pay them. Note that if we do go to a floor system, the rate paid on excess reserves will become our instrument, and we will need to agree on how to set that rate going forward. In my view, that rate should be decided by the FOMC. In summary, under a quantitative easing regime, the magnitude of the quantitative easing should be an FOMC decision. To the extent that the quality of assets on our balance sheet complicates future monetary policy decisions, the asset makeup of the Fed’s balance sheet should also be in the FOMC’s purview. One option that has been discussed is for the Fed to issue its own debt—other than Federal Reserve notes, I assume. I am uncomfortable with this proposal. It is likely to require congressional approval, and oversight will no doubt be sought since the Fed’s securities will be public debt. This potentially generates opportunities for the Congress to control our debt ceiling and perhaps the pricing of our securities, in ways that may limit our ability to conduct independent monetary policy. Thus, I am very skeptical that this would be a good path to follow. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Yellen. MS. YELLEN. Thank you, Mr. Chairman. This is an extremely important discussion, and I am glad that you have arranged a special session. I very much appreciate the comprehensive and outstanding memos from the staff. At our October meeting, we agreed to take whatever steps were necessary to support the recovery of the economy, and that principle guides my thinking on monetary policy at the zero bound. In most circumstances, I see few December 15–16, 2008 43 of 284 advantages to gradualism, and certainly whenever we approach the zero bound, I think the funds rate target should be quickly reduced toward zero. As to the level of the lower bound, my default position is that we should move the target funds rate all the way to zero because that would provide the most macroeconomic stimulus. For example, every 25 basis point cut in the target typically takes about 25 basis points off the prime rate and associated borrowing rates. The institutional concerns about Treasury fails and Treasury-only money market funds merit consideration, but I don’t consider them serious enough to ban lowering the target to a very low level. Still, the surprising results we obtained from paying interest on reserves should make us chary about predicting the reactions of financial markets to new circumstances, so there may be some benefits from allowing the funds rate to trade between zero and, say, 25 basis points. Let me now turn to the third set of questions on communication strategies. Looking ahead, I believe that there could be significant benefits to communicating effectively the FOMC’s intentions to hold the target funds rate at a very low level. The Japanese experience at the zero bound suggests that this is one channel that can work, and the evidence suggests that our own guidance that began in 2003 similarly influenced longer-term rates. We learned then, though, that it is hard to convey the conditionality of such intentions and the multiple influences on the optimal setting of the funds rate. Still, I favor trying to include forward-looking communication on policy expectations in future FOMC statements. We could also consider using the FOMC minutes to provide quantitative information on our expectations. For example, we could reveal the funds rate projections that implicitly accompany our quarterly economic projections, publishing ranges and central tendencies of the federal funds rate along with those for GDP growth, unemployment, and inflation. The December 15–16, 2008 44 of 284 advantage of this approach is that it would provide a clear future path to the funds rate that is conditional on the economic environment pertaining to output and inflation relative to our goals. We did discuss this approach before, and I remember that a number of you were uncomfortable with it. But circumstances have changed, and there could be particular value now in adding the federal funds rate to our projections, and in fact, we could consider a trial run. I believe that, in addition to providing guidance on the likely path of future interest rates, we should become more communicative about our longer-term inflation objective to avoid a decline in inflation expectations as inflation drops over the next few years below desirable levels. One way to accomplish this is to include quantitative information on our longer-term projections in the Summary of Economic Projections (SEP), as the Subcommittee on Communications has recommended. We could go even further to endorse a Committee-wide long-term inflation objective, although that is something that we would have to further consider carefully. We could supplement including longer-term projections in the SEP with language in the FOMC statement that is akin to that used in 2003, when the Committee referred to an unwelcome decline in inflation. Alternative B does take a step in that direction. The bracketed language in alternative A goes further by specifying a medium-term Committee inflation target. This is a big step, and one that deserves thorough debate. There are theoretical papers demonstrating the potential benefits in a liquidity trap of committing to an inflation rate after the economy recovers that is higher than we would actually want ex post because raising inflation expectations lowers real rates, thereby stimulating the economy. In theory, by committing to more inflation than we actually want later on, we could generate extra stimulus now. But this strategy requires a strong commitment device because the Committee will have an incentive to renege later on when the economy has recovered. I do understand the December 15–16, 2008 45 of 284 attractions of such a strategy in theory, but I am not at all convinced that the benefits would exceed the costs in practice. It would be enormously difficult to explain and could harm the Fed’s overall credibility as an institution. Moreover, it is not only real rates but also nominal rates that influence housing demand, and any increase in longer-term nominal rates triggered by higher inflation expectations could adversely affect this key sector. Let me now turn to the nonstandard policy tools that the FOMC and the Board have authorized. I wholeheartedly support the many actions that have been taken to increase liquidity in the financial system, as well as those designed to increase credit availability and lower borrowing costs. Going forward, I support both the purchase of agency debt and MBS by the System Open Market Account and purchases of long-term Treasury debt. Both existing evidence and the market response we just saw to the recent announcements and comments concerning such programs suggest to me that such purchases can push longer-term borrowing rates down. Other new programs—for example, to improve credit market functioning in A2/P2 commercial paper and in commercial and private-label residential-mortgage-backed securities—are well worthy of consideration. Naturally, the potential benefits and costs of each new facility or program need to be assessed before adoption. Formulating the guidance from the FOMC to the Desk regarding how these new programs should be described remains a challenge. I think a possible formulation could have the FOMC setting some objectives for levels or movements in Treasury yields or MBS spreads, but those open up thorny issues, and I think that this is something we really have to study further. With respect to the FOMC’s operating regime going forward, I oppose switching from a regime based on targeting of the fed funds rate to one based on a quantitative target for the monetary base, excess reserves, or the overall size of our balance sheet. The Board or the FOMC December 15–16, 2008 46 of 284 or both, in my view, should consider the merits of each program on its own, without any presumption of PAYGO. Most of you probably recall that PAYGO was a budget device employed by the Congress to constrain the federal deficit to a target level. In our case, an overarching decision by the FOMC about the size of our balance sheet or the monetary base would force tradeoffs among our various programs to hit that total, similar to PAYGO. Imagine, however, that the commercial paper market were to revive, allowing us to terminate the CPFF. Excess reserves would decline, but that decline would have no negative effect on economic activity, so there should be no presumption that some other program should be expanded to restore the monetary base to its previous level. Theory suggests that when the monetary base is increased by purchasing conventional SOMA assets, its expansion should have little or no effect on the behavior of banks or asset prices more generally after the zero bound has been reached. Abstracting from expectational effects, the evidence generally supports this view. While the quantity of money is surely linked to the price level in the very long run, most evidence suggests that variations in the base have only insignificant economic effects in the short or medium term under liquidity trap conditions. This makes the base an inappropriate operating instrument for monetary policy in a zero bound regime. As Japan found during its quantitative easing program, increasing the size of the monetary base above levels needed to provide ample liquidity to the banking system had no discernible economic effects aside from those associated with communicating the Bank of Japan’s commitment to the zero interest rate policy. I think my views on this mirror those that you expressed in your opening comments, Mr. Chairman. With respect to the directive, the version proposed in the current Bluebook specifies the types and amounts of mortgage-related assets that the Desk should buy and the objective of these purchases—namely, to boost activity in the mortgage and housing markets. Language of this December 15–16, 2008 47 of 284 type is consistent with the policy approach I support, in which each credit facility program and asset purchase decision is judged on its own merits, according to whether it improves the availability of credit or lowers its cost, thus stimulating the economy. I support this approach to drafting the directive going forward. It is one way in which the Committee communicates the logic of monetary policy. But I think we do need to go further—as you emphasized, Mr. Chairman—in providing clear explanations to the public about the objectives of the various facilities, how they work, and why they are part of a coherent monetary policy strategy. With respect to governance, I endorse the suggestion that you made, Mr. Chairman, about how we should proceed—that is, to work together collectively to forge and communicate a consensus view of the entire Committee to the public, while adhering to the particular responsibilities that the Board and the FOMC each have according to our governing legal document, which is the Federal Reserve Act. CHAIRMAN BERNANKE. Thank you. President Bullard. MR. BULLARD. Thank you, Mr. Chairman. I also want to thank the staff for preparing these memos. They are very stimulating, a great discussion of a very difficult topic, and I know it was a lot of work. I also want to agree with the Chairman that all comments in this arena are in the spirit of optimal monetary policy, which is the only way I would make any comments here at the table. What is the best policy? What will get the economy back on track soonest? That is always what we are trying to think about here. The truth is that there are lots of ways that you might think about what the optimal policy is, so that is what the debate is about. Let me begin with the first part of the memo asking for comments saying whether we should go quickly or gradually to zero. I think the most important element is somehow to switch away from nominal interest rate targeting once the target approaches zero because at that point December 15–16, 2008 48 of 284 the target just ceases to make any sense and you leave the private sector in the dark about any signals that they might be receiving about where the Committee intends inflation and monetary policy more generally to be going forward. To go quickly to zero is effectively what we have already done with respect to the federal funds rate, at least in terms of the actual federal funds rate, and if I am reading the Greenbook appropriately, according to the staff Greenbook forecast, it is evidently not going to help very much going forward. I think we did go to zero fairly quickly here. I do not find the Reifschneider–Williams paper, which I know carries some weight around here, very compelling, so let me give the brief reasons behind that. For one thing, you are taking a model and you are extrapolating far outside the experience on which the model is based. That might be a first pass, but that is probably not a good way to make policy, and I wouldn’t base policy on something like that. There are also important nonlinearities. This whole debate is about nonlinearities as you get to the zero bound, and in my view, they are not taken into account appropriately in this analysis. You have households and businesses that are going to understand very well that there is a zero bound. It has been widely discussed for the past year. They are going to take this into account when they are making their decisions, so you have to incorporate that into the analysis. That is a tall order—there are papers around that try to do that, and many other assumptions have to go into that. The third thing I think is important is that, in other contexts, gradualism or policy inertia is actually celebrated as an important part of a successful, optimal monetary policy. Mike Woodford, in particular, has papers on optimal monetary policy inertia, and many others have worked on it. In those papers, it is all about making your actions gradual and making sure that they convey some benefit to the equilibrium that you will get. All of a sudden, in this particular December 15–16, 2008 49 of 284 analysis, when you are facing a zero bound, that goes out the window, and I don’t think that it is taken into account appropriately in the analysis. Also, it is thrown out the window exactly at a time when you might think that the inertia and the gradualism are most important, which would be in time of crisis when you want to steer the ship in a steady way. So I think that we have a long way to go to understand exactly how to behave near a zero bound, and I would not make policy based on that particular analysis or the subsequent work. But as I stated at the beginning, I think it is a moot point anyway because the effective fed funds rate is trading near zero. We are there. We have arrived. Does the zero bound impose significant costs on financial institutions? In general, to this I would say “no,” as the markets can adjust. More important, markets should be expected to adjust to the optimal monetary policy that we set. We are not in the business of keeping particular markets working in the particular ways that they have worked in the past. I don’t want to disrupt things so rapidly that we upset the apple cart. On the other hand, I think the attitude should be that, given enough time, we should expect markets to adjust appropriately. I guess that is what I think about that issue of going quickly or not. We talked for a minute about communication strategies. Three were mentioned in the memo. The first was to hold the federal funds rate at zero until specified conditions obtain. The second one was the FOMC will act to counter inflation below target, and the third one was to accept higher inflation later. In general, I think that the communication idea is important and valuable to think about in this situation. This is because it plays to the rational expectations, forward-looking aspect of the behavior of households and businesses. My sense is that the benchmark forecasting models embodied in the Greenbook or in a prominent private-sector forecast such as Macroeconomic Advisers may understate these kinds of effects because they December 15–16, 2008 50 of 284 don’t completely incorporate the forward-looking elements probably as much as we would like. That is because it is very difficult to do. So I think that the communication thing is the right idea. But I do not think that communicating that we intend to hold the federal funds rate at zero until specified conditions obtain will have much effect because the market already expects that we will maintain the rate at zero until conditions improve. That strikes me as a way of saying that we have hit our constraint, we are bound by our constraint, and so we are effectively doing nothing further. I wouldn’t want to get into that kind of message in the communication game, and the communication game is a tricky one. If we went that route, I think deflation would develop. The economy would become mired in a deflationary trap similar to Japan’s, which I illustrated last time. In general, my feeling is that understanding the Japanese situation as something like a steady state is more how we need to think of it. In a steady state, the markets are clearing, the expectations are consistent with outcomes, and there is no pretense of returning to the previous situation unless you eliminate that steady state or somehow shock the system out of that steady state. In Japan the policy rate has not been above 1 percent for fourteen years. Fourteen years! That starts to sound to me as though the best way to think about this is that there may be multiple steady states out there, and you may be at risk that the dynamics will send you to the deflationary trap. Our understanding about the dynamics of those—I know because I have worked on them myself—is very poor. Exactly how they would work and how you would get coordination on one versus the other is a very difficult question. That research is in its infancy. But the concept that you might think about the possibilities in the situation as being multiple steady states should perhaps be entertained more seriously around the table here. December 15–16, 2008 51 of 284 It is much better to say, as far as a communication strategy, that we are constrained on interest rates and therefore we are switching to something else. I think a monetary base, reserves, or some kind of quantity measure would be fine. The reason you want to do this is that you want to remind the private sector that we control inflation and that we intend to keep inflation close to our target. This is a way to tell a story about how you are going to do that—a way to signal to the private sector. So to get the intended effect in the minds of the private sector, you eliminate references to the federal funds target and force them to rethink their views of monetary policy and rethink what we are doing. Of course, this has to be done in a reasonable way. It can’t be done in a willy-nilly way. Also, all the issues that have ever come up around this table about monetary targeting and reserves and all the difficulties with that would come up again. But I think it is a great way to make the switch, much as Volcker did in 1979, and get the private sector to reorient to the new reality. So, yes, it is very important to stress that we will counter inflation below target—I guess that is the second part of this question—and the idea of, well, you could say we are going to accept higher inflation later, perhaps much later. Although being a theory guy I like that because you are playing on rational expectations, it doesn’t seem as credible to me with the private sector. The way we are looking at it now, you would be talking far into the future, promising some more inflation—you know, in 2013 we will do 5 percent or something like that. It just seems too far away to have a lot of effect on our situation right now. Let me talk briefly about purchases of agencies and longer-term Treasuries. In general, I think this is okay, but I do not think we should expect a lot of impact from this. I think the effect will be marginal. I might remind the Committee that the famous Operation Twist from the 1960s was generally judged to be ineffective, and that is why I think the central banks did not, December 15–16, 2008 52 of 284 generally speaking, play games on the yield curve in the past. I guess I would prefer agencies to the longer-term Treasuries because of the more direct correlation with the mortgage markets. I think that might help our case a little in this current situation, but I wouldn’t expect a lot out of that policy. Expansion of 13(3) credit backstops—I see this as likely, the way policy is going. I think it is helpful in some circumstances. I would like to see us work harder, maybe much harder, on the metrics for success of these facilities and perhaps rework or discontinue facilities that may not be meeting expectations. We saw some justification here earlier in the report by Bill Dudley, which I interpret as saying that the goal is to reduce risk premiums from what markets say they should otherwise be. Frankly, I am not sure in all cases what the purpose of the programs is. We have a lot of them out there. We have ideas. We should quantify that. We should be assessing, and then we should turn around and say, “This one is working. This one is not working.” I would like to see a lot more in that direction. I understand that we haven’t done it so far because, obviously, we are running on all cylinders. We are fighting very hard here. But going forward, that is something we should be thinking about. Our other nonstandard tools are useful. Again, I think we need to reestablish with the private sector that the central bank controls the medium-term inflation rate, even in environments where the nominal interest rate is zero. A simple way to communicate this is to start talking more about reserves, the monetary base, and the monetary aggregates. Again, this has to be done in a reasonable way. We understand that taking out a program is going to change things, and we need to communicate that effectively. We understand that the links between money growth and inflation may not be exactly what we would like them to be, but this is the situation we are in December 15–16, 2008 53 of 284 because our interest rate channel has turned off. So in normal times, I would prefer to communicate in terms of interest rates, but that is not the situation that we are in right now. Let me talk a bit about the directive to the Desk. In my opinion, the directive should be in terms of the quantity of reserves, letting the level of the federal funds rate trade as necessary— again, not unlike the Volcker situation. Presumably, the federal funds rate would trade close to zero on average. The prescription to express the directive in terms of reserve quantities has a long tradition here on the Committee. That language was used at least through 1994, if I have it correct. I remember when I was first in the Federal Reserve System we would talk about the degree of pressure on reserve positions, and so there is ample precedent inside the System to work this way. I think that would keep everything working smoothly in terms of governance. I see no reason not to go in that direction. The introduction of new programs that are intended to have a minimal effect on the level of reserves, as occurred before September of this year, would not interfere with the reserves objective of the Committee. Others do interfere with that objective, and in that case they would need to be approved here. But my sense of the Committee here, though I can’t speak for everybody, is that I don’t think we would have any pushback on that, and we would keep the governance thing very clear if we did it that way. So that would be my preference. I agree with the Chairman that we want the best policy. We want to work in a cooperative manner, and I think that is one way to do it here. When the market turmoil abates, then we should begin setting target ranges for reserves or monetary base growth. Once the crisis is past, then we can begin setting a federal funds target again, maybe coming back with a range initially for the federal funds rate and then gradually December 15–16, 2008 54 of 284 moving back into the targeting regime, which I agree in normal times is a much better way to communicate policy. Let me talk just for thirty seconds on the communication of alternative tools. Above all, we have to communicate that we control medium-term inflation even when nominal interest rates are zero and that we intend to keep inflation near target. That is the overriding objective in this situation. Otherwise, you are going to let inflation probably drift far below target, and the market will be scratching its head about, well, what are you going to do about it? Okay. Thanks very much. CHAIRMAN BERNANKE. Thank you. Why don’t we take fifteen minutes for coffee and then come back and continue. [Coffee break] CHAIRMAN BERNANKE. President Hoenig, whenever you are ready. MR. HOENIG. All right. Thank you, Mr. Chairman. I would like to start off also by saying how much I appreciate this. I think it is an important opportunity for us not necessarily to agree—because committees are designed to bring different views together and, one hopes, to come to consensus—but to hear one another and to feel more comfortable knowing where we are as we move from here. So I really do appreciate this opportunity. I am going to go through the questions in somewhat the order they were given, and let me begin by discussing the first two questions on policy strategy. The key issues here are how low to move the fed funds rate target and at what speed. I agree with the view that keeping your powder dry is no argument for not going immediately to zero. However, I think that there are other good reasons for not going to zero at this time. In fact, the condition of the financial December 15–16, 2008 55 of 284 markets is a strong argument for being especially cautious at this juncture about going toward zero and about how fast if we were to choose to do that. It is clear from the studies, at least the way I read the studies that were provided—which I would also add were just excellent—that the market dysfunction in some very important markets, including the Treasury market, increases substantially as you move toward the zero bound. At what precise level this occurs is not defined, but evidence does suggest that it is a genuine issue. Indeed, markets are clearly showing signs of impairment in that the effective federal funds rate is trading well below the current target of 100 basis points. It would be unfortunate if our monetary policy actions were to cause major and avoidable effects on the functioning of these markets, especially with the current fragile state of the financial system and when the benefits, as I interpret them, are not obviously significant. I believe we can minimize the damage, so to speak, in these markets by maintaining the fed funds target above 50 basis points—I prefer 100—and by taking actions to ensure that the effective funds rate trades closer to the target over time, recognizing where we are starting from. The way to do this, of course, is to put limits on the size of the current swaps and liquidity programs—I suppose that is, as others have said, a size limit on the balance sheet—to the point that the Desk can begin to sterilize the reserve injections of these other programs. We are not there, I realize, but I would like to see that as the goal. Turning to question 3 on communication strategies, there is evidence that communications about the future policy path may have measurable effects on interest rates and other asset prices, especially in circumstances where the markets and the central bank have different views about the future policy path that need to be reconciled. Especially in the United States, a statement about the policy path is likely to be more influential on market expectations December 15–16, 2008 56 of 284 than a statement on inflation right now. As to the statement about the policy path, it is possible to have a significant effect on longer-term rates when market views about the policy path differ significantly from our views and there is credible commitment to keep the target rate low for a very long period of time. In general, I think that it is difficult to construct a very specific statement that is credible to markets and does not unduly tie the hands of this Committee. Consequently, if the Committee decides to adopt language about future policy actions, I would prefer more-general rather than more-specific condition statements. I would note that the moregeneral language we used in ’03 through ’05 appears to have been more effective than the Bank of Japan’s more-specific conditioning statements during the period of quantitative easing. As to the inflation communications, I would be opposed to a statement that suggests that inflation risks have threatened the dual mandate and that the Committee will act to mitigate this risk. I also expect inflation to come down over the next few months, but this reflects considerable unwinding of temporary factors, as we noted elsewhere, and the risk of deflation is modest at this time. I also would be strongly opposed to a statement that suggests that we would accept higher-than-normal inflation rates in the next few years. While such a statement might be appropriate in a deflationary environment, the U.S. economy is not yet at that point. Instead, our inflation rate has been higher than acceptable for the past five years, I believe in part because of our willingness—understandably, but still our willingness—to err on the side of accommodation. In the future, should inflation come in very low for a sustained period of time, such a statement about accepting higher inflation might have some benefit in preventing a sharp decline in inflationary expectations. But in today’s circumstances, such a statement could lead markets again to conclude that we would respond very slowly to higher inflation pressure in the future. I think it would confuse and not actually clarify. December 15–16, 2008 57 of 284 On nonstandard policy tools, I am okay with expanding the purchase of agency debt and mortgage-backed securities and longer-term Treasuries. Right now, all, in my view, are government guaranteed. However, I am not in favor of direct support of private securities through backstop credit facilities or other procedures. I am of the view that we have stepped far in the direction of credit allocation and have undertaken actions that are fiscal measures and not appropriate for a central bank, even in a crisis like this. In my opinion, the long-run costs to the economy and the Federal Reserve of engaging in credit allocation exceed the near-term benefits of supporting limited segments of the market. There is a relative price effect. In terms of agency and Treasury purchases, I agree that the immediate focus should be on reducing the agency spreads over comparable Treasuries. Treasury rates have come down a good deal, but agency spreads have widened. Normally, private yields move with the Treasury rates, as we know. However, the current crisis has largely broken the usual connection. Therefore, I don’t think that actions to lower Treasury rates further will have much effect on other rates, and I would concentrate more on bringing other rates down. However, in the coming months, as the economy begins to recover, Treasury rates will likely come under upward pressure. To the extent that markets begin to incorporate a view of the policy path that differs from ours, I think we might want to consider purchases, as discussed here, of longer-term Treasuries at that time or perhaps altering our communication strategy then. On the form of the directives, I would generally favor quantitative targets for Desk purchases. Although it will be somewhat difficult for this Committee to determine appropriate quantitative targets, I don’t think we want to move in the direction of specifying targets for interest rates or spreads for these other instruments because the exit strategy for these approaches could be very disruptive for the financial markets. December 15–16, 2008 58 of 284 In terms of communicating our use of nonstandard tools, if we go that way, I think that the more we say, the better for everyone. It is important to articulate the range of options under discussion; and when they are announced, it is important to discuss not only how they will be implemented but also how they would be expected to help in achieving our objectives. Right now confidence is quite fragile, as we all know, and so it is important that we send positive and constructive messages and not unduly surprise the markets with our actions. Two other issues not directly related: As we talk about our policies going forward, I think we really do need to spend a little more time talking about what it means in terms of the deleveraging process that is going on. People talk about it freely, but I don’t think it is clear in anyone’s mind and would perhaps affect our actions. Also we need to talk about the potential effects of the fiscal policies that will be unveiled soon. Thank you very much. CHAIRMAN BERNANKE. Thank you. President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. I add my thanks to the staff for the excellent summaries, particularly those that covered the Japanese experience. My reading of that experience argues for acting aggressively and moving directly to whatever lower bound we consider the effective minimum. The economic outlook has deteriorated sharply, and as I look at the incoming data and our near-term forecasts, I find it reasonable to expect that we will see more troubling data by the time of our January meeting. I concur with the Greenbook assessment that the outlook calls for a cumulative reduction of 75 basis points over the next two meetings. At the risk of jumping ahead a little, my preference is to get there at this meeting. If there is an argument for a more gradual two-step approach, it is that more communication is needed to explain the Committee’s strategy and condition the markets for a zero lower bound policy regime. I was on the receiving end of this December 15–16, 2008 59 of 284 argument at my Atlanta board meeting last week—which Don Kohn witnessed as a guest—at which some directors strongly resisted moving to the lower bound without, in their view, a clearly articulated statement about how policy will operate going forward. Mr. Chairman, in your speech two weeks ago you made a good effort to prepare the public for the possibility that the Committee may soon have to operate with policy targets that are unfamiliar. But it strikes me that there is a chicken–egg problem of when it is appropriate to lay out the new approach. Again, I read the Japanese lesson as move aggressively but at the same time communicate very clearly the whys and hows of the policy course. President Plosser pointed out in his memo circulated last week—and I believe President Lacker noted last meeting—that we have at least implicitly entered into a quantitative easing regime already. The fed funds rate has been trading for some weeks near the level that we are likely to find as the lower bound. I think we must move to a decision at this meeting on communication strategy, independent of whether or not we move to the lower bound in one step. I don’t see that this need is significantly reduced by delaying the move to the lower bound, especially if that destination is inevitable, as I believe it to be. On the question of costs of the zero lower bound policy to markets and financial institutions, in my reading of the analysis and the background memos taken as a whole, maintaining the effective funds rate at a level somewhere near 25 basis points may help avoid problems in some markets that would otherwise arrive at zero. I think we have to be concerned that at absolute zero the infrastructure of some markets might atrophy as market participants shift resources in the direction of operations where profits are more attainable. These concerns might argue for stating the federal funds rate target in terms of a range, and I would support a lower bound in the range of 0 to 25 basis points. December 15–16, 2008 60 of 284 As regards communication strategies, to state the obvious, financial market participants would prefer to know as much as possible about the level of rates in a zero lower bound regime, the duration of adherence to that policy, and when and on what basis the policy will change. The Committee can’t fully satisfy those needs, but we can provide assurances that equip market participants with a clear framework for planning and anticipating change of policy. I think it is important to communicate that we intend to stay the course with this policy until some combination of materially improved conditions obtain in both financial markets and the general economy. That is to say, we should indicate that the policy is not short-term shock treatment to be quickly reversed, unless, of course, conditions dictate. As regards indicating specific conditions that would inform a change of policy or a change of course, I favor an approach that addresses conditionality in general terms using language such as “the Committee intends to hold the federal funds rate target at this level until such time that it judges conditions are present for material and sustained improvements in financial market functioning and economic growth.” I prefer to reference general economic conditions rather than to use phrases like “near zero for some time” as in Bluebook alternative B. Further, I think it is appropriate to reinforce that our policy will be calibrated based on our longer-term inflation objectives. I am not comfortable with formal statements indicating that the Committee is willing to accept higher rates of inflation than it normally would find desirable. In my view, the goal is to avoid entrenching expectations that deviate too much from our explicit or implicit price stability objectives in both inflationary and deflationary directions. I think this goal is best pursued by stating our commitment to medium-term price stability. This statement can be in general terms, but I would also support the more explicit numerical reference in Bluebook alternative A. December 15–16, 2008 61 of 284 As regards more purchases of agency debt, agency MBS, and long-dated Treasuries, my view is that open market operations should be conducted in the manner that enhances overall market liquidity in the most efficient and least disruptive way. This may well be by purchases of agency debt and MBS beyond the level announced. However, to the extent that enhancing overall market liquidity requires efforts to directly manipulate prices in particular markets beyond the federal funds market, I think we may be better served by developing specifically targeted facilities to do so. As regards the further expansion of liquidity facilities, to date we have attacked dysfunctional market conditions in the interbank funding market, the Treasuries market, the commercial paper market, the mortgage market, and, shortly, the asset-backed securities market. The more we migrate with these facilities in the direction of general corporate debt and other nonfinancial issuers’ markets, the more our policy actions involve contentious issues of moral hazard, possible distortion of the necessary process of relative price discovery, and the appropriate division of labor between the central bank and the Treasury. I think that we just need to keep this in mind as new facilities are considered. The extension and broadening of existing facilities, and possibly new facilities, may be necessary. I judge that the broad policy of targeted facilities has been successful to date. Regarding nonstandard tools, I find myself in agreement with the thrust of President Plosser’s suggestions. In a quantitative easing regime, it makes most sense to express our directive in terms of a quantitative target. And as regards your comments earlier, Mr. Chairman, I tend to look at this target question as a tradeoff between targeting quantities versus prices or rates, and I believe that the quantitative target approach is the correct approach, even if we decide to operate with the common understanding that our short-term objective is, for example, December 15–16, 2008 62 of 284 to generate a particular path for long-term Treasuries or agency debt. Based on my reading of the literature and history as well as on my own experience, I have doubts about our capacity to reliably control specific relative asset prices, at least in markets unlike the federal funds market, where we are the monopoly supplier of the asset being traded. But that does not preclude setting quantitative targets for the purchase of particular assets and evaluating the appropriateness of those targets against a variety of outcomes, including the interest rates that emerge in those markets. I am, however, predisposed toward the line of thinking expressed by President Lacker in his pre-meeting memo. By choosing to express the directive in terms of the monetary base or some measure of reserves, the decisions of the Committee remain in the range of traditional monetary policy. My conjecture is that a reserve base quantitative directive would help to draw a clear line between traditional monetary policy decisions in the purview of the FOMC and the enhanced credit policies implemented under 13(3) authority. Let me move to the communication approaches. Again, internalizing the Japanese experience, we will be well served by a significant and coordinated communication effort. Our press statement might be supplemented by an additional explanation of whatever new operational procedures we adopt, followed by a public statement, perhaps even a press conference, by the Chairman. Throughout this crisis, we have been provided excellent support in the form of talking points. These have been a great help to me and my staff in providing accurate and timely information on the various policy actions taken by the Federal Reserve. With similar assistance in this case, I think we can collectively commit to providing the sort of common voice on the facts that will promote public understanding of the direction in which we decide to head. Thank you, Mr. Chairman. December 15–16, 2008 63 of 284 CHAIRMAN BERNANKE. Thank you. President Evans. MR. EVANS. Thank you, Mr. Chairman. I, too, would like to add my thanks to the staff for an excellent set of memos—very good analysis. I would agree with pretty much everyone that the economic outlook and financial stress warrant further relief for financial conditions, so I am going to be supporting, ultimately, further quantitative easing as needed. I have to admit that I am not quite sure what the most effective form of that easing is. It just doesn’t seem obvious to me. But I certainly embrace your suggestion, Mr. Chairman, of continuing the regular briefings, and when necessary, those should be meetings to affirm certain programs that are on the table. I agree with all of your comments about how important confidence is. Let me turn to some of the specifics of the questions about the standard policy issues with the fed funds target. With a deep recession looming and inflation receding, I see no reason to keep our fed funds powder dry. There is no reasonable uncertainty at this point about the deepness of the recession or the financial stress, and I think the economy would benefit from further financial accommodation. Because we can’t really hit our fed funds target because of the breadth of our lending programs that are on our balance sheet today, I think the damage to the Treasury repo and money market mutual funds is unavoidable at this point. For our policy actions, I think that we should continue to communicate in terms of our objectives. In my opinion, this strategy covers most of the issues asked of us. The fed funds rate will be low for some time under our forecast. I don’t think there is much doubt about that, and our forecast helped with that. Disinflation risks are part of this outlook, and I think that should be well understood. We can communicate that in our speaking. If our inflation target were explicit and we talked about it more—higher future inflation expectations than just, if it were the case, ½ percent or lower—that would be part of the communication calculus. As things stand, December 15–16, 2008 64 of 284 our long-term projections may be adequate here, but more explicitness in general would be helpful. It is interesting to me that alternative A encompasses all of these in relatively muted language. Frankly, if we are expecting a big impact from that statement, I think we need to include a bold font typeface, [laughter] because I don’t think it will be picked up necessarily. But I think it is really well done. In terms of the questions on particular interventions, the memos brought forward pretty clearly that the effect of the interventions depends on the size of the operations and where the markets are. The memos were very good about talking about individual markets and making me aware of a number of details, but they were often pretty much in isolation of how they would flow through to other markets. It is not exactly clear to me how important that segmentation or separation is to achieve the goals that we are hoping for from those interventions. I suppose in well-functioning markets you might expect more of those funds to be flowing across those markets, and so you would be generally providing market liquidity. It would flow around. In the current situation, with more stress, there probably is more separation. Is that ultimately going to mean we are more effective? I am not even sure because there is the added stress that has to be dealt with. So the particular interventions are not exactly obvious to me, and portfolio rebalancing could have implications. In one of them, there was a correlation matrix—for a particular size of operation, where agencies are influenced in one way or Treasuries are influenced—about when we would see other prices move around. That is possibly a guide to this leakage. But, of course, those are unconditional correlations, as I understood them, and I am not exactly sure how the exogenous interventions that we are talking about would translate from those correlations. It is really an identification problem at some level. My takeaway from that is that I find most comforting the December 15–16, 2008 65 of 284 quantitative easing additions that improve total market liquidity. It seems to me that the Treasury and agency purchases are the safest. When we get into credit allocation, we have these facilities in place, and we will probably need to do more. Mr. Chairman, you talked about the unwinding consequences that the Committee will have to worry about, and I think that they are also pretty important. Last, on the nonstandard approaches for quantitative easing and what that means for the Desk, I guess this is a harder problem with the dual governance issues than I had really anticipated. I would have thought that it was relatively straightforward—once we hit the zero bound on the funds rate that we would identify that we need to expand the balance sheet. I kind of like it in terms of the asset side. The Committee could authorize a broad range of what that would mean. We could reaffirm the existing lending programs—not approve them, for that is the role of the Board—and point to the important role that they are playing. Our statement could provide guidance on the sizes, which would pretty much just be a restatement of the existing sizes of the programs. But we could provide ranges of how the Committee might expect that to be conducted over the intermeeting period if something arose that required an addition, or we were being briefed on new programs as they were rolled out, that could be part of it. All of that said, I accept your good faith approach—the more we talk and the more that we understand this and are consulted, it should be adequate. In terms of communicating to the public, under the approach that I just mentioned we would basically state that the fed funds target is essentially zero because of all of the lending facilities. We’d have some statement about the range of the balance sheet, something that is not supposed to be so constraining but that would be somewhat helpful. The descriptions of the Fed lending programs would be part of that—they are well done—and the term sheets, and we would December 15–16, 2008 66 of 284 reinforce our commitment to the policy mandates that we have in our statements and our forecasts. So, just to conclude, I think we can go further down the quantitative easing policy path. I am not really convinced that this is going to do everything that we are hoping, and I am a little concerned as we get to the point where we have an intense desire to effect more that we might tend to disagree a little more. But I am confident that we will think it through very carefully. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kohn. MR. KOHN. Thank you, Mr. Chairman. I want to join the others in thanking the staff for their work. These are very difficult issues, and I think you have brought to bear a lot of what little information we have on these subjects and have kind of kept me out of trouble for the last week. My wife thanks you as well. [Laughter] I think the questions in the first set are largely moot, as a number of people have said. We are already close to the zero bound, and because I think moving there aggressively under the current circumstances is the right thing to do, I don’t have any regrets about that. Like President Yellen, I came into this situation, at least a couple of months ago, wondering why zero wasn’t the right lower bound. I recognize the market issues that might obtain—sort of as President Bullard said, I wonder whether markets won’t adjust as we go on—but so close to zero, the difference between 6½ basis points and zero isn’t going to matter very much. But I think we ought to keep our eye on how markets are functioning, whether they adjust, and where we should be. Now, once we are at a minimum—and I think we ought to get wherever we are going at this meeting, as soon as possible (a number of people have said that, and I agree)—we can’t December 15–16, 2008 67 of 284 influence actual expected short-term rates with our actions. We do need to rely on other methods to change relative asset prices—longer-term rates relative to short-term rates, private rates relative to government rates, nominal rates relative to expected inflation—and that is where the communications and the size and the composition of the asset portfolio come in. Both the communications and the portfolio actions can be effective and influential, but I think we need to recognize that we are losing our most powerful policy instrument. The effects of these other aspects of our policies are uncertain, and it will require some trial and error to figure out where we are going. With respect to communications, I do think it would be useful to tell people the conditions under which we expect to keep rates low and the conditions under which we would be prepared to raise interest rates. I think we can tell them if we think it is going to be soon or if it is going to take some time. But I agree with your point at the beginning, Mr. Chairman—and President Plosser and others said this—we should emphasize the conditions rather than the time period. We shouldn’t commit to a time path. I think something like this should help long-term nominal rates better reflect our expectations for the path of policy and could be especially important if markets come to anticipate a firming before we actually anticipate firming. It could come into play, particularly in the context of some massive fiscal stimulus, which seems to be coming. I don’t think we want the effects of that fiscal stimulus diminished or crowded out by increases in long-term rates that are based on a false assumption about the effect of the fiscal stimulus on monetary policy. I think being clear about where we want inflation to be over the long run will probably help anchor inflation expectations a bit better—keep them from drifting down when inflation itself is very low and keep real interest rates from rising—and thereby reduce the odds of December 15–16, 2008 68 of 284 persistent deflation taking hold. We will have an important opportunity to take a step in that direction if we agree to our longer-term forecasts in January. As President Yellen noted, the Subcommittee on Communications is recommending that. I think voting on an inflation target would be a substantially bigger step. That is, we would have to reach agreement on that. It could be a more powerful signal of our intentions, and it might become necessary. I certainly think we ought to discuss it. It has a lot of implications that we need to look at, including where we will be in a couple of years. I think we need to be careful. A number of people—outside commentators, anyhow—have noted that they thought that we kept our eye too much on macro variables in the low inflation period and that gave rise to these asset-price increases. I disagree, but I think it is an open question. I have seen comments from other members of the FOMC wondering whether we should look at more than just the path for consumer prices when we are setting monetary policy. But let’s not do something now without thinking about how it is going to play five or ten years down the road. I also agree with your point, Mr. Chairman, about congressional consultation. Having an inflation target won’t have any effect if it is repudiated by the Congress. As soon as we make it, it could have a negative effect. I think changes in the size and composition of our portfolio can affect relative asset prices. I guess I think, President Evans, that changes are more likely to be effective at times like these, when markets are illiquid and participants have very, very strong preferences for one sector or another. When private parties seem unwilling to lend to each other, substituting Federal Reserve credit for private credit can be quite effective. Carefully designed programs can reduce the cost of credit and increase the availability of capital to households and businesses. I see where we are as a natural extension of where we have been. Really since August 2007, we December 15–16, 2008 69 of 284 have been using our balance sheet to try to stimulate credit markets. At first we sterilized that by selling Treasury securities. Then we sterilized it by the Treasury selling Treasury securities. Then that program ran out, and we thought we could sterilize it by interest on excess reserves, and it didn’t work. But I don’t think we have crossed a sudden barrier in the last month or two. It is true that the base has begun to rise because we have run out of the other sterilization options. But I do think it is a natural extension of where we have been for a while. That brings me to the monetary base. I find myself more skeptical about the effect of increases in the monetary base per se than what I hear around the room. Such increases I think are supposed to affect asset prices by inducing banks to substitute into higher-yielding assets. Give them a bunch of reserves, and they substitute into higher-yielding assets like loans. But I wonder how effective that is when short-term rates don’t decline with the increase in the base because we are pinned at zero—that is, we are in a liquidity trap—and when banks are reluctant to expand portfolios because they are concerned about capital and their leverage ratio. So I don’t really understand the channels through which an increase in the monetary base, under these circumstances, is supposed to affect economic activity. We have seen a huge increase in the base over the last couple of months and no effect on the money supply. Now, that is very short term, I agree. Your observation, Mr. Chairman, was that we saw a big increase in the base in Japan. I agree with President Lacker that they weren’t as dedicated to that as they might have been, but I just don’t see any evidence that the base isn’t going to be absorbed in a declining money multiplier rather than an expanding money supply and increased activity. I don’t understand the channels. I think the base, as we are setting this out, is determined by the people who use our credit facilities. I think that is very important, and I don’t want to upset that. So I would be very, very hesitant to restructure the directive in terms of the quantity of reserves or the monetary December 15–16, 2008 70 of 284 base. I would have to understand much better what that means, and I wouldn’t want to constrain the use of liquidity facilities with such a restraint. I think the situation in the 1970s and early 1980s was very different. First of all, the October 6, 1979, meeting that went to monetary targeting was a natural evolution of a lot of work that had relied more and more on the money supply as a way of communicating about policy over time. Second, it was about constraining inflation, holding it down. I do agree, Jeff, that “too much money chasing too few goods” is something that people kind of understand. I am not sure that they understand the opposite—too little money chasing too many goods, or whatever, as a cause for deflation. I think it would be very, very difficult to communicate what that meant and how that was supposed to work. So it is a very different situation than we had back then. I do think we can help by increasing and directing our asset expansion in particular directions. We have seen evidence, as Bill showed us in the MBS and GSE purchases and the commercial paper facility. Also I favor the consideration of purchases of long-term Treasury bonds. I think that will help to lower longer-term rates in an environment of large liquidity and term premiums. I would consider expanding our purchases of MBS and GSE debt, if it looks as though they might help bring down mortgage rates. I agree with others who have said that they would be very reluctant to specify such operations with a rate target because I don’t think we can really control that. So I think that talking about quantities would be much better, as we have done with the MBS. I would also continue to look for other ways to use our discount window to help restart credit markets or substitute for private markets in which the functioning is impaired, and I would be open to a variety of possibilities. December 15–16, 2008 71 of 284 I agree that credit allocation is very uncomfortable for the central bank. We are into that. We have been into that for a while. I wish we didn’t have to be there. But I don’t see any evidence that the private sector is going to start lending anytime soon on its own. If I saw that some of those other markets with which we weren’t involved and weren’t likely to get involved—like the junk bond market that Bill showed us in that chart—were beginning to open up without our help, that would be fine. But nothing is happening out there in the markets that we are not touching. I don’t think that is only because everybody is waiting for us to intervene in those particular markets, because there are a bunch of them that they know we can’t or won’t intervene in. So we need to remain open to possible further credit market interventions. This raises very difficult governance issues. Our inability to sterilize and the huge increase in our balance sheet raise very difficult questions about how the Board and the Reserve Banks together carry out their shared responsibility for achieving the objectives of the Federal Reserve Act. It is not so much about legalities as it is about how to reach the best decisions and how best to explain those decisions to the world at large. We have always worked in a collaborative and cooperative way, and I think we need to continue to do that. Crisis management strains the normal collaborative and deliberative mode of Federal Reserve operations. Decisions get made on short notice, often over a weekend, but as you said, Mr. Chairman, we can work at improving our collaboration. The FOMC, as a body, will continue to have the major influence on our communications about the outlook, the likely path of rates, and the acceptability of the inflation outcome. The key elements in our communications have always been and will remain under the control of this group, and that is a large part of what we will be doing. I agree that we should, when consistent with fulfilling our obligations to protect financial stability, consult more and earlier on liquidity facilities. December 15–16, 2008 72 of 284 I hope that we can emerge from this discussion and subsequent ones with an agreed-upon framework for what we are doing and what motivates it under these unusual circumstances. I think we—the Federal Reserve System, the FOMC, all of us—should consider issuing an explanatory document on these matters that we can all agree to. I wrote this before this meeting. Now that I have heard the meeting, I am not sure it is possible. But I think it might be worth the effort. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Are you in charge of drafting it? [Laughter] President Stern. MR. STERN. Thank you, Mr. Chairman. Let me make some comments, first about nonstandard policies, then about communication, and finally a bit about the balance sheet, governance, and so forth. With regard to the nonstandard policies, Bill Dudley’s charts 24 and 25 showing the spreads narrowing with intervention and spreads tending to widen elsewhere seem to make a pretty compelling starting point at least, not only for the value of the programs in place but perhaps for considering additional ones. I guess I am kind of wary about that at this point. A sentence in one of the staff papers that pertains to this—let me also compliment the staff for the quality and the volume of what they have produced here—caught my attention: “It is difficult to provide specific recommendations for further intervention at this time, in part because facilities that are most obviously valuable to address current conditions have already been put in place or are in train.” That is one concern I have—that we may be heading toward diminishing returns. In addition, as I think somebody has already observed, there is a possibility that, if we carry this too far, we interfere with what would otherwise be normal and healthy market adjustments. Some of that is going to have to work its way through. Finally, one thing from the Japanese experience is the so-called preservation of zombies, which, whatever you December 15–16, 2008 73 of 284 might say about its short-run value, clearly wasn’t of value to the long-run health of the economy. So my preference as far as nonstandard tools would be to emphasize purchases of longer-term Treasuries and of GSEs and mortgage-backed securities. At least at this point, that is where I would want to put my emphasis. With regard to communication, as I think President Evans said, reiterating our longer-run objectives, indicating—given conditions as we perceive and expect them—that the funds rate is likely to remain low for a considerable period of time or, alternatively, that reserve provision is going to remain generous, however we want to say it, is acceptable. There could be some value, if we can get there, in specifying an inflation target, and certainly the effort to provide longerterm steady-state forecasts will work in that direction. I think we need to be a little careful, though, as Governor Kohn suggested, to think through a variety of issues that are associated with this. I can even imagine that, even if we were to agree on an inflation target and even if the Congress had no objection, it might be a bit of a distraction at this point and there could be a lot of debate external to the System whether it is the right target and why or why not, and so on and so forth. Of course, that is not our principal concern at the moment. With regard to the balance sheet and governance issues, I certainly can get comfortable with the consultative, collaborative approach you described. There might be some value from a credibility point of view—I put this more as a question than a conclusion—in trying to specify some numerical range for the base, reserves, or something in that the public could monitor whether in fact we are doing what we say we are doing. To the extent that we are concerned about the possibility of excessive disinflation or of deflation, this would be a way for the public not only to take our word for it but also to monitor that in fact we were conducting policy in a way consistent with that. President Lacker, in his discussion, indicated that emphasizing the December 15–16, 2008 74 of 284 base was a way to emphasize, at least in the longer run, that we weren’t intending to let inflation get too low. I put this as a question—this could be a way of helping credibility because the public could monitor it. Thank you. CHAIRMAN BERNANKE. President Rosengren. MR. ROSENGREN. I would also like to join the chorus of people thanking the staff, in particular the staff members who were working on the memos on Japan. Having done some work on Japan myself, I know that getting the institutional details right is far from easy, particularly when you are not a native speaker. So I much appreciated the work in that area. The probability of a severe economic downturn accompanied by deflation is too high, and the effective fed funds rate is already very close to zero. This combination calls for aggressive, nontraditional policies. My reading of the parallel Japanese experience highlights two general principles. The first is one that President Stern highlighted. There is a macroeconomic impact from what we do in bank supervision. Banking problems should be addressed expeditiously, with realistic write-downs of problem assets and recapitalization of problem banks. In particular, we should prevent perverse incentives where problem borrowers are supported while healthier borrowers are starved for credit as banks try to satisfy balance sheet constraints and avoid further loss recognition. Second, monetary and macroeconomic policies to address financial dislocations should be proactive and forceful rather than released gradually over an extended period of time. In the context of the questions that we have been asked to address, I’d like to encourage us to take three actions. First, I would explicitly state that the Committee seeks to achieve a core PCE inflation rate of 2 percent in the medium term. For the second time this decade we are approaching the zero nominal interest rate bound. Setting too low an inflation target threatens to place us in our current December 15–16, 2008 75 of 284 predicament too often. In contrast, by setting an explicit target at 2 percent, we will indicate our resolve to take nontraditional policies necessary to achieve that goal. Because the inflation target adopted under the current circumstances would be designed to raise inflation expectations and stimulate the economy, this may be a particularly propitious time to adopt such an explicit target. A 2 percent target would also be consistent with our own revealed preference as the core PCE inflation rate has averaged 1.94 percent, very close to 2 percent, over the past ten years. Second, during the past recession, 30-year conventional mortgage rates reached 5¼ percent. The current rate has been hovering at 5½ percent and has reached that level only since we announced our program to purchase $600 billion in GSE debt and mortgage-backed securities. The housing sector remains the epicenter of our problems. Given the current outlook, I would suggest using facilities to move toward an interest rate target, for example, by reducing by 100 basis points from current levels the conventional 30-year mortgage rate. Lowering the 30-year conventional mortgage rate would reduce the cost of purchasing new homes, encourage refinancing by those with sufficiently high credit scores and equity in their homes, and support fiscal policies that are targeted at more-troubled homebuyers. It would help troubled and healthy homeowners, stimulate the most distressed area of our economy, and help financial institutions exposed to problems in housing. Such a target would be understandable to the general public, and actions already taken have made some progress in this area and serve as an example. I would focus on the mortgage rates rather than the Treasury yield curve because lower Treasury rates seem to be having little effect on rates paid by households and businesses, and the desire to avoid credit risk has already brought 10-year Treasury rates to lows not seen in most recent recessions. Third, our facilities for short-term credit have been successful. Short-term commercial paper rates have fallen as a result of our programs, as was highlighted by Bill Dudley, and the December 15–16, 2008 76 of 284 rollover risk at the end of the year has been mitigated by the commercial paper program. Increasingly, however, I have been hearing complaints about banks pulling lines of credit when they are up for renewal primarily because the banks are facing balance sheet issues. One possible remedy might be to extend our commercial paper facility to highly rated firms for longer maturities than are covered by the commercial paper market. All three suggestions would be easily communicated and understood by the public, would address directly the areas of the economy in which financing has become particularly difficult, and would highlight our resolve to avoid a deflationary economy, such as Japan experienced for over a decade. I would just end with the note that I agree with the Governor Kohn on the monetary base for two reasons. The first is that I do not think our facilities have been particularly well designed to set a quantitative target. Many of the facilities are open ended. Go through the following thought experiment. Suppose a money market fund once again breaks the buck. The AMLF will probably go up $150 billion or $200 billion. I would expect the commercial paper facility to go up. I would expect that most of the bank facilities would also go up. If we were limited by a quantitative target at the very time that we actually want those facilities to be expanding, we would be constrained. I do not think that is a good idea in the current situation. The second reason comes from my reading of what happened in Japan, and this goes to some of the remarks that the Chairman made. The monetary base in Japan did expand very rapidly. When banks are capital constrained, expanding reserves very rapidly does not translate into an expansion of the broader balance sheet. So we could very easily see a situation in the United States in which banks continue to be capital constrained for some time. Despite increasing the monetary base, we might not see an expansion in terms of other assets. That is exactly why I agree with the Chairman that we should be focused on the asset, not the liability, side of the balance sheet. December 15–16, 2008 77 of 284 CHAIRMAN BERNANKE. Thank you. President Pianalto. MS. PIANALTO. Thank you, Mr. Chairman. I also want to start by thanking the staff for the excellent background materials they provided. While I certainly wish we were not in this circumstance, I do think that this is a critical conversation for us to be having at this meeting, and the background materials were extremely helpful. I am going to proceed directly to the questions that Brian provided as I believe they cover the major issues well. I have some general answers to the questions, but I think that we are going to be learning a lot in the process of implementing policies into ever more uncharted waters. On the question of whether the Committee should quickly move the target fed funds rate toward the zero bound or get there more gradually, I strongly support moving quickly. I agree with the memos that the Japanese experience points to the value of moving aggressively. Also, we have already moved beyond the targeted fed funds rate as many have commented, and so we are merely confirming a reality. On the questions pertaining to the costs to financial markets or institutions and the limits to our rate reduction, I think the notes covered very well the costs to some money market funds. Bankers in my District have also expressed concerns about additional margin squeezing that they will face with a lower fed funds rate. So, yes, there are significant costs to financial markets and institutions. However, I believe that the current environment and our need to allow the fed funds rate to trade close to zero trumps these costs, and in my view a 25 basis point fed funds rate is an appropriate minimum. Regarding the question about the communication strategy, I think another lesson that we have learned from the Japanese experience is the role of effective communication and the role of anchoring inflation expectations. So I do see the benefit in communicating that the Federal Reserve December 15–16, 2008 78 of 284 intends to hold the target fed funds rate at a very low level until specified conditions are obtained, and that the Committee sees a sizable risk that inflation in the coming quarters could be appreciably lower than is consistent with price stability. I also see that there may be some value to communicating that our policies might result in a temporarily higher inflation rate in the future, both to indicate this possibility and to signal a willingness to make sure that the risk of deflation dissipates before we alter our course. Although we have not adopted a formal inflation target, I do believe that the release of our longer-term projections as suggested by the Subcommittee on Communications will be helpful in managing inflation expectations. Moving to questions 4 and 5 regarding nonstandard policy tools, my own preference is for a mixed strategy—that is, some direct Treasury and agency purchases and some expansion of our private asset purchases using the TALF. I support your view, Mr. Chairman, that we should keep our focus on expanding the asset side of our balance sheet. I think we should consider increasing the purchase of agency debt and mortgage-backed securities beyond the levels that we have already announced. I also see advantages in initiating large-scale purchases of longer-term Treasury securities. These actions should help to lower interest rates across a broad spectrum of longer-term assets. As we have talked about, direct purchases also fit more naturally into the FOMC’s governance structure, whereas the TALF-like approach is more awkward to fit into the FOMC’s purview. As some have commented, direct purchases might expose our System Open Market Account to some capital losses, but that seems an acceptable risk for monetary policy in such a challenging environment. I do think that the focus of our FOMC meetings next year should be on evaluating and adjusting the composition and size of our purchase of securities in response to changing economic conditions so that the directive need not build in explicit conditioning on market and economic December 15–16, 2008 79 of 284 circumstances. Further expansion of our credit backstop facilities under section 13(3) is also likely to be beneficial in current circumstances. I think the CPFF has been a helpful addition to our facilities, and I am hopeful that the TALF will be equally effective. So, in summary, I favor applying all of these approaches and remaining flexible. I also believe that a clear starting point on how the Committee would formulate its directive would be to direct the Desk to purchase specific quantities of assets. As a formal matter, we might need to include “up to” in our directive language, but we should anticipate that the Desk would be successful in meeting that objective. I think that the uncertainty surrounding the effects of our actions makes longer-term interest rates or spreads too unreliable to be communicated as targets. Finally, on the question of effectively communicating nonstandard policy tools, I liked the language in some of the Bluebook alternatives for our policy options. However, because of the historic nature of implementing nonstandard policy tools, I think that a good communication plan should also include a formal press conference or a speech in which, Mr. Chairman, you announce the changes. That would serve to emphasize the change in our procedure and eliminate some of the uncertainties about the role of the fed funds rate target. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. First Vice President Cumming. MS. CUMMING. Thank you. Again, I’d also like to thank the staff for the excellent notes. It’s useful to start out with our near-term goals, as most of us have done, to provide stimulus and support for the economic recovery and to prevent too large a fall in inflation. The root problems, I think, are worth focusing on for a second: insufficient global demand, hurdles to economic activity from a severely impaired financial system, and as I’ll report tomorrow, behavior that is influenced by confusion and fear among businesses and households that are tending to reinforce the downward trend of the economy. December 15–16, 2008 80 of 284 That environment, I think, gives us some goalposts to look for in terms of framing the strategy. I find very appealing Marvin Goodfriend’s characterization of the duality of the central bank’s policy. We have a monetary and what he calls a credit policy at the same time. In normal times setting the fed funds rate influences financial conditions, especially credit markets, in a fairly predictable manner, and this Committee from time to time has discussed where overnight rates and financial conditions have diverged. In these times, we’re observing a major disconnect between overnight rates and financial conditions that is reflected in huge spreads but also in a lack of transactions and in nonprice rationing in markets. So coming back to the question of what some of our goals are: To address the problems that we see, communication is really the essential element, and we should be aiming for maximum impact in whatever actions we take and also in our communications. I think, therefore, that we should bring rates down now as far as we think we can take them. But the more important decision is articulating what we are going to do going forward, why we are doing it, how long we are planning to do it, and under what conditions we would stop doing it. Some of the confusion that is out there about what the Federal Reserve has been doing reflects the fact that our operations really cover two very different kinds of things. On one side we are expanding liquidity and supporting the recovery of financial markets by the CPFF, the MBS purchases, and the upcoming TALF. In other facilities we are preventing catastrophic market outcomes through asset disposition, such as the Bear Stearns transaction, AIG, and the recent transaction we’ve had with Citi. In addition, there are a lot of technicalities and legalities to these facilities that make it hard for the general public to understand what we are doing. So more fundamentally we need to communicate what we want to accomplish, and that importantly involves our commitment to price stability, as many have said here December 15–16, 2008 81 of 284 in the sense of keeping prices in the medium term rising in line with our 1½ to 2 percent preference, and our commitment to a resumption of sustainable economic activity. When I turn to look at what kind of facilities we should be thinking about going forward, once interest rates are down to their minimum level, there are really a few things that I would highlight. First, in many ways we could influence expectations about short-term policy rates through our long-term debt purchases, as many have said. In particular, when we try to lean against expectations expressed in the yield curve that rates are going to rise soon, and we’re seeing some of that today, we can intervene in markets that directly affect major elements of aggregate demand, and I would see that as a very important role of our agency MBS program and also the CPFF to address where firms are really being starved of working capital. Because of its structure, the TALF provides a very broad umbrella under which we could do intervention, again, where we see credit markets failing and economic activity impeded by the lack of finance of a wide variety. I think that we should look at the CPFF and the TALF more as backstop facilities that provide the credit we need but also build in a kind of exit strategy so that, when spreads come down, there is an opportunity for the market basically to tell us, “You can wind this down now.” We need to communicate the criteria by which we are choosing these markets. We have mentioned these three big market segments. I think simpler is much better than having something that’s very complicated or having many, many facilities. As part of this, the crucial thing is to provide to the marketplace some kind of conditional commitment. If we don’t feel that we’re ready yet for the inflation target, certainly between this meeting and the next we really need to think about what kind of conditional commitment we could make—what conditions in the marketplace would lead us to feel that our work was largely done. December 15–16, 2008 82 of 284 I would also note, though, that the historical notes made the excellent point that the risk is that we withdraw stimulus too quickly—that we believe the patient is healing when, in fact, the patient is merely stabilized. So our commitment must be both ambitious in its level and compelling as it is communicated to the public. I think we need to return to the expository approach that the Fed and then-Governor Bernanke took during 2002 and 2003, by which we carefully laid out the elements, the foundation, and the expected outcomes of our approach in that period. As valuable as it was in 2002-03, it is even more valuable today, when confusion and anxiety are shaping behaviors that will amplify the downward forces in the economy. I also endorse the recommendation that many have made to think about a press conference. The need for reassuring communication to the public is, I think, very great. I would add two more thoughts. Of course, it is really crucial that we are coordinating our policy with Treasury, and there are many ways in which we do that today—certainly, we need coordination of fiscal and monetary policy. I frankly would like to see more of our asset-disposition activities taken on by the U.S. government so that it would be easier for us to describe the facilities that we have as supporting the market and restoring market functioning. I also believe, as I’m sure that many of you do, that we will probably need some kind of agreement with the Treasury vis-à-vis our exit strategy. I particularly underline the real possibility, which several have mentioned here, that we may want to raise interest rates well before the markets are really fully healed or fully sustainable by themselves. We’ll need to be able to negotiate that in the sense of both the path we take and the understanding we have with the fiscal authorities. Then just to conclude here, I also very much want to endorse the point that President Rosengren made about needing to fix the banking system and doing it sooner rather than later. There really is no ability for the economy to function without a strong banking system. Certainly I December 15–16, 2008 83 of 284 believe that you are hearing, as I am, of many instances in which the rationing that is going on through the banking system right now is reaching a destructive potential. In that kind of world, I think we need to turn our attention to that. The Federal Reserve is one of the most important supervisors in our country and in the world, and I think we can do a lot to lead to the very tough actions that need to be taken there. Thank you. CHAIRMAN BERNANKE. Thank you. Several people have mentioned press conferences. I should say that we’re looking very carefully at the idea of doing quarterly press conferences with the release of the projections, along the lines of the Bank of England. If we decide to do that—and input from the Committee is welcome—the first one would be in February. It would coincide in this case with the Humphrey-Hawkins additional presentation. I have a speech at the London School of Economics in mid-January in which I will be able to lay out a lot of these issues. I don’t know if that’s soon enough, but I don’t know whether we think we should do more communication or not. That’s something we can talk about tomorrow perhaps, but I did want you to know that we are looking at the quarterly press conference model. President Fisher. MR. FISHER. Mr. Chairman, my colleague Harvey Rosenblum made an interesting point the other day that we’re at risk of being perceived as migrating from the patron saints of Milton Friedman and John Taylor to a new patron saint—Rube Goldberg. [Laughter] By the way, I’m going to give a speech on Rube Goldberg next Thursday—I do think that it is important not to make it needlessly complicated. So I think it’s very important that we have this discussion. I welcome the discussion and welcome the papers so that we can not only have a cognitive road map for ourselves but also figure out how we’re going to clearly articulate a deliberate change in regimes to the public. I want to underscore what you said at the beginning of this conversation, Mr. Chairman. December 15–16, 2008 84 of 284 We should be guided by what’s best for the country—period—and not get into internecine concerns about governance. It’s what’s best for our economy and what’s best for the world economy. I’d like to talk about three points. I want to talk about the current predicament in very general terms. I want to touch on governance and then on communications. First, with regard to our current situation, it’s pretty clear that purchases and sales of fed funds have been distorted by risk aversion, distrust of counterparties, and fear of pending bank insolvencies. Quantitative easing resulting in massive excess reserves, we’ve talked about that; complications arising from the transition to paying interest on required and excess reserves—as you pointed out earlier, this is a regime shift that we’re still trying to effect and perfect; the need for GSEs to invest overnight money at any positive rate; bank capital shortages that prevent the GSE funds from being arbitraged; and quite possibly the FDIC’s temporary liquidity guarantee, although that seems to be a minor factor—in these circumstances, focusing on the fed funds target seems to me to be a diversion of our focus and energy, and I sent around a memo to that effect. Moreover, the shortterm riskless rate, the T-bill rate, is virtually zero. Reductions in the targeted fed funds rate cannot lower the riskless rate any further. Adding to our difficulties is the fact that we simply do not know how financial intermediaries or money and capital markets will behave and function when interest rates get this low. We do have the Japanese example. We are not Japan. I have worked and lived in Japan, and we have learned from what they’ve done. But the fact is that we have no sustained experience in the modern era in the United States with T-bill rates and the effective fed funds rate trading near zero. We do know that money market funds will become unprofitable if rates get much lower. Let me just say to those who sort of dismiss that, I think we might look a little foolish if we drove some of them out of business, especially after creating two special facilities to support their continued December 15–16, 2008 85 of 284 intermediation functions on the basis that they were critically needed for their roles in the commercial paper market. Furthermore, I’ve spoken with several community bankers, and I subjected Governor Duke to some of that during her visit to Dallas. Their unanimous response to a further reduction in the targeted fed funds rate would be to set a floor for their prime rate at its current 4 percent level or some of them are suggesting that they would switch to a lending rate based off LIBOR—again, with a floor to protect their margins, which are being severely tested. To the extent that larger banks depend on deposits as a source of funding, reductions in the fed funds target rate from current levels could damage their profitability also, and this goes to one of the points made by President Rosengren and First Vice President Cumming. We do have to bear in mind that it’s important to have a vibrant and healthy banking system across the country. In this new and untested interest rate environment, it is, in my opinion, tenuous to assume that the fed funds target rate is the marginal cost of funds to a bank and that all of the usual and customary costs in pricing relationships will hold. If deposit rates approach zero, as they are likely to do for all but the zombie banks, it’s probable that the demand for currency will increase, a prospect that I would prefer to avoid. To sum up, we’re in an interest rate environment in which the linear properties of our model are likely breaking down. So where does this leave us? It leaves us with the critical need to refocus our strategy and communication efforts on what we have been doing and will continue to do—namely, restore the public’s confidence and trust in financial intermediaries and financial markets, reduce term liquidity and credit spreads to something approaching more-normal levels, improve the flow of credit through financial intermediaries and financial markets, and restore economic growth and reverse the spillover of inflationary pressures from asset markets to the markets for goods and services. Operationally it seems to me that we need December 15–16, 2008 86 of 284 to shift our focus away from the fed funds rate target—parenthetically, which we cannot control—to something that we might better influence—namely, the reduction, or perhaps a better phrase, the normalization of liquidity and credit spreads. The fact is that we have already entered this domain, and by stating it that way—that is, approaching the normalization of liquidity and credit spreads— we would have a clear exit strategy, and we could discontinue this focus when spreads return to something approaching normal. This has the additional advantage that it is a conditional commitment. I would avoid any reference to specific targeting for the monetary base or the size of our balance sheet. We simply do not know in current circumstances how fast or how far, as I referenced earlier in my question to President Lacker, we need to expand our balance sheet to restore normal spreads or normal credit flows. Some of our facilities—for example, the MMIFF—have worked with almost no usage. Others have acquired extensive usage. In sum, it seems clear to me that focus on the target fed funds rate is misplaced in the current environment. If we are to restore the functioning of the credit markets, we need to address that objective explicitly. With regard to governance, in addition to reading the 21 papers that were sent out and the Bluebook, this last week I read a novel called World without End written by Ken Follett. It should have been called A Book without End because it goes on for 1,000 pages. [Laughter] It’s about the plague in the fourteenth century. One of the interesting lessons from reading that book is that the monks in that period, who dominated society, reverted to the old orthodoxy learned from the Greeks. They were the best educated. They were the Oxford-educated intelligentsia. But by reverting to the old orthodoxy, they did not learn what the nuns learned, which is what you learn from practice. The reason I mention this, Mr. Chairman, is that I think there is great value, as we try to figure out and articulate the new regime, to have these shared discussions at the table. I want to December 15–16, 2008 87 of 284 thank you in that sense for your comments, not only about good faith but also about the need to have this discussed broadly within the FOMC and not just adhere to the old orthodoxy. All of us have different levels of experience and backgrounds, and we learn from those different levels of experience and backgrounds. Finally, on the issue of communications, one of my colleagues often says that, if you’re Elton John, you are expected to sing “Bennie and the Jets” every single time and at every single concert. It seems to me that, once we get and hone our message, we must repeat it incessantly and stay on message in order to have it penetrate. In Austin, you gave what I consider to be a hallmark and—not trying to flatter you—for monetary policy a historic speech. What was Bloomberg’s first reaction? The Fed may cut rates further. The message was lost. We all need to stay on message. But I think it’s very important, whether we have press conferences or whether you give speeches, that we need to hammer the theme of the new regime that we are about to embrace over and over and over again. So I didn’t pick “Bennie and the Jets” just because of your name, Mr. Chairman. [Laughter] But I do hope you remember that we must have that constant refrain. If we’re going to sell something, we have to sell it by repeating it, not asking the press to interpret it for us but to get the message out in—excuse me, Governor Kohn—full frontal view. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. I’m in awe of a presentation that has Rube Goldberg, the Black Death, “Bennie and the Jets,” and full frontal view all in it. [Laughter] Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. I’m a visual thinker. [Laughter] So I’ll begin where Governor Fisher ended his remarks. To thank Brian, David, and Nathan for two reasons: First, obviously I thought you did a great job, and second, I didn’t want to be the first jerk around this table not to acknowledge you. So I felt some burden now to be 15 for 15 and thank you for the work. December 15–16, 2008 88 of 284 Let me make three background points and then try to answer some of the questions that Brian asked of us. First, I think we have two risks in the zero lower bound discussion. One is overstating the importance of our judgments today in helping the economy get back to potential. The second risk is understating the importance of prospective Fed actions given our frustration that our policy accommodation to this point has only partially offset the deterioration and credit weakness in the real economy. The first trick is getting that balance right, recognizing that our actions are important but probably not determinative, at least solely determinative of the outcomes, given what markets will end up doing with the messages we send and given the need for fiscal and other policies. The second trick is that, notwithstanding our announcements or what we take to be our target, the effective rate is likely to be very close to zero for quite some time. So maybe more precisely in this context, the zero lower bound problem could be understood to mean that the expected protracted period of weakness will come because monetary policy is unable to provide enough stimulus to generate a robust recovery. That is true as far as it goes, but we shouldn’t assign more import to this problem than it deserves. That is, the protracted period of weakness is not simply or largely about monetary stimulus. It’s about a broken financial architecture of which the official sector response, including monetary policy, is only one piece. At the same time, monetary policy can’t be as efficacious as desired and is constrained by these zero lower bound problems. Thus, we don’t have a free pass to stand idle. Incremental interest rate policy may be of limited value, but it’s still relevant in stimulating demand. Second point—the judgments today are made harder by the degree of market discontinuity and market dysfunction. I take very seriously the risk that reducing the fed funds rate to zero could further degrade the functioning of financial markets and do so at a very inauspicious moment. Getting that market functioning is our way out of this mess, and though we would in normal December 15–16, 2008 89 of 284 markets expect money market mutual funds and regulated and unregulated financial institutions to adjust, there’s a lot about their behavior in the past six months that hasn’t followed normal custom. I worry at this time, when we’re trying to get markets to respond, about putting an incremental burden on their reaction function. The current period is distinguished from 2003 and other antecedents by the broader systemic fears about our system of credit intermediation, and I agree strongly with the idea advanced in the materials that were presented last week that the level of the Treasury repo rate is more critical to Treasury market functioning and the functioning of other markets than the target rate or the effective fed funds rate. The deterioration in repo market liquidity that Bill and others spoke about correlates strongly with lots of other bad things—fails in Treasury markets, the inability to predict market clearing prices, and the inability to hedge other assets. During this period, in which we have seen this unfortunate behavior, everything else seems to have gone wrong as well, so it is hard to draw any causation here. But I do worry about those market effects. As a third point, on balance I’m inclined to believe that the macroeconomic benefits of pushing the envelope to get to zero may be outweighed, particularly now, by additional financial market problems. In more normal circumstances, disruptions in these markets could be addressed quickly by changes in market practices. But there is reason to worry this time how quickly they could come. Let me turn now to some of the questions that Brian raised. First, on the question of whether we should move or keep our powder dry, I think it’s clear that, once we decide and we know where we want to go, we should move as swiftly as possible to get there. But I think the key word there is “readiness.” So when we want to make this final move, we need to be ready in three respects. First, the Board and the FOMC have to be ready in terms of what our consensus is. December 15–16, 2008 90 of 284 Second, the markets must really understand why we are making this change in regime—they need to comprehend fully what is driving our policies. Third, we have to have an operational ability to perform and execute, and that’s really a question for Bill and his colleagues as we continue to expand our facilities. The second question was about the cost of reducing the fed funds rate target to zero. I would put it simply that the zero lower bound in my opinion isn’t zero, but it is lower than 1 percent. I’m not sure if it’s 25 or 50, but I would be probably cautious about pushing beyond the point of our comfort. Third, in terms of the benefits of communications, we are judged by our actions far more than our words, and I think the markets have gathered a view of what our reaction function is. So when we talk about the need for our communication language to emphasize the conditionality of it, I think that’s quite consistent with how we’ve talked previously about our forecast. Our judgments on policy are dictated by our forecasts. As our forecasts change, so too might our decisions. So I think I’d put our communications in that regard. In terms of introducing or reintroducing an inflation target at this point, I’m not sure that it would, at least in the short and medium term, drive the kind of market reaction that we would expect. I think markets would be wondering, after long discussions over the previous eighteen months about subcommittees and communication policies and inflation targets: Why now? Is it that we’re actually now more concerned about inflation expectations and the medium-term view of what’s consistent with price stability than we were during much of that period in which we were talking about inflation that was higher than our expected range? I’m not sure I have been able to internalize and conclude why that would be appropriate at this very moment to introduce into our statements. December 15–16, 2008 91 of 284 In terms of nonstandard policy tools and the purchase of large amounts of agencies and Treasuries, I think that the Chairman’s point about the composition of the asset side of our balance sheet is key. In a different regime, I would have been uncomfortable about agencies. But my view is that they are wards of the state at this time. The U.S. government has said so. To the extent that we can provide our fire power to both the Treasury market and the agency market, it is probably worthwhile to do both. We probably have an opportunity to test the importance of some of these nonstandard policy tools in executing the timing and process and making public our announcement to this point of providing up to $600 billion in aid to this market. I would prefer to avoid setting a ceiling on conventional rates—that’s not the role of the Fed. Better to leave that announcement to others. I think it is also critically important with respect to agencies that we make sure we understand the posture and policies of the new Administration. If they think that the agencies are effectively going to be treated like wards of the state, I’d feel more comfortable. In terms of the expansion of credit backstop facilities, my first concern would be that I’d defer to Bill and his colleagues about operational bandwidth. Second, I think we probably have an opportunity—and you do, Mr. Chairman, in your speech early next year—in announcing what our criteria are and what our framework is for expanding our credit backstop facilities. Third, I’d say that we do need to address, probably in that same period, our exit strategy and clean up any edge problems that might have developed during this period. The CMBS market is in lousy shape. I think that’s not largely because of what we’ve done, but there is a gravitational pull on the bit of liquidity that is out there to the residential market and away from the CMBS market. There’s probably an opportunity for us to try to clarify that in the context of the TALF program. Finally, in terms of other nonstandard tools that would be particularly useful, again, I think it would be important to state publicly in all of our discussions the need for the fiscal authorities to be December 15–16, 2008 92 of 284 taking first losses and ensuring that the new Administration, the new Treasury, is prepared to support the Fed in that so that they’re in the credit-loss business and we are really just using our facilities and knowledge to put that into place. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. MR. KROSZNER. I thank you very much. I will make it 16 out of 16 on the excellent work of the staff, but I think also something that comes through from that is that we have to have a great deal of humility given the situation that we’re in. We can use analogies from Japan. We can use analogies from other parts of history or from Sweden, but there are a lot of parts that are unique, and a lot of what we’re doing is, as I think President Bullard said, outside where some of the data have been in the past. So we do have to come at this with a little humility. Actually, the Japanese experience weighs very heavily on me because that’s perhaps one that I know well and in which I see perhaps the closest analogies. One of the facts that President Bullard mentioned is extremely important and weighs heavily on me—they have had their target rate at less than 1 percent for almost a decade and a half. But something that President Bullard didn’t focus on is how little growth they have had in that period. We are moving into an era of very low interest rates, and we want to revive growth and think about how we can do that, and that gets to the overall objective. I think we also want to avoid the problems that Japan has had because it would probably not be a good idea to be in a regime in which we feel forced to have the fed funds rate at less than 1 percent for a decade and a half. Clearly, there are theoretical, empirical, and practical reasons for moving rapidly. The Japanese example is very clear on that. Practically, we are largely already there. Also, I simply can’t imagine that over the next 6 or even 12 weeks we’re going to get data that would make us think that we shouldn’t be moving interest rates down or that we aren’t in a state of the economy in December 15–16, 2008 93 of 284 which we have to do something fairly aggressively. We already see some disruptions in the markets because of the low effective rates. We have to be mindful of these consequences and monitor them closely. As has been mentioned a couple of times, we have the comparison of the markets in which we’ve intervened that seem to be working a bit better and the markets in which we didn’t intervene that aren’t working as well. Although I actually do agree with that interpretation, we have to be a bit careful about that in going forward because there could be some unintended consequences, such as in commercial paper. A1/P1 interventions can help that market out, but they could have some unintended consequences for A2/P2. Just because the other markets are not improving as these are, we have to be careful about drawing conclusions that it must mean that we need to intervene in market Y and market Z and A, B, C down the line. That’s not to say that I think that what we’ve done so far has not been helpful. I do believe that it has been, but I think we just have to be very, very careful about those unintended consequences. Communication strategy, as so many people have said, is crucial because we’re stepping into a new world. We basically have a lot of explaining to do, and one of the key things to explain is that we have not gotten to the end of our tether, that there’s still a lot more that we can do, even though a lot of the world thinks that, once we have “given up” on interest rates or gotten down to our lower bound, we can’t be that effective. We have to be very effective in arguing that, no, that’s not the case. In the discussion, a number of people mentioned that trying to provide a framework for understanding this is really, really crucial. Explaining that we may need to keep interest rates at a low level for a while based on the conditions in the economy is important, but that doesn’t mean that low interest rates are not helping economic recovery. We should be expressing concerns that December 15–16, 2008 94 of 284 inflation could fall below the level that we consider consistent with our dual mandate. I think that’s something that is also very important to talk about—methods that we could use to attack that. I think this does in the broad sense raise the value of an inflation target. But I would be very concerned, as I think President Stern and some others mentioned, at this point about getting into that debate because, even if we did go to the Congress and a few members of the Congress said that’s okay, that still would be a very big debate and I think a distraction from exactly where we want to go. But we need to think about that over the long run, particularly if we start to see the inflation rate going down or if we see that we’re not being effective at fighting expectations of deflation. But I think for the moment that it would be too much of a burden on our communications and would perhaps cause too much confusion in the market. They have gotten all of these new facilities. We’re stepping into a new world potentially depending on our decision tomorrow. If we also then introduce an inflation target at this time, it may just be a lot to digest. But I think it is a discussion that we need to continue to have. In terms of the specifics of the actions that we need to take moving forward, once again, I think the lessons of Japan are important. We want to focus a little more on the asset side than on the liability side. The Chairman characterized things in a very effective way to argue that we’re not doing precisely the same thing and that we potentially can be more effective. I think it’s not just about some particular reserves level. The example that President Rosengren gave is one that weighs on me. We need to be nimble in responding to different problems. We may have new facilities. We may purchase more or fewer securities. Being constrained by or picking out a particular number for reserves doesn’t seem to be the most effective way to build our credibility that we will fight these problems. Although there is a long history in the Fed of looking at things like the monetary base, nonborrowed reserves, and such, I think there are good reasons that we moved away December 15–16, 2008 95 of 284 from them. Of course, I’m from the University of Chicago, and so Milton Friedman is spinning right now, [laughter] but money demand has not proved to be a very stable function over time, particularly now. The money multiplier has certainly been anything but stable, making it more difficult for us to focus credibly on a particular reserves level to see what the ramifications are for the rest of the economy. That is not to say that we shouldn’t have an eye on those issues. But given the uncertainties, I would be reluctant to focus on that. I think a focus on the asset side is much more effective. Ultimately in all the programs and actions that we undertake, we have to think about the exit strategy, as a number of people have mentioned. I think that’s very important for us both with longer-run expectations and in just making sure that, as we do intervene, we minimize the amount of distortion. In some sense we are purposefully distorting what the market is doing now, but in some sense we think of the market as being distorted from where it normally would operate. So we have to be at peace with that. We need to do that. But we also want to make sure that as much as possible we try to restore that functioning. Making clear that we do these things with reluctance and do want to get out of them to restore the normal market functioning will again be a very important part of our communication strategy to make this all work. Thanks. CHAIRMAN BERNANKE. Governor Duke. MS. DUKE. Thank you, Mr. Chairman. I’d like to make it unanimous in thanking the staff. For me, particularly, you have extended the process by which every hour that I’ve been here has been deeply educational and have helped put the things I’ve been doing since I got here in some sort of a context. Along those lines, the one thing I thought I might address is the economics of the world from whence I came—and that is the economics that bank managers are facing today— because I think that’s an important part of this discussion. I’m sure most of you have heard from December 15–16, 2008 96 of 284 bankers really pleading not to lower the rates, and there’s a very good reason for that. I actually expanded the number of banks that I normally talk to—in addition to Federal Advisory Committee, the North Carolina bankers and some of the Texas bankers—and the plea was unanimous: Please don’t lower the rates. The reason for that really goes to the prime rate, not the fed funds rate. If the prime rate moves down, I do believe that dollar for dollar it’s going to reduce bank profitability. If we were to go to zero, if prime were to go to 3 percent, I think it would take our entire banking system on an operating basis to an unprofitable level. To give you an idea, the non-interest operating costs of banks have not changed an awful lot over the last seven or eight years. They fluctuate about 5 basis points, but it’s a little over 3 percent of assets in non-interest operating costs. The non-interest income that offsets that may be 60 basis points. So you are looking at a 240 basis point hurdle that margins have to get over. The interest yields right now are 40 basis points lower than they were in 2002, going into the 1 percent fed funds rate. Credit costs are certainly higher. They’re higher by 10 to 18 basis points. Fee income is lower by 10 to 16 basis points. If you put all of that together, profitability is already lower by 60 to 75 basis points. On a marginal basis, deposit competition is fierce. CD rates are in the 3½ to 4½ percent range. Money market accounts are around 3 percent. New entrants into the insured deposit arena are intensifying this competition still further, and the banks are incredibly bitter about nonbanks coming into that arena. Lower-cost funding is available from some nondeposit sources, but the banks are feeling pressure from their examiners to limit usage of noncore funds, including discount window borrowings. A bank issued the FDIC-guaranteed debt last week, three years at a cost of 2 percent plus the 100 basis points that they pay the FDIC. So that cost is 3 percent. All of these costs are in excess of the prime rate. December 15–16, 2008 97 of 284 On the asset side, the banks are shying away from purchases of securities because of markto-market concerns. The new loans that are being booked are being tied to prime, but they’re tied to prime with floors, with those floors generally in the 5 to 5½ percent range. Some existing loans have floors, although many do not. Home equity loans, credit card loans, and smaller bank commercial loans are typically tied to prime. Prime might reference that bank’s own prime—and some banks did not lower their prime or were slower to lower their prime the last time we changed the fed funds target—but more commonly it will reference New York or Wall Street prime. Larger loans and mortgages are more likely to be tied to LIBOR, although I understand that competition in recent years has moved toward contracts that give the borrower the option at any time of using a prime-based rate or a LIBOR-based rate. With pressure on both sides of the interest margin, credit costs are sure to rise, and with the prospects for fee income down, the banks are uniformly begging for no change. When asked how they might manage with lower rates, most said that the only choice they would have at this point would be to shrink their balance sheets rather than compete for business at a negative spread. The other rates that affect bank profitability have not moved with the fed funds rate, and so in this case it is about spreads, not rates. Now, it’s certainly possible that individual banks are exaggerating the effects that lower rates will have on their institutions and that their reactions will not be as strong as they claim. However, my question is, What if they are right? If we get down to a 25 basis point regime and we find out that it simply puts our banking system out of business, how do we then reverse that and move back up, and how do we explain that change? I’m not as familiar with the economics of money market funds, but I have to assume that their pressures are similar, and the note indicates that they might be willing to operate at a loss for a time. But the more we communicate that this would be an extended amount of time, how long December 15–16, 2008 98 of 284 would they be willing to operate at a loss? No matter where we set our fed funds target, there’s really very little that we can do differently, as in starting tomorrow. The current actual rate reflects a broken market. There are much lower volumes in the fed funds market right now, and a much higher percentage of those are with institutions that can’t earn interest on reserves. So, Bill, I still see some hope for the fed funds market coming back. Over time, as banks get more comfortable with each other, the opportunities to get a little higher yield as well as to open up an unsecured borrowing source will lead banks back into the fed funds market. But if that market did start to revive a bit, I would hate for us to be in a regime in which, at that point, we had to pressure it again to bring the rates back down. For this reason I think suspending the fed funds target as a policy tool rather than lowering it might be the safer course because it would let prime find its own level and the banks might not necessarily feel pushed to lower prime if we did not change our target. I had a number of notes on communication, most of which have been said. But the one point I’d like to make is that, when I think of communication, I think of it on a retail level. I think about our communication to consumers and to business owners rather than to the more sophisticated audiences that the notes tend to refer to. I think we have to be sure that we do communicate on a retail level—that we communicate on the nightly news, local newspaper level. Many of you have backgrounds in education, and I think at this point it’s our job to teach and explain what we’re doing and how it might affect individual consumers and individual businesses. In that sense, it’s important that we stay on message and that we have very clear terminology that we use over and over again. Even in the conversation today, the term “quantitative easing” was used differently by different speakers. December 15–16, 2008 99 of 284 I do think we have to be careful, again, on the fed funds rate target. I noticed the same thing that President Fisher did as far as the Chairman’s December 1 speech. Any time we talk about the fed funds rate, it is the only thing that’s going to be reported. Finally, I also think we have to be careful about references to the experience in Japan. We should emphasize the differences and the reasons that we expect to be successful because, in many places, references to the experience in Japan lead people to believe that we’re in for a very, very dismal future, and I don’t think that’s what we want to communicate. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Thank you all. I actually would like to try to distill some impressions from our discussion and, going even a step further, maybe draw some very tentative conclusions for the statement and decision tomorrow. I do that in the spirit of fairness because tomorrow you have a chance to rebut what I say now. So let me just draw some tentative conclusions, and if you disagree or if there are multiple options, perhaps you can respond in our gorounds tomorrow. First, with respect to the level of the fed funds rate, I think generally speaking people want to be aggressive. They recognize the difficulty, the severity, of the situation. Some were somewhat fatalistic, saying, well, we can’t really keep the rate much above zero anyway, so it’s somewhat of a moot question. With that said, Governor Duke was just the last of a number of people who did point out that there are various institutional, market, and other considerations that would suggest trying to keep the rate above zero if possible, although she had a very interesting alternative, which is just not to have a target, which might be helpful in at least a few contexts. Let me ask Bill about feasibility here. Suppose for the sake of argument that we had a range of 25 to 50 and we set the interest rate on reserves at 50. Would that be feasible? Could that work? December 15–16, 2008 100 of 284 MR. DUDLEY. It might work eventually, but right now I would guess the spread between the effective funds rate and the target would be bigger than that. We’re sort of running that experiment right now. The market consensus is that the Fed is going to reduce the target 50 basis points at this meeting. That’s incorporated in the current federal funds rate trading because it’s the lowest interest on excess reserves during the two-week maintenance period. We’re trading in a range of about 10 to 15 basis points. We don’t have that much information, but right now that spread is probably 35 to 40 basis points. So I think we probably couldn’t do what you said. If we worked on it—you know, took the GSEs and made it so that they couldn’t sell fed funds and did a few other things—maybe we could get that spread down to 25 basis points over time. Brian, do you have anything? MR. MADIGAN. I agree. CHAIRMAN BERNANKE. All right. Well, that’s relevant information. So it may be that our options are a range of 0 to 25 or no target, but those are two options that I would point to. I should also say, as I discuss the statement here, I think that in a very real sense this is a transitional meeting. I mean, we can’t go from 0 to 60 in one meeting, and I think we have to allow for the possibility that there will be further refinement as we go forward into January. So I raise, as the first point, exactly how we state the policy decision. Do we make reference to the funds rate? Are we okay with a 0 to 25 range? I hear and recognize the concerns about too low a rate, and it’s just a question of feasibility in the short term. One advantage about having a range is that we could indicate that over time we’re trying to get to 25. That would be at least slightly helpful, I think. The second issue I want to mention is communication. I thought there was actually a good bit of consensus. A number of people spoke somewhat approvingly of an inflation target or some broader inflation objective, but I didn’t hear much sentiment for doing it immediately or in the very December 15–16, 2008 101 of 284 near term. I think it is something that we ought to take very seriously, particularly if inflation starts to drop further. We should do it in a prepared way, and I need to consult and so on. But I agree with the comment that this is a long-term objective that we have. This may be an excellent opportunity to do it because not only is there no tradeoff between growth and inflation in this context but also there won’t be any suspicion that we’re choosing a rate that’s convenient. I mean, we are probably below the rate that we would choose as a target. So it might be worth considering in the longer term. For tomorrow, though, I did hear quite a bit of interest in conditionality in terms of the ZIRP (zero interest rate policy) type of strategy. We had—I think it was in alternative A, paragraph 3—a statement that said, “The Committee anticipates that weak economic conditions are likely to warrant a federal funds rate near zero for some time.” I wonder if that meets what people were talking about, or were there people who wanted to express it more explicitly in terms of our qualitative objectives or otherwise? I hear a willingness to have at least a qualitative conditionality for our policy. I would invite overnight or tomorrow any alternative phrasing that people think might be more effective. It is an important decision to make. The third issue—and I’m just making very high level comments here; I have a whole bunch of notes that I’m not going to repeat at this point—has to do with our various programs and purchases. I think that the great majority of the Committee is comfortable with MBS and Treasury purchases. At least that’s what I heard. I took a majority to be in favor of, or at least accepting, the credit facilities that we have. There were requests for more metrics, more explanation, more criteria, more exit strategies, and so on, and I think those were all valid points. What I take from this is that these asset-side programs, the credit facilities as well as the MBS and other programs, are part of our new regime, that most people view them as part of our new regime, and that the December 15–16, 2008 102 of 284 inclusion in our statement of some reference to these kinds of programs, as in the variants that were circulated in the Bluebook, would probably be desirable. A point of considerable discussion and some contention, with respect to both governance and communication, was the use of a measure of the base or excess reserves as a quantitative indicator of monetary policy. With those who advocated it, I think there were really two objectives, if I may. One was to have a measure of monetary policy that would influence expectations and, if effective, would raise inflation expectations and the like. But another function of that, I believe, was the desire to have, from a governance perspective, the FOMC setting some kind of indicator of monetary policy. With respect to the use of, say, the base as a measure of monetary policy, I would say that for tomorrow we’re pretty far from being able to feel comfortable doing that. We haven’t done the work. We haven’t done the analysis of the transmission mechanisms. We haven’t looked at what monitoring ranges and how they might work. So it would be a radical step to take in one meeting. I leave that open as we continue to think about what the right indicators of policy are. I understand the desire for governance. I think what I would propose—and again, by all means, respond tomorrow—would be, at least in our directive, that we have, as somewhat suggested already, the Committee affirm or otherwise indicate its approval of quantitative programs— $500 billion MBS; $100 billion GSE debt; $200 billion for TALF, if you are willing; et cetera—and pursuant to that, that the Board make a regular practice of bringing any new program or any expansion of existing programs to the FOMC for review and discussion. That may not be entirely satisfactory, but it would certainly indicate to the public that the FOMC has reviewed it from a monetary policy perspective, and it would appear in the directive, the minutes, and so on. I put that out as just a possible compromise on that issue. December 15–16, 2008 103 of 284 I think those are the main elements of the statement and the directive. I heard a lot about a desire for an explanatory document, talking points, other supporting material, speeches, and press conferences. We hear that, and it will be very important for us to try to develop such materials. I said at the beginning that I think it’s unusually important for us to try to speak in a unified way externally, not because I want to avoid dissent—and of course, everyone’s views can be expressed—but as Governor Duke pointed out, because I think we have an educational mission here that needs to be taken seriously. So the more consistent we can be in our explanations and our discussion, the better it will be. Those are just some things that I drew from the discussion. Again, you’ll have an opportunity tomorrow, at least one go-round or maybe two go-rounds, to agree or disagree. Any comments? Final thoughts? All right. The first question is, What time do we begin tomorrow? We are scheduled for 9:00 a.m. I think that would be adequate. Does everyone feel comfortable keeping their economic go-round remarks reasonably short? That’s the tradeoff. If everyone is game for that, we’ll start tomorrow morning at 9:00 and now adjourn the Board meeting—you didn’t notice that—and also just remind you that there’s a reception and dinner available for your convenience. There will be no business conducted at that dinner. Thank you. See you in the morning. [Meeting recessed] December 15–16, 2008 104 of 284 December 15, 2008—Morning Session CHAIRMAN BERNANKE. Good morning, everybody. Let’s start off today with the economic outlook. Dan, will you be taking the lead? MR. COVITZ. 3 Thank you. I will be using the packet of charts that starts with the staff presentation on financial markets. The charts for the other two presentations are included in this packet and follow mine. As shown in the top left panel of your first exhibit, long-term nominal Treasury yields posted their largest intermeeting decline in over twenty years. The primary explanation for this decline, outlined to the right, is that investors markedly revised down their economic outlook, leading both to a lower expected path of monetary policy and to continued flight to high-quality assets and away from securities with credit and liquidity risk. Yields also fell following Fed communications regarding alternative monetary policy tools, such as the purchase of long-term Treasury securities, agency debt, and mortgage-backed securities. One measure of flight to quality, shown in the middle left panel, is the covariance of percent changes in stock prices and Treasury yields. When investors pull back from risk-taking, stock prices fall, and so do Treasury yields, resulting in a positive covariance between the two. When flight-to-quality effects are substantial, prices in both markets are volatile, making the covariance particularly large. In recent months, the covariance soared to well beyond its 2002 peak. Since the October FOMC, it has come down somewhat but remains extremely elevated, an indication of continued and substantial flight to quality. Another perspective on investor perceptions is provided by the equity risk premium, shown by the red shaded region in the panel to the right and measured as the difference between a trend year-ahead earnings-to-price ratio on S&P 500 stocks and a real long-run Treasury yield. This measure ballooned in midNovember as stock prices and Treasury yields fell and then narrowed a bit over the past month, as indicated by the plus signs. Even so, the risk premium remains extraordinarily wide. Yield spreads on 10-year corporate bonds, shown in the bottom left panel, increased further over the intermeeting period. The spread on high-yield bonds (the red line) topped 1,600 basis points, and the spread on BBB-rated bonds (the black line) exceeded 600 basis points. The BBB spread is now comparable to average levels recorded on similarly rated bonds during the Great Depression. Changes in corporate bond spreads can be decomposed into changes in one-year forward spreads. As shown in the panel to the right, the 117 basis point intermeeting increase in the 10year BBB spread reflects increases in forward spreads across the term structure, consistent with investor flight to quality and away from risk. In addition, the forward spreads ending in two years and five years increased more than the spread ending in 10 years, suggesting that investors have become more concerned about credit risk in 3 The materials used by Mr. Covitz, Ms. Aaronson, and Mr. Ahmed are attached to this transcript (appendix 3). December 15–16, 2008 105 of 284 the medium term—that is, more concerned about the possibility of a protracted economic downturn. Your next exhibit examines recent conditions in the commercial paper market. As shown in the top left panel, outstanding financial CP and ABCP (the black and red lines) dropped in September and October but since then have partially rebounded. In contrast, nonfinancial commercial paper outstanding (the blue line) has been relatively flat, although nonfinancial programs rated A2/P2 (not shown) have contracted roughly 40 percent since early September. The noticeable increases in financial CP and ABCP around the time of the last FOMC meeting reflect the implementation of the Federal Reserve’s commercial paper funding facility (CPFF), which ramped up quickly and now holds roughly $300 billion of highly rated commercial paper. The recent stability is also likely due to flows back into prime money market funds since early November (shown by the red bars above the zero line in the panel to the right). According to recent surveys of money-fund managers, prime funds have substantially increased their holdings of ABCP, reportedly reflecting the confidence provided by the asset-backed commercial paper money market mutual fund liquidity facility (AMLF), which stands ready to provide banking organizations with nonrecourse loans to fund purchases of highly rated ABCP from 2a-7 money funds. Turning to pricing, the middle left panel shows that the spread on overnight A2/P2-rated nonfinancial CP (the blue line) trended down over the intermeeting period. About half of the reduction in A2/P2 spreads reflects a sample shift toward higher quality overnight issuers, while the other half of the spread reduction is due to improvements in pricing for a constant sample of issuers, suggesting a positive spillover from sectors of the market directly affected by the Fed liquidity programs. The overnight ABCP spread (the red line) also declined, on net, over the intermeeting period. In contrast, overnight yields on CP from highly rated nonfinancial and financial programs (not shown) have traded at levels close to the effective federal funds rate for the past several weeks. To examine year-end pressures, the panel to the right shows the gap between thirty-day and overnight A2/P2 yields. This gap has been volatile but has trended up since late November, when the 30-day rate from our smoothed yield curve began to reflect trades that crossed year-end. Year-end funding pressures are explored further in the bottom left panel. The red bars show average percentages of paper that were placed over year-end as of mid-December from 2003 to 2007. The corresponding percentages for 2008 are denoted in blue. The first two bars indicate that, with respect to getting past year-end, programs rated above A2/P2 as a group are ahead of their average pace over the previous five years. In contrast, the second two bars show that lower-rated programs are behind. Overall, as outlined in the bullet points to the right, conditions in the commercial paper market appear to have been stabilized by the various policy interventions in this market. Even conditions in the nonfinancial A2/P2 sector, which falls outside the government liquidity and guarantee programs, December 15–16, 2008 106 of 284 have improved, but the sector remains strained. Year-end pressures appear substantial for lower-rated programs. The remainder of my briefing reviews funding flows in longer-term markets, starting with financing for nonfinancial businesses. As shown by the red portions of the bars in the top left panel of exhibit 3, investment-grade bond issuance has held up fairly well in recent months, while speculative-grade issuance, shown by the blue portions of the bars, has dwindled to nothing. This pace of financing does not appear to pose substantial near-term funding pressures for the nonfinancial corporate sector as a whole. As shown by the blue bars to the right, the volume of speculative-grade bonds due to mature is relatively light in 2009 and 2010 before it moves up somewhat in 2011. Moreover, the pace of investment-grade bonds that will mature in coming years, denoted by the red bars, is comparable to recent issuance levels. In addition, as shown in the middle left panel, liquid asset ratios for firms rated speculative- and investment-grade remain relatively high. Perhaps more troubling for nonfinancial businesses is that funding from banks has slowed. As shown in the middle right panel, C&I loans expanded rapidly in September and October reportedly reflecting, to a substantial extent, a wave of drawdowns on existing lines of credit. However, the expansion of C&I loans halted in November. Equally striking, the plot in the bottom left panel shows that the change in commercial mortgage debt, based on flow of funds data, turned substantially negative in the third quarter, as the outstanding amounts both at banks and in securitizations fell. Overall, nonfinancial business borrowing, shown on the bottom right, has slowed sharply this year, and with financial conditions expected to remain tight and investment projected to be weak, the staff forecast calls for borrowing to remain very tepid through at least 2010. Household credit is the subject of my final exhibit. Mortgage debt, shown by the blue line in the top left panel, is estimated to have contracted in the second and third quarters, in combination with the continued decline in house prices, shown by the thin black line. We have very little data for mortgage debt in the fourth quarter, but MBS issuance in October, shown to the right, was somewhat below the already low thirdquarter level. Other types of household debt have also begun to contract. As shown in the middle left panel, revolving and nonrevolving consumer credit rose only a bit in the third quarter and then fell in October. While the slowdown in consumer credit likely reflects, in part, a reduction in demand, the secondary market for such credit has also become substantially impaired. As shown to the right, issuance of ABS backed by auto and credit card loans slowed markedly in the third quarter and was near zero in October and November, as quoted spreads on BBB and AAA ABS (not shown) soared. Results from the Michigan survey, shown in the bottom left panel, suggest that the contraction in household debt reflects both the reduced supply of credit and weak demand. As shown by the black line, an unprecedented share of households has pointed in recent months to tighter credit as the reason that it has not been a good time to purchase an automobile. At the same time, the percentage citing concerns about the economy, plotted in red, has increased to the top of its historical December 15–16, 2008 107 of 284 range and remains the reason mentioned most often by respondents as a deterrent to purchasing an automobile. With financial markets under stress, consumer credit likely will need to be funded mainly on bank balance sheets in coming quarters. However, as shown in the panel to the right, banks’ unused loan commitments for both households and businesses have declined substantially this year, as net new commitments have not kept up with drawdowns on existing lines—another indication of the tighter supply of bank credit. Stephanie will now continue with our presentation. MS. AARONSON. I will be referring to the exhibits that follow the green nonfinancial cover page. The indicators that we have received since the last FOMC meeting suggest that real activity has been contracting rapidly, and as Dan has described, financial conditions have continued to deteriorate. Starting with the labor market, private payroll employment (the inset box in the top panel) plunged 540,000 in November, and the figures for September and October were revised down noticeably. All told, November’s drop brought the three-month decline in private employment (the black line in the top panel) to an annual rate of 4.2 percent—a much steeper pace of job loss than we were expecting in the previous Greenbook. The retrenchment in November was pervasive across both goods- and service-producing industries. As shown in the middle left panel, initial claims for unemployment insurance have continued their steep climb since the November survey week, consistent with a further large drop in employment in December. Meanwhile, in the household sector, nominal sales at the retail control grouping of stores (the inset box in the middle right panel) declined 1.5 percent in November, which given a large energy-driven price decline, translates into an increase in real spending for the month. We had been expecting real outlays in this category to fall further. As shown by the rightmost blue bar, with the latest retail sales number, we now think that real PCE on goods other than motor vehicles is on track to fall at an annual rate of 5¼ percent, not as bad as the 9¼ percent decline we projected in the Greenbook but still very weak. Near-term indicators of consumer spending point to further weakness in the coming months. Notably, the Reuters/University of Michigan survey index of consumer sentiment, plotted in the bottom left panel, remained at recessionary low levels in the first part of December. Sales of light vehicles (the bottom right panel), which slumped in October, fell further in November, to an annual rate of 10.1 million units, a much slower pace than we had anticipated. Anecdotal reports suggest that sales are soft again this month. Given the weak fundamentals for demand and tight credit, we project vehicle sales to remain depressed over the next several months. As shown in the top left panel of exhibit 2, residential construction has continued to slide. Single family starts fell further, to 441,000 units—somewhat lower than our expectations—and permits continued to move down last month. In the business sector, new orders for nondefense capital goods excluding aircraft (the red line in the top right panel) dropped for a third straight month in October; and with orders falling below shipments for a second consecutive month, the backlog of unfilled orders December 15–16, 2008 108 of 284 shrank further. Yesterday, the Board released data on industrial production in November. Total IP (the inset box in the middle panel) fell 0.6 percent in November. Excluding the effects of rebounds from the Boeing strike and September hurricanes, IP moved down 1.6 percent last month. The black line in the panel plots the threemonth diffusion index of manufacturing IP, a measure reflecting the net fraction of industries that experienced an increase in production. As you can see, over the past few months that number has plummeted to 21, indicating that the contraction in industrial activity has been remarkably widespread. Overall, the incoming data led us to steepen significantly the contraction in real GDP that we are forecasting for the current quarter and the first quarter of next year. In these two quarters, we expect output to decline at an average annual rate of nearly 5 percent. In both quarters, a significant chunk of the revisions has come in private domestic final purchases (lines 3 and 4 of the table). In addition, the available indicators suggest that firms are acting aggressively to limit unwanted increases in their inventories. As shown in line 5, firms have been drawing down inventories at a moderate pace in the second half, and we expect even faster liquidation next quarter in response to the sizable contraction under way in final sales. Your next exhibit focuses on the medium-term outlook, starting with some of the key background factors that have influenced our thinking about the outlook since the October Greenbook. On the downside, as noted earlier, financial conditions have deteriorated further in recent weeks. As can be seen in the top left panel, the index of financial stress that we track continued to rise sharply. One important component of that increase in stress has been the further widening of corporate bond spreads for investment-grade issues (shown by the gray shaded area in the top right panel). In addition, equity prices are lower than we projected, taking an even bigger bite out of household resources. Meanwhile, in the external sector, the path of the dollar (shown in the middle right panel) is somewhat stronger than in our October forecast, and the outlook for foreign economic activity has weakened further. Shaghil Ahmed will have more to say about these developments shortly. As you know from reading Part 1 of the Greenbook, in light of the intensification of recessionary forces that emerged over the intermeeting period, we based this forecast on the assumption of a lower level of the federal funds rate than in our previous projection (not shown). In addition, we now assume that $500 billion in new fiscal stimulus actions will be enacted early next year, on top of the roughly $165 billion in the stimulus package enacted earlier this year. These assumed fiscal actions include permanent tax cuts for most individuals, higher transfer payments, grants to state and local governments, and support for housing. As shown in the bottom left panel, these new federal programs boost the impetus to GDP growth from fiscal policy considerably relative to our assumptions in the October Greenbook. Two other factors also provide more support to real activity in this forecast. First, mortgage rates (the bottom right panel) have fallen about ½ percentage point since the October Greenbook. With the spread over the 10-year Treasury yield still quite wide, we project that mortgage rates will fall further over the projection period. Second, oil prices (not shown) have fallen more in recent weeks than we anticipated in the December 15–16, 2008 109 of 284 October Greenbook; the lagged effects of these declines provide a greater lift to spending in 2009. The top left panel of your next exhibit summarizes our medium-term projection. On balance, we expect that the factors restraining activity will far outweigh the supportive influences, with real GDP falling at an annual rate of 3 percent in the first half of next year. The decline is led by a steep drop in business fixed investment (lines 5 and 6). In the second half of the year, real activity begins a slow recovery as PCE (line 3) picks up and residential investment (line 4) begins to stabilize. In 2010, the recovery is projected to gain momentum as household spending strengthens further and business purchases of equipment and software begin to rise. As is typical, the recovery in nonresidential investment is expected to lag. By postwar standards, we are projecting a deep, prolonged recession and a very sluggish recovery. The middle left panel provides some perspective. The black line shows the level of real GDP, indexed to its own peak, in the second quarter of 2008. By way of comparison, the red and blue lines show the paths of real GDP during the recessions that started in November 1973 and July 1981, respectively. As can be seen, the projected contraction in real GDP in the current episode is about in line with that experienced during those two earlier “big” recessions, but our projected recovery is noticeably more prolonged. The box to the right summarizes some of the important factors that impede the projected recovery. First, we think that the economy will continue to face significant (albeit moderating) financial headwinds over the next two years, with elevated risk premiums, restrictive lending conditions, and general uncertainty restraining real activity for some time to come. Second, tight monetary policy did not help generate the current recession, and we don’t see monetary ease as likely to generate as much impetus to recovery. In fact, as the third bullet point notes, the federal funds rate is already close to the zero lower bound, greatly limiting the scope for conventional monetary policy to provide further stimulus to real activity. The importance of this last factor is illustrated by the bottom set of panels. The exercise is similar to the simulations presented in the Bluebook, except that this one allows the federal funds rate to turn negative. The green line in the bottom left panel shows the simulated federal funds rate path. If unconstrained, the optimal funds rate would fall below zero in early 2009 and drop to negative 5½ percent in the third quarter of 2010. In this scenario, the unemployment rate, shown in the middle panel, peaks at 7¾ percent in 2009—about ½ percentage point lower and a year earlier than in the Greenbook projection. The four-quarter change in core PCE prices, shown at the right, bottoms out at just over 1¼ percent in mid-2010 and then turns up, in contrast with the continued deceleration in the extended staff forecast. In the context of the zero bound, achieving an outcome for real activity and inflation consistent with the unconstrained optimal control exercise would likely require some combination of greater fiscal stimulus and nontraditional monetary actions than we have built into the current projection. December 15–16, 2008 110 of 284 Your final exhibit summarizes the outlook for inflation. As shown in line 1 of the top left panel, we now project that total PCE price inflation will slow to about 1 percent in 2010, while the core rate (line 7) falls to 0.8 percent. The decline in inflation reflects a combination of widening slack in resource utilization, reduced energy and materials prices, and a net decline in core import prices; these factors also push down long-run inflation expectations. I should note that we received data on the November CPI this morning. The total CPI fell 1.7 percent, driven by a sharp drop in energy prices. The core CPI was unchanged last month. We had been expecting an increase of 0.1 percent. One measure of resource utilization, the unemployment rate, is projected to reach 8¼ percent in 2010. In our forecast, the wide unemployment rate gap puts substantial downward pressure on costs and prices. However, as suggested in the middle left panel, we may be overstating the downward pressure on inflation caused by slack. In particular, the current cycle has been associated with especially large employment declines in several industries, notably construction and finance. If these declines are leading to an unusual amount of employment reallocation across industries, structural unemployment would increase, which in turn would raise the NAIRU. The remaining panels present some analysis of the issue using a measure of sectoral reallocation and a set of Beveridge curves. The middle right panel depicts an index of sectoral employment reallocation across industries. The index is based on the growth rates of employment in 15 industries relative to the growth rate of total employment, adjusted at the industry level for typical cyclical movements in employment shares and is similar in spirit to a measure constructed at the Chicago Fed. As can be seen, even after removing the typical cyclical behavior, increases in sectoral reallocation often occur around recessions, which is not surprising since each business cycle produces a unique set of imbalances. Indeed, the amount of sectoral reallocation indicated by this measure has been rising over the past year or so. However, to date it remains low relative to previous spikes in reallocation. Another way to determine whether there has been a rise in structural unemployment is through the so-called Beveridge curve, two versions of which are shown in the bottom panels. The version at the bottom left plots the unemployment rate, adjusted for the Emergency Unemployment Compensation program, on the horizontal axis against the job openings rate, measured by the Job Openings and Labor Turnover Survey (JOLTS), on the vertical axis. The bottom right panel shows a Beveridge curve calculated using the Help-Wanted Index as the measure of job openings. If there has been a significant increase in structural unemployment, then one would expect that for a given level of the job openings rate, the unemployment rate would be unusually high—that is, to the right of the plotted Beveridge curve. This might occur, for example, if many of the job openings were for nurses but a disproportionate number of the unemployed were bond traders, who are not qualified for the job openings. [Laughter] So, what do these Beveridge curves say about structural unemployment? The blue and red circles in the two panels show the data points for the third quarter of 2008 and for the most recent months available. The latest readings from the JOLTS December 15–16, 2008 111 of 284 do stand to the right of the estimated curve, while the latest readings from the HelpWanted Index are closely in line with past experience. At this point we are reluctant to draw strong conclusions from just a couple of observations from either measure, and we read the evidence as consistent with at most a small increase in structural unemployment thus far. Of course, these data do not tell us what will happen in the coming quarters, when we anticipate further job losses in financial services and continued weakness in construction and manufacturing. Shaghil will continue our presentation. MR. AHMED. I will be referring to the exhibits that follow the blue International Outlook cover page. Financial markets in foreign economies remain stressed but have not suffered further pronounced deterioration since the October FOMC meeting. As shown at the top of your first exhibit, government bond yields in major industrial economies have dropped, likely reflecting further expected monetary policy easing, lower inflation expectations, and a firming of the belief that economic recoveries are not around the corner. Equity markets, shown in the middle left, have changed only moderately, on net, since your last meeting, compared with large declines in previous months. The emerging-market aggregate CDS spread, shown in the middle, has been volatile but remains elevated. As shown to the right, gross private capital inflows to emerging markets through debt and syndicated loans have continued to trend downward. The exchange value of the dollar against the major foreign currencies (the black line in the bottom left panel) has moved down a little since the last FOMC meeting. Some bilateral exchange rate movements were substantial, however, with the dollar appreciating markedly against the pound and depreciating against the yen. As shown to the right, the dollar has appreciated somewhat against the currencies of our other important trading partners, driven by movements in the Mexican peso and the Brazilian real. Earlier this month, the dollar registered one of its biggest daily increases against the Chinese renminbi in recent years, although this shows up only as a tiny blip in the chart. We believe that Chinese authorities will allow the renminbi to depreciate somewhat in the coming months; NDF (nondeliverable forward) contracts also imply an expected depreciation of the renminbi against the dollar over the next year or so. Incoming evidence on economic activity abroad continues to be grim. As shown in line 1 of the table in exhibit 2, we now estimate that foreign economic growth was below 1 percent in the third quarter. Although growth in Canada (line 7) and Mexico (line 12) surprised on the upside, readings elsewhere were generally weaker than expected, with real GDP contracting in the United Kingdom, the euro area, and Japan (lines 4 through 6). As shown by the red bars in the middle left panel, net exports made significant negative contributions to growth in these three economies. Domestic demand (the blue bars) was also soft. Growth in emerging Asia (line 9) was barely positive in the third quarter, reflecting subdued growth in China (line 10) and substantial contractions in most of the newly industrialized economies (shown in the middle right). December 15–16, 2008 112 of 284 With data from the current quarter pointing to greater weakness than we expected and a substantially more pessimistic U.S. outlook, we have further slashed our forecast for total foreign growth to minus 1½ percent in the current quarter and minus 1¼ percent in the next, before a recovery to a positive but still relatively weak average pace of about 1 percent through the remainder of next year. The widespread nature of the economic slowdown in large part seems to reflect trade linkages. As depicted at the bottom, in recent years U.S. economic growth (the black line) and the growth of total real exports of our major trading partners (the green line) have been significantly related. Although foreign exports are affected by many factors in addition to U.S. GDP, the relationship shown and the gloomy outlook for U.S. economic activity through next year paint a bleak near-term picture for foreign exports. Your next exhibit focuses on the advanced foreign economies in more detail. Data from Europe point to a sharp slowing in the current quarter. The timeliest indicators are PMIs (purchasing managers’ indexes), which, as shown in the top left panel, have plummeted in recent months in both the United Kingdom and the euro area, reaching levels well below those observed during the 2001 downturn. As depicted to the right, in Japan, exports (the black line) and industrial production (the blue line) have contracted during the current quarter, and conditions in the labor market have deteriorated further, as manifested by the decline in the ratio of job openings to applicants (the red line). Indicators from the current quarter in Canada, shown in the middle left, point to weakness in real exports and a continued drop in housing starts. Authorities in advanced foreign economies are attempting to shore up aggregate demand through fiscal stimulus. As listed in the middle right panel, many countries have announced stimulus packages, including Germany, France, and the United Kingdom. We estimate that the actual stimulative content of the packages announced so far is likely to be small but expect that additional measures will be introduced next year. The total fiscal stimulus that we are assuming should boost growth in the advanced foreign economies by ¼ to ½ percentage point at an annual rate from mid-2009 through 2010. The possibility of bigger fiscal initiatives is an upside risk to our outlook for foreign growth. Many of the foreign central banks have become more aggressive in easing monetary policy, as can be seen at the bottom left. Since the last FOMC meeting, the Bank of England and the ECB have slashed policy rates by a total of 250 basis points and 125 basis points, respectively, and the Bank of Canada and the Bank of Japan have lowered rates by smaller amounts. More rate cuts are expected in all of these economies, which could bring rates in Japan back down to the zero lower bound. As shown on the bottom right, inflation in the advanced foreign economies is now expected to recede at a faster rate than previously projected, reflecting sharp declines in commodity prices as well as diminished resource utilization. Turning to emerging-market economies, as shown in the top left panel of exhibit 4, the recent behavior of Chinese industrial production, total exports, and December 15–16, 2008 113 of 284 imports from Asia is now reminiscent of developments during the year 2001. The plunge in imports from Asia casts doubt on the notion that China has become an independent engine of growth in the region. As depicted to the right, Korean exports and aggregate industrial production in Korea, Singapore, and Taiwan are plummeting. In Mexico, third-quarter output was bolstered by expansion in the agricultural sector, but as shown in the middle left, exports have moved down sharply, and consumer confidence has dropped below 2001-02 levels. In Brazil, too, shown on the right, there has been some softening in exports (the black line), which had been supported by high commodity prices, although industrial production (the blue line) has held up a bit better. With prospects for exports in the doldrums, policy stimulus has become all the more important to the outlook for emerging-market economies. As noted in the bottom left, monetary easing has continued, with interest rate cuts in many emerging Asian economies, including China and Korea. China, Malaysia, and Brazil have also lowered bank reserve requirements. In addition, fiscal stimulus packages have been announced in a number of economies, most notably China. China’s 16 percent of GDP spending package considerably overstates the ultimate effects on growth as it includes some previously announced projects, its implementation may take longer than announced, and the federal government is slated to pay for only 30 percent. Discounting the headline number, we estimate that the Chinese package could boost growth 1 to 1½ percentage points per year. Other countries, such as Korea and Mexico, have introduced smaller but still sizable packages, which we expect will give some impetus to growth. In sum, our near-term forecast calls for total foreign growth to be the weakest since 1982, and as sketched out in our alternative simulation in the Greenbook, there would appear to be downside risks even to this forecast. Your final exhibit focuses on the U.S. trade outlook. Weak global demand has contributed to falling prices for food and metals, which have led a sharp decline in nonfuel commodity prices (the blue line in the top left panel). Oil prices (the black line) also have continued to move down rapidly, but futures prices project some recovery ahead. The fall in commodity prices has exerted downward pressure on U.S. trade prices (shown in the top middle panel); both core import prices and core export prices dropped markedly in October and November, which for import prices were the largest monthly declines in the fourteen-year history of the index. A sense of the extent of weakness in global demand can also be seen in shipping rates (shown to the right), which have taken a nosedive. As in the 2001 recession, U.S. real exports and imports of goods (shown in the middle left) are now trending down. Imports (the red line) have been moving down all year. The falloff in exports (the black line) is a more recent development and, in part, reflects hurricane-related disruptions and the strike at Boeing. As shown in the table, growth of both real exports of goods and services (line 1) and real imports (line 3) was noticeably weaker in the third quarter than we had previously estimated. December 15–16, 2008 114 of 284 For the current quarter, we see both real exports and real imports contracting sharply, reflecting the slowdown in global demand. Looking ahead, our projections for a stronger broad real dollar (shown in the middle right) along with our weaker outlook for foreign growth have led us to revise down sharply our forecasts for exports, especially in 2009. In the near term, our projections for imports have also been marked down considerably. As shown in line 5, the contribution of net exports to U.S. growth is expected to swing slightly negative in the current quarter, following large positive contributions earlier this year. The current quarter’s contribution is considerably weaker than projected in both the October and the December Greenbooks, as last week’s export data surprised us on the downside. Next quarter, with a substantially greater step-down in imports than in exports, we expect the contribution of net exports to U.S. growth to jump back up, before returning to negative territory for the remainder of the forecast period. That concludes our presentation. CHAIRMAN BERNANKE. Thank you. Remind me what your anticipation of the current account deficit is for next year. MR. AHMED. I think the deficit goes down to about 3 percent. MR. SHEETS. Yes. We see the current account deficit, as Shaghil said, bouncing between 3 and 3½ percent of GDP through 2009 and 2010. In the near term, you have much weaker foreign growth and a stronger dollar, but that is offset by the lower level of oil prices, so that keeps the current account deficit around the 3 to 3½ percent range. CHAIRMAN BERNANKE. Okay. Thank you. Questions for our colleagues? President Bullard. MR. BULLARD. I was just looking at the policy rates abroad here—this is the picture in exhibit 3, I guess. It shows the ECB, the Bank of Canada, and the Bank of England all leveling out before they get to zero. Do you have a sense of what the plans are there, or what they are saying about that, or are we going to see a sort of global move to zero? What is your sense of that? MR. AHMED. Looking at the policy that is going forward, first of all, we are forecasting here what we think they will do, not necessarily what we think they should do. Given their past December 15–16, 2008 115 of 284 behavior, we think that they will be ratcheting up the rates the first chance they get. The timing is a bit different, but the rates are broadly in line with market participants’ expectations. In the case of the euro area, for example, at the end we are even a little lower than the market participants are expecting. MR. BULLARD. So this is from surveys of market participants? MR. AHMED. No. This is our projection. MR. BULLARD. Right. But you are getting the information from surveys and other things. MR. AHMED. It is informed by surveys, yes. MR. SHEETS. I would add that I think the ECB in particular has a real aversion to policy activism. In fact, Trichet was on the wires this morning indicating that they are not really comfortable with where they are right now. They may pause in January, and I think it really would take a more severe outcome for activity in the euro area than what we have incorporated in our forecast to get the ECB down to zero. Nevertheless, that is a risk. I would say that there are downside risks here. I would put a higher probability on seeing the Bank of England or the Bank of Canada go to zero. But as Shaghil emphasized, here we are basically just writing down what we think they are going to do, and we generally follow the futures markets fairly closely. But it certainly would be a surprise to me if, over the next six months, we saw other major central banks in the proximity of zero. CHAIRMAN BERNANKE. President Fisher. MR. FISHER. Just a comment on the projections for China—these numbers seem to be less than what they are saying officially. Am I correct? MR. AHMED. Yes. These numbers are less. December 15–16, 2008 116 of 284 MR. FISHER. That sort of jibes with the reports that I am hearing back from the CEOs doing business in China. In fact, the cutback has been much more dramatic than they expected. Semiconductor firms, for example, have put ship-stop orders, meaning they are stopping for lack of payment, and the retailers are seeing a noticeable drop in attendance at their stores. But I think that our numbers are more fitting. MR. AHMED. I think the latest official numbers don’t incorporate the November data, which just came out—actually, they came out yesterday—and some trade data since the Greenbook. MR. FISHER. But you are saying that we do expect further currency depreciation. MR. AHMED. In the near term, yes, through the first half of next year. MR. FISHER. I have three questions, Mr. Chairman. One on the commercial paper market. What is the spread between A1/P1 and A2/P2 right now? MR. DUDLEY. For term, it is a huge spread, probably 300 basis points or so, but overnight it is much smaller. MR. COVITZ. As you go out the term, it is even more. MR. FISHER. So the incentive for A1/P1 borrowers is to do everything they can to keep that status, obviously. It is a much more attractive proposition. MR. DUDLEY. Yes. MR FISHER. Which leads to more-conservative financial management and business management. You do everything you can not to become an A2/P2 borrower, to slip off the A1/P1 ladder. December 15–16, 2008 117 of 284 MR. DUDLEY. Historically BBB was the sweet spot of the corporate capital structure, and that was associated with A2/P2 commercial paper borrowing, which people thought was safe. It turned out not to be quite as attractive as they had thought. MR COVITZ. I think over history this isn’t the only time when A2/P2s have come under stress. Whenever there were disruptions in the market—for example, after the California utilities defaulted in the early part of the decade—A2/P2 outstandings plummeted, and A2/P2 spreads rose, though not nearly to this magnitude. This is truly extraordinary. But that is a portion of the market that is under stress because this market in general tends to be very, very skittish. At the first sign of trouble, there is quantity rationing. I didn’t show the outstandings of the A2/P2s, but they have gone down—as I think I mentioned—40 percent in the last couple of months. So quantity rationing is already taking place, and they are having trouble getting over year-end. MR. FISHER. I guess my point is that the way in which it works is that it gives people incentives to be even more conservative in the financial management of their operations. On household credit, do we have a sense of how much shift is taking place between credit card usage and debit card usage? Under these conditions of duress, has that been a noticeable change, or is it just marginal? MR. COVITZ. I don’t know those data. MR. FISHER. It might be something to look at next time. Finally, on the inflation table in exhibit 5—and you have talked about the numbers that were released this morning—do you see additional monthly deflationary numbers on the headline CPI, or could you see this happening for a prolonged period, say for a quarter? We have a table here for 2008, 2009, and 2010. On the top line, the PCE price index, do we envision monthly or perhaps quarterly extensions of deflationary headline numbers? December 15–16, 2008 118 of 284 MR. STOCKTON. No. We have another two months of small declines anticipated as the energy prices continue to pass through and then, beyond that, some small increases. So we don’t see this as an extended period of negative headline. MR. FISHER. So December/January? MR. STOCKTON. December/January—exactly. MR. FISHER. And what is the order of magnitude? MR. STOCKTON. We are looking for about minus 0.5 percent in December and minus 0.1 in January. We are also not expecting the core figures to remain as low as they have been running for the past month or two. We do think that they have been held down by some very significant declines in air fares. That could continue for another month or two—again, as the energy price pass-through works. They have also been held down by some very large declines in lodging away from home, which is a volatile series, and it is not likely to sustain this level. Despite the fact that we don’t see them as low as they have been the past two months—that is, declining to flat—we are expecting some fairly small increases going forward. We have core inflation heading down, and all of these exhibits have shown a significant reduction in price pressures coming from import prices, from energy prices, and from broader commodity prices as well as the increase in slack that, as Stephanie pointed out, is keeping a real lid on labor costs. MR. FISHER. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. President Lacker. MR. LACKER. Thank you, Mr. Chairman. Our staff does such a fine job. Maybe my hearing is going, but I missed the names of our staff presenters. Can we get them introduced to us? MS. AARONSON. I’m Stephanie Aaronson. December 15–16, 2008 119 of 284 MR. COVITZ. I’m Dan Covitz. MR. AHMED. Shaghil Ahmed. MR. LACKER. Great. Thank you very much. I have a question for Stephanie. You know, they do such a great job. CHAIRMAN BERNANKE. Jeff, are you feeling okay? [Laughter] MR. STOCKTON. We apologize for our lack of manners. [Laughter] MR. LACKER. Maybe it is a southern thing, I don’t know. [Laughter] The sectoral reallocation is really intriguing, and it is something that I have been curious about in this whole episode. The measure is not one I am familiar with. It is one for which you count each industry as a unit, right? MS. AARONSON. Exactly. It is a Lilien type of dispersion index. This isn’t actually how we calculate it, but it is essentially how the industry’s share of employment changes relative to total employment. So it is the growth in that industry’s employment relative to total employment. What we do is that we know that over the business cycle each industry has a typical pattern—durables employment goes down a lot during recessions whereas, say, health care doesn’t go down that much. Those types of changes aren’t typically associated with sectoral reallocation. That is, we don’t really think of those things that are typical over the cycle as being associated with an increase in the NAIRU. We want to take those out, so we take out the typical cyclical movements, such as manufacturing always goes down in a recession and finance is acyclical. MR. LACKER. And housing always goes down in a recession. MR. AARONSON. Housing and construction always go down, so we take that out, and then we say, okay, so now there are these atypical movements that are greater than we usually December 15–16, 2008 120 of 284 see. That is what we would consider the sectoral reallocation. That is what is left over. You can see, as I mentioned in the briefing, that actually during recessions there is a lot of sectoral reallocation, even once you take out the usual declines in employment that differ across industries. That is because each recession has different causes. Different industries have grown a lot during the boom—like finance recently or, say, communications during the late 1990s—and those sectors are going to shrink more than usual during the recessions and get back to more of an equilibrium state. That is what is going on here. MR. LACKER. Yes. So it is sort of a bummer that these go up in the recession if you are trying to measure what is happening to the NAIRU. But I always thought of the phrase “sectoral reallocation” as having to do with the theories of the business cycle in which cyclical downturns are caused by an unexpected decline in a given industry that causes resources to shift out of that industry and that it takes time for them to be absorbed into some other industry. From that point of view—if you are trying to measure that component as opposed to policy-induced, widespread declines in activity—I would think you would want not to take out the cyclical part. I am thinking about housing. We devoted a lot of resources to housing in 2005, much less now. Those resources thrown on the market, in fact, are the proximal cause of the initial downturn in employment growth. A lot of ancillary industries are related, so I would think that, if we didn’t take out the usual housing cyclical thing, which is really sharp in the early periods, you would see a bigger rise here. MS. AARONSON. I have looked at that, and actually, it doesn’t make that much of a difference. Construction goes down in every recession, and so by that measure sectoral reallocation is higher in every recession. I mean, construction is contributing more to sectoral reallocation here than in previous recessions because the declines have been larger. So that fact December 15–16, 2008 121 of 284 is captured. The fact that construction is having a larger-than-typical decline is precisely what is captured here. But even if you said, okay, well, maybe in every recession industries shrink and that is associated with some sectoral reallocation, the measure actually looks very similar—not just across the current episode but across all the episodes. MR. LACKER. Yes, yes. I guess it is also related to how you think about the NAIRU. To some extent, if unemployment goes up in recessions, then what unemployment is supposed to be goes up in recessions as well, it seems. I have a question about the first exhibit. It is the first set of exhibits. It is also about commercial paper. Would you folks encourage us to view the improvement that has taken place in the A2/P2 market as a measure of how the A1/P1 market might have improved had we not intervened? It is sort of a baseline, right? It is like the control group. MR. COVITZ. I think it is very difficult to interpret it that way because the intervention did happen and the bulk of the improvements happened subsequent to the intervention. MR. LACKER. What sort of spillovers from our intervention in A1/P1 do we expect perhaps to have influenced or to have led to an improvement in A2/P2? MR. COVITZ. I think that the decline in the A2/P2 overnight suggests improvement. But there is some concern about sample selection, and you have to worry about that at the same time. It could be just that you are getting higher-quality issuers in the A2/P2 sector. But it turns out you’re not. It turns out that it explains only about half of that decline. MR. DUDLEY. You know, it also may have helped the money market fund industry to keep its money knowing that there was a facility outstanding that could provide liquidity for that sector because we did see inflows back into the money market mutual funds. December 15–16, 2008 122 of 284 MR. LACKER. So their willingness to buy A2/P2 may have been affected by another program, not the CP one. You are saying the money market fund program— MR. DUDLEY. They provided more stability to the system as a whole. MR. ROSENGREN. To the prime money funds. MR. LACKER. So we can’t separate the individual programs. MR. ROSENGREN. There is a second factor. There has been discussion of extending the A1/P1 program to A2/P2, which the industry is certainly aware of, but I would highlight with the A2/P2 that a lot of the mutual funds do not want to hold it over the end of the year. Most of the A2/P2 borrowers are having trouble rolling over year-end. There is a real risk that that market will have to rely on backup lines of credit, and it’s not clear whether the A2/P2 market comes back after the New Year, if that happens, or in what capacity it does. So I think the real test will be to look at this chart in January or February. MR. LACKER. Well, you wouldn’t expect speculation about imminent extension of the program to A2/P2 to support the overnight rate for A2/P2 unless they expect it to be implemented overnight. A question about strains: To what extent are we able to disentangle whether the market is strained or the issuers are strained? MR. COVITZ. In the CP market itself? MR. DUDLEY. You can look at credit ratings, for example, or what’s happening to their profitability. It is highly likely that the strains in the CP market are more dramatic than any change in the underlying financial condition of the A2/P2 borrowers. MR. COVITZ. You could think about what the default risk is, say, for the corporate sector. You could break down a pretty simple model of defaults conditional upon our outlook for the economy, and that would have the default rate rising. December 15–16, 2008 123 of 284 MR. LACKER. But you don’t observe investors’ expected defaults themselves. MR. COVITZ. You don’t, but you can take a guess at what you think that is, and it is higher. It is not at Great Depression levels under any of the models I’ve looked at. It’s not even at the levels of default rates in 2002. MR. LACKER. So you are saying that this paper is underpriced. Is that how you measure strains? I am always curious as to what strains mean. MR. COVITZ. The way that I’m referring to it is just that risk premiums are really, really large. I’m not saying that they are necessarily irrational. I am just saying that they are really, really large. MR. LACKER. Thanks. Great job. CHAIRMAN BERNANKE. President Evans. MR. EVANS. Thank you, Mr. Chairman. I have a question or observation, which is of the optimistic variety although it presents sort of a challenge. In the medium-term outlook in exhibit 4, if you focus on 2010, the Greenbook projection has real GDP growing at 2.4 percent. We’re beginning to come out of this. The unemployment rate is peaking. If you could implement the optimal control federal funds rate, it would be bottoming out. Maybe that would mean whatever quantitative easing credit programs we would be doing would be at their peak and maybe would be coming off. But it is also the time that the inflation rate is low and continuing to fall. This is going to be a tension for us as we start thinking about, and we are about to engage in mentioning, the possibility that inflation could be—well, whatever—lower than ideal. What would you guess the risks might be around that inflation forecast? How hard is it going to be for us not to continue to worry about inflation being low or to communicate that inflation is going to continue to be low even though things are improving? Just any kind of advice would be helpful. December 15–16, 2008 124 of 284 MR. STOCKTON. My guess is that, if our baseline forecast evolves in the way we are expecting here, you are still going to be worried about the downside risk to inflation even if, in fact, we were in the process of bottoming out because there will still be a very substantial output gap. On the commodity price side, things are fairly stable, and at least in our forecast, inflation expectations are probably drifting down some. On the other hand, there are upside risks to that inflation forecast as well. I do actually think that our baseline forecast, on the assumptions that we have had to make in constructing it, is reasonably well balanced because another possibility is, in contrast to the gradual downtrend that we’re expecting in inflation expectations, that inflation expectations will be stickier, you will be able to convey a greater sense that you wouldn’t want inflation over the longer haul moving down below 1 percent, we won’t get as much disinflation into inflation expectations or into labor costs, and you’ll get greater stability there than we’re expecting. So to my mind, looking ahead, monitoring how those inflation expectations evolve in the context of an economy where things are weakening will be very important. MR. EVANS. Thanks. CHAIRMAN BERNANKE. President Bullard. MR. BULLARD. On the same topic—the medium-term outlook and, in particular, the optimal control exercise at the bottom, which is showing us how we’re constrained—is there some quantitative policy that we could undertake that would get us to the green lines here, maybe by creating more inflation than we would think desirable in the long run? MR. STOCKTON. The point of constructing this optimal control is to say that, gee, if you weren’t constrained, here is how we thought optimal behavior—the sort of optimal outcome— would be, given the shocks. You’re asking me whether or not there are quantitative policies that you could put in place. I was actually hoping that you folks were going to be able to tell me. December 15–16, 2008 125 of 284 [Laughter] You face a challenge in constructing policy, but we have collectively a challenge in understanding how whatever policies you implement are actually going to show through into our longer-term outlook. The point here is that, in the absence of some nonconventional monetary policy actions or substantial fiscal stimulus, we see a very extended period of weak activity, high output gap, and declining inflation. MR. BULLARD. Sometimes what people do is they say, okay, suppose you could just control inflation directly, which we know is hard, but suppose then you just trace out an optimal path for inflation that would get you to the green line. MR. STOCKTON. Obviously, if you could levitate inflation expectations, that would be one thing. The other thing is that note 21 in the package we sent you included some exercises that suggested, if you took actions that could significantly reduce the long-term Treasury rate and compress mortgage spreads, there would be ways in which you’d be able to provide more stimulus for the economy. Now, all those things we suggested, at least the ones that we showed in that note, weren’t sufficient to get you back to equilibrium quickly. But there are policies, obviously, that we think will be able to provide some stimulus. MR. BULLARD. This optimal control exercise then would have an objective that would be a quadratic objective in some real output or unemployment— MS. AARONSON. Minimizing the unemployment rate and the deviations of inflation from its target. MR. BULLARD. That’s saying that you wouldn’t be willing to suspend your inflation target for a while to improve things on the real side. I think that might be helpful as well because then the Committee could think about what those tradeoffs are. In ordinary times, you might have a certain weight on the two objectives, but you might shift that in other situations. December 15–16, 2008 126 of 284 MS. AARONSON. If I can also just put this in a little more context—by the end of 2010, the gap on the unemployment rate between the baseline and the optimal control is about 1 percentage point. So if you use a simple rule of thumb from an Okun’s law type of model, that would be a couple of percentage points on the level of GDP. GDP would have to grow a couple of percentage points faster over 2009 and 2010 to close that 1 percentage point gap in the unemployment rate between the baseline and the optimal control. CHAIRMAN BERNANKE. President Lockhart. MR. LOCKHART. Question for Nathan. In an earlier meeting, if I recall correctly, there was mention of the European banks’ exposure to emerging-market sovereign debt—a concern about the trend lines in that sovereign debt. Are you tracking that in any sense? My concern is that there could be another full-blown debt crisis of some kind coming. It is not covered in these charts, but do you have a sense of default risk on the part of emerging-market sovereigns? MR. SHEETS. The European banks are particularly exposed, much more so than U.S. banks or Japanese banks. A big chunk of that exposure is to central and eastern Europe, and as you suggest, we see significant risks to the European banks as a result of that exposure. What makes it even a little dicier is that exposure is concentrated in several countries, particularly Sweden, Austria, and to a slightly lesser extent Italy. Recently there has been significant economic turmoil in Hungary and Ukraine. The Fund has stepped in, and the EU has helped as well with large financing packages. The latest one we’re watching very closely is the situation in Latvia, where the exchange rate is significantly overvalued. The external position looks very, very dicey. The Fund is in there negotiating a program. There has been a lot of back and forth about what should be done with the exchange rate regime. The banking system also looks vulnerable—so what should be done with the banks? It is not exactly clear how all that is going to be resolved. My personal feeling is that, given December 15–16, 2008 127 of 284 the risks—and the Europeans recognize the extent of the risks—if Latvia goes, it could blow out the rest of the Baltics and then sweep around into Central and Eastern Europe and then feed back into Western Europe. So I see the risks there as being of first order for the Europeans. Given that recognition, I think that the EU and major European governments are going to do what’s necessary to make sure that the situation in Latvia stabilizes at least for a while. The end game over the next several years is very much an open issue for a lot of these economies that were in ERM-II and evolving into hoping to adopt the euro. I think that there are potentially some very pronounced vulnerabilities and some painful adjustment that will need to happen in some of those Central and Eastern European countries. So absolutely that is a major risk. It’s one we’re watching as closely as we can. MR. FISHER. Nathan, you would probably have been arrested for treason if you had said that in Latvia—literally. The economist who gives a negative forecast is arrested for treason. Stay here. [Laughter] CHAIRMAN BERNANKE. Other questions? If not, let’s start our go-round with First Vice President Cumming. MS. CUMMING. Thank you. I thought I would make a couple of points that underscore the substantial increase in the downside risks that we incorporated into the forecast that you all received on Friday. That change was really encouraged by our economic advisory panel, which suggested that the downside risks were much larger than we were estimating at the end of November. First, we have been meeting, as of course all of you do, with small business people. Bill Dudley put a panel of investors together, too, and I have a couple observations out of that and our discussions with community bankers. One is that the cutbacks in financing are very real. There is a December 15–16, 2008 128 of 284 lot of evidence that the banks are going in and looking at lines and cutting them back to both investors and the small-business community. The small business community is also on the receiving end of much tighter financial management at their larger customers—that is, the people they’re supplying—as those firms are not paying their bills or are extending the terms on which they pay their bills to a much greater number of days. That has induced a hunkering-down mentality on the part of the small business owners. The other sobering thing they pointed out to us—and this is very much in line with Governor Duke’s comments about the community banks yesterday; we hear the same thing—is that small businesses and the community banks can hold out for a while but not forever; margins are getting squeezed, and financing is getting squeezed. The precautionary actions that the small businesses are taking will help them for a while, but they can’t hold out for more than six or nine months. That is a particularly sobering statement for us in the Second District because, despite the fact that we are at the epicenter of the financial industry in New York—a major driver for the Second District economy—we have only just barely started to feel the effects of layoffs and reductions in activity in the city. Our regional leading indicator index went down very, very sharply in the month of October, but that is still to be realized in the economy. In particular, when we have looked at past episodes, the declines in incomes that we have suffered in the region have ranged between 4 percent and 10 percent in the financial industry when we actually get into one of these adverse periods. That decline is usually spread over three or four years, so we are really talking about something that could last a good bit longer than six to nine months in our District. Second, we do a survey of inflation expectations that is in many ways similar to the Michigan survey, and our survey results are almost completed and are very similar to those of the Michigan survey. But we do ask one question that isn’t asked there, and that is about the longer December 15–16, 2008 129 of 284 run—that is, the 2010-11 outlook for prices and inflation. From that we can impute a risk of deflation, which was 6 or 7 percent in early October and is now 12 percent. So that risk of deflation seems to be growing even in the kind of population that is surveyed by the Michigan folks. Thank you. CHAIRMAN BERNANKE. Thank you. President Rosengren. MR. ROSENGREN. Thank you, Mr. Chairman. As requested, I will be brief. Like the Greenbook, we see an economy in which the unemployment rate remains very elevated, and inflation is below my target for several years. Our own equations would indicate that these elevated unemployment rates are likely to put even more downward pressure on the inflation rate than forecast in the Greenbook. The labor market is extremely weak, and there is a significant risk of deflation. I believe that greater use of nontraditional policies will be needed to mitigate more-severe outcomes than encompassed in the baseline forecast. On the financial side I would just highlight two points. First, many banks are placing interest rate floors on home equity loans and on commercial loans. Pervasive use of floors may make the choice of which low federal funds target to pick of little relevance to actual borrowing costs. We may want to consider surveying banks to get a better understanding of where these floors are currently being set. Second, many firms are reporting that their lines are not being renewed and are asserting that it reflects problems with the bank not the borrower. Discussions with community banks indicate that, for smaller borrowers, community banks are benefiting from this trend. However, it may be useful to understand better how the reductions in lines, particularly at troubled banks, are affecting the overall economy. Just a general point. I think bank micro behavior is going to be very important for macroeconomic outcomes, and we might want to increase the amount of effort that we are putting December 15–16, 2008 130 of 284 into understanding both their financial condition and how their behaviors may be changing over the next six to nine months. Whether that’s done through the bank supervision process or the loan officer survey or which mechanism we use, I think we need to probably get a little more intelligence on exactly what those trends are. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Lacker. MR. LACKER. Thank you, Mr. Chairman. The economic news since the last meeting has certainly been grim, and our presentation today bore that out. Our directors and other District contacts are quite gloomy, and their reports are also consistent with a broad-based pullback in discretionary outlays by consumers and firms. In these circumstances with the funds rate around 1/8 percent, it is hard to see a benefit of prolonging any further reduction. I agree with the staff analysis that any potential dislocation in money market institutions is likely to be minor, and I observe that, to the extent that money market institutions provide value to the economy in the form of circumvention of prohibitions on interest and other legal restrictions on financial arrangements, the traditional welfare analysis would count their demise as a benefit rather than a cost. But I have to admit I haven’t tried explaining that to a money market fund manager. [Laughter] The hard question now, I think, concerns the possibility of deflation. We have seen negative overall inflation since energy prices peaked in July—it was 1.8 percent for the PCE at an annual rate since then and 4½ percent before today’s release for the CPI—and the core indexes have softened notably as well. I still think we are going to be able to avoid this fairly easily, but I do not think the risk is negligible. It is one of the most dangerous prospects we face right now, and we have to pay very close attention to it. The reason I think it is going to be easy to avoid is that we have seen declines in core inflation before when energy prices fell—mid-2005 and late 2006 are recent December 15–16, 2008 131 of 284 examples. Further, compensation growth does not yet appear to be slowing rapidly, although those data are fairly dated and so it is hard to sense what the last couple of months are going to look like. The key to avoiding deflation, of course, is our ability to shape expectations about the future course of monetary policy. I had a spirited discussion about this last night over salad with Governor Kohn and Mr. Eggertsson. This is essentially what all the models tell you—that staying out of a deflationary equilibrium requires commitment to paths for the monetary base that are inconsistent with a steadily falling price level and that commitment to keeping the nominal interest rate low is not sufficient. Now, it is sort of hard to get a handle on this. It took me a while, but the key to thinking about this is that models with Taylor-type rules embed within them the perfect credibility of inflation returning in the long run or over a medium term to the targeted rate that is built into the Taylor reaction function. If instead you take those models and just allow arbitrary fiscal and monetary policy rules, that is when you are forced to face the result that committing to an infinite series of zero nominal rates is not sufficient and that you have to keep a monetary aggregate from declining along with the price level. One way to think about this is that it is just like preventing inflation. To prevent inflation, we have to prevent expectations that the value of money will fall in the future. To rule that out, we have to rule out expectations that the quantity of money is going to rise continually, and we do that with interest rates. This line of reasoning is different from the reasoning you get in a Phillips curve with purely backward-looking expectations, where you have a recursive relationship between real growth and inflation. Instead, in any model with a little forward-looking stuff, you have expectations driving things. Preventing deflation is the same thing—preventing expectations that the value of money will rise indefinitely. To do that you need to prevent expectations that the December 15–16, 2008 132 of 284 quantity of money will fall indefinitely, and you would like to do that with low interest rates, but you cannot at the zero bound. So you have to influence expectations about the future course of the base. This to me is the simple intuition for that. All of this is just to suggest that our ability to communicate is going to be crucial. MR. KOHN. Including over salad. [Laughter] CHAIRMAN BERNANKE. All of these strategies are time-inconsistent, of course. So we have to be willing as a Committee to sit here and accept higher-than-normal inflation ex post. I just point that out. We have to ask ourselves if we would be willing and if the public would be willing to accept that. MR. LACKER. “Time-inconsistent” is another way to say that they require commitment. CHAIRMAN BERNANKE. I understand. I’m just saying that there are also different ways to do it. We could also just target a higher inflation rate, which is probably another way of doing it. MR. LACKER. Right. You could target the inflation rate not falling. I mean, we don’t have to go all the way. This is the subtle thing about this. I think the pure Taylor rule overstates our credibility, but people do not think that we are going to follow it perfectly. They don’t have very diffuse priors over what policies. We are somewhere in-between, and I think bolstering that credibility is important. Something I was going to say in the policy round—given that we haven’t announced a target, we ought to try that first. That comes first, before saying that we are going to move our target up for a little while. CHAIRMAN BERNANKE. I would just comment—and I think that your point is a good one—as we go forward, we are going to be thinking hard about how to influence expectations. Absolutely. Your point is also right, as we discussed earlier, about why we need additional policies besides our zero rate policy, either other kinds of quantitative policies that are obviously linked to December 15–16, 2008 133 of 284 base movements or fiscal or other policies as well. So I don’t think there is that much disagreement on the analysis. MR. LACKER. No, I do not think so. The point I was making about the base is that none of those is sufficient to rule out deflation without specifying what the base is. CHAIRMAN BERNANKE. Okay. President Pianalto. MS. PIANALTO. Thank you, Mr. Chairman. The reports from my contacts have been very weak for several weeks now. Sadly, I feel as though the data have been catching up with the anecdotal comments that I have been receiving for a while. I have been hearing a lot of comments along the lines of “orders have fallen off a sheer cliff,” “the lights were suddenly switched off,” and “my business is dead in the water.” One thing I have noticed is that the negative outlook has spread to more and more corners of the economy, even those corners that had remained robust for a relatively longer period. For example, one of my directors, who runs a manufacturing company and exports 70 percent of his products, is a producer of highly specialized equipment that is used in steel production. He has few competitors and no debt, and until recently he was feeling very comfortable with a two and a half year backlog. Last week he reported that the backlog has essentially vanished. His customers’ problems have now become his problems. This has become a typical refrain. We had become used to hearing companies talk about their desire to hold onto liquidity. Now businesses are also focused on how they are going to protect themselves in this weakening economy. Even businesses with a healthy amount of cash are cutting back sharply on investment, hiring, and production plans. In this environment, it is clear that forecasts need to be revised down sharply. Like the Greenbook, my own projection, which seemed pretty dire just a month ago, has also been revised down sharply with the incoming data and anecdotes. The question now is how long and how deep a December 15–16, 2008 134 of 284 decline we will experience. At the same time, it also remains difficult to judge how far disinflation will go. My projection sees substantial output gaps and energy prices that are likely to remain low. That has caused me to lower my inflation projection further as well. My inflation forecast now is clearly below desirable levels for much of 2009. Still, it looks as though the risks remain very much to the downside for output and inflation, if only because further downside misses are getting more and more problematic. The insurance metaphor, I think, has been exhausted. We are now more in a situation of treating mass trauma. Perhaps some of our actions will later be judged as having gone too far. But in my view, right now it clearly is better to ensure that the treatment is large enough rather than risk falling short. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Plosser. MR. PLOSSER. Thank you, Mr. Chairman. The Third District economic news is similar to the national news. It’s all bad. Our December business outlook survey, which remains confidential until Thursday, will post another very weak number. In November the number was minus 39.3. The December reading will be released, and it will be minus 32.9—somewhat better but still deeply in negative territory. New orders, shipments, and employment are all very weak. Price indexes on the survey have fallen appreciably below zero for the past two months and are near their lowest levels since we began the survey in 1969. This is after being at nearly their highest levels over the same interval just a few months ago. Moreover, firms are expecting prices to continue to decline. November’s reading marked the first time that the future prices-paid index has been negative. The mood is generally quite grim. The Greenbook also paints a very bleak picture. I would like to think that this isn’t the most likely outcome, but it is increasingly difficult to argue against that based on recent economic data. I have revised down my own forecast, of course. Although I’m still not quite as pessimistic as the Greenbook, I admit that the Greenbook is no longer an outlier as I am used to December 15–16, 2008 135 of 284 thinking about it. The forecasts for output are nearly as bad as or are worse than the economy experienced in 1974-75. Inflation has moderated significantly, and near-term inflationary expectations have also moderated. Our December Livingston survey participants see CPI inflation averaging just ½ percent in 2009. In the Greenbook, forecasted core inflation will be just over 1 percent next year and will decelerate to ¾ percent in 2010. With the growth prospects so weak and inflation expectations decelerating, the appropriate real funds rate obviously will probably decline, raising the possibility as we discussed yesterday that the zero bound on nominal rates will pose a problem for us. At the same time, since mid-September the effective funds rate has been trading well below the FOMC’s target of 1 percent. As we discussed yesterday, we are effectively conducting monetary policy through quantitative easing—by which I mean an expansion of the Fed’s balance sheet by both conventional and nonconventional means. I have no objections in principle to this easing process; but as I discussed yesterday, I believe that we need to acknowledge publicly that we are now in a new regime, with a new way of implementing monetary policy, and that it is a deliberate choice of this Committee. Otherwise we risk confusing market participants or implying that we are no longer in control of monetary policy. But in doing so, we need to communicate how this policy will be conducted going forward. The Board of Governors and the FOMC will have to decide how they will handle the governance issues surrounding this new regime. It seems clear to me that monetary policy determinations should remain in the purview of the FOMC regardless of whether we are using standard or nonstandard policy tools. Thus, I think we have to come to grips with three very important policy issues at this juncture. They include (1) how to implement monetary policy via an expansion of our balance sheets for standard fed funds targeting; (2) what decisionmaking process the FOMC and the Board December 15–16, 2008 136 of 284 should use in implementing these policies via the balance sheet expansion; and (3) how to communicate all of these to the public in a transparent and, most important, credible fashion. I agree with the Chairman that we need to maintain and embrace the collaborative process between the Board of Governors and the FOMC, which has been our method of moving forward during this crisis. But I remain convinced that in these times of uncertainty we need to be explicit and to communicate that monetary policy remains under the purview of the FOMC. As we discussed yesterday, our primary goal is to set policy that yields the best economic outcomes for the economy, consistent with our dual mandate. I think our history demonstrates that the institutional structure of the FOMC and clearly articulated goals and methods yield the best policy. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. I think President Fisher at the last meeting actually proposed that, since we all knew where the economy was, we just suspend discussion and get on to what to do about it. Forgive me for a six-week reaction function here, President Fisher, but I tend to agree with that. I will be very brief. The points I will make have either been made or will be made, I am sure. [Laughter] We are facing dysfunctional financial markets, a rapidly weakening real economy, and a very negative psychology, a darkening mood. In addition, I am picking up in my contacts uncertainty or even questioning of what can be done and what good anything close to conventional monetary policy will do. My board of directors, advisory councils, and other contacts reflect deepening pessimism, and many of those contacts confirm the view that consumer activity and the economy in general pulled back dramatically in September and October. I have adjusted my forecast similarly to the Greenbook and commercial forecasters. I think it is very difficult at this point to forecast with any confidence that conditions will gel in a way December 15–16, 2008 137 of 284 necessary for a recovery. The Greenbook sees a somewhat sharper snapback by midyear, reflecting the influence of a fiscal stimulus, than I am prepared at this time to project. Our forecast assumes a protracted period of weakness through all of 2009, somewhat more along the lines of the “more financial stress” scenario in the Greenbook. Regarding financial markets, I would just comment that the pressures on the hedge fund sector have clearly not abated and may be intensifying. Over the weekend we picked up rumors of a Fed intervention that has not been discussed here, so I presume that it was just a rumor. Nonetheless, rumors were circulating that a major hedge fund group was about to collapse and that our people were “in,” so to speak, over the weekend. As Bill mentioned yesterday, the Madoff scandal certainly has not helped the picture regarding hedge funds. Regarding risks, it is not my baseline scenario, but the risk of deflation obviously cannot be ignored, and the apparent speed of disinflation is quite a concern. The Atlanta staff prepared several forecast scenarios, and there were some plausible downside scenarios that really were quite ugly. So to preview later comments, I think the balance of risks at this point is decidedly to the downside and justifies a trauma-management approach—or, in more normal terms, a risk-management approach—of acting aggressively at this meeting. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you, and if there has been any intervention in hedge funds, the Chairman is unaware of it. [Laughter.] MR. LOCKHART. I am relieved to hear that. MR. FISHER. He just wanted you to know about it, Mr. Chairman. MR. LACKER. You said “has been”? [Laughter] CHAIRMAN BERNANKE. President Hoenig. December 15–16, 2008 138 of 284 MR. HOENIG. Thank you, Mr. Chairman. The Tenth District’s economy, like the others, has systematically worsened. Layoffs are increasing. Our retail sales are down. The housing market is certainly not improving, and manufacturing has weakened. In our two stronger areas, energy is showing a pretty good slowdown with these falloffs in prices, and rigs are being stacked; the agricultural sector is also feeling the pressure as commodity prices fall. So it is uniformly poor. As far as the national economy and outlook go, I have no major differences with the outlook that has been presented by others. I would tell you that we have done different projections ourselves. I think a lot depends on what will be developed on the fiscal side as we move from here, and I am kind of waiting to see about that. I do have one other comment and perhaps request as we think about this, and it follows on yesterday’s conversation. It strikes me, as I look broadly and see what’s happening in our own region, that the intermediation process is broken as it goes through the banking industry and then more broadly than that. The deleveraging process that is under way is actually accelerating—it is worsening and complicating our ability to fix the intermediation process. As a result, we as the central bank are going around that process as we try to get credit working, and I understand that. But it does have consequences—some good for those particular markets where we’re bringing intermediation forward but also perhaps some not so good as other sectors are left behind in that. My point is that we really do have to focus, in working on the fiscal side with the Treasury or whomever, on fixing the broken intermediation process, and that is the banking industry. I know we are working with the TARP. It needs some additional work. But out of that comes my request. We spent a fair amount of time yesterday talking about the Japanese experience. I wonder if we wouldn’t benefit if we looked at the Nordic experience of the early ’90s—how you go in, take a look at that, and how you conduct policy around that—and have a discussion among ourselves December 15–16, 2008 139 of 284 because I think there are some lessons there that we might learn to our benefit as we move forward from here. That’s a suggestion I have, not just my report on the District. Thank you. CHAIRMAN BERNANKE. Thank you. It was a good suggestion. I have looked at that example and had a chance to talk with Stefan Ingves, who is the Governor of the Central Bank of Sweden and was very much involved in that. It was a very good and prompt response, but it was different from our current situation in that the banks were already mostly insolvent and no longer functioning when the government intervened. They took the standard steps of taking off nonperforming loans—so the usual process. They still had a significant recession. I think the basic lessons are there, but we have some characteristics in this particular episode—banks still functioning, the complexity of the assets, and so on—that make it even more difficult. MR. HOENIG. I agree with that, but at the same time, I see the similarity. When you don’t go in and try to drive it back quickly, you get the Japanese outcome of prolonging it. I don’t know where the banks are yet, but I know that things are getting worse and that the intermediation process is broken. So just maybe there is something in-between—something that can be done that forces outcomes for some of these banks. Even though they are not insolvent as such, we have poured a ton of equity into those institutions, and I am not sure if we shouldn’t have added some other elements to that that might have helped on the other side. That’s my point. CHAIRMAN BERNANKE. If you can indulge just one more observation, which is that one thing we learn from these episodes is that the political economy matters tremendously. The public is very reluctant to get involved in putting money into banks, and only when they become persuaded that doing so is essential do you get that result. In Japan it took a long time. In Sweden it was much quicker, and that’s an important element. A two-hander from President Bullard. Yes. December 15–16, 2008 140 of 284 MR. BULLARD. May I just make one comment on that? For those of you who have not read about the Nordic experience, Seppo Honkapohja, who is a member of the Board of the Bank of Finland, has given a speech within the last two months. You can probably go to the Bank of Finland web page. There may be other information, but that is just one summary from a person who lived through it and has been involved in policy for a long time. CHAIRMAN BERNANKE. Thank you. President Yellen. MS. YELLEN. Thank you, Mr. Chairman. In my view, cumulative recessionary dynamics are deeply entrenched, with mounting job losses leading to weaker consumer spending, tighter credit, more job losses, and so on; and this nasty set of economic linkages is gaining momentum. Like the Greenbook, I anticipate a long period of decline, and in fact, the consensus forecast is that we’re now in the longest and one of the deepest postwar recessions. I hope that a recovery will begin in the middle of next year, but the risks seem skewed to the downside for several reasons. First, compared with the average recession, we face unusually difficult financial conditions. My contacts complain bitterly that even firms with sterling credit ratings have difficulty securing credit. Some banks appear reluctant to lend because financial markets are skeptical about the quality of their assets and their reported net worth. An accounting joke concerning the balance sheets of many financial institutions is now making the rounds, and it summarizes the situation as follows: On the left-hand side, nothing is right; and on the right-hand side, nothing is left. [Laughter] The second factor skewing risk to the downside is the unusually fearful and pessimistic psychology that’s developed. One director, who heads a national department chain, predicts carnage in the retail sector after year-end, as stores close after trying to hold on through the holidays. Although some stores have been able to keep sales up to reasonable levels, heavy price discounting will translate into huge losses. Businesses have also generally turned very December 15–16, 2008 141 of 284 cautious, hoarding cash and slashing capital spending. A third factor that worries me is that, in contrast to many past recessions, this one is global in nature, and the fact that it’s a worldwide slowdown—while lowering commodity prices, which is good—is also going to make it harder for us to pull out. Turning just very briefly to the labor market, the Beveridge curve chart that Stephanie presented during her briefing suggests that we have seen an unusually large increase in the unemployment rate recently in comparison with the decline in job openings, at least in the JOLTS data. I think one interpretation might be that the unemployment rate has risen in part because we have had an unusual rise in labor force participation during this recession. Labor force participation has been higher than would be expected, particularly for three demographic groups: young adults, married women, and older workers nearing retirement. Analysis by my staff estimates that this rise in participation could reflect behavioral responses to unusual credit constraints and wealth declines. Specifically, young adults aged 20 to 24 years appear to be entering the labor force in unusual numbers, and that might reflect diminished access to student loans. Similarly, more married women are entering the labor force, and that’s a possible reflection of diminished access to home equity and credit card loans. Finally, an unusually large number of older workers are in the labor market, and that may reflect the negative wealth shock associated with the collapse of housing values and the plummeting stock market. All in all, I expect the anomalous increase in labor force participation to put continued upward pressure on the unemployment rate. With respect to inflation, developments since our October meeting have again lowered the outlook. I’m particularly concerned about the disinflationary effect of actual and prospective economic slack. During the postwar period, core PCE inflation has actually fallen at least ¾ percentage point in every single year in which unemployment has averaged 7½ percent or more. December 15–16, 2008 142 of 284 Given that in each of the next two years the unemployment rate is predicted to average at least 8 percent, it seems quite likely that by the end of 2010 core inflation will have fallen at least 1½ percentage points. That creates a very real risk of deflation. So under these circumstances, I definitely believe that we should do everything in our power to stimulate aggregate demand. CHAIRMAN BERNANKE. Thank you. President Evans. MR. EVANS. Thank you, Mr. Chairman. As gloomy as our last meeting was, conditions have deteriorated substantially further since then. Practically all of my contacts reported that economic events had turned sharply lower once again in the last three to five weeks. This goes well beyond the auto sector and other parts of the District that have been struggling for some time. The most optimistic comment from my directors was this, “At least Iowa is going to hell slower than everywhere else.” [Laughter] It is tough to follow that accounting joke, you know—that was good. More seriously, the most optimistic theme I heard from a number of business contacts went something like this, “We are conserving cash and furiously cutting costs by year-end. But we hope to pause in the first quarter and take stock of where conditions appear to be heading. Then, we will act accordingly.” Frankly, I doubt such a wait-and-see pause in cost-cutting will occur that soon. For the purposes of this meeting and our actions over the next few months, I agree with the main thrust of the Greenbook projection. We are facing large contractions in the next two quarters, and I don’t expect to see meaningfully positive growth before the fourth quarter. I think we need substantial further accommodation after today’s meeting. I see the timing and the size of those actions for the most part being shaped by the large recessionary forces in train and the enormous financial headwinds. December 15–16, 2008 143 of 284 The disinflationary forces in play clearly are strong, but currently I do not expect that they will prove large enough to generate outright deflation. In terms of my earlier question about the Greenbook forecast—as I understand the way it was put together—if the quantitative easing helps, monetary policy would be somewhere between the funds rate at zero and the optimal control. So, in fact, it would be a little better than I first suspected. Inflation would be somewhat above that path. That might be a useful benchmark to watch for if we are fortunate enough for the forecast to be that stable, but time will tell. Quantitative easing should also lead to an increase in the monetary base. I don’t know if there was any lasting conflict between your comments and President Lacker’s, but I think that what we have contemplated will lead to the base increasing and that will generate expectations about inflation beyond just Taylor-rule dynamics, I would guess. In fact, there is certainly a lot of discussion and criticism out there that our balance sheet is going to lead to large inflationary risks. I don’t share that, given how I think we will unwind the programs. But that certainly would help, and it would move us in that direction. So I will keep an open mind on deflationary risk. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Stern. MR. STERN. Thank you, Mr. Chairman. Well, as just about everyone has said—and I certainly agree—the near-term outlook is grim. Virtually all the anecdotes of any consequence that I have received recently have been negative. Payroll employment has been, obviously, dropping significantly; and if you look at the trajectory, if that kind of trajectory continues for any length of time beyond the next month or so, it will surpass the declines in employment that we typically have seen, certainly in the last three recessions. December 15–16, 2008 144 of 284 My outlook for the real economy for the next five or six quarters has essentially the same profile as the current Greenbook. I do have a somewhat better recovery starting in the second or third quarter of 2010, but at this point I have to admit that it is more hope than conviction. It is based on a diminution of many of the factors that are currently restraining the economy and producing the significant contraction that is under way. As far as the inflation outlook is concerned, I don’t have quite as much disinflation as the Greenbook does, but I wouldn’t say that we are all that far apart at this point. One footnote to that: I do get a lot of comments and questions along the lines that President Evans mentioned— “Gee, with that expansion in your balance sheet, with all those reserves, aren’t we going to have a lot of inflation in the future?” Maybe I ought to say “yes” to that question. CHAIRMAN BERNANKE. President Bullard. MR. BULLARD. Thank you, Mr. Chairman. I will be brief. In the Eighth District, there is a clear and sharp downturn, as in the national picture. There is a clear turn to survival strategies, and you really see that when key CEOs and other figures start talking about lower capital expenditures for 2009, cutting the lower levels in 2008 in half or more. I think that’s very consistent with the Greenbook. The effects on our District from any auto restructuring may be substantial, and that is something I have ratcheted up here in the last few months. A common theme among all contacts—and it echoes some of what has been said around the table here—is that rate cuts at this point will have no effect on the macroeconomy. Their thinking is, well, of course, since short-term Treasuries are trading at zero—I think one-month Treasuries actually hit zero here a bit ago—they are not going to have any effect. But as Governor Duke pointed out yesterday, and I think this is an important concern, the impact on bank profitability may be substantial, exactly at the wrong time. First Vice President Cumming picked that up, too. I think December 15–16, 2008 145 of 284 that is a concern. I think it suggests favoring an option of de-emphasizing the federal funds rate as a target at this meeting, as we will get to in the policy discussion. But then you might not trigger this prime rate cut that would otherwise normally accompany a major move by the Fed. On the national picture, I expect a sharp downturn in the fourth quarter and the first quarter. Expectations are extremely negative now and extremely fluid. I think that is probably the biggest factor facing us going forward into 2009. The expectations are so fluid that they portend a deflationary environment if we do not control the situation very soon. I am also very concerned about the global aspect because we haven’t really seen this kind of coordination across the globe in the rapid movement to probably zero interest rates. I don’t think we really know what that means going forward. We are going to be looking at bad news coming in at least until summer, and we have no way at this point to signal a reaction to that bad news via normal policy. That is the gravity of the situation, and in some ways it is the downside of a preemptive policy. Had I been on the Committee earlier this year, I would have supported the preemptive policy to try to avoid this situation. But one downside of it is that you do not have the ability to continually react as bad news comes in. In sum, I think we are moving to a Japanese-style deflationary, zero nominal interest rate, situation at an alarming pace. To stay in the game and control expectations, we need a Volckerlike transformation, something like—although the situation is different—the ’79 announcement, which knocked private-sector priors off the idea that they should trigger all reactions to announcements on nominal interest rates. You need a dramatic move that emphasizes this new reality. Continued focus on the federal funds rate at this point would not face that reality. Above all, we have to establish in the minds of the private sector—and maybe in our own minds as well—that we control medium-term inflation. We should take the attitude that we can December 15–16, 2008 146 of 284 create the inflation we need to stay near target by one means or another. I think, actually, this may be an excellent time to set the inflation target, although it sounds as though we are drifting away from that. But if I can argue for it for a few minutes here, I think it might have an important effect on the navigation through the recession during 2009. Of course, in normal times, to undertake some action like that, we would want a lot of study, and we would want to have time to talk it through with the Congress and other interested parties, as we would for interest on reserves. But we don’t have that luxury right now. We want to take the action now to help control the situation, and I think we could sell that as a work in progress, which can be modified later. But we do want to keep these expectations under control in this very fluid situation. Thank you. CHAIRMAN BERNANKE. Thank you. President Fisher. MR. FISHER. Mr. Chairman, thank you. President Rosengren talked about micro behavior, and at the beginning, First Vice President Cumming talked about the hunkering-down mentality. I have been focused on the microeconomic behavioral responses to our current situation. As one of my CEO contacts outside my region said, we are basically all, in his words, “chasing the anvil down the stairs,” and that is that the behavioral responses of both businesses and consumers are driving us into a slow-growth cul-de-sac and a deflationary trap. One CEO I talked with was quite pleased that he could borrow $40 million over the weekend for a total of $250. That is great from a commercial paper standpoint; he is an A1/P1 issuer. However, were he to go to the longer-term debt markets, it would cost him 7½ percent. So they can finance their daily operations easily. But in terms of their long-term planning, they and others are responding—and I see this uniformly across my contacts—out of concern about the high cost of debt and the spreads over Treasuries, by doing what any businesswoman or December 15–16, 2008 147 of 284 businessman would do. They are planning on less cap-ex, and they are cutting back on their plans for acquisitions of the weak, which they would like to take advantage of under the current circumstances. They are also responding to the situation by cutting back on head count. So, Chris, there is very much a hunkering-down mentality, not just in my District but across the country. That leads to further economic weakness—that plus the fact that they are chary about issuing and paying for things with shares in a very weak market. I am hearing more and more worries about their pension liabilities and how they are going to be able to finance those. Obviously this is leading to the kind of economic behavior that none of us would like to see. On the consumer side, you see a similar behavioral pattern. It seems that after Black Friday, according to my sources, there was weaker behavior than one had expected. The spending pulse data that I get from one of the large credit card companies reflect what one would expect under these circumstances—that is, a shift to nonbranded products, smaller purchases of items, a rotation out of credit cards to debit cards and cash payments according to the pay cycle, and overall an expectation, on both the business and the consumer side, that things will get cheaper if they wait longer and they postpone either their cap-ex or their consumer purchases. The one ray of sunshine that I was able to find is that one large law firm, Cravath, has announced that it is not increasing its billing rates in 2009, [laughter] and other law firms are actually planning to respond by cutting their billing rates. One woman whom I know summarized it this way: “This is the divorce from hell. My net worth has been cut in half, but I am still stuck with my husband.” [Laughter] CHAIRMAN BERNANKE. Thank you. Governor Kohn. MR. KOHN. I am not going to even try to top either of those anecdotes or jokes. I agree certainly with the thrust of the comments around the room. The economy is in a steep decline. December 15–16, 2008 148 of 284 There was a break in confidence somewhere in September that took what had been a gradual decline in employment, production, and output and made it much, much, much, much steeper. The feedback loop between the financial markets and the real economy just intensified—turned up many, many notches at that time. Households and businesses, as President Fisher was remarking, are very worried, and they are acting in a way to protect themselves. They have cut back on spending, and they have cut back on lending. I think the response of businesses is particularly interesting. They responded very, very rapidly to the falloff in demand with cuts in employment and production. So we are not even getting the sort of automatic stabilizer effect that we usually get from a buildup in inventories and a bit of labor hoarding as demand drops. Thus businesses’ actions are just accentuating the weakness. As many have remarked, the weakness is global, everywhere, including in emergingmarket economies where, as Shaghil showed us, the inflow of capital has slowed substantially. There is no real region to lead the globe out of this swamp we are in. Financial markets remain very strained. I think of particular concern are the securitization markets. When they are not operating, a lot of credit to households and businesses won’t be available at the same time that the banks are tightening up very sharply. We have seen in these charts that household and business borrowers with anything less than very high credit scores are just finding credit either extraordinarily expensive or unavailable. As a consequence, a very sizable output gap has opened up. I think we can see that the decline is going to remain steep for some time. The multiplier–accelerator effects of the drop in demand we have seen over the last couple of months have to feed back through consumption and investment. I don’t think we have seen the full effect of the tightening in credit conditions and the decline in wealth from the end of September on. December 15–16, 2008 149 of 284 You can see the continuing economic decline in the initial claims data, the weekly IP, and the anecdotes we heard around the table on sales; and financial markets are going to remain impaired for a while despite our best efforts to open them up. There are huge losses in the capital of intermediaries to absorb, so folks will be very cautious about making loans. As long as investors, savers, households, and businesses see the economy in steep decline, the fear that is gripping the financial markets and the economy isn’t going to abate very rapidly. Inflation is decelerating across a broad front, and that is going to continue. Economic slack will be increasing, cost pressures will be abating, and the ability to pass through cost increases will be highly constrained. So far, longer-term inflation expectations seem to have been reasonably well anchored, though they are very hard to measure. But I agree with President Bullard that we are going to need to watch this very, very closely for signs of a disinflationary dynamic taking hold. I think what happens to the economy and inflation over the latter part of next year is extremely uncertain. We have huge changes in forecasts in very short periods of time, and I suspect, like the staff, that the improvement in financial markets and the rebound in the economy will be gradual, in part reflecting the limited power of monetary policy. But even if we thought that a sharper rebound next year was a distinct possibility, I don’t think it would matter very much for our policy purposes here today. The trajectory, the economic decline, the extent of the output gap, and the degree of disinflation in train all imply that our task at this time is to try to limit economic weakness. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. Several quick points. First, the latest leg of deterioration, which began in mid-September, is showing few signs of abating, as Governor Kohn suggested. I think the November retail sales data look like a head fake. Revisions to December 15–16, 2008 150 of 284 September and October, as the Greenbook suggested, make us think that November was probably worse and December worse still. So in some ways I think our job is difficult because the weakness seems to be accelerating. Globally, the deterioration is found everywhere. The data are playing catch-up. I am less optimistic that foreign activity will perform as well as the Greenbook suggests and that foreign activity will respond in 2010 because of lags in policy response and less flexibility in their labor markets, their product markets, and their political markets. The depth and the degree of the fall in data and policymakers’ expectations overseas, particularly in Asia, are remarkable, shocking even, and I think we are likely to see policy responses there that are hard to judge but are likely to be changing pretty quickly. In terms of U.S. households, real household net worth has collapsed about 15 percent or so through the end of the third quarter—more than in 2001 and more than in 1974. Ongoing declines in financial markets and house prices are likely to depress wealth further in the fourth quarter and beyond. So-called savings from lower energy prices look as though they pale in comparison to what else is happening to U.S. household balance sheets. As we have discussed before, every asset everywhere in the world is being revalued, and households are feeling it. In terms of financial markets, I will underscore what Dan suggested and what Bill suggested yesterday—the significant overall deterioration in conditions. We all have a tendency at this point in the year to say, “Well, there are a lot of year-end effects, and we are not going to really know until we get through this period.” We have had baby versions of year-end effects in the quarter-end effects in almost every meeting that we have had, and I have been a little dismissive of those. I would say that there does appear to be more year-end stuff going on in these markets than there has been since this period of weakness began. December 15–16, 2008 151 of 284 If you think about the two former investment banks that have balance sheets and yearends that close at the end of November, this is the last quarter in which they will have that. They have had more demands and more interest in, in effect, renting out their balance sheet as their customers’ balance sheets end in December than they ever have had. The prices that are being paid for them to rent their balance sheets—to take exposures off the balance sheets of their clients—suggest that maybe, just maybe, the year-end effects are more significant this time than they were in the previous six or seven quarters. It doesn’t give me a ton of optimism, but in January, market functioning could look a little better, and I think that would be the best news we have seen for a while. You have heard me say before that, until we see market functioning improving and until we see these markets clearing, it is unrealistic to expect the real economy to turn. I still think that is true. Turning to two final items, inflation and the fiscal package—on the inflation front, although there are risks in this environment for prices to fall below those consistent with price stability, I still believe that these risks are not likely to materialize in the medium term. So I take stock of, but ultimately discount, the Greenbook’s deflation alternative simulation. On the fiscal front, more, bigger, faster is what is going to happen inevitably to what I would describe as the first fiscal package of 2009. The trillion dollar number over two years, which is now being bandied about, is larger than the Greenbook forecast and looks almost assured, with a greater share going to the states in my view than in the Greenbook forecast, more toward public infrastructure, perhaps less toward tax cuts on a relative basis than in the Greenbook, but bigger. I would be surprised if that initial package isn’t supplemented through larger annual appropriations and another stimulus package, if not by the end of 2009 then by 2010. As a result, my own sense would be that the 2010 deficit is likely to be significantly larger than the December 15–16, 2008 152 of 284 Greenbook forecast. Now, knowing the precise contours of this fiscal package is tough. I would say the only good news is that the duration of the slowdown is likely to suggest that the fiscal package may end up being somewhat more permanent in its incentives and somewhat more permanent in its effects; and I suspect, because of that, it is likely to provide some good news to the economy. But I wouldn’t expect that to happen in the next twelve or eighteen months, other than perhaps a bit of benefit on the arithmetic. In terms of changing the overall contour, pace, and strength of the resilient economy, I would say that is still quite a way off. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. MR. KROSZNER. Thanks. President Lockhart’s forecast about what members would say about the forecasts I think has turned out to be right, and I certainly don’t want to disappoint. [Laughter] So I agree with what others have said, and I think most everything has been said about the intensification of the recessionary flames around the world. What I will do is just quickly look at it from the perspective of part of the banks’ balance sheets and the things that may not be left on those balance sheets, to just underscore how I think this is going to be protracted for the financial services sector for a while. On the consumer side, as many people have mentioned, the very sharp step down in employment, the very large job losses, the increases in the unemployment rate, and the decreases in wealth have been leading to very significant increases in consumer delinquencies and very high roll rates—that is, people who become delinquent rolling directly into charge-off. This is happening not only on the credit card side and on a lot of different parts of the consumer side but also in mortgages, for which we are seeing exactly the same kind of thing. Although the most recent numbers that came out from the Mortgage Bankers Association suggested some December 15–16, 2008 153 of 284 stabilization in foreclosure starts, that actually had more to do with the laws in various states slowing down that process rather than any real change in the underlying economics. Of course, we still have a lot of option ARM types of resets that will be coming through in 2009. So a lot of pressure is there, and as was mentioned, housing prices are still going down. We haven’t yet seen as much of an actual downturn in commercial real estate, but undoubtedly that will occur as fewer people are shopping in shopping malls and as a lot of other commercial real estate projects don’t have the payoffs that people expect. Also, an enormous amount of refinancing is going to be necessary during the next few months, and having to pay an additional 600 or 800 basis points really changes the economics of a lot of these projects, if they can even get the refinancing at an additional 600 to 800 basis points. For leveraged loans, another piece of the balance sheet, as people have said, there is very little activity going on in takeovers. The only positive there is that the failure of certain deals has taken some of the pressure off certain banks’ balance sheets. On the commercial and industrial side, as we have noted, the investment-grade market for debt issuance seems to have maintained itself, but that is really one of the few markets that is there. If any challenges come in there, it could be very, very difficult for firms to finance investment. We certainly have seen the spreads going up recently, even if the volume has come back a bit. But as we have seen in the non-investment-grade part, the spreads have blown out, and the financing is not there. That tends to be a little more of what many banks have on their balance sheets, and so I think that is representative of the challenges that the banks are going to have. That suggests that we have a lot of challenges in banking and financial institutions’ balance sheets to come that have nothing to do with any particular level of assets or accounting December 15–16, 2008 154 of 284 issues but just real economic factors that are going to be affecting the balance sheets. So the credit headwinds are going to be very, very strong for a number of quarters going forward. The points that President Rosengren made are extremely important ones. We have to think about, as we move to the zero lower bound, how that is going to affect behavior of financial institutions. Certainly, the staff memos were good on addressing some issues, but I think that other things that have been mentioned, like imposing minimums or floors on interest rates on loans, we have not carefully analyzed or really understand well. There may be a variety of other responses that we don’t understand well that we really do need to get a better handle on, both to see how the effects of traditional monetary policy change—the transmission mechanism—and to think about the nontraditional aspects of monetary policy that we would be undertaking by using our balance sheet. So where can we use it most effectively? If the financial institutions are changing their behavior, we need to be cognizant of that and think about where we need to try to unfreeze markets if we are going to be using our balance sheet in that way, and I think it is very important that we do so. I will underscore also what other people have said about the great importance of clearly articulating what we are doing. It is not that we have given up and that the Fed is impotent but that, through changes in our balance sheet, we can be quite potent in particular markets and in general. That then brings us to whether we can be too potent and raise inflation concerns. Exactly as President Stern said, we should be so lucky to have that as our problem. We do need to make sure that we maintain credibility and show that we feel that we can and do act to offset concerns about deflation. It is very difficult to tell what the price-level evolution is likely to be over the next year, but I do think that there is a real concern about that, and we have to take that very, very seriously going forward. I think we would, obviously, be able to get out of these December 15–16, 2008 155 of 284 different programs, and we need to think about getting out of them at some point. But right now the key is getting into the programs, using the nontraditional approaches, to make sure that we offset a deflationary psychology that could develop. Thank you. CHAIRMAN BERNANKE. Thank you. Governor Duke. MS. DUKE. Thank you, Mr. Chairman. Yesterday I talked about the income statement of the banks. I would like to talk a bit about the balance sheets now. Up to this point, for the small and medium-sized community banks, it has been pretty much business as usual. But now even those banks are finding it increasingly difficult to lend. Community banks and regional banks are trying, but it is tough. Funding is tight and expensive. It costs 3½ percent to keep a CD and 4 percent and up to attract one. The smaller banks are especially bitter about pricing against Citi and those nonbanks that have recently converted to bank holding company and thrift holding company charters. For a bank to qualify for TARP funding, the examiners are raising the bar on noncore funding. One bank reported a meeting with both the OCC and the Fed in which the OCC criticized, and the Fed defended, the bank’s use of the discount window. Examiners are raising the bar on capital: 12 is the new 10 on risk-based capital. Borrowers are not in nearly as good shape as they were. The best credits are choosing not to borrow, and they are adjusting their plans so that they get through on their own cash flow. So the requests coming into the banks are more and more likely to be desperation requests—loans to cover operating losses or to meet payroll. Cracks are appearing in C&I loans. Some banks are exiting loans to entire industries, especially auto dealers, marine and construction trades, and retail. The performance of commercial real estate, especially retail properties, is deteriorating. Hospitality is falling off rapidly, and office buildings are expected to be next. Apartments are still okay, and all of this is December 15–16, 2008 156 of 284 in addition to problems with construction loans. Lower mortgage rates are helping refinance, but it is not the best time of the year to judge what it is going to happen with purchase activity. There are still issues with jumbos, with down payments, and with requirements for very high credit scores. As we have talked here, it occurs to me that perhaps the traditional tools of monetary policy are all directed at bank credit, and the strongest nontraditional tools that we have are addressed more to the securitization markets—the TALF and the purchase of GSEs. In this instance, most of the problems are not really caused by a cutback in bank lending but a complete collapse of the securitization markets, and so that is why these tools may be more necessary. I asked questions also about the TARP capital and got different reactions. Several bankers said that they didn’t need it, they were scared off by the ability of the Congress to change the terms at any time, and they had elected not to take it. Some took it because they thought they could leverage it into good business. Some took it as cheap insurance. Some took it to be in a position to acquire in what they see as the necessary weeding out of weaker players, and they think that should happen sooner rather than later. Several complained about delays in providing terms for smaller banks. Every single bank was adamant about the evils of mark-tomarket accounting and other-than-temporary impairment. There is a big diversion between market losses and credit losses, so that leads to bankers who are afraid to buy securities because they are worried about further marks as the markets go down. But they are also unwilling to sell securities because they don’t believe that the current market price adequately reflects the potential credit losses. There is some speculation that the mark-to-market losses will absorb all of the TARP capital that was just injected, and I think that is something we might want to December 15–16, 2008 157 of 284 calculate as fourth-quarter reports come out. Then, the next big writedown is on servicing portfolios as lower rates spur refinancing activities. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. And thanks, everyone, for a very concise but also very informative roundtable. Why don’t we take a coffee break until 11:30. Thank you. [Coffee break] CHAIRMAN BERNANKE. Why don’t we reconvene, have a brief summary of our goround, and then I will make just a few additional comments. The participants noted that the economic downturn has intensified sharply recently with significant downside risks to the outlook. Recessionary dynamics have set in, with interplays among real and financial variables. The economy is likely to contract through early next year, with considerable uncertainty about subsequent developments. Consumption, employment, and production indicators have weakened further. Financial conditions remain very strained, with improvement in some areas, but many the same or worse. The global economy has also slowed markedly. Looking more specifically at different sectors, credit conditions continue to tighten, with credit lines not being renewed and banks, including smaller banks, hunkering down. Securitization markets are still largely dysfunctional. The overall deleveraging process continues to be a powerful drag on activity. Delinquencies are increasing, implying greater credit losses for banks and other lenders, with small businesses being among the borrowers facing tighter conditions. Banks continue to face intense balance sheet pressures and are reluctant to lend or make markets, and feedback effects from worsening credit quality to the balance sheets of financial institutions are evident. Regarding the consumer, spending continues to contract, as households face ongoing pressures with respect to wealth, income, credit availability, and job security. Psychology is very December 15–16, 2008 158 of 284 negative, and luxury and discretionary expenditures are being cut back. Labor market developments have been negative as well, with accelerating job losses and participation finally declining after remaining high for a period of time. The latest housing numbers suggest a continued contraction in that sector. The fall in mortgage rates has sparked some refinancing and purchase mortgage applications, but the longer-term impact on housing demand is not yet evident. Nonresidential construction is projected to fall significantly, reflecting poor fundamentals and tight credit. Federal fiscal policy will likely provide aid to states, including funds for infrastructure, but the size and the timing of the economic impact of that policy remain uncertain. Manufacturing production continues to slow, along with new orders, capital spending, and business expectations; mining and drilling activities have been reacting to the decline in commodity prices, as has agricultural activity to some extent. Export demand has weakened with the sharp slowing in the global economy of recent months and the strengthening of the dollar since the summer. The sharp global slowdown, including emerging markets, will make recovery more difficult. Manufacturing surveys show that firms expect considerable near-term weakness and declining pricing power. Finally, inflation looks set to decline significantly, reflecting falling commodity prices, rising slack, limited pricing power, and falling inflation expectations. Participants cited the risk that inflation could fall below desired levels. That is just a very quick summary. Any comments? Let me make just a few additional comments, but I won’t add, I think, a great deal of insight to our discussion. I will just note for the record here that the NBER has finally recognized that a recession began in December 2007. I said in the Christmas tree lighting December 15–16, 2008 159 of 284 ceremony that they also recognized that Christmas was on December 25 last year. [Laughter] The Committee was a little more forward-thinking. We began cutting rates, of course, in September 2007 and did 100 basis points of cuts in January 2008. Despite our efforts, this recession, in terms of duration and depth, is likely to be equal to or greater than the two largest previous postwar recessions, those in 1974-75 and 1981-82. There are a number of reasons that may be the case, and some of them were already discussed by the staff. The financial conditions are the most obvious difference between this recession and the earlier ones. A number of previous recessions have had financial headwinds of one type or another. For example, the current financial crisis and housing correction bear some family relationship to the stock market decline and the capital overhang in the 2001 recession. But overall, the financial aspects of this episode are, I think, much more serious than in previous cases. To cite two aspects: One, as Governor Warsh noted, there has been a big impact on household wealth. The flow of funds accounts show a decline in nominal wealth of about 11 percent in the last year or, as he said, a decline in real wealth of about 15 percent. This is going to lead to an increase in saving, which would be desirable in the longer term but in the short term is going to create dislocation. Two, this financial crisis has affected the intermediation of credit far more severely than any other episode since the 1930s. We have already seen a big impact on intermediary capital and bank activity. The deleveraging process is continuing. It is very intense. Again, reduced risk-taking, deleveraging, all of those things are not necessarily bad, but the adjustment process is a very difficult one. A second reason that this recession could well be more severe than the previous ones has to do with the cyclical position of monetary policy, a fact also noted by the staff. The 1974-75 and 1981-82 recessions were basically generated by a tightening of monetary policy, and when December 15–16, 2008 160 of 284 the Federal Reserve decided to let up, essentially conditions began to rebound. Obviously, in this case, other factors have driven the downturn. Monetary policy was proactive in trying to promote recovery. But given where we are today, at the zero lower bound, we are unable to ease policy in the way that we saw in those previous episodes. This suggests, as others have noted, the need for additional policy actions, either on our part or by the fiscal authorities, to get the economy moving again. Finally, a third reason that I think this episode is particularly severe is the global nature of the downturn, which a number of people have also noted. It has always been said that, if the United States sneezes, the rest of the world catches cold. So there has always been a certain amount of coherence or synchronicity between U.S. downturns and those around the world. But the extent of the global downturn this time is really quite exceptional. It is striking that global growth over the past few years has been between 4 and 5 percent, and now the Greenbook is looking at a 1.6 percent decline for global activity in the fourth quarter and a decline of about 0.6 percent in the first quarter. That is quite a big difference between what we might think of as potential and actual growth. So, as I said, there are a number of reasons to think that this is going to be a very severe episode and that we are far from being at the turning point. I won’t go through the sectors. We have all discussed consumption, employment, housing, commercial real estate, and financial markets. These are all aspects of the downturn that continue to be exceptional and very worrisome as we look forward. I will make just a couple of comments about inflation or disinflation. The forecast is for significant disinflation—perhaps not deflation, although deflation is easily within the standard errors of the forecast. A number of factors may affect this forecast or create risks on both sides. December 15–16, 2008 161 of 284 Stephanie talked about structural unemployment perhaps being a factor that might make the effect of slack less than otherwise. On the other hand, there may be some evidence that the Phillips curve is steeper when unemployment is high—that is, recessions tend to have a greater impact on inflation than do small changes in growth. That only goes to say that there is a lot of uncertainty about exactly how far the inflation rate will fall. Although we might reach a technical deflation, I guess it is worth pointing out here that there is nothing special about zero. That is, from this point on, any further disinflation will have the effects of making a given nominal interest rate a higher real interest rate. It is making monetary policy de facto tighter and perhaps having debt deflation effects as the real value of debts and debt payments becomes greater as inflation falls. Because we are already at the zero lower bound, obviously that constraint is already in play. So I think we shouldn’t focus too much or focus the public too much on the deflation line, on that zero number. It is not all that consequential. Rather, the disinflation process—and a very low rate of inflation—is a source of concern. Just to summarize, I don’t think my outlook differs very significantly from what I have heard around the table. I think the issues are what we do about it, and in that spirit, we should turn now to the policy round. So let me turn to Brian to introduce the monetary policy alternatives. MR. MADIGAN. 4 Thank you, Mr. Chairman. I will be referring to the package labeled “Material for FOMC Briefing on Monetary Policy Alternatives.” This package includes the October policy statement, draft policy statements for this meeting, and associated draft directives to the Desk. Alternatives A and B have been revised somewhat relative to the versions that were distributed in the Bluebook, partly reflecting yesterday’s discussion. In addition, as shown in bold in paragraph 1 of alternative A, it seemed appropriate in current circumstances to incorporate a sentence on financial conditions, as the Committee has done in its recent statements; the same sentence has also been included in alternative B. We have presented a total of four policy alternatives for your consideration. Given the unusual circumstances, 4 The materials used by Mr. Madigan are appended to this transcript (appendix 4). December 15–16, 2008 162 of 284 the statements associated with all four alternatives depart to some degree from the statements that have typically been issued by the Committee in recent years. Alternative A represents the sharpest departure. Rather than starting with the policy action, the statement would begin by describing the economic situation, noting that the economic outlook has weakened further. It goes on to say that inflation pressures have diminished quickly and that inflation could decline for a time below the rates that best foster economic growth and price stability. Reflecting what seemed to be a consensus yesterday, the sentence in brackets articulating a medium-term inflation objective has been dropped. We have also bracketed the clause indicating that inflation could drop for a time to very low levels, partly because some Committee members might not yet be convinced that such an outcome is a serious risk at this time and to avoid raising such concerns prematurely. The third paragraph would indicate that the Committee judges that it is not useful to set a specific target for the funds rate. It would explain that judgment by noting that, as a result of the large volume of reserves provided through liquidity programs, the federal funds rate has already declined to very low levels. It would also note that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time, avoiding the use of the “near zero” phrase. The clause “weak economic conditions are likely to warrant” implies some conditionality, but the conditions under which rates would be raised are not spelled out. The fourth paragraph would set out a general plan for implementing unconventional policy to support the functioning of financial markets and stimulate the economy. It reiterates that the Federal Reserve will be buying agency debt and mortgage-backed securities and indicates that those purchases could be ramped up if conditions warrant. It indicates further that the FOMC is evaluating the potential benefits of buying longer-term Treasuries. It also indicates that the Federal Reserve will be considering other ways of using its balance sheet to support credit markets and economic activity. We suggested dropping the word “actively” to avoid a suggestion that a new facility will be announced imminently. Over recent months, the discount rate has moved in lockstep with the target federal funds rate, at a level ¼ percentage point above that rate, and very recently the rates on required and excess reserves have been set essentially by formula equal to the target federal funds rate. Because a target federal funds rate would not be established under this alternative, those formulas could not be used. We have suggested that, under this alternative, the Board act to lower the discount rate 75 basis points, to ½ percent, and that the interest rates on required and excess reserve balances be reduced to ¼ percent. The positive interest rates on reserves would maintain some upward pressure, albeit perhaps modest, on the federal funds rate, consistent with a view that there are some costs in terms of financial market performance of driving the funds rate literally to zero. The discount rate of ½ percent would maintain a fairly small penalty for borrowing at the window. December 15–16, 2008 163 of 284 In certain substantive respects, alternative B, the next page, is similar to alternative A. Most important, federal funds would trade at about the same very low rates as in alternative A, partly because the discount and reserves interest rates, discussed in paragraph 5, would be set at the same levels as in alternative A. Also, the wording of the rationale section of the statement—paragraphs 2 and 3—is essentially identical to the corresponding paragraphs for alternative A. However, alternative B differs from alternative A by explicitly setting a target range for the federal funds rate of 0 to ¼ percent, as shown in paragraph 1. We have restructured the introduction to the discussion of unconventional policy measures in paragraph 5 so that it is generally similar to the corresponding paragraph in alterative A. Also, the final sentence of alternative A, paragraph 4, has been substituted as the last sentence of alternative B, paragraph 5. Both alternatives A and B would put the Committee clearly in the realm of unconventional policymaking going forward. The various policy interest rates would be reduced to very low levels, several unconventional policy tools will already have been implemented, and the statements would indicate clearly that further unconventional tools could be deployed. The Committee might choose either of these alternatives if members had an outlook similar to that of the Greenbook or if they were especially concerned about the downside risks. Both alternatives would constitute somewhat more vigorous policy action than market participants anticipate for this meeting, and accordingly it is possible that financial markets would respond favorably. On the other hand, there is some risk that confidence could be undermined if the main message that comes through is that the Federal Reserve is out of ammunition. As was noted yesterday, such alternatives place a premium on Fed communications that convincingly indicate that the Federal Reserve can still provide monetary stimulus. Under alternative C, on the next page, the Committee would reduce the federal funds target rate 50 basis points today. The Committee might choose this option if it agreed that further monetary stimulus is warranted by the evolving economic outlook but was unsure that it would be necessary, or desirable, to reduce the target federal funds rate to around zero. The rationale for the action presented in paragraphs 2 and 3 would be fairly similar to those of alternatives A and B. Paragraph 4 notes the downside risks to the outlook and indicates that the Committee will use all available tools to promote its dual objectives, suggesting that the Committee will consider further reductions in the target federal funds rate and that further liquidity measures could be forthcoming. You could fine-tune the message regarding the federal funds rate by explicitly indicating that you are willing to or not willing to cut the funds rate further. Under this alternative, we have assumed that the discount rate would be lowered in line with the target federal funds rate to 75 basis points; the draft included in the Bluebook erroneously indicated that the rate would be lowered to 50 basis points. Because the FOMC would set a target rate under this alternative, we have assumed that the reserves interest rates would continue to be set via the existing formulas, so that those rates would move down to ½ percent absent further changes to the target funds rate. As Bill noted yesterday, although these interest rates on December 15–16, 2008 164 of 284 reserves would provide some upward pressure on the funds rate, that pressure is likely to be more than offset by the large supply of reserves, and paragraph 7 notes that federal funds are likely to trade below ½ percent. Although this approach provides a straightforward expectation for the funds rate, it has an unappealing aspect in that the Committee would be changing its target while simultaneously admitting that the target will not be hit, implicitly raising the question of the meaning of the target. Nonetheless, this statement is likely consistent overall with market expectations, and a pronounced market reaction one way or the other seems unlikely. Under alternative D, the Committee would keep the target federal funds rate at 1 percent. The rationale portion of the statement would acknowledge that the nearterm outlook has deteriorated and that significant downside risks are present. However, the statement would note that the broad range of policy actions taken in recent months should help, over time, to improve credit conditions and support a return to moderate growth. The statement would recognize that the federal funds rate would likely average significantly below the target for some time, but it would not imply that a further reduction of the target rate is being contemplated. It thus suggests that the Committee would seek to return the actual federal funds rate to 1 percent over time. Overall, this statement would surprise market participants considerably, both in terms of the decision regarding the target funds rate and in suggesting that further monetary policy stimulus, through conventional or unconventional policy, is unlikely. The final two pages of the package provide draft directives to the Desk that incorporate some changes relative to the versions that were included in the Bluebook. The directive for alternative A would provide some quantitative guidance for the Desk’s open market operations while reserving some role for an assessment of evolving market conditions, specifically the language that “the Committee directs the Desk to purchase GSE debt and agency-guaranteed MBS, with the aim of providing support to the mortgage and housing markets. The timing and pace of these purchases should depend on conditions in the markets for such securities and on a broader assessment of conditions in primary mortgage markets and the housing sector. By the end of the second quarter of next year, the Desk is expected to purchase up to $100 billion in housing-related GSE debt and up to $500 billion in agency-guaranteed MBS.” The directive would not specify a target range for the federal funds rate, while that for alternative B would. The directive for alternative A would state explicitly that the Committee has suspended setting a target for the federal funds rate and that it expects federal funds to trade at exceptionally low levels. The directive for B establishes the fed funds range of 0 to ¼ percent. In line with one of the points raised yesterday, that the size and the composition of our entire balance sheet affect the Federal Reserve’s monetary policy stance, the final sentence of the revised directives for alternatives A and B states an expectation that the SOMA Manager and the Committee’s Secretary will keep the Committee informed of ongoing developments regarding the System’s balance sheet that could affect the attainment over time of the Committee’s objectives of maximum employment and price stability. December 15–16, 2008 165 of 284 The directive for alternative C, on the next page, is generally similar to that for alternative B. But it would acknowledge that federal funds are likely to trade below the ½ percent target rate set under this alternative. The directive for alternative D would include a similar recognition but with a target federal funds rate of 1 percent. In addition, this alternative would not provide specific guidance on open market purchases. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Questions for Brian? President Lacker. MR. LACKER. Thank you, Mr. Chairman. Brian, the first sentence in alternative B says, “The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to ¼ percent.” In the staff analysis of various options for implementing interest on excess reserves, I think option 4 was the one that is closest to the reality of what we are implementing now—just a straight interest rate on excess reserves and an overprovision of reserves to drive it down to the floor. In that analysis, the staff anticipated that it would be a floor, which it turned out not to be. But it anticipated that, with that floor in place, the effective funds rate would generally be above the floor, and it envisioned choosing a rate on excess reserves ¼ point below our target rate. So do you envision in this that we would have to take any measures if suddenly the downward forces on the effective rate would bring the funds rate above ¼? Or is this just under the supposition that it would take a while and that it is unlikely to get above ¼? You see, back in the early analysis there were forces that you believed would lead it above ¼, so I am wondering how you are thinking about it. MR. MADIGAN. President Lacker, the forces that we were thinking would bring it above ¼ were largely a risk premium—the difference between federal funds, which have some amount of credit risk, and deposits at the Federal Reserve, which of course do not. I think we would not anticipate that we would need to do anything very different from what we have been doing—just continue to provide a very large amount of reserves, which is a byproduct of our December 15–16, 2008 166 of 284 liquidity provisions. With the interest rate on balances set at ¼ percent, that configuration of balances and rates would result in a federal funds rate somewhere in the range of 0 to ¼. MR. LACKER. Okay. Well, the reason I ask is that I am a little hesitant to set an upper bound on a range without understanding what sort of mechanism we would have for making that credible. That is why I asked about that. Two more questions. One, the word “zero”—can you help me understand the thinking about why we should be a little averse to using that word? MR. MADIGAN. Well, one reason might be that, if you gave some weight to the view that very low interest rates do have costs in financial markets and you wanted to preserve some rhetorical or substantive leeway, you would want to have a somewhat positive interest rate, to the degree that you could achieve one, but still a low level. MR. LACKER. Okay. One final question. We, in the late 1970s, adopted a set of guidelines regarding agency debt and modified that in the late 1990s. I don’t have a copy with me. I think the latest adoption of that was January 2003, and I believe it is permanent. I think it is still in effect. I think it states that our purchases are not intended to channel funds to any specific sector. I am wondering about the staff’s interpretation of the consistency between our GSE debt and agency-guaranteed MBS purchases, and that guidance. MR. MADIGAN. I do have that guideline here, and you are correct, President Lacker. The first paragraph of the guideline says that System open market operations in agency issues are an integral part of open market operations, designed to influence bank reserves, money market conditions, and monetary aggregates. The second paragraph says that open market operations in those issues are not designed to support individual sectors of the market or to channel funds into issues of particular agencies. As you remembered, in my briefing yesterday I did raise the question as to Committee members’ views of the allocation of funds to particular firms or December 15–16, 2008 167 of 284 sectors. It is possible that the Committee may want to modify, suspend, or repeal this guideline at some point. MR. LACKER. They do seem inconsistent, though, and I think it is something, Mr. Chairman, that we ought to consider. CHAIRMAN BERNANKE. Noted. I think I am somewhat at fault here. I did consult with everyone on the Committee and discussed what we were going to do. I would say that, going forward, we should probably bring all such plans to the Committee. MR. LACKER. Thanks. It would be good to have that public. It is a public document, is it not? Or it is not a public document yet. It is on the Committee records, right? MR. MADIGAN. I believe it is public. MR. LACKER. Okay. It would be nice to have that in conformance with what we are actually doing. Thank you, Mr. Chairman. I appreciate that. CHAIRMAN BERNANKE. President Fisher. MR. FISHER. May I ask two questions, please? With regard to alternative A, I am curious, Brian, as to how you think the bankers would respond to that in terms of their pricing behavior and loans and prime. Second, our friend from the New York Desk, how do you think the markets might respond to alternative A—not overnight, by the way, which I couldn’t care less about, but over the longer term. MR. MADIGAN. On the former, just a guess, I would think that without any target federal funds rate—and given the well-known issues that we have been discussing about pressures on banks—it is possible that the prime rate would not be reduced by the full extent of the implicit reduction in the money market conditions that the FOMC would be targeting. But I don’t really have a good sense as to what would happen quantitatively. December 15–16, 2008 168 of 284 MR. DUDLEY. I think the market will be slightly confused, but I think they will figure it out quite quickly. They will scan the document and figure out, well, what does this really mean? They will be surprised by the magnitude of the interest rate reduction. As I said yesterday, most of the dealers are clustered around a 50 basis point reduction in the target. MR. FISHER. Even though we are not stating a specific target, it would be implicit in the change in the level of the discount rate. MR. DUDLEY. We are saying here that we are at exceptionally low levels of the funds rate for some time. I think they will understand that this is it and that the funds rate is going to be very, very low. Obviously, the next day you will probably observe a federal funds rate that is no more than a couple of basis points, would be my guess. MR. FISHER. Thank you. CHAIRMAN BERNANKE. President Plosser. MR. PLOSSER. Just a follow-up on that. I am a little confused that we don’t set a target but we are operating under an interest on reserves scheme by which we pay a deposit rate, which in fact we just lowered. Is there some kind of disconnect between what is in alternative A, paragraph 5—lowering the discount rate and the interest rates on reserves—and not noting a change in the target rate when, in fact, we have already established that the deposit rate is going to be the target rate. So I am confused. Maybe the markets will see through this, but I don’t know. I am not quite sure I understand what is going on and how this would work, in terms of communications or interpretations. MR. DUDLEY. I think the markets would look at this as saying it is a substantial rate cut. The funds rate has been trading soft to the interest rate on excess reserves by a considerable margin. The interest rate on excess reserves was cut considerably, so they will figure out that, December 15–16, 2008 169 of 284 therefore, the funds rate is going to trade at an exceptionally low level. But you are right—it will not be quite as straightforward as putting it out there right up front. MR. PLOSSER. I guess my trouble is that the Committee judged that it is not useful to set a specific target for the funds rate and yet this will be interpreted as that we reduced the target in effect. CHAIRMAN BERNANKE. We can discuss this in the go-round. President Evans. MR. EVANS. May I just ask Bill Dudley if he could describe how he anticipates his operations would differ between alternative A and alternative B? How would you do things differently? MR. DUDLEY. I think we wouldn’t do things differently to any meaningful degree. CHAIRMAN BERNANKE. Other questions? I think it might be helpful to flag just a few things about which I would particularly appreciate the Committee’s advice. The first is the issue that President Plosser was discussing, which is alternative A—not specifying a range or a target—or alternative B—specifying a range. I think that the argument for specifying a range is that it seems a little clearer. If you look at, for example, the Japanese experience, even when they were in quantitative easing, they still had a target for the call rate, as I understand it. There are some counter-arguments, which Governor Duke and others have raised, about the impact on banks and so on. That is question number 1. Question number 2—and this doesn’t preclude other points, of course—is that in paragraph 3 of alternative B, for example, we have bracketed just for your reference the risk of inflation’s declining below optimal levels. I would be interested to know your views on whether or not to include that bracketed phrase. Third—again looking at alternative B—in paragraph 4 we have the conditional statement that “weak economic conditions are likely to warrant exceptionally low levels of the federal December 15–16, 2008 170 of 284 funds rate.” A little informal polling suggested that people were sort of okay with this way of stating the conditionality. But if there are any concerns about that or, alternatively, if you would like to include a reference to disinflation as one of the conditions, that is just something I want to flag as a question. A fourth and final point I want to flag—and President Yellen pointed this out to me—in paragraph 5 we have a sentence saying that “the Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.” I think to put that in there we should feel that sometime in the next few meetings there is a significant chance that we would in fact engage in some kind of a program. We don’t want to put it in there if it is a complete red herring. So those are four points that I have, but of course, you may have other questions or issues that you want to raise. Governor Duke. MS. DUKE. Mr. Chairman, just one response to President Lacker’s and President Plosser’s observations, which I think are related. If you set the rate that we are going to pay for interest on reserves the same as the target rate for fed funds and the market does repair itself and resume, then you would expect there to be some risk spread over the rate that we are paying on interest on reserves. So if we don’t set a target or we set the target something higher than the rate that we are paying, at least if the markets do start to resume, then the Desk isn’t in a position of then having to try to drive the rate back down again. CHAIRMAN BERNANKE. Thank you. All right. Let’s begin the go-round. We’ll begin with President Rosengren. MR. ROSENGREN. The bleak outlook calls for aggressive action. With the effective federal funds rate already well below our target, there is a logic to moving to the floor at this December 15–16, 2008 171 of 284 meeting and redirecting attention to nontraditional policies. Thus, I am comfortable with alternative B and would reduce the interest rates on required and excess reserves to 25 basis points. In terms of the questions that the Chairman just posed, I am comfortable specifying the range of 0 to ¼ percent. I would actually keep the bracketed information. I am okay with the conditionality. I would remove the reference to the Treasury securities, and for the future I would certainly want to think about expanding the purchase of GSE and agency mortgagebacked securities beyond $600 billion. Also I would support, at a future date, setting a target of 2 percent for the core PCE inflation rate. CHAIRMAN BERNANKE. Thank you. President Bullard. MR. BULLARD. Thank you, Mr. Chairman. I support alternative A, so let me just talk for a few minutes about what I like about it. I like the language “not useful to set a specific target for the federal funds rate” in alternative A because I think this will begin the process of getting the private sector to think in alternative terms about monetary policy. That would be similar to the moves made during the 1979-82 period. Let me just stress that I think the whole process is going to be very difficult. We have an entire generation of private-sector financial market participants who are conditioned to think only in terms of a federal funds rate target as the whole definition of what monetary policy is. I might remind the Committee—if it needs reminding, and it probably doesn’t—that it is a big country out there. When you start talking to others outside the particular participants in financial markets, the level of understanding of monetary policy is very limited. The subtleties get lost, and so it is going to take a lot of time and effort to convince everyone and to explain to everyone that we are switching to new policies. I expect, in fact, that it will probably be a three-year period that will be marked by controversy December 15–16, 2008 172 of 284 over headlines that are of the form, “What is the Fed doing?”—much like the 1979-82 period, when there was continuing controversy and continuing efforts to explain. I also like the paragraph that places emphasis on alternative policies. I would keep the bracketed information. I thought the conditionality was okay. I will say about the alternative policies, those policies have unknown impact, and so we don’t want to be too detailed here because they may have to evolve in the future. I would take out the part about the longer-term Treasury securities. I would put in the inflation target. I said before that I think it is an important point to be able to reassure and anchor expectations in this very fluid situation, which may rapidly unravel on us. This is a good opportunity to do this, and I would go ahead with that. I don’t think it is that different from our longer-term projections, but it is much more direct and communicates much more clearly to markets that we have a medium-term inflation target. On the question of what should be in the directive, I will say this: I see it as somewhat dangerous for this Committee and for the nation to say nothing about the level of reserves or the monetary base. It is true that it may not be inflationary now or in normal times, and it may not have been inflationary in Japan. But there are many examples around the world where money supplies got out of control and inflation was a very serious problem. It could be explosive in some parts of the world, especially if there were a large loss of confidence in the U.S. government or in the performance of this Committee. So I think we want to reassure the world that we are carefully monitoring that situation, that we have our eye on it. As several people have commented around here, a common refrain among business leaders we talk to is, “What the hell is going on? You know, your balance sheet is way up. Isn’t that going to be inflationary?” And we are saying “no,” but I think we need to give continual reassurance that we are December 15–16, 2008 173 of 284 monitoring that situation, we have it under control, and we are thinking about it. I also think, as President Stern said yesterday, that it would help signal our intention to keep inflation near target, other than simply promising to do so, which is just pure reliance on our credibility. You have something quantitative that you can point to. Obviously, it has to be done in a sensible way that allows us to bring in other programs and expand the balance sheet in other ways. I think it is just a matter of making a statement that we are keeping our eye on the whole situation. As far as the other alternatives, let me disparage them for a minute. [Laughter] I don’t know—we haven’t gone all around the table here—but I don’t want to be naming targets that we don’t intend to hit. So I don’t want to say that we have a target but we are not actually going to do it. If we are going to do that, then we have to change the language somehow that whatever the number that we are naming is not really a target. Okay? I would be very averse to doing anything like that. In alternative B, the first sentence states a target range for the federal funds rate. My feeling about this is that effectively, in the big picture, no one will read past that first sentence. They will just say, “Oh, yes, the Fed lowered interest rates.” The idea that we are switching to some new regime or that markets have to start thinking in alternative ways about monetary policy is going to be lost. If you wanted to put a more aggressive spin on this, this is the donothing option. The effective federal funds rate is near zero anyway, so this is just saying, “Well, this is business as usual. We are going to sit on our hands. We are constrained by the zero bound, and we are not going to really change anything.” So I see it as important to get the markets off this, and I see alternative A as one way to do that. But maybe you all will convince me otherwise. Thank you. CHAIRMAN BERNANKE. Thank you. President Lacker. December 15–16, 2008 174 of 284 MR. LACKER. Thank you, Mr. Chairman. Given the dismal state of the economy, and with the funds rate averaging around 1/8 percent anyway, I don’t see any reason to wait to bring the fed funds rate down to effectively zero. I agree with the staff analysis that any dislocation of the money funds is likely to be minor. My board put in for a 75 basis point cut in the discount rate. When I looked over at my small bankers, I was afraid one of them was going to throw a shoe at me. [Laughter] I escaped that. CHAIRMAN BERNANKE. That is going around. [Laughter] MR. LACKER. So I support alternative A. I think it makes sense to deemphasize the funds rate target. For reasons that were illuminated by Brian earlier and reasons that Governor Duke alluded to as well, I don’t think a target range is useful. We don’t want to discourage hope among our community bankers that we might get above ¼ percent should conditions normalize to some degree. We do set an interest rate on excess reserve balances, or more precisely, the Committee’s reduction in the federal funds rate target reduces the rate on excess reserves, given the Board’s adopted formula for setting the excess reserves rate. We have a similar sort of governance disconnect between the discount rate approval decisions of the Board of Governors and the federal funds rate decisions taken by the Federal Open Market Committee. We have managed to coordinate those very effectively, with cohesion and with consensus. It seems to me to make sense to take the same approach to the excess reserves rate. I like the language in alternative A, paragraph 3, where we abandon the target and indicate that the funds rate is likely to be near zero for a while. The conditionality, the way it is expressed there or in B4, is fine with me. I like the idea of shifting attention to the interest rate on reserves by including the statement in the related actions sentence of A5; that further cements the governance coordination that we have in mind there. December 15–16, 2008 175 of 284 I think it makes eminent sense to be very explicit very soon about our numerical objective for inflation. Monetary policy at the zero bound is all about discouraging expectations of deflation. If we haven’t tried first announcing an explicit objective for inflation, we don’t have any excuses if we fail to prevent a fall into a deflationary equilibrium. But I am sympathetic to the notion that it might not be best to slip it in the statement in the dead of night without any fanfare. It might encourage the view that it is a temporary expedient and that we might abandon this language in some future statement, should we find it convenient. I think it would be better to do this and issue a separate statement very clearly articulating that the Committee has adopted a numerical inflation objective, here is what it means, here is how we interpret it, and here is why we do it. Perhaps January would be the right time to do that, and we could, between now and then, lay the groundwork for a clearer and more forceful communication. I think it is likely to have a bigger effect on financial market participants and the public should we do so. Without that statement about an objective, the sentence that precedes it—specifically the phrase that is in brackets in A2—is a little scary. So I would prefer to leave that bracketed thing out if we are not going to include the inflation objective. The fourth paragraph in alternative A and the corresponding paragraphs in B and C discuss how we are going to conduct monetary policy while the funds rate is at zero. I think they are intended to signal a shift toward quantitative measures, but I found the language ambiguous and confusing. None says anything about the monetary base. None says anything about the size of our balance sheet. In other words, they don’t indicate that the credit programs wouldn’t be sterilized. I think the phrase “use our balance sheet” is ambiguous. It doesn’t necessarily mean expand the size; it could mean put some stuff on it. So I would like to see us find a way to December 15–16, 2008 176 of 284 improve the clarity of the language in paragraph 4 regarding the quantitative measures that I think it is intended to communicate. That paragraph also mentions two programs: the agency debt purchases, which we talked about earlier—let me set that aside—and the TALF, which the Committee has not been asked to formally consider and approve. Now, I can appreciate the strict constructionist governance view of who gets to approve them; it is not important that we vote on them. But I have been thinking about this in terms of the ideal—the vision you portrayed and described for us yesterday of a cohesive consensus-building decisionmaking process. I compared the TALF and what the Committee has heard about it. Contrast that with the deliberations we gave to the extension of foreign exchange swap lines to emerging-market countries. There were fairly extensive briefing memorandums provided to the Committee, and there was a fairly lengthy discussion of that step. In contrast, we were basically informed about the TALF rather than consulted in any meaningful sense. Part of the problem here is that this paragraph conflates the use of our balance sheet with expansions of the base, and these are two distinct policy actions. In the current circumstance, unsterilized lending does increase the base. But we have been doing these programs since before that was true, and the distinction doesn’t come through clearly in the language here. There is a tension here because a couple of different plausible theories are floating around about how this stuff affects the economy and our objectives and how things are going to work at the zero bound. I am not sure that we are going to settle on a single theory. In fact, I am sure that we are not going to settle on a single theory. But we should strive, in the interest of consensus, for a statement that encompasses a range of plausible views. We have done that in the past in December 15–16, 2008 177 of 284 finessing things like different views of the Phillips curve and the like, and I would urge us to try to do that here rather than take a monolithic approach. Finally, let me say something about the directive. The new drafts of A, B, and C add a sentence, the operative words of which are “keep the Committee informed,” and it is that the Secretary and the System Open Market Account Manager would keep the Committee informed. This is somewhat short of the language you used yesterday, which admittedly might not be appropriate for the directive. But I wrote the language down, and it is that the Board would bring programs to the FOMC for review and discussion. I like the sentence that is added in the sense that it is a step in the right direction toward your vision of a collaborative body seeking consensus on these issues. But I am afraid that this language won’t do much to dispel questions that have arisen in the press about our governance cohesion and decisionmaking. So I personally would prefer to go as far as we could in that direction. Thank you very much, Mr. Chairman. CHAIRMAN BERNANKE. Jeff, I just want to make a couple of comments. A very small one is that, in an early draft, instead of saying “entail the use of the Federal Reserve’s balance sheet” we had “entail increasing the size of the Federal Reserve’s balance sheet.” We thought that might not be appropriate because things go on and off. MR. LACKER. Other things pull it down. CHAIRMAN BERNANKE. Right. We were probably going to do that as a trend, maybe not day to day, but it has some of the flavor of increasing the base. So that is one just observation. On the TALF, we have added a presentation today from Bill Dudley and Pat Parkinson. MR. LACKER. Excellent. Thank you. December 15–16, 2008 178 of 284 CHAIRMAN BERNANKE. Finally, on the directive, there is a bit of a difference, which is that I do think we need to bring new programs, et cetera, for your information, as I said before. But this is actually a stronger statement in that it also means that we should report to you on the ongoing implications of existing programs for the base and for the balance sheet. So there is a bit of a difference in those two concepts. MR. LACKER. Thank you. Mr. Chairman, I do like the “increase” statement, and I think we could easily explain that we are looking at a partial differential effect. CHAIRMAN BERNANKE. All right. One possibility is “entail increasing the size.” There is some risk there, but I think that would be the general trend that we are considering. Others can comment. MR. DUDLEY. I think the real issue is what happens to the CPFF, what happens to the swap programs, and the take-up of the TAF. Those are the three big elements, and they conceivably could run down in the first quarter. CHAIRMAN BERNANKE. You could say “increasing over time the size” or something like that. MR. DUDLEY. Or “likely to.” CHAIRMAN BERNANKE. Yes. That was the reason we switched. MR. LACKER. The statement doesn’t have to stand for the whole first quarter, does it? MR. DUDLEY. No. But I think the issue is that, because we have open facilities, we just can’t guarantee what their take-up is going to be relative to what they are today. The swap lines are roughly $600 billion; those could come down. MR. LACKER. Well, each facility makes the balance sheet bigger than it otherwise would be. December 15–16, 2008 179 of 284 MR. ROSENGREN. A lot of these could go down quite substantially if conditions improve, and we wouldn’t control that. CHAIRMAN BERNANKE. Right. That was the concern we had—that it wouldn’t necessarily be a monotonic increase, that it could have ups and downs depending on usage and so on. MR. LACKER. Well, I have in mind here the confusion that some around this table have reported hearing from the public about what we are doing with our balance sheet. I think acknowledging that it is expanding in size would be an important feature. CHAIRMAN BERNANKE. All right. Well, we can hear from others about that as well. President Evans. MR. EVANS. Thank you, Mr. Chairman. I certainly agree that more accommodation is needed. We need to take actions to provide, as best we can, the quantitative easing equivalent of the optimal control path as discussed in the briefing. I am not sure ultimately how feasible that will be, but it is a good goal for us over the next few months. Now, in terms of the differences between alternative A and alternative B, as I understood Bill Dudley, there is no operational difference in these two options. It really comes down to how we want to communicate with ourselves and also the public. I tend to favor alternative B, certainly for now, and maybe alternative A later. After all, if the funds rate is going to go to zero in reality, then alternative A might be the right language. But we will have time to see that. This is a reasonable sequencing. The action today that we are dropping the funds rate target range 75 to 100 basis points is big, and certainly that will be the first thing that they see in the first line. I think they will continue reading. The language on the conditionality about the funds rate being exceptionally low is certainly okay today. The language says, “The Committee anticipates that December 15–16, 2008 180 of 284 weak economic conditions are likely to warrant.” I guess there is some question as to whether or not we should include the dual mandate here—that disinflationary forces are also part of that. I could go with the consensus there, but I would just raise that as a question. Regarding the bracketed risk that inflation could decline for a time below optimal rates— the rates that we think are best—back in 2003 this is what got a tremendous amount of attention. That is another reason that, as people read further, it could have a very large effect. It seems to be accurate. One way to deal with that would be to allow the minutes to capture that discussion, at least this time, and perhaps to put it in next time. It depends on the accumulation of how many of these large noteworthy developments we want in the statement here. I would be even more comfortable if that type of statement were accompanied by a context such as that we would be seeking conditions of inflation being around 2 percent. I realize that this may not be the ideal time to include that without a more extended discussion. But I would be okay with the bracketed information, if that is the consensus. I think we should probably omit the Treasury purchases if we don’t think that we are going to do that by March. Certainly, omitting it today is low cost. Given all the information, it is probably overload. I am okay with the language in the directive. Accompanying the language is all of the discussion about the collaboration that we have between the Board and the Committee generally, and so I have a very good feeling about that. I think that it will tend to evolve as this goes on, whether or not it is maximum thresholds or just changing the composition of all of this. So those are my preferences. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Governor Kohn. December 15–16, 2008 181 of 284 MR. KOHN. Thank you, Mr. Chairman. Like the others who have spoken before me, I think this situation is very serious. We need to do all we can, and I think we need to recognize the reality of where we are. So either alternative A or alternative B does that to a significant extent. I guess I have a slight preference for alternative A as a better recognition that we are not really controlling the federal funds rate in here. We have these other balance sheet things going on, and to me alternative B has a little of the flavor of drawing your target around the hole we have already made in the barn door, or whatever, and pretending that you have some control that you don’t really have. So I think A is better. President Bullard made a very good point that A tends to refocus attention on these alternative policies that we all agree will be the focus of our attention going forward. But I could live with either A or B. In terms of some of the issues you raised—so going down alternative A—in paragraph 2, the bracketed language, here I agree with President Lacker. I think my slight preference would be to wait until January to do this. Whether or not we have an explicit inflation target as we come out of the January meeting, we can debate in January. We will, I hope, have at least these long-run projections, and this bracketed language can be explained in terms of those long-run projections. Right now, it kind of sits out there. We haven’t yet explained what we think the rates are that best foster economic growth and price stability in the longer term. By the end of the January meeting, we can do that. So I think I would wait for that. I think the conditional language in the third paragraph is helpful, and I would favor keeping it in. It is appropriately conditioned on weak economic conditions. If other people wanted to add “the disinflationary forces,” which I think come primarily from the weak economic conditions, that would be okay with me, too. But I am fine with this. December 15–16, 2008 182 of 284 In the first sentence of paragraph 4—this is a small point—I would take out the “to continue”: “The focus of policy going forward will be to support the functioning . . ..” When I first read the “to continue,” it sounded as though we are just going to continue what we are doing now. So I would take that out, but that is a small point. On the discussion about whether we should put the size in, I am a little worried about putting it in because the balance sheet has grown so rapidly. If it came down because year-end pressures abated and because the swaps with all of those foreign central banks might tend to come down after the end of the year, I don’t think that the Committee would necessarily want Bill to be replacing every dollar of Eurodollar swaps that came down with something else. I think we are talking about a long-run trend in the base, and we need to be careful about not trying to leave the impression that in every intermeeting period we would expect the base to increase, especially when we don’t control that size. So I would be a little cautious about that. Certainly, if we did include “increase the size of the balance sheet,” I also would say something about the composition. In my view, it is actually the composition more than the size that is going to influence relative asset prices, even though I do recognize that over very long periods, if we keep the base from declining, it would be hard to have prices decline. But I am not sure that is really an effective way to deal with expectations in the short or intermediate run. I would include the purchases of longer-term Treasury securities. Among other things, I think we ought to do it sometime in the next few months. The fact that you have already talked about it, if we omit it—I guess I disagree with President Evans here—I don’t think that will be low cost. We have a series of things we are doing, and that is not part of it. I think there could be an adverse market reaction. Going back to the base for a second, I agree that we need to do a better job of explaining, as I said yesterday, what this new framework is, how the increase in December 15–16, 2008 183 of 284 reserves and the base fits into it—if we can come to some conclusion on that—and why under these circumstances a very large increase in the base isn’t inflationary and how that comes about. We need to do a much better job of explaining these kinds of things. But, again, I would be hesitant to put an explicit target in terms of the level of reserves or the base in there because I don’t really understand the channels through which they influence prices or activity in the short and intermediate terms. Finally, on bank profits and the effects there, ordinarily I wouldn’t worry about bank profits. It is just a transfer between the owners of banks and households and businesses, and quite frankly, transferring some income to households and businesses seems like a pretty good idea most of the time in these circumstances. I agree that it is more ambiguous than usual, given the worries about the financial sector. Still, we are doing a lot for the banks. We are giving them capital. We are guaranteeing their liabilities—we, the government, that is. This will reduce the rates at which they borrow from the discount window and from each other, so they are getting something there. I think banks are going to need to figure out how to operate at these really low interest rates, so I wouldn’t let my concern about bank profits stop me from doing either alternative A or alternative B. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. MR. LACKER. Mr. Chairman? CHAIRMAN BERNANKE. Yes. MR. LACKER. Just a thought in response to Governor Kohn’s comments: Would the phrase “add to” do a better job than “increase the size of” in conveying the sense that these programs are going to make the balance sheet bigger than it otherwise would be, rather than lead to an absolute increase in the size of the balance sheet? December 15–16, 2008 184 of 284 MR. KOHN. I am not sure those words help me, actually. “Add to” sounds the same as “increase” to me. I have missed the subtlety here. MR. LACKER. Other things held constant. MR. KOHN. Ceteris paribus. We could put that in there. CHAIRMAN BERNANKE. It is already Greek anyway. [Laughter] President Lockhart. MR. LOCKHART. Thank you, Mr. Chairman. My preference is to move in this meeting to the consensus lower-bound range for the funds target, and I prefer the range of 0 to 25. So I believe either alternative A or alternative B will work as serviceable options, and I can live with either one. But I actually lean toward alternative B. I think it is the clearest, and with the inclusion of the language related to deflation, it is also internally more consistent. In particular, my preference is to indicate that the FOMC intends to keep the policy rate low until economic and credit conditions improve, and I think it is appropriate to emphasize that our policies will be calibrated based on longer-term inflation objectives. As I said yesterday, I am thinking that the conditionality language could be stronger. Specifically, I have in mind something along the lines of a statement that reads that “the Committee intends to maintain this range for the federal funds rate until such time that it judges conditions are present for material and sustained improvements in financial market functioning and economic growth, and the Committee believes that this policy course is consistent with its medium-term price stability objective.” I think that kind of language could fit at the beginning of paragraph 4, around that area, in alternative B. I think that is stronger than the implicit conditionality that is already in the statement. In my rounds of contacts before the meeting, one conversation did resonate with me. It was a call from a financial market participant for hearing December 15–16, 2008 185 of 284 what the plan is and what the strategy is and affirming that there is a plan. I think stronger conditionality language would respond to that need in the marketplace. As regards the questions, I think I have already covered some of them. I would prefer the specifying of a range in alternative B. I would lean toward including the language “and sees some risk that inflation could decline” because it ties in with the “all available tools” language at the beginning of paragraph 4. In other words, I think, if we include that language in paragraph 3, we are setting up a risk and the “employ all available tools” responds strongly to that risk. Regarding the inclusion of the long-term Treasury securities, I am persuaded by Governor Kohn’s comment that we should include it. It is consistent with whatever public discussion we have had to date, including your speech of two weeks ago. So that is all. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Yellen. MS. YELLEN. Thank you, Mr. Chairman. I think, at the end of the day, alternatives A and B really amount to the same thing in terms of policy. So I could live with either, but on communication grounds, my own strong preference would be for B. I think it is important at this juncture for the FOMC to state very clearly what it wants the federal funds rate to be, that we want it to remain close to zero, and I think we best do that by specifying explicitly a rate or, as it is, a range. Both A and B eliminate the gap we have had between the target and the reality of where the funds rate is actually trading, but B eliminates that gap by embracing the current reality as desirable. In contrast, it seems to me that A is saying that the Committee is all but helpless to affect the funds rate, so, after all, it would be a charade to set a target. Then it kind of acknowledges, well, but, you know, the funds rate trading near zero is really not such a bad thing, given the December 15–16, 2008 186 of 284 weakness in the economy. I think we have greater command over the funds rate’s destiny than alternative A suggests. If the Board and the FOMC really wanted to push the effective funds rate up above zero, say to 50 or to 100 basis points, the Board could choose to raise the rates paid on reserves and the discount rate, and we could get it up, even though we have all of this enormous quantity of excess reserves and even though interest on reserves isn’t working in quite the way we expected. I agree that it would be a bit odd to be setting the interest on reserves and discount rates above our target for the federal funds rate. But it seems to me it could be done, and we are not powerless to accomplish it. So I don’t like the suggestion that we are just helpless to move the funds rate. I think we should say that we don’t want to move the funds rate up. I don’t want it to trade above the 0 to 25 basis point errange. I certainly don’t want that. I think the forecast is grim. I think we should go as low as we can as fast as we can without harming the functioning of money markets, so keeping the funds rate trading in the 0 to 25 range is desirable. If it were to be the case, following President Lacker’s earlier question, that we suddenly saw the interest on reserves floor working better and fed funds started trading above 25—the funds rate could, for example, move up to 50 or so—I would hope that the Board would actually lower the interest rate paid on reserves to hold the funds rate in the 0 to 25 range. So I think we should go down and do it decisively in one step today. On the other matters, in alternative B, paragraph 3, I favor including the bracketed language suggesting that we expect and are not happy to see inflation declining below levels we consider consistent with price stability. I agree with President Evans on the merits of doing that. I like the forward-looking language from A that has been added in bold to B concerning the odds that we will keep the funds rate low for some time. On the Treasuries, I am worried about making an announcement or giving a hint that we are not going to follow through on them pretty December 15–16, 2008 187 of 284 quickly. I am personally in favor of and support buying longer-term Treasuries, and I haven’t heard a lot of opposition to it. If we really are going to do it and do it pretty soon, I have no problem with including language to that effect. But I don’t think we should throw a hint out there unless we intend to follow through. With respect to the wording of the directive, I am happy with it. With respect to the issue about the monetary base and increasing the size of our balance sheet, I would endorse Governor Kohn’s remarks on that topic. CHAIRMAN BERNANKE. Thank you. President Hoenig. MR. HOENIG. Thank you, Mr. Chairman. If we were still working with the framework of targeting the fed funds rate, I would prefer D, and I would accept C, and I would vote accordingly. But I think what I’ve heard in the past two days is that we have really abandoned that framework, and this is kind of a ratification of that. I think that our framework now is actually in A and B in the statement that we are going to “expand its purchases . . . as conditions warrant.” If that’s the case, then going with A, in which you don’t set a fed funds rate or talk about it, is probably preferred. I also think that we’re now in a credit policy type of framework, and it bothers me. I have a lot of sympathy for what Presidents Lacker and Bullard said. I would prefer, rather than a statement that says “as conditions warrant,” that we have some kind of a monetary base criterion for the future. This is something that we ought to think about. At the same time, I do not think that we should have inflation below optimal in this statement. I don’t think we’re there, and, at this point, I think it should not be hinted at. I think that “purchasing longer-term Treasury securities” goes with the conditionality statement anyway. We’ll do what it takes, and if it takes purchasing longer-term Treasuries, that’s it. That is what we have unless we go back and look at a new framework that we need to get out December 15–16, 2008 188 of 284 and talk about with the public, and I hope that as our meetings and our discussions progress, we begin to focus on that. Thank you. CHAIRMAN BERNANKE. Again, as I said yesterday, this is a work in progress. MR. HOENIG. I agree. CHAIRMAN BERNANKE. We’ll keep working on it. I didn’t quite get your proposal. Do you propose leaving in the sentence about Treasuries at this meeting? MR. HOENIG. If we’re going to have statements that say we’re going to purchase mortgage-backed securities as conditions warrant, I don’t think “purchasing longer-term Treasury securities” is a much different step from that, so we can leave it in. CHAIRMAN BERNANKE. Okay. President Pianalto. MS. PIANALTO. Thank you, Mr. Chairman. Obviously, for us to counteract the powerful forces that are weakening our economy and financial markets, we should provide maximum monetary policy stimulus as quickly as possible, and conducting monetary policy on the basis of a fed funds rate target is no longer the best strategy. I do think it is time and it would be helpful to begin focusing the public’s attention on the unconventional approach to monetary policy, and I think alternative A does a better job of doing that. What I like about alternative A is its straightforward characterization of the policy situation and how we plan to respond to it. I support leaving in the language that is bracketed in alternative A, paragraph 2, about the risk that inflation could decline for some time below rates that best foster economic growth and price stability. The reason I say that is that we have been using the language that the Committee expects inflation to moderate for some time now, and given the discussion, I think we expect that situation to be getting worse. So I would support leaving that in. I would also leave in paragraph 3 the more forward-looking language about keeping the low level of the fed December 15–16, 2008 189 of 284 funds rate for some time. I also would keep in the language on the potential benefits of purchasing longer-term Treasury securities. I assume that the minutes that are released in three weeks are going to say that we discussed it and that we will be evaluating it. So I would just leave it in. Also, given the dire economic outlook that we are talking about and the aggressive response that we think monetary policy should take, I think just saying merely that we stand ready to expand the purchase of agency debt and mortgage-backed securities isn’t aggressive enough. I do realize that there are a lot of important questions that are left unanswered, such as determining the mix of assets to purchase and how to know when enough is enough, and then how to shrink our balance sheet when the time comes. But I do think that adopting alternative A is taking a big step in the direction of giving the public some indication of what we plan to do. Finally, I know you just said that we will come up with some language and some framework around what we are doing. But as discussed in yesterday’s conversation, having some talking points even in the near term so that we are consistent in our language on what we are doing would be helpful. At a time when there is a lot of confusion out there and markets are as fragile as they are, having us all talk about this in the same way would be helpful. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Stern. MR. STERN. Thank you, Mr. Chairman. Well, as several people have observed—and I agree—I don’t think there’s any significant policy difference between A and B. That’s certainly where I am. From a communication point of view, I have a mild preference for B. I think it’s a little clearer on the margin and would be helpful in that regard. So I would work off B as to some of the issues and suggestions that have been raised. With regard to the first issue, I would not include the information in brackets in paragraph 3 at this point. I think Governor Kohn made a good point that we’re likely to be much better December 15–16, 2008 190 of 284 positioned to do that in January in conjunction with the SEP and the longer-term projections. Let me be clear. I am in favor of inflation targeting, but I think exactly how and when we get to that is important. So I wouldn’t want to do that simply in a casual way and do it too rapidly. As I look at paragraph 3, I have a couple of other questions. The first sentence says that “inflationary pressures have diminished quickly,” which is certainly true, but I think it may be more important that they have diminished appreciably. So I would just make that point. I might also say, rather than “the Committee expects inflation to moderate in coming quarters,” which I think is probably true, that you might just say “the Committee expects modest inflation in coming quarters.” The reason I’m putting it that way is that I’m trying to get out of this point precisely about whether it is or isn’t going to run below what we think might be consistent with the dual objectives. I think the conditionality in paragraph 4 is fine. If there’s a good way to strengthen it, doing so would also be fine with me. But trying to modify these things on the fly is always difficult. Finally, I would include the thought about purchasing longer-term Treasuries. I think we should, and because I think we should, I think we should say that. So I guess that covers the topics I want to cover. CHAIRMAN BERNANKE. Thank you. Maybe I should ask Bill. Do you see any purely operational issues in the next few months if we decide to purchase longer-term Treasuries? MR. DUDLEY. We can do it, but we’re under a strain. As long as we don’t start until sometime in January, I think we could manage, as long as you don’t ask us to do it every day. CHAIRMAN BERNANKE. We won’t. MR. KROSZNER. Every other day? MR. DUDLEY. How about once every couple of weeks? CHAIRMAN BERNANKE. President Plosser. December 15–16, 2008 191 of 284 MR. PLOSSER. Thank you, Mr. Chairman. These are, indeed, troubling times, and I think in troubling times it’s even more important that we be as transparent and clear as possible. I think it’s time that we publicly convey that we have entered a new monetary policy regime. To do otherwise perpetuates the view that we are no longer in control of monetary policy rather than that we have opted to implement policy through a different means, particularly our balance sheet. There’s ample room for judgment here and disagreement, but, Mr. Chairman, with all due respect, I’m deeply troubled by elements of the steps that we are taking today. In effect, I interpret our proposed actions as substituting credit-allocation policies for monetary policies. Both the expansion of our balance sheet and the fed funds rate are now determined or will be now determined by decisions about which markets or firms are deemed worthy of our intervention and support and some assessment of how much money we want to throw at them. I think we all agree that we are looking for the best policies. I think that it’s also true that best policies are based on clearly articulated goals and objectives and in credible and systematic actions to achieve those goals and objectives, and they can also be credibly communicated to the public. I feel that our approach to credit policy comes up lacking in each of these dimensions. Our goal may be to prevent systemic risk, but we haven’t clearly defined what that is or the criteria that we’re using to decide whom to lend to and when to lend to them. It’s very important for both clarity and transparency that we rectify this deficiency, or we may continue to create moral hazard and to see market after market after market seek our help. The message from the literature we discussed yesterday is that near the zero bound our credibility and our commitment to generate inflation and prevent expectations of deflation to develop are paramount. My reading of the proposed language is that it does little to signal that commitment. Indeed, it seems to suggest that our primary objectives are and will continue to be December 15–16, 2008 192 of 284 credit interventions. Confusing our monetary policy objectives with our credit policies is not the kind of message that I’m comfortable with. I think we need to be careful not to convey to the market that monetary policy has become ineffective, and I don’t think anyone at this table wishes to do that. President Lacker articulated the importance in the current environment of keeping inflation expectations well anchored, and measures of the base—or if you would rather, look at the asset side of the balance sheet, either way they’re both measuring the balance sheet—are a means of anchoring those expectations. I don’t think the language of the directive or the statement is clear enough in addressing either the effectiveness of monetary policy or the credible commitment to avoid deflation or even to maintain inflation near our target, which is clearly not deflation. I’m not quite as fearful of deflation as President Bullard or some others, but I think we need to be mindful and reinforce our commitment to low but stable inflation. On the governance side, I continue to believe that the FOMC is the appropriate body for making monetary policy decisions and that replacing monetary policy with credit policies that are unconstrained by this Committee is to violate both good governance and the spirit of the operating understanding of the FOMC. Yesterday and in my memo to the Committee earlier this week, I argued that the directive and the statement should clearly state that we are in a new regime and should articulate how that new regime will operate going forward. My interpretation is that the proposed language, particularly alternative A, does help indicate that we are moving to a new regime. That’s important, and therefore, I lean in that direction. But that language fails to articulate how that new regime will operate, except to say that the Board of Governors will continue credit market interventions. It says nothing about the terms and strategies that we’ll employ to do so. The implicit message is—and I think the market will clearly interpret it this way—that the FOMC has December 15–16, 2008 193 of 284 ceded monetary policy decisions to the Board of Governors, and I think that will be damaging. Such a step, in my view, is not good policy, nor is it good governance, and it may have political ramifications as well. Once the Committee sets the precedent that the Board of Governors can assume sole responsibility for monetary policy, we run the risk of losing the strength and the diversity of views that the System has always brought. My sense is that this Committee’s setting some kind of cap on the size of the balance sheet was an effort to clarify the role of monetary policy in contrast to credit policy. I think the reaction I heard yesterday around the table was a litany of reasons why setting base growth targets is not appropriate. While that might be an interesting debate to have, that was not the point I was proposing. I was requesting that we have a debt ceiling, if you will, and that the FOMC would review and adjust that debt ceiling as it deemed appropriate—not targets for balance sheets per se. Such a debt ceiling would not prevent the Board of Governors from managing the asset side of the balance sheet via 13(3) lending. Only when unsterilized lending exceeded the debt ceiling might formal approval be required from the FOMC. Mr. Chairman, my discomfort is not a matter simply of good governance. It is more fundamentally about the lack of clarity, discipline, and transparency that the strategy is offering, and I have deep concerns. I’d like to offer a couple of suggestions for the Committee to consider about language, and I’m working off alternative A, which I think is probably the working hypothesis here. So to answer your questions, Mr. Chairman, I have been and continue to be in favor of an explicit inflation target. Most of you are aware of that. I am sympathetic to the view, as I think President Lacker said, that slipping it in in the dead of night is probably not the right way to go about it. I would add that I do not like the bracketed phrase regarding the Committee’s seeing some risk of inflation coming in too low. As President Lacker suggested, it might cause fear in the marketplace. But I do think we December 15–16, 2008 194 of 284 could change the second bracketed statement, which was struck out: “In support of its dual mandate, the Committee will seek . . . a rate of inflation . . . of about 2 percent.” I think we could change that and heighten the importance of inflation to us and our dual mandate by saying something to the effect of “in support of its dual mandate, the Committee will seek a low and stable inflation rate over the intermediate term.” That would be short of specifying an inflation target but would reinforce the notion that we are still committed to achieving a low but stable inflation rate. My biggest problem is with paragraph 4, which I think could be simplified greatly. I would like to emphasize that monetary policy remains in the purview of the FOMC and that we have entered a new regime. So I would propose, just for the sake of getting it on the table, that paragraph 4 be simplified to say that “the focus of the FOMC’s monetary policy going forward will be to continue to support the dual mandate and the functioning of a financial market to stimulate the economy through open market operations and other measures that entail the use of the Federal Reserve’s balance sheet.” Then I would say, “Today the FOMC affirms the expansion of the Fed’s balance sheet up to $3 trillion and will periodically review and adjust that in the pursuit of our dual mandate.” Repeating the litany of credit-market interventions that we have engaged in seems just repeating what we’ve already done. I’m not sure that serves much purpose in the context of monetary policy making at this point. I’m not opposed to buying GSEs. I’m not opposed to buying longer-term Treasuries. I think we need to modify Brian Madigan’s statement about the conditions under which we should purchase GSEs so that we are being internally consistent, but I don’t have any objection to it. So I think we could be clearer. We could be less confusing in our policies by emphasizing again our commitment to keep inflation stable and at a positive level and clearly indicating that quantities do matter and that this Committee is responsible for those quantities and will interact with December 15–16, 2008 195 of 284 the Board of Governors and our credit policies to see that we can achieve the goals that we all decide on. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. President Fisher. MR. FISHER. Mr. Chairman, before I get started, I do think that President Plosser has raised good issues on the governance matter. I hope that we will continue to discuss this, bearing in mind that there may be changes in the composition of the governors with a new President and given the faith that we built up with the existing governors, so that we have to get at least our lines of understanding clear as we go through time. As to the alternatives that we face, the problem with the economy isn’t the interbank lending rate or even the riskless rate. The problem with the economy and with the financial markets is that intermediation has broken down. I think our actions should forcefully be directed toward the clearing of blockages in the financial plumbing and not just fiddling with the faucet. It’s the availability and distribution of credit that is problematic. In that sense I like alternative A. In fact, President Stern, I like its ambiguity, and I’ll tell you why. I am quite worried that stating zero to 25 basis points will bring down upon us the wrath of bankers. I do think it’s important that community banks be profitable and that they be healthy. First Vice President Cumming pointed this out in her comments, and to me this alternative gives us substantial wiggle room, as it were, in its ambiguity. Vice Chairman Kohn pointed out that paragraph 5 is good for the bankers. Without stating a specific target fed funds rate, it allows them to price their loans according to how they see fit. That appears to be taking place anyway. There is a separation between the fed funds rate and the prime loan rate. So unless I’m missing something, bankers should positively interpret both paragraph 1 and paragraph 5 in terms of their operating leeway. December 15–16, 2008 196 of 284 I would suggest that this is an important step forward in making clear the way we’re going to operate henceforth. It does indicate a regime change, and as President Bullard pointed out, I think we have to be forceful in doing so. I could diddle with the language, but to be even more forceful I would transpose paragraph 4 and paragraph 3. That is, the first two paragraphs strike me as fine. At this juncture I would not put in an inflation target because I don’t think we’re prepared for it as a Committee. I’m comfortable leaving in paragraph 2 that we see some risk that inflation could decline below optimal rates for a time. After all, we just got the number that makes that very clear—minus 1.7 on the headline rate. But then I would go immediately into what our focus is going to be. I rather like President Plosser’s one edit to make clear that it’s the focus of the FOMC’s policy. After we have laid that clear—and if, indeed, just parenthetically we are going to make some Treasury purchases, we should include that in there; if we are not, we should not—then in what would be paragraph 4, strike “in current circumstances” and say that “the Committee judged that it was not useful to set a specific target for the fed funds rate.” You’re making it very clear that we have a regime change. As to the content of paragraph 4, assuming we are going to be purchasing longer-term Treasuries, I’d leave it as it is. Stay on message. Repeat it over and over and over again. You started with your speech in Austin, and that makes it operative. I have no problem with it, and I would urge it be included as written. So my suggestions, in summary, are that we embrace alternative A; we transpose paragraphs 4 and 3; we take out the wording “in current circumstances” because obviously we’re judging things in current circumstances; and we not include an inflation target at this juncture but do include the rest of the bracketed language in paragraph 2. I believe this is sellable to our bankers, and I believe it’s a good way to proceed. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. First Vice President Cumming. December 15–16, 2008 197 of 284 MS. CUMMING. Yes, thank you. Like others, I see the circumstances as requiring the most action we can take. Therefore, I would favor alternative A somewhat over alternative B, but I could live with either. I think that alternative A has the advantage, which President Bullard described and others have referred to, that it does signal a significant change in what we’re doing and draws attention to it. If anything, it probably provokes more dialogue with us as a central bank, which I think at this point is a good thing. Turning to the next paragraph, I’m a bit concerned that inflation is, in fact, moderating very quickly. This morning’s number for the total CPI is 1.1 percent. That would lead me to ask whether we are expecting inflation to moderate or are, in fact, seeing inflation moderating. This point is similar to President Stern’s. That would also lead me to leave in the bracketed point about the future and the concern there because I think it’s better if we put it on the table than have people say, “Don’t they see that as a problem?” To that end, I also want to endorse the kind of broad strategy statement that President Lockhart put forward. I actually came into the meeting with a very similar sentence from my staff, really talking about what our goal is. I think it does help to set the stage for what follows here, and this was a focus on improving conditions in financial markets or financial intermediation and ensuring a recovery in output and maintaining low inflation. CHAIRMAN BERNANKE. I’m sorry. What was the beginning? MS. CUMMING. I think that President Lockhart was proposing that it follow paragraph 2, perhaps in its own paragraph. We would raise the question of the risk of too low inflation but then have the next paragraph really speak to what our goals would be, and I thought the sentence that you had sounded good. MR. LOCKHART. I can confuse the matter by saying that I was thinking of it in alternative B, and Ms. Cumming has it in alternative A. So somewhere in there. December 15–16, 2008 198 of 284 MS. CUMMING. Then continuing with this, I would comment on the next paragraph. I’m very sympathetic to the idea that President Lacker was putting forward—that we somehow need to talk about our expectations about the size of the balance sheet. I was going to offer one suggestion: Perhaps for the “entail the use of” phrase in the first sentence of paragraph 4 we could substitute “sustain the size of the Federal Reserve’s balance sheet at very high levels”—something that would indicate that we expect the balance sheet to remain really large but doesn’t talk about whether we’re increasing it from today. Just a thought. I would leave in the sentence on the longer-term Treasuries in large part because we have already talked about it publicly and the language here gives us the opportunity to evaluate and does not necessarily commit us to those purchases in the future. In any case, we would need to explain whether or not we’re going to purchase longer-term Treasuries, having raised it already. On the directive, I would say that I am comfortable with the directives as written. There might be room, if we found the right language for the size of the balance sheet, for inserting that sentence in here, for example, whatever we take from the first sentence of paragraph 4. I also think that, as part of this monitoring that the System Open Market Account Manager and the Secretary will provide for the Committee, there really is the opportunity to develop much better disclosure of what the Committee is doing, what our balance sheet looks like, and what actions we’re taking— some kind of ongoing monitoring that could be shared with the public that I think would also be very helpful in explaining what the Federal Reserve is actually pursuing in the near term and what it is doing with the balance sheet. I was really impressed by something that President Lacker said yesterday, which is that— and I paraphrase—we are in uncharted waters but we are groping our way forward. I think that it is a great metaphor for where, in fact, we are. Some of these questions—such as what specific December 15–16, 2008 199 of 284 forward-leaning language we’d like to put in our statement over time and how we think about the monetary base versus the credit policy type of actions that we’re taking—are all things that I think we will continue to learn about and explore. What I had put forward is that, as we come to understand them better, we have an opportunity to communicate with the public and help them understand better what we are, in fact, doing. Thank you very much. CHAIRMAN BERNANKE. Thank you. Governor Warsh. MR. WARSH. Thank you, Mr. Chairman. As others have said, the choice among these alternatives, particularly A, B, and C, is not really a choice about the effective rate. It’s a choice about our clarity, our conviction, and maybe most important, our readiness in announcing a new regime. As I described yesterday, I think the zero lower bound is not zero, and so there are risks particularly in these markets of going there or threatening to go there. So the balance of my suggestions and edits come from the zero phobia. [Laughter] First let me talk about C briefly. Alternative C is a sort of way station. It is our last chance to describe the old regime and to pivot to a new regime, whether the new targeted rate was 25 or 50 basis points. But seeing that there doesn’t seem to be much interest in that, I won’t try to reconcile the music and lyrics of C, which announces a target and then says we’re going to miss it; but I had a couple of suggestions to try to bring that together. So let me confine the balance of my remarks to the choice between A and B. I think in alternative A we are all-in. It makes the new regime explicit. It is likely to be somewhat of a surprise to markets and puts a large burden on all of us—particularly you, Mr. Chairman—not only in the next few hours but really for the next days and weeks in describing with great rigor what the new regime is. I think we’re up to that, but it is certainly a tall task at a time of great uncertainty in markets. The way I would try to make that task a little easier is through various December 15–16, 2008 200 of 284 channels—suggesting that we are in some ways revealing the new target in paragraph 5 by suggesting that the implied effective target is 25 basis points, given what our change is on the discount rate and the interest rate on reserves. So that, I think, has a way of making the transition to the new regime less massive than it might be and reinforces my zero phobia point. I think that’s one way in which the bold, new regime with a lot of explanation in the next few weeks can at least be not as scary to the markets in the next couple of days. What about alternative B? If we were to go in that direction, I’d make one modest suggestion. In the first paragraph, I would insert the word “between”—so “the Federal Open Market Committee decided today to establish a target range for the federal funds rate between zero and ¼ percent”—to suggest that you’re not going to be at that endpoint. Now, I’ll admit that’s not a massive change, but it makes me feel a bit better about my phobia and about how markets, banks, and others might react knowing that that is a point you do not want to cross. So a suggestion there. Now, on your open question, setting a range in terms of the optimal level of inflation or not, I’m not crazy about a range. But if we have a range, I think it is scary, lurchy, to include it today, and so I wouldn’t do it. Conditionality, I think, is fine. I don’t feel strongly about our considering Treasury securities. I do like Governor Kohn’s suggestion about deleting “to continue” because bold new regimes aren’t continuations of what we’ve done. They’re bold and new. So I think that’s an important change by Governor Kohn. Thank you. CHAIRMAN BERNANKE. Thank you. Governor Kroszner. MR. KROSZNER. Thank you very much. Obviously you have a bleak outlook. It’s very important to act quickly and decisively, and I think it’s clear from the discussion that our choice is between A and B. But as a number of people have mentioned, the economic substance is probably December 15–16, 2008 201 of 284 nearly identical in alternatives A and B. Our exposition of it, though, can make a very big difference. There are an enormous number of moving parts, and there is a lot to digest. We potentially have here, as I count them, seven new things that people have brought up. That’s just an enormous amount to deal with, and I think some of them we want to delay. The inflation target is very important, but it brings up issues here, and I’m not sure that we want to talk about something like that now. So let me just quickly run through these. We have to think about the dynamic of what we are going to say next time. What is this committing us to talk about? First, the rate cut is one very big issue—75 versus 50 basis points. Although some market participants think it will be 75, I think that will still be news, but I think it’s very important for us to move there. Second, just moving to a range is something new; I think that is something that is actually quite newsworthy in and of itself. Going to no target at all is extremely newsworthy, maybe too newsworthy to include with all these other things. I think of this and the discussions that we’ve had as setting up an extremely valuable template for how we should be thinking about the statement and what we need to be explaining today as well as over the next few meetings. So I would actually say that, given all of the moving parts and all of the changes, talking about a range either “between” or “of” zero to ¼ percent would make a lot of sense. I don’t think we’re introducing any more ambiguity. I think we’re introducing a bit of ambiguity especially for people who are not that well informed by saying that we don’t have a target anymore. What President Yellen said was that it could easily be misinterpreted as “gosh, we don’t really have control over these things anymore anyway.” I don’t think any of us believes that, and I think there’s more of a chance of that misinterpretation, which I don’t want us to have, if we do that today with all the other changes than if we waited a little. I still think the range is a pretty big shift. December 15–16, 2008 202 of 284 Expressing concerns about inflation being less than the level fostering economic growth— again, I think that’s something that I would prefer to wait on. I like President Stern’s edit about talking about the appreciable diminution of inflationary pressures, but I would wait on putting in the phrase about whether the level is too low to be consistent with fostering economic growth. I mentioned the inflation target. I think we should wait on that. We’re introducing conditionality, which I think is valuable to do, and I think the phrase there is fine. We’re talking about old and new programs as well as balance sheet issues. As a number of people have mentioned, we have already talked about standing ready to expand the purchases of agency securities as conditions warrant. So that’s forward leaning already. If we are committed to doing the Treasury securities fairly soon, I think we should just go along with that and feel comfortable with that. But we do have to think a bit about the precedent of making concrete new policies that we’ve generally talked about in this statement. Is it something that we want to do going forward? Does this commit us to doing that? I don’t think so, but I think we should just think about that. Then I think it’s very important that we talk about the use of the balance sheet. I agree with Governor Warsh that to be bold you don’t say “continue to.” But we are talking about some existing programs, so in some sense we are continuing. I’m not quite sure exactly where we want to go on this, but I just wanted to raise that ambiguity. On the balance sheet, though, I go back to the Chairman’s remarks from yesterday. It is important to think about the composition of the balance sheet, not just the size in and of itself—Governor Kohn also made reference to this—so I would be very wary of focusing on the size here. I think that just talking about ways to use the balance sheet is the appropriate way to go now. If we have more experience and understand better how the size might evolve over time, how the different programs we have might fluctuate, I’d feel more comfortable with that. If we talk about the size or commitment to growth of that size or expecting it December 15–16, 2008 203 of 284 to be large, just as a number of people said, it could suddenly shrink, and we don’t want people to think that we’re changing monetary policy because of that. Some of these things would just be changing over time. Thank you. CHAIRMAN BERNANKE. Thank you. Governor Duke. MS. DUKE. Thank you, Mr. Chairman. I do favor alternative A. In terms of what will happen with the prime rate, I frankly don’t know, but I think it will leave the banks to determine their own prime rate and floors as they wish. I would not minimize the fact that we are actually still setting a rate for the interest on excess reserves as well as the discount rate. This experience with interest on reserves is brand new for us, and I don’t think we’ve had enough experience to know how it is actually going to work. It does leave room for the spread to establish itself as the fed funds market regenerates, and I think it gives us some room to have some experience with that regime. I think this communicates the regime change better than any of the other alternatives, and at the end of the day, this is a communication document. I would strongly echo President Pianalto’s comments that, in this new regime, we really need to stay on the same page to avoid total confusion in the marketplace. I know that independence of thought is one of the strengths of this body, but if we could for a time set that aside at least in public and all speak from the same talking points, it would make all of our policies more effective. In terms of the specifics of the statement, I would defer to another day the language in brackets in paragraph 2 of alternative A. The conditional language I would keep in. About the phrase “to continue” and really all of paragraph 4, to my mind, although we are continuing some of the things that the Board has done, it has not necessarily been clear that all of these have been considered by the FOMC. To me this takes everything we are doing and puts it in the middle of this table and gives us time to discuss which of them we like, what we might use or not use, and how we December 15–16, 2008 204 of 284 might express the degree to which we would use all of these tools. We’ve made a lot of progress in a very short time in coming to the broad outlines of the things that we might do going forward, and in coming meetings we’ll actually contour those more and make them more specific. I would include that as well. As to whether or not we “use” our balance sheet or “expand” our balance sheet, I would leave it at this point as “use our balance sheet” and have further discussion on that. Thank you, Mr. Chairman. CHAIRMAN BERNANKE. Thank you. Boy, you’ve left me a simple task. Yes, a twohander from President Fisher. MR. FISHER. Mr. Chairman, I just want to come back to a point I suggested. Is there any sense in transposing paragraphs 3 and 4 to emphasize the new regime? CHAIRMAN BERNANKE. Well, let me comment. MR. FISHER. Yes, sir. CHAIRMAN BERNANKE. President Lacker. MR. LACKER. In light of our discussion of “use of” in this balance sheet quantitative, I was going to point out that President Plosser’s suggestion about a specific number for an upper bound on the size of our balance sheet would remedy the problem that we were discussing there. In addition, it would greatly alleviate the deep discomfort I and perhaps others may have about our governance practices and the extent to which they’re publicly known. I would also emphasize that there are two theories about the effect of our balance sheet and that this is written from the creditspreads point of view, and it would be useful to encompass both. CHAIRMAN BERNANKE. Let me just say, generally speaking, that we are making a lot of changes here. I’d like to suggest that we move gradually. But one suggestion I did like and would propose to see if it helps you is First Vice President Cumming’s suggestion of saying that December 15–16, 2008 205 of 284 we’ll provide support with measures that sustain the size of the Federal Reserve balance sheet at a high level. That makes it very explicit. Later we can go further about quantitative guidelines and so forth, but for the moment we’re saying that the balance sheet size itself is of importance. MR. LACKER. Because the word “size” is a quantitative word, it does a lot better than “use of,” which is ambiguous about sterilization. So to that extent I view First Vice President Cumming’s suggestion as very positive. CHAIRMAN BERNANKE. President Plosser, does that satisfy you for today? MR. PLOSSER. Would you read that again, please? I’m sorry, Mr. Chairman. This is very difficult. CHAIRMAN BERNANKE. Just for today, “the focus of policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level.” MR. PLOSSER. I think it is the focus of the FOMC’s monetary policy. CHAIRMAN BERNANKE. The focus of the Committee’s policy. MR. PLOSSER. Of the Committee’s policy—fine. CHAIRMAN BERNANKE. Is that okay? MR. PLOSSER. Yes, much improved. CHAIRMAN BERNANKE. All right. So in the spirit of trying to move gradually and not just overwhelm the market, I would like, as I say, to move halfway to where we want to be. There was a slight majority in favor of alternative A, but I’m very concerned that, if we don’t say anything about the funds rate, there is just going to be confusion. I am also concerned about the view that President Yellen, Governor Kroszner, and others raised if we sort of say that we’re not targeting it December 15–16, 2008 206 of 284 anymore. It suggests that we’re indifferent to the rate or that we have no ability to raise it. What does it mean to say that rates will be kept low for a long time, if we don’t have some view on that? Again, I would cite the Japanese precedent. I understand the concerns about community banks. I do think that’s not a reason that should control our policy, and they certainly can change their pricing policy. So let me make some suggestions. Brian, will someone take notes? Then we can come back. In order to be conservative and avoid risk, I would like to propose alternative B. In the first paragraph, I would take Governor Warsh’s suggestion and say “target range for the federal funds rate between 0 and ¼ percent.” MR. LACKER. I’m sorry. Say that again. CHAIRMAN BERNANKE. “Target range for the federal funds rate of between 0 and ¼ percent.” MR. LACKER. “Of between”? CHAIRMAN BERNANKE. Oh, sorry. Not “of between” but “a target for the federal funds rate between 0 and ¼ percent.” MR. LACKER. So the target is between. MR. KOHN. A target or a target range? CHAIRMAN BERNANKE. Target range. MR. LACKER. Target range is between. CHAIRMAN BERNANKE. “The target range for the federal funds rate between 0 and ¼ percent.” MR. LACKER. So the target range is to be between those two numbers. CHAIRMAN BERNANKE. All right. Okay. Scratch it. Paragraph 1 is the same. That’s simple. Paragraph 2 is the same, including the additional sentence about financial markets, no December 15–16, 2008 207 of 284 longer bolded. Paragraph 3, President Stern was right about “quickly.” Why don’t we say “appreciably”? Now, a lot of people have talked about inflation targets. I think we should look at that very seriously. Today is not the day to do it. Maybe that should be introduced simultaneously with concerns about deflation. I propose that we strike the bracketed material but put the word “further” after “moderate”: “The Committee expects inflation to moderate further in coming quarters.” The fourth paragraph as is—most people were okay with the conditionality there. In the fifth paragraph, strike “continue to”: “The focus of the Committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level.” You know, I get the sense from the Committee that they will entertain purchases of Treasury securities in the next quarter or so. In order not to jerk the market around too much, I think we should therefore mention it and leave it where it is. So the only change in paragraph 5 that I’m proposing is in the first sentence. MR. KROSZNER. So the last sentence will have “continue to” or not? CHAIRMAN BERNANKE. Okay. Let’s see. Yes, I think it has to be there. “The Federal Reserve will continue to consider ways of using its balance sheet.” I think we have to say that because we have used it. MS. DUKE. Would that say “the Committee”? CHAIRMAN BERNANKE. Sorry? MS. DUKE. Would that say the “Committee will” or “the Federal Reserve will”? Perhaps “the Committee will continue to consider ways to use the Federal Reserve balance sheet.” CHAIRMAN BERNANKE. “The Committee will continue to consider ways of using the Federal Reserve’s balance sheet.” I think we should leave it where it is. Just leave it ambiguous for December 15–16, 2008 208 of 284 now, if that’s okay. So those are the changes. Brian, would you like just to read that? Are you able to read it that? Do you have the information? MR. MADIGAN. Yes. CHAIRMAN BERNANKE. Would you go ahead and read the thing? MR. MADIGAN. “The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to ¼ percent. Since the Committee’s last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further. Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters. The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time. The focus of the Committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term December 15–16, 2008 209 of 284 Treasuries securities. Early next year, the Federal Reserve will also implement the term assetbacked securities loan facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.” CHAIRMAN BERNANKE. And then the related action. President Plosser. MR. PLOSSER. This is a clarification, Mr. Chairman. I hate to be difficult, but in thinking about this as a step, we talked about an inflation target. What other steps do you see that we need to clarify as we try to make this process more—I’m looking for some forward-looking language here. CHAIRMAN BERNANKE. Well, we need to talk about it. I think there are two promising directions. One is to have an inflation target or something close to an inflation target, depending on how the Committee decides, what we think is feasible, and so on. The other would be to develop a more formalized structure for discussing the integrated responsibilities we have with respect to the balance sheet, and that could involve quantitative ranges, for example. I didn’t quite like your ceiling because I think in some cases you might want to have a floor. But I don’t think, as I said yesterday, that we can describe our policies in a single number, and I don’t think that a target for the overall size of the balance sheet is a sufficient statistic for what we’re doing. But I do think that, for governance and other reasons, we can talk about ranges, consultation, and so on, about the size of the balance sheet. Okay? Again, I apologize that this is an imperfect document. Given the many moving parts, as I said, I wanted to try to keep it from being too overwhelming. This is going to be a big enough step as it is. Governor Kohn. MR. KOHN. Just one further clarification. By sustaining the balance sheet at a high level, we’re not promising that it won’t fall from here, right? Just that it will be higher than it ordinarily would be. December 15–16, 2008 210 of 284 CHAIRMAN BERNANKE. That it’s going to be above $800 billion for some time I would think is a fair statement. Does anyone else have a comment? Governor Warsh. MR. WARSH. I apologize for the bad English that I offered before, but an alternative to the first sentence that you read that would, I think, be English to Jeff’s fair point—it would be to delete the word “target.” So it says, “To establish a range for the federal funds rate between zero and ¼ percent.” So those are your two options. MR. LACKER. But it’s the same issue. “Range” is the noun, and you’re saying that the range lies between those things, and you’re not telling everyone what the range is. CHAIRMAN BERNANKE. It would be a range of 0 to ¼ percent. I think that would be right. PARTICIPANTS. Right. MR. WARSH. Withdrawn. CHAIRMAN BERNANKE. President Fisher. MR. FISHER. Mr. Chairman, I can’t support that, and I’ll tell you why. I do feel that we had an elegant solution in alternative A. I firmly believe that if we target 0 to 25 basis points—the effective funds rate we all know is trading at 1/16—it is going to create enormous backlash. It is unacceptable to me to say that the bankers will figure out how to deal with this. They can’t. Second, as far as money market funds are concerned, the expense load is usually 30 basis points. So for whatever it is worth, I will be a minority of one, but I cannot support that. Alternative A was elegant in that it made no statement. Then, and I think very important, by dwelling on this business of what our target rate is, we diminish what we’re doing, and what we’re doing is changing things fundamentally, which I fully support. December 15–16, 2008 211 of 284 So for whatever it’s worth, I understand all the counter-arguments. Janet and I have talked about this. I know what people are going to say. I think (a) it is an unnecessary distraction, (b) it creates a potential political backlash, and (c) it is counterproductive. So I just want to state it myself straightforwardly and honestly—I may be the only person at this table, but I’ll vote against that. If you give us alternative A, I’ll vote for it. I know I’m one of 17 at this table—there are more than 17 people at this table. I apologize, but I don’t think it’s necessary to make the funds rate clear. It’s implied in what we’re doing, but alternative A gives people enough ambiguity to steer around it, and that’s my opinion. I apologize. CHAIRMAN BERNANKE. I think confusion is an extraordinarily dangerous thing for us. MR. FISHER. The key is paragraph 4 in alternative A—that is what we’re doing. CHAIRMAN BERNANKE. No, I agree with that. What B says is that this is the end of one regime and the beginning of another. The first one says that this is the end, and then we say what are we doing going forward. I think that clarity is needed. If we did what you’re suggesting, I don’t know for sure what would happen, but I think there would be a lot of commentary and questions: “What are they saying? What do they mean?” That would be much more than what B does. I understand your point. I thought hard about it, and I know that there was a mixture of views. Governor Duke. MS. DUKE. I’d like to ask one question just, again, about going forward. We talked about what you would do differently tomorrow under alternatives A and B and determined that it was nothing. What would you do going forward if federal funds started to trade above 25 basis points under alternative B? MR. DUDLEY. Well, I guess we would stop doing reverse repos to signal our protesting of the fact that the fed funds rate is trading soft to its targets. That’s the first thing we’d do. I have to December 15–16, 2008 212 of 284 say that I think the probability of this happening is extremely remote because banks are balance sheet constrained and therefore aren’t going to do that perfect arbitrage. Maybe in a normal world it would be possible to get fed funds to trade above the interest on excess reserves, but in this world it’s just extraordinarily unlikely. But if it were to happen, we would signal our unhappiness with that, and the first thing we would do is we’d stop doing the reverses that we’ve been doing every day to protest the softness in the funds rate. MS. DUKE. But you would be able to pull it back down. MR. DUDLEY. I don’t know how quickly we could pull it back down. Look. I don’t think that this is going to happen under almost any conceivable circumstance, but if it were to happen, we would basically add reserves to protest what we’re seeing. Time would pass. We’d have another FOMC meeting, and we would make an adjustment to the framework. But I think this is an extremely remote possibility. CHAIRMAN BERNANKE. First Vice President Cumming. MS. CUMMING. I think that, if we see the risk of institutional factors, like the way the prime rate is linked to rates, really getting in the way of good policy, we have an obligation to work with the banking community, work with other regulators if necessary, and work with the SEC if necessary to clear those institutional obstacles. So I wouldn’t let the institutional things be something that gets in our way, rather they would be something that we can really help overcome where we see problems. That link could be changed, and we may want to work actively with the banking community to make sure that it happens. CHAIRMAN BERNANKE. No, clearly the banks are not required to move their prime rate with anything in particular. December 15–16, 2008 213 of 284 MR. FISHER. Of course. They can always have their markup, but you can also reverse the argument and say, so why do you want to cut rates? Again, I think we’re pushing on a string here, Mr. Chairman. Forgive me for speaking, but the guts of what we’re doing and the importance of what we’re doing, which I fully support, are in paragraph 4, and I believe we’re distracting from that by focusing on the fed funds rate. CHAIRMAN BERNANKE. I agree with what you’re saying about the important part, but it is nevertheless the case that—as President Yellen pointed out—if we wanted to, we could raise the funds rate if we put on enough pressure. Therefore, in an important sense a decision is being made here to end this particular policy approach and to move clearly to another one with the words “the focus of the Committee’s policies going forward will be” and that is described in a lengthy paragraph. I am just so concerned about what will happen if we say we’re not going to target it. What does that mean? Is it going to be 5 percent tomorrow? I just fear the confusion. President Hoenig. MR. HOENIG. In terms of what we’re going to be speaking about regarding the new regime, I think it was easier when we had alternative A and we were going to a new regime than when we’re saying, “Well, okay, we’re going to end this regime here.” I’m giving this speech; I get questions. We’re going to end this regime, and we’re going to go to this. So now I’m in the middle of a transition, and I’m trying to explain it, but other than, “Yes, we left this behind, and here we are going forward.” So that’s my concern about the middle step here. I guess in your opinion it’s easier to explain going from “Here’s the old regime; we’re going to stick to it for a little while longer and then . . .” CHAIRMAN BERNANKE. No. Today is the end of the old regime. We have hit zero. We can’t go further. Going forward, this is what we’re going to do. I think that’s clearer. Again, December 15–16, 2008 214 of 284 I’m just concerned about not saying what we’re doing with the funds rate. Are we going to let it do whatever it wants to do from today? I think that’s just going to create volatility. Again, I’m sorry for those who are in disagreement. MR. DUDLEY. For what it’s worth, Mr. Chairman, I agree with you. I think the market will be more confused about alternative A than alternative B. If that’s important, then that should be part of the decision. MR. FISHER. But I asked you that during the question period. MR. DUDLEY. I said substantively we’re not going to conduct policy any differently, but the market will be more confused about A than about B in terms of having to process what this means. Now, it will get to the right answer eventually, but it will be more confused in terms of processing information, in my opinion. MR. KROSZNER. I just want to underscore that, because that was my concern in moving toward B rather than A because I certainly agree that the economic substance is the same. But I do think there’s much more of an opportunity for misinterpretation by the market, and for us to say that we don’t have control of the fed funds rate is the main concern that I have with A. I think B is very clear. The idea of talking about a range, including zero, is something that at least as far as I know the Fed has never done before, and I think that’s an enormous shift. That will be seen as a real shift. But to go to A would have ambiguity and would be very difficult to explain to people who are not real aficionados that we’re not saying, “Gosh, we really don’t have the opportunity to fix the federal funds rate anymore. That piece is broken.” MR. FISHER. I heard eleven people argue the case for alternative A. I counted them. CHAIRMAN BERNANKE. Most of them said it was pretty close, and it’s a matter of communication. It’s my judgment that we are just going to cause a lot of criticism and a lot of December 15–16, 2008 215 of 284 concern and confusion if we do it now. I also agree that it’s fairly close. But my feeling is that the concern of clarity is more important to me. Others? Would you call the roll, please? MR. MADIGAN. Mr. Chairman. CHAIRMAN BERNANKE. Yes. MR. MADIGAN. There is also the issue of the directive. CHAIRMAN BERNANKE. The directive would stand as we’ve written it, with the additional sentence at the end? MS. DANKER. Yes, that’s right. The vote will encompass the statement as Brian Madigan read it and the draft directive for alternative B as was shown in the handout. Since it is longer this time and we are short of time, I won’t read it. Chairman Bernanke First Vice President Cumming Governor Duke President Fisher Governor Kohn Governor Kroszner President Pianalto President Plosser President Stern Governor Warsh Yes Yes Yes No Yes Yes Yes With some reluctance, I will vote yes. Yes Yes CHAIRMAN BERNANKE. Thank you. Could we bring lunch back? Would that work? MS. DANKER. That doesn’t usually work well in a recorded session. CHAIRMAN BERNANKE. That doesn’t work well? All right. Let’s have half an hour for lunch. MR. MADIGAN. The Board meeting, Mr. Chairman. CHAIRMAN BERNANKE. The Board meeting is adjourned. Hold on. The Board will go into my office. Everyone else, lunch. We will take a half hour break, and then we have just a few short items afterwards to complete. Okay? Thank you. December 15–16, 2008 216 of 284 [Lunch break] CHAIRMAN BERNANKE. Let’s reconvene briefly for a couple of other items. On consideration, in order to maintain a united front with the Committee, President Fisher changed his vote to vote “yes” on the resolution. We have two items. First, Governor Kohn is going to talk a bit about our longer-term projection, and then we would like just to hear a bit from Bill Dudley and Pat Parkinson about the TALF. We have had several previous briefings on this, but we will update this and talk a bit about its implications for balance sheet management. Governor Kohn. MR. KOHN. Thank you, Mr. Chairman. You should have gotten memos from the Subcommittee on Communications having to do with the longer-term projections. In considering the trial run and also the current situation, in which the ’09, ’10, and ’11 projections really weren’t settling down and didn’t look as though they would soon settle down into what would be consistent with where we would want things to be in the long term. In these circumstances, the subcommittee thought it would be a good idea to go ahead with a quarterly extension of the projections to give the public a better idea of where we thought output, growth, employment, and inflation were expected to be over the longer run. We made four recommendations within that overall recommendation. We recommended that we do it quarterly, not just once a year, and that the discussion be integrated with the rest of the quarterly projection process in the Summary of Economic Projections. We also recommended that we continue to do this for total PCE inflation but, as we did in the trial run, not do it for core PCE to emphasize to the public that it was the total we were looking at over the long run and not the core. We thought that the questionnaire should ask each participant to provide “your best assessment of the rate to which each variable would converge over the longer December 15–16, 2008 217 of 284 term (say, five to six years from now) in the absence of shocks and assuming appropriate monetary policy.” This would be something that didn’t emphasize the fact that it was five or six years but where things would settle down and it might take five or six years to settle down. So those are our recommendations. Did I missing anything—I’m looking at the subcommittee members? After today’s and yesterday’s discussions, I think the subcommittee will also take another look at whether the Committee should move further in the direction of an inflation target and get some material to the Committee before the January meeting. I think we are not looking for a vote on this today, but if anybody has any views about whether this is the appropriate direction in which to go, I would like to hear them. CHAIRMAN BERNANKE. President Lacker. MR. LACKER. I think the subcommittee ought to consider whether, if the Committee adopts a 2 percent or whatever inflation objective, it might be more confusing than clarifying for us to also be issuing these long-range convergence projections. My first cut at thinking this through—I haven’t given this a lot of thought—is that, if we are going to say our target is X, I don’t see why we would even need these. CHAIRMAN BERNANKE. This is why they need to look at it now because I think they really are substitutes. MR. LACKER. Yes, I think they are substitutes. MR. KOHN. You might still need the output and unemployment. MR. LACKER. What for? We don’t control—well, you know that—sorry. CHAIRMAN BERNANKE. Any other comments or questions? December 15–16, 2008 218 of 284 MR. PLOSSER. I guess, given the zero lower bound issues that we have been discussing and some of the consequences of being there, the difficulty of dealing with policy in that environment, in previous meetings on this topic we have talked about the prospects of specifying the funds rate path or the range of the funds rate paths of Committee members and their projections. It was suggested earlier that, had we done that previously, we might be in a position to signal to the markets more about our commitment to inflation or something like that. So I guess what I’m saying, in the context of both inflation targeting and its projections, giving that a second round of thought, in terms of how it might fit in with that, would be useful under some circumstances. CHAIRMAN BERNANKE. Okay. Anyone else? All right. Let me turn to Bill, who very kindly learned that he was on the program about fifteen hours ago. MR. DUDLEY. It is better than the time I found out I had to discuss a Stiglitz paper in grad school about 12 hours ahead of time. That was harder. I read the Stiglitz paper three times, and then I started to understand it. [Laughter] What I thought I would do, if I could, is invert the order and start with the balance sheet issues and then go into the TALF because I think that there is a broader question of our exit from all our liquidity programs. That is a very legitimate issue. You can imagine a circumstance that sometime in the future we still have an inflated balance sheet, and we actually want to raise the federal funds rate target. The question is, Would we be able to do so? The good news, of course, is that a lot of our facilities are going to go away pretty naturally—the swaps, the CPFF, and the TAF. We may have to give it a bit of a nudge, but those programs should downsize pretty automatically. Even after that, we are still going to have on our books a lot more agency debt and a lot more agency mortgage-backed securities. We’re going to have loans outstanding that are associated with Bear Stearns and AIG. We are going to have longer-term Treasuries. We have potentially a very large funding obligation to Citigroup, if its losses go through the FDIC and TARP money. Then, of course, the TALF could also still be on our balance sheet, depending on what the terms of those TALF loans are. I am going to come back to that a little later. Generally, I am not worried about our ability to raise the level of interest rates, even if our balance sheet is still inflated at the time, for a number of reasons. First, I think the interest rate on excess reserves does work, just not quite as well as we had December 15–16, 2008 219 of 284 hoped. The gap between the interest on excess reserves and the effective funds rate has been running in the 40 to 50 basis point range. That means that, if we were to raise the interest rate on excess reserves, we would raise the whole complex of interest rates, including the effective fed funds rate. The gap is as large as it is because, when balance sheet capacity is scarce, people have to be paid to use their balance sheet to arbitrage that difference. But I think that gap today is pretty stable, and we can expect that, as the balance sheets return to a more normal condition, over time that gap might actually narrow as people say, “Well, gee, I have more balance sheet capacity to do this arbitrage.” So that would be point number 1. Point number 2 is that we can probably take active steps that reduce the cost of that arbitrage to banks today. We can limit the GSEs in terms of their fed funds sales, and we can also reduce the balance sheet consequence of the arbitrage by potentially removing those purchases from the leverage ratio, giving them a little regulatory relief, which actually makes some sense because there is really no risk to a bank that is buying fed funds from another bank and putting them on deposit with the Fed. There is no interest rate risk overnight. So that is something that we might want to consider. Another thing that I think is important to recognize is that there may be other means of addressing our excess reserves problems. The first point is that interest on excess reserves is probably good enough to do a reasonable, if somewhat sloppy, job in pushing up interest rates. In addition to that, we have other ways of addressing excess reserves in the system. We have the ability to change our monetary policy framework. We had a meeting earlier this year in which we discussed some of the potential places we might want to go. To drain excess reserves, if we decided that was necessary to get better control of the federal funds rate, we could do reverse repos with a broader set of counterparties, like money market mutual funds. We could do that using the agency debt on our balance sheet and using the Treasury debt on our balance sheet, and we could probably do that in size, since the money market funds would be very happy to be our counterparts. Second, we could also change the monetary framework in a more radical way. One can imagine a system by which we set voluntary reserve targets for banks at pretty high levels, where the rate they got if they were above the target dropped off considerably and the rate they got below the target dropped off considerably. So we could basically give the banks incentives to hold the amount of their excess reserves that actually are in the banking system. Third, the Treasury could help us, as it was helping us for a while. The SFP bills actually did work. The problem was that, as the Treasury’s borrowing needs skyrocketed, it started to worry about running into the debt limit. What actually happened—it was a political issue—it didn’t want to notify the Congress 60 days ahead of time that it might hit the debt limit, and that is really why it started backing away from the SFPs. Now, we could resolve this in a couple of different ways. One, if the debt limit were raised enough, you would have plenty of room. Or you could December 15–16, 2008 220 of 284 potentially exempt the SFPs from the debt limit, and you could argue that doing so makes sense because there is debt here and there is cash on the Federal Reserve balance sheet, so no real net debt is created. Last, you could gain legislative authority to issue Fed bills, which I think is actually a little more radical step. But the attractiveness of that, of course, is then we have complete control over our destiny, and you don’t have the mushing together of church and state, where we are at least somewhat dependent on the Treasury for managing our monetary policy. So the bottom line for me is that I don’t think we should be concerned about the large size of our balance sheet constraining our ability to manage our interest rate policy going forward. That should not be a driver of what we decide about our liquidity facilities. So why is this important? Well, the TALF, just to recap, is a program in which we would basically lend funds against AAA-rated consumer asset-backed securities on a nonrecourse basis to basically anyone—not quite anyone, not foreigners, but pretty much anyone who wants to do it—and we would conduct these transactions through the dealer community. In the TALF program we would be offering three things to investors. First, they would be offered more leverage than they can get today because the haircuts that we would put on the securities would not be the 50 percent type of haircuts that the market is putting in place today. They might be 10 percent, 20 percent, or 30 percent. We are still negotiating, determining that. So investors could get a lot more leverage than they can get today. The second thing that would be offered is protection against tail risk, and that is something that investors very definitely can’t get today. Because the loan would be nonrecourse, the investor could lose only the amount of the haircut, and that is really important in a world where prices are very volatile. So that would significantly reduce the mark-to-market risk of investing in the securities from the perspective of investors. Finally, probably the most important thing, we would be providing term funding. People could buy these securities, which are of relatively long duration. It depends on what security you are looking at, but the securities probably range in duration from two years to seven or eight years, if you are looking at student loans. So this facility would not work if the term were very, very short. We have been in the process of going out and talking quite extensively to issuers and investors over the past couple of weeks. The Board staff has been involved. The New York Fed staff has been involved. Basically what we found out is that they like the program. The leverage is not quite as important as we thought. They said they could live with less leverage rather than more leverage. They like the protection against the tail risk. The nonrecourse nature of the loans, of course, is very attractive. But the main thing on which they focused and that they said was most important for the success of the program was the length of the term of the loans. When we went forward with the initial term sheet, we were talking about a one-year term, and the investors have come back quite forcefully and said that a one-year term is not sufficient. The program will not work with a one-year term. Now, maybe they are exaggerating the degree to which it wouldn’t work, but it does seem fairly credible December 15–16, 2008 221 of 284 that there is no reassurance that one year from now we are going to be completely out of the situation that we are in today. So, certainly, it is completely legitimate to be worried as an investor about the rollover risk one year from now, given that these are assets of longer durations. Where I come out on all of this is that I think we really do need to be attentive to that concern, and we should try to make the term of the TALF loans as long as possible, subject to protecting the Fed, obviously, from credit losses. If we were to make it short term, I think there is a high probability that the program would fail. I think that would be a huge blow to our credibility. Up to now we have done pretty well in wheeling out programs that have done what we said they were going to do. I think this is a particularly important program because of its ability to be expanded in multiple directions. The Treasury is very, very interested in this program as a way of using TARP capital efficiently. So to wheel this out on terms that are too short and that make the program unattractive would be very, very damaging to our credibility. My view is that we should be willing to offer these loans at term. I would favor three years. I think if we do that, this program will be successful. Obviously, if we do that, we are going to have more balances on our books. This program was originally conceived of as about a $200 billion program. That is probably as big as it would get for consumer ABS, but obviously, if we expand it to CMBS and other things, it could be considerably larger than that. So that is sort of where we are. Pat, do you have anything you want to add? MR. PARKINSON. No, I don’t think so. Again, I think the message, as Bill is saying, from the investors and the issuers was that a three-year term would greatly enhance the chances of success. Indeed, I think our friends in the Treasury Department, at least in the case of government-guaranteed loans, would like to go even longer than that. But both the Board staff and the New York staff thought that it would work best at three years. MR. DUDLEY. Three years gets you far enough along that reasonable people will believe that three years from now you might actually be able to get private-sector financing for this stuff. CHAIRMAN BERNANKE. I am going to need to consult on an informal basis with the other Board members on this. But in the spirit of our discussion yesterday, I invite questions or comments, which will inform our thinking on this as well. Does anyone have any questions or thoughts on this? President Lacker. December 15–16, 2008 222 of 284 MR. LACKER. You said that investors who bought this and put this and got the lending would have the haircut at risk, right? MR. DUDLEY. Yes. MR. LACKER. They would get all of the upside? MR. DUDLEY. Yes. MR. LACKER. So if spreads close in the marketplace, then they get the upside—so we are essentially lending to them to make a leveraged bet on the securities. MR. DUDLEY. The purpose of this facility is not to give investors profits. The purpose of this facility is to address the fact that lending spreads on AAA-rated securities are extremely wide right now and the securitization market is closed. The idea is that, if you offer moreattractive terms than those available in the market, the demand for these securities will increase, issuers will be able to sell these securities at better prices and lower spreads, and the consequences of that will be lower lending rates and improved credit availability to households. The goal at the end of the day is not to do anything for investors. The goal is to harness investors’ profit motivation to drive down spreads in the AAA market. MR. LACKER. I understand. Now, why are spreads high? MR. DUDLEY. Our view is that spreads are high mainly because people can’t get leverage—that is number 1. Number 2, the traditional buyers of these AAA-rated assets either have disappeared completely, like SIVs and bank conduits, or have balance sheet constraints. So the risk capital hasn’t really been willing to come in because they can’t get the financing to make it worth their while. You know, LIBOR plus 300 is not an attractive proposition for someone who is using capital on an unleveraged basis. December 15–16, 2008 223 of 284 MR. LACKER. When I think about leverage and the demand for a given security, if I, as an investor, am going to make a leveraged purchase, then whoever is giving me a loan to make that is also taking a risk position in the security. So the demand that leveraged investors make is really a joint demand by them and the lenders. Everything you have said sounds as if demand is low. Am I missing something here? MR. DUDLEY. The demand is low for these securities today. It is low because of lack of leverage. MR. LACKER. In other words, I’m saying that people who would provide funding also have a low demand or a low evaluation of the value of those securities. This all amounts to a bunch of people out there putting a low value on these securities. MR. DUDLEY. No, I don’t think that is quite right. We are in basically a market disequilibrium, where the traditional buyers of these securities have vanished. In a normal market environment, it would be completely reasonable to lend against these securities on a leveraged basis. But the people who would do that lending—banks and dealers—are balance sheet constrained, and that is why they are not willing to make those loans. If we had a normal banking and dealer situation today in which they were willing to extend loans to their counterparties, they would be providing the leverage. But that is just not happening. MR. LACKER. Do you mean they are not making purchases? They still exist—right?— you said buyers vanished. MR. PARKINSON. The lenders, I think he was saying. Some of the buyers vanished in the sense that they were SIVs or a lot of them were actually securities lenders who were reinvesting their cash collateral in this, and they have learned a lesson about doing that. December 15–16, 2008 224 of 284 MR. LACKER. What evidence do you have that their absence from the market doesn’t reflect just adverse views about the value of the securities that we should treat the way we treat all other security evaluation decisions that market participants make? MR. DUDLEY. Well, I think the counterfactual is what the investors tell us. They tell us that that is not the case. MR. LACKER. Well, wait. These are the ones who would be aided by this program, right? MR. DUDLEY. If you look at AAA-rated assets, the historical credit risk on these assets is very, very low. MR. LACKER. Over the cycle or in a recession? MR. DUDLEY. Yesterday we talked about AAA tranches of student loans, which are 97 percent backed by the Department of Education. They are selling at LIBOR plus 300 or LIBOR plus 400. It is hard to say that those securities are priced there because of credit risk. MR. LACKER. What would a security like that have sold for in 1974 or 1981? MR. DUDLEY. I would be very surprised if you saw anything similar to what we are seeing today. MR. LACKER. Well, they didn’t exist them, so we can’t look it up, for one. So how do we know these are out of bounds with what they would have traded at? MR. DUDLEY. Jeff, this is all a judgment call. We have been making lots of judgment calls. MR. LACKER. Yes, I know. But you are not giving us any evidence about this, Bill. You are not bringing anything coherent that is— December 15–16, 2008 225 of 284 CHAIRMAN BERNANKE. There is an ongoing discussion about whether prices in markets are in some sense Pareto optimal prices or whether there is liquidity risk, other premiums, that the central bank could do something about. I don’t know any way to resolve it. We have the same discussion each time. President Hoenig. MR. HOENIG. All right. So we are going to give them a three-year term to give them assurances that they don’t have to worry about rolling over. I am assuming that, as the market improves—and it should over the next year or 18 months—this would be almost self-liquidating because it would then become attractive to these parties to leave now and that would be taking it off our balance sheet. Is that the operating assumption? MR. DUDLEY. Well, it really depends on what rate we are charging for the loan. Presumably we are going to charge for the loan at a rate that is attractive in times of extremis and somewhat expensive in normal times. So the question really is, Will the market financing improve quickly enough to make the market a cheaper source of funds? I don’t think we can count on all of these loans going away before the end of the term. I think we have to presume that the term could actually be three years because we just don’t know whether the financing will be available from the private sector sooner. MR. HOENIG. That puts us at risk of taking a loss, then, if we should decide to reverse the policy action. MR. PARKINSON. But we could accelerate that process by raising the minimum rate at which we would lend and so make it a higher spread above LIBOR. If we are going to do it through an auction—there are still some questions about how to allocate the credit within this program—and if there is a minimum rate at which we would make funds available in the auction (that would be the December 15–16, 2008 226 of 284 spread over LIBOR) and we adjust that spread upward, we’re giving them more of a push to go back to relying on market financing. MR. HOENIG. That would be the ideal—to push them back out as quickly as possible when the market straightens out. MR. DUDLEY. Well, I think the idea would be that the window for this program would not be three years. It would be a shorter period of time. So the program would come to an end by the end of 2009 perhaps, but the loans that we had made during that period could be outstanding for some time beyond that. MR. HOENIG. But we’re talking about a lot of assets on our books. MR. DUDLEY. The other thing that we should talk a bit about is credit risk to the Fed in all of this. I think the important thing to recognize here is that the credit risk to the Fed is quite low because the Federal Reserve is protected by two things. One, it is protected by the haircuts. The Fed’s risk is a credit risk not a mark-to-market risk. Two, the Fed is also protected by the TARP money. The way this will work is that, to the extent that people put securities to us, we take those securities and we place them in a disposition SPV (special purpose vehicle) that’s capitalized by TARP money. We’ve been doing a lot of work recently about how risky these assets are and what the risk of loss is to the Fed. It turns out that it’s very hard to generate scenarios in which the Fed has any meaningful risk of loss. MR. HOENIG. I have no problem with that. What I’m thinking about is, if we do define a new regime, how we conduct policy. How are we tying ourselves down now relative to what we might want to do in the future in moving these assets on and off our balance sheet? I think that the more flexibility we have in moving them out, the more flexibility we have in any new regime we put forward, and to me that’s important. December 15–16, 2008 227 of 284 CHAIRMAN BERNANKE. Governor Kohn, did you have a comment? MR. KOHN. A comment and a question. One comment, to follow up on your comment, Mr. Chairman, to President Lacker—I think there’s pretty good evidence that there are liquidity strains in the market, beyond just credit strains, impinging on the price of these securities. One piece of evidence I would cite is the difference between on-the-run and the off-the-run Treasury security rates, which have gapped out by 40 or 50 basis points even from—well, I’m not even sure where they are relative to ’98, but I think they’re at record levels. The unwillingness of people—by “people” I mean market makers—to take positions and to do trades—their caution—is affecting the pricing of all kinds of securities well beyond the credit risk, and obviously there’s no difference in the credit risk in on-the-run and off-the-run Treasury securities. MR. DUDLEY. Cash bonds versus derivatives, for example. MR. KOHN. Right. The point that Bill made yesterday was that the equivalent things are selling at very different rates and no one is doing the arbitrage. Second, I like the model that Bill just described in which the Federal Reserve supplies liquidity but the private sector plus the Treasury takes the credit risk. I think that puts us in the right place and puts the taxpayer in the right place. So I think it’s a good idea to get this thing working and look for other opportunities to use it with the agreement of the Treasury. We can’t do it by ourselves. My questions are that I thought we had some feedback along two lines I’d like to hear your comment on. One is that AAA wasn’t enough, that when we started this we thought doing just AAA tranches would restart the markets. So comment on that. The other question is about the nonleveraged purchasers of this paper. We’re not really catering to them, and will it be successful soon? December 15–16, 2008 228 of 284 MR. DUDLEY. Okay. On the AAA—it is really for specific classes. I think we’ve heard that somehow the AAA would not be sufficient mostly from the auto loan area. It’s hard to judge how credible that is, given that the AAA is the big bulk of the capital structure. So if you’re getting good financing for most of the capital structure, it’s hard to believe that you can’t pay people at the bottom of the capital structure a high enough rate to induce them to do that. So I think I’m a little skeptical that this is true. I think that this program will be successful even if we confine it to just AAA. MR. PARKINSON. Even of those who are saying that today they’re having trouble not only placing the AAA but also placing the other tranches, a number say that, if you could start pricing the AAA tranche, that would make placing the others a lot easier. Basically you’d be determining how much of the spread income from the underlying assets has to go to the AAA, and that tells you how much you have left to compensate the lower rated. MR. DUDLEY. You can figure out the economics better once you know how much you have to pay for that 75 percent of the capital structure. MR. KOHN. On the nonleveraged? MR. DUDLEY. I don’t think this program addresses the nonleveraged, but I think there’s not much nonleveraged interest in this sector at this point. MR. PARKINSON. Well, that’s the fundamental problem. Again, some of them were these classes of investors, who are no longer around. Even if they were around, I don’t think we’d want them around—the SIV and securities lenders et cetera. But then you have the pension funds, the insurance companies, and so forth that are not in the market, and this really doesn’t do anything at least initially to bring them back to the market. We have scratched our heads at some length trying to figure out a program that the Federal Reserve could develop that would entice them into December 15–16, 2008 229 of 284 the market. But I think the fundamental problem is that our tool is the ability to lend, and if we’re lending, there has to be a borrower. If you’re talking about pension funds or life insurance companies that are not leveraged investors, it’s just not clear how we can do much to help them get enthusiastic again about buying these securities. In the longer run, the agenda of providing liquidity to markets has to be joined with the reform agenda and figuring out what we can do to bring back confidence in structured credit products by those types of investors. There are lots of recommendations out there—from the President’s Working Group and the Financial Stability Forum—and SIFMA came out with a long study about restoring confidence in the securitization markets. All of that, unfortunately, is going to take a while to implement, and as with so many other things these days, we’re in uncharted territory. Nobody knows for sure, I think, whether any of those things, even though they make sense, will really be sufficient to bring those investors back. But as much as we try to come up with programs to address that, it seems at the moment to be beyond our power. MR. DUDLEY. May I add just one thing to that? It’s also not clear to me that the private sector won’t be clever enough to take these things and package them into securities that have the equity and the leverage embedded in them and sell them to people who want to get high rates of return. It might be a pretty interesting proposition. CHAIRMAN BERNANKE. President Lacker. MR. LACKER. So are there any other constraints of a legal or regulatory nature on participants in this market? Is there anything that keeps any hedge fund in the world from buying these things? MR. DUDLEY. Yes, we’re still working on— MR. LACKER. No, no, no, not the program—the underlying securities. December 15–16, 2008 230 of 284 CHAIRMAN BERNANKE. In general. MR. LACKER. In general. Anyone could buy them, right? MR. DUDLEY. The issuers have to basically conform with the TARP executive comp restrictions. MR. LACKER. No, no, no. Even not participating in the program. There are no limitations on the investors who can participate, for example, in the market for asset-backed student loans. MR. DUDLEY. Well, there is in this program, in that we’re trying to figure out the right way of restricting it to U.S. investors. MR. LACKER. Excuse me. The program doesn’t exist yet. Right now, today, is there anything that restricts a hedge fund in London from buying an asset-backed security. MR. DUDLEY. I don’t think so—not that I’m aware of. MR. PARKINSON. No. MR. LACKER. The reason I ask—the point that I’m making—is that you can reference theories but, at the end of the day, it’s not just those predictions. It’s the whole range of things about the theory. We haven’t, in this, seen many theories put on the table, and the ones that have been—things like cash-in-the-market pricing—just don’t seem to match up well with the facts. There’s a gigantic, billions of dollars worth of investors out there who have the capability of buying any of this stuff. In Treasuries, people are capable of arbitraging that on-the-run and off-the-run thing. To explain this by appealing to some market segmentation seems really weak in this environment. You know, I welcome discussing theories under which these are Pareto improving programs, but I haven’t seen one that’s convincing yet. December 15–16, 2008 231 of 284 MR. PARKINSON. I think it comes back to the point that Bill made earlier. If you’re a hedge fund, even LIBOR plus 500 is still not a rich enough return to that hedge fund unless you can borrow against those securities and leverage it up into a higher return. And until 18 months ago you could have gotten the financing from Deutsche Bank, the Swiss banks, or any of our fine U.S. banks; but it doesn’t appear at the moment that any of them are terribly interested in lending on a secured basis even to the strongest of hedge funds. They’re simply hiding somewhere. MR. DUDLEY. I think we’re in disequilibrium. We’re in a disequilibrium in which the dealers and banks that used to do this lending are in the process of dramatically shrinking their balance sheets. Goldman announced their fourth quarter today. They shrank their balance sheet by 18 percent from the end of their third quarter to the end of their fourth quarter. That’s certainly not any notion of equilibrium in the marketplace, and I think that is what’s causing the stresses in the securities markets. MR. LACKER. Are we preventing equilibration? I mean, what are we doing? We’re in the middle of an adjustment process, it takes some time. MR. DUDLEY. The way I look at it, President Lacker, is that the deleveraging process is happening at a very rapid rate, and that speed can cause quite a bit of damage to financial conditions and, therefore, to the real economy. To the extent that we intervene and slow down the pace of that deleveraging, we can probably mitigate the degree of damage to financial conditions and to the real economy. That’s how I think about it. MR. LACKER. I look forward to seeing the model. MR. FISHER. We’re bridging. MR. DUDLEY. We’re bridging—exactly. December 15–16, 2008 232 of 284 CHAIRMAN BERNANKE. President Lacker, I guess there are at least a couple of theories you could have. One of them has to do with capital. If you think that certain types of intermediaries have specialized knowledge and their ability to lend depends on their capital, then there are informational asymmetries in which clearly exogenous destruction of part of that capital is going to affect equilibrium outcomes in the market. That’s one possibility. The other class of models has to do with liquidity, where you have thick or thin markets depending on “I trade if you trade” and so on and you have markets in which nobody is trading and so no one wants to be the first to enter. By becoming a marketmaker, you can perhaps generate more activity. I think there are some interesting perspectives out there. MR. LACKER. I’m familiar with those models. We don’t have time to discuss them now. CHAIRMAN BERNANKE. No, we should discuss them off line. President Rosengren. MR. ROSENGREN. The loss of the securitization market is really important, so I think this facility is a very important innovation. My question is, How important were the conduits to this market, and how confident are we that there will be structures to bring back the securitization market? Or are we basically bridging to these things going on bank balance sheets or other types of financial intermediaries? How do you see this? I guess the question is, From your perspective, what is this a bridge to? MR. PARKINSON. I think the conduits were more important in some asset classes than others. In credit cards, for example, the conduits were pretty important. But even there they were important in recent years. I think they were important in recent years because spreads kept on coming down and down and deterred the real money investors that traditionally invested in these products—they were no longer interested. Yet the underwriters were able to keep the game going at those low spreads by resorting to selling to conduits and securities lenders and those sorts of things. December 15–16, 2008 233 of 284 So over time, if we could deal with some of the issues around confidence and ratings and the other things that may be deterring the real money investors from entering the market, there is a hope of bringing them back and going back not to 2007, when it was conduits and that kind of stuff, but to, say, 2002, when you had real money investors buying these securities. MR. DUDLEY. Also how you go through the cycle and what the loss experiences on these securities are going to be are hugely important. If this is the worst recession in 30 years, that’s going to be a very interesting data point in terms of what the credit losses on the securities are. If it turns out that the credit losses are low and the securities are robust, I think that will create more demand for these securities over time. You have to weigh that, of course, in terms of what leverage we are going to require financial institutions to carry and how leveraged they can be, and where we set those two standards will determine what goes through the capital markets versus what goes through depository institutions. CHAIRMAN BERNANKE. President Hoenig. MR. HOENIG. Do we have in mind a limit as to how broadly we would make the credit facility available? CHAIRMAN BERNANKE. Currently we have the class of securities. We’re looking at consumer and small-business ABS. MR. DUDLEY. The Treasury has basically committed $20 billion of TARP, and we think that’s going to fund a program of roughly $200 billion of credit cards and auto loans and so on. MR. HOENIG. I ask that question because there are some very important industrial companies that have been financing at fairly attractive rates and are now going to have to refinance that at far less attractive rates. I think that will have every bit as significant an impact on the December 15–16, 2008 234 of 284 economy as the mortgage-backed securities. So unless we think through how we limit this, I think there’s a legitimate case for just about anything. MR. DUDLEY. Well, I’m sympathetic with your view that broader is better than narrower because of all the boundary issues that one creates. I think we all are sympathetic with that. MR. FISHER. For example, would you consider AAA industrial-grade credits? MR. DUDLEY. I think we would consider it. The real issue is the Treasury’s willingness to use TARP money. We can’t do any of this without the Treasury’s commitment, so we’re somewhat constrained in our ability to broaden it in the dimensions that we might want to broaden it. MR. PARKINSON. We’ve heard from practically everyone that’s not within the class of consumer ABS and SBA loans. We have heard from the commercial real estate people and from the auto dealers about their floor plan loans; we have heard from the banks that would like to get the motorcycles and leases. But also corporate loans—the CLO (collateralized loan obligation) market also is shut down. So there is no question. Again, we’re in a hard place because, if we weren’t constrained in part by the TARP capital and our concerns about our balance sheet, we would maybe be able to have a much broader program in which we didn’t have to make these kinds of decisions. But given that there’s only $20 billion of TARP capital and we’re willing at this point to go only to $200 billion, you can’t really say we’ll take all these different asset classes. MR. HOENIG. Which makes my point. We really have to focus on fixing the intermediary process in the United States. There’s no limit to this. The refinancings coming due are huge. CHAIRMAN BERNANKE. That’s agreed and understood. Again, the limits include the TARP capital, our own willingness with respect to the balance sheet, and so on. There really are limits to what this can accomplish. President Plosser. December 15–16, 2008 235 of 284 MR. PLOSSER. But in some sense, just to follow up on this point, the limits are what is really important here because, as long as we don’t define some limits and we just say limited by TARP capital, well, that doesn’t really answer the question. As long as the markets act as if we or someone else is going to step in and rescue them from any more lending arrangements they happen to be facing, the incentives for the intermediary system to repair itself or to gradually adjust are going to be limited. I’m worried about the lack of definition about what constitutes a legitimate market or instrument or firm that we wouldn’t save. CHAIRMAN BERNANKE. That’s a good point, and I think one thing that is a problem now is the transition between Administrations. We’ll soon have a new Treasury Secretary and a new Administration. I think it’s very important—I’ve discussed this with Tim Geithner and others—that as soon as possible we lay out a broad strategy. What are the components of our strategy? What are we going to do going forward? MR. PLOSSER. And what are the limits to it? CHAIRMAN BERNANKE. Well, implicitly, what are the limits to it? How are we going to approach the banking issue? What are we going to do about failing firms? How are we going to try to address the securitization markets? I think the more clarity we can provide—I fully agree with the critique that lurching is very bad, and we need to provide an overview. There is a lot of sympathy from the new Treasury to do that, and we just have to overcome the fact that we’re in a transition at the moment. But I take that point. It’s a very good point. MR. PLOSSER. By the way, Mr. Chairman, I want to thank you. I thought your exchange of letters with Senator Dodd, I guess it was, over the automobile issues was well done. CHAIRMAN BERNANKE. I don’t think you read it, though. [Laughter] MR. PLOSSER. Excuse me, I read about it. December 15–16, 2008 236 of 284 CHAIRMAN BERNANKE. Other questions for Bill? MR. LACKER. I just want to raise two things that worry me. One is that, when these programs are small, you subsidize X percent of the credit market. The other 1 minus X percent, the effect on their rate of return, their borrowing costs, probably is small. But when X gets near—I don’t know where it is now—⅓ or ½, then our subsidization is raising borrowing costs for everyone who doesn’t get money. CHAIRMAN BERNANKE. It’s not clear. The commercial paper market might be a counter-example to that. MR. LACKER. There are some models in which that is the case. It’s not obvious how we rule them out. The second thing is—I don’t know how you evaluate this—you must be thinking whether this means that in every moderate-sized recession henceforth we’ll view the Federal Reserve’s best policy as extending— CHAIRMAN BERNANKE. It’s not a moderate recession, and it’s not a normal financial downturn. MR. LACKER. Right. Every recession of the size we’ve now seen 3 of in the last 50 years. So every recession of that size? CHAIRMAN BERNANKE. You have to have a deep recession and a financial crisis. That’s pretty unusual. Twice a century, or once a century so far. MR. DUDLEY. I’ll give you an example—the VIX has never been this elevated this long since the Great Depression. MR. LACKER. So you’re saying that you’re not concerned about setting up expectations for the next recession. December 15–16, 2008 237 of 284 CHAIRMAN BERNANKE. Certainly I’m concerned. I’m very concerned. But I’m also concerned about getting through this recession. So those are the tradeoffs. MR. LACKER. Okay. CHAIRMAN BERNANKE. Other questions about the program? If not, let me just tell you that I’m going to be doing a call with the press at 3:15 in the Special Library. Any FOMC member who has nothing else to do and would like to join is welcome. Michelle has given your Public Affairs people the phone number so that they can listen in, and we’ll see how that goes. The next meeting is Tuesday-Wednesday, January 27-28. The meeting is adjourned. Thank you. END OF MEETING