Meeting of the Federal Open Market Committee on

January 25'26, 2011

A meeting of the Federal Open Market Committee was held in the offices of the Board of Governors in Washington, D.C., starting at 1:00 p.m. on Tuesday, January 25, 2011, and continuing at 9:00 a.m. on Wednesday, January 26, 2011. Those present were the following:

Ben Bernanke, Chairman

William C. Dudley, Vice Chairman

Elizabeth Duke

Charles L. Evans

Richard W. Fisher

Narayana Kocherlakota

Charles I. Plosser

Sarah Bloom Raskin

Daniel K. Tarullo

Kevin Warsh

Janet L. Yellen

Jeffrey M. Lacker, Dennis P. Lockhart, John F. Moore, and Sandra Pianalto, Alternate Members of the Federal Open Market Committee

James Bullard, Thomas M. Hoenig, and Eric Rosengren, Presidents of the Federal Reserve Banks of St. Louis, Kansas City, and Boston, respectively

William B. English, Secretary and Economist

Deborah J. Danker, Deputy Secretary

Matthew M. Luecke, Assistant Secretary

David W. Skidmore, Assistant Secretary

Michelle A. Smith, Assistant Secretary

Scott G. Alvarez, General Counsel

Thomas C. Baxter, Deputy General Counsel

Nathan Sheets, Economist

David J. Stockton, Economist

James A. Clouse, Thomas A. Connors, Steven B. Kamin, Loretta J. Mester, Simon Potter, David Reifschneider, Harvey Rosenblum, Daniel G. Sullivan, David W. Wilcox, and Kei-Mu Yi, Associate Economists

Brian Sack, Manager, System Open Market Account

Patrick M. Parkinson, Director, Division of Banking Supervision and Regulation, Board of Governors

Nellie Liang, Director, Office of Financial Stability Policy and Research, Board of Governors

William Nelson, Deputy Director, Division of Monetary Affairs, Board of Governors

Linda Robertson, Assistant to the Board, Office of Board Members, Board of Governors

Charles S. Struckmeyer,'' Deputy Staff Director, Office of the Staff Director, Board of Governors

Lawrence Slifman and William Wascher, Senior Associate Directors, Division of Research and Statistics, Board of Governors

Andrew T. Levin, Senior Adviser, Office of Board Members, Board of Governors

Joyce K. Zickler, Visiting Senior Adviser, Division of Monetary Affairs, Board of Governors

Daniel M. Covitz, Associate Director, Division of Research and Statistics, Board of Governors

Gretchen C. Weinbach, Deputy Associate Director, Division of Monetary Affairs, Board of Governors

Beth Anne Wilson,'' Assistant Director, Division of International Finance, Board of Governors

Bruce Fallick,'' Group Manager, Division of Research and Statistics, Board of Governors

David H. Small, Project Manager, Division of Monetary Affairs, Board of Governors

David M. Arseneau, Senior Economist, Division of International Finance, Board of Governors; Stefania D'Amico and Edward M. Nelson, Senior Economists, Division of Monetary Affairs, Board of Governors; Norman J. Morin, Senior Economist, Division of Research and Statistics, Board of Governors

Mark A. Carlson, Economist, Division of Monetary Affairs, Board of Governors

Randall A. Williams, Records Management Analyst, Division of Monetary Affairs, Board of Governors

Patrick K. Barron, First Vice President, Federal Reserve Bank of Atlanta

Mark S. Sniderman, Executive Vice President, Federal Reserve Bank of Cleveland

''Attended Wednesday's session only. '' Attended Tuesday's session only.

David Altig, Alan D. Barkema, Glenn D. Rudebusch, Geoffrey Tootell, and Christopher J. Waller, Senior Vice Presidents, Federal Reserve Banks of Atlanta, Kansas City, San Francisco, Boston, and St. Louis, respectively

Julie Ann Remache, Assistant Vice President, Federal Reserve Bank of New York

Ay''eg''l ''ahin,'' Officer, Federal Reserve Bank of New York

R. Jason Faberman'' and Robert L. Hetzel, Senior Economists, Federal Reserve Banks of Philadelphia and Richmond, respectively

'' Attended Tuesday's session only.

Transcript of the Federal Open Market Committee Meeting on

January 25'26, 2011

January 25'Afternoon Session

CHAIRMAN BERNANKE. We will come to order. The new members of the Committee this year are Presidents Evans, Fisher, Kocherlakota, and Plosser. First Vice President Moore is once again serving for San Francisco. Is First Vice President Pat Barron here?

MR. BARRON. Yes.

CHAIRMAN BERNANKE. This is Pat's last meeting, because he's retiring. Let me congratulate you and thank you for your service in Atlanta. [Applause]

MR. BARRON. Thank you.

CHAIRMAN BERNANKE. This is our organizational meeting, so we have our usual items. The first item is electing Committee officers. Governor Yellen, do you have a motion?

MS. YELLEN. I would like to move the nomination of Ben Bernanke as Chairman. CHAIRMAN BERNANKE. And I would like it to be known that I meet the residency

requirement. [Laughter] Are there other nominations? [No response] In favor? [Chorus of ayes] Opposed? [No response] Thank you. Governor Yellen.

MS. YELLEN. I would like to nominate Bill Dudley as Vice Chair.

CHAIRMAN BERNANKE. Comments? Other nominations? All in favor? [Chorus of ayes] Opposed? [No response] Thank you.

All right, we now turn to the nominated staff officers of the Committee. Debbie will read

the list.

MS. DANKER. Secretary and Economist, William English; Deputy Secretary, Deborah Danker; Assistant Secretaries, Matthew Luecke, 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, James Clouse, Thomas Connors, Steven Kamin, David Reifschneider, and David Wilcox; Associate Economists from the Reserve Banks, Simon Potter, Loretta Mester, Daniel Sullivan, Harvey Rosenblum, and Kei-Mu Yi.

CHAIRMAN BERNANKE. Other nominations? [No response] It's a very good group. All in favor? [Chorus of ayes] Opposed? [No response] Thank you.

Next we have to select a Reserve Bank to execute transactions for the Open Market Account. New York once again is willing to serve. Any other nominations? [No response] All in favor? [Chorus of ayes] Opposed? [No response] Thank you.

The manager of the System Open Market Account, Brian Sack, is once again willing to serve. The New York Bank will have to ratify that if he is elected. Other nominations? [No response] In favor? [Chorus of ayes] Any opposed? [No response] Thank you.

The next item is the proposed revisions to the Program for Security of FOMC Information. This is the memorandum that was circulated to you from Scott and Debbie. It makes two changes to the current Program for Security. The most important change sets out a process for investigating breaches of FOMC security that involves an evaluation by the General Counsel and the Secretary in the first round, and then, if a second round is necessary, the Inspector General of the Board has agreed to investigate. Just for clarity, my sense is that we are trying to address breaches related to the discussion of materials prepared for the meeting, such as the agenda, memos, briefings, and other sorts of things that are part of the background for the meeting, as well as descriptions of what happened at the meeting, characterizations of other people's comments, and so on. What we do not intend to address here is the expression of your

own views, your own policy assessments, and so on. So we're trying to keep the meeting itself separate and not disclose the items I mentioned.

Regarding the second change, the Chairman already has authority to make special exceptions for disclosure of information, and, obviously, there are legitimate reasons for this. The change now specifies that, in doing so, the Chairman should inform the Committee when those exceptions are made. I would like to note that there are some routine, minor, administrative cases, such as allowing a noncitizen staff member to participate in producing the minutes or assigning the work to a transcriber who works with the tapes. Of course, I will inform you of things like that if you so desire, but I hope that such minor administrative matters of that sort will be excepted.

This memorandum was circulated, and there were no comments. I'd like to open the floor for some brief comments now, and I hope that we can vote on it as part of the organizational section of this meeting. However, if the Committee feels that a more lengthy discussion is necessary, we do have a longer period of time tomorrow on communications, so, if necessary, we can defer it until then. Would anyone like to comment on the memorandum?

MR. TARULLO. May I ask a question about it, Mr. Chairman?

CHAIRMAN BERNANKE. Yes, Governor Tarullo.

MR. TARULLO. Janet, could you give a little more context for the kinds of information that the subcommittee had in mind in thinking about the need for a better, more stringent process? I am thinking of this more as a lawyer rather than as a member of the FOMC, so I think it would be helpful to make sure that everybody understands what actually is being proscribed and why it's being proscribed. For example, there's a lot of information in the Tealbook every six weeks, and I don't think any of us think that information needs to get Class I confidentiality

treatment, certainly not as time goes on. So my question, then, is how people, particularly staff, are to be able to distinguish what was intended by the Committee in making these revisions, on the one hand, as opposed, on the other hand, to the literal embrace of the language of the revised regulation.

MS. YELLEN. Our intention was consistent with what the Chairman just said. We're concerned about potential leaks of documents or their contents that are discussed in an FOMC meeting as well as leaks about the substance of discussions, such as who said what. As far as publicizing past data that just happened to appear in the Tealbook, such as historical movements in the exchange rate, I wouldn't think of that as a violation.

We're certainly not trying to be legalistic about this. We wanted to add a procedure to cover what happens if there are violations. It begins with a process of triage in which anything that's reported to the Secretariat would be reviewed by the Secretary, the General Counsel, and the Chairman, and only things that are considered to be significant breaches would go to investigation. I think that section VII tries to make that clear, namely, that things have to be judged to rise above a certain threshold.

MR. TARULLO. Can I give one concrete example? I won't belabor this. Suppose a senior staff person is speaking to a group of academic economists and refers to the staff projections for housing prices over the coming year, something which I, at least, receive only in the form of the Tealbook. Some other memo may produce that information, of course, but that's where I see what the staff expects. Is that information intended to be proscribed or not intended to be proscribed?

CHAIRMAN BERNANKE. I think that would be proscribed because it represents an official view of the staff. However, if the staff member said, 'here are some factors that suggest

that house prices may decline,' without attributing it to the staff or to the Tealbook or to the FOMC, then I think that's acceptable.

MR. TARULLO. Just out of curiosity, does that apply to us, too, for example, during testimony?

CHAIRMAN BERNANKE. Yes. As you know, the Chairman has some special responsibilities, for example, to report to the Congress twice a year and so on. In such testimony, I have talked, for example, about the projections, which, of course, typically come out at about the same time as the testimony, and I described the objectives and the rationale of the Committee. I would argue that that's an appropriate thing to do.

I think it's also fine'and, in fact, desirable'for a member of the Committee to speak publicly along the following lines after, say, a decision made by the Committee: 'Here's what we, the Committee, decided. Here's the logic behind this decision. Here's what we think this action may do.' I think that is all fine. Again, the things we're trying to avoid are, first of all, the leakage of confidential materials, which are, obviously, not materials that could easily be replicated by any outsider using, for example, FRED from the St. Louis Fed, and, second, the leakage of characterizations of discussions taking place within the meeting, such as who said what. In contrast, discussing the sense of the Committee and the goals of the Committee or the individuals' outlooks and policy views is entirely appropriate.

MS. YELLEN. Suppose something came out in the minutes that described the staff projection, and it happened to say that in this round the staff lowered its forecast for house prices. That would be fine, but anything that wasn't in the minutes about Tealbook projections wouldn't be.

MR. EVANS. In the house price example, it's pretty easy. I usually just say that I've seen a number of analyses from the private sector where many people are calling for a further price decline of 10 percent or whatever, and I would assume that's unobjectionable.

CHAIRMAN BERNANKE. President Hoenig.

MR. HOENIG. My thought is a little different. I don't get too confused on what I can say about data and what it may mean. But when I read articles in the paper that say, 'Inside the FOMC there were discussions, and so-and-so said this and so-and-so said that,' to me, that's an obvious a violation. In that case, you might call for a review or an investigation'whatever word you want to use.

CHAIRMAN BERNANKE. There are news stories that say that the FOMC is considering options for what to do with their LSAP program, for example. Now, that is something that a reporter could pull together from speeches and interviews that are entirely legitimate. And I don't think that that's necessarily a problem. However, a verbatim or nearly verbatim report of the debate at the FOMC with some of the specific arguments or numbers would clearly be a violation.

MR. HOENIG. Right. It's usually a judgment call, but the clear indicators are when they start going inside the meeting and saying, 'This was discussed,' and, 'here's where so-and-so or such-and-such came out.' I think that's where you get the issues.

CHAIRMAN BERNANKE. That's correct. President Lacker.

MR. LACKER. We submit projections for various meetings, but we also talk in public about the outlook, and I'm assuming that that's fair game, namely, that I can report my projection in public and submit the same projection.

MS. YELLEN. I think so.

CHAIRMAN BERNANKE. Yes. President Fisher.

MR. FISHER. I'd like to pick up on Tom's point. It's not just what's said in the meeting; it's also very importantly the materials that were prepared for the meeting. I'm not a lawyer, as you know, so I view this as a sort of housekeeping issue'it's restating an ethic, and the ethic is that we do our utmost to maintain confidentiality of things that others might profit from or otherwise use improperly. I think you basically know what it is and know what it's not. To me, this is just an updating'for example, we had to update the word Greenbook to Tealbook. We worked a lot on this, but the more I thought about it, the more it seemed to me that this is just a housekeeping matter and that we need to bring it into the modern era, particularly given the kind of scrutiny we're getting. I wouldn't read too much into it beyond the fact that we clearly have an ethic here which I think (1) needs to be preserved and (2) needs to be as pristine as possible. How you put a precise legal definition on that is probably beyond my capacity.

MR. TARULLO. Just to be clear, the reason I raise this question is principally because of the staff throughout the System. They're going to be reading something which they were not present at the creation of, and they just need to be able to understand what the implications of this are for them.

MS. YELLEN. Dan, it's our intention to try to devise a set of guidelines for the staff after this is approved for the FOMC.

CHAIRMAN BERNANKE. Other comments? [No response] Are we okay voting on this now? In favor? [Chorus of ayes] Any opposed? [No response] Okay, thank you.

We turn to the next item, authorization for Desk operations. This is the annual authorization, right, Brian?

MR. SACK. Right.

will include approval of the System's warehousing agreement with the Treasury. Thank you.

CHAIRMAN BERNANKE. Thank you. Questions for Brian? President Lacker. MR. LACKER. Brian, how do the daylight repurchase agreement procedures that you

settled on to implement this differ from collateralized daylight overdrafts that all the Reserve Banks make available to domestic banking institutions? And if they differ, why?

MR. SACK. The intent of the policy is similar, of course, in that it's to provide collateral on intraday credit extended. In the course of business for regular FIMA accounts, daylight overdrafts inevitably occur, given the volume of transactions that take place in them. The proposed procedure essentially identifies assets that are currently held in their accounts that will either be earmarked as collateral for these transactions or that, in some cases, could even be moved to a separate account for those who are heavier users. Although it's similar in intent, it's also a little different, because we manage these custodial accounts already, which have assets in them, so it's a slightly different procedure in terms of allocating that collateral for this purpose.

CHAIRMAN BERNANKE. Other questions? Vice Chairman.

VICE CHAIRMAN DUDLEY. I wanted to introduce Julie Remache, who is sitting next to Brian Sack. This is her first time at an FOMC meeting. Welcome, Julie.

CHAIRMAN BERNANKE. Welcome. Other questions for Brian? [No response] Seeing no further questions, are we prepared to vote on these two authorizations? All in favor? [Chorus of ayes]. All opposed? [No response] Thank you.

Now for the entertainment portion of our program, [laughter] the staffs of the Board and the Reserve Banks have prepared a special topic on structural unemployment. I was very impressed with the amount of work and the range of research that's being done on this topic, so

I'm looking forward very much to hearing their overview. Let me turn to Dave Stockton to start it off.

MR. STOCKTON. Thank you, Mr. Chairman. Obviously the issue of structural

unemployment has come up quite frequently, and discussions around the table in the last couple of years have involved trying to grapple with the implications of this really deep recession and the sort of imprint it might be leaving on labor markets. Simultaneously, the research community of the Federal Reserve has been hard at work on this issue. While we consider the work we've done thus far to be more of a progress report than 'the final word' on the topic, last week we did post 10 papers and a rather lengthy summary memo, and I think the page length was roughly equivalent to that of War and Peace. [Laughter]

Today we have three presentations that could be characterized as a very intelligent set of CliffsNotes reviewing that work. Bruce Fallick is going to introduce some of the key issues and discuss how the Board staff has incorporated some features of structural change in labor markets into the Tealbook projection. Then Jason Faberman and Ay''eg''l ''ahin will discuss and summarize the large body of research that System economists have been producing, looking at a number of specific aspects of how developments of the past few years may have affected the behavior of labor markets. I'd like to express my appreciation for the very considerable efforts of Loretta Mester, Dan Sullivan, and Bill Wascher in organizing this session. It was, needless to say, a very big job, and they executed it with their characteristic energy and insight. Now I'll turn the floor over to Bruce.

MR. FALLICK.1 Thank you. I'll be referring to the materials in the packet titled 'FOMC Briefing on Structural Unemployment.' Unemployment can be thought of as divisible into two components, one that I will refer to as structural unemployment, and the other as cyclical.

1The materials used by Messrs Fallick and Faberman and Ms. ''ahin are appended to this transcript (appendix 1).

Finally, I want to emphasize that, while the jobless in the U.S. are exiting unemployment at a historically low rate, they are still exiting at a faster rate than those in continental Europe. The lower panel of exhibit 10, which comes from my work with Elsby and Hobijn, shows the historical averages of unemployment inflow and outflow rates for selected countries. As seen in the figure, the high rates of both make the U.S. an obvious outlier. Even the current record low outflow rates in the U.S. are still above the flow rates observed in continental Europe.

As summarized in exhibit 11, our review of recent research finds that extended UI benefits, changes in the recruiting behavior of firms, and skill mismatch have had measurable effects on the unemployment rate over the period 2007 to 2010. Studies found little evidence that geographic mismatch or house-lock has contributed significantly to the rise in the unemployment rate. Finally, we do not view a European-style hysteresis a likely outcome for the U.S. labor market. However, because of the high number of long-term unemployed workers, who tend to exit unemployment slowly, a quick turnaround in the unemployment situation seems much less likely than in earlier recoveries.

When interpreting these findings, please keep in mind that these effects are not mutually exclusive and, thus, not additive. For example, an increase in skill mismatch exacerbates the disincentive effects of extended UI benefits. With that, I turn it over to Bruce to conclude.

MR. FALLICK. Thank you. We asked the research staffs at the 12 Reserve Banks to provide estimates of concepts at least somewhat analogous to the Board staff's estimates of the effective NAIRU. The table at the top of the final exhibit shows these estimates, as well as the Tealbook assumptions, for three points: before the financial crisis in 2007, the current time, and 2015, as well as the increase between the first two points. The numbers for the current period include the effects of extended unemployment benefits for the Board and for those Reserve Banks that thought them relevant and included them in their estimates. The lower panels show the estimates graphically, with the larger bubbles representing a larger number of Reserve Banks. The panel to the left shows the levels; the panel to the right shows the increase from before the crisis to the current time. The pre-crisis estimates cluster around 5 percent, although they range as high as 7'' percent. Most viewed structural unemployment as having increased since then, and many expect the increase to be mostly reversed by 2015. The estimated increases are centered around 1'' percentage points, but they range from essentially zero to 2'' percentage points. Moreover, I think I can say without fear of contradiction that a considerable range of uncertainty surrounds each of our estimates. We would be happy to take your questions.

CHAIRMAN BERNANKE. Thank you very much again for very thorough,

comprehensive work. Beth Anne, you're available for questions, too, is that right? Yes. Beth

Anne will take international questions. Are there any questions for our colleagues? President Fisher.

MR. FISHER. In the last table, it's not clear to me whether those are our NAIRUs'or what are those numbers?

MR. FALLICK. That depends. Each Bank was asked to provide an estimate of that quantity that the staff thought would be useful in this context. We would describe that as a NAIRU; in other cases it was described as an unemployment rate consistent with price flexibility, or an unemployment rate that is not susceptible to monetary policy. A variety of definitions were provided.

MR. FISHER. I would caution you that it depends on what your thinking was pre-crisis versus post-crisis. For example, a lot of our thinking in Dallas has been conditioned by questioning the basic principle of the NAIRU because of globalization in terms of workforce capacity and the willingness of people to hire and where they wish to hire. So, the Dallas Fed indicates a minimal increase in the NAIRU, but we've been thinking about it this way for years, before the crisis. The work you've done is great, and this has been an illuminating discussion, but I just wanted to know what this table is purporting to show, and I would caution you against reading too much into the table.

MR. KOCHERLAKOTA. I guess what I took from the table'and you can certainly build on this, Bruce'is that there was a considerable range and a considerable amount of uncertainty about each of these points. Would that be a fair conclusion?

MR. FISHER. Well, that was his point. Well-summarized.

CHAIRMAN BERNANKE. Okay. Questions, comments? President Lacker.

MR. LACKER. This is a question for Ay''eg''l. The notion of mismatch depends

critically on the notion of heterogeneity among workers and among worker'firm matches. In the literature on income inequality, there has been a fair amount of effort devoted over decades to the measured dispersion of income across workers. A lot of that work uses detailed demographic data to explain some of those differences, but there's still a fairly substantial amount of variation across workers' incomes that's not attributable to any observable characteristics. My understanding is that the magnitude of that dispersion has increased, that is, the amount attributable to unobservable characteristics has increased. I also have the impression from this mismatch literature and from the excellent introduction given by all of the staff papers that the number of observable characteristics of workers and firms that is used in these investigations is much smaller than in the inequality literature, where you have fairly extensive demographic data. Therefore, you'd expect the heterogeneity that is unmeasured by the econometrician to be much larger here than in the inequality literature results. In your investigation, you've failed to find evidence for mismatch, but of course, there could be mismatch that you're just not measuring. So I wonder if you'd be willing to characterize your sense of the extent to which available data sources, like JOLTS and the others that you've exploited, are able to capture heterogeneity that might be relevant to mismatch or the extent to which there's unmeasured heterogeneity floating around that leaves us uncertain about the conclusion.

MS. ''AHIN. That's an excellent question. We know from Mincer-style regressions, as you said, that we can only explain up to 35 percent of variation in wages by looking at observable characteristics. So the approach that we took is to try to understand the characteristics of unemployed workers and try to match them with the job openings that we have been seeing. Unfortunately, the biggest restriction while doing this exercise was on the worker

side. On the worker side, we could observe the industries and their occupations, but other than that, we could not really observe much. So our hope is to get UI records'from certain states, at least'and try to use information about unemployed workers to come up with more detailed measures of mismatch. We hope these will include demographics, locations of the workers, education levels, experience levels, et cetera.

MR. LACKER. That's interesting. I have another question, Mr. Chairman. The presentation is titled 'Briefing on Structural Unemployment.' At one point in the discussion, you connected this to the NAIRU, and at another point there was discussion of a category of change in unemployment that was ruled out of your change in structural unemployment on the grounds that it was cyclical. This has me puzzled as to whether there's any reason to care about structural unemployment other than for its implications for policy dynamics and the NAIRU. Do we have an independent interest in some concept called structural unemployment, or is this all about the NAIRU and I should just go back to thinking about economics the way I usually do?

MR. FALLICK. I was trying to represent only the Board staff's view of the matter, which sees it in terms of a NAIRU.

MR. LACKER. I see.

MR. FALLICK. Obviously, as the previous discussion of terminology made clear, I think, there may be a variety of views around the System about whether that equation is reasonable.

MR. LACKER. You have this EDO model that's in the class of post-1970s general equilibrium models, many of which have the property that any shock affecting economic activity affects the NAIRU, and thus, you would expect the NAIRU to fluctuate at a cyclical frequency. I'm wondering whether that property of that model has influenced the staff's thinking about this.

MR. FALLICK. I think it's fair to say that the concepts that are inherent in EDO do not track well the description of structural unemployment that I've given here. Of course, that's only one input into the staff thinking, even in terms of econometric models.

MR. STOCKTON. But obviously we've devoted a great deal of resources to EDO. We're looking at the forecasts of that model meeting by meeting and trying to understand the coherence between those forecasts and those of both of our other large-scale macro models, FRB/US and the staff judgmental forecast. We are paying attention to EDO, looking at its output and thinking about what its implications are for our forecast.

MR. LACKER. Well, in that effort, there are two objectives that I would assume you'd be interested in. One is just the pure forecasting, and the other is policy advising. I think the implications are very different from models like your EDO model, in which the counterpart of NAIRU could be as high as 8.9 percent (which is where I think the St. Louis Fed has it and which is also close to my estimate'no matter what my staff said [laughter]) and from models where your reference level of unemployment'what you call structural unemployment or NAIRU'is, by design, filtering out business cycle frequency influences. The urgency of some of our discussions around here obviously depends on that.

MR. EVANS. Could you remind us what the forces in EDO are that would have the unemployment rate move around the way that President Lacker is talking about? I just don't recall.

MR. REIFSCHNEIDER. Why don't I step in here? First, different DSGE models have different shocks embedded in them, and EDO probably has more than your typical DSGE model. One of the things in EDO is an economywide risk premium shock'that's how it's labeled. That shock explains the overwhelming percentage of the slump that we just experienced. In the

identification scheme inside of EDO, that shock doesn't really represent a shock to potential output, so that, in EDO's inflation dynamics, the falloff in output that's driven by that shock is putting downward pressure on inflation. There are other shocks in the model that are not.

MR. LACKER. What other shocks?

MR. REIFSCHNEIDER. Well, there are various shocks in EDO, such as preference shocks, as there would be in any DSGE model. You might say that those are shocks to demand, for example, and those would shift the concept of potential output such that they would tend to minimize the gap. But the biggest thing going on in EDO, the shock that is causing the gap to open up and to be very wide, is, again, this economywide risk premium shock. In other words, the way EDO tells the story is that a very big increase in slack has opened up, and that is putting downward pressure on inflation. A different DSGE model might parse the data very differently: It might say that, indeed, a lot of what we might think of as a falloff in demand in this cycle is having an effect on a flexible-price concept of output, or something like that. I guess the point I want to make is that the identification assumptions used in DSGE models, and one's interpretation of what they would imply for inflation, can yield very different results when you do variations on those identification assumptions. This is something that a number of people have commented on.

If you ask whether a DSGE model would tell the story differently from, let's say, FRB/US, the answer is 'maybe'it depends on the DSGE model.' So EDO's telling of the tale in a lot of ways is not that different from FRB/US, but another DSGE model, like, say, the Smets'Wouters model, would tell the story very differently. This is a cautionary tale about our ability, as far as econometrics goes, to identify exactly what is driving things.

MR. LACKER. I understand the difference in the results you get from different models, but at a previous meeting you explained to us that you had EDO, a self-contained, general equilibrium model, and then outside of EDO you estimate a statistical trend to capture potential. So when you tell the story told by EDO, you're talking about the story told by the combination of EDO and your ad hoc statistical trend for potential. Am I right about that?

MR. REIFSCHNEIDER. No. I think that, when Mike Kiley was doing the briefing, he pointed out that, in some sense, there are three different concepts of 'trend''let's call it that' in EDO. One is a smooth statistical filter, a Beveridge'Nelson type of thing. Another is a production type of concept, and that would be closer to what's in FRB/US. A third is a flexible-price type of concept, which would be more like what's in a lot of other DSGE models.

Let me come at this issue another way. We can ask: What shocks should monetary policy try to offset, and what shocks should it not try to offset, in the sense that policy can't do anything about them from a social welfare viewpoint? The answer is: It depends on the nature of the shock. Even the economy-wide risk premium shock is an issue. For example, if you thought in late 2008 that the shock represented households that suddenly really hated risk a lot more than they used to, then a policymaker might say, 'Well, welfare is such that, if a whole set of household behaviors is changing, then it might be optimal to let that happen. Monetary policy shouldn't offset it.' But if, instead, you thought households suddenly felt that the world was a lot riskier than it used to be, then monetary policy might want to offset that, particularly if doing so changes the risk distribution.

Where I'm going'and, incidentally, I'm being pushed in my abilities, because I'm not the best person to talk about this'is back to the issue of the nature of these models. I'm referring both to DSGE models and to models like FRB/US, which is more elaborate. The nature

of these DSGE models is that there's a set of identification assumptions used in them from which people will draw welfare implications. I think you could say that it's really pushing the ability of those models in their identification assumptions to say, 'Oh, I can draw welfare conclusions from that to say what shocks monetary policy should try to offset and what shocks it should not.' I think that's taking it right to the limit. Now, there are definitely different views on that.

MR. PLOSSER. Should that make us more or less comfortable with the view that is produced in FRB/US? If it's that hard to identify these things, the same problems occur in a different context with FRB/US, right?

MR. REIFSCHNEIDER. Oh, yes.

MR. PLOSSER. So you can't really distinguish between these two based on this point. MR. REIFSCHNEIDER. Ultimately, I think it's hard to say when economics would ever

be at the point that it could actually make welfare judgments that you could really trust. But there's another way of looking at it: Suppose the Committee is focused on one side of its mandate and asks, 'What level of the unemployment rate or of GDP would be consistent with price stability?' Eventually the answer comes out to be something that you just learn about over time, and, as you learn about it, you revise your views about what potential output or what the labor market slack would have to be. That's something you just have to observe, react to, and then adjust policy accordingly.

MR. LACKER. Thank you. I'm glad we cleared that up. [Laughter]

MR. STOCKTON. That was somewhere between an answer and a filibuster, and I'm not sure which. [Laughter]

CHAIRMAN BERNANKE. President Evans.

MR. EVANS. Whenever we talk about structural unemployment'I realize that there are different definitions that probably are relevant to this'it seems to me that it's inevitably about the limits of monetary policy. There are at least a couple of different views that one could take. One is that you might think that monetary policy is not capable of improving the unemployment rate at any time, in other words, unconditionally that is not really appropriate for monetary policy. If that's your viewpoint, this discussion really is not very important at all, because these issues never come up. Or you could take the view that unemployment is amenable to changes in monetary policy. I take that view. And you could worry about ineffectual attempts to reduce the unemployment rate through monetary policy, that is, the case where monetary policy gets to the point where it can't reduce the unemployment rate without somehow spurring more inflation. I would say that's a very important issue, and that's how I interpret these analyses. If there's another perspective, I'm not quite sure what that perspective would be, and I'd enjoy some discussion of it.

My best assessment of these excellent and very broad analyses is that the contributions of mismatch are relatively small compared with the 9.4 percent unemployment rate, which would imply that there's still room for monetary policy. Another point that seems to come out of this, if I understood it correctly, is that mismatch is relatively transitory. We brought this issue up as a potential obstacle to effective monetary policy actions, and if it were something that is permanent or at least persistent, that would be troubling. But it seems that, as the unemployment rate begins to go down, it's likely that this mismatch is going to decline, too, so the structural unemployment rate will go down. Following that course, I don't think it would have substantial inflationary effects if we were quite accommodative for quite some time. If mismatch is higher,

then we should expect to see inflation higher. That's a test for us, and we could respond appropriately.

In terms of the analysis, I do have one question, and I'd enjoy hearing your perspectives on it. I noted that there was not a lot about dispersion in wage growth. There's structural unemployment, and then there are wages, and the questions are how wages might respond and what role monetary policy could have in that. If mismatch were a big deal'with some industries doing poorly, and other industries doing well but struggling to find qualified workers'I might have thought that would show up in wage growth dispersion and that there'd be some sectors where things are pretty strong, so we'd see big differences in wage growth across industries. But my staff showed me data that says dispersion is lower than normal. Do you have any thoughts or comments about that?

MS. ''AHIN. First of all, I agree with your summary; we were actually surprised to uncover this cyclical component of mismatch. Even if the level of mismatch stays constant, when the economy goes through high levels of separations and the unemployed pool gets bigger, this effect gets amplified. So, as the unemployment rate starts going down, this effect will go down.

In terms of wages, I haven't done any work on that, but the San Francisco Fed's memo written by Mary Daly, Rob Valletta, and Bart Hobijn actually looks at exactly what you said. They looked at the employment cost index and average hourly earnings series for different industries, and they tried to link this to quit behavior. So the question is: Do we see industries that are trying to hire and not managing to do so, and in industries where quit rates are different, do we see anything on wages? They found that there are broad-based movements in wages.

MR. FABERMAN. I would like to add to that, going back to some of the points I discussed'and let me note that this is another thing on which we don't have very good research at this point. Movements in the real wage are also going to affect the response of people collecting UI benefits, as well as how intensively firms go about filling their vacancies. If firms feel the real wage is too high relative to what they're looking for, that's obviously going to affect how selective they are in whom they hire. If workers collecting UI benefits view the real wage as too low, they may keep rejecting offers until they find a wage that's acceptable. So mismatch dispersion measures aren't necessarily the only way to think about how wages are going to be affecting some of the things we're looking at.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. Thanks, Mr. Chairman. I want to thank the authors for their papers, and I want to thank Ay''eg''l, Jason, and Bruce, in particular, for their thoughtful discussion. I learned a lot from all of the papers. I think what affected my thinking the most was the treatment of the house-lock effect. Before I read these papers, I would have said that was something to be really concerned about, but I came away convinced that it is probably relatively unimportant.

I'm going to say a few words'actually, maybe more than a few. I'm always asked, 'What's the biggest surprise since you took over this job?' I don't give the true answer, but I'll give it now, knowing that it will not be revealed to anybody, because it's FOMC-protected, for five years. [Laughter]

MR. TARULLO. Unless it's in the minutes, Narayana.

MR. KOCHERLAKOTA. I think this is not going to make the minutes.

MR. TARULLO. It depends on what you say.

MR. KOCHERLAKOTA. I think the biggest surprise to me was that I managed to be referred to as the 'godfather of structural unemployment.' Therefore, I think I have to say more than a few words. First, I'll say something about definitions. This term 'structural' goes back probably to the Cowles Commission, and maybe even before then. Its meaning really depends on who you are and what you're doing. 'Structural' means the things you can't affect using the policy tool you have in hand. So if I'm the Congress, you know, what I can do to the unemployment rate is a lot more than what I can do sitting here at the FOMC table. I'll talk about that in a second. I guess I heard two different definitions of structural unemployment, one from Bruce and one from Jason. I really liked Jason's. For us it's about what we can do and what amount of unemployment is amenable to accommodative monetary policy.

So how do you think about that? I think the shock that hit our economy in 2007 is basically very much a demand-oriented shock. There was a fall in net worth, there was a shock to borrowing capacity, and investment and consumption demand fell. With a purely classical model, such as a model you'd draw in class, this is going to have very little effect on economic activity, because what happens is the real interest rate just falls immediately and sufficiently to ensure that investment and consumption return to their pre-shock levels. Now, this assumes something about the shape of the supply curve, and I'll come back to that in a second. But if you have a vertical supply curve, that's the way it's going to work.

Now, this is not the way the world works. Why is that? Well, there are three reasons that I can think of and probably more that others could come up with. One is related to the fact that inflationary expectations have stayed pretty well anchored since 2007. And with the zero lower bound on the nominal fed funds rate, this means that the real interest rate probably has not been able to fall enough to return consumption and investment to their pre-2007 levels.

The second problem is that the classical story ignores changes in the demand for labor, in the willingness of firms to hire workers at a given real wage. Some of these changes in labor demand are compositional effects that are lumped under the rubric of mismatch. The work discussed today did a good job of going after this, but basically firms are looking for a different mix of tasks relative to the skills in the labor force. Some of this is obvious; for example, we're probably not going to need as many construction workers in 2015 as we had in 2007. But some of it is, I think, much more subtle. When we talk to firms, we hear over and over again that they have been led to adopt changes in their production methods that will lead them to use a different mix of workers going forward. But some of the changes in labor demand are more aggregative. President Fisher has emphasized this in his speeches; for example, firms anticipate higher future taxes, and they're concerned about regulation, health care legislation, and what kinds of costs those developments will impose on hiring. These are all shocks to labor demand.

Third, there are movements in labor supply, that is, the willingness of workers to supply labor at a given real wage. And, again, there are multiple influences. Higher unemployment benefits will deter labor supply. When I work, I work to spend today, but I also work to spend in the future, so a decline in the real interest rate also leads to a fall in labor supply. In conflict with that is the notion that a fall in net worth usually would lead people to supply more labor at a given real wage. So I've identified three problems with the classical response of instant adjustment. One is that the real interest rate doesn't fall enough, and the other two are these movements in labor supply and labor demand.

Monetary policy is about the real interest rate. That's our job, that's our goal. Our job is to get that real interest rate to go where it's supposed to go. We cannot shift these labor curves. Even if we could get the real interest rate to where we want it to be, that is, even if we could

literally make it the minus 400 basis points, say, that the Taylor 1999 rule would call for, labor demand and labor supply changes could still alter the unemployment rate. So, the unemployment rate that will prevail in the absence of price and wage rigidities is what I see as the natural rate of unemployment. The papers that were discussed are about trying to get at this natural rate. I think they do a good job of going after two particular sources of why that natural rate might have moved'the unemployment mismatch and the effect of extended benefits on unemployment.

Now, people's takeaways from this can differ. You can clearly see that from our little chart at the end. Taking into account the nonadditivity of all of these things, I would have said about 2 percentage points of the increase in unemployment could be attributed to these two sources. There are a lot of uncertainties, up and down, so I'm not going to argue that. And it can change over time. We could think the long-term unemployed might lose some skills. Also, unemployment benefits might be reduced. So those go different ways. It could be that the natural rate will go up or down in response to those things.

But the papers are not informative about the other sources of change in labor demand or labor supply. We don't know how much unemployment is due to firms' concerns about future taxes or regulation. And then there's the question of the real interest rate effect on labor supply that I mentioned earlier, namely, when real interest rates go down, people supply less labor, because they're working for today and saving for the future. Well, real interest rates have come down 200 basis points since 2007, if you look at TIPS yields. But in the absence of price rigidities, according to the Taylor 1999 rule, we would have probably lowered them another 400 basis points, some 600 basis points down.

There are two sets of estimates about this real interest rate effect in the literature'the micro estimates, and the macro estimates. I won't even tell you how much of an effect on labor supply you could get out of the macro estimates'the employment-to-population ratio would fall by something like 700 basis points in response to the shock. I think the more plausible estimates come from the micro data, and they would still imply that the employment-to-population ratio would fall by 90 to 150 basis points.

What's the takeaway from all of this? I think Dave's discussion with President Plosser and President Lacker really hit it. You cannot rely just on unemployment. However we try to correct it, using very careful work as our guide to the existence of inflationary pressures, we're going to have to look at a lot of other indicators. I'll talk about some of that later when we talk about economics and policy.

The second lesson is reflected in the Minneapolis Fed memo on improving data. Obviously, my staff members wrote it, and I really like what they did. We talk a lot about it, and I think it's absolutely true that unemployment imposes large losses on the citizens of this country. But there are a lot of key questions that we are struggling to answer, and we struggle because we don't have the data. The right way to approach this is to collect the data. The data might cost millions of dollars to collect, but it might end up saving the economy billions if we have a better idea of how to treat unemployment. So the Minneapolis Fed memo provided some ideas about what kind of data you might want to go after.

I have to say that all of the careful work, with all of the other uncertainties that are layered on top of it, merely convinces me that we're going to have to look at a wide range of things besides the unemployment rate, however corrected, as a measure of inflationary pressures. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. I thought this was very nice work and a very nice presentation'I really enjoyed it and found it a pleasure to read. I'm going to make a couple of comments, and I think they're going to dovetail with the previous discussion here.

I'd say that the takeaway from these ten memos is that the research on this question, as good as it is, is not yet able to provide a satisfactory answer. I'm going to suggest that, to make progress, we have to move away from the partial equilibrium analysis emphasized here and toward more general equilibrium analysis with monetary policy explicitly included. I'm going to give you a rundown of what I think that means and what I have in mind, because there is literature on this.

The question is: Should we analyze the labor market by itself or in the context of a fully articulated macroeconomic model with monetary policy included? I think the answer is that you've got to have the fully articulated model in order to get the answer to the question that we face around this table, namely: How much impact can monetary policy have on unemployment?

Work in this direction does exist, although it was not stressed in these memos, so I am going to stress it here. The literature began in the 1990s with papers by David Andolfatto in the American Economic Review, and Monika Merz in the Journal of Monetary Economics. They used a very basic idea, namely, to take Diamond'Mortensen'Pissarides labor search theory and merge it into otherwise standard business cycle models. If you go through all the pain of doing that, the model will produce a business cycle, but then there will be frictional search-theoretic unemployment, which will also fluctuate in response to shocks to the economy. The unemployment in that model is an equilibrium unemployment rate, and it is bouncing around all the time as the economy gets hit by shocks. But there are no other frictions in those models, and

there's no monetary policy at all. I would say that those papers were moderately successful and surely pointed the way for future research'these authors were writing before the modern era of New Keynesian macroeconomics really got started.

Since the publication of those articles, there have been a lot of contributions, in

particular, the sticky-price New Keynesian macro models associated with Mike Woodford and others. Therefore, the natural question would be, if you took that kind of a monetary policy model, but with no unemployment, could you put Diamond'Mortensen'Pissarides into it and get a sensible answer to these kinds of questions? The answer, actually, is 'yes,' and it has been done. One example I know of is Mark Gertler, Luca Sala, and Antonella Trigari recently in the Journal of Money, Credit, and Banking. What do they do? They take the same kind of exercise as in Andolfatto and Merz, but they put it in Woodford's model of monetary policy. In this model, then, there's labor search-theoretic unemployment, and the level of unemployment is going to be fluctuating in response to shocks to this economy, so you might very naturally call this the natural rate of unemployment or the equilibrium rate of unemployment. But in this model, because of sticky prices, the unemployment rate that you actually observe will not be equal to this frictionless or search-theoretic unemployment rate. And, because there is a gap between those two unemployment rates, it is going to be the natural variable of focus for monetary policy. It is what you would be trying to determine, and it is what you would be trying to reduce in the model.

Gertler, Sala, and Trigari actually do calculate this, and, for those of you who have stayed with me this far and are interested, you can check their figure 7, which actually plots it pre-crisis, which is when they wrote the paper. You could calculate it post-crisis'it's an exact analogue of the New Keynesian output gap.

I think this is the most promising way to think about this issue. Of course, these calculations are complicated; furthermore, I think we heard Dave Reifschneider saying earlier that he doesn't really trust these models yet, which is very sensible. But, at the same time, conceptually, this is definitely the way to go. We've got to get busy and work on this and go forward. I think it is important to pursue this line of research and try to make further progress in this area.

What is the bottom line intuition? I think it works this way: The economy is hit by a large shock, which generates a lot of unemployment, but that would happen whether prices were sticky or flexible. So the relevant variable for monetary policy would be the difference between the sticky-price and the flexible-price levels of unemployment. This difference is likely to be small, so I would look at the high level of unemployment as not being very informative for monetary policy at this point. Also, there would be a great deal of uncertainty about the size of this gap. If we do further research, we might be able to pin this down better'we might be able to reduce that uncertainty, and we might be able to change the intuition, because maybe the intuition is wrong. That's what research is for, and the assessment remains to be seen. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Evans, do you have a comment? MR. EVANS. I wanted to pick up on something very interesting that President

Kocherlakota raised and that ties in to some commentary that President Fisher has made before. Narayana started off by talking about whether or not something is invariant to a monetary policy intervention. As I have understood President Fisher's comments, businesspeople are very concerned about new regulations, health care reform, and so on, in part because they don't know exactly how much that is going to cost. I have heard this from them myself. These higher labor

costs induce them to change their production processes, in part to go towards a higher-skilled and higher-wage worker. That's part of a capital'labor choice, and it depends on relative prices.

My thought is that something that is perhaps not invariant to monetary policy is wages. There's a lot of resource slack out there, a lot of people unemployed. And if wages were lower, that would be an offset to these business costs, right? I tried to engage my directors on this point at our last meeting. I acknowledged the commentary about higher business costs and asked what if real wages were 20 percent lower'I purposely chose an outlandish number. Interestingly, they just refused to engage in that discussion. Instead, in their commentary, they talked about demand effects, saying that they really are not comfortable that the demand is going to be there. So I think that unemployment that is attributable to firms' concerns about higher business costs is potentially amenable to monetary policy, in the sense that a hike in prices in an environment of sticky wages could lower real wages. I agree completely the question is: What is invariant to policy? And I think that if you think about this more carefully, there are a lot of things that can be affected by policy.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. I agree with this wholly, that is, that rationing shows up in the labor market because the real wage is too high to hire more people. Indeed, I have this same conversation you described having with your directors, and the response is, 'Wages? Wages don't matter. What matters is the quality of human being we're hiring.' To be honest, I think they think this because they have a nominal wage set in their heads for a particular job, and that's it, that's the end of the story. The tenor of my remarks is not to say, nor do I believe I have ever said, that sticky nominal wages are not part of the issue. I think that that is captured in our ability to adjust the real interest rate. If we can get it down far enough, then basically the real

wage will adjust to clear labor markets as well. We have one instrument'with large-scale asset purchases added on, et cetera.

MR. EVANS. My own view is that we've been in a liquidity trap, and we're stuck at this interest rate, so higher inflation is one aspect that would lead to a solution.

MR. KOCHERLAKOTA. I'm sympathetic to that'you and I agree on the concepts. The question is the quantities, and, unfortunately, those are hard to come by, and I suspect it will remain hard to do so even if I looked at the Gertler, Sala, and Trigari paper.

CHAIRMAN BERNANKE. President Fisher, did you have a comment?

MR. FISHER. I have asked the same question. I think the answer is that employers find lower-wage workers outside the domestic workforce. So that's the release valve. Nobody wants to say, 'Well, you know, I'm willing to pay someone a substantial fraction of what we paid them before.' It's socially unacceptable, and it's not necessary, because they have options. This is what globalization is all about. So I think it is effected by looking to other workforces.

CHAIRMAN BERNANKE. Anyone else?

MR. FISHER. Maybe it's not the world we want, but that's the world that we live in. Whether you like the social philosophy or not is not the issue. It's a question, Mr. Chairman, it seems to me, of another source of friction, but you have pointed out that this is just one source of friction. If you are trying to allocate capital, it affects the capital allocation decision. That's the simple point that I've been trying to make.

CHAIRMAN BERNANKE. Well, you have identified a concept economists have talked about called efficiency wages, which is that people's effort may depend on the wage they receive, so cutting wages may not be a good strategy. Anyone else have a question or comment?

I'd just like to say a few words'and I'm going to regret this. [Laughter] What President Bullard, as well as, I believe, President Kocherlakota and President Lacker, described was a much more complicated machine with all of the pieces'that includes monetary policy, it includes the real side, it includes labor supply, and so on'which recognizes that if there's a big shock, then everything is going to move to some extent, including what we would think of as the natural rate of unemployment. But I think that, even though the terminology is different, the concepts are not unrelated. In particular, the point that you're making is that what FRB/US calls U* depends on lots of things, and it can move around. And these studies were trying the best they could to get an empirical grip on how much it has moved. Knowing how much it has moved is important, because, as Charlie was saying, it helps us estimate how much space we have in terms of monetary policy expansion, what the unemployment rate will likely be five or ten years from now, and what the determinants of inflation and other things will be. But, as you point out, there are a lot of factors affecting U*, so all the presenters can say is that they have tried to identify some of the important ones and tried to give quantitative estimates of how big they are. But, clearly, as in all of the problems we face, everything is moving, and that makes it more complicated, certainly. President Kocherlakota.

MR. KOCHERLAKOTA. I certainly agree with everything that you said, Mr. Chairman. When I hear people talk about this, there's a distinction between structural things, that is, things that are moving more long term, and cyclical things, that is, things that are moving at a cyclical frequency, or medium term, shall we say. I think some of the things that happen at a cyclical frequency are not so amenable to monetary policy, and they pose challenges for us to correct using our main instrument, which has been the real interest rate, so I'm not sure that's the right distinction.

In the discussion today, the story was, 'Well, mismatch is small, so that means there is clearly room for monetary policy to be accommodative.' That step in logic is not clear to me, because many other factors can move U* around. Let me note that I absolutely don't want to undercut the value of the work that was presented: The papers were very good, and I learned a lot from them. It's just that there are lots of other factors, that's all.

CHAIRMAN BERNANKE. President Lacker.

MR. LACKER. I agree, as well, with everything you said and with what President Kocherlakota said. Just to cast this in a different light, let me note two things. First, the exclusion of cyclical from a definition of 'structural' is to some sense a priori. And what we've learned from the models we've developed and explored and done a lot of research on since the 1970s is that that's a poor assumption and that there are a lot of models in which that just isn't true. I think that is part of the fault line here. Second, I would point out the distribution of estimates of how much room we have. We're at 9'' percent unemployment, and we have estimates that we're anywhere from 4'' percentage points to 0.6 percentage point away from our mandate-consistent unemployment rate. There's a substantial difference in the sense of the urgency one would attach to conducting policy in a way to reduce unemployment. So it's consequential for policy.

CHAIRMAN BERNANKE. You can also define 'structural' and 'cyclical' in a

statistical sense. Whatever model you can write down, unemployment in the real world tends to come back to more or less the same level after a business cycle is over. There's a very sharp pattern of rise and slow decline back to a normal level.

MR. LACKER. Right. But there's nothing in a statistical approach that connects that, without any other assumptions, to what we can do with policy. Right?

CHAIRMAN BERNANKE. Well, there are the relationships with that to inflation, for example. Any other comments? Yes.

MS. ''AHIN. I would like to make a quick comment about the DSGE models with search frictions. In my opinion, they have two major shortcomings. The first one is that generally they assume complete markets, and, in a model where we assume complete markets, policies like unemployment insurance are completely irrelevant, so we can't really understand their effects. The other shortcoming is that generally workers are homogeneous, which makes it harder to study issues like mismatch. These were the two main reasons that we wrote the papers as we did.

CHAIRMAN BERNANKE. Thank you.

MR. FABERMAN. I just wanted to add to that. I agree that moving towards models that incorporate search frictions into a New Keynesian or any other type of DSGE model is a great way to go. But there is one note of caution about search models in general'regardless of whether they're embedded into an RBC [real business cycle] model or some kind of New Keynesian model'that I'd like to bring to the Committee's attention. People who write down theories of labor market search incessantly fight each other about how the wage is determined in the bargaining between workers and firms. Dozens of models have different ways to do it, and those ways vary quite a bit in the flexibility of that wage in the aggregate. Some are completely flexible, such as the standard Mortensen'Pissarides type models. Other models, such as those in work by Rob Shimer and Bob Hall, incorporate wage rigidities, both in a nominal sense where the price is actually sticky, and in what the workers' outside options are relative to what they're being offered.

My main point is that, in terms of thinking about policy and the real interest rate and

what's going with the real wage, in these models, the definition of the real wage is very muddy.

I don't know how much simpler it's going to make your life to use them, because, while they

helped introduce search frictions and some heterogeneity and new ways to think about the labor

market, they also add new complications precisely in the wage, the one thing you want to think

about the most with monetary policy.

CHAIRMAN BERNANKE. If the Senate had had the good sense to confirm Peter

Diamond, we could have wrapped this up in 10 minutes. [Laughter] All right, I understand that

coffee is ready, so let's take 20 minutes for a break.

[Coffee break]

CHAIRMAN BERNANKE. For the next item on our agenda, let me turn to Brian Sack

for an update on financial conditions.

MR. SACK.2 Thank you, Mr. Chairman. I'll be referring to the materials labeled 'Financial Market Developments and Desk Operations.' Over the intermeeting period, financial markets continued to develop in a manner that reflected an improving economic outlook and that, in turn, should provide support to economic growth.

As shown in the upper left panel of your first exhibit, Treasury yields largely leveled out following their sharp increases in the last two months of 2010. On balance over the intermeeting period, Treasury coupon yields moved up 5 to 15 basis points, with the 10-year yield now trading around 3.4 percent.

With yields having stabilized to some degree, it may be a good time to look back and assess why yields moved up so sharply in the period following the November FOMC meeting. To a large extent, the sharp selloff in Treasury securities over that period was driven by greater optimism among investors about economic growth prospects and the anticipated policy response from the Federal Reserve in terms of both short-term interest rates and its balance sheet.

As shown to the right, investors brought forward the expected timing of increases in short-term interest rates, with the implied policy path from federal funds and Eurodollar futures rates now approaching 50 basis points in the first quarter of 2012.

2The materials used by Mr. Sack are appended to this transcript (appendix 2).

The bottom right panel focuses on the effects of faster asset sales. The scenario assumed in the memo involves selling all of our MBS holdings over an 18-month window instead of the 5-year window in the Tealbook baseline. This policy approach would be aggressive, as it would necessitate MBS sales at an average pace of about $40 billion per month. The resulting increase in the supply of securities to the market is roughly equal to the average pace of net issuance of agency MBS generated by the entire market at the height of the housing boom. The more aggressive sales, if begun at the same time as in the baseline scenario, would return the size of the SOMA portfolio to its steady-state level about a year earlier than in the baseline scenario.

Treasury remittances under the more aggressive sales scenario decline more quickly, as shown by the red line. The primary reason is that selling more quickly compresses the capital losses that would be realized over five years into a shorter period. As a result, remittances to Treasury suffer sharply in those years, but are then higher in the latter parts of the forecast period. Under the specific assumptions made in this scenario, remittances remain positive.

Not surprisingly, the most significant effects on Federal Reserve income occur if faster MBS sales were to take place under a scenario of high interest rates. In that case, the capital losses are larger and, hence, compressing them into a shorter period can easily push Treasury remittances to zero. In the memo, we presented an income projection under the high interest rate path described earlier and asset sales that are as fast as the one just described but that are accelerated to begin this year. Under those assumptions, as shown by the light blue area, remittances to Treasury fall to zero for a period of two years, and a deferred credit asset of between $5 and $35 billion would be realized on the balance sheet.

In closing, it should be noted that there is a wide range of possible outcomes for Federal Reserve income, as markets and policy decisions can evolve in a number of directions that can differ from the scenarios presented in the memo. Our intention is to provide you with a few potential outcomes to serve as useful reference points.

Thank you. That concludes my prepared remarks.

CHAIRMAN BERNANKE. Thank you, Brian. Are there questions? President Plosser.

MR. PLOSSER. Brian, you mentioned changes to the Supplementary Financing

Program, and you said it was now something like $200 billion. Is that right?

MR. SACK. Right. The current balance is $200 billion.

MR. PLOSSER. Is that reflected in the balance sheet scenarios that you work out later?

MR. SACK. In the income projections? Yes.

MR. PLOSSER. I'm referring to income and size of the balance sheet going forward, and I ask because that will raise the size of our balance sheet by $200 billion, right?

CHAIRMAN BERNANKE. It raises only the reserves.

MR. ENGLISH. It doesn't change the size of our balance sheet. It changes the composition of our liabilities.

MR. SACK. It would have a modest effect on the funding cost of the portfolio, because that balance would reduce the amount of reserves in the system by that amount. We assume it does run down. And does it return?

MS. REMACHE. It returns. It declines to zero at the time that the portfolio resumes its steady-state growth. So it stays at $200 billion throughout the projection, and then is run off as reserves return to $25 billion.

MR. PLOSSER. Okay. Thank you.

CHAIRMAN BERNANKE. Governor Warsh.

MR. WARSH. Thank you, Mr. Chairman. Brian, regarding the Treasury purchases, you noted in the memo that we had, ex ante, understood that we would be breaching the old

35 percent rule of thumb, and in certain issues you found that we might be as high as 70 or

75 percent. My question is: Are those higher percents clustered in a certain place along the Treasury curve, or are they randomly around the areas that we're buying? I ask, because there would be greater concern if they were all around a particular term that would be of interest to investors, for example, if they were all seven or eight years, whereas, if we were making the market but doing so with issues spread more broadly over the curve, it would be less worrisome. MR. SACK. First of all, the concentration of our holdings isn't quite as high as you

suggested. Our highest holdings right now are at 60 percent, and, under the new thresholds that

the Desk published, we will only move up in 1 percent increments per operation, so that will slow how quickly we move up. We have two issues at 60 percent and two others that are above 50 percent. If we look at our top ten holdings in terms of concentration, all of them are old bonds except one, so, certainly, that's the group for which this is relevant. The maturities of those holdings range from 2015 to 2020, so it's mostly in that 5- to 10-year sector. But it's not overly concentrated in any particular year.

MR. FISHER. Excuse me, Brian, can you explain 'old bonds'? Is it in terms of price gains over book value? Or does 'old' mean that we bought them some time ago?

MR. SACK. 'Old' means 'issued a long time ago,' so that they're carrying a high coupon. They tend to be less liquid and less desirable to market participants, which makes them appear cheap in our relative value analysis, so the method we use inclines us to purchase those.

VICE CHAIRMAN DUDLEY. In essence, we're buying the bonds that people don't want, as opposed to buying the bonds that they really want to hold.

CHAIRMAN BERNANKE. President Fisher, did you have a question?

MR. FISHER. Actually, I have a statement, Mr. Chairman, because I want to thank Brian and Bill English for pulling together that memo. I don't know how many people read it thoroughly. It's a subject I have been pestering you about for a long time, and I know it has been an annoyance. But I learned a great deal from it, in addition to the exhibit you just presented. It does condition our deliberations; for example, if we decided to have more rapid asset sales combined with an adverse interest rate scenario, it might result in nonremittances to the Treasury for quite an extended period. So I want to thank you and your staffs for putting this together. I think it's a very important memo.

The other point I would make is that it's the kind of memo I wish we had had before we entered into the program, in that it would have informed our decisionmaking. Sensitivity analysis is so critical in understanding the consequences of what you do. And when you commit to buy $1.25 trillion worth of any asset, it is helpful to have this kind of analysis in place. I gather you have had to build this from the ground up, almost from CUSIP up. It's great work, and, at least from this corner of the table, much appreciated. I'm sure it is by everybody, and I want to thank you.

CHAIRMAN BERNANKE. President Fisher, I know we have had memos like this

before.

MR. FISHER. Brian and I have talked a great deal. This is a very complicated piece of work'there are so many moving parts'and I don't recall, at least in my six years, something this thorough. But, of course, the programs have changed, the way we conduct monetary policy has changed. Even though we have had work like this before, I still think this group deserves a big pat on the back, because this was a very difficult exercise. I don't know how many hours you spent on this. I'm trying to impart a compliment, Mr. Chairman. I think Brian needs compliments every now and then.

MR. SACK. I'll take it. [Laughter] Of course, we presented an analysis of the risks on several occasions along the way, but it is true that we now have the machinery in place to do a much more comprehensive analysis of a wider range of scenarios.

MR. FISHER. Good.

CHAIRMAN BERNANKE. The Vice Chairman has a two-hander.

VICE CHAIRMAN DUDLEY. I have a quick question: How should you think about the asset sales piece, because that's different from the interest rate path? The interest rate path,

presumably, reflects the pursuit of our dual mandate and the financial markets' reactions to the economic environment. The asset sales piece is, in some ways, discretionary'we could do it or not do it, and we could do it quickly or do it slowly. How do you think about that when you're doing this analysis?

MR. SACK. First of all, if we believe that the balance sheet has had effects on financial conditions, then the primary consideration for you in how to manage the balance sheet and whether to sell assets would be the effects on financial conditions and the economy. In terms of income effects, selling assets can concentrate returns. It's possible that, say, long rates would move up, but they do so because of greater optimism about the economy and an expected higher path of short-term interest rates. In that sense, the higher rates, or the capital losses that would be realized by selling assets, are essentially just the present value of the future costs that the portfolio would face. So, to a large extent, the asset sales are just reallocating the timing of when losses are realized, which is probably another reason not to make that income stream the primary objective.

VICE CHAIRMAN DUDLEY. It is not completely invariant to the losses you realize, because there's a term premium that you earn if you hold it until maturity and that you don't earn if you sell the asset early.

MR. SACK. That's exactly right. You are giving up a term premium, and you can see that in the projections. In fact, we did a scenario, which wasn't reported in the memo, where there were no asset sales, and the total effect on income over ten years was on the order of $100 to $125 billion. So there's a sense that because of a term premium we're earning an excess return. And if we sell assets and shrink that, we're giving up some expected income. In addition, we're affecting the timing of when it's realized.

CHAIRMAN BERNANKE. President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. Under the worst-case scenario, the high sales/high interest rate, you have a deferred credit asset accruing. First, is there precedent for that? And, second, has that been discussed with Treasury?

MR. SACK. That was an official accounting change, and, in effect, that deferred credit essentially allows us to use future SOMA earnings to offset losses today. There is no precedent in the U.S., because it's a new treatment.

CHAIRMAN BERNANKE. President Lacker.

MR. LACKER. It's exactly analogous to a deferred tax asset in U.S. corporate accounting, I believe.

CHAIRMAN BERNANKE. Governor Warsh.

MR. WARSH. As I understand it, the losses that could ultimately generate this deferred asset would be losses that eat through the income and are the realized losses on the assets that are actually sold. This doesn't account for imputed losses on assets comparable with those that were sold, if they were somehow marked to market at that point. The question that comes out of this is: Do you think markets would, if we are in that sale mode, look through the assets that are not marked to market and query whether or not there are higher embedded losses that they should look through in order to evaluate the capital adequacy, to the extent that it matters, of the Fed's balance sheet?

MR. SACK. Let me note a couple of points. First, we do report the market value of the portfolio on a quarterly basis, so the amount of unrealized gains or losses would be apparent to the market and, indeed, is already apparent to the market, regardless of what sales regime we're in. Second, I think it's very important for markets to understand the message that these income

streams and these losses, whether realized or unrealized, have no operational consequences for the conduct of monetary policy. They don't compromise our ability to tighten financial conditions or do whatever other operations we need to. If that message is understood, it's not clear to me that this results in any significant credibility problem for the Federal Reserve.

MR. LACKER. I'd just like to qualify that point. Given the current magnitudes, that's true as a practical matter, but it's not a universal principle. For example, we could run out of the ability to reduce reserves and reduce the base if our asset values fell. So, in theory, it could impede our ability to withdraw stimulus, but, at the current magnitudes, we're pretty far away from that, right?

MR. SACK. Yes, that's exactly correct. I was ignoring that for the purposes of simplifying the discussion. It affects the value of our collateral that we can use to drain reserves through reverse repurchase operations. But the value of the collateral would have to fall dramatically, given that we have more than $700 billion of currency out there. Also, of course, we can drain without collateral by using the Term Deposit Facility.

CHAIRMAN BERNANKE. President Plosser.

MR. PLOSSER. I'd like to restate my question about the SFP a little more precisely. When SFP goes away, we transfer out of the Treasury, and they become excess reserves, in effect. Right? We've just entered a program where we're going to blow excess reserves up by $600 billion, and the transfer I just mentioned is going to increase excess reserves by another $200 billion in the process. I was trying to get at the notion that, in part, that's an effect on income, because now we're actually paying income out on the excess reserves that these are converted to, which reduces our net income.

The policy question is: How does that affect our ability to drain reserves when the time comes, given that reserves are going to be $200 billion higher because of this action? This action may end up affecting what we face in terms of the pace of asset sales or our ability to drain using reverse repos and other things. In other words, the end of SFP could make the draining problem bigger than it otherwise would have been.

MR. SACK. You're right about the income effects, but, given the level of short-term interest rates, that's trivial today.

MR. PLOSSER. But as interest rates go up on interest on reserves, we're going to be paying more and more out.

MR. SACK. That's correct. And in terms of affecting our draining, if the SFP balance goes down to $5 billion, then $195 billion of reserves will enter the system for that reason between early February and early April. If the SFP balance were not taken back up at some point, then that would increase draining needs by that amount. I will note that the Treasury intends to emphasize the flexibility with this program in its statement. The last time the debt ceiling became binding, the program was taken down to $5 billion, but then, once the debt ceiling was raised, it was brought back up. I don't think we want to prejudge what's going to happen, because it will depend importantly on how the debt ceiling is raised, but the Treasury is at least retaining that flexibility and could bring the program back up in size.

CHAIRMAN BERNANKE. Governor Duke.

MS. DUKE. I'm just curious about the market's perception that we'd be more likely to sell Treasuries than the MBS. It seems to me that the last time we talked about this we talked entirely about selling the MBS. Maybe that was because we had proportionately more of them at

the time, but we kept talking about getting back to an all-Treasury portfolio. So the market's perception seems a little odd to me.

MR. SACK. That was, for me, one of the more surprising aspects of the survey results, and, unfortunately, we didn't ask any questions that would allow us to understand that result better. In some of the written comments, though, a few members noted that Treasuries were easier to sell and would be less disruptive to the market, so, for at least a couple of respondents, that seemed to be the reasoning. But we could explore that in more detail, and I agree with you that it was surprising.

MS. DUKE. My question is partly why, but the other part is whether, at some point, there is anything we should do about that? In other words, whenever we start talking about exit, should we be talking more about getting back to all Treasuries?

MR. SACK. Well, in general, I think it's appropriate. If and as the Committee moves towards a well-defined strategy, that could be communicated at some point to allow markets to prepare and adjust.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I'll say one thing about the remittances. I think it's important not to view this purely as an operational issue or purely as a communication issue with markets. I think we can all agree that it's going to be solved. However, I think the challenge is communication with the broader public. We're going through a high revenue period right now, and it's often advertised as, 'Boy, the Fed is doing great!' The flip side of that is if remittances fall to $5 billion, then stories are going to be written about the Fed saying that it's facing challenges, that it has been running irresponsibly, and so on. I'm not saying that this challenge should influence policy, but it should influence communication.

My second point is also about communication. It strikes me that, when we ask questions of the dealers, we, in some sense, tip our hand a bit about what the realm of policy choices might be. I admit that I don't know how to get around this. We do want to have information from markets, but asking the questions of markets is also transmitting information. I'll put this issue on the table as something that perhaps we can talk about when we get to the discussion of the work of the subcommittee on communications that we're going to have later.

CHAIRMAN BERNANKE. Let me comment on both issues. On the first issue, you're right, there are going to be communication challenges. In most scenarios, the projections strictly dominate our non-quantitative easing income stream. Even in these worst-case scenarios, though, over a five-year average, we're still doing about the same. So I think we can manage that, except in the most extreme scenarios.

On the second issue, Brian and some of his staff raised the question of whether we would want to release publicly the questionnaire that we give to the dealers. The idea would be to do it before the meeting'at the same time that we circulate it to the dealers'which has the advantage of putting everybody on the same footing. My own thought was that we should wait and see, partly because I was concerned that circulating it would just create more speculation. It seemed to me the better thing, if that really was becoming a problem, would be just to stop circulating the questionnaire at all. You have identified a problem that Brian and his staff have looked at, and it may be something we need to discuss as a Committee.

MR. KOCHERLAKOTA. Yes, both extremes seem unsatisfactory. I don't know in my own head where I stand on this, but I think it is something we should try to solve.

CHAIRMAN BERNANKE. Why don't we agree to think about that?

MR. SACK. Can I just say a word? We believe that the survey does not reveal information to the respondents, and we try to be very careful to construct it so that it does not. But public release is still an issue, in that doing it would eliminate any perception of asymmetric information.

MR. KOCHERLAKOTA. If it's truly not revealing information, then I guess it would be okay to release it publicly. We can talk more about this.

CHAIRMAN BERNANKE. Anyone else? Any further questions? President Lacker. MR. LACKER. Thank you, Mr. Chairman. My question for you, Brian, has to do with a

couple of things related to the difference between the path that our asset purchases induced for the asset side of our portfolio and the path that reserves and the monetary base have taken. The discrepancy has been pretty large in the last couple of months. For example, in December we bought a lot of assets, but reserves went up just $2 billion and the Treasury general account went up a ton. Then, in January, we had AIG repaying the New York Fed'as an aside, I'd like to congratulate the New York Fed on the repayment of the AIG credit'which is almost a

$50 billion reserve drain. Then, in February and March, with the Treasury running off the SFP, it's going to add $200 billion. Then, it wasn't clear from your documentation what the Treasury is planning with the TGA.

I have a granular question: What's the Treasury thinking about the TGA? They used to peg it at $5 billion back when we sterilized stuff. It's sort of a pain. At the magnitude of our balance sheet, this is, perhaps, not likely to be material, but it's bordering on a material effect on our reserve position. When we get to the point where we're running off reserves, maybe a couple of years from now, we could get into situations where the management of the TGA makes a material difference in what happens to reserve balances. So I'm wondering how we should

think operationally, in the Committee's deliberations, and whether the Treasury is giving you any more color about its intentions for the TGA and whether it's worthwhile to try to influence Treasury to provide us with a little more surety about its TGA strategy.

MR. SACK. Let me say a few things about what's been going on with the TGA and then say a couple of things about what I think it means for policy implementation. You're right that the TGA has been unusually large and very variable'it has been swinging between $10 billion and $100 billion, which is very different from the old regime, where it was very steady at a low level, like $5 billion. The reason is that the Treasury used to use its accounts in the private sector, the TT&L and TIO accounts, to absorb those fluctuations in its cash balance because it could get a higher return. That return is tied to short-term interest rates. With short-term interest rates having moved to near zero, and given that those programs have some operational costs, they've taken those programs down to a very trivial level, and they're just letting the cash balances in our account fluctuate.

In terms of policy implications, we don't regard that as a problem, given our current directive, which is to manage reserve conditions consistent with a funds rate from zero to 25 basis point. We have so many reserves in the system it doesn't matter much if they're fluctuating by $100 billion because of this factor. But, as we move into a regime where it becomes more important to manage reserves more precisely'for example, that might be the case when short-term interest rates begin to rise'then we'll have to come to a solution. Of course, if short-term interest rates are rising, it will be very natural for Treasury to start to move funds back to the banks, and we'll see a return towards the old regime, but, depending on the exact timing and the exact directive we're given, we could come back to this issue with Treasury.

MR. LACKER. Part of my question was motivated by the discussions we had in

December 2008 and January 2009 about the fact that in the past the SOMA had a one-for-one

relationship with reserve conditions and the funds rate, and yet we were embarking in early 2009

on programs that would break that relationship. I thought we agreed to take a cohesive approach

within the Committee, even though, as a governance matter, there were separabilities in the

governance of some of those things. We sit around here and talk about adding $600 billion to

assets under the assumption that it's going to add $600 billion to reserves, and it turns out that,

under some scenarios, reserves are going to go up $800 billion because of the debt limit. So

there's a bit of a disconnect in focusing on just the asset side, and that's what I was suggesting

that we could be thinking about going forward.

CHAIRMAN BERNANKE. Well, if we determine that it was creating problems or

distorting our policy, we certainly could talk about sterilizing some of the differences. Certainly

we're technically able to deal with that. Any other questions? [No response] If there are no

further questions, then we need a vote to ratify domestic open market operations.

MS. YELLEN. So moved.

CHAIRMAN BERNANKE. Any objections? [No response.] Thank you. The next item

is the economic situation. I'll call on Dave Reifschneider to lead off.

MR. REIFSCHNEIDER.3 Thank you, Mr. Chairman. Steve Kamin, Nellie Liang, and I will be referring to the material titled 'Staff Presentations on the Economic Outlook.' Overall, the data that have become available since the December Tealbook closed suggest that the economy expanded somewhat more rapidly late last year than we anticipated. As shown in the upper left panel of your first exhibit, real consumer spending accelerated noticeably in recent months, accounting for much of the upward surprise in aggregate demand. However, because the fundamentals continue to look less impressive, we have carried only some of the recent momentum into the current quarter.

3The materials used by Messrs. Reifschneider and Kamin and Ms. Liang are appended to this transcript (appendix 3).

MS. ZICKLER.4 Thank you. I'll be referring to the 'Material for Briefing on FOMC Participants' Economic Projections.'

In broad terms, as shown in the top panel of exhibit 1, you are expecting a sustained recovery in real economic activity over the next three years, marked by a noticeable step-up in the rate of increase in real GDP this year followed by further gradual acceleration during 2012 and 2013. Although you anticipate that the decline in the unemployment rate'the second panel'will remain relatively modest in the coming year, you project a more noticeable tilt down in joblessness as the expansion strengthens. Regarding inflation'the bottom two panels'the central tendency of your projections shows total PCE inflation relatively stable over the next three years. However, your projections show a gradual uptrend in core inflation over the period.

Exhibit 2 provides more detailed summary statistics for your projections and compares them with those that you made in November and with the staff Tealbook forecast. Starting with the change in your near-term projection since November, as shown in the first two lines, you have marked up your expectations for the increase in real GDP this year, with the central tendency now nearly 3'' to 4 percent. Many of you indicated that the stronger-than-expected data on production and spending that we have accumulated since November, along with the passage of the fiscal package, led you to view the recovery as having gained some strength that should carry through 2011. A number of those who did not change their forecasts significantly noted that the recent news had led them to shift their assessment of the balance of risks surrounding their forecasts from weighted to the downside to broadly balanced. That said, the recent news did not alter significantly the central tendencies of your expectations for the pace of real activity in 2012 and 2013, which call for real GDP to increase between 3'' and 4'' percent in 2012 and between 3'' percent and 4'' percent in 2013. This general pattern of revisions is also reflected in the updates to the Tealbook forecast since November.

Your projections suggest that real GDP will increase at above-trend rates over the next three years, supported by accommodative monetary policy and improving credit and financial market conditions. A number of you noted that fiscal policy should provide some temporary stimulus this year but should be a drag in 2012. Your narratives indicated that many of you believe that the ongoing expansion will be led by sustained increases in consumer and business spending, and a number of you suggested that improvements in household and business confidence and in labor market conditions should help to reinforce the rise in private demand. Nonetheless, many of you commented that, while the recovery appears be on a firmer footing, the headwinds from the limited improvement in the labor market, lingering household and business uncertainty, and problems associated with the weak housing and nonresidential real estate markets are likely continue to exert some drag on economic activity over the forecast period.

4The materials used by Ms. Zickler are appended to this transcript (appendix 4).

Although your level of uncertainty was little changed from the November SEP, you now view the risks to your forecasts'summarized in the panels to the right'as noticeably more balanced than in November. In particular, almost all of the participants who previously saw downside risks to their projected increases in real GDP now view them as balanced, and several of you now see upside risks to your forecasts. The most frequently mentioned upside risk to GDP growth was the possibility that the recent strengthening of private demand marked the beginning of a more normal cyclical rebound in economic activity. To the downside, a number of you cited the recent declines in house prices and the problems in real estate markets, which could have greater-than-expected adverse effects on consumers and on credit availability, and the possibility of more serious spillovers from fiscal austerity and sovereign debt problems in Europe.

On inflation, the shift in the distribution was similar to that for real GDP, with several of you moving your assessment from risks weighted to the downside to balanced risks and with one additional participant now judging inflation risks to be to the upside. Several of you cited large resource gaps and the possibility of a slower- than-expected economic expansion as downside risks. However, a number of you commented that you saw the likelihood of deflation or further unwanted disinflation as having lessened. Some of you noted that highly accommodative monetary policy posed an upside risk to inflation, and several saw another upside risk in the possibility that prices of energy and other commodities would continue to increase faster than anticipated. This concludes my prepared remarks.

CHAIRMAN BERNANKE. Thank you. Brian Sack, you had a comment?

MR. SACK. I have a very brief one. I want to correct a figure that I cited in my answer

to Vice Chairman Dudley. I had said that an alternative scenario without asset sales could raise

cumulative portfolio income by $100 billion to $125 billion. Unfortunately I was looking at the

wrong column. The effect relative to the baseline was actually $50 billion. So the point is right

that asset sales can reduce cumulative expected income, but I overstated the magnitude.

CHAIRMAN BERNANKE. Thank you. Are there questions for our colleagues?

President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. I have a question for Nellie'it's not a

fair question [laughter], so just try, if you could, to do your best to answer. The middle right

panels on exhibit 5 and on exhibit 12 deal with European exposure. One of the things we learned

in the crisis is that it's not the first degree of separation, it's the second'that is, it's your

exposure to the people that have the exposure to risky entities. Steve commented that the Greek sovereign debt situation is probably unsustainable, which suggests that it's moving toward some form of restructuring or default that may be managed or unmanaged, and it may trigger a lot of concern about other countries' debt. Do we have any sense of our system's exposure to the people who have the exposure and the risk that could come from a contagion getting started?

MS. LIANG. In the table in exhibit 12, the middle right, the data are from the BIS consolidated banking statistics, and they are an approximation of the U.S. banking system's exposures to debt in these countries. As the table indicates, it's estimated to be $67 billion to Greece, Portugal, Ireland, and another $52 billion to Spain. Those are small amounts, but the exposures to France and Germany can be large'some of their large banks are big counterparties in transactions that we have. I don't know if we have strong supervisory data, but we have these data, which are not exactly the same. If you give me a minute, I can get that.

MR. KAMIN. Nellie, can I make a few remarks while you're looking?

MS. LIANG. Please go ahead.

MR. KAMIN. We do believe that the Greek sovereign debt is unsustainable, but a couple of points are worth making. First of all, there is some chance that the European Union will decide to bail out Greece completely so that they do not have to default or restructure their debts. I don't know what the chance of that is, but that is certainly in the probability space. Second, we don't place that high a likelihood on a full EU bailout for Greece, and instead we place a much higher likelihood on Greece's undergoing some kind of restructuring. It is our working assumption for our forecast, and it is also our hope, that this process occurs a bit down the road, when investors will have had a good opportunity to 'ring-fence' Greece away from the other countries. That is, investors understand that Greece's situation is unsustainable, and when the

restructuring occurs, they won't be surprised, they'll be ready for it. If that, indeed, occurs, then, not only is our exposure to Greece close to de minimis, but the exposure of the other large Western European banks to Greece is not so great either. Basically, as long as you can keep the investor sentiment stabilized, the direct exposures to Greece are probably small and can be maintained. The problem that we had back in May was that we were in an atmosphere of very great uncertainty, where nobody had ever seen an industrial economy close to default. In that atmosphere, expectations ran rampant, and all types of global financial markets were highly destabilized. It's our assumption that that will not occur if Greece has a restructuring, let's say, a year or two down the road. But, obviously, that's a hope, not a certainty.

MS. LIANG. President Lockhart, I don't have the BIS data on the U.S. exposures to the core Europeans through the banking systems. These data are going to be updated, and we're expecting to have a new set next week. We can pass that along, and, as you might guess, there are significant exposures to, say, Germany and France, because they're big countries.

MR. LOCKHART. As I said, I realize it wasn't a fair question, but I was trying to get a sense of what the real risk might be. Thank you.

CHAIRMAN BERNANKE. Vice Chairman.

VICE CHAIRMAN DUDLEY. Thank you, Mr. Chairman. I have two questions on fiscal policy. First, in exhibit 3, I was a little surprised to see the state and local government showing a positive fiscal impulse this year. It didn't track all the articles I've been reading about big imbalances and layoffs, so I'd just like to understand what the source of that is.

My second question is on the payroll tax holiday at the federal level. How do you see that working through the economy in terms of the data? Are people going to smooth that out, or

could it show up in the first quarter as an outsized effect, since this is going to be concentrated there?

MR. REIFSCHNEIDER. Let me answer the second question first. For the payroll tax, we do think there will be smoothing. We're thinking it will bump up growth in consumer spending starting in the first quarter. But our view is that only about 30 to 40 percent of the reduced payroll taxes will show up in increased consumption in 2011, and some more will show up in 2012; consumers will be spreading the spending out over time. People with much lower incomes will probably spend it right away, but a lot of people are not super constrained in terms of liquidity, and, in our view, they're likely to spend it more slowly. That lessens the degree to which spending gets pushed up in 2011 and then falls off a cliff in 2012.

VICE CHAIRMAN DUDLEY. I was worried that it might be hard to read the numbers over the next couple of months, because if you get strong consumption, you're not going to be sure if that's just a temporary factor or not.

MR. REIFSCHNEIDER. Yes, that's definitely true, and even three years from now it will be hard to read the numbers and tell what happened, although we'll do our best. That will be a bit of a question mark as we go through 2011 and into 2012 as well.

Now let me answer your first question. In the bottom left panel of exhibit 3, that's state and local net of their spending out of grants; so, if you calculated their total spending and included the federal grant effect, that would be a slight negative, not a positive. But when you read the news accounts, and you see the trouble that Illinois and California and many states are in, it's natural to wonder how this could be. Part of the answer is to look back at what they did just this last year'while local governments were cutting their payrolls, the states themselves,

interestingly enough, actually increased their payrolls a little bit, despite all of the pressures they've been under.

VICE CHAIRMAN DUDLEY. And the pressures could come from the spending side. They could be spending on pensions and health care.

MR. REIFSCHNEIDER. That's true. But they're going to be under a lot of pressure, so they're not going to be increasing their spending by any large amount, and, indeed, spending growth is going to be close to zero this year. So states are by no means any significant contributor to the nation's growth in this forecast.

I think the positive fiscal impulse comes back to the room created by higher tax receipts'we do think tax receipts have been growing and that they'll continue to grow at about the rate of GDP, which, of course, is not super fast. As I understand it, in the mid-session reviews, states' budget situations are coming in somewhat better in a lot of cases than was expected, and, in general, it's not coming in worse than expected, although, to the extent that some of them kick the can down the road, it may be as bad as they expected. Given that, we think that will enable those states to avoid massive cutting in real spending on purchases and things like that, but that is a risk.

CHAIRMAN BERNANKE. Governor Tarullo, did you have a comment?

MR. TARULLO. I just wanted to add a couple of things to what Nellie said in response to President Lockhart. When we get the BIS numbers, there are three things to keep in mind. One, our experience has been that the BIS numbers tend to overstate actual exposures just because of the way they count and what they characterize as an in-country exposure as opposed to an exposure to a foreign subsidiary of your own country's companies.

Two, since May we've been tracking this pretty carefully through the LISCC, and it's pretty clear that our large institutions have been reducing exposures not only directly to the periphery, but also to those who hold a lot of periphery debt. How much? That's a little harder to get our arms around, but the trend has been clear. In contrast, as Nellie pointed out, the money market funds don't have a penny less exposure to Europe today than they did a year ago'they've just reallocated which countries the exposure is in.

Three, if you look at credit default swaps for the large European banks, the big French and German banks have not seen that much of a run-up in their CDS spreads. One assumes that that's in no small part because of an assumption that the French and German governments would back those banks were they to take a significant hit from Spanish, Portuguese, Irish, and Greek banks, which is probably a reasonably well-grounded assumption.

So, for all of those reasons, it's really hard to come up with numbers, and most of us who have been puzzling over this for the last six or eight months are left with a sense that it's a pretty big potential exposure if things really go south, but it has been getting somewhat smaller over that same period of time.

MR. LOCKHART. Thanks, Dan.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. Thanks, Mr. Chairman. I'm going to follow up on this line of questioning from President Lockhart and Governor Tarullo. It's a question we've been puzzling over in Minneapolis. It seems that if you look at the sovereign debt in Europe, the situation looks just as bad today as it did in April and May in terms of the spreads. And yet there doesn't seem to be any evidence of the contagion that alarmed us so much in May'I think the VIX

popped over 40 at some point. So that contagion story that was such a factor in our discussion in May doesn't seem to be there now. I'm looking for stories to explain it.

MR. KAMIN. Shall I start and you follow?

MS. LIANG. I'll start this one. Just to corroborate Steve's remarks, in April, May, and June, when the European CDS did start rising, the correlation with U.S. asset prices was enormous. The second time around, it just wasn't visible at all. In large part, it has to do with some of the facilities that were set up in Europe.

MR. KAMIN. Well, I think that's the major element. When this erupted in May, it was very novel, as I mentioned before. We hadn't really had the experience of an industrial economy coming close to default'though, of course, we had had many instances with emerging market economies'and there were no institutions in play to address the problem. There was tremendous uncertainty about how far European authorities would go to put money on the table to backstop these economies. So in that situation of tremendous uncertainty, you had dislocation throughout global markets. Since then they've responded in a number of ways that have given investors heart.

For example, they bailed out Greece in a somewhat ad hoc manner, and then they followed that up with actual institutions, such as the European Financial Stabilization Mechanism and the European Financial Stability Facility, which were established to backstop further sovereign runs. They were used in the case of Ireland, and in fact, they came to Ireland's rescue somewhat more readily than to Greece's.

More recently, recognizing that they still don't have enough money in the kitty, they've been actively discussing enlarging it. Ideally, that would have gone through this month, but in fact, it was postponed to a European summit in March. In addition, it's now recognized that the

stress tests of banks that were done last summer probably were not severe enough, and they're undergoing another round of tests. All of these things together are giving investors some confidence that the situation is getting dealt with.

CHAIRMAN BERNANKE. Thank you. Governor Raskin.

MS. RASKIN. Thank you, Mr. Chairman. This question is for Nellie, and it refers to the real estate piece on exhibit 11. You said that the estimated losses from potential mortgage put- backs ranged from $25 billion to $75 billion and that they could be material for a few firms. You then indicated that this estimate reflected a markdown in light of notable settlements with Fannie and Freddie. My question is whether the markdown took into account future probable put-backs. In other words, did you look at the full universe of what those put-backs could be?

MS. LIANG. The estimate I cited comes from work by Mike Alix and staff at the New York Fed, so it was done in a pretty comprehensive way. They literally looked at the private- label securities that these firms had. They had the loan portfolio of mortgages originated. They had the firm-specific default rate for each bank. They estimated how much of that might be attributed to deficiencies in the process, and then the strength of the securities. On the basis of that, they then took estimates of the GSE put-backs'the recent claims give you some idea. And then they had to assess how much the private-label investors would be able to claim. So that's why there's a range, because they had to make some assumptions about how high those claims could be. These current assumptions are that the private-label investors would not be more successful in putting back than the GSEs, which have a pretty sophisticated system. To sum up, the estimate is based on the full portfolio of originations, firm-specific default rates, and firm- specific put-back assumptions. So I think it does incorporate the full view. The $25 to

$75 billion is a pretty broad range, though, because it's hard to know how successful they'll be in court, which is really the probability you have to write down.

MS. RASKIN. But leaving the private-label stuff aside, did you take into account the full range of GSE put-backs?

MS. LIANG. Yes, I think we have the estimates of the outstanding GSE put-back claims, plus an estimate of claims to come. I think that's all in there.

MS. RASKIN. Thank you.

CHAIRMAN BERNANKE. President Fisher.

MR. FISHER. I'd like to ask a question about exhibit 7, the bottom right-hand corner, and, in particular, about commodity prices. First, it's uncanny that both lines moved straight to the right. Also, I'm curious to know what your nonfuel index is based on. You may have mentioned it.

MR. KAMIN. No, I didn't.

MR. FISHER. Okay. Would you kindly mention it?

MR. KAMIN. It's based on a combination of indexes of different types of nonfuel commodity prices that are published by the IMF, I believe. We take them with the IMF weights and we reconfigure them to match the weights that are based on United States imports. Once we have those weights, we re-weight each group, and the groups are beverages, other food, metals, and agricultural materials. We then get futures curves for some of the different commodities in each of those groups to create projections of these commodity prices for each group, and then, using the weights, we come up with the aggregate projection.

MR. FISHER. So it's more model-based and it uses futures curves to the extent we have

them.

MR. KAMIN. Well, it's much more futures-based than it is model-based. MR. FISHER. And we know the record of futures curves.

MR. KAMIN. Right, exactly.

MR. FISHER. I point that out.

MR. KAMIN. It is exactly based on futures curves, which are highly fallible and yet not apparently more fallible than humans. [Laughter]

MR. FISHER. Very good. I have just a couple of points. First, for certain key industrial commodities, such as iron ore and so on, I wouldn't underestimate the impact of the Australian floods. The backup in shipping and the short-term price pressures that seem to be emerging on that front are extraordinary. Second, I still wonder about the substitution effects; maybe this could be the subject of another conversation. I'm not talking about physical demand, which, one would assume, will grow over time as the economies improve and as China moves up the food chain, and so on. I'm talking more about demand that's financially driven. For example, if I put on my old hat as an investor, right now I'd be looking for greater returns on my portfolio. Of course, the U.S. stock market has done brilliantly, but, with my surplus liquidity, I'd be tempted to look to, say, Brazil or Russia with at least a portion of my portfolio. As these countries erect more capital barriers'and the Brazilians have been a bit active here'a perfect substitute for Brazil, if you plot the two markets together, is the copper market, and there's no carrying cost of copper futures. A perfect substitute for the Russian market is the oil futures market. My point is that I didn't notice any discussion of how much of the trade is financially driven and how much of it is physically driven, and I think that's something we need to contemplate. I don't want an answer right now, but I think it's something we need to continue to think about in terms of driving prices upward and becoming a vicious circle.

Third, I just want to say a word, for what it's worth, about Chinese inflation. What I'm hearing from my contacts is that, for retailers who sell nonfood goods in the United States and source in China, the demands are now 40 percent. It's a combination of labor inflation running about 15 percent per year as computed in their five-year plan, and transportation and other costs. The U.S. retailers hope to whittle it down to 8 to 10 percent through negotiation. According to one CEO of a major retailer, who at one point ran the largest retailer, this is the worst inflation he's seen in 25 years, and it's sourcing out of China and alternative markets.

MR. KAMIN. Well, that's very interesting. I would just mention that, first of all, we are quite focused and eager to put more resources into looking at the effects from within China, such as wage pressures, on the prices of the goods we import from them. Second, we have been doing and will continue to do a great deal of work trying to parse out the relative factors pushing up commodity prices. We are very attuned to the role of futures market and financial demands in that regard, and we'll continue to do work on that.

MR. FISHER. Thank you.

CHAIRMAN BERNANKE. Other questions? [No response] If not, I understand that there are drinks available followed by dinner, and there will be no business, just for your convenience. Tomorrow let's start at 9:00 a.m. sharp with the economic go-round. Thank you.

[Meeting recessed]

January 26'Morning Session

CHAIRMAN BERNANKE. Good morning. Why don't we get right to work and begin our economic go-round? President Lockhart is up first.

MR. LOCKHART. Thank you, Mr. Chairman. The improved tenor of the incoming data has been clearly reflected in the comments coming from business contacts in the Sixth District in this intermeeting cycle. The best characterization of those comments is more optimistic than before the December meeting but still a bit tentative, cautious, and reluctant to place significant bets on stronger demand. As the data show, the pace of consumer spending has clearly picked up, but our conversations with retailers, some of which have national scope, convey little sense that they are preparing for a stronger year in 2011. I draw this conclusion from our queries about inventory, store expansion, and hiring. The inventory of unsold homes continues to weigh on residential real estate markets in the Southeast. Reports from our survey of Realtors are consistent with the current Tealbook's forecast of a modest drop in house prices. The data also indicate that business investment in equipment and software remains buoyant. Our contacts in the region tell us the lion's share of this investment is oriented to further productivity enhancement and streamlining of supply chains and distribution systems, not a response to an improving economy. Our directors and contacts pretty uniformly stated the view that gains in labor productivity have not been exhausted and will continue to take priority over hiring.

Regarding labor market conditions and prospects for hiring, our most recent round of discussions with business leaders in our District evoked some widely held views that may be relevant to yesterday's discussion of the NAIRU. We heard a lot of comments to the effect that job descriptions have been, and continue to be, transformed to require broader skills, modern technology savvy, and generally a higher degree of versatility and flexibility, even in positions

that are relatively low on the totem pole. We heard such comments about truck and car sales personnel, truck drivers, and agricultural workers, to mention a few. The CEO of a large auto retailer described the extension of the salesperson's job into financing arrangements, warranty negotiation, and documentation. This seems to be occurring across a spectrum of industries and occupational lines. The message we heard is that the new employee is not so easy to find and that many of the unemployed lacked the skills and the attitude to fill these redefined jobs.

Turning to my forecast, with some comparison to the Tealbook, my economic growth forecast has been revised up a little, but not materially. In reality, my forecast for growth, unemployment, and inflation are really not much changed from my November submission. I continue to hold the view that headwinds from a variety of sources will restrain growth to a pace a little under 3'' percent this year, keep unemployment elevated, and allow for only a modest rise in core inflation.

My forecast for inflation is slightly higher than the Tealbook's, and, as I mentioned, my forecast for GDP growth is slightly lower. On balance, I don't think the differences in the near- term outlook between what I submitted for this meeting and what I read in the Tealbook are all that significant. While I have not incorporated the recent rise in commodity prices into my inflation outlook, for largely the same reasons delineated in the Tealbook, my recent conversations with business contacts have introduced more caution into it. These conversations reflect a growing sense that attempts to pass through higher commodity prices to the consumer are about to be implemented across a range of products. I heard that price hikes in apparel, transportation and delivery services, household goods and hardware, and grocery products are in the works. There is much uncertainty whether these price increases will stick, but this is the first indication I've heard that businesses believe they have pricing power. Influenced by this

anecdotal feedback, I have changed my assessment of the inflation risk from weighted to the downside to balanced. I also think the specter of deflation is less likely today than it seemed last fall, in part due to the effect of our policies. Regarding economic growth and employment, I still see the risks as broadly balanced. However, if pushed to express a bias one way or the other, I am now tilting in the direction of the upside. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Rosengren.

MR. ROSENGREN. Thank you, Mr. Chairman. Over the intermeeting period, the tenor of the incoming data has improved. Most private forecasters have been raising their estimates of the last quarter of 2010 and the first quarter of 2011. Like the Tealbook, I am expecting growth over 2011 to be between 3'' and 4 percent, somewhat above the most recent Blue Chip forecast. While the consumption and investment data have generally improved, continued problems in housing and state and local government spending should prevent the economy from growing much faster than 4 percent this year.

The problems with residential investment cause me particular concern. Boston staff has done some research that suggests that spillover effects from a weaker housing market are a significant risk and found that the magnitude of the risk was qualitatively very similar to the scenario in the Tealbook that involved an intensified real estate slump with spillover.

Even with somewhat more robust growth, it is likely to be at least four years before we reach full employment. While we have discussed issues with structural employment at length, I would highlight that both directors and members of my various councils have highlighted how easy it is to hire qualified workers. And I would note that the New England labor market is much tighter than most other parts of the country, because only in Rhode Island is the unemployment rate above the national average. I will give just one example. A retail grocer in

New England is planning on expanding by opening four additional grocery stores and needed to hire 500 workers. He had more than 4,000 applications for the jobs, with lines extending well around multiple city blocks. And he was struck by how many had previous experience running bakeries, butcher shops, other grocery stores, or had other skills particularly relevant to the grocery business. Contacts expanding in high-tech, restaurants, and financial services have similar stories and have remarked on how many highly qualified candidates are available. The problem remains too few jobs, not too few skilled workers.

Given the excess capacity in labor markets and the downward trend in both core inflation and compensation, returning to a 2 percent core inflation rate in the medium term will certainly require years of much stronger data than we have seen to date. We still see evidence of this in the inflation data: Despite the increase in energy prices, many key areas have experienced price declines over the past year, including motor vehicles, household appliances, and apparel. The low inflation rate and the likelihood that it will remain below our target over the medium term gives us ample room to encourage faster improvement in labor markets and to put the economy on a stronger footing.

I would like to compliment the staff on the material they are providing in the financial stability report. I also remain concerned that the European problems pose downside risks to the United States. At the last meeting, I highlighted the risk that money market fund exposures to Europe could be a channel of transmission from Europe to the U.S. financial markets. Some of the smaller money market funds over the past year have had exposure to peripheral sovereign debt, and, when worrying about the financial stability of money market funds, it is the smallest, rather than the largest, that tend to pose the greatest risk of breaking the buck and initiating another broad run.

A second transmission channel I have not focused on in my earlier comments consists of European banks in peripheral countries. The pictures in the financial stability packet show how much the CDS spreads have widened for Spanish banks, as more attention has been given to sovereign debt problems in Spain. Banco Santander, one of the largest banks in the world, has had its CDS rise from 83 basis points at the beginning of 2010 to 292 basis points more recently. The CDS on the other large Spanish bank, BBVA, has risen from 85 in the beginning of last year to 314 more recently. Investor concerns about some of these large European banks highlight the urgency of getting our own economy on a solid footing, so that we can withstand any additional significant financial shocks in the coming year. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Hoenig.

MR. HOENIG. Thank you, Mr. Chairman. My outlook for the District economy is very similar to that for the U.S. economy. We expect improvements, as others have said and others will say around the table. Therefore, I'd like to spend just a few minutes, if you will, being like a 'broken record' again and focusing on asset values and some of the things that I see coming and some of the things that I am worried about from a broad perspective.

Certainly, we have seen and discussed higher commodity prices, but we've also seen lower interest rates and lower exchange rates, which have fueled a surge in farmland values nationally, not just in my District, raising concerns for me about inflation in asset values in agricultural real estate markets. Since June, for example, grain prices have doubled, and futures markets suggest that prices could remain elevated through 2014, but historically low interest rates and low cap rates are needed to justify the current farmland values that we're seeing across the country. By the beginning of 2010, U.S. farmland values had risen more than 25 percent from their 2005 levels, lifting the total value of U.S. farmland to north of $2 trillion. Over the

past year, farmland values have posted double-digit gains, with additional gains expected in 2011. While farm operators own the majority of U.S. farmland, nonfarm investors are buying more land now; according to a recent survey by Iowa State University, investors accounted for about a quarter of Iowa's farmland sales. Low interest rates, which have pushed capitalization rates down, contributed to the recent spike in farmland values as one asset class. And I use farmland as an example, because other asset classes are being affected as well.

Capitalization rates on U.S. farmlands have fluctuated over time, falling in periods of negative real interest rates, like the 1970s and the 2000s, and rising during periods of higher real rates, like the 1980s. According to the USDA data, for example, Nebraska's capitalization rate on cropland was 5.1 percent at the beginning of 2010, well below its historical average of

7'' percent. Despite regional variation, capitalization rates on farmland values have fallen to record lows across the nation, with rates below 5 percent in almost all states. Oklahoma and Texas have lower capitalization rates due to mineral rights, inflating land values even further.

Given the low cap rates, farmland values face significant interest rate risk. For example, irrigated cropland in eastern Nebraska is valued at about $5,000 per acre. A historically low capitalization rate of 5 percent is needed to rationalize this land value at current corn prices and yields. If interest rates were to rise and lift cap rates to their historical average of 7'' percent, the capitalized value of irrigated farmland in eastern Nebraska would fall by a third, to $3,300 an acre. If cap rates were to rise to 10 percent, as they did during the 1980s farm crisis, land values could drop by half. Additional analysis suggests that other regions face similar kinds of effects. Rising interest rates could also cut farmland values by reducing farm revenues. Historically, higher interest rates tend to raise exchange rates, thus limiting agriculture exports'even though

we do have strong global demand right now'which, in turn, depresses commodity prices and farm revenues.

In 1981, the spike in real interest rates led to higher exchange rates and contributed to lower agricultural exports. Exports, commodity prices, and farm revenues dropped, which pushed farmland values to their 1985 lows. If a similar event occurred today, farmland values could fall. For example, if cap rates return to their historical average and corn prices drop to just $4 a bushel, which was the 2009 average, irrigated land values in eastern Nebraska would fall by almost 50 percent, to $2,700 per acre. Other regions face similar risks. In sum, rising interest rates could trigger a sharp decline in farmland values.

Yesterday we talked about asset values for commercial and residential real estate, and I understand that situation. But I'm also thinking about the future and what values we are going to distort. About 450 community banks and regional banks across the country have high concentration levels of agricultural loans'above 300 percent of their capital. That was the commercial real estate kickoff for us. If you lower that threshold just a little, the number of banks with those exposures increases. Some of the largest banks as well had agricultural loans and land loans, but had pulled back from those. But as these values and this enthusiasm increase, I think you'll see those large banks go back into making land loans or other operating loans in this sector. Also, the Farm Credit System announced this morning that they were reducing their interest rates across the board by 35 basis points, because their profits are so good, their capital is rebuilding, and they want to provide this interest rate benefit to borrowers, because demand is back.

My point is that we want to be thoughtful not just about the problems we have'and we have plenty of them'but also about the problems we may be buying across a number of asset

classes. It's the unintended consequences that I'm concerned about right now. Thank you very much.

CHAIRMAN BERNANKE. President Hoenig, have you brought these issues to the supervisory group?

MR. HOENIG. Yes. In fact, our senior person in Kansas City is working with the folks here at the Board. We've suggested that we need to be thinking about how we deal with these banks on a national basis in terms of the underwriting standards that go with this situation. What happens, of course, is that, when the asset values go up, the bank's loan-to-value numbers go up, and the bank feels very secure. But when developments start going the other way, the bank gets caught below the line.

CHAIRMAN BERNANKE. Governor Duke.

MS. DUKE. I'd like to add to that. I've talked to a number of community bankers, and they tell me that a large proportion of these sales are for cash, so they're not necessarily financing them. What they're afraid of is that the farmers are using their cash in the purchases today, and that, a couple of years from now, when they have worse years, they'll be back to borrow against the cash that they invested.

MR. HOENIG. Right. There are strong cash flows coming off their property right now. MS. DUKE. It's not the financing of the property.

MR. HOENIG. But there is a lot of financing of the land part. There are also a lot of loan repayments, because the cash flows are so strong right now. But that's my point: Things are so good that you can move the price up, and then you are only borrowing 50 percent to 70 percent against it and assuming that the value will go up further. Of course, two or three years from now, you will get caught behind, and that's the thing we're worried about as we share this.

CHAIRMAN BERNANKE. But the particular emphasis ought to be on the exposure of the financial institutions.

MR. HOENIG. Absolutely.

CHAIRMAN BERNANKE. President Evans.

MR. EVANS. Thank you, Mr. Chairman. Many of my business contacts started off saying that things weren't that much different from our last call. As we talked further, it usually became clear that their attitudes continued to improve this month. My inference is that their businesses are picking up in line with their rising expectations. For example, manufacturers have been doing well recently and are saying they expect that to continue. The Chicago purchasing managers' survey rose sharply in December and picked up further in January to its highest level in more than 20 years'that result will be released January 31. More firms appear to be expecting increases in demand and laying the groundwork to expand production when the time comes. ArcelorMittal reported record sales to steel service centers who are building inventory in anticipation of demand, and this is coming on top of a good base of orders from automakers and other original equipment manufacturers.

Many firms remain reluctant to make permanent additions to workforces. However, the CEO of Manpower told me that many of their client firms have asked them to be ready to supply more temps in the next few months. The clients are expecting a burst of demand, but they are uncertain about the timing, and, when it does materialize, they expect to have a hard time hiring workers quickly enough by themselves. He also mentioned that a number of firms have openings that they are taking longer than usual to fill. These companies feel that there are a lot of good people out there right now, and, with demand not fully recovered, they can afford to wait

and make sure they get the best person. This is probably consistent with the results that we saw yesterday on the drop in recruiting intensity.

With regard to costs, although there is talk about higher commodity prices, few of the increases are being transmitted into higher prices for final goods and services at the moment. Manufacturing CEOs that I spoke with suggested that their planning for these cost increases was still adequate to avoid outsized price increases. They do devote considerable resources to managing these costs, and, at the moment, they think things are okay.

U.S. steel manufacturers are trying to decide how much capacity to bring back online. This is a difficult decision, given foreign competition. Foreign orders today would hit the market in six to eight weeks, about the same length of time as domestic capacity would take to ramp up, so, if it came at the same time, that would be bad for prices, in their view. Looking ahead, these forces are a potential dampening factor for currently high steel prices. Pass-through is also an issue. One of our financial contacts noted that hedge funds are shorting firms that are exposed to commodity price increases on the assumption that they lack the pricing power to pass these higher costs on to customers. We'll see.

I see the anecdotes as being consistent with the incoming data, which show that activity is on a better upward trajectory right now. I hope this momentum will build into more consistently solid growth than we saw in the first year and a half of the recovery. We need it, because we've got a long way to go.

The Board and Bank staff analyses on labor markets summarized yesterday have been helpful in honing my thinking about current resource gaps. Undoubtedly, the baseline for unemployment has risen some, but there continues to be substantial slack in labor markets. And

if monetary policy can help ameliorate this unsatisfactorily slow decline in unemployment, that's our policy job, in my judgment.

Turning to the outlook, our forecast for economic growth and inflation and the rationales underlying them are broadly similar to the Tealbook's. With regard to growth, I'm more optimistic today than I was at our last meeting, but I need to see several more months of consistently better data'say, running through the spring'to be pretty confident that we've experienced the sustainable step-up in growth that's in our forecast.

With regard to inflation, our forecast has it rising some over time but still coming in under 1'' percent in 2013. Our battery of statistical approaches to forecasting inflation continues to point primarily at further declines or, at most, flat inflation at a low level. However, we decided to go with an inflation projection that rises somewhat over time on the basis of what appear to be inflation expectations that return towards a mandate-consistent level. That's what we need, but it still seems a touch speculative to me. We'll actually have to see underlying inflation move up in line with these forecasts in order to have confidence in these expectational effects. In light of these forecasts, I see only a small risk that we'll face an unpleasant conflict between our employment and inflation goals over the foreseeable future. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Pianalto.

MS. PIANALTO. Thank you, Mr. Chairman. The most recent data have led me to raise my estimate of growth in the near term, but this morning I'd like to focus my comments on the more policy-relevant medium-term outlook. My outlook is for less rapid growth in 2012 and 2013 than the Tealbook baseline. My outlook for inflation gradually heads higher through 2012 and 2013 and is above the Tealbook baseline.

Given the importance of this outlook for my policy perspective, I want to talk about the key aspects of my projection. First, I see the economy as only slowly adjusting to the shocks of the recession. As one of my business contacts noted, the recovery seems to be a 'tale of two cities,' where parts of the economy are more or less recovering, while other parts are still facing considerable demand uncertainty and receiving little working capital. I suspect the more positive aggregate data are masking some of the current unevenness of the recovery. Major sectors of the economy are still facing significant headwinds that will only slowly abate.

With the employment-to-population ratio still 5 percentage points below its pre-recession levels, it is important to look for clues about hiring plans. The special Beige Book survey tells us that there are just as many firms seeking to expand their workforce this year as there are firms planning on holding their workforce steady. That could be read as a pretty optimistic indicator for employment growth, but, based on what we've learned from our Beige Book respondents, I think these survey responses are unlikely to result in a dramatic increase in employment growth. Specifically, in follow-up questions we asked these respondents, we discovered that, while most of them anticipate some hiring, it's not that much and primarily will be on a highly selective basis.

The path toward higher aggregate employment is still complicated by the large fraction of small businesses that are not expanding. For many of these firms, job growth is likely to be slowed by problems of credit availability. My staff recently published some estimates using the New York Fed's credit panel and other data sources to quantify an ongoing problem of credit availability for small businesses linked to home equity lending. They found that roughly one- quarter of small businesses rely on equity in their homes for financing, whether through personal guarantees or home equity lines. As a result, declining home prices can reduce the amount of

collateral and, hence, the amount of credit available for many small businesses. The affected businesses are predominantly smaller firms, yet our researchers found that the aggregate reduction in credit through home equity is potentially quite large. A banker on my board of directors confirmed that this was a critical issue for small businesses and that it would continue until the owners' residential equity positions improved. Thus, it seems likely that weaker credit availability for start-ups and other small businesses constitutes an ongoing headwind. These tepid hiring plans and the small business credit issues are just a couple of examples of ongoing headwinds that I see dampening output growth over the medium term. Partly for these reasons, my GDP projection is at the low end of the Committee's range and below the Tealbook path.

Even more critical to thinking through the policy environment is the medium-term outlook for inflation. The Committee's projections for 2013 range from 0.6 percent to 2.0 percent, a range that's wide enough to be associated with very different policy paths. As I noted earlier, my projection for inflation is above the Tealbook's, but it's in the middle of the Committee's central tendency. PCE inflation statistics reveal that the typical U.S. consumer's purchases have experienced a significant disinflation since 2008. The good news in this area is that my staff's analysis of the incoming CPI data point to a leveling-off of the underlying trend inflation rate. Indeed, the median CPI was up 1 percent over the last six months of 2010 on an annualized basis after being up just 0.3 percent for the first six months in 2010. A little over a third of the consumer's market basket had prices that were lower at the end of 2010 than they were at the end of 2009. However, the disinflation momentum was more prevalent in the first half of 2010.

While these developments suggest that disinflationary pressures may be drawing to a close and that the risk of outright deflation has diminished, inflation clearly remains very low.

At this point, in the face of continuing weak labor markets, labor costs are likely to increase only gradually, which should limit the upward momentum in inflation even if the recovery accelerates. The BVAR model that my staff uses has the characteristic that inflation is quite sensitive to unit labor costs and not so tightly connected to GDP growth. Inflation expectations are also a critical factor in the inflation forecast, but I see current inflation expectations as being consistent with my outlook. In the Cleveland Fed model, which accounts for a time-varying inflation risk premium, inflation expectations are at or below 2 percent over the projection horizon. Inflation expectations near mandate-consistent levels, but above current inflation rates, should support a gradual rise in inflation toward 2 percent. And my projection has core inflation reaching 1.7 percent by the end of 2013.

Given the improving data and stronger sentiment we have recently seen, it is tempting to boost the outlook for output and inflation. But we've seen swings in the data before that have proven to be only temporary. I prefer to think about the stronger incoming data as helpfully offsetting some of the downside risks to the economy that I've been worried about for some time. Accordingly, my near-term outlook is now brighter relative to December, and I've shifted my balance of risks for both growth and inflation from being on the downside to being balanced. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Plosser.

MR. PLOSSER. Thank you, Mr. Chairman. Economic conditions in the Third District have continued to improve. The regional economy has shaken off the summer doldrums and recovery is gaining some momentum as it enters the New Year. Our business outlook survey of regional manufacturing showed strength in both December and January, and the general activity index is up to about 20 in both of those months. Underlying that, the indexes of new orders and

shipments both improved substantially in January. Our manufacturers expect activity to continue to improve over the next six months. Perhaps more encouraging is the jump in the employment index from 4.3 to 17.6 in January, the highest value we've seen for that index since April 2006.

Third District retailers and auto dealers report increases in sales at the end of last year compared with year-earlier levels. Although service sector firms gave some mixed reports, on balance, activity has been rising. The health care and information technology sectors showed some growth, and activity related to real estate, construction, and finance, while not great, seemed to have firmed a bit and stopped declining.

Payroll employment in the three states increased on a three-month moving average basis ending in December, based on data released yesterday. The unemployment rate has been moving steadily down, falling to 8.7 percent in December for the three-state area, from a high of

9.4percent in July'a drop of 0.7 in less than six months. This is consistent with the improvement in the employment readings we receive in our manufacturing survey.

On the pricing front, we continue to see increased price pressures. Many of our manufacturers continue to report an increase in input costs in January, and there are growing signs of an ability to pass these prices on to customers both in current prices and in expectations of future prices. During the early part of the recovery, firms held back on price increases even though they faced increased costs. That attitude appears to be changing. For example, one of our directors is a national manufacturer of floor coverings; the company has suffered greatly through the housing bust and is putting through a 5 percent price increase in light of the continuing rise in materials costs. This is his first price increase in two and a half years, and he reports that others in his industry are facing the same challenge, as margins continually get squeezed. Another director, from a large national baking company, says that his industry and he

will have no choice but to raise prices this year in light of higher food commodity prices'that is, flour, sugar, et cetera. These two anecdotes do not by themselves constitute compelling evidence of the future path of prices, but they are illustrative of our business outlook survey's prices- received index, which has turned abruptly positive, rising from minus 3.3 in November to plus

9.4in December and 17.1 percent in January. That's the highest value it has taken on since August 2008.

Thus, my sense is that, as the recovery picks up steam and firms become more convinced that demand increases are going to be sustained, they will feel more confident that they can put through price increases and have them stick. Given how much ground these firms may feel that they have to make up, these price increases may move in a fairly nonlinear manner once they start. Labor costs are not the only things that matter to these firms when it comes to pricing. Thus, looking at wages and unemployment may not be the most important key to understanding future price pressures. Of course, our policy needs to focus less on what prices and inflation have done over the last year and focus more on what they're likely to look like in the coming year, and on this score I see the risks clearly to the upside.

Turning to the national economy, I've made little change in my forecast since our submission in October. I'd been interpreting the summer slowdown as a soft patch, not the start of a cumulative decline in activity. Thus, acceleration in activity seen in the fourth quarter was consistent with my outlook. I expect economic growth to be about 3'' percent per year over the next two years. I believe that the data are consistent with a self-sustaining recovery. I think that firms are becoming more convinced of that as well. My economic growth forecast is a bit weaker than the Tealbook, and Philadelphia's DSGE model suggests that growth may be stronger than my forecast. Thus, I believe that there are upside risks to my growth forecast, as

the usual dynamics of an economic recovery could outweigh the drags from household deleveraging and the housing slump.

I also see a somewhat faster decline in the unemployment rate and a faster acceleration in inflation than the Tealbook. As I've said at previous meetings, I am very wary of basing policy on some notion of an output gap or an employment gap, because both have both conceptual and measurement problems. One only needs to look at the range of estimates of the natural rate of unemployment we discussed yesterday and the error bands around those estimates to see that the unemployment gap measures are not very precisely estimated. Output gaps suffer from the same measurement issues that the unemployment gap does. Orphanides's research shows that ex post revisions of the output gap are of the same order of magnitude as the gap itself, and it's particularly hard to measure the gap near cyclical turning points. This is probably one reason the gap gets little weight in empirical estimates of New Keynesian Phillips curves. Indeed, the Philadelphia model suggests considerably higher inflation pressures than the Tealbook. Again, my view is that inflation risks are to the upside in the medium term.

I think we need to remember these risks as we contemplate policy in an environment in which output growth and probably employment growth are likely to be above trend. In my view, if we focus on the growth rate of output and the growth rate of employment rather than the levels of gaps, we will have a better chance of staying ahead of the curve rather than falling behind it. Taylor rule formulations based on growth rates, for example, suggest that monetary policy is about right, and, thus, there's no need for extended LSAP programs that seek to drive short-term real rates lower. Given my outlook and my focus on growth rates, I believe we will need to begin removing policy accommodation considerably sooner than anticipated by the Tealbook.

We need to begin preparing for that time by discussing what our exit path will look like and the communication strategies we will need to implement it.

As a brief aside, I draw the Committee's attention to yesterday's handout of our economic projections. The charts presented on the risks to GDP and inflation have flip-flopped fairly dramatically since November. GDP and inflation risks were heavily weighted to the downside in November, and now those risks are marginally weighted to the upside. We should make sure that the minutes and our statements are consistent with this change in direction, and I'll have more to say about that in the policy go-round. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. In the course of our discussion yesterday about the natural rate of unemployment, I mentioned that I thought it would be useful for us to consider a wide range of measures of inflationary pressures, in addition to the natural rate of unemployment and the gap between the current unemployment rate and the natural rate, and I'll elaborate on that now. In discussions with a number of our local contacts, we asked about their ability to raise prices, and the basic response was the same. Many firms are facing input cost pressures because of the rise in commodity prices'some of these firms are actually producing those commodities, so they're pretty pleased about that [laughter], and we should keep that in mind. Other firms are trying to pass these input prices on to their consumers, but they are not finding, as a general rule, that the demand is sufficiently strong to support these attempted price increases. As a result, firms are absorbing the input cost increases by cutting margins and not by raising prices. In a similar vein, we heard from contacts about their plans for wage increases. There are signs of labor shortages in North and South Dakota. Also, in some high-growth areas, like health care and IT, wage pressures are starting to build. All in all,

though, wage increases were relatively moderate from 2010 to 2011. So, if you look at the most granular level, inflationary pressures do seem subdued in the Ninth District.

If you look at the national level, it seems to me that there are a number of possible ways to think about gauging inflationary pressures, that is, to think about the degree of slack in the economy. One approach that we tend to emphasize is the difference between the current unemployment rate and the natural rate of unemployment, but as discussed yesterday, there are many uncertainties associated with that approach.

So I'll suggest three deliberately simple-minded approaches that we could add to that approach. The simple-mindedness of these approaches should give us some confidence that they will be robust across a wider class of models, but, of course, it's useful to augment them with more econometrically and theoretically sophisticated approaches as well.

The first is a very simple NAIRU approach. It just looks at the difference between the current inflation rate and lagged inflation, and it's trying to get at the acceleration in inflation. A lot of slack should lead the inflation rate to fall, and if there's not much slack, then the inflation rate should be falling very little or rising. Second is the New Keynesian approach. It takes the current inflation rate and compares it with expected inflation. If you look at a simple, simple version of the New Keynesian Phillips curve, this difference is proportional to the output gap. Third is a purely statistical approach, and here I'll refer to the Stock-Watson recession gap that we heard about in Jackson Hole. That's a difference between the current unemployment rate and the minimal value of unemployment over the current and the past 11 quarters.

Consistent with what I said about the Ninth District, all of these aggregative measures indicate that inflationary pressures in the U.S. are currently low. Starting with the NAIRU approach, inflation decelerated in 2010, and core inflation decelerated by 90 basis points from

2009 to 2010. The New Keynesian measure gives a similar result. If we look ahead at inflation forecasts, zero-coupon inflation swaps, the median Blue Chip forecast, the Cleveland Fed forecast'they're all pointing to inflation of around 1.7, 1.8 percent in 2011. So this measure, the difference between 2010 inflation and what we expect in 2011, is also negative, which implies that inflationary pressures are low right now from the New Keynesian perspective, as well. Moving to the third measure, unemployment was around 5 percent in the first quarter of 2008, so the Stock-Watson recession gap is large.

But what about as the year progresses, as President Plosser emphasized? I think it's useful to contrast what I'm going to say to what President Evans said in his remarks. Which one of us turns out to be right will be critical in thinking about policy as we go forward. At the granular level, we received some information that firms were anticipating larger wage pressures by the end of the year. Of course, we have to wait and see whether that transpires or not, but those kinds of wage pressures would be much more difficult for firms simply to absorb in their profit margins and would more likely to lead to price increases.

What about at the more aggregative level? The simple NAIRU approach is going to tell you that the forecasts'from the zero-coupon inflation swaps that I mentioned, the Blue Chip forecast, and my own projection, for that matter'are all for inflation to accelerate in 2011 relative to 2010. That measure would say we've got inflationary pressures building by the end of 2011. Now to the New Keynesian approach. By the end of this year, the inflation forecast for 2012 compared with the forecast for 2011 shows a relatively small difference, something like

1.8to 1.9 percent. So by the end of 2011, the New Keynesian approach is going to be saying that there's not much of a gap anymore, and, again, it will imply that inflation pressures have built by the end of the year. Finally, the Stock'Watson recession gap says unemployment was

near 5 percent three years ago, as I said. By the time you roll to the beginning of 2009, unemployment is 8.2 percent. So if unemployment is falling to near 9 percent by the end of 2011, that gap has now shrunk from around 4'' percent to less than 1 percent. Stock and Watson also proposed a similar gap in terms of capacity utilization, and that version of the gap seems likely to vanish completely by the end of the year.

In my view, the expected paths of all three of these measures of inflationary pressures would point to a need for policy tightening by the end of the year. But in all three, it really comes down to: How is inflation going to behave over the course of 2011? I think we should start to plan for various contingencies now. My own prediction, as I've described, is that we would have to start to think about tightening by the end of 2011, which is more than a year earlier than the Tealbook's projection'and I was interested to see that it's only about six months earlier than what's in the New York Fed's forecast. Monetary policy is all about contingency planning, and I'll talk about one way to construct a plan for all of the possible contingencies that we face in the next go-round. Thanks a lot.

CHAIRMAN BERNANKE. President Kocherlakota, I was a bit confused on one point. Stock and Watson in their paper actually projected inflation, and they suggested there was significant deflation risk. Did you get a different result?

MR. KOCHERLAKOTA. I think they're going to turn out to be wrong on this point. If you use the forecasting model that they talked about in Jackson Hole, they would have forecast significant disinflation from that point forward. All I was saying is that, by the end of 2011, that model is not going to have those same pressures in there.

CHAIRMAN BERNANKE. Okay. Thank you. First Vice President Moore.

MR. MOORE. Thank you, Mr. Chairman. In the 12th District, holiday sales for retailers generally exceeded expectations. My contacts also noted a shift in spending away from generic products towards more luxury items. My staff has discouraged me from describing these luxury items in any detail after my comments on Spanx at our last meeting [laughter], so I won't do that, but I will say that this shift towards these luxury items suggests a more secure, less cautious consumer.

The outlook is gloomier for state and local government spending. In California, total general fund spending has been cut by almost 20 percent over the past three years, and further cuts are on the way as the state struggles to balance revenues and spending. Among other effects, these cuts have squeezed public resources directed to nonprofit organizations. Our contacts in these organizations have stated that this is leading to widespread consolidations in an attempt to salvage some semblance of services.

Turning to the national economy, recent data have generally been quite favorable.

Consumer spending and auto sales have picked up, business investment is rising, and exports are making a solid contribution to growth. A downside risk to the outlook is the housing market, which the Tealbook describes as 'moribund.' One definition of moribund is 'at the point of death.' That might overstate the situation a bit [laughter], but it is certainly hard to detect much of a pulse in construction. With 20 percent of current mortgages underwater and house prices still falling, there is no prospect of an imminent residential resurrection. Continued house price declines could also lead to additional defaults and foreclosures, putting further pressures on bank balance sheets and credit availability.

Still, the predominance of good news since our last meeting has led to a sizable upward revision to last quarter's real GDP growth. The greater momentum has also boosted our GDP

growth forecast to 4 percent this year and 4'' percent next year. However, fast growth for a couple of years is not enough, as unemployment is projected to remain stubbornly high. Analysis by my staff that was detailed in the FRB San Francisco background paper described yesterday suggests that the bulk of the increase in unemployment reflects weak labor demand and not a rise in structural unemployment. In the special Systemwide survey on hiring plans, the number one factor restraining hiring was low expected sales growth. Currently we put the effective natural rate of unemployment somewhere around 6'' percent, but almost all of the recent increase in the natural rate should be unwound over the next few years.

A key indication of the significant slack in labor and goods markets is the downward pressure on wages and prices. Importantly, the weak demand for labor is evident in last year's widely dispersed slowdown in wage growth. Going forward, the downward pressure on prices from slack is offset by anchored inflation expectations and higher commodity prices.

As noted in the Tealbook, higher commodity prices seem to be driven by greater demand and by supply shortfalls, not speculation. In particular, after examining high-frequency data, our staff found no evidence that commodity prices jumped right after our announcements of large- scale asset purchases and monetary accommodation that have taken place since early 2009. Of course, only a small portion of the surge in commodity prices will pass through to core inflation. On balance, we expect core PCE inflation to remain at or a bit less than 1 percent both this year and next.

Before wrapping up, let me say that, in light of yesterday's discussion on structural unemployment, I'm now seeing the ongoing search process for a new 12th District president in a different light. [Laughter] For example, I'm no longer taking it so personally when people use the terms 'mismatch' and the '12th District president situation' in the same sentence. In

addition, I realize I need to have a chat with our search committee about the concept of low recruiting intensity. [Laughter] In any case, I'm hoping, as I'm sure you are, that if the ongoing nature of the opening is the result of a structural problem, it's the type that will dissipate soon.

CHAIRMAN BERNANKE. And maybe the wage will move over time. [Laughter] President Lacker.

MR. LACKER. Thank you very much, Mr. Chairman. A hard act to follow, so I'll stick to business. The data we've seen over the last couple of months is notably better than we were expecting just two or three months ago. The cumulative effect for me is much more confidence that the recovery is firmly in place and has picked up speed.

What we've seen in the Fifth District is consistent with this assessment. I'll start with the household sector. Nothing is more central to the recovery than the revival of consumer spending, and, in our surveys, the diffusion index for retail sales has been notably weak throughout most of the recovery and, as recently as November, stood at minus 16. In December it swung to plus 25, and the reading for January improved further to plus 33. Our broader service sector index has shown improvement similar to that of the ISM nonmanufacturing index at the national level. It rose to plus 21 in December, and that's the highest level in several years. It came to plus 12 in January, which is still a positive reading. I won't recite more of these District numbers, but, like the other regional diffusion indexes, our manufacturing measure was strongly positive for December and January'I think we've heard similar reports from Philadelphia and other Districts.

Our anecdotal reports this month also support a more confident view about the recovery. One noticeable swing in recent months is current reports from some of our banking contacts, who are reporting improvements in loan quality and the emergence of new loan activity. More

broadly, outside of banking, we've also heard noticeably more positive reports and fewer negative reports than in the recent past.

Turning to the national economy, I agree with the Tealbook that we've entered the new year carrying more pace than seemed likely a few months ago. Several developments stand out. Consumer spending growth has picked up and now looks more solid than it once did. Labor markets are improving. Private employment continues to expand at a somewhat increasing pace. Initial unemployment claims continue to fall. The NFIB hiring plans index surged, and real disposable income is on an upswing. In addition, I think investment in nonresidential structures has not been quite as weak as some of us had anticipated, and that suggests we may have reached a bottom in commercial construction now.

All in all, I think a more bullish view of the outlook is warranted. In my projections, I've written down 3.9 percent for GDP growth for 2011'spurious precision, perhaps, but close to the Tealbook's forecast. Obviously one wants to be careful about reacting to the data in marking up one's outlook, but I think the improvement in the outlook is unmistakable.

The inflation outlook is also firmer now, I think, than it was several months ago. The Tealbook estimates that PCE inflation was 2.3 percent over the three months ending in December. Measures of near-term inflation expectations, both TIPS-based and survey-based, have moved up by roughly a percentage point since the summer'a fairly substantial move. The surge in energy and commodity prices obviously has played a role, but our experience with such surges in the past several years suggest that they'll show up soon in core inflation as well. I also think there's little doubt that deflation risks are notably reduced now and fairly minimal.

In sum, I think this recovery is looking less in need of monetary stimulus than it did a few months ago. Personally, I seriously doubt that our asset purchases have made a material

contribution to the improvement in the outlook over the last few months. If we continue to get economic reports consistent with stronger growth'two reasonably healthy payroll employment reports, for example'then I think at the March meeting we're seriously going to want to consider scaling down our purchase program. Thank you very much, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. The Eighth District economy continues to improve at a moderate pace. Many businesses report stronger revenue, better profitability, and improved household consumption. Holiday retail sales were quite robust. Some businesses plan to boost capital expenditures during 2011, and there are a few tentative indications that firms in the District may be more inclined to hire new workers this year. This is the first time that I have heard even tentative indications of that.

Residential real estate in the District remains weak. Some parts of the District, in fact, seemed to experience renewed deterioration in conditions during the second half of 2010. Agribusiness in the District continues to be characterized by optimism for 2011, driven in part by higher prices for many of its products. There seems to be increasing anecdotal evidence of land prices accelerating beyond what seems to be supported by fundamentals. That's something I'll be keeping an eye on in 2011.

Large businesses headquartered in the District continue to report brisk business and remain optimistic for this year. Booming Asia continues to be an outsized factor for many of these firms, but most are also reporting good results for domestic business. Europe, so far, remains a steady source of business for these firms. I did not detect problems in the EU, at this point, from the perspective of these businesses.

Nationally, prospects for the economy seem to have improved rather markedly relative to last summer. I attribute part of the improvement to this Committee's asset purchase program. I think that this program did four things. It put downward pressure on short-term real yields, it put upward pressure on expected inflation as measured by market-based TIPS, it contributed to a rally in equity markets, and it contributed to downward pressure on the trade-weighted value of the dollar. In my view, these are classic signs of monetary policy easing. They are exactly what you'd expect to observe had we been able to lower the funds rate substantially in reaction to weaker signs from the economy. So, to me, this recent experience shows that the asset purchase policy can be used effectively to substitute for ordinary monetary policy, although, whether the Committee wishes to use this tool is, of course, dependent on the judgment of the members.

I would also say that the asset purchase program has been very successful in getting the focus off of the federal funds rate and how long it will be at zero and moving the focus on to balance sheet policy instead. So I think the signaling aspect has been extremely valuable to the Committee. It is, of course, too early to make a complete assessment of the program. In particular, most measures of actual core inflation from one year ago remain below 1 percent. I would like these to move higher before I feel completely comfortable that the downside risk on inflation has been mitigated effectively, but we will have to see how these measures evolve during 2011. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Fisher.

MR. FISHER. Mr. Chairman, I'm going to talk purely about the economy as seen through my own District and about my conversations with various CEOs. Before I do, I want to thank President Hoenig for pointing out the need to contemplate unintended consequences as well as intended consequences. I would say that is true not only when we enter into a program,

but, as President Plosser commented, it is true also when we exit. And I want to come back to try to pay a compliment to the New York Desk for the work that they did on the various exit scenarios, and I hope they will not interrupt me this time, because I think we need to contemplate what the cost of exit is and how we exit.

Now I will turn to the economy and, in particular, to developments in my District, because it has been an engine of economic growth and employment growth. We have looked closely at the data, and the Texas share of U.S. employment growth for last year amounted to 19 percent of total nonagricultural growth'40 percent goods production and 60 percent services. So Texas is not quite North and South Dakota, but I think it is not an unimportant indicator of where we may be going. Let me just give you some summary statistics. Our payroll employment rose at a 3 percent rate in December. Our Texas manufacturing outlook survey is indicating expectations of capital expenditures and future business activity at a level that we have not seen for over three years. Construction employment rose at a 3.6 annual rate. And we are beginning to hear that convenience stores are reporting increasing traffic, which is usually an indication of a pickup in construction activity in terms of those workers' consumption. Service sector employment grew at a 2.3 percent annual rate in November; we are still looking at the December rate. The key number that I wanted to mention is temporary employment, which rose at a 19'' percent annual rate'Charlie, I think you mentioned Manpower. Our manufacturing outlook survey had a very interesting statistic. We asked about the hiring intention six months out. The ratio of firms expecting to hire versus those expecting to lay workers off is now at

19 to 1'not insignificant. So our surveys raise the prospect that this recovery might actually generate more jobs than we had expected.

There are two offsets to what is happening in our District, but it is happening in all Districts. One is that the state does have a fiscal shortfall. In the typical Texas manner, I doubt it will be met by tax increases, but, rather, it will be met by continued severe cuts in social services. In the state's budget, 75 percent goes to education and health, and, unfortunately, I think the cuts are going to come out of the education side as well as the health side. The second offset is in our Texas manufacturing survey, where the proportion of firms that expect to be able to pass on higher prices by midyear rose to 37.2 percent, the highest level in almost three years. And the prices received index is now running at the highest level in three years. So that's my District.

I'd like to turn to what I have gleaned from the roughly 30 CEOs I speak with. You're the only one that has that list, Mr. Chairman, and I will summarize that quickly. I think it's fair to say that the view of that group collectively is that fears of a double-dip recession have faded into the rearview mirror. Confidence is higher in the direction of final demand moving forward. The best summary quote is, 'We are moving forward at 3 knots, not at 20, but it's definitely forward motion.' The same holds true even among small businesses, according to my contact at AT&T; he said the company is seeing the highest small business demand for connectivity and for services that they have seen in the last three years. By the way, according to the casual dining industry'for example, Chili's and the middle brands'despite GE's withdrawal from the financing business, franchises are able to raise capital now, which is something they haven't seen for three years. Improvements in final demand seem to be more likely, liquidity is abundant, and many regard the prospects on the tax and regulatory front as potentially better'I stress 'potentially,' because these are hard-headed people, who are hopeful, but wary. I'm finding

more that are saying they are contemplating expanded domestic cap-ex, and some are at least beginning to budget for domestic payroll expansion.

On the inflationary front, those with rising input costs are planning price increases. Many have the ability to pass through increases automatically, for example, the rails and others. But to return to a point raised earlier, they are uncertain about their pricing power. And I have tried to drill down with my interlocutors specifically on this issue. Generally speaking, those in the bottom two quartiles in the retailing sector appear to be budgeting for 8 percent increases on the apparel side, particularly as we get to back-to-school season, because of the higher prices of inputs such as cotton. And Mr. Tarullo will be very happy to know that that has also led to higher prices of polyester, because polyester is a substitute for cotton. I noticed him nodding off during my statement'[laughter]'so I just wanted to make sure he was paying attention. But when you really do press, they're still uncertain as to how much, given the weak demand we have, they'll be able to pass through. Nonetheless, the intention is to pass through whatever they can get away with. The business community has worked very hard to preserve the margins, which have become extremely taut, and they are quite worried about it.

So, in summary, Mr. Chairman, I would say there is more than enough liquidity in the system. Businesses and financial intermediaries are flush with funds. Money is burning a hole in the pockets of many, sensing that fiscal and regulatory policy might become friendlier. Businesses are beginning to budget for cap-ex, including, hopefully, more in the United States. And some additions to domestic payrolls may occur, although those additions and investments are still earmarked to drive productivity and, therefore, are likely to have less of an impact on unemployment than is desirable. The outlook, according to the CEOs I surveyed across the

country, is the most upbeat it has been in two years. But inflation is a concern. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Vice Chairman.

VICE CHAIRMAN DUDLEY. Thank you, Mr. Chairman. Well, speaking for myself, I have a very inelastic demand for cotton, and I don't see any leisure suits in my future, regardless of what happens to cotton prices. [Laughter]

I think we all agree that the economy has regained some forward momentum. It is now on more solid footing, and the prospects for a virtuous circle have improved. In other words, faster final demand growth stimulates more rapid employment and income gains, which, in turn, provides further support for household and business spending.

At the same time, I wouldn't get too excited about all of this. The pace of economic growth is still pretty tepid relative to the depth and duration of the recession that preceded it. And while the labor market is improving, the rate of private-sector job creation has not yet been sufficient to push down the unemployment rate in a sustained manner. Even if we were to start to see more sizable employment gains, I think we should be inclined to let that run for a while, given the amount of slack that currently exists in the labor market. This is going to necessitate some patience on our part. I think policy should remain accommodative long after economic growth picks up to a more robust pace.

In terms of the debate about the level of NAIRU, I thought the staff papers were excellent, and what I took away from it is that NAIRU probably is somewhat higher than it was before, due to the extended unemployment compensation benefits and increased mismatch. But I think it's important to stress that the effect of the extended unemployment compensation benefits is almost certainly going to be temporary rather than permanent, so I'm not sure that it's that

relevant over the longer term, and there is, as the papers point out, a cyclical component to mismatch. More importantly, we probably shouldn't spend too much effort trying to fine-tune our estimates of NAIRU today. Whatever it is today, it's likely far below the actual unemployment rate. Thus, in my view, the mostly modest differences that we have in our point estimates shouldn't have substantial implications for monetary policy currently. Moreover, it's important to emphasize that we will be able to fine-tune these estimates once we see how compensation and unit labor costs respond to faster economic growth and to the drop in the unemployment rate, which, I hope, will take place this year.

On the inflation side, I think the big story in the news is the continuing rise in commodity prices, which is lifting headline inflation above core inflation. However, I think it's important not to overreact to this development either. The pass-through of commodity price pressures into core inflation has typically been very limited in the United States, and headline inflation is still below nearly all participants' estimates of the inflation rate consistent with the FOMC's dual mandate. Moreover, underlying pressures outside of commodities are still very subdued. I would note that unit labor costs are still declining on a year-over-year basis, and profit margins are elevated relative to historical norms at this stage of the business cycle.

One area that I do think we have to keep our eye on is inflation expectations. Five-year, five-year forward TIPS measures are at acceptable levels, and survey measures still don't show any meaningful increase in longer-term inflation expectations. But if we did get a significant increase from here, that would be a concern. To my mind, at this stage of the business cycle, and given the amount of excess slack in the economy, it would be a rise in inflation expectations that would be the most likely way that we'd get a sustained upturn in actual inflation.

Therefore, I think we have to be mindful of our own role in influencing inflation

expectations through how and what we communicate to market participants. I think we need to emphasize our ability to exit smoothly from our enlarged balance sheet when the time comes, even if that time lies far off into the future. And we have to emphasize our commitment to do so. I think we need to be very clear in our communications about why we're keeping monetary conditions very accommodative'that is, because we're so far away from our dual mandate. But we also need to emphasize that our keeping conditions accommodative today does not compromise our commitment to keep inflation contained over the longer term.

In terms of financial stability risks to the outlook, let me just discuss two areas briefly' Europe, and state and local government finances. With respect to Europe, I believe that the 'muddle through' course continues to remain the most likely outcome. The leadership of the core European countries is fully committed to the euro. This means that, if expansion in the capacity of the EFSF is required, it eventually will be forthcoming. But the road is likely to be bumpy, because this is a very complex bargaining game that makes it difficult politically for the necessary aid to be extended before it's absolutely needed. Right now, we seem to be in a sort of a peculiar place. Market participants expect the resources will be supplied to protect Spain, but, because of these expectations, market conditions are generally stable, and this means that the policymakers aren't under much pressure to provide this backing immediately.

In terms of state and local government finances, the rise in municipal bond yields has sparked much discussion of credit risk. However, I think the increase in yields is at least as much due to a shift in the demand'supply balance as it is to a fundamental deterioration in debt funding capacity. The demand from the household sector has cooled as poor mutual fund performance had led to outflows from municipal bond funds. In response, yields have had to

back up sufficiently to attract so-called crossover investors, such as insurance companies, taxable income funds, and hedge funds. And although many states have large deficit holes to fill this year, the aggregate amount of the shortfall is actually not that big. If you sum it across all of the states, it looks to be about roughly 1 percent of GDP. The much bigger problem for states and localities is really the longer-term unfunded commitments for pension and health care retirement benefits. This may ultimately lead to a hard landing, but I don't see that happening this year.

Finally, the debt ceiling could become an issue this spring. I know this usually turns out to be just theater, but it does strike me that there's more capacity for mischief here than usual. Apparently, some members of the Congress are discussing how payments can be prioritized, so that the impact of a binding debt ceiling would constrain discretionary spending but would allow payment on Treasury debt to continue. If we really go down that path, it would imply that the debt ceiling could be pretty messy. Thank you.

CHAIRMAN BERNANKE. Thank you. Governor Yellen.

MS. YELLEN. Thank you, Mr. Chairman. I, too, am encouraged by recent news

suggesting that, outside of housing and nonresidential construction'sectors which remain mired in gloom'private spending and production gained some momentum toward the end of last year. The improved tone of the data is mirrored in the anecdotal reports I hear. Businesses seem slightly more optimistic about future sales and a bit more willing to hire and invest. The more positive tone of the data improves my confidence that the recovery is on firmer footing and will gradually pick up steam going forward. My modal forecast has changed only marginally in response to incoming data, but my assessment of the risks to the outlook for economic growth and inflation has become more balanced.

The forecast I prepared for today's meeting is very close to that in Tealbook and in my November projection. I raised my forecast of economic growth in 2011 by a few tenths of a percent, reflecting upside surprises in consumer and investment spending and the enactment of the fiscal package. But these positives were offset by developments since November, suggesting a deeper and more persistent housing downturn and steeper declines in house prices than I previously anticipated. The large overhang of existing homes for sale, the bulging foreclosure pipeline, the inability of homeowners with negative equity to trade up, and continuing tight lending standards are depressing house prices throughout the country. I expect the resulting negative wealth effects to take a toll on consumption.

For 2012, I lowered my growth forecast a few tenths to reflect the shift from this year to next year in the onset of fiscal drag. All in all, I now anticipate that, by the end of 2013, the level of real GDP will be a few tenths higher and unemployment a tenth or so lower than my November forecast. The essential contours of my forecast are unchanged. I envision a recovery that will strengthen but proceed slowly by postwar standards. As a consequence, unemployment will decline only very gradually, remaining around 7 percent at the end of 2013.

Turning to inflation, I have been surprised by the sharp upward movement in commodity prices, but data on core prices, compensation, and unit labor costs have been consistent with my previous forecast. And I continue to project that inflation will remain notably below the

2 percent level that I consider consistent with our dual mandate and will rise only minimally over the forecast period. A key issue with which I grappled during this round was how much to revise up my forecast of consumer spending in response to stronger incoming data. I ultimately decided that the staff's decision to revise up the level of consumer spending, but not the growth rate beyond mid-2011, is a sensible and balanced response. It seems dangerous to overblow the

significance of the surprise when it is out of line with the fundamentals, particularly changes in employment, wages, and wealth. As David discussed in his presentation yesterday, these factors have had a remarkably good track record in explaining fluctuations in consumer spending and the personal saving rate since the onset of the crisis.

Of course, perceptions concerning current and future labor market conditions and

income, and other factors, like access to credit, also influence consumption, and the staff tried to capture these influences with measures of sentiment. Yesterday's jump in confidence in the Conference Board survey suggests some improvement, but other surveys thus far reveal no significant or sustained rebound, even though most measures of sentiment are off their recessionary lows. Moreover, as David noted, the staff forecast assumes that sentiment will improve going forward, and the Tealbook growth forecast stands well above the Blue Chip consensus and near the top of our own central tendency.

On the labor market, in spite of December's drop in the unemployment rate, the number of new jobs in recent months has fallen short of the number needed just to accommodate the growing population. The decline in labor force participation, very modest gains in wages and compensation, and continuing perceptions in surveys that jobs are exceptionally difficult to obtain, all suggest that the labor market remains quite weak. I interpret the quit rate'the fraction of employed workers who voluntarily resign their jobs to search, exit the labor force, or take another job immediately'as a good measure of fear and perceived opportunity. Papers prepared and circulated for yesterday's discussion show that the quit rate is exceptionally depressed. The quit rate is now above the lows reached in the depth of the recession, but I take the very modest increase as a signal that improvement in the labor market is, thus far, quite modest.

The most significant change in my forecast versus November pertains to my assessment of the balance of risks. In November, I considered the risk to both economic growth and inflation as weighted to the downside, and I now consider them balanced. On the downside, I am particularly concerned about spillovers to spending and financial markets from further house prices declines and consider the risks well illustrated by the two alternative simulations in Tealbook. And, of course, spillovers to financial markets from European sovereign debt developments are a continuing source of downside risk. That said, I see more upside risk now that the recovery will be stronger than my modal forecast. For example, auto sales were quite strong during the fourth quarter, and this could foreshadow more robust spending due to pent-up demand for durables than is incorporated in the Tealbook baseline. I was struck that that baseline envisions declining vehicle stocks per capita over the entire forecast period.

With respect to inflation, like market participants, I am less concerned about deflationary risk than in November. Spikes in commodity prices create upside risks, but I agree with Tealbook's assessment that any pass-through to core inflation is apt to be quite modest. And I read the anecdotal reports as suggesting that firms still have little or no pricing power.

CHAIRMAN BERNANKE. Thank you. Governor Warsh.

MR. WARSH. Thank you, Mr. Chairman. Like many of you, I am encouraged not only by the improved economic data but also by the new tone in Washington. I'm sure many of you saw that last night the Congress had people sitting cross-party, cross-philosophy, and, in doing so, I think they're following our lead. After all, we've got Narayana and Charlie sitting next to each other, and Janet and me sitting next to each other. As for Jeff, we've got him surrounded. [Laughter] I'm not sure whether that new tone of civility is going to carry through the balance of our discussion today.

In preparing my remarks, I had at first entitled them, 'No Nation Is an Island.' But then I realized that some nations actually are islands [laughter], so I put a new title to my remarks: 'The U.S. Is Not an Island.' Let me talk about the U.S. economy first as if it were an island, because my sense is that developments in the United States would be considered quite encouraging in that case. We look a bit stronger and a bit more settled from the perspective of markets and the economy and politics. But beyond the island, the rest of the world looks decidedly less settled, decidedly less strong. Focusing first on the United States, the improvements on the real side of the economy appear to be real. I take a little less momentum from recent data in the fourth quarter into my 2011 forecast, in part because of the arithmetic of the GDP forecast that staff rightly took us through regarding net exports and so on. Still, there are encouraging signs that the Tealbook forecasts going back a couple of sessions seem to be more on point than off. Having said that, I'm still a bit more cautious than they are. Yet, I'm impressed by tax revenues that are flowing into the federal government and into states and municipalities, and I expect the deleveraging headwind to subside materially in 2011.

I will spend most of my remarks, though, on the risks to this improving modal forecast, given the current global policy conjuncture. Four risks come to mind. The first is geopolitics. I see an incredibly unhealthy brew of divergent recoveries across the world, increases in food and commodity prices, and, frankly, power vacuums in certain countries and certain regions. Second, as I will discuss in more detail, inflation'it's getting hard and harder, in my view, to deny inflation risks, if not real inflation problems, among many of our trading partners, and that's likely to lessen the flexibility that monetary policy has, at least in the eyes of many market participants. Third, as I will also discuss in more detail, is sovereign funding costs. The costs of capital for the countries that have been better prepared, better insulated, such as the United

States, Germany, and France, might well be the story of 2011. Fourth, as many people, including Vice Chairman Dudley, described, is the European crisis. Before I get into those risks, I have to note the improvements in financial markets, which continue to be highly supportive of the real economy. Now, if any of those trends were upset, I think the consequences for the real economy would be significant.

If you view the Treasury yield curve as a rough and ready indicator for the state of the domestic, or even the global, economy, you would have to note a few remarkable things. One is the run-up in yields and the steepness of the curve, which is probably mostly about good economic developments. The spread between the 30-year bond and the 2-year note has reached its widest level in history in the intermeeting period, and that has certainly gotten my attention. At 398 basis points, that spread has surpassed the previous peak of February 2010 and has put peaks from earlier recoveries in the rearview mirror. Now, at some level, this could mean a robust recovery. It could mean that the markets are gaining confidence, that the risks of deflation and double dip recessions are de minimis, and that's a view I share.

Why do I worry? Because it also could be something else. It's still hard for me to divine what the Treasury curve is telling us. If term premiums were to move beyond the current levels, which, according to memos from Nellie Liang and the group, appear normal, it could turn out that sovereign funding costs for the advanced foreign economies like the United States move up in 2011, not just as a sign of improved economic fundamentals. What else could cause the spreads to widen? Inflation risk premiums could. If they were to move up materially, output gaps notwithstanding, Treasury curve steepening could make the recovery harder to pull off.

Let me turn to some of those global risks. I would say, in sum, that the upside inflation risks in the medium term are materially greater than the risks around GDP. Inflation risks are

spreading from the smaller emerging markets to the BRICs and the advanced foreign economies, and the question is: Will they spread to us? Start some months ago, even quarters ago, with the situation in Vietnam and Indonesia. Then, take the narrative through increases in inflation risks in Brazil, Russia, India, China, and, more recently, South Korea. Think about the policy conundrums in the United Kingdom. Think about policy risks for the European Central Bank. You see many policy authorities taking ad hoc measures, in addition to policy rate changes, to try to contain this surge in inflation. Some are successful and some are likely to have far less positive consequences. I think markets perceive that policymakers are losing the flexibility to respond should these inflation risks become more significant.

None of the cases I've mentioned are perfect analogies to the situation in the United States, but choosing a country that actually is an island'the United Kingdom'might be the best example we can find. In spite of large spare capacity, austerity in fiscal projections, and a series of one-off factors that are no doubt driving headline inflation, inflation risks have many worried. Governor King gave a strident and, I daresay, strong defense of the United Kingdom's monetary policy yesterday, but he was forced to acknowledge that, over the course of the last 46 months, inflation has been above the Bank of England's target for 41 of those months. At some point, he seemed to acknowledge that that could likely move up expectations, and he would be prepared to take action. He noted upside risks to inflation, and I think many in markets are taking that speech to suggest that he might need to do some modest monetary tightening, even though that involves huge communication challenges and could do some harm to the growth trajectory in the United Kingdom.

I say this not because they're in a situation that's impossible. I say this not because the analogy between them and us is perfect. But if you think about the good, healthy debates at the

Bank of England going back some months about whether they should engage in their own version of QE2 and how divided they were, I suspect that that option is, at least given the current set of facts, off the table. I think that should remind us that we need to be cautious, that we need to be watching the data, and that the situation in front of us, even if the economy improves with the vigor that the Tealbook suggests, could be one that is quite a difficult challenge for policymakers.

Finally, a risk related to continental Europe. One challenge that has been touched on both by staff and many of you is the refinancings that are necessary in Europe over the course of 2011. They have $1.3 trillion that must be rolled over in the next 12 months. Most of that is front-loaded, and most of that is funded in the short term. Market commentators seem to have taken great comfort from the fact that many of those countries that need to roll over much of their funding have been 'successful' in doing so. But if you look closely at the successes in funding by some of the peripheral countries, you might take far less comfort. First, many of the buyers of the securities are many of the same institutions that give us concern. Second, many of those that are buying the debt are doing so based on the implicit guarantee that the stronger countries would be there to bail them out if anything went wrong. A couple of you noted that, to the extent that the U.S. economy only slowly but surely improves, we could see the European problems find their way into our economy through financial markets. I think that is the most likely channel for harm to the United States.

Another takeaway for me from the European situation is that the core of Europe matters most in 2011, that is, the situation in France and Germany. I think the reason that markets were so nervous in the spring about problems in the periphery is that they weren't sure whether Germany was going to step up and foot the bill. Markets have now become convinced that

Germany has rededicated itself to the euro, that Germany has decided against some of the screams within the political classes, and that it will defend the euro, so that now markets are less nervous about problems in the periphery. I think that will hold true unless German sovereign rates move away from them not because of improved economics, but because the contingent liabilities of the periphery have to be paid for by someone, and markets demand that out of the long end of the German yield curve. If that should occur, I would expect that the German political leadership would have to revisit this cause. I can't predict that it will occur, but, if it does, I could see a scenario where sovereign rates at the long end move up pretty significantly in most countries around the world.

In addition, it's not just core countries that will matter in 2011, but also core banks. I think Eric made proper reference to the 'strong banks' in Spain as one example. The CDS spreads for a couple of the strong banks have moved. Regulators still seem to believe that they are going to be just fine, that the bank restructurings that are necessary in Spain and in Germany are not among the core institutions. But if that assumption turns out to be faulty, if it turns out that these institutions do not have either the quality or the quantity of capital that they purport to have, I would say all bets are off and the situation in Europe could become very significant.

With that preoccupation with the downside risks, I will end where I began by saying the data have been more comforting for us in the U.S., but our gaze will probably have to look over a couple of oceans to decide whether our 2011 projections come true as many of us hope. Thank you.

CHAIRMAN BERNANKE. Thank you. Governor Duke.

MS. DUKE. Thank you, Mr. Chairman. Credit quality continues to improve, with some banks showing quite dramatic improvement in the fourth quarter and most banks expecting

continued improvement next year. As credit metrics in the outlook improve, however, some bankers are already seeing the first signs of conflict between their accountants and their regulators over the proper level for reserves. Running through major loan types, C&I lending, with the exception of small business, was never a major credit problem in this cycle. Auto has returned to normal, with loans available across the credit spectrum. Credit card charge-off rates are declining, in some cases sharply, and are expected to return to normal levels this year. Residential mortgage lending is the area of greatest concern. Entry into delinquency brackets has slowed, but exit from delinquency has also slowed, with problems in foreclosure procedures across all major servicers. In commercial real estate, the outlook is, oddly, brighter. Banks are beginning to see reductions in the dollar level of problem loans. When loans are restructured or extended, it takes 6 to 12 months of demonstrated performance under restructured terms before the loans can be upgraded, and some early restructures are now passing this threshold. In addition, banks are aggressively selling troubled real estate assets and are finding ready buyers at or above their marks. Fundamentals such as vacancies and average rents range from stable to improving. Investors have lowered cap rates in line with interest rates, and more sales transactions are occurring. Bankers did caution, however, that continued low interest rates hold the key to the outlook for commercial real estate. Risks to the outlook for credit improvement more generally are declining house prices, unemployment, and interest rates.

Loan demand is still quite weak. Competition continues to heat up for C&I loans and is gradually moving down from large commercial lending well into middle-market lending, and a few banks reported seeing a brief but noticeable pickup in small business application flow in December, but no one was ready to call it a trend. In our aggregate bank data, we have seen growth in C&I loans and in residential mortgages. Banks are becoming increasingly focused on

the need to generate assets. The C&I growth is due to some increased demand primarily for transaction needs, such as the opportunity to buy something'equipment or mineral rights, et cetera'at a bargain price, or to fund mergers and acquisitions. Bankers have yet to see demand prompted by business expansion, and, while they're still adding to approved credit lines, usage of existing lines remains at historical lows.

Mortgages held at banks are increasing, but overall mortgage debt is still declining. Banks are choosing to retain portions of GSE-eligible and non-eligible originations to offset declining portfolios and weak demand in other areas. Similarly, credit card securitizations are extremely low, as banks elect to keep the production on their balance sheets. Finally, bankers caution that they still have significant loan portfolios in liquidation or runoff mode that will mask new production for some time. All of this leads me to believe that loan supply is not meaningfully constrained by capital or liquidity but rather by assessments of creditworthiness and prospects for recovery. Meanwhile demand from creditworthy borrowers continues to be weak.

The Small Business Lending Fund initiative that has been passed by the Congress and launched by Treasury allows Treasury to purchase preferred stock from banks with total assets less than $10 billion and is designed to incent them to increase small business lending. The rate on the stock drops from 5 percent to 1 percent for banks that increase lending by 10 percent within two years. Conversely, the rate increases to 7 percent for banks that do not increase lending, and the rate goes to 9 percent after four and a half years for all banks. For healthy small banks that already have TARP capital under CPP, it would make sense to exchange that for capital under this program with the potential for lower rates and the elimination of compensation restrictions. For healthy banks without TARP, it could serve as bridge capital until more

permanent capital sources become available or in anticipation of the need to replace trust preferred as a source. Less healthy banks that are in need of capital due to existing losses are not likely to be approved for the program. As of January 10, Treasury reported 71 applications, of which 38 were non-TARP and 33 were TARP banks, and we're working with the other agencies on approval processes. However, the President doesn't need to look very far for needless regulatory burden. Under the legislation, for banks to receive credit for small business loans made, every small business borrower must certify that he or she is not a sex offender and must update that certification annually that he or she has not become a sex offender in the previous year.

Finally, banks' earnings are quite threatened by the loss of revenue from debit card interchange fees. The industry had drifted into a model where checking account profitability was largely generated by overdraft fees and debit interchange income. With both of these sources of revenue sharply curtailed, most banks are looking at restoring checking account fees and charges for debit cards. In addition, many are rethinking branch networks and looking for ways to lower deposit delivery costs. None of these measures is likely to offset the revenue loss. Look for a significant hit to profitability upon implementation, and only slow recovery as new fees are implemented. Also looming is the threat of credit card interchange restrictions. With interest margins reduced by lower levels of earning assets and stronger competition for the assets that are available, as well as severe regulatory hits to noninterest income, banks are likely to struggle for core operating income. The struggles may be masked for a time by improving credit costs and reserve releases.

Turning now to the economic forecast, I subscribe to the staff forecast as described in the Tealbook and agree that downside risk is less than the last time we met. I would offer two

nuances based on my conversations about credit. First, I fear that the outlook for real estate investment, even at the revised lower levels, might not materialize. As I've said in the past, this concerns me because this investment is a much more significant fraction of the forecast for improvement of GDP growth than it is of the overall economy. In addition, while employment in construction was less than 7 percent of overall employment at the peak, through December 2010, net job losses in the construction industry are nearly 30 percent of total jobs lost.

Second, as credit availability returns, there appears to be a bifurcation between the haves and the have-nots. Large companies have credit; small companies have not. Companies in the health-care or energy sector have credit; companies in businesses related to real estate have not. Consumers with high credit scores have multiple credit card solicitations; subprime borrowers are likely to be closed out for some time. Homeowners or potential homebuyers with significant equity or down payments can get mortgages for purchase or refinance, while others cannot access the best rates even with good income and credit scores. We could be surprised by continued strength in consumer spending if its recent improvement turns out to be driven by greater confidence among the haves, because that group may not be as credit-constrained as the averages would suggest. While I'm seriously concerned about the ugly social consequences of such a bifurcation, I think it might provide some reason for optimism about growth in consumer spending. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Tarullo.

MR. TARULLO. Thank you, Mr. Chairman. With respect to the economy as a whole, I think what we've seen is characteristic of the kind of recovery that occurs after major financial shocks, which is to say it has been a gradual, somewhat jagged path of recovery. Therefore, inferring from what many of you have said, the interesting question for 2011 is whether we're

going to break out of that pattern of some ups and downs and instead get a stronger, more self- reinforcing recovery dynamic, or whether the continued drag from the housing market and more hope than realization of increased employment gains will once again pull us back down a bit and return us to a jagged pattern of recovery. On those latter points, I would agree with what many have said already. I just want to add a point on the housing market. I think the problems with foreclosure documentation now look to be on the bad side of initial estimates of the delays and costs that will result. Quite apart from irregularities at individual servicers, the MERS problems run very deep indeed and are almost surely going to result in some delays and quite a bit higher costs than I think many expected.

With respect to the recoveries from financial crises, obviously this is a time when the economy is more susceptible to shocks than usual. I think Bill covered the shocks quite well, so I would just associate myself with his comments.

I'll make a couple of remarks on the euro-zone problems. I agree with those who have said the biggest short-term risk comes from the euro zone. It's relatively calm right now, both because of the rumors of more European-level initiatives and because of the ECB purchases of sovereign debt ahead of auctions. Europe is not using this period of calm to get ahead of the problem, which they would probably be best advised to do by building a credible firewall in Spain through strengthening the European backstops for sovereign debt, accelerating the programs of disclosure for all banks, and presenting a credible plan for recapitalization of at least the cajas.

However, Spain is moving ahead unilaterally on a variety of structural reform fronts. They also seem willing to address bank transparency and cajas recap issues, but I sense that they're somewhat reluctant to go full speed ahead when European policies are proceeding at such

a stately pace, for example, on stress tests at financial institutions generally. I think at this point most, if not all, of the important policymakers throughout the euro zone believe that proactive steps are indicated, and they're being held back by significant domestic political problems in both the stressed and the core countries. As all of you know, Ireland's government is endangered as Irish citizens see what the failure to regulate their banks is going to cost them. The German ruling party has faced coalition problems as German citizens resist the idea that they should pay for what they see as fiscal irresponsibility in the periphery. Portugal doesn't want a program at all, notwithstanding the fact that officials in the core countries are trying to push it upon them. So the mantra that Europe has the financial and technical resources to contain the problems remains true, but I think there is some continued risk that, if it were to spread to Spain, a reactive ad hoc response might not be enough owing both to the size of sovereign debt and to some of the unknowns around Spanish bank liabilities.

I want to turn now to the credit environment here in the United States or, more accurately, to the two credit environments that I think we currently have: one where credit is at least perceived by many to be in unreasonably short supply, notwithstanding the positive developments in the economy as a whole, and another where we may'and I emphasize 'may''be seeing the early signs of some frothiness. With respect to the first environment in which small and medium-sized businesses operate in particular, it's clear that lending to such firms has been quite circumscribed, at least as judged by historical standards. We have all heard complaints from representatives of such businesses that they cannot get loans that they say could be used to expand their businesses and create new jobs. We have all also seen the surveys and analyses that suggest that the problem is, at its root, a lack of demand by these businesses based upon a lack of assurance about future demand. I suspect many around this table share my

frustration at not being able to reach conclusions based principally on data rather than impressions, though. Again, I suspect that, like most of you, I'm inclined toward the lack of demand explanation.

But when, in the course of conversations with labor economists and in anticipation of the discussion we had yesterday, some of them explained the still slow pace of job creation in part by what they characterized as a credit squeeze on smaller businesses, I decided to try, at least, to find some other sources of data that might put the issue in some perspective. I looked at the BLS business employment dynamics data series, which breaks down job growth and destruction by size of firm to see how job creation in the present recovery compares to those following prior recessions. Unfortunately, the series doesn't go back to the major recessions of the early 1980s and mid-1970s, it's pretty badly lagged (by almost eight months), and it still doesn't give all of the information that would be useful. Other than that, it's actually a terrific data series. [Laughter] Given all the qualifications on how useful this inquiry would be, I looked at the shares of gross job creation by small, medium-sized, and large businesses in the recoveries from the mild recessions of the early years of both of the past two decades and compared them with the proportion of job creation in the early stages of the present recovery'this is gross job creation, not net. It's interesting that the shares of gross job creation by the smallest businesses'that is, those with 1 to 10 employees, which I assume are generally excluded from borrowing from banks'and by the largest businesses'those over 1,000, which we know to have had good and cheap access to credit for some time now'are both modestly but noticeably higher than their shares in the previous two recoveries. Therefore, the share of job creation by medium-sized businesses is several percentage points lower than in past recoveries. This observation is consistent with the story of an unusual credit squeeze on small and medium-sized

businesses, though it hardly validates that story. And in truth, the biggest fact that jumps off the screen as one looks at this data series is how few total jobs are being created relative to any time in the last 20 years.

Switching now to the other environment, that in which credit is not only readily available but perhaps so abundant and cheap as to invite a kind of domestic variant on a carry trade, it's obvious how sustained low interest rate conditions can create such an environment. Tom has been talking about them for well over a year. But I, at least, have assumed to date that these risks are more likely once greater confidence in the likely trajectory of the economy has set in and, thus, certain asset classes are commanding more assurance about their future value trajectory. So until recently, I hadn't seen much in either the financial stability memos or elsewhere to raise concerns, but now I think there are at least a few potential warning signs. The financial stability memo package that Nellie summarized yesterday identifies the leveraged loan market and farmland prices as worth watching'because Tom spent a good deal of time on farmland, I'm not going to say anything more about it. The leveraged loan market, with its duration advantage for investors over junk bonds, seems to be growing rapidly. I notice that just this month Prudential, PIMCO, and Nuveen have all started leveraged loan funds. Of course, the loans themselves are still originated with banks. So we can take advantage of our strengthened links between financial stability analysis and supervision to provide CPC teams and Board staff with some background and some things to watch for. A similar exercise is clearly going to be useful for the banks that provide lending for farmland acquisition.

While our supervisory function provides a good window onto developments in these specific markets'as well as potentially serving as a tool for affecting those forms of credit, if necessary'there may also be some new areas of leverage or financial engineering that don't so

closely involve our supervised institutions. One interesting example of this is innovations in ETFs, including leveraged and synthetic funds. Bill Dudley and I were at an FSB meeting on assessing vulnerabilities a couple of weeks ago, and there was a fairly interesting and extended discussion of the changes in the ETF industry. Leveraged and synthetic funds are still a pretty small part of the ETF universe, but they're growing rapidly. It's noteworthy, to me at least, that, of the five big U.S. players in this universe, only one is a bank holding company, and it is clearly grounded in plain vanilla ETFs and a classic asset management function, so that innovations are taking place outside the regulated sector. We can inquire into whether any leverage is being provided by banks, of course, but it may be that other channels of monitoring, such as through the SEC, are needed. This, of course, raises the question of what tools would be available were we to observe developments that we think are troublesome in any of those areas. I think we can all agree that more-targeted tools are far preferable to monetary policy as a means of controlling any emerging asset bubbles, particularly when credit is still constrained in key parts of the economy. Thus, as I suggested a moment ago, this question of tools for use outside regulated institutions could become quite significant over time. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Raskin.

MS. RASKIN. Thank you, Mr. Chairman. The economy has entered 2011 with more momentum. We're seeing promising upticks in business investment in equipment and software, and potentially sustainable increases in industrial production. Appearing positive but not yet definitively propelling are improvements in auto sales and net exports, which are also moving demand. Conditions in the labor market have improved modestly, but considerable slack remains. Despite these upward positive trends, the housing market, in particular, continues to be troubled and is exerting downward pressure on economic growth. The housing market shows no

signs of emerging from the significant overhang of real estate that is in foreclosure or entering the foreclosure process.

I continue to be troubled by the failure of financial institutions to address comprehensively the underlying causes of mortgage documentation and related servicing problems. Giving short shrift to these problems unnecessarily elongates the pace of sales of foreclosed properties, which contributes to lower priced and lower quality housing stock, both of which will result in weaker consumer demand and stunted national growth until addressed.

In addition to these persistent operational risk factors in servicing, home foreclosure rates will likely be higher this year as financial institutions publicly assert that they have fixed their internal servicing problems and restart the foreclosures that had previously been halted. In other words, the properties subject to foreclosure that were held back by financial institutions during the robo-signing period will most likely come to market, and these surges will increase the uncertainty of supply, resulting in further uncertainty regarding home values. If more documentation and processing problems resulting from operational inadequacies come to light, the delays in the recovery in the housing market will be extended. In addition to the elevated volume of home foreclosures, elevated inventories of unsold homes and high vacancy rates for commercial properties contribute to the overhang exerting downward pressure on home values. The quality of many homes also has deteriorated, resulting in more downward pressure on prices. In short, the day of reckoning, when institutions that service loans address the failures in their processes and systems, apparently has yet to come, and, therefore, the process of clearing the housing market will remain fitful and unpredictable. All of these possibilities could depress house prices, discourage potential homebuyers, and depress housing starts.

I'm also not certain that the allowance for loan and lease loss reserving that banks have done in response to foreclosure-related investigations and litigation is adequate for future losses. If such investigations and litigation entail significant cost, concerns could be renewed about the adequacy of bank capital. There also could be further damage to the confidence of firms and households, leading to delays in purchases of business capital and consumer durables. If severe deficiencies in reserves were to materialize, credit availability could again contract.

Inflation expectations have remained anchored despite the fact that core inflation remains low. This stickiness benefits the recovery by preventing the natural contraction in economic activity that would occur were real interest rates to rise more dramatically. My previous forecast noted that reductions in employment, income, and wealth had left many households with the need to repair their severely distressed balance sheets. In short, I don't believe that consumer confidence has returned yet to the levels that would be necessary for a faster paced recovery.

My previous forecast also noted continued uncertainty regarding the mortgage documentation problems, which, as I've described, act as a continuing drag on the resurgence of the housing market. I believe these problems have not yet been resolved. In fact, I think they could be exacerbated by related problems, such as the facts underlying the adverse ruling by the Massachusetts Supreme Court regarding mortgage assignments 'in blank.'

Neither my prior forecast nor my current one explicitly considers any additional, that is, beyond the baseline, effects of consolidation at the state level. In particular, even after making deep spending cuts over the last two years, states continue to face large budget gaps. At least 46 states struggled to close shortfalls when adopting budgets for the current fiscal year, which began July 1 for most states. Fiscal year 2011 gaps total $130 billion or 20 percent of budgets in these 46 states. To comment upon President Dudley's observation that this shortfall is a small portion

of GDP, I would add that these gaps come on top of the large shortfall that 46 states faced in fiscal years 2009 and 2010. States could continue to struggle to find the revenue needed to support critical public services for a number of years, threatening hundreds of thousands of jobs. Even for those states whose gaps have been filled and whose budgets are balanced, this story may not be over. Families hit hard by the recession will experience the loss of vital services throughout the year, and the negative impact on the economy could then be prolonged. In terms of federal aid to states, about $60 billion remains to mitigate these 2011 fiscal problems. By 2012, this number will be $6 billion.

Continued high unemployment could keep state income tax receipts at low levels and increase the demand for Medicaid and other essential services that states provide. High unemployment combined with households' diminished wealth due to fallen property values could continue to depress consumption. Thus, sales tax receipts also would remain low. These factors suggest that state budget gaps could continue to remain larger and last longer, themselves manifestations of a slow recovery. Thank you.

CHAIRMAN BERNANKE. Thank you very much. Thank you for a very good go- round. It's 10:55. I understand coffee is ready. Why don't we take 20 minutes?

[Coffee break]

CHAIRMAN BERNANKE. David, did you have any report to make on data?

MR. STOCKTON. We circulated a table on the new single-family home sales that came out this morning.5 As you can see, they rose a whopping 17.5 percent to 325,000 units. However, to place that increase in perspective, I would direct your attention to the lower left panel that shows the graph. I think this constitutes something pretty darn close to 'moribund' in

5The materials used by Mr. Stockton are appended to this transcript (appendix 5).

our view. We had been expecting some rebound at 315,000 units, so this is a little better than we expected, but not enough to change our basic story.

CHAIRMAN BERNANKE. Thank you, David. I'd like to thank the Committee again for the useful go-round. Let me try, as usual, to summarize and then I'll make a few comments.

The tenor of the incoming data has increased most participants' confidence that a moderate recovery is under way and will continue through 2011. Consumption spending has been relatively robust recently, and investment in equipment and software and exports have also been relatively strong. Payrolls are expanding only slowly, but other indicators in the labor market, including UI claims and surveys of employers, are more positive. Regional and national surveys of producers remain encouraging. However, overall the economy's adjustment continues to be uneven and slow. Residential construction is a particular weak point. The fiscal compromise enacted in December will provide some additional stimulus, but state and local governments remain a source of fiscal drag. Commodity prices have risen, but measures of core or trend inflation remain low. Risks to both growth and inflation appear more balanced than in the past.

As noted, household spending has picked up recently with a surge in auto spending, more luxury spending, and good holiday sales. There are still some questions about the strength of the supports for consumer spending, for example, employment, income, and wealth. In particular, the inventory of unsold homes, high rates of foreclosures, and tight credit continue to push down house prices, hurting household wealth as well as bank balance sheets, and unemployment seems likely to come down only very slowly. Nevertheless, household confidence has improved slightly.

Many businesses are expressing cautious optimism about the durability and strength of the recovery and are laying the groundwork to expand production when the time comes. Much investment is aimed at productivity enhancement rather than expanding employment, however. Some participants reported that they had heard that skill requirements are being upgraded and that some of the unemployed are underqualified, while other participants suggested that workers at all skill levels still remain easily available. Much hiring is focused on temporary workers. Uncertainty about domestic regulations and taxes may have declined somewhat. Global demand is strong, but the divergent pace of recoveries around the world, building inflation in emerging markets, and sovereign debt costs pose risks to the global recovery. Among key sectors, manufacturing, services, and agriculture are showing strength. Construction remains weak, though commercial construction is showing signs of bottoming out. Larger firms face no shortage of credit or liquidity, but credit remains tight for smaller firms.

Financial conditions remain supportive. European sovereign and banking problems have been more quiescent of late but remain unresolved and pose risks to the U.S. through money market funds and peripheral banks, among other channels. U.S. banks have had better asset quality and are making more loans, but they face problems, including servicing and mortgage documentation issues, loss of fee income, tight interest margins, and weak loan demand. There may be some frothiness in the leveraged loan market. State and local finances do not appear to pose major short-term risks, but these risks could increase in the long run. Rising farmland values are another risk to financial stability.

Core and other trend inflation measures remain quite subdued, although indicators such as the median CPI suggest that the ongoing decline in inflation may have stopped. Higher prices for commodities and for imported goods, especially from emerging market producers, have

raised input costs for most firms, although unit labor costs remain very low and profit margins are high. Firms will try to pass through some of these higher costs in some areas, but it is not yet clear whether they can make price increases stick. Inflation breakevens have risen in recent months. Overall inflation expectations seem to have normalized close to the mandate-consistent level. Participants debated the value of resource slack as a predictor of inflation and suggested other measures, including the rate rather than the level of output growth, as well as a suite of statistical models. There was agreement, however, that inflation risks have moderated and that inflation trends should be closely monitored. Any comments? [No response] Okay.

I would like to add just a few things. Like all of you, I was pleased with the intermeeting data, and I think the economy is certainly making progress towards a sustainable recovery with fading downside risks, and that's very encouraging. In particular, I think the real news was the strength in household spending in the fourth quarter, which was about 4 percent growth. Of course, it depends on how you look at it. Under some theories, consumption spending is a perfect predictor of future income, and in that context that would be very encouraging. But I think that I wouldn't go that far, so the question remains, as Governor Yellen mentioned and as the Tealbook mentioned, about the extent to which we should carry through the innovation from the fourth quarter into 2011. I think we should do so a little bit, but we also should be somewhat cautious. First, consumption spending in the fourth quarter was heavily concentrated on autos, which could be a very positive sign, on the one hand, since durables are, of course, pro-cyclical, but, on the other hand, there could be some quirky elements to that, and it will be important to see if that strength persists. The other point is that, as Governor Yellen mentioned, consumption fundamentals still remain somewhat weak. In particular, labor income has been quite anemic. Real disposable income increased at only about a 1 percent annual rate in the second half of

2010, reflecting very slow increases in hours, low labor participation, and slow growth in wages. Of course, we also see that'even though deleveraging has been going on'with declining house prices, wealth-to-income ratios have not really improved very significantly. Higher gas prices also are a minor negative. So I do expect households to be stronger in 2011, but I think it's a bit premature to fully extrapolate forward the strength of their spending in the fourth quarter. It will be somewhat more difficult at the next meeting or two to evaluate the underlying path of household spending because of the payroll tax cut that will cause a big surge in disposable income in the first quarter. So that will be a challenge for us as we try to ascertain the durability of the recovery.

I think what most of us are waiting for, and what I'm certainly waiting for, is to see a couple of strong employment reports. That would do a lot to increase my confidence that firms are back in an expansion mode, and that they have increased their confidence about the recovery, and, in particular, that labor income will be forthcoming to support household spending as well. It has been disappointing to this point that, despite many straws in the wind, the job gains have still remained fairly limited. So we'll have to continue to watch for that.

That being said, I think we should continue to remember, as I mentioned last time, that we are starting from a very deep hole. The employment-to-population ratio, which is now less than 58 percent, is at the business cycle low and is as low as it has been in many years. I noted in a newspaper column the other day the interesting fact that, for the first time in 30 years, the employment-to-population ratio of prime-age, that is 25 to 54 years old, workers in the United States is lower than in Western Europe. This is a striking turnaround, given our image of Western Europe as having very low employment-to-population ratios. Again, I look forward to

one or two strong job market reports as an important indicator, recognizing that the situation is not going to turn around overnight.

We had an interesting discussion around the table on inflation. I think it's pretty fair to say that there is essentially no domestically generated inflation. All the inflation we're getting is from abroad, that is, from commodity prices and from import prices. And that, in turn, is arising from what I would characterize as deep problems in the international monetary system and in the global economic system. In particular, the export-led strategies of emerging markets' particularly China, but others as well'has led them to overheat. They are, indeed, facing inflation risks, as Governor Warsh mentioned, and, as President Fisher has reminded us on many occasions, they can export those inflation risks to us via commodity prices and import costs.

I'm not quite sure what to do about that. The Federal Reserve Act says we should be making policy for the United States, not for the world. So how are we supposed to respond to a situation where many countries are, in the old language, not playing by the rules of the game? I think this is an area where we need a broader d''tente, quite frankly, and during discussions of the international monetary system in the G-20 under France's leadership, I hope that we can make some progress. In the meantime, we're just going to have to figure out the appropriate tradeoffs, and, in particular, make sure that commodity prices and import prices do not begin to infect the domestic inflation rate. I take that, of course, very seriously.

As a bit of encouragement, I would note that some fundamental correlates of inflation in the United States remain very well controlled. Nominal GDP growth, for example, which I've mentioned before, was less than 4 percent in 2010 and in the fourth quarter of 2010. The Tealbook forecasts nominal GDP growth to be 4.8 percent for 2011. It's pretty hard to get 3'' to 4 percent growth and high inflation and still have nominal GDP growth of less than 5 percent.

So I think that's an indicator we can continue to pay attention to. Unit labor costs are another indicator'they declined for the entire year of 2010, and they're projected to grow at a

0.4percent rate for 2011 and 2012, so that, too, will be an anchor on inflation. Of course, I think we all agree that vigilance on inflation will be necessary, and one thing that would certainly make me seriously rethink our policy stance would be an upsurge in inflation expectations or a serious upsurge in commodity prices. We would have to take those very seriously if, indeed, they occurred. That being said, given the unique nature of where inflation is coming from, I think a bit of patience is probably a good idea.

We had differing views on whether or not our current asset purchase policy is working. You may not be shocked to hear that I lean more towards President Bullard's view on this subject. [Laughter] Of course, it's always very difficult to know (as Barney Frank has said, you can't put a counterfactual on a bumper sticker), but the evidence suggests, first, that, as President Bullard noted, the response of a wide range of financial indicators has been consistent with what you would expect in a monetary easing or in a situation where risk aversion had declined, both of which are outcomes of LSAPs. In particular, I mentioned last time that the increase in equity markets, the decline in equity volatility, the pattern of interest rates declining first and then increasing as expectations for economic growth broadened, the rise in inflation breakevens, the decline in credit spreads, the decline in the dollar, the rise in commodity prices, and so forth, are all consistent with a monetary ease. Then, since August or September, when I think this policy should really be treated as beginning, we've seen an improvement in the outlook. So I think that's all consistent with believing that there is at least some benefit emanating from the LSAPs.

Of course, that's one observation, so, to double my sample size, I asked the staff to calculate the same statistics for the months following March 2009, which was our previous

attempt. Without going through the details on all seven of those financial indicators, the patterns were exactly the same, and the lag between the action and the response of the economy was about the same. So there is, I think, some evidence that this has been helpful, recognizing, though, that there are important costs. President Fisher has been particularly assiduous in pointing out the balance sheet costs and expectational costs, and we'll need to take those into serious consideration as we reevaluate this policy going forward.

To wrap this up, I think the news basically has been encouraging. The economy looks stronger. This is still more prospective than actual. We should continue to watch very carefully what develops in the labor market, and we need to keep a close eye on commodity prices and inflation expectations as possible indicators that the inflation situation is becoming more worrisome. I'll stop there unless there are any questions or comments. Yes, President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I didn't catch what you said about prime-age workers. Were the statistics you were quoting about prime-age males or prime-age males and females?

CHAIRMAN BERNANKE. I'll check it for you, but my recollection was all prime-age workers.

MR. KOCHERLAKOTA. Okay. Thanks.

CHAIRMAN BERNANKE. If there are no other questions or comments, let's go ahead to the policy discussion, and I'll ask Bill English to introduce this round.

MR. ENGLISH.6 I will be referring to the package labeled 'Material for FOMC Briefing on Monetary Policy Alternatives' that was distributed earlier. The package includes the four draft policy statements and the associated draft directives that were distributed to the Committee yesterday.

6The materials used by Mr. English are appended to this transcript (appendix 6).

monetary accommodation when that becomes appropriate and so could lead to a greater-than-desirable increase in inflation that would be costly to reverse.

The statement under alternative C would provide an assessment of the outlook similar to that under alternative B but would drop the reference to factors constraining household spending and would note that 'business investment is rising.' The second paragraph would end by stating that 'there are some indications that the economic recovery is strengthening.' The final paragraph of the statement offers the option of providing an explicit numerical inflation objective, which might be seen as helpful if the Committee were worried that inflation expectations could come unmoored. However, the Committee may want to undertake additional preparatory work before taking such a significant step.

A decision to slow the pace and reduce the intended size of the Committee's securities purchases at this meeting would surprise market participants. The result would presumably be an increase in longer-term interest rates, lower stock prices, and a rise in the foreign exchange value of the dollar.

Finally, the Committee may feel that, with the economic recovery continuing, and probably gathering strength, further expansion of the Federal Reserve's securities holdings is not necessary to achieve the Committee's objectives. In that case, members might choose to stop adding to the Federal Reserve's securities portfolio immediately and signal a less accommodative policy path in the future, as in alternative D, page 5. That approach could seem particularly appropriate if members judged that much of the current elevated level of unemployment reflects a rise in structural unemployment that cannot be effectively addressed by additional monetary stimulus, as you discussed yesterday afternoon. In addition, some members may also be concerned that continued extraordinary policy accommodation could lead to the development of costly macroeconomic or financial imbalances.

An announcement along the lines of alternative D would come as a very substantial surprise to market participants. Interest rates would rise significantly across the yield curve, equity prices would fall sharply, and the dollar would appreciate.

Draft directives for the four alternatives are presented on pages 6 through 9 of your handout. Thank you, Mr. Chairman. That completes my prepared remarks.

CHAIRMAN BERNANKE. Thank you. Are there any questions for Bill? [No

response] Before we start the go-round, let me make a somewhat orthogonal comment. In

alternative C paragraph 5 there's a reference in brackets to a numerical inflation target, which we

put there as sort of a placeholder. You may recall that we've been discussing off and on the

issue of improving our communication and credibility by using a numerical target'we discussed

it at the videoconference in October. We have not yet come to any conclusion on that issue, despite the fact that there is quite a bit of interest in that approach around the table and that this may be a particularly good time from a political receptivity perspective. So, as I mentioned last time, this might be something we want to keep alive as we go forward.

After the last meeting, President Plosser came up to me and asked if he could be of any assistance on this, and I suggested that he might want to talk informally to a few people across the spectrum of the Committee to get a sense about whether there was any way forward on this. He said he'd be glad to do that, and he spoke to a few people during the intermeeting period. I wanted to mention this to everybody so that you'd know that some informal discussion has been going on, and I hope that's okay. It seems we've had plenty of formal processes on this in the past, and maybe just a few informal conversations could be useful. Everybody is, of course, entitled to have his or her own conversations or to contact Charlie, as you wish. If we make some progress in terms of a proposal or an approach, then perhaps we could turn it over to a more formal process and bring it forward to the Committee once again. In any event, we surely would not make any change to our communications strategy without a full formal review and Committee decision. Any concerns, questions? [No response] Okay, then let's turn now to the policy go-round, and I have President Lacker first.

MR. LACKER. Thank you very much, Mr. Chairman. From the comments during the economic go-round, I think everyone acknowledges the extent to which the prospects for economic growth have improved over the last couple of meetings, although there's also wide recognition of the need for a bit of caution about how exuberant one gets about them. I'm in the camp of doubting that our asset purchases made a huge contribution to the improvement, notwithstanding your observations, Mr. Chairman. I say that because I personally doubt that

changes in long-term yields have been very important to firms' investment and hiring decisions or to consumer spending decisions, which seem to have been at the core of the improvement in the outlook. The way in which growth has strengthened has reduced my assessment of the likely benefits of our asset purchases. I also doubt that we've had that much effect on yields so far. At the same time, I think the stronger outlook brings forward the time when we're likely to want to remove monetary stimulus. To my mind, then, it has raised the risk that continued balance sheet expansion will prove excessive, in the sense that it sets back the starting point for us to remove stimulus.

Let me note a couple of points. One is that bank reserves have not changed much at all since we began this asset purchase program. We're about to see a $450 billion increase over the next two months in bank reserves, so that undergirds my sense that we haven't seen much effect yet from what we've done, and we could well see a lot in the next couple of months. The second point has to do with inflation, and I think you were correct, Mr. Chairman, in your comments about the importance of being careful with this surge in commodity prices that's coming from overseas and affecting our headline inflation rate. Our experience over the last couple of decades has been that there is a measurable effect on core inflation from these energy price surges, so that's another justification for some caution about inflation going forward.

For me, the case for continuing the program is eroding a bit. I don't think it's reasonable to scale it back right now'in any event, we've done nothing to prepare markets for such a change, as is our well-established custom. It does seem to me, however, that there's a reasonable chance of data coming in over the next couple of months that are consistent with stronger economic growth. And I think you're right to highlight the employment report'if we were to get very strong employment reports in the next couple of months, I think that would change the

whole tenor of the outlook markedly, both in markets and within our Committee, and I think we'd seriously want to consider adjusting our asset purchase program in March.

In light of these thoughts, I see value in preparing markets for that possibility'not promising, but preparing them for that possibility through your testimony and through the minutes reflecting our concern about that possibility. I actually liked the original version of the last sentence of paragraph 3 of alternative B, despite the fact that it seemed to imply that we didn't review our program in December. We used the future tense there and the present tense here.

I also have concerns about other parts of the statement. Paragraph 1 of alternative B seems more downbeat than I think we are around the table. I think paragraph 1 in alternative C does a much better job of capturing where we are on the outlook. In particular, this litany of factors restraining household spending seems a bit discordant, because, as you said, the big news in the fourth quarter was that consumer spending was stronger than we thought. Therefore, I'd advocate substituting the first paragraph of alternative C for the first paragraph of alternative B.

I have one more thing. I applaud your initiating conversations and further discussions about an explicit numerical objective for inflation. I would just add this observation about these four words, 'or a bit less.' In the past, I've brought up my brother-in-law sitting in front of retirement planning software and calling up his brother-in-law who is on the FOMC and asking him what number he should put in for inflation for the next 20 years. And I'm wondering what I'd tell him if our objective was '2 percent or a bit less.'

MR. WARSH. We're going to get to that in the communications section. [Laughter] MR. LACKER. Even though I've advocated 1'' percent, I'd be happier with 2 percent

than with '2 percent or a bit less.'

CHAIRMAN BERNANKE. Thank you. President Rosengren.

MR. ROSENGREN. Thank you, Mr. Chairman. I support alternative B as written. We should stay the course. Inflation remains well below my inflation target and output well below potential through 2012. With the very low inflation rate forecasted to continue for several years, we have ample room to be accommodative and encourage more rapid growth. I expect to complete the entire purchase program. Our purchase program is certainly consistent with our dual mandate. In fact, it would be justified if we had a sole mandate of targeting 2 percent inflation over the medium term. Thank you.

CHAIRMAN BERNANKE. Thank you.

MR. FISHER. Could you take a little bit longer, President Rosengren, with your summary? [Laughter]

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I will take up some of President Rosengren's time. [Laughter] I support alternative B, but I would recommend some changes in language. Like President Lacker, I prefer the first paragraph of alternative C, because I think it does a better job of reflecting the change in the data that we've seen in the intermeeting period, which is the point of that paragraph. In paragraph 4 of alternative B, I would like to propose the following edit: Change 'stable inflation expectations' to 'stable longer-run inflation expectations.' I think short-run inflation expectations have not been as stable as longer-run expectations have been, and, since we're probably more interested in longer-run expectations anyway, it's worthwhile putting that in.

If I'm being asked to choose between the last two sentences of paragraph 3, I prefer the penultimate one to the ultimate one. My attitude is: If we're not changing our program, then why change the language?

I wanted to say a few words about the future. As I said earlier, I think monetary policy is an exercise in contingency planning and in risk management. I think the Tealbook does a great job of identifying the key risks. On pages 6 and 7 of Part B of the Tealbook, the staff leads us through a very imaginative scenario'I applaud them for taking it on, and I think what they did was really cool. They take the NAIRU as actually being 6'', but the central bank will only learn that fact slowly. The analysis concludes with the following sentence, which I viewed as ominous: 'The inflation consequences would be much larger and more persistent if the public were to misread higher-than-target inflation as a sign that the FOMC had raised its long-run inflation target.' Given the reaction to the second LSAP, this kind of miscommunication and misinterpretation is a real possibility, and we should be thinking about conducting monetary policy to manage our exposure to this risk.

To that end, I'm going to describe three scenarios under which we'll need to make a decision about our strategy. For simplicity, I'm going to say that our next decision point is June, though, obviously, whether it actually is or not depends on what happens. The first scenario' and, by the way, I don't think it's the most likely case'is an adverse one. Unemployment remains near 10 percent. Quarterly and year-over-year inflation remains subdued at, say,

1 percent or even less than 1 percent. Short-run and longer-run inflation expectations remain in the 1'' to 2 percent range. This basically describes the status quo. In this scenario, I do not believe there's a need to expand the LSAP or to contemplate exit in the near term. I think the current monetary policy stance would be appropriate. Of course, we can all imagine scenarios

even worse than this, and, if they materialized, we would, I think, want to expand the extent of our accommodation. Because of our conversations last fall, we have a pretty good understanding of how that accommodation might work, although I would recommend expanding our set of tools beyond the LSAP.

Let me turn now to what I view as the most likely scenario. Output growth in the first quarter is at least 3 percent, maybe closer to 4 percent. Employment growth averages 200,000 jobs per month for the next six months. Unemployment gets down closer to 9 percent than

10 percent. That scenario sounds like the Tealbook, but I want to add a key element that I was stressing in my economic go-round statement: Inflation has averaged between 130 and 150 basis points in the first half of the year, and market expectations imply that inflation will be about

170 to 200 basis points over the coming year from June to June. This scenario is consistent with my own forecast for inflation, and, perhaps more importantly, it's also consistent with the Blue Chip and financial market forecasts. If this scenario materialized, all three of the auxiliary measures of slack that I described in my economic go-round would have fallen in the first half of the year. And, presumably, we should be thinking about them as being even more likely to be at or near zero by the end of 2011. So the Committee would need to begin internal preparations for exit, and, in particular, we would need to decide whether we still liked the sequence of moves we seemed to have reached a consensus on last year: First, remove the 'extended period' language; second, start draining reserves; third, raise rates; fourth, start selling assets. In addition, we'd need to decide the optimal time frame for the preferred sequence of moves. Do we think about one, two, three, or even four meetings from initiation to get to the key step of raising rates? I think both kinds of topics would be appropriate in June, given what I've described.

The third scenario is the 'good news' outcome'and, like the first scenario, I think it's unlikely. However, I also view it as troubling, because I think we're largely unprepared for it. In this scenario, things turn out very well compared with what we expect. Output grows at close to 5 percent in the first quarter and looks just as strong in the second. Headline inflation in the first half of 2011 is over 2 percent, and core is between 1'' percent and 2 percent. Employment growth averages nearly 300,000 per month, although unemployment would still be above

9 percent. If this scenario materialized, we might need to initiate the first steps of our exit strategy as soon as August. We might need to compress the time we take for the four steps that I've described.

In considering the latter two scenarios, I think it would be very useful to have staff

analysis to address two specific questions by our April meeting. The first question is: If we drop the 'extended period' language, what do markets expect about when we're going to raise rates? Is it three months, six months? And what would be the consequences of moving faster or slower than markets expect? The second question, and President Lockhart has stressed this point before, is: How many reserves do we need to drain to be able to raise rates effectively? And how fast can we possibly do it without adverse consequences? I think that having this analysis in hand in April would put us in position to react to these last two scenarios in a thoughtful manner. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. I think that in 2004 there was an occasion where the language changed at one meeting and then there was an increase at the subsequent meeting. So there was only a one-meeting delay between the language change and the action. Obviously we can work that through. President Evans.

MR. EVANS. Thank you, Mr. Chairman. I want to start by talking about the Chicago Bears. I was going to try to link this point somehow to President Fisher's discussion of the Texas Aggies the last time, but, instead, I'm going to link it to paragraph 1. I've been in Chicago now for almost 20 years, and I've reluctantly come to embrace the Bears. This year, the Bears really weren't that great of a team'the fundamentals weren't really that good. But, somehow, things picked up, and they made the playoffs, and they made the championship game. Then, with all of the buzz in town, people got excited. And if you lost your discipline, you could sort of convince yourself that the Bears were really quite good. [Laughter] And, you know, they were quite good. However, they ran into a team that beat them, and that's because the fundamentals really were not as good as everybody had come to believe. And I think that the economy is a little bit like that. We've had some good numbers recently. That's very helpful, but the fundamentals are not quite as strong as we'd like. So I'd prefer paragraph 1 in alternative B as it is written'it's closer, certainly, to the way I view things.

Mr. Chairman, I support alternative B, and I view it as having several essential elements. Let me elaborate on my reasoning. As I first began articulating in the summer of 2010, I continue to hold the view that the U.S. economy requires aggressive monetary policy accommodation in order to be confident that we will escape our current liquidity trap conditions. These conditions emerged following a recession of historic proportions, an unusually rapid fall in underlying inflation, and a financial crisis that erased $11 trillion of net wealth at current count. These lost funds represent savings that households were banking on for future consumption and things such as college and retirement needs. I think the growth in the U.S. economy will be restrained by these losses for some time. The fundamentals are still sort of weak. Under your leadership, Mr. Chairman, our subsequent policies have been very helpful for improving the

economy's trajectory, and I fully supported them, and I agree with President Bullard's assessment of the asset purchase programs, although, of course, others can disagree about that.

However, my preferred policy course would have added an explicit and potentially substantial policy boost by adopting a state-contingent price-level target. Such a communications tool would still add a welcome commitment that our accommodation will not be withdrawn prematurely'and I think we're going to be talking about this all year long. Still, our additional communications regarding mandate-consistent inflation objectives have been a welcome step in that direction. In my view, our current approach is a pragmatic, second-best policy. For me, it's a compromise that I can embrace as long as the economic and inflation data continue to improve along the lines that we're expecting and we move towards our mandated goals, and as long as our policy accommodation is not withdrawn prematurely.

I recently stated publicly, while I was on a panel with Mike Woodford at the American Economic Association meetings in Denver, my view that our $600 billion of asset purchases helped to reinforce our policy statement that short-term nominal interest rates will remain exceptionally low for an extended period of time'that's what our FOMC statement says. It was a great pleasure to have Governor Yellen in the audience. Professor Woodford, of course, has also advocated price-level targeting. During the discussion, he agreed that committing to keeping rates exceptionally low was important, and, to his mind, more important than the actual asset purchases themselves. Therefore, I think this continues to be a combination that has some attraction within the economics profession and is a mainstream view of the current U.S. situation, although it is not necessarily widely accepted.

The other essential element is the target scale for our asset purchases. My reading of the data continues to be that it is too early to make a judgment about whether $600 billion or more or

less is appropriate. Directional improvements in economic data have been very welcome. More improvement is needed through the spring to add confidence to this assessment. I won't be surprised if the Committee's ultimate judgment is for a total asset purchase of $600 billion'as I already stated, the more critical judgment is to keep short-term rates exceptionally low for an extended period. I currently believe this will be important until actual data for broad-based, underlying, and sustainable inflation are coming in at at least 1'' percent year over year. If President Kocherlakota is right and we do get that kind of reading on inflation, I really don't disagree with his views on that scenario'but I view getting that reading as less likely. In any case, the data will come in, and, as they play out, we'll evaluate our strategy.

In terms of commodity prices, there are certainly risks, and we've faced them before. It seems to me that the analysis suggests that commodity prices don't impart that much pressure on inflation. Let me give you an odd example. Before our board meeting last Thursday, Dan Sullivan came to me and said, 'You know, we've got this inflation dashboard that a couple of our directors wanted us to put together, and it looks at different indicators. And right now, commodity prices are flashing red.' I said, 'Oh, that's surprising. I didn't know that inflation would be rising.' And he said, 'No, no, no, no. The commodity price indicator is indicating lower than average inflationary pressures.' That's totally counterintuitive, right? Let me tell you how this works. We use an analytical approach that tries to convey the additional information contained in the commodity price indicator, that is, 'additional' relative to the history of inflation. Well, in a regression that looks at past inflation, those data are signaling low inflationary pressures. When you tell the program to look at commodity prices, it basically says, 'Thanks for calling.' In other words, it doesn't add anything, because it just can't overcome the disinflationary effects. Of course, we can have different views on the type of analysis, and

outcomes can differ. For example, the outcome was different in 2008, when we were somewhat worried about commodity prices. Even I started worrying about commodity prices in August 2008, and inflation ended up falling. Now, if you like to put weight on Phillips curves, this analysis is not a hard thing to embrace, because unemployment went up'a lot of slack was created'and inflation went down. If you don't like to look at resource gaps, then it's even more puzzling that inflation fell, but that's not for me to talk about.

So, on that basis I think that if inflation gets up to 1'' percent, then we'll have to start worrying about it. And, of course, we have to monitor it'no doubt about that. We also have to look at the labor market trajectory and have confidence that it's trending towards a path that can plausibly be characterized as consistent with our mandate. I agree that a couple of strong jobs reports would help add that confidence. So, Mr. Chairman, I support alternative B and the important elements therein. Thank you.

CHAIRMAN BERNANKE. Thank you. President Plosser.

MR. PLOSSER. Thank you, Mr. Chairman. Last fall when we deliberated whether or not to institute a new round of LSAPs I expressed my misgivings about that strategy. In my view, the potential costs of such a policy, which I viewed as occurring in the intermediate to longer term, outweighed what I perceived to be the short-run potential benefits. I still hold that view.

Determining the appropriate timing of when to begin to reverse the path of policy always poses a challenge for this Committee. By necessity, we have to make this decision with some degree of uncertainty, given the lagged effects of monetary policy on the economy, the imprecision and uncertainty surrounding our forecast, and even revisions of data at times. That part is nothing new. However, I view the risk of getting behind the curve this time as likely to be

higher than usual. Both the size and composition of our balance sheet complicate our exit strategy, raising the risk that we won't be able to respond as rapidly as we should to curtail potential inflationary pressures. My view is that our focus on the level of output and the level of unemployment gaps raises the chance that we will not act soon enough. Thus, there are costs associated with the LSAPs that could loom large in the not-too-distant future.

I will repeat the point that I made in the economic go-round. From firms in my District, I hear a lot of talk about commodity costs, as well as a lot of talk about their reluctance to raise prices. While in some cases firms are seeing solid profits, many firms perceive their margins as being squeezed by the rise in costs and they're starting to consider seriously raising prices. If those firms believe that they're far behind the curve in that process, then we could be facing a time when those price increases may come fairly rapidly. And we may find ourselves in a position where we have to react both quickly and perhaps aggressively.

We talk a lot in this Committee about managing tail risk. It seems that we focus more on downside tail risks than on the other tail of the distribution. I'm simply pointing out that this is a risk we face and that we'd better be prepared for managing that risk or managing the outcomes if that comes to pass. I think President Kocherlakota's description of three scenarios is a good way to think about that.

In the fall, I thought the potential benefits of the LSAP did not outweigh the potential costs. I think economic growth began picking up in the third quarter of last year, not in the fourth'we had a 1 percentage point increase in growth rates from the second quarter to the third quarter. Deflation risks, as we have all noted, seem to have subsided. I think growth rates are going to be somewhat above trend for the next two to three years, and I believe that employment is going to pick up.

However, mine was not the prevailing view in the November meeting, and the Committee decided to go ahead with the second round of purchases. I accept that. In considering policy today, I recognize, though, that there are costs to introducing policy volatility. We risk confusing the public about our policy direction if we change too much or too often, without sufficient justification or conditions to warrant it. I think that source of uncertainty is something that we should try our best to keep small. I think that is the situation we are in today. So I don't think it would be prudent to begin curtailing the LSAP program today, even though I wasn't in favor of instituting it in the first place.

Moreover, I have never been a fan of trying to fine-tune policy when we are using the short-term interest rate as our policy instrument rather than asset purchases, so I think it would be a particularly bad idea to convey to the public that we can fine-tune LSAPs. In my view, LSAP policy should not be viewed as business-as-usual monetary policy. LSAPs are an unconventional policy tool, which should be reserved for times of economic crisis'when inflation expectations are falling, when there is a danger of sustained deflation, and when we are operating at the zero bound.

I don't think this is a policy we should try to fine-tune, because we do not have enough understanding of the effects that different amounts of purchases will have on the real economy in order to calibrate an asset purchase program to achieve our objectives. This means, I think, that once we have instituted a program, then there needs to be a clear change in the outlook to justify a change in the program. I don't think that has happened at this point, but I don't rule it out either. For example, it is certainly possible that, over the next few months, the economic outlook will strengthen further, with inflation rising and employment growing at a more robust pace. In that case, I would like us to be in a position to be able to curtail the LSAP2 program early. Even

if that doesn't happen, if the forecast plays out as laid out in the Tealbook, I would not favor another round of LSAPs if the economy performs under that scenario. In either case, I think we need to start planning for the eventual end. This means our communications need to be sufficiently flexible so that we will be in a position to allow the LSAP program to end in June, or earlier if the outlook calls for it.

We should also consider changes in the language that will allow us to implement other parts of our exit strategy, which may be raising interest rates, curtailing reinvestments in MBS, or other strategies we might want to consider. Furthermore, stressing economic growth rates, inflation, and inflation expectations in our description of the economic conditions would help convey the types of information on which we will be conditioning a change in policy direction down the road. By continuing to stress the level of unemployment, we risk creating expectations that this Committee will delay tightening until the level of unemployment reaches some desirable target. That would make our task even more difficult and make it hard to act in a timely manner.

Regarding the language, like President Kocherlakota and President Lacker, I think the tone of paragraph 1 in alternative B is too negative on the economy and is inconsistent, I believe, with the kind of language we have used here. In fact, as I noted earlier, the chart showing the balance of risks in our own forecasts has switched dramatically since November, and I think that the minutes and our statements need to reflect that change. I don't think alternative B, which looks a lot like alternative B from the last meeting, reflects that change. So I would prefer paragraph 1 of alternative C as a substitute in alternative B. In particular, I think phrases like 'Employers remain reluctant to add to payrolls' are too negative. It would be better to talk about payroll growth.

In paragraph 2, I would prefer that we de-emphasize the level of unemployment. We know that unemployment rates lag the economy and that the Committee will need to reduce policy accommodation before the unemployment rate falls to anything close to an acceptable level, regardless of what the natural rate is, which we don't know. If we continue to point out that the unemployment rate is high, it will be harder for us to explain why we are reversing course when unemployment is still elevated in many people's eyes. Instead of saying that the unemployment rate is currently elevated, I would prefer to say something like, 'Currently, employment is growing, but at a modest pace.' After all, there is a difference between employment and unemployment rates, though, of course, they are closely related. But the timing and behavior of unemployment rates and employment have different cyclical properties, and I think we need to acknowledge that.

I am fine with the proposed change in the last sentence of paragraph 3 in alternative B. However, given that we are making a change, I would like to convey more, again, about the conditioning variables that we will take into account when the time comes. So I would prefer that we say, 'The Committee will continue its practice of regularly reviewing the pace of its security purchases and the overall size of the asset purchase program in light of incoming information,' and then add 'on inflation, inflation expectations, and output growth. It remains prepared to adjust the program as needed in the future.' I think that gives a better signal about what conditioning factors we will be looking at and thinking about.

Regarding paragraph 4, I am okay with maintaining the 'extended period' language at this meeting, but I think that we will need to change that language as we prepare for exit. This might coincide with the time when we decide that we will not continue the LSAP program, and, obviously, if we let it run until June, we will have to make a decision before June and signal

whether we are prepared to continue it or discontinue it. So we will have to think earlier about those sorts of language changes. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Pianalto.

MS. PIANALTO. Thank you, Mr. Chairman. I support alternative B. The data since the last meeting have been more positive, but I do not think the change has been significant enough to warrant a shift in our policy. The economy is still facing substantial headwinds, and the inflation rate remains very low.

I did find the mention of an inflation target in alternative C to be an intriguing addition. I'm quite supportive of more firmly establishing a numerical objective for price stability, and I look forward to being able to put a sentence such as the one that is in alternative C into our statement in the not-too-distant future. But, as Bill English mentioned, I don't think we are ready to take that step today. We still have some work to do to prepare the public to understand why a numerical objective should be seen as an improvement in our policy framework and how we intend to operationalize the objective. I also recognize that, before we can prepare the public, we need to work through some of our own differences of views on the role of the numerical objective in our policy process. Nevertheless, I do believe that there is much common ground within the Committee on this issue, and I would be in favor of having a structured discussion of this issue very soon.

Regarding the language options in alternative B, I favor adding the updated $80 billion pace of asset purchases. And given that every word change is scrutinized, I have a slight preference for keeping the last sentence in paragraph 3 the same as it was in our December statement. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. I support alternative B for today. I would counsel that we wait a meeting before adopting something like paragraph 1 from alternative C. Although I am sympathetic to that, I wouldn't do it at this meeting. I also think that the 'continued its practice of regularly reviewing' clause is fine. Basically, I think it is too early to consider deviating from our November decision at this juncture. I would urge the Committee to take the idea that the program is reviewable and changeable very seriously, and I want to advocate that adjustments could be made in either direction, depending on the performance of the economy, and remind everyone that the economy does tend to be uncooperative with our best forecasts. Adjustments could be very slight. For instance, the pace of purchases could be slowed while simultaneously moving back the end date of the program, keeping the total amount of purchases unchanged. This might be viewed as giving the Committee more time to assess the strength of the economy during 2011, if that was considered desirable.

I agree with President Plosser that the March/April time frame will be the appropriate period to consider any changes to the course of action agreed to in November and, hopefully, to set, or at least to sketch out, an appropriate policy course for the second half of 2011.

I would also stress that monetary policy is an ongoing process, and not a series of one- time actions. I would implore all of you to stay away from the idea that there is such a thing as QE3. There is a continuing process of balance sheet policy. Management of the balance sheet will remain important for some time, and I encourage the Committee to think in terms of active management, either higher or lower, for the foreseeable future.

I think commodity prices bear watching, and I want to comment on President Evans's notion of commodity prices. President Evans said, 'Maybe they don't matter, because they do not seem to enter a regression once the regression has lagged inflation.' My comment is as

follows: A good inflation-targeting central bank, which I, of course, think that we are, will find that only the inflation target matters. You keep taking actions to keep inflation close to target, and then, when you run a regression, you find that it is only lagged inflation that matters, because the policymaker is taking appropriate action to keep inflation near target. But that seems to me to be different from saying that you shouldn't take the signals that the economy is sending you as a reason to take action.

I also now think that the rise in commodity prices in the spring of 2008 badly damaged the U.S. economy, at least in retrospect, and exacerbated problems that already existed in financial markets, eventually leading to the collapse of many of the nation's largest financial houses. So we have to be very much on guard about this commodity price issue this time around. I also agree with you, Mr. Chairman, that global interactions are a key concern going forward. I have written on this. I have strong opinions on this, but I am going to spare all of you my comments on this and save that for another day. Thank you.

CHAIRMAN BERNANKE. Thank you. First Vice President Moore.

MR. MOORE. Thank you, Mr. Chairman. I favor alternative B. A few minutes ago, President Evans used an analogy involving 'da Bears,' but as a non-Chicagoan I wasn't really fooled a bit by the Bears' regular season success. [Laughter] To me, it was clearly noise and not signal, as it relates to the playoffs. Then, a few days ago, President Fisher compared monetary policy with playing a higher level, multidimensional chess game. I was never much of a chess player'even at two dimensions, I couldn't figure it out. So I thought about what analogy I might use, and I recognize that I do have a fondness for Formula 1 racing, which I learned the other night I have in common with President Lacker. So that is where I'll go today.

The financial crisis was like an in-race accident, and our race car had to undergo major repairs. Now we are back in the race, but facing a large gap that developed with the lead cars'a gap which I will equate to the resource slack in our economy. I expect very fast GDP growth this year with the economy running on all cylinders. But it is important not to confuse fast growth with full or near-full employment. Just because you are running faster laps than the leaders doesn't mean you are going to catch them soon when you are running from as far back as we are. Even with fast growth, it's going to be a long trip to full employment. And this distinction between growth and levels seems crucial to me for our policy communications. Thank you.

CHAIRMAN BERNANKE. Thank you. President Hoenig.

MR. HOENIG. Thank you, Mr. Chairman. Today we have talked about evidence that the economy is growing at a more sustainable pace, and I certainly agree with that. I also see further upside risk to current forecasts, as do the analysts in most of the recent Blue Chip surveys, and I do think that the first paragraph in alternative C is more appropriate than the one in alternative B. The economy is undergoing a major and necessary rebalancing. It is taking place, and I think it is risky to try to accelerate that. We must be careful. The process takes time.

We should, therefore, begin to remove policy accommodation slowly to make it more balanced as the economy rebalances. Obviously, an early challenge we face is to reduce the large and growing level of excess reserves. I am not concerned with the ability of our reserve draining tools. We have tested them, and I think they are sufficient. My greater concern is the natural tendency of this Committee to delay the start of removing policy accommodation, leading to new financial imbalances and longer-term inflationary pressures.

I very much agree with President Kocherlakota, in that I think we should begin to think about exit now, so that we can address it in a timely and systematic way. Bill English commented today that if we change the language, we'll upset the markets'I agree with that, and we're going to hear it over and over. That encourages us to delay our actions. But the longer we delay, the greater will be the disruption, both expected and actual, to markets when we do move to tighten. So we have to keep that in mind, and that's why I think this analysis that President Kocherlakota outlined is so important. The first step that we have to take will be to shift our public statements from indicating a need for more monetary stimulus to indicating sufficient stimulus is in place to attain our long-run goals of maximum employment and stable prices. I won't go into detail on the wording in the paragraphs, because I've already indicated that I agree with looking at this longer term.

I also want to discuss price targeting. My inclination is to favor it. Rather than calling it a target of 2 percent or a bit less, we can talk about the central tendency of participants being

2 percent or a bit less. I know we think that's the right thing, but I want to point out that this crisis we just went through was not caused by missing our inflation target. It was caused by our fear of deflation, which caused us to push real and nominal rates down for an extended period of time, and that led to asset price bubbles and the consequences of their bursting. Therefore, adopting an inflation target doesn't mean we will not find ourselves causing other imbalances in the future, unless we take a look at our policy as more than inflation targeting. I will end with that. Thank you.

CHAIRMAN BERNANKE. Thank you. President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. I support alternative B. I think the wording in paragraph 1, with the slight updates, is appropriate as presented. I think President

Fisher suggested in a note before the meeting adding a clause to the end of paragraph 2 that said something like: 'though there are indications that the recovery is strengthening.' I am sympathetic with that, because I think that most of our 2011 forecasts, including my own, have been revised higher, and I don't think that is inconsistent with paragraph 1.

I support keeping the 'extended period' language in paragraph 4. I think the phrasing still pertains, and I am wary of making a change at this juncture, given the intense attention this phrase has had in past months and the likelihood that dropping it or stating an explicit date would set off an unintended market response and certainly would mislead markets regarding how policy may play out.

With respect to the addition of the numerical inflation target language bracketed in alternative C, paragraph 5, I am hesitant to support this in this statement. I do, in general, support the notion of a more explicit inflation objective as part of our framework. However, I think that further official policy communication moves in that direction ought to be taken only after the Committee has come to a more formal decision about whether and how to implement a more explicit inflation target.

On the question of dropping or adding guidance on the quantity of purchases to $80 billion'here comes a double negative, which I love'I see no reason not to include the language that was added yesterday that raises the number from $75 to $80 billion. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Fisher.

MR. FISHER. Thank you, Mr. Chairman. A couple of things come through from listening to the conversation that we had earlier about the economy. One thing that's very clear is that things have shifted. I think our words and our deeds need to recognize that the economy

is much stronger. It has moved forward, and it has more forward momentum and sustainability than was the case last summer and autumn when QE2 was proposed and formulated. As a corollary to that, I think the economic expansion seems much less vulnerable to shocks. Like President Plosser, I have made it very clear in my public statements and at this table that I would have not supported QE2, but QE2 is in place.

One thing that is fairly clear to me is that inflation is at an inflection point. It could'and I stress 'could''come under considerable upside pressure from what I consider to be reduced slack in the global economy and possibly less slack here in the United States than is generally appreciated. And one could make the argument that a continuation of QE2 purchases will only add to this inflationary pressure. I am concerned about the fact that businesses and banks seem to be drowning in liquidity. I think it's leading not just to speculative activity of the kind that President Hoenig and others have mentioned, such as farmland price appreciation, but also to the misallocation of resources. So I am eager to normalize the allocation of credit as soon as it is feasible. In addition, I do worry about the inclination I'm hearing from business leaders to want to exercise pricing power. They will look for any excuse they can to do so, because their margins are so tight and because they're eager to grow their top lines and sustain their stock values. But I think we're going to need a couple more months of data to confirm that directional shift.

I also feel that there have been some negative consequences to QE2, some of which affect those most deeply in need. It has certainly exposed many pension funds as the Ponzi schemes that they are, and it has hurt the small saver significantly, particularly in the lower income quartiles.

I could argue for alternative C. I could even argue for alternative D, but I won't. I'm convinced the economy is on a sustainable growth trajectory, but I could be too optimistic. I think we need a few more months of evidence to support my convictions before reducing or stopping the additions to our balance sheet.

I do think we should be communicating about our flexibility. I do believe there is some value in our making more positive statements about the economy. After all, we heard them at this table, and we believe them.

With regard to the difference between alternative B and alternative C, I think reputational risk cuts two ways. President Plosser referred to this in a different fashion, but some do argue that we damaged our reputation with QE2. Some might argue that we shouldn't have undertaken QE2, but I think shifting gears too quickly would indicate weakness, in that we would not be sticking to our conviction at least until we see the whites of the eyes of recovery. So I am in favor of alternative B. I listened very carefully as President Kocherlakota and President Plosser advocated substituting paragraph 1 in C for paragraph 1 in alternative B. I think you could probably take care of their concerns without making that substitution by adding what President Lockhart just endorsed, namely, putting a comma at the very end of paragraph 2 after 'disappointingly slow' and adding, 'although the economic recovery is strengthening.' Alternatively, in the first sentence of the first paragraph you might say 'confirms that the economic recovery is strengthening.' So I don't see a need for the substitution of the first paragraph from alternative C into alternative B if we don't want to change too many words. But I would suggest that we find a way to indicate the mood that was expressed at this table, namely, that the economic recovery is, indeed, strengthening even though it is still constrained. And I

believe President Lockhart's endorsement of my suggested sentence is the way to do it rather than shifting those paragraphs.

I would add one word in the first paragraph. 'Employers remain reluctant to add to domestic payrolls.' In a sense, that's one of the problems that I've been talking about for quite some time, and you point out the difficulty of differentiating between our role here as the U.S. central bank and other pressures that are developing worldwide. But I still find employers are reluctant to add to domestic payrolls.

With regard to the $80 billion sentence, I'm a little worried about that. It is the truth, but at the same time, I think the markets will pick that up. There will be much discussion about it. It's much ado about nothing. We're still on a $600 billion pace, and that number could change as early as our next meeting'it could be 85 or it could be 75. So I'm not in favor of pointing that out. I would end the sentence with 'securities by the end of the second quarter of 2011.' And I rather liked President Kocherlakota's insertion of 'longer-term' between 'stable' and 'inflation expectations.' Those are my suggestions, Mr. Chairman. I will support alternative B. I would like very much if we could improve the tone from the standpoint of economic recovery strengthening.

Finally, I have a comment on your comment on inflation targeting. I have argued at this table that, as long as we have a dual mandate, we have to be extremely careful with regard to targeting inflation because then that might impose upon us some more specific unemployment target. I have come to conclude over my now almost six years of experience at this table'which is not much, but it's certainly better than where I started'that the employment mandate is a very slippery political slope. It's also evident to me that there is some shift in sentiment in terms of those that have given us our franchise and given us that mandate, and I think it might be time to

think about preparing to shift to a single mandate of inflation and letting the politicians worry about unemployment through fiscal policy. So I welcome the discussion, Charles. I look forward to talking to you about this and giving my ideas to you. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Yellen.

MS. YELLEN. Thank you, Mr. Chairman. I favor alternative B. I'm comfortable with the wording of the first paragraph of B as it stands, but I could support a mild upgrading of the outlook along the lines that President Lockhart suggested. Although incoming data have strengthened my confidence that the risks have become more balanced, my modal outlook has changed very, very little since our last meeting. I continue to anticipate that unemployment will remain undesirably high and inflation undesirably low'below the 2 percent rate that the majority of the Committee has indicated is their preferred inflation objective'for the foreseeable future.

With respect to policy, I'm comfortable for now with our current stance. Optimal policy simulations and rule-based recommendations in Tealbook indicate that economic conditions continue to call for a highly accommodative policy. By the various metrics in Tealbook, we do not have our foot too heavily on the gas. With respect to our LSAP program, I continue to think that the bar for not completing the announced $600 billion of purchases should be high, and that hurdle has not been breached. My reading of the evidence is similar to yours, Mr. Chairman. I think the program has had a modest but positive impact on financial conditions, and it may deserve some credit for diminishing market anxiety about deflation. Fears that the program could cause an outsized decline in the dollar or trigger a rise in inflation expectations have not materialized. We should continue to evaluate the program in light of incoming evidence, but I don't think the proposed change to the last sentence of paragraph 3 is needed or desirable. Any

change at all in the wording will arouse market speculation about our intentions, so I would prefer to keep the language identical to December.

With respect to our external communications regarding future policy in the days ahead, I think we should be clear that we recognize the need to withdraw policy stimulus as the economy recovers and that we have the tools and commitment to do so. I see an advantage in emphasizing the Committee's commitment to a specific numerical inflation objective. As the discussion in Tealbook makes clear, a well-understood and credible commitment would provide protection should the timing of our exit'in spite of our best efforts'turn out to be too late. I think markets are aware of the Committee's inflation goals, but it could be advantageous to strengthen this commitment by making it explicit, as in alternative C. Clearly, we would need to lay the groundwork before adopting a numerical objective, but I support the efforts of President Plosser on this initiative, and I think this could be a good time to make progress on a longstanding communications goal.

CHAIRMAN BERNANKE. Thank you. Governor Warsh.

MR. WARSH. Thank you, Mr. Chairman. President Bullard said that he hoped there was no such thing as QE3. I don't think I heard that the way he intended it, but it did pique my interest. [Laughter] Not to re-litigate old battles here'I suspect many of us have not changed our ex ante views in light of incoming information'but my sense is that we would not be the first in Washington to declare a highly debatable policy an enviable success and end it in due course.

On what basis could we say it was a success? We could, I think rightly, look at the change in the deflation risks and'much more so than any great successes on financial markets or employment or GDP'take perhaps more credit for the change in inflation risks between the

time we announced the program and the time that we pivoted away from it. So I think that is the way we hope that the $600 billion program is 'successfully' accomplished, and we move on. The name of the game strikes me as always having been about what's next. It was rarely a question of whether we were going to do what we said we were going to do. I think we are going to live up to our word and do the $600 billion, but the markets are still questioning what happens next. In light of that, Mr. Chairman, I favor alternative B.

Regarding the language in paragraph 1, let me start by saying that I think President Kocherlakota described a sequencing we all had in mind some time ago as we were provisionally thinking about exit. Perhaps at the March meeting, or at a meeting thereafter, we might want to describe the pivot in a way that markets could come to understand without adding unnecessary uncertainty. One way to do this is to make the first paragraph quite a bit more upbeat than paragraph 1 in alternative B, even if the rest of the language in the statement were exactly as it is now. That would, I think, be a very useful way to signal to markets that we have with some conviction changed our view to the upside on the status of growth, and would make them aware that there is a very serious debate about policy going forward. So with that chess move in front of us, it strikes me, frankly, that alternative B as written might be a little more cautious than current market expectations. Markets seem to be more enamored with the recent economic data than I sense that this group is. If we left the first paragraph of B as it is now and the data come in on the upside, as we would hope between now and March, that might give us a very nice way to describe in some careful, methodical way our change in views. Partly for that reason, and partly because I think the consensus in this room is closer to paragraph 1 in B than in C, I'd favor B as it is now with a view towards exit and next steps.

On paragraph 3, Mr. Chairman, I think staff has now rewritten this $80 billion per month in a way such that it shows that the $80 billion is the arithmetic that comes out of the steady commitment to do $600 billion. So I'm certainly open to the suggestion of President Fisher to end the sentence at '2011,' but if New York and Brian and the guys feel that the per month basis is the way in which they've communicated it and they'd rather that communication come from us than the New York Desk, I think we've at least mitigated the risk that they overread what the $80 billion per month is. To the extent we do add that new red language with $80 billion per month, I think that's additional impetus not to change another word in paragraph 3. So I prefer the bracketed language to the new language therein. I support alternative B with those suggestions.

CHAIRMAN BERNANKE. Thank you. Governor Duke.

MS. DUKE. Thank you, Mr. Chairman. I favor alternative B. The outlook looks a little brighter than it did the last time we met, and most around this table seem a bit more confident. Indeed, most of my conversations with bankers started with comments like, 'Things look a little bit better,' and 'people have a little more spring in their step.' So there does seem to be a little more optimism.

On the question about reserves, I've been paying a lot of attention not only to changes in our balance sheet, but also to changes in the aggregate balance sheet of banks, and I've been trying to think about what that might cause banks to do. My conclusion right now is that reserves are unlikely to affect either the price and availability of credit, or financial conditions, or even the economy, unless there's a significant change in either loan demand or deposit supply. Right now there is just so much liquidity that I don't think the change in reserves is having much effect, so I'm not concerned about that at the moment.

At the same time, the market seems pretty convinced that we're going to purchase the full $600 billion in Treasuries, no more and no less. So with all of the potential uncertainty in the outlook'whether it comes from house prices or commercial real estate or state and local governments or potential spillover from peripheral Europe'it makes no sense for us to tinker with the one thing about which there seems to be a little certainty.

Turning to the language, I want to make sure that we don't send a signal that we don't intend to send'and I didn't get the feeling that anybody around the table wanted to send such a signal. Regarding the first paragraph, I could live with the version from alternative B or C, and I'm not sure which one I would vote for if you forced us to choose one or the other. In paragraph 3, I have a strong preference for stopping the sentence at 'second quarter of 2011' and leaving out the discussion about the pace of purchases forever. The reason is that I think if we've given the total amount and we've given the time, then that calculation is left to anybody to figure out, whereas now we're in a position of having to change from $75 billion to $80 billion, which might give the impression that we're doing some tinkering and fine-tuning. I think it points up the risk of having both the pace and the total amount in the statement. But if we're going to have an amount in the statement, I think it has to be the right amount. I don't think it makes sense to have an amount that we know to be incorrect.

For all of the same reasons, I would go back to the original language and would not use 'continued its practice of.' The change in tense is not conveying any important information that I can see, and it might give people the erroneous impression that we're intending to signal that we're having more of a conditional discussion than we actually are.

On the inflation target language, the problem I have with inserting that, first of all, is that I think it would be interpreted as much as a political statement about this whole discussion about

our dual mandate as it would be any statement of our intentions. Inserting ourselves into that question about our mandate seems to me to raise all kinds of questions about independence. I think we have the right to independence about how we get to our mandate, but we don't really have independence as to what our objectives are, so I'd be very uncomfortable about putting it in there. Also, if we're going to put a number on inflation and we have the dual mandate, it seems to argue for a number on unemployment, and in fact, I had the '2 percent or a little less' in a speech in January, and the very first question I got from the audience was, 'Well, if that's your number for inflation, what's your number for unemployment?' And I think that's a little difficult.

Finally, I'm still not certain that we can agree on what that number is, even if we decided to put the number in the statement. Those are my comments. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Tarullo.

MR. TARULLO. Thank you, Mr. Chairman. This is easy. I associate myself with Kevin on everything he said about the language in alternative B. I associate myself with Betsy on everything she said about inflation targeting. Thank you.

MR. KOCHERLAKOTA. You beat Eric. [Laughter]

CHAIRMAN BERNANKE. Trying to make yourself redundant, Governor? [Laughter] Governor Raskin.

MS. RASKIN. Thank you, Mr. Chairman. I, too, support the action described in alternative B and the statement in alternative B which reaffirms the intended increase in securities holdings and the pace of purchases that the Committee first announced in November. The economic recovery is, in fact, continuing. The growth in household spending picked up late last year, and business spending on equipment and software is rising. However, housing and

labor markets remain weak, and the action described in alternative B, I believe, reflects that. The actions and language of alternative B should reinforce investor confidence that the economic recovery is proceeding and that employment and inflation are evolving in a manner consistent with a gradual return to levels more consistent with the Committee's dual mandate.

Adjustments to the program should not be made at this time. The adverse consequences of unexpectedly discontinuing or reducing the current program would be unsettling to business and household confidence, and, given challenges in communicating, such a change would require great care. In addition, there are significant benefits to waiting for additional information pertaining to the strength of the recovery and likely trajectory of inflation before deciding to make an adjustment to the stance of monetary policy.

I also want to weigh in on the debate regarding the inclusion of the $80 billion. President Lockhart stated it in the negative, seeing no reason not to include the language. I think President Fisher has also raised some good points regarding the precedent it sets of always having to communicate in terms of what the monthly pace would be. I just want to insert a somewhat different perspective on that language. As the communications experts know best, there are several audiences listening and critiquing the performance of this Committee, and these audiences include financial participants on Wall Street as well as business participants on Main Street. They include politicians of all ambitions. In my case they include a neighbor who continues to corner me in the express lane at the grocery store right when I'm pinned in between the tabloids and the gum, asking for clarification. [Laughter]

I think we learned from the communications around the LSAP program that some of these audiences can only hold one number in their heads at a time. That number, I think, currently is $600 billion. So another perspective on this debate is that if we inject another

number, in this case the number is $80 billion, to certain audiences it could appear to be something new, something that was recently decided, something that could be misinterpreted as a fresh round of money printing. That is not at all what is intended, and that is not at all what has occurred or been decided at this meeting. So, at the very least, I think putting in that number could encourage some kind of speculation about why the quantity of purchases implies a pace of $80 billion rather than $75 billion, and, given that this Committee has not made any change in the course of the LSAP program, we may need to consider whether the $80 billion figure will signal some kind of fine-tuning or something that we have not, in fact, decided. Thank you.

CHAIRMAN BERNANKE. Vice Chair.

VICE CHAIRMAN DUDLEY. Thank you, Mr. Chairman. I favor alternative B. In terms of language, I think it's okay to be a little cautious in terms of upgrading our economic outlook, as Governor Warsh suggested; if the news comes in good, then we can upgrade the outlook in the future, and I don't see any reason to race ahead right now.

In terms of the rest of the language in B, I think we should make the fewest changes possible. I don't see any reason to disturb the expectations that the market has that we're likely to do $600 billion of large-scale asset purchases. So I would not include the language about the $80 billion. I just think that adds complication and detail that's not really necessary, and I don't think Brian thinks that's necessary or helpful.

MR. SACK. The Desk wasn't advocating putting $80 billion in the statement. We've already moved to a purchase pace of $80 billion, and we've explained in our FAQs how to reconcile that with the FOMC statement. I don't think it has caused any confusion among market participants.

VICE CHAIRMAN DUDLEY. And as far as the language about 'will' or 'continued,' I think it's just better to leave well enough alone. I just think there's no reason for change. If we make the change, people are going to be confused about why we're making the change. If the meaning is almost the same, what's the point of making that small adjustment?

In general, I just want to add two other thoughts. I think we are a little bit at risk of getting ahead of ourselves here in the whole discussion about where we're going. If I remember correctly, there was a lot of excitement last winter about improvement in the economic outlook, and we shifted our focus away from other means we could take to make monetary policy more accommodative and shifted it toward exit, and that turned out to be premature. So I think we have to remember that we haven't gotten that much good data for that long. We're very far away from full employment, so I think a little bit of patience is appropriate.

I think that's also important in terms of our communications because we don't want to give people the sense that we're itching to exit just for the sake of exiting. If we were to do that, it would cause people to tighten financial conditions, and that could actually potentially harm the economic growth outlook. Obviously, if the inflation news turns worse, and if the economy is growing very robustly, then, of course, it's appropriate to change. But I think it's very important not to get ahead of ourselves; we actually need to see economic information that warrants a change in policy.

Finally, let me thank the staff for all their efforts preparing the material on the SOMA net income and the different environments for interest rates and the asset sale program. I thought that was very useful for understanding the risks. But I would emphasize that I consider these issues very secondary to the policy objectives of achieving our dual mandate. In fact, I'd be quite happy if we had a very strong and sustained expansion that led us to tighten monetary

policy and that resulted in a sharp decline in our net interest income. In that case we'd obviously be a lot closer to achieving our dual mandate, but also the revenue-generating effects of a strong recovery would almost certainly overwhelm the effect of a drop in Federal Reserve remittances to the Treasury. The goal here is not to maximize the Federal Reserve's remittances to the Treasury.

CHAIRMAN BERNANKE. Thank you very much. Again, a good discussion.

The economy is kind of like an ocean liner, which does take a while to move, and I think we have to be patient. We are seeing signs of sustainable recovery, but they are still somewhat nascent; in particular, we haven't seen any strong employment reports yet. So I would advocate maintaining the status quo. I do believe the policy has been helpful. We can differ on exactly how much and in what way, but I do think it has been supportive of the recovery. So I recommend alternative B.

There was some discussion about strengthening paragraph 1 in B to make it like paragraph 1 in C. I can make a quick proposal. There are two differences between these two paragraphs. One is that the paragraph in C strikes out the things that are constraining consumption growth, and the other is that the paragraph in C basically says business investment is rising and drops out the nonresidential part. One proposal is the following, given that I think all the things that are affecting household spending are still relevant: Where it says 'business spending on equipment and software is rising,' insert a comma and then say, 'though employers remain reluctant to add to payrolls.' That drops a negative sentence, and that's pretty consistent with the suggestion from President Fisher, for example, about firms investing in order to improve productivity rather than to improve employment.

MR. FISHER. So the sentence would take out 'while investment in nonresidential structures is still weak'?

CHAIRMAN BERNANKE. Yes.

MR. LACKER. It makes it seem that the category of nonresidential structures is what has improved.

VICE CHAIRMAN DUDLEY. It's a little weird to take it out, given that it's still very weak and that it was in the last statement.

CHAIRMAN BERNANKE. Well, C says, 'business investment is rising.' Do you think that's more accurate?

VICE CHAIRMAN DUDLEY. No, but I'm saying that in the December statement we had, 'while investment in nonresidential structures continues to be weak.' To take that out implies that somehow that's no longer the case. And that hasn't changed.

CHAIRMAN BERNANKE. Well, we had some indication that it was bottoming out. We do change the emphasis periodically. Does anyone have a view on this? Governor Tarullo.

MR. TARULLO. Mr. Chairman, it's the one thing, though, that hasn't really changed. That's where I think there's a bit of dissonance. If you think it's a good idea to up the optimism level a bit, I think a lot of people around the table would be open to suggestions, but I'm not sure that one does it.

CHAIRMAN BERNANKE. Well, do we believe business investment is rising? PARTICIPANTS. Yes.

CHAIRMAN BERNANKE. Are we okay with that? How about 'business investment is rising, though employers remain reluctant to add to payrolls'? We look to the Research and Statistics staff.

MR. STOCKTON. It's true.

MR. REIFSCHNEIDER. I don't know if it accomplishes what you want, but it's true. MS. YELLEN. That still gets rid of the nonresidential portion.

CHAIRMAN BERNANKE. Right.

VICE CHAIRMAN DUDLEY. Another option is to change the phrase 'the economic recovery is continuing.' Instead, we could say something like 'the economic recovery has strengthened somewhat.'

CHAIRMAN BERNANKE. Okay. I'm willing to do that. The only objection I had was that it would say 'the economic recovery has strengthened, though at a rate'' We're confusing derivatives here. It's as if it's strengthening but not strengthening fast enough.

VICE CHAIRMAN DUDLEY. No, you could just say 'and the growth rate is still not sufficient''

CHAIRMAN BERNANKE. Okay.

MR. FISHER. Yes, you could say it 'strengthened, though the growth rate has '.' That

was one of my suggestions.

CHAIRMAN BERNANKE. All right.

MR. LACKER. Though it is still insufficient.

CHAIRMAN BERNANKE. Okay. Are we okay with 'has strengthened'? VICE CHAIRMAN DUDLEY. I would say 'has strengthened somewhat.'

MR. FISHER. It has either strengthened or it hasn't strengthened. But the Chairman had an interesting suggestion. Could you repeat your suggestion, please, Mr. Chairman?

CHAIRMAN BERNANKE. ''has strengthened, though the rate of economic growth has been insufficient to bring down''

MR. FISHER. I think that's a fair statement.

VICE CHAIRMAN DUDLEY. It is just a question of where you want to put it on the

dial.

MR. STOCKTON. I have one small thing. We'll get the first reading on fourth-quarter GDP later this week. We've written down 3.8, which is stronger than 2.6 percent, but the confidence interval around that number is really big. And this current-quarter estimate of 3.8 is based on a 3'' percentage point contribution from net exports offset by a minus 3 percentage point contribution from inventories, both of which are poorly measured and subject to considerable uncertainty. So while our reading of the economy is that things have strengthened, I just wanted to make clear that it's not as if that number is written in stone at this point.

VICE CHAIRMAN DUDLEY. You could say 'appears to have strengthened.' CHAIRMAN BERNANKE. All right. May I ask indulgence to leave paragraph 1 in B

as it is for now and to save changes in our text for next time? I'd like to leave that paragraph as it is, if that's okay, with the understanding that we will overcompensate in March.

MR. TARULLO. Kevin's strategy.

VICE CHAIRMAN DUDLEY. That was Governor Warsh's strategy.

MR. KOCHERLAKOTA. As long as we can use the word 'rocking' in March, that will be fine. [Laughter]

MR. TARULLO. But in which paragraph, Narayana?

MR. PLOSSER. Mr. Chairman?

CHAIRMAN BERNANKE. Yes.

MR.PLOSSER. One way to address this is to make sure that the discussion in the minutes gives a little more positive sense.

MR. FISHER. There was a more positive sense at the table.

CHAIRMAN BERNANKE. My summary of the discussion begins, 'The tenor of the incoming data has increased most participants' confidence that a moderate recovery is under way and will continue.'

VICE CHAIRMAN DUDLEY. That's a good summary of it.

CHAIRMAN BERNANKE. All right.

MR. LACKER. That's rocking. [Laughter]

CHAIRMAN BERNANKE. I gave it a try. I did consider the 'strengthening' phrase at the end of paragraph 2. But, if you'll notice, that creates a zigzag sentence where we're happy, but we're sad, but we're happy. [Laughter] In paragraph 3, I've heard very different advice on the $80 billion. I'm hearing from New York, though, that you think this is worse for markets rather than better for markets.

MR. SACK. I just think it's not necessary.

CHAIRMAN BERNANKE. The advantage of putting it in is that this is a parameter that we can move at some point if we were to change the pace while keeping the total.

VICE CHAIRMAN DUDLEY. I think it's highly unlikely, though, that we would want to do that.

CHAIRMAN BERNANKE. President Bullard.

MR. BULLARD. Let me give an impassioned speech for keeping it in. CHAIRMAN BERNANKE. Take it as read. [Laughter] All right, I take full

responsibility for leaving it in. I realize there's a slight risk there, but there's also a risk to dropping it. It's something that we could, in fact, vary if we taper or if we change the pace. Let's leave the next sentence as it was last time, and let's drop the other change. The only

change in the statement, therefore, is to add the phrase about the pace of $80 billion. Everything else is as written. Okay? Any other comments?

MS. SMITH. Can I just make a comment?

CHAIRMAN BERNANKE. Yes.

MS. SMITH. From a communications perspective, I really think that's a mistake. CHAIRMAN BERNANKE. The $80 billion?

MS. SMITH. Yes.

CHAIRMAN BERNANKE. All right, explain why.

MS. SMITH. I think we've taught market participants to take every word of this statement seriously. And I think it conveys a policy judgment that you all didn't make. So I'm comfortable that what is on the New York Fed website, as explained to me, has made this point. I'm afraid that if you do this, it's hard for us to explain that it really doesn't mean much, particularly if you want to use it later to fine-tune: Now this signifies nothing, but later it may signify something important. So I think you want to hold that in reserve until you are really communicating something important.

CHAIRMAN BERNANKE. Did she convince you, President Bullard?

MR. BULLARD. I feel very strongly that this $600 billion number really hurt us, because it put us in the same category as a lot of others' policy actions, and it got us away from the idea that this is ordinary monetary policy. And I think the pace of purchases gets closer to saying it's ordinary monetary policy.

I'm a little miffed that we're not at $75 billion. It's up to the Desk to keep us at $75 billion'I know there are technical factors involved. I would very much like to keep it in. And I

saw the fact that we had the pace of purchases and the total amount as a compromise, and now we'd be pulling back from that, in my view.

CHAIRMAN BERNANKE. No, I agree. President Fisher.

MR. FISHER. I feel equally passionately. [Laughter] So let us cancel each other out. I would suggest that we listen to the good advice that Michelle just gave, because I think she is right.

CHAIRMAN BERNANKE. All right. I am going to take a straw vote, so I can share the responsibility. [Laughter]

MR. KOCHERLAKOTA. I wasn't sure what Michelle's advice was.

CHAIRMAN BERNANKE. Her advice was to drop the $80 billion.

MR. KOCHERLAKOTA. And to stop at 'the end of the second quarter of 2011'? CHAIRMAN BERNANKE. Yes. All in favor of not having the $80 billion? I count ten.

All in favor of including the $80 billion? Okay, we'll drop it. President Bullard, your concern is noted, and we'll take measures to try to make sure that all of the dimensions of our policy are reflected in our discussions. Brian.

MR. SACK. I just wanted to make it clear that the reason we're in this situation is not that we haven't been keeping pace. It's because the program didn't start on November 1, but the 'about $75' was calculated as if it did start November 1.

CHAIRMAN BERNANKE. We should have figured that out.

MR. SACK. We thought 'about' gave us enough flexibility.

CHAIRMAN BERNANKE. Okay. Debbie.

MS. DANKER. This vote will encompass alternative B and the directive for alternative

B from the packet. I am going to read paragraph 3, just to make sure I've got it right, and we all know what we are voting on.

Paragraph 3: 'To promote a stronger pace of economic recovery and to help ensure that

inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November. In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.'

CHAIRMAN BERNANKE. Thank you very much. We have one more item, which is the communications issue. We can try to do that now, or we can have a 20-minute lunch break. Is there a preference? People have flights?

VICE CHAIRMAN DUDLEY. How about during lunch?

CHAIRMAN BERNANKE. We can do it during lunch, I suppose. It's only a question of speaking loudly, okay?

MS. DANKER. And keeping all'

CHAIRMAN BERNANKE. 'the food away from the microphones. All right, why don't we break for lunch? We'll return here, and we'll immediately go into this last item of discussion.

[Break]

CHAIRMAN BERNANKE. Let's recommence the meeting, please. Thank you. I see Charlie coming, so we will just go ahead and get started. The last item is on communication, and I want to thank the communications subcommittee for the work they have done and the ongoing discussions they have had. So let me turn it over now to Janet.

MS. YELLEN. Thank you, Mr. Chairman. I would like to begin by thanking Governor Duke and Presidents Fisher and Rosengren for serving with me on the subcommittee. And I want to thank all of you for the very helpful input that you have given us so far.

As you may recall, the Chairman gave our subcommittee a three-part charge. He asked us first to assure appropriate treatment of confidential FOMC information, including our contacts with the press; second, we were to develop policies to avoid the perception that individuals outside of the Federal Reserve System are able to gain inappropriate access to FOMC information that could be valuable in forecasting monetary policy; and, third, we were to develop policies to ensure that the public communications of FOMC participants do not undermine the Committee's decisionmaking process or the effectiveness of monetary policy.

After consultation with many of you, the subcommittee thought that the best way to accomplish the first objective was to strengthen the Program for Security of FOMC Information by adding an explicit enforcement procedure, and yesterday afternoon you voted on an amendment designed to accomplish that. So I consider that aspect of our work complete.

To make progress on the remaining two charges, we thought it would be sensible to take them up sequentially. Today we are particularly seeking your thoughts on how to address the second charge. What policies should the Committee put in place to avoid perceptions that individuals outside the Federal Reserve System are able to gain inappropriate access to valuable FOMC information? We'd like to hear your thoughts on this topic, and our hope is that we can return soon, potentially in March, with a revised proposal, and then return to the third question for discussion.

We circulated a set of questions that you should have in front of you to guide discussion, and we'd like to have a full go-round of the Committee to hear your views. We ask you to address three questions. The first pertains to access. Should there be limitations on access between FOMC participants and individuals or firms that stand to gain financially? And, if so, where would you draw the line? The second question pertains to content. Should there be limitations on the content of meetings and conversations, if access is permitted? And, third, if limitations on access and/or content are desirable, should we establish a formal policy concerning these matters, or simply develop some informal guidelines?

On that issue, you may recall that, in our memo to you dated January 6, our subcommittee suggested that contacts with financially interested outsiders should, at least in our view, be addressed by a formal policy. We're concerned that any perception, whether it's based in fact or not, that financially interested outsiders have inappropriate access to FOMC members or information creates severe reputational risks for the Federal Reserve. Our subcommittee thought it important for the Committee to have in place a formal policy, the important thing being that it would be binding on all FOMC participants and not just a guideline that's voluntary. It would state, in effect, that it is not acceptable for FOMC participants to convey information'

whether it's covered by the Program for Security of FOMC Information or whether it's outside of that program'that would be likely to confer financial advantage on particular private consultants and businesses.

In contrast, we proposed in our subcommittee memo to you that other matters should be addressed by informal guidelines, matters such as the blackout period, guidelines about staking out firm positions, and so forth. But we're seeking your input and reaction on this question today, so the third question to you is: Do you agree with our subcommittee that we need a formal policy on this? Let me stop there and begin the go-round.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I want to thank the subcommittee for their work on this. I tend to agree with what Governor Yellen has said. Given the kinds of risks that are involved for the Federal Reserve System in this matter, I think a formal policy is something that we should be thinking about. I have to admit, though, that, since I have not engaged in any of this kind of activity myself, I'm not sure exactly what the formal policy should consist of. Certainly, in considering the issue of potential limitations on content, the point that says, 'You should not be characterizing deliberations at FOMC meetings,' seems clear enough to me. I think it's reasonable to consider having another staff person at these meetings, which seems like a good check. Beyond that, I guess I'm willing to be led by others' judgments.

CHAIRMAN BERNANKE. President Hoenig.

MR. HOENIG. Thank you, Mr. Chairman. And thanks to the subcommittee'I really do appreciate the work you've done on this. When these questions were circulated, it triggered my memory, so I went back and looked at FRAM, and I think it may have the essence of what we need. It's a matter of what you want to formalize, because right now these are voluntary

guidelines. In paragraph 5 of FRAM it says senior officials 'should strictly preserve the confidentiality of System information that, if revealed, could benefit any person or impair the effectiveness of System operations and policies.' I think formalizing that would put us all on notice. The next one involves considering invitations to speak at meetings sponsored by profit- making organizations. 'Such officials should carefully weigh the public benefits likely to be derived'against the possibility that their participation might afford such organizations a prestige advantage over competitors.' I think that's a good guideline for us to continue to follow. Paragraph 7 says, 'In public speeches and relations with news media, senior officials should be particularly mindful of''and I will shorten this part to 'conflicts'''and, in addition, should avoid statements that might suggest the nature of any monetary policy action that has not been officially disclosed or that might confuse or mislead the public with respect to the monetary or other policies of the System.' And the last paragraph I will mention is senior officials 'should feel free to express their personal views concerning questions of System or public interest, but they should carefully consider whether their remarks might create public misunderstanding of the System's actions, or impair the effective formulation and implementation of System policies or lessen the prestige of the System.'

So we have much of what we were talking about, and it's a matter of formalizing the voluntary guidelines. I would be in favor of formalizing them first.

Another issue is whether we make this public, so that everyone knows we're on notice. I think this is something we ought to consider, because then it not only puts us on notice, but it also puts them on notice. I think that pretty much reflects my comments relative to the questions. Thank you.

CHAIRMAN BERNANKE. President Rosengren.

MR. ROSENGREN. I am on the subcommittee and I asked to go towards the end, and number 3 was towards the end. [Laughter] The subcommittee had to wrestle with wanting to make sure that there wasn't undue access that provided the appearance of financial gain, and trading that off against the need to understand developments in the economy and financial markets. So it's really important to find the right balance. I would highlight that, to the extent that we formalize things, the rules have to be clear and enforceable.

Let me start with the second issue, which refers to the potential limitations. I actually do think that FOMC meetings should be kept confidential other than what's in the minutes, which provide the public recounting, so that we basically shouldn't be talking about these meetings to anybody in public or in private.

In terms of meetings with individual financial market participants, I have already instituted the practice of having somebody else in the room with me. It can be the head of our supervision division, the head of the research division, or a communications officer, and the reason is to make sure that absolutely nothing is being conveyed that's not already in the public domain. And I have become much more careful about footnoting speeches that I've previously given to make it clear that it is already in the public domain, so that nothing being conveyed in our discussion is different from what has already been said publicly either by me or provided in the FOMC minutes. I think those are all important things to think about. I am in favor of them. I've already implemented them.

In terms of the limitations to access, I do think some of it's the frequency. If the same person who potentially is closely monitoring the Fed is regularly meeting with you, even if nothing is conveyed during those meetings, I think the appearance of very, very regular meetings potentially is a problem. So I've also changed my practice in that respect'even with somebody

else in the room, I have tried to make sure that I don't meet with the kind of regularity that would in any way provide an appearance of undue access to any one individual or organization.

In terms of centralized reporting, I think that could become very cumbersome. I'm actually not opposed to it, but I have talked to some others who are less comfortable with it. The one area where it might be useful to report press contacts centrally is if it's only to one individual news organization, or one individual reporter, just so that, if there is a leak, there will already be a record within the organization that highlights whom you talk to and when. I wouldn't expect that it would be necessary, but it would provide a way to make sure we could quickly refer to people's logs and know who talked to what reporter when.

In terms of interactions at conferences, I don't think we want to limit that. I think it is important to have social interactions. And when it is in a group setting or when press is there, it is very unlikely to result in a problem. So I think that either at conferences or when media are present, then I wouldn't really be too concerned about who else is in the room. And I certainly think that we should not speak to forums where there are only clients of an individual firm. That definitely gives an appearance that you are giving financial gain to one organization. So there have to be multiple organizations before I would be willing to do that.

CHAIRMAN BERNANKE. Governor Tarullo.

MR. TARULLO. Can I just ask Eric to clarify something? Did I draw the correct inference that you regard this as governing discussions with members of the general media, as well as people whose purpose is to generate direct or indirect trading profits from predicting monetary policy actions?

MR. ROSENGREN. I think the questions were focused on the individuals that can directly get financial gain, but I think that we should think about how it should apply potentially to reporters as well. That's my own personal view.

MR. TARULLO. Could you explain that? My assumption had been that the reason we were not including talking to reporters here is because we had a shared view that whenever the reporter used whatever he or she got, it was immediately available to the world on the web. But maybe I'm missing something.

MR. ROSENGREN. No. In terms of financial gain, if I only talk to one Wall Street Journal reporter every other month, and I didn't talk to a New York Times reporter or a Fox News reporter or a Bloomberg reporter, I think that would give an appearance of supporting one news organization over other news organizations. So I do think that we have to be careful, to some degree, to spread our access to the press around, just as we spread our access to potentially interested financial parties around. But that's my own personal view.

MR. TARULLO. Thanks.

CHAIRMAN BERNANKE. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman, and thanks to the subcommittee for doing all of the fine work on this. I have to agree with President Hoenig. My experience being around the Fed was that I thought we were already doing most of this, and I thought there was a code. So maybe it's a matter of reviewing that code.

I'm going to make some general comments that may go in a different direction. My view is that our discussions of communication tend to be very negative and very risk averse'in fact, I would say they exhibit extreme forms of risk aversion. There is too much worry that something might be said to someone that might be inappropriate'and certainly we need to worry about

that'but that should not be the primary concern of our communication policy. Our communication policy should be a positive statement of what we are trying to accomplish with communications, and we should think in terms of broad strategic communication policy from this Committee. Ideally, I would go so far as to adopt metrics about whether or not we are accomplishing our goals through our communication policy. I think the general judgment over the last three years is probably that we are not accomplishing what we want to accomplish as a Committee.

My feeling is that our existing strategy has too often allowed others to define the Fed and to define this Committee, and we need to have strategies and ideas about how to get our ideas out there. To put everything in a narrow framework about whether somebody will make a misstep at some point is not helping that. I think that, because we have this view, and it is a longstanding view around the Fed, it has allowed public relations problems and misinformation to fester, and I am very worried that this might do lasting damage to the institution.

I do not think that rules can be written that encompass every situation in which we might find ourselves, and I also think that anyone we talk to, in principle, could profit from anything that we say. So I don't think you can have a prescriptive thing that maps out every single situation. I don't think that's a good way to go.

One general policy would be to convey the same messages in all forums and never reveal confidential information about what is going on in the Committee itself. I think pretty much everybody adheres to that. In general, I think that active engagement with all audiences should be encouraged. That should be something that we are trying to do and trying to get done. By 'all audiences,' I mean financial markets, business leaders, the general public, and, in fact, I would greatly expand our contacts. I would try to think about whether we're doing enough and

whether we're communicating with certain audiences. Obviously, we're missing certain groups of people, and they're going off and developing their own ideas about what we're about and what we're doing. To put limits on that is going to impair our ability to get messages across and may damage the institution.

So I would prefer a positive statement that emphasizes engagement with all audiences. We certainly do not want people to profit from what we're doing, but, in some sense, any time you utter a word, I suppose somebody can trade on it. I would, however, dispute the claim that you can trade successfully on very much of what anybody says around here'I certainly think not, but maybe people think that they can. We're giving our own views about where we think policy should go, but each of us is just one voice on a big Committee. Certainly, the Chairman is different. The Chairman has a huge megaphone, but the Chairman's interactions are more prescribed, probably, than are those of the rest of us.

Also, many of us talk to a variety of councils that come into the Banks. Are we going to say that that guy on the council might turn around and profit? I think this is just a very difficult thing. So you have to follow this code where you say, 'I'm giving you my own positions.' I say the same things all the time. I have the same messages all the time. And I'm happy to try to communicate those messages. But I don't think that you can prescribe that such-and-such situation is out of bounds.

MS. YELLEN. Could I just ask a follow-up question?

CHAIRMAN BERNANKE. Sure.

MS. YELLEN. Do you think it would be okay to talk to the clients of a financial firm behind closed doors about your personal views on monetary policy?

MR. BULLARD. Well, like everything else, I think it's a judgment that has to be made.

MS. YELLEN. They could be benefitting.

MR. BULLARD. It's possible that the audience is so large'I did one that was 400 people, and it was basically the whole financial community in the town.

MS. YELLEN. Well, suppose the sponsor is a financial firm, and the firm has arranged a conference for clients, and you're asked to be the speaker.

MR. BULLARD. In that case, you could insist that members of the public be allowed. Or, if media are there, then your comments are going to get reported anyway. Also, we put our speeches and the Q&A on the web after the event. So, given that, are you imparting special information to a select group? I don't really think so. Are you giving the same messages you always give? Do you want to communicate with this group? Yes, you probably want to get certain messages across to this group.

MS. YELLEN. Okay.

MR. EVANS. Jim has got a good point. I'm not quite sure how to define this. There must be financial industry councils that the New York Fed or other Reserve Banks have, and you talk to them, maybe with more Fed people there. But if it's not open to the public, I'm not quite sure exactly how that's different from the private meeting with a financial firm's clients. I think a little more definition of the examples that we're contemplating would be very, very helpful.

MS. YELLEN. An example is that Merrill Lynch asks you to come to a client conference where you will be the main speaker.

MR. EVANS. I've never done that, but I think there are probably some examples that we all have shared where there might have been a dinner that felt a little uncomfortable.

MS. YELLEN. I know exactly what you're talking about, and I would regard that, after having contemplated it, as something we absolutely shouldn't do.

MR. PLOSSER. But suppose it was a conference and, as Jim said, there were 300 or 400 people there, and the press was there. Would it matter? If the press was there, which essentially makes it public, you would probably write your speech for that conference just as you would write any other speech.

MR. FISHER. But imagine this news article: 'Charles Plosser met today with selected clients of Goldman Sachs and said the following.'

MR. PLOSSER. I'm asking a question. I wasn't trying to propose an answer.

MR. FISHER. You asked for an example. It seems to me that the optics there would not be good.

MR. BULLARD. Okay, but we do something much worse than that'we meet with Goldman Sachs in private right now.

MR. FISHER. I don't.

MR. BULLARD. I think we do.

MR. EVANS. Well, what about talking to 30 CEOs before every FOMC meeting?

MR. FISHER. I'll tell you how I do that, because that's important. The ground rules are that I will impart no information, and I will only listen.

MR. EVANS. Oh, you don't have a conversation with them?

MR. FISHER. And they're not financial firms. I do not impart a thing, including my own views.

MR. EVANS. Well, you could talk to financial firms, too.

MR. FISHER. And if Toys R Us can make a profit off of my interaction, that would be something. But we have very strict rules.

CHAIRMAN BERNANKE. Okay. President Lockhart, would you like to enter into the conversation?

MR. FISHER. I do think, though, that we have to think about the optics here as well. MR. LOCKHART. First, let me say thanks to Tom for pointing out FRAM'I think it's

a good foundation. Over and above that, I really favor an informal set of guidelines and principles that puts the emphasis on exercising good judgment and taking perhaps greater care going forward. I think strict limitations on contacts who might'I emphasize the conditional' generate trading or positioning profits is unworkably broad and, certainly, in my case, might interfere with the usefulness of many contacts. Likewise, defining a strict frequency limit or rule, I think, goes too far.

I don't favor centralized reporting, but I do think it's reasonable to assume that each participant will maintain a record of meetings and contacts. And I do favor some tightening of elements of the guidelines. For example, meetings with most parties, and certainly those with the press, should include, if possible, a public information officer as an associate or someone from the research department'a witness, if you will. I think events in which businesses, clients, and prospects are the exclusive invitees, should be avoided or discouraged, even if the media are present, because I don't think that changes the appearance of privileged access.

I think participants should refrain from characterizing FOMC deliberations before the publication of the minutes, and then, after the minutes are out, they should characterize FOMC meetings in a manner consistent with the minutes. And, of course, I think we all agree that we should adhere to a defined blackout period. That's something I think should be strictly defined.

On the question of expressing personal views on monetary policy that have not been stated publicly, again, I think this goes a little too far and should be left to judgment. I accept the spirit of this guideline, because it does suggest privileged access to insider views.

And, finally, if guidelines and principles are adopted by this group, I think they should be made public.

CHAIRMAN BERNANKE. President Plosser.

MR. PLOSSER. Thank you, Mr. Chairman. My views are a lot like Jim's. I think part of what makes policy good is transparency, and the more transparent we can be, the better off we would be in general. Policies that are controlling can backfire on us. Tom's point about FRAM indicates that there are already guidelines in place about what we should and shouldn't do. I don't think we can legislate good judgment here.

I would note that this mostly refers to FOMC participants, not staff, whereas the guidelines in FRAM suggest senior officials'

MS. YELLEN. It's our intention to develop corresponding guidelines.

MR. PLOSSER. I'm not accusing anybody, but staff contacts with the private sector and the media can also create these kinds of issues.

MS. YELLEN. We intend to address that.

MR. PLOSSER. I think one of the things that oftentimes gets us into trouble or misunderstood is when we go off the record. My impression is that the Board, for example, gives very few on-the-record interviews, and, instead, the discussion is oftentimes on background.

MR. KOCHERLAKOTA. Charlie, are you talking about contacts with the media at this

point?

MR. PLOSSER. I'm talking about the media or some people who are Fed watchers. MR. KOCHERLAKOTA. Okay.

MR. PLOSSER. My own personal approach is never to say anything to anybody that I wouldn't say publicly or haven't said publicly, for example, in a speech. I think there are lots of gray areas here. I agree that it would not look good for one of us to speak at a Goldman Sachs venue, but, at the same time, all of us, I suspect, have spoken at banking conventions sponsored by a not-for-profit organization, such as the American Bankers Association, but basically the attendees include clients and donors and funders. Is that acceptable, whereas something else may not be? Or what about a university event, where alumni are raising money to support the institution? There are lots of cases where it begins to get a little fuzzy, so I'm leery of trying to legislate that kind of controlling policy.

I want to encourage communication. I want to have more communication, not less, and have more open communication and less behind-the-scenes communication. I think enforcement is going to be really, really difficult, and, again, I think we just can't legislate good judgment. I would prefer that we adopt broader guidelines that apply to everybody and then trust that we will use our best judgment, rather than adopt an attitude where we sow seeds of suspicion by trying to control behavior tightly. That's just my general philosophy.

CHAIRMAN BERNANKE. Thank you. First Vice President Moore.

MR. MOORE. Thank you, Mr. Chairman. I don't have much specific to offer here. I would just make the observation that I think the Federal Reserve System is perceived as being very cozy with the financial sector, and very distant from the general public. And, in that context, I think anything we can do to suggest less coziness with the former and closer proximity to the latter, would serve us well. Thank you.

CHAIRMAN BERNANKE. Thank you. President Pianalto.

MS. PIANALTO. Thank you, Mr. Chairman. I also want to thank the subcommittee for their work on this important issue. As I was developing my answers to the questions, I found myself gravitating to the second issue, which is the potential limitation on content. By limiting what we communicate to information that's already available to the public, we greatly minimize the actual or perceived problems associated with individuals who stand to gain financially from their interactions with us.

There is an analogy in the private sector to this'the SEC's fair disclosure rule. That rule prohibits the selective disclosure of material and non-public information to selected persons, such as securities analysts or institutional investors, before that information is disclosed to the general public. The regulation requires that, when material information is intentionally disclosed, it be disclosed publicly and not selectively. That line of thinking helped me answer some of the questions.

In question 2A in the subcommittee's memo regarding content, I think the strict adherence to the Program for Security of FOMC Information that we approved yesterday is essential. That means not sharing the views of others, or even characterizing the FOMC conversations, and letting the minutes provide the summary.

In question 2B, I also don't think that anyone should have non-public information, even about a Committee member's own views. Our own views would have to be presented publicly before they are given to any individual.

Regarding question 1 on access, I think that FOMC participants should strive, as others have said, to avoid being in situations where it might appear that we're giving confidential information or information that isn't available to others. That means paying close attention to

the venues that we select, as we've been discussing, as well as to the frequency of questionable contacts, so that, again, we avoid the appearance of any favoritism.

Finally, regarding whether this should be informal or formal, I agree with Governor Yellen that it should be formal, and I think that sharing it with the public will help us respond to requests and help us explain why we aren't accepting some of the requests. Thank you.

CHAIRMAN BERNANKE. Thank you. President Evans.

MR. EVANS. Thank you, Mr. Chairman. I want to thank the subcommittee for putting in a lot of hard work on a very difficult subject. I did write a fairly detailed response to the subcommittee, so anything that's in that response but that I don't bring up in this discussion still applies. I also appreciate the perspective that Tom brought to bear from FRAM. That accords pretty well with what I would have hoped that we already had in place, so I agree with that.

At times, I've thought that the reason we sometimes see questionable things from Fed staff in the newspaper could be that there is just not sufficient training for all of the staff and that we aren't always very clear about what the security guidelines mean. I know that, for information security and ethics training and so on, we have online guides and even certification exercises, so maybe we could do something like that every year on this issue. At any rate, I think that training could help, and FRAM is already on point on a lot of the issues.

I agree with Jim and Charlie and others in thinking that we need to communicate a lot more. I think we've been undertaking very difficult monetary policies that are hard to explain. During a very difficult period, they're susceptible to being picked apart, fairly and unfairly. We need to make sure we have a policy in place that allows us to go out and explain, as best we all can, what we're trying to accomplish and why it's the right policy. So, if we go down a

particular path that ends up putting a lot of restrictions on how we're supposed to talk, and so on, it will work against enhanced communication.

As Charlie Plosser said, it's really hard to legislate good judgment, so we're counting on everybody to use their best judgment. I'm not optimistic that we're going to be very successful if we try to write the guidelines down in a legalistic fashion. I think we need access to the kinds of parties, such as the financial sector, whom we're concerned about. I agree that talking to a closed meeting of financial clients is inappropriate, and we need to be careful about that. But when I talk to people in the financial sector, if I ask the right questions and know what to probe for, I come away with something pretty useful for what we're doing. I don't think it's enough to count on New York and the Board of Governors to have a monopoly on that information without our having our own independent perspective. So we need to figure out how to do that.

I think having more examples of the bad choices would be helpful. At the moment, I've just got a bunch of straw men on my list, and I don't know if I should be very upset because it's so proscriptive, or if instead I completely agree about talking or not talking to that particular group. I guess we don't really want to name the particular individual who might be responsible for a lot of this whole discussion. Is it bad that we talk to certain people quite often? I felt uncomfortable after I saw something that this person distributed to his clients, and I stopped agreeing to do that type of phone call for quite some time'even without the rules. Sometimes financial groups have invited me to speak and, to assure me that it's appropriate for a Fed official to do this, they've said, 'Don Kohn came and talked to us.' I know Don has good judgment about these things. I know that he also knows how to talk to people and not say things he shouldn't say. [Laughter]

MR. TARULLO. He did it for 40 years, Charlie.

MR. EVANS. Yes, that's exactly it. Don once told me, 'The minutes come out tomorrow. I always read the minutes very carefully, because that reminds me of the language in which we talk about various things.' Do the rest of us do that before we talk to a group? I know I don't. I think The Wall Street Journal is particularly effective at getting certain messages out, so we need to be careful about how restrictive we might be'I can talk to a whole bunch of people and not get any press.

I think informal guidelines would be better than strict ones, and I, personally, speak openly anyway when I talk to people. So I don't think I am giving different messages to different people. I just say what I want. If I thought that the rules were pretty proscriptive and difficult, I might be tempted to regularly post my observations on how I thought things were going and have it in a nice place on a website. That may or may not be in line with what you are actually trying to get across, but it would be in the spirit of communicating very openly to everybody.

MR. KOCHERLAKOTA. In 140 characters or fewer. [Laughter]

CHAIRMAN BERNANKE. President Lacker.

MR. LACKER. Thank you, Mr. Chairman. I, too, want to thank the subcommittee for putting in time and effort and good thinking to help us on this. I strongly support an effort to come to a mutual understanding about the standards of integrity we expect of each other, and I think that's really worth doing.

I've been wrestling with this since the subcommittee sent out materials for us to review. I thought I had a grip on a number of principles, but I realized I hadn't thought deeply about what they're grounded on. I think it's difficult to draw bright lines, and that's what I am struck with in reading what you have distributed. Let me take this phrase as an example: 'individuals

whose purpose may be to generate direct or indirect trading profits.' I'm often at receptions around the District, where I talk to people who are members of the public. As someone else remarked, virtually any of them could have a portfolio on which they could make a decision that might reflect what they thought they gleaned from what I said. I think we all know what we're trying to capture'the Macroeconomic Advisers of the world'but the net is drawn too loosely.

The other issue is predicting monetary policy, and that stuck in my head for a bit, because, if you look at this from a broader perspective, we've been on a three-decade journey towards greater transparency, towards fuller communication. I think we talk a lot more about our individual views than we used to. I haven't gone back and compared speeches, but my general sense is that, over the last 20 years, members of the FOMC'Governors and Presidents'say more in public about their own views than they used to. We used to be much more guarded. Central banks around the world over the last 20 or 30 years have become much more forthcoming, and I think there's a really good reason for that. I think that we all understand that we are more effective the more the public understands about how and why we do things. We want people to understand our reaction function, so, in some sense, we want people to be able to predict monetary policy. That creates an inevitable tension. Obviously, if markets expect a move of 25 basis points, and somebody tips them off that it's going to be 50, that's a problem. But, explaining macroeconomics to somebody presumably doesn't prejudice a decision and helps what we're doing going forward. Between those two poles there's going to be some fuzziness; for example, the elements of macroeconomics that you choose to enlighten people about can convey information about your views'in fact, this is a time-honored Fed communication practice that we use to hint about one thing or another.

This is a hard issue to resolve, and it draws me strongly to the idea of dealing with it in terms of principles rather than prescriptive, detailed, legalistic rules. Along the same lines, I think that centralized reporting is going to absorb a lot of time and effort on a small fraction of cases that are sort of blurry; for example, people will be spending time trying to figure whether they should report something or not, and it's not likely to be worth the effort. I think what we're going for should be a mutual understanding of the general principles involved, which are selectivity of access and inappropriate disclosure, or the perception of those two things.

I think what President Bullard said is really important. Imagine that we adopt a formal policy on communications. Imagine that it's also secret. So we adopt a secret policy on communication'well, that doesn't seem right. I think we're going to be drawn towards releasing our policy. And I think President Bullard is right that we want to frame it in the broad context of the value we see of communicating to American citizens. I also think First Vice President Moore is right that we're perceived as cozy with Wall Street when the reality is that we spend a ton of time with the citizens around our Districts.

In sum, I think it would be useful to have that come through in a statement of what we think our communication is about, and how we do it with integrity. I would urge the subcommittee to think about it from both the positive side and the negative side and try to craft a philosophical statement that starts things off and says something like, 'Yes, communicating to the public is important, because they need to understand what we do, why we do it, how we do it, what goes into our thinking,' and so on. Then, 'At the same time, there are some things we need to keep confidential for the integrity of the process. Here is how we constrain that.' But put that as part of a broader, more positive message about communication. These are my initial thoughts on this, and, at this time, it is all I have to offer.

CHAIRMAN BERNANKE. President Fisher.

MR. FISHER. Unfortunately, Mr. Chairman, I have to leave, because I'm giving a speech tomorrow morning to the Armstrong Dad's Club at a local elementary school'it's not about monetary policy. [Laughter] I apologize for not being able to stay. I do think this is a very good suggestion. We have talked about this. I don't want to talk too much because I'm on the subcommittee, but we should frame it in the positive sense that President Bullard and others mentioned, that we're attempting to communicate more broadly. I think John hit the nail on the head'we're viewed as being too cozy with Wall Street and too opaque to the public. If we phrase it that way, we can also point out some things that we do not do, such as provide inside information to unnamed former Governors who are consultants, so that they can make a profit. I think we could emphasize that within a positive context.

I think President Lacker is right that having very bright lines is extremely difficult. I think good judgment, in the end, is what is required. What we are really talking about here is reaffirming an ethic that makes us an exceptional institution. There are some bright lines, however; for example, Sandy referred to the SEC fair disclosure rule. I'm also sympathetic to broadening the group, as Charlie said, because it's not just principals at this table but also the staff that have access to inside information, and we have to be very careful not to allow anybody to trade on it.

But the general principle that has been expressed here, which is fairly new for our subcommittee to hear, is to put it in a positive context. Our job is to communicate as broadly as possible, to inform the public, and not to have certain subsets of the public have privileged information from which they either might profit or it might be interpreted that they are benefiting at the expense of others. If I may be excused, I would be grateful. Thanks.

CHAIRMAN BERNANKE. Thank you. Have a good flight. Vice Chairman. VICE CHAIRMAN DUDLEY. Thank you, Mr. Chairman. I agree with Jeff on the

communications. We don't want to make it look like we are trying to clamp everything down. In fact, we want to frame it so that we're actually opening things up and communicating to people in a fair, transparent way, so that everyone has equal access to the information.

It seems to me there are two broad guidelines that we're trying to conform to. One is not to communicate material, non-public information to privileged parties; we want to avoid that at all costs. Included in that material, non-public information would be, of course, any talk about what happened at the FOMC meeting, because that is material and it is non-public; for example, one wouldn't talk about what someone said at the FOMC meeting. I don't know that we have to define each of those little pieces, and, instead, if we use the category 'material, non-public information,' I think we all know what that is and can make judgments about that.

The second broad guideline is a bit more difficult'we shouldn't participate in any forum or meeting that provides a commercial benefit to that party. This is particularly relevant to accepting speaking engagements. Therefore, for example, I shouldn't go speak at Goldman Sachs and talk to their clients. And I would never do this in a million years, believe me, and the reason is that Goldman Sachs benefits from that. I'll give you an example of how far this can go. I had a phone call from someone that used to be my boss who wanted me to give him a reference to another financial firm, and I refused, because I felt that if I gave him a positive reference, which he probably deserved, I was generating a commercial advantage for that person. So we don't want to do anything that provides a commercial advantage to a party.

Now, the reason why this gets tricky is that it's hard to say where it ends. Speaking at a financial firm for its clients is obviously out. Speaking at an advisory firm for its clients or that

is going to use the information somehow, is obviously out. But how about a university? I gave the commencement address at New College. Well, it's probably beneficial to New College to have me as their commencement speaker, and that is probably creating some commercial advantage to them. So does that mean I can't be the commencement speaker at New College? Here's another tricky example. Let's say you're going to meet with the board of directors of one of the banks in your District. Well, it's good for that firm to have that contact'it probably makes the board of directors feel better about being on that bank's board. I think that's probably okay, but there's a gradation of cases, and I think it's very hard to draw the line precisely at the point where the commercial advantage is significant enough that it's out of bounds. One that's clearly out of bounds is talking to a firm that's a Fed watcher'that person you spoke to is going to take that information and sell it for profit.

I think the principle is clear, but exactly how far down you go is a little bit more difficult. Maybe we can specify examples that are very clearly out of bounds, specify gray areas, and then specify some things that we think are acceptable, say, doing a speech for a nonprofit organization.

MR. LACKER. A trade organization.

VICE CHAIRMAN DUDLEY. Trade organizations.

MR. ROSENGREN. A fundraiser for a nonprofit would be okay?

VICE CHAIRMAN DUDLEY. Well, that's an interesting question'for a university, for example.

MR. ROSENGREN. If the organizer invites only wealthy alumni from a university for the sole purpose of raising the endowment of that university, do you think that would be okay?

VICE CHAIRMAN DUDLEY. I don't know.

MR. LACKER. How is that different from a Chamber of Commerce?

VICE CHAIRMAN DUDLEY. Remember that you're not disclosing material, non- public information. There are two separate things here. But I think this is tricky. I think the education one is the particular one that we need to spend a little bit of attention on.

Let me just make a few other points. I actually am in favor of reporting all meetings. I think this is just a transparency thing. If you don't report them, then people are always going to be suspicious of whom you're meeting with, and if we're all doing the right thing and meeting with the right people, then we shouldn't be embarrassed by whom we're meeting with. I just don't think it's that big a deal to report it.

I think it's useful, as others have said, to have a third party in attendance when possible, be it someone from research, communications, or the executive office. That provides protection if you ever get into a 'he said, she said' situation, because the third party can actually repudiate what the person reported you said if you didn't actually say it.

I would prefer to have a formal policy, even though the formal policy may just be these high-level principles. It seems to me that we want to have something written down. I'd much rather tell the Congress that I have a formal policy than an informal policy. How could I justify saying, 'Oh, we just have an informal policy about how we communicate'? I think that would be hard to defend.

Finally, on the staff issue, this is a red herring, in my opinion. Speaking for the New York Fed, we went through the crisis for years and dealt with all sorts of special stuff. As far as I'm concerned, nothing ever leaked from anybody. So I don't think it's a staff issue. I really think that's off point. I think it is about us, how we behave, how we talk. I don't think the staff is the problem. I really, really don't.

MR. EVANS. Could I just add to your point on the formal versus the informal policy? I don't think it's as easy as just sort of saying, 'I call it formal. You call it informal.' I can imagine somebody saying, 'Well, a formal policy is one where there's some kind of audit trail, where there's some check against what you're actually doing.' And I think that's where we would trip up.

VICE CHAIRMAN DUDLEY. A written record of whom you met with would be part of that formal process, right?

MR. EVANS. Well, okay. But, if it ends up being something that is an audit trail like our internal audit or something like that, then it's going to take on a very different nature, and I think we'll end up tripping over the little things. It's one of the things auditors do'they say, 'Here's a list of what you say you do, and here's what you actually did, so you missed on a bunch of things.' That could be embarrassing.

MS. YELLEN. Well, it seems to me that a formal policy could be a statement of ethical principles, possibly couched in the positive way that you and Jim and Jeff and others have proposed. It could be a clear statement of what one's ethical obligations are. Obviously, there are gray areas when it comes to specifics. But the idea is that, even though it's not quite enforceable, a positive answer to the question 'Do you adhere to high ethical standards' is not voluntary, it's obligatory.

MR. BULLARD. I had one comment on Vice Chairman Dudley's remarks. I thought that the most out of bounds thing that you could do is to talk to a board of directors, especially of a financial institution. I was taught in the Fed that that was the most out of bounds. And you, in contrast, have the idea that, if that same bank has its clients in with a big group, that's what's out of bounds. I think that difference shows how murky this is. When you talk to the bank directors,

you're going right into the bank, and that could be perceived as giving inside information directly to the financial institution.

MR. LACKER. The context is that our supervisory staff frequently meets with boards of directors of banks we supervise.

MR. BULLARD. That's different.

MR. LACKER. Occasionally, these are large, prominent firms. The Reserve Bank President is invited along. There are times when I accompany my staff for a particularly important meeting.

MS. YELLEN. But for supervisory purposes.

MR. BULLARD. To talk on supervisory matters.

MR. LACKER. Right, but it can happen that one is quizzed about macroeconomic information. It hasn't happened to me though.

CHAIRMAN BERNANKE. Governor Warsh.

MR. WARSH. Thank you, Mr. Chairman. I have a few broad comments. First, I view this subcommittee that Governor Yellen is heading as important and the successor to a long set of communications discussions. I don't view the discussion that we're having or should be having as the 'gotcha' committee because of particular ill things that we're trying to root out. If that comes out of a broader discussion of how we best communicate and what things are to be avoided, that's fine, but I don't think that this should be reflected as somehow catching bad guys, and that's what is occupying our time.

Second, I favor constitutions, not penal codes. I think the penal code concept suggests somehow that there has been a grievous breach in decorum, respect, comity, civility. I haven't seen any of that, even in the big fights we've had over LSAPs. I think we run real risks to the

integrity of this organization if we decide that we're going to set up controls, audits, systems, processes, and procedures. We would look a lot like other agencies and a lot less like the Federal Reserve a couple of years after that. So put me in the camp of constitutions. Constitutions aren't something that people can disobey. Constitutions matter. They impact people's behavior. Views and interpretations of constitutions are important, but I think they're very different from penal codes. If you look at countries that start out with 10-page constitutions and then have thousands of pages'I'm thinking of particular countries in South America'you see republics that are breaking apart at the seams.

Third, I think we've got different classes of counterparties, each of which demands a different set of judgments. For example, regarding market participants, I agree with Charlie Evans that you can get a lot out of having a discussion with them, so it strikes me as a discussion that should be encouraged and not discouraged. That doesn't mean there shouldn't be rules of the road. Another class is the people who stand between us and the real world to communicate' I get nothing out of those discussions, though I see what they get. As a result, I would bring different rules of the road to the frequency and necessity of those sorts of conversations. Finally, there's the press. I think that's a different discussion from the one we've been having and it should be thought of differently with different rules. I don't have any perfect solutions but I wouldn't conflate the press with intermediaries who stand between us and financial markets.

I have just two more. Fourth, the Chairman is different from the rest of us. And it strikes me that not only is this Chairman different, but Chairmen are different, and we should think about the discretion they might need, because their communication of policy is fundamentally different from that of Governors and Presidents. As a result, I think we wouldn't want to constrain the Chairman with rules, particularly at times of crisis.

Fifth, I think Bill rightly brings up the point of material, non-public information. Let me combine that with the discussion about the need to communicate more, to tell people more about what we think. In my view, the world hears from a lot of us all the time, and there's a big difference between the frequency of communication and their understanding of how we're thinking about policy. I don't happen to share the view that more is always and everywhere better. If I can only say to group X what I said in a public speech, then, for those of us who tend to speak less frequently, you feel compelled to get your evolving set of thoughts on the record on a monthly basis, otherwise you run afoul of the penal code. I don't think that that's necessarily good. I trust everyone around here to make his or her own judgments about how frequently they should speak, and I wouldn't want to tie private comments to the most recent things that were said in the speech to the local Rotary. Thank you.

CHAIRMAN BERNANKE. Thank you. Governor Duke.

MS. DUKE. Thank you. I have just a couple of thoughts, and going through this process has opened my eyes to how difficult it actually is. First, a number of people have talked about judgment, and in information security or control mechanisms, there's always the basic tenet that your overall security program is only as good as the weakest link. In this situation, our reputation is only as good as the weakest judgment among us, so the judgment calls that each of us makes will affect the reputation of us collectively. I think it's important to keep that in mind and continue to discuss it.

Second, I think one thing we really are trying to guard against is sort of 'synthetic' confidential information. We all understand what the actual confidential information is'the written materials, what's said in this room, and so on. But what about the things that each of us is thinking, the things we're talking to each other about not in a formal FOMC meeting, and the

opinions that we have? By talking to each of us, somebody could create confidential information. Given that, I do think we need some coordination mechanism to understand who's talking to whom in order to avoid the appearance, if not the reality, of somebody being able to create synthetic information.

Finally, there's a tendency to think of this communication issue as covering conversations in formal settings, but, in reality, each of us is always an FOMC participant, and, just as Governor Raskin gets caught between the tabloids and the gum, I've been tackled in bars and I've been tackled on the beach [laughter] by people wanting me to explain what it is we're doing. If I felt that the only answer I could give them was something I had already said in a public setting or in a speech, I would have to start tweeting, I really would. So I think we have to be careful about prohibiting saying anything that you haven't said in public. Doing so could create an awful lot of noise from things being said in public just so that they could then be said in private.

Finally, I come down in favor of formal principles with some suggested guidelines that go along with them, and I think it does make sense for those to be positively framed rather than negatively framed. Thank you.

CHAIRMAN BERNANKE. Thank you. Governor Tarullo.

MR. TARULLO. Thank you, Mr. Chairman. My first point picks up on something that Kevin said and a couple of people echoed, but it was notably absent from the beginning of the go-round, and that point is that there are discrete issues here. The one that I think is front and center is that of exclusivity of access, particularly exclusivity associated with profit and trading for profit. The issue of communication seems to me a different one'related perhaps, but a much more difficult one'and, as you said, Jim, one that has more affirmative elements to it and

not simply negative elements. As you could tell from my earlier question to Eric, I, like Kevin, think the issues of the press are perhaps deserving of some conversation, but they're separate, as well, in part precisely because if the press itself is acting ethically, exclusivity is not an issue.

They literally are speaking to the world whenever they repeat something that they have heard from one of us.

My second point is a little hard to say, but I'm going to say it. I disagree with Kevin on this notion that somehow the Federal Reserve is special and that the rules that apply to the rest of the government don't apply to us. I'll be honest and say that's one of the things that has concerned me about the Federal Reserve in the two years that I've been here. I'll begin with ethics. There have been some things that I have seen'and, again, it's hard to say this' particularly associated with some of the behaviors of some directors at Reserve Banks that just shouldn't be allowed, and I think we need to formalize things considerably more than they have been formalized.

The third point is that rules are hard. Rulemaking is difficult because you always have under-inclusion and over-inclusion. This is why rulemaking processes are not a straightforward exercise, and why rules are not always the best approach to take. But, Charlie, precisely because one cannot legislate good judgment, there are times when one needs to legislate behavior. I think there are circumstances in which the potential for over- and under-inclusion is sufficiently circumscribed that one may need something approaching a rule, even though, in a lot of other areas, principles and examples and guidelines are more appropriate mechanisms. In a way, some of this discussion was like a first-year law class. People state a position, and some people create a hypothetical that's at the edge of that position to show how you can't possibly have a rule.

Well, of course, you can have a rule, but you can't necessarily cover everything with that rule. Several people have been explicit about this, and I agree with them.

The most disturbing thing right now is the phenomenon of someone who comes in, talks to most or all members of the FOMC and then to a group of paying clients, essentially advertising that fact and suggesting that there's a special kind of information. This is not limited to one person, and this is not just Macroeconomic Advisers, although they have been mentioned. Way before I was at the Fed, I heard people going around town saying, 'Oh, yeah, I have lunch with X and Y at the Fed, so I kind of know where they are, and this is where the Fed is heading on this.' I think this problem is more serious than most of the people around the table think it is, and I have believed since I've been here that there was a real problem waiting to explode. Now, we've had a lot of bad press, which has been about other things, but I really think there's the potential for problems here. And I have to say that it's not just limited to, as I said, the Larry Meyer type of issue at all. I think Larry is going to bear the brunt of a lot of this in some respects, but it really isn't limited to him. We're not at the point of being able to write that rule, but that doesn't mean we don't need to be in favor of doing so. I would add that I really think we need rules for the conduct of directors of Federal Reserve Banks. I really do. Thank you.

VICE CHAIRMAN DUDLEY. Regarding what particular things?

MR. TARULLO. There have been meetings where people are formally here in their role as directors and they have attempted to lobby me on applications dealing with their institutions and/or pending regulatory issues. In one case, even when I suggested to the individual that it was inappropriate, he persisted with my colleagues and attempted to come by my office the next morning. I just think we need a code of conduct to prevent that sort of thing.

CHAIRMAN BERNANKE. Governor Raskin.

MS. RASKIN. Thank you, Mr. Chairman. I, too, want to thank the members of the subcommittee on communications for helping to guide this discussion. I have certainly learned a lot listening to everyone's comments. Certainly, the notion of having an overarching philosophical statement is a good one, so, in that spirit, I would offer the following. In considering why central banks communicate with outside people, I start with the overarching principle that they do so to enhance transparency, and there are really two fundamental purposes in doing so. First is accountability. There's enormous power inherent in a central bank, so the political process has the ongoing responsibility of evaluating whether our exercise of that power is meeting society's goals. In other words, the public has to have information to conduct an effective evaluation of our work. The second reason we aim to enhance transparency is that we're in the business here of managing expectations of inflation and of the future path of the policy rate. In thinking about the second reason, which is essentially about the conduct of monetary policy, my evolving view is that we want to make sure that we remain accountable while at the same time we want to make sure that we are correctly managing expectations. And we want there to be an explicit responsibility. To use Governor Duke's metaphor, we wear the FOMC hat when we're in this room, and we wear it when we're outside this room. And, because we're in the business of managing expectations, anything that we communicate is, in essence, communicating something about our personal views or the Committee's views.

If we believe in this second purpose of transparency, then we have a collective responsibility to make sure that our communications serve the policy paths that we have agreed to. When we significantly depart from this responsibility, we undermine the Committee's decisions, and we inject significant suboptimality into the policy decisions.

So when you think through the notion of the optimizing the work that we do here, I think you can see guidance evolving towards one that includes some notion of timing. We've been talking about content, but there's also a notion, I think, of timing. So in other words, we think through when it is, how long we're going to give decisions time to play out, and at what point we let views come in that could be shaping, in essence, the policy decisions that are made in this room.

I'll summarize by saying that I think the FOMC is a collegial committee and is

responsible for the conduct of monetary policy, and as such, its responsibility extends through the whole decisionmaking time line. It extends to pre-announcement effects of prospective actions. It extends to what goes on in this room and persuading colleagues of the views expressed when we do our deliberations, and it also extends to the effects of our policy statements and the minutes on market expectations. I will stop there.

CHAIRMAN BERNANKE. Thank you. President Kocherlakota.

MR. KOCHERLAKOTA. Yes, I'd like to follow up on Governor Raskin's comments because I thought you laid out a really good way to think about things. I would just add one aspect. I think another role in our communication is listening. Communication is not just us talking and telling people what we want them to hear. Part of our role is to listen to what's going on in the economy. That's where you end up in these private settings, really. It's not so much that I have any interest in privacy, but rather that the person talking to me might have an interest in privacy.

CHAIRMAN BERNANKE. Thank you. Would you like to sum up?

MS. YELLEN. It's great that we're all in agreement. [Laughter] I appreciate the wide range of views we've heard. I think that, at a minimum, what I would try to accomplish is to

articulate some overarching philosophy concerning communications that expresses both its positive value and the ethical principles that we need to adhere to in order to make sure that we don't create undue private advantage. How we get past there isn't obvious; the gray areas here are immense. I share the view many of you have expressed that these contacts are very valuable as we carry out our work, and I think our subcommittee really needs to think about whether we can devise any more-concrete guidelines about how the philosophy applies in specific situations. Again, I appreciate the views you've expressed, and, obviously, we have our work cut out for us.

CHAIRMAN BERNANKE. Thank you all very much. The next meeting is March 15. The meeting is adjourned.

END OF MEETING

Meeting of the Federal Open Market Committee

March 15, 2011

A meeting of the Federal Open Market Committee was held in the offices of the Board of Governors of the Federal Reserve System in Washington, D.C., starting at 8:30 a.m. on Tuesday, March 15, 2011. Those present were the following:

Ben Bernanke, Chairman

William C. Dudley, Vice Chairman

Elizabeth Duke

Charles L. Evans

Richard W. Fisher

Narayana Kocherlakota

Charles I. Plosser

Sarah Bloom Raskin

Daniel K. Tarullo

Janet L. Yellen

Jeffrey M. Lacker, Dennis P. Lockhart, Sandra Pianalto, and John C. Williams, Alternate Members of the Federal Open Market Committee

James Bullard, Thomas M. Hoenig, and Eric Rosengren, Presidents of the Federal Reserve Banks of St. Louis, Kansas City, and Boston, respectively

William B. English, Secretary and Economist

Matthew M. Luecke, Assistant Secretary

David W. Skidmore, Assistant Secretary

Michelle A. Smith, Assistant Secretary

Scott G. Alvarez, General Counsel

Nathan Sheets, Economist

David J. Stockton, Economist

James A. Clouse, Thomas A. Connors, Steven B. Kamin, Loretta J. Mester, David Reifschneider, Harvey Rosenblum, Daniel G. Sullivan, and David W. Wilcox, Associate Economists

Brian Sack, Manager, System Open Market Account

Nellie Liang, Director, Office of Financial Stability Policy and Research, Board of Governors

Maryann F. Hunter, Deputy Director, Division of Banking Supervision and Regulation, Board of Governors; William Nelson, Deputy Director, Division of Monetary Affairs, Board of Governors

Linda Robertson, Assistant to the Board, Office of Board Members, Board of Governors

Transcript of the Federal Open Market Committee Meeting on

March 15, 2011

CHAIRMAN BERNANKE. Good morning, everybody. I would like to begin by

welcoming John Williams to the table. John has been at 18 previous meetings, so it is not a new

experience for him, but this is a new position. We welcome you, and wish you the best of luck.

MR. TARULLO. Doesn't he have to sing? [Laughter]

MR. FISHER. The FOMC song; it's a great one. [Laughter]

MR. WILLIAMS. I've been around long enough to know the tune: 'It's a Small

World.' [Laughter]

CHAIRMAN BERNANKE. Governor Warsh is not with us today, as you can see. He'll

be leaving at the end of the month, so this would have been his last meeting. We will, of course,

miss Kevin very much. We will have an opportunity at the April meeting to honor him and say

good-bye.

Our ever-alert staff has informed me that today is the 75th anniversary of the FOMC.

The first meeting was in March of 1936. This is meeting number 725. If we keep going, we will

eventually get it right. [Laughter] We would like to celebrate, but somebody has taken away the

punchbowl. [Laughter] However, there will be a 'Happy 75th Anniversary' cake at lunch

today, so you'll understand where that is coming from. Without further folderol, item 1 is

financial developments and open market operations. Let me turn it over to Brian Sack.

MR. SACK.1 Thank you, Mr. Chairman. Investors generally read the incoming economic data over the intermeeting period as somewhat better than expected. However, the escalation of political turmoil in the Middle East and North Africa (MENA) and, more recently, the devastating earthquake and tsunami in northeastern Japan weighed on market sentiment, leaving many asset prices relatively unchanged since the last FOMC meeting.

1The materials used by Mr. Sack are appended to this transcript (appendix 1).

described at the last FOMC meeting: Income remains very elevated for the next two years, falls to a trough that is roughly in line with historical norms, and then increases once the portfolio begins to expand again. However, the current income projection is slightly below the path from the last FOMC meeting, reflecting the earlier timing assumed for increases in short-term interest rates and for decreases in the size of the balance sheet.

We also thought it would be useful to report on what the SOMA income path would have been under a counterfactual assumption that none of the asset purchase programs ever took place. Just to be clear to President Plosser and others'this is not a possible policy choice at this time. [Laughter] This exercise is, instead, a conceptual one conducted to help us arrive at a measure of the total effect of all of the programs on SOMA income.

Defining an appropriate counterfactual path for this exercise is challenging, and doing so requires a set of assumptions, which we have refined since the last FOMC meeting. Our approach is to assume that the balance sheet grew primarily as a function of the expansion of currency and capital since 2007 and that the procedures for adjusting the balance sheet that were in place before the crisis were maintained. In addition, we assume that interest rates followed the same path as in the baseline projections over this period. This latter assumption is a useful simplification, but it is likely to bias the counterfactual income estimates down slightly, since the purchase programs reduced the yields at which longer-term Treasury securities would have been obtained over time in the counterfactual portfolio.

The counterfactual path of SOMA net income derived under those assumptions is shown by the red dashed line in the bottom-right panel. The effects of the asset purchases on SOMA income can be measured by the difference between that path and the baseline projection (the blue line). As can be seen, the asset purchase programs are projected to boost SOMA net income substantially from 2009 to 2014, reflecting the additional coupon income from the acquired assets. By 2015, the relative income paths cross, as income in the baseline path is weighed down by the higher interest payments on excess reserves and the capital losses on asset sales'factors that are absent in the counterfactual path. Nevertheless, the amount by which the asset purchase programs reduce income in 2015 and beyond is much smaller than the increase in income through 2014, leaving the cumulative difference in the income paths positive and sizable.

Of course, other assumptions for the path of interest rates or the management of the balance sheet could produce substantially different results. The uncertainty surrounding these projections is considerable, as was discussed in the memo for the last FOMC meeting. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Are there questions for Brian? President

Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. Brian, I had a question about how the equity premium is being calculated'you take a ratio of some kind of earnings divided by the price index and then subtract out some measure of the risk-free rate, is that how it's being calculated?

MR. SACK. Right. It's based on current dividends, a projection of dividend growth that comes from analysts, and market interest rates.

MR. KOCHERLAKOTA. I'm asking because I've seen other forecasts that use different measures of earnings, like a 10-year moving average of earnings. Were you using last year's earnings?

MR. SACK. No. This uses a forward-looking measure of earnings from analysts' expectations. This is the Board staff's measure that appears in the Tealbook and elsewhere.

CHAIRMAN BERNANKE. Vice Chair.

VICE CHAIRMAN DUDLEY. I should point out that there is probably a bit of overoptimism in the analyst estimates. If you look at their earnings forecasts over time, they tend to be optimistic in terms of what earnings actually occur. So that probably causes that equity risk premium measure to be biased upward a bit.

CHAIRMAN BERNANKE. Governor Tarullo.

MR. TARULLO. Thank you, Mr. Chairman. Brian, I would guess that the primary dealers canvassed by the Desk reveal the most about likely market reactions to tapering or nontapering. But I have noticed that economists, not traders, seem more evenly split than the primary dealers on whether we are going to taper, so there is at least some difference of view out there in the market. Are there any factors that would militate in favor of tapering, maybe

differences in circumstances between now and last year when we observed the relative dominance of the stock over the flow effect?

MR. SACK. Even in the previous round of asset purchases we weren't convinced that tapering was necessary, but it seemed like a prudent risk-management strategy. To the extent that there are flow effects, this would essentially space them out gradually over a period of time.

As I said, at that time we thought most of the effects came from the stock, and what we've learned looking back on that program gives us even greater confidence in the stock view. We also feel that we are pushing much less dramatically on the Treasury market than we were on the mortgage-backed securities market. At one point we owned something on the order of

80 percent of the total outstanding stock of the current coupon that we were buying in MBS. In Treasuries, looking across all coupons, we own less than 20 percent today. Given our smaller presence relative to the market and the liquidity of the market, we think we can back away without much or any market impact.

Of course, you can make the same argument you made back then. If there were no costs to tapering, then introducing some schedule of tapering could minimize any risks that are left, even if we think they are small. But that would be a decision for the Committee about whether it saw any costs to tapering that would outweigh that. I would argue that there is perhaps a very small benefit to tapering, just for insurance, but it's very marginal in our view.

MR. FISHER. So the answer to Dan's question is that the dealers are better informed about the market dynamic and the stock argument than the economists appear to be.

MR. SACK. It depends on which set of economists you're talking about, because economists are also involved in responding to the dealer survey. So at least this set of economists who are watching these issues carefully took the view that we're not likely to taper.

MR. FISHER. May I ask a question?

CHAIRMAN BERNANKE. President Fisher.

MR. FISHER. Brian and I have talked about this, but not this bluntly'is there any reason why the dealer survey can't be shared with the FOMC principals as it goes out, so we know what's in the dealer survey? After all, Brian, you are operating on our instruction, and the Desk is responsible for collecting the responses. It would be interesting for us, I think. I had a chance to look at the survey once, but as a matter of course, is there a reason why we don't have a dealer survey circulated amongst the principals of the FOMC? Is there any reason not to? We might learn something from it. Do you feel uncomfortable with doing that?

MR. SACK. We are certainly not against receiving input from the FOMC.

MR. FISHER. No, not receiving our input, just letting us see what is in the dealer survey. MR. SACK. I see. There may be some consequences about whether it then officially

becomes FOMC material; there may be some issues we need to think through. MR. BULLARD. If it gets reported here, is it not FOMC material? CHAIRMAN BERNANKE. After the fact.

MR. FISHER. May I just ask that that be considered, Mr. Chairman? I don't think it's a big deal, but I just think it would be helpful for us. Again, it would bring us up to date. All of us are intensely interested in the reports that Brian gives us. It would help us process better the responses, as Brian reports them to the Committee. And, after all, he is conducting this on behalf of the Committee. We are members of the Committee. Unless there is a legal reason not to do it, I'd like it to be considered.

CHAIRMAN BERNANKE. President Fisher, are you talking about getting the questionnaire in advance or the results?

MR. FISHER. I'm talking about the questionnaire. Brian summarizes the results very adequately for meetings.

CHAIRMAN BERNANKE. Oh, getting the questionnaire in advance. Why don't we investigate to see if there are any legal or security issues regarding that possibility? I think, in general, more transparency within the Committee is better, but I can think of one issue, which is that we don't want the dealers inferring too much about policy intentions from the questions on the questionnaire.

MR. FISHER. The Committee is not surveying the dealers. I just want to see what the questions are that are being asked to the dealers. Also, I wouldn't recommend that we do our own analysis of responses. That is the responsibility of the Desk.

CHAIRMAN BERNANKE. We'll look into that.

MR. SACK. In this survey, we were able to make this inference about tapering without adding an additional question because we already had a question about the size and duration of the Treasury program. To preview what could happen for the next meeting, I think we do intend to ask more extensive questions about exit strategy, very similar to what we did in early 2010. At that time, we got a very complete reading of their expectations of exit strategy, and I think we would like to update that for the April meeting.

CHAIRMAN BERNANKE. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. I just want to follow up on the tapering issue. I was a little surprised that it has become the default that we would end abruptly, and I thought that, as you described, the end of the MBS purchase program was successfully tapered. There was a lot of market talk at the time that if the Committee didn't continue MBS purchases, mortgage rates would go up sharply. That was effectively mitigated by our tapering program,

and not too much happened when we pulled out of that market. I thought that the default would be that we would do something similar. I understand the arguments that you just made, but why not do something similar, because otherwise you are exposed to adverse events that would occur in the first two weeks of July, and then would be blamed on the Committee, and then the Committee would be under pressure to reinstitute purchases in order to get those yields to move in the way that markets thought they should move. So I thought that that tapering would be the default, but it seems like it has gone the other way.

MR. SACK. Well, I'll just repeat that I think there is perhaps a marginal benefit to tapering to provide insurance against a market outcome, even if we don't expect it. But our judgment is that it's a fairly marginal benefit at this point.

CHAIRMAN BERNANKE. Other questions for Brian? President Lacker.

MR. LACKER. Thank you, Mr. Chairman. Brian, the markets group did a nice piece on the effect of the increase in the FDIC premium on funding conditions. My understanding is that that's likely to discourage several large institutions in the United States in how they conduct arbitrage of borrowing in the RP market, and that they are planning to reduce their reserve holdings with us. Also, I understand that a large part of the increase in reserve holdings in the past several weeks has been among U.S. affiliates of foreign institutions, and that they seem to be funding that increase with borrowings from their parent. I was wondering if you had any insights into this trend, which seems likely to continue, and whether you think that it is going to have any impact on how the effect of the FDIC premium plays out in U.S. funding markets and, in particular, the shift to funding these reserve holdings of foreign institutions through parents. There's this rabbit hole, and you wonder from where the parents are funding the increased dollar

holdings. And is that affecting the U.S. money market? Does that end up being funded by

money market mutual funds that are holding an increasing share of foreign bank paper?

MR. SACK. I don't have a lot of insight into the distribution of reserves between the

domestic and the foreign entities. I think that is something we would have to look at. In terms of

the FDIC fee, you are correct: the assessment fee will come into place April 1, and it will raise

the cost of keeping reserves on the balance sheet and doing the arbitrage that should keep other

short-term interest rates relatively close to the interest rate on reserves. We anticipate that this

could widen the gap between market interest rates and the interest rate on reserves by a couple of

basis points. That is essentially what we see in the markets. If you look out to federal funds

futures contracts in the middle of the year, they are trading around 14 basis points. That's a

couple of basis points below where the effective federal funds rate is today.

CHAIRMAN BERNANKE. Other questions for Brian? [No response.] Okay. Seeing

none, we need to vote to ratify domestic open market operations since January. May I have a

motion?

MS. YELLEN. So moved.

CHAIRMAN BERNANKE. Without objection. Thank you. We turn now to item 2, the

economic situation, and I will turn to Dave Stockton.

MR. STOCKTON. Thank you, Mr. Chairman. By the admittedly extreme standards of the past few years, this intermeeting period was a relatively quiet one for the staff projection, at least on the domestic front, and, accordingly, we have made only small changes to the forecast. As usual, we've had to grapple with some surprising crosscurrents in the data, but none were so strong as to seriously challenge our view that a moderate recovery is under way and, despite the usual quarter-to- quarter noise, is slowly gaining strength. The major tension that we encountered in assembling this forecast was the contrast between the weaker-than-expected readings we received on spending and the generally stronger-than-expected readings on conditions in labor markets, in the industrial sector, and from surveys of business sentiment. In response to the incoming information, we lowered our GDP growth

of bank stress test results in June. Suffice it to say that we will continue to monitor these developments closely.

Our outlook for the foreign economies, along with our projection of a moderately depreciating dollar, should fuel real export growth of more than 9 percent in 2011 and 2012. Folding in the January trade data that we received after the Tealbook closed, we expect real imports to bounce back this quarter, expanding more than 11 percent, but then to move down to a pace of around 5 percent through the forecast period. Net exports, after subtracting '' percentage point from U.S. GDP growth last year on average, are expected to make a small positive contribution of about '' percentage point this year and next. Notably, we see the current account deficit narrowing to 2'' percent of GDP by the end of 2012. With the higher path of oil prices, the oil import bill will widen some, but the solid pace of export growth should push the non- oil trade balance to essentially zero by the end of next year. Thank you, and we're happy to take your questions.

CHAIRMAN BERNANKE. Thank you very much. Are there questions for our

colleagues? President Fisher.

MR. FISHER. Mr. Chairman, I'd like to ask a question both of Dave and of Nathan.

Dave, you gave a rather extended monologue on inflationary pressures, and you concluded by

referring to the TIPS-based measures that Brian talked about, and added a comment about the

Michigan survey. Would you say that long-term inflationary expectations remain stable?

MR. STOCKTON. I think I would at this point.

MR. FISHER. Based on those new data points, you still feel that way?

MR. STOCKTON. Yes. I mean, reasonably stable. As Brian noted, we don't really see

much evidence yet in the TIPS markets that there's been a significant shift in inflation

expectations. What we have on the upside on inflation expectations comes from the first half of

March in the Michigan survey. Even those longer-term expectations tend to be sensitive to

gasoline prices. As I indicated, even if you look at the increase in the 5- to-10-year ahead, and

make some reasonable adjustment for the fact that near-term expectations have increased

significantly, that upward movement, even if you abstract from that, might be one tenth or two,

which is within the range in which things have been moving. But I think that certainly is going to bear watching going forward.

MR. FISHER. Nathan, you talked about Japan in terms of the impact of the devastation particularly on the Japanese equity markets. Could you give us just a first glance'and I realize this needs to be studied'as to what kind of impact it might have on the price of key commodities, such as lumber, iron ore, and steel, that will likely be imported to rebuild Japan? And then the supply constrictions on autos and other products that they do export, or the price effect, say, on semiconductors. Have you had a chance to at least initially think that through?

MR. SHEETS. Given the rapidly moving events, any answers to those questions are still highly speculative. If they're able to quickly get a handle on this situation, and it is similar to what we saw with Kobe, then I would say those kinds of effects would be minimal. But if the situation continues to escalate'for what it's worth, that seems to be the message we are getting from the Nikkei. Following the Kobe quake, the response was very similar to what we saw yesterday in equity markets. But then there was a modest bounceback, rather than the 10 percent plunge. So it seems to me that there is a lot of concern. If anything now, the risks are tilted to the downside. Substantial disruptions there would require substantial rebuilding, and as you suggest, would probably put some downward pressure on commodity prices in the very near term when they weren't being imported there. But over the medium to long run, as they were rebuilding, it could be a substantial upward impetus.

MR. STOCKTON. We would probably expect to see some upward pressure in the tech sector from the supply chain disruptions that occurred. I think Japan provides a significant fraction of the wafers that are used by Taiwan to actually punch out the semiconductor chips. Almost certainly, there will be some upward pressure in that area.

CHAIRMAN BERNANKE. President Evans.

MR. EVANS. Thank you, Mr. Chairman. In reading the Tealbook discussion of the inflation projection, I wasn't surprised, but it does rely heavily on resource slack. Maybe it's the fact that the section on resource utilization immediately precedes the inflation discussion that reminds us of that. I know that many around the table are uncomfortable with this type of inflation forecasting, and I know that some have suggested that we focus a little more attention on growth rates. You don't emphasize growth rates so much for inflation determination. Would you care to discuss the evidence and provide a little bit of a guide as to how we might think about that?

MR. STOCKTON. I wouldn't want to overstate the importance of slack. In the models that we use, in terms of year-to-year variation in core inflation rates, slack still only accounts for a small fraction of those year-to-year variations. But we do think there is evidence to support the view that levels of slack, especially when they are as large as they currently are, place downward pressure on inflation. In the context of stable inflation expectations, however, as that slack is taken up, there will be some upward pressure on inflation. This is not an accelerationist view of price determination that underlies the basic forecast.

In at least some of the models, there has been evidence that there are some speed effects. They tend to be small, and they're not the dominant factors. You can see speed effects most importantly operating through things like intermediate materials prices, which are set in more auction-type markets, and as demand improves, it isn't the level of slack that matters, it's the actual change in supply and demand that matters. That shows through in the initial phases of recovery when you are getting a significant pickup in the industrial sector'there are more-rapid gains in intermediate materials prices, at least for a time. Then, of course, when that initial phase

is over, those price increases generally tend to slow down. That is what we call the chief speed- type effect, and that effect is built into our basic forecast here. I think we'd look at both of those things, but clearly we do believe that the evidence in both wage and price determination is that the level of slack is an important determinant of prices.

CHAIRMAN BERNANKE. President Bullard.

MR. BULLARD. I just have a couple of questions, Mr. Chairman. We often say with the Michigan survey that it is very sensitive to gas prices. So what is the correlation between gasoline prices and the movements in those expectations? Do we know?

MR. STOCKTON. If you run regressions to take a look at the importance of food and energy prices, there is a little bit of excess sensitivity, but mostly the coefficients on those regressions suggest that gasoline prices affect price expectations in the same way that gasoline prices affect overall inflation. So there tends to be in the short run some excess sensitivity, but over the longer term, not so much. We had a picture in yesterday's pre-FOMC briefing of both the short-run and longer-term responses to the Michigan survey, and you can clearly see short- run inflation expectations responding quite significantly to gasoline price spikes.

MR. BULLARD. Yes. I've said this myself many times, so I'm very familiar with it. But does it matter? One of the things that we often say about movements in key prices is that it might feed through to expectations and more general price increases, and this is the danger, and this is what we're worried about. Should we be dismissing that, or should we be taking that on board as an important indicator?

MR. STOCKTON. I think to the extent that you think the rise in oil prices or gasoline prices will be temporary, that would be an important piece of your forecast of how those expectations will evolve. If you think that's not going to be temporary, then you might think

you'd get a more persistent rise in inflation expectations, if those prices continue to rise at the rapid pace they have of late. You're right, it's the level of inflation expectations that matters. It's not the source.

MR. BULLARD. Okay. My other question is: Is slack large in Europe, and is that going to temper inflation developments in Europe?

MR. SHEETS. Our reading of the output gap in the euro area is somewhere between 3 and 3'' percent of GDP. Certainly, our feeling is that that would be a factor weighing on underlying inflation in Europe. The spike that they are seeing is very much driven by various kinds of energy prices. Underlying inflation, core inflation there, is running about 1'' percent.

CHAIRMAN BERNANKE. Governor Tarullo.

MR. TARULLO. Nathan, doesn't that vary a good bit, though, by country? That is, the amount of slack.

MR. SHEETS. Absolutely. That figure that I cited was for our estimate of the euro area as a whole. Now, the ECB may have a more narrow assessment of how much slack there is, but German unemployment is down relative to before the crisis by 2'' percentage points, while Spanish unemployment is up 10 or 12 percentage points. So there is a dramatic difference between the peripherals and particularly Germany.

MR. PLOSSER. So what would you say about the United Kingdom, then? MR. SHEETS. Which bit?

MR. PLOSSER. The amount of slack versus the inflation rates in what you'd call underlying core there.

MR. SHEETS. We also see a fair amount of slack in the United Kingdom. Our view is that it's been special factors that have driven up U.K. inflation'depreciation of the pound, taxes,

energy price increases, and so forth'but we have been telling that story now for quite some time, and the Monetary Policy Committee of the Bank of England has been telling that story for quite some time. I think all of us are getting a little bit uncomfortable as to whether there may not be something more there with the inflation story as headline inflation reaches the 4 percent range. My reading of the breakevens for the United Kingdom is that I do see a gentle upward climb in those breakevens, and I think there maybe has been a little bit of increase in inflation expectations. They have a very complicated monetary policy conundrum there. I think it's striking that at their last meeting they got dissents on both sides: They had two folks who were dissenting for tighter policy, and one who was dissenting for easier policy. They are in a very difficult situation.

CHAIRMAN BERNANKE. President Bullard, were you done?

MR. BULLARD. I just wanted to ask a follow-up question. Is regional variability in unemployment in Europe different than it is in the United States? There is regional variability in the United States, with significant differences.

MR. SHEETS. I'm not sure we have a state counterpart to Spain, for instance, but there is a fair amount of variability in Europe, and there is a fair amount of variability across the U.S. states.

MR. BULLARD. Maybe not at the state level, but probably at the county level'very high unemployment.

MR. SHEETS. Yes, sure, if you go down there, but then the counties would be a smaller, more concentrated geographical area than one of these countries, with the possible exception of Luxembourg.

MR. BULLARD. And Liechtenstein.

MR. FISHER. San Marino.

CHAIRMAN BERNANKE. President Trichet has been making this argument'and I would just inject that I don't find it completely plausible'Germany is 2'' percentage points below the pre-crisis level in terms of unemployment. Spain is 12 percentage points above the pre-crisis level. They don't have a common fiscal authority. They don't have common unemployment or retirement funds. I think the problems that they face in terms of heterogeneity seem to me to be much deeper than ours, although we certainly do have some.

MR. BULLARD. I'm not sure what the numbers are.

CHAIRMAN BERNANKE. President Lacker.

MR. LACKER. Thank you, Mr. Chairman. I would like to ask more on the staff's thoughts on this dilemma about oil price futures projecting a return to low rates of change, and yet they keep getting it wrong. Just as a context for this, a stylized characterization of the four years from the end of 2003 to the end of 2007 is that core ran 2''. We kept seeing energy price increases. We kept thinking they were about to flatten out, but they didn't, and we ended up with overall inflation of 3 percent averaged over four years. You might judge that something of a failure, at least a disappointment. So what kind of scope do you see for the line of reasoning that would say, 'The futures markets may say this, but let's act as if they are going to get it wrong and reduce the target core we want to try and run on a sustained basis, just to leave room for an upward trend in the relative price of energy.' We get these financial stability reports, by the way, that routinely question the market's assessment of a whole range of asset classes. Why don't we do that with the oil futures prices as well?

MR. SHEETS. That's a broad question. Obviously it's one that we're struggling mightily with. Looking at the path of oil prices and other commodity prices over the past

decade, it does seem like there's a trend there, and I think we could go back over the various Greenbooks and Tealbooks over the last 10 years, and essentially each time the staff has said, 'It's going to flatten out.' One point here is that we have looked far and wide for other frameworks that would dominate the futures markets, and we haven't found anything better. We present the futures markets in our forecast as a useful intellectual benchmark. I would say that if the Committee's view is that prices and the risk to oil are skewed upward relative to what we're writing down, the Committee is free to incorporate that into its deliberations, but we are just trying to provide an intellectual benchmark that's defensible and coherent for oil prices. That said, we're continuing to look, and over the next six or eight weeks we are going to look even harder than we ever have before, into other ways and other approaches that we might use to forecast oil prices and other commodity prices. In particular, it strikes me as if there might be something about China's share in the global economy that might be useful to us in doing these forecasts. As you say, it's a dilemma; it's a challenge. Obviously, as asset-like entities, commodity prices are very, very hard to forecast, and consistent with that, the essential random- walk nature of the futures forecast is more or less what you would expect for that kind of a thing.

CHAIRMAN BERNANKE. President Lockhart had a two-hander.

MR. LOCKHART. Nathan, regarding the predictive power of futures markets, I had the impression that they had individual idiosyncrasies. In the case of short-term oil futures, my sense was that the spot price and the storage cost create the curve. The futures price is obviously different than the spot because of the addition of the storage cost. Whereas for a food commodity, it would be more a question of predicting supply and demand, with maybe something else factored in. In foreign exchange, we know that futures prices are no prediction of the future spot rate; they're just interest rate differentials.

MR. SHEETS. Right.

MR. LOCKHART. To what extent is using just commodity futures as a benchmark a valid approach?

MR. SHEETS. As I noted, we have looked at a variety of other approaches and assessed their forecasting power and also their biasness or lack of biasness in forecasts, and we have not found anything that dominates the futures curves. The way we've characterized the futures curves, and I think it's the correct characterization, is that they are not very good, but they're at least as good as everything else that we've looked at so far, but we're going to continue to look. It's also true that if you look at the disaggregated futures curves, as you've indicated, you get heterogeneous stories for heterogeneous commodities. For instance, as I mentioned, right now many of the food commodities, given these weather shocks, are expecting declines going forward, and that seems to be a perfectly plausible, perfectly reasonable expectation. It's the best we've got. There are underlying stories that are useful in helping us think through what is going on in these markets. We'll keep looking.

CHAIRMAN BERNANKE. President Plosser.

MR. PLOSSER. Just to follow up, Dennis's points about both costs of carry and storage have become important elements in how you think about the actual path of the futures curve. Have you looked at predictive content of the overall shift in the curve as opposed to the level? Because I thought there was evidence that when the whole curve moves, it tells you something more than the path, and I think that is what Dennis was getting at. I wonder if you had any thoughts about that.

MR. SHEETS. In some sense, that is the random-walk nature, that these whole paths are typically moving around just for the spot price. The question is how much in addition to a random walk we are getting from the futures curve. It is just a little bit.

MR. PLOSSER. I don't know whether it's a random walk or not. We're talking about predictability here.

MR. SHEETS. Yes, that's right, how much additional predictive power do we get in the futures curve relative to the random walk. And the answer is, it's a pretty darn close call. I think that is consistent with your point that it is the movement of the up and down of these curves, but that that movement is generally being determined by what's going on in the spot market.

CHAIRMAN BERNANKE. Vice Chairman.

VICE CHAIRMAN DUDLEY. Nathan, I wish you the best of luck in your search. [Laughter]

MR. STOCKTON. If he's successful, he won't be sitting here anymore either. [Laughter]

VICE CHAIRMAN DUDLEY. Let me put it this way. If there was an easy solution to be found'the private sector has hundreds of people that have searched everything to find it. So you have to be skeptical that there's a better way.

MR. SHEETS. Right. The question is, can we find a better benchmark to condition the forecast on. I think that's the question, which may or may not have better RSME kinds of properties or better biasness or unbiasness properties. But are we conditioning the forecast on the right set of assumptions? My guess is that I'm going to come back at the next meeting and say, 'Look. Here's the futures curve. This is what we're conditioning on.' We want to keep looking, but I'm not na''ve about it either. I agree with what you're saying.

CHAIRMAN BERNANKE. Other questions? President Bullard.

MR. BULLARD. I just have one more question, Mr. Chairman. In your discussion, Nathan, you talked about weather disturbances and food prices. Do we have independent evidence that global weather patterns have been particularly different from other years, other than looking at just prices of food products and so on?

MR. SHEETS. You're pressing me here. My expertise in meteorology is limited. MR. BULLARD. I thought that there are a lot of data on this, and we could actually

check that independently instead of just relying on the stories that are told in financial markets. MR. SHEETS. Right. There are numerous anecdotes. In addition, we are being affected

by 'La Nina' kinds of developments, which have been extraordinary and unusual, and it is reasonable to expect that they are going to normalize in coming years. We have been in touch with the USDA and others so that what we're saying is consistent with what other agencies are saying, what other analysts are saying, and the broad view of the markets.

CHAIRMAN BERNANKE. Anyone else? [No response.] All right, thank you very much. We're ready now for the economic go-round, and we'll start with President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. As we collected inputs from our business contacts and directors over the last two weeks in the Sixth District, we probed especially on economic growth assumptions, including changes in outlooks as a result of oil prices, business cost pressures and pass-through intentions, and on planned investment, including motivations for expenditures. Most sources described the economy as stronger and increasingly self-sustaining but voiced concern about the potential adverse effects of continued upward pressure on oil prices. Contacts representing industries with little connection'namely, the auto industry, food retailing, and tourism'point to $4 per gallon gasoline as a tipping point for consumer budgets.

According to these sources, at $4, significant changes in consumer spending behavior should be anticipated. Some contacts expressed concern particularly about the region's economy continuing to be weighed down by excess residential real estate and the potential for resumption of falling home prices. Our questioning on actual business cost pass-through from rising commodity prices was mixed and inconclusive. However, a number of contacts across a wide spectrum of businesses are at least entertaining the idea of trying to push higher costs along. A few are confident they will be successful, but most are taking a wait-and-see approach. We heard little from our contacts about continuing disinflation, and it's clear to us the tone of the conversation around inflation has shifted to upside inflation risk and, in their view, reality.

There are a few upside developments to report. Industrial activity is strong in the Sixth District. Air travel nationally, both business and pleasure, is much improved from this time last year, and wage pressures remain light, particularly for lower-skilled and less-educated workers.

While conditions across business and industrial sectors differ, most have evidenced improvement in the last few months, and business executives are cautiously positioning their companies for higher business activity. The exceptions are largely associated with homebuilding, commercial real estate construction, and building materials.

Turning to my outlook, my baseline outlook looks essentially the same today as it did the last time we met. I continue to expect the economy to gradually gain strength over the course of this year and next. My growth path for the economy is more modest than the Tealbook's. The difference owes largely to my assumption that businesses will continue to be cautious regarding capital spending for business expansion as well as new net hiring. This results in a more modest rise in private spending over the forecast horizon.

I have not revised my inflation outlook and still see the underlying price trend on a path consistent with our price stability mandate. That said, I think the price conditions, as opposed to inflation conditions, are creating quite tricky circumstances that present communications challenges. Nonmonetary pressures on prices'that is, commodities' supply and demand, for example, affected by weather'combined with rising global demand from strong economic growth in emerging markets and accelerating recovery in advanced economies, combined with rising risk premiums in petroleum markets reflecting unrest in the MENA region are fueling increasingly vocal inflation anxiety. My conclusion is, all indications of expectations bear very close watching.

Anticipating the policy round discussion of statement language, let me add that my reading of the core inflation data since November leads me to the view that the word 'subdued' may not aptly characterize what has occurred. As I see it, there has been an upward firming of the inflation trend as was intended.

My sense of the balance of risks associated with my economic growth projection is reasonably balanced. It is worth mentioning, however, that prior to the emergence of the Middle East'North Africa unrest and the resulting rise of oil prices, I was moving toward an outlook that acknowledged more upside than downside risk to growth. Two downside considerations are in my mind returning the scales to balance. As I said, oil prices and, second, a resumed decline in home prices could damp household confidence and sap some of the strength coming from consumer spending.

I think the risks around the inflation projection are also balanced, but here I make that judgment with more apprehension. While longer-term inflation expectations measured by TIPS or household survey data are still inside their range of the past five or six years, they are at the

upper ends of those ranges. It seems to me, therefore, a lot depends on those expectations remaining steady. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Rosengren.

MR. ROSENGREN. Thank you, Mr. Chairman. Since our last meeting, we have received data which, after taking into account the noise created by inclement weather, seems largely in line with what we had been expecting. What had not been anticipated at the last meeting were the changes sweeping the Middle East that have contributed to higher oil prices or the horrible tragedy unfolding in Japan. It's probably too soon to know whether developments in the Middle East will cause a temporary spike, which would have very little effect on the outlook, or a more permanent change in the price of oil. However, assuming that oil prices remain elevated and adding to that the greater degree of near-term fiscal restraint under discussion in recent weeks, the net effect of these changes from the past meeting is to leave my inflation forecast little changed, but to reduce somewhat my outlook for the future growth in the economy.

Like the work presented in President Evans's analysis, work done by Boston staff suggests that the impact of the oil supply shocks will have minimal impact on the underlying inflation rate in the medium term. This econometric result likely derives from a number of factors. First, commodities account for a relatively small share of our economy, as a labor- intensive service sector has become more important. Second, with longer-term inflation expectations well anchored, perhaps due to the greater confidence in the Federal Reserve's commitment to controlling inflation, a change in the relative price of commodities is unlikely to pass through into final goods prices. Finally, with significant slack in labor markets likely to remain in the economy for some time, it is unlikely that rising commodity prices will have much impact on wages and salaries.

Together, these factors likely account for why over the past two decades even large food and energy price movements have had minimal impact on underlying rates of inflation. Thus, while recent food and energy shocks will cause total measures of inflation to diverge temporarily from core, we expect total inflation to return to the core inflation rate over time, leaving little or no imprint on the core inflation rate. Given that core measures remain well below 2 percent and that there remains significant slack in the economy, I expect it to take some time before the inflation rate settles at 2 percent.

While the effects of oil price shocks on inflation are likely to be quite modest, they are likely to have a contractionary effect on economic growth. Boston modeling implies that recent increases in oil prices will shave roughly 0.4 percentage point off GDP growth and cause the unemployment rate to be roughly 0.2 higher than it would be absent the oil shock. In addition, if the Congress were to implement additional spending cuts this year of $50 billion, that would also reduce GDP by roughly the same magnitude as the oil shock. While I'm pleased that the incoming data have been broadly consistent with a mild recovery, the contractionary effects of the oil shock and fiscal austerity, coupled with continued risks from housing, state and local spending, and international events, have persuaded me that continued accommodative monetary policy is necessary to support this modest recovery and to provide some insurance should any of these risks materialize. Thank you.

CHAIRMAN BERNANKE. Thank you very much. President Hoenig.

MR. HOENIG. Thank you, Mr. Chairman. To Nathan, I want to just suggest that when I became a member of the FOMC, I had a friend give me a crystal ball to use, and over the years it has done just about as well as our models. [Laughter] So feel free, if it would be any help to you.

I'm going to focus on my District because the District is moving pretty much in parallel with the nation, with a couple of exceptions, which I'll mention. The District is continuing to expand. It has since the last FOMC meeting in several areas. Our labor market is improving. In fact, in some of the high-skilled areas, we're seeing some indications of shortages. But other than that, of course, we have a lot of slack there as well. District manufacturing activity continues to strengthen, thanks to export activity. Our input costs have risen further, and a few contacts are indicating that they are purchasing additional raw materials way in advance, as they try to anticipate higher future costs. More District contacts also reported higher prices for finished goods, and expectations for higher finished goods prices increased sharply in our last survey.

One exception, of course, is energy, which in our region is picking up a lot of momentum as they shift from gas to oil, and we're seeing a lot of investment activities in those areas, and some increase in employment in those areas as well. In addition, strong global demand and tight inventories continue to push our agricultural commodity prices up, and we are seeing increasing amounts of interest from money managers and others in not only our commodity side, but in the land side as well. As I have been pounding away at the fact that our land speculation is getting more out of hand, my most recent example is a pretty strong signal that we're heading in the wrong direction: In a conference we had on lending in Omaha a few weeks ago, one of our staff was talking with one of the possible lenders that was looking at activities; the individual was in lending from Los Angeles and felt that lending in movies was too risky and was turning to land. They were actually looking for land deals in the region, so it's in trouble. Other than that, the inflation outlook continues to be modest but building, and we will continue to watch that in our region as well; I think it is very similar to what we're seeing at the national level. Thank you.

CHAIRMAN BERNANKE. Thank you. President Evans.

MR. EVANS. Thank you, Mr. Chairman. By most accounts, the economy has improved over the intermeeting period. The commentary I received from my business contacts this round was quite good. I can't even recall anyone bringing up concerns over regulatory uncertainties or other such annoyances.

Most sectors reported increasing momentum in line with or even a bit better than their earlier business plans. Overall, my reports from business contacts seem consistent with my January forecast, which had GDP growing at about a 4 percent rate over 2011 to 2012. However, I continue to hear plenty of caveats around these good reports. For example, although no one has seen it yet, many contacts were concerned that higher energy prices might become a drag on demand, as President Rosengren mentioned. Nevertheless, the good news outweighed the bad, and I now feel more confident about my earlier strong outlook.

My manufacturing contacts were particularly upbeat. Automakers are increasing output, and home appliance production is still doing surprisingly well. Heavy equipment manufacturers are benefiting from robust replacement demand, even for construction equipment. Here, though, is one of those caveats that temper my enthusiasm. One story I heard was that in order to raise cash during the downturn, many construction and equipment leasing companies sold their equipment to firms operating overseas. Think of this as eating your seed corn. Now they are buying new equipment to restore their capacity. This is a good development, but it is most likely a short-run rebound effect rather than a signal of a more fundamental strengthening in the domestic construction industry.

Clearly, the strength in manufacturing is generating strong demand for steel. ArcelorMittal is running its current U.S. capacity just about flat out, and they are in the process

of bringing one of their three remaining idle blast furnaces back into production. Steel producers complain that iron ore prices are outrageous. At the same time they're pretty satisfied with their ability to raise prices to their customers. Of course, this means steel users are all complaining about costs. It's often hard to get these manufacturers to say how much of the cost they are able to pass on to their customers, but I got the impression that many are taking some hits to their margins. Ford was explicit about this, noting both that they were facing higher commodity prices and that the competition was driving the vehicle transactions prices lower. Also, other than the obvious direct effects on gasoline and the like, I heard few reports of downstream price pressures emanating from the pass-through of higher energy costs.

I also am not hearing of any cost pressures from wages. Indeed, most current indicators suggest substantial restraint. Because you've all seen the reports, I'll simply say, 'Madison, Wisconsin.' Another example is the recent Caterpillar labor negotiations. Caterpillar signed a contract with the UAW that gives them negligible labor cost increases for the next six years. I'm pretty sure that if we go back to the previous episodes like the 1970s when inflation rose well above our goals, price increases were strongly reinforced by sizable wage pressures. Those channels are absent today.

Of course, even though current wage growth is weak, the labor market clearly has improved over the past few months. This is an important piece of good news that we had been waiting for, but the extent of improvement is still difficult to read. Larger payroll employment gains are welcome, but they are still modest relative to the declines during the recession. On the other hand, the dramatic and continued reductions in the unemployment rate have clearly been greater than we expected. It would be especially encouraging if these improvements in the household data reflected a step-up in hiring. However, most of the drop in the unemployment

rate over the past few months was due to a decline in transitions of workers from employment to unemployment. In other words, the flow into unemployment dropped because of fewer job separations, and Dave Stockton mentioned that job losers are down. But the flow out of unemployment and into employment has not improved significantly'not yet. This is consistent with the story from JOLTS, so the two surveys, payroll and household, are consistent. Layoffs are down, but hiring has yet to pick up in a meaningful way. It is also in line with conversations from my business contacts who still don't report robust hiring plans. While there has been an improvement, I don't think we're looking yet at a vibrant labor market with robust hiring.

More generally, I continue to believe that there still is substantial slack in labor and most product markets, in addition to the factors I just talked about. I would also note that the Tealbook's revised assumptions on labor input only subtracted a few tenths off of the GDP gap, and with unemployment and vacancies both falling, the Beveridge curve is clearly looping back, as you suggested it would at earlier meetings, Mr. Chairman. This reinforces my take-away from our discussion last meeting: I don't think we saw any evidence then that the bulk of the increase in unemployment was structural. Various estimates all suggested that monetary policy could reduce slack.

This assessment of resource slack also continues to be an important downward influence on our inflation outlook. As an offsetting factor, the downside tail risks on inflation expectations appear to have fallen substantially. So inflation expectations may have a firmer upside anchor, and while I don't think cost pass-through will be large, we do expect some effects similar to those built into the Tealbook for many of the reasons that I mentioned in the memo that I circulated to the Committee.

For a variety of reasons we have moved our inflation forecast up a couple of tenths. We now see core PCE reaching the 1'' percent range in 2013; that would still be well below the

2 percent rate that I think is consistent with our price stability mandate. Until core, median, and trimmed mean measures of underlying inflation reach 1'' percent on a year-over-year basis, I don't see how we can feel confident that we have escaped the zero-lower-bound risks of the current unpleasantness. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Pianalto.

MS. PIANALTO. Thank you, Mr. Chairman. Over the past few weeks, I have been hearing more comments from my business contacts about the need to begin thinking about tightening monetary policy. In part, these comments reflect continuing improvements in the economy. But, more importantly, the recent surge in oil prices has heightened concerns about inflation.

I realize that we have differences of opinion about the outlook for GDP growth over the next few years, but I think the growing public attention on inflation merits a careful review of our inflation projections. So this morning I am going to focus my comments on why I expect core inflation rates to only drift up gradually from current levels and to remain below 2 percent for the next couple of years.

I see three key pieces of evidence to support my moderate inflation outlook'the current low underlying inflation rate, limited pass-through of commodity prices, and low inflation expectations that are embedded in financial markets. On the first point, the current low underlying inflation rate, we have only recently seen clear evidence that the disinflation that started in late 2008 has ended. I could use a variety of statistics to make this point, but I think the median CPI illustrates this point particularly well. As recently as late 2008, the median CPI

was running at 3 percent. It bottomed out in the third quarter of last year at just '' percent, and today the increase in the median CPI stands at 0.8 percent. While the disinflation trend appears to have ended, the median CPI and other core inflation measures have bottomed out substantially below 2 percent. In light of the fact that history shows us that core inflation is highly persistent, and research has shown that core measures are superior predictors of future inflation, this is one set of reasons that I think underlying inflation will likely remain moderate.

On the second issue of commodity prices, my staff conducted an analysis of the effects of larger-than-expected increases in energy and commodity prices that persist through 2012. Their results show only limited effects from these persistent shocks on core inflation. These results are consistent with the estimates from models like FRB/US and the one that President Evans used in his memo. The most important result from these analyses is that this Committee has time to offset any upside surprises in inflation if we were to see such a scenario develop. The modest pass-through reflected in my inflation forecast is also consistent with the anecdotes that I am hearing from my business contacts. My contacts have been talking a lot about trying to pass along input price increases. And while many businesses would like to pass on commodity price increases, my business contacts have also revealed that there are important limits to pass- through. The CEO of a construction firm reported that many construction contractors are simply eating cost increases because of the hypercompetitive construction market. His view is that some of these contractors will not make it, but they also would not survive if they raised prices. A plumbing fixture company described in detail the engineering process that allows them to experience a large increase in copper prices and then, through efficiencies and product redesign, convert that into minor price increases at the wholesale level. At that point, they evaluate how much of a price increase a particular customer will tolerate, and right now it's not much. I read

the comments from my business contacts as indicating that, yes, firms are interested in passing on price increases, and some are succeeding. But the dynamics that limit pass-through help to explain why consumer price increases have been so limited after months of commodity price increases.

Turning to inflation expectations, my third point in the inflation outlook, the big worry is that if commodity prices persist, they could push up long-term inflation expectations, leading to higher core inflation over the medium term. This is well represented in the Tealbook's 'persistent rise in inflation' scenario. In addition to monitoring inflation expectations five and more years out, I like to consider the expectations over a policy horizon of just three years. The Cleveland Fed inflation expectation model identifies inflation expectations, real interest rate, and risk premium components over a three-year horizon. Our model shows that inflation expectations remain low, although expected inflation over the next three years does show an increase of 30 basis points from December to March for the headline CPI. However, that

30 basis point increase is front loaded, with most of the inflation expectations increase occurring over the next 12 months when we would expect pretty significant headline inflation numbers, just on the basis of recent energy prices. In fact, since December, our estimate of inflation expectations for the coming 12 months has increased by nearly '' percentage point. In the next two years, though, expected inflation stays 20 to 30 basis points below 2 percent.

I think the evidence that I have discussed supports a baseline outlook where underlying inflation is only gradually increasing. However, I certainly recognize that the risks to the inflation outlook are numerous, and that they may be growing. The heightened inflation concern expressed by some of my business contacts is worrisome. These views may make inflation expectations more volatile, particularly when the nation is facing significant, if likely transitory,

commodity shocks. This concern has caused me to shift the balance of risks on inflation to the upside. The risks to the outlook for economic growth have also expanded with the tragic developments in Japan and continued unrest in the Middle East. However, with the recent labor market news surprises to the upside, I still see the risks to growth as balanced. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Plosser.

MR. PLOSSER. Thank you, Mr. Chairman. Economic conditions in the Third District continue to improve, even though some of us were snowed in in January. Manufacturing has been particularly strong. The general activity index of our Business Outlook Survey hit a seven- year high in February, surging from 19.3 in January to 35.9 in February. The March data, which will be released this Thursday'so it is embargoed until then'show another strong jump from

35.9to 43.4. This is the highest reading for the general activity index since the early 1980s. The survey is showing broad strength across the board. The index of new orders in March jumped from a high level of 23.7 in February to 40.3 in March. Indexes for shipments and employment all continue to be in strong territory and have been rising for about six months now. The future activity index, which asks questions about activities six months from now, surged very strongly in March from an already high level. I would caution, though, that the survey was taken before the tsunami and before the turmoil in Japan, so we would have to temper that interpretation. Nonetheless, it was a very strong reading about expectations going forward. Some contacts credited global markets as drivers for new demand, and, in fact, in some instances rising global prices have made local firms more competitive, allowing them to reclaim work previously lost overseas. Our Beige Book contacts indicate that retail sales, including autos, have been rising on

a year-over-year basis. Even though bad weather in January kept buyers away, many auto dealers used clearance sales in January to boost sales.

Labor market conditions are firming in Pennsylvania, where employment has risen at an annual rate of about 0.7 percent over the past three months and the unemployment rate has fallen to 8.2 percent. The rebenchmarked data indicate that employment levels in the District are slightly higher than originally reported. Employment growth in New Jersey and Delaware are not quite as robust, but Delaware, in particular, is a small state, so the readings can be quite volatile.

My staff's state coincident indicators, which summarize economic developments, indicate that activity over the past three months has strengthened in Pennsylvania and New Jersey in particular. The staff's leading indicators indicate activity in the District is projected to continue to improve over the next six months. Business contacts remain optimistic about the future. Many are now saying that business is 'good' or 'strong.' One electrical machinery manufacturer told us that he will break ground on a new plant expansion in April. They do expect exports to be a major source of future revenue going forward.

At our last meeting I talked about the emerging strength of increased price pressures. These have continued to develop over the intermeeting period. In February, prices-paid and prices-received indexes in our manufacturing survey hit their highest levels in three years. The data from March showed further increases, continuing that trend over the past several months. There is a growing indication that firms have some ability to pass on these prices to customers. In response to a special question in our February survey, more than 57 percent of the manufacturers said they had already put through price increases since the start of this year. The most common increase was 3 to 4 percent, but some firms reported very large increases. In

response to a different question, nearly 60 percent of all respondents said they planned to increase prices over the next three months. Given the recent increases in energy and commodity prices, I expect more firms are going to be willing to test their pricing power, particularly as concerns about the recovery's sustainability abate. Thus, I see inflation risks as clearly to the upside both in our District and in the U.S. economy more generally.

I also note that the Tealbook has revised up its forecast of both total and core PCE from January. So far, inflation expectations have remained anchored, though we need to be vigilant to make sure they continue to remain so. I would suggest that if the rise in oil and commodity prices appears to be passed through to other prices, and we thus see a rise in all prices or core prices, that will occur because monetary policy is accommodative. While this might mean that there is just a one-time increase in the level of prices as monetary policy allows all prices to rise with the higher oil prices, it could become more damaging if, in fact, during that transition, expectations of inflation begin to change. Then our responses would be much more difficult.

As the Tealbook alternative scenarios clearly show, the low level of pass-through of large price increases is contingent upon expectations of inflation being well anchored. The alternative scenario in which long-run inflation expectations are more sensitive to this persistent rise in headline inflation is a pretty ugly scenario, with core PCE inflation reaching 3'' percent in 2013 and remaining there for at least the next two years, the end of the forecast horizon. Economic growth is significantly lower and the unemployment rate is significantly higher than in the baseline. I don't think we should take the possibility of this outcome as trivial. The current experience in the United Kingdom, and to a lesser extent, the EU, as we were talking about earlier, where inflation is rising in spite of what appear to be large output gaps, should make us at least somewhat uncomfortable about relying on these gaps too heavily to control the inflation

process for us. After all, as Dave Stockton noted, gaps really do have only a small predictive content for inflation'not zero, but relatively small'and thus large movements in inflation remain unexplained by such models.

I have made little change to my forecast. The situation in Japan after the devastating earthquake and tsunami is serious. The nuclear reactor risks have created even more uncertainty. However, at this point, it is difficult to see exactly how this situation is going to resolve itself, or how it will impact global economic growth and the United States. I do believe Japan has the capacity to overcome this tragedy and recover. For now, I continue to expect output growth in the United States to be above trend over the next two years, employment growth to strengthen, the unemployment rate to move down gradually, and inflation to move toward 2 percent. The outcome of my forecast is similar to that of the Tealbook, but I have a somewhat steeper policy path to go along with it. I believe we will need to tighten policy considerably sooner than in the Tealbook, even though the Tealbook's revisions have moved the liftoff two quarters earlier than their January forecast. The Tealbook now has liftoff in the third quarter of 2012. But if we are to ensure that inflation expectations remain anchored, I think we will need to start reversing course well before the end of this year, if the forecast plays out as imagined in the Tealbook.

Taylor rules based on growth rates, rather than gaps, suggest that monetary policy is about right now. But as economic growth accelerates this year, policy will need to start tightening. We need to begin preparing for that time by discussing what our exit path will look like and communicating that strategy to the markets. We will need to prepare them for the exit before we implement it. I will have more to say about that in the policy go-round. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. I just want to comment that we will be talking about the exit strategy at the next meeting. Bill, is that correct?

MR. ENGLISH. That's right.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. In general, the Ninth District economy is on a better path than the national economy. Unemployment is below 7 percent in the District. Some of this is driven by the oil boom in North Dakota where employment grew by nearly 5 percent last year. But even in the much more diversified economy of Minnesota, unemployment is now down to 6.7 percent. So this follows up on President Bullard's point that there is considerable heterogeneity even among U.S. states in their unemployment experience.

More generally, there is confidence in the Ninth District in the recovery. Firms have more certainty about federal taxes in the wake of the election and the subsequent fiscal deal. They are less worried about the ultimate impact of the health care reform. And as President Evans observed, their complaints about incipient regulations seemed less vigorous than in the past, although I would say there is one group that would distinguish themselves in that: We had our first meeting of our Community Depository Institutions Advisory Council, and the bankers in that group were fairly quick and vigorous in their complaints about regulation. So there are people out there that will complain about regulation.

This optimistic frame of mind means that many firms seem ready to expand hiring. Firms see little or no pressure on wages over the next year or two, but some do plan major price increases by the end of 2011 in response to increases in other input costs. At the national level, I found the discussion of labor force participation on pages 11 and 25 of Book A of the Tealbook to be thoughtful and useful. For me, it highlighted the challenges of predicting the evolution of

labor supply, and, hence, labor market slack, over even a relatively short horizon like 12 or 24 months. When you look at the graph on page 25 of Book A of the Tealbook or the graph on page 11 of Book A of the Tealbook, the Tealbook is basically predicting an uptick in labor force participation and a reversion to a trend that is fitted to data that go back about 10 years. The question is: Will we see that uptick or not? I agree with the Tealbook that there are definitely reasons to expect that the answer to the question might be yes, but I think there is also evidence that is just the opposite. As we all know, unemployment fell from 9.8 percent in November to

8.9percent in February, which is the same as it was in April of 2009. In an accounting sense, more than half of this decline can be attributed to people who left the labor force. The question for us that's important in terms of slack is: Should we expect those people to return to the labor force, putting downward pressure on wages and prices as the economy improves, or not? One way to try to get some insight into this question is to look at the U-5 unemployment series. This is a broader measure of labor force underutilization that includes people who have not looked for work in the past four weeks but report themselves as, nonetheless, ready to work. Presumably, these are the people who are most likely to reenter the labor force as the economy improves. They are sometimes referred to as being marginally attached to the labor force. If you look at the U-5 unemployment rate, it has mimicked the behavior of the standard unemployment series. It too has fallen sharply over the past three months to return to roughly its April 2009 level. My conclusion from that'and if you break down the series into more components, you could reach the same conclusion'is that relatively few of those who have left the labor force during the past three months view themselves as being marginally attached to the labor force. This is all in an accounting sense, of course, but those are the conclusions you would reach from looking at the U-5 number. This is very suggestive, and I would only say that it leads me to be uncertain about

the path of labor force participation. And, these uncertainties translate directly to uncertainty about any measure of labor market slack that we use to gauge the appropriate level of monetary accommodation.

This issue about what slack is will become really important. For example, if you look at the Taylor rules on page 37 in Book B of the Tealbook, set the slack terms there to zero, and just think about inflation at 1.2 percent, the results would not be a justification for our current level of accommodation. We would have to have interest rates be significantly higher than the zero lower bound at that point. So the discussion about slack is very critical for justifying our current level of accommodation.

I would say the right way to think about slack is through the behavior of core inflation and the behavior of the forecast of core; that's likely to prove a more reliable gauge. In particular, what I mean by that is if you look at the Taylor rule, either the 1999 one or the 1993 one, the last term is this y minus y* piece. My uncertainties about labor force participation mean that I think y* is hard to measure. And what kind of price setting you follow can give you a different way to substitute in for that, using core inflation as a way to proxy for that. If you are using a New Keynesian model, a scaled version of the difference between core inflation and expected future core inflation is the right way to proxy for that in the simple, crudest versions of those models. In late 2010, that difference was a big negative number, because core was so low. But I expect that difference to be much closer to zero by the end of the year, because forecasts of 2012 core are likely to be real close to realized 2011 core. If you are a fan of the NAIRU models, you could replace that y minus y* by a scaled version of the acceleration of inflation, the difference between current core and lagged core. In late 2010, again, that difference was a big negative number, a good justification of our accommodative monetary policy. But I expect core

to be along the lines of the Survey of Professional Forecasters done by the Philly Fed. I expect that core inflation will be between 1.4 and 1.5 in 2011. That means that difference between annual core inflation and lagged annual core inflation will be close to 70 basis points by the end of the year. I continue to expect by the end of 2011 reliable measures of slack will not support our current level of monetary accommodation. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Williams.

MR. WILLIAMS. Thank you, Mr. Chairman. It is a great honor and privilege to be here. My immediate predecessors in this seat left big shoes to fill, both in terms of intellect and wit. Regarding the latter, I expect I will fall well short in my ability to integrate references to cultural icons like Lady Gaga into our discussions. I do promise, however, to keep my comments about control undergarments to the bare minimum. [Laughter]

The intermeeting data have been mixed. On the positive side, the ISM survey has been very strong, especially in manufacturing, and auto sales surprised to the upside. The drop in the unemployment rate over the past three months has also been very encouraging. On the downside, real GDP growth, both the last quarter and the current quarter, now look to be about

''percentage point weaker than we were expecting at the time of our last meeting. A portion of this downgrade may be due to unseasonably bad weather. Still, my business contacts express little enthusiasm about the pace of spending. Consumers appear very cautious about buying certain big-ticket items, such as furniture and appliances, in part because rising gasoline prices are draining their purchasing power and undermining their confidence. Looking ahead, we trimmed our forecast for GDP growth this year by about '' percentage point to about 3'' percent. This downward revision reflects the somewhat more subdued tone of recent data and also the greater likelihood of near-term fiscal restraint from the recent spike in oil prices.

Fiscal retrenchment is evident in all levels of government. State and local governments have cut employment and compensation and increased taxes. And at the federal level, the budgetary endgame is not at all clear, but recent developments point to a bit less fiscal impetus, and deeper cuts and even a temporary government shutdown cannot be ruled out.

The other notable factor restraining economic growth is the jump in oil prices. Various estimates using a range of methodologies suggest that the recent rise in oil prices will reduce real GDP growth this year by a few tenths of 1 percentage point. Indeed, the consensus on these estimated effects is one of the very few things that macroeconomists appear to agree on. Given the ongoing turmoil in North Africa and the Middle East, there is a risk of another jump in oil prices, which of course would further slow the recovery. On inflation, increases in oil prices are causing a sizable bump in the headline rate, but I don't expect that to last for long or leave much of an imprint on core inflation. Again, the research literature is in remarkable agreement that oil price shocks have a minimal effect on core inflation in the post-Volcker period. President Evans's memo, which I greatly appreciate, confirms this.

Another potential concern on the inflation front comes from rising non-oil import prices. Indeed, my business contacts all tell me they expect sizable increases in prices of imports, especially from China this year. They also say that they will try to pass on these increases to consumers, although their conviction on this wavers regarding whether they will be able to make these increases stick, given the weak economy. In any case, it is important to remember that imports account for only about 13 percent of the value of total consumption based on input- output relationships. Perhaps more surprisingly, imports from China account for only 2 percent of U.S. consumption. Even for clothing and shoes, which are very import-intensive, only one- third of value added is imported. The rest is domestic factors, including distribution and retailing

margins. So despite the increases in non-oil import prices, with 87 percent of consumption reflecting domestic factors'notably, U.S. labor compensation'I don't anticipate that we will be importing a significant sustained rise in inflation. Instead, we revised our core inflation projection up only modestly over the forecast horizon. This revision primarily reflects a projected lower path for the unemployment rate going forward, and, therefore, somewhat less slack.

Following the discussion of structural unemployment last time, my staff has reexamined the benefits of using slack to forecast inflation. This question has been a subject of considerable analysis and debate, both in research journals and at this table, of course. Resource utilization is difficult to measure, and in normal times the effects of output or unemployment gaps on inflation are frequently dominated by other factors, such as supply shocks. But in the current circumstances, when utilization rates are far below normal, the effects of slack, I think, are more evident. One way to gauge the importance of slack is to compare the forecast performance of forecasters who use slack with those that do not. My staff has done just that, using the fact that respondents to the Survey of Professional Forecasters report whether or not they use a NAIRU concept in forecasting inflation. For the past three years, SPF forecasters who do use a NAIRU have been about 30 percent more accurate in forecasting core inflation than the forecasters who don't. This accuracy advantage is consistent with research presented by Jim Stock and Mark Watson at last year's Jackson Hole conference. They show that measures of slack do help forecast inflation after recessions. And given the significant amount of slack in the economy today, I expect core inflation to remain low, averaging slightly above 1 percent this year and next. Thank you.

CHAIRMAN BERNANKE. Thank you. President Lacker.

MR. LACKER. Thank you, Mr. Chairman. Our Fifth District contacts have struck a tone of greater optimism in the comments we've heard over the past several weeks. Consumers seem to be more confident. For example, sales of ski passes have doubled at a Virginia ski resort, and advanced bookings at coastal resorts are coming in strong. Several auto dealers have experienced an uptick in business as well. One dealer reported allowing more customers to walk away over price negotiations, confident that other customers will be willing to pay the price they want. In fact, most business sectors are improving, and they convey a real sense of firming demand for their products that goes beyond mere inventory restocking. We have also heard of expanding capital budgets to undertake investments that were postponed during the recession and early stages of the recovery. Even in the commercial real estate sector, some companies are revisiting expansion plans that had been set aside, and although decisions may still be several months off, they're making preparations for work to begin later this year or early next year. Finally, we hear that many businesses have started hiring workers or expect to hire relatively soon to meet their increased orders.

News from our contacts was even more heavily dominated this time by reports of rising commodity prices stemming from increased global demand, and while some are absorbing increased costs through reduced margins, many are passing through these higher prices or have plans to do so in the near future. The ability to pass these costs along seems related to a lack of competition in some instances or, in other cases, the sense that the entire industry is making similar moves despite fear that demand may be affected. As an example, our sources in the textile industry report that they have had to raise prices even though customers resist, and they cite industry expectations of substantial demand destruction. Two aluminum extruders reported passing along their higher raw material costs, and while one of them cited some competitive

pressures that might limit further increases, the other stated that the loss of competitors in the industry during the recession had diminished overall capacity by 20 to 25 percent, which made them more optimistic about being able to pass along cost increases.

Domestic oil price developments since our last meeting and the uncertainties emanating from both the Mideast and Japan seem to have tempered the near-term growth outlook a bit, but I agree with the Tealbook in seeing little effect beyond the near term. A wide array of signs continue to indicate a broad acceleration in economic growth under way. Household spending continues to show, I think, decent momentum despite horrendous weather and a sharp climb in energy prices. Business investment in equipment and software continues to show strength. Both of the ISM indexes are at lofty levels; payroll employment is picking up pace as well.

As for inflation, the core numbers remain quite modest. Year-over-year core PCE is up just 0.8 percent. If you'll forgive me, I'll commit the sin here of mentioning the three-month inflation rate: Three-month core inflation has been rising and is now 1 percent. I think we should be mindful of the risk that core inflation increases quite rapidly in the near term. Anecdotal reports about the desire to pass on input price increases to customers are ubiquitous; a lot of us have talked about this around the table today. Of course, just wanting to pass on price increases doesn't mean firms will actually try to do so, or, even if they do, that they'll be successful in making the prices stick. I think that's reflected in a lot of the uncertainty many of you have conveyed about your firms' prospects, whether they think they actually can pass on those price increases. But if consumers and firms expect widespread price increases, we may see it happen. If they expect widespread pass-through, it may actually come to fruition. Indeed, we've seen one-year-ahead inflation expectations in the Michigan survey rise quite sharply since last year, up from 2.7 percent in October to 4.6 percent for this month. And in the last two

months, short-term TIPS breakeven spreads have risen beyond what I think would be implied by energy prices alone.

I think that current expectations about commodity price pass-through could be shaped in part by the experience of 2003 and 2004, when the 12-month core inflation number rose from

1.4percent near the end of 2003 to 2'' percent in the space of just nine months, a relatively sharp acceleration. Then, as now, the economic recovery had been disappointingly slow for some time, but it was gaining firmer footing toward the end of 2003. Then, as now, disinflation had been the FOMC's major policy preoccupation just a few months earlier. Then, as now, energy prices had been rising fairly rapidly, driven by a surging growth in emerging markets. And then, as now, the Greenbook, as it was then called, was projecting that the energy price surge would be temporary after which inflation would fall back down to around 1 percent mainly because of the large output gap they saw as weighing down on inflation. The Greenbook estimate of the output gap in late 2003 was minus 2 percent, and a negative gap was expected to persist over the eight- quarter forecast horizon. Instead, we saw core inflation ratchet up pretty rapidly and remain about 2'' percent for the rest of the expansion, and what is worse, as I mentioned earlier, overall inflation averaged 3 percent for the following four years, from the end of 2003 to the end of 2007.

From a business's point of view today, you can see why this might be an opportune time in the business cycle to push through price increases. They've been hunkered down for several years now. Demand has been relatively low. Their margins have been compressed. They've been squeezing out costs. A lot of spare capacity has been eliminated from their industry. When overall industry demand picks up, it's plausible that the elasticity of demand for their output will fall, and they can expand margins again. So in that context, I think it's worth considering what

the typical business is hearing about the overall inflation outlook that might influence their expectations about how widespread such pass-through is going to be, including what they're hearing about inflation from us. But I'm going to save that discussion for the policy round. Thank you very much, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. The Eighth District economy continues to expand at a moderate pace. District business contacts remain optimistic for 2011, but possibly slightly less so than at the time of the last FOMC meeting. District employment growth was not as strong as the nation as a whole during the October to December time frame, but District unemployment for 16 metropolitan statistical areas has been running somewhat below the national unemployment rate. Foreclosure rates are rising in the District, but remain well below national levels. Some businesses are clearly planning on hiring new workers in significant numbers during 2011. This is especially so for large businesses with sizable cash holdings. These businesses have been profitable and are looking for ways to introduce new products and expand market share.

Commodity price movements are a clear cause for concern in the District. I, as others here, received an earful about that during the intermeeting period. Industrial businesses and agricultural firms worry about input costs and profitability. Retailers worry about pullback by households. One convenience store retailer reported that gasoline volume growth had slowed but had not yet turned negative despite the sharp rise in prices in the last few weeks.

The combination of an improved outlook for 2011 along with rising input costs has many business leaders uneasy about price increases. Some intend and expect to push through price

increases in their own product lines this year or very soon. Many think a bout of inflation may be brewing.

In the national context, the U.S. economy continues to have reasonably good prospects for 2011. I continue to expect above-trend growth for the year, along with an attendant improvement in labor markets. As always, there are risks: developments in North Africa and the Middle East are one; the European sovereign debt crisis remains as another; possibly the recovery from natural disaster in Japan, as news comes in on that; and certainly, the U.S. fiscal situation as well. In each case more negative developments would have to transpire before material threats to the U.S. economy would be realized. In particular, in my view, oil prices would have to go higher persistently before they'd really threaten the U.S. recovery, or Europeans would have to fail to reach agreement on the sovereign debt situation. Again, I was encouraged by the developments last Friday on that dimension.

On oil prices, I would stress that this is not a 'Hamilton' oil shock, at least not yet. Jim Hamilton is well known for being the guru of oil price shocks. He has a special way that he wants to measure that variable. The current rise in oil prices is nothing like what you'd need on that metric. Of course, you could say, 'I don't like his variable,' but he constructed that variable in order to get empirical significance and to tell the story that you'd like to tell about oil price movements and the effects on the U.S. economy. I think everything that's going on with oil depends on what happens going forward, and it is not as large as other oil price movements, at least not yet.

In the absence of further developments, the outlook remains decidedly improved from last autumn, and that's why I think we should be contemplating, but only contemplating, the long journey back to a more normal monetary policy this summer and fall. In my view, quantitative

easing has been quite successful in that it convinced markets that this Committee is unwilling to allow the United States to slide into the zero-nominal-interest-rate, mildly deflationary equilibrium that was potentially on the horizon last summer and that Japan has experienced over the last 15 years.

Since we embarked on QE2, many measures of inflation have bottomed out and turned higher, and market-based measures of expected inflation have definitely turned up. The five- year TIPS expected inflation rate was 120 basis points and falling during the summer. It has recently been as high as 230 basis points. Indeed, according to the recent TIPS market, this Committee is set to miss its implicit inflation target of 2 percent or so on the high side at any horizon: 2 years; 5 years; 10 years; or 5-year, 5-year forwards. I take this as a measure of success at this juncture, but I would not want to overstay our welcome and allow these expectations to go higher. Let me stress, then, that I do not regard the TIPS expected inflation measures as unacceptably high at this point. But they have been rising and will probably continue to rise this year if the economy performs as well as we forecast it will and if there are no further downside shocks that materialize in the meantime. Of course, all bets would be off if that occurs.

The following combination gives me pause: one, a relatively strong outlook for the U.S. economic growth; two, rising inflation expectations beyond our implicit inflation target; and three, an ultra-easy monetary policy that will take a long time to normalize. This combination could potentially lead us to be behind the curve if we're not very careful going forward.

Two recent developments also give me pause. One is that the ECB looks set to tighten this spring. This took me by surprise. Euro-area harmonized unemployment is 9.9 percent, a full percentage point higher than what we have. Now, to be clear, the low on that measure over the

last 10 years was 7.2 percent, and over the last 18 years or so, it's almost always been above

8 percent. Still, it seems like there's a lot of slack in Europe. Also, the HICP, the Harmonized Index of Consumer Prices, the ECB's preferred price measure, is just slightly above 2 percent year on year. With inflation more or less at target and quite a bit of slack in the economy, it did take me by surprise that they're planning on tightening. But my reading is that the ECB is saying that it is taking a step toward normalizing policy with the understanding that policy will still be very accommodative even after it takes a move in that direction.

The other recent development is associated with the Middle East turmoil and the dollar. We did not see the flight-to-safety effect as strongly as I would have expected coming from the Middle East turmoil. So this is the dog that didn't bark. I wouldn't make too much of it at this point, although I thought it was a little suggestive that the United States has used up some credibility on inflation.

These two developments suggest to me that we should be prepared to signal markets through concrete action that we are willing to begin the process of removing policy accommodation. I wouldn't do it now, but in the meetings ahead. Even if we begin to remove accommodation policy, it will remain ultra-easy. As I've said many times before, I don't think the first move should be on rates. I regard that as unnecessary given our balance sheet policy. Instead, I think we should take steps to shrink the balance sheet first. One way to do that would be to pull up a little bit short with QE2'not at this meeting, but at the next meeting.

Let me make a very brief comment on President Evans's fine memo. I thought it was very nicely done, and I really appreciate the work. I think it helps make the debates here more transparent. I thought it was exceptionally clear. It helped me think about the issue of the appropriate policy response to an increase in commodity policies. As it says in the memo, I still

think we need a more structural framework to get to the bottom of this issue, and I will try to provide a few comments on this through the SDS comment process going forward here.

Let me make one further comment, and I will be done. It's on core versus headline. A lot of the discussion here, I think, makes core be an end in itself. I think that that is problematic for the Committee. We only care about the prices that households actually have to pay at the end of the day. So core can only be a vehicle to an end, it can't be an end in itself. Let me stress that since the year 2000, core and headline price indexes have actually diverged. Headline inflation since 2000 has been about 25 percent. This is either PCE or CPI. Core inflation, since the year 2000, has been about 21.5 percent. It's 25 percent versus 21.5 percent, a 3'' percent difference in the levels of those indexes over that 11-year period. Too much focus on core is telling the median household that they are richer than they are by 3'' percent. The households unfortunately are not fooled. They have to pay those prices, and they know that they're not

3'' percent richer than we're saying that they are. Thank you. CHAIRMAN BERNANKE. Thank you. President Fisher.

MR. FISHER. Thank you, Mr. Chairman. I'm going to comment on three things: first, on my District, where activity remains robust; second, on inflation, where I am wary'and a little comment on overall economic activity for the nation; and third, I want to conclude with comments on the financial markets, where I see disturbing signs developing. In all of those areas, I will not comment on Lindsay Lohan.

As far as my District is concerned, I reported last time that payroll employment had risen at an annual rate of 3 percent in December. It continues to rise at that rate, and, in fact, we see it accelerating. Temporary employment rose at an almost unprecedented 29.1 percent annual rate in December; we see that trend continuing. And construction employment, very importantly,

rose at a 22 percent annual rate in December; we see that trend continuing. And interestingly, convenience store sales, where the average purchaser is a 27-year-old Hispanic in my District, have seen sales pick up by 7 percent year to date. So we see increased activity in the construction sector.

If you update the figures on employment through January, with all due respect to my colleague from Minnesota, there are, as you pointed out, regional differences. I was going to declare Texas to be the 'Bavaria of the United States,' but that may go to Minnesota. However, given the numbers that we have, year-to-date total nonagricultural employment in terms of our share of employment growth in the United States is roughly 50 percent'49.5'for the month of January. In terms of the numbers employed in the services sector, Texas accounts for

78.9 percent of the employment growth in January. So we continue to steam along.

Our leading index recently rose to its highest level since the third quarter of 2008. We looked for negative signs. One of the negative signs in our surveying is that prices-paid indicators continue to rise, with a growing number of firms planning to pass along price increases to customers later this year, and I will comment on that a little bit further when I talk about my national economic survey. We do have a negative, of course; like all states, we have a budgetary imbalance. I fully suspect, given Texas's tradition, that they will take it out of education and health care and not in increased tax revenues.

As far as inflation is concerned, I do want to point out a couple of things. Our trimmed mean suggests that December's underlying rate was not quite as low as that indicated by the core, and that January's rate was not quite as high as indicated by the core measurement that we more typically use. Our trimmed mean PCE is running at about 1 percent, similar to December's 1.1 percent. The 6- and 12-month trimmed mean rates are holding steady at 1.1 percent and

0.9percent respectively. Both the Dallas and the Cleveland trimmed mean have shown upward drift, however, on the 6-month horizon. There is one change, and that is that January's Dallas trimmed mean showed the lowest level of items registering price declines since the inflation scare of August 2008, and this is for the third straight month. The number of items showing price declines was roughly 30 percent of the basket.

With regard to pass-through and the comments that were made, I remain a little bit wary. For example, processed foods. One company I surveyed at the beginning of the year was budgeting $800 million in inflation increases. They just revised that at their board meeting last week to $2 billion, and they expect to pass through whatever they can pass through because the prices of processed food appear to have some leeway in terms of the pricing for consumers.

In apparel, if you look at the data that were recently released by MasterCard SpendingPulse, we have seen a 3 percent increase in each of the last two months. The price of apparel has decreased for 20 years. Every retailer I surveyed'big box or lower- or higher- income quartile, across the spectrum'is pricing in increased prices, mainly because of the price of cotton or its nearest substitute, which is paraxylene. In terms of even those products that we would consider to be nonrelated to raw material price increases, I find it interesting that AT&T has moved every single price category forward and priced in price increases. So I think we need to be a little bit worried about the assumption that non-oil commodity prices are not having an effect on business expectations. I think President Lacker talked about that quite correctly, and I would second some of the points he has made. We're building in a mindset here that may, indeed affect expectations as well as the reality of inflation.

With regard to wage pressures, in our Eleventh District surveys and our Beige Book survey, we find that higher wages are being reported by some high-value-added firms,

particularly in accounting, in airline and aviation, and in high-tech manufacturers, all of which are reporting slight increases in wage pressures for highly skilled positions. So I think this is something we need to watch carefully.

Last, on Japan, and this may be affected by my having lived and made a business there for a period of time, but the devastation is overwhelming. Almost all raw materials are imported in Japan. You add to that the price pressures'even though they seem to be somewhat abating with somewhat slower growth in China'on steel, which is up 14 percent year to date, or the prices of imported protein, or, as you pointed out, the price of semiconductors in terms of the constriction of supply, or the supply of autos likely to come out, referencing back to the comment on Ford Motor Company, and I view the developments in Japan as having an inflationary bias. You have to remember how relatively isolated and how export driven that economy is, and the fact that they are extremely dependent on imported goods. So whether it's lumber, steel, or other inputs, or the output that they produce, I would expect there will be constraints and inflationary pressure.

Let me conclude by commenting on the financial markets. Again, I think we're seeing signs, Mr. Chairman, of increasingly imprudent risk-taking. We've seen a surge in covenant-lite loans. Thirty billion dollars have been issued in the first two and a half months of this year. That compares with $24 billion for all of 2006 and $100 billion total for the boom year of 2007. There have been $15 billion in year-to-date dividends'payouts by private-equity-controlled companies, all using leverage. That equals the running rate of last year, which was a record year. Payment-in-kind toggle notes, or PIK toggle notes, as they're known, are an increasingly active methodology employed in the market. According to the March Senior Credit Officer Opinion Survey on Dealer Financing Terms, which was reported on page 69 in the Tealbook, traditionally

unlevered managers, insurance companies, and pension funds are increasingly using leverage through OTC derivatives and repos, and the same can be said for hedge fund activity. Retail investors are plowing fresh money into equities at the highest pace in two and a half years. The current rally that we have just experienced is the sixth richest on record, going back to 1932, and the third most rapid. By the way, the two that were even more rapid were in 1932 and 1933, which I find of interest.

Crude oil noncommercial futures contracts are climbing dramatically, and they're markedly higher as the oil trades are at ever higher prices. I think that's something we should monitor. And just to put this in perspective, the total volume outstanding on the NYMEX and the ICE, which is the Intercontinental Exchange, now exceeds six times the storage capacity of Cushing, Oklahoma. This can cut both ways, but this activity has accumulated momentum and accelerated as prices have gotten higher, and the fact that Cushing, Oklahoma, inventories are abnormally clogged up because you can't release from Cushing as much as you're taking in means to me that we have to be extremely wary in terms of the volatility that might be created in the movements of these futures markets. Whether or not they're accurate indicators, there certainly is an enormous amount of activity. I believe that activity is undermeasured because it doesn't take into proper account the derivatives that trade off of those markets.

And one more data point from AutoNation and Experion'they show approvals for 38 percent of the subprime customers at year-end. Now, that's not quite 50 percent, which was the level just before the crash, but it's up significantly from the 18 percent average level for 2009.

I would say in summary, Mr. Chairman, I'm seeing signs of the intoxicating ambrosia of cheap money and readily available money. I think it is exacerbating price movements, and it

may well be adding to inflation. As you know, I remain extremely wary as to the utility of the recent round of the $600 billion-plus in purchases, and I think we have a lot to be mindful of. I agree with President Bullard. Given the pace of activity and the change in the mood that has taken place in the country, we may have to move much more quickly in terms of undoing the monetary accommodation we've provided, which would be a happy case, not a sad case. Thank you.

CHAIRMAN BERNANKE. Thank you very much. It's 11 o'clock. I understand coffee is ready. Why don't we take 20 minutes?

[Coffee break]

CHAIRMAN BERNANKE. All right. Thanks very much. Let's continue the go-round with Vice Chairman Dudley.

VICE CHAIRMAN DUDLEY. I feel like I am going to be the proverbial two-armed economist today. On the one hand, even though real GDP in the first quarter looks to be somewhat weaker than we expected a month ago, I think you could also say that the growth outlook remains considerably better than where we were last summer. In particular, we look closer to a virtuous circle in which rising demand boosts employment and income, which lifts confidence and spurs further gains in demand. I think the improvement in labor market conditions is particularly important in this regard. But on the other hand, there are two big new developments on the supply side that give one pause about being too optimistic about both the growth and the inflation outlook. The first risk, of course, is that oil supply disruptions lead to a further increase in oil prices. The good news is that Saudi Arabia still has considerable excess capacity and has indicated a willingness to use it. The bad news with respect to the oil price outlook is the high level of uncertainty and the likelihood that the tails are fat. I find it very hard

to be confident about what is going to happen next. Is this a temporary upward blip that will be reversed as soon as the Saudi oil production fills the gap? Or is this just the early stage of a much more substantial shock as political instability spreads? Even in the more benign scenarios, as the Saudis pump more oil and their excess capacity shrinks, there will be less room to absorb other shocks. For example, what is happening to the Japanese nuclear electricity generation capacity is another shock. And, of course, if Saudi oil production itself were to be disrupted for any reason, then we would be in a very tough spot.

Similarly, on the inflation side of the ledger, on the one hand, price pressures remain muted outside of commodities, and wage trends remain soft. But on the other hand, I am becoming more worried that inflation expectations could become unhinged. There are four factors that are causing a little more anxiety on my part. First, the commodity price pressures that are already in train are likely to push headline inflation, as measured by the PCE index, above 2'' percent on a year-over-year basis by the middle of this year. Although this increase will likely prove temporary, I think it still could, nevertheless, have consequences for our credibility, especially if other countries are responding to similar pressures by tightening their own monetary policies.

Second, consumers, as I found out in Queens last week, generally believe that prices are rising considerably more quickly than inflation statistics. [Laughter] People see higher prices every day when they go to the grocery store or the gas station, so even though we rely on the reported inflation statistics, the beliefs of the average consumer are quite different. And I think that's potentially important for our credibility as well.

Third, we already see some updrift in inflation expectations. Although the TIPS five- year, five-year forward measure has increased only very modestly, the most recent reading of the

University of Michigan consumer inflation expectations is more disturbing. I could take a little bit of consolation from the notion that some of this always happens when there is a big increase in gas prices that shows up in the 1-year measure, but then some of it drifts into the 5-to-10-year measure. But it is a pretty big increase; it is the highest level since August 2008. In New York, we run a separate survey; our longer-term measure, which is a 2-to-3-year forward inflation expectations measure, has also drifted up, but not quite as much as the Michigan survey. In that survey, consumers are also showing more uncertainty about what inflation is going to be in future years.

The fourth consideration is that this is all happening at a time that we are doing monetary policy in a very different way, where our balance sheet has expanded very sharply. Even though I think the interest on excess reserves is a tool that will be completely sufficient to keep inflation in check, there are people who are much less confident that that tool will work. So our enlarged balance sheet I also think is a factor that potentially threatens to undermine our credibility, even if we are actually right that the IOER is sufficient. I think that points to us doing a better job to educate people about our ability and determination to use the IOER rate when the time comes to restrain credit demand. I think we can do a better job on that front, actually, making the case that we have the tools, because we have not completely solved that problem yet.

Another risk area that Nathan touched on is what is going on in Europe. The euro sovereign debt/banking crisis isn't over by a long shot yet. I think on the positive side of the ledger, as Nathan pointed out, the EFSF has been bolstered. I think another positive is that Spain has made some progress in differentiating itself from some of the more troubled European sovereigns. In Europe, we hosted a luncheon on Friday for the Spanish minister of finance and the governor of the central bank, the Bank of Spain. We brought in a bunch of investors, and I

think the officials made a pretty good case that Spain is different from the other peripheral countries. For example, they pointed out that this debate about how much money the cajas need is not really that interesting, because even if they need '50 billion as opposed to '15 billion, that's still well within the capacity of the Spanish government to supply. Second, they pointed out that Spain is actually doing pretty well competitively. They haven't lost any market share in international goods markets, and the country has begun to tackle some of the tough structural problems in terms of their labor market. So that is the good news.

On the side that is not so good, while the financing agreement helps strengthen the financing mechanism, I think a number of things have actually taken a turn in the wrong direction. The first thing that has gone in the wrong direction in Europe is that the political support among voters in the core countries, to provide aid to the peripheral countries to finance their ongoing deficits and refinance maturing debt, seems to be eroding at the same time the willingness of the peripheral countries' citizens to countenance further belt tightening is waning. So we run a risk that we are going to soon get to the point where the leadership on both sides that want agreement can't deliver politically what they need to do in terms of what they want to see happen. I thought it was noteworthy that the new Irish government refused to commit to raise the corporate income tax rate in Ireland in exchange for a 1 percentage point reduction in the financing costs of their rescue package. That told me that positions are starting to harden.

Second, it is becoming increasingly obvious that the debts of some of the peripheral countries will need to be restructured. This creates a bit of a Hobson's choice. On the one hand, failure to move forward on that front in terms of restructuring makes the outlook more murky, and makes it impossible for these countries to begin to tap the markets on their own again on reasonable terms. On the other hand, moving forward with restructuring puts increased pressure

on the banks throughout Europe that have large exposures to these peripheral sovereigns. So they are in a very difficult spot.

Third, there is the risk that the current round of European stress tests will not be imposed in a way that resolves whether the core banks have sufficient capital. Remember, last summer there were stress tests, and those ultimately lacked credibility, because the Irish banks passed the stress tests, and then several months later they were in a great deal of difficulty. A couple of problems have been raised about the stress tests that they are planning to conduct. The first is that they are going to use national definitions of Tier 1 capital that differ quite a bit, rather than a common Tier 1 standard. Also, the press reports that I have read also suggest that the sovereign debt stress that is going to be assumed is not very severe. In fact, it may at times be less stress than what is currently implied by the 10-year government bond yields in some of the peripheral countries. So it's hard to take a stress test very seriously if it's not more stressful than the yields you actually see in the markets today.

And fourth, the market anticipates the ECB will be beginning a tightening cycle at the April meeting. I think that action is going to underscore the growing gap between the optimal policy for the core countries, such as Germany, which I think is actually pretty close to full employment versus the peripheral countries in which economic activity is contracting and slack is actually growing.

At the end of the day, I continue to think that they will muddle through in the end, because I think the commitment of the political leadership in the core countries to Europe is intact. But I think it is going to be very messy.

CHAIRMAN BERNANKE. Thank you. Governor Yellen.

MS. YELLEN. Thank you, Mr. Chairman. The data we have received since our last meeting support the view that the recovery is gathering steam and has become self-sustaining. Private demand, rather than temporary fiscal stimulus or inventory investment, is increasingly powering the expansion. Even so, there are ongoing drags from housing, nonresidential construction, and state and local government spending, along with new downside risks relating to possible near-term federal spending cuts and the negative spillovers from higher gas and commodity prices, and broader uncertainties relating to the Middle East, North Africa, Japan, and the euro area. These risks to the recovery have grown in recent weeks, and they diminish my confidence that we will enjoy smooth sailing ahead.

With respect to private spending, I am encouraged that business surveys and anecdotal reports have taken on a more optimistic tone. Businesses appear far more upbeat about sales and express greater willingness to invest and even hire. These improved attitudes are consistent with the patterns we are seeing in capital spending. Recent signals pertaining to consumer spending have been harder to read, but, on balance, they too point to at least moderate growth in line with disposable income. And surging auto sales suggest a release of pent-up demand.

Consumers are hardly ebullient, but they seem more optimistic and for good reasons. The stock market has recovered, labor market conditions have improved somewhat, those with jobs have less reason to fear losing them, and the burden of debt payments has abated to more normal levels. Further, a tax cut is beginning to show up in paychecks. Of course, declining house prices are a continuing negative for household wealth and borrowing capacity, and the intermeeting evidence suggests that this trend continues unabated.

Anecdotal reports suggest that access to financing, especially for car loans, has improved even for those with poor credit histories, and this may be an additional factor boosting purchases.

Looking forward, though, I am concerned about the vulnerability of consumer spending to further upward movements in oil prices. And in this regard, the plunge we saw last Friday in the Michigan survey's consumer sentiment measure, serves as a wakeup call.

History shows that gas prices are highly salient to households, and rising prices at the pump can quickly affect consumer confidence. In recent weeks, the negative effect of rising gas prices on confidence has apparently overwhelmed all of the positive factors that were and should be boosting confidence. We should expect some toll on spending, because higher oil prices affect not only consumer psyches but also their purchasing power. Auto purchases could be especially vulnerable.

Turning to the labor market, I see hopeful signs of improvement. Employment is rising in both the establishment and household surveys, initial claims have declined, and an increasing fraction of firms indicate an intention to add to their payrolls. That said, like President Evans, I am skeptical that conditions have improved and slack has diminished by quite as much as Tealbook assumes, based on the 0.9 percentage point plunge in the unemployment rate since November. Such a large decline in the unemployment rate over a short period of time is historically unprecedented, and to my mind, the patterns in the data are hard to interpret. In particular, I don't see much auxiliary evidence to corroborate such a large improvement. For example, even though employment has expanded in both the household and payroll surveys, overall job gains since employment stopped falling have been modest, and the gains since November are far too small to account for such a large drop in unemployment. Furthermore, there is no evidence of a rebound in labor force participation'something I would expect to see during a recovery. Hours have also been flat, and this leaves me wondering whether a portion of the recent decline in unemployment may reflect a shift of discouraged workers from the

unemployment pool to those counted as out of the labor force. For example, about 3.8 million workers lost their jobs between November 2008 and March 2009, and those who are still unemployed would have exhausted extended unemployment benefits in recent months. I recognize that such an interpretation of the data may be completely wrong, but I do see a significant mystery here, and I hope we can unravel it in the coming months.

Turning to inflation, it is clear that headline inflation will be elevated in the months ahead due to surging energy and commodity prices. Friday's Michigan survey shows that rising gas prices have not only lowered consumer sentiment, but already boosted inflationary expectations. The survey reveals a sizable increase in inflation expectations one year ahead and a smaller increase in inflation expectations at the 5-to-10-year horizon. I view this development with concern, but I am not alarmed because, as David and others have noted, the pattern we are seeing is quite typical. Consumers commonly react strongly to contemporaneous movements in inflation, particularly to gas price increases. In other words, they overreact to recent inflation data. This suggests that when headline inflation comes down, as I expect it will if commodity prices either stabilize or reverse course, consumer inflation expectations should fall in tandem. We have seen this pattern repeatedly in the past. With respect to pass-through from higher commodity prices, the evidence points strongly to only very limited pass-through to core inflation and inflation expectations since the mid-1980s.

I want to thank President Evans for carefully laying out the evidence in his memo to the Committee, and I would like to say that I completely agree with the conclusions he draws. Thanks to well-anchored inflation expectations and limited pass-through, our Committee has had a good deal of flexibility in responding to such shocks as oil prices escalated between 2004 and 2008, and my expectation is that monetary policy will probably not need to respond this time

around either. That said, it would be dangerous for us to take the stability of long-term inflation expectations for granted. So we must be vigilant in monitoring data bearing on pass-through of commodity price increases to core inflation, second-round effects on wages, and movements in inflationary expectations in the days ahead.

CHAIRMAN BERNANKE. Thank you. Governor Duke.

MS. DUKE. Thank you, Mr. Chairman. My conversations with bankers were pretty brief this time. Most reported seeing very little change in credit since the last time we spoke, with continued gradual improvement in credit quality and weak loan demand as universal themes.

The question I normally ask the CEOs that I speak with is: What are the most important things that you are worried about, that are on your mind? Well, due to the timing of the calls, it didn't seem appropriate at this point to discuss interchange fees, because the comment period had closed'or capital plans, because the results have not yet been communicated'or mortgage servicing, given the ongoing settlement talks with various government entities. After carving out these three items, there was very little left to report. [Laughter]

As I read through the Tealbook and the staff forecast, I kept noticing the assumption for easing of credit conditions. And while I do see evidence of easing, I think the improvement is quite uneven across product types and markets. Unsurprisingly, the products where conditions are closest to pre-crisis norms, competition for new loans is most vigorous, and volumes are returning, are also the products where the delinquency and charge-off rates never got very far out of line. Nonrevolving consumer loans, primarily auto and student loans, are the best example of this, and Governor Yellen and President Fisher have both already mentioned auto lending. Auto dealers are attributing stronger sales to the broad availability of credit, and bankers attribute

growth in auto loans to stronger demand. Bank and nonbank lenders report terms and conditions in auto lending are at historical norms, and the pricing, volume, and composition of auto ABS would similarly indicate a return to normal. So I think it is entirely possible that the auto market could be a barometer of demand unconstrained by tight credit conditions. Student loans are also growing at a strong pace, but they show up as a negative on bank balance sheets as the government has now taken over the guaranteed student loan program. Several factors are probably interacting to produce the growth. The legislation authorized higher maximum loan sizes. Lower home prices have resulted in less home equity availability'a historical source of loans for education. Tuition costs are rising as states and foundations have less capacity, and reduced job availability could be leading more people to seek additional education. I don't worry very much about a credit-funded bubble in autos, but there are growing reports of students ending up with debt that is much larger than the earning power of their degrees, and the inability to relieve the debt load as these loans cannot be discharged in bankruptcy.

The other bright spot in lending is business credit. Delinquency and loss rates on C&I lending spiked during the recession but only to levels typical for recessionary periods, and they are now declining in typical cyclical fashion. C&I lending is the only category of bank lending that is still showing growth. However, loans made by large banks to large firms appear to be the primary reason for this growth. Small loans to businesses have been falling for all three quarters since banks began reporting the data on a quarterly basis. And while C&I loans at banks under $10 billion are down for the year, they did grow slightly from the third to the fourth quarter, possibly a sign of a little momentum. Interest rate spreads on C&I loans are coming down for larger loans, but not for smaller commitments. However, every bank now reports more competition for C&I loans. Demand still seems to be driven by loans for acquisitions or one-

time transactions, and credit line usage remains at historical lows. Unused lines of credit are up, likely due to new line approvals that are not yet drawn. And the NFIB survey still shows declining levels of small businesses that sought new credit, indicating weak demand, and fewer respondents saying credit is more difficult to obtain, indicating improved availability. All in all, the business credit market appears to me to be ready to fund demand by businesses whenever it materializes. New issuance of CMBS continues to grow from low levels with some notable but not yet alarming relaxation of terms from the very tight standards of the early new issuances. And while overall commercial real estate loans in banks are still declining, the decline is driven primarily by steep drops in construction and land development portfolios. Rents and vacancies seem to be improving, with particular improvements in multifamily and hotel cash flows. Indeed, if there is an area where I would look for overheating, it would be in multifamily.

Credit card delinquencies are approaching normal levels, and charge-off rates are dropping sharply, but issuers report that their portfolios are increasingly skewed toward transactors who pay off monthly balances rather than those who fuel their spending through higher credit card debt. And credit card balances continue to decline, as do available credit lines.

Everything related to residential real estate, whether it's construction lending, mortgage lending, or home equity, is mired deep in the mud.

Completely unrelated to credit, I was a lot more confident that the recovery was on firm footing before this spike in gas prices. I am much more worried that higher gas prices will cause skittish consumers to pull back again than I am about the effect on inflation, and I am concerned that businesses that are unable to pass through price increases will offset risk to their profit margins with renewed reluctance to hire. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Tarullo.

MR. TARULLO. Thank you, Mr. Chairman. As the minutes have passed, I have been trying to mentally cut back my statement. So I'm going to extemporize a bit.

The first point, on which I agree, I think, with virtually everybody, is that since our last meeting, the gradual recovery in the U.S. economy looks better grounded than ever. But as many of you have commented, the external risks'and I would say largely non-economically originating risks'are substantially larger than I think any of us anticipated.

I won't dwell on an assessment of the economy right now. I do want to identify two questions, which I think will have some salience for us going forward. One is probably a secondary question but was raised by Dave Stockton in his presentation, which is whether the less-than-expected levels of personal consumption expenditures observed over the last couple of months are more due to a growing set of concerns about these external problems, such as oil price increases or otherwise, or whether they have more to do with a chronic sense of concern about job prospects or other things more internal to the U.S. economy.

The second question, I think, is actually substantially more consequential, and this is the one raised variously by Charlie, Narayana, and Janet, which is to say: What is going on in the labor market? And exactly what conclusions can we, or should we, be trying to draw from the decline in the unemployment rate, notwithstanding the quite modest pace of net job creation along with the observed decline in the labor force participation rate? I think this one will have a lot of consequence for us as we have to make decisions over the course of the next year, and, like Janet, I am a little skeptical of at least some people's reactions'nobody on the Committee, but some people's reactions'which is to say, well, let's just assume that the trend for longer-term labor participation needs to be adjusted downward yet again. I just don't think we know enough. Maybe looking at the U-5s is one way to get at the information; maybe there are other methods

as well. But something is going on here that is not jumping out coherently from the different data streams.

The last comment I want to make is to try to draw together thematically a lot of the very trenchant observations that Bill Dudley made about various international developments. I think what is unusual about the adverse and worrisome developments for our economy right now is that they are dominantly noneconomic in origin. They are grounded basically in political or, more recently, natural factors, and they are also dominantly, though not exclusively, foreign. Obviously first is the possibility of oil supply disruptions, which could be somewhere between problematic and paralyzing, depending on how they go forward. But, look, we are just not particularly well equipped to make an assessment of how likely supply disruptions in Bahrain or any other Middle Eastern/North African country actually are. I'm not sure how confident the guys down C Street are in their ability to make those predictions either, but we surely can't.

Second are the persistent sovereign and bank debt problems in the euro periphery. I am a little bit more like Bill. I read it a little less optimistically than the staff has, I think. The way I looked at last Friday's agreement is that Europe is still doing just enough to keep a step ahead of the problems rather than clearly outpacing them. This pattern, I think, keeps open the possibility that some catalyst will accelerate the crisis quickly enough that the rather slow-moving European policy apparatus cannot keep up. I do think that our financial institutions in the United States have reduced their direct exposure to potential crisis countries substantially, although the transmission of problems from the periphery to core European country banks could still have an effect upon U.S. financial institutions and our own economy. I continue to restate Nathan's mantra that Europe has both the financial and technical resources to contain this set of threats,

but the condition that one needs to add is: if the political will to do so is present. Understandably, the domestic and intra-European politics of all of this are very difficult.

Then there is Japan. I really don't think that we know nearly enough at this moment to speak with any confidence about what the medium-term impact of the tsunami and the consequent problems with the nuclear industry are going to be on Japan's economy, much less the growth or inflationary effects on the rest of the world. Ordinarily, we might think that, notwithstanding the human tragedy, the reconstruction efforts of a rich country would provide a medium-term fiscal boost, particularly since the devastation largely spared Japan's industrial base. But the scope of damage to the power infrastructure in particular, coming in the context of more than a decade of economic stagnation and unfavorable demographic changes, raises at least the possibility of substantially less transient and more negative effects. So my point in rehearsing all of these possibilities is that they are very hard to work into an economic model, formal or intuitive. We are more in the realm of uncertainty than of calculable risk, at least risks calculable through economic analysis.

Indeed, even the list of lesser but domestically grown potential downside effects on medium-term economic growth contains items like the legal uncertainties around liability for the foreclosure imbroglio and the prospect of accelerated fiscal contraction driven by larger political debates. In these circumstances, it would obviously be imprudent to downplay these possibilities. And while we may need to react should one or more of these risks be realized, it is certainly not clear to me that even the most serious of these largely external risks has any immediate implications for monetary policy. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Raskin.

MS. RASKIN. Thank you, Mr. Chairman. The economic recovery is proceeding at a moderate pace, but as I've noted before, reductions in employment, income, and wealth have hurt households since the onset of the financial crisis. I don't want to restate many of the excellent points that have been raised around the table, so I'll use my time to underscore but one aspect of my outlook.

In short, the views of your so-called business contacts are supported by the views of my so-called household contacts. [Laughter] Admittedly, with two teenagers at home and one home from college, all of whom consume large amounts of milk, cereal, facial cleansers, and gasoline, the age of my sample size is skewed to the downside. That said, consumers who are full adults and run households face more downside risk from higher prices at the pump as well as a groundswell of fiscal austerity facing the nation at all levels of government. As we know, consumer sentiment tumbled in early March, reversing just about all of the improvements since last October. Optimism on the employment outlook among consumers also retreated. The Reuters/Michigan Consumer Sentiment Index primarily attributes the overall swoon in sentiment to surging gas prices. This swoon would tend to be consistent with the fact that the drop in confidence is considerably steeper among lower-income for whom gas prices are hitting especially hard than for higher-income households. This sharp reversal of what had been an upward drift in consumer sentiment between October and February is disconcerting. It doesn't bode well for economic growth. The rising cost of food and fuel, especially if these factors continue to rise, together with the effect of suboptimal job creation, could hinder or even derail growth in consumer demand.

I'd also like to remind the Committee that the housing market is also hindering growth in consumer demand. Household equity is far from being restored. From 2005 to the end of 2010,

$6.8 trillion in home equity has been lost. With our staff's assumptions of there being a

$0.03 loss in consumption for every $1.00 loss in home net worth, this $6.8 trillion in lost home equity represents a loss of more than $200 billion in consumption. And given the delays between drops in household equity and changes in consumption, the losses to consumption have not all been realized.

House prices continue to decrease, and despite household efforts to pay down their mortgages, home equity continues to fall. Indeed, cash refis are flat at zero. So not only is the so-called wealth effect of housing on consumption flat, but the ability of homeowners to tap quickly into any equity to fund household needs and other consumption is all but gone. The housing market still shows no signs of emerging from the significant overhang of residential real estate that is in foreclosure or entering the foreclosure process.

The baseline forecast of continued recovery depends importantly on steady improvements in, among other things, consumer confidence and the willingness of firms to hire, but these improvements may be materializing slowly. If so, risk aversion among households will increase, boosting precautionary savings by households and making firms more reluctant to boost capital spending and increase payrolls. The recent payroll tax cut, which was effective in January of this year, appears so far to be unnoticed by consumers, and if it remains as such will not have an appreciable effect on consumer spending.

I haven't addressed the economic impact of the earthquake and tsunami tragedies in Japan on household net worth, but I believe they loom large and will exert downward pressure on household consumption. The consequences on consumption and economic growth are not yet fully known, but, if realized, will slow the path toward recovery. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you, Governor Raskin, and thank you all. As usual, I'm going to attempt a summary of the discussion. Bear with me, and then I'll make a few additional comments.

Indicators continue to point to a strengthening though moderate recovery in 2011. Private-sector demand may be leading to self-sustaining growth. Labor market conditions have improved as unemployment fell significantly, though payroll growth has been somewhat less strong overall. Housing remains a drag on the recovery, as do fiscal policy, both at the federal and state and local levels. In addition, the effects of the Japanese situation remain unclear. With respect to inflation, the most important developments were, again, higher prices for oil and other commodities, which have increased headline inflation and contributed to some increase in indicators of inflation expectations. On net, risks to economic growth appear relatively balanced, while risks to inflation have shifted somewhat to the upside.

Consumer behavior reflects mixed influences, though auto sales remain strong. On the one hand, tax cuts are showing up in paychecks, and as noted, labor market conditions are improving. Unemployment is down, although in part this improvement reflects fewer layoffs and exits from the labor force rather than new hiring. The decline in the labor force may be either cyclical, reflecting the expiration of unemployment insurance, or structural. On the other hand, higher gas prices have drained spending power, reducing confidence and expectations for recovery while increasing expectations of inflation. Special concerns might arise with $4 per gallon gas, along the lines of the Hamilton theory of oil price effects. Home equity declines have reduced household wealth. Credit availability for most households'for example, in areas such as auto loans'has improved, however.

In the business sector, cautious confidence in the durability and momentum of the recovery is growing. Capital budgets have expanded in some cases to replace lost capacity, although at least some firms remain cautious about hiring. (I had a hard time trying to characterize firms' attitudes toward employment.) Wage pressures are low except possibly in a few narrow fields. That pattern is evident in recent union developments. Strong demand abroad is also stimulating production and exports, including agricultural exports. Higher commodity prices are leading to intensified cost pressures, some of which firms will attempt to pass through to consumers. Higher energy prices are also seen as a threat to demand by some firms. Among key sectors, manufacturing, energy, capital goods, air travel, and agriculture were reported as strong. Processed food, apparel, and steel are among the industries looking to raise prices. Construction and construction lending remain generally depressed.

Financial conditions were mixed over the intermeeting period. It remains to be seen whether recent European proposals will calm the sovereign debt crisis there. The dollar showed less flight-to-quality behavior during the recent MENA disruptions. U.S. banks see improving credit quality and weak loan demand (and we're not allowed to talk about anything else). [Laughter] However, credit conditions have improved in some areas, including autos, student loans, and C&I, although small businesses are doing relatively worse in that respect. Some risks to financial stability have been noted, including greater leverage and risk-taking by private equity funds, increased speculation in commodities, reduced covenants on bonds and leveraged loans, banks' exposures to Europe, and high farmland values.

Finally, on inflation, core inflation and other measures of inflation trends appear to have bottomed out but remain low. Some noted that ongoing slack in labor markets, limited pass- through of commodity prices, and stable inflation expectations should keep inflation trends low,

but others saw core inflation rising as economic growth proceeds. Near-term headline inflation is showing the effects of significant increases in gas prices and, to a lesser extent, in food prices. As noted, increased commodity prices have raised costs for many producers, which they will try to pass on to final users where conditions permit. Import prices are also up. Business surveys show higher prices paid and received. That said, wage costs are low and mark-ups are high, providing an offset for raw material costs. Higher near-term inflation has shown up in some increase in inflation expectations'for example, in consumer surveys'and public attention to inflation has increased. Inflation breakevens in the TIPS market have increased to levels in the upper part of recent ranges, though much of the effect is front loaded. The enlarged Fed balance sheet may have influenced inflation expectations. The increase in headline inflation may well be temporary. However, close monitoring of inflation and inflation expectations is essential, and communication will present difficult challenges.

Any comments? [No response] Well, let me just add a few thoughts, and some of them will build on comments that some of the folks around the table have made.

There were some negative developments over the intermeeting period. Obviously, we've talked a lot about geopolitical disruptions, which have led to oil price spikes, and the Japanese situation, the implications of which are not yet known. We saw some fiscal tightening, although depending on how that plays through, if we get a longer-term budget deal, it could end up being a positive. Ongoing concerns with housing and the banking system should be noted, particularly recent developments on the foreclosure problems and the servicing issues. Finally, some of the downward revisions we saw in Q4 and in consumption in Q1 suggest a bit less vigorous expansion in some dimensions than we thought in January.

That said, on the whole, like most of you, I am cautiously confident. The labor market report for February was encouraging; we're beginning to see, I think, what may be a sequence of stronger payroll gains. The drop in unemployment has been noted, as well as the fact that the Beveridge curve has shifted somewhat back toward where it began. The strength in the labor market is supported by surveys, like ISM surveys, for example. There have been other strong indicators, such as equipment and software investment, factory output, auto sales, and the like. So overall, the recovery does appear to be continuing'perhaps not as powerfully as we would like, but the longer it goes on, and the fewer times the Tealbook has to be revised between meetings, the more encouraging that is. So I do agree with people around the table that we are beginning to see more evidence that the recovery is self-sustaining.

There was a lot of discussion about inflation around the table, which, of course, is up in the near term. I'd like to address that from a number of dimensions. First, I think it is worth noting'just a bit of perspective'that the commodity price increases we've seen so far are not going to take headline inflation very high. According to the Tealbook analysis, the maximal

12-month PCE headline inflation will be 2.3 percent in June, and it will move down from there to 1.8 percent in December. That's, of course, under the usual assumptions about flat commodity prices and the like. But I would note that in 2008, this Committee was facing an inflation rate that was 3.6 percent in January and hit 4.5 percent in July before falling to

4 percent in September. So we have dealt with these commodity price increases before, and we have not necessarily seen any catastrophic movement in inflation expectations. That being said, as I will make clear, I don't take any of this lightly.

I do think as we talk about inflation'and a lot of the focus has been on whether

commodity prices are being passed on or not'we need to keep in mind the basic economics of

how monetary policy should respond to commodity price increases. The theory is very well established, but it is worth saying once again. There are essentially two cases. The first case is one in which it's a supply shock, that is, the increase in commodity prices is being driven by some set of factors outside of monetary policy or in which it's otherwise exogenous to the domestic economy. In that case, what the economy is trying to do is propagate a relative price shift, trying to say that the relative price of this commodity versus other goods and services has changed, and somehow the system has to accommodate that. Now, if we believe that nominal wages, in particular, are slow to adjust for whatever reason, then the only way that the commodity price relative change can emerge in the system is through a temporary increase in headline inflation. The alternative case, which would be to tighten monetary policy enough to avoid the increase in headline inflation, would require that we force down wages, which, in turn, would require presumably a significant negative impact on the economy. So in these cases, for whatever reason, we think the commodity price increases are largely independent of monetary policy'and I'll come back to whether that's the case currently or not'there is a very clear implication that so long, obviously importantly, as inflation expectations remain stable'and that's something many of you addressed'then we should be relatively willing to look through temporary movements in commodity prices rather than reacting strongly with monetary policy.

Now, I note that Vice Chairman Dudley laughed at himself on the communication issue that he has. There is a communication issue: Because monetary policy should not address these things doesn't mean they're not painful. It doesn't mean they're not affecting people's lives.

And we clearly, in talking about it, should in no way downplay the effect of high gas prices and high food prices on people's standards of living. So we must do that, but that doesn't necessarily mean that in all cases monetary policy has to respond vigorously to commodity price increases.

So what is the situation? How much of an argument can we make for the exogeneity or partial exogeneity of the commodity price increases that we've seen recently? I think the case is moderately good, although obviously not complete. Clearly, in the oil area, geopolitical factors have been very important; they've driven up oil prices quite significantly. On food, there has been a rather severe concatenation of bad weather conditions. The USDA has confirmed that, for a wide variety of staple crops, weather conditions in the past year have been exceptionally bad. This, in fact, shows up, as Nathan mentioned, in the futures market. For example, the cotton futures for a year from now are about half of what they are in the spot market, suggesting that there is a strong presumption that normalization of crops in the year to come will bring prices down or at least stabilize them. So I think there is some case for paying attention to the futures market in this case. And, of course, there's an interaction between energy prices and food prices. Higher energy prices tend to raise food prices as well.

Now, of course, there's also a global demand element to the increase in commodity prices, and there the linkage to U.S. monetary policy is more complex. When I'm trying to make a simple argument, I talk about the relationship between U.S. monetary policy and, say, oil prices. I point out, first, that the United States is consuming less oil and producing more today than it did five years ago or three years ago, and so overheating of the U.S. economy is not directly influencing net supplies of oil demand in the global economy. It's also the case that the decline in the dollar is not remotely enough to explain the movement in commodity prices. In particular, commodity prices are much higher in all currencies, not just in the dollar. So if there's a relationship between U.S. monetary policy and global commodity prices, it's more indirect. The story that I think is most plausible is one where you have a world in which some emerging market economies are intentionally keeping down their exchange rates in order to

expand their export markets. They are, therefore, importing, to some extent, U.S. monetary policy, which is inappropriate for their economies.

We have a situation in the world today where industrial production in the advanced industrial economies is still below the level at the beginning of the crisis, while in the emerging markets it is between 20 and 25 percent above the level before the crisis. So we have very much a two-speed recovery, and in a well-functioning international monetary system, those countries that are growing quickly and, in fact, are overheating would allow their exchange rates to appreciate and would tighten, raise interest rates, and reduce the inflationary effect of their growth. They are doing that to some extent, but obviously not completely, so the question remains: What is our responsibility? I think it's a hard question. On the one hand, our mandate is to address the U.S. economy, and so in some sense we have to worry about the feedback. On the other hand, it seems rather unfair that the emerging markets can essentially force us to maintain a suboptimal economy so that they can keep their exchange rates at a comfortable level and maintain undervaluation and trade surpluses. So it's a difficult question. But clearly, I think everyone would agree that this effect is being mediated not just from U.S. monetary policy decisions, but also through the decisions being made by policymakers in emerging markets, and in that respect, it's a difficult question.

The main counterargument to the view that we should not be responding too aggressively to commodity price increases is, of course, the one that people around the table have made, which is that even exogenous price increases in commodities could, in principle, unhinge inflation expectations for whatever reason. And in that respect I am in full agreement with everyone around the table that we need to watch that very carefully. My feeling is that so far that that has not happened. The movement in all of our various indicators remains still well within

historical ranges, particularly in the TIPS market. Almost all of the changes, as Brian Sacks showed, have been in the near-term expectations. The longer-term inflation compensation is not much changed, even though one would presume that inflation risk premiums are a little bit higher than they were. Forecasts from the SPF and elsewhere are, in fact, below where they've been in recent years. There's as of yet not much evidence of pass-through, et cetera. So I don't think that that mechanism is as yet a reason for alarm. That being said, that is the mechanism by which even exogenous commodity price increases can be translated into inflation domestically, and that is something to which we have to pay very close attention going forward.

Let me say a word about the comparison of U.S. monetary policy with other countries. There were a number of people who mentioned the ECB, for example, and there's a meme in the international press, you know, that the ECB is so hawkish and the Fed is so dovish, and that's a difference in our constitutions or something. In fact, if you condition on economic conditions, it's not at all evident that the ECB is more hawkish than the Federal Reserve. Just to give you a little exercise that I did, and I recognize it's an imperfect exercise, if you take the Taylor (1993) rule, which puts a relatively low weight on output gaps, then you can compare the conditional tightness of any two countries by just taking the difference between the Taylor-rule implications for the two countries. In particular, if you ask what is the difference in the policy rate that is warranted by the Taylor rule in a given country, the answer is it should be 1.5 times the difference between the inflation rate in that country and the U.S. inflation rate minus half of the gap in that country minus the U.S. gap. That essentially tells you what the difference in policy rates should be. When you do this exercise, you find, for example, that while the actual euro- area rate is 60 basis points higher than the U.S. federal funds rate, the difference implied by the Taylor rule is 215 basis points. The reason is that the output gap there is much lower and the

inflation rate is higher. For the United Kingdom, they're 40 basis points tighter than we are; the implied difference from the Taylor rule is 405 basis points. For Canada, it is 310 basis points. The only country that is easier than the United States is Japan, which of course is also constrained by the zero lower bound. So in that respect, I think if you condition on economic conditions, the difference is much less evident than some of the superficial discussion would suggest.

In particular, though, I realize that the output gaps are a question. Although the ECB's output gap for its own area is apparently lower than our estimate, putting that aside, there really is a major difference in what's happened to unemployment here and in other countries. For example, our unemployment rate is 4.3 percentage points above the two-year average before the crisis, whereas the EU's increase in unemployment is 2.0 percentage points. So there's been a much bigger increase in unemployment here than in other countries. The same is true in the other countries for which I compared, and in particular, imagine being at the ECB in Frankfurt and taking into account the fact that the German unemployment rate is now 2.6 percentage points below what it was before the crisis. So it's not all that shocking that the ECB is talking about tightening, and it's not evident from that that the Federal Reserve is behind the curve. So I thought that was worth mentioning.

I think we're still constrained by the zero lower bound, notwithstanding the considerations I discussed today. I think further that'and again, anticipating the policy discussion'given all that has happened in the world, now is not the time to be shocking markets with our policy decision. That being said, once again, I've heard what you've said around the table about inflation risk; I've heard what Presidents Fisher and Hoenig said about financial instability risks. I do think we need to become more and more attentive, and I think that by the

April meeting, we should be providing fairly definitive guidance to the markets about what we're

going to do with our purchase program and possibly with additional measures. But, again, I

don't think that today is necessarily the day to do that.

Let me stop there and turn now to Bill English to introduce the policy round.

MR. ENGLISH.2 Thank you, Mr. Chairman. I will be referring to the package labeled 'Material for FOMC Briefing on Monetary Policy Alternatives.' The package includes the three revised draft statements that we distributed yesterday, along with associated draft directives.

Turning first to alternative B on page 3, Committee members may think that the medium-term outlook for real activity and inflation remains broadly in line with their expectations at the time of the January meeting, and, accordingly, that no change in the course for monetary policy is called for. Even after the declines in the unemployment rate over the past few months, policymakers may see unemployment as too high and likely to remain so for some time, and they may anticipate that higher energy and other commodity prices will boost headline inflation only temporarily, as long as longer-term inflation expectations remain anchored. Indeed, because higher commodity prices can also be expected to reduce real income and damp consumer spending, policymakers may think it appropriate to leave policy unchanged in the face of such a shock. With measures of underlying inflation still low, you may be inclined to continue with the current purchase program at this meeting and wait for additional information on output, inflation, and inflation expectations before deciding on your next step. Moreover, Committee members may be concerned that unexpectedly discontinuing or reducing the purchase program could cause confusion about the Committee's intentions and thereby weigh on household and business confidence, particularly given the elevated uncertainty caused by the recent events in the Middle East, North Africa, and Japan.

As for the statement language, the first paragraph would be updated to suggest somewhat greater confidence in the recovery and to acknowledge the run-up in commodity and oil prices. Paragraph 2 would no longer suggest that progress toward the Committee's objectives has been 'disappointingly slow.' Instead, it would note the temporary boost to headline inflation from energy and other commodity prices, and say that the Committee expects limited pass-through to underlying inflation. The language added yesterday emphasizes that you will 'pay close attention to the evolution of overall inflation and inflation expectations.' Finally, in paragraph 3, the bracketed words could reintroduce the pace of asset purchases as an addition to their cumulative total. However, doing so would likely lead market participants to believe that the Committee was signaling the likelihood of some change in its plans'perhaps an intention to adjust that monthly total before long'that you might not intend.

2The materials used by Mr. English are appended to this transcript (appendix 2).

The language of alternative A would suggest that the Committee had not upgraded its view of the economy, noting only that the recovery is continuing and that employment remains at low levels. Paragraph 2 would end by noting that 'downside risks to the economic outlook remain significant.' Paragraph 3 would confirm that the Committee 'will' purchase the full $600 billion of longer-term Treasury securities, and that it is 'prepared to expand and extend the purchase program' if needed to achieve its objectives. The fourth paragraph would provide more-explicit forward guidance about the expected path for the federal funds rate by specifying that exceptionally low levels were likely 'at least through mid-2012.'

Finally, I wanted to briefly return to the issue of tapering the Federal Reserve's purchases of Treasury securities that Brian raised earlier. Tapering would involve gradually reducing the pace of purchases over coming months and, if the Committee still intended to reach $600 billion of purchases, extending them into the third quarter. As Brian noted in his Desk report, the depth and liquidity of the Treasury market suggests that significant tapering is unlikely to be necessary to avoid an adverse market reaction, and that most market participants do not appear to be expecting tapering. Nonetheless, you may find some amount of tapering attractive as a form of insurance against an adverse market reaction to the end of purchases.

There are several other issues that the Committee might want to consider regarding the possible desirability of tapering. If it were to taper, the Committee would have more time before the end of the program to make adjustments'either up or down'to the overall volume of purchases if that became appropriate. However, some policymakers may be worried that tapering could increase public uncertainty about the Committee's intentions regarding the size of the program and so could prove counterproductive. The Committee also might be concerned that an extension of the period over which purchases are completed could, if macroeconomic conditions changed sufficiently rapidly, lead to an undesirable delay in the Committee's move toward exit.

Draft directives for the three alternatives are presented on pages 6 through 8 of your handout. Thank you, Mr. Chairman. That completes my prepared remarks.

CHAIRMAN BERNANKE. Thank you, Bill. Any questions for Bill? [No response]

Seeing none, we can turn to the policy go-round, and we'll start with President Rosengren.

MR. ROSENGREN. Thank you, Mr. Chairman. I support alternative B. I also believe

we should complete the full $600 billion in the government securities purchase program. On

balance, the oil shock and fiscal austerity have not significantly altered my view on medium-

term inflation pressures but have made me somewhat more concerned about the strength of the

recovery.

I would note that President Hoenig's comments as well as the financial stability memo have highlighted that agricultural land prices are rising quite rapidly in many farm states. I do not believe that this is a reason to raise rates or to alter monetary policy. However, I do believe it warrants careful supervisory scrutiny. Higher farmland prices are a reaction to improvements in developing economies and their ability to spend more on importing food, as well as to a series of disruptions that have hurt food production in other areas of the world. Tightening monetary policy will do little to effect farmland prices, but it will almost surely make a slow recovery even slower. While monetary policy is probably not appropriate for targeting agricultural and other commodity prices that I do not expect to have broad effect on overall prices, as I discussed earlier, supervisory policy could be quite effective in the case of surging agricultural land prices. Requiring higher underwriting standards for land purchases and requiring banks to conduct stress tests to assess the adequacy of their capital in the event of a rapid reversal of farmland prices does seem appropriate.

In terms of the tapering that we had just discussed, I think it's going to be very difficult to actually have that communication strategy at this point, so my preference would be not to taper.

CHAIRMAN BERNANKE. We are, in fact, as I understand it, talking to banks about the farmland situation, and Kansas City is playing an important role in that. President Lacker.

MR. LACKER. Thank you, Mr. Chairman. As I said earlier, I see parallels between our situation today and the unexpectedly rapid increase in core inflation in 2003 and 2004. In late 2003, the recovery was disappointingly slow. We were expecting persistent slack to hold down inflation, perhaps to lead to outright deflation. Energy prices were surging. Flat futures curves led us to believe energy prices would level out. Our estimates of economic slack led us to believe that core would remain low. Instead, as economic growth picked up, core inflation rose

rapidly, from under 1.5 percent to 2'' percent. That pickup in inflation turned out to be persistent. Core inflation remained around 2'' percent and bounced right around there for the next four years, and that set the stage for our inflation outcome over that four years, which turned out to be not that great'3 percent overall headline inflation.

As I said earlier, in assessing this risk, I think it's useful to consider the perspective of a typical business person trying to figure out their pricing strategy. On the one hand, core inflation has been running relatively low in the last couple of years. And if they've been paying attention, they've probably heard of Fed officials emphasizing their commitment to price stability. On the other hand, their firms' experience coming out of the last recession, although many years ago, may be present in their mind and may suggest that now's the right time to expect an increase in inflation. They are no doubt aware that the Fed has been purchasing securities and flooding the banking system with liquidity. They may have come across some fringe commentators or bloggers or maybe even some political figures ranting about hyperinflation right around the corner. In the reporting on QE2, they may have picked up that the Fed wants the inflation rate to be higher than it is now, and they may have not been exposed to the excellent statements you've made, Mr. Chairman, making very clear that we do not intend to overshoot an inflation rate of 2 percent. So there may be a substantial number of business people who have absorbed ideas suggesting there's a substantial risk of higher inflation ahead. Some of the ideas they've absorbed may be not well founded, but they might affect inflation nonetheless. I recognize that the risk that core inflation ratchets up is always with us, but what I've tried to do is make the case that at this time in the business cycle, that risk is more present for us, more pressing, and ought to be considered substantially more urgent now than is typically the case. I think this risk poses very difficult challenges for us. We should, of course, do anything we can through

statements and communications to enhance our credibility and get the message out about our expectations regarding inflation. But actions often speak louder than words. And I think we need to be prepared to take actions to keep core inflation under control in this episode.

For today, I feel an irresistible attraction to alternative C, but I can support the status quo with the economic updating in alternative B at this meeting. At our next meeting, if core inflation were to continue to rise, if we were to see another very strong employment report or other signs of stronger-than-expected growth, I would strongly support reconsidering ending the asset purchase program earlier. Beyond that point, my best sense is that we're going to need to take action sometime this year, either initiating asset sales or raising the funds rate by the end of the year.

As for tapering, it strikes me as excessive fussiness about the timing of purchases, and the challenges to communication suggest we just follow through, if that's what we're going to do, on a pre-decided schedule. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I support alternative B, but I would like to propose changes to the third sentence of paragraph 2 of alternative B, and I'm suggesting these changes because I think the tension in the public's mind about what's going on with headline inflation and our accommodative stance makes it important for us to clarify. So with that backdrop, I would propose replacing the word 'temporarily' with the word 'currently,' and I would propose dropping the word 'headline' from that sentence. Then in the next sentence, instead of saying 'limited pass-through to underlying inflation,' I would say, 'The Committee expects these effects to be transient,' comma, 'and' instead of 'but,' 'it will pay close attention to the evolution of overall inflation and inflation expectations.' The impact of

these changes would be to say that we are seeing upward pressure on inflation right now, but we are not reacting to them because we expect those changes to be only transient in nature.

As President Bullard articulated, I do think our ultimate variable of interest is headline, but it's over a sufficiently long period of time. The reason we're not reacting to these changes is not because they're showing up in headline, it's because of the fact that we expect them to be sufficiently short lived. So that's my proposed change to alternative B.

VICE CHAIRMAN DUDLEY. Would you read the proposed change?

MR. KOCHERLAKOTA. Do you want me to read the whole thing?

CHAIRMAN BERNANKE. Read the two sentences that you changed.

MR. KOCHERLAKOTA. 'The recent increases in the prices of energy and other commodities are currently putting upward pressure on inflation,' period. 'The Committee expects these effects to be transient, and it will pay close attention to the evolution of overall inflation and inflation expectations.'

CHAIRMAN BERNANKE. I think, actually, that's very good. Is there a feeling around the table?

PARTICIPANTS. Yes, I agree. Very good.

CHAIRMAN BERNANKE. All right.

MR. FISHER. May I ask one question, Mr. Chairman?

CHAIRMAN BERNANKE. President Fisher.

MR. FISHER. This is picky, but why use 'and' instead of 'but'? If you say 'and,' you're sort of dismissing it. If you say 'but,' you're saying we have to pay attention.

MR. KOCHERLAKOTA. Yes, but'sorry, 'but' is fine.

MR. FISHER. I hate to butt in.

MR. KOCHERLAKOTA. You did that just for that reason, I'm sure. [Laughter] CHAIRMAN BERNANKE. So the idea is: ''these effects to be transient, but it will

pay''. Yes.

MR. KOCHERLAKOTA. That's fine.

CHAIRMAN BERNANKE. All right. I think that's very constructive, thank you. Who's next here?

MR. KOCHERLAKOTA. I have a few more words to say.

CHAIRMAN BERNANKE. I'm sorry. You've contributed so much already.

MR. KOCHERLAKOTA. Well, thank you. I'm opposed to tapering our purchases; I agree with both President Rosengren and President Lacker on that. I like the preliminary discussion of exit in the Tealbook. I'm looking forward to a fuller discussion in April. Certainly, I don't think we'll be in a position at that point to settle this question of when exactly exit will begin, but I'd like us to begin to settle on the sequencing of timing and moves after a given start date.

In the last six weeks, the Tealbook has moved up its projection of our first interest rate increase to the third quarter of 2012, but I anticipate exit to be a multimeeting process that will most likely begin three to four meetings before the actual raising of rates. I would think it would begin with the changing of language, but that's something we can start to discuss next time. If my forecast is right, that would mean we will start the process in about a year. Of course, raising rates in the third quarter of 2012 is a point forecast, and the Tealbook also includes a 70 percent confidence interval for that point forecast. That error band includes an increase in the fed funds rate of 50 basis points by the end of 2011. So that's what's in that 70 percent error band.

In a similar vein, it's instructive to look at table C of the March 11 memo to Reserve Bank Research Directors from Thomas Tallarini. (I stole it from my Research Director. I don't think I'm supposed to be looking at those things.) That table uses simulations of FRB/US to estimate the probability that the fed funds rate will exceed 25 basis points at some point during the year 2011, and the table reports that estimated probability as being 52 percent.

So monetary policy is about risk management, and good risk management means being ready for the possibility that we may need to initiate exit by as early as September or November, and I hope we do that planning for that possibility. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Evans.

MR. EVANS. Thank you, Mr. Chairman. I favor alternative B. The editing suggestions seem fine with me.

The outlook is improved. Underlying inflation continues to be low, so I expect to support completing our $600 billion of purchases until we're finished in June. I have a preference for no tapering of the program.

There is a clear risk for policy and our credibility if inflation expectations were to increase substantially. I think we all understand and agree on that. I did take a little additional comfort from Brian Sack's report that indicated that the one-year forward inflation breakevens have only increased a touch once you start looking two years and out, and so most of the shift has been in the near term. But we need to keep the inflation expectations risk front and center, so I wholeheartedly agree that we should monitor that.

Still, I think resource slack is important, and I welcome President Kocherlakota's insightful comments about slack estimates from the simplest New Keynesian models. I am a

little skeptical about the sturdiness of these conclusions, and I think he used the term 'reliable measures.' I'd like to see more on that, I agree with that assessment.

Inflation dynamics from the simplest New Keynesian models don't seem to match the data. It actually takes quite a lot of work in order to introduce mechanisms like that, and, in fact, some New Keynesian models that don't have enough of the inflation dynamics embedded in them likely have mean reversion baked into their inflation forecast. If they don't have enough inflation persistence, and then they see data that show a drop in inflation, they're going to see that inflation goes back up, and 2 percent is probably what's baked into that model. So I'm really not sure what confidence we should have coming out of those types of models unless the match of the model with the data is reasonable. I think that's something that we have to understand. In the DSGE versions that we use in Chicago, we put a lot of emphasis on the channels that help induce more inertial inflation dynamics, and I would say, like Jeff Fuhrer's research has emphasized on this, it's a very important feature. I'd like to see similar slack assessments coming from models that match the data better, and in the memo that I circulated on commodity prices, I had a line in there that alluded to this. I think there's risk in putting too much weight on theoretical constructs that don't really describe the data nearly well enough. I'm not quite sure how much emphasis we should put on that.

In terms of policy going forward, the Tealbook has the assumption that the interest rate takeoff will occur in mid-2012. Yes, that could happen; I could see that that could be acceptable even with my outlook and concerns. I still expect that core PCE inflation at that time is going to be 1'' percent or less, so I'm a little nervous about that, but if the facts change, I will change my opinion on that.

Thinking about exit strategy, I can even imagine a reverse tapering of our $600 billion asset purchase, along the lines that Presidents Kocherlakota and Bullard have previously mentioned, that might take place before the rate liftoff. I'd just like to understand the possibilities there a little bit more, so in the discussion that we have about exit strategy, perhaps a little more emphasis on that than what the consensus was over a year ago.

Putting it all together, given the outlook and the inflation risks that we face and the slack estimates that I think are appropriate, I am comfortable with alternative B, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Kocherlakota.

MR. KOCHERLAKOTA. Yes. I thank President Evans for his close attention to my remarks.

MR. EVANS. I learned from President Bullard last time.

MR. KOCHERLAKOTA. I will just articulate one thing, which is that I am only emphasizing one aspect of the New Keynesian model, which is the Phillips curve itself, and so when you want to evaluate what I'm saying, you want to do it like a GMM test, or something like that, of that one particular equation. So that's the only piece of the model that I'm exploiting.

MR. EVANS. We have research evidence on that from the Chicago Fed. Jonas Fisher and Marty Eichenbaum did work looking at exactly that type of GMM Euler equation, and it doesn't do very well unless you add more dynamics to that, but we could go back and look at that more carefully.

CHAIRMAN BERNANKE. With great reluctance, I think I'd point out it's getting a little bit latish. [Laughter] Let's try to minimize the research program component today. President Plosser.

MR. PLOSSER. Thank you, Mr. Chairman. A second round of LSAPs is nearing its scheduled conclusion in June. As you know, I was not in favor of this policy when it was implemented last November, and I certainly cannot support another round of purchases. The current forecasts simply don't justify any serious consideration of a new round of purchases. The Tealbook suggests the possibility of extending the time frame for the purchases, the tapering plan. I don't support a tapering plan. I don't think that is necessary. The argument for LSAPs is they work through stock effects and not flow effects, so I'm not quite sure why the argument for tapering makes a lot of sense in that context. I don't think the end will be disruptive to markets. We've been telling them what we were going to do. Let's just go ahead and do it and not worry about it so much. I think the only justification for tapering would be to say that we decided to cut back on the stock effects and say we were going to go to $40 billion per month, but that would be the only justification in my mind to change the pace at this point. Thus, I'm assuming the program will end in June, which means that our April statement will need to signal the LSAPs will end in June and that no further purchases are anticipated at that time. I don't think it's too soon for us to consider what changes we will need to make in that statement and plan for them now using appropriate language in today's statement.

Let me make three points about the language of the alternatives we're considering today. First, the recovery is gaining momentum. I think that was fairly apparent from the discussion around the table by people's descriptions of the economy. I think it's important that we convey this in our description of economic conditions in paragraph 1 so that the markets will understand that the LSAPs will end in June as anticipated. You'll recall that in January some of us felt that our statement read a little too negatively on the economy, given our forecasts, and indeed, the Committee did get some criticism along these lines once we released our January statement. I

think we should make sure that our statement language is well calibrated to our read on the current conditions and our forecast. To my mind, the tone of paragraph 1 in alternative B read better in the Tealbook than it did in this most recent version. But I think actually paragraph 1 in alternative C is even a better characterization of economic conditions. After all, this Committee, in terms of its forecast, is still forecasting well above trend growth for the next two years. I think the one thing that might help in paragraph 1, alternative B, is that I might suggest dropping the word 'somewhat' from the first sentence and suggest 'is on a firmer footing' rather than 'somewhat firmer footing.' 'Somewhat firmer' seems like there are too many adverbs and adjectives here to describe what's going on. Just a thought.

Second, as the economy continues to strengthen, I think we will need to begin revising our policy course later this year, as I suggested earlier. This means our language in paragraph 4'that economic conditions are likely to warrant exceptionally low levels of the funds rate for an extended period'is beginning to ring untrue. We should consider the alternative C language that changes 'extended period' to 'some time' and 'exceptionally low' to just 'low' if not at this meeting, then perhaps at our April meeting. We have to remember that we can change the language and even raise rates considerably and a policy will remain very accommodative for some time to come.

Third, I strongly support Professor''Professor'? He's still a Professor'Kocherlakota's recommendations on paragraph 2. I think we got a quick unanimous read on that; I support that. Paragraph 2 also is a statement about the economy's performance relative to our mandate. Thus, I'm a little uneasy about phrasing this in terms of the unemployment rate. After all, our mandate is about price stability and maximum employment, not about the unemployment rate. They are, of course, related, but they are different. Moreover, we will need to begin exiting from

accommodation well before the unemployment rate is at a level that is acceptable to the average person. So the language of continuing to stress the unemployment rate as our indicator may complicate our communications as we plan on exit. I think we need to find an opportunity'if not today, then in April'to start using mandate-consistent language in this paragraph, talking about the level of employment or the level of unemployment rather than unemployment rates. Unemployment rates, as we know, lag the economy and lag both employment levels and unemployment levels.

Finally, as I discussed at our January meeting, I think it is extremely important that we begin planning for our exit from this period of extraordinarily accommodative policy, and I'm glad we'll be reopening this discussion in April.

In my view, our exit strategy should be thought of as a plan, and it should have the following desirable characteristics, which I would suggest: First, the plan should be a systematic one, entailing some degree of commitment to the way we will execute the strategy, since this will reduce uncertainty in the markets and in the public's mind. But it also should allow for some conditionality on the evolution of economic conditions as, in fact, all good monetary policy should do. Second, the plan should be easy to explain to the public and to market participants, and we should make every effort that when we decide on the plan, that we, in fact, communicate it to the public. Third, the plan should be able to return us to a 'normal' operating environment in a timely way, and I think we need to communicate to the markets what that normal is. That is to say, the plan ought to articulate where we're going. From my perspective, what I mean by 'normal' is that we're using the funds rate once again as our policy instrument, running under a corridor or operating system in which the primary credit rate and the interest rate on excess reserves are the upper and lower boundaries, respectively, of that corridor. This Committee has

not decided on that, but I take that as my notion of what we think is a likely outcome for what's normal. But we need to communicate that. I note that if that is the normal plan, then this will necessitate shrinking the volume of excess reserves by a significant amount to get there, which will entail selling assets, not just relying on redemptions. And fourth, I would say that we need to return the composition of our balance sheet predominantly to U.S. Treasury securities.

Whatever exit plan we have, it seems to me, needs to get us to those places. This is going to be a tricky process to unwind from our extraordinary degree of accommodation. Having this Committee publicly commit to a numerical inflation objective could prove quite helpful to this process as it will help keep inflation expectations well anchored, which is essential to our success in exiting, as illustrated in the Tealbook scenario where inflation expectations, in fact, rise; I talked about that earlier, and that is not a very attractive scenario for us.

I think we can think about asset sales in two pieces. I think of there being an underlying trend of asset sales, at a basically low, modest level, that would go on a continuous basis; I call those continuing sales. You might also think about a set of conditional sales, sales that would expand more or less depending on the state of the economy, and, in fact, we might even relate those to when we choose to make funds rates decisions. Thus, we could establish a modest rate of selling assets, speed that up as we raise rates, and slow it down when we choose to pause, if necessary. I don't want to go into more details of that. The important thing is that by tying our asset sales to both unconditional and conditional decisions, meaning a steady state of sales and a set of sales that were related to our target interest rate, they will be state contingent and dependent on the same factors then that govern our interest rate decisions. I think such a systematic approach will reduce uncertainty in the markets about our exit plan and commit us to

getting back to normal in a timely fashion. I think those are the key elements in my mind that might make for a good plan.

Rather than spell that out in more details now, I'm going to be circulating a memo to the Committee in a few days with a little more detail about how I'm thinking about that, and I hope that it will provide some food for thought as we get ready for our April discussion. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Pianalto.

MS. PIANALTO. Thank you, Mr. Chairman. I support alternative B, and I also support the changes that President Kocherlakota has recommended in the language in paragraph 2. I am more confident today than I was at our January meeting that an expansion is taking hold, and although I expect headline inflation to be close to 2 percent this year, I expect core inflation to rise only gradually toward 2 percent over the next few years.

The most significant risk I see on the horizon is that the pass-through from oil and other commodity prices to core inflation proves to be much greater than the empirical evidence suggests it will be. As we talked about today, one mechanism through which this could occur would be for persistently high headline inflation to destabilize longer-run inflation expectations. Of course, the key to stability of long-run inflation expectations is policy credibility, and we should do everything we can to buttress the confidence in our resolve to maintain price stability. That's one of the reasons, like President Plosser just mentioned, that I support publicly announcing an explicit numerical inflation objective. And with the potential for inflation expectations to be more volatile with energy and commodity price shocks, I think the sooner we clarify our inflation objective the better.

Finally, given Brian's comment, tapering of our final asset purchases doesn't appear to be necessary. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. I'll be brief. I generally support alternative B for today, with an eye toward a version of alternative C at a future meeting. I would not change the extended period language as it is changed in alternative C any time soon. I think as soon as we do that, it will signal imminent rate hikes. So I think we want to be very careful about that. I counsel patience for today because I'd like to gather more information on developments in the Middle East and North Africa, and I would like to get past the late March period, which is supposed to produce a deal in Europe. So I'd like to get more information on both of those situations. Hopefully, those situations will not develop into full-fledged global macroeconomic shocks, and we'll be able to assess the situation at our next meeting.

I have a few comments on alternative B. In paragraph 2, the phrase 'limited pass- through to underlying inflation' makes it seem as though core inflation is a goal in itself. However, President Kocherlakota has conveniently eliminated my concerns here. So I fully support what he has suggested. He gets exactly to the ideas that I wanted to get through, which are that what we want to convey is that we think this is temporary, and we're going to watch the situation closely, which I think is what the change does.

I would like the pace of $80 billion, which is down in paragraph 3, to be included in the statement. I think that could be done here with little fanfare. That would give us a dimension on which we can adjust going forward. So I'd like that in there. Please insert sufficient passion with that part of my speech. [Laughter]

On tapering, my colleagues are wrong on this. You should be tapering. So I'll be the excessively fussy guy. I think it's just prudent policy to engineer a smooth transition. I see little merit in an abrupt stop. Either nothing will happen, which is what you are all saying, or rates will jump up in that window and we'll get blamed for it. So I don't see any reason to do that. It should be easy to taper, and why not do it? It will take that risk off the table.

I do appreciate the sudden conversion of the Committee to rational expectations macroeconomics, but it's not the right policy at this juncture.

CHAIRMAN BERNANKE. Adaptive learning. [Laughter]

MR. TARULLO. Mr. Chairman.

CHAIRMAN BERNANKE. Yes.

MR. TARULLO. Jim, isn't there a little bit of tension between wanting to include the $80 billion and favoring tapering?

MR. BULLARD. Well, if we're going to say it's $80 billion now, we can adjust it if we're going to taper, I think.

CHAIRMAN BERNANKE. President Fisher.

MR. FISHER. May I just ask for a clarification, Mr. Chairman? The last time we discussed the $80 billion, as I remember, Michelle spoke passionately about not including it. Could someone just review the reason we did not include it last time very quickly before we proceed?

CHAIRMAN BERNANKE. Well, because it involved a change from the previous $75 billion, and the concern was that there would be confusion. I think now the question that Bill English mentioned in his presentation was that, at this point, reinserting it might create some confusion of a different type about what our plans are. I put it in there because I do feel that we

did strike this compromise some meetings ago. President Bullard and I talked about the elimination of the unfortunate change in the rate of the pace of purchases at the last meeting. But the majority of the Committee last time felt that it was not appropriate to include it just for communication clarity. If there are others who want to change their views and want to reinsert, I'll give you a chance, so let me know later at the end of the round. Okay. President Williams.

MR. WILLIAMS. Thank you, Mr. Chairman. I favor alternative B. We're still falling well short on both parts of our dual mandate, and I expect that that situation will continue for quite some time. Therefore, the current very accommodative stance of monetary policy remains entirely appropriate. The recent oil supply shocks don't fundamentally change this calculus. This conclusion is illustrated by the very small funds rate responses to the oil and commodity price shocks reported in President Evans's memo, as well as other research using alternative methods. Of course, the success of this strategy is dependent crucially on maintaining well- anchored inflation expectations, and in the current circumstances, then, it's important to note there are still no signs that the rise in headline inflation is spilling over in any significant degree to underlying price or wage inflation or into longer-run inflation expectations. Of course, as many of you have already noted, we must watch these developments very closely and be ready to adjust policy as needed.

I very much like the wording President Kocherlakota came up with. I do have a slight tweak to that. If you look to the phrase'let me see if I can read this right''but it will pay close attention to the evolution of overall inflation and inflation expectations,' given that we've gotten rid of the 'core' idea, I would suggest deleting the word 'overall' there.

CHAIRMAN BERNANKE. I think that's a friendly amendment.

MR. WILLIAMS. And finally, I am opposed to excessive fussiness myself, so I do not see the benefits, really, of the tapering.

MR. PLOSSER. Mr. Chairman.

CHAIRMAN BERNANKE. President Plosser.

MR. PLOSSER. I am fine with the suggestion that President Williams made. I think that's good. I do think, just to give the staff and others some food for thought, we also use the phrase in this statement several times, 'underlying inflation rate''is that a code word for 'core'? And I think as we try to move away from the language of 'core,' thinking about how we use the phrase 'underlying inflation' is something that I think we need to give some thought to in the future.

CHAIRMAN BERNANKE. So just one word on that, which is that in an inflation- targeting regime, we would be talking about medium-term objectives. And that's really what we have in mind here. I think that 'underlying' abstracts from the temporary fluctuations associated with commodities.

MR. PLOSSER. So we might want to think about moving toward language' CHAIRMAN BERNANKE. One way to change that is we would move toward a

medium-term type of description. MR. PLOSSER. Exactly.

CHAIRMAN BERNANKE. President Hoenig.

MR. HOENIG. Thank you, Mr. Chairman. As I think we have all noted around this table, the recovery continues to gain strength and increasingly appears to be sustainable, and there have been significant recent improvements in the labor conditions. While we would all like to see stronger growth and lower unemployment, the fact remains that the economy is

undergoing a major and necessary rebalancing that includes the deleveraging of consumers, businesses, and financial institutions. Thus, having this kind of economic growth in that environment is, I think, an impressive thing. Now, this process will take time, and maintaining a zero rate is as likely, in my opinion, to impede the process as it is to help it. You heard around the table that we are seeing new leverage being introduced almost as we speak.

I also want to comment on President Rosengren's point, which I think is an important one and a good one, but I think he has it backwards. Low rates are, in fact, in place and designed to increase asset values, and that's what they're doing. I gave the example of agriculture, because it is immediate, I know it, but it is an example; there are other asset values that are increasing fairly significantly now using leverage. And I think this increase, whether it's an acquisition of a company to expand under very low interest rates that causes an appreciation in value, has to be taken into account. So if you are going to now have supervision calibrate the movement in the asset value that your monetary policy was designed to increase, you are going to have to have your army stand pretty tall to do that.

If you take, for example, this agriculture situation, we can go into a bank, and the loan-to- value ratio for the land has been priced up to 70 percent, which isn't a bad number, and if you look at it with the prices and the cash flow you say, 'Ah, that's a great deal. It should pay off. Let's stress test it.' And you say, 'Well, if you have 300 or 400 basis points, it's too low, because those prices will come down.' What do you tell the banker? Raise capital? Do you classify the loan? No, because the cash flows are good, the asset value is there, and the appraisal is terrific. The problem is, in that situation'and there may be others'you also have a GSE down the road who is making loans for agricultural land that are sweetheart deals. So you tell the banker to get out of the way? The problem is, the policy that we have taken on is designed to

move asset values, and it's working. The problem is: How long do you let it stay in place? My point is that we need to move to a more balanced policy. Specifically, we need to be, again, preparing the market for a rate increase soon, so that you don't get the imbalances that a collapse, whether in agriculture or the high-yield market that we talked about earlier, where yields are at historical lows. That is what we need to be thinking about.

I see little need to continue purchasing longer-term Treasury securities. Instead, I recommend the purchases end sooner rather than later, and at something less than the number that's been tossed out there. I also recommend that we begin to form an exit strategy as soon as next time, if not sooner, to stop reinvesting principal payments from our securities holdings and to allow the size of our balance sheet to begin to stabilize and shrink. Also, I continue to recommend that we change the forward guidance on the targeted level of the federal funds rate, because this banker I'm talking to says, 'You've got to let rates low for an exceptionally long period.'

The point is that we are still in the process of crisis policy that's keeping rates artificially low, moving asset values up, causing these banks and others in the market to take on increasing risk by design. Supervision, as good as it may be, can't offset or fine tune any better than monetary policy can fine tune. And that's what I'm really worried about. I am just pointing out that our current highly accommodative monetary policy needs to be turned down'not made tight policy, but needs to be turned down'and the sooner the better, so that we don't create a new set of financial imbalances and develop longer-term inflationary expectations, because if we wait until we know we have it, it's too late. If history has taught us anything, it has taught us that.

So that's where I am on this. I know I am outside this Committee's boundaries, but I really strongly feel we are on a path that has a whole new set of issues that is coming at us, not next year, but in the long run. That's why I'm also concerned about an intermediate type of discussion, when the long run is where we really are setting things up for future challenges.

So that is my issue around asset values. It is not just agriculture. I think that's important. Thank you.

CHAIRMAN BERNANKE. Thank you. President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. I support alternative B, but I do have some suggestions on language, and I'd like to get to those in just a moment. But first, I'd like to comment on why I think B is the correctly calibrated policy for the situation.

I have a pretty mainstream view relative to those around the table regarding the most likely path of the economy. I see the most probable path as continuing expansion at a moderate pace, continuing but gradual employment progress, and acceptably well-behaved and stable underlying trend inflation. So that's a mainstream view.

What has changed in my assessment of the situation is the range of risks and plausible negative scenarios that would deviate significantly from a baseline scenario. Analysis by my staff suggests that an immediate, large, and sustained-for-some-period rise of oil prices would push the economy close to recessionary territory. At the same time, I take seriously the risk identified in the Tealbook alternative entitled 'persistent rise in inflation.' In that scenario, high and rising commodity prices lead to an unanchoring of medium- and longer-term inflation expectations. I think these two negative but opposed risks are very roughly balanced, but if I had to rank order them today, I would give a little bit more immediacy and weighting to the higher inflation concern. That said, I don't think there is yet compelling evidence of a magnitude that

requires a response that longer-term inflation expectations are becoming unanchored. But I would note, as I did in the economic go-round, that the TIPS indicators are at the top end of the range we've been depicting as stable, and the recent Michigan survey involved a tick up of longer-term household inflation expectations.

A firming of policy, as others have suggested, may be needed sooner than we would otherwise intend. But I think any signaling of that change before we are more certain it is needed will create unnecessary volatility in asset prices. For that reason, I would prefer not to change the current asset purchase program, and I oppose the tapering idea. Nor would I change, at this point, the 'extended period' funds rate guidance.

So my basic thought is: Stay the course for the time being. With employment levels improving, but having still so far to go to reach the desirable and achievable position, I don't favor a tightening action as in alternative C. Likewise, because I see rising inflation borne of shifting expectations as a real risk, I don't support alternative A. So net-net, I think B is the right answer at this juncture for the economic circumstances and the array of plausible negative developments.

Let me comment on statement language. First, I like President Kocherlakota's suggestions that refine the language in paragraph 2. Regarding the characterization of inflation and commodity price rises, as I commented in the previous round, I think describing measures of underlying inflation'and per President Plosser's recent question, I take that to mean, technically, core and trimmed mean PCE measures'as 'subdued' somewhat misrepresents recent activity in those measures. I am concerned that this language could make the Committee appear out of touch. Over the past three months, all measures of inflation have risen, and for that

reason, I prefer a description of measures of underlying inflation that says: 'Measures of underlying inflation, while firming recently, remain low.'

In paragraph 4, I think we repeat the 'subdued' language. My concern with that repeat is, one, it's redundant; and two, as I have just suggested, it's not quite aligned with recent data movement and could serve to antagonize the public, conceivably, and ultimately undermine our credibility. So in paragraph 4, I would simply suggest that we delete the language starting with 'including,' so that the sentence reads: 'The Committee will maintain a target range for the federal funds rate at 0 to '' percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels for the federal funds rate for an extended period.' My concern, Mr. Chairman, is around not only the use, but the repeat use of the word 'subdued.' Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. So looking at that for a second, has there been a significant movement in core up? I don't think on a 12-month basis that's really the case.

MR. LACKER. The three-month rate rose to 1 percent.

CHAIRMAN BERNANKE. President Plosser.

MR. PLOSSER. Yes, just a suggestion. I agree with President Lockhart about the 'subdued' language'it makes me a little nervous. Couldn't we just say that 'Inflation expectations have remained stable, and measures of underlying inflation have firmed'?

CHAIRMAN BERNANKE. No. How about 'have remained low'? How is that? Would that work for you, President Lockhart? I think the part about getting stronger and firming'I think that goes against what we are trying to say.

MR. LOCKHART. Well, we want to say that they're not falling anymore.

VICE CHAIRMAN DUDLEY. It's still a subdued trend, though. It's a trend, as opposed to a recent movement.

CHAIRMAN BERNANKE. Well, you don't like the word 'subdued.' 'Low' means low. They're low. They're not trending anymore. We got rid of 'trending downward.' I wouldn't change paragraph 4 very lightly, Dennis, because that's such an important paragraph. Would you be okay with changing 'subdued' to 'low' or 'have remained low'?

MR. LOCKHART. This is at the end of paragraph 1?

CHAIRMAN BERNANKE. Paragraph 1, yes.

MR. LOCKHART. 'The measures of underlying inflation have remained low'? CHAIRMAN BERNANKE. Yes. Is that okay? What do you think? Anyone?

MR. LOCKHART. Well, my concern is that the attention of many of our audiences is going to be on the last three months, not the trend, as Bill is suggesting, and that we are inviting a view that we are not in touch.

CHAIRMAN BERNANKE. Well, this is a question of describing the medium term, and we may want to think more about how we will explain our medium-term objectives in the future. But for the time being, we're talking about the 'underlying trend,' which basically means indicators like trimmed means and so on that have not really moved much.

MR. LOCKHART. Maybe we could say, then, 'The measures of trends of underlying inflation have remained low.' So you emphasize the word 'trends.'

MR. FISHER. Mr. Chairman?

CHAIRMAN BERNANKE. Yes?

MR. FISHER. I think I'm pretty hawkish on this issue.

CHAIRMAN BERNANKE. Yes.

MR. FISHER. I'm very concerned about inflation. I think to say 'low' is even worse than saying 'subdued,' and I prefer to keep the language as it is. I'll argue some other things when I have my intervention, but if we say 'are low, the trends are staying low,' I think it undermines our credibility. I think it's a mistake.

CHAIRMAN BERNANKE. All right. Why don't we just put this in the inventory of stuff we are going to come back to at the end?

MR. PLOSSER. Put it in the parking lot.

CHAIRMAN BERNANKE. Dennis, anything else?

MR. LOCKHART. I'm finished. Thank you.

CHAIRMAN BERNANKE. Okay. President Fisher.

MR. FISHER. I'm sorry I jumped in, then. I didn't know I was going next. A couple of things are evident from this conversation. One is that there is a feeling at the table that the recovery is gaining momentum. The second is that we're obviously taking caution to express ourselves on inflation carefully. The third is that President Rosengren's statements are getting longer. I view him as a model of efficient expression, and I'm not sure how to read that, President Rosengren, but I'm going to study the entrails to try to understand it. And the fourth is, I'm delighted to hear President Lacker talk about how the average businessman or businesswoman thinks.

MR. LACKER. Took some imagination. [Laughter]

MR. FISHER. Yes, sir. Back to the subject matter. I am against tapering. If I felt that there was any risk that we might advocate tapering, or extending the program, then I would argue alternative C, because I would like to begin tapering now down to lower levels. But I read the drift at the table, and I am encouraged by the likelihood that this experiment with this extra phase

of LSAPs, whether you were for it or against it, as I was, is coming to an end. And I can live with alternative B under that assumption.

I'm sorry to do this, because I know President Tarullo is about to squirm out of his seat. MR. TARULLO. Governor Tarullo.

MR. FISHER. Governor Tarullo. Well, maybe someday, 'President' Tarullo. One slight editorial suggestion'I apologize'and that is with regard to a suggestion made by President Plosser in writing. Our mandate does not refer to the unemployment rate. The suggestion I have is in the second paragraph. Instead of what we have as a second sentence, I would say, 'Although the level of unemployment has recently declined, it is still elevated.' Take out the word 'rate.' This is a problem that we have to deal with. We are talking about the level of employment or unemployment in our mandate. I also don't like the word 'remains.' 'Remains' has a stickiness to it, and it sounds like we are reluctant. But the fact is, it is still elevated, and so I would say, 'Although the level of unemployment has recently declined,' which is a fact, 'it is still elevated.' Then you could go on to say, 'The measure of underlying inflation''I think President Kocherlakota's suggestions are excellent.

I do not believe we should put a pace of $80 billion a month into the statement. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. The last thing'repeat the last thing you said. MR. FISHER. Sir?

CHAIRMAN BERNANKE. I didn't understand the last thing.

MR. FISHER. I do not believe we should put the $80 billion a month in the statement. Thank you.

CHAIRMAN BERNANKE. All right. Thank you. Governor Yellen.

MS. YELLEN. Thank you, Mr. Chairman. I favor alternative B with the changes proposed by Presidents Kocherlakota and Williams. I am comfortable with the stance of policy for now. I favor completing our announced program of Treasury purchases and maintaining the 'extended period' language.

The outlook for economic growth has improved somewhat. But regardless of how one reads the labor market, there is an awfully long road to travel to attain our maximum employment objective. In addition, both headline and core inflation remain subdued, in spite of rising commodity prices. I therefore believe we can be patient in withdrawing accommodation. That said, recent commodity price increases do create inflationary risks. And while past experience provides comfort, it does not guarantee future results. We must certainly monitor incoming data carefully, and it is conceivable that we may need to respond. Indeed, all along, our 'extended period' pledge has been tied to economic conditions, including subdued inflation trends and stable inflation expectations.

With respect to tapering, I see no particular need, given our past experience and Brian's discussion, to taper our purchases as the program winds down. On paragraph 3, therefore, my preference is to exclude the bracketed language. Information on the pace of purchases would be needed if the Committee intended to vary the pace in coming months, but without tapering, I believe it would be more confusing to markets to include wording we omitted last time.

Looking ahead, the risks to the outlook for both inflation and economic growth have, to my mind, increased considerably. We need to be prepared to respond to whatever developments unfold in the days ahead. So even as we return to planning for an eventual exit from our accommodative policy, I consider it important to remain prepared to provide additional stimulus should downside risks to the expansion materialize.

CHAIRMAN BERNANKE. Thank you. Governor Duke.

MS. DUKE. Thank you, Mr. Chairman. I favor alternative B. I do believe the recovery is on firmer footing, but that belief is tempered by uncertainty about the effect of higher gas prices on consumer and business confidence, uncertainty about the effect of unrest in the MENA region, problems in peripheral Europe, and the horrors unfolding in Japan. And it's also tempered by the memory of our belief this time last year that the recovery was gaining momentum.

I would applaud the changes offered by Presidents Kocherlakota and Williams, and I believe that they are more significant than simple wordsmithing. I think one of the biggest difficulties we face in our communication and our credibility is the disconnect between a discussion of headline, underlying, trimmed, core inflation, and pass-throughs that takes place in this room and the conversations that take place among the general public and business people about the rising costs of gas, food, and health care. So I think framing our discussion of inflation in terms of near term and medium term is probably easier for normal people to understand than any of these other measures.

Second, to the pace of $80 billion a month, I think we learned at the last meeting that it creates confusion to make small changes to the amount often necessitated by technical factors. And we now have evidence that the stock is more important than the flow. I think a consistent communication of the total stock that we intend to purchase or, when the time comes, to sell across a definitive time frame will give an indication of the pace of sales without creating another item that we have to potentially adjust. So I would not be in favor of adding that one. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Tarullo.

MR. TARULLO. Thank you, Mr. Chairman. I favor alternative B with Narayana's first- degree amendment and John's second-degree amendment. I am sympathetic to Dennis's comments on the language here, but I guess, Dennis, my reaction is, we've already added the two sentences in paragraph 2. I favor the addition of the last clause, the 'close attention' clause, to the second of those sentences for many of the reasons that you articulated. On my theory that people pay attention to the changes in the statement as much as to what is in the statement itself, I think people's attention will already be drawn some to the recent inflation question.

On Richard's suggestion, I am indifferent, Mr. Chairman, but I certainly have no problem saying, 'Currently, unemployment remains elevated,' as opposed to 'the unemployment rate.' And I probably feel a little bit more about that now than I might have previously, precisely because it's not at all clear to me what the unemployment rate is doing right now.

That's all. Thank you. Oh, and the $80 billion a month, I don't have strong views on

that.

CHAIRMAN BERNANKE. Okay. Governor Raskin.

MS. RASKIN. Thank you, Mr. Chairman. I also support the action described in alternative B. I am comfortable with the current stance of monetary policy and underscore the need for vigilance and care as we watch the current course of commodity prices and their potential for dislodging stable inflation expectations. That said, the path to full recovery is prolonged by several risks. One significant risk that has been underscored today is the extent to which slowdowns in consumer spending and continued weakness in housing markets raise concerns about the strength and durability of the recovery. The run-up in energy costs, if it persists, also could weigh on household spending and on non-energy goods and services, and the turmoil in the Middle East and the disaster in Japan may exacerbate this effect. This question

alone suggests a high threshold for making an adjustment to the purchase program. Unexpectedly discontinuing or reducing the current program at a time of heightened uncertainty regarding households' abilities to absorb higher food and gas prices would prematurely inhibit the consumption component necessary for more-robust growth.

I also support the President Kocherlakota changes to paragraph 2, as further amended by President Williams, and look forward to debate on changes proposed by President Lockhart and President Fisher.

CHAIRMAN BERNANKE. Thank you. Vice Chairman.

VICE CHAIRMAN DUDLEY. Okay. Thank you, Mr. Chairman. Before I talk about the choices for this meeting, I just want to talk briefly about the risks in terms of higher inflation expectations for our choices over the medium term.

In the economic go-round, I raised my concerns that longer-term inflation expectations could become unhinged, and that would obviously be problematic in terms of inflation. But I want to stress here that I also worry about the other side of the equation, that premature tightening could wrack a recovery that is still fragile. In this regard, the U.S. experience in 1937 is quite instructive: Commodity prices were rising quickly then, wholesale inflation was climbing noticeably, and even consumer prices were rising despite a tremendous amount of slack in the economy. What happened in 1937 is that Federal Reserve officials changed their communication strategy and began emphasizing the risks of higher inflation, and they also raised reserve requirements. What happened was that the U.S. economy quickly fell back into recession. So we should be concerned about inflation expectations and the risks that could add to inflation, but we really should understand that it is a two-sided risk.

With that said, for the time being, my preference is to be as patient as we can be and to work as hard as we can through our communications to try to keep inflation expectations well anchored. Some of this we can control through our communications; some of it we can't control. But we should do the things we can do to keep inflation expectations well anchored by how we communicate with the market.

In terms of today's decision, I would support alternative B. I think it accomplishes what we want to do. It recognizes the improvement in the outlook. It makes it clear that we do not expect commodity price pressures to feed through to underlying inflation. And I think it makes no changes, as written, in terms of our policy message.

There is no question in my mind at this point that we should complete our $600 billion Treasury purchase program, because it is helping to achieve our objectives. I don't think it's necessary to taper purchases as we come to the end of the program. I don't think there's any likely substantive benefit. Market participants do not expect tapering. So I think that putting it in would just create questions about what we are up to, as opposed to actually accomplishing anything constructive.

I would not insert the '$80 billion a month' phrase for the same reasons that we didn't insert it last time. It would needlessly create uncertainty about why we put it back in.

In terms of the other changes, I am happy with the Kocherlakota change and the Williams change. As for President Fisher's change'I'm perfectly comfortable living with 'unemployment' as opposed to 'unemployment rate.'

CHAIRMAN BERNANKE. Okay, thank you all. Well, as I said earlier, I don't think this is the time to be making major changes in our policy, but I understand the concerns and issues that people have raised, and there are risks, I think, in both directions.

I think that April will be a very important meeting. It will be a meeting where I hope that we will be able to provide clarity to the markets on our future plans regarding purchases, at least, and hopefully we will make progress on exit strategy discussions as well. So, again, that will be an important meeting.

With respect to the statement, people have focused on alternative B, which, of course, I agree with. In paragraph 2, there has been strong acceptance of President Kocherlakota's amendment with the Williams addition, which I will read quickly: 'The recent increases in the prices of energy and other commodities are currently putting upward pressure on inflation. The Committee expects these effects to be transient, but it will pay close attention to the evolution of inflation and inflation expectations.' In general, I don't like to make unnecessary changes, but I guess I am okay changing the 'unemployment rate' to 'unemployment,' if that makes people more comfortable.

MR. PLOSSER. Well, I suggested that in my memo earlier, so I think it's a good idea. MR. EVANS. Mr. Chairman, can I offer a comment on that?

CHAIRMAN BERNANKE. Okay.

MR. EVANS. This is a very serious change, and I'm not sure I understand it. The language on the unemployment rate is very familiar; we all understand it. We have spent a lot of time talking about what a natural rate of unemployment is, and we have talked about structural unemployment. So we sort of understand 5, 5'' percent, whatever your favorite number is. Now, with the new language, we are talking about the level of unemployment. How many millions of people are unemployed today, and do we have an idea of how many million unemployed it will have to be so that it will no longer be 'elevated,' but it will be 'improving'? What is the right number when we get to an acceptable level? Is it zero million unemployed? I

just don't know the answers to these questions, but with all of the time we spent trying to educate people on the natural rate, we might have to do that on the levels.

CHAIRMAN BERNANKE. Okay. I think people would read that as 'unemployment rate.' But I'll tell you what, we are going to take straw votes in just a minute on a couple of items. That's one of them. The second one is another suggestion of President Plosser, to strike the word 'somewhat' in the second line. And the third is President Lockhart's. I'm trying to find a solution at the end of paragraph 1. How about 'and inflation trends remain low'? Is that better?

MR. LOCKHART. You are emphasizing the word 'trends,' which is just a longer term than the last three months.

CHAIRMAN BERNANKE. As opposed to 'underlying.' Okay.

MR. LOCKHART. I am not sure you have enough people supporting the view that the word 'subdued' is a problem around the table. So you should really go with the majority of the Committee.

CHAIRMAN BERNANKE. Well, that's what I plan to do. [Laughter] All right. Let me ask, is there any further comment on 'somewhat,' which slightly strengthens it? Is there any objection to making that change? Anyone?

MR. FISHER. Which one is that, Mr. Chairman?

CHAIRMAN BERNANKE. Dropping the word 'somewhat' in the second line'is that okay with you?

MR. FISHER. I'm in favor.

CHAIRMAN BERNANKE. Okay. All right. We'll do that. The second proposal is to change, at the end of B1, 'measures of underlying inflation have been subdued' to 'and inflation trends have been low.'

VICE CHAIRMAN DUDLEY. 'Trend' 'low' is a funny construction.

CHAIRMAN BERNANKE. What's the right construction?

PARTICIPANT. Moderate.

VICE CHAIRMAN DUDLEY. I'm not sure, but'

CHAIRMAN BERNANKE. 'But inflation trends are subdued''would that be any

better?

MR. PLOSSER. I think one of the efforts here is to convey the notion that we have expressed concern about falling inflation. We are confusing rates and levels, and so, while it may be subdued, it has also stabilized in the sense that we are no longer getting more disinflation. I guess that is the concept.

CHAIRMAN BERNANKE. Well, I was suggesting, 'measures of underlying inflation remain low,' which suggests that they are low but not falling anymore. That doesn't help you, though.

MR. PLOSSER. I prefer 'subdued' to 'low,' but'

MR. FISHER. Yes, I do, too.

VICE CHAIRMAN DUDLEY. I think it's fine the way it's written.

MR. LACKER. We use the same language again in paragraph 2: 'measures of underlying inflation.' You know, making that variation'

CHAIRMAN BERNANKE. Fine, fine. Okay. I'm worried about time. With apologies, so the only change we're making in B1 is to drop the word 'somewhat' in the second line. And,

finally, with apologies to President Bullard, I didn't hear much support for putting in the $80 billion. So let's strike that. Again, with apologies. Any further comments? President Lacker.

MR. LACKER. Can I respectfully suggest we change the word 'transient' to

'transitory'? It has a less ephemeral connotation, and it is I think a more broadly used term. CHAIRMAN BERNANKE. Any English majors who care to comment on 'transient'

versus 'transitory'? [Laughter]

VICE CHAIRMAN DUDLEY. I think 'transitory' is a little better. CHAIRMAN BERNANKE. All right. 'Transitory' it is. Anyone else? Any

comments? Bill.

MR. ENGLISH. I'm sorry. What was the decision on 'unemployment' versus the 'unemployment rate' in the second sentence of paragraph 2?

CHAIRMAN BERNANKE. We haven't decided.

MR. ENGLISH. If I could just point out one thing there. I think the intent when that sentence was originally written, which I think was following the October videoconference, was to point to the long-run projections in the SEP, which is why we picked up the unemployment rate.

CHAIRMAN BERNANKE. All right. It's linked to the SEP. That's right.

MR. ENGLISH. So that would change if we made it 'unemployment' rather than 'unemployment rate.'

CHAIRMAN BERNANKE. Well, we are going to talk in a few minutes about linking up our statement and our policy to the SEP more explicitly, and 'unemployment rate' is what we forecast.

MR. KOCHERLAKOTA. I agree with President Evans. This would be a major change

and something we should do with tremendous contemplation and thought, not in the last three minutes.

CHAIRMAN BERNANKE. Okay. Again, with apologies to many good suggestions, we

are making the changes that were suggested by President Kocherlakota with the Williams addition, and we are dropping the word 'somewhat' in the second line. If there are no further comments'Matt.

MR. LUECKE. This vote will cover alternative B on page 3 with the changes indicated

by Chairman Bernanke, as well as the directive for alternative B on page 7 of the handout.

CHAIRMAN BERNANKE. Thank you very much. We have an additional item on communication. What I would like to recommend is that we go get some lunch, come back to the table, and have a brief discussion, if that would work.

[Lunch break]

CHAIRMAN BERNANKE. The last substantive item is a recommendation on communications from Governor Yellen's subcommittee. As you know, she is going to talk about the idea of having press conferences.

I will be happy to answer questions, and so on, from my perspective as well, but I just want to say one thing before I turn the floor over to Janet, which is that I want to thank President

Plosser and his colleagues for the good work they did on a numerical objective for inflation. I just want to be clear that this discussion today is motivated by timing considerations. It is not intended to be a substitute'I think, in fact, it will be a complement'for our discussion on the numerical objective, which Governor Yellen's subcommittee will take up in due course and bring back to the Committee. So let's keep this discussion today separate from that, if we could, and see what progress we can make. Let me turn this over to Governor Yellen.

MS. YELLEN. Thank you, Mr. Chairman. I would like to begin with a few comments concerning the subcommittee's rationale for moving ahead with press conferences. And I'd like to then highlight a couple of aspects of the arrangements that we are recommending.

When the subcommittee on communications was reconstituted last fall, a crucial element of our mission was to consider approaches for ensuring that the public understands both the consensus of the Committee and the diversity of views among individual participants. One obvious pitfall of our existing communications framework is that after the end of each blackout period, the timing and sequencing of participants' speeches and other external communications has been rather random. And it's become increasingly apparent that such a random ordering can contribute to public confusion about our monetary policy decisions.

In considering how to redress this problem, we looked closely at the experience of other central banks, especially ones where monetary policy decisions are made by committees. Although the communications practices of foreign central banks are diverse, we found it notable that press conferences are held by all of the major foreign central banks, and, indeed, by nearly all central banks in foreign industrial countries, the only exceptions being Australia, Denmark, Iceland, and the national central banks of the euro area. Such press conferences are uniformly seen as an important and effective communications tool. Moreover, for central banks like the

ECB and the Bank of England, regular press conferences seem to have been particularly helpful recently in highlighting the consensus of the policy committee in a context where a diversity of views has been readily apparent to the public.

In light of those considerations, the subcommittee recommends that the Chairman

conduct quarterly press conferences in the afternoon after the conclusion of each two-day FOMC meeting. The ECB, the Bank of England, and the Bank of Canada each conduct press conferences while the markets are open. The purpose is to allow any news to be digested into market prices.

Now, to accomplish this, we would need to issue the FOMC statement somewhat earlier after two-day meetings. And, in particular, we would propose that the first day of each two-day meeting would start two hours earlier so that we could conclude by 11 a.m. on the second day, issue a statement at 1:15 p.m., and then begin the press briefings at 2:15 p.m.

The approach recommended by the subcommittee would ensure that the Chairman is the first person on the Committee who communicates with the public after each two-day FOMC meeting. As in each of his speeches and testimony on monetary policy, the Chairman would try to convey the sense of the Committee's thinking at these press conferences while making note of the diversity of views, as appropriate. Of course, given the dynamic and interactive nature of a press conference, it is important to recognize that the Chairman would need to have full ownership of the answers that he gives in Q&A, and we recommend that this same principle would apply to any prepared remarks that he would present at the start of each press conference.

One significant benefit of initiating these press conferences is that there could be a corresponding shortening of the blackout period following each two-day FOMC meeting. Needless to say, no Committee participant should be present at the press conference themselves,

and FOMC participants should not have contact with media representatives afterward. Moreover, the subcommittee recommends that all forms of external communications'that includes speeches, editorials, and media interviews'would be embargoed until the end of the postmeeting blackout period. But the subcommittee thinks that a blackout period ending at noon Eastern Time on the day after two-day FOMC meetings would be appropriate. Such an arrangement would help keep public attention focused on the FOMC meeting statement and the Chairman's press conference for a full media cycle, including the TV news on Wednesday evening, as well as the newspapers on Thursday morning. Under these arrangements, each of you would be completely free to communicate your own individual views on monetary policy starting on the Thursday afternoon after each two-day FOMC meeting. I should also note that our subcommittee has not yet reached any conclusions about other potential changes in the blackout period, such as the timing of the blackout for one-day meetings. Rather, any such recommendations will be brought forward for your consideration at a later date.

Our subcommittee believes that press conferences could be particularly useful if the Chairman is able to make reference to the contours of the latest SEP projections in his opening remarks as well as in Q&A. Such an approach would likely draw greater public attention to our economic outlook and could be helpful in explaining how the Committee's policy strategy is informed by our longer-run projections for output growth and unemployment and our individual assessments of the mandate-consistent inflation rate. And, in fact, by incorporating information from the SEP, we believe that these press conferences would significantly enhance FOMC communications regarding the Committee's overarching policy framework as well as our specific policy decisions.

Of course, to the extent that these press conferences draw greater public attention to the SEP, it will be helpful to keep in mind that the SEP itself is a communication tool that may well evolve somewhat over time. For example, one fairly obvious limitation of the SEP is that it doesn't include any information about our individual assessments regarding the appropriate path of policy, even though our projections for economic activity and inflation are contingent on these policy assessments. The Chairman may wish to respond to any such questions by noting that potential enhancements to the SEP will be considered as part of the Committee's ongoing efforts to enhance our public communications.

Finally, the subcommittee recommends moving forward with these press conferences starting with the April FOMC meeting. The April meeting is a two-day meeting. It is the last meeting until October that will not be followed with Humphrey-Hawkins testimony. That meeting may be particularly consequential, because the Committee will be deciding whether to complete the final phase of our $600 billion asset purchase program, and we may well be considering certain aspects of our policy strategy over horizons extending beyond the end of June.

About 10 days ago we circulated'and I hope you have in front of you'a set of questions to guide our discussion now. I am not proposing we have a full go-round, but it would be very helpful if you would make note of any specific concerns you might have about moving forward with this initiative, and if you would indicate whether you agree that the first such press conference should take place following the April FOMC meeting. Let me stop there and, rather than have a full go-round, please feel free to make comments or pose questions to either of us.

CHAIRMAN BERNANKE. Let me add quickly that I am very comfortable with this proposal. I think the difference between the Fed and other central banks has become quite striking'every other central bank does have this method for communication.

I am sure it is something we will learn about as we go; we'll be learning by doing. But I want to assure everybody that my objective is both to present the modal view'that is, the policy decision' quickly after the meeting, or at least quarterly'and to give some sense of what was discussed and what diversity of views there was. So my goal would be to represent the views of the broad Committee.

In terms of documents, my assumption is that they would have in advance the Committee's statement, which we would continue to develop as we do now, and they would also have just the SEP numbers'not the full narrative description, but the numbers in the projections. I would simply go over those numbers, and I would try to talk about the day's policy decision. I think a useful objective here is to try to put the policy decision in the context of the longer-term SEP, which then in turn will generate more interest in the SEP. But let me stop there, and, again, either one of us can answer questions, or we would be eager to hear your comments.

MR. HOENIG. I have a question, and I do have a comment. Governor Yellen, when you say 'full ownership' of remarks and Q&A, what do you mean by that, in terms of the Chairman's having full ownership of that? In terms of, he is responsible for it, or in terms of, it reflects the full range of views?

MS. YELLEN. I guess what I mean is that if he makes some remarks, they are his remarks as opposed to something that he would need to have approved by the Committee. The FOMC statement would remain, obviously, a full Committee statement.

MR. HOENIG. Okay. The second question that I have is around the idea that we are comparing ourselves with other central banks. I may not have this right, but if I read it right, the United Kingdom doesn't actually have a press conference after its meeting; it's when it releases its projections. So that's different than what you're suggesting.

MS. YELLEN. That is different.

MR. HOENIG. And that is not unlike our Humphrey-Hawkins'I mean, in the sense that we put out our projections and respond to questions before Congress. My other point is'and I'm a little uneasy about doing this, but'at the ECB, they don't produce minutes, and they don't have a vote. So it's a different model altogether than what we're talking about here. And my concern around that is, as we compare ourselves with them, we are not comparing the same things. There's a question of handling the difference in views. We have a broad range of views, sometimes broader than others, and I know that the Chairman represents those, because he does the summaries very nicely. But we do have minutes that are released, we do have a statement, and if we want to really have that incorporated, my question is: Why don't we concentrate on moving the minutes up more quickly, so that you have them out sooner? And we also have transcripts that others don't.

This Chairman, I understand, would do it very well, but as you get the Chairman up there trying to represent very different views in this press conference, sometimes more different than others, the concern is that you get that out there clearly. And then, a day later we're out giving speeches, and if it doesn't line up, we're going to have some real problems. What we're going to do over time is be forced to the mean. That is, you don't want to get too far out of line, if you didn't quite hear it that way. And what people hear and do are sometimes quite a bit different.

So those are some of the concerns I have about going forward with this. And I apologize, I didn't send notes in, because I got to this later than I wanted to. But those are the things that occurred to me as I was reading this on the plane here.

MS. YELLEN. Dennis.

MR. LOCKHART. Janet, obviously, a press conference after four of our meetings a year really adds a great deal of clarification to what the Committee is thinking. Did you discuss at all whether any change in the statement format would be required at those meetings or at all?

MS. YELLEN. I don't think we are envisioning any change in the way the statement would be crafted. And we would be getting the statement out to the press an hour before the press conference begins, so that reporters have a chance to absorb it, and then ask intelligent questions at the press conference.

CHAIRMAN BERNANKE. To give an example, what the ECB does is they have a statement that the President reads, to start. And it consists, as I understand it, of several paragraphs of general outlook material prepared by the staff in advance of the meeting, and then a policy paragraph, which is similar to our statement, and then it's agreed upon by the Council.

VICE CHAIRMAN DUDLEY. I want to observe that before doing this, I would imagine we will be more inclined to change the statement when the Chairman is about to give a press conference, because he will be there to be able to explain it very quickly. So it may actually free up the statement a little bit compared to what it is right now, where we are very hesitant to change the statement, because we're always worried about how people will interpret it. This would probably mitigate that issue a little bit.

MS. YELLEN. Narayana.

MR. KOCHERLAKOTA. I'm going to say two conflicting things. On the one hand, I think'and this follows up on some stuff that Tom was mentioning as well'this is an institutional change, and it transcends any particular person who is the chair at this time. I think that we all have a great deal of confidence in Chairman Bernanke's ability and desire to communicate the broad cross-section of views. But this is going to be an institutional change that will transcend this particular individual.

On the other hand, I would say that'and, actually, this also follows on what Bill was saying'last August we had I think a one-day meeting, and at that meeting we made a change in policy in terms of reinvesting the MBSs. There were good economic reasons for doing that, but it was a very confusing period. I guess the question would be: Did you give any thought to doing this after every meeting? And the final thing I will say is that there are a lot of talented public affairs people around the system, and I, at least, feel like I can't get my PA people involved right now in this because it is Class I FOMC; they aren't Class I. If there is a systematic way to get the PA community involved in our discussions of communication, I think that would be good for the Committee.

MS. YELLEN. I guess on the issue of what happens after one-day meetings, the thought here was to begin in a more controlled way with two-day meetings. But there's nothing in this proposal that ultimately would rule out having this after other meetings as well, but we certainly didn't want to start there.

MR. KOCHERLAKOTA. I feel it's distinguishing the meetings in an unusual way. It's not like we only make important decisions at two-day meetings that require a lot of clarification. So if we are going to go down this path, I actually would suggest thinking about doing it every time.

MS. YELLEN. The distinguishing feature of the two-day meetings is the economic projections and the ability that that would give the Chairman to explain our overall framework and put decisions into the context of them.

MR. KOCHERLAKOTA. But those June projections would still be available in August. CHAIRMAN BERNANKE. Michelle, what is the feasibility of ad hoc press

conferences, if necessary?

MS. SMITH. If you've got something really important to say, an ad hoc press conference will certainly get the attention of people you are trying to communicate with. [Laughter] The bar is high for an ad hoc sort of gathering. Logistically, it's possible, if there's nothing that makes it impossible. So you could do it. The New York Fed would probably say that predictability of these sorts of things for market participants is preferred.

VICE CHAIRMAN DUDLEY. It helps lower the temperature level.

CHAIRMAN BERNANKE. No. I was just saying, in case of a situation like Narayana was talking about.

MS. SMITH. Certainly.

MR. ENGLISH. Another issue that you might want to think about is feasibility. The discussion today was such that we would not have been able to get a statement out at 1:15 p.m. So for one-day meetings, if we are going to have a press conference at 2:15 p.m. and get a statement out at 1:15 p.m., we are going to be beginning at 7 a.m. or we are going to be beginning the evening before. I think there is a question of, how quickly can the Committee get its business done? And if we seriously are going to have press conferences after one-day meetings, I am just not sure there is time to do it.

MS. SMITH. It might be helpful to mention that there are two basic models

internationally. There is the Bank of England/Bank of Canada model that has these sorts of things four times a year that happen with the release of their projections or their inflation report. Then you have the ECB/Bank of Japan model, which is basically every meeting no matter what gets announced and on the same day.

I think what has come out of this is more of a hybrid approach. Not every time the Committee meets are you doing something that the world isn't prepared to accept and to understand. Sometimes it is. Sometimes it's more jarring; it needs some explaining. I think one vulnerability here was exactly Narayana's point, that you could have an important meeting at a time that doesn't sync up well with your quarterly plan, in which case you could improvise. You could decide to have the Chairman give a speech the next day or two days later and, really, we could pull that together. That is certainly possible. What you did back in the fall when you decided to embark on LSAPs was the Chairman had an op-ed in the Washington Post the next day. You could improvise to get your message out on those times, but we are blazing a hybrid path between what the world central banks have got going.

MS. YELLEN. Jeff.

MR. LACKER. I wonder, given President Kocherlakota's comment, whether there would be some hesitance to take actions in between press conference meetings, and I am not quite sure what the answer to that is, but I think it is worth considering.

The other thing is, why 2:15 p.m.? Why not on the hour? I have always wondered this about the statement. Is there something magic in markets about quarter after?

MR. TARULLO. It's the alignment to the constellations.

MR. LACKER. Alignment to the stars. [Laughter]

MS. YELLEN. The answer, I guess, is that the bond markets close at three. MR. LACKER. Oh, three o'clock, right, when the bond markets close.

VICE CHAIRMAN DUDLEY. As late as possible so that you could actually get it out before the bond markets close.

MR. LACKER. Okay, great.

MS. YELLEN. Sarah.

MS. RASKIN. One question I have has to do with the scope of the rule, so to speak, and that is, I assume that the blackout period, although shortened, covers everybody, even individuals who may have dissented at the meeting; is that right?

MS. YELLEN. Absolutely. Everybody is covered. It would be until noon the next day. It covers everybody and all forms of communication on the economy or monetary policy.

MR. TARULLO. This is probably a good moment to indicate that I think the subcommittee proposal is fine, a good idea, although some of these issues do bear a little bit of thinking. I have to say, I am concerned about ending the blackout period sooner, and I'm concerned about it, I think, precisely because of the scenario Tom laid out, which is: Ben gives the press conference, and then there are a bunch of people waiting for 12:01 p.m. the next day to go out and give their own gloss on what's happened. And I fear that the dominant play here may end up being defecting, in which case you get a lot of people doing it.

I understand the notion of trying to give vent to different or dissenting voices, but I guess, because my observation has been that we have had plenty of dissent, and much of it public, and I'm not sure it has been particularly useful for the Committee as a whole, that maybe we want to rethink a little bit the acceleration of the end of the blackout period.

MR. LOCKHART. And as a practical matter, Michelle, can we produce a transcript that is in our hands in what would be, I guess, 22 hours?

MS. SMITH. Yes, we could. Our intent would be to have this webcasted live. It would be covered live, and we would have redundancy on the transcript. We have had brief conversations with the FOMC Secretariat about having the transcription service that puts the meeting transcript together also do that. And our experience is that almost every time the Chairman is out in public, a transcript gets produced by the news services quickly, sometimes very quickly. I e-mail it to you all pretty frequently. Sometimes it has got some slight spelling errors in it, but we would clean that up and get it to you very quickly, and you would have a video. The video of the entire event would live on our website.

MS. YELLEN. Charlie.

MR. PLOSSER. I'm generally very supportive of this. I think transparency is a good thing, as a general rule. I do share a little bit of the concerns about how this might work in different regimes with different Chairmen, and I don't know that I know the answer to that problem, but I think it's something to give some thought to.

The other thing is, I want to pick up on an observation that Bill made, which I thought is very interesting. I have often felt and expressed the view that our statements are very confining at times. Our language is very confining, and I've often said I wish I could blow up the statement every meeting and write a new one so that we don't feel so constrained about how we say things. Bill's observation was the thought that, well, might this be a mechanism where we can become more flexible in the way we write the statements, and I didn't hear anybody else say anything about that. I thought that is an intriguing idea, and I wonder what the subcommittee had thought about this or what other people might think about that. It was just a reaction.

MS. YELLEN. My own sense is that's entirely possible that we may come to view ourselves as having greater flexibility in the statement once the Chairman is just several hours later taking Q&A about our policy and commenting on it. But it's hard to predict exactly how that's going to evolve over time.

CHAIRMAN BERNANKE. We could look at the ECB and some other models to see what they do.

MS. SMITH. As people probably know, the ECB issues a very terse statement. Their policy statement is about one sentence long and just says what the council did. Then in Trichet's remarks at the press briefing, he does what you all do in your statement. So, again, it's a little bit of a hybrid.

MS. DUKE. I would like to respond to Tom's concerns and to say that I was probably the person on the subcommittee that was the most reluctant to come around to this idea for a lot of the concerns that you expressed. I guess what I was struggling with is, we had a statement that was the Committee's statement and then later on we had minutes that reflected what happened in the meeting. So my question was: If the Chairman is out there giving a press conference, where does that fit? Is it a restatement of the statement or is it a preview of the minutes?

And that's where, I think, using the SEP is a good way not only to draw attention to them, but to look at it in a little bit different light, so that now I view both the statement and the minutes as a check on, if you will, a Chairman who wanted to go out and just put forth one point of view because both of those are going to actually come out as well as statements made by others. So I think that weighs against the concern that this is out there for all regimes. I mean,

future Chairmen can go out and say whatever they want to, but it's going to be in the context of these other communications that are still going to be out there.

MR. KOCHERLAKOTA. One quick logistical thing, which is, you want to have some way to confine the scope of questions. You probably don't want to be taking questions about debit interchange, for example.

MS. SMITH: I'm happy to take any and all questions.

MR. HOENIG. Betsy, and to Governor Tarullo's point, one of the things that makes me a little bit uneasy is that you're talking about the blackout period. Well, the blackout period originally was because we didn't announce anything, and you had to wait until markets figured it out, and so you didn't want to get ahead of them. Now we have the statement, which mitigates that need. But now Governor Tarullo wants to extend the blackout period because the Chairman speaks, and we don't want people contradicting it.

I'm not sure that you're allowing for the diversity of views you get out there. And, you begin to say, well, we're going to confuse people more because the Chairman spoke here, and now we're going to have a speech that's a day and a half later. Those are things I think we ought to think through carefully because this is a regime change. This is a big deal in terms of what we're doing and how we are going to affect the dynamics of the Committee going forward. Now, it's more of that long-term concern that I have.

MS. YELLEN. Dennis.

MR. LOCKHART. I think I heard Tom say, 'extend the blackout period.'

MR. HOENIG. No, no. I'm opposed to Governor Tarullo's point to extend it. I think it is inconsistent with why we originally had the blackout.

MR. LOCKHART. But isn't the practice today two days after the meeting?

MS. SMITH. Correct.

MR. LOCKHART. So this would be shortening.

MS. SMITH. The end of the workweek. Through Friday.

MR. LOCKHART. Dan, do you want to make it longer than two days?

MR. TARULLO. No. I just want to keep it where it is now.

MR. LOCKHART. Keep it where it is now. Okay.

MR. LACKER. Yes. I think it's easy to overestimate the problems caused for us by diverse views being expressed in public. I have a clear sense that over the last 10 years, the sensitivity of financial market prices to any one individual Committee member's statements, other than the Chairman of the Committee, has steadily declined, and I think that's because we all speak more often about our views. The answer to sensitivity to individual bits of information is sometimes more information. That is to say, the more we're all speaking, the less markets are moved by any one communication of ours.

I'd strongly support this press conference, and I think there are going to be some subtleties about it that are going to emerge in practice. I think we're going to have to resist the urge to wait to do things at just these quarterly meetings. I think when we want to do something, we're going to have to have the courage to go ahead and do it. I think noon the next day is the right balance. I think it's right to give clear airwaves to the Chairman, but I also think it wouldn't be right to impose too much of a burden on him to communicate for several days on behalf of other people's views. I think his articulating faithfully the range of views is fine, but this outlet of people being able to contact other Committee members relieves some of the pressure on him to be very faithful about everyone's views all the way around the table. So I support this.

MR. TARULLO. Janet, can I have a go at this again? I've seen the very interesting study of the actual impact on markets of utterances by different members of the FOMC, and needless to say, having seen that study, I'm not worried about the impact on markets of utterances by different members of the FOMC.

I guess what I am worried about, Jeff, in my view, at least'reinforced by conversations with members of the Congress, members of the media who have covered the Fed for a long time, and academics'is that the stature of and respect for the Committee as a whole has been adversely affected by a perception of not just good, solid policy disagreement within the confines of the meetings, but a sense that there's a bit of a free-for-all, and there's a bit of a competition for the airwaves. I would have thought that the preferable outcome would be self-restraint by everybody, but that's why I referred to game theory. I think there are a lot of incentives to go in the other direction, and once somebody starts talking, then other people have the same incentive.

In an ideal world, I think, you'd have a press conference by the Chairman, and then the dominant reaction of other members of the Committee would be, 'Yeah, that was pretty fair, good,' and that's it. Then very occasionally somebody feels, 'I really think that he or she missed something pretty fundamental that I think is important to say.' What I fear, though, is that the afternoon after the press conference will become more Babel-like, so that's the concern. It's not that people shouldn't express their views. They certainly should. I do think that the way in which we have evolved, with no one intending it to be this way, is that by so much, so frequently, and in so many media expressing variant and idiosyncratic views, there's been some damage to the institution as a whole. That's what I'm trying to get at.

MR. LACKER. I don't share the perception that the institution has been damaged, but this has been illuminating for me. I think one could anticipate the press calling all of us for

interviews for Thursday at 12:01. I think it's conceivable that some people will accept, and then something like that might emerge, and I think that's something that maybe we should talk about and deliberate about. I mean, I think the equilibrium we have now is that we don't race to the end. We wait for our regularly scheduled appointments with the public in order to say what we have to say, and that has some attraction, I think.

VICE CHAIRMAN DUDLEY. There is a compromise. By extending the blackout a little bit longer, through the end of Thursday, there's a quiet day. So the Chairman speaks, there's a quiet day, and then on Friday people can speak. Friday is not a great day to go out because you don't get that much coverage as you go into the weekend. So if people need to speak on Friday, they can. So that might be a way of balancing those two things.

I think it would be useful to have a little gap between the Chairman and other people because you don't want to get into 'he said/she said' kind of stuff. So separating it by a full day might be helpful that way.

MS. YELLEN. It does sound helpful. I note there are a lot of conferences; often our Banks have conferences on Fridays, so it has been a problem for people that we need to make speeches on the Friday after an FOMC.

MR. LOCKHART. That would be a nice benefit.

MS. YELLEN. I think it would be very useful to get a sense of the Committee on when to end the blackout period after these two-day meetings. Betsy, do you want to weigh in on that?

MS. DUKE. I know we weren't going to talk about the one-day meetings, but because the one-day meetings happen a day earlier, and this Friday thing has come up before, if we were going to end it on Thursday after the two-day meetings, would we also want to end it on Thursday after the one-day meetings?

VICE CHAIRMAN DUDLEY. Why not?

MS. SMITH. I think so.

VICE CHAIRMAN DUDLEY. That would be nice.

MS. YELLEN. Dennis.

MR. LOCKHART. I go with Dan's approach here. I was very comfortable with two days after a meeting ending on Wednesday, which effectively means that you're not saying anything until the following Monday, in most cases. I am perfectly comfortable with that. I don't necessarily see a compelling need to get out very quickly, and I do think that it invites a lot of what we would consider to be more 'short-termism' in the discussion. So I'm okay with the current policy.

MS. YELLEN. Other comments on this? Jim?

MR. BULLARD. I think it's a great idea, and I think we're catching up with other central banks on this dimension. So I think that's very good. I'm not sure I have strong views about the blackout. I think we behave strangely after the meeting because most organizations, once they have something to say, they would send everybody out to go say it, and we don't do that. We let others spin ours. We let financial markets spin what we have to say, and I don't think that that's a great thing to do. This press conference will help mitigate that. Also, just from scheduling, I like the Friday because a lot of times that's where the conflict is. But other than that, it won't make any difference to me.

MS. YELLEN. Charlie.

MR. EVANS. I agree with Jim in the sense that I think this is a great idea to have the press conferences. It is good to get the Chairman out front with the right message. If the blackout ended so that we could have a Friday conference, that would be great. If push comes to

shove, I guess I wouldn't be horribly opposed to keeping the blackout period the way it is right now. But I do think it would be of benefit; I don't think that the risk is that great.

MS. YELLEN. Let's see if we can get a consensus; let me try to get an overall sense of how people feel about the blackout period and when to end it. In a way, I think Bill has come up with a nice compromise between the two things. Let me put his proposal forward first, which is, the blackout period would run through Thursday. On Friday, people would be free to go out and give speeches, and that addresses the issue of conferences on Fridays. Hopefully, people would show self-restraint, though. I do hope this isn't going to become, 'Oh, the Chairman got out there, so now we have to race to give interviews the moment the blackout ends.' But let me try Bill's compromise approach: Blackout would go through Thursday. By a show of hands, how do people feel about that?

MR. FISHER. Close of business or midnight?

MR. LACKER. Those are different? [Laughter]

MR. ROSENGREN. What were going to be the formal choices that you have?

MS. YELLEN. I was thinking of these three choices: Thursday at noon is one choice; end of the day on Thursday'I guess, midnight'is the second choice; and current blackout time on Friday is the third choice. Starting with the one in the middle, because it got considerable support. [Show of hands] How about the shorter blackout period, through Thursday at noon? [Show of hands] And the longer blackout period, our current practice going all the way through Friday? [Show of hands] So it looks to me like, Bill's approach.

MS. DUKE. Richard, you didn't vote.

MR. FISHER. No, no. I'm a member of the subcommittee. I'm trying to not to interfere with the process. [Laughter] So, Tom, your argument is that we should end it at noon on Thursday?

MR. HOENIG. Well, my argument is that the original blackout was there because we didn't announce anything.

MR. FISHER. So we're shortening the blackout period. At least we got Friday out of this thing.

MR. HOENIG. That's a positive. [Laugher] It's not good enough, but it's a positive. MS. YELLEN. Okay. So I guess I'm seeing considerable support for Vice Chairman

Dudley's suggestion.

MR. WILLIAMS. Can I ask a clarifying question? Is this just about the two-day meetings?

MS. YELLEN. Yes, this is just about the two-day meetings. There's no change that we're proposing for the one-day meetings or beforehand, but that's something our Subcommittee could also take up and might come back with further proposals concerning the blackouts.

MR. FISHER. I thought the proposal was'again, being a member of the subcommittee I want to be careful and listen'that even for the one-day meetings we'd end it for Friday as well. Is that right?

MR. WILLIAMS. I think that's what I was asking.

MR. EVANS. I thought you started out the discussion saying we were only talking about the press conferences after the two-day meetings. And you weren't going to talk about anything else. Now, you may have indicated something that was sympathetic toward that, but'

MS. YELLEN. Okay. So I did start out by saying we're only talking about the blackout after two-day meetings. We have drifted into a discussion of why not shorten it after the one-day meetings, and the subcommittee really hasn't discussed that, but it would be useful to have a sense.

MR. PLOSSER. Just a quick reaction. I think it's kind of silly to have them different. It's going to be hard for people to understand and hard for markets to understand.

MR. KOCHERLAKOTA. It's going to be hard for us to keep track. [Laughter] MR. PLOSSER. Much less us keeping track.

MS. YELLEN. Suppose we said, for all meetings the blackout period goes through Thursday midnight?

PARTICIPANTS. Yes. It's a good start.

MS. YELLEN. Yes?

PARTICIPANTS. Yes.

MR. LOCKHART. What was your question again?

MS. YELLEN. We just cut a day off the blackout period.

MR. LOCKHART. So it's the end of day Thursday.

MS. YELLEN. Right. For all meetings, whether there's a press conference or not. So Friday, now, we're proposing, is okay. Anybody have a'Bill, you have a look of discomfort.

MR. ENGLISH. Well, there is an annoying complication. Sometimes we push meetings back because there are meetings in Basel, for example, and people are traveling back, and so we have meetings on Wednesday'I think we have one coming up next year.

MR. LUECKE. That's right.

PARTICIPANT. Is that a one-day meeting or two-day?

MR. LUECKE. It's a one-day actually.

MR. ENGLISH. It's a one-day meeting on Wednesday. Push the blackout back to Friday?

PARTICIPANTS. No, no, no. Just leave it at Thursday.

MS. YELLEN. Okay. Fridays we're free.

CHAIRMAN BERNANKE. Casual Friday.

MS. SMITH. Can I mention something about that? I would not recommend that we tout the end of our blackout period one day sooner as a dramatic increase in transparency. It's really just a practice that you all have adopted over the years; it's not a hard rule. So you might get laughed at.

MR. LACKER. You mean, you might get laughed at.

MS. SMITH. I might get laughed at. [Laughter]

MS. YELLEN. Okay. Thank you.

CHAIRMAN BERNANKE. Thank you. If anyone has any questions or suggestions, please call me or Janet, and if necessary we can issue some kind of document and have a call or whatever we need to do. We'll be thinking about the format, but I've given you a general idea. The goal of it basically, of course, is to try to increase the understanding of what we're doing and, in particular, link it up to our longer-term approach. So I'm hopeful it will work well.

VICE CHAIRMAN DUDLEY. So we should assume the April meeting starts at noon? CHAIRMAN BERNANKE. So that was the plan. April meeting, and we'll keep you

posted. One implication is that if you have changes to projections, they have to be done by the end of the first day instead of the end of the second day. All right. If there's nothing else on this topic, I want to remind you that the next meeting is April 26 and 27.

MR. LACKER. At noon.

CHAIRMAN BERNANKE. At dawn. [Laughter] The meeting is adjourned. Thank you. Have a good trip home.

END OF MEETING

Meeting of the Federal Open Market Committee on

April 26'27, 2011

A joint meeting of the Federal Open Market Committee and the Board of Governors of the Federal Reserve System was held in the offices of the Board of Governors in Washington, D.C., starting at 10:30 a.m. on Tuesday, April 26, 2011, and continuing at 8:30 a.m. on Wednesday, April 27, 2011. Those present were the following:

Ben Bernanke, Chairman

William C. Dudley, Vice Chairman

Elizabeth Duke

Charles L. Evans

Richard W. Fisher

Narayana Kocherlakota

Charles I. Plosser

Sarah Bloom Raskin

Daniel K. Tarullo

Janet L. Yellen

Christine Cumming, Jeffrey M. Lacker, Dennis P. Lockhart, Sandra Pianalto, and John C. Williams, Alternate Members of the Federal Open Market Committee

James Bullard, Thomas M. Hoenig, and Eric Rosengren, Presidents of the Federal Reserve Banks of St. Louis, Kansas City, and Boston, respectively

William B. English, Secretary and Economist

Deborah J. Danker, Deputy Secretary

Matthew M. Luecke, Assistant Secretary

David W. Skidmore, Assistant Secretary

Michelle A. Smith, Assistant Secretary

Scott G. Alvarez, General Counsel

Thomas C. Baxter, Deputy General Counsel

Nathan Sheets, Economist

David J. Stockton, Economist

James A. Clouse, Thomas A. Connors, Steven B. Kamin, Loretta J. Mester, David Reifschneider, Harvey Rosenblum, David W. Wilcox, and Kei-Mu Yi, Associate Economists

Brian Sack, Manager, System Open Market Account

Jennifer J. Johnson, Secretary of the Board, Office of the Secretary, Board of Governors

Patrick M. Parkinson, Director, Division of Banking Supervision and Regulation, Board of Governors

Transcript of the Federal Open Market Committee Meeting on

April 26'27, 2011

April 26 Session

CHAIRMAN BERNANKE. Good morning, everybody. Welcome to the marathon

FOMC meeting. [Laughter] Thank you for accommodating the early start. As you know, we

have an extra go-round today. I hope this will not be the norm, but we'll just have to see how

things evolve.

Given the topics this morning, I thought we would make this a joint FOMC'Board

meeting, and so I need a motion to close the meeting.

MS. YELLEN. So moved.

CHAIRMAN BERNANKE. Thank you. Without objection. Let's begin, as usual, with

financial developments and open market operations, and I'll turn to Brian Sack. Brian.

MR. SACK.1 Thank you, Mr. Chairman. It was a complicated intermeeting period in financial markets, as investors had to contend with several significant global developments affecting risk sentiment, with domestic events highlighting the fiscal challenges facing the United States, with economic data that led to a sizable downgrade to expected GDP growth in the first half, and with a notable further rise in energy and commodity prices. While these developments led to some volatility in asset prices during the period, they did not significantly alter investors' perceptions about the likely course of the economy or monetary policy on balance.

As shown in the upper-left panel of your first exhibit, the expected path of the

federal funds rate is virtually unchanged from the last FOMC meeting. This outcome is somewhat remarkable, given the number of important developments just noted and the large number of speeches delivered by FOMC members expressing diverging views on policy prospects. Current market prices suggest that investors expect the federal funds rate to remain near its current level over the rest of the year and then to move higher in the first half of next year. The Desk's survey of primary dealers shows a similar pattern, with respondents putting the highest odds on the first increase in the federal funds rate target taking place in the first half of next year, although they also see significant odds of policy tightening being delayed until the second half of that year or later.

1The materials used by Mr. Sack are appended to this transcript (appendix 1).

use the tools to drain about $500 billion of reserves over a six-week period, with that total about evenly split between the two tools.

The bottom-right panel addresses the effectiveness of paying interest on reserves for controlling the federal funds rate. Specifically, it reports the expected gap (in basis points) between the IOER rate and the effective federal funds rate for different combinations of the amount of excess reserves and the level of short-term interest rates. For example, with $1.5 trillion in excess reserve balances, the federal funds rate would be expected to trade 16 basis points below the IOER rate when the latter is set to 25 basis points, corresponding to the rates observed today.

As can be seen by moving to the right on the table, the relationship between the effective federal funds rate and the IOER rate is expected to tighten as the level of reserve balances declines, with a fairly tight range reached at $500 billion of reserves. Even at very high levels of reserves, though, paying interest on reserves is seen as providing fairly effective control of the federal funds rate. Indeed, with excess reserves near their current level of $1.5 trillion, the expected gap only widens to

25 basis points as the IOER rate is increased to 2 percent.

Finally, on a topic unrelated to the earlier material, I would like to request a vote to renew our long-standing bilateral swap lines of $2 billion with Canada and

$3 billion with Mexico. Ahead of the meeting, Nathan Sheets and I sent the Committee a memo recommending renewal of the swap lines at this time. Our proposal is to keep the swap lines in their current form. Thank you.

CHAIRMAN BERNANKE. Thank you, Brian. One other vote that we will be

requesting is the ratification of foreign exchange transactions over the intermeeting period. So I

thought I would just say a word about the intervention that the Federal Reserve participated in

with respect to the yen.

As you know, the FOMC delegates to the Foreign Currency Subcommittee'the

Chairman and Vice Chairman of the FOMC and Vice Chair of the Board'the authority to

authorize interventions if they are sufficiently small and if time does not permit consultation with

the full Committee. I think both of those conditions were easily met. As you know, we haven't

intervened for more than a decade, but following the earthquake and tsunami, there were some

quite extraordinary circumstances. The Japanese called the G-7, cited large moves in the yen in

relatively illiquid trading conditions, and asked for us to participate in a joint intervention. I

think there was some basis for their concerns about the foreign exchange market, but I think the response of their colleagues was more about solidarity for the courage that they were showing under extreme circumstances. So under the leadership of Treasury Secretary Geithner and the other G-7 leaders, we agreed to participate in an intervention.

It was a very short time lag; the time between the call when the Japanese made the request and the actual intervention announcement was less than two hours, so there was really not time to consult. The amount involved was very small'$500 million from the Fed,

$500 million from the Treasury'with most of the intervention being done by the Bank of Japan. There was no commitment to any additional action, and I don't expect any, barring some major unanticipated developments. This appears to have met the criteria set forward by the Committee, but I wanted just to add that in case there are any questions or comments on that subject.

Now let me open the floor for questions for Brian on his presentation or anything on the foreign exchange market. Any questions? President Lacker.

MR. LACKER. Yes, a couple of questions for Brian. If the debt ceiling is resolved on time, have you been in conversations with the Treasury about the pace at which the Supplementary Financing Program will be reinstated?

MR. SACK. We have not been in active discussions about that, given the uncertainties about the debt ceiling. I think there is general agreement that the SFP could be brought back up to its previous size with a sufficient increase in the debt ceiling. But no, we haven't had detailed conversations about it recently.

MR. LACKER. Okay. My second question has to do with MBS sales. In discussing the Treasury sales, you noted the large difference between the magnitude of our holdings and the magnitude of their sales and holdings. And you said that Fed sales, because they would involve

such a large amount, could have implications for market pricing and market functioning. In preparing for this meeting, I looked at the November transcript where I asked you about the pace of our purchases, and what sort of factors you thought would motivate limiting the pace of our purchases. You said essentially two things: One was operational capabilities, and the other was the potential for affecting market functioning. You were careful to distinguish between the pricing effect, which, as you noted, was presumably the desired effect of the policy, and what you called market liquidity. And what you described was that we didn't want to create too much of a one-sided market by buying too much, resulting in lower trading volumes between other parties and higher bid-asked spreads and all.

So going in the other direction and selling things, do you think about the effect on market functioning the same way? I mean, it's unlikely to result in a one-sided market, right? We are putting more things out there, and a lower trading volume seems unlikely because there is going to be more float out there. How do you think about the potential market-functioning effects, apart from the pricing effects? The broad motivation for this question, obviously, is, how fast could we conceivably think about selling our assets?

MR. SACK. I think about the market-functioning aspects in many of the same ways' though maybe not entirely. I think rapid sales could be difficult for the market to digest and could result in a one-sided market where dealers have more trouble making markets and where other participants are less inclined to participate, given the heavy flow coming from one single seller. So I think the same concerns would apply if we are talking about a pace of sales that's very high.

One thing we've learned from the Treasury decision, though, is that the pace that they have set out, of up to $10 billion a month, seems to have been fairly easily digested so far. It

does not seem to be raising any problems with market functioning. And $10 billion a month is not a lot of net supply relative to the history of the MBS market. In the early 2000s, there was $200 billion to $300 billion of net supply coming to the market each year'something on the order of $20-some billion a month. There is not much net supply coming from fundamentals today, so the Treasury adding their $10 billion to net supply hasn't been too disruptive.

There's one difference: When you are selling assets out of your portfolio, these are seasoned securities, or what are called specified pools; they're not the production securities in the TBA market. We had a little bit of uncertainty about gauging whether $10 billion was a lot or not, because these were seasoned securities, but I think what we have learned from the Treasury program is that the market has been able to digest that. The concerns about market functioning, I think, would apply if the Committee were to consider much more rapid paces of MBS sales than $10 billion.

MR. LACKER. Can I follow up, Mr. Chairman? I want to learn more about this concern about market functioning. The way I thought about your comments in November was that'for the standard market microstructure model'marketmakers commit some capital based on expected returns and expected deal flow. If we are buying a lot, I can see why the market would shrink and the number of marketmakers ought to shrink. But my intuition about flipping that around and applying it to a situation where we are selling would be that the number of marketmakers would increase and spreads would fall. Do you have some other model in mind, or am I missing something in applying the standard model to this?

MR. SACK. Yes, I do. As I said, I have many of the same concerns with market functioning in terms of selling. But I agree with you, it is not the same, and there are some things that are asymmetric. In terms of the available float, tradable float to the market, that's

very different. When we were buying very actively, we were removing a lot of the tradable float, and that was likely impairing market liquidity. And, of course, when we're selling, we are providing supply to the market that it can trade. However, as I mentioned, we are not selling the most actively traded TBA securities in the market. We will be selling these more seasoned, more specific pools, which may limit that benefit to some degree.

The concern I was raising was that, if the market thought that there was a single seller who would be in very aggressively, and maybe unpredictably, it would be harder for marketmakers to make markets and provide liquidity to the market. So it is the uncertainty, I would say, about what the effect of a very aggressive sales program would be that would limit market functioning. But I want to emphasize that this would be at paces well above what the Treasury decided upon. We think that there is some room to sell at a decent pace without causing significant market disruption.

MR. LACKER. Okay. You took pains to reduce the uncertainty about the pace of our purchases, and I'm assuming you did the same thing for the sales, too. So the uncertainty around our sales can't be large, can it?

MR. SACK. Well, I think that would depend on what the FOMC communicated. And then, given what the FOMC has communicated, we would decide if there were additional details for the Desk to communicate. But I agree that communicating about the sales strategy would help.

MR. LACKER. That seems like a price effect'that they're uncertain where the price is going to be, as we are'and that seems like a policy consideration as opposed to market functioning.

MR. SACK. Of course, in addition to the market-functioning aspects, as policymakers, you will also worry about the market-pricing effect, because we would assume that more-rapid sales programs would put upward pressure on long-term interest rates.

MR. LACKER. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Other questions for Brian? President Bullard. MR. BULLARD. Thank you, Mr. Chairman. I am looking at figure 24, 'Expected

Spread between IOER Rate and Federal Funds Rate.' If I'm reading this correctly, IOER goes up and the spread gets larger. Why is that? I would think the arbitrage would be the arbitrage, given the fees that are in the market. So why does the spread go up?

MR. SACK. The current level of the spread is constrained by the arbitrage, but it's also constrained by the zero bound on nominal interest rates, which is presumably limiting the spread that we see. Let's say the arbitrage hypothetically required 30 basis points. We know the fed funds rate wouldn't go to minus 5, so the zero bound is providing a limit on how big that spread can get. I think what you are seeing is that, as IOER goes up, that limit goes away, and the spread increases. Having said all that, at any level of the IOER rate, we think that arbitrage is relevant and does put a cap on how big that spread can be, because if that spread gets too large, firms will come in and do the arbitrage. So that's why the spread only rises to 25 basis points, even with such a large amount of reserves.

MR. BULLARD. Okay. That makes sense, but then the zero bound is still a factor, I guess, between, say, 1 and 2 percent on the IOER?

MR. SACK. Under the story I just told, you would expect the same gap at 1 and 2, and that's not consistently represented in the table. For some of the columns, you see that pattern' that the gap widens a lot from 25 basis points to 100 basis points on IOER, and then widens only

marginally more as you go to 200 basis points on IOER. That's true for all of the columns except for the first one. So, my guess is that the gap that we will see between market interest rates and the IOER rate could widen as we move up from current levels, but, for the reason you noted, will reach a constant level, a steady-state level, well before the IOER rate gets to

2 percent.

MR. BULLARD. Okay. Thank you.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I have a question about figure 23. This represents the primary dealers' estimates of our draining capacity. I was wondering what the staff's own estimates would be of that number.

MR. SACK. This is the draining capacity over a short time.

MR. KOCHERLAKOTA. The intermeeting period, a relatively short period of time. MR. SACK. I'll speak for myself, and maybe not the staff as a whole. My own

impression is that these responses are pretty aggressive, especially on the reverse repo side. If the mandate were to drain $500 billion of reserves or more, I think it may be prudent to spread that process out a bit more than over one intermeeting period.

When we do reverse repurchase agreements, we are taking funding away from dealers and other participants in the market. So there has to be this change in short-term credit flows because, ultimately, the reserves are going to come out of the banks; it requires a change of how the credit flows. I think we are unsure about how easily the market adjusts as it moves through that chain, and so I think there is good reason to be gradual and to give the market more time than six weeks to make those adjustments.

I think the capacity to ramp up term deposits quickly is perhaps a bit greater than reverse repos because it doesn't require any re-intermediation of credit. It's just a change in the nature of banks' assets.

MR. KOCHERLAKOTA. A relabeling, almost. If I might follow up, I understand your concerns on reverse repos. What would be your concerns about what kinds of constraints we would face in terms of the use of TDFs?

MR. ENGLISH. I think on the term deposits, the question is simply that there's a lot of uncertainty about the level of reserves that people will provide to us at a given price. I mean, at a high enough price, we are pretty confident we could drain a lot of reserves, but we don't know what that supply curve looks like.

I think another issue that would suggest that having a little more time would be helpful is that some institutions have not participated thus far in our TDF operations but have suggested that, if this gets serious, they would want to sign up and begin participating. We would want some time to get the new entrants integrated into the TDF program so that there would be more capacity as they came in.

MR. KOCHERLAKOTA. Thanks.

CHAIRMAN BERNANKE. President Plosser.

MR. PLOSSER. Yes'a clarification, Brian. I'm looking at figures 17 and 18 on page 3 about the GC repos and the securities lending. You made a comment that part of the problem was the lack of Treasury collateral in some of these markets, which helps to explain a little bit of the rise in the securities lending and some of the differences in the repo rates. Is that related at all to the fact that we are buying most of the Treasuries that are coming out through our purchase plan, and that we are actually making Treasury collateral scarce in doing this exercise?

MR. SACK. The underlying market conditions coming into the FDIC fee were relevant. We've been conducting asset purchases, and that has left less collateral in the market than it otherwise would have had; at the same time, the Treasury has run down the SFP, which also has taken Treasury collateral out of the market. So there was a backdrop of less collateral available, but it wasn't causing significant disruption or problems for the market. What happened with the FDIC fee was much more of an abrupt shift. Just to be clear, we had expected the repo rate to move down roughly in line with the federal funds rate for the same reasons that apply to the federal funds rate. But what happened was that the adjustment was more abrupt. It seemed that the decision by some market participants not to do the arbitrage'not to fund themselves in the repo market, pulling that collateral out of the market'really made it difficult for the market to adjust in the short term. I would say that the things you point to provide a backdrop of some shortage but not problems, but then the FDIC fee resulted in a much more abrupt adjustment.

MR. PLOSSER. But if you go to the other panel, with the securities lending, since November there's been a rather marked increase in securities lending by the Fed. That's the background you're talking about?

MR. SACK. That is the background I'm talking about, and I think in part that upward trend is related to us taking Treasury securities out of the market.

CHAIRMAN BERNANKE. President Fisher.

MR. FISHER. Mr. Chairman, I don't know if the questions are over, but I would like to move that we accept the proposal for the extension of the swap lines from Mexico and Canada and approve the Desk operations as you suggested.

CHAIRMAN BERNANKE. Thank you. So there are three measures: open market operations, foreign exchange operations, and the swap agreements.

MR. FISHER. I would like to move acceptance of all three.

CHAIRMAN BERNANKE. Thank you. Before we do that, though, let me just make sure'Governor Duke, did you have a question?

MS. DUKE. I just had one question. Can you give me a sense of the relative size of the Treasury GC repo market and the current fed funds market?

MR. SACK. Yes. There are different ways to measure this, but one way is to compare average daily volumes among dealers. For federal funds, we've been seeing $40 billion to $50 billion of transactions daily. For Treasury GC repos, just to the dealers, it's been

$500 billion to $600 billion. MS. DUKE. Thank you.

CHAIRMAN BERNANKE. President Lockhart.

MR. LOCKHART. Brian, a more general question on your outlook for the effect of the FDIC fee on the repo market. When we were considering the zero lower bound, we were concerned that there could be a destruction in the infrastructure that would occur over time with professionals leaving because they couldn't operate at that low level, and then generally that there could be a relationship to IOER and its ability to have the effects we want as we begin to raise it. Can you generally talk about your concern about whether this fee complicates our life over the longer term?

MR. SACK. Yes, I can. There's been a slight decline in funding activity in these markets as the FDIC fee was imposed, but it's been fairly modest. Even at these new prices, it seems like there is active intermediation of credit taking place, and, in that sense, the markets continue to function.

Another pressure point, however, is the implications for money market mutual funds. At this point, essentially, Treasury-only money funds will be operating at a loss, and essentially the fund complexes will likely be subsidizing those funds if they want to continue to offer them.

They may choose to do so. Many of them feel that these types of funds are an important part of a suite of products that they offer customers. As repo rates got extremely low, we did have several money funds raise complaints to us about this phenomenon, with at least one indicating that it couldn't sustain some of its funds beyond the summer at these levels. So I think what we will do is continue to reach out and listen to that type of anecdotal evidence. At this point, that was just one fund, but we are going to try to get a sense of how widespread it is. There's no doubt that as Treasury repo rates and Treasury bill rates come in, that's going to put additional pressure on the profit margins of the money funds. The prime funds still seem quite okay. There is enough yield pickup as they move into other products that we don't think at this point that they're generally under pressure.

CHAIRMAN BERNANKE. Any other questions? [No response] All right. We have a motion on all three of these measures. Let's take them one at a time. Open market operations' can I have a second?

MS. YELLEN. Second.

CHAIRMAN BERNANKE. Any further questions or comments? [No response] Without objection. Foreign exchange transactions'second?

MS. YELLEN. Second.

CHAIRMAN BERNANKE. Thank you. Any comments or questions? [No response] Without objection. And, finally, the renewal of the standing swap agreements with Canada and Mexico. I need a second.

MS. YELLEN. Second.

CHAIRMAN BERNANKE. Thank you. Any objections, comments? [No response] All

right. Thank you.

Let's go on, next, to item 2, Strategies for Removing Policy Accommodation. A

memorandum was distributed from the staff on April 19, and we will begin with Bill Nelson

making a presentation. Bill.

MR. NELSON.2 Thank you Mr. Chairman. At its meeting a year ago, the Committee discussed strategies for removing policy accommodation and normalizing the balance sheet over time. Shortly thereafter, in response to a weakening in the economic outlook and the threat of deflation, you instead provided additional policy accommodation by expanding the balance sheet further. At the risk of tempting fate [laughter], last week the staff again sent you a memo on strategies for removing accommodation and normalizing the balance sheet.

In your previous discussion, you appeared to agree on two broad principles for your exit strategy. First, the SOMA portfolio should be returned to a normal size and an all-Treasuries composition over the intermediate term, which will require sales of agency securities at some point. And second, sales of SOMA securities should be implemented using a framework that would be communicated in advance and at a pace that potentially could be adjusted in response to changes in economic and financial conditions. Issues that remained open included the appropriate sensitivity of sales to changes in the economic outlook, how quickly sales should proceed, whether to redeem Treasury securities in order to shrink the balance sheet more rapidly, and whether to use reverse repurchase agreements and term deposits to drain reserves before raising your target for the federal funds rate. In addition, you will now also need to decide when to stop the reinvestment of principal payments on agency securities into longer-term Treasury securities. And, of course, you will also have to decide on the appropriate sequence for these policy actions.

To some extent, these decisions can be reduced to choices about a few key policy issues. The first issue is the timing and pace of balance sheet reduction. Both raising short-term interest rates and reducing the Federal Reserve's holdings of longer-term securities would restrain economic activity by tightening financial conditions, so there is a degree of substitutability between these two policy levers. To accomplish essentially the same outcome, the Committee could sell assets sooner and faster but raise the target for the federal funds rate later and more slowly, or you could sell assets later and more slowly but increase the federal funds rate target sooner and faster. You likely see the key advantages to selling assets sooner and faster to be the more rapid return to a normal policy environment, the reduction in any upside risks to

2The materials used by Mr. Nelson are appended to this transcript (appendix 2).

approach similar to option 1, except redemptions would begin later, at the same time sales commenced, and principal payments on agency MBS would continue to be reinvested in Treasury securities.

The two options produce different paths for Federal Reserve income, remittances to the Treasury, and realized and unrealized capital losses'that is, the options discussed in the memo, not the options that the presidents introduced. The cumulative amounts of remittances to Treasury under the two approaches are similar, in part because the projected paths for longer-term interest rates in the two options are little different. However, remittances are somewhat lower in the middle of the decade under option 2 because the relatively rapid pace of securities sales at that time boosts realized capital losses. Remittances under option 2 subsequently move above those in option 1 because the earlier completion of sales means that realized losses end sooner. The Federal Reserve would report larger and more long-lived unrealized capital losses under option 1 because of the later start and slower pace of asset sales. The risks to Federal Reserve income and remittances to the Treasury would also differ across the options, as discussed in the memo.

Last week the staff also provided you with an additional background memo on longer-run policy implementation frameworks. In the staff's view, the Committee can choose an exit strategy independently of its choice of a longer-run policy framework. Any exit strategy will likely involve an elevated balance sheet with the federal funds rate target near the IOER rate'as in floor-type systems'for some time. If the FOMC desired to eventually move to a corridor-type system for the federal funds rate, it could do so by continuing to drain reserves until they reached a level that would be associated with the federal funds rate trading above the IOER rate. Alternatively, the FOMC could maintain a floor-type system for the federal funds rate by halting the decline of the balance sheet at a higher level of reserves.

We've distributed a handout titled 'Strategies for Removing Accommodation' that reproduces the list of questions for your discussion that was circulated late last week. That concludes my prepared remarks. We would be happy to answer your questions.

CHAIRMAN BERNANKE. Thank you. Are there questions for Bill? Governor

Tarullo.

MR. TARULLO. Thank you, Mr. Chairman. Bill, in the memo that you circulated

earlier, and to some degree in your presentation this morning, there is a hint, but not an explicit

statement, of the proposition that the choice between option 1 and option 2, and variants thereon,

would be tied, at least, to the relative pace of tightening that we would eventually want to

undertake. Is that a correct inference to draw?

MR. NELSON. I don't think so. Just because we calibrated the two options so that they delivered the same amount of monetary tightening, they remove accommodation to the same degree and deliver the same macroeconomic outcome.

MR. TARULLO. So let me ask this question somewhat differently. To what degree would the pros and cons of the two options be different depending on whether the Committee's ultimate choice was a fairly gradual tightening or a fairly rapid tightening?

MR. NELSON. I suppose one advantage of option 2, of sales earlier, is that if the Committee felt that it needed to tighten quickly, it would drain reserves more rapidly and thus set up the commencement of tightening of the federal funds rate sooner. On the other hand, if the Committee felt that it needed to tighten more gradually, it might be reluctant to engage in asset sales earlier because there is a lot of uncertainty about their effect on the economy. It would seem that at a point when the economy might be on less firm footing, the asset sales might pose greater risk.

MR. TARULLO. Okay. Thank you.

CHAIRMAN BERNANKE. There's a question from President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. A question both for Bill and Brian Sack. I think you suggested that we may want to drain in advance of moving the fed funds rate. Do you have any sense of how sharp the market reaction would be in long rates to the beginning of draining? My thoughts: The market would anticipate that that is a precursor, obviously, to moving the fed funds rate, and there would probably be an immediate reaction. Is there any way to estimate how much that reaction would be?

MR. NELSON. I can't think of any way to estimate that. I agree that it would certainly be a communication challenge, if you were to drain and mean it to be just a change in the

liabilities on your balance sheet and not the commencement of tightening. I think people would realize that by draining, you are setting the groundwork for raising the IOER rate and the target federal funds rate. So I think the market reaction would be sharp, but it would in part depend upon the communications.

MR. SACK. I would just add, I think most of us would argue that the statement language is a much better vehicle for conveying information to the market about the expected timing of policy action. And, indeed, one of the reasons that in the memo we put draining after changing 'extended period' was just for that reason. I would argue that, through your communications, you should try to make it clear'if you agree'that the draining patterns aren't intended to be a signal about the timing of policy tightening because I think the statement is a much clearer signal in that regard.

MR. ENGLISH. But that said, I think the basic point is right'when the market perceives that the Committee is starting in the direction of tightening, they'll react to that, and you'll see some effect in markets. How large or small that is will depend, I think, a great deal on how that is communicated: what the statement says and, potentially, speeches, press conferences, whatever it is around that. But it will be a moment when communication will be very important.

CHAIRMAN BERNANKE. It would also depend on what expectations were before that announcement was made. President Plosser.

MR. PLOSSER. Is there any reason to believe that that reaction will be any different this time than it would be in any other tightening cycle where we reverse? In most cycles we reverse course at some point. Is there any reason to believe that's any more of a concern in this period than in any other period?

MR. SACK. I think that in any period, the evolution of expectations of tightening is going to tighten financial conditions in advance of the actual policy tightening. And in most cycles that would occur exclusively through the FOMC statement, because you wouldn't have these other steps in the process, such as redemptions or reserve draining and so on. So I think the ultimate effect on markets is going to depend on the same thing, which is how the expectations of the policy evolve, and it is a matter of managing which policy steps are conveying those signals.

CHAIRMAN BERNANKE. Other questions?

MR. HOENIG. I have one.

CHAIRMAN BERNANKE. President Hoenig.

MR. HOENIG. Just curious. Let's assume for the moment that inflationary pressures become more pronounced and the markets become more convinced that it is perennial if we don't take an action. Which of the options' in terms of either moving your funds rate or selling assets at that point 'do you think would have the greatest effect on changing expectations about inflation?

MR. ENGLISH. I guess it is not obvious to me that there would be a big difference between the two. Either way, if the Committee was clear that it was concerned about inflation, that it was taking steps to tighten policy to address those concerns, I would have thought the communication would be clear, I'm assuming, and the market would react appropriately.

MR. HOENIG. Then it wouldn't matter which option you'd choose'at that point you'd want to move more quickly, right? So that would push that option forward.

MR. ENGLISH. The steps would come in more rapid succession, I agree, and I think you could do that under either option.

MR. SACK. My own view, though, is that your big gun is the short rate. So a change in the 'extended period' language signaling an earlier, more rapid tightening of short rates, I think, would be your most powerful instrument for tightening financial conditions.

MR. HOENIG. Rather than selling the assets?

MR. SACK. Right. And you can see that in the staff's simulations right now. At the end of the second quarter when the asset purchase programs finish, the staff estimates about 40 basis points of effect on the term premium from our elevated asset holdings. So selling the assets more quickly would shrink that effect. But, of course, you could achieve a lot more tightening than that, if desired, through the path of the short-term interest rate and the signals that you send about it.

MR. HOENIG. So, you would begin with the repos and so forth to get the rate up more quickly and then allow your balance sheet to run off?

MR. NELSON. You can drain a considerable amount very quickly with redemptions as

well.

MR. SACK. I agree with what Bill and Bill said, that the entire sequence could be shifted and accelerated, but I was answering the question: Out of all the tools, what do you think the most powerful tool is? I think we would all agree, it's still your traditional policy instrument.

MR. HOENIG. Okay. I appreciate that.

CHAIRMAN BERNANKE. Other questions? [No response] Okay. In a moment we'll begin a go-round to hear views on these and other issues. There are some questions that staff provided just as thought starters, but I'm sure you won't constrain yourselves necessarily. [Laughter]

Let me say a word about what I would like to get out of this. I will have to discuss this with the press tomorrow, and I would like to provide as much information as I can, but no more than I should. Certainly, what I will say initially will be that we discussed this issue, that a discussion of the exit process is a separate thing from making the decision to exit, and that it doesn't necessarily signal any change in our stance; it's a separate issue. I want to emphasize the provisional aspects of this'that, as President Hoenig was suggesting, if conditions were different than anticipated, we might want to change the timing, pace, and so on. It would depend on economic conditions, and then our communication will try to provide as much information as possible about that. Those will be some general points, but beyond that, if I can get from this discussion some principles'for example, that the interest on excess reserves is the main tool supported by reserve drains, that the balance sheet will be adjusted in certain ways'those obviously would be helpful. If not, I will just be more general.

One final note on this: The operating framework per se is a big topic and it is not necessarily part of our discussion today, but it does have some bearing potentially on, for example, how quickly we reduce the size of the balance sheet. For example, if we want to use a floor system, we might not need to reduce the balance sheet as quickly. To the extent that the operating system bears on this issue, you should feel free to bring that up. Again, I'll be taking careful notes, and I hope I can come up with some general principles, which I will then review with you to see if I can get a sense of the Committee from this discussion.

Before ending, without trying to preempt the discussion at all, I thought I would make a couple of observations that I found useful in thinking about this. One is simply that redemptions are a pretty powerful tool here. If we were to begin redeeming both Treasuries and MBS in December 2011, as assumed by the Tealbook, that would reduce the size of the balance sheet by

more than $1 trillion over four years, and we would be back essentially to normal size in four and a half years. Now, that may be too long for some, but my point is only that that's the baseline and that redemptions alone do move us in the right direction relatively quickly. But obviously some may wish to go more quickly than that. And of course, that doesn't account for the need to swap around MBS, Treasuries, and so on to get the composition right.

The other observation I had that I found useful in thinking about this is that it's important for us to keep in mind that, in a policy sense, the sales and redemptions of assets and the movements in the interest paid on reserves are substitutes. To the extent that you do more of one, you have to do less of the other, and as we discuss these policy tools, I think it is important that we not treat them in some sense as independent; they are part of a unified process.

With those preliminary observations, I see President Bullard is first, and we can begin our go-round.

MR. BULLARD. Thank you, Mr. Chairman. I will try to be provocative. I am moderately worried about the Committee's approach to exit strategy so far. Let me give you one of the main ideas I'm going to expound on here and then I will go into the rest of my remarks.

I am concerned about the moment in the exit strategy when we plan to potentially drain very substantial amounts of reserves and simultaneously raise rates. This part seems risky to me because two types of accommodation are being removed at the same time, and, combined with negative economic developments, that could send the economy back into recession right at that juncture. I see that as a possible policy mistake. I'm going to call that the 1937 scenario, and my comments are directed toward getting something a little more continuous, prudent, and potentially reversible as the baseline exit strategy.

Accordingly, I'm going to recommend a version of option 2 from the English'Nelson' Sack memo. I'll give you a defense of the LIFO policy, the last in'first out policy, in my remarks here. I would probably put less emphasis on quickly normalizing the balance sheet than the memo does. The speed, in my view, should be dictated by economic events, not an artificial desire to get back to normal. I have one background remark before I give you my defense of the LIFO policy, and that is that I think QE2 was quite successful by conventional metrics on monetary policy easing. I think any reading of financial market developments since last fall would tell you that real interest rates on safe assets declined, expected inflation increased according to TIPS markets, the dollar depreciated fairly substantially, and equity markets rallied fairly substantially. That's about as classic as you can get in this business for what is supposed to happen around the time of monetary policy easing. I think QE2 was quite successful in that sense, and it is very apparent if you listen to financial markets. I think it helped us considerably in avoiding a scenario like the one observed in Japan over the last 15 years, and now we are somewhat beyond that point.

Now, you might ask, 'Why was it successful? How did it work?' I think probably the best explanation of that is that the large balance sheet is a way for the Committee to threaten higher inflation with some probability. With policy rates near zero, higher expected inflation drives real interest rates lower and has all the effects that I just described. This has the same net effect as conventional monetary policy'that is, interest rate targeting. Because the policy had important financial market effects, reversing the policy will undo some of those effects, and I think that we have to be very cognizant of that. We want to be careful, therefore, in reducing the size of the balance sheet, and we want to do it in a prudent way.

Let me give you the defense of the LIFO policy: last in, first out. I think this policy has five important attributes, which I'm going to discuss here in turn. One is simplicity. You're just turning around and starting to go back on the same path that got you to this point. I think that's very easy for everyone to understand and very easy to communicate, so I like the simplicity of the policy. I think it has better reversibility properties. It's easier to pause or even reverse course if necessary, and I'll talk about that. The economy doesn't always cooperate with our best-laid plans. I think it's prudent. As I described, the effects of QE have been pretty substantial. It doesn't really come through in our models in the way it seemed to in reality, so I think we should be very careful about removing accommodation along this line. It's complementary to the future use of IOER and the federal funds rate. You're setting up a situation where you have a lower level of reserves in the system. That's going to help us going forward. And finally, it is politically alert. It avoids unnecessary overreliance on the IOER and the criticism that will naturally flow to the Fed from the overreliance on that mechanism.

Let me take each of these in turn. First, simplicity. The last easing action we took was to build up the balance sheet. The first natural step toward removing accommodation would be to reverse that. I think that's very easy to explain and easy to understand in the context of the most recent FOMC policy actions. When we think about previous tightening cycles, of course, we didn't have this balance sheet policy out there, but now that we do, I think this is the most natural way to proceed. Other sequencing, in my view, is arguably far more complicated and more convoluted to try to explain, for example, why you are going to do step 1 versus step 4. I think allowing balance sheet runoff is an example of this simplicity. It is a very easy thing to do; it reverses a policy change that we made in August. However, I do have one complaint about that aspect, which is that the autopilot route is not optimal under almost any analysis I'm aware of.

It's a bureaucratic response. I can imagine that we might do it to get to a compromise policy on the Committee, but I do not think we should use that as an excuse for not following what would be the optimal strategy.

The second attribute that I said was useful is this reversibility aspect. Unfortunately, the economy does not always cooperate with our best-laid plans, and I think this normalization process, if we can get started on it, will take a long time because we've got an ultra-easy policy. It's going to take quite a while. There are going to be moments during that process when negative shocks hit the economy, and we are going to have to be ready and able to adjust in that circumstance. So the process of reducing the balance sheet through asset sales can proceed at a faster or slower pace as needed. You can go on pause or even increase the balance sheet'you have some flexibility there'and it's reversible if necessary. Again, I think the reason why this policy worked is that it is a way to threaten higher inflation, get higher inflation expectations, and lower real rates in a zero nominal interest rate environment. Draining the reserves all at one time takes that threat away all at once, plus you would increase interest rates. So that would be one view of option 1, and at that point, that sounds a little discontinuous to me and possibly a policy mistake '' la 1937. Instead, I would gradually remove the threat of higher inflation by gradually reducing the balance sheet at a pace dictated by events, and then at some point, probably when reserve levels are lower, we will still have to drain the remaining reserves and raise the IOER and the federal funds rate. But we can do that when reserve levels are lower and not when they are at really high levels, as they are today.

The third aspect, I think, is that it's a prudent policy. Again, our baseline models, Tealbook and otherwise, are not well equipped to analyze the current situation. We have little experience here and little historical data on which to base that analysis. We do the best we can,

but I do not think we should rely too heavily on these models to make policy decisions at this juncture. Again, QE2 had substantial effects'take some of that back slowly, keeping inflation and expected inflation close to target.

The fourth attribute is that it is a complementary policy to eventually raising interest rates. Every step along the path of reducing reserves at a pace that respects developments in the economy brings us closer to the normalization of monetary policy that we eventually want to get to.

Finally, the LIFO policy is politically alert. LIFO avoids the unnecessary overreliance on the interest rate on excess reserves. I think a policy of very large reserve balances at large banks, combined with higher IOER, will unfortunately be viewed very negatively across the political spectrum. It is an explosive issue for this Committee: more money to the banks. You're forcing them to hold reserves, then you're paying them more on it.

Obviously, I don't care what people think very much. If it was an optimal policy, then we can and should defend it and we should just say that's the optimal policy. But I think it's not the optimal policy, and it's unnecessary to exit in that particular way. And, therefore, that policy will be difficult to defend. People will be able to say'legitimately, I think''There are other ways to do this. You didn't have to do it this way.' So, I think it is better to at least begin to reduce reserves via asset sales before we get to the point where we have to pay substantial interest on whatever reserves are remaining. This LIFO idea is simple, reversible if needed, prudent, complementary to the eventual raising of the federal funds rate, and politically alert.

I'm looking forward to the discussion today. I think it will be important, a great discussion. We probably cannot solve everything at a meeting like this, and in any case, no

matter what we decide or think we decide, we will probably have to remain flexible down the line.

Let me come to the questions that were asked by the Chairman that will be easy to answer here. As a first step, should we stop the reinvestment policy? I would say to that, okay, but again, autopilot is not optimal.

Should we actively manage the balance sheet? I have been a proponent of that for a long time, so the answer there is yes.

Should we sell assets before raising the federal funds rate? I think the answer to that is yes. That's been the gist of my comments here, and again, I would let economic conditions dictate the pace of sales.

And on four, which is a set of true'false'uncertain statements: Should we shrink the SOMA to the size necessary to implement monetary policy on a lower reserve base? I think, yes, we should do that. I think that is what normalization of monetary policy means for the United States, and that's how people will understand it. I think it facilitates an eventual transition to a corridor system; at least my understanding of where many members of the Committee are is that we eventually want to be in a corridor system.

Do we want an all-Treasuries portfolio? I say yes to that. And should we adjust sales in response to economic events? I would say yes to that, too.

So that's my insertion of a speech defending the asset-sales-first policy. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Bullard, I do have a question about this, which would be very helpful if you would address'one issue about this is the speed. Is there a speed limit? If we think that, say, $200 billion of sales is equal to 25 basis points'to

take a rough example'then if we were doing 25 and 50 basis point equivalent moves, that might require a very rapid disposition of assets. So, A, there's the market absorbency issue, but, B, you talked about politics. If we were to sell assets that quickly, we would be, I think, more likely to suffer capital losses, which are also not attractive politically. Do you have any concerns about any speed issues on this approach?

MR. BULLARD. On the capital losses issue, I think we have repeatedly and effectively said that we don't make policy here based on capital gains or losses. So I think we have been pretty effective on that, and we can defend that part.

On the speed issue, I think, again, you have this large balance sheet because this is a way to threaten higher inflation in an environment in which you have zero policy rates, and you can reduce it at a pace that keeps inflation and inflation expectations close to target. So it seems as if that could be dictated by events. If you can go faster, you can go faster. I appreciate that there might also be considerations about absorption. And, again, even if you aggressively followed my kind of policy, I think you would get to some point where you said, 'Okay. We're going to have to drain the remaining reserves and start to move the funds rate up because it's just not enough.'

CHAIRMAN BERNANKE. Thank you. President Hoenig.

MR. HOENIG. Can I ask President Bullard a question? As you're describing your strategy, you're selling out of the portfolio. Is that what you're saying?

MR. BULLARD. Yes.

MR. HOENIG. And that would have effects, but you wouldn't actually change the fed funds rate or the interest on reserves'for how long?

MR. BULLARD. Well, it would be a version of option 2, so I'd wait as long as I could, I suppose.

MR. HOENIG. And conditions would tell you when to make that move'in terms of what? Inflationary expectations, events, and so forth?

MR. BULLARD. I'd definitely keep an eye on inflation and inflation expectations. It is possible you could start reducing the balance sheet and you're really not getting enough bang for your buck out of that, and then you might say, 'Okay, we're going to have to drain reserves,' and bring out the big gun and raise the funds rate.

MR. HOENIG. Thank you. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Lacker.

MR. LACKER. Can you repeat? You used a tradeoff number'I just want to make sure I have it right'that a certain number of billion dollars is equivalent to a certain number of basis points. Was that of the fed funds rate's worth of easing?

CHAIRMAN BERNANKE. The staff can correct me. I believe we've viewed

$150 billion to $200 billion of securities in our portfolio as being roughly equivalent to 25 basis points. Is that about right?

MR. ENGLISH. We were saying that the $600 billion purchase program was roughly like a 75 basis point reduction.

MR. LACKER. Does it mean if we sold $1.6 trillion it would be like having a 4 percent fed funds rate, leaving the IOR rate at 25 basis points?

VICE CHAIRMAN DUDLEY. You'd be going from minus 4 to 24 basis points. CHAIRMAN BERNANKE. We currently have about 200 basis points' worth of ease

coming from securities, according to the staff assessment.

MR. LACKER. Attributable to?

CHAIRMAN BERNANKE. Attributable to our excess holdings of securities.

MR. LACKER. Right. I'm just doing the math. If we got down to $1 trillion on the balance sheet, if we sold all our assets, that would be the equivalent of 4 percentage points?

CHAIRMAN BERNANKE. Two percentage points.

MR. LACKER. But the market wouldn't work the same, right?

MR. ENGLISH. All of these are approximations.

MR. BULLARD. Mr. Chairman, could I make a comment on that issue? Again, I don't think our models are a great guide in this kind of environment. So I think what you should do is experiment with it and then see, in particular, where inflation and inflation expectations go and that would help dictate the pace.

CHAIRMAN BERNANKE. President Plosser.

MR. PLOSSER. Thank you, Mr. Chairman. I want to thank the staff for their memos on exit and monetary policy implementation frameworks. I think they hit on most of the important issues that we need to grapple with as we formulate a strategy.

In my view, I think our strategy needs three basic principles. First, I think we need to articulate a plan to the public telling them what monetary policy framework we are normalizing to, then offer them a plan about how to get there. Second, the plan should be systematic to the extent it's possible, entailing some degree of commitment to the way we'll execute the strategy. This will also reduce uncertainty in the marketplace. And third, it should allow for some conditionality on the evolution of economic and financial conditions. Like always, our policy should be state-contingent.

I am in strong support of the corridor system over the floor system as our normal operating framework, although I recognize that we will need to operate on something like a floor system for some time as we exit, given the size of our balance sheet. In my view, the political risks of operating a policy with a very large balance sheet, of potentially unlimited size, are just too great. The floor system makes our balance sheet largely a new discretionary instrument, yet we have almost no theory on how we use this new tool, except perhaps at the zero bound.

How big is too big? What criteria will we use to decide the size of our balance sheet? Without some constraints imposed on the size and uses of the balance sheet, we will find many ideas proffered from all over government as to how we should use it to someone's advantage, whether it be to reduce government debt or to be a development bank for some grand industrial or infrastructure policy. I think these risks overwhelm any efficiency gains one could posit that are associated with the floor system. Besides, the corridor system likely captures the biggest portion of the efficiency gains, so the marginal benefits of going to a floor system, I think, are relatively small.

The background memo suggests that we don't need to decide now whether to use a corridor versus floor system, because we will learn along the way about the calibration between the IOER and the funds rate. True, but this doesn't address my concerns. There will be learning, but I think we need to know where we're headed and to convey that to the public if we are to develop an appropriate strategy because, as Bill said, it may affect the pace of sales you choose and other aspects of your exit strategy. Moreover, clearly signaling that we will be shrinking our balance sheet to a more normal size would help anchor expectations of inflation by reassuring the public that we will not let our large balance sheet lead to higher inflation. If we are to prevent our balance sheet from creating unacceptable inflation down the road, we will have to

sell assets maybe at a pace more rapidly than some would prefer at this point. Thus, one of the aspects that we need to communicate is that we will need to be able to signal to the market that we are prepared to do just that. In the early stages of this crisis, we talked about the speed at which we cut rates and adjusted policy, and we also talked about the chances that on exit, we may have to be just as aggressive coming out as we were going in. And we need to make sure the public understands that we are prepared to do that, if necessary.

Getting to a corridor system will require us to shrink our balance sheet within a reasonable time frame and will require asset sales. If our goal is to return to an all-Treasuries portfolio, we will need to sell MBS. In general, I believe we should aim to sell assets fairly quickly but without disrupting the market. We have argued all along that the effect of asset purchases is through stock effects, not flow effects; thus, I don't think selling assets will be that disruptive, nor do I see why there seems to be so much concern about a moderate pace of sales similar to the pace at which we purchased those assets. Moreover, holding on to assets, which are a good source of collateral in the financial markets, when there is an appetite and a growing economy for these types of assets in the marketplace could be more distortionary than supplying that collateral.

Finally, I think that the pace of sales should vary with economic conditions'that is, it should be state-contingent. Now, I offered one such suggestion on how to do that in my exit strategy memo'namely, because the public generally understands how our interest rate decisions reflect the outlook for inflation and growth, we could tie our sales to the interest rate changes. Let me clarify that I am not suggesting that we use asset sales as a separate policy instrument, as the staff memo seems to suggest; I believe we should rely on the interest rate as our primary policy instrument. Instead, I want our sales pace to be responsive to economic

conditions. Tying the volume of sales to changes in interest rates is just one way of doing that. Actually, the way I think about it, such a strategy eliminates asset sales as a separate discretionary policy tool, as the sales are triggered by the same criteria as our interest rate decisions. If economic conditions are such that we want to raise our policy interest rate, then we should be able to speed up our asset sales, because in such cases economic growth would be stronger and inflation likely to be rising. Once the balance sheet is normalized, we have full control over the funds rate, and, obviously, the sales program would come to a halt. I also think that the alternative of separating these tools and using them independently is dangerous. It risks having either the interest rate instrument or the balance sheet getting behind the curve in our exit strategy.

I think we have less confidence in exactly the effect on market conditions and interest rates from our asset sales than we do about the effect of interest rates, so the degree of tightening we are likely to be achieving with asset sales is highly uncertain at this point. Now, others might prefer a different method of achieving a state-contingent policy. That's fine, so long as we articulate what criteria we will be using for determining that pace of sales. But leaving sales to be a wholly discretionary decision only adds uncertainty and confusion to the marketplace. And making the sales completely unresponsive to the economy by putting them on some predetermined path is likely, as President Bullard suggested, not to be optimal, and it may not even be very credible. Or if the economy was likely to weaken, this Committee would most likely choose to slow the pace of sales if they thought that was necessary.

We justified the first round of asset purchases as credit easing to help stabilize fragile financial markets. Financial markets are no longer fragile. Hence, we should begin unwinding

these purchases and explain that we are doing so not as a tightening move, but as a move toward normalcy as markets return to normalcy.

Let me summarize by highlighting the questions that were submitted in the memo. On question 1 regarding investments, I do think that the natural first step in exit would be to stop reinvestments of both agencies and Treasuries. The natural time to do that is in June when the LSAP2 is completed. I note that the Chairman will have another press briefing in June, and that will give him the opportunity to fully explain what we are doing and add commentary.

On question 2, regarding whether asset sales should be on a predetermined or preannounced path or actively varied with response to the economic outlook, I do think we need to announce a plan so the public understands where we are headed and how to get there. I also think we should vary the pace of sales with market conditions. My guess is that we will do that anyway. Therefore, we should explain to the public the criteria that we'll be using. The idea of tying it to interest rate decisions simply says we are using the same decision for asset sales and interest rate decisions. If you really believe they are substitutes, you could do them together. If you really wanted to calibrate the difference, you could raise interest rates at a little lesser pace and sell assets at a more rapid pace to get the same effect. I'm not as confident that we can calibrate it that carefully, but you certainly could do that.

Regarding the sequencing of actions in question 3, I would not be in favor of delaying liftoff of the funds rate in favor of asset decisions. I think we should sell assets and raise them concurrently. The policy rate will remain our instrument of monetary policy even if, practically, it is the IOER for a while. In my memo, asset sales would simply be a byproduct of the decision, not an independent decision. The point of asset sales is to return our balance sheet to a more normal size and composition so that we can run a corridor system.

Finally, question 4'I agree with all the points. We should shrink the SOMA portfolio to the size necessary to implement our monetary policy framework. I think the framework should be a corridor system. We should return to an all-Treasuries portfolio, which means we will need to sell agency securities. We should be transparent and communicate our exit plan, including how our asset sales will be adjusted in response to changes in economic conditions. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Plosser, I think you did answer this question, but just so I understand it: If you're tying interest rates and asset sales, suppose the Taylor rule says interest rates have to rise by 25 basis points. Presumably, you would then actually raise it by 12'' basis points, and then'

MR. PLOSSER. Well, again, that's where I was talking about the calibration. If we were comfortable enough with the calibration, you could choose to split the difference, if you will. I don't know that I'm as confident about that calibration, but I would be open to discussing that. The key, I think, is that we tie the two together, so that they're not two independent decisions that we are making in some way; that's what I was trying to get at.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I found the staff memos immensely helpful, and I thank the staff for their work on them.

Exit has two components, timing and sequencing, and I will focus my remarks in this go- round on the issue of sequencing. Timing, of course, is critical, but I will have more to say about that in the later go-rounds.

In general, as my own memo suggested, I like the sequencing in option 1. With that said, I will describe three ways in which I think option 1 in the staff memo could be improved. I will

answer the four questions and then close with a comment about the FOMC statements that the staff proposed for use in connection with exit.

Option 1 in the staff memo has four steps that take place over 15 months: step 1, end reinvestment; step 2, three months later, drop 'extended period' language and begin reserve draining; step 3, six months after that, raise the fed funds rate; and step 4, six months after that, increase the fed funds rate and begin a gradual process of asset sales.

I would make three changes to this plan. First, I want to continue to reinvest payments received from MBS, because one of the things I felt I learned in 2010 was that failing to reinvest MBS payments is a way to generate pro-cyclical monetary accommodation. More specifically, when conditions weaken and long rates decline, people prepay their mortgages; a policy of MBS redemption then implies a fast withdrawal of accommodation, exactly what we don't want when conditions weaken. This is a poor paraphrase, I think, of words that Vice Chairman Dudley uttered last August. Hence, when we end reinvestments, we should do so only for Treasuries.

Second, I don't see the need to begin redemptions before dropping the 'extended period' language. We will still need to drain reserves before raising the fed funds rate. Ending reinvestments three months earlier than dropping the 'extended period' language will have little intrinsic macroeconomic impact, and I think that it is going to introduce lots of uncertainties into the minds of market participants. What I would be willing to do is to combine what I called steps 1 and 2 of option 1'that is, do three things at once, which is to drop the 'extended period' language, begin reserve draining, and end reinvestments of Treasuries all at one time. The staff's plan defers sales until six months after the increase in the fed funds rate. That deferral is okay with me, but I have to say that I don't really see the sharp economic distinction between

redemptions and sales. So I would also be willing to start selling MBS and Treasuries simultaneously with ending reinvestments.

Third, as written, option 1 puts six months between dropping the 'extended period' language and raising rates. I'm not sure why six months is the right length of time. This was the context of my discussion with Brian and Bill earlier about how much time we really need to be thinking about reserve draining. That's the operational gap that I think we have to contemplate, but basically I would consider a two- to four-meeting gap, so three to six months, as being a more appropriate interpretation of the term 'extended period.' And I think we could do a reasonable amount of reserve draining in that time frame as well.

Those are my three changes. I want to continue reinvesting payments from MBS. I would not use ending reinvestment as my first step. I would, instead, combine that with dropping the 'extended period' language and beginning reserve draining. And the final thing is that I think we don't have to wait six months between dropping the 'extended period' language and raising rates. I think three to six months is probably a more appropriate interpretation.

Let me turn to the questions. I have answered a lot of them already, but I'll go through them anyway. As I said earlier, I would not use redemptions as the first step; the first step should be to drop the 'extended period' language and simultaneously begin reserve draining. Redemptions could take place at the same time as that. As indicated, I would want to continue to reinvest MBS proceeds into Treasuries.

I like a slow, largely predetermined path of sales. I agree with President Plosser and Bill that asset sales and fed funds rate increases are largely substitutable ways of affecting the economy. And I think that our economic understanding of the impact of asset sales on the economy is pretty much in its infancy, so I would not use something we don't have such a good

understanding of as an active tool of policy. We needed to use asset purchases because the fed funds rate was at zero, but we can always reduce accommodation by raising the fed funds rate. If the fed funds rate were to hit zero again'as President Bullard points out, negative shocks could hit us in the midst of what we consider our exit strategy'we may need to slow or reverse the path of sales if the deterioration in economic conditions were sufficiently severe.

My answer to question 3'I've used sales and redemptions as basically substitutable ways to reduce the size of the balance sheet. I don't think that balance sheet reduction should begin before you remove the 'extended period' language from the statement. Other than that, I don't have strong views as to when we start. As long as the staff is confident in the efficacy of reserve draining'and I hope we will be able to build that confidence'sales and redemptions can begin after raising the fed funds rate. I don't see why we need to wait six months, but I'm also happy to do so.

Okay. On question 4, the true'false'uncertain choices, I think I've got 'true' on all of these. I realize, of course, there was no right answer to this question, but'[laughter]

MR. PLOSSER. What really matters is your explanation, Narayana.

MR. KOCHERLAKOTA. I'm going to be terse on these. In terms of 4a, I agree with the statement. Consistent with the view expressed in 4a, I prefer a corridor system to a floor system, ultimately. There are definitely some economic benefits to the floor system, which research around the System has pointed to, but all in all, I think the benefits are outweighed by its relative unfamiliarity. I agree with the statement in 4b as well, and I agree with the statement in 4c, except that I always want to be thinking about asset sales and redemptions as being a bundle, a way of reducing the balance sheet as one, so I would talk about asset sales and redemptions being implemented within a framework.

Let me close by saying a word about the suggested FOMC statement about raising the fed funds rate target. This is on page 16 of the exit strategy memo. These are certainly early days to be talking about this kind of stuff, but there are some subtle governance issues we are going to be facing as we move into our exit strategy here. The suggested statement includes a reference to the Board of Governors' action on interest on reserves. I think including the Board of Governors' action in the FOMC statement is confusing and potentially problematic from a governance point of view. I would, instead, make the FOMC statement about the FOMC's actions. The Board of Governors can release a separate statement, presumably at the same time, that could read, 'Consistent with the FOMC's change in its target for the fed funds rate, the Board of Governors voted to change the interest rate on reserves to be' whatever it is. Thank you, Mr. Chairman.

MR. ENGLISH. Well, our intention here was to follow what was done in the past when there were changes in the discount rate and we were aligning the discount rate with changes in the fed funds target. We had the FOMC statement and then, at the very bottom of the press release, there were a couple of sentences saying that the Board of Governors had moved the discount rate. So we were not aiming to do anything new here'just what we thought was the standard procedure.

MR. KOCHERLAKOTA. I guess what I'm thinking is, maybe we should be doing something new, given the novelty of the situation. That's all I'm suggesting.

CHAIRMAN BERNANKE. President Plosser.

MR. PLOSSER. Yes. This is a question both to you, Mr. Chairman, and Narayana. If we think about sales and the IOER'federal funds rate as substitutes, let's suppose the Taylor rule says that the funds rate ought to be 2 percent. Assuming that these are really substitutes, if we

haven't sold assets'and let's just say there's 200 basis points of ease within the portfolio'that means we need to set the IOER at 4 percent. That means if we don't sell, we are going to have to be raising rates faster than we might otherwise choose to do in that environment. Am I understanding that correctly?

MR. KOCHERLAKOTA. That is a correct interpretation of what 'perfect substitutes' would mean.

CHAIRMAN BERNANKE. That is right.

MR. PLOSSER. Whew, I'm glad I passed that test. [Laughter]

CHAIRMAN BERNANKE. And by the same token, if you sell, then you can delay the increase in the fund rate. I would point out, just as a factual matter, that if we begin a redemptions process in December of this year, for example, that 200 basis points is going to shrink away pretty quickly.

MR. PLOSSER. Well, over four years, right?

CHAIRMAN BERNANKE. No. I asked the staff to look at this, and because of the anticipation of a declining balance sheet, even though they estimate that there is a 200 basis point effect as of the fourth quarter of 2010, by the fourth quarter of 2012'that is, a year and a half from now'that would be down to 70 basis points just from redemptions. So that part will get smaller over time, even if we just do redemptions. And part of that is because it depends not just on the size, but on the expected path of sales.

MR. PLOSSER. Okay.

CHAIRMAN BERNANKE. Okay. Are we ready for President Fisher? President Fisher. MR. FISHER. Thank you, Mr. Chairman. You asked for some principles. The

principles, or desiderata, that I would suggest before going into the questions are, first, we wish

to normalize the conduct of monetary policy as quickly as economic conditions allow. To me, that means returning to a system of an active funds market in which the funds rate is the principal instrument of monetary policy.

A second principle would be an obvious one but I think needs to be restated'that we support growth in real activity while guarding against both deflation and excess inflation. To me, that means getting the monetary base back on an approximate 5 percent pre-crisis growth path within a reasonable time'say, three to five years.

The third would be to stop distorting the allocation of capital in favor of housing. To me, the faster we get out of MBS, the better. Shedding those holdings need not result in a rapid shrinkage of our balance sheet. We can always reinvest some or all of the proceeds in Treasuries, but I do believe that we must get away from that kind of asset allocation and social engineering.

Fourth, this may be offensive, but I think we must shut the door, lock the key, and throw it away from the principle that we are ever again going to proceed down the path of monetizing the debt of our government.

And, fifth, we should seek to reduce our exposure to capital losses, but I think that any good portfolio manager, particularly given the mix that we have, can balance that out. I don't accept the formal aspect of not worrying about capital losses because of whatever leeway we have been granted by Treasury or other authorities. I think we are subject to political criticism there. Part of my principles, or desiderata, would be to reduce our exposure to capital losses or at least balance out the losses and gains. To me, that means probably reducing and moving away from our long-term exposure as we proceed to sell assets.

And then, the sixth principle, which is very important to me, would be that we, in all our decisionmaking, maintain the full power of the Federal Open Market Committee in making these various decisions. So now let me turn to the questions that were asked.

With regard to the first'Should the first step be to stop the current policy of reinvesting principal payments from agency securities?'the decision to reinvest principal payments was motivated by having the funds rate at zero. To me, it's a no-brainer that we would want to end the reinvestment program as soon as the Committee was convinced that the time had come to start normalizing policy, just as we have now decided or, I believe, will decide'we will see what the policy round indicates'to stop QE2 expansion. I call the principle the 'stop digging' principle, and to me I would stop digging at least in terms of mortgage-backed securities as soon as we have the leeway to do so.

In terms of the second question about removing policy accommodation'Would we prefer to put asset sales on a largely predetermined or preannounced path?'I think I have heard my previous interlocutors reference this, but to me the 'prudent man' principle applies here. We have never been in a situation like the one we find ourselves in now. You could detect that in the little mini debate or discussion between Bill English and Brian in response to the question of Mr. Hoenig. I think we need to retain as much flexibility as possible to respond to unforeseen or unforeseeable developments as we get back to normal. I do believe some forward guidance would be important. I think President Plosser's proposal is a good attempt to suggest some forward guidance, but we've got to make sure we don't put ourselves in a straitjacket, and not be carried away with confidence about rational expectations or efficient markets. There are some competing needs here. I think we need to allow maximum flexibility.

With regard to the third question about sequencing actions to remove accommodation, and whether we would sell assets before or after or at the same time, I would again suggest that we maintain as much flexibility as possible. I am very sympathetic to President Bullard's argument for LIFO accounting. It is eminently sensible, but, again, maintain flexibility. One advantage of cleaning out the balance sheet before raising rates is that it would at least potentially eliminate the issue of whether the funds rate or the IOER becomes the main policy instrument. I feel strongly that a channel system is preferable, with the funds rate being the main policy instrument and the IOER being some distance below that in normal conditions. But, in my opinion, as long as we have trillions of dollars in excess reserves sloshing around the banking system, the funds rate and the IOER are going to have to move pretty much in lockstep with one another, with the IOER being the real determinant of a bank's willingness to lend out reserves. I am not so sure about the real practicability of the massive use of reverse repos and term deposits to prevent excess reserves from spilling out into the broader economy. I know we've tested those channels, but, given the newness of those instruments, Brian, one might wonder whether they can be used on a scale sufficient to control the excess liquidity that is out there. A middle course of raising the funds rate, IOER, and selling assets all at the same time is probably the best course of action. I think we will have to feel the market to see which is the most effective.

With regard to the statements in the fourth question, the answer is yes, yes, and yes to the first three. With regard to the fourth, about asset sales being communicated to the public in advance, again, I want to be careful we don't put ourselves in a straitjacket. As a former portfolio manager, I would want to maintain as much flexibility as possible. The answer, really, comes down to where I started this discussion or where others have raised the question: What are we trying to get to? What is the purpose of our normalization? I would want to make sure

that we don't put the words before the subject. If we determine the res, the reason for what we're going to do, then it might be more easy to communicate what we intend. But, again, maintain the flexibility. Do not place us in a straitjacket. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Williams.

MR. WILLIAMS. Thank you, Mr. Chairman. I, too, would like to commend the staff on their memo. It was very helpful in thinking about many of the practical issues involved in implementing an exit strategy. I think these are very difficult issues. I have been listening to each person who has gone before me, and I completely agree with the importance of flexibility and with the principles that should be guiding the policy. Many of the thoughts that people have already expressed I agree with, although I come to slightly different conclusions. I am actually, in the end, going to be closer to President Kocherlakota in my views, but I think these are very fine differences, and these are just difficult issues in terms of communication. I think we have to recognize that going forward.

In approaching the questions, I too found it useful to focus on what I thought of as the underlying principles of what we're aiming to do. To me, the most important consideration in designing our exit strategy is to get the timing right in terms of the macroeconomic objectives that we have. Obviously, we have the long-run objective of normalizing our balance sheet. But in terms of the details of sequencing, I think that saying when to begin redemptions or drain reserves or exactly how this is structured should not obscure or hinder our pursuit of the appropriate policy stance.

Now, in thinking about the different choices, I think the evidence shows that the effects of the LSAPs depend on the expectations of the future size and composition of our balance sheet. That's where I start from in terms of thinking about how this works. I view reducing the size of

our balance sheet as working through the same basic channels on the economy as increases in the funds rate, and I see these as being substitutes in terms of the macroeconomy. I also agree with President Kocherlakota's point that both redemptions and sales affect the size of our balance sheet, and I tend to think of those together as opposed to separately. However, there are some critical differences that make these instruments imperfect substitutes in practice. They have already been mentioned. I'll briefly go through two of them. Although our recent experience has provided us with a much better understanding of the effects of the LSAPs than we had just a few years ago, there is still a great deal of uncertainty around these effects. I think the uncertainties about the effects of changing LSAPs far exceed those of comparable movements in the fed funds rate, and this high degree of uncertainty suggests, per the Brainard conservatism principle, that we should follow a cautious and gradual approach to changing the balance sheet going forward.

Second, compared with the fed funds rate, the public still has limited experience and understanding regarding the use of the balance sheet as a policy instrument. This suggests that an active use of the balance sheet, as suggested in option 2, would face greater communication challenges and risks of confusing markets, compared with using the funds rate as our principal policy instrument. These considerations, along with the operational constraints, in terms of the maximum size of asset sales, argue for a steady path of reducing our balance sheet that is preannounced and well communicated. I don't like the word 'deterministic' because it obviously could change in response to conditions. But there should be a relatively high hurdle to modifying the path. I think this approach leaves the fed funds rate as a primary instrument of adjusting the stance of policy either up or down in response to change in economic conditions.

This brings me to another consideration in sequencing the exit strategy: the fact that the short rate is currently constrained by the zero lower bound. To me, this argues for holding off on shrinking our balance sheet until the short rate is well away from the zero bound so that we have the needed flexibility to add accommodation through a rate cut if economic conditions warrant. Again, I'm thinking that the fed funds rate is the primary instrument that you move up and down in response to a change in conditions. So, in this way, I think I would prefer to begin the process of shrinking the balance sheet, both in terms of redemptions and in terms of sales, only after we have instituted a few rate hikes, as envisioned in option 1.

Let me go through the specific questions quickly. On number 1, again, I've viewed redemptions in the same way as asset sales, so I would actually prefer to hold off on any reinvestments until after we raise the funds rate. On number 2, I prefer a path of asset sales that is preannounced and well communicated. And on 3, my view is that we want to lift off the zero lower bound first in order to regain the flexibility to use that instrument as appropriate before we begin asset sales. On number 4, I thought that was an apple pie question, and I'm all for apple pie, so I agree with all of the statements in number 4. [Laughter] I am in favor of eventually returning to an all-Treasuries portfolio with a corridor operating framework. Thank you.

CHAIRMAN BERNANKE. Just for my notes, you said to begin the redemption process after raising rates.

MR. WILLIAMS. And basically thinking of it symmetrically with asset sales. CHAIRMAN BERNANKE. Okay. It's 12:30 p.m. I understand that lunch is ready.

Why don't we recess until 1:00 p.m., bring our lunch back here, and we will still be eating at 1:00, but we'll just recommence the meeting at that point. Okay? Thank you.

[Lunch break]

CHAIRMAN BERNANKE. Okay. Why don't we recommence our meeting? We will continue with President Lacker.

MR. LACKER. Thank you, Mr. Chairman. My preferred strategy for removing policy accommodation, like several others of you, would involve using the funds rate target supported by movements in the interest rate on reserves as the primary instrument of monetary policy. I think asset sales should begin quickly, and I'd advocate that they should proceed at a pace that's significantly more rapid than any of the options shown in the staff's memo. I think that at approximately the rate at which we purchased assets is a good benchmark. The pace of sales should be more or less predetermined, and while we should reserve the right to alter the pace in light of incoming information, I think as President Williams said, the bar for such alterations should be set on the high side. I'll explain my preferences before I touch on the four 'Exodus' questions.

Our asset purchase program was designed to address problems in credit markets and to ease monetary policy, with short-term interest rates at their lower bound. Credit markets seem to be functioning reasonably well right now, and the zero bound doesn't interfere with using interest rates to remove policy accommodation.

The arguments for using asset holdings as a policy tool, thus, aren't symmetric, and they have less force when interest rates are rising. So for me, our large-scale asset sales program' and I'm assuming we're going to refer to this as the LSAS?

CHAIRMAN BERNANKE. You heard it here first. [Laughter]

MR. LACKER. For me, the LSAS should be designed primarily to return our portfolio to normal as rapidly as possible and to help facilitate, as best we can engineer it, the use of the

federal funds rate target as a policy instrument, and not to use our sales program to make short- term, contingent adjustments to monetary conditions.

Now, it is true that heroic work has been done by the New York Fed staff and others as well to try to estimate the term structure effects of LSAPs, but I think we should be careful not to place too much weight on those estimates. They're not very precise, and the identification assumptions are open to serious questions. As a result, I don't think they provide a really strong, reliable basis for using the LSAS as a substitute for interest rate policy or constructing a policy menu in which asset sales trade off against interest rate increases.

As I said, I think asset sales should occur at a relatively rapid pace'specifically, about the same pace at which we purchased assets, around $100 billion a month. I see several reasons for doing so. First, I haven't heard any objections or any convincing stories or theories or evidence about how a well-communicated program of sales would impede market efficiency. I am sure that the more rapidly we sell things, the more rapidly prices might fall or adjust, but I think we've all come around to the stock view rather than the flow view. Price effects, I think, are separate from the efficiency effects that I was discussing with the System Open Market Account Manager earlier.

Second, I see high levels of reserve balances as exacerbating the uncertainty about the effects of our policy rate on the economy, and this is evident in the Desk survey. It showed significantly more variation in what the average view of the spread would be with high balances than with low balances, and I would assume that the uncertainty around those estimates is larger for high balances than for low balances as well. I think high reserve balances are likely to push down other interest rates relative to the interest rate on reserves, and as the Manager said, the zero bound undoubtedly limits that effect; I don't think we have a good sense of just how strong

that limiting effect is. So it seems likely that the magnitude of the effect of high reserve balances on other rates relative to the IOER is going to be different; it's going to change as we increase the interest rate on reserves. Related to policy uncertainty is that I think the high level of reserves amplifies the ever-present risk associated with ex post policy mistakes. With

$1'' trillion of excess reserves, banks essentially have many months of rapid loan growth that's prefunded, and they could draw on that if they view lending opportunities as evolving more favorably. Now, this would quickly become apparent, of course, but I don't think we can rule out the idea that inflation expectations would become unhinged simultaneously with an explosion in lending.

Another reason I prefer a rapid pace of asset sales is to get us out of the credit allocation business. This obviously has the most force with the MBS. Our MBS purchases were unique; they were exceptional and motivated by an assessment that the functioning of those markets was in some sense impaired. Whatever one's view about that assessment of market functioning, those unique and exceptional circumstances clearly have passed, and I think we should acknowledge as much by selling those assets quickly. One way to drain reserves without having to rapidly reduce our asset holdings is for us to issue our own short-term debt, and I want to acknowledge the hard work the staff has done to design, build, and test systems for conducting reverse repos and selling term deposits. But I think these are very unattractive tools, and I strongly oppose using them. Issuing new short-term debt in order to reduce reserve balances and in order to avoid having to sell longer-term debt to effect a similar reduction in reserve balances constitutes a really excessive fine tuning of our intervention across the term structure. It sets the precedent of essentially running a hedge fund, issuing'that is to say, shorting'some securities in order to go long on some other securities. This is more credit allocation to the extent that we

use this to avoid having to sell MBS. And if it's Treasuries we're avoiding selling, this amounts to offsetting the term structure of the debt issued by the Treasury. Either role strikes me as fundamentally inappropriate for an independent central bank. We should issue monetary liabilities funded by a broad, evenly weighted portfolio of Treasuries and leave it at that. I understand that it's possible market rates will not track the IOER closely if we raise interest rates before asset sales have made much of a dent in the balance sheet, but if this occurs, let's accelerate asset sales rather than issue our own debt.

Let me briefly address the four questions. Should our first step be to stop reinvesting MBS proceeds? I say yes.

Should we stop reinvesting Treasury proceeds? Here we're asked to think about reinvesting Treasury proceeds or not, and I prefer to think of this in terms of the size and composition of our balance sheet. Given a path for the size of our balance sheet, how do we want to achieve that? My preference is for a corner solution in which, for any given reduction in asset holdings, we achieve it through MBS sales, and under that principle, the next step after halting MBS reinvestments would be to sell MBS rather than stop reinvesting the Treasury proceeds.

Should asset sales be predetermined or preannounced or highly contingent? As I've said, and with due respect to others like President Plosser who have argued for a more contingent approach, I would prefer a relatively predetermined pace. Of course, nothing we do is predetermined, but I'd envision the funds rate being our main tool and there being a fairly high bar for deviating from a preannounced pace of sales.

Should we start selling before or after we raise the funds rate? I'd prefer to move fairly quickly in winding down our balance sheet. I think we ought to move quickly toward selling

assets along the LIFO lines that President Bullard and others have suggested and sell them at a fairly rapid pace, barring some unforeseen dramatic worsening in the outlook.

So, question 4, do you agree with each of the following statements? Yes. CHAIRMAN BERNANKE. President Pianalto.

MS. PIANALTO. Thank you, Mr. Chairman. I also want to compliment the staff on the background memos and an excellent summary of the options for the exit strategy. I found them to be quite helpful.

As I look around the table, it appears, as individuals, we look like we're in pretty good shape, but our balance sheet has put on quite a few pounds. The staff has given us two paths to weight loss, a gradual path of weaning us off second helpings and bad calories and a more aggressive strategy of balance sheet bariatric surgery. [Laughter] Although we don't have to accept either one of these options in its entirety, I personally prefer option 1 largely as it is laid out in the staff memo. I favored this option last year, and I still find it to be a framework that is clear and reasonably simple to articulate.

I'd like our exit process to appear as familiar and understandable to the public as possible, with the effects that we can reasonably predict from past experience. Therefore, I'd like short-term interest rates to be our primary policy instrument.

Turning to the questions that were provided, in response to question 1 on sequencing our actions to remove policy accommodation, I support beginning the exit process by halting reinvestment of principal payments for agency and Treasury securities. I prefer to get to an all-Treasuries balance sheet over time, which taken by itself would favor halting only the reinvestment of agency securities. However, there are other issues to consider, and we could shrink the balance sheet somewhat faster and explain our actions more simply and effectively in

this first phase by halting all reinvestments of both agencies and Treasuries. Next I would begin to increase our fed funds rate target and the IOER.

In response to question 2, I would prefer to commence asset sales some time after we begin to increase interest rates. I would sell agency debt and agency MBS over a five-year period. I strongly prefer to sell them gradually and on a preannounced path. I think that a preannounced path would help to minimize market concerns about surprise asset sales. That approach would also reinforce a focus on short-term interest rates as our primary policy instrument. I'm not in favor of tying asset sales to changes in the economic outlook unless the outlook were to shift significantly. By putting our asset sales in the background, we can again better focus the public on our adjustments to the fed funds rate and the IOER.

In response to the third question, as I said, I do prefer to sell assets some time after increasing the fed funds rate. I don't place a high priority on rapidly reducing the size of our balance sheet. Instead, I envision us operating for some time with total reserve balances in excess of what would be required in a mature interest rate'targeting framework, even though we would be shrinking the balance sheet over the intermediate term through redemptions and passive asset sales. As we shrink our balance sheet through asset sales, I would put greater priority on reducing our holdings of agency securities than Treasuries. As the economy strengthens and we renormalize policy, we should return to the bedrock principle of Treasuries-only that we've followed in the past.

I agree with the statements listed under question 4. I would make one clarification to the third statement because, as I said, I would adjust the pace of asset sales only if there's a significant change in the economic outlook. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Evans.

MR. EVANS. Thank you, Mr. Chairman, and thanks to the staff for a couple of very nice memos, which were very helpful in thinking about these issues.

I find that I can't completely separate my current assessment of appropriate monetary policy in discussing the exit strategies here, but I'll try to do that. I think it is important that however we go about approaching this, we want to continue to focus on our policy goals and the loss function that we'll be facing and make the appropriate choices in that way. With that in mind, a couple of the''principles' is too strong a word, but'things that I'm thinking about are that I favor an approach that allows for considerable patience in our initial steps toward tightening. I think we want to have the opportunity that, if we start embarking upon this and things happen differently than we are expecting with the economy and inflation, we haven't committed ourselves to a path that is too difficult. We want to maintain flexibility, and we want to have flexibility in both directions because, again, things can happen. We want to maintain optionality in each direction. Now, fortunately, I think that both of the options described in the staff memos can allow for this flexibility, and I simply point to the fact that they have calibrated options 1 and 2 to have about the same amount of policy restraint imposed along the way. So I don't find myself in wild disagreement with either approach.

I do continue to modestly favor option 1, which would entail increasing the federal funds rate before we embark on asset sales, but the way that I tend to think about monetary policy is perhaps a little too simplistically, given the complexities that we have right now. I tend to think of it in terms of the single dimension of our policy restraint, and I think I can map a lot of what you're talking about into that dimension.

I do worry a little bit when we talk about how the funds rate is a familiar tool, we've used it before, and everybody understands that. I think that's certainly true when we're able to put

pressure on reserves the way we always have in the past. But as soon as we start wondering about whether or not our reserve draining tools will actually be as effective as we think and whatnot, we're going to be relying on arbitrage between interest on excess reserves and the funds rate. And while in theory that should work, in practice I'm not quite sure how all that will play out. If we find that we start off on that path and, it is not working out, there will be credibility risks, but at any rate, that's the approach I favor.

On the four questions, yes, I think the first step should be to stop reinvesting. I think of this more in terms of the signaling effect that we get from that because of the unique feature of redemptions versus sales. I think the Treasuries could be reinvested if the balance sheet, the size of it and its composition, was satisfactory, along the lines that President Lacker was suggesting. We ultimately want to end up with a Treasury balance sheet, and so if that works, that's fine.

In terms of actively varying the pace of asset sales, that's not my first choice. I would use the reserve draining tools. But if the state of monetary policy required a quicker restraint, then we'd want to consider upping asset sales faster. Ultimately, that could be a point of compromise between the different views.

In terms of sequencing, I think option 1 is best in my opinion, so that would be sales later'again, making sure that the response to the ultimate stance of monetary policy is really important. And I agree with all of the last three statements as well.

CHAIRMAN BERNANKE. Thank you. President Rosengren.

MR. ROSENGREN. Thank you, Mr. Chairman. As I think about exit strategy, my philosophy would be driven by three guiding principles. First, tightening occurs when we shrink our balance sheet or raise interest rates. If we were to choose to shrink the balance sheet in the late fall, as in the Tealbook, that would, in effect, be our first monetary policy tightening, even

though the federal funds rate would still be at the zero bound. In my view, the start of any tightening action should be primarily focused on when, looking ahead two to three years, the tightening is needed to prevent us from overshooting our inflation or employment mandate. Second, returning to more traditional monetary policy is desirable and requires shrinking the balance sheet. We should shrink the balance sheet in a way consistent with achieving the right macroeconomic outcome. In the short run, that probably means relying on a floor system. And third, while returning to an all-Treasury portfolio is a long-term goal, it should not be a short- term goal. Given the fragility of the housing market, I would not sell any of the mortgage- backed securities until after we have commenced raising short-term interest rates.

So how would I apply these principles to the actual sequencing? Once tightening was appropriate to avoid overshooting on inflation or employment mandates, I would start by allowing mortgage-backed securities to roll off the balance sheet as they matured, which would begin the process of shrinking the balance sheet. After determining the impact of not reinvesting the proceeds for mortgage-backed securities on long-term interest rates and the economy, and assuming further tightening was appropriate, I would begin allowing both Treasury and mortgage-backed securities to roll off the balance sheet as the securities matured. If even more tightening was necessary, I would consider selling short-dated Treasury securities, which would reduce our balance sheet more quickly without realizing significant capital losses or having as large an effect on long rates or mortgage-backed securities.

If we use a rough rule of thumb that's a little bit more conservative than what was discussed before'$250 billion in excess reserve reductions as roughly equivalent to a 25 basis point reduction of the federal funds rate'we have roughly six 25 basis point increases in balance sheet reductions. Should the economy falter, we could slow down redemptions, and if

further tightening was appropriate, we could speed up the time we would return to a normalized size for the balance sheet. Given the natural runoffs in the balance sheet once we begin the redemptions, the balance sheet does begin to shrink relatively quickly if we allow both Treasury and mortgage-backed securities to run off, as the Chairman earlier observed.

If even more tightening is necessary before our balance sheet size has normalized, we would begin by raising interest on excess reserves. Given the Tealbook forecast, I can imagine this would be necessary a year or more after we begin the redemption process. I would use the interest on excess reserves as our principal short-term interest rate until we had normalized the balance sheet. After we had normalized the size of our balance sheet and begun raising interest rates, I would commence with sales of mortgage-backed securities. However, depending on housing conditions, the status of Freddie and Fannie, and our willingness to realize capital losses, I could imagine extending the asset sales to be more gradual and to have an all-Treasuries portfolio by 2020.

In terms of the four questions asked, for the first one, I am fine with reinvesting the principal payments from agency securities, but as I just mentioned, I would stagger it. I would start with mortgage-backed securities and then let the Treasury securities roll off. The reason I want to shrink the balance sheet is that I have somewhat more uncertainty about how the tools are going to work with large excess balances, so I would actually prefer a strategy that gets our balance sheet to shrink initially, just to have more certainty about how our short-run tools are going to work.

In terms of the second question, I think we could conduct it much the way we did the increase in securities. We would announce a reduction in the balance sheet over a fixed period of time, but it would be conditioned on what the economic outcomes were, and we could change

either the time or the amount, but the presumption would be that we wouldn't change it unless something relatively significant had occurred.

In terms of sequencing in the third question, one of the challenges is that sequencing in part does depend on conditions. So if we're going to have a very gradual tightening, then a strategy of asset redemption may actually take care of, at least initially, some of the tightening that we would need to do. If it needs to be more rapid, then we have to include not only asset redemptions, but also the interest on excess reserves going up.

And in terms of the three statements in the fourth question, despite all of us having guiding principles that are different, I think we all agree on all three of the statements.

CHAIRMAN BERNANKE. It shows there is constructive ambiguity. [Laughter] President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. I, too, would like to thank the staff for their framing of a complex set of issues and tradeoffs. Before I answer any questions, I'd like to express some preliminary views.

First, as others have said, I see the endgame as a return to a balance sheet configuration that aligns with more-normal conduct of monetary policy and has the best chance of effectiveness in shaping economic conditions consistent with our mandates. I see that configuration as all-Treasuries, scaled at a level that supports the use of the fed funds rate target as the central policy instrument operating within a corridor structure.

To some extent, removal of accommodation will effectively begin with an announcement effect resulting from our first communication about exit. I think it is possible with good communication to limit the announcement effect on the announcement of ceasing reinvestments, and I think we may be able to limit an announcement effect even with the initiation of small asset

sales, but this will require skillful communication, and it seems to me that the timing would best coincide with the Chairman's press conferences so that he can explain that a rise in the fed funds rate is not necessarily imminent.

The unknown of the announcement effect associated with the first step may be an argument for not taking this action too far in advance of the decision to implement the full exit plan. I think the objective should be that any substantial announcement effects on long rates would occur when we have decided to actively begin removal of accommodation and not before. Said differently, I'd place a high priority on avoiding any actions that inadvertently cause policy tightening to begin before the Committee has arrived at a consensus that tightening is warranted by economic conditions. Because in my view we will be in new territory in unwinding the policy actions of the last three years, I prefer an approach that recognizes that there are a number of unknowns. This in my mind argues for a simple and conservative plan that minimizes the risks of market distortions and can be relatively easily communicated. I would favor an accelerated pace of asset sales only to the extent that policy effectiveness and market function are not put at risk.

With those preliminary comments, let me give answers to the four questions. For question 1, I agree that the first step should be stopping reinvestment of principal payment of agency securities, and I would also stop reinvestment of Treasuries at that time.

For question 2, along with the question of starting the cessation of some or all reinvestments comes the question of when. My thinking is that we would stop reinvestment when the Committee agrees that conditions have evolved to the point that any notion of QE3 can be taken off the table. I favor a predetermined and announced-in-advance path for asset sales. There may be some learning involved as the asset sales proceed, so my preference would be for

an approach that is relatively conservative in terms of the pace of sales. As I said, I do not view a quick reduction of the balance sheet as an end in itself. I would not want to implement sales at a pace that would add a lot of de facto tightening beyond what we intend with interest rate policy. I think it will be possible to communicate a predetermined asset sales program and at the same time convey that the program could be revised or halted if conditions dictate.

For question 3, I would prefer to start asset sales simultaneously with beginning to move the fed funds rate and the interest rate on excess reserves. Given the unknowns, I'm wary of too much sequencing and too many moving parts that have to be coordinated. In my thinking, when the Committee decides it's time to move, all the wheels are set in motion.

I agree with the thrust of the statements in question 4. In some respects, I think the exact process we use to remove policy accommodation is less important than our communications about the timing, magnitude, and conditionality of our planned actions. I would not want any early communications on a framework to impact private expectations in such a way that we end up with a de facto removal of accommodation before we make the decision to change the policy stance.

To summarize, the approach I would recommend tries to achieve simplicity and the least risk, and it's really a two-step approach. At a point not long before active exit, we cease reinvestment of both MBS and Treasuries. Then, simultaneously, we raise the interest on reserves rate and the fed funds rate target, and begin a gradual, orderly, preannounced program of asset sales. We leave to the Desk the decision on draining operations as a tactical move to improve the ability to hit the fed funds rate target, and we communicate that the pace of sales will be reviewed periodically in light of economic conditions. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Hoenig.

MR. HOENIG. Thank you, Mr. Chairman. A couple of people around the table have mentioned 1937, and I think it's an interesting comparison and one we should keep in mind. I think it was in that period that we have some similarities to today. There were efforts to increase taxes and concern about excess reserves that were sloshing around, and I think we doubled reserve requirements overnight, which caused a major shock to the economy. And I certainly would agree that we do not want to shock the economy. And I don't think we're going to double reserve requirements'I certainly hope not'or take actions that would move us in that direction.

The second thing I want to observe is that, as we deal with this exit strategy, I think we will be adjusting it as we learn because whether you like the definition of 'perfect substitutability' or not, we have no idea what the substitutability is between our fed funds rate moves and our removal of the sizable assets on our balance sheet. So it's going to be a careful learning experience for us.

The third thing I want to note is that in part our comments on option 1 or option 2, as I have listened to them around the table, depend on our own intuitive feel for how close we are to needing to take action. I can understand that, because it has influenced my own view; I think that as we look at the economy today, we should be talking about where we are in terms of our accommodation, and that we should in fact be thinking about removing accommodation. It is highly accommodative, as we will talk about later today and tomorrow, and we need to think about doing that. That means I would focus on the fed funds rate, as we always do. And to your point, President Bullard, I think that is what people understand best. They don't understand QE3; they just know it's out there. But they do understand moving interest rates, especially the fed funds rate. And that's what we need to focus on. One other point'I don't know that we

will know whether QE2 has been successful at least until the year 2015. It's a long, long gestation process.

Around those issues, then, how do I answer the questions? How do we proceed, subject to the idea that we need to be thinking about our fed funds policy? I do say yes to the first question that we should in fact stop reinvestments as conditions allow us. But my first step in the exit strategy is to change the forward guidance from exceptionally low interest rates for an extended period of time. That is the key, that is the signal, and we should be thinking about that as we think about exit. With that, our next move should be to move the fed funds rate up'

1 percent by year-end or something'but that means the process has started.

Then, the second question. I think, after raising the fed funds rate to some point, I would pause and assess our economic prospects'where we are, what the effects have been, whether we shocked the market, what are the conditions. When and if conditions warrant, I would then begin again to normalize policy at a deliberate pace, raising the fed funds rate and redeeming and selling securities concurrently to the extent that we can. There is judgment here. We would regularly review changes in the fed funds rate and asset sales in light of incoming information and adjust the exit program as needed to best foster maximum employment and price stability' long-term, stable variables, not short-term ones. As long as conditions unfold as expected, I would also expect to continue normalizing policy at some regular pace. Of course, if economic conditions do not unfold as expected, then we should prepare ourselves to normalize policy more or less rapidly based on those conditions, as we judge them at each meeting.

For the third question, my preferred sequencing is that we raise the fed funds rate from its crisis level to closer to 1 percent as quickly as possible, ideally by year-end. I believe we should then normalize both the fed funds rate and the balance sheet in terms of size, composition, and

duration. I think that part of the reason we are doing these repos and so forth rather than selling assets is that we want to keep the duration on our balance sheet and out of the rest. I think we should try and get that transitioned as well, so we should be selling assets as we can, and on a faster timeline as well.

On question 4, yes, I agree. Of course, my definition of 'intermediate term' may differ from your definition of 'intermediate term.' And that should be a discussion that we have here. I think it's important. I would expect that we can renormalize policy and our balance sheet more timely than either option 1 or option 2 outlines. But I am willing to debate that over time, as long as we get on the path to take this excess accommodation out of the system before we get a very bad surprise on the other end.

With three interest rates'the federal funds rate, the interest rate on excess reserves, and the discount rate'I believe we will eventually move to either a floor system or a corridor system. Before making this decision, though, I would prefer to see how events unfold as we move toward a more normal stance on monetary policy overall. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Vice Chairman.

VICE CHAIRMAN DUDLEY. Thank you, Mr. Chairman. My preferences pretty much track option 1. First, I prefer to start with ending the reinvestment of agency debt and agency MBS. While I agree with President Kocherlakota's point on the pro-cyclicality of agency MBS, and because I made that point last August'[laughter]'I would point out a couple of important caveats that I think make it less important right now. One, the amount of prepayments is actually quite low today. Two, if we are actually tightening and long-term rates are going up, then the prepayments will drop even further. We won't be in that range of where the pro-cyclicality is very powerful. And, three, if the economy is strengthening and housing turnover picks up, the

pro-cyclicality will actually go the other way. We will get more housing turnover, and there will be more churn in the agency MBS market from a healthier housing market. So I am willing to accept what I would view as more limited pro-cyclicality in exchange for wanting to shrink the balance sheet. Second, I would end the Treasury reinvestment. And third, I would eliminate the 'extended period' language.

Now, whether you do these as a package or you do them in a sequence, I think it really depends on economic conditions at the time. I really don't want to prejudge whether we do all three together, or whether we do one and then the other and then the other. It depends on why we are tightening monetary policy. I can imagine if we were tightening monetary policy because inflation expectations were rising, we might want to do it in a more subdued sequence. But if we saw that the economy that was very strong, we might want to do it all together as a package.

Second, I'd drain a large quantity of reserves. I don't think this is absolutely necessary for the conduct of monetary policy, but to the extent that people are worried about the large quantity of the reserves in the banking system and that this could lead to an inflationary problem, we should take steps to attenuate those concerns.

Third, I would raise the interest rate on excess reserves. I do believe this tool is sufficient to manage monetary policy. The signal I take away from the change in the deposit insurance premiums and its impact on the IOER'fed funds rate spreads is that the arbitrage works pretty efficiently because we had a little test case here where we basically changed the arbitrage conditions slightly, and we had a slight impact on the IOER'fed funds rate spread in a way that was pretty predictable. So this tells me that I think the arbitrage is going to work pretty well. We'll see a federal funds rate that is modestly below the interest rate on excess reserves.

And then, last, I would sell the agency MBS and agency debt assets, and I would do so at a measured, predictable pace. I don't think it's necessary to sell these assets; I'm less hung up on the fact that we have agency MBS assets on our balance sheet. But in the medium term, I think the Committee has a consensus that we want to go back to an all-Treasury portfolio. If you want to get there in any reasonable time frame, then you are going to have to sell agency MBS.

I don't believe it makes sense for time-varying sales tied to changes in interest on excess reserves. I think it is too complicated and too difficult to explain. Also, if the sales effect works through changes in expectations on how fast the stock is likely to change, shifting around the sales rate will cause changes in people's views of what the future stock is likely to be. I think that will create volatility in longer-term rates and might even lead to a higher risk premium and higher long-term rates as a consequence. So I think that's a risky strategy.

I generally believe that the sales rate should be relatively slow, because faced with a choice of a flatter yield curve or a steeper yield curve, I would favor a flatter yield curve. The more you rely on asset sales, the more you are going to steepen the yield curve, which I think potentially has negative consequences for financial stability. Also, the more asset sales you do, the more likely you are to incur losses on your portfolio that can create political difficulties for the Fed and potentially pose a threat to the Fed's independence. So, on the asset-sales side, I would like to go relatively slowly. The asset sales pace, of course, could be adjusted, but I think the bar to adjustments should be pretty high because I don't think we want to create uncertainty about what those stock effects are likely to be over time.

With respect to question 4, I think that we all agree that we want to go back to a SOMA portfolio that is no larger than what is consistent with implementing our monetary policy framework. But we should recognize that that size might be somewhat different, depending on

whether we are going to a floor system or a corridor system. We might want a slightly bigger balance sheet if we are headed to a floor system. I think it is premature to decide whether we want a floor system or a corridor system, because we are going to find out a lot about how well a floor system works over the next few years. If that system works very well, we might decide that the simplicity, in terms of how you actually implement a floor system, might make it attractive. So I wouldn't want to rule it out a priori.

I think we should be heading back to an all-Treasury portfolio, but we shouldn't be heading back to the same Treasury portfolio we had before. I think we should have a Treasury portfolio that is much more weighted toward short-term Treasury securities, so that in a crisis you can just let the Treasury securities run off very quickly'you don't have to sell Treasury securities, and you don't have to worry about whether you are taking losses. At some point, it's going to require us to actually buy a bunch of short-dated Treasury securities, if we agree that that is a good portfolio to have. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Kocherlakota.

MR. KOCHERLAKOTA. Thanks, Mr. Chairman. I wanted to follow up on this point that I learned from Vice Chairman Dudley last August, and now I'm apparently going to have to unlearn it. [Laughter]

My concern is that if we adopt a policy of redeeming MBS'suppose we do that in December 2011'and conditions soften in 2012 and longer-term rates fall, we will then be put in the position of stopping the policy at that point, because it could well be at that stage that we will begin to see people starting to pay down their mortgages more rapidly, just as we did in August 2010. My vision, as I think I have heard from others around the table, is that the balance sheet track should be going on slowly downward in the background. If we redeem MBS, we are going

to be in the position of balance sheet management immediately. That is what I took away from that.

VICE CHAIRMAN DUDLEY. Can I respond to that? I think what you are describing is an environment where you don't want to be tightening at all. If you start tightening and then all of a sudden decide you don't want to be tightening, then I don't really have a problem reversing the agency MBS reinvestment policy.

CHAIRMAN BERNANKE. Okay. Governor Yellen.

MS. YELLEN. Thank you, Mr. Chairman. And let me add my thanks to the staff for their helpful background papers and to President Plosser for his thoughtful memo.

As I reviewed those materials, I was struck that the problem before us is a classic example of an underdetermined optimization problem. There are a number of free parameters and a multiplicity of ways we can set our instruments to attain any particular macroeconomic outcome. In selecting among the various options, I believe we should focus on approaches that, first, serve to simplify and, therefore, facilitate our internal decisionmaking as we respond over time to evolving economic developments. And, second, we should focus on approaches that facilitate clarity in our external communications to the public.

An analogy might be helpful in explaining what I have in mind. Imagine that our Committee is the flight crew of a Boeing 747. We need to land at night at a nearly deserted airport, but we discover that the air traffic controller has fallen asleep on the job. [Laughter] The good news is, we have a brilliant and highly experienced pilot, and all of us trust him to accomplish a safe landing. Nonetheless, we have to keep in mind a few key facts. First, the instrument panel of a Boeing 747 has lots of dials and instruments. There is no unique right way to adjust them during the approach. Second, the cockpit is crowded, and the crew needs to work

together harmoniously to execute a successful landing. And, third, the passengers are all listening on the intercom system'[laughter]'and may be prone to panic. Our communications need to be clear, simple, and reassuring.

How does this analogy apply to our exit strategy? Well, first and foremost, I suggest that we agree on where we're landing. [Laughter] In the context of our exit strategy, where we are landing includes a number of distinct components. The first relates to our dual mandate objectives. We need to be clear, both internally and in our public communications, that, first and foremost, our exit strategy is designed to facilitate their attainment. Second, the Federal Reserve is also responsible to contribute to the effective and efficient functioning of financial markets, so we should avoid needless disruption. And, finally, there are questions relating to the ultimate size and composition of our balance sheet and the operating strategy we've planned for the conduct of policy when life returns to normal. I consider it desirable for us to decide and communicate early our decisions concerning all of these matters, not leave them unsettled for months or years to come.

In this regard, I support all three principles listed in item number 4 of the 'Questions for Discussion' handout, and I think it would be very helpful, Mr. Chairman, for you to convey them in your press conference tomorrow. I think it would also be beneficial for us to reach some consensus on our long-run operating framework. And I personally could support a return over time to a corridor-style operating framework in which the fed funds target is our primary instrument of monetary policy, even though I do see some advantages of a floor framework.

Turning next to our landing procedures, the memos and our previous discussion make clear that there are many options consistent with any given macroeconomic outcome. All in all, I see a strong rationale for following a KISS'or Keep It Simple, Stupid'approach. I see a

compelling case for setting the path of the federal funds rate target in a state-contingent manner that would be consistent with our past practice and with market experience and expectations. Those of us in the cockpit have followed this approach in the past, so it should facilitate our decisionmaking process. For the passengers, too, it is familiar, and therefore likely to be reassuring. And, in particular, I would be strongly opposed to an exit strategy in which adjustments for both our balance sheet and the federal funds rate target are highly state- contingent.

Making use of two monetary policy instruments at the same time has no clear benefits but would surely introduce a further layer of complexity into our decisionmaking process and our public communications. I think we should follow a largely predetermined approach to normalizing the size and composition of our balance sheet. I would prefer for us to agree on that approach as soon as possible and explain it clearly to the public.

Regarding the initial stages of the descent, I would support stopping reinvestment of principal as a first step, and my assumption has been that that would include both Treasury and agency securities. But I think it would be useful, in light of the issue that President Kocherlakota raised, to maybe just see a bit more staff analysis on the implications of allowing MBS to run off. I suspect that a decision to suspend our reinvestment policy will clearly signal the onset of policy firming to the markets and the public. Therefore, I am not certain there is any particular advantage in waiting to drop the 'extended period' language. It might, instead, be helpful to follow a simpler exit sequence in which we move simultaneously to suspend reinvestment policy and change our forward guidance.

Turning to the issue of asset sales, I think they should be gradual, predictable, and announced in advance. Beyond that, I am open to considering various possibilities. For

example, I would be open to decoupling our strategy for normalizing the size of the balance sheet from our strategy for normalizing its composition. My assumption is that it is the size of our longer-term securities holdings, rather than their composition as between agency and Treasury securities, that affects term premiums and the stance of policy. I also assume that such a shift would have only a negligible effect on MBS spreads. If these assumptions are correct, we could begin to normalize the composition of our balance sheet fairly soon. For example, the Desk could initiate gradual and predictable sales of agency MBS maybe on the order of

$10 billion or $15 billion a month, reinvesting the proceeds into Treasuries.

I would only want our balance sheet to begin shrinking when we have concluded that the process of policy firming should commence. When that point arrives, though, along with suspending the reinvestment policy, we could also stop rolling over the proceeds of these MBS sales into Treasuries. This strategy would facilitate a moderately faster shrinkage of our balance sheet and would reduce the quantity of bank reserves by a nonnegligible amount before any increase in IOER. An advantage of this strategy is that, with a smaller quantity of reserves, we may have greater confidence in the ability of our reserve draining tools to sufficiently tighten the link between IOER and the federal funds rate. I may be wrong to worry about this link between IOER and the federal funds rate, but, like President Evans, I do have some concerns about how tight that link will be. And I think a tighter linkage between these rates would prove helpful for both internal decisionmaking and external communications.

CHAIRMAN BERNANKE. Thank you. Governor Duke.

MS. DUKE. Thank you, Mr. Chairman. I would also like to commend the staff for the work on the memos, and I will confess that I failed to identify this as an underdetermined optimization problem. [Laughter]

Over the last several years, I have supported asset purchases as our only option for

easing. But when it comes time to tighten, we can return to the short-term interest rate tool, and I believe we should. I agree with Brian Sack; it is still the strongest tool in our kit. I can't quarrel with the political risk of maintaining a large balance sheet or the credit allocation argument. But, still, I favor the use of the short-term interest rate tool whenever and as soon as it's available and would address our concerns about the balance sheet only when our interest rate tool is fully functional again. We have experience with it. The public has experience with it. It's easier to calibrate and to communicate.

In December 2008, when we made the decision to reduce the fed funds target to its current level, I worried about many of the consequences that we've discussed again here today' the narrow potential for spreads to adjust to preferred levels, pressure on the recovery of operating costs in money market funds and in banks. I am also concerned about the potential distortions created by near-zero short-term interest rates. So I favor the strategy that gets nominal short-term rates back into a normal range the soonest. I say 'short-term interest rates' because I think there is some risk in focusing on the fed funds rate as long as that market is limited to GSEs and a handful of counterparties. I think the lesson we should take from the recent experience with the FDIC assessments is that short-term markets may react differently depending on whether they are dominated by U.S. banks that can earn interest on excess reserves and must pay FDIC assessments, foreign banks who can earn interest on excess reserves but do not pay FDIC assessments, or other players who do not have access to excess reserves as an investment alternative but also do not pay FDIC assessments. Along these lines, I believe we may observe different results in the use of the reverse repo tool compared with term deposits,

and I believe banks will bid differently on term deposits when they are offered in size and with an expectation of increasing rates.

I'm a little bit concerned about the airline analogy, because now I am going to talk about throwing fuel overboard in order to reduce our landing weight. [Laughter] While I favor the exit sequence outlined in option 1, I fear that we might have to reduce our balance sheet more than we think to get reserves down to the point where temporary draining tools can tighten the link between IOER and other short-term rates.

Turning to the specific questions asked, I agree that the first step should be redemption of agency securities, and I would favor redemption of Treasury securities only if that step was not anticipated to push back the first use of the interest rate tool. I would put assets on a predetermined, preannounced path, subject to infrequent adjustments. I would not be in favor of any asset sales that delayed liftoff of the funds rate. However, once the funds rate was returned to a level that allowed us to use it for tightening or easing'say, fed funds at 2 percent'then I might favor asset sales that reduce the balance sheet more rapidly but delay further increases in the funds rate. I agree with all the statements in question 4, as long as adjustments to asset sales are not viewed as an active policy adjustment tool. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Tarullo.

MR. TARULLO. Thank you, Mr. Chairman. Bill Nelson suggested that there may be some variants on the two options he presented. I have counted 14 so far. [Laughter] And I think I am going to use a strategy taken in the very best exam that I ever read from any of the roughly 2,000 students I have ever had, which was to refuse to answer the question that I had put on the exam. I should also add some of the worst exams I ever got were ones that followed a similar strategy. [Laughter]

As I have listened to everybody today, I am a bit concerned about where we're heading and what we think we are communicating by this discussion. And mindful of the Chairman's introduction where he suggested we are trying to find some principles, I am going to try to identify some principles rather than programs. I think many of you have felt the tension between these and have suggested where there is some flexibility or where you are open to other things. But for present purposes, I think it is particularly important to arm the Chairman with a smaller number of first principles that can be developed, as appropriate, over the coming meetings.

First, I think that the strategy we pursue here should be about, and principally about, our monetary policy aims in the short run. That may sound almost tautological, but I don't think it is. Some people are offended by having MBSs on the balance sheet, and some people are worried that we appear to be monetizing debt by having Treasuries on the balance sheet. Well, we've got both of them on the balance sheet. And those decisions were taken, and I wouldn't want to see our exit strategy affected by some idealized desire to either have or not have some of these assets on the balance sheet as an ongoing matter. Let's instead focus on what is the best way to achieve, as we believe appropriate, the removal of accommodation when the time comes. So that translates into, I think, a fair number of operational decisions that need to be made along the way, but ones that should be pretty straightforward.

Second, as the Chairman suggested, I think anything that we communicate ought to be provisional. And although I didn't take the notes that he's been taking, because I don't have to synthesize everything, it seemed to me that at least half of you have suggested'whether state- contingent or provisional or conditional'some adjective that suggests we shouldn't be locking ourselves in too much right now.

Third, I also would like to see a pretty clear separation of the 'when we exit' from the 'how we exit' questions. I think Tom is absolutely right'everybody's views are affected, at least on the margin, by our policy predispositions. But, again, in terms of public communication right now, I think it's really quite important to keep those distinct, even though it is perfectly legitimate to address both of those questions.

I would say that my fourth principle would be a certain degree of caution, particularly with respect to unintended consequences of things we don't understand as well as we wish we did. Narayana suggested that we don't rely too much on models for thinking about what the impact of large-scale asset sales will be, and I think that's a caution well taken. I, like Bill, worry about yield curve effects if, for example, you had too many assets sold too quickly. Listening to you and trying to pull some of what different people have said together, it seems to me there have been concerns about getting the balance sheet to a manageable state so that our effect on the federal funds rate will proceed as we would like it to. At the same time, a lot of people have shown concern that there not be too much riling of the markets because we are not really entirely sure of how asset sales will be received. A number of you have also said that some measure of predictability will both advance the aim of avoiding too much riling of the markets and allow people to plan a little bit more going forward.

All of those suggest to me that a fairly cautious but straightforward and largely, though not totally, predetermined approach to asset sales, redemptions, or both is probably what's warranted here. I see a certain appeal to going in reverse, what Jim described as the LIFO approach. But I think there are a couple of points of distinction that we should be aware of. One is that the effects of these sales may differ from the effects of the purchases of the same assets precisely because the macro and financial environments in which the transactions are taking

place are quite different. Second, to a considerable extent, we didn't have a whole lot of choice about the sequence that was followed on the way in. You guys moved interest rates down to zero before I got here. Then you had your 'extended period' tool, and then it became necessary to think about large-scale asset purchases. But on the way out, we do have a choice, and I think that assessing the pros and cons of various sequences and various combinations is probably the better optimization of policy here.

There are multiple instruments available for the removal of accommodation, and I think a number of you have identified them. I genuinely don't have strong priors on those, so I would just reiterate that I think the principle should be a focus on the desired near-term monetary policy effects, thereby putting into a secondary position what I termed 'idealized aims'; second, that this is provisional; third, that we separate 'when' from 'how'; and, fourth, that, particularly with respect to asset sales, we try to adopt a gradual and predictable approach. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Raskin.

MS. RASKIN. Thank you, Mr. Chairman. I appreciate the richness of this debate regarding the parameters of exit, and while I believe it premature to begin the exit program, it's certainly not premature to discuss the contours of what will be a process that, if poorly conceived and poorly communicated and poorly received, could lead to unintended macroeconomic consequences. For that reason, I applaud the fact that we're now having this discussion, and while not being present for the precursors to the analysis that began in April of last year, appreciate both that there's been a lot of careful thought on this topic and that the duration and components of the accommodation are different now than they were in April of last year.

I have several observations. First, I want to underscore the Chairman's view that public statements regarding exit not confuse the notion of 'when' with the notion of 'how.'

Second, both options for sequencing, as presented in the staff memo, assume that a sizable amount of reserve draining will be conducted before the first anticipated increase in the federal funds rate target. I'm still grappling with how such a sizable amount is going to be reduced in a mere six months in option 1 or in a mere three months in option 2. I understand President Lockhart's concern about starting the draining too early, but if reserves are as high as $1.6 trillion and the required reserve level at which movements in the federal funds rate affect loan balances is at something like $74 billion, how do we drain $1'' trillion in the short period of time without disruptions? If these reductions prove to be too slow and there is strong evidence that a recovery is self-sustaining, perhaps we would then feel it necessary to engage in some accelerated asset sales ahead of a preannounced schedule in order to drain.

Third, I want to make sure we understand the current effect of the GSEs in the federal funds markets. Commercial banks are awash in reserves. So my question is whether the largest sell-side participants right now are Fannie Mae and Freddie Mac. Now, footnotes 17 and 18 of the staff's memo on the long-run policy implementation frameworks describe why limits to arbitrage have resulted in market rates typically being in the range of 10 to 15 basis points below the interest rate on excess reserves. So if we suppose that the Chairman and the Secretary of the Treasury agreed that Fannie and Freddie could no longer be part of the federal funds market, would we then remove the ability for commercial banks to trade with the GSEs in such a way as to eliminate the gap between market rates and the interest rate on excess reserves? So then if the federal funds rate were at the IOER, the FOMC, it seems to me, would have greater control when it begins to raise the IOER because the fed funds rate would move exactly with it.

Fourth, regardless of whether Fannie and Freddie remain part of the federal funds market, I want to underscore the communication challenge that was raised by President Bullard and others that will need to be addressed, and that is that raising the interest rate on excess reserves will result in annual payments to banks, which will certainly require some explanation to the Congress and others in the public.

Finally, when we discuss asset sales, we assume that such sales include sales of Treasuries in addition to sales of agency debt and agency MBS. As we've heard, there are permutations to how these sales are executed that involve sales of one type before sales of another type, and from this perspective, I think it's worth remembering that MBS have a more direct linkage to mortgage rates than do Treasury bills. Also, it's worth noting that President Kocherlakota's observation regarding the pro-cyclicality in MBS sales needs to be factored in ahead of time as well, if we decide to start MBS sales ahead of Treasury sales.

I will turn quickly to the questions. One, Should the first step in exit be to stop the current policy of reinvesting? I would say, yes. I think that redemptions would generate a significant reduction in the balance sheet under an approach that is operationally simple, easily communicated, and not disruptive to markets. For the second question, it is also my view that putting asset sales on a largely predetermined and preannounced path is preferable. I haven't yet bought into the full substitutability of the two tools primarily because of a lack of a robust experiment in that regard. Third, at this moment I probably would favor starting to sell assets after the increase in the federal funds rate. I don't place a high priority on reducing the size of the SOMA portfolio quickly, especially if that would delay liftoff of the federal funds rate. Of course, I would say that subject to the caveats I mentioned regarding the ability to drain or a

dangerous supply shock that would trigger a big jump in inflationary expectations. And I do agree with the three statements in question four. Thank you.

CHAIRMAN BERNANKE. Thank you very much, and thanks, everyone, for a very useful discussion.

In terms of synthesizing [laughter] this discussion, we have a short-term and a long-term issue. In the weeks ahead as the staff adroitly puts together the minutes, as they always do, I hope that they will go carefully through the transcript and try to identify the main themes that will help us think about how we'll go forward.

I have a more immediate problem, which is that tomorrow I'm going to be asked what the Committee has determined about exit strategy. So I'm going to try to put some principles or bullet points down here'Debbie is going to write them down for me'and then let me go through them, and we can decide if some should be struck or qualified or whatever.

First is that we had a useful discussion.

MR. TARULLO. I disagree. [Laughter]

CHAIRMAN BERNANKE. And second, relating to what Governor Tarullo said, the most important thing, of course, is to meet our monetary policy objectives, and the pace and sequencing of our actions will be driven by those objectives. In particular, the fact that we're discussing exit does not necessarily carry implications for near-term monetary policy.

Now, getting into more substance'first, I think most people were willing to say that they thought that the federal funds rate/IOER should be the principal tool for responding to macroeconomic developments. I would add that, as a practical matter and taking into account President Lacker's very astute comments, to make IOER effective, it will probably need to be

supported by the draining tools that we've discussed in this room for some time. So I would put the funds rate /IOER in the center of our strategy.

Second, I would say that our forward guidance and our communication will provide as much warning as possible as we move toward the point where we begin to raise the short-term interest rate.

The remainder of the points, some of which may perhaps be controversial, bear on how we're going to deal with the balance sheet. The first one is that I believe that a pretty strong majority agreed with the view that restarting redemptions'and I wouldn't be specific about agencies versus Treasuries, et cetera'could be something that might happen relatively early in the process. Next'and here I would turn to the three statements on the sheet'one objective we have is that in the intermediate term we want to return to a normal monetary policy framework. I don't think it's time to start talking to the public about corridors and floors, but maybe a 'normal framework' that I think most people would interpret as something close to a corridor system.

The second of these principles is that our exit strategy involves going to an all-Treasury balance sheet.

The third principle bears on the question of the pace and conditionality of asset sales, and there we got quite a bit of divergence, particularly when weighted by enthusiasm. Now, a majority of the speakers did prefer a relatively steady pace of sales, although a couple of those folks were for very rapid sales and others were for more gradual sales, so it's a little hard to rank those views. On the other hand, I think most of the people who favored a relatively gradual sales process were open to the proposition that the pace of sales could be adjusted if macroeconomic conditions called for it. So I would propose to summarize that detailed discussion with the last of the three bullet points, which says that there will be a framework that will be 'communicated

to the public in advance, and at a pace that potentially could be adjusted in response to changes in economic or financial conditions.' I think the 'potentially could be adjusted' leans a little bit toward nonconditionality, but I think it includes the possibility that we can respond and we will respond if economic conditions warrant.

Finally'and this is a difficult one'When will the asset sales take place? Now, again, in simple counts, a pretty clear majority, but again with different motivations and different perspectives, favored asset sales after the increase in the federal funds rate. We had a few people who suggested a contemporaneous move, such as President Plosser and President Lockhart. President Bullard, of course, made his very interesting intervention about the LIFO principle. A few people, like President Lacker, wanted to move very quickly, so that, implicitly, sales would come very early. I think, looking at the balance of the discussion, what I'd like to do is say something like 'most, but not all,' or 'many,' or something like that, 'saw sales as taking place,' and I would say here, again, vaguely, 'relatively late in the process,' which would encompass, perhaps, 'contemporaneous with the increase in rates,' like President Hoenig suggested, or 'afterward''but again, acknowledging that some people had a different perspective.

So these would be some interim things that I would try to report, again, as asked. Some of these details may not come up, but I suspect some of them will.

MR. FISHER. Could you clarify, Mr. Chairman, that last point? I have a feeling that will come up.

CHAIRMAN BERNANKE. The last point, yes. I've got a little diagram here that shows the interest rate being increased, and then the question is: Where do asset sales come on this timeline? I note that a few people were in the contemporaneous camp'and, President Fisher, I

have you there with an arrow pointed to the left, meaning that you're happy to go along with the Bullard perspective. That being said, a pretty significant majority still were on the right side of that line'that is, suggesting that asset sales should begin after the interest rate increases would begin, and that's consistent, I think, with the view that the federal funds rate is the key policy tool. I think this is an area where there was legitimate and interesting ongoing discussion that we shouldn't cut off.

Again, what I proposed was to hedge in two ways. One, we would say that 'most, but not all,' or 'many,' or something like that, 'preferred,' and then to use some term like 'relatively late in the process' to encompass contemporaneous or later sales. This may be even a little too weak, but that was my thought.

I'd be happy to go through any of these again. I don't promise even that they'll come out exactly as I just spoke them. President Plosser.

MR. PLOSSER. I have just two observations. I think you're being asked to synthesize a lot of diverse views, and I understand that. I think your first point was that the asset sales or the reduction in the balance sheet would depend on economic conditions. I would encourage you to say that they can either be slowed down or speeded up, because I think the tone of how you say it will suggest that it's only likely to go one way. It would be helpful to say that it could go either faster or slower depending on economic conditions.

CHAIRMAN BERNANKE. Okay. Well, 'at a pace that potentially could be adjusted in response to changes.'

MR. PLOSSER. Up or down.

CHAIRMAN BERNANKE. Yes, up or down.

MR. PLOSSER. Okay. On the last part, I would recommend against the phrase 'relatively late' because I think that connotes a longer period of time, and it may not be longer. I would suggest that you consider something like, 'Many of the participants agreed that asset sales would begin after''just 'after'''initial rate increases.' And 'after' can mean it could be short or it could be long. It just leaves it undefined.

CHAIRMAN BERNANKE. Can I say 'after' if I say 'many' and I'm very clear that there's still an open debate on this question?

MR. LACKER. Would it help to say 'after in the sequence?'

CHAIRMAN BERNANKE. Okay. In the sequence we had last year the redemptions weren't much of an issue. Now we have redemptions early or one of the first steps. We have changes in the language, obviously, as one of the first steps. We have in the center of this process the increase in interest rates supported by draining tools. And then, most, but certainly not all'and we have an ongoing debate'preferred that the sales begin after the first increase in the IOER.

President Bullard, I know you're going to be giving your point of view, and I think it's an interesting point of view, but I'll try to make sure that I am clear that these things are not fine lines.

MR. BULLARD. I do think you're summarizing the disparate views of the Committee fairly well, but I think this issue about redemptions being a lot different from asset sales is potentially confusing. In a sense we are starting with the balance sheet if you went by the sequence, but we're going to start in a certain way with the balance sheet.

CHAIRMAN BERNANKE. Yes.

MR. BULLARD. And it's just that the Committee seems to be reluctant to go as far as I would in wanting to adjust that.

CHAIRMAN BERNANKE. Well, it's true that they both shrink the balance sheet, but redemptions are predictable, passive, but I agree that there is sort of a LIFO principle there though.

MR. BULLARD. Yes.

CHAIRMAN BERNANKE. So I agree with that. Any further comments? Governor Tarullo.

MR. TARULLO. Can I just ask a question? In the same spirit in which I spoke in the go-round, I guess I would just ask the question of how deeply you want to get into this tomorrow, given where the Committee is right now. That is, one strategy is to try fairly, as I think you have in your summation, to characterize how the Committee breaks down on a number of substantive dimensions with some specificity. Another would be to try to identify genuine consensus where it's there, and I think you've got it on those three true'false questions, but in other areas, maybe intentionally to generalize so as not to get too deeply into some of these questions. For example, as I was listening to these guys at the end of the table, I found myself thinking a little bit differently about the redemption versus asset sales point than I had before, and to me it's not so fundamental to our approach. Maybe it is to some people. I guess I just wonder whether in a press conference you want to begin talking about those things, thereby potentially inviting further specific questions. My question is not a rhetorical one. It's a genuine one.

CHAIRMAN BERNANKE. I think I have to balance, as you say. I mean, I can't go into too great a detail, but I hardly can deny that we had this conversation because the minutes will come out and many of these issues will be on the table. President Fisher.

MR. FISHER. I want to second that point. I think the more you begin to process, the more you're likely to get questions that force you further to process. I think providing these general outlines and a direction is what counts here. You're going to have subsequent press conferences, but it could be a trap. So I agree with Governor Tarullo on this front, and I would just be as general as possible.

CHAIRMAN BERNANKE. On the other hand, the point of this is to be more transparent and to provide some help and guidance.

MR. FISHER. Still, you're going to get questions on specifics of sequence and all of these kinds of things if you're not careful.

CHAIRMAN BERNANKE. Well, I obviously won't be able to answer detailed questions, because I don't know the answer.

MR. TARULLO. I don't think this is a matter of being more or less transparent in a sense because I think you're trying to communicate where we are at this point.

CHAIRMAN BERNANKE. I will try to do that, but I did want to make sure I knew where we were. [Laughter] President Lacker.

MR. LACKER. I find myself very sympathetic to Governor Tarullo's points. On this last issue, which seems to be the one where it comes to a head, do you worry that just mentioning the views of a majority might lead a stampede of opinion to focus on that and treat it as if it's a decision? And the constructive alternative would be to mention that there are a range of views. The majority seems to favor, but there are those who have other views and we haven't decided.

CHAIRMAN BERNANKE. I said I would say that.

MR. LACKER. Oh, okay. Mention the other views as well.

CHAIRMAN BERNANKE. I will be clear. Where appropriate, I will give a range of

views. I just don't want to be clearly less forthcoming than the minutes will be on something

like that, if asked. I'm not going to go out and say, 'Here's the deal, guys,' and give them the

story. But if asked about that, I'll try to convey the sense that there was a range of views.

All right. Well, I hope that all the press conferences will not generate this problem, but

thank you for that conversation. Any other comments? [No response]

CHAIRMAN BERNANKE. Well, wouldn't this be a great time for a break? [Laughter]

I'm informed the coffee is at'three o'clock?

MS. DANKER. We can just go look and see if it's there.

CHAIRMAN BERNANKE. All right. My right-hand woman is going to go look. Is it

ready?

MS. DANKER. Keep going.

CHAIRMAN BERNANKE. We should keep going? Okay. We can hear the staff

presentation and then at three o'clock we will have a coffee break. So let me turn this over now

to David Wilcox.

MR. WILCOX. Thank you, Mr. Chairman. It's been a humbling realization as the hours have gone by that the only shot I have at garnering a round of applause would be to say, 'Nathan and I will now be happy to take your questions.' However, I am going to dash any hopes you might have along those lines and give you my full prepared remarks.

As you know from the Tealbook, a lengthy list of indicators came in to the disappointing side of our expectations during the intermeeting period. I will keep the recitation here short and come back to some of these items later in my remarks, and simply note now that both the residential and nonresidential construction sectors succeeded in tripping on the already-low bars we had set for them in the March Tealbook; state and local spending was similarly even softer than we had expected;

Based on these considerations, we boosted our forecast of core PCE inflation both this year and next by 0.2 percentage point, to 1.4 percent.

As for headline PCE inflation, factoring in the direct effects of the incoming data on domestic retail energy and food prices brought our forecast for topline PCE inflation this year up to 2.2 percent'three-tenths faster than we had projected in the March Tealbook. Next year, we have food and energy prices decelerating sharply, essentially in line with available readings from futures markets, and as a result, topline PCE inflation falls back to 1.2 percent.

It's a little difficult to compare our inflation outlook with those of outside forecasters, partly because the most recent available Survey of Professional Forecasters dates from mid-February, and partly because the Blue Chip survey does not poll its participants about PCE inflation but focuses instead on the CPI. But it might be worth noting that our outlook for overall CPI inflation is essentially the same as the Blue Chip's forecast for this year and 1 percentage point lower next year. With regard to core PCE inflation, our projection is a couple of tenths higher than Macroeconomic Advisers' for both this year and next, and a couple of tenths lower than the somewhat dated SPF projection for next year.

Similar to our analysis with regard to real GDP and the unemployment rate, we continue to see the amount of uncertainty surrounding our inflation projection as elevated relative to the standard of the past 20 years, and we see the risks around our forecast as balanced. And now, Nathan will continue our report.

MR. SHEETS.3 Even as recent readings on economic activity in the United States have surprised on the downside, data for the foreign economies have come in somewhat above our expectations. With the notable exception of Japan, industrial production and PMIs in the advanced economies have generally remained upbeat. And monthly indicators for the EMEs have also shown strength. We now estimate that foreign GDP rose at a 4 percent pace in the first quarter, nearly '' percentage point more than in our last forecast. Looking ahead, we see foreign growth in the current quarter dipping to 2'' percent, down more than '' percentage point from March, mainly reflecting the effects of the Japanese earthquake. Thereafter, growth abroad should recover to a 3'' percent pace, as the rebuilding process in Japan commences, supply chains normalize, and strong growth in the emerging market economies continues.

Given the favorable expected performance of foreign activity, coupled with

continued projected depreciation of the dollar (mainly against the emerging market currencies), we see net exports making a positive contribution to U.S. GDP growth of roughly '' to '' percentage point on average over the forecast horizon. Notably, our forecast implies that the trade balance excluding oil imports will turn positive in 2012 for the first time in two decades, marking an important milestone for U.S. external adjustment.

3The materials used by Mr. Sheets are appended to this transcript (appendix 3).

But my colleagues David Bowman and Joseph Gruber have observed that these upward surprises in commodity prices came in step with corresponding upward surprises regarding the strength of emerging Asian economic growth. As shown in the bottom panels, consensus forecasts of the long-term growth rates of industrial production in China and in the rest of emerging Asia also were consistently revised upward over this period. As we have noted previously, these emerging Asian economies accounted for much of the increased consumption of oil and other commodities over the past decade. In addition, on the supply side, forecasts of world oil production and copper extraction have tended to surprise analysts on the downside, falling short of projections over the past decade. This work underscores the role of fundamentals in explaining commodity prices, but it also finds that movements in commodity prices are driven by surprises in growth, more than by the pace of growth per se. This suggests that it may be fruitful to adjust the futures curves to account for differences between staff forecasts of global growth, exchange rates, and other relevant variables and the private forecasts that implicitly underpin these curves. We have not yet fully tested whether this approach would in fact produce commodity price forecasts that have improved forecasting properties, but it would at least yield projections that were directly conditioned on the staff's outlook. We plan to have more to say about these issues by the time of the June FOMC meeting. Fabio will now continue our presentation.

MR. NATALUCCI.4 I will be referring to the package labeled 'Material for Briefing on FOMC Participants' Economic Projections.' Exhibit 1 depicts the broad contours of your current projections for 2011 through 2013 and over the longer run. As shown, you continue to expect a gradual economic recovery over the next three years, with GDP growth'the top panel'picking up modestly for this year as a whole and accelerating further in 2012 and a bit more in 2013, while the unemployment rate'the second panel'slowly trends lower. With regard to inflation'the bottom two panels'although you anticipate that total PCE inflation will move up this year, you project this increase to be temporary, with headline inflation moving back in line with core inflation in 2012 and 2013. However, you generally see core inflation gradually edging higher over the next two years.

Exhibit 2 reports the central tendencies and ranges of your projections for 2011 through 2013 and over the longer run; the corresponding information about your January projections is indicated in italics, and the current and January Tealbook projections are included as memo items. On balance, your forecasts for this meeting point to somewhat lower GDP growth and slightly higher inflation over the forecast period than you projected at the time of the January meeting. In your forecast narratives, almost all of you indicated that these changes were the result of weaker- than-expected incoming data and higher commodity prices. A number of you also pointed to greater odds of a tighter stance of fiscal policy during the forecast period. All of you marked down your projections for real GDP growth this year, with the central tendency of your estimates, shown in the top panel, noticeably lower than in January: Most of you now anticipate that real GDP will increase about 3 to

4The materials used by Mr. Natalucci are appended to this transcript (appendix 4).

rate (not shown)'are greater than the average levels that have prevailed over the past 20 years.

As shown in the upper-right panel, about half of you continue to view the risks to output growth as balanced, although a number of you now judge that those risks have become tilted to the downside. The most frequently mentioned downside risks to GDP growth included further increases in commodity prices, a tighter-than- anticipated stance of fiscal policy, and an even-weaker-than-expected housing sector.

Your assessments of the risks attending your inflation projection'shown in the bottom-right panel'have shifted noticeably to the upside, reflecting concerns about further increases in commodity prices, a potential rise in inflation expectations, and the possibility that the current highly accommodative stance of monetary policy will be maintained for too long. These concerns, along with the upward revisions to your projections for inflation that I noted earlier, help explain why many of you believe that the Committee should begin to remove monetary policy accommodation earlier than is assumed in the Tealbook. This concludes my prepared remarks.

CHAIRMAN BERNANKE. Thank you. Questions for our colleagues? President

Fisher.

MR. FISHER. I have two questions for Nathan. We are still accommodative. The Brits

appear to have stopped, but, as you mentioned, the Europeans are tightening and others are

tightening. What do the Europeans see that we don't see? In your opinion, is it a difference in

mandates, or do they see the world differently?

MR. SHEETS. I think it's a variety of factors. The difference in mandate and

perspective may be a bit of it. But the real challenge for the ECB is the heterogeneity of

performance and what the ECB Governing Council is trying to do is trying to balance this. The

German economy is just absolutely performing at an extraordinary pace. Unemployment there in

February actually fell to 6.3 percent, so they are getting to a point where unemployment is almost

3 percentage points lower than when the crisis started. And Germany is 30 percent of the

euro-area economy. So you have the vast majority of that economy performing at a pretty solid

pace and where slack is more limited. And then you've got a fraction of the economy that is

struggling in extraordinary ways. But, you know, putting that into perspective, Portugal, Ireland,

and Greece together amount to roughly 6 to 7 percent of GDP in the euro area. So it is very small; it's just a small fraction of Germany.

We have looked at this by a variety of metrics, and it seems like where they are is reasonable based at least on one benchmark Taylor rule. So I think that the differences really equate to differences in economic conditions between the United States and the euro area. But then I think, as a secondary factor, there are some differences in perspective and mandate that also are having an effect.

MR. FISHER. Mr. Chairman, when we talk about our U.S. situation, one of the restraining factors we envision on inflationary pressures, even though we revised our numbers upward, is our amount of slack, and particularly significant unemployment. So I'm wondering, Nathan, if you would describe to us how much slack you see outside the United States. And, how well and how able are we to measure global slack?

MR. SHEETS. Okay. Well, to answer your second question first, our ability to measure global slack is very, very limited. We do our best; we have some benchmark estimates, but there are huge confidence bands around our estimates. But our sense is that right now activity for the emerging market economies is pretty well close to what our best guess of potential is. And for what it is worth, we have sort of massaged some of the IMF estimates. That said, our estimate of slack and what the IMF is seeing are not that different. For the major emerging market economies, output is approaching potential. Then, as I described, the situation in Europe is that the vast majority of that economy is performing pretty well, but then you've got this extraordinarily soft spot where, frankly, I don't even know how to begin to think about what the output gap is'in Spain, for instance, where you've got a 20 percent unemployment rate, or in Ireland. I do believe that there's a fair amount of slack in the United Kingdom, but, on the other

hand, you've got offsets there with inertia in the inflation process that I don't fully understand. And then, Canada seems to be performing very strongly.

So my sense is that, for the global economy as a whole, there is still a little bit of slack mainly in certain industrial countries, but the global economy is performing very well, and the amount of slack is diminishing.

MR. FISHER. Thank you.

CHAIRMAN BERNANKE. President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. Again, for Nathan. At least if you've followed the press, there has been an intensifying discussion of Chinese inflation and their tightening. Do you see any concern that they will actually have to tighten enough to materially slow down their growth rate?

MR. SHEETS. Chinese inflation has been creeping upward. The latest reading was 5'' percent, 12-month change, which is higher than what they are comfortable with. The Chinese authorities are moving their monetary policy, both interest rates and reserve requirements, as well as a number of the quantitative tools that they have'maybe these days we would call them macroprudential instruments; previously, we would have called them interventions in the economy [laughter]'to try to rein in credit. And it seems like that they are having some success. So our baseline forecast for China is one where the Chinese economy slows to 8 or 8'' percent, and inflation comes down some, but, as you point out, I would say there are both upside and downside risks around that forecast. It may be that the economy doesn't slow as much as we think it will, and then the authorities will really have to put on the brakes. That could generate an outcome there of sharper slowing than what we expect.

That said, the Chinese authorities have been faced with these kinds of problems a number of times over the last decade, and each time have been successful in guiding the economy onto the smooth-landing course, and that is our expectation again. If something different happened there, then our outlook for the global economy would be quite a bit different. We really are getting to a point where China is becoming another engine of global economic growth, and without it we would have a softer global outlook than what I've discussed.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I have a question about the debt ceiling. As noted in the Tealbook, it appears that investors are still pretty sanguine that some kind of deal will be reached, and that the debt ceiling will be raised by July. In my own thinking, though, I see this as being a risk that we should take account of. I was wondering what the staff perceives to be the economic and financial risks or consequences if the debt ceiling really isn't raised.

MR. SACK. As I mentioned in my briefing, I think the markets are very sanguine about the debt ceiling issue. It's hard to find any evidence that they are anticipating a significant problem. I mentioned the Treasury bill curve, which doesn't show any effects. Implied volatility of long rates has come down.

MR. KOCHERLAKOTA. Markets have been wrong, though, before.

MR. SACK. Well, my point was going to be that many of us are surprised that there is not a bit more concern. I think it's uncertain how the Treasury would deal with the situation. We know they have a set of tools that they would employ. But if pushed to the brink, there is the question of what other steps they may take to be able to service the debt.

If it went to the worst-case scenario where there was actually a default-type event on U.S. Treasury debt, I think it would be a significant market event. And the effects would be in the directions you would expect'a bigger risk premium priced into the Treasury curve, a weaker dollar, and downward pressure on U.S. asset prices if foreign investors and others reevaluate the situation here. So I think it could be consequential if we got there, but certainly our hope and expectation is that we won't end up there.

CHAIRMAN BERNANKE. Other questions? [No response] Okay. Seeing none, I understand now the coffee is ready, so why don't we take a 20-minute break and be back at 3:25 p.m.

[Coffee break]

CHAIRMAN BERNANKE. Okay. Hope that was refreshing. We are ready for our go- round on the economy, and we'll start with President Evans.

MR. EVANS. Thank you, Mr. Chairman. My business contacts continue to report good economic fundamentals, similar to our March meeting. Despite the projected first-quarter GDP growth rate of 1.7 percent, there were very few indications of slower momentum in growth. My manufacturing contacts continue to be upbeat. Only the auto sector suggested a temporary slowing in growth prospects due to the supply chain disruptions from the Japanese difficulties. Labor markets are continuing to improve. With regard to pricing, there are many reports of first- round price increases due to higher energy and commodity costs. At the moment, second-round effects seem minimal.

Turning to the national outlook, I had been relatively optimistic about economic growth prospects. At our previous meetings this year, I indicated that I expected GDP to grow about

4 percent in 2011 and 2012. We don't appear to be seeing that kind of pace in the first half of

this year, but as of today, I don't see a fundamental change in economic momentum. So I think the 4 percent mark is a good projection for the second half of 2011 and for 2012. That puts us broadly in line with the Tealbook.

That said, this is the second time we are facing a period of sluggish growth following the trough of the 2008'09 recession. Suppose first-quarter GDP growth comes in at the Tealbook's

1.7percent projection. I'd see that as a reminder that achieving escape velocity from our liquidity-trap conditions is still not a slam dunk. We shouldn't forget that a successful launch must still overcome a number of significant headwinds. Households have lost a lot of net worth and now face a hit to purchasing power from higher gasoline prices. Both of these limit the scope for a sustainable pop in consumer spending. Housing's contribution to this recovery is AWOL, and nonresidential construction isn't doing much better. And state and local governments are still trimming expenditures and payrolls. Indeed, listing these headwinds also is a reminder of why we are writing down 4 percent growth numbers instead of the 5-plus numbers that we'd like to see following a very deep hole from the recession.

In terms of inflation, the U.S. economy is being hit by substantial relative price changes from global economic forces with respect to food, energy, and commodity prices. We likely are going to see some larger quarterly numbers for inflation in the first half of the year, but the key question centers on the medium term. What PCE inflation are we likely to see in 2012 and beyond? Clearly, we do have a large amount of monetary accommodation in place, which makes many nervous about rising inflation. However, it would be quite unusual for inflationary momentum to build in the absence of rising labor costs and wages. I know there are disagreements around the table, but I still see the evidence favoring the view that a substantial

degree of resource slack is holding back inflationary pressures. I think it's important to defend this view vigorously, and I'd like to do that now. [Laughter]

Theoretical and empirical research objections have been leveled at this kind of analysis. These often note the unobserved nature of output gaps and resource slack. By my reckoning, Presidents Plosser, Kocherlakota, Lacker, and Bullard have spoken on this issue, and I suppose I should add President Fisher after today's reminder. In addition, President Lacker has often voiced skepticism of numerous statistical relationships between observable variables and inflation. As I understand the context of such comments, these correlations are uninformative for policy due to the endogeneity of the variables. There is a literature on this.

I would like to report some results from my staff's work with DSGE models that attempt to pin down the exogenous factors that are influencing inflation dynamics. In the policy debate over statistical correlations, economic structure, and truly exogenous factors, this is a clearly useful way to proceed. It is in line with the research program articulated by Lucas, Sargent, and others.

The Chicago research model builds on my 2005 Journal of Political Economy article with Christiano and Eichenbaum, and if you like the discipline of peer-reviewed work, you have to love this one because we spent over five years in that review process. [Laughter] The Chicago model is estimated on data over the period from 1987 to 2008 and has many desirable attributes that allow it to describe quite well the quarter-to-quarter movements in macroeconomic data. Here is the recent policy development: The model has been surprised by the increase in core inflation over the past six months. The forecast error for core inflation relative to what we thought six months ago is about '' percentage point higher on a year-over-year basis. Coming over two quarters, that's a substantial increase. In studying the model's results, it seems to be

struggling with the apparent softer growth in productivity as well as the increase in core inflation.

What factors account for these developments? In the model, part of the rise in inflation reflects announcement effects of our continued accommodative forward guidance for monetary policy. That was an objective of our asset purchase program. In addition, the Chicago model sees four other exogenous factors as important in explaining these observations. The first factor is that a small, adverse, neutral technology shock has hit the economy. In the model, this will reduce output and productivity growth and increase inflation. This is a potentially troubling shock because it imparts inflation persistence. That is, it has staying power, and I was nervous when the staff showed me this development.

The second factor captures an exogenous increase in households' willingness to supply labor and is also persistent. In the model, this increases both hours and output while productivity falls due to diminishing returns in production. But here, inflation is lower, due to lower marginal costs. The net effect of these first two shocks leaves productivity growth lower, as the data have shown recently. The initial rise in inflation is somewhat smaller when both factors are accounted for: The technology shock was up; the labor supply shock was down.

The last two exogenous factors that the model finds important in explaining the data are transitory shocks to the markups on prices and wages. These shocks boost core inflation but have only a temporary effect. These are the types of shocks that give rise to commentary in past Tealbooks, like: 'We think the movement down or up in core inflation was temporary and unrelated to resource slack or other fundamentals.'

Our final model analysis finds a substantial and constructive role for these transitory shocks. So, summing across all of these recent developments has interesting implications for the

time path of the Chicago DSGE model's inflation forecast. The model's projection for core inflation over the four quarters of 2011 is higher at 1.6 percent. But core inflation falls to a bit under 1.0 percent in 2012 and 2013.

What's my bottom line here from the DSGE model? My staff's analysis of the exogenous factors indicates that a good portion of the recent run-up in core inflation is likely to be transitory, and I didn't refer to resource slack or output gaps once. The model analysis is in terms of exogenous factors. Changes in pricing pressures work through variations in marginal costs, a fundamental economic concept. That recent inflation developments are most likely transitory is also a robust finding from analysis of recent inflation and term structure data. That is, this conclusion is also supported by a modern finance model we run that produces inflation forecasts from no-arbitrage affine models of the term structure of interest rates.

These implied inflation forecasts also revised up a good deal in the near term, but they are only up a tenth or two in 2012 and still just reach 1.4 percent by 2013. This is analysis of market data with state-of-the-art term structure finance modeling. This model allows for feedback from energy prices to core but finds that feedback to be very small, which is also consistent with the alternative but complementary VAR evidence I discussed at our March meeting. Furthermore, this assessment also aligns well with our standard battery of Stock-and- Watson-style statistical models, which continue to forecast very low core inflation throughout the projection period. As it turns out, the endogeneity issue didn't disturb the result as it aligns with the structural model analysis.

We in Chicago have searched high and low for research-quality evidence on the nature of the inflation persistence over our projection period using a variety of state-of-the-art models. Taking into account recent developments, it continues to be exceedingly difficult to find

analytical research-based evidence that inflation is about to overshoot our target over the medium term. Consequently, I feel quite comfortable that my views, which lean strongly toward continued substantial accommodation, are well within the mainstream of modern macroeconomic and monetary research. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. I'm going to focus mostly on anecdotal reports from the Sixth District, and those anecdotal reports that I've recently received from directors and other contacts are more positive than the tenor of the incoming data. While these contacts acknowledge that the pace of economic activity weakened in the first quarter, there has been no significant falloff in business confidence about the outlook since the last meeting. In many cases we are getting reports that suggest a stronger economy than the macro numbers would indicate, and this is puzzling considering the incoming numbers.

On the positive side, manufacturing activity remains quite strong in the District, consistent with the national numbers. The strength in auto manufacturing, in spite of some rescheduling associated with Japan-based supply chains, heavily influences this perception. Transportation- and logistics-related businesses continue to experience very strong demand. Tourism is strong in Florida and other tourist areas in the Southeast, helped in part by international visitors. Convention business is returning nicely, which is taken as a sign of improving confidence in the economy. This has spurred a significant increase in capital expenditures in the tourism sector.

On the more negative side, housing markets in my District remain distressed with no clear signs of improvement, but, at the same time, with not a lot of deterioration. Perhaps more noteworthy, some retailers reported a falloff in sales as the quarter proceeded. One large home-

improvement retailer has measured fewer visits, which is attributed to shoppers reducing their outings to save on gasoline. And there is acknowledgement that poor weather, of course, in the early part of the quarter affected first-quarter numbers.

Overall, however, retail sales in the District appear to be up modestly from the last meeting. In our monthly survey of Sixth District retailers, the majority of respondents reported a slight increase in both sales and traffic in March. About three-fourths of them indicated that they expect sales to increase in the coming months, and overall sentiment continues to be positive.

Consistent with the measured optimism expressed in most of our conversations, we did not as of yet detect any widespread backing-off of investment plans. However, our director that represents the large retailer that I mentioned earlier did note that cap-ex budgets would have to be cut if the decline in the pace of activity that they're experiencing persists much longer, and many of our directors agreed. So in this instance, I did pick up some wavering on the outlook.

Labor markets in my District appear to have firmed a little. Demand for workers has improved in line with the pickup in hiring nationally. I think it's a reasonable thesis, broadly speaking, that firms have pushed productivity enhancements close to their limit and are now reaching the point of needing new workers to keep expansion going. In our first-quarter survey of small businesses, 42 percent of respondents reported that they expect to add workers over the next six months, up from 29 percent at year-end. Views on wages and on wage pressures have shifted slightly. Wage and benefit pressures have moved from neutral or even downward to moderately upward. We did hear greater concern about talent retention, and I note that the NFIB and the Duke CFO survey in March showed upticks in the wage'cost outlook.

Our contacts continue to voice concern over cost pressures, especially material costs deriving from commodities. What is noteworthy is how broad-based these material cost

pressures seem to be. We are hearing some concern that margins are tightening and are projected to tighten, and that pass-through inhibitions are weakening.

Chief among the commodity prices, of course, are oil and fuel. I see the direction of oil prices as a major swing factor in economic performance for at least the near term. Based on so-called expert analysis, if there is such a thing, and conversations with knowledgeable observers of developments in the Middle East, I think there is no better working assumption than the one that oil prices have leveled off but will remain elevated near current levels for some time. The possibility of a spike from current price levels represents a significant downside risk to my outlook.

Our District-level soundings suggest to me that the economy is at something of a pivotal juncture. Gasoline prices and energy prices more generally will influence the evolution of the economy in the near term. Right now the general sentiment seems to be that the negative influence of higher energy prices is likely to be transitory, but this view is cautiously held, and there is a sense that the prevailing optimism about the balance of the year is fragile.

As I said, anecdotal reports I've heard seem mostly inconsistent with professional interpretation of incoming data and are in tension with the results of our recent model runs. The suite of models that we ran in preparation for this meeting almost uniformly suggest a downward revision to our 2011 growth outlook on the order of '' to '' percentage point, and this is similar to the downward adjustment of the Tealbook baseline. In my forecast submission, however, I decided to give some weight to the economic intelligence we're getting from our contacts. So I'm holding to the view that the economy is on a moderate growth path, and that the slowdown in the first quarter suggested by the incoming data is really an initial shock effect that will not persist. This is to say that the fundamentals have not changed that much.

As regards the balance of risks, I see the risk to economic growth to the downside connected to the risk of a further oil price shock. My assessment of the inflation risks is clearly weighted to the upside. Although expectations remain in the territory reasonably described as 'anchored,' expectations have drifted higher and are at the top of the recent historical range. Despite exceptionally high rates of unemployment, wage growth seems to be firming. This, along with the drumbeat from businesses that inflationary pressures continue to build, raise some concern on my part that we may not be able to count on inflation expectations as a restraining influence on underlying inflation. Although normally one would think of these two risks, the oil price shock to growth and the inflation risk, as moving against each other, in my view there is a scenario where we get higher inflation and a weaker economy. But this is not my base-case outlook, and, as I said, that outlook holds to a moderate-growth path with a slight backup on the full-year growth estimate and tame core inflation measures for the forecast horizon. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Rosengren.

MR. ROSENGREN. Thank you, Mr. Chairman. The judgment on the data since our last meeting is a split decision. Labor markets are improving, albeit slowly, but spending is slower than I expected. Most of the good news has come from the labor markets. Payroll employment in recent months is growing at a rate consistent with a gradual decline in the unemployment rate. The unemployment rate has fallen a full percentage point over the past four months, to

8.8 percent, lower than I expected last fall.

This improvement in the labor market is still not affecting labor costs, with wages and salaries growing quite slowly. The quiescence in wages and salaries is consistent with substantial slack in the labor market. This assessment of slack is consistent with the significant

revision in the JOLTS data, which now show many fewer vacancies over the past five years. The revision was primarily a result of reestimating the birth-death model, which had overestimated the number of new firms and job openings being created during the crisis. The very low quit rate also suggests that considerable slack remains in the labor market. A worker concerned about the outlook would be reticent to quit a job for fear of the inability to secure better employment elsewhere. While the quit rate has risen off its lows, it remains substantially below its level after the last recession. With existing workers reticent to move and the low participation rate indicating that opportunities are not attracting workers back into the labor market, we need much more improvement in labor markets than we have seen to date.

While progress in labor markets has been slower than I hoped but more than I forecast, recent data on spending have been slower than I hoped and less than I forecast. GDP growth over the past four quarters has averaged only 2.8 percent, just slightly above potential. At the beginning of the year, I had expected growth in the first quarter to be well above potential, but now it looks as if growth will fall well short of that.

Over the past four months, most forecasters have been revising down their first-quarter estimate with each new data release. Like many of these forecasters, I have been surprised by weaker-than-expected consumption, housing, and state and local spending. A key question is:

Given the surprise in incoming data and the likelihood of more fiscal tightening than I originally expected, how much of this weakness should be carried into future quarters? While I'm assuming that this is a lull rather than a trend, the strength in spending for this year is in the forecast but has yet to be reflected in the data.

Despite the significant food and energy shocks, my estimate of core inflation, like that of the Tealbook, remains well below 2 percent over the forecast period. I focus on core inflation

because over the period from 1985 to the present, whenever total inflation has diverged from core inflation, total has tended to return to core, perhaps consistent with well-anchored expectations. While we need to continue to monitor inflation expectations and inflation trends, the evidence to date is consistent with inflation over the forecast horizon remaining under 2 percent.

Like the Tealbook, my forecast has an unemployment rate at the end of 2013 well above full employment, and core and total PCE inflation well below 2 percent. However, my forecast achieves this outcome with a federal funds rate that remains at the zero bound longer than assumed in the Tealbook. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Fisher.

MR. FISHER. Mr. Chairman, economic growth in our regional economy appears to be accelerating, and, notwithstanding some soft spots, we think that the Eleventh District is about to turn in its best performance since 2007. Our payroll employment grew at a 2.6 percent rate in the first quarter and at a 3.6 percent rate in March, and on almost every front we have significant activity, including multifamily construction and rents that are on the rise across the Texas metropolitan areas. We've been assisted by robust economic growth in Mexico, which is growing at 4.8 percent.

There are some areas of concern, particularly that input and selling prices are increasing faster. And as I mentioned last time, we did find a typical Texas way to resolve the budget'by cutting everything, including education and social services. The joke is, and it's a horrible one, that we've gone from the electric chair to electric bleachers in Texas. It's a hideously interesting way to resolve our program issues.

From the standpoint of employment growth, as you know, I like to brag on the percentage of jobs we've created as a percentage of the whole in the United States. The good news is, while we continue to grow, the rest of the United States is catching up with us, and I think it reflects the comments that have been made at the table.

Bearing in mind the great virtues of modeling and academic precision, I'd like to turn to the U.S. economy and address three questions that were raised in the domestic briefing. One is that employment is proceeding. Second, GDP may be understating the momentum of the economy, a point that I believe President Lockhart made in his presentation. And a very important point he made is that inflation seems to have some intrinsic momentum. These are the points that I'm picking up from my anecdotal evidence, and as you know, I do a fairly thorough survey, to the best of my ability. Mr. Chairman, you know who is on my list. I'd like to summarize that for the group since we've heard a lot of macroeconomic data, but I'd like to provide for the table the microeconomic inputs.

What was previously a faint theme is now a very loud, uniform drumbeat on two fronts, according to my interlocutors'that is, the CEOs and CFOs that I talk to across all of our Districts. The first is that cost inflation is pushing forward price increases in all sectors beyond energy and basic commodities, and the second is that excess liquidity is giving rise to faster and looser decisionmaking by financial intermediaries, something that I referenced before. Final demand is growing, although at a lesser pace, and the reason given by my interlocutors is that inflation in basic necessities is becoming a factor dampening consumer confidence and tempering the rate of expansion. The ease with which credit is available is being exploited by businesses, but it is simultaneously giving rise to trepidation of what might ensue. As one of them said, we've seen this movie before, and just recently.

To a person'and I mean to a person across all sectors: public, private, large, small, whatever sector in which they operate'my contacts feel that they and, in general, American businesses large and small, public and private, have, as President Lockhart pointed out earlier, achieved tremendous operational efficiency such that they have no fat from which to absorb widespread and pervasive cost increases, and they must protect their margins by passing these cost pressures on to consumers. To be sure, they're not sure how much leeway they have, but it does alarm me to hear from one interlocutor'whose name I will mention because I think it's of value, Bill Simon at Walmart'that Walmart has approved increases. These are not yet announced, and they're not for public use. They are to be implemented in the June time frame in much higher orders of magnitude than I would have expected'for example, dairy products up 15 percent, all Proctor & Gamble products up 5 to 7 percent. As reported in the Wall Street Journal this morning'I presume everybody reads section B? Nobody reads section B [laughter]'5 to 7 percent in diapers and tissues from Kimberly Clark; blue jeans up 8 percent.

Walmart is an interesting interlocutor. They force their suppliers to go through their entire cost structure. In the ugly parlance of one of them, they're known as the cost proctologists because they examine absolutely everything. They have concluded, and I quote, 'Practically all of our suppliers' cost structures have been rationalized. They've achieved remarkable operating efficiencies, which is revealed in the macroeconomic data. They have severely limited room to absorb broad-based inflation,' end of quote.

An example'a separate retail chain, Michaels, which sells 40,000 products in

1,040 stores in 48 states, is planning price increases of seasonal goods, which is one-third of their 40,000 products, of 8 to 10 percent, and their CEO put it this way: 'Commodities will swing up

and down in price, but wage inflation is real in China, India, Vietnam, and the inherent cost to manufacture everywhere, including the United States, is going up.'

My smallest contact, John Faulkner, a dry cleaner with 20-odd employees, was almost offensively blunt in echoing what I heard from everyone in size up to Rex Tillerson at Exxon, or, say, Burlington Northern, or TI, or AT&T: 'I have no problem getting credit or money. That's the good news. The bad news is that inflation in all my inputs is killing me. I haven't increased wages for my people. I'm sure as heck not going to hire more until I sense my other costs can be controlled even if bankers pay me to take their money.'

Every CEO I talk to, large or small, public or private, is now budgeting for and managing to inflation, and I think this addresses your point of the inherent carryover of inflationary numbers. The question is for how long, and perhaps we could turn to Chicago's model to get a sense for that.

As to the effects of excess liquidity on behavior of financial operators, I see only an intensification of the very disturbing patterns I reported at the last FOMC. Continued accommodation is encouraging a debasement of prudent credit practices and an enhancement of speculative impulses, some of which only add to inflationary pressures. I note that in the Tealbook on page 59, the pace of institutional leveraged loan issuance in the first quarter was about the same as the pace for the entire year of 2007, and the expected nonfinancial year-ahead defaults have come down significantly; I note also that they have come down to nearly the same level that they were in 2007 before all the defaults occurred. As an example, I'll point to Energy Future Holdings. You may remember, that's the electric utility that just refinanced the

$45 billion leverage buyout that was done by KKR, TPG, and Goldman. Their CEO confided in

me that the covenants in the refinancing they achieved last week were 'even better this time than what we got in 2007.'

I agree that many current inflationary variables may be transitory. I accept that over the past 25 years inflation expectations have been largely unaffected by commodity price fluctuations because of the inflation-fighting mindset that we have at the Fed, which is not in question. I can also understand the reasoning behind the initiation of the current LSAP program. Even though I did not think it was necessary, I will grant that it has lifted stock prices and increased investor returns. But here's the summary point. Based on anecdotal input, for what it's worth, I fear that we are, first, on the edge of losing the faith of the business community and households as to our inflation-fighting resolve'I think that needs to be reemphasized, a very important part of what you will do tomorrow afternoon, Mr. Chairman'and, second, planting seeds of financial recklessness, some of which are beginning to sprout. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Plosser.

MR. PLOSSER. Thank you, Mr. Chairman. Economic conditions in the Third District improved moderately over the intermeeting period in all sectors except construction. Employment in our three states increased at an annual rate of 1.4 percent during the three months ending in March, comparable to the pace in the nation. The unemployment rate now stands at 8.4 percent, 0.4 percentage point below the national rate.

Pennsylvania has shown considerably more strength than New Jersey, where the government sector has been shedding jobs at a very rapid pace. The stress on state and local budgets is probably the biggest risk at this time in our District's economy: Large budget deficits loom. In fiscal year 2012, the Center on Budget and Policy Priorities is projecting a budget

shortfall in Pennsylvania of $4.2 billion, or about 16 percent of the 2011 fiscal year budget, and a shortfall of $10.5 billion for New Jersey, 37 percent of its budget. Delaware's is more modest' a shortfall of only $208 million, about 6.4 percent of its budget.

The region's manufacturing output continues to increase in April, but to no surprise, it did pull back from its 30-year high, which is what it was in March, to a more moderate pace, but still one consistent with continuing modest growth. The indexes of new orders, shipments, and employment also weakened somewhat this month but still point to continued expansion. Exports account for a little more than 12 percent of manufacturing output in our District. In response to a special question, 80 percent of the firms said they haven't experienced supply disruptions from the recent crisis in Japan or any other international event. Ten percent indicate they were currently experiencing some problems, and another 10 percent expressed some concern of possible future effects. This is something we will continue to monitor, but the effects are modest.

In the real estate sector, talking to two very large homebuilders suggests that traffic to date is up significantly over last year this time, and their sales volumes over the first quarter of this year are well above what they were last year.

We continue to see signs of increasing price pressures on firms who are becoming better able to pass along their increases to their customers. Although the prices-paid index in our April survey decreased, it remains at a very, very high level. The prices-received index, though, unlike the other indexes in April, moved up again; that is eight consecutive months in which the prices- received index has risen. Firms are continuing to expect that they will be making further price increases over the course of the second half of the year.

In an environment where policy is very accommodative, the key to assuring that commodity price increases don't pass through to general inflation is that inflation expectations remain well anchored, which in turn depends on the credibility of the Fed to deliver on its price stability mandate.

Core inflation has been accelerating, and the Tealbook has been revising up its forecast. Forward inflation compensation 5 to 10 years ahead has been moving up, and the Tealbook says that the staff models indicate that the rise is driven mainly by liquidity and inflation in risk premiums rather than increases in expected inflation. Unfortunately, I don't take much comfort in the fact that inflation risk premiums are rising. I read that as an indication that our credibility may be less stable than I'd like it to be.

My forecast has not changed much since January. I revised down slightly my economic growth for the first half of 2011 because of the weaker consumption data we saw in the first quarter. But I held the second half of 2011 and 2012 roughly the same. I believe the weakness we have experienced is due to temporary factors, such as the severe weather we had in January and February, the initial shock from the sharp rise in oil prices, and some supply disruptions from the earthquake and tsunami in Japan. Financial markets have taken all that potentially bad news in stride, suggesting that firmer recovery is shaping up. Earnings continue to be strong, and firms are doing well. I continue to expect output growth in the United States to be slightly above trend over the next two years, employment growth to strengthen, and the unemployment rate to move down. I revised up my inflation forecast for this year but expect some reversal of that increase next year as oil and commodity prices stabilize or perhaps reverse course.

As the economy continues to recover, we will need to begin withdrawing policy accommodation. Given inflation developments, I think that time may be sooner than what's

priced into the federal funds market, which expects the funds rate to increase in the first half of next year, and very likely sooner than what is in the Tealbook, which assumes no change in the fed funds rate until the third quarter of next year. My forecast incorporates a steeper policy path, with a reduction in accommodation beginning sometime in the second half of this year.

Our colleague Tom Hoenig has been saying that even after exit begins, policy will remain very accommodative for some time to come. I think we should make an effort to explain this to the public and prepare them for the start of normalization. I have also been sympathetic to his view that moving away from the zero bound could be very beneficial to the functioning of financial markets and would not amount to significant tightening as policy would continue, as I said, to be very accommodative. We have a very good opportunity to convey some of these ideas over the next two meetings'this meeting and in June'and begin to change our language substantially, because the Chairman will be holding press briefings at which he can be more expansive than a one-page statement can be. I think we should take advantage of that opportunity. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Pianalto.

MS. PIANALTO. Thank you, Mr. Chairman. The incoming data point to a more mixed picture than I was expecting when we last met. We are again in the position of trying to judge whether a slowdown early in the year will extend further into the year. Overall, I agree with the Tealbook that most of the slowdown is transitory. In my remarks, I will focus on how I revised my projections since our last submission in January.

First, I do see the incoming data as pointing to a surprisingly weak first quarter. Given the range of weak indicators, I agree with the staff estimate of 1.7 percent GDP growth in the first quarter. There is no shortage of potential explanations for a softer quarter, ranging from

severe winter weather to the run-up in oil prices related to the developments in the Middle East and North Africa.

While much of the softness looks temporary, there is reason to take some signal from the recent data and expect some additional softness in growth beyond the first quarter. In projections from our econometric model in Cleveland, rising materials prices play a lead role in slowing the anticipated pace of GDP growth relative to a few months ago. While I have previously reported small effects of commodity price changes on GDP growth, in our model, overall materials prices affect the economy more than commodity prices do. While I don't anticipate that materials prices will continue to soar, the increases that we've already seen were enough to modestly slow the projected pace of growth. I should also note that my manufacturing contacts have mentioned that materials price increases are importantly affecting activity and profit levels, although not enough to derail growth in their businesses. Putting all of this together, since January I have pulled down my forecasts for GDP growth for 2011 and 2012 by about '' percentage point to around 3 percent in both years.

The one bright spot among an array of disappointing data releases was the April report on labor market conditions, which confirmed the downward trend in the unemployment rate and confirmed a pickup in private employment gains. Taking a closer look at the implications of unemployment for slack in the economy, my staff presented evidence that labor market slack is not going to go away very quickly. One reason is that despite recent declines, unemployment remains stubbornly high. A second reason is that, based on historical norms, firms have plenty of room to increase both hours per week and the number of workers. Finally, the labor force participation rate is likely to rise as many individuals who would normally be participants in a stronger economy finally return to the workforce. So while labor markets are improving, there is

still a lot of slack in labor markets, and therefore, I don't see wage pressures picking up any time soon.

Labor market slack aside, the upward drift in core inflation in recent months and the rise in materials prices have led me to bump up my core inflation projections from my January submission. I now expect core PCE inflation of about 1'' percent in 2011 and 1'' percent in 2012.

At our last meeting, there was some discussion about how quickly core inflation can rise in light of the significant increase in core inflation that surprised the FOMC in 2004. My staff examined the chances of a similar rise in core inflation in the current environment. To formally assess this risk for 2011, they relied on a small forecasting model that incorporates current conditions, which include variability of economic growth and inflation that is somewhat higher today than it was in 2004. According to that model, even with today's elevated volatility, the chance of a significant jump in core inflation, combined with modest GDP growth, is only about 20 percent. Now, clearly, this is enough of a risk to merit paying attention to, but we should not react too hastily when higher probability outcomes show a more gradual increase in core inflation. In my view, the chance of a surprise rise in core inflation is much lower today than in 2004, because our economy is much weaker today than it was then. For example, the unemployment rate is more than 3 percentage points higher than it was in the first quarter of 2004.

On inflation expectations, in the Cleveland Fed model, which accounts for a time-varying inflation risk premium, inflation expectations are at or below 2 percent out to 14 years. That said, inflation expectations at horizons of three to five years ahead have risen and are now similar to the levels they were last spring. After the spring of last year, inflation expectations

started to drop with the growing signs of weakness in the economy. This was a critical factor in my decision to support additional asset purchases. So we should not be worried about inflation expectations at these levels, but I would not want to see them continue to rise.

In my judgment, the risk to the outlook for GDP growth remains balanced. While the recent weakness in most of the incoming data point to a risk of a sustained soft spot in the recovery, the surprising strength of employment suggests the potential for a stronger recovery.

On inflation, I think the risks are more to the upside than the downside because of the rise in input costs and the threat that inflation expectations could move higher in response. Still, the most likely outcome is a gradual rise in core inflation with moderate GDP growth. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I have talked to a number of business contacts throughout the Ninth District over the past six weeks, and the high rate of headline inflation was very much on their minds. One concern was that elevated oil and food prices would drive down demand for other goods and so choke off the recovery. But the other real concern was that headline inflation would leak into what we at the Fed like to term 'underlying inflation' and generate a persistent high-inflation scenario.

In terms of the latter concern, many retailers pointed out that increases in input prices were putting upward pressures on their costs. However, they remained uncertain about their ability to pass those cost increases on to consumers. One offered story, though, is that they believe that the current high rate of headline inflation will give them, quote'unquote, 'more cover' to initiate price increases in nonfood and non-energy goods and services. According to this story, a firm can raise its prices more rapidly because households believe that all of their

prices are rising more rapidly. This story would mean that the apparently transitory increase in headline inflation has the potential to generate a self-fulfilling increase in expectations about core inflation'a self-fulfilling increase that could well prove to be persistent. This story'that transitory movements in headline inflation can translate into persistent movements and inflationary expectations'is one that bears watching. Fortunately, there is little evidence so far that this upward pressure on longer-term inflationary expectations is happening. For example, the five-year, five-year forward breakevens remain in historical ranges. The Cleveland Fed's measure of expected inflation over the next 10 years, which President Pianalto was just referencing'I like that, because it attempts to strip away both liquidity and risk premium affects'has risen since last summer, but it does remain below 2 percent.

So medium-term and longer-term inflation expectations do seem stable for now, but this risk that the transitory becomes permanent is one that we need to be prepared for. And I'm not sure that we are. If we look at our standard monetary policy rules, they are silent about how to respond to changes in longer-run inflationary expectations. What triggers are we using to tell us that longer-run inflation expectations have risen? Do breakevens need to rise to 3'' percent,

4 percent, 4'' percent? Do the Cleveland Fed measures need to hit 2.2 percent, 2.5 percent? How aggressive should we be if the economy were to hit these triggers? As far as I can tell, we don't have a systematic approach to dealing with this kind of scenario, and I think we do need one.

In contrast, our policy rules are clear that the level of accommodation should track core inflation. I took what President Evans was describing from the very interesting work that was being done in Chicago as proposing not tracking core inflation but some filtered vision of core, which is trying to tease out the persistent component of core. That would be different from the

kind of rules we have traditionally been using, and it would be interesting to see if those kinds of rules, using historical data, would actually perform better than the rules we've typically used. But for now, I think I would rather stick to the rules the Committee has typically used, the ones that track core. And as a result, and as my memo on reducing accommodation indicated, I am going to be tracking PCE core inflation carefully in thinking about the appropriate timing for reducing policy accommodation.

The Tealbook now forecasts that core PCE inflation will be 1.4 percent over 2011. My own outlook has not changed that much. It continues to be that PCE core inflation will be

1.4percent or possibly even higher. And our own rules indicate that the FOMC should respond to that increase in core inflation by raising the fed funds rate. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Williams.

MR. WILLIAMS. Thank you, Mr. Chairman. Well, we've heard a lot about disappointing news on the economy. There was some good news that baseball's regular season has begun. And as you all know from reports from John Moore, we follow very carefully the relationship between the U.S. economy and how the San Francisco Giants perform on the field. Unfortunately, like the U.S. economy, the Giants got off to a lackluster start so far this year, but these early stumbles haven't yet caused me to change my assessment that they'll both perform well for the remainder of the year.

The recent economic data and the anecdotes I hear from my business contacts have generally fallen short of expectations in terms of economic activity and suggest upside risks to inflation. Nonetheless, I still see a moderate recovery in train, with underlying inflation remaining low. The open question is whether my optimism, both regarding the Giants and the economy, reflects an accurate reading of fundamentals or just a form of denial. [Laughter]

Overall, my projection is very similar to that in the Tealbook, with the unemployment rate falling only gradually over this year and next, and headline and core PCE price index inflation dipping back down to around 1'' percent next year as the effects of the surge in commodity prices recede. I'll focus my remaining remarks on just two issues. One is the disappointing tone of recent data that David Wilcox commented on, and the other is the implications of price increases of oil and other commodities.

First, like the Board staff and most private forecasters'I am taking from what I've heard so far from most people here'we have significantly revised down our forecasts for the first quarter in response to the weaker-than-expected incoming data but have left our medium-term forecast largely intact. For me a key question is whether these data might be signaling significantly less underlying strength in the economy than we're expecting. In this regard'and this may be different from what President Lockhart reported'I am struck by how pessimistic and cautious my business contacts sound these days'much more downbeat than a month ago, let alone at the beginning of the year. Indeed, they speak of a crisis of confidence among households who see gasoline prices going up, up, and up, and who everyday read tales of sovereign default, nuclear meltdown, and war. One homebuilder says he sees no shortage of qualified, interested buyers, but they are afraid to pull the trigger; they worry that if they lose their job, they won't find a new one.

So far, despite the angst I sense from my contacts, I am sticking to the story that the recent data have been a temporary aberration and that the pace of recovery should get back on track. In this assessment, I am encouraged by the continued gains in payrolls in the manufacturing sector and the resilience of consumer spending in the face of significant increases in food and energy prices. And even though lending conditions still appear relatively tight,

overall financial conditions have continued to improve. Still, the weakness in recent data and the lack of confidence I hear from my business contacts raise a red flag of possible downside risks to the outlook.

Second, prices of oil and other commodities have continued to move up. These are unwelcome developments both for output and inflation. In terms of output, higher gasoline and food prices are a drag on household spending. And I'm particularly concerned about how they're affecting confidence in line with the crisis-of-confidence views I mentioned earlier.

In terms of inflation, rising food and energy prices are pushing headline inflation uncomfortably high in the first half of this year. I expect that these price increases will leave some imprint on core inflation. Indeed, my business contacts, very much like President Fisher said, continued to stress that they expect businesses to try to pass on past cost increases. They mentioned specifically China and other sources of imported goods, along with energy prices, and they will continue to try to pass these cost increases on to their customers'in particular, they mentioned the second half of this year. This is a comment that we have been hearing pretty consistently for the past few months. I will emphasize, as I think I did last time, that they used the word 'try' in terms of passing this on, given the economic climate, but it is something that we definitely hear, especially from retailers in our District.

But I also expect these effects on underlying inflation, in terms of the inflation rate, will be transitory, consistent with the academic literature, and President Evans's recent analysis; here I was referring to your analysis from the last meeting, but your new analysis would be consistent with that, too. I'll highlight two reasons for this expectation of muted second-round effects from the bump-up in headline inflation under wages or underlying inflation. First, importantly, the U.S. labor market today is characterized by relatively little real-wage rigidity. And here I am

thinking about COLAs, or automatic cost-of-living adjustments, or other impediments in the labor market. Now, this contrasts starkly with many European economies where institutional features of labor markets likely contribute to real-wage rigidity and the second-round effects of inflation on wages that were in evidence there. I think the United States is very different from Europe in this regard, and that's important in terms of thinking about inflation.

Second, inflation expectations, I would say, remain remarkably stable in the United States, despite the sizable swings in commodity import prices. Admittedly, households' short- term inflation expectations surged in the past few months, and this does raise the worry that workers could try to bargain for higher wages, and that could potentially ignite a wage'price spiral. I don't see that as a major risk. Research at the San Francisco Fed has consistently found that household inflation expectations tend to be overly sensitive to recent data. In particular, as reported in the Tealbook, household inflation expectations are highly responsive to food and energy price inflation. Futures prices suggest that the prices of most commodities won't keep rising at double-digit rates and will probably stabilize. And based on past patterns, as food and energy prices stabilize, household inflation expectations should also come down to more normal levels.

In sum, I expect the recovery to remain on course and for underlying inflation to remain low. But there are numerous risks to this outlook, and I'll be watching the data carefully, looking for signs of a shift in the underlying trends, both in terms of output and inflation. Thank you.

CHAIRMAN BERNANKE. Thank you. President Hoenig.

MR. HOENIG. Thank you, Mr. Chairman. First of all, our region of the country is doing well-to-booming. If you look at the downside, our housing market is comparable to other areas

where there was a buildup of supply that exceeded the buildup in household formation; that we're working through. Once you get by that, our manufacturing sector came down slightly in our most recent survey, but that was from a record high and we are seeing that continue to expand. Our retail sales did slow down in the first part of the quarter, but did pick up pretty significantly in March, which, from our point of view, is very positive. Agriculture is continuing to do very well'a boom'and energy is also in a boom environment.

To add an anecdote on my concern for leverage, I think it is worth sharing this. We have a pretty sizable energy company, recently formed in the past five years. It shifted its strategy toward oil, away from natural gas. And they were able, because of the low cost to leverage, to buy 1 million acres of development rights on land in our region for about $200 million'$200 an acre of development rights. They then formed a royalty trust and took approximately 65,000 of those acres from which they had borrowed the $200 million, went on an international tour and raised money from sovereign wealth funds for rights to this royalty unit, and then closed their deal here in the past few weeks for rights on 65,000 of the 1 million acres for $238 million. So leverage is doing well in our part of the country: low cost of borrowing, easy money, lots of liquidity sloshing around, here we go. So I bring that up as a caution to this Committee.

On the national level, I agree'information we have received since the last meeting indicates that the economy recovery continues and that our labor markets are improving modestly but steadily. Household spending and business investment in equipment and software both continue to expand, while at the same time improving their balance sheets, which is good, from my point of view. Since the last meeting, we have also seen that inflation expectations have remained, as we say, contained, except that what we are seeing for energy, food, and now a broader basket of goods indicates confidence may be waning in that particular sector. One thing

on unemployment'if you break it out, we are seeing pretty significant improvements in employment for college graduates. We are seeing less in terms of high school and non'high school; I'm not sure monetary policy can solve that, and I think we should be mindful of that.

One other thing that I worry about is that while we talk about our very accommodative policy as necessary, we also see these energy and commodity costs rising and moving forward. And, yes, they may transitory, but I'm afraid that when you have wages that are not rising, real income is falling, and high prices in that environment actually kill demand because incomes can't keep up. And the effect on that middle income group that we are so concerned about supporting is going to be negative, not positive. So we may not see the inflationary pressures three and four years from now, but that may be because we have a new economic crisis built around the fact that we put all of this liquidity into the system, built these commodities up, and when the prices adjust and come down, it will be because we have starved the middle class in terms of real-wage increases.

I think we need to be careful about how long we leave this very accommodative

monetary policy in place, because we are creating imbalances. They are going to correct. And that, of course, will fall most heavily on those with middle and lower incomes. Thank you.

CHAIRMAN BERNANKE. Thank you. President Lacker.

MR. LACKER. Thank you, Mr. Chairman. Reports from our contacts indicate that the Fifth District economy continues to grow. Our April survey released this morning indicates that manufacturing is expanding, though not quite as broadly as before. Our respondents remain quite optimistic about future conditions, though, and many have plans to hire in the first half of the year. Several firms told us of difficulty finding adequate workers, because they preferred to collect unemployment benefits or can't pass drug tests. Service-sector activity is expanding

more broadly now, and our retail index swung strongly into positive territory this month with big gains posted for sales revenue and shopper travel. Expectations for demand over the coming six months improved noticeably as well.

Commercial real estate markets continued to show signs of improvement in some areas of our District. While vacancy rates are mixed across the District, strong markets such as Washington have been able to attract financing and investment. Several contacts have noted the availability of construction financing for federal buildings, educational institutions, and medical facilities. They called this the 'feds, eds, and meds sectors.' And the data center market is said to be exploding.

Commentary on inflation pressures was once again widespread, as many of you have remarked as well. Price growth picked up in both our manufacturing and services surveys this time, and is at or approaching the all-time highs for those series that they reached in 2008. Manufacturers report passing on cost increases to industrial users but indicate difficulty passing them on to retailers.

It's worth noting that the current wage index has picked up in both manufacturing and nonretail service sectors, and the manufacturing wage index number is the second highest on record. At the national level, in response to softer data, the Tealbook has lowered its near-term forecast for GDP, and I think that makes sense. It seems reasonable to pull down projections for consumer spending in light of the energy price increases and other gloomy news, although I haven't pulled down my forecast quite as much as the Tealbook's. In addition, the Tealbook has written down a lower trajectory for residential investment this time, which I also wholeheartedly endorse. The first-quarter numbers for housing managed to underperform my already minimal expectations, and I continue to expect housing activity to remain at exceptionally low levels for

an extended period. In fact, my housing forecast looks more like the Tealbook's fed funds forecast'[laughter]'for that matter, my fed funds forecast looks more like their housing forecast.

On the other hand, the outlook for exports and business investment in equipment and software looks pretty good at this point. I'd part company with the staff with respect to second- half core inflation; they have it, I think, settling down, and I have trouble dismissing the many anecdotes we've heard from firms that are having their margins squeezed and are expecting to raise prices later this year. We've gotten those reports for several months now, and they come from various-sized firms and various industries and various locations around the District, and they are reminiscent of what we were hearing in 2004 when core and overall prices did accelerate appreciably. My best guess is that we'll see a relatively permanent step-up in core inflation to near 2 percent. I don't view this as inconsistent with our reads on the expectations of the public regarding inflation beyond the near term, and those appear to be reasonably well anchored at this point. And I think that is going to temper the extent to which a significant part of firms' cost increases are incorporated into final prices, and that should keep core from rising much above 2.

But I don't think we can take those favorable expectations for granted. I think we need to be sure to validate those expectations. They rest on some presumptions about our actions and statements, our reaction function. So we are going to have to make sure our actions and statements in the coming year do validate those expectations. In my view, this is going to require that we return policy to a neutral stance more promptly than the Tealbook assumes.

Two final comments. One, President Kocherlakota very aptly noted that the policy rules to which we make frequent reference leave out changes in inflation expectations, because when

we apply them in the models we leave out any doubt in model agents' minds about the likelihood that we are going to stick to that policy rule. There is empirical work done by a former colleague of mine, Marvin Goodfriend, an essay from about a decade and a half ago called 'Monetary Policy Comes of Age' in which, for the period after Volcker and Greenspan, he documented instances in which longer-term bond rates rose by a substantial amount in a very short amount of time, more than could be attributed to a change in expected real rates, and from which the Committee inferred were changes in inflation expectations. And the Fed reacted strongly to counteract that and to tighten policy by more than we otherwise would have. I think that's the place to look for guidance as to what magnitude of response one ought to presume in a reaction function like that.

Finally, in response to President Evans's remarks, I would like to disavow any unhealthy preoccupation with endogeneity or exogeneity [laughter] and ask you to consider an experiment: Start a DSGE model projection with initial conditions in which slack variables are less than they really are'say, in your last period, say the fourth quarter'because of a configuration of shocks that lead them to be less than they otherwise would be, and in which marginal costs are commensurately lower. My conjecture is that you would get a higher inflation forecast, and I think that experiment could motivate commentary to the effect that slack will keep inflation low. As you can see, there is nothing essential about endogeneity or exogeneity there. I don't think that thought experiment is inconsistent with anything you said, so the attribution to exogenous shocks versus slack'I just don't see the distinction there.

Now, I haven't seen your group's research, and it's been a little while since I reread Christiano, Eichenbaum, and Evans, at least a few weeks'[laughter]. But more to the point, my guess is that agents in that model and in your paper'back to my other comment'have

100 percent confidence in a reaction function. I don't believe real-world agents are quite that confident. For evidence, you could look at the five-year, five-year forward last year when in the summer we had this fall in inflation expectations, and it seemed inconsistent with us being believed with 100 percent probability to be following a constant rule.

I will say, though, to President Evans's credit, he has given me a brilliant idea. I think I am going to ask my staff to do research extending my JPE article.

CHAIRMAN BERNANKE. It'll take five years to get published, though. [Laughter] President Bullard.

MR. BULLARD. Thank you, Mr. Chairman.

MR. EVANS. Mr. Chairman, can I say something?

CHAIRMAN BERNANKE. Do you want a rebuttal?

MR. EVANS. No'the reason I mentioned slack is that there's not an output gap in that model. I mean, slack is when you put it into the Woodford-type of style, and you talk about the different type of market equilibrium. We can construct a slack variable; that's a concept that we did for the inflation dynamics. But per se, marginal cost is really the relevant thing. So you have to work pretty hard to come up with a concept that looks like a Woodford slack variable. But the object that you would work on to get at what you are talking about'which is a valid experiment, I'm not denying that'would be to pump different shocks in there.

MR. LACKER. What you say is exactly true. The inflation dynamics run off marginal cost. There is this link that one can draw in many models, a one-to-one relationship between the level of marginal cost and the level of the variable that seems to accord with the notions of slack.

MR. EVANS. I was trying to skip that additional assumption, which often is at the heart of what people are objecting to, which is, it's not observable. But we can talk about this more. I

understand that we're going to have some discussions about DSGE models at upcoming meetings as well.

MR. LACKER. Okay, great.

CHAIRMAN BERNANKE. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. The Eighth District economy continues to expand at a moderate pace. Businesses associated with agriculture, in particular, seem to be doing quite well. This may be affected by recent wet weather in the District, but we'll have to see on that. Land sales, as I have reported before, seem to suggest pretty rich valuations. Commodity price increases are a key concern, as they are all around the table here. Gas prices are nearing levels which might importantly influence household behavior but don't seem to have done so quite yet. I agree with Presidents Fisher and Lacker that many CEOs view higher commodity prices as forcing price increases for other goods, and in particular, for their own goods. That seems to be a very prevalent view and much on the minds of business leaders.

Reports on housing and commercial real estate in the District were mixed. Foreclosure rates in the District remain lower than for the nation as a whole by a substantial margin. Anecdotal reports in the District seem to indicate moderate improvement in labor markets'more ideas about hiring from more firms. Banks continue to report relatively weak loan demand, and I think we should all keep in mind, there's an awful lot of banks out there that are in pretty weak condition still, and we've got a long way to go on that dimension.

Transportation businesses in the Eighth District seem to indicate moderate to strong growth ahead. They are worried about energy prices possibly increasing further from here, but they seem to be okay for now. Most of these firms make surcharges to cover energy price changes. They do worry about that cutting into demand eventually, but for now, things seem

pretty robust. There is some shifting that is occurring in the industry to lower-cost, slower transportation and away from the higher-priced products and the faster products. Technology businesses also report robust activity'in fact, incredibly robust activity. There is something of a boom in certain technology labor markets. Competition for talent is fierce. The comment I got from a major technology firm was, 'It's like 1998 when it comes to hunting for talent in this area.'

Nationally, it appears that the first quarter will be weaker than was once expected, and weaker than I expected late last year and early this year. But I agree with the Tealbook assessment that the second quarter and the second half of this year is likely to be stronger than the first quarter. Part of that is based on somewhat stronger labor market performance over the last six months than expected. I also agree with President Lockhart that anecdotal evidence that I have heard seems to be at odds with the pretty soft Q1 numbers. To me, that suggests that there are special factors driving the first-quarter number. We will see what it is; we haven't actually seen the first-quarter number yet.

We obviously face substantial risks in the economy, and the ones I am going to list here are the same ones cited by President Williams. I do worry about all of them. First and foremost is oil prices and continuing turmoil in the Middle East and North Africa. My main comment on that is that it does not appear to be a so-called Hamilton shock so far. Jim Hamilton is a leading researcher on this topic. For him, the price would have to go quite a bit above the moving average of the price over the past three years, so that would be actually a very large number on West Texas Intermediate. I'm not sure quite what to think about that, but I do think that households are maybe a bit better equipped to handle high energy prices than they were in 2008 when it really was a shock. One of the things that happened in 2008 was that we went through

$100 a barrel oil for the first time in March 2008, and then it went up almost 50 percent from there in the next three months. People started to wonder, is the world coming unhinged? And I think that really changed household behavior. I'm not quite sure what we'll get this time around, but obviously it bears very close watching.

On Japan, I just don't see the situation getting worse from here. I see it slowly getting better. There are anecdotal reports in the Eighth District about plant shutdown or slowdown, so that is affecting manufacturing, as we heard in the staff reports. That is important, but I see those as temporary factors. It may be a little bit more persistent than I would have thought over the past couple of weeks.

On Europe, I was in Europe. I do see renewed tension there. I do see some potential for continuing problems. I got two views in Europe. The private-sector view seems to see bad math for Portugal, Greece, and Ireland. They see trouble ahead. I saw a public-sector view that sees delay as a strategy. I didn't think this is a good mix. The private sector seems to smell blood in the water, and I'm a little worried that this is going to get away from the Europeans. They have been very good about addressing problems. Hopefully, they'll come through again this time, but I am a little worried about that situation. The problems there are not really resolved. It continues to be a risk from our perspective.

The U.S. fiscal situation'your guess is as good as mine. Outcomes remain unclear. It is still a wild card, in my view. Despite these risks, though, the best bet is, all of these will be resolved in a reasonable way and that the outlook for the U.S. economy is still reasonably good for 2011.

I'm going to turn now to remarks on core versus headline inflation, because this is a key topic for us, and I have several remarks. First of all, in my view, control of headline inflation

over the medium term is the policy goal. These are the prices that people actually pay, and so this is the index that we have to work with. Core is not the policy goal, though I think it sometimes seems to be, because we refer to core so often and use it so much in our analysis. It's true that headline inflation is generally more volatile, but so what? That is the policy problem that we face, and that's our job. It is not really our job to make our policy problem simpler than it really is. There are stories that take the view that if we adjusted policy in reaction to the volatile consumer price index, or PCE inflation index, we would get an unstable feedback loop and cause havoc in the economy. Stories about unstable feedback are unproven, in my view. There's very little research on this. And, anyway, you'd have to adjust your policy rule so that you adjust in an appropriate way given the volatility of the inflation rate that you are looking at.

One reason to look at core, obviously, is as an indicator of future headline inflation. I am not convinced by this argument, and I have five remarks on it. The statement that core predicts future headline is usually associated with univariate forecast models. That is, inflation as a function of past inflation alone, appropriately measured, without other variables. This is not how we normally forecast inflation as a Committee; we include other variables such as inflation expectations and slack variables, as was just being discussed. One example would be Stock and Watson at the Jackson Hole conference last year, but there are many other examples.

A second remark is, in my view, core has little theory behind it. It comes to us from the 1970s where we just threw out certain prices because they were inconvenient to look at. It has a long and venerable tradition around the table, but it doesn't have much to commend it from any statistical perspective or any theoretical perspective.

One might think that what we're doing is throwing out the components of inflation that have the highest signal-to-noise ratio for the various components. If you look at simple measures

of the signal-to-noise ratio, energy indeed has the lowest signal-to-noise ratio, so it would make sense, if you want to pick one off, to throw out energy. Food is actually not the second-lowest signal-to-noise ratio in the inflation index, and in fact food actually has a relatively high signal- to-noise ratio. So the food part doesn't make very much sense. Results like this, and all the things I am going to talk about, are also very dependent on the sample considered; that is always a problem when we are looking at issues like this.

You may not care about theory as much as I do, so let's just think about empirics alone. But the empirics are also weak. In the paper by Julie Smith, which is sometimes cited on this topic'forecasting future headline inflation with some measure of core inflation, including a traditional core inflation measure'the traditional core inflation measure actually has the highest root mean square error in predicting future headline inflation. So other types of core measures do better in that particular paper. Results, again, are sensitive to the sample period for all measures. And as is typical of empirical work in this area, it's going to be very sensitive to what time period you are going to look at. It is hard to get really clean results that warrant the kind of emphasis that we put on it around the table here.

Now, a very legitimate issue for the Committee is: What subset of prices, if any, could be the central bank target? If you don't want to target the overall measure of inflation, there may be reasonable ways to think about some subset of prices that are the prices that you want to emphasize and that you want to target and talk about. There is a literature on this question, and that literature does have the potential to rationalize a focus on a subset of prices instead of the overall price index. But so far, this literature seems to have very little influence at the FOMC, and this may be because the typical recommendations that come out of the literature are almost nothing like what we typically talk about here at the table.

One result from the literature is that you should focus on the sticky-price sector; that comes from Woodford and his coauthors. You would arrange the prices by the ones that are the most sticky, you would create an index of that, and then you would target that. That would be an argument for looking at some subset of prices instead of the overall prices. We don't do anything like that as far as I know. Another result, if you look at it in an international context with sticky prices, comes from Clarida, Gal'' and Gertler who have a multicountry model. In that model you would focus on the domestic sticky prices and forget about the import prices. We don't seem to do anything like that.

Even though these are not popular conclusions'and maybe they shouldn't be, maybe they are not established enough in the literature'it may be fruitful to think more carefully about why we might wish to focus on a subset of prices, or, otherwise, just abandon that, and say we are going to focus on the overall price index. Then we could better rationalize what we do than what we do now.

Now, if you don't care anything about that, then let's just talk about practical concerns on core versus headline. Obviously, it is a problem for us to refer to core measures because people say that they have to pay the other prices. That always happens when commodity prices are rising in the U.S. economy. So I think we should certainly deemphasize core inflation as an ultimate goal, and, indeed, some of our rhetoric has moved away from talking so much about core inflation to talk about headline inflation as the medium-term policy goal. I would go so far as to possibly take core PCE inflation out of the FOMC projections. I think it gives it too high of a status. And, as I'm arguing here, it doesn't have enough credibility to warrant that status.

Temporary headline inflation movements can just simply be called 'temporary.' We can just say, yes, inflation is high right now, but we don't think it's going to continue to be high, and

that's the way it is. We don't have to refer to core to make that argument. And we can do other things to smooth out data measurements. We can look at inflation movements from one year ago, for instance, as a way to smooth out movements in inflation as opposed to excluding certain categories of prices.

One final practical consideration on commodity prices. We often say that the increases in commodity prices are due to global demand, evidently outstripping global supply. I have made this argument many times myself, and presumably China and India are key drivers in this argument'that is, they are key drivers of the global demand in commodities markets. But then we turn around and we say that we think the situation is temporary, but the situation with China and India is not a temporary situation. This is going to go on for decades. I think that citing the global factors that you know are going to continue for decades gets us in a bit of a trap when we turn around later and say, 'I think these are going to be temporary factors.' Even though I've done it myself, I'm not sure that that is always the best argument.

The bottom line is that I think core versus headline inflation is a long-standing issue for the FOMC. It's certainly a hot topic right now, and I'm sure it will continue to be in the future. Maybe now is the time to deemphasize core inflation. If you want a less volatile measure, use one that is perhaps more defensible, something that we can point to and say that we've got a better rationale for it, other than that it has been used for decades here. I think that might be helpful to the Committee going forward. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Bullard, you raise valid points about the relationship between core and future headline, but I think the idea that we target core inflation is kind of old. I think everybody around the table does target forecasted headline inflation, and I just want to mention that tomorrow in my press conference I will be highlighting

the projections, and I'll be focusing entirely on headline inflation, but on the forecast of headline inflation in the medium term. Your comment about taking core out of the projections is an interesting one, though. I'll have to keep that in mind. Thank you. Vice Chairman.

VICE CHAIRMAN DUDLEY. Thank you, Mr. Chairman. On the activity today, I think I share the views of many people around the table that, while activity looks better than last summer'faster job growth supported by a healthier financial system, and a trade sector that looks more likely to make a persistent contribution to growth, which I think is very valuable' it's disappointing relative to where we were at the last FOMC meeting, with real GDP growth in the first quarter quite slow and the rebound in the second quarter quite modest.

I think what is striking to me is that this is occurring at a time that fiscal and monetary policy is on very stimulative settings. The state of monetary policy ease will start to moderate if we complete our large-scale asset purchases, and fiscal policy is going to turn significantly restrictive in 2012, even in the absence of additional fiscal measures by the Congress. We calculate that we are on track for fiscal restraint in 2012 of about 1 percent of GDP, which is pretty sizable if the economy is going into that growing at a 3 percent-plus type of rate.

In terms of the first-quarter GDP print, I agree with David Wilcox's comments, it does seem to overstate the weakness. The ISM surveys, the industrial production data, the consumer spending, and the labor market developments all seem more positive than that. So either we will have upward revisions to the data over time or the production will go into inventories. We'll just have to wait and see how that plays out.

I do think, though, that there are some significant risks to economic growth posed by higher energy prices. I note that the magnitude of the increase in the oil bill for households is roughly comparable in size to the payroll tax cut. The problem is that the payroll tax cut is

temporary and reverses the beginning of next year, and it's not clear how long the energy prices are going to stay elevated.

On inflation, I think that there is no great surprise that the higher oil prices are feeding into headline, and, of course, there's a little bit of spillover into core. Where I'm maybe a little bit more concerned than the staff is on inflation expectations. I think you can point to the data and say, well, they're still reasonably well anchored in the sense that the University of Michigan consumer expectations five-year measure has come down in the April survey after going up a lot in March, and you can point to different measures of five-year, five-year forward TIPS breakevens showing different things, but I do think there's quite a bit of risk here if you take a look at the whole picture. We have very stimulative monetary policy with a large Federal Reserve balance sheet. We have fiscal policy on an unsustainable path. We have significantly higher gold prices, significantly higher silver prices. We have a dollar that's actually weakened quite a bit over the past few weeks. I think that while you could still argue that inflation expectations are well anchored, if I worry about what is going to happen next, I think the risks are very predominantly on the side that they could become less well anchored.

In terms of the systemic risks that we face, there are a number of things that are concerning. Nathan touched on some of them. The European problem is not going away; there are at least four problems there. First, Greece is lagging behind where they need to be. In other words, they are not performing up to their commitments, so that means that they need more resources. Second, the political constraints I discussed at the last meeting are becoming more binding as core European countries are less willing to provide that additional aid that Greece in fact needs. Angela Merkel has suffered some political setbacks, and the Finnish elections showed that those who do not favor aid are gaining political ground. So as a consequence of

that, some of the German authorities have put restructuring on the table after keeping that very much off the table for many months. This is not a timely development, because it obviously sets in place very bad dynamics leading to much higher interest rates in the periphery, lower prices, and that, of course, just reinforces the likelihood that the restructuring will have to take place. It also raises the potential needs, because if the Greek debt were restructured, then the Greek banks would be impaired by a greater margin. So you not only need more money for the Greek government to continue its operations, but also for the Greek banks to be able to stay in business. It is not at all clear where those resources would come from. And as Nathan pointed out, this all increases the contagion risk to Ireland, Portugal, and even Spain. Spain up to now has been able to sail away from the rest of the periphery, but there could be political setbacks in Spain, so I don't think that they are out of the woods by any stretch of the imagination. The final problem in Europe is that there is really no viable exit strategy. The financing mechanism that is supposed to succeed the EFSF would be a financing mechanism in which the debt issued from that facility would be senior to the existing debt, so all of the incentives are for private investors to exit. All this means is that all of the debt of the periphery is now getting concentrated in public hands' either the ECB directly holding the debt, the ECB financing the debt, or the EFSF funding the debt. So it's not really clear how this is going to play out over the medium to longer run.

A second issue is Japan. The supply constraints have gotten most of the attention. What struck me, though, when I was there a couple of weeks ago is that there is also a pretty sizable demand shock in Japan. Tokyo is as quiet as it's ever been, and a lot of the leadership in Japan is talking to people about how you need to go out and go back to business as usual, go to parties, go out drinking, do all these sorts of things. But nobody feels like doing that. And I completely understand that. One, it is a terrible tragedy, and people are in mourning. But, two, you can't

get away from what has happened, because every day there are aftershocks. We were in Tokyo for 36 hours, and there were at least six earthquakes in that 36-hour period'one of them when I was actually speaking. The chandelier started to swing, which is a little disconcerting, [laughter] because every time one of these earthquakes starts, you don't really know what the ultimate magnitude of the earthquake is going to be. So I think it is very difficult for them to get back to business as usual.

The Middle East'North Africa also remains an issue. I guess the news there is that not much has spread beyond Libya to other oil producers. But the bad news is that it looks like a complete standoff in Libya. Also, the bad news is that Saudi Arabia has basically said they were going to pump additional crude, but the crude either isn't forthcoming or it's not demanded because it's not as high quality as the Libyan crude. The Saudi promises haven't actually led to additional supply, and there is not actually an oil response to that increased willingness of the Saudis to pump oil. So it seems to me the risks there are very much on the side of oil prices staying higher for longer, and crimping real income.

Then, finally, we have our own little set of risks that we talked a little bit about earlier' the Treasury debt limit ceiling. I think that there's a real risk here, in part because the two sides are really far apart, and because they are both looking for political advantage going into the next election cycle. There is really a risk that the brinkmanship turns into miscalculation. And the risk there is greater because the markets aren't taking it seriously, and people can say, 'What's the big deal? Markets aren't worried about it, so let's go to the edge.' I wouldn't make much of the S&P putting the U.S. on negative watch. I think that is just catching up with reality. I think what really matters is what the Congress does or doesn't do over the next couple of months. Thank you.

CHAIRMAN BERNANKE. Thank you. Governor Yellen.

MS. YELLEN. Thank you, Mr. Chairman. My view of the modal outlook is little changed since our March meeting. I agree with the contours of the Tealbook and in particular with the judgment that the first-quarter soft patch probably reflects idiosyncratic factors with relatively little bearing on the outlook. I anticipate economic growth at a moderate pace during the second half of the year and expect it to strengthen over time.

An armada of headwinds is constraining the recovery: higher food and energy prices, falling housing prices, ongoing weakness in residential and nonresidential construction, intense pressures on state and local government spending, and, beginning next year, significant fiscal drag from the federal budget. Nonetheless, I anticipate that the impetus from investment and consumer spending, along with robust global growth, will prove powerful enough to overcome these drags. Business confidence has improved markedly. Manufacturing activity is robust. Our accommodative monetary policy has caused credit and broader financial conditions to ease, supporting aggregate demand through many different channels. There are heartening signs of improvement in the labor market, and recent data suggest that unemployment and vacancies are now tracing the cyclical pattern that has been typical of past recoveries. I see this as encouraging evidence that unemployment is mainly cyclical, not structural, and should, therefore, revert to normal as the recovery proceeds. My bottom line is that the U.S. economy appears to be in a self-sustaining recovery that is proceeding at a moderate pace. I expect the output gap and unemployment to decline, but slowly, so both will be substantially higher than normal levels at the end of the forecast horizon.

Turning to inflation, measures of underlying inflation remain well below the 2 percent level I consider consistent with our dual mandate. For example, the market-based core PCE

price index has risen less than 1 percent over the past year, and at an annual rate of 1.2 percent over the three months ending in February. These inflation outcomes partly reflect healthy productivity growth and modest wage increases. Unit labor costs have barely increased since 2007. Moreover, inflation expectations remain generally well anchored. Higher commodity prices have naturally caused headline inflation to surge in recent months. Core inflation has also picked up somewhat as producers are passing through a portion of their higher input costs into the prices of a broad range of goods and services. However, as long as commodity prices generally level off, I expect that by around midyear, headline inflation will revert to rates close to those of core inflation, which in turn should decline significantly over the second half of this year. With exceptional slack in the labor market throughout the forecast horizon, I see little chance of the second-round effects that would occur were employers to boost wages in an effort to compensate workers for the real income losses they have sustained. And here I agree very much with President Williams's comment that there is virtually no evidence in the United States of real-wage rigidity. Therefore, I expect inflation to remain subdued throughout the end of the forecast horizon.

My modal forecast is benign, but the risks surrounding it keep me awake at night. As policymakers, our job is to be prepared to respond to a wide array of potential threats, and some could necessitate more-rapid policy tightening, whereas others would call for additional policy accommodation. We therefore need to maintain open minds on the future stance of monetary policy.

The most obvious risks relate to commodity prices. Higher food and energy prices are sapping household purchasing power, and the effect is evident in consumer surveys and anecdotal reports of retrenchment by the lower-income households most severely affected.

Anecdotal evidence also suggests that the uncertainty associated with recent commodity price trends is causing some businesses to put expansion plans on hold. These existing downside risks are compounded by the possibility that futures prices notwithstanding, commodity prices could escalate a lot further, potentially derailing the incipient recovery. Were such a scenario to materialize, we might well conclude that policy should be more accommodative than in the Tealbook baseline. Of course, we must also be prepared for the possibility that a further surge in commodity prices could push up inflation and inflationary expectations, triggering a wage'price spiral to take hold. Such a development would necessitate a significant policy response. Our experience during 2002 to 2008, when oil prices more than quadrupled, but measures of underlying inflation remained close to 2 percent, gives me comfort that commodity price movements need not trigger such an outcome, but we cannot take such a benign scenario for granted.

I actually have quite a long list of risks that I worry about, but I'll mention just one other. A second risk that worries me relates to fiscal policy. Meaningful efforts to cut the federal budget deficit could produce a significant and extended drag on economic growth in the years ahead. The recognition in the Congress that a multiyear budget plan to stabilize the U.S. debt-to-GDP ratio is essential to fiscal sustainability and longer run economic growth is heartening. Failure to enact such a package would threaten our financial stability, while an extended period of delay would be associated with elevated uncertainty that could start weighing heavily on the spending decisions of households and businesses. However, the needed fiscal adjustment is substantial, and a program on the necessary scale could be associated with significant fiscal drag that would reduce the equilibrium real interest rate in coming years. In

this scenario, a highly accommodative stance of monetary policy could be appropriate for quite some time.

CHAIRMAN BERNANKE. Thank you. Governor Duke.

MS. DUKE. Thank you, Mr. Chairman. Bankers and bank analysts are increasingly less worried about credit quality and much more worried about the ability of banks to generate asset and revenue growth. Credit metrics are within or rapidly approaching long-term acceptable standards in commercial lending, auto lending, and now in credit cards. Classified assets are declining at larger banks and leveling off at smaller banks, and a number of bankers point out that a significant portion, up to one-third, of CRE assets classified as nonperforming have continued to pay as agreed. Absorption of commercial space continues but at low rental rates. Still, cash flows support debt services as long as interest rates remain low.

Even in residential mortgage portfolios, new entrants into delinquency are slowing. Bankers suspect that this improvement could be seasonal as tax refunds could be helping borrowers catch up, but they point out that, at least, if borrowers are using the cash from tax refunds to make mortgage payments rather than something else, that would represent progress. It's also possible that this is finally a manifestation in mortgages of the credit cycle that we already saw play out in auto and credit cards, as fewer borrowers are losing their jobs and newer loans are of much higher quality. I also believe that the sharply lower delinquency rates across products and across borrowers are indicative of less financial stress among those who still have access to credit or credit outstanding, possibly a signal that we're coming to the end of deleveraging, especially among consumers. However, I would point out that this signal would not apply to the long-term unemployed, those who have found jobs at much lower wages than they had previously, or those with severely delinquent or underwater mortgages.

Demand for all types of credit remains weak. There's some growth in C&I lending primarily reported by larger banks lending to larger companies, but it is still event driven, such as for loans to fund mergers and acquisitions. Those who reported lending for working capital or capital investment cited loans to strong sectors such as manufacturing, energy, and agriculture- related businesses. There also appears to be some slight pickup in small business lending and evidence that small businesses perceive loans as slightly easier to get. Banks reported easing of terms and rates in commercial lending in the SLOOS. Easing is usually prompted by competition, and, indeed, in my conversations, a few bankers characterized competition for C&I loans as aggressive. A number of banks reported some demand and some appetite for new CRE loans, primarily for purchases of existing properties, refinances, and multifamily. Banks also reported easing standards in consumer credit in the SLOOS. However, the bankers pointed out that during the recession, credit performance for a given credit score band had deteriorated, so the cutoff scores were raised. What they now report as easing is really a return to the previous levels.

One of the key assumptions in the Tealbook forecast is that the economic recovery will be supported by increasing credit availability. Overall, my impression is that credit conditions are considerably easier than they were at the height of the crisis, but that, with the exception of residential real estate lending, they're probably pretty close to as good as they're going to get.

Even as loan demand remains weak, deposits continue to show strong growth. Bankers are having a tough time finding ways to employ these additional deposits. Most have already replaced much of their wholesale funding with deposits. Some are actively using lower interest rates to discourage new deposits and refusing to bid on large deposits, and rates are reportedly

being quoted in the single digits for large deposits, consistent with the rates we're seeing in other short-term markets.

Finally, lest we get too complacent about reserve levels, as a final indicator of bank balance sheet preferences, we could look at banks' willingness to hold reserves. About two- thirds of the reserves created since we started the LSAPs in November have been absorbed by foreign banks, and a few large U.S. banks have substantially reduced their individual holdings of reserves even as the aggregates have increased. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Tarullo.

MR. TARULLO. Thank you, Mr. Chairman. Since our March meeting a lot has happened, but I don't think the basic lay of the land has changed significantly. Two features continue to frame the picture. First, the economy certainly has some self-sustaining momentum, but still not at a particularly robust pace. The well-documented obstacles to a sharp recovery from recession that has been induced by a financial crisis have proved just as enduring as Ken Rogoff and Carmen Reinhart predicted. At some point, obviously, obstacles such as the overhang of foreclosed homes will recede into the background, but this hasn't happened yet. Second, there continue to be an unusual number of essentially political or geopolitical risks, many of which were rehearsed by Bill a few minutes ago, that could slow even further the modest speed of the recovery.

Last week I found myself lowering my economic growth projection under the cumulative weight of these risks. Strictly speaking, I guess I probably shouldn't do that, because I think we're supposed to give a modal projection rather than a number discounted based on the combined likelihood and severity of significant risks. But the very number and persistence of these risks, particularly the potential for more political turmoil in key oil-producing regions,

makes them hard to exclude from even a baseline projection. And as I think John mentioned earlier, some appear already to have negatively influenced consumer confidence.

This may seem like a relatively pessimistic read of the economic landscape, and I have three responses to that. One, relative pessimism has served me pretty well in the last couple of years. [Laughter] Two, I note that the central tendency of the FOMC has come down to where I was in January, and I've just gone down a little bit further. And, three, I do weight the risks to economic growth to the upside in my projection, and I suspect a number of you actually weight to the downside.

Rather than going into more detail on the projection, I want to spend the rest of my time on how we're going to go about thinking about inflation over, I suspect, the course of the next several meetings. A lot of people have already addressed it today. Over the weekend, one of the many things I did instead of hunting for Easter eggs was to go through the transcripts of the FOMC from the middle part of 2005 and from all of 2008, periods during which there had been big run-ups in oil prices and, to some degree, other commodity prices, to see how the FOMC was assessing what was going on and to see whether we can learn anything from that experience.

I'll return to that in a moment, but I first want to say that I think what a number of you have tried to do today is to both develop a model or a theory or at least a mechanism for how commodity prices or other current headline inflationary forces would carry forward into future inflation. And then I think some of you have tried to specify what some of the tangible data- driven indicators of those trends would be, and that seems to me not only the right but the essential way to think about this going forward. We both have to have a concept of how we think current pressures would persist over time, and, because we can't for good reason afford to

wait until that actually happens, we have to try to identify what kinds of data would give us some fairly strong basis for believing it will happen.

But I contrast that with just stating things that might happen, and this is what one learns by going back and looking at the transcripts. Concerns about commodity prices, particularly reports of what businesses are saying'and there was a lot of this in 2005 and 2008'read like this: 'Man, we have just shifted. We are now thinking in inflationary terms.' And of course, about six months later they weren't. So I think that's the kind of information that we have to discount because it hasn't proved particularly probative in the past. Anecdotes can help us question what sorts of data streams would be useful, but ultimately, we need to be a somewhat data-sensitive group when we start to make our decisions.

So let me try to add one piece of information here, but this is hardly dispositive. I'm looking again at labor markets, which won't surprise you, and I begin with a somewhat puzzling phenomenon of the unemployment rate having dropped so much in the last six months despite a rate of net job creation that was, until recently, quite tepid, and even today is not particularly robust. Without any more information than that, I think one would assume that the reason for this phenomenon is a drop in the labor participation rate reflects the combined effects of extended UI benefits expiring, the long-term unemployed becoming discouraged and leaving the labor force, and the impact of a couple of years of a declining trend in participation because of an aging population, which is just now showing up on the other side of the recession after having been masked by the big dislocations of the past couple of years. And I think there's something to all these explanations. The Board staff has been trying to dig deeper in order to quantify each of these effects, and I suspect their analyses will be of considerable importance not just for present purposes, but for monetary policy going forward.

But there are indications, admittedly preliminary, suggesting that something else is going on here, and I'll mention two. First, if trend participation is to be an important part of the explanation, one would expect it to show up principally through demographics'that is, participation rates begin to decline pretty dramatically for each five-year band of people beginning at age 55. Even if, as seems the case, the participation rates of older Americans are increasing now based both on choice and economic necessity, there's such a gap between the rate for 50-year-olds and rate for 65-year-olds that this shift would be swamped by the fundamental fact of the baby boomers getting old.

This logic of changing trend participation will probably be reflected in the data over the medium term, but it has not been reflected in the data for the last year. The BLS doesn't publish age-specific data on employment and unemployment as quickly and as thoroughly as one would like, so we've got to be a little cautious in drawing conclusions here. But reading the seasonally adjusted household numbers over the last year or so, one sees something at odds with the trend explanation. In each of the prime working decades of 25- to 34-year-olds, 35- to 44-year-olds, and 45- to 54-year-olds, the numbers of unemployed have been falling, but in each cohort, the number of employed workers has risen by less than the amount by which the unemployed have fallen. Indeed, if we look at 35- to 44-year-olds, whose participation rate is historically the highest among any age group, we see that the number of both employed and unemployed has fallen. So there are fewer people in that age cohort employed today than one quarter ago, two quarters ago, and three quarters ago. Significant numbers of this group have obviously left the labor market. Now, on the other hand, contrary to what one might have expected, the number of employed 20- to 24-year-olds has increased during this same period, which is something you

wouldn't predict demographically. The number of employed people over age 55 has also increased, more in line with what labor participation trends might have predicted.

But going back to that central point about the three prime-age working cohorts, if the trend explanation is, for the moment at least, not so convincing, we have to look to some of the other standard explanations, such as exhaustion of UI benefits, to see if those are stronger. That is, prime-age workers may be dropping out in large numbers after having exhausted their UI benefits. Perhaps that's true. I'm sure it is to some degree, but some yet unpublished research by Alan Krueger suggests that something else is also going on here. Based on what I believe was his examination of raw rather than published BLS data, he finds that in the past couple of years, the recently unemployed have been more likely to leave the labor force than the long-term unemployed. Now, this, obviously, is a reversal of traditional trends.

Alan offers several hypotheses as to why, although he cannot demonstrate any of them right now with currently available data. What's important for my purposes is that most of these hypotheses, particularly when combined with recent age-specific labor participation rates, suggest that there may be even more slack in the labor markets than the unemployment numbers would suggest, even when they are read through the lens of labor market participation trends. One of the most significant of his hypotheses is that middle-class people with a working partner have shifted pretty quickly to getting more education or training to improve their skills. Presumably such people will be back in the labor market at some time in the future.

All of this raises more questions than it answers, but when seen in combination with the still very low level of quits and other factors, including the relative stagnation of unit labor costs, I think it pushes toward there being a greater output gap and a lower medium-term NAIRU than the usual employment statistics would suggest. While I continue to think that the unemployment

rate may tick up again later this year as people are lured back into the labor market by some increases in job creation, Krueger's research implies that this may not be the case. But even if the unemployment rate continues to decline, his analysis suggests that there will still be more real slack in labor markets.

So let me conclude not with strong assertions about labor markets, but instead, again, to suggest that for all of us over the course of the next few meetings, it's going to be critical to try to identify specific kinds of data and specific kinds of activity in parts of the labor market that, in a concrete fashion, would reflect some impact of changing inflation expectations or tighter labor markets. And I think that's the only way, probably, we're going to be able to develop a consensus on what's going on, as opposed to reverting somewhat less helpfully to our priors as to what the models look like untethered from data. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Fisher.

MR. FISHER. I want to just address one issue the Governor raised' and I admire the way you spent Easter weekend. I think if you look at the transcripts thoroughly, what you'll see is that what we were hearing from business reporters, to which I am a devotee, was a significant buildup in price pressures leading up to August 2008, and they were right. They did not anticipate the collapse in demand that occurred as a result of the financial crisis, and that's when you began to see a reversal in expectations. I think we have to be very careful to dismiss microeconomic decisionmakers. They should supplement and complement the data. Data are history. What we're trying to get a sense of is things at the margin. I always preface my comments by saying 'for what it is worth,' and for what it is worth, I think it is valuable to listen to those who actually allocate resources, decide who to hire, and price products.

MR. TARULLO. I anticipated that [laughter], which is why I went back to 2005,

because we didn't have a financial crisis following 2005, and there were many of the same kinds of expectations. And I guess, Richard, what I'd say is that the 2008 transcripts are probably more a lesson in the need to look at what else is going on. I have to say, I was taken by the relative downplaying of financial risks and the relative playing up of inflationary risks in the middle part of 2008.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I think these observations about the labor market are spot on. I will say, I've spent some time looking at these data too, and I think it's very confusing. One thing I would point to'and I think I mentioned this last time'is looking at these broader measures of unemployment and thinking about the marginally attached, et cetera, I would have thought that if we were seeing a group of people leaving the labor force who were about to pop back in, you would have seen more of an increase in the group of marginally attached workers than we've seen.

MR. TARULLO. I would think that there should be something to that as well, Narayana. And it is frustrating to use the published BLS data because they simply aren't as granular as would be useful to us. But that's why one of Alan's hypotheses is particularly interesting, which is that people are going into training or, in some cases, going into child care for their own kids for some specified period of time.

MS. YELLEN. I just wanted to ask the staff'isn't it the case that the broader measures of unemployment have declined less than the official measure?

MR. WASCHER. Right. From that standpoint, people who want a job but have dropped out of the labor force and still indicate that they want a job might have accounted for

0.2 percentage point of the decline in the unemployment rate over the past year.

MR. KOCHERLAKOTA. Certainly I accept that amount would be about right, yes. CHAIRMAN BERNANKE. Governor Raskin.

MS. RASKIN. Thank you, Mr. Chairman. The moderate pace of the recovery is continuing. The economy continues to face a number of headwinds limiting its ability to grow faster. These headwinds include higher gasoline prices, reduced government spending at both the state and national levels, and a housing market characterized by low equity values, supply overhang, and deteriorating quality.

Historically, my projections have been more pessimistic than the staff's because of my continued concern regarding the housing market, low state and local spending, and the slow resumption of consumer demand. Wanting to offset this pessimism with the seemingly good news that the unemployment rate was looking lower'and not daring to wade into the debate over modern finance models between President Evans and President Lacker, nor having really the extensive list of interlocutors known to President Fisher, and, finally, seeing no short-term end to the fact that I will always be last in the economic go-round [laughter]'I had no choice but to hit the road last week in search of some observable data and traveled to an unemployment center.

The one I visited is known for its cutting-edge approach in providing training, job prospects, credit counseling, foreclosure counseling, and other enhancements to people moving in between jobs. I claim no academic precision to the sampling here, nor do I claim anything about the temporal dimension to these observations. I went to the unemployment center with no

preconceived notion except data from the latest household survey showing that the number of people involuntarily working part time had increased by 90,000 in March to 8.4 million. The household survey also indicated that the nation's 13'' million unemployed people have been out of work, on average, for at least 39 weeks. With all of this labor available, one question I had is whether the recent increased inflation could lead to a wage'price spiral of the kind that typically ignites the runaway levels experienced in 1979 when inflation was 13.32 percent. Another question I had is whether improvement in the unemployment rate alone should cause us to claim 'mission accomplished.'

What I observed at the unemployment center'actually, it was more positively called an employment center'is a pipeline that carries the newly unemployed between jobs. The existence of jobs at the end of the pipeline is what motivates people to even enter the pipeline and participate in services provided throughout the process, such as resume writing, computer literacy, one-on-one counseling, and foreclosure prevention. The quality of the jobs at the end of the pipeline was not particularly exciting. The day before I was there, the city's stadium had been rented by Monster.com to accommodate job seekers and employers. The job seekers showed up in droves, but the bulk of vacant jobs represented by the few employers that participated looked mostly like multilevel marketing jobs that paid commission only and were based on the number of friends you signed up.

Not all job seekers were uneducated. Most recent additions of job seekers to this particular employment center were college and graduate-school educated. On the day of my visit, they were pharmaceutical company employees, and they were clogging the pipeline, in the view of the less educated, because the more educated were settling for jobs that were lower paying and of a kind that the less educated were vying for. Once the less educated saw that they

were losing out, they left the pipeline, thereby abandoning the retraining programs that could have been of some benefit and increasing the time these people remain jobless and with insufficient income.

Another group of employees clogging exit from the pipeline were the so-called surviving employees. These employees have jobs but are so demoralized and exhausted by being the sole survivors holding onto their jobs and picking up the slack of the laid-off employees that they, too, are looking for jobs. Once they add to the competition for a vacant job, they bump away the unemployed in the pipeline who believe themselves to be increasingly stigmatized by the length of time they've been without work. So the existence and attractiveness of jobs at the end of the pipeline determined whether people even entered the pipeline to begin with.

For the recently unemployed, the challenge of this employment center was to tighten the link between the employer doing the layoff and the about-to-be-laid-off employee so as to get the employee into the employment center before being laid off. This way the employee would stay engaged in a job search. Of course, despite enhancements like resume writing, one-on-one counseling, and computer literacy training, the only real enhancement seems to be a high probability of their being a job.

I'll stop there but sum it up by saying that this picture, were it to be duplicated somewhat consistently across the country, is not a picture of robust job creation, nor one that seems susceptible to setting off a dangerous wage'price spiral, nor one that shows bargaining and negotiation over wages to be anything but concessionary. It's a long way of saying that labor markets will be strong when the economy can absorb the people who want to reenter the job market. Thank you.

CHAIRMAN BERNANKE. Thank you, and we compliment you on your original research.

I would do a better job of summarizing this conversation if I had overnight to do it. If your patience will last just a minute more, I'll give my own views on the outlook, and tomorrow we'll start with a summary, and then we'll turn to the policy go-round.

I have not a great deal original to say about the real side. I agree that the weakness of the first quarter is mostly due to temporary factors, much of which should come back. And like the rest of you, I think a moderate recovery is going to continue as those factors reverse and as the labor market continues to improve and generate income. We've seen some stabilization in the saving rate, which suggests that as labor income grows along about a 3 percent path, consumption should also grow. Note has been taken of the industrial sector, which is doing quite well and is relying to some extent on very strong export demand from emerging markets. As I've said many times before, notwithstanding the positive direction, we are still in a very deep hole. For example, total hours of work, which is a good summary of labor input given all the different margins on which labor can be varied, is still about 6 percent below pre-recession levels, not even taking into account any trend increases in labor supply. Paradoxically though, I think that actually increases to some extent the projection of near-term economic growth because there is a little bit of a bounceback effect that you would expect to see after a deep recession.

That said, I marked down my outlook for the rest of this year and next year by a few tenths. We've talked a lot about oil and commodity prices. Of course, they're a drag on growth as well as a source of inflation. I think there's also a lot of uncertainty and lack of confidence, at least on the household side now. There were some striking polls to the effect that notwithstanding the improvements in the economy, households are very demoralized about the

near-term economic future. Housing and commercial construction are very weak. Like a number of people, I'm a bit worried about fiscal drag. Next year we will see, for example, the end of the payroll tax cut, the end of investment expensing, the end of the grants to states and localities, the end of the extended unemployment insurance, as well as ongoing phase-out of fiscal stimulus. And so that's a pretty powerful drag, and it's going to take some momentum to overcome that. And in general, I think the momentum seems just a bit weaker, even if the first quarter overstates the weakness, than it was at the last meeting.

So to summarize, I still expect, broadly speaking, continued recovery at a moderate pace. I marked down my projections just a little bit.

There was a lot of discussion today of inflation and of easy monetary policy. And while I agree with many of the points that were made and I understand the concerns, I'd like to make just a couple of somewhat countervailing points.

It's true, of course, that headline inflation has increased. As Governor Yellen noted, quote, 'underlying inflation''and I'll come back to that'is still quite low. The staff estimate of the 12-month change in core PCE for this month is still about 0.9; market-based core is 0.9. The Dallas trimmed mean PCE is 1.0, and the core CPI is 1.2.

Now, President Bullard noted concerns with core, and I agree absolutely that what we're interested in is headline inflation. But I think if you look into the price index a bit, you'll see that a remarkably large amount of the recent inflation we've seen actually is attributable to an increase in essentially one commodity, which is oil. Moreover, there seems to be a good chance that the increase will be temporary. So, for example, since our January meeting oil prices are up $27, which is about 30 percent. Other commodities have risen, but much less. For example, copper is up 3 percent during that period, wheat is up about 3 percent, corn is up about 15

percent, but sugar has declined fairly significantly. Oil really stands out as being the commodity that has increased very significantly. And oil by itself is actually a big source of the pickup in headline inflation. For example, if you look at PCE inflation and don't take out energy or food, rather just take out gasoline and fuel oil, then three-month PCE inflation drops from 4.56 to 2.39, and the six-month change drops from 3.33 to 1.45. So that one very narrow product category is a big part of the pickup that we've seen recently.

I think there's a case, as we explain to our students, that this is a relative price increase. We know some very explicit reasons why oil prices have gone up, why demand has increased and supply has fallen. Of course, the dollar has also fallen, and there are a number of factors involved. I think arguably that the relative price effects that we don't have much control over are certainly part of that phenomenon, and we know how to address that.

I mention that this is seen as temporary. We all have concerns about futures markets and so on, but it is striking that as oil prices have risen $27 since January, the far future oil prices have risen $7.50. There really is a pretty strong presumption in the markets that this oil price level will be reversed, and you can see the reason, which is that the problems in the Middle East and North Africa presumably at some point will be reversed. So I just raise that point. It doesn't invalidate the concerns about pass-through or about inflation expectations, any of those things. But I think at least the initial shock here is not really entirely monetary. I think there are some real factors going on.

The other theme I heard around the table was about how incredibly easy monetary policy is, and of course, it is easy, but when judging the stance of monetary policy, everything should be conditional on the state of the economy. The question we want to ask is, 'Is the monetary policy appropriate for the economy?' and not 'Is it easy or tight in some absolute sense?' In this

respect, I was very pleased to see President Kocherlakota's analysis using Taylor rules, which gives you a way of thinking about whether interest rates are about where they should be or not. Now, when I worked with his memo, as I will explain, initially I ended up disagreeing with it, but then I did some more work and I ended up agreeing with it. So let me just tell you my thought process, but I think it's also instructive for thinking about the state of policy and thinking about where we likely should go over the next year or two.

The underlying assumption in Narayana's memo is that he uses a Taylor (1999) rule, which has a 1.0 coefficient on the output gap. In order to create a baseline, he assumes that in the fourth quarter of last year we were more or less at the right place as far as accommodation is concerned. I asked the staff to give me their view, based on their assessments of the output gap, et cetera, and their calculations showed that based on the same Taylor rule and despite the fact that we were near zero, of course, monetary policy in the fourth quarter of 2010 was still

200 basis points tighter than the Taylor (1999) rule would suggest.

Regarding that gap'and I'm sure Narayana would fully understand it'50 basis points of it came from what I'll call the LSAP adjustment. In particular, Narayana assumed 250 basis points of ease coming from our securities purchases. The staff, particularly Dave Reifschneider, who was responsible for all of these estimates, suggests that the number in 2010:Q4 was closer to 200 basis points, a 50 basis point difference. Obviously that's false precision, but the

200 basis point number was based on more detail about the expected exit strategy in terms of redemptions and sales. So that's 50 basis points. The rest of it comes from differences in output gap estimates; as Narayana pointed out, a lower output gap obviously gives you a higher desired interest rate.

Rather than try to adjudicate that difference, I just went ahead and, taking the projections that we now have, I tried to ask: What does Taylor (1999) tell us about where policy should be? In order to look forward instead of backward, I looked at the fourth quarter of this year, 2011, and the fourth quarter of next year, 2012, and that gives you some sense of what the model is saying in terms of our likely trajectory.

First of all, I had to figure out the output gap. My first stab was to take the middle of the central tendency of our projections for the fourth quarter of this year, which was 8.55, and to subtract from that the middle of our long-run NAIRU estimates, which is 5.4. That gave me 3.15 as the unemployment gap. I multiplied that by 2 to get 6.3 percent as the output gap. Thinking about it now, if you use that, of course, you get very easy policy recommendations and using that kind of approach suggests that we should still have zero interest rates at the end of 2012. In thinking about that, I recognize that an objection to that would be that we should probably be using a higher unemployment rate and higher NAIRU reflecting unemployment insurance and some temporary factors and so on. So I replaced the 5.4 percent with 6 percent, which is the staff's current temporary level of the NAIRU. That gives me an output gap of 5.1 percent in the fourth quarter of this year, which is essentially the same as where the staff is. They estimate 5.0 percent. So that's a simple estimate of the gap.

With respect to inflation, I stayed away from core, and what I said was: Let's look at the forecast for the following year. What is the forecast for 2012? The middle of the central tendency of the total PCE inflation forecast for this Committee was 1.6 for 2012. That's higher than the core inflation estimates either by the Committee or by the staff, so I used that. It's a more conservative number. And I used a goal of 2 for the inflation target.

An important observation here'and this came up in my earlier exchange with President Plosser'is that what I call the LSAP adjustment, which is the additional easing being created by our securities purchases, is going to be waning over time under the baseline Tealbook assumption that we begin redeeming securities at the end of 2011 and then have slow sales later on. You have to take that into account, and in particular, when you do that, the LSAP effect for the fourth quarter of this year is down from 200 to 120 basis points.

Put that all together, Taylor (1999) suggests that the correct level of the funds rate, inclusive of all securities purchases, for the fourth quarter of this year is minus 50 basis points. If you do the same analysis for the fourth quarter of 2012, the LSAP correction becomes 70 basis points. Again, using 6 percent as the NAIRU, what you get for the end of next year is plus

55 basis points.

What this particular guideline'which is, I think, a fairly reasonable framework for thinking about policy'tells us is qualitatively pretty similar to what Narayana found, which is that somewhere early in 2012 we should probably be raising interest rates above zero according to this particular calculation. I'll come back to weaknesses in just a second. I think it's striking that this is actually very close to what the markets are currently expecting; the markets now expect basically a 37 basis point funds rate in May and a 90 basis point funds rate in November'pretty close to what I found. So our policy is easy, but at least by one metric, it isn't inappropriate, given the state of our economy.

Now, having said all that, I really do not feel sympathetic to John Taylor's recent view that we should, more or less, just follow the rule and ignore all other considerations. I think that's probably not the right way to make monetary policy, and so let me just mention a few issues. One is that, of course, you might ask, well, why Taylor (1999). Why not Taylor (1993),

which has a somewhat smaller coefficient on the output gap? I think it's important to note that both of those rules do give you the same long-run results: They both give you 2 percent inflation in the long term; they both give you U equals U* in the long term. The difference is where you are in the Taylor curve. And essentially, what that says is that, if you use Taylor (1999), you are willing to accept a little more volatility in inflation over time in order to smooth out the business cycle just a bit. It's not an issue of allowing a higher inflation target.

The question then might be: What has the Fed actually done? If you look at rolling regressions that try to estimate the Taylor rule for the Fed, the current estimates of the long-run coefficients are 0.94 for the output gap and 1.73 for inflation, which is almost exactly the 1999 Taylor rule, and you get the same results if you use the data before 2001; it's not just a product of the 2001'03 period. One other observation is that this does assume a pretty strong effect for LSAPs. So if you actually don't think LSAPs were very effective, then you need to be a lot more dovish than you are now, because you're taking away a couple hundred basis points of effective ease.

Of course, one of the reasons that you wouldn't want to use a Taylor rule without some additional insight is that, of course, it's way too simple, and I have a long list of objections here. Let me just mention one that this Committee is very concerned about. Taylor rules have nothing in them, as we mentioned today, related to inflation expectations and they have nothing in them related to asset price bubbles. When you see things like that, you to want to be a little bit more restrictive.

Again, I think we have to watch out for those things. I think we do have to look at what's going on in the economy and use our judgment, but I just want to push back a little bit on the view that monetary policy is radically easy and that we need to waste no time moving'you

know, by 8 o'clock tonight, we should basically have the funds rate up to 100 basis points. It's true that monetary policy is easy in an absolute sense, but relative to where the economy is, a standard analysis suggests that we are not particularly inappropriate and that, indeed, easy policy would be justified for some time to come.

Again, let me just end by saying two things. One is that I don't believe in simple rules as superseding thought, and I think we do have to consider issues like the ones that President Hoenig has raised, for example. And the other is, again, to thank Narayana for bringing this into the conversation. We will be making a lot more progress if we think quantitatively about when we should move, what conditions should cause us to move, and how easy or tight monetary policy ought to be.

Okay. Thank you very much. I understand that a reception is just now beginning for ex- Governor Warsh, followed by dinner. If you have any changes in your projections, please provide them as soon as possible. We will be reconvening at 8:30 tomorrow morning. Thank you.

[Meeting recessed]

April 27 Session

CHAIRMAN BERNANKE. Good morning, everybody. I'm going to start the meeting today by completing the go-round from yesterday. I'll give you my quick summary of the discussion on the economy.

As a diversion while we're doing that, we're going to have some photos taken. We've learned that photos not taken during the meeting have much jollification going on.

MR. LACKER. So we should act naturally.

CHAIRMAN BERNANKE. Well, act your usual spiteful selves. [Laughter] Okay. So again, thank you for the useful go-round yesterday.

Participants generally see the continuation of a moderate recovery, strengthening somewhat over time, notwithstanding a surprisingly weak first quarter and some ongoing headwinds. Businesses remain relatively optimistic, although they remain concerned about the effects of higher commodity prices both in their own costs and on the buying power of consumers. The labor market is somewhat stronger, with payrolls and vacancies up and unemployment down. State and local fiscal contraction and possibly future federal fiscal consolidation are shaping up to be a possible drag on growth. The debt limit also poses some financial risk. International factors are affecting the U.S. economy, including disruptions in the Middle East and North Africa, which, together with a lack of compensating production by Saudi Arabia, are affecting oil prices; the impact of the Japanese disaster on supply chains; and higher inflation and wage costs in emerging markets. Europe is still grappling with sovereign debt problems. Oil prices are a particularly important downside risk for growth, although the level of oil prices does not yet qualify as a Hamilton shock. On net, the risks to economic growth seem roughly balanced. On the inflation front, increases in food and especially energy prices have led

to a recent acceleration. In light of uncertainties, both about how commodity prices will behave and the extent of potential pass-through to other prices, inflation risks seem to the upside.

Consumers are in a negative mood'a crisis of confidence?'with higher gas and food prices offsetting the payroll tax cut. However, growth in consumer spending remains moderate, and retailers in some areas are seeing increased sales and traffic. Labor market conditions are mixed. Hiring is weak, though firms may be forced into the labor market as they reach the end of productivity gains. There are upside wage pressures for a few specialized types of workers. On the other hand, there may be significant disguised unemployment, and fieldwork suggests that many of the unemployed see very little prospect for reemployment at a job comparable to the one that they had before. Housing remains generally distressed, with prices flat to down, though sales volume and traffic were reported higher in a few areas.

For the most part, as noted, businesses continue to show confidence in the recovery. Investment in equipment and software is up. Many producers are facing powerful cost pressures, some of which they have already, or plan to, pass on to consumers. They have little fat in their operations, so that passing through cost increases is the only way to protect margins. Among key sectors, manufacturing, energy, agriculture, transportation and logistics, and tourism were reported strong. Manufacturers in particular are upbeat, except that some auto producers are having difficulty obtaining parts normally produced in Japan.

Financial conditions have improved a bit further. Earnings are strong, and equities are doing well. Banks are seeing better credit quality but are concerned about top-line revenues. Loans to small businesses are up, and there is substantial competition among banks to make C&I loans. Risks to financial stability exist, including greater leverage and risk-taking in areas such as leveraged loans and land acquisition. Excess liquidity may be a source of this problem.

As noted, inflation has risen very significantly in recent months primarily because of energy prices and, to a lesser extent, to other commodity prices. Underlying inflation measures remain low, however. The degree of pass-through into underlying inflation measures for commodity costs will be an important variable to watch, as many firms report that they believe at least some of their cost increases can be passed on. For example, prices-received indexes are up. Some participants supported'and presented econometric evidence for'the view that ongoing slack in labor markets has restrained wages and unit labor costs, limiting second-round effects and likely causing the inflation bulge to be temporary. Inflation expectations by some measures are up a bit. Forward inflation breakevens have increased somewhat to levels near the top of recent ranges by some measures, although the Cleveland expectations measure remains below

2 percent. Public attention to inflation has increased, which may give firms 'cover' to pass on costs. The lack of theory on how monetary policy should respond to inflation expectations is an important gap. The increase in inflation will in the end be transitory if commodity prices stabilize and pass-through is limited. However, close monitoring of inflation and inflation expectations is essential to prevent any more lasting pickup in the rate of price increases.

So that's my summary. Any comments? [No response] Seeing no comments, before we go on to the policy round, David Wilcox, I believe you have some data to report.

MR. WILCOX. Yes. The advanced report on durables was received this morning. We obviously haven't had a chance to look at it carefully, but we were looking for a strong report. At first blush, it looks like we got one, and our preliminary take is that it should leave our projection about unchanged for the first quarter.

CHAIRMAN BERNANKE. Thank you. Any questions? [No response] All right. Then we're ready to go to our monetary policy go-round, and I'll call on Bill English to start us off.

MR. ENGLISH.5 Thank you, Mr. Chairman. I will be referring to the package labeled 'Material for FOMC Briefing on Monetary Policy Alternatives' that was distributed earlier. The package includes the three draft statements, including the changes that we distributed on Monday, along with associated draft directives.

Turning first to alternative B on page 3, notwithstanding the softer-than-expected tone of the indicators for the first quarter, Committee members may see the outlook for real activity and inflation going forward as about in line with their expectations at the time of the March meeting, and so believe that no change in the near-term course for monetary policy is called for. Policymakers may anticipate that higher energy and other commodity prices will boost headline inflation only temporarily because they see commodity prices leveling out and longer-term inflation expectations remaining stable. Moreover, because higher commodity prices reduce real incomes and damp consumer spending, policymakers may feel that the monetary policy implications of the resulting higher inflation are countered by weaker output and employment, suggesting that no adjustment to the trajectory for policy is necessary.

More broadly, policymakers may see unemployment as too high and likely to remain so for some time, as suggested by your SEP submissions. And, as discussed yesterday, a number of potential measures of underlying inflation have moved up from their lows, but remain around 1 percent. Indeed, most of you project PCE inflation in 2012 to be below your estimate of its mandate-consistent level in the longer run, and only three of you see it coming in higher. You may also judge that longer-term inflation expectations are not that different, on balance, than at the time of the March meeting. The Michigan survey median 5-to-10-year inflation expectations measure reversed its March rise and is in the middle of its range over the past several years. The Board staff's forward measure of inflation compensation from nominal and indexed Treasury yields has fallen back in recent days and is now up less than 10 basis points, on net, since March and remains within the range seen since the crisis. Against this backdrop, you may believe it is appropriate to complete the current asset purchase program at the end of June and wait for additional information on output, inflation, and inflation expectations before deciding on your next step.

As for the statement language, the first paragraph would be updated to suggest

somewhat less confidence in the strength of the recovery and would acknowledge that overall inflation has picked up in recent months. Depending on your assessment of the market- and survey-based measures of inflation expectations, you might want to soften a bit the statement that 'longer-term measures of inflation expectations have remained stable' by adding the word 'generally' that is shown in brackets. With Monday's changes, paragraph 2 has been updated to clarify that higher commodity prices have increased headline inflation, but the Committee continues to anticipate that inflation will fall back to mandate-consistent levels over time. Finally, in paragraph 3, the statement would indicate that the Committee 'will complete' the $600 billion of intended purchases announced in November. It would go on to note

5The materials used by Mr. English are appended to this transcript (appendix 5).

effects of higher energy and other commodity prices on household spending. In this environment, members may think that a move toward easier policy is more likely than one toward tighter policy over coming months, and that emphasizing that the door is open to additional policy accommodation could reassure households and businesses and so support the recovery, even if no policy change were ultimately required.

The statement for alternative A would note that the recovery is proceeding at a moderate pace, but more slowly than had been anticipated at the time of the March meeting. It would also note that higher energy costs may be weighing on household spending. Paragraphs 1 and 2 would suggest somewhat less concern about inflation expectations and the inflation outlook than in alternative B. Paragraph 2 would also note increasing downside risks to the outlook for economic growth. Paragraph 3 would confirm that the Committee 'will complete' its purchases of $600 billion of longer-term Treasury securities and that it is 'prepared to expand and extend the purchase program' if needed to achieve its objectives. The fourth paragraph would provide more-explicit forward guidance about the expected path for the federal funds rate by specifying that exceptionally low levels were likely 'at least through mid- 2012.'

Market participants would be surprised by the adoption of alternative A. Interest rates and the foreign exchange value of the dollar would likely fall, and stock prices would probably increase.

Draft directives for the three alternatives are presented on pages 6 through 8 of your handout. Thank you, Mr. Chairman. That completes my prepared remarks.

CHAIRMAN BERNANKE. Thank you very much. Are there questions for Bill?

President Evans.

MR. EVANS. Maybe I shouldn't have been surprised. Maybe I should have studied this

a little more carefully, but in alternative B, there's new language relative to what was put in the

Tealbook; in paragraph 2: 'Other commodities have pushed up inflation in recent months.' I

noticed in your analysis you referred to it as headline inflation. It seems like a noticeable change

in our assessment.

MR. LACKER. Which part? Paragraph 2?

MR. EVANS. Paragraph 2. We say, 'measures of underlying inflation continue to be

somewhat low' and then we say that increases in energy prices have pushed up inflation in

recent months. Then we're going to say 'and a decline in inflation to rates consistent with' our

mandate. So we're now talking about inflation being too high relative to our mandate, whereas we've had an extended discussion about inflation being low relative to our mandate. It seems it needs some modifier like 'headline inflation' or 'near-term inflation' or something.

MR. LACKER. Wouldn't 'inflation' without a modifier be presumed to refer to headline, and a modifier be presumed to be required to refer to something else, like core or underlying or forecast?

MR. EVANS. Inflation is a general rise in all prices, and we're pointing to a relative price increase as moving inflation. So I think it's a very subtle point.

CHAIRMAN BERNANKE. I think we're anticipating the discussion. The origin of this change was actually President Lacker's memo, which was circulated. And yes, again, 'inflation' is intended here as headline inflation, as distinguished from underlying, and President Lacker's memo made the point that, instead of talking about the general term in the context of price stability, we could talk about the desire to have overall inflation come back down to what we think is the appropriate level. But this is obviously open to discussion in the go-round. So why don't we just do it in that context?

Any other questions for Bill? [No response] All right. If not, President Williams, you're

first.

MR. WILLIAMS. Thank you, Mr. Chairman. I favor alternative B. Although we're experiencing a bulge in headline inflation'I guess I used 'headline''underlying inflation remains low, and our forecast is that overall inflation will fall well below desired levels next year, and I expect significant resource utilization gaps to continue for quite some time. Therefore, the current very accommodative stance in monetary policy remains entirely appropriate.

In terms of the wording in the statement, I actually like the changes that were made over the weekend and in the Monday draft. I think it is important to recognize that inflation is above desired levels currently and explain that we expect that to come down. I would also maintain the description of longer-term inflation expectations as 'stable' rather than 'generally stable.' I think this is an important point, as Bill mentioned. Both survey and market-based measures are within the ranges that have prevailed over the past decade, and I think we should be careful not to change the language on something important like this based on what has proven at times to be volatile data. We see that in the Michigan survey; it popped up, and then it has come back down. We've also seen that in the breakeven inflation. So I definitely would keep the word 'stable.' Thank you.

CHAIRMAN BERNANKE. Thank you very much. President Lacker.

MR. LACKER. Thank you, Mr. Chairman. I believe there are reasonably strong arguments for choosing alternative C from a certain point of view and not providing further stimulus at this time. The recovery seems well established, and price stability often requires preemption, especially at this time of the business cycle. Despite those arguments, though, I can support alternative B. We've encountered enough speed bumps in this recovery to make cutting back on stimulus perhaps less urgent right now. In addition, in our discussion of exit strategies, I didn't hear any convincing reasons to doubt that we could withdraw stimulus at a fairly rapid clip if need be, and I take it as a corollary of doing whatever it takes to provide sufficient stimulus that we stand ready to withdraw stimulus at whatever pace is required to keep inflation well contained as the expansion unfolds.

Regarding language, I did, indeed, make three suggestions regarding paragraph 2(b), two of which were adopted in this draft. The motivation was to provide, similar to President

Kocherlakota's suggestion last time, more connection to real life in our description of inflation. It just seemed to me 'currently putting upward pressure on inflation' was more consistent with an overall inflation rate that hadn't risen yet and was threatening to, and yet we'd had so many months of inflation well above what we want that it was worth acknowledging to the public that we understand that inflation is, indeed, too high right now, and why.

And about relative price changes, President Evans, I understand that when oil prices go up much more rapidly than other prices, it's a relative price change, but if it brings the average up, then it's inflation as well, and you can't deny that. I mean, if there aren't offsetting declines in other prices that keep the average constant, one is equally entitled to call it an increase in overall inflation as well.

I also was concerned about this language about underlying inflation. I think it's widely interpreted as a code word for core inflation, and I had two concerns about sentence 2. One of the main ones is that rather than relying on the notion of overall inflation converging to what we think of as underlying inflation over time, why not communicate that we think the rise in inflation is transitory; why not come out and say, 'We expect inflation to decline soon'? It struck me as more clear to say it that way. The other thing is that sentence 2 is one of the five places we refer to the mandate in this statement, and we say underlying inflation is low relative to what the Committee judges'I'm not sure we've ever spelled out underlying inflation and made clear that it's our forecast and not core. My concern with sentence 2 is that it's open to misinterpretation that our interpretation of the mandate has to do with core rather than overall inflation. Evidently there were countervailing concerns about sentence 2. I'm anxious to hear what they were.

CHAIRMAN BERNANKE. Thank you. President Rosengren.

MR. ROSENGREN. Thank you, Mr. Chairman. I support alternative B. Given the weakness in spending over this quarter, there remains significant uncertainty about the strength of the recovery. Furthermore, by the end of 2013, I expect unemployment to be too high and inflation to be too low, even assuming completion of the Treasury securities purchase program and keeping the federal funds rate at the zero lower bound longer than in the Tealbook.

I continue to see many downside risks to the outlook. Problems in Europe, fiscal austerity measures, tightening in emerging markets, and weakness in the first quarter in consumption, local government spending, and housing could spill over into future quarters. Any one of these factors could exert enough drag on future growth to put my forecast at serious risk.

Given the low inflation rate, we have plenty of room to encourage faster growth in the economy. I hope the economy is strong enough that we can begin removing accommodation by allowing redemptions in the late fall, but that depends on receiving stronger data than we have seen so far this year.

In terms of language, I share President Evans's concern'I actually like the previous language in that sentence better.

CHAIRMAN BERNANKE. Okay. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I support alternative B. I'm not totally happy with paragraph 2 as written. I think it's an attempt to be what the younger folks might call a mash-up between President Lacker's version and the original. At the risk of confusing things still more, let me make a suggestion, which would be to drop the last part that's highlighted in red'the 'and a decline in inflation to rates consistent with the Federal Reserve's mandate''and replace it with 'in a context of price stability.'

I think what's confusing about the paragraph right now is, we talk about underlying inflation being low, then inflation goes up to being high, and then we're talking about what we want it to come down to be. I find the paragraph confusing when I read it. I think my suggestion may be more helpful, but maybe others will have ideas about how to address this.

MR. TARULLO. Narayana, you'd keep Jeff's first change and revert to the original language for the second?

MR. KOCHERLAKOTA. That is correct, yes.

MR. LACKER. Mr. Chairman.

CHAIRMAN BERNANKE. President Lacker.

MR. LACKER. On the seesaw pattern of referring to low inflation and high inflation' my suggestion would have eliminated references to inflation in sentence 2, which would eliminate the up-down.

MR. KOCHERLAKOTA. I remember that.

CHAIRMAN BERNANKE. I don't want to interject, but it may help a little bit to know that in my remarks to the media later today, I'm going to be focusing very much on the projections, including the near-term projections vis-''-vis the longer-term objectives of the Committee, so I think there will be more opportunity to explain this particular configuration than would otherwise be the case. That's a central goal of my presentation. President Hoenig.

MR. KOCHERLAKOTA. I'm sorry, Mr. Chairman.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. As I think about the evolution of future policy, I continue to focus my attention on core inflation. Core inflation was under 1 percent over the course of 2010.

Our estimates in Minneapolis are that the output gap was around minus 4 percent at the end of 2010, and given these conditions, as you highlighted, Mr. Chairman, it's appropriate for monetary policy to be highly accommodative, and it is. The Board of Governors' staff estimates suggest that the LSAPs are generating enough stimulus so as to be roughly equivalent to a fed funds rate of minus 2'' percentage points. I guess there's some range between minus 2 and minus 2'', but I'll stick to the rough equivalence.

Now, some observers have suggested that this level of stimulus should remain in place as long as inflation expectations remain stable, but such an approach is inconsistent with the kind of rules we have in the Tealbook, and they're inconsistent for a good reason. If we waited until inflation expectations move, we'd actually probably have to impose much bigger employment costs on the economy to try to get them back to where we want them to be. So it's, I think, a better policy to adjust our level of accommodation as the economy moves towards the Fed's targets. The staff now forecasts that core PCE inflation will be 1.4 percent in 2011. My own forecast is slightly higher, and these kinds of increases in core PCE inflation would argue for a reduction in accommodation.

At the same time, unemployment will be at least 1 percentage point lower at the end of 2011 than in November 2010. This change, too, argues for a reduction in accommodation'and I think Governor Tarullo made some good points yesterday'assuming, of course, that the natural rate of unemployment did not fall by as much over the same time frame.

Mr. Chairman, I found your comments on my memo to be very helpful yesterday. In particular, I have to say that I had really underappreciated the notion that accommodation is being removed as we move closer to a date when our holdings of longer-term securities return to a more normal level. I think this idea is a very important one and a very intuitive one.

If I'm sitting there as a member of the public thinking the Fed is going to hold onto their long-term securities for 30 years, and six months pass, well, not much accommodation is being removed by that. But if I'm thinking it's going to be more like three years that the Fed is holding onto those securities, when six months pass, then there's a fair amount of accommodation being removed. This really points to the need to have some strong communication about what our expectations are for the date of eventual balance sheet normalization when our holdings in long- term securities return to something consistent with what we think of as being normal.

There's a variety of ways we could do that communication. We could do it during the press conferences. I heard, and I don't want to overstate this, a fair amount of agreement among members of the Committee that we were planning to get back to something like a normal balance sheet over a five- to six-year time frame. But another way to do it would be to add a projection. We offer our projections of longer-run inflation; we could offer a projection of a date that we expect balance sheet normalization to take place. Right now, though, the communication is proceeding in a rather informal way. I think our main communication is President Williams's working paper, and that's probably not the best way for us to communicate these things, with all due respect. [Laughter] But I do continue to anticipate that in the fall the Committee will need to respond to the changes in economic conditions by taking the first steps toward raising the fed funds rate. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. There have been several good suggestions about how we might change the projections, and I'm sure the Subcommittee will be eager to dig into those.

MS. YELLEN. Will do.

CHAIRMAN BERNANKE. Yet another possible suggestion, of course, is to project the funds rate itself.

MR. KOCHERLAKOTA. Oh, that is a good suggestion.

CHAIRMAN BERNANKE. President Hoenig.

MR. HOENIG. Thank you, Mr. Chairman. I prefer alternative C. Economic growth, as I've said many times, will most likely continue to be moderate, as consumers and businesses and financial institutions balance their increasing spending motives with the need to deleverage, which is in process and has to take place. This process will take time, and maintaining a zero policy rate, I think, invites future imbalances that will undermine longer-term growth, which is our mandate. Inflation is increasing. Energy and food inflation have been especially notable, obviously. The broader inflation measures are moving higher as well. I am concerned that maintaining our highly accommodative policy stance amid a recovering economy, even though modest, and rising underlying inflation puts us behind the curve and risks a repeat of the policy mistakes of the '70s and the 2000s. We are just inviting trouble by staying too low too long.

To rebalance the risks to the outlook, we need to rebalance our monetary policy, and I would start modestly, by taking the 'extended period' language out. And I'd also at least consider seriously stopping our investments at the $450 billion number. Thank you.

CHAIRMAN BERNANKE. Thank you. President Plosser.

MR. PLOSSER. Thank you, Mr. Chairman. Our second round of LSAPs is nearing its scheduled conclusion in June. I was not in favor of this policy when it was implemented in November, but I see little to be gained at this point of ending it early. We are almost done.

As we discussed last time, I thought it important that our April statement signal that LSAPs will end in June, and alternative B, paragraph 3, does that. In general, I do prefer the

language in alternative C, but like President Lacker, I can live with something closer to B. However, I would like the statement to go somewhat further in preparing the public for exit and giving the Committee more flexibility, so that it can act sooner rather than later, if necessary. I think this is a good time to begin changing the language. Because the Chairman is having a press briefing after this meeting and the next meeting, it gives us opportunities to make more- extensive language changes in the statement than we might feel comfortable doing otherwise. The Chairman will be able to explain what we mean by our changes rather than letting the public divine what we meant.

First, I think we should take the opportunity when the LSAPs end in June to also stop reinvestments of MBS. We should signal this in the statement by saying the Committee will complete $600 billion of longer-term Treasury purchases by the end of the quarter, and at that time intends to end the policy of reinvesting principal payments from securities. The market has reacted quite benignly to the Treasury sales of MBS. I don't anticipate such an adverse reaction to our announcement that investments will end, and it will help prepare the public for our eventual exit. I think paragraph 4 is becoming more problematic, given the inflation and inflation expectation numbers. Are inflation trends really subdued? Are inflation expectations really stable? I think we should consider adjusting the language, if not today, then in June. Is 'extended period' consistent with potentially raising the funds rate, as President Kocherlakota suggested, by year-end?

Even the Tealbook puts a nonnegligible chance of raising rates this year, although the point forecast suggests a longer period before liftoff. We don't want to mislead the public, but paragraph 4, I'm afraid, might do that. Instead, I think we could say, 'The Committee will maintain the target rate of the federal funds rate from 0 to '' percent today, and based on its

outlook for the economy and inflation, anticipates that it will remain low for some time to come.' This works, because paragraph 2 discusses our outlook for inflation'the fact that we expect the effects of higher energy and commodity prices to have transitory effects on general inflation. And paragraph 1 explains that labor market conditions are improving. Because we are releasing new forecasts at the press briefing, changing the language to refer to projections seems sensible.

I would also note that among the various policy rules in the Tealbook, the so-called growth rate or first-difference rules suggest that the funds rate should be about 50 basis points this quarter and 90 basis points by the third quarter. Of course, different rules give different guidance, and I have argued before why I like something more like the first-difference rule, in part because of measurement problems, but I won't repeat those arguments today.

A couple of wording choices we talked about last time could be implemented today and explained during the press conference. I would like us to consider changing paragraph 2 so that it refers to'and I raised this point last time''employment' or 'unemployment' rather than the 'unemployment rate.' Our mandate is in terms of maximum employment, not the unemployment rate. Labor force participation rates are a variable we have even less control over than we do employment. By emphasizing the unemployment rate, we risk giving the idea that we won't begin exiting until the unemployment rate is back down to the natural rate. But this is misleading. I believe we will need to act before the unemployment rate gets back down to a normal level.

I think alternative C's characterization of where the economy is relative to our dual mandate'namely, that employment and inflation have moved somewhat closer to the levels that the Committee judges is mandate consistent'rings truer than paragraph 2 in alternative B,

which seems to brush aside the recent increases in inflation and inflation forecasts. That is why I generally prefer alternative C.

We also should consider clarifying what we mean by underlying inflation. As President Lacker was suggesting, we had this conversation last time as well. I think we have some concept of inflation over the medium run, not just core inflation in mind. So why don't we say that, rather than referring to underlying inflation?

I'm also worried that claiming expectations remain stable may not be entirely credible. Indeed, some have argued that, in fact, expectations of inflation have risen, reflecting the abating concerns about deflation. Five-year, five-year TIPS have risen considerably since last fall, and so to say that inflation expectations are stable may be a little bit awkward. In fact, if we recall, we wanted to get them up somewhat since last fall.

So I would suggest that the last sentence of paragraph 1 reads something like as follows: 'Inflation has picked up in recent months, but longer-term inflation expectations remain within historical norms, and indicators of inflation over the medium term are subdued.' I think that language would fit well with the Chairman's emphasis on our forecast in his press conference, and he could get away from using underlying inflation.

MR. TARULLO. Can you read that again, Charlie?

MR. PLOSSER. 'Inflation has picked up in recent months, but longer-term inflation expectations remain within historical norms, and indicators of inflation over the medium run are subdued.'

MR. TARULLO. Thanks.

MR. PLOSSER. I think communication and transparency are very important policy tools at this point. This will be especially true as we choreograph our exit of this period of

accommodation. The changes in language that I am suggesting are some of those I believe that we might need to implement in the next couple of meetings to prepare the public for the start of an eventual exit. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. And that indicators of what remain subdued, at the end?

Sorry.

MR. PLOSSER. 'Indicators of inflation over the medium run remain subdued.' As opposed to 'underlying inflation,' and that would play into the forecast language.

MR. LACKER. Which medium run, past or the future'going which way?

MR. PLOSSER. I'm thinking future. Or you could say, 'forecast of inflation over the medium run.' That's why this language 'underlying inflation' is confusing, because it's interpreted as core. What you are really talking about is your predictions of where inflation is going.

CHAIRMAN BERNANKE. That's fair. We have a lot of work to do, I think. Your particular suggestion is very interesting, but it would also require work in the second paragraph, too.

MR. PLOSSER. Yes, because 'underlying' shows up there as well.

CHAIRMAN BERNANKE. Right. Thank you. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. The Committee decision on asset purchases obviously was made at the November meeting. We said that that decision is subject to review, depending on developments in the economy. Today, the economic outlook is generally better than what was expected at the time of the November decision. In addition, the inflation outlook is somewhat less benign than it was at the time of the November decision. First-quarter GDP will probably come in weaker than what was expected earlier this year, but, as the

economic go-round yesterday indicated, many believe that the outlook for the remainder of 2011 remains relatively robust. Also, many comments suggested that the Q1 GDP weakness seems inconsistent with other measures of the strength of the economy. So, the November decision was considered reviewable. We've got a stronger economy than we had thought at the time, and we've got a little bit higher inflation and inflation expectations than we thought at the time. This suggests to me making a small move to adjust the policy, and in this respect I would agree with some of the comments made by President Kocherlakota.

Now, I know that there are objections around the table to making small moves, and so I'm going to disabuse you of those objections. [Laughter] Many of the comments yesterday all around the table suggest that we set a high bar for this type of policy action'a high bar. I want to argue that this is the wrong intuition for Committee behavior. It is bureaucratically convenient but unlikely to be optimal policy.

The high-bar argument suggests not taking action unless it is absolutely called for. So there is a bias toward inaction. This is known in engineering and elsewhere as an Ss policy. You only act when certain limits are met on the high side or the low side. If you behave this way, this will create a range of inaction; you'll take no action in the middle, and you will take one action if you go above the high limit and one action if you go below the low limit. If the limits are extreme, which they might be for a Committee like this, the range of inaction is actually quite large. The example would be driving a car and steering and trying to stay in your lane. When we're driving our car, we are making small adjustments all the time as we are steering, but if you had an Ss policy, you might say, 'I am only going to adjust the steering when the car actually goes to the very edge of the lane, and then I will make the adjustment to come back to the center.' You have a range of inaction. You don't adjust the steering wheel at all

until you actually hit the limit, then you come back to the middle. If you drove like that, you would have a more volatile path down the highway than you do when you are making small adjustments all the time. In the car example, the cost to action is very small, so you might as well make adjustments all the time. This keeps you in the middle of the lane, and you throw out the Ss policy. It wouldn't be the right thing to do. The Ss policy is not optimal unless there are some significant fixed costs to action. But for a Committee like this, I think there are no real costs of this type. We can make small adjustments if we want. Creating this range of inaction through a de facto Ss policy is less than optimal for this Committee. I also think this creates confusion in markets, because in many circumstances where the economy has changed we don't actually do anything in the range of inaction. This just leaves a big question mark out there in the private sector. They're saying, 'Well, what are these guys doing? They're not doing anything.' The private sector doesn't get any signal when we are sitting in the range of inaction. And you might say, 'Well, we are always talking.' I don't think talking matters. What they care about is whether or not we taking concrete action. The communication can only help explain the actions that you actually take or plan to take. It can't be a substitute for actually making the decision to take concrete action.

So with that, I am going to support option B with the caveat of completing $500 billion of asset purchases instead of the $600 billion. I think that the situation that we are in is that the FOMC apparently intends to go on hold at the end of June. Going on hold to me would mean that we keep the near-zero policy rate, we keep the 'extended period' language, we keep the size of the balance sheet held constant, and we create a bit of a presumption, because we're going on pause, that the next policy move would be to remove accommodation without really committing to that and waiting for more information to come in. And all of that seems entirely sensible to

me. But I think finishing our asset purchases just a bit short of where we said in November would still be planning to go on hold in June in the same way I just described, but with a slightly smaller balance sheet. This would help send a signal to markets that we are paying attention to recent developments. We'd still be going on hold in June, but there would not be quite as much accommodation through the asset purchase program as what we initially planned. Also, doing it this way wouldn't signal the next move, except that the next move is presumably, since you're going on pause, to remove accommodation, if the economy continues to perform as expected. Many of you have noted the risks out there, and those could, of course, move against us. I think that doing something like this might help us. I have no illusions about adopting this, but I think if we played it this way, this might help the FOMC during the May'June time frame.

And on that, I want to make some remarks on Vice Chairman Dudley's comments

yesterday, which I thought were very helpful in this regard. We do face an environment of rising inflation expectations. It's not terrible, but further increases along this dimension would be unwelcome; we've got two months to go before the June meeting. The fiscal stalemate is not helpful to us and is hurting inflation expectations in this regard. The dollar is weakening pretty substantially, and I am a little concerned that the dollar, even though there are a lot of crises around the world, is not really viewed as a very good safe haven in the last few months. Investors are flocking to traditional inflation hedges. A lot of that doesn't make any sense to me, but I think it is some investor behavior to pay attention to. You've got the ECB tightening with us not really signaling that we are going to follow anytime soon.

All of this is very manageable, but July 1 is a long way away, and I'm a little worried that things could get a little bit away from us during the intermeeting period, and signaling a little bit toward less accommodation might be a bit helpful. I think that another problem for us is that

June will not be a good moment to act, because in June our asset purchases will be wrapped up. The way the discussion is going now'and depending on how the economy performs'we're evidently planning to end the program there and go on hold, so that won't be a good meeting to take any other action. I think the meeting to do this is now.

Let me comment for just a minute on our uber-easy monetary policy. It is very easy in absolute terms. It's also appropriately easy, conditional on the state of the economy. I do agree with this, although Taylor rule calculations can be sensitive to details, as our Tealbook shows, and as the literature certainly shows.

The main idea about describing our policy as very easy is that it is going to take a long time to normalize policy. You've got zero rates, and you've got a large balance sheet. Those things take a long time to normalize. It may be prudent for the Committee to get started at some point, so that policy adjustment can be more gradual, and we can adjust the pace of removing accommodation according to events. We can take pauses at some point. Then the Committee may not have to move as aggressively later. So I think there is something to consider in the fact that policy is very easy in absolute terms.

I just want to caution everybody that these Taylor rules also are calibrated using data from the Great Moderation time frame which had relatively small shocks to the economy, certainly a different situation than what we have today. So we may want to supplement those calculations with some judgment about how the situation has changed versus, say, the 1990s or the 2000s. I agree with President Plosser on difference rules, which get rid of the gap-type problem and let you calibrate policy without having to know what the gap measure is. Those rules are all subject to many technical qualifications, but I think they are important.

Also, I want to stress that the 2004 to 2006 tightening is certainly questionable. Many view it as having been too slow, too mechanical, and possibly having allowed bubbles which caused problems. These are some of the points that have been repeatedly stressed here by President Hoenig and for which I have some sympathy. That kind of bubble argument doesn't come into'and the Chairman mentioned this yesterday'the normal Taylor-rule calculation, because it's just not part of the model. So we have to pay a lot of attention to that going forward.

The bottom line is that there is plenty to mull in this unprecedented situation for monetary policy, and I just wanted to make a few of these points during my chance for the policy discussion here. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you, President Bullard. President Pianalto.

MS. PIANALTO. Thank you, Mr. Chairman. I support alternative B. In general terms, my outlook is not that dramatically different than it was in March. My forecast is for moderate output growth, unemployment rates that remain elevated, and core inflation rates that are still below our mandate-consistent levels.

Like the Tealbook, I revised up my projection for core PCE inflation. This revision moved up my expected date for the first increase in the fed funds rate by one or two meetings. However, my outlook is still consistent with the 'extended period' language in alternative B.

While my outlook does not support the quicker policy response offered by alternative C, I am concerned about the upside risk to inflation. Temporarily high headline inflation presents a price stability risk if we're not able to keep longer term inflation expectations anchored. Fortunately, as I mentioned yesterday, a range of financial market indicators suggests that longer-term inflation expectations remain mandate consistent, and, in my view, I think we need to maintain those expectations right where they are.

I would not use 'generally' in front of 'inflation expectations' in the last sentence in paragraph 1. I would leave it as it is. I also think that providing greater clarity on our exit strategy would help us with our policy credibility and help us to maintain inflation expectations at their current levels. Being more specific with the public about our policy intentions and the methods that we're going to use would help to offset some of the public concern about our ability to control inflation with such a large balance sheet.

I think another step in helping us with policy credibility and maintaining inflation expectations anchored would be to publicly announce an explicit numerical inflation objective. As we have been discussing, I think this is going to be a difficult time to describe our outlook for inflation to the public. Setting an explicit numerical objective would help with that communication. It would also force us to be clear on which measure we are targeting. So I hope that we can return to that issue at a future meeting.

I also share the concern that has been raised by several of my colleagues about the new language in paragraph 2. That is, stating in paragraph 2 that underlying inflation is low, but then stating later on that we are going to see a decline. But, Mr. Chairman, given your comments that you will address this at the press conference this afternoon, I am comfortable with the language as it is in this new alternative. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Evans.

MR. EVANS. Thank you, Mr. Chairman. I support alternative B. I support the announced $600 billion of additional asset purchases. I support maintaining the 'extended period' language. I broadly agree with the Tealbook's policy assumption, basically, which is a fairly extended accommodation. In making this recommendation, I continue to focus on our dual-mandate goals for the economy. Whether you look at real GDP, nominal GDP, or

employment, we continue to be far below levels that I associate with a well-functioning economy related to pre-recession levels. I think that we are still pretty far below that.

Because President Plosser keeps mentioning the unemployment rate in the context of the statement, I always remember what Chairman Greenspan and Don Kohn used to say: When you talk about unemployment, the measures are pretty variable; they move around month to month in ways that require a lot of understanding. The labor force also moves around a lot. But something about taking the ratio of those cleans this out, and the unemployment rate is a fairly stable measure. It doesn't move around very much. I think you are asking for more explaining if you move away from that the unemployment rate; I'm not bothered by the unemployment rate at all.

In terms of inflation, I would just like to make a side comment for the record, because President Fisher yesterday mentioned again this language like, 'Our policies have been monetizing the debt.' And I just want to be very clear on the record that I disagree completely with that characterization. I think that monetizing the debt is when you permanently replace debt with money. Our discussion yesterday was all about the fact how that is not going to be a permanent replacement, and so I just think that is a mischaracterization of our policies.

Now, for inflation. I guess I didn't study the new language carefully enough over the weekend, but I do have some sympathies to this idea that inflation has been higher, and we do need to acknowledge that. One thing I have learned from going out and talking to the public is that we need to acknowledge what they, and in fact, we are all experiencing. So I'm sympathetic to that. But the current paragraph 2 has got this, you know'down, up, underlying inflation, somewhat low, and then we refer to commodity prices as having pushed up 'inflation.' I just think that in talking about this'even as I heard Bill English describe this, he sort of slipped in

'headline inflation' when he mentioned that'it needs a modifier. As it stands, it has the opportunity to rebrand what we mean when we talk about inflation if we don't have that modifier. Inflation is a general rise in all prices, and I don't think we've got that uniformity in price increases at the moment. And, our forecast that you are going to talk about, Mr. Chairman, shows the central tendencies up in 2011, but in 2012, and then rising in 2013. So it is not just that we are going to decline to rates consistent, but we're going to go down, and then we are going to go up, and we're below that. I'm sympathetic to trying to get this right. I would, in fact, be willing to talk about the entire path. And while you can do that during your press conference, this is new territory, and the statement will be out there. I am nervous about that. I don't believe medium-term inflation is too high. I think we are in fact below the mandate. I think this is a very notable change in language, and so I want to be very careful on that. Thank you, Mr. Chairman.

MR. BULLARD. Mr. Chairman?

CHAIRMAN BERNANKE. President Bullard.

MR. BULLARD. I just have one question for President Evans on monetizing the debt. Some of the options that we look at actually do talk about just leaving the balance sheet larger and operating under a different operating system. So if we did that, would you consider that monetizing the debt, since that would be a permanent increase in the size of the balance sheet?

MR. EVANS. Well, I appreciate that, and I think one characterization is this permanent placement. But, overall, I think inflation is really low, and so the fact that we move to a different operating procedure where maybe we contemplate a floor where more of it would be permanent'I mean, this is not a partnership with the Treasury; this is not Zimbabwe or anything like that or hyperinflation, period. And to even talk about monetizing the debt'I mean,

President Fisher has used words like 'dangerous' out in the public, and I think this is not helpful. So, yes, I would disagree with that characterization.

MR. FISHER. Is it all right if President Fisher makes a comment? I am delighted to hear you say it was a temporary phenomenon. I am especially delighted to hear you make it clear that this is not what we're going to do. And I think we have 100 percent agreement at the table.

Thank you for clarifying that.

MR. TARULLO. Mr. Chairman'I don't think we have 100 percent agreement, President Fisher, because you have been saying publicly that we have monetized the debt. And I don't think that that was either the intention or the action of this Committee. So I wonder if you agree with the other part of President Evans's statement.

MR. FISHER. I believe we temporarily did so. I believe the numbers are there. That's my belief. The beauty of this Committee is we have a diversity of views. I don't want to waste our time on this discussion, Mr. Chairman. I think we should get back to addressing the alternatives.

CHAIRMAN BERNANKE. Okay. Thank you. President Lacker, you've got a two- hander?

MR. LACKER. Yes. I heard you (President Evans) say something about inflation that made me wonder if we understand inflation in the same way. You said it's not inflation if it's not a broad and uniform increase in prices.

MR. EVANS. No. I said inflation was a general increase in all prices. I didn't state it in the negative way that you did.

MR. LACKER. Well, so, relative prices change at the same time inflation goes up. Does the change in relative prices negate there being inflation? If half the prices go up at 40 percent and the other half don't change, do we not have 20 percent inflation?

MR. EVANS. I just think inflation is a monetary phenomenon. And whether or not we generate a higher increase in all prices, it comes down to the policy assumption that we have here. Our medium-term inflation forecast is for something lower than that. This doesn't look like inflation to me. Most of our models have a single price index. We don't even talk about uniformity of prices. That's just my assessment.

CHAIRMAN BERNANKE. Okay. President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. I support alternative B. I think the situation calls for a steady-as-she-goes posture. I think there are scenarios that would call for a policy adjustment earlier than I think the Committee would otherwise intend. But at this juncture I would not signal anything that suggests a change of policy in the near term or any likelihood of deviating from the announced LSAP2 plan. This could create unnecessary volatility in the economy at this time when crosscurrents have produced somewhat more ambiguity than was the case at the beginning of the year.

Turning to the statement, the characterization of the economy in alternative B is broadly consistent with my own reading of the current circumstances and outlook. Because various TIPS measures are up since the last FOMC meeting, I can see the case for describing longer-term inflation expectations as 'generally stable' rather than 'stable.' But I am not convinced longer- term expectations are so out of line as to warrant this potentially significant change in language, which could come close to sounding like an FOMC call to action.

I am, I have to say, somewhat sympathetic to President Evans's suggestion of a modifier. I think there is some potential for our treatment of inflation in this statement to still be confusing. But, in some respects, in response to President Plosser's recommendations, all things considered, I think in this statement I would keep changes limited. I would introduce few or no new ways of describing or explaining, even if I'm sympathetic with the thinking. I would put the emphasis on the press conference and try to keep this statement as spare as possible. Thank you, Mr.

Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Yellen.

MS. YELLEN. Thank you, Mr. Chairman. I support alternative B. I consider the current stance of monetary policy to be warranted by economic conditions. The unemployment rate remains well above its longer-run sustainable rate, and, as I noted in the economic go-round, this gap mainly reflects a shortfall in aggregate demand rather than structural factors. Moreover, longer-run inflation expectations remain reasonably stable, and I anticipate that headline inflation will subside later this year to a level close to underlying inflation, which remains substantially below my assessment of the mandate-consistent inflation rate. I expect the economic recovery to continue at a gradual pace and inflation to remain subdued over the next several years. I, therefore, support the continuation of our forward guidance that the federal funds rate is likely to remain exceptionally low for an extended period.

And I support the completion of our $600 billion asset purchase program. I think the effect of that program began working its way through the pipeline even before we announced it last November, and market expectations have been conditioned all along on the assumption that we would follow through and complete the purchases. So in response to President Bullard's argument that we should stop early, I would say that the failure to complete the program would

surprise markets, and it would boost longer-term rates right now. In effect, such a decision would amount to a withdrawal of policy stimulus now, and that's a policy shift that I don't consider warranted at this time. I also think it would impair the Fed's credibility and unnecessarily whipsaw financial markets.

My views on the appropriate path for monetary policy generally accord with the Tealbook baseline, but I see risks to the inflation outlook that could warrant an earlier onset and more rapid pace of policy firming. In particular, if a continued run-up in commodity prices appeared to be sparking a wage'price spiral, then underlying inflation would begin trending upward and a policy response would be imperative. In light of the experience of the 1970s, it's clear we cannot be complacent about the stability of longer-term inflation expectations, and we must be prepared to take decisive action, if needed, to ensure that they remain firmly anchored. On the other hand, our policy decisions and communications must also take into account the fact that there remain material downside risks to economic activity and inflation. At our March meeting, we generally agreed that the recovery was on a firmer footing, but the incoming information over the past six weeks has been notably less upbeat.

I still expect the recovery to proceed at a moderate pace, and I'm glad we have resumed the exit strategy discussions. But let's be mindful of the possibility of d''j'' vu. We could still discover over the coming months that the modest pace of GDP growth last quarter was more than just a soft patch. Given the very high bar for launching a third round of asset purchases, this suggests that we should be cautious about moving too quickly to initiate the process of policy firming.

On the various language issues, I do understand the logic of including the bracketed '[generally]' in paragraph 1, and I could certainly live with doing it. On balance, I guess I do

think it would be quite a significant change and would be perceived that way by the markets. I'd prefer to omit it. I think longer-term inflation compensation, as measured by TIPS, is within historical ranges, and staff analysis supports the view that the recent uptick since our last meeting is actually due to changing liquidity and inflation risk premiums. So I could go either way on that, but would prefer to omit it. And on the language in paragraph 2, on balance, I would support President Evans's suggestion that we include the modifier 'headline' in front of 'inflation.'

Finally, I wanted to mention that I really appreciated Narayana's memo about using the Taylor (1999) rule to gauge the appropriate timing of policy liftoff. I've actually been a long-time proponent of using simple rules as benchmarks for monetary policy, which is not to say at all that we can just put policy on autopilot, blindly following the prescriptions of any single rule. I don't think'and the Chairman's discussion yesterday showed this'that we can use them to absolutely pinpoint a moment when we need to begin tightening. But I think that giving greater prominence to such rules could facilitate our internal decisionmaking process and would be helpful in explaining what we are doing to the public.

CHAIRMAN BERNANKE. Thank you. Governor Duke.

MS. DUKE. Thank you, Mr. Chairman. We are near the end of a third go-round, and I have no case to make for a change in policy. So I had planned to fly in the face of FOMC tradition and stop speaking, but in listening to all of the discussion, I am struck by 'core inflation,' 'underlying inflation,' 'headline inflation,' 'inflation in the medium term,' 'inflation expectations,' 'inflation projections,' and even now, 'unmodified inflation.' And I think it's really important, if we are going to build credibility, if we are going to emphasize our commitment, that we start to talk about inflation in the same way and what we mean about it.

This debate between President Evans and President Lacker about what is inflation and rebranding inflation says a lot about where our disagreements are. I think having disagreements about the level of inflation is one thing, but having disagreements on what we're talking about when we talk about inflation actually creates a lot of confusion. And I just don't think we can build that credibility until we're all speaking about the same thing. I was very pleased to hear the Chairman say yesterday that core inflation is now yesterday's news and that we're actually going to pay attention and talk about the things that real people are actually seeing and help people understand what that means in terms of inflation. And I think that's important in all of our discussions.

Moving to the statement, having listened to all of that, I was originally agnostic on having 'generally' before 'stable' in paragraph 1, but I think we probably ought to leave it out. It seems like an extra modifier that I wasn't sure there was a lot of support for.

And then, in paragraph 2, I would agree with President Kocherlakota's suggestion that we go back to 'in a context of price stability' at the end of that sentence and leave out 'a decline,' because I got to thinking'all right, pushed up inflation to where, and a decline from where, to a level that's consistent'where's that level? It created three questions in my mind, and I think if we go back to the original language on that last sentence, it would be helpful. I know you disagree with me, Jeff, but anyway, Mr. Chairman, those are my thoughts. I support alternative B.

CHAIRMAN BERNANKE. Thank you. Governor Tarullo.

MR. TARULLO. Thank you, Mr. Chairman. I support alternative B as well, but I should say, I support it with the understanding that paragraph 3 genuinely is communicating neutrality with respect to the potential for adjustment of holdings in one direction or another in the future.

As people could tell from my remarks yesterday, I'm on the lower end of projections with respect to expectations for economic growth. I continue to think that growth is going to be a problem. Monetary policy is becoming trickier, and there's no question but that the inflation concerns that a lot of people have raised are something that we are going to need to be watching carefully. But I don't think at this juncture, given what I heard to be most people's expectations that these effects would be transitory, that we want to do anything like beginning to move toward the exits, which I think ending reinvestment or changing the language would surely be.

With respect to paragraph 2, I found myself sympathetic both with Jeff's suggestions for changes and with Charlie's concerns about those changes, because I think Jeff is trying to do what Betsy suggested, regularize the use of the language, which would probably be good for us all. But I think Charlie's point is, given how many terms have been used at this point, it might sow more confusion than clarity to do so.

So although I actually was comfortable with the two changes that are incorporated here, like Betsy, I am attracted to Narayana's compromise, which is to say, 'other commodities have pushed up inflation in recent months,' but then return to the 'in a context of price stability,' and then perhaps allow the Chairman to use a little bit of his time this afternoon to begin this process of clarifying exactly what we mean as we talk about inflation.

And I don't have a strong view on 'generally.' I think, at the margin, I would omit it. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Raskin.

MS. RASKIN. Thank you, Mr. Chairman. I support alternative B, because the economic recovery is too halting and uneven to warrant a substantial shift now in the stance of monetary policy. The unemployment rate has come down, but it remains high relative to other labor

market indicators, which show a high number of people wanting full-time work but finding only part-time work. Wage gains are minimal, and unit labor costs are not changing.

Measures of inflation have moved up, reversing a small part of their decline since 2008. That said, the run-up in energy prices is slowing consumer spending. In addition, political unrest in the Middle East and North Africa, and the resulting upward pressure on oil prices, have increased the likelihood of an adverse shock to real incomes and to household confidence and, to a lesser extent, business confidence, and thus to private domestic final demand.

If there are further increases in oil and commodity prices, and a more-than-transitory spillover to other prices, one could imagine inflation expectations becoming unanchored. Given these conditions and others that have been discussed, I think that the current stance of monetary policy strikes me as appropriate. Thank you.

CHAIRMAN BERNANKE. Thank you. President Fisher.

MR. FISHER. Well, I was thinking through what we heard from David Wilcox yesterday, and from the Bank presidents in particular, and the dissonance that is being reported. My notes to myself summarized them as follows.

On economic growth, like the old saw about the music of Wagner, 'It's not as bad as it sounds,' and on inflation, like gangsta rap, it's worse than it sounds. I think so much depends, Mr. Chairman, on, really, what you say at this press conference and your comportment, which I am very confident about.

In looking at the statement, I think less attention will be paid to the statement than is normal. Almost as much attention will be paid to you as is being paid to what Kate Middleton will wear at her wedding. [Laughter] And I am grateful for that distraction.

On the statement, I think Mr. Evans has a very good point. Here are the facts. The headline PCE price index posed an annualized rate of increase of 4.9 percent in February. That's its fastest one-month rate of increase since June of 2009. That makes three straight months of headline readings in excess of an annualized 3 percent rate. I would have no problem with inserting the word 'headline' between 'pushed up' and 'inflation.' I think he makes a good point. Generally speaking, I agree with Mr. Lacker's amendments. I'm glad that they were reflected in alternative B. I like President Kocherlakota's inclusion of 'in the context of price stability''it takes some of the seesaw out. But I think the most important amendment that's been suggested thus far was President Plosser's, which is to conclude the first paragraph by saying, 'longer-term inflation expectations remain within historical norms,' et cetera, et cetera. I believe I heard him say, 'indicating' whatever''over the medium term' rather than the 'medium run.' But I would accept that language.

Let me just make a general comment about some of the tempers that seem to have flared during this discussion. The beauty of this Committee is that it reflects diversity. There are academics, there are very serious scholars at the table, there are actually three former bankers at the table, and there are people with a supervision and regulation background. I don't think we should discourage diversities of view. I take a chapter out of Oliver Wendell Holmes: 'Do not be bullied out of your common sense.' And, moreover, that it is very important that we adhere to both education in the obvious as well as investigation of the obscure. One of the great things about this Committee is we have the talent and capacity to look at things in great depth, but we also have the ability to take soundings in the field. And, as I mentioned earlier, those soundings I wouldn't disparage, I would use to complement and supplement what we analytically and intellectually infer from our discussions and from our models.

Mr. Chairman, I think that, in addition to the statement and the suggestions that I have just made, the important thing today is really this press conference. I think it would be prudent for you to make a firm statement in your conference as to our resolve in containing inflation. I thought your summary, as you presented it at the beginning of this discussion, was spot on. I was tempted to embrace alternative C and to dissent at this meeting; I will not do so. I would ask that you do, indeed, focus and reassure the markets about our intent to contain inflation and seek price stability, because there are some doubts out there, whether they are deserved or not. And I would conclude by saying that you might also consider noting during your press conference that the Committee is aware of, and is monitoring, the resurgence of some financial practices that could prove to be counterproductive. This is a concern we haven't discussed as a group and we don't include in the statement, but I sense it is out there and I would like to put any notion that we are not aware of it to an end.

So, in summary, I would support alternative B, with the amendments I mentioned, particularly the end of the first paragraph with President Plosser's suggestion. I would insert the word 'headline' before 'pushed up inflation,' because that, indeed, is the fact. And I would accept Narayana's truncation of the last sentence in paragraph 2. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Vice Chairman.

VICE CHAIRMAN DUDLEY. Thank you. I support alternative B. In terms of our large-scale asset purchase program, we should finish the $600 billion. Stopping here would send an inappropriately strong signal that we're starting to remove accommodation relative to the actual effect that the $170 billion would actually have. You would have a very strong market reaction relative to what the actual effect would be on the balance sheet.

With respect to future large-scale asset purchase programs, I get the sense from the Committee that the bar is quite high for a couple of reasons. One, deflation is no longer a significant risk. Two, the economy looks better than last summer, and three, which hasn't been mentioned, there is more interest rate risk as the size of our balance sheet increases. So while the language in paragraph 3 is neutral in terms of prepared to adjust up or down, I view the bar as pretty high to further large-scale asset purchase programs, at least at this time based on what we know about the outlook today.

In terms of the statement, there is this question about whether inflation expectations are 'stable' or whether inflation expectations are 'generally stable.' You know, we debated this in New York, and we came to the conclusion that 'generally stable' was probably a more accurate description of what we're actually seeing. And I guess my preference is to have paragraph 1 call it how we see it and not shade it because of worries about market reaction. That said, I do agree that the change will be noticed, but I think that being as accurate as possible is important in terms of maintaining our credibility. Putting in the word 'generally' could actually be productive in the sense that it might show a greater concern about inflation expectations, which might keep inflation expectations better anchored. It could prove beneficial to us rather than problematic, and I do favor putting in 'generally.'

In terms of President Plosser's suggestion of historical norms, I guess my problem there is: What time period does 'historical norm' apply to? Does it include the 1965'82 period? And how do we feel about it being within historical norms? There's no view of whether the idea of historical norms is acceptable or not, so I think it's a little vague in terms of how people would interpret it.

In terms of paragraph 2, I favor keeping the last sentence unchanged, 'in the context of price stability,' because it avoids this low-high-low pattern of that paragraph in introducing so many different concepts. I think it keeps the paragraph simpler, and, to President Lockhart's point, maintains our practice of only making changes when we think the changes are actually necessary and a distinct improvement. If people don't want to do that, I could accept it. I could certainly accept inserting the word 'headline' or 'overall' as the modifier to the inflation rate in that paragraph. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you very much. Let me try to start by saying something about policy, then turn to general issues of communication, and then we'll try to wordsmith the statement a little bit.

We are in good time here, so'not that I'm going to tempt everybody to turn into E. B. White [laughter], but anyway.

The big policy action that's being proposed under alternative B is to announce the end of what to my distaste, but nevertheless unavoidably, is now known as QE2. There have been some postmortems of this already in the media. My own view'and I appreciated President Bullard's comments on this yesterday'is that the program was reasonably successful. It was undertaken at a time when we were concerned about the sustainability of the recovery. It was not clear that growth was sufficient to reduce unemployment, and deflation risk, although not high, nevertheless was building as core measures fell below 1 percent, and at that point, of course, headline and core were pretty close. What our policy did was clearly demonstrate that we can affect financial conditions even though the zero lower bound is binding; that's intellectually a historically important development to show to be the case. I think there's little doubt of that even among the skeptics. In addition, the forecasts and outlooks between August and January

generally improved, and in particular, of course, deflation risk is largely gone and the recovery seems self-sustaining. That has been slowed a bit lately by the oil price increases. As I argued yesterday, I don't think that's really due to QE2, although some others might disagree, but again, I think that it's been generally a successful exercise.

Some of the commentary that claims otherwise, I think, does so only because it seems to assume that we somehow claimed that this was going to be a panacea, that it was going to solve all of our deep economic problems. We never made any such claim. At one point we published work that said it would cause 700,000 additional jobs, or about 30,000 a month, which is hardly a game changer, but certainly something that, at least at the time, most of us thought was worth doing. I'm sure there's some rationalization here, but in my own view, it was the right thing to do, and it was a very important experiment. I would like to complete it both because I think it is needed substantively and because I don't like the signal that not completing it would send.

Going forward, as some have noted, further actions of this type would have to meet a very high bar. In particular, I think we'd need to be looking again at real concerns about the sustainability of the recovery and about deflation; slow recovery, for example, is not going to be sufficient. Of course, if further stimulus is needed, we could reconsider alternative measures, such as changes in language and so on, but let's leave that for the future. My modal forecast at this point is that we will go on hold for a short period, at least, to see what's happening, and if things go as I hope they will and as we all hope they will, we can begin a process of gradual exit through many of the steps that were outlined in the various discussions yesterday. But we'll see, of course, as always. Policies always stay contingent and provisional.

I'll just say one word about President Bullard's useful interjection about Ss rules.

There's always some degree of that in Committee discussions. In particular, another example is

the fact that we always move in 25 basis point increments; we don't move in 10 basis point increments. In my view, part of the reason why that doesn't constrain our ability to respond continuously is because our language and our signals do allow for some variation in effective tightness by changing expectations in markets. But I agree that we certainly want the markets to respond in a way that is consistent with the incoming news flow.

Let me just say a word about communication. There have been a number of really good issues raised. First, in terms of general framework, I think we basically have a framework. I think a lot of it was expressed in the document that President Plosser and his group put together in their discussion of numerical inflation objectives. It's pretty much a modern centrist macroeconomic framework. But it's also true that in terms of our language, between 'underlying' and 'overlying' and 'temporary' and 'permanent' and everything else, that we are getting so deep into the code words that we need Alan Turing and the Enigma machine to figure some of it out. [Laughter]

Now, I'm very flattered about all the comments you made about how my press conference in 30 minutes is going to clarify all these matters [laughter] and straighten everybody out, and I will do my very best, I promise. I do think that the press conference over time, in conjunction with the evolution of our language, will be an important adjunct and will allow us to clarify and be more explicit about the framework, about the role of the numerical objective, about the role of short term versus long term, about inflation forecasts, and the like. But I think that we do need'and I charge Bill English and others with this'as we move even toward the next statement, to step back a little bit and try to clarify our framework, make it a little sharper so that we can link it up to the language in a more transparent way. Again, a number of other useful suggestions about communications were raised today and yesterday. I think that taking core

inflation out of the projections is something we should discuss. It would send a very strong signal, and it's not evident what role it's playing at this point if we have our explicit forecasts.

As I said yesterday in response to President Bullard, future headline inflation is our objective, and I don't think anyone doubts that. I think many of the critics either don't understand or don't want to understand what the role of core inflation is: It's just simply an intermediate indicator or a forecasting device. At the same time, as we discussed the projections, additional good suggestions were made; one was that if we can do it in a way that would not be confusing, given the many dimensions of the balance sheet, maybe we could begin to provide some information on our balance sheet expectations or on our policy rate expectations. This is not something I necessarily advocate doing in the next six weeks because it's complex and there's not a whole lot of international experience to draw on, but I think we should be thinking about that.

I have one other suggestion to make, and I've thought about this for almost 15 minutes now. [Laughter] President Kocherlakota made a very good point, which is that because the amount of effective stimulus does depend on expectations about how the balance sheet is going to evolve, and given the novelty of this particular tool, it would be very useful if we could provide more information to the public about how that's going to happen. We certainly have had some very good discussions. I think there are some areas where a majority of the Committee is in one place or another, but maybe we could begin a process of trying to put together a white paper or something like one that we would approve and release, that would say whatever it is we can agree on, and would try to provide at least some guidance to the public about how this process is going to unfold. Now, as I said, I've thought about this for 15 minutes, and I'm sure the staff are all canceling their vacations as I speak [laughter], but it would be good, I think, if we

could try to come up with something as a group. Of course, the trouble with these open discussions is that while they're extremely informative, at some point, obviously, we're going to have to make choices, and it would be good if we could figure out exactly what it is we agree on, where we don't agree, and how are we going to decide. So that might be one way forward. At a minimum, we should try to go back and summarize what was learned in the discussion yesterday'in the Tealbook, in the minutes, and elsewhere'to try to lay out those points. I think we have a lot of work to do in strengthening our framework and our communication. Press conferences are an opportunity, but they are not by themselves going to be sufficient, so I hear that loud and clear. Particularly at this critical stage, I think we need to keep thinking about that.

All right. Now, as usual, I'm trying to keep track of some of the various issues. I think there was broad support for alternative B for various reasons. If I'm not mistaken, I think there are really only two questions that we need to decide. The first has to do with the characterization of inflation expectations in the last sentence of alternative B, paragraph 1, whether or not they remain 'generally' stable. I think I've heard three possibilities here. One is just to stay where we are and say that it remains stable. I personally have a mild preference for that because I don't think there's much evidence of any kind of significant change in inflation expectations. Now, Bill will argue that if you add up enough small changes, you get a significant change, so I'm basically open to whatever the Committee wants to do. Again, I have a slight preference not to change the language because it will create knock-on effects in the 'extended period' language, and so on. But if we decide to change it, two suggestions have been made. One is to add the word 'generally,' and the other, from President Plosser, was to say something like, 'inflation expectations have remained,' and I would say, 'within recent normal ranges.' President Plosser, I would take that part. I would discourage the second part, although I think it's very useful,

about 'medium term' because we then have the same issue in the second paragraph, and we would have to restructure the whole thing. I'd like to propose that we just systematically try to create a vocabulary that encompasses all of the various concepts that we have for inflation, but I don't want to do that on the fly. So question number one is how to characterize inflation expectations in paragraph 1.

Question number two has to do with the changes in paragraph 2. There are two changes here. The first one says, 'Increases in the prices of energy and other commodities have pushed up inflation in recent months.' Frankly, I think if we just have that change, and if we decide to eliminate the second one just for the moment'again, I'm open to discussion'but because our previous statement said, 'are currently putting upward pressure on inflation,' unmodified, I'm not quite sure why a change is needed. Once you start talking about the decline in inflation, et cetera, then it's becoming more complicated. One option, which I think I heard at least a plurality favor, was just to keep the first and drop the second, returning to the old language in the last sentence. The other alternative I guess I would propose would be to accept both changes and maybe to put in 'headline inflation' in both places.

MR. EVANS. I agree with your characterization, Mr. Chairman. It's really the last part, where it mentions a decline in inflation to rates consistent with the Federal Reserve's mandate, that made me think differently about it. If you drop that one along the lines of President Kocherlakota, I do not have a problem with the 'pushed up inflation in recent months.' That's just fine.

CHAIRMAN BERNANKE. I don't want to complicate it further, but you could say, 'gradual return to higher levels of resource utilization and to levels of inflation consistent with

the Federal Reserve's mandate,' without getting into ups and downs. That would be another way to do it.

VICE CHAIRMAN DUDLEY. I think it's easier just to keep it the way it is. CHAIRMAN BERNANKE. Okay. I withdraw that then. All right. So those are two

questions. I'm going to take a straw vote on both of these in just a minute, but does anyone want to make a further comment'let's start with the first one, on inflation expectations?

MR. PLOSSER. Mr. Chairman? Can I just make an observation?

CHAIRMAN BERNANKE. President Plosser.

MR. PLOSSER. It's about two pieces of the language that are tied together. One is the issue of what we mean by underlying inflation. That was what I was trying to address. And I understand what you're saying. We use it several times, so we've got to figure out a way around, but I think we need to work our way out of that language. And the second is the context of price stability. I've never quite understood exactly what that meant, and I think part of President Lacker's effort was to get away from that. I would be happy if we made a commitment for the staff, as we move through the next set of languages, to try to clean up both of those concepts in a way that we're consistent through this, which I think was what your earlier suggestion was. I think that's going to be important going forward for us.

CHAIRMAN BERNANKE. Okay. Well, again, certainly the staff, Bill and others, hear that. Point taken. President Lacker.

MR. LACKER. If I could just add to that. Betsy is right and you're right, I think, that we need to take a systematic look at the language that we use to communicate about inflation. I don't think we're far apart at all on the facts. I think we all understand it. It's choosing the language to communicate what there is a consensus about.

I think, broad brush: The recovery is continuing, we know inflation is high, and it's going to come down. Those are the three things we want to communicate with the statement, and to go back to the context of price stability is to rely on people comparing context of price stability and high current inflation and realizing, oh, they're saying it's going to come down. I mean, to me, it's an oblique and, to my mind, unnecessarily indirect way of stating, 'We expect inflation to come down.' So I just wanted to get that point in.

CHAIRMAN BERNANKE. I think that's a perfectly viable option, as long as we put in 'headline.'

MR. LACKER. Yes, I'm not against putting in 'headline.' I mean, I think over time we're going to want to drop that. We could use 'overall' just as well.

CHAIRMAN BERNANKE. Yes, 'overall' would actually be even better, I think. Vice Chairman.

VICE CHAIRMAN DUDLEY. Earlier in that paragraph we do say that we expect these effects to be transitory, so we are setting up the idea of why we think that we're going back to price stability. If we hadn't mentioned the transitory nature, I would be more in agreement with you, but we do mention it. So that, I think, sets up what follows.

CHAIRMAN BERNANKE. Yes, that's true. President Kocherlakota.

MR. KOCHERLAKOTA. I'll say a couple things. First, I think references to 'headline' should be avoided. I think in the systematic overview of language that will take place in the next six weeks we will regret using that language. The use of the term price stability is to connote two things at once, and perhaps it's too oblique to do that. One is that inflation will decline from its current high levels, but it's also to say that underlying inflation will return from its current low levels to 2 percent.

MR. LACKER. What's 'underlying inflation,' in this context?

MR. KOCHERLAKOTA. I think of 'underlying inflation' as being our best possible forecast'

MR. LACKER. Forecast is going to return to'?

MR. KOCHERLAKOTA. Our actual forecast is for inflation to do this'to go up, and to come down below, and then to reach target from below. I think it's a very subtle and artistic forecast. [Laughter]

MR. LACKER. It doesn't say what our forecast is going to do, what we expect our forecast to do, which is different than what we forecast inflation to do.

CHAIRMAN BERNANKE. All right. Okay. President Lacker, would you be okay for this meeting to restore the ambiguity of 'in a context of price stability?'

MR. LACKER. Yes.

CHAIRMAN BERNANKE. Thank you. That's with the understanding that this is not a satisfactory situation. I think President Kocherlakota's point about starting to throw in 'headline,' adding yet another term, is going to be an issue. So I'm perfectly okay with 'pushed up inflation in recent months' because I think that's accurate, if that's okay with everybody.

All right. Let's restore the last sentence of alternative B, paragraph 2, and keep the change 'have pushed up inflation,' not 'headline inflation'''have pushed up inflation in recent months.'

So then our remaining question is about inflation expectations. Let me just see first if there's a plurality to leave it where it is, and if there isn't'let's vote the following way. Change or no change, and then if there's a change, we'll figure out which change is better. President Plosser?

MR. PLOSSER. Can I just say one thought that just occurred to me?

CHAIRMAN BERNANKE. Yes.

MR. PLOSSER. Rather than 'recent historical norms,' you could say, 'inflation expectations remain at acceptable levels.' That doesn't address the volatility of them necessarily. But maybe that connotes too much.

CHAIRMAN BERNANKE. That's a little anxiety producing.

MR. PLOSSER. Yes, I withdraw that. I'm sorry.

CHAIRMAN BERNANKE. All right. In the interest of coffee, I'm now going to ask how many people would like to just leave the characterization of inflation expectations as 'remained stable,' and how many would like to consider an alternative. How many would like to say 'remained stable'? [Show of hands]

CHAIRMAN BERNANKE. Okay. Well, ten is a majority, so we'll just keep that language. Any other comments or questions? [No response]

CHAIRMAN BERNANKE. Okay. Again, I thank you for both your input and your willingness to work flexibly with the Committee. We're ready for a vote. Debbie.

MS. DANKER. This is on alternative B, the statement in the handout, as well as the directive. In the handout, it is as written in the handout. The 'generally' is struck, and the final sentence of paragraph 2 reads, 'The Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability.' Chairman Bernanke.

MR. ENGLISH. Do you want 'continues to' to go back in there so that the sentence is staying the same?

CHAIRMAN BERNANKE. Shouldn't we make the last sentence identical to the previous statement?

MR. ENGLISH. That is what I was suggesting.

MS. DANKER. Keep 'continues to.' Okay. All right. 'Continues to' is now in there.

CHAIRMAN BERNANKE. Thank you very much. We are very efficient. The next

meeting is June 21 and 22. As you know, the press conference is at 2:15 p.m. If anyone is here and wants to see it, there will be a screening available in the Special Library across the hall.

In a moment I will call the end of the meeting and then have coffee, and for those who would stay, Linda Robertson will present a congressional update'optional. And now we are still having lunch, I guess?

MS. DANKER. I think they're going to bring it at 11:30.

CHAIRMAN BERNANKE. Okay. At 11:30, for those who would like to have lunch; don't ever tell me that there's no such thing as a free lunch. All right. The meeting is adjourned. Coffee for 20 minutes, and then those who want to hear an update on congressional developments, please come back to the table.

END OF MEETING

Meeting of the Federal Open Market Committee on

June 21'22, 2011

A joint meeting of the Federal Open Market Committee and the 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 21, 2011, at 10:30 a.m. and continued on Wednesday, June 22, 2011, at 9:00 a.m. Those present were the following:

Ben Bernanke, Chairman

William C. Dudley, Vice Chairman

Elizabeth Duke

Charles L. Evans

Richard W. Fisher

Narayana Kocherlakota

Charles I. Plosser

Sarah Bloom Raskin

Daniel K. Tarullo

Janet L. Yellen

Jeffrey M. Lacker, Dennis P. Lockhart, Sandra Pianalto, and John C. Williams, Alternate Members of the Federal Open Market Committee

James Bullard, Thomas M. Hoenig, and Eric Rosengren, Presidents of the Federal Reserve Banks of St. Louis, Kansas City, and Boston, respectively

William B. English, Secretary and Economist

Deborah J. Danker, Deputy Secretary

Matthew M. Luecke, Assistant Secretary

David W. Skidmore, Assistant Secretary

Michelle A. Smith, Assistant Secretary

Scott G. Alvarez, General Counsel

David J. Stockton, Economist

James A. Clouse, Thomas A. Connors, Steven B. Kamin, Loretta J. Mester, David Reifschneider, Harvey Rosenblum, Daniel G. Sullivan, David W. Wilcox, and Kei-Mu Yi, Associate Economists

Brian Sack, Manager, System Open Market Account

Jennifer J. Johnson, Secretary of the Board, Office of the Secretary, Board of Governors

Nellie Liang, Director, Office of Financial Stability Policy and Research, Board of Governors

Robert deV. Frierson, Deputy Secretary, Office of the Secretary, Board of Governors

Transcript of the Federal Open Market Committee Meeting on

June 21'22, 2011

June 21 Session

CHAIRMAN BERNANKE. Good morning, everybody. Because this is a joint FOMC' Board meeting, I need a motion to close the meeting.

MS. YELLEN. So moved.

CHAIRMAN BERNANKE. Thank you. We are starting very early, and I thank you for arranging your schedules that way. We have an awful lot to accomplish today, and I would certainly like to get to the end of the economic go-round. So let me just ask everyone, where possible, to be succinct and to be aware of the time.

That being said, I would first like to take a minute to note that, with high probability, this will be the last meeting for Dave Stockton before he ambles off into the sunset. [Laughter] Dave joined the Federal Reserve in 1981 as the inflation specialist in the section that was known as Wages, Prices, and Productivity. That year, the CPI clocked in at about 10 percent. [Laughter] However, after '81, of course, it began to come down very steadily. After successfully bringing inflation under control, Dave rose rapidly through the ranks and was appointed division director in 2000. In all, he has attended 170 FOMC meetings, including 84 as division director and FOMC economist. At his first meeting back in November '85, he delivered a lengthy presentation to Chairman Volcker and the rest of the Committee on the effect of dollar depreciation on the U.S. economy. They must have liked it, because they invited him back almost immediately. As far as the macroeconomics is concerned, perhaps it will suffice for today simply to note that Dave's time as director included both the last years of the Great Moderation and the period that I am confident will become known as the Great Immoderation. [Laughter] Economic historians will puzzle for years over Dave's role in all of that. [Laughter]

Dave has given us the benefit of his keen insight as a macroeconomist, his unparalleled grasp of

the inflation mechanism in the United States, and the hallmark of his time here, the wit and

humility in which he has wrapped it all. Never before has the owner of the staff forecast

compared its shelf life unfavorably to that of a jar of mayonnaise in the Mojave Desert.

[Laughter] So, Dave, on behalf of the Board and the Committee, we want to thank you for a job

exceedingly well done. Thank you. [Applause]

Our first item today is our special topic on DSGE models, and I will call in just a moment

on Michael Dotsey from the Philadelphia Federal Reserve Bank. He will be supported by Marco

Del Negro from New York, Jeff Campbell from Chicago, and J. P. Laforte from the Board. I

really appreciated the summary memo and the background papers that we got; a lot of care went

into trying to make this intelligible and understandable to everybody. And it was a great

example of the collaborative effort between Board researchers and Reserve Bank researchers. So

let me turn to Michael.

MR. DOTSEY.1 Mr. Chairman and FOMC participants, good morning, and thank you for giving me the opportunity to introduce the System's DSGE project to you. First, I would like to give you a brief overview of dynamic stochastic general equilibrium, or DSGE, models and indicate how they can provide useful input into the policy process. Then I will illustrate two uses of the models: their ability to identify economic disturbances that are responsible for a given event'in our case, the Great Recession'and their use as a forecasting tool. In my discussion, I will concentrate on the relative strengths of the methodology, but I will also make you aware of the pitfalls. I will conclude by describing other uses of the models that the FOMC might be interested in.

Let me begin by reviewing the methodology employed in DSGE models. Specifically, what are DSGE models, what makes them special, what are their strengths and weaknesses, and how should they be used in conjunction with the other tools available to policymakers?

As summarized in exhibit 1, DSGE models are small to medium-sized economic models. Thus, they are much smaller than FRB/US but generally larger than simple time-series models such as vector autoregressions. Notably, DSGE models are also

1The materials used by Mr. Dotsey are appended to this transcript (appendix 1).

CHAIRMAN BERNANKE. Thank you very much, again, for the collaborative work that you have done. I think it is very encouraging that staff is trying to introduce new research developments, at the same time maintaining an eclectic and broad-based approach to forecasting and analysis. A particular advantage of these models, as you point out, is that they give you an opportunity to create stories that are economically well-grounded. They also let you look at policy analysis in a way that will take into account the potential behavioral responses to changes in policy regimes. Those things are very useful, and I commend the staff for doing this work. I think it is an important part of our collective progress in analyzing the economy.

Let me kick off the Q&A round and ask whether the concept of a utilization rate ever appears in these models. For example, in housing, we would think that the notion of vacancies affects the marginal product of constructing a new house. In both capital and labor, you would think that utilization would be relevant. Because that requires departing from a truly neoclassical kind of production function and allowing for perhaps some fixed coefficients, it may not be feasible, but I am just curious if thought has been given to that.

MR. DOTSEY. I agree with you on these things. Right now, the models that we have mix extensive and intensive margins, and we really don't talk about things like unemployment. It is true that deviations of where the model is from a steady state are very important, and those are gap-like concepts, but not exactly what you may be asking about. A lot of those types of things, though, are on the DSGE framework. I think that many of the things you suggest are doable; they just haven't been done yet. They involve a lot of work, and researchers have to figure out which ones they want to attack and in what order. As I mentioned in my briefing, developing more realistic labor market sectors, where we can actually look at unemployment measures in more detail, are certainly front and center. None of our models incorporates that.

CHAIRMAN BERNANKE. Okay. Thank you. Any other questions? Vice Chairman. VICE CHAIRMAN DUDLEY. Thank you. I have two sets of questions. One, how

have the models done in terms of forecasting? You show the current forecast, but if you back things up six months or a year ago, or two years ago, how have they actually done? And when a model does poorly, how do you assess that? Is that because there were shocks or because the model was misspecified? How do you interpret what is a good model versus what is a bad model?

My second set of questions is going to maybe go in the same direction as the Chairman was going. How do you think about balance sheet constraints in the context of these models? For example, right now you have changes in credit standards and credit availability. Do the models just take those and translate them into a particular shock?

MR. DOTSEY. Okay. With regard to forecasting, there has been only a little bit of work done with these particular models formally testing how well they forecast. In particular, the EDO model has done some exercises, I believe, over the 1997 to 2004 period, and I think the answer is that it does about as well as FRB/US.

Some other work that I have read by somebody at the ECB has looked at three or four different DSGE models'the Smets-Wouters model, something very close to EDO'and has looked at model averaging. In those particular exercises, when you start looking three and four and five quarters out, the DSGE approach seems to outforecast what was in the Greenbook when it comes to output growth, does slightly less well on inflation, and actually, surprisingly, does a little bit better at predicting the Committee's own behavior three, four, and five quarters out. These are not our models, and certainly, if you were to use the forecasts from our models, I agree

that one of the things that we need to be able to bring to your attention is how well their forecasts have done over a period of time in comparison with others.

In terms of trying to think about misspecification'and I'm going to let some of my colleagues pipe in, if they want to, because they are the actual experts on model development. When you start seeing really, really huge shocks that have to drive everything and the shocks take on a very persistent type of character, then you can be somewhat skeptical of the model. That is a signal that something outside the model that is driving things. Then you may have to say, 'Well, maybe in this particular case, because it is just large persistent shocks and is not something endogenous to the model, we are not looking at your DSGE model today.'

In terms of credit standards, I believe in the New York model'I'm going to let Marco answer this in a minute'those types of things reflect, for example, how much net worth people have and how risky the borrowers are, and that will influence credit spreads endogenously. In the EDO model, the risk premium is, as you say, exogenous. But there are models on the shelf that do look at these net worth characteristics and how they do affect credit spreads, and I believe that those could be incorporated into the framework as we go forward. I would like to turn to Marco, who has done more work on this, if that's okay.

MR. DEL NEGRO. Let me address one thing about the misspecification. Of course, big forecast errors translate into shocks in this model. That has to be the case. However, because these models are estimated, the econometrician learns, and the model learns, from past mistakes. The model hates having big forecast errors. [Laughter] And, therefore, parameter estimates adjust. That happens, for instance, for the incorporation of financial frictions with data coming from the crisis.

Getting back to your question about the balance sheet, the New York model has, in a very coarse way, an idea of leverage. Leverage is fundamental to explain the financial frictions in the model. So, at a very high level, we can talk about leverage'of course, probably not to the very specific extent that you want us to talk about it, but there is model development in terms of having a finer banking system. We hope that in the future we will be better able to address your questions. The other models also address, to some extent, these other shocks, like marginal efficiency and investment shocks, that capture financial frictions. Thank you.

MR. REIFSCHNEIDER. Let me piggyback with a comment related to forecasting with EDO. As Mike said, the published paper on the forecasting ability of EDO only went through 2004. But, actually, J. P. Laforte, Rochelle Edge, and Mike Kiley looked at it through a more recent period in a sort of pseudo real-time forecasting exercise using the actual data published at the time. And we have also had the actual real-time forecasting experience of EDO. I think it really shows what Mike said, in the sense that EDO does about as well as a lot of techniques. As Mike Kiley would immediately say, 'That's not a fantastic standard to hold it to,' [laughter] but it does as well. So these models are useful for forecasting. In terms of what has been happening over the last year or so, I'd say the way EDO has been surprised is in many respects the same as the way FRB/US and the staff forecast in general have been surprised'that is, this recovery has turned out to be slower and more prolonged'and we're having to reassess what is going on as the weakness persists. And that relates to the point Marco made: The model errors raise the question of what exactly is going on out here.

CHAIRMAN BERNANKE. President Williams.

MR. WILLIAMS. To start, I would like to thank Mike and all of the System staff who worked on this project, which has been going on for quite some time. I think this work illustrates

some of the valuable synergies between policy analysis and academic research. I especially applaud the approach of comparing and contrasting alternative models, which illustrates the tough modeling choices and tradeoffs that all researchers face when developing models for policy analysis, and I think, more importantly, provides different perspectives on the economy and policy.

I have two questions for Mike. First, what do you see to be the key advantages or insights of the DSGE models over, say, FRB/US in thinking about the current situation and the appropriate stance of policy today? And my closely-related second question is, what do these models tell us about the impact of the events of the past three years on potential output'or, in the parlance of DSGE models, the natural rate of output'and the output gap?

One purported advantage of DSGE models is they provide a theoretical basis for distinguishing between shocks to supply and demand. Indeed, in many DSGE models, supply shocks'that's shocks to preferences and technology'account for a significant share of economic fluctuations. This distinction between supply and demand shocks is a critical issue for monetary policy because policy should respond differently, depending on the nature of the shock. I am particularly curious about the New York Fed's model, which shows very persistent effects of the financial crisis on output. In the New York Fed model, does this primarily reflect a decline in potential output or a very persistent output gap?

MR. DOTSEY. I am not an expert on FRB/US, so I don't think I can really say exactly what the weaknesses are of FRB/US versus the DSGE framework. What I can say is what you alluded to'that the DSGE framework, because of its manageable size and the restrictions associated with forward-looking and optimizing behavior, allows us to, as you said, characterize the shocks. We can look at impulse-response functions that we know are related to a

fundamental type of shock, rather than something that may be just a reduced-form forecast error, and see how that plays through the economy, giving people an idea of how the model works.

In regard to gaps, there are numerous ways to construct gaps. The models themselves don't find most of those constructions as a first-order part of the model. So basically, the gaps that most of us can tell you about are where we are relative to the steady-state growth of the economy. And most of these models were a long way away, between 4 and 10 percent. Regarding the New York Fed model, I'll let Marco field the question.

MR. DEL NEGRO. I want to clarify a little bit of what Mike said. Gaps, I think, are an important part of these models. In fact, getting back to your questions, the headwinds'a slower recovery from the financial crisis'is largely a gap story; it's not a trend in output now being lower. It's a gap caused by shocks that have a very prolonged effect on output, depress economic activity, and therefore keep inflation low. Now, maybe what Mike was referring to, and you as well, is that there are various ways of measuring gaps. One is related to the trend in output, and another is relative to a hypothetical universe without nominal rigidities. Well, the second way is actually very challenging, as shown in a recent paper by Justiniano, Primiceri, and Tambalotti, because it involves a number of conceptual and measurement issues. We don't yet have measures of this alternative gap, but it plays a role in the model, and we can certainly provide them to you in due time.

CHAIRMAN BERNANKE. Governor Yellen.

MS. YELLEN. I want to thank you very much for an excellent presentation, and to applaud the staff's work in the collaboration that you have going here on DSGE models. I think it's extremely valuable, and I agree with you that these models can play a very useful role in medium-term forecasts. I hope that the Committee will be able to routinely look at forecasts

generated by the suite of models you've described, along with FRB/US and SIGMA and other models that we have here at the Board.

I just want to make one suggestion about something that I would find useful. I've long been a fan of using simple rules as benchmarks for monetary policy. And I think macroeconomic models can play a key role in formulating and comparing these rules. President Williams has written important papers showing that, in gauging the performance of simple rules, it is important to use a range of alternative models to help identify rules that would be robust to uncertainty, particularly uncertainty about the structure of the economy, as well as shocks. So I want to suggest and encourage staff to potentially conduct an analysis of simple monetary policy rules using the DSGE models that you have presented to us today, and we could do the same thing using other models at the Board'FRB/US and SIGMA, which is an open economy DSGE model that's been developed here. I know we've talked about possibly having a future discussion of monetary policy rules, and I think this would be a potentially useful part of it.

MR. PLOSSER. Governor Yellen, we've talked a little bit about this, and Philadelphia made a suggestion a while ago to staff that one of our two-day meetings in the future might be about such robust policy rules and variations. Using these models as input into that exercise might be a way to push these things along together, so I would encourage that. That's a great idea.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I just had one quick question for Mike, which is, how do the models capture the large-scale asset purchases and their impact?

MR. DOTSEY. First, we don't have a rich term structure or any type of market segmentation in the asset market. So with regard to QE2, that's not going to be done directly.

But there are other studies that we can piggyback on that indicate how much so many hundred billions of dollars of assets move down the 10-year Treasury rate, or whatever maturity you are doing. And then there are other studies that translate that into a funds rate'type of decision.

Putting it in terms of the funds rate, and perhaps relaxing the zero lower bound constraint would be a way that these models could, in an indirect way, handle that. QE1 seems different, and that is handled directly in the New York model because when QE1 came along, a lot of spreads went down quite rapidly. And those do directly affect what is going on in the New York and Chicago models. For Philadelphia, in the Prism model, it's going to affect what kind of marginal efficiency of investment shocks we are going to be seeing. But I regard QE1 and QE2 as two different policies that the models would incorporate in two different ways.

CHAIRMAN BERNANKE. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. I want to commend the staff for excellent work here on the DSGE framework, and, of course, I'm a big champion of this kind of work. I think DSGE models are very useful for organizing our thinking on important aspects of macroeconomic behavior. The best and most valuable feature is that everything has to add up in the model: Equilibrium conditions and budget constraints are respected, expectations are treated consistently, and businesses and households are viewed as doing the best they can, given the environment and the prices that they face. In some sense, DSGE is the only game in town, so it's really just economic models.

The key use is to investigate pet theories. We policymakers often have a few fundamental driving factors in our minds when thinking about how to interpret macroeconomic events. One can build a DSGE model with those factors in play, and then see what the implications would be for key macroeconomic variables. That is very much what is going on

here in this set of papers. Often, perhaps very often, the proposed explanation for the event will not match some key facts. I do not regard that as a failure so much as a key piece of information. It is very informative because it suggests where the theory is right and where it needs improvement, and it helps modify our thinking relative to our priors that are embodied in our pet theories. So at its best, this process can be extremely valuable in making the types of judgments that have to be made around this table.

One remark that I do have, and I want to get your comment on, is that I do not think forecasting is necessarily a good metric for models like this. Macroeconomic systems have a certain amount of ambient noise in them. Because of this noise, there will always be clear limits to how well we can forecast. We do not really forecast the economy at all. We really track the economy in an engineering sense. And when we have to predict, we naturally predict that the variables that are away from their means will simply return to their means. So better forecasting may not be a reasonable expectation for this class of models, or really for any models, that we might write down. The goal, instead, is better policy. An alternative policy may deliver dramatically better outcomes for households, even though the forecastability of the economy has not improved at all. That is, under policy A, we would obtain one equilibrium outcome, and under policy B, a different equilibrium outcome, and one of these two possibilities may be strongly preferred to the other. But the forecastability is the same in both cases due to the ambient noise, and due to the fact that a good forecast will actually change behavior in the economy'we are talking about forward-looking businesses and households in the economy' and that will reduce forecastability. There are going to be limits to how well you are going to be able to forecast in a macroeconomic system. DSGE models, at their best, can be very useful in

identifying better policy interventions, even when there is no improvement in forecastability. I don't know what you think about that.

MR. DOTSEY. I agree with part of it, and I disagree with part of it. I agree with you that forecasting should not be the only emphasis on these models. These are small models that are tightly parameterized. I don't share Mike Kiley's view that the glass is half empty. I say, 'The glass is half full,' and that these models, as tightly parameterized as they are, and not taking account of all the additional degrees of freedom that the big models have, are doing about as well. However, if they were forecasting so abominably that we thought that they had no attachment with reality, then we might want to step back and ask, 'Do we really want to use these models for any of the other things they are designed to do?' The fact that they are forecasting about as well as reduced form models, which is pretty good, suggests that they are in an area where they can do the types of experiments you want and be informative as well.

So I agree with the general thrust of what you are saying, but I think forecasting still is somewhat important. I think the Committee would not want to pay attention to models that couldn't forecast at all. For instance, if we did the Great Recession exercise, and we all found out that technology shocks were driving the entire Great Recession, you might ask, 'Well, why would I want to look at these models for analyzing anything that looked like a banking crisis in any detail?' But we didn't find that, so that's reassuring.

CHAIRMAN BERNANKE. President Evans.

MR. EVANS. Thank you, Mr. Chairman. I want to thank all of the staff that contributed to this project. I agree that it's a great example of collaboration. I've heard accounts of how things are going in Chicago, and I think that it's been very exciting that people have been working so well together.

I'm very sympathetic to the comments that President Bullard just made, and it makes me think about what the role of judgment is in so much of our analysis, and on the occasion of Dave Stockton's last meeting, I think it is right to think about how important judgment is. As I think about how the staff forecast is put together, there are a lot of different analyses that need to be taken into account in order to put together the type of forecast that's very difficult to get out of a model, even one as flexible as FRB/US or one like the DSGE models. But I think that the FRB/US model and the DSGE models can help inform how those analyses and forecasts evolve, if not quarter by quarter, then over time, and to get the story. What I like so much about the DSGE models, at least in terms of how we think about it in our Bank, is that they tell a story about how things are playing out in the economy. There's really a beginning and a middle and an end to this story. There's a beginning that starts off with the exogenous impulse, the shock, however you want to characterize it. There's a middle: There's the propagation that the model grinds out. And there's an end as the economy goes through the transition to the longer-term resting point. I think it's very valuable to understand some of the stories that these models can tell, and I agree with Jim that it may not generate the best forecast, but it helps us with better policy thinking.

Getting to my question, here's an example that I'm thinking we might struggle with over the coming meetings or longer. Coming through the expansion in the middle of the past decade, we saw strong growth, and we thought that that was associated with higher potential output, a higher level of output. Then we get to the Great Recession, and we have these shocks, financial in nature, and other factors, which led to a dramatic recession, and now the models are telling us there's a big gap. But I think we're going to be wondering, if we haven't already, what about the 1970s? What about policymaking during that time period, when policy was highly

accommodative for a long period of time? Was it to achieve something that ultimately wasn't achievable, a higher growth rate? Athanasios Orphanides and others have looked at that period and seen that potential output wasn't as high as we thought. I think these models can help inform how the current story may or may not play out. I understand that our measures of the output gap are highly uncertain, but for each of those uncertain estimates, the model will tell a different story as to what those shocks are that led to a lower level of potential output beginning in the middle of the past decade. I think that these kinds of analyses can help us with that. We'll probably have to continue to innovate on the models, but I wonder if you have a reaction to that.

MR. DOTSEY. I think that's very similar to what Governor Yellen alluded to in terms of robustness. Certainly, measurement error can be introduced into these models, and then robust rules in the style that John Williams's research has explored over a number of years can be undertaken, given the kinds of uncertainty we might have about measuring a gap or even what conceptually we think a gap is. I think these models can certainly deal with what kind of rules would be most beneficial under those types of uncertainty. A lot of John's work was in a linear rational expectations environment and some of it was in a learning environment, and both of those types of environments are amenable to the scale of models that we have on the table.

CHAIRMAN BERNANKE. Other questions? President Lacker.

MR. LACKER. Thank you. I, too, want to commend the staff. This is an excellent use of your time and energy, and I found it very useful. These might not be at the ideal state we'd want them to be at and are certainly not ready to fully supplant FRB/US in our arsenal, and I'm not sure we'd ever want to. But to me they look like they provide a really excellent complement to what we have, and I would encourage you to keep working at this and give us some practice with it.

I think you're right about the advantages of this. I agree with what President Bullard and President Evans said, that the coherence of these models offers a tremendous advantage. They're internally consistent. There's a clear narrative that emerges, and you can take the narrative to the real world, and you can say, 'All right. Do I see this element of the narrative in the real world?' One way to think about these models is as an artificial world. It's like Second Life or these online universes, only you guys haven't done the graphics engines yet. [Laughter] The way to work with them is this interplay between looking at the model, seeing what it's telling you, looking at reality, going back and maybe changing the model or reinterpreting the model'and I think that practice with that is what's going to both improve the model and give us a better sense of how to use it.

In reading the memos, I found myself in unfamiliar terrain because we're used to talking about macroeconomic conditions and the macroeconomic outlook using a certain kind of language, but we're not used to saying 'marginal efficiency of investment.' I mean, you don't see Larry Meyer saying 'marginal efficiency of investment' or 'risk premium shocks' very often. So I think, while we know how useful these models are, it's going to take some practice in terms of thinking in the categories that the models lead you to think within.

I have a question, and this is more for Dave Reifschneider than you, but your reaction would be useful as well. It has to do with this limitation you cited, that they're not large scale yet, and it made me think back to an article Chris Sims wrote many years ago about the Board's forecasting procedure. He said that it's articulated at such a disaggregate level that you can compare model behavior in individual sectors with industry analysts, and you get this interplay between model and industry analysts. Now, you don't have the chemical industry per se or

anything at that level of detail, although in certain cases, like housing, you do have individual sectors. I was just wondering how much of a limitation you think that is.

That said, I commend you guys for doing this. I think it would be useful for us to see this on a regular basis, like two or four times a year, and to get this kind of a package. Maybe we wouldn't need to spend as much time on it because you've introduced us to the structure, but we could take a little time to work it into our practice. I think that would be really valuable. I'd just emphasize one thing, and this harkens back to discussions we had about two years ago. There really isn't an alternative to models. This goes with what President Bullard said. The advantage of these things is that you put the cards on the table. If you have a narrative, if you are telling a story, if you think you know or have a sense of what's likely to happen, you've got a model in your head. These at least have the benefit of putting everything about it on the table and checking that it's an internally consistent model. With that, I'd be interested in a response to the question about scale.

MR. REIFSCHNEIDER. Scale is a difficult issue because the interests of the FOMC are very diverse, and one might think, 'Oh, to handle all the sorts of questions that come up, we'd have to build this gigantic thing.' And FRB/US is pretty big, but it does not have the scale that covers all the questions the Committee does. So we have to supplement FRB/US with a lot of other types of analyses. Some of that we can do in DSGE models. When we go with SIGMA, for example, we're doing a lot of international analysis, and we're using a different model for that because it's well designed for answering those sorts of questions. EDO also does a better job of handling certain things, such as how you're interpreting data in real time, or doing signal extraction about what's really going on in the supply side, or what might be going on with risk premiums or things like that. That's a statement that all sorts of different models bring different

things to the table. That's also why, in preparing the staff forecast, we use single equation models, we use reduced form models, we use special-purpose models'we do all sorts of thing. We've been maintaining a tradition of trying to not pile all our eggs in one basket, which some other central banks, particularly smaller central banks, have had to do because they have limited staff resources. We've had the luxury, between both the Board and the System as a whole, of being able to maintain a variety of models, pose a variety of questions, and get a variety of analyses, and I think that's a strength.

At some point you face the question, if you are dealing with a workhorse model, of what's the minimal set of things that has to be in it to be useful for the Committee. We faced that with FRB/US; we didn't put in everything, but we put in a great deal. I don't know that a workhorse model has to be as big as FRB/US; it doesn't have to have as many bells and whistles. It's possible'and I think this is what we have been doing in recent years'that we can do the job with multiple models as opposed to relying solely on one model. Along those lines, if you think about the forecasting process underlying the Tealbook analysis that we've been giving the Committee over the past couple of years or so, it is informed by FRB/US and EDO as well as a whole bunch of other things. FRB/US, EDO, and SIGMA also appear in the Alternative Scenarios, and EDO and FRB/US are used in Book B analyses et cetera. So we're using a range of models, and it's a question of what tool seems most useful for the particular question at hand.

MR. DOTSEY. I agree exactly with David. I won't reiterate. You eloquently, probably more than I, indicated what some of the strengths of these models are, but I think that they are still a bit too small. For example, fiscal policies are problematic; these models don't have distortionary taxation and details along those lines. We're also building better financial intermediation sectors, which are really important, and there may be a few other things. Do we

have to go to the level of a chemical industry? Probably not, and we would lose the transparency that these models can give that's so important. But like Dave just indicated, I think the group involved in the project views our work as complementary work for the Committee; these models have certain strengths, and we'd like to make them available to the Committee. And you have other models that have other strengths, and like you're saying, you should be looking at more than one thing because we don't have the model of the United States economy or the world economy.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. Yes, thank you, Mr. Chairman. I'll, first of all, second what others have said, that this was a really excellent piece of staff work. I spent the week reading through it very carefully with the help of my research director, Kei-Mu Yi, and we learned a tremendous amount in part because people were really generous with their time in answering all of our questions. We really appreciate it. I wanted to follow up on something that Governor Yellen and President Lacker said about what would be interesting to see going forward. I think it would be great for the group of workers on this project, as well as the Committee, to see output from this project, I would say, on a quarterly basis'not as much as we saw here, but something more concise along the lines of, What's the forecast? What's the story behind the forecast? I could imagine a report of about a page and a half that would be pretty useful.

A couple of quick comments about why this would be useful, beyond the fact that I think that we don't have the model of the U.S. economy and seeing things from a wider range of models would be good along those lines: One is something that Governor Warsh mentioned last year, and I thought it was a great point. Governor Warsh was struggling with how to get Reserve Bank economists more integrated into the process of thinking about the FOMC; this project is

one way this can happen because we already have that kind of interaction taking place, and I think that would be fantastic. The other thing that I'll emphasize about these models'and Mike, quite rightly, I think, has pointed to some of their failings or deficiencies'is that I am really impressed with how fast people have been able to build on them in the past two or three years, especially in light of events. You don't want to think, in our constantly changing environment, about a model as being a static object; it's more of a dynamic process. We're always going to be building and adding onto it, and these models have proven very amenable to that process, in part, I think, because of their structure, but also in part because this is what the people in academics are really good at using. For instance, Mike was mentioning the fact that the models that were being used within the current DSGE group don't have unemployment. Well, there's a very nice paper that just came out, I guess, a couple of months ago by Gal'', Smets, and Wouters that is a DSGE framework that builds in unemployment. I think that we're going to be able to build better models through our interactions with the academe by having this kind of model, or a suite of models, as Governor Yellen said, that we constantly use. I think the dialogue about what we want to see and what this group can provide would be better if we start to see something from them on an ongoing basis. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Plosser.

MR. PLOSSER. Most of what I wanted to say has already been said. I think most of you remember the conversation a year ago when we talked about inflation dynamics. A lot of the discussion was about different models that produce different types of inflation; that's where all of this got started a little over a year ago, and they've made a great effort to pull this together. I would like to reinforce what Narayana just said, about seeing a summary of these models on a fairly regular basis. It's a lot about model uncertainty. We need to understand that we don't

know the true models. The second thing I want to tie back into is that there are lots of potential directions this can lead us and having this work being done in the System allows us to do potentially a wide range of things, so I want to encourage the production of that information. If we're working with multiple models in the System, they will give us a platform as Janet Yellen said, for thinking about simple rules or robust rules. We'll learn over time what the Committee wants to hear and how we'll best communicate that, but I think this is very good work and will supplement things that go on in this Committee very well. I want to encourage that process.

CHAIRMAN BERNANKE. Any other questions? [No response] Let me again thank you for this effort. And just for the record, note'as President Kocherlakota did'that this presentation was just the tip of the iceberg. There's a lot of background material, and a number of members of this Committee were specially briefed, so it was a very substantive educational process. Thank you for that.

Item two on our agenda is called 'Refining the Exit Strategy,' and let me explain what we have in mind here. In April we had a very good discussion of the substance of the issues surrounding our exit strategy. Let me just say as clearly as I can that we do not want to repeat that entire discussion today. We've already done that work, and time will simply not permit it.

What motivates this, from my perspective, is really two things. The first is that our discussion last time took the form of people saying what their first-best preference was on each dimension of the exit strategy. What we didn't get was the sense of whether or not there was a modal strategy that most people, in the interest of comity, communication, clarity, and so on, would be willing to accept even if it were not their first best. So I just wanted to probe a little bit to see if it's possible for us to come to something closer to a consensus. Perhaps it's not, but it would be worth knowing that. The second motivation is communication. I have, of course,

another press conference tomorrow and then the Monetary Policy testimony in a few weeks. Even if I don't take the opportunity to actually talk about the exit strategy, I'm almost certain to be asked about it. Because I'm going to have to say something, I'd be much more comfortable if what I was saying was consistent with as broad a group within the Committee as possible.

The staff, using the minutes and input from the Committee, created a set of general exit strategy principles'broad, high-level principles.2 What I'd like principally to do today is to have a go-round and ask people: Are you broadly comfortable with this approach? Are there things that you're not completely comfortable with, but that you're willing, nevertheless, to accept for the purpose of trying to create a consensus? Or are there one or two items that you want to point to that make it really impossible for you to support some kind of consensus document? Based on what happens in our quick discussion, I think there are several possibilities. If a very strong majority of the participants'and I think participants should be the relevant voting group here, because this is a multiyear plan'say, 14 or 15 of the members and participants around the table, were willing to accept something like these principles, then we could note in the minutes that there's a significant degree of consensus. I would ask you at the end if you want to actually reproduce this document in the minutes or simply want to have a broader description of it. On the other end is the possibility'and probably a very likely possibility'that there is significant disagreement, in which case I would suggest that we just briefly say in the minutes that there was further discussion, and try to summarize what the points of agreement and disagreement are very briefly. We would want to be brief'because we want to be careful not to emphasize an exit discussion at this moment because, of course, we have not yet taken any decision to actually begin an exit. I hope we can respect the limit of an hour for

2The materials for the discussion of exit strategy principles are appended to this transcript (appendix 2).

this item, which means that when we ask you to speak in the go-round, I hope you'll try to keep your comments to about two minutes or less.

Now, before we have that go-round, there are a couple of items on the set of principles that we probably should resolve before we go around the table. If you look at your handout, you'll see three things highlighted in red. The middle one, which says, 'During the normalization process,' was a suggestion by President Plosser, which I think is not at all substantive but simply tries to make it a little bit more clear exactly what was intended. So if there are no objections, I would take that change as just given.

There are two more-substantive issues, though. The one I want to address first is in paragraph 6. We circulated a document indicating that the ultimate goal of the exit is to return to a system in which conventional open market operations are used to keep the federal funds rate near its target, which I think very strongly suggests a system similar to what we had before the advent of unusual measures. President Plosser, in a memo that was posted on SDS, suggested being more explicit about our preference for a corridor system at the end of this process. As a result, in paragraph 6, there are two alternatives: One is the original language 'near its target,' and the other is the federal funds rate 'within a corridor,' and so on. What I'm going to do is to ask President Plosser and the Vice Chairman, in either order, to take a couple of minutes to explain their preferences. Then what I'd like to do, if the Committee is agreeable, is to take a quick straw vote; whichever approach gathers a majority'and abstentions are fine'is the one we'll use as the basis for our statement. A second suggestion was made by President Kocherlakota and distributed to the Committee. He suggested language in paragraph 4 to make more explicit the length of time between the change in our extended period guidance and the likely first increase in the federal funds rate. He suggests that we use three to six months, or I

guess you could say two to four meetings, as the measure. After we look at the first issue, I'll ask President Kocherlakota to say a word about this, and we'll likewise see what the Committee's preference is. At that point, again, I hope very crisply, we'll go around the table to see to what extent people are comfortable with this broad approach, and if they are not comfortable, if they could give an indication of what elements are, for them, deal killers.

I hope we can make this work. I reserve the right at any time to call a coffee break and pretend it never happened. [Laughter] All right. The first issue is the question of whether or not we explicitly refer to a corridor. President Plosser, would you want to go first?

MR. PLOSSER. Thank you, Mr. Chairman, I appreciate that. As I said in my memo, I think we deserve to be as clear as we possibly can about where we are headed. Indeed, if you think about what 'normalization of the balance sheet' means, then if we are on a floor system, or we don't specify a corridor system, there is no definition of what normalization means. There is no level of the balance sheet that is determined. So I think we need more clarity here.

I also would argue that in the April minutes we were fairly explicit about it. In the April minutes we said that monetary policy will 'eventually operate through a corridor-type system in which the federal funds rate trades in the middle of a range, with the IOER rate as the floor and the discount rate as the ceiling of the range, as opposed to a floor-type system in which a relatively high level of reserve balances keeps the federal funds rate near the IOER rate.' That was in the minutes of our last meeting, and by my count, 9 or 10 people spoke about their preferred system. Eight of them, I believe, preferred a corridor system, and two said we could wait to decide. I see no reason to keep the public in the dark about this, and I think there are disadvantages to the floor system, which I want to try to articulate.

Many of us have different reasons for favoring the corridor over the floor. To me, one of the primary reasons is political risks of operating monetary policy with a very large balance sheet of potentially unlimited size. Those political risks, I think, are very great. By decoupling the level of the federal funds rate and the size of the balance sheet, the floor system makes our balance sheet essentially a new discretionary free parameter, a new tool of policy. We have very little theory to guide us on how to use that new tool, except perhaps at the zero bound. I stopped to think about our experience over the past two years as we struggled to determine the appropriate way to use our balance sheet as a policy instrument, to determine the effectiveness of that policy, and to understand its transmission mechanism. Because we were at the lower bound and needed a policy tool, we forged ahead using our judgment, but we didn't have much experience to inform that judgment.

The floor system puts no constraint on the size of the balance sheet, but we don't have much experience to inform that judgment. And without some theory, it seems to me, on which to determine an optimal size of the balance sheet, and without some constraint imposed on the size of our balance sheet via an implementation framework, we might find it very difficult to fight against ideas proffered from others in government as to how we might use that balance sheet to one sector or another's advantage. We could be asked to engage in credit allocations rather than monetary policy. We could be asked to fund government debt to fund government spending. We would have few defenses, because, presumably, the balance sheet is uncorrelated and unrelated to the delivery of monetary policy. So it would be very difficult for us to say no. This Committee and Chairman, I think, most likely would surely resist such calls, but can we be as confident about future Committees? Given the political whims in the Congress, formalizing such

a discretionary framework might put our independence at risk. While today we may view such actions as a tail risk, it would have serious consequences were it to occur.

In terms of the efficiency of the floor system, it's true that under the floor system there is no opportunity cost of reserves, and banks wouldn't need to engage in inefficient activities to economize on reserve balances as they do in a corridor system. But given that we now have the ability to pay interest on reserves, which reduces the opportunity cost of holding reserves, and, therefore, reduces the associated inefficiencies, we have reduced the wedge in the inefficiencies greatly just by paying interest on reserves. As a staff memo from April indicated, there are ways within a corridor system to minimize these costs further, and to lower the administrative costs on the Federal Reserve associated with a closer management of the supply of reserves. To my mind, the risks to the floor system vastly outweigh any potential efficiency gains.

Others favor a return to the corridor system for other reasons. It's more familiar to us, and several central banks around the world use a corridor system. It also avoids some of the governance issues we would need to contend with under a floor system in which the IOER rate would effectively become the policy rate. Here again, the Chairman has pledged to continue engaging this Committee in setting the IOER rate. But is that enough to bind future chairmen? We are concerned about the institution here. Does having the decision rights for IOER resting solely with the Board contravene the Federal Reserve Act's requirement that the FOMC set monetary policy? This is a knotty governance question. Are the advantages of the floor system truly large enough to justify a review of such governance issues and potentially challenge the Federal Reserve Act?

For whatever reasons, many Committee members have already discussed their preference for a corridor system. So why should we want to pull back from our April minutes statement?

Why not just go ahead and announce that that is our goal? It tells the public that we will shrink our balance sheet, and we will shrink it enough to operate in a corridor-like system. What can we learn during the intervening period? We can learn something about a floor system because for some time we'll be operating on what looks like a floor system, as the balance sheet is very large. But I'm not sure we would learn anything more that would convince me that the costs are sufficiently small or the benefits sufficiently large to maintain a floor system. I think delaying serves no particular purpose. It muddles our intentions. It creates its own source of uncertainty. And so I would argue strongly that we go ahead and commit that a corridor system is going to be our operating environment going forward, and part of our job is to get us there in a way that is consistent with the dual mandate.

CHAIRMAN BERNANKE. Thank you, President Plosser. Vice Chairman. VICE CHAIRMAN DUDLEY. Thank you, Mr. Chairman. My preference,

unconstrained, would be to omit the entire sentence that begins, 'In particular, the size of the securities portfolio,' because I think it unnecessarily commits us to the direction of a corridor system. But failing that, I am willing to live with the sentence as it stands without the bracketed language. Let me explain why that's my strong preference. My view is that there's no reason to commit to a corridor system now. In the next few years we will learn a lot about operating a floor system. It doesn't make sense to commit to a corridor when we don't have all the available information to make an informed choice about whether we prefer a corridor system or a floor system. And the costs of waiting to get this information are very low, because market participants are not at all focused or care about whether we make this choice today. So if we wait, nothing bad happens; there is really very little cost to waiting.

Now, I agree with President Plosser that, if there was no possible chance that a floor system could be superior to a corridor system, there would be no point in waiting to get new information. But I do think that there are a number of reasons to think that the floor system might potentially be superior. So I want to talk about some of the potential benefits of a floor system.

The first thing is that if we had a floor system, there would be more reserves in the banking system, and that might actually help the payment system operate more efficiently. With a corridor system, in contrast, you are going to have more intraday credit extension, and you are going to have more interbank transactions as people try to get to flat, vis-''-vis one another. As a result, there is going to be more interconnectedness through the banking system. With a floor system, we anticipate that some of the major payment systems like CHIPS and DTC would have fewer payment fails, because there would be more lubricant in the system. There would be earlier settlement times, and you would have fewer delays in terms of executing payments. And there would be less congestion in terms of settling the systems at the end of the day. A second potential benefit of a floor system is that excess reserves could help banks satisfy their liquidity requirements more easily because there would be more liquidity in the system as a starting point. Third, it's very possible that a floor system might be operationally more efficient. If you think about how the SOMA Manager would execute operations on a day-to-day basis in a corridor system, every day the Desk would have to do a careful calculation of money demand, money supply, and how much reserves need to be added or drained from the system. A lot of those fine- tuning operations would probably go away in a floor system because the little shocks to money demand and money supply would not have consequences for the actual level of short-term rates. As a result, the operations conducted by the SOMA Manager would be much simpler. And

fourth, a floor system might reduce the volatility in short-term interest rates that is caused by those shocks in money demand and money supply. In other words, the SOMA Manager makes a forecast of how many reserves the system needs to keep the funds rate at its target. But to the extent that the SOMA Manager makes a bad forecast and does not hit the desired demand for reserves in the system, then that introduces volatility into short-term rates.

Now, in all of this, I'm not saying I favor a floor system. I'm not arguing for a floor system over a corridor system. All I am arguing is that it is bad policy to rule out a floor system at the current time given the chance to learn a lot about how a floor system operates in practice. Now, Charlie said just now, and in his note, that in the April FOMC minutes, the Committee members generally favored a corridor system. I went back and looked at the minutes, and I don't read it quite the same way. Here is what the minutes said, at least the sentences I picked out of the minutes: 'Some participants also noted their preferences about the longer-run framework for monetary policy implementation. Most of these participants''those who had noted their preferences''indicated that they preferred that monetary policy eventually operate through a corridor-type system.' So that's most of some participants, and 'most' of 'some participants,' as far as I can tell, doesn't necessarily mean a majority. I think the staff actually counted seven people who expressed a preference for a corridor system. Another important thing is that this was really not put on the table as something that we are actually considering, corridor versus floor. Do we want to rule out a floor system at the current time? This is not something that we really discussed or debated at the last meeting. So what I'm asking is to keep the current language in place, without the bracketed language. I think that is a reasonable compromise. Let's learn before we commit to either a corridor or a floor system.

Charlie raised the issue that a floor system would presumably allow a balance sheet of any particular size. I would offer President Plosser the notion that we could commit to keeping that off the table by language that might say something like, 'the smallest balance sheet consistent with what is needed for the efficient execution of monetary policy.' So if you're really worried that a floor system might lead to an unlimited balance sheet size, we could take that off the table by basically committing to the smallest balance sheet necessary for the efficient implementation of policy. I think that would address your concerns that the balance sheet would be this discretionary tool of policy.

CHAIRMAN BERNANKE. Okay. Thank you very much, both of you, for very cogent arguments. Also, I should say that the Vice Chairman and President Plosser have both said that they are prepared to live with, or are prepared to accept, whatever the Committee decides. Are there any pressing questions for either the Vice Chairman or President Plosser? [No response] All right. What I would like to do now is take a straw vote on this particular item, and abstentions are okay. This is for all participants. How many would like to keep the language where it is and say 'the federal funds rate near its target' through open market operations, but exclude specific reference to a corridor system?

MR. PLOSSER. Mr. Chairman, can I just make one comment? One of the concerns about the floor system that I didn't mention earlier is that under a floor system, we don't know for sure what will happen to the fed funds market, whether or not it will survive, and therefore whether or not we can keep a rate depending on whether that says an active market when there are plenty of reserves. I don't know the answer to that question.

VICE CHAIRMAN DUDLEY. I think we do know that, because we have a federal funds market even today, with a balance sheet that is much bigger than what we would operate under a floor system.

MR. PLOSSER. But the volumes are way down.

VICE CHAIRMAN DUDLEY. Right. But I think we have a balance sheet today that is far greater than what we would have under any reasonable floor system that we would think to operate. And we haven't flooded the market, so I don't think that's a fair comparison.

CHAIRMAN BERNANKE. President Lacker.

MR. LACKER. I view the Vice Chairman's proposed language change about 'the smallest balance sheet consistent with' as attractive because it is attempting to commit to avoiding the kind of credit allocation that would come from expanding our balance sheet at a given funds rate, which is one of the major concerns. In your straw poll, I was wondering if you could find a way to have that be an option.

CHAIRMAN BERNANKE. All right. Let's firm up the language. It was, 'and the associated quantity of bank reserves are expected to be reduced to levels'''the smallest levels consistent with the efficient implementation . . .'?

VICE CHAIRMAN DUDLEY. That would be fine.

CHAIRMAN BERNANKE. All right. I'll come back to that in just a second. I'm aware of Arrow's voting paradoxes and all that. [Laughter] So what I would like to do is the following. I'm going to ask for a straw vote on the original two propositions, and then we'll take the winner and ask if we would like to compare it with this alternative language. President Bullard.

MR. BULLARD. Mr. Chairman, I think if we went to the minimum size of the balance sheet, then there would be no difference between the two systems. Is that right, or very little difference? There's a point of continuity there.

CHAIRMAN BERNANKE. I knew this was going to happen. [Laughter] The efficient implementation of monetary policy suggests that if there are substantial benefits from a floor system in payments and in reducing volatility and so on, then the smallest balance sheet would be consistent with a floor system.

All right. Debbie, will you help me count? Those in favor of the original language: 'near its target,' without referring to a corridor system? [Show of hands] Okay. So the majority are in favor of that.

Then, we want to compare that with the following language: 'The associated quantity of bank reserves are expected to be reduced to the smallest levels that would be consistent with the efficient implementation of monetary policy.'

MR. PLOSSER. Can I question the word 'efficient' here? What do we mean by that? What are the criteria to decide what 'efficient' is?

CHAIRMAN BERNANKE. It leaves the possibilities open. On the one hand it says that if we were to go to a floor system, we would have the smallest balance sheet that would allow that system to work properly. But 'efficient implementation' means that we would have to judge that that smallest balance sheet version of the floor system is effective in maintaining the funds rate near the target, minimizing volatility, and achieving collateral benefits like improved payment systems and the like.

All right. Who favors the change that I just described: 'reduced to the smallest levels that would be consistent with the efficient implementation of monetary policy'? Can I see

hands, please? [Show of hands] Okay. I guess that's going to be a compromise. President Fisher.

MR. FISHER. I would just ask for clarification whether this does not rule out our going to a corridor system.

CHAIRMAN BERNANKE. Absolutely not. In fact, my own personal view is that it's likely the preferred system.

MR. FISHER. Thank you.

CHAIRMAN BERNANKE. President Kocherlakota, a word on your amendments? MR. KOCHERLAKOTA. Sure. Thank you, Mr. Chairman. My proposed change was

grounded in my feeling that when we remove this phrase 'extended period,' it will be a very important step for the Committee in the process of exit. I was concerned about the fact that, at least in my own mind, I was not clear about what that step is supposed to be communicating. I felt it was important, as best we can, to have some kind of shared understanding of what that step would mean. I have offered, by way of change, my own interpretation of what that step would mean. It could be that, as we will find out shortly, there is sufficient lack of consensus on this point and that we don't want to finalize it at this time. But I my main point is that I think we should have some clarity about what this step would mean as part of the exit process. In terms of my own thinking about it, what it would mean to me is that at that point, we would be anticipating that the first increase would be two to four meetings out.

CHAIRMAN BERNANKE. Okay. Is there anyone who, conditional on making this change, would prefer a different time than three to six months? Governor Yellen.

MS. YELLEN. I have a difficulty with President Kocherlakota's interpretation of 'extended period,' although I completely agree with him that it's appropriate for us to discuss

and clarify what we mean. I don't think that dropping 'extended period' should imply that the Committee anticipates raising the target funds rate in three to six months. I would, instead, say that it means it will be at least three to six months. It could be a lot longer, because my interpretation is that when we include 'extended period' language in the statement, we are saying the FOMC sees very low probability that it will need to tighten in three to six months, or two to four meetings. Once the probability has risen sufficiently that we think we might need to tighten'but we could be talking about a probability that is a lot lower than 50 percent'then it becomes appropriate to drop the language to give the Committee flexibility to move as needed. But when we drop it, we may not anticipate moving. The odds may be lower than 50 percent. And, in fact, the funds rate target could well'depending on how things materialize'stay exceptionally low for a very long time, even though we got rid of the language.

MR. KOCHERLAKOTA. Governor Yellen, are you proposing to add the words 'at least' before the word 'three'? Is that the substance of the proposal?

CHAIRMAN BERNANKE. Conditional on making the change.

MR. KOCHERLAKOTA. I am perfectly happy with that as an amendment, if that's the nature of the amendment. I don't have a problem with that.

CHAIRMAN BERNANKE. Pretty substantively different. Vice Chairman. VICE CHAIRMAN DUDLEY. I agree with Governor Yellen's statement because,

exactly as she says, saying that you are not going to keep the federal funds rate low for an extended period does not necessarily mean you are going to tighten three to six months later. It depends on the data.

CHAIRMAN BERNANKE. We don't need to have a complete debate about it. [Laughter] Give us a chance to vote.

MR. PLOSSER. I'm a little bit concerned about symmetry here. The Chairman at one point last year talked about 'extended period,' and we gave the example where, in the Greenspan era, they dropped some language that they changed the very next meeting. Could we be in an environment where we didn't want to wait that long'that things would change, and we may have to move sooner than three months? I'm a little bit worried about the asymmetry that you are building into it that might put us at risk of not moving as fast as we might have to.

CHAIRMAN BERNANKE. It does say 'anticipates.' But that's fine. By the way, when asked about this, without a great deal of forethought, in my press conference in April, I said 'a couple of meetings,' which is about three months, but it could be more, obviously. Governor Raskin.

MS. RASKIN. Thank you. Mr. Chairman, I just want to remind the Committee that what we are discussing here are exit strategy principles and not concrete intentions. And whether or not there are any conceptual concerns with the addition of Narayana's sentence, I would say that it does somewhat stick out from a tonal perspective in the sense that it reflects a current anticipation and a precise number of months. If you look through the tone of the principles, there really is nowhere else where we indicate with precision what exactly the timing would be. One possible way of moving through this is to pick up the 'probable' language that we use in paragraph 5, where we indicate 'probably within a few months' and tack that onto the end of the first sentence in paragraph 4, where we could then indicate that it would probably be within a half-year, or whatever it is, after the modification of the forward guidance. I think that would be more consistent with the tone of the set of principles that we're talking about.

CHAIRMAN BERNANKE. I understand that point, but 'probably within a few months' is likely shorter than most people would want to say.

MS. RASKIN. I would suggest, 'probably within a half-year after the modification of the forward guidance.'

CHAIRMAN BERNANKE. Okay. President Fisher.

MR. FISHER. I have problems with the ritualistic sequencing of all this. We'll talk about that later. But in this case, just to take your concern, Governor Yellen, and Mr. Plosser's excellent point, I would just say, 'When economic conditions warrant, the Committee will begin raising its target for the federal funds rate.' We don't know if we're going to do it within one month, three months, or six months. Why are we pinning ourselves down here? And then we create expectations. Even saying 'a couple of meetings,' Mr. Chairman, again'with all due respect'we'll do it when it's appropriate. So why not simplify the language? I respect President Kocherlakota immensely, but I think we are making this much more complicated than we should. I would simply have it say, 'When economic conditions warrant, the Committee will begin raising its target for the fed funds rate.'

CHAIRMAN BERNANKE. Well, that's the status quo, basically. Let me take President Rosengren and President Bullard, if I could ask your indulgence, and then we could go to the vote. President Rosengren.

MR. ROSENGREN. My preference would be to have no timing in this set of principles. This is a sequence discussion, and I'm very comfortable with the sequence, but I'm less comfortable the more we tie it to timing. And the more we tie it to timing, the harder it's going to be to get a consensus on when the timing should start. So I think we should think carefully about hardwiring the timing. The more language we put in here that gets into timing, the more likely it is that we are going to have a discontinuity. I really think this should be a sequencing, not a timing, discussion.

CHAIRMAN BERNANKE. President Bullard.

MR. BULLARD. Okay. I'll also be brief. I'll agree with President Rosengren and President Fisher that it's not so clear why we want to tie this down. At the time that we make such a decision, we'll want to assess economic conditions and give an indication that the Committee currently anticipates a certain timing. That seems to me to be the way the Committee has operated in the past, and it would make a lot of sense in this circumstance.

CHAIRMAN BERNANKE. Okay. Let's go to a straw vote. How many would like to retain the existing language, which says, 'When economic conditions warrant, the Committee's next step in the process of policy normalization will be to begin raising its target for the federal funds rate, and from that point on, changing the level,' and it does not make reference to three to six months? How many prefer that approach? [Show of hands] Okay. So, I think, Narayana, you're outvoted. Your point about clarity is a good one, and these are actually very subtle points, because if you are, for example, interested in providing more accommodation, saying that it will be at least three months is one way. However, I think the Committee has spoken on that.

So we have a document. We have 20 minutes or so, and I am going to ask each participant to say, first, if you can broadly accept this. If you have a couple of objections to things that are not your first best but you're still willing to accept it, of course, you can say that. If you have some reason that you cannot accept it, then explain what that is. We'll keep track of that and try to put together an appropriate summary for the minutes, which of course will be subject to the Committee's vote and approval. Let me begin with President Kocherlakota.

MR. KOCHERLAKOTA. I am very happy with this document. I thank you, Mr.

Chairman and the staff, for preparing it. I think it's a very valuable practice for us to continue to do this, to summarize consensus as we develop it, at least for internal purposes. I realize this will

not be released publicly, but we can even think about going to the next step, of releasing such consensus publicly. But at least for our internal purposes, I think it's great to do these summaries, and I'm very happy with the document as is.

CHAIRMAN BERNANKE. Thank you. Governor Tarullo.

MR. TARULLO. Thank you, Mr. Chairman. I'm not sure if Richard and Eric would extend their observations to the other time parameters that are in here: 'At same time or relatively soon thereafter.' I'm slightly uncomfortable with those, but if there's a consensus around the language that's in here, I'm happy to go with it.

CHAIRMAN BERNANKE. Thank you. President Rosengren.

MR. ROSENGREN. I agree with Governor Tarullo. The goal is to communicate sequence but maintain the flexibility to react to changes in economic conditions. I'm very comfortable with the sequence that's laid out in this memo, but I prefer basically no time subscripts in the document. So let me just give one example. My own personal preference would be to shrink the balance sheet first and allow time to pass so that the ability to affect interest rates is enhanced. If instead we decide to tie the end of reinvesting to the ending of forward guidance, I would then want to end the reinvesting at a later time than I would if they were not tied. So my personal preference would be, for example, in paragraph 3, to change the phrase 'At the same time or relatively soon thereafter,' and make that the word 'next,' so it would read, 'Next, the Committee will modify its forward guidance.' And then in paragraph 5, in the second line, I'd like to take out 'probably within a few months' and just leave the actual timing to be figured out, depending on economic conditions.

CHAIRMAN BERNANKE. Are you amenable to the whole document collectively?

MR. ROSENGREN. I'm comfortable with the document. I could go with it as it is, but my preference would be to take out the time dimension.

CHAIRMAN BERNANKE. All right. A couple of participants have raised the time dimension issue, and President Rosengren pointed out two places. If there are others who have similar concerns, I think they should probably say so. President Fisher.

MR. FISHER. Mr. Chairman, I'm in favor, as is President Rosengren and I sense Governor Tarullo, of taking all time references out; I think it unnecessarily binds us. So I wouldn't include 'probably within a few months' in the fifth paragraph and 'over a period of four to five years' in the sixth paragraph. Any reference to time, I think, puts us in a straitjacket, and conditions may well change. I know no one at this table who five years ago expected us to be where we are today. So it just doesn't make sense to me to have a specific time reference, and that would be my first point. I'm a little uncomfortable, possibly out of ignorance, as to whether it makes sense to declare that we would raise rates first and then sell. It might incur losses. It might move the yield curve. I would like to say, in paragraph 5, 'Sales of agency securities from the SOMA will likely commence sometime after the first increase in the target for the federal funds rate,' but then go on to say, 'though the timing of sales,' and then use the very last part of that sentence, 'could be adjusted in response to material changes in the economic outlook or financial conditions.' To me that's operationally a commonsense way to phrase it, rather than saying 'probably within a few months.'

In summary, I would like all time references to be taken out. I think that's a sensible thing to do. I would also suggest an editorial change in the fifth paragraph in that it allows us at least the opportunity to adjust the timing. In the language in paragraph 5, I would say, 'Sales of agency securities from the SOMA will likely commence sometime after the first increase in the

target for the federal funds rate, though the timing of the sales could be adjusted in response to material changes in the economic outlook or financial conditions.' I think we need to be as opportunistic going out as we were going in. I understand the need for us to have a sense of what our priorities are, but I don't want to be locked in, in case economic or financial opportunities present themselves. And to me, that would be a sensible way to write that sentence or that paragraph.

CHAIRMAN BERNANKE. Okay. If others share this view, I think we should just downplay the timing issues in our discussion in the minutes. Thank you. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. I'm not very comfortable with this timing sequence. As you know, I prefer a more explicit LIFO or last in'first out exit strategy than the one outlined in this 'Exit Strategy Principles' document. The principles do call for a balance sheet'first strategy in that the first step is to cease or reduce reinvestment. I would follow that step with asset sales and manage the balance sheet down in a state-contingent manner.

My judgment is that the recent asset purchases and the associated buildup of the size of the balance sheet had a fairly clear effect on expected inflation in the United States. This policy helped us avoid the mildly deflationary outcome that Japan has experienced over the past decade or more. Inflation has moved higher and more quickly than would have been predicted without the asset purchases. I do not think that these purchases were neutral, and I do not expect asset sales to be neutral. I think it would be a bit more prudent to sell assets first and in relatively small amounts and then gauge the effects in a state-contingent manner. This would be a balance sheet tightening as opposed to what we've got in the exit principles. We could then change language and raise rates somewhat later in the process if we did it this way. I think this would keep expectations in check while rates continue to remain at zero. It would also dovetail with the

reserve reduction in the System that will help us on the day when we want to actually raise rates. The outlined strategy puts sales essentially on an autopilot basis. As I see it, there's not very much that's optimal about that.

CHAIRMAN BERNANKE. I'm going to take that as a no. [Laughter]

MR. BULLARD. That's a no.

CHAIRMAN BERNANKE. President Williams.

MR. WILLIAMS. Thank you, Mr. Chairman. I'm comfortable with this approach. I actually think it does represent what I heard to be the consensus at the April meeting. I am sympathetic to the point that Presidents Rosengren and Fisher brought up about being somewhat uncomfortable with the very specific timing, and I think it's probably better to stick with the general principles of the sequencing, and I would agree with removing 'probably within a few months' and the other case where we're being very specific on timing. I agree with the general idea of how the sequencing should go, but I will mention just one comment. I think you and we all will be asked for the rationale behind this particular sequencing of steps. So here we are agreeing on what the sequence is, but I know that we all will be asked by reporters why we chose one instead of another, and I think we should have some more discussion, perhaps, about that. I'll give you one example. This may seem to be a no-brainer to some'maybe I'm just overthinking this or just not thinking hard enough about this, but I'm still not 100 percent clear on why reinvestments is the obvious first action out of the blocks. Maybe if we have time at some point, we could have a discussion about not only what the right sequence is, but also what the talking points are regarding why this makes the most sense.

CHAIRMAN BERNANKE. I have a couple of reactions to that. One is that stopping reinvestment is a relatively passive thing. It doesn't involve us actually going out and making

sales. We don't take capital losses. It doesn't address nearly so directly the concerns about the MBS market being relatively oversupplied during this period. So it seems like a more passive way to go, and, therefore, something that's worth doing. It also has the benefit, over a period of time, of bringing the balance sheet down. I think one obvious argument'and I understand President Bullard's point'for raising rates first is that if you rely on balance sheet contraction as your primary tightening tool, given market-based limits and so forth on how fast you can do that, then you push the first increase in the funds rate off quite a while potentially, and there are people, including President Hoenig and others, who think that the very low rate has damaging effects on financial stability. That's a tradeoff that I think some participants at least would not like.

President Pianalto.

MS. PIANALTO. Thank you, Mr. Chairman. I am very comfortable with this broad set of exit strategy principles. I agree with the sequencing of steps in the normalization of policy, but I also favor, as others have already mentioned, removing the time references to give us more flexibility. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Lacker.

MR. LACKER. Thank you, Mr. Chairman. I prefer last in, first out, and never using reserve draining tools. Otherwise, I can support this [laughter], and I'm not troubled by the timing references. I think we're trying to say what we agree on, and I think the timing references that are in there are things you can agree on. The ones we couldn't vote to put in were ones we didn't agree on. So I can support the adoption of these principles even though I'd prefer something much different.

CHAIRMAN BERNANKE. Thank you. President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. I, too, support the principles here. I just finding myself feeling that'and I hope this isn't too cavalier, but'this is close enough for government work at this time. I think we have so much to learn in this process. There are so many unknowns that, at this juncture, I would posit some principles that we agree on without pinning ourselves down to, particularly, timing. The sequencing here is logical, although I think it may be highly compressed when the first steps are made because the market will react and tightening will have begun in the longer rates. I also would hope'my own personal view'that by getting this out through the press conference or however, we will reduce the chatter about exit among ourselves and in the market because I think it's not an appropriate time for continuing chatter. I have sympathy with the arguments regarding the corridor outcome largely because it's the most familiar, but again, I agreed with the earlier decision. And finally, we haven't talked about this much, but I think President Plosser suggested three to five years if we're going to have an explicit time frame in the document for asset sales purposes. I thought that also made sense simply by buying more time because we don't know exactly how long it's going to take. So overall, I am supportive of these. I think this will do the job for the time being.

CHAIRMAN BERNANKE. Thank you. President Hoenig.

MR. HOENIG. Mr. Chairman, I like this, thank you. I don't think it will end the discussion, but I think it will clarify things for people and will be very helpful, and I hope it is public as quickly as you can feel comfortable doing it. Thank you.

CHAIRMAN BERNANKE. Thank you. President Evans.

MR. EVANS. Thank you, Mr. Chairman. I support these principles in general. I do agree with President Rosengren's suggestions about taking out the timing. On item 3, I caved on that one. I didn't like it, but I couldn't find better words than that. I suppose 'next' is pretty

good on that link. I think in general the sequencing here is quite good. I didn't like any tight links between certain actions. They were stronger than I'd liked, and the conditionality is very appropriate here. I can fully support this.

CHAIRMAN BERNANKE. Thank you. President Plosser.

MR. PLOSSER. Thank you, Mr. Chairman. I'm generally supportive. I think this is a big step forward in informing the public about how we're thinking about this, and putting this out as a public document in some form will be very helpful. Obviously, I still prefer a corridor system. I wish we could make that more explicit. I have one other suggestion in terms of the timing issues. I'm comfortable with taking them out, but if we take them out, as President Fisher said, we should also take out the 'four to five years' as well as the 'few months' or the 'relatively soon thereafter.' Those should come out as well because we may be faster than that or longer than that. It would be fine with me if all those would come out. I would like to make one other suggestion, and this is basically for clarity. In paragraph 5 where it says in the last sentence, 'but it could be adjusted in response to material changes,' I would like to see that 'be adjusted up or down,' to be explicit that the Committee could choose to speed up sales or slow them down'just add 'up or down' after 'adjusted' to be clear that they understand they could go both ways.

CHAIRMAN BERNANKE. That seems like a friendly amendment. Okay.

MR. FISHER. Mr. Chairman. Could I just make it clear that I support taking out all the time references in every paragraph? 'Five years' and the 'three years.'

CHAIRMAN BERNANKE. Vice Chairman.

VICE CHAIRMAN DUDLEY. I'm comfortable with the memo as amended. I agree with taking out the time references. I think the only time reference that one might want to

continue to include is the 'over a period of four to five years,' but I think that's too narrow, four to five years, because as this plays out, if you ended reinvestment and the agencies are writing off for several years, you might want to have a broader range. So I'm completely happy with how the Committee decides. I don't feel strongly about it, but I think that one is a little different than the other time references.

CHAIRMAN BERNANKE. Governor Yellen.

MS. YELLEN. Thank you, Mr. Chairman. I support the proposed exit strategy principles. My preference is to remove the time references in line with President Rosengren's suggestion, but I saw including the more specific time frames as an attempt to compromise. I do think it is very valuable to reach consensus here. I think, if we can endorse a consensus view, it will simplify our communications, reassure markets, and enhance the predictability of market responses to our actions. I think this is very worthwhile. I'd prefer no timing references but could live with it as is.

CHAIRMAN BERNANKE. Governor Duke.

MS. DUKE. Thank you, Mr. Chairman. I support the sequencing with the elimination of all the time references. My only concern with the document was that, as written, taking step 2 engages the gears for step 3, and taking step 4 engages the gears for steps 5 and 6'it seems like that would make it difficult to calibrate and maybe even to begin the exit strategy. So without those, I'm fully in support of it.

CHAIRMAN BERNANKE. Thank you. Governor Raskin.

MS. RASKIN. Thank you, Mr. Chairman. I am broadly comfortable with the approach set forth.

CHAIRMAN BERNANKE. Thank you all very much. This turned out to be very helpful. [Laughter] I appreciate the comments. When asked, in fact, I think I will say a little bit about this in the press conference, with a strong caveat that this does not imply immediate implementation of this exit. I have heard very clearly, I think, from a majority that we should take out timing references, and so I will do that in my public communication. I suggest as a next step that the staff might try to rewrite this a little bit and see if it can gain the same level of support or even more support than it had today. If it does, we could consider making it an addendum to the minutes. If not, or if there are enough serious concerns, then the alternative is to describe the basic points with the appropriate 'most' or 'all' or whatever, as it applies. Vice Chairman.

VICE CHAIRMAN DUDLEY. Yes, I heard that there might be support for actually making it an addendum to the minutes'something pretty close to what we actually talked about.

CHAIRMAN BERNANKE. Yes, I'm much more optimistic about that than I was an hour ago.

VICE CHAIRMAN DUDLEY. Is your proposal to circulate something tomorrow? CHAIRMAN BERNANKE. I certainly don't want to get involved in an editing session

here, given the time constraints and so on. Why don't we simply send out something soon, get feedback, make a judgment about whether or not we've made a Pareto improvement on this existing document, and then, based on that overall assessment, we can decide how to proceed.

MR. FISHER. Just a thought'in terms of what you say tomorrow, which I think is very, very important, I would say as little as possible about this subject unless you're pressed, and the reason for that is, first, we made substantial progress, but we still have more to go in terms of complete consensus, and second, we can get into this later when we get briefed on financial

markets, but I think we're in a very sensitive time. My recommendation would be to go very easy on this, and after all, what you say is what people are going to hear, and that's what they're going to interpret is our policy.

CHAIRMAN BERNANKE. Part of my reason for this was that I anticipate getting asked the question, in which case I would have to respond. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I just wanted to follow up on President Rosengren's suggestion about replacing 'at the same time or relatively soon thereafter' with the word 'next.' I'm sympathetic to the idea that we don't want to have references to exact times, so I'm happy with that. But on the other hand, the word 'next' does remove the possibility of doing something 'at the same time.' So I would prefer to see something like 'at the same time or thereafter.'

CHAIRMAN BERNANKE. Okay. Thank you. President Hoenig.

MR. HOENIG. I don't mean to be throwing this out loosely, but I know I heard a lot of desires to see all timing taken out. However, if you want to create chatter, let everyone start guessing as to whether it's three or four or two years. This gives them rough guidelines that I think can be helpful. As you work on the amendments, keep that in mind as well.

CHAIRMAN BERNANKE. Thank you. President Lacker.

MR. LACKER. For what it's worth, without the timing references, specifically 'four to five years' regarding normalization of our balance sheet, I find myself in President Bullard's camp of being unable to really support this. We've talked for a while about wanting to normalize our balance sheet, and we've talked for a long time about wanting to do that relatively expeditiously, and to me, if all that's left is the sequence, and I don't support the sequence, I couldn't support this.

CHAIRMAN BERNANKE. Did I understand you correctly to say that your key issue

was the 'four to five years'?

MR. LACKER. Yes. It's a key element.

CHAIRMAN BERNANKE. But with that number you'd support it?

MR. LACKER. Yes, some definite number.

CHAIRMAN BERNANKE. Again, we'll try to get a document that people can support.

If not, we'll simply report the preponderance of opinion on the issues.

Okay. Thank you very much. I understand lunch is ready. Let's take about half an hour

to get lunch and sit down, and then we'll go into Mr. Sack's presentation.

[Lunch recess]

CHAIRMAN BERNANKE. Okay. Why don't we reconvene? We're at item 3 on the

agenda, 'Financial Developments and Open Market Operations,' and let me turn it over to Brian

Sack.

MR. SACK.3 Thank you, Mr. Chairman. Financial markets reacted sharply over the intermeeting period to intensifying concerns about the outlook for economic growth and to ongoing developments in European debt markets.

As shown in the upper-left panel of your first exhibit, the expected path of the federal funds rate shifted down significantly over the intermeeting period. Market participants are now pricing in the first rate hike in the second half of 2012 and see a shallower path for subsequent rate increases than envisioned at the time of the last FOMC meeting. This timing is roughly consistent with the primary dealer survey conducted by the Desk, shown to the right. Respondents reduced the probability of the first rate hike occurring by the first quarter of next year, and they see considerable chances that it will not take place until the second half of 2012 or 2013.

The primary driver of the revision to policy expectations was the weaker-than- expected data on economic activity. As summarized by the economic news index of one major dealer, shown in the middle-left panel, incoming data generally came in well below the expectations of investors. Although market participants saw some of the weakness in the data as transitory, they also appear to have marked down their

3The materials used by Mr. Sack are appended to this transcript (appendix 3).

The survey also indicated that the sequence of policy steps expected during the removal of policy accommodation was largely unchanged from the previous survey and in line with the strategy described in the April FOMC minutes. As shown to the right, this sequence is expected to put the overall size of the portfolio on a downward trajectory that is very similar to the path assumed in the Tealbook. Thank you, Mr.

Chairman.

CHAIRMAN BERNANKE. Thank you very much. The Vice Chairman wanted to say a couple of words on the Maiden Lane II sale.

VICE CHAIRMAN DUDLEY. Yes, thank you, Mr. Chairman. There has obviously been a lot of press about Maiden Lane II sales, and Maiden Lane II sales have been cited as a factor'in fact, some people would even claim primary factor'for the weakness in the nonprime RMBS market, but also more broadly than that, CMBS and a whole variety of different asset classes. As Brian said, we feel very strongly that this is not really the main factor. The deterioration in housing and the decline in risk appetite seem to be much more important. It's hard to believe that $15 billion market value of assets could generate such large effects, especially when it's important to recognize that the nonprime RMBS market is actually shrinking over time because there's no new issuance. So this is a market that's actually amortizing over time.

I want to give you briefly an update of where we stand. The next big event is going to be on July 15, when we actually publish the results. I'm going to give you a heads up about what those results are going to look like. The good news is that the sales that we've actually done have gone very, very well. We've put out nine bid lists. We sold $10 billion, face amount, which is roughly one-third of the portfolio. So we've achieved $4.7 billion of actual proceeds, and we're running about $400 million ahead of our December 31 marks which, if you remember, were the basis of AIG's bid for this portfolio. Part of that reflects the fact that we have positive carry on these assets, but a lot of this reflects the fact that the bids we got for these assets were

quite a bit higher than our marks. There's been no issue in terms of, Do you get bids for the assets, to sell the assets? We've had multiple bids on all of the assets. We haven't faced the issue of being left with 'cats and dogs' at the end; we can sell everything. There are bids for everything. We may not necessarily like the bids that we get, but there's actually plenty of demand to take these off our hands.

The bad news is that there has been, as Brian showed in one of his charts, a significant decline in prices in this market. As a result, the outlook going forward for prices for the remaining two-thirds of the portfolio is quite a bit less favorable than the prices we've actually achieved to date. If we sold everything that we hold today at the current market prices' instantaneous, no positive carry'we would achieve overall a $1.1 billion profit, which would be smaller than the $1'' billion profit that we would have gotten if we'd accepted AIG's offer. What's our response to this? Well, our response is we're going to slow down the pace of sales to reflect the deterioration in market conditions and to reflect the fact that we're in the summer months where there's going to be fewer people around. So you'll see fewer bid lists from us, and we may also reduce the proportion of securities that we actually sell. Up to now we've sold

75 percent of the securities that we put on offer, and we may be a little less aggressive than that. Now, in all this, time is our friend. We have a positive carry as these securities amortize. If we slow down and prices stay steady, we'll actually do better than the $1.1 billion. So that's where we stand, and I'd be happy to take any questions.

CHAIRMAN BERNANKE. Are there any questions? President Lacker.

MR. LACKER. Help me understand this strategy. Do you place greater value on the upside option, given the occularity about the AIG offer, than the market, or do you think that these are underpriced? The market prices are going to take into account the carry, right? So this

change in strategy should be present-discounted-value neutral. So I'm wondering whether you have a different idea than the market about the value or you see a higher value than the market on the upside option, given the appearance and the optics relative to the AIG offer.

VICE CHAIRMAN DUDLEY. Because these are risky assets, there's a big risk premium on these assets. So the yield on these assets is actually high relative to a risk-free asset. With respect to AIG, the issue about not accepting AIG's offer was not really about the price that they were paying for the assets, it was the fact that we thought that there were significant financial stability issues associated with selling what have obviously been very risky assets all to one entity. We also were concerned about the lack of a level playing field in the sense that these assets should be available broadly to whoever wants to buy them. We committed, when we started this process, to basing the rate of sales on market conditions, and market conditions have deteriorated. We're also in the summer months where demand is less because there are fewer people at their securities firms. For those reasons, we're going to slow down a bit.

CHAIRMAN BERNANKE. Okay. We can turn to questions for Brian, and if anyone wants to ask Bill another question, that's fine, too.

Brian, let me ask you about the release date on the swap agreements. Because of the timing of my monetary policy testimony, I believe that there will at least be a serious consideration of releasing the minutes on July 12, and of course, that will contain the information. That creates a little bit of a concern for me. Is there any way to move this up? For example, if we say that Bank of Japan will be considering, when would the next latest possible date be? What's your thought on that?

MR. SACK. I didn't learn that the minutes were going to be accelerated until yesterday. It's certainly an option to have the statement come out earlier from everyone except the Bank of

Japan, with an indication that the Bank of Japan would be expected to take a similar action. If so, we can bring it forward at least several days. I think the Bank of Japan didn't want it too far in advance of their action, but there's some flexibility there. The other thing is, given the timing of their meeting, we would like to release the statement in the morning. So perhaps we could consider whether a release in the morning ahead of the minutes would still be acceptable. We're thinking of a 9:00 a.m. release.

CHAIRMAN BERNANKE. Okay. Now we're open for general questions. President

Fisher.

MR. FISHER. On the swap lines, there are no current outstanding balances'is that correct? And they've been minimally utilized, including from Japan?

MR. SACK. That's correct. There was a small amount of activity from Japan over the life of the lines and a larger amount from the ECB, although still relatively small, at the beginning of the lines. They haven't been actively used in a while, but yet we continue to think that their presence is a useful backstop.

MR. FISHER. And they're open ended in terms of the amount?

MR. SACK. Yes, they're open ended, with the exception of the line with the Bank of Canada; the other four are open ended.

MR. FISHER. Mr. Chairman, I think that's also a selling point to our critics. We put them there. They haven't been heavily utilized. The pricing is important. I don't know if the timing is right'you asked for approval. I'd like to move that we approve this, unless we have other discussions on the swap lines.

CHAIRMAN BERNANKE. We'll vote as soon as the Q&A session is over. Thank you. The pricing terms, plus 100 basis points, are intended to keep utilization minimal unless conditions actually are worsening. President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. Brian, regarding the debt ceiling, you noted two things. One, this could be very disruptive if taken to the limit, and, second, that the market has not yet priced that into bond prices. When do you think the market will begin to react to a lack of resolution if we go right up to August 2?

MR. SACK. That's very hard to say. We're in a very awkward equilibrium where the markets assume there will be an outcome because not having an outcome would be so catastrophic. However, that assumption means you don't see any pressure in markets, and it relieves the pressure on the political process. And the problem is that the markets may be expecting this to go up to the last minute, so they may be expecting an eleventh hour solution. I think that means that there's a chance we won't see any significant source of pressure in the markets until we're right against the deadline or so, perhaps late July or very early August.

CHAIRMAN BERNANKE. President Plosser.

MR. PLOSSER. I have a question about the reinvestment policy going forward. The table on exhibit 4, chart 20, shows that the reinvestment strategy has the same maturity structures that we have been doing. What are the tradeoffs to thinking about changing the maturity distribution, skewing it perhaps more toward short-term securities or Treasury bills? What's the thinking about the mixture, the maturity structure of the reinvestments going forward?

MR. SACK. As I noted, this strategy of course will keep the duration of our purchases in that same range of five to six years, which is slightly higher than the duration of the portfolio in total. Our thinking was that that was a good maturity range to be in. It isn't too different from

the maturity of the portfolio. It maintained the current policy and seemed consistent with the idea of policy going on hold, which I think is how many FOMC members have described what the stance of policy will be after June in terms of keeping the balance sheet unchanged. And we thought that, from a communication perspective, this was also the simplest outcome, to simply maintain that current distribution.

MR. PLOSSER. What would be the consequences, do you think, in the markets of skewing that slightly toward shortening the maturity structure a little bit?

MR. SACK. In a portfolio-balance type of theory, a shortening of the structure would put a bit of upward pressure on yields. We tend to think of the portfolio as having the effect through the duration risk it removes, so if we shift toward shorter maturities, we're removing less duration risk, but it would be quite modest.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. Brian, I had two questions related to the debt ceiling. The first question is about credit default swaps on U.S. debt: Are their prices showing any movement at all related to concerns about the debt ceiling? And the second question is, when you talk to market participants, do you perceive any contemplation of some kind of extraordinary unspecified intervention by the Federal Reserve to maintain market function in the wake of hitting the debt ceiling or breaching the debt ceiling?

MR. SACK. On the first question, five-year CDS, which is the most liquid part of the structure, has moved up modestly but not dramatically. The one-year measure, in fact, has moved up noticeably, but we don't put a lot of weight on that evidence because the CDS market for U.S. sovereign debt is very small. I think the net outstanding amount from DTC data is something between $4 billion and $5 billion. So we're pretty dismissive of that signal. We

would prefer to look at the yields on actual Treasury securities to make inference about the likelihood being priced into the market.

In terms of the Federal Reserve's role and whether market participants are talking about that, I have not heard a lot of discussion about that. As I noted in my briefing, we've begun contingency planning. We want to make sure that our operations can be conducted in these circumstances. We've also begun a process of thinking about how those operations might affect the market and how that may interact with the debt ceiling; there are a number of issues there. For example, if we're buying Treasury securities and there were securities with missed payments, would market participants want to show us large amounts of those securities to get rid of them and not have to deal with the market consequences? If those particular securities have cheapened a lot, do our existing procedures bias us toward buying them? Would they have the same incentives to give us those securities in securities lending? And, last, might there be a substantial need for funding if the repo markets dried up that we would have to meet with repurchase agreements? We have a list of those kind of issues that we're working through, but we're not yet to the point where the market is really focused on that next step.

CHAIRMAN BERNANKE. President Lacker.

MR. LACKER. Thank you, Mr. Chairman. Just to follow up on this, are you approaching that task with a principle in mind that you don't want our actions at the Desk to blunt the market effects of a nonpayment event? To some extent, anything we do there is essentially ameliorating the consequence of a fiscal action and implicates us in fiscal action. I wonder how you're thinking about that. I understand that, at the same time there's a concern about market functioning as well.

MR. SACK. There are some issues that I think are covered under the current directive. If upward pressure on repo rates were to drag the federal funds rate up as well, the current Desk directive would mandate that the Desk do RPs and inject reserves, so those I'm taking as given. More broadly, in terms of how the operations may be affected or how the operations could be changed in response to the consequences'that's an area where I would seek consultation from the Committee. I'm assuming the Committee does not want to structure operations for the sole purpose of helping the markets through the debt ceiling problems. If you wanted to go to the extreme, you could imagine operations like CUSIP swaps, where we would buy defaulted securities and sell nondefaulted securities out of our portfolio. I'm sure there are a number of very creative things we could do to help the markets through a debt ceiling problem. I'm assuming there's not an appetite to go to those extremes. However, there's a lot of area in between the extremes in terms of how the operations we conduct regularly will be affected, and those are the things we'll be sorting through. If we're doing anything outside of our regular operations or outside of what we see necessary to meet the directive, we would consult with policymakers.

MR. LACKER. Do you view a CUSIP swap as beyond the pale?

MR. SACK. Yes, absolutely.

MR. LACKER. Okay. But there would be a securities lending operation, right?

MR. SACK. Yes. The authorization to the Desk for securities lending is in part based on market functioning, so that's a standing facility that I assume we would maintain. The authorization for buying and selling Treasury securities, as would be needed for a CUSIP swap, is tied directly to the directive, and the directive does not have a broad market-functioning aspect

to it. I think to design operations for market-functioning purposes that involve buying and selling securities would require some kind of consultation with the Committee.

CHAIRMAN BERNANKE. President Fisher.

MR. FISHER. I just want to make sure I understand this. We do have contingency plans in place. So you have some decision-tree analysis here.

MR. SACK. Yes. We started with a half-page list of potential issues related to the debt ceiling, which has now grown to four pages. There are a large number of issues we need to think through in terms of how our systems work, how our pricing feeds work, whether the way we do relative value analysis for valuing collateral that comes in or for buying assets outright is affected by all of this'there's a whole range of issues. We are working through them. I wouldn't say we've worked through them completely at this point, but we are now making good progress.

MR. FISHER. Well, I would expect you to be doing so, and if it does require coming to the Committee, you've said you would but, obviously, first you have to develop all the possibilities. So thank you for answering that question.

CHAIRMAN BERNANKE. I guess my thought, Brian, is that you should think about options for preserving market function, and so on, and if we get close to this point, we can obviously have a teleconference and have a decision about which, if any, we want to adopt. President Lacker.

MR. LACKER. Obviously, you understand the importance of the appearance of maintaining distance from funding a fiscal crisis with our balance sheet. But back to President Lockhart's question, it strikes me that August 1 is probably not the time for us to figure it out. Because market participants have a long history of watching our actions in securities lending and

market operations, communicating to them before then our stance regarding this might be useful in order to avoid putting us in a box where we're forced to act in a way we don't want to in order to forestall a discontinuity. I'd urge you to put effort into this as up front as possible and, if consultations with the Committee are needed that those be done earlier rather than later.

CHAIRMAN BERNANKE. I'm quite confident that if August 2 passes, that there won't be an immediate default. I think it would take some time, but there are dates like August 15 where there's a big coupon payment required that would be much riskier. But I think end of July would no doubt be sufficient time from the Committee's point of view.

MR. LACKER. Does the federal government have enough payment-delay options outside of the Treasury redemptions, these weekly notes, to be able to get through to the 15th?

CHAIRMAN BERNANKE. I think it does'Bill, you can add to this. It has a number of unattractive but nonetheless available options, like selling MBS and so on, to raise revenue, and, of course, there's tax revenue. If they prioritize and decide not to pay Social Security, for example, which of course is a political disaster, they could still make the principal and interest payments, certainly, for a couple of weeks. President Kocherlakota.

MR. KOCHERLAKOTA. At the risk of being repetitive as to what President Lacker already said so eloquently, Mr. Chairman, I think it will be important, in advance of any big event in the markets, for us to be clear to the markets about what our stance is. I think we might be clear within this Committee, but it's going to be important as well for that clarity to go through to the markets. Maybe that can be done by late July or early August or something like that.

CHAIRMAN BERNANKE. Any other questions? Then we need to vote to ratify domestic open market operations since the April meeting. Can I have a motion?

MS. YELLEN. So moved.

CHAIRMAN BERNANKE. Without objection. Okay. President Fisher has moved to

approve the extension of the liquidity swap lines. I would just add that we've had a number of

calls lately concerning the Greek situation. There's a lot that could be happening in the next few

weeks there. Japan seems to be improving, but still there's some financial risk related to the

disaster. So I think our stance, which is a penalty rate, no current outstanding balances, but

providing what could be a very important backstop, is desirable. Are there any other comments

or questions about the swap lines? Concerns? [No response]

CHAIRMAN BERNANKE. All right. In that case, all in favor, say aye. [Chorus of

ayes] Any opposed? [No response] Okay. Thank you. Let's go on now to item 4, the

economic and financial situation, and let me turn to Larry Slifman.

MR. SLIFMAN.4 While we're changing players, the materials we'll be using are titled 'Material for Staff Presentation on the Economic Outlook.' As we highlighted in the Tealbook, the economic news that we've received since late April has been almost uniformly to the downside of our expectations. At the time of the last Tealbook, we were seeing signs of softness in many of the key spending indicators. But we discounted those indications in light of what appeared to be ongoing improvements in the labor market and factory output. One data point that affected our thinking in the current Tealbook was the May employment report. As shown by the red line in the upper-left panel of the first exhibit, private payroll employment is estimated to have increased only 83,000 in May.

Another key data point was the downward revision to manufacturing IP in the first quarter and the tepid pace of expansion so far in the second quarter.

Meanwhile, as highlighted in the middle-left panel, the news for consumer outlays has been disappointing. Moreover, the BEA revised down the historical estimates of real DPI, leaving the published first-quarter level nearly $70 billion lower than we had anticipated in the April Tealbook. In addition, consumer sentiment remains at a low level. Accordingly, we project that real PCE will rise at only a 1'' percent rate in the second quarter, compared with the 3 percent pace that we wrote down in the April Tealbook.

4The materials used by Mr. Slifman, Ms. Wilson, Mr. Reeve, and Mr. Covitz are appended to this transcript (appendix 4).

Despite these signs, it seems unlikely that even a fairly rapid correction in valuations, at this time, would trigger a disorderly deleveraging process. As shown in the bottom-left panel, the majority of dealers in the Senior Credit Officers Opinion Survey (SCOOS), which was completed in early June, reported that the current use of leverage by their 'most favored' hedge funds has been somewhat middling'well below pre-crisis highs and well above post-crisis lows. In addition, conversations with dealers since early June suggest a noticeable pullback in leverage and risk-taking in recent weeks, which should help to ease valuation pressures.

One additional emerging risk to financial stability is from the development of new products. As outlined in the lower-right panel, these innovations appear to have arisen in response to proposed liquidity regulations inducing banks to lengthen liabilities and new liquidity rules further restricting MMF investments in longer-term securities. For example, putable CDs allow banks to issue long-maturity securities, while investors have the option to shorten the maturities, and extendable repurchase agreements allow investors to purchase what appear to be short-maturity securities but give the banks the option to lengthen the maturities. Going forward, monitoring these products will be an important part of our overall effort to better understand and track maturity transformation and liquidity in the U.S. financial system. Seth Carpenter will continue the presentation.

MR. CARPENTER.5 I'm going to be referring to the package labeled 'Material for Briefing on FOMC Participants' Economic Projections.' Exhibit 1 depicts the broad contours of your current projections for 2011 through 2013 and over the longer run. As shown, you expect a gradual economic recovery over the next two and a half years, with real GDP growth'the top panel'little changed this year from its pace in 2010 and then increasing modestly in each of the next two years. The unemployment rate'the second panel'steps down slowly over the same period. With regard to inflation'the bottom two panels'the central tendency of your projections for PCE inflation indicates a transitory increase this year before it settles back in 2012 and 2013 to levels roughly consistent with or just slightly below your estimates of its longer-run, mandate-consistent level. Your projections of core inflation generally remain at or somewhat below 2 percent over the forecast period.

Exhibit 2 reports the central tendencies and ranges of your projections for 2011 through 2013 and over the longer run; the corresponding information for your April projections is indicated in italics, and the current and April Tealbook projections are included as memo items. You generally see somewhat weaker real activity over the forecast period than you did at the time of the April meeting, but your forecasts for inflation have not changed appreciably on balance. In your forecast narratives, most of you indicated that these revisions were the result of disappointing incoming data on production and spending and elevated energy and food prices.

The central tendencies of your longer-run projections'detailed in the column to the right'show that over time, the annual rate of increase in real GDP is expected to

5The materials used by Mr. Carpenter are appended to this transcript (appendix 5).

The Tealbook forecasts for both total and core inflation in 2012 and 2013 are in the lower part of the central tendency ranges of your projections.

The next exhibit summarizes your assessments of the uncertainty and risks that you attach to your projections. As indicated in the two panels on the left-hand side, a sizable majority of you continue to judge that the levels of uncertainty associated with your projections for both real GDP and inflation'as well as for the unemployment rate (not shown)'are greater than the average levels that have prevailed over the past 20 years.

As shown in the upper-right panel, there has been a noticeable shift in your views about the risks to your GDP growth projections, with a substantial majority of you now seeing the risks as weighted to the downside. The downside risk to GDP growth that you most frequently mentioned included the persistent weakness in household income and spending, uncertainties about the domestic fiscal outlook, possible spillovers from the European debt situation, and a slowdown in economic activity in emerging economies.

Your assessments of the risks attending your inflation projections'shown in the bottom-right panel'have also shifted somewhat, with a majority of you now seeing the risks to the inflation outlook as generally balanced, although several of you continue to see upside risks. Some of you noted that although you expect the inflationary effects of elevated food and energy prices to abate, these effects could prove to be more persistent. Others pointed to the risk that monetary policy could remain accommodative for too long, resulting in an undesirable rise in inflation.

The last exhibit is an alternative presentation of the ranges and the central tendencies for GDP growth, unemployment, and PCE inflation. This exhibit presents the same information about these projections as is presented in exhibit 1; however, a fan chart is used to depict the dispersion in views instead of a so-called box-and- whiskers chart. The Chairman intends to distribute the fan chart, along with the table, shown in exhibit 2, in conjunction with his press conference tomorrow afternoon. While the fan chart was judged to be more helpful in the context of the press briefing, we plan to continue to use the box-and-whiskers chart for now in the SEP that is published with the minutes. That concludes my prepared remarks.

CHAIRMAN BERNANKE. Thank you very much. A couple of things. First, it is still

possible to change your projections if you have new information. It would be very much

appreciated it you could do it after the end of this meeting. There will be staff in the Special

Library who can help you do that. If you can't do it by today, I implore you to do it by the

beginning of the meeting tomorrow morning, because this information will be released on an

embargoed basis at 1:30 p.m. tomorrow. Second, the Conference of Presidents requested that we

have an opportunity for those around the table who wanted to make observations or comments about the financial stability situation to do so, and we will do that very shortly. But let's first do the Q&A, and then we'll come back and allow people to make comments about the financial stability issues.

Let me start with a question for Trevor about the approach to forecasting commodity prices he described. You showed no forecasting benefit, but all you're really doing there is augmenting the futures curve by something which is effectively the difference between your forecast and other people's forecast. So I think what you're basically just saying is that over the sample period that you tested this on, the Tealbook forecasts weren't noticeably better than private-sector forecasts.

MR. REEVE. That is right. We actually did a little bit better on the dollar than our perception of outside forecasters, which we take to be, basically, a random walk, because through most of that period we were projecting some modest depreciation; but we lost a little bit on global growth.

CHAIRMAN BERNANKE. But in the memo that you circulated, if I remember correctly, you found that futures curves actually are more informative when they are sloped either up or down. So an alternative forecasting method would be one that puts a heavier weight on those situations and, otherwise, when it's flat, uses some other types of information. Why didn't you make that forecasting comparison?

MR. REEVE. Well, actually that observation is a big reason that we retained futures as our starting point in the first place. Alternative approaches that we tried along the way were just relating commodity prices more directly to our expectations of global economic growth and the dollar and any other factors that we could find, disregarding the information in futures. But we

found that you really are throwing away that useful information when you have a material slope to the futures curve. So this was a way that we wanted to preserve that useful information but then basically just tweak it based a bit on how we view the world evolving a bit differently than maybe outside forecasters do.

CHAIRMAN BERNANKE. Mine is just a suggestion to take a weighted average of the two types of forecasts and put a heavier weight on futures when they're far from being flat. Okay. Questions for anybody? President Rosengren.

MR. ROSENGREN. I have one question on the downgrade risk of Bank of America and Citigroup. Let's use Bank of America as an example because it has Merrill Lynch underneath it. If Bank of America were to lose its A1/P1 status, would that affect its ability to serve as an investment bank? This may be too detailed'and if so I can take it offline'but are we concerned about the investment bank model under bank holding companies if A1/P1 status is lost?

MR. COVITZ. I think probably yes, but I'm not sure exactly which functions they wouldn't be able to conduct and which functions they would be able to conduct. It's pretty clear that if they no longer have an A1/P1 rating, their ability to support entities'provide liquidity support or credit support'would go away right away. I think in the past when something like this has happened, and providers of support have been downgraded to tier 2 status, the rating agencies give the structures a little time to actually make that adjustment. They don't instantly say, 'Okay. All of these structures are downgraded right away.' But ultimately they would be.

CHAIRMAN BERNANKE. Governor Tarullo.

MR. TARULLO. Maybe Bill and I could supplement this a little bit, because we have been talking about this a lot in the context of B of A and Citi, but also, to some degree, Morgan

Stanley. And I think, Eric, our best understanding, which Bill may want to supplement, is that in the past, it's been very hard to conceive of anybody surviving as an investment bank with an A2/P2 rating. Bank of America may present a somewhat novel experiment, insofar as they're such a huge retail bank, with a very big liquidity base and lots of deposits and all the rest, which is associated with the investment bank, but it's by no means clear that that would be the case. So I think our expectation has been that, at best, it would be a significant challenge for B of A, and probably more than a significant challenge for Citi and Morgan, which is what's led to all of the planning by Richmond and New York over the course of eight or nine months since this first became a possibility. Bill.

VICE CHAIRMAN DUDLEY. Yes. I think we are worried about it, and I think one of the issues is, what happens to people's willingness to take that entity as a counterparty? So it's not just their own funding, it's also their transactions in, say, the OTC derivatives markets. One thing that is very hard to assess here is, what is the damage to the franchise? And how does that manifest itself over time? You could have a situation where nothing happened very dramatically on day 1 or day 90, but the franchise of the entity would erode over time. The bank's funding costs are also likely to be higher, and that's also a competitive disadvantage in terms of generating reasonable returns on equity. All of these things might have a medium- to long-term effect. I think it's a little harder to judge from historical experience, though, because usually what happens is, when you get downgraded to A2/P2, you're on your way to something even worse. And so you never really know what would happen if they were downgraded to A2/P2, but then their earnings performance subsequently improved. We just don't have a lot of examples of that type of survival.

MR. FISHER. Mr. Chairman, may I ask these two gentlemen'in the early '90s, we had a problem with several banks being downgraded in terms of their commercial paper, including Citi. They weren't as reliant on short-term funding back then as they are now, and, of course, the complexity of their business was less so. But are there any lessons we learned from that experience?

VICE CHAIRMAN DUDLEY. There's a difference between a bank and a bank holding company, and how do you fund the nonbank subsidiaries? That's really the key issue, I think.

MR. TARULLO. That's right. And the second thing is, I think there was a lesson, Richard, insofar as with all three of these institutions, there's been a heavy emphasis on liquidity preparation over the course of the past eight or nine months. The liquidity preparation doesn't do anything to address the business-model question that Bill was just describing, but it does mitigate the potential for a sudden discontinuous event.

MR. FISHER. Thank you.

CHAIRMAN BERNANKE. Questions? President Hoenig.

MR. HOENIG. I have a question on exhibit 2. It's around the discussion of why consumer spending is so sluggish, and you compared it with the three past recessions. I'd be curious, did you track, for example, the ratio of personal debt to disposable income and compare it with those three periods? Because although you say one-fourth of the mortgages are underwater, I think it could be more than that; it could be just the leverage that the consumer is working off that is slowing consumption.

MR. SLIFMAN. I did not actually do that cyclical comparison. I am going to put that on my to-do list, however, because I think it's a good point. But without having the actual facts in front of me, I would suspect that your hypothesis has a lot of plausibility to it.

CHAIRMAN BERNANKE. President Lockhart.

MR. LOCKHART. Turning to exhibit 6 on the forecasts of the external sector, my question relates to China and perhaps to Japan. What, notionally, is the confidence interval you have around those forecasts for the second half and next year'the sharp bounceback in Japan, but more importantly, perhaps, the relatively flat and still very strong growth in China. Put differently, is there any risk of a China slowdown that really does change the global outlook?

MR. REEVE. There are always risks. We're always mindful of them and looking as carefully as we can to find them. In the case of China, obviously, policymakers there have been trying to engineer a slowdown from unsustainably rapid growth. So far they seem to have done a pretty good job at doing that. One of the main indicators for that is that outstanding bank loan chart that is shown in the exhibit. There were some fears earlier this year when some soft readings were coming in; they were a little bit hard to interpret because of the lunar new year and the strange dip in retail sales and so forth. But I think a lot of people took confidence from the May readings, which showed investment picking back up and retail sales still expanding at a healthy pace. House prices, which are a big concern in a lot of cities in China, have essentially stabilized and are not either increasing at really rapid rates or in a freefall. So far, it seems like the overall pattern of macroeconomic policies that the authorities have undertaken is achieving the type of reduction in the very rapid rates of economic growth that they were looking for. And, of course, as you noted, that's our baseline forecast. There certainly are risks around it. Some people are worried about power outages later this year and other disruptions that could emerge. But so far, we actually feel quite positive on the Chinese outlook.

CHAIRMAN BERNANKE. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. Back to exhibit 2 and these charts comparing the recessions of '73, '81, and '07. I've looked at charts like this myself, and my comment is that the '70s was a really volatile period in the U.S. economy, and the economy behaved very differently after 1984. It's true that these are the previous two recessions that are the most severe, but on the other hand, the economy doesn't seem to have behaved this way for 25 years, so I'm not quite sure that's the right comparison. What I try to look at instead is the period coming out of the 2001 recession and the '90''91 recession, even though those recessions weren't as deep. And there the current recovery looks roughly similar. Although there are some differences, it does look more similar to those cases. In this recession there was a huge drop-off, which I would interpret as a bursting of a housing bubble, and then the recovery has been very similar to the last two. So that gives you a very different perspective on how to think about this recovery as opposed to looking back to the 1970s. But again, we haven't really experienced that for 25 years.

MR. SLIFMAN. Obviously, the comparisons you're talking about are ones where you, in effect, index them from the trough rather than from the peak, and the charts do look different if you were to do that. It's all in the eye of the beholder, but it would seem to me that the more relevant comparisons were to start at the peak, so that one could take in the extraordinary depth of this recession. And it was for that reason, then, that it seemed the right thing to do, to compare it with other deep recessions. But I grant you that, in some sense, it depends on the question that you are trying to address.

MR. BULLARD. I'm just saying, from a recovery perspective, I'd welcome a theory of why those recoveries look different in the earlier era than they look in the modern era.

MR. SLIFMAN. Another thing we did was to look, for example, at the residuals in spending equations at different points in the recovery. Typically at this point in a recovery, you would expect, for example, that, because of pent-up demand and deferred purchases that occurred during the recession, consumer spending would be higher than one might expect based simply on income and wealth and the usual other kinds of right-hand-side determinants, whereas now it's just the opposite. Consumption is far below what might be expected. The facts that you present are the facts, but in terms of trying to get some purchase on why this recovery just doesn't seem to be getting any traction, I think that focusing on these problems in the household sector provides some insight.

MR. BULLARD. Okay. Let me put it a little more strongly. You're pining for something that hasn't happened in a quarter-century.

MS. WILSON. Can I step in? When we've looked at the similar charts to what you've looked at for the United States, and we've included a broader range of recessions, we found that the results that were shown here hold in terms of the components. So aggregate GDP, you're right, shows up more in the middle'this current recovery indexed to the trough looks fairly in the middle of the range. But Larry's point about the weakness of consumption'as well as the unemployment rate'still holds true. The components are where you see differences. You can tell by looking at Larry's charts that if you index the trough, investment is actually going to look pretty strong now, but what you're going to see is incredible weakness in consumption as well as on the labor market side, and of course in housing. And those results still hold regardless of where you index.

MR. BULLARD. For those of you that are interested, I'll put out our advertisement. All of these kinds of charts are plotted on the St. Louis website, not just for the United States, but also for other countries, monthly and quarterly.

CHAIRMAN BERNANKE. It's a propos that President Bullard just commented that this recession followed the popping of a housing bubble. Larry Slifman made a similar comment. I think there is an important and interesting distinction between whether it was the housing bubble or the housing bubble plus the financial crisis. We have some evidence on financial crises, but we have also seen housing bubbles around the world that weren't accompanied by a financial crisis. I think Australia is one example. You may not know off the top of your head, but do we have any sense of whether recessions are very deep and recovery is very slow when there are housing bubbles popping but not a serious financial crisis?

MS. WILSON. What we've done is that we've taken a series of about 150 episodes and broken them down the way the IMF has broken them down, by various types, so we know something about financial crises and banking crises. However, there are not a huge number of observations of housing crises, and while it's very difficult to say, I'm sure that for the housing component itself, you could find a difference. Comparing banking and financial crises and normal recessions, when you index to the trough, it's extremely difficult to identify a difference in the pace of recovery. You do see differences, to some extent, in how deep or how long the recession is. But on the way up, you don't see huge differences, in the aggregate, although you see various differences in the components.

MR. SLIFMAN. Could I add one more comment? This is related to the point that President Hoenig was raising as well, and that is, we have seen in the United States other times when, regionally, there have been sizable declines in house prices. It happened in California in

the early 1990s, for example. The big difference was that, even though we had sizable declines in house prices, we did not see a spike in households having negative equity because in those days, you had to put 20 percent down. But when you put zero down and house prices fall, that's a big change. I think that's an important difference between the situation that we faced in the latter half of the past decade and previous periods of past declines.

CHAIRMAN BERNANKE. Thank you. President Fisher.

MR. FISHER. I have a question for Beth Anne, Mr. Chairman, if I may. When we went through your exhibit about the bond spreads and so on, I didn't hear anything about France. And the reason I mention that is because, in visiting the ECB last March, including with Mr. Trichet, the subject of the French primary deficit came up'that perhaps it is much worse than anybody really knows. Last Wednesday, which was an interesting day in the marketplace, for the first time I heard, at least from my interlocutors, some concern that this is a shoe that would drop at one point. So I wondered if you've done much work on that, if you have any insight into it, and if not, if you would be kind enough to look at it, because so much of what we have been hearing about Greece is obviously somewhat discounted in the marketplace as it seems to get worse and worse. But the one thing that would be a total surprise, if it were to occur, would be a surprise coming from the French fiscal situation, particularly given that they're an anchor country.

MS. WILSON. In terms of the fiscal situation, per se, France was running about a

7 percent headline deficit with about a 5.3 percent primary deficit last year and is expected to reduce that to 5.6 on the headline this year and 4.7 next year. So they are certainly above Germany, which is the star player here, but it doesn't look particularly disturbing. We have seen a run-up, just like many other countries, in their government debt, which went from an average of about 60 percent of GDP in the 2000 to 2006 period, and we anticipate will be about

86 percent of GDP'so, obviously rising, but not at a level that would disturb us. You may have gotten different information than what we have here, but I think what is somewhat disturbing is that France is exposed to the periphery countries, and it has a number of institutions with some high concentration in Greek debt and other peripheral debt. You're starting to see spillovers, not necessarily coming from the French fiscal situation itself, but from its exposure to the peripheries. But I wouldn't discount the political difficulties they are all facing in terms of bringing deficits down over time. At this point, we haven't heard anything, but we will certainly keep our eyes and ears open.

MR. FISHER. Thank you.

CHAIRMAN BERNANKE. President Lacker.

MR. LACKER. Yes. I just want to make an observation on the discussion following President Bullard's question, relating that discussion to our DSGE presentation. You cite low expected income growth as a cause for sluggish consumption growth. In all those models, though, it's all together. You don't have business and consumer confidence floating around as an exogenous variable. The economy is on some path, and consumers and businesses are expecting some path, and their income expectations are geared off of that. So from that point of view, looking at the household sector might lead you to look somewhere else, right? If their income prospects look poor, then you might peel back the onion. Maybe it's hiring prospects that are poor, and for some reason they are not getting hired. I wonder about your reflections on that sort of perspective.

MR. SLIFMAN. When you give a briefing, you have to give things linearly, sequentially. But obviously these things are all endogenous, and there are interactions among all of them. I think I tried to stress in my remarks that low expected income interacts with fears

about future job loss, concerns about further house price declines, and concerns about geopolitical situations'that all of these things interact with each other to affect short-term spending decisions. Yes, there is some longer-term spending path that we would expect households to converge to over time, but in the current situation, over the period that's relevant for us, I think that, for a variety of reasons, households can get thrown off those paths or choose to go off those paths for a while.

MR. LACKER. I was wondering whether some impediment to hiring would necessarily show up as lower consumer spending growth.

MR. SLIFMAN. Absolutely. Part of your consumption plan is going to be related to income, which is going to be, of course, related to labor market conditions.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. I was going to add to what President Lacker said, that I think there's a way to put Larry's comments on the situation in a DSGE framework. Think about a DSGE model that layers on more heterogeneity among households and maybe has some income uncertainty for households as well. If you think about those households as facing higher amounts of income uncertainty, possibly because of the impediments to hiring that President Lacker points to, those people are going to be engaging in more precautionary saving to buttress themselves against those risks. And then that will show up in the form of lower individual consumption, and then aggregate up to lower aggregate consumption. We live for the day when we have a DSGE model with full and complete markets and that allows for heterogeneity.

CHAIRMAN BERNANKE. Vice Chairman.

VICE CHAIRMAN DUDLEY. The chart showed exports above imports. Are the imports weak relative to our actual growth rate? In other words, do we think there is import

substitution going on? And if so, how much, and how significant is it? You can have trade improvement for three reasons: One, our exports are strong; two, our economic growth is weak; and three, our imports are weak. But import substitution could be another factor. We hear a lot of anecdotal reports about the United States getting more competitive relative to China and other places. I was wondering if that is showing up at all.

MR. REEVE. Well, the way that shows through in the way we do our projections is really through the exchange rate. And, certainly, the lower value of the dollar in this projection over time is a restraining force on imports and a supportive force for exports. In that sense, I think some of that actually is occurring. But in terms of the question, are imports out of line with domestic demand growth or GDP growth? Not really. Our model, which includes U.S. activity and the exchange rate, is doing a pretty good job tracking import growth. If anything, core non- oil imports are maybe just a touch higher than that model would suggest, but not materially so.

VICE CHAIRMAN DUDLEY. Thanks.

CHAIRMAN BERNANKE. Other questions? [No response] This might be a good time to take a coffee break, and come back at 3:30 p.m.

[Coffee break]

CHAIRMAN BERNANKE. The next item on our agenda is billed as a chance for

Committee discussion of financial stability issues. This represents a request from the Conference of Presidents that we have an opportunity for some discussion on this area. I would like to get to the economic go-round in time to, if at all possible, get through it today. So I am not encouraging a full go-round on financial stability. That being said, anyone who would like to make comments, observations, ask questions'I see Nellie Liang is at the table'about issues related to the financial markets and financial stability, of course, is welcome to do so. We will

solicit your views after the meeting as to whether this format is effective or if there are other ways to do it. But today, again, we will take comments from whoever would like to speak, and I have on my list here, first, President Rosengren.

MR. ROSENGREN. Thank you, Mr. Chairman. I would like to thank the staff for a very comprehensive overview of financial stability issues and for getting it to us early enough that we could actually digest it for this meeting. I plan to expand on a theme that has been emphasized already in the briefing materials and has been an area of focus both at the Board and elsewhere in the System; it concerns the continuing risk posed by the structure of money market mutual funds. Money market mutual funds played a pivotal role in the disruptions to short-term credit markets during the crisis. During the crisis, a credit loss resulting from Lehman at a non-bank-sponsored prime money market fund caused a run on money market funds more generally and evaporated their demand for short-term credit instruments. I fear they could play a similar role were European problems to evolve in unexpected ways.

Let me be more specific about my concerns. If one looks at the top-yielding prime money market funds on June 7, their gross yield ranges from 37 to 44 basis points'a very healthy yield for 2a-7 funds that are restricted on both maturity and duration of assets. However, of these 12 funds, 9 funds yielded a net return of 3 basis points or less for investors. As a result, taking less risk would not affect the investors who are only receiving 1 to 3 basis points, but would have an effect on the management fees. Of the 12 high-yielding prime funds, only 1 was sponsored by a bank, and it is 1 of only 2 funds to experience growth year to date among those 12. The 4 smallest funds experienced double-digit declines in assets under management.

How are these prime money market funds obtaining such high gross yields? In part, it is by taking credit risk, including to European financial institutions. Let me give just one example.

The highest-gross-yielding fund has taken a large position in Dexia CDs yielding 66 basis points, while the Ambassador Money Market Fund'the only fund to see significant year-to-date growth among these 12'holds a substantial stake in Dexia commercial paper. Dexia is partly a Belgian and French government-owned bank and has recent five-year credit default swap quotes of

326 basis points, more than double that of Citigroup and Bank of America, who we discussed earlier for possible downgrades. Dexia has a '4.3 billion direct exposure to Greece and is on credit watch for being downgraded. Note that money market fund investments are intended to be invested in highly liquid, low-credit-risk assets. The high credit default swap rates on European banks that are among the assets held by money market funds indicate that many financial market participants view these as having significant credit risk.

While the outcome of events in Europe is unclear, it seems that some money market funds are making investment decisions partly based on expectations of European government support, not unlike the assumption that was a problem for the Reserve Fund when Lehman failed without government support. However, taking credit risk with a promise of a fixed net asset value means that if they are right, they get high management fees, but if they are wrong, they risk another serious disruption to short-term credit markets in the United States. This may be a particularly acute risk given the examples I provided of funds with exposure to Dexia. Both of these funds are managed by small, independent asset managers that may not be capable of providing the noncontractual sponsor support that has served as the primary backstop to this industry.

What can we do to reduce this financial stability risk? A group of academics that met at Squam Lake have suggested capital buffers that convert funds to floating-rate NAVs if the capital buffer is breached. There are a variety of other suggestions, but two and a half years after

the run on money market funds, there still has been no agreement. Given the risk to financial stability, the Federal Reserve should be actively advocating for more progress on this issue. The Chairman and several Presidents have raised this as an issue publicly. I would hope that we will strongly encourage the SEC to take action, and, in the absence of a major change, to try to use the FSOC to encourage more aggressive action. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you, President Rosengren. I share your concern. I want you to know that we have in fact worked with the SEC, both in the FSOC as well as through a roundtable they recently held on these issues that Governor Tarullo attended, and I think we have had some effect. Certainly, Mary Schapiro is very sympathetic to the idea of some of these stronger measures, but we'll keep monitoring it, and I hope you'll keep us informed as well. Vice Chairman.

VICE CHAIRMAN DUDLEY. Thank you. First of all, I want to thank the staff, Dan and Nellie. I thought that was a terrific presentation that covered a lot of material, and there were some interesting exhibits that presented the information in a way that I hadn't seen it before. It was extremely helpful.

I want to talk about two issues that I have been talking about for a while, Europe and the federal debt ceiling. On Europe, let me be very brief. I suspect that we will avoid a catastrophe in the near term as Greece reluctantly agrees to do more and the private sector participates by rolling over some debt on a 'voluntary basis.' But even if we get this outcome, we should not be very comfortable with where we are. The intersection of what Greece can or will do, and what the core countries demand'especially from a political perspective'continues to shrink, and we seem very close to a null set. We might not get to a null set this time, but we are not very far from getting to a null set. I can easily imagine Greece falling short of its objectives 6 to

12 months down the road, and then we will have another episode, and at that point we actually could reach the end of the road.

With respect to the debt ceiling, I would only reinforce Brian's comments. We are on a very risky course. No one knows precisely what will happen if the debt limit is not raised in a timely manner in August, but we do know it will be a mess. Not only would there be short-term disruptions to financial markets and the macroeconomy, a default, even if temporary, could have a lasting effect on U.S. debt costs and the role of the dollar as a reserve currency. So I would encourage everyone in this room to raise the alarm in their public comments and in their private discussion of this. The Chairman spoke about this issue I think quite forcefully recently. I think the more people that make it clear that this is really serious, the better. I am particularly worried because the financial markets up to now are so relaxed that the debt limit will be raised in a timely way, and I worry that this is going to give false comfort to those that think a temporary default would not be particularly harmful. And I think we really need to lean against that notion as hard as we can.

CHAIRMAN BERNANKE. Thank you. President Lockhart.

MR. LOCKHART. I was going to bring this up later, but I think this is an appropriate time to ask a question raised by Vice Chairman Dudley's remarks. Even though we will come back together again in early August, is it appropriate to be doing some contingency planning around the early August period, just to know what we would do under various circumstances? I took Brian's comments earlier to be that, essentially, he's clear on operational questions, but if it turned out to be a big deal, it would be back to the Committee to have to decide how to respond.

CHAIRMAN BERNANKE. Well, either Bill or Brian can add on, but the earlier discussion that Brian led was about contingency planning from the Federal Reserve's operational

point of view, and much of that is mandated by the directive of our normal procedures. I asked Brian'and I think he is already thinking that way anyway'to consider possible actions that we might take to stabilize markets to the extent we can, with the thinking that if we came close to that time, the Committee would be able to talk about them and see what we were comfortable doing. So from the Desk's point of view, I think we have a plan going forward.

The other consideration is, we have been strongly discouraged by the Treasury from doing the kind of planning that would involve talking to the private sector. For example, we have no idea whether the computer systems of BNY, JPMorgan, and the FICC and so on can even manage. It might be a Y2K type of event in the sense that they don't contemplate the possibility that they wouldn't receive principal and interest. The Treasury's reasoning is that it doesn't want to create too much anxiety in markets, and its view is that it intends not to default until it was unavoidable. You know, we are continuing to talk to the Treasury, and I think at some point we may just have to say, as supervisors and regulators, that we need to do this on our own, and the Treasury doesn't have to take responsibility for it. We are, I think, very close to the point where we have to fish or cut bait on those kinds of issues. So those are the two areas where we are planning. President Lacker.

MR. LACKER. Just following up on our earlier discussion'I understand the need for stabilizing the market, but at the same time, would it make sense to contemplate a bright-line policy, like 'We will not take a defaulted security'?

CHAIRMAN BERNANKE. Well, that's something for the Committee to discuss. We have competing public policy objectives here. One of them is to avoid Armageddon in the financial market. We have done some pretty non-bright-line kinds of things in the past to avoid that Armageddon.

MR. LACKER. I would just point out that the ECB seems to have drawn a pretty bright line, but this is a very different situation.

VICE CHAIRMAN DUDLEY. I have some sympathy with what President Lacker is saying. You don't want to give comfort to make the debt default more likely. But at the same time, if a debt default were to occur, you don't want to make it much worse in terms of the consequences. You are balancing those two basic issues.

CHAIRMAN BERNANKE. I see no harm in having a list of the options, and then we can make some decisions.

MR. SACK. Yes, I think it would be useful to write out some of the Desk policy issues that could arise in coming weeks and consult with the Committee on approaches they would like to take and where you would like to draw the line. For example, I would assume we would draw the line past what you just said. I would think we would probably want to continue to take securities with delayed payments in open market operations. Excluding them could seem like a very negative market signal about how we were assessing credit quality. But we could lay all those issues out in a memo and get some guidance from the Committee.

MR. LACKER. This is obvious, but we are facing a couple of decades of fiscal stringency. If they actually cross this line, our behavior is going to set a profound precedent here. So the usual time consistency considerations tip the scale a little bit toward a solid contingency plan.

CHAIRMAN BERNANKE. Of course. I would say that I don't think there is anything we can do within our powers to prevent a default from having extremely negative consequences, if only because of the effect on expectations and the creditworthiness of the U.S. Government.

Whatever we do, I don't think it's really a question of us being able to completely eliminate the

expectations factor or prevent it from being extremely stressful. All I can say is, I think we ought to discuss taking into account those expectational effects in what we are prepared to do. President Hoenig, I have you next.

MR. HOENIG. Thank you, Mr. Chairman. I really thought this was a good report, and the chart show was enormously useful as we think about it, because one of my concerns has been that we have this fairly fragile equilibrium at these very low interest rates. You can see it come out in different forms. And I thought President Rosengren's point about money markets was right on. I think another area is the repos that are also funding longer-term assets under the guise of short-term liabilities. It is a problem that I think needs to be addressed.

In my region you see it in different ways, as I mentioned before. Agriculture is still moving very, very much toward leverage as gains are recognized and new opportunities present themselves. We are seeing it in energy, where there are now huge profits on some of these drilling projects, and they are leveraging that up for incredible turnovers. I think it's something we need to pay a lot of attention to, and I know we are. One element of the ag sector I want to mention once again is the effects of GSEs. There are two things'what they say and then what they do. And they are saying they are tightening their standards, but when you look at what the Farm Credit System is doing, it's something else. Our commercial banks and ag banks are fairly concentrated in agriculture loans, but still less concentrated than the Farm Credit System, and yet the Farm Credit System is maintaining half the reserve levels as the commercial banks are in that area; it is setting the standard, and it drives you toward the lower common denominator. So you see the leverage going up, and we are seeing big increases on a quarterly basis now in that sector. We are seeing big increases associated with energy, and then some leverage deals on energy. As they search for these returns, we are seeing the financing around money markets on a broader

scale than other repos. This is very helpful, and the use of leverage around this is going to only grow. How we work our way out of this very fragile equilibrium matters, and that's why this exit strategy, I think, was so important, that we had that discussion today, and I think it gives us, if you will, a guide for beginning to think forward on how we deal with this. This is a very good report. These are things that are emerging that we should pay attention to, and I think it will serve us all well. Thank you.

CHAIRMAN BERNANKE. Thank you. Would anyone else like to comment? President Fisher.

MR. FISHER. On the financial stability, I do want to thank Nellie for her good work and for the work of the 70 people, as I understood your footnote, which were affiliated with it, and for the presentation we just had. I distinguish between the faucet, which is how we address monetary policy, and the sprinkler system, which is how we water the lawn of the economy. That is, we either have it distributed properly so that we don't kill it with inflation, or starve it and destroy it with deflation. I think this financial stability aspect of it is very, very important. The transmission mechanism is critical. And I do want to tip my hat to Governor Tarullo for the work he is doing in terms of 'too big to fail,' which to me is one of the major hindrances to the proper conduct of monetary policy'all the work he is doing on capital ratios and other aspects of getting our system right. I think it is very important that we focus on the shadow banking system and the trip wires that are out there'for example, those that Eric and the staff have pointed out'because it puts us in a very difficult position.

One of the risks that I think we need to contemplate and that I worry about is the possibility that we could have a significant selloff in the market. This wasn't discussed in terms of financial stability, but having been a market operator, I know these things can happen

sometimes inexplicably. Let's say that we had a 20 percent selloff in the S&P. What would we do? I'm going to switch here from the sprinkler system to what I call the souffl''; souffl''s don't rise twice. And by that I mean that I'm not sure that we can just pour on more large-scale asset purchases or more quantitative easing. I think the impact of this, as it goes through time, becomes less and less potent. I would ask you to consider that as a financial stability risk, in addition to the specifics we have gone through in terms of the specific banks, the short-term funding of those banks, the exposure of money market mutual funds, and also some of the risks that you have in your much longer paper dealing with, say, Goldman Sachs and JPMorgan. I think this is a very valuable exercise. I don't think we can conduct monetary policy without considering how the sprinkler system works and what Rube Goldberg devices are being attached onto it or where the leaks are and what the repair mechanism needs to be. I think this should be a part of our ongoing discussions. It is so much better than we had before. When Governor Warsh was here, he would bring up certain issues, I would bring up issues, others would bring up issues'this is much more systematic. Again, I want to pat you on the back, Nellie. And if I could pat 70 other people on the back, I would. Having an organized discussion here rather than pulling out layers of anecdotal evidence that we can layer on top is very, very important. So I want that to go down as registered.

CHAIRMAN BERNANKE. I agree with you, President Fisher. I think we are making very good progress, with the intermeeting memos, the operations of the Office of Financial Stability, and these kinds of discussions. Your comments raised a useful point. At the beginning you talked about a number of things, like the shadow banking system and so on, which might be amenable to regulatory or microeconomic-type policies. I think it's important for us to have enough granularity so that we can decide when the first line of defense is appropriately

microeconomic regulation, which gives more cushion to monetary policy to focus on macroeconomic conditions. But the stock market is an example where microeconomic regulation probably wouldn't work, and we want to think about that, although I resist any Greenspan'Bernanke put ideas.

President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. Now I want to mention some anecdotal evidence, following up on something President Hoenig said. My banking supervision group and I have heard concerns expressed repeatedly from banks that specialize in ag lending about what they consider weak or lax underwriting practices being used by the Farm Credit System. Now, the Farm Credit System, when you think about the big banks in the United States, is relatively small'it's $200 billion in assets'but it owns about one-third of all the farm debt in the United States. Its failure is an interesting thing to think about, because it wouldn't be systemic from the point of view of the U.S. economy, but it would certainly be systemic, I believe, in terms of the agricultural sector, which is often viewed as being more significant from a national perspective than its weight in the national income and product accounts would suggest.

The Farm Credit System is a government-sponsored enterprise; it raises funds by issuing debt, and that debt is highly rated, probably because it's a government-sponsored enterprise. Now, I have to say that we should take into account that our banker contacts who tell us that the Farm Credit System's underwriting practices are lax are competitors with the Farm Credit System, and their concern should be viewed in that light. At the same time, the fact that we kept hearing about this means I think that those comments are sufficiently prevalent to warrant further investigation by the Board of Governors, and perhaps by the FSOC. One thing that's worth

noting is that the FSOC has no representation from the Farm Credit Administration, who is the safety and soundness overseer for the Farm Credit System. So in some sense, there is no direct way for this to get to the attention of the FSOC. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Nellie.

MS. LIANG. This issue has come up. The FSOC and the Board have had that discussion. The FDIC is also concerned. You're right, the Farm Credit System does have about one-third of the outstanding farm credit debt. On your point about its failure, it has a huge surplus so that seems not to be an issue. But we have heard complaints about them causing community banks to loosen their standards. We have been watching it. Whether it's a systemic issue or if it's just something to point out and have examiners be aware of this issue is still in discussion, but it's good to hear it being raised again.

CHAIRMAN BERNANKE. President Rosengren.

MR. ROSENGREN. I would be interested, Mr. Chairman, from your own perspective, in how the FSOC is working and how that process is going. Do you have any observations?

CHAIRMAN BERNANKE. Well, as is often the case, all the real work gets done by the staff, and I will ask Nellie to comment in just a second. [Laughter]

We have a meeting only about every eight weeks or so. We're doing some important assigned tasks, like developing the criteria for evaluating SIFIs. We've also had some useful interactions: As I mentioned earlier, I think that the money market mutual fund discussions have moved the SEC's position and have increased the possibility of a stronger credential system for money market mutual funds. But because it only meets periodically, it doesn't have the ongoing working relationships that would be necessary for a truly interactive and effective council. That being said, of course, we have bilateral relationships with many of the members, and they've

been quite extensive in the process of Dodd'Frank rulemaking, for example. Moreover, there are many committees of the FSOC, which are made up of senior staff and even deputy principals in some cases, and my sense is that a lot is happening in those. Perhaps Nellie could give us her sense of how it is working.

MS. LIANG. Yes. There are about five or six committees that have been set up. One is the Systemic Risk Committee, and that one is very busy trying to write an annual report, which will be released, we expect, near the end of July. That's a key committee that I think is going to form the core of what FSOC will do going forward. It wasn't as active over the past year. Going forward, it's designed to get staff together to discuss emerging risks they're seeing. So you would have the SEC and the CFTC and all of the banking regulators, et cetera, get together and have discussions that will allow issues about risks to bubble. Then that committee would make decisions about what to bring to the principals for discussion. In the past year there hasn't been a lot of discussion because there has been so much work under Dodd'Frank to finish. There has been a whole slew of studies and proposed rules to write. As a result, when the principals get together, it's just all about approving a study or rules, without much opportunity for discussion. But I think that will change. One of the two big issues on the table right now that the principals have started to engage in, and the staff has worked quite a bit on, is the designation of the nonbank systemically important institutions. The FSOC was heavily criticized for not being very transparent about how they were going about this process. They were going to put out a proposed rule in May and pulled that back, but we'll put out another document for comment fairly soon. We are trying put something out to the public that reduces some of the uncertainty about what institutions might be evaluated further for designation. There is a view out there that

the designation could encompass hundreds of firms; because there is just so much uncertainty, there's an effort to try to reduce some of it.

The second piece right now is the annual report. There will be a couple of sections on topics like: What does the system look like? How it has evolved since the financial crisis? There will be a big section on emerging threats. It won't sound too different from what some of you have been hearing lately in terms of what the key threats or the vulnerabilities in the system are, including bank capital, liquidity, money markets, and infrastructure. And then there are some recommendations that we're now crafting. The principals will have to make decisions about which recommendations they would want to include in the annual report and to sign the reports. That's what will be going on over the next four to six weeks.

MR. FISHER. What's the time frame?

MS. LIANG. The goal is to release something in late July. Dodd'Frank's anniversary is July 21, and something around that time is the goal.

CHAIRMAN BERNANKE. Mr. Fisher, did you have a comment?

MR. FISHER. When you say they're going to issue suggestions, are these remedies to mitigate the risk or to deal with risk if it occurs?

MS. LIANG. For example, if we were to highlight vulnerabilities'the banking system, capital cushions, short-term funding instability, for example'the recommendations could be to continue to pursue money market reforms, which probably is something that the FSOC has come to view as important because they have made a lot of progress on money markets. On the bank capital, it could be to implement the Dodd'Frank enhanced prudential standards, plus to have the supervisors continue with their CCAR exercises, the internal capital planning processes, something along those lines. These will all get negotiated over the next few months, but it would

tend to be structural, regulatory reform at this point, trying to stay away from fiscal policy and monetary policy.

CHAIRMAN BERNANKE. Other comments? [No response] All right. I hope that was helpful, and it is certainly the case that Nellie and many other people have contributed to making financial stability a more explicit part of our policy discussion. I think it's only to the good to do that. All right, we're ready now for our economic go-round, and I'll start with President Rosengren.

MR. ROSENGREN. Thank you, Mr. Chairman. Since our last meeting, my business contacts in New England have turned surprisingly negative. This negative sentiment particularly pertains to smaller businesses that are not seeing significant increases in demand and are deciding to put off additional hiring or investments until it is clear that we have a more self- sustaining recovery. When I press these business leaders on the causes for their change in sentiment, they focus on domestic, not international, concerns, and particularly cite that incoming data continue to surprise on the downside, and they do not see what will turn that around. Unfortunately, I share the disappointment with the incoming data. For most of this recovery, the Boston forecast, like many other forecasts, has expected that in a couple of quarters, economic growth would pick up. However, with each additional quarter we keep pushing back when the self-sustaining recovery begins. Since the beginning of the recovery, we have only grown slightly above potential, and our forecasts have been too optimistic, resulting in serially correlated errors.

What accounts for the inability of this recovery to make significant headway in reducing the significant slack in the economy? First, I think we have underestimated the financial headwinds generated by the financial crisis. The impaired balance sheet of many consumers and

businesses reduces their access to capital and makes them sufficiently risk averse that they are not anxious to take risks even if loans are available. Second, our housing policies have been unsuccessful. Housing prices are unlikely to rise as long as there's a large overhang of vacant and foreclosed homes. We need policies that return people to sustainable housing situations but quickly remove the inventory of unsold homes. Housing is one of the sources of serially correlated errors in the forecast, and our research suggests those errors explain a significant fraction of recent forecast errors, a greater fraction than can be explained by housing's share in GDP or its obvious connection to household durable goods purchases. Third, more recently we have underestimated the move to more austerity at local, state, and federal levels.

What's my current forecast? Well, the Boston forecast, once again, foresees an acceleration in economic growth in a couple of quarters. And while it's technically a self- sustaining recovery, the growth rates we envision in the out quarters continue to slip lower and lower. While such acceleration is our best guess, I am becoming less and less confident that we will actually get that outcome, and even with that forecast of accelerating growth, I'm expecting the unemployment rate to remain above 8 percent at the end of 2012.

So what about inflation? The DSGE models presented earlier had inflation in 2013 ranging from 0.3 percent to 1.5 percent. The Tealbook has inflation measured as core or total PCE at 1.5 percent in 2012. The Boston inflation forecast is a little below the Tealbook forecast. Thus, despite some increase in core inflation from extremely low levels, these forecasts all expect us to be well below 2 percent at the end of the forecast period. I would also note that some of the increase in current measured inflation is related to higher measures of owners' equivalent rent. This is striking given that mortgage rates have fallen, housing prices have fallen, and foreclosures remain elevated. So at a time of increasing affordability for new home buyers,

their reticence or inability to purchase new homes has caused a shift to rentals. I would view this as reflecting more the dysfunction of the current housing market than any significant risk that inflation in the medium term was at risk of breaching my target of 2 percent.

If these forecasts are right, we will continue to miss on both elements of our mandate for several more years. What about the risks to this forecast? I see significant risks to the downside, but I will focus only on one, the international risk. While the Europeans may manage a temporary infusion of money for Greece, I am seeing little evidence of significant mitigation of the underlying problem. The primary deficit remains problematic. The debt-to-GDP ratio continues to rise, there seems to be limited political tolerance for more austerity in Greece, and the political desire in the rest of Europe to subsidize Greece seems to be ebbing with the passing of time. Given my modal forecast and assessment of risks, it's critically important that the economy begin to grow above potential. Tomorrow I will discuss the implications of this assessment for an appropriate monetary policy that balances all of the risks in the economic recovery. Thank you.

CHAIRMAN BERNANKE. Thank you. President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. Overall sentiment of our business

contacts and directors in the Sixth District remains positive, but they are not as optimistic as they were before the last FOMC. Several directors mentioned greater uncertainty around their cautious optimism for the second half. Few of our contacts cited major changes to their plans for the remainder of the year. Among the larger contacts we spoke to, the indications of a slowdown were mixed. Those that expressed disappointment in activity levels cited causes we had heard before: higher gasoline prices that reduced shopping trips or ate into consumer discretionary spending and supply chain disruptions that affected auto manufacturing. A large package

shipping company headquartered in Atlanta'you can guess who it is'has seen a general slowing of domestic volume year to date. In contrast, the country's largest home improvement retailer is seeing very strong traffic in sales volume, to some extent defying broad perceptions of the economy. Tourism remains quite strong across the region, both international tourists and domestic. Our New Orleans directors were notably bullish about the energy industry in the Gulf. They foresee strong activity and job growth in the coming year.

We asked a number of contacts about the pass-through of higher input costs. The atmosphere seems to have shifted from resistance on the part of major buyers to being resigned to some pass-through from suppliers, and a number of contacts across several sectors spoke of having raised prices or having plans to do so soon. One grocery chain attributed rising fresh- produce costs to higher fuel costs, and I'm hearing similar accounts from business contacts in places I wouldn't expect. The distinction between energy and non-energy consumer goods and services that was suggested in the first draft of the policy statement may not be so neat a distinction.

Turning to the national outlook in comparison with the Tealbook, the Atlanta Bank's forecast and the Tealbook are now essentially the same, whereas earlier there was some separation in terms of the overall trajectory, with Atlanta being more pessimistic. We decided to hold to our basic forecast path of rising economic growth and interpret the recent incoming numbers, particularly the household spending data, as a temporary setback. Our forecast incorporates a modest second-quarter number, but jumps to a GDP growth number above

3 percent in the third and fourth quarter. I actually find this an awkward moment to make a call regarding the implications of the recent disappointing data. I am 'tentative' about both the growth and inflation pictures and won't be holding to my forecast much longer if incoming data

continue to disappoint. I took note in our recent board meetings of concerns expressed by more than one director about the economy simply being on a longer-term weak growth path, say, a

2 percent economy. Also, as was mentioned earlier in the financial stability discussion, I think the shock risk has risen dramatically with the debt ceiling, Greece, and Europe, and as my question inferred earlier, the potential of a slowdown in China.

As regards the balance of risks, I assess the risks to economic growth as heavily, if not exclusively, weighted to the downside. The alternative scenarios in the Tealbook ably covered the most obvious downside risks. Regarding inflation, I think there is a reasonable chance that core inflationary pressures play out for longer than I assume as final prices come to reflect the influence of elevated commodity prices. I don't expect this to be on a protracted basis, but I'm concerned that such a story might adversely affect inflationary sentiment with uncertain follow-on effects thereafter. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Plosser.

PRESIDENT PLOSSER. Thank you, Mr. Chairman. Since our last meeting, I have revised down my forecast for economic growth in 2011 from 3.2 to 2.8 percent. This adjustment is driven by obvious temporary factors, in my mind, that we have much discussed: adverse weather, floods in the Midwest, oil prices, supply chain disruptions, and concerns about the fiscal situation both in the United States and abroad. I admit that these effects are proving somewhat more persistent than I had anticipated earlier this year but still consider them largely transitory in nature. Similar to the soft patch we saw last year, I don't perceive a significant change in the underlying fundamentals that will push the economy back into a recession. I continue to expect output growth in the United States to be slightly above trend over the second half of this year and employment conditions to improve gradually.

The Third District economic conditions mirror the nation. Payroll employment growth in our three states weakened somewhat in May. Unemployment rates, though, edged down in Pennsylvania and Delaware, but inched up in New Jersey. For the three-state region, unemployment now stands at 8.2 percent, down '' percentage point since December and almost a full percentage point below the national rate. The region's manufacturing activity weakened this month. The index of general activity has fallen over the last three months and actually turned negative in June. The indexes of new orders, shipments, and employment also weakened this month with new orders turning negative. The slowdown in activity has also weighed on regional manufacturers' expectations. Our survey is showing the same kind of behavior it showed last summer and early autumn when the economic expansion hit the soft patch. At that time, we experienced some weak positive and some negative readings in our survey for about four months before activity strengthened.

Thus, while I've changed my risk assessment around my GDP forecast from tilted to the upside to balanced, I've not changed my overall forecast for 2012 and beyond. I've been projecting a weaker pace of expansion next year all along, in contrast to the Tealbook and other private forecasters. The April Tealbook projected 2012 output growth of 4.2 percent while my forecast has been about 3 to 3.5 percent all along, which is still above trend. I didn't think we'd see as much strength in this recovery because I thought the structural changes that we're facing in this economy had to work through, and, given the nature and depth of those economic shocks, would weigh on economic growth for some time to come. The Tealbook forecast now looks like mine.

I also hear views from my directors about the financial sector'concerns about deals being done on Wall Street, sales of firms where the leverage ratios are growing, where firms are

promising financing at very, very favorable EBITDAs, and lots of leverage and lots of money to lend for deals. They're concerned that the types of deals they're seeing, in fact, look a lot like the deals that they saw before the crisis and the run-up to the crisis.

I have made little change to my inflation forecast. Both total and core inflation have accelerated significantly since the beginning of this year. Year-over-year PCE inflation has risen over 1 percentage point. Core PCE inflation has risen about 0.3 of a percentage point so far this year. In the Third District, price pressures remain high. In our June manufacturing survey, there continued to be more firms reporting increases in prices paid and received than are reporting decreases, although the indexes are down from their extreme highs we saw earlier in the year. You wanted to hear some further evidence on the ability of firms to pass on their higher input costs to their customers. In response to a special question, half of our firms told us they had been unable to pass on cost increases, and about half said they had already raised prices significantly since the beginning of the year. About 20 percent of the firms reported that they had instituted price surcharges, and 14 percent said their current contracts already contained escalation clauses. I do expect some deceleration in headline inflation over the second half of the year as oil and commodity prices stabilize or perhaps even reverse course somewhat, but not as much as in the June Tealbook. I project inflation to be around 2'' percent in 2012, which is up from 1 percent in 2010. My forecast is higher than the Tealbook, which is projecting about 1'' percent this year. But I note that the Tealbook has consistently revised up its inflation forecast over the past six months. I found the chart on the bottom of page 33 in Tealbook, Book A, which shows the evolution of the staff forecast for inflation, pretty unsettling. We need to take seriously the possibility that we could be missing some emerging signs that medium-term inflation is accelerating. This is particularly troubling in an environment where our policy is very

accommodative. Given inflation developments and the upside risk I see to inflation forecasts, I think we may very well need to take some action to withdraw some accommodation sooner than what's priced into the funds futures market or in the Tealbook. In fact, if the current forecast plays out, I believe we may need to take action before the end of the year, which means we will need to signal that that's a possibility sooner than that.

As we discussed in the last meeting, if we were following the Taylor principle, policies should respond to changes in inflation so long as there is no reversal in the unemployment rate or output growth. As you know, I'm not a big fan of output gaps, but even in their revised forecast, the staff projects that the output gap will be down '' percentage point this year and another full percentage point next year. Given this, the acceleration in inflation indicates that we should be acting to reduce the degree of policy accommodation. Ending redemptions is one step, but we should be prepared to take further action as well. Even when we begin to reduce the level of accommodation, policy will remain very accommodative for some time to come. A 1 percentage point funds rate is an accommodative policy. I think we should make an effort to explain this to the public and prepare them for the start of normalization. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Pianalto.

MS. PIANALTO. Thank you, Mr. Chairman. The latest economic news has been pretty discouraging. I have been wrestling with determining how much of the surprising information represents temporary noise or a more fundamental change in momentum. At this point I judge the recent slowing in output and employment as mostly temporary, but I regard much of the increase in core inflation this year as signaling a lasting upward shift in the path of inflation.

The uncertainty surrounding this assessment is extraordinarily high. In my view, the level of uncertainty around my outlook is higher than it was at the April meeting, and the balance

of risks is even less favorable. Let me explain my reasoning. In terms of the most likely outcomes, there are a few reasons that I view the recent slowing in the pace of the recovery as mostly temporary. First, some portion of the deceleration of GDP growth has been due to a pullback by consumers in response to past increases in food and energy prices. We're now seeing those prices level off or, in the case of gasoline, decline. So these effects should start to wane. Second, economic growth has also been temporarily slowed by disruptions to motor vehicle production and sales associated with the earthquake in Japan. Third, while the pace of job growth in May was disappointingly slow, gains were much stronger in previous months. As the temporary negatives dissipate, I expect that GDP growth will pick up to about 3 percent and remain at that rate in 2012 and 2013.

My forecast for these years continues to be more pessimistic than the Tealbook's because I continue to see the headwinds as being greater. Housing poses such a headwind. With house prices still falling and inventories still high, I don't expect residential investment to add significantly to GDP growth in the next couple of years. In contrast, the Tealbook forecasts that residential investment will grow at 6 percent next year. Through the effects of house prices on household wealth and consumer confidence, the continued woes of the housing market are also likely to hold back consumer spending, which is the key to the pace of the recovery. I expect consumer spending to expand a little more than 2 percent this year and a little more than

3 percent in 2012 and 2013. The pace of the recovery will also be slowed by cutbacks in government spending. On a medium-term basis, budget pressures likely mean that federal spending will grow more slowly than in the decade before the crisis or perhaps even fall. Many state and local governments will have to cut spending through the next year as stimulus funds from the federal government wind down and property tax revenues continue to fall. Even if

governments can avoid cutbacks, they won't be able to increase spending, as in past economic recoveries.

Turning to the inflation outlook, with gasoline prices easing off, overall consumer prices should slow in coming months. As to the underlying trend in prices, measures of core inflation, including the median and sticky price measures that are produced at the Cleveland Fed, have clearly moved higher this year. That said, in May the median and sticky price measures suggested less inflation than did the CPI excluding food and energy. Whether the broader increases in core inflation will last or lead to yet higher inflation is uncertain. The Tealbook interprets a fair chunk of the recent increase as temporary, and forecasts have fallen for core inflation from 2011 to 2012 in response to a large output gap and other forces. I'm instead inclined to treat the increase in core inflation this year as an upward shift in the path of inflation, although it does not signal an ongoing rise in inflation. I expect PCE inflation to gradually rise from about 1'' percent in 2011 to 2 percent over the next two years.

I base this inflation assessment on a few key factors. First, I have shifted the path of inflation up in light of the historical sluggishness of inflation, which suggests a lasting effect of the increase in core inflation this year. Also, the historical tendency for core inflation to rise during economic recoveries leads me to expect increases over the next few years. The reasons I expect only a small increase in inflation are that longer-term inflation expectations remain stable and labor cost pressures are very subdued. According to the model maintained by my staff, inflation expectations a few years forward have recently dipped a little and remain below 2 percent. With unemployment still very high, growth in labor costs is likely to remain low. New research done by my staff shows that recessions have long-lasting effects on growth in compensation.

I'll conclude by returning to the considerable uncertainty surrounding my outlook. While I've been saying uncertainty is elevated for the past few years, I believe that the level of uncertainty surrounding the economic growth outlook has increased since the last meeting. I base this assessment in part on the string of disappointing data releases and in part on the reports from my business contacts. A number of my contacts noted a growing sense of unease in the business community, and some reported a sharp falloff in activity in the past month. At this point my contacts haven't reacted too much to the swing in sentiment, but an increase in uncertainty makes a further erosion of business and consumer confidence a significant risk.

At the same time that the level of uncertainty has risen, the balance of risk has shifted in an unfavorable direction. In my view, the risks for GDP growth have shifted to the downside for some of the reasons I just mentioned, but in my view, the risk to inflation remains tilted to the upside. I worry that core inflation could continue to increase more than projected, especially if I prove to be wrong on the direction of energy and other commodity process or if longer-term inflation expectations become unanchored. As we'll no doubt discuss in the policy go-round, these recent changes in risks have added to the challenges for monetary policy. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. The Eighth District economy is showing some signs of a slowdown consistent with recent developments in the national economy. However, the June data, where available, do seem to indicate better business conditions going forward. Transportation companies in particular reported good business in the first weeks of June. Large firms remain lean and profitable, with plenty of cash. They are looking for opportunities to expand to take advantage of the continuing boom in Asia. The agricultural

industry in the District has been slowed by a wet spring, but poor weather has not so far been enough to hamper the outlook for agribusiness income in 2011. The recent pullback in commodity prices is likely to be helpful for many District businesses, as it means more disposable income for households. It appears that the recent experience with $4 per gallon gasoline did not significantly dent volumes at a major convenience store retail chain.

The District experience with consumer behavior and response to gas prices provides a small piece of evidence that Hamilton is right. Jim Hamilton, from the University of California' San Diego, has argued over many years that an oil price shock must send the price of oil significantly higher than recently experienced in order to really alter household behavior in a large enough way to send the economy into a prolonged downturn. And $4 per gallon gas has reduced disposable income for other purchases, to be sure, but does not appear to have caused a wholesale change in household behavior as it did in 2008. Partly because of this, it seems reasonable to me to look through the recent weakness in U.S. data toward better prospects for the second half of this year.

The U.S. economic outlook has been weighed down during the spring because of four global events, any one of which could develop into a significant global macroeconomic shock. I think none of the four will actually become a shock large enough to put the United States into recession. However, we have worked our way through only two and one-half of these events. The events are Japan, oil price increases due to disruptions in supply coming from the Middle East, the European sovereign debt crisis, and the U.S. fiscal situation. The effects of the disaster in Japan, while more significant than I had originally through, are now fading and are projected to be temporary. Commodity prices are retreating, as we sit here at this meeting. Europe is in the process of trying to resolve its way through the latest hurdle, but remains worrying as several,

including Vice Chairman Dudley, have commented already. There are certainly worrying questions about the willingness of Greece to repay under any conditions. There's no real longer- term solution on the table. I think restructuring will eventually be necessary. I think it can be carried off effectively, but right now it seems quite difficult to do without causing a global crisis or further crisis in Europe. Despite all this, I think a temporary solution is likely and will push this off to some future date. On the U.S. fiscal situation, I think a deal is possible and likely, but that event lies a little bit ahead of where we sit today. All in all, I think this assessment augurs for looking through the current weakness. The slowdown that we have seen so far in the United States this year does not strike me as being as severe as the one last summer that led to further easing by this Committee.

The prognosis for a second-half resurgence and a resolution of remaining key risks requires patience on the part of the Committee. We will have to wait and see whether stronger data materialize or are confirmed before we can evaluate the situation further. That puts the Committee in a 'wait and see' mode for the time being. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Lacker

MR. LACKER. Thank you, Mr. Chairman. Since the last meeting, we've continued to see a flow of soft economic reports: Retail sales, payroll employment, personal income, and national and regional manufacturing indexes have all been disappointing. It looks to us like a temporary soft patch in an otherwise recovering economy, and information from our District contacts supports that idea. Survey respondents have been mentioning the Japanese earthquake and tsunami, and most expect the effects to dissipate. This month we've heard reports of increased sales from manufacturers that are active in global markets as well as those supplying stronger sectors of the domestic economy, such as energy, transportation, and medical research.

And the composite index for Fifth District manufacturing, which fell sharply by 16 points in May to a reading of minus 6, actually ticked up 11 points at least so far in our preliminary numbers, which are almost all complete, for our June report that's due to be released next week some time. Reports from our region are consistent with this recent sluggishness being more of a temporarily lull than a protracted slowdown.

There are a number of one-time factors you can point to that can plausibly explain the soft patch being temporary. In addition to supply disruptions related to the Japanese disaster, there's the run-up and recent easing in gasoline prices and the spate of adverse weather. Others have mentioned these around the table. Soft patches are not unusual in growing economies, and some potential sources of strength remain. The fundamentals for export demand continue to look reasonably promising, and business investment demand continues to advance despite relatively modest overall sales growth. This is the second major soft patch in this recovery, and that makes it even more disappointing. When the recovery began in mid-2009, some economists hoped it would be relatively rapid, comparable in pace with the recoveries following other deep recessions, like the two that Larry Slifman showed us earlier. We did see a decent pickup in GDP growth in early 2010, and that prompted discussions of our exit strategy. In the fall, though, disinflation and a weakening growth outlook prompted our QE2 asset purchase program. But as the year ended, consumer spending firmed and the pace of employment gains increased, and that provided some grounds for optimism that economic growth was finally picking up, but now once again we're seeing slower growth than we had hoped.

It's easy to see why you would have expected a more robust recovery two years ago. Real GDP in the U.S. has shown a remarkable tendency, going back over 140 years, to return to a simple trend line corresponding to 3 percent annual growth. The exceptions, of course, are the

Depression and the period in World War II where it went above that line. But other than that, it generally goes back to that line and sticks remarkably close to it. That suggests that sharp declines are going to be followed by growth more rapid than trend'that is, significantly above 3 percent growth. But as the staff presentation makes clear, that's not what we've seen; that's not what we've gotten so far. Real GDP growth has averaged just 2'' percent over the last two years, and the level of employment is almost 5 percent below its cyclical peak. In contrast, two years after the big recessions of '73''74 and '81''82, which Larry Slifman showed earlier, real GDP growth had averaged more than 5 percent per year, and employment was about 4 percent higher than the previous cyclical peak. We seem to have had the worst of both worlds'a sharp, deep recession, as in the pre'Great Moderation era, together with a sluggish recovery, more typical of the Great Moderation era.

Obviously, if real GDP grows only around 3 percent, it will never catch up with that trend line. In that case, real GDP would trace out a parallel trend line that lies significantly below the one we've been on or around for 140 years. Even if growth gradually rises toward 4 percent over the next year or two, as in the Tealbook, it will still look as if our economy has experienced a downward shift to a new, much lower trend line. Now, admittedly, this type of large, highly persistent step-down in real GDP happens very rarely in the historical record, but for several decades now, many other developed economies have been tracking a trend line that's lower than ours'parallel but lower than ours. If you plot per capita GDP for OECD countries, the ones in Europe and Japan, which suffered in World War II, have come back growing more rapidly than ours but seem to have converged to a trend line that's at a parallel level below ours. One explanation that's been offered for the level difference between per capita measures for Europe

and the United States is differences in tax and regulatory regimes that increase the cost of doing business in those countries.

It's also been suggested that the United States could now be in the midst of a transition to a more European type of policy mix. This would be consistent with the widespread anecdotal reports we we've been getting for a year and a half about regulatory and tax changes that discourage business expansion. It's also consistent with our earlier discussion about sluggish consumer spending growth and was the motivation for my question about whether some impediments to hiring like regulatory and tax policy could be resulting in lower income growth which, of course, shows up in lower consumption growth. If policy changes are having such macroeconomic effects, we may need to accommodate ourselves, since they're outside of our control, to a persistently lower path for per capita output for some time to come. Now, there's certainly no conclusive evidence or proof that this is the case, but I think it's hard to rule out this disheartening possibility, given what we know. It's worth noting that to the extent that economic growth is being held back by the evolution of tax and regulatory policies in the United States, there would be virtually nothing monetary policy can do to correct the problem. Moreover, if we misdiagnose the problem as a deficiency of aggregate demand and adopted stimulative monetary policy to try and correct it, we would just raise the inflation rate and have little lasting effect on growth.

The current economic weakness is occurring alongside of a reversal of disinflation. Last year, year-over-year core PCE inflation declined from 1'' percent to 0.7 percent from April to December but then reversed'it's risen to 1 percent. And over the past three months, core PCE inflation has been running at an annual rate of about 2.3 percent. There isn't much to suggest, as President Pianalto argued, that this increase was driven by transitory factors. In that case, I agree

with President Pianalto. This looks like a fairly persistent step-up. In this connection, I think the evolution of the forecast on page 33 is pretty interesting. It shows that since last fall, the core inflation forecast has been steadily revised upward, but the forecast for real GDP has been revised down a little bit on net. The GDP forecast was revised down through September, and then in November, under the assumption of the QE2, it was revised up. However, since then it has been revised down again, and that's consistent with the notion that perhaps QE2 had very little lasting effect on economic growth but, if anything, just raised inflation. It also suggests that further stimulus aimed at pumping up real growth would be futile and would risk raising inflation too high.

CHAIRMAN BERNANKE. Thank you. President Williams.

MR. WILLIAMS. Thank you, Mr. Chairman. The intermeeting data have been worrisome. The extent of the bad news is starkly evident in the Tealbook projection, which shows a steep downward revision to growth this year and next'a remarkably large revision for just two months. Furthermore, despite the deep cuts to the output projection, the Tealbook has also shifted to a downside skew to the risks of the growth outlook. This combination of a downward modal revision to the growth forecast and downside risk assessment is a truly sobering development, but it's consistent with what we see in financial markets, such as lower Treasury yields, the faltering stock market, and the rise in high-yield bond spreads since our last meeting. The key question for the outlook for both output and inflation is how much of the recent news is transitory and how much reflects more lasting influences, clearly what a number of you have already been referring to. Now, I agree that many transitory factors have been working to push down output during the first half of this year. These include unseasonably cold and snowy winter weather, Japan-related supply disruptions, and the spike in energy costs,

especially the $4 per gallon gasoline, which I think we still have in California even today. Indeed, my business contacts trace much of the source of the first-half moderation in consumer spending to this spike in energy prices. They refer to both the direct hit to disposable income, but also the psychological punch to confidence that staggered consumers. In this regard, the substantial decline in oil prices and now, more recently, gas prices since our April meeting should help.

I remain stubbornly confident that the economy will bounce back from its recent stumbles. The recovery appears intact, though with significantly less underlying momentum than I had previously thought. Like the Tealbook, I expect economic growth to pick up in the third quarter of this year and to average about 3'' percent over the second half of this year and next year. With this return to above-trend growth, I expect to see renewed improvement in labor market conditions.

My business contacts provide two notes of optimism. First, my contact at a major Japanese auto maker reports that the Japanese auto industry is returning output to pre-crisis levels more quickly than initially estimated. Some plants are already operating at 90 percent of pre-crisis levels, and they're expected to be at full capacity shortly. Second, my contacts are quite enthusiastic about the economic boom developing in Silicon Valley. To give just one indicator, home prices in the Palo Alto'Cupertino area are up double digits from a year ago. New IPOs for private-share sales for LinkedIn, Facebook, Twitter, and other social media companies are providing a shower of cash. But we're nowhere near the craziness of the dot.com era of the 1990s'well, at least not yet. My contacts stress several important differences between the current episode and the dot.com bubble. First, any bubble-like exuberance is limited to a relatively small set of companies, and even these generally have solid customer bases,

revenues, and in some cases, even profits. For example, Facebook, with reportedly well over

600 million users worldwide, is no Pets.com. Furthermore, the broader tech sector, including, for example, Cisco and Intel, has matured considerably over the past decade. Some of the most actively traded tech stocks have valuations that seem reasonable, certainly by comparison with the levels of the dot.com era. Finally, my contacts describe a very different financing environment. The amount of venture capital in play is on par with its pre-crisis level, well below the dot.com surge, and a healthy dose of investor skepticism is evident. Importantly, from a policy perspective, I hear of no indication that near-zero interest rates are fueling the bubble in the venture capital sector.

Turning to inflation'and I guess this is my defense of core inflation'the story in the first half of this year was a sizable bump-up in headline inflation, and the second-half story may well be falling oil prices and an undershooting of headline inflation. These extreme movements in oil prices over the past few years reflect the underlying economics of inelastic short-run supply and demand in this market. Such idiosyncratic volatility is a reason energy prices are typically stripped out to formulate measures of underlying inflation. Indeed, research shows that including the measure of underlying inflation in forecasting models helps in forecasting headline inflation, and this result holds across a variety of samples and specifications. Various alternatives measures of underlying inflation all perform about equally well. The simplest of these'that's the ex food and energy core'I find to be a useful series to keep an eye on. It's also completely consistent with how we treat a variety of macroeconomic series. We look at core capital goods, which exclude the volatile aircraft and defense categories, and core retail sales numbers. Of course, I'm not'and I don't think anyone is'arguing that core inflation

should be the goal for policy. It's simply that core inflation has proven useful in forecasting overall inflation and provides a straightforward summary statistic for underlying inflation.

Let me turn to how I'm interpreting recent inflation numbers. Despite the dramatic fall in oil prices since our last meeting, I'm actually a bit more worried about the outlook for inflation, much along the lines of President Pianalto, and that's because of the somewhat firmer readings we have gotten on core inflation in recent months. It appears that there has been somewhat more pass-through of import and commodity prices into the core measures than we anticipated, and similar to the report from President Lockhart, my contacts have repeatedly stressed the pressures they are facing from higher raw materials costs, energy and transportation costs, and price increases from China. Still, they see recent price increases as a result of a confluence of a number of factors that are raising the level of prices rather than indications of a much higher inflation trend. This view is consistent with market-based measures of inflation expectations having retraced their increases from earlier this year. Therefore, looking ahead to next year, I see both headline and core inflation settling in at around 1'' percent.

In sum, looking through the temporary factors affecting output and inflation, I expect the recovery to continue, albeit at a more muted pace, and inflation to return to levels below my preferred long-run goal of 2 percent. Thank you.

CHAIRMAN BERNANKE. Thank you. Vice Chairman.

VICE CHAIRMAN DUDLEY. Thank you, Mr. Chairman. As widely noted, we've hit another soft patch. The key question is, what are the causes? Only by understanding the reasons for the soft patch can we gain confidence about its duration and the medium-term trajectory of the economy. It's clear that some special temporary factors played a role. First, the run-up in gasoline prices crimped real disposable income, and this weighed on consumer spending and

confidence. Supply disruptions stemming from the Japanese catastrophe limited motor vehicle output, and may have also depressed demand, as incentives were cut and some popular models were in short supply. In addition, there is considerable sentiment for the view that the ongoing housing market mess has played a role, with renewed weakness in home prices crimping household wealth and dampening confidence. And the price declines may have caused prospective home buyers to hold off, even though housing affordability has improved dramatically over the past few years. Bankers and other business people we talked to also cite regulatory uncertainty, although it's hard to see why, if this were indeed important, it would bite so abruptly.

Regardless of the cause, the weakness of the economy has to be viewed as quite striking at a time when monetary policy is viewed as very stimulative and the healing process following the crisis is evident in a number of areas, including household debt service burdens and credit availability. I would argue that there is a bit of a puzzle here. I'd like to suggest that there may be another factor'namely, monetary policy may not be as stimulative as we think it is. In this regard, I'm not arguing that monetary stimulus is less powerful than normal because of the housing mess or the fact that there are still necessary balance sheet adjustments in train. I'm making a different argument'that the degree by which monetary policy at a given accommodative setting stimulates real economic activity may diminish over time. This is not something that we've had much experience with, because normally the economy responds quite rapidly to easier monetary conditions. As a result, this will not show up empirically very clearly in our models or via econometric estimation. Put simply, we typically don't stay at very accommodative settings very long, so we don't have much empirical evidence by which to judge this.

Let me explain what I mean in a bit more detail. Monetary policy at a given setting might provide less lift to the economy over time because either the linkage between the federal funds rate and financial conditions or the linkage between financial conditions and the real economy may weaken over time. For example, as short-term interest rates stay low, the yield curve will flatten and stock prices will rise, but eventually the yield curve will have a more normal shape and the stimulative effects of monetary policy will peter out. Japan would be a good example of this. Similarly, the effects of easier financial conditions on aggregate demand may also diminish over time. Consider, for example, the prospective homebuyer or car purchaser who responds to a drop in interest rates by moving up the timing of the purchase. The homebuyer or car purchaser who purchases today will then not purchase tomorrow. To the extent that monetary policy influences the timing of purchases, its effects will peter out over time.

If I am correct that the degree of stimulus at a given rate setting to the economy lessens over time, this has a number of important implications. First, we might need to increase our degree of accommodation to have the same desired effect as earlier. Of course, this may not be easy to do at the zero lower bound and with an already enlarged balance sheet. If we cannot or will not do more, we should expect the recovery to be less robust because monetary policy has lost some of its power. Second, it implies that exit might need to wait until later because monetary policy will become less stimulative over time just as a natural matter of course. There may be less reason to exit early because the degree of monetary policy stimulus naturally wears off over time. Third, early tightening might actually exert considerably more restraint than we anticipate if policy is not providing that much of an impetus to economic growth at present. We don't have much experience sitting at the zero lower bound for years, and I hope we won't repeat

this in the future. That's why I think we must be open-minded and challenge our assumptions that the current stance of monetary policy is as stimulative as we think it is. I have encouraged my staff to work on this issue, and I would encourage others to do so as well. Thank you.

CHAIRMAN BERNANKE. Thank you. President Hoenig.

MR. HOENIG. Thank you, Mr. Chairman. First of all, our region has slowed as others have around the May'June time period. We are seeing some pickup more recently. Our regional factory activity has decelerated a little more than we thought it would, but it has appeared to stabilize, and we've seen some real pickup in our technology industry, especially in the communications sector. Certainly energy remains strong and agriculture remains strong, with very sizable profits in those sectors.

Turning to the national economy, I do expect that the outlook over the next several years is one of moderate growth for GDP. I think that reflects the fact that we are going through a necessary rebalancing due to both demographics and leverage, as households, especially an entire generation, are saying, 'I want to get this debt off my balance sheet.' And we have a younger generation that had too much and has to get it off the balance sheet, and they're pulling back. Businesses are repositioning themselves, and certainly local governments have to get rid of a lot of commitments and a lot of debt. The federal government is the only exception to that at the moment, and we see what they're doing with that. I do, though, expect a resumption of moderate growth. I think it's a testament to this economy that, given the amount of leverage we are trying to work our way through, we have seen economic growth at 2'' to 3 percent. As far as inflation goes, I think it's inevitable as long as we keep our policy as accommodative as it is. It will slowly'not rapidly, but slowly'increase, and we will have to watch that as we go forward from here. In terms of the risks, I think they're real. I think we have a very fragile equilibrium.

If you think about how many things we're worried about that could draw us back into a slowdown, it's pretty amazing. And when a situation in a country the size of Greece has the world at risk, we know how fragile this economy of ours is, global and nationally.

Solutions are not simple, I realize, and I know that's a discussion for tomorrow, but I'm not sure that keeping ourselves in this highly accommodative situation indefinitely will do anything but make it more fragile to where something very minor will tip us back, and that's what we have to be mindful of. Thank you.

CHAIRMAN BERNANKE. Thank you. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. Like the Tealbook, I believe there has been a slowdown of the pace of the recovery since our last meeting, and I think this slowdown has been influenced by temporary factors'factors that will reverse themselves in the months to come. My forecast for real GDP growth is similar to the Tealbook. I'm expecting growth to accelerate to close to 3'' percent over the second half of 2011, and I'm expecting growth to be between 3'' and 4 percent over the course of 2012. My relative optimism is shared by Ninth District business contacts. We'll be releasing a midyear business poll in our fedgazette later this month. That poll shows continued moderate improvement in business conditions in the Ninth District over the past year, with broad-based increases in sales and employment. Consistent with my national forecast, respondents in our District predict that the next 12 months will be even better. They indicate, too, that labor markets are relatively slack. By and large, they are finding that workers are widely available with muted wage pressures, and to put that in context, I should add that unemployment in our District is well under 7 percent. Firms do expect to expand hiring in the coming 12 months, and that labor markets will tighten slightly.

The poll also shows that firms expect to be able to raise prices over the next 12 months. This finding is consistent with what I see as the national inflation story. Over the past six months, annualized core PCE inflation was 1'' percent; this is a sharp acceleration of the rate of inflation. From April to October 2010, annualized PCE core inflation was 0.6 percent. Such a rapid rate of increase in six-month PCE core inflation has occurred but twice in the past 15 years. Other more broadly based measures of inflation paint a similar picture. The trimmed mean PCE inflation calculated by the Dallas Fed was 1.7 percent from October 2010 to April 2011. The median CPI reported by the Cleveland Fed was 0.9 percent from April to October of 2010 and then rose to 1.9 percent, annualized, from October 2010 to April 2011. Like the Tealbook, I do expect core PCE inflation to be 1.7 percent over the course of 2011, but unlike the Tealbook, I see core inflation accelerating still further into 2012, and I think this is a symptom of the fact that I see potential output as being lower than the Tealbook does, perhaps for some of the reasons that President Lacker mentioned.

The behavior of inflation points to diminution of slack in the economy over the past six months, and I think that the behavior of labor markets also does. Unemployment has fallen from

9.8percent in November 2010 to 9.1 percent in May 2011. Roughly half of this decline is accounted for by people finding jobs. The employment-to-population ratio has risen'small, but it has risen'by 0.2 percentage point. The rest of the decline in unemployment is due to people leaving the labor force. Now, a key question is: Are the people who departed the labor force waiting on the sidelines to jump back in when conditions improve? The Bureau of Labor Statistics provides monthly estimates of the number of people who are marginally attached to the labor force'more formally, those who were not currently looking for work but who would like to work and have looked for work in the past 12 months. That number has fallen by 9 percent

over the past half-year. This is suggestive that many of the recent departures from the labor force will not be temporary. More generally, as the unemployment rate falls, people find jobs or people decide that they're no longer available for work, and both of these decisions reduce the pool of available workers for a firm looking to hire. From the point of view of monetary policy, both kinds of decisions work in the same direction: They increase wage and inflationary pressures. That's why forecasting models tend to use the unemployment rate and not labor force participation as a predictor of future inflation.

I fear these recent data are reflective of longer-term uncertainties. Like most of you, I believe that the unemployment rate will fall back to between 5 and 6 percent by 2016, and in that sense, I do think labor market slack will normalize, but I am highly uncertain about how that reduction will be accomplished. Will the unemployed find jobs or will they leave the labor force permanently? The answer to this question is a critical one for the United States economy and for our thinking about monetary policy because it really will shape the longer-run behavior of what we consider to be potential output. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Evans.

MR. EVANS. Thank you, Mr. Chairman. The incoming data clearly show a reduction in the recovery's already modest momentum. In particular, the revisions to income, weak jobs and claims numbers in May, and the softness in second-quarter consumer spending throw cold water on my previously more optimistic forecast for a strengthening in aggregate demand. At this time it's hard to tell how persistent this weakness will be. My business contacts say their own businesses are still doing well. Indeed, several large manufacturers, like Caterpillar and Deere, continue to register very strong sales.

Like the Boston outlook, our baseline scenario is that economic growth will inevitably pick up to average about a 3'' percent pace in the second half of this year and in 2012. These rates are down three or four tenths from our last projection. Nevertheless it's easier to see the downside risks to the forecast than the upside potential. An important ingredient in my 3'' to

4 percent recovery rate is stronger consumer expenditures. Such pickup requires more robust job growth to kick spending into a higher gear. The labor market, though, is a continuing risk. I only heard a few firms talking about hiring more permanent workers. My contacts basically repeated their mantra: Businesses will continue to emphasize productivity gains and keep labor costs flexible. Translation: No robust hiring is planned.

More generally, uncertainty is substantial. Businesses have become more concerned about the economic landscape, but things are still only at the worrying stage, so the actual impediment to growth remains small for the moment. Substantial problems due to a financial distress cascade in Europe are still seen by nonfinancial firms as a vague tail risk. The U.S. budget debate is also adding to the climate of uncertainty and caution. To summarize my feelings about economic growth, writing down a forecast of 3'' percent over the next 18 months continues to be a nice intellectual exercise in the power of positive thinking. [Laughter]

With regard to inflation, I admit that a case can be made that today there is more reason to worry that underlying inflation could be headed higher. After all, we've had the recent increase in core inflation piled on top of the already higher overall index. But I would like to stop at this point and, in line with President Williams, defend what I'm talking about in terms of underlying inflation. Recently in the press and other places, it seems like it's almost a dirty word to mention the core CPI or underlying inflation. To me, underlying inflation is the component of total inflation that's persistent and useful for forecasting inflation over the medium term. I agree

that this is a pretty common concept in so many other things that we do for forecasting the real economy, like core orders and things like that. My view is that the core and median CPI, PCE, and trimmed mean fit this characterization, and they're very helpful for forecasting inflation.

We convened our academic advisory council last week, and many of the participants were uncomfortable with our assessment that inflation expectations remained well anchored, and disconcertingly, even the most ardent efficient marketer among them didn't think we could rely on financial market data or other such indicators to provide reliable forewarning that inflation was going to take off. This viewpoint I find maddeningly short on actionable state-contingent triggers. People just throw up their hands and don't really help me think about what we should be looking at, no matter how hard I press them.

Having noted these inflation worries, the recent higher inflation data have caused most of our inflation models to revise up a bit, but nearly all still generate forecasts for total inflation well below 2 percent in 2013. Interestingly, the model that focuses most squarely on financial market data, the one that uses the term structure of Treasury interest rates, has a noticeable bump-up in core inflation to 1'' percent in 2011, but then sees core inflation coming down to 1'' percent by 2013. I'm sure that these dynamics would be the same for other measures of underlying inflation, such as the median and trimmed mean measures. This model builds an overall inflation forecast by adding in expected price changes for food and energy, and that analysis projects total PCE inflation over the medium term will be well below my 2 percent goal. I just do not see the medium-term risk to inflation as accelerating, as others have mentioned. Indeed, the model's 2013 inflation projection is a bit below its previous forecast. This reflects the decline in nominal interest rates we've seen in this period, as well as TIPS breakevens, inflation swaps, and inflation caps. They all suggest that financial markets are not expecting an

outbreak of inflation. After putting all of our model and anecdotal information together, we submitted a forecast that has both overall and core inflation coming down to about 1'' percent in 2012 and staying there in 2013. Now, there are upside risks to this inflation forecast, but inflation continues to be below what I think of as our goal, 2 percent over the medium term, and I think that we should be symmetric in our attitudes toward these policy losses. After all, I think of 2 percent as a goal, not a catastrophe or a ceiling. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you very much. President Fisher.

MR. FISHER. Mr. Chairman, I am going to dispense with my usual sunshine report about my Federal Reserve District, if only for fears that the governor of Texas will run around saying we've created 3 trillion percent of the jobs'[laughter]'in America, but with one exception. I want to say that whatever momentum President Pianalto has in her District is solely due to the fact that the Dallas Mavericks trashed LeBron James and the Miami Heat. [Laughter]

Very quickly, Mr. Chairman, what I'm hearing is that liquidity is not an issue. I have talked about that before; I won't repeat it. There is no question that the rate of the recovery has slowed, and I just want to make a few comments on this inflation discussion that we have heard from many of our colleagues. With regard to the trimmed mean, which, as you know, is our guidepost in terms of the PCE inflation, the fraction of prices declining has come down to

29 percent in the last PCE measurement. In two of the last three months, the number of components increasing at a rate greater than 2 percent have exceeded 50 percent, and that number has been near 50 percent in three of the last four months. Having said that, we have seen a rise in the trimmed mean, but over the last 12-month period, and even the 6-month period, we are really still talking about 1'' to 2 percent. So it has risen from 1, or actually from 0.9.

The anecdotal evidence is something of a cognitive dissonance message. Going back to President Lockhart's initial intervention, we are hearing from the big-box retailers that they are indeed passing through price increases. In one particular instance, starting at the end of June, 40 to 50 percent of their entire product line will put through price increases of between 5 and

8 percent. Dissonance comes from those with alternative business models. Dollar General, for example, has made it clear it is just going to eat into its margin to buy market share, so there's a bit of a tug of war taking place. We are hearing constant concerns about escalating prices in China due to not only wage increases in an effort to push people inland, but also the transportation differentials and the structural changes associated with the infrastructure of moving inland; you are still running at 15 to 18 percent in terms of adjusted labor costs. The good news is that people are looking elsewhere in terms of changing their supply chains and are doing so rather quickly. This puts Mexico, by the way, despite its crime problem, in a much better light. I was reminded at the last meeting that I have to be careful about using anecdotal evidence, but I think it's not clear yet whether or not these companies will succeed in pushing through these price increases. Yet significant price increases, on the order of 5 to 8 percent, are indeed planned at present on some basic products, ranging from diapers to paper products to essentials. We'll have to see what happens, because I think that might affect inflationary expectations.

With regard to job creation, one of the things that I am concerned about is the constant effort by businesses to enhance productivity. This was mentioned earlier, I believe, by President Evans. Again, they're using inexpensive money, widely available capital, to continue to drive their productivity'and I know the numbers have come down'to try to do as much work and have as much output in goods and services with the least amount of human labor possible. So I

remain very concerned about job creation in the United States. And I think this dampening of demand and this slowdown that we have all discussed here may further that process and retard the process of job creation. I will report one thing I have noticed in my own sampling of anecdotal evidence from the CEOs and have now heard from other people. For example, Ivan Seidenberg's last act as the head of the Business Roundtable was to instruct the staff to reduce the estimations of cap-ex and headcount, because what both of us have noticed is that those that operate internationally seem to be much more optimistic about the United States than those that operate solely in the United States. So I am worried about job creation. I do note that there's a tug of war taking place on the price front. It is driven not simply by commodity prices, and I think that still needs to be resolved. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Yellen.

MS. YELLEN. Thank you, Mr. Chairman. Like everyone around this table, I grappled with two main questions in developing my forecast for this round. First, does the unanticipated weakness in economic activity evidenced since April represent a temporary soft patch or, instead, a more significant and disturbing absence or loss of momentum? And second, does the recent escalation in inflation represent a temporary bulge or, instead, portend a more persistent upward shift in the medium-term inflation outlook? I found the second question easier to answer than the first, so let me start with inflation.

The key question bearing on the medium-term inflation outlook is how to account for the very substantial increase we have seen in core. For example, core PCE inflation in the three months ending in April, and core CPI inflation in the three months ending in May, were

1.9percent and 2.5 percent, respectively. And that contrasts with 0.8 percent and 0.6 percent

inflation for the same indexes in 2010. Delving into the details, it appears that a large fraction of

this increase was attributable to surging commodity and food prices and the Japanese supply disruptions. In particular, exceptionally large increases in the PCE prices of transportation, restaurant services, and motor vehicles and parts explain a substantial fraction of the run-up in the core PCE. A whopping 0.8 percentage point of the roughly 2 percentage point step-up in core CPI inflation reflected higher prices of new and used motor vehicles. With popular models in short supply, there has apparently been less discounting and fewer incentives, and pressures have spilled over to the used car market. We should also not be surprised to see limited pass- through of recent commodity price increases in a broad array of non-energy goods and services. Our directors and business contacts have told us consistently that they intend to pass higher input costs on to their consumers, and it seems obvious from the data that they have succeeded. Importantly, commodity prices have stabilized, even receded a bit, and Japanese production has come quickly back on line, so these pressures on core should dissipate going forward. With stable longer-term inflation expectations, minimal cost pressure from wages, moderate productivity gains, and a higher projected path for unemployment, I anticipate, in line with the Tealbook, that inflation over the forecast period horizon will decline below the 2 percent level I consider most consistent with our dual mandate.

Turning to the weakness in spending, I had a much harder time deciding how large a share to attribute to rising food and energy prices and the Japanese supply disruptions. Higher food and gas prices have taken an obvious toll on cash-strapped consumers. This is evident in anecdotal reports indicating that businesses catering to lower-income consumers have seen particularly large declines in sales. The response of consumer spending to the increase in higher food and energy prices may have been abnormally large in recent months, given that a sizable fraction of households are currently underwater in their mortgages and heavily credit and

liquidity constrained. And with exceptionally high unemployment, many households may be unable or reluctant to respond by tapping precautionary savings. However, with commodity prices having stabilized, even receding slightly, and Japanese production coming back on line, it seems reasonable to project that the growth rate of consumer spending will pick up noticeably in coming quarters. That said, I followed the Tealbook's lead and lowered slightly my medium- term economic growth forecast in response to incoming data. I also revised my risk assessment relating to growth from balanced to skewed to the downside. These revisions reflect the broad-based character of the recent weakness and my growing concern that business confidence is eroding, causing firms to put plans for capital projects and hiring on hold'a response I see as exacerbating the slowdown and creating the potential for a self-fulfilling negative feedback loop to develop, a phenomenon that could cause the recovery to stall.

During the past month or so, I have met with Reserve Bank directors here at the Board and on a visit to Cleveland, and I have been carefully reading the reports that the Reserve Bank presidents submit in conjunction with your discount rate requests. The two words that crop up continually are 'uncertainty' and 'caution.' Survey measures of business confidence have declined, and a growing, albeit ill-defined, sense of malaise has surfaced. It reflects uncertainty about the strength and the durability of the recovery, along with myriad other worries including concerns about ongoing sovereign debt issues in Europe and the United States, uncertainty about fiscal and regulatory policy, and anxiety about geopolitical risks in the Middle East and North Africa.

In this regard, an interesting Tealbook box documents that uncertainty, while below the highs achieved during the financial crisis, is now abnormally high. Interesting theoretical work by Nick Bloom at Stanford has modeled time-varying uncertainty. Bloom finds that increases in

uncertainty can lead to large drops in economic activity because a rise in uncertainty makes firms cautious. It causes them to pause hiring and investment. Of course, our Chairman's early research focused on exactly such behavior. He developed a theory of cyclical investment fluctuations based on the idea that events whose implications are uncertain can depress investment by temporarily increasing the returns to waiting for additional information. Waiting is a way to avoid costly mistakes. The reports of Reserve Bank directors provide abundant evidence of such behavior. They routinely report that, because of heightened uncertainty, they are postponing hiring and investment decisions, and, more generally, deferring commitments. In financial markets, we have witnessed a pullback from risk-taking activity that may reflect similar motivations. For example, conversations of our staff with market participants after the June SCOOS survey point to a broadened, persistent decline in the use of leverage by investors. Our staff notes that this phenomenon appears to be longer-lived and to lack any specific and identifiable trigger, instead reflecting a confluence of worries about sovereign debt, geopolitical risks, and a slower pace of recovery. Market participants report that this pullback has been accompanied by a significant decline in market liquidity.

While firms and investors are apparently waiting for the fog of uncertainty to lift, my modal outlook is that it will. It is premised on the assumption that a revival in auto production and sales next quarter, coupled with diminishing drag from food and energy prices, will cause economic activity to rebound in coming quarters, in turn diminishing business uncertainty, improving confidence, and setting the stage for moderate economic growth. The current weakness is, thus, a soft patch. But I also attach some probability to a darker scenario in which businesses' responses to uncertainty add to the numerous other headwinds and financial risks and end up aborting an already fragile recovery.

CHAIRMAN BERNANKE. Thank you. Governor Duke.

MS. DUKE. Thank you, Mr. Chairman. My first observation is that the commercial banking conditions are not nearly as twitchy as financial markets. As Governor Yellen noted, financing conditions in the dealer space tightened noticeably in recent weeks. Reports covering bank credit have followed the same contours for months. Bankers are still reporting slow but steady progress on credit quality, and all are facing weak loan demand. It's hard to judge, but I get the sense that those who are seeing their outstandings increase are the ones who had less significant credit problems originally, and now have less dollars invested in runoff portfolios or are losing less volume to charge-offs.

New production seems about the same everywhere at levels one-fourth to one-third of pre-crisis levels. In areas where there is volume to be had, competition is ferocious. All banks characterize the competition, in C&I lending especially, as irrational, and they call out each other's names'particularly at the upper ranges of the middle market. For quality credit, banks are competing on price, terms, and hold amounts, which is the portion of a credit they will hold in syndicated deals. Competition for small business and lower-middle-market deals seems a bit more disciplined, at least so far, and several larger banks reported that smaller banks were entering the market for C&I lending as they were being forced out of commercial real estate lending, but they warned that the smaller banks lacked the same level of controls, covenants, infrastructure, and experience in commercial lending that the larger banks have.

Auto lending may also be emerging as a battleground. As you might recall, auto lending was the first product to return to normal. A few banks talked about increasing focus or entering this market, and another traditional auto lender complained that at any given price point, other

banks are buying deeper into the credit pool or lending at higher loan-to-values than has been prudent in the past.

All this competition stems from pressure on earnings, as deposits continue to grow and banks have no place to invest the funds. This became really evident when nearly every CEO, unprompted, told me exactly how much cash he was carrying. Clearly, the incentive to lend is there, but the demand is not, and banks do not yet have any stomach for easing credit standards to get it. In addition to the lack of loan demand, the profit dynamics of checking accounts are changing radically, with regulatory restrictions on overdraft fees, higher FDIC insurance costs, interest on commercial accounts, and, of course, the prospect for reduced income from interchange fees.

Finally, anxiety levels are quite high about capital and liquidity requirements, stress tests, and regulatory burden. On the side of displaying confidence in the future, however, unassisted M&A heated up in the last week, with the positions of the fifth-, sixth-, and seventh-largest banks, in terms of deposits, shifting twice in the last week.

In reviewing my notes, I started to muse, like Vice Chairman Dudley, and it occurred to me that there are still significant populations of borrowers that have not been able to take advantage of lower rates'or, in the language of the DSGE memo, those who are still facing risk premium shocks. [Laughter] So I wonder if we might be able to increase the effectiveness of the actions we have already taken by looking at some ways to reach those who have not yet been able to refinance or restructure at the lower rates. First, in the mortgage market, as rates fell, those with good credit, income, and equity refinanced, often more than once, but there is still a significant number of performing mortgages with higher coupons that for some reason have not been able to refinance. We should look at them and try to figure out why. Second, although we

have steadily pressured lenders and servicers to modify residential mortgage loans, when lenders modify commercial real estate loans, including reducing interest rates or even removing interest rate floors, they are labeled as troubled-debt restructures, and the banks who do them are subject to additional examiner pressure. So we should take a look at the incentives or disincentives to reduce rates on commercial mortgages. Third, guidance recommending increased risk management as construction and commercial real estate lending approached 100 percent and

300 percent, respectively, of capital are now almost universally regarded as caps. Banks that are over one or more of the guidelines have reduced CRE loans by more than 11 percent, while those who are comfortably below the guidance have reduced CRE by less than 2 percent. The population of banks may not be exactly the same, but more than half of the dollar decrease in CRE outstanding over the past year is in portfolios held by banks that are at or close to one of the guidelines. And while losses have been high in construction lending, they have been significantly lower in loans on existing properties, and lower still on owner-occupied properties. Revisiting these guidelines and the way they are being enforced, especially the overall CRE limit, could enable some borrowers to refinance commercial properties at lower rates and some small businesses to access more credit. And it might also allow some smaller banks to lend more in real-estate-secured credits that they understand and less in some of the C&I space that they don't.

And because the theme of this meeting has been models, I would like to challenge the notion of a single representative household making decisions based on rational expectations. In my experience, most of the households I saw as a banker made spending decisions based on how much money they could put their hands on. [Laughter] A lot of that came from debt'from growing credit card balances, home equity loans, cash-out refinances, and using home equity and

cash-out refinancing to pay off credit cards and reload for more spending. In those years, spending grew faster relative to income than we might have expected. Now that mortgage, home equity, and credit card debt is shrinking and consumer spending is disappointing, it seems likely to me that housing wealth and the ability to tap into it through debt may be more important to consumer spending than investment wealth. Finally, the inability of a growing number of credit- impaired borrowers, combined with additional regulation on mortgages and credit card products, means that a large population of consumers have no access to credit and can only react to higher food and energy prices by cutting spending on other things. I guess the model in my head has at least two households: one that is making rational choices based on preferences and expectations, and another that is just trying to survive using whatever nominal dollars they can put their hands on to buy the things they need. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. The polite term for those folks is 'liquidity constrained.' [Laughter] Governor Tarullo.

MR. TARULLO. Thank you, Mr. Chairman. I want to give my own rendition on a theme on which Eric, Jeff, and Bill have already played variations'and that is, the way in which the gap between what most people, including many of us, expected in terms of the recovery and what has actually happened should affect the intellectual constructs that we are bringing right now in thinking about policy. If you count this quarter as complete, there have been eight quarters since positive GDP growth reappeared in the middle of 2009. And of those eight, growth was significantly above trend in only two, 2009:Q4 and 2010:Q1. These, of course, are the two quarters that probably benefited the most from stimulus spending and, to some degree, probably from relief that a full collapse of the financial system had been averted. There is only one other quarter with above 3 percent annualized growth, and just barely so. Of the other five,

one was just about at trend, given the central tendency in our forecast, and four of the eight had economic growth well below trend, as reflected in the central tendency. So this looks to me a lot less like a case of cruising along and occasionally hitting a soft patch than a case of slogging through mud and once or twice hitting a stretch of dry pavement.

Similarly, while the supply disruptions caused by the Japanese earthquake are surely transitory, the lower level of defense outlays early this year probably is, and the run-up in commodity prices may be, I recall that some other less-than-robust growth quarters over the past couple of years have also been explained by reference to transitory factors. The factors in question may well have been transitory, but new negative transitory factors still seem to keep cropping up. This pattern suggests that the dominant narrative during the past year and a half of a recovery characterized by solid, if unspectacular, growth as the economy recovers from a serious recession may not be the best diagnosis of what has been going on. And if that's the case, there are obviously potential implications for policy. And, in fact, to wrap in the earlier discussion, I think the differences among the DSGE models that Michael was explaining earlier today reflect a lot of this, because, as we saw, the depressing New York Fed DSGE model seems to do best, I think, because it places so much weight on the breakdown of financial intermediation, which is obviously related to what we've seen over the past couple of years. This leads to a search for a better explanation for the past couple of years, one in which I know the Board staff is vigorously engaged right now, and some suggestions about which were offered earlier by Jeff and Bill. Jeff offered what I might characterize as a neo-declinist explanation.

MR. LACKER. I thought it was neoclassical. [Laughter]

MR. TARULLO. And Bill offered the explanation that monetary policy has maybe been too timid. Mr. Chairman, I'm not sure if you want to try the second one out in your press

conference tomorrow, but these are two possible explanations. I think there is a third, which may not be inconsistent with Bill's'that what made this recession so different from the other two recessions that Larry was talking about is that this is a financially induced recession.

Returning, once again, to the Rogoff'Reinhart theme that I have mentioned so many times before, there is probably some good reason to believe that the effects of a financial crisis that results in a serious recession take substantially longer to work themselves out more fully. I think when we look at the performance factors that have been consistently overestimated'the house price recovery and PCE, in particular'we see that they may well be linked to the etiology of the crisis itself. So it does seem as though some emphasis upon the continuing effects of the direct impact of the crisis on housing markets, on the operation of financial intermediaries, and on residential mortgage securitization, and on servicing could accumulate into something that has a continuing drag upon not just household wealth, but also consumer confidence and, as Tom was mentioning earlier, the repair of household balance sheets.

I would suggest one other thing, which some people have mentioned a number of times over the past couple of years, and that is the degree to which some secular changes in the economy that were under way before the crisis have maybe been accelerated, and have in turn exacerbated some of the problems associated in particular with job creation. For instance, if we have had a number of relatively mature industries that were already beginning to restructure, and they lost employees very, very quickly during the recession, and other industries have, understandably, not picked up the slack, you'd have a bigger effect on unemployment. Another interesting phenomenon of this recession is that, unlike the past several, there has been relatively little creation of new businesses that, in turn, add employment. There have been lots of new businesses formed, but they are overwhelmingly sole proprietor businesses, which are deemed

businesses just because people file a Schedule C. In terms of new businesses that actually add employees, the performance in the recovery from this recession has been the worst since these numbers were kept. Other things may be going on with job creation that have been exacerbated by the housing crisis and its aftermath.

This is all hypothetical, obviously, just as I know Jeff and Bill were offering hypotheses. But I do think that there may be implications for policy going forward'and not just retrospective, better explanations for what has happened over the past couple of years. I will hold those for tomorrow. But at the very least, I think we all need individually to come to grips with the degree to which our own expectations over the past couple of years have been'maybe for some of you they haven't'more or less continuously dashed. We need to find a better explanation, I think, as to why, and thus what we may want to do in the future.

Now two other points that have very little, if anything, to do with this theme. One, regardless of what the right metaphor is, whether it's cruising along with soft patches or slogging along and hitting a little bit of dry pavement, there is no question but that the economy is particularly vulnerable right now for all the reasons that many of you have mentioned. Janet talked about the Middle East and North Africa, which is an area that almost fell off of everybody's radar over the last couple of months, but of course it's still there, as are a bunch of others that are not front and center. I think this raises the possibility, to change transportation metaphors, of a stall-speed risk, and thus something else to be watching for. And then a final point on inflation. I asked staff and others a bunch of questions about inflation, and I was struck by the fact that they perceived persistent inflation in services. I am told that the lion's share of the explanation for that is in rents. And if that's the case, that could be another byproduct of a dysfunctional housing market. I suppose if I'm questioning whether otherwise conventional

explanations of transitory factors are actually holding, we should probably watch this as well over the next couple of quarters. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Raskin.

MS. RASKIN. Thank you, Mr. Chairman. The moderate pace of the economic recovery continues to be shaken by various forces. As a result, in the short and medium terms, we seem to be moving further away from our mandates. And, as we learned from this meeting's financial stability presentation and memo, financial stability, too, is presenting a key risk. To my mind, the forces that are shaking us off the moderate growth path are related to declining home values, rising prices, and growing and longer-term unemployment, all of which are weighing on consumer confidence. Wrangling over the debt ceiling isn't helping as our lawmakers remain at odds over raising the cap by $2.4 trillion. The Conference Board shows a dip in the confidence index, even from April. Americans are more pessimistic about the economy and their income prospects. Something I had never heard of before I came here, the so-called misery index, which means what it sounds like it means, is on an upward trajectory.

As I have noted before, one fulcrum of concern is housing. Residential construction has subtracted from growth in GDP in four of the seven quarters since June 2009. That is a contrast with the past three recoveries, when housing added to economic growth for at least a year and a half following the downturns in the 1980s, 1990s, and early 2000s. Two years ago home prices stopped falling, as low prices, along with homebuyer tax credits, spurred a surge in sales.

Demand then collapsed last summer when those credits expired. Markets currently don't have enough buyers to absorb a steady flow of foreclosed properties. This phenomenon is broad based. Twelve of the 20 metropolitan areas tracked by Case-Schiller have posted new lows. Only the Washington, D.C., and Seattle metropolitan areas saw month-to-month growth. Indeed,

the share of mortgage borrowers who have negative housing equity has moved up further in recent quarters to above 25 percent. This figure translates into about 12 percent of all households. These falling equity values dent consumer confidence. They remind homeowners that each month they are making monthly payments on mortgages that exceed the value of their homes; it underscores that the investments in their homes are shaky and not capable of being drawn upon for home improvements, college tuition, or unforeseen medical expenses. Some of these homeowners will throw back the keys, but even more will attempt a modification in order to try to get some relief from a burdensome monthly payment. Those who become delinquent will get on the slow train toward foreclosure.

This is a train to nowhere, not just for the homeowner, who will soon no longer be a homeowner, but for the bank that holds the mortgage. The large bank holding companies most actively involved in mortgage-related activities continue to add provisions for repurchase losses. Repurchase reserves for the four largest bank holding companies now stand at about

$11.8 billion, which, even at that staggering amount, is believed by many supervisors to be insufficient. Foreclosure is also a train to nowhere for the economy, because increased foreclosures are a continued rightward drift in supply, further depressing home prices.

One of the big pressures on the demand for housing is the creation of households by younger people. In a sign of the interconnectedness of the problem of unemployment, many young people'who are suffering more than average from unemployment right now'are doubling up, moving in with friends, with family, and with landlords by necessity, who themselves are struggling to pull together the monthly mortgage payment and are posting extra rooms in their houses on Craigslist to bring in extra cash. During normal times, about

1.25 million households would be created each year, but that figure now stands at roughly

750,000. If falling prices cause buyers of all ages to delay purchases, prices will be pushed even lower. One possible method of halting this rightward shift in supply is to intervene with homeowners before delinquency and move them away from the entry point to the foreclosure pipeline. Properly structured short sales are one way this could be explored. In addition, interventions that consist of government purchases of vacant properties in the foreclosure pipeline could also slow a rightward supply shift and a downward demand shift.

To sum up, both declining home values and more, and more longer-term, unemployment are weighing on confidence and consumption. The effects of this dampening seem to be more evident because growth in GDP is not robust enough to mask them. It's like the turbulence you feel on an airplane, which is always worrisome, but is all the more worrisome when the plane is flying closer to the ground. Alternatively understood, the behaviors that are emerging from the intersection of the housing market, unemployment, and confidence impose social costs that are showing up in slow consumption and slow growth in ways that are now unmasked and ways that we are only beginning to understand. We don't completely understand these interactions of depressed indicators, but they seem entirely relevant to our assessment of economic conditions and the future path of our economy.

CHAIRMAN BERNANKE. Thank you very much, and thanks, everyone, for what I thought was a really interesting discussion. I'm going to recess the meeting in just a moment, so that we can all go home and take a shower before the British Embassy dinner. [Laughter] First, let me just say that tomorrow morning we'll start with my summary, and then we'll go into the policy go-round. We also have a short item with Governor Yellen relating to the external communications policy.

Before you leave, make sure you have a copy of the exit strategy statement. The staff has made some changes based on the discussion we had earlier today. If time permits'and I certainly don't guarantee that it will'we could look at it collectively tomorrow at the end of the meeting. Otherwise, we'll be in touch with you by long distance just to see whether this is an improvement or not. Again, at this point, I don't think we are completely committed to putting this in the minutes, but I think it would be a good outcome, if we can get sufficient agreement. So take a look overnight, if you have a chance.

We'll start tomorrow at 9:00 a.m., and I'll see you shortly at dinner. Thank you. [Meeting recessed]

June 22 Session

CHAIRMAN BERNANKE. Good morning, everybody. Thank you again for what I thought was an unusually constructive discussion yesterday. Let me start the morning with my attempt at summarizing the economic go-round.

Participants took note of the recent weakness in the economy as incoming data have almost uniformly disappointed. In part, this soft patch is the result of factors likely to be temporary, including the effects of the Japanese disaster on supply chains, the impact on consumers and firms of the sharp rise in energy prices earlier this year, bad weather, and concerns about fiscal developments. Most participants saw a moderate recovery still in train, strengthening somewhat over time, but most also saw some longer-lasting loss of momentum and marked down their forecasts accordingly. A more pessimistic view is that the strong quarters of economic growth since the end of the recession have been the exception rather than the rule, as financial and economic headwinds have been stronger than we thought or potential output growth is slower than we thought. Overall, downside risks to growth have increased as the slow pace of the recovery brings the economy near stall speed and makes it more vulnerable to new shocks. Inflation, both core and headline, has risen recently. Again, some of the factors involved may be temporary, such as the rise in commodity prices that has recently reversed and the effects on prices of the supply chain problems. On the other hand, input costs other than labor remain high in absolute terms, and firms will try to pass these costs on if they can; also, core inflation tends to be persistent. The risks to inflation seem more balanced than at our last meeting, but a number of participants still see those risks as tilted to the upside.

Consumers remain cautious, and spending has remained subdued. In part this reluctance to spend reflects high gasoline prices, especially on liquidity-constrained consumers, and the effects of supply chain disruptions on auto sales, effects that may dissipate. The recent

weakening in labor markets, pessimism about income prospects, and stressed household balance sheets are also negative factors. A weak housing sector has also restrained consumer confidence. In the housing sector, prices have continued to fall in most cities, and sales and construction remain depressed, in part because potential buyers are afraid of buying into a declining market. About 25 percent of mortgage borrowers have negative home equity, implying restricted access to credit and a greater propensity to default.

In the business sector, there are some signs of greater caution since the last meeting, especially among smaller businesses. Surveys generally show reduced expectations for orders and production, especially in manufacturing. As noted, although commodity prices have come down, input cost pressures remain significant. High gas prices have affected consumer demand and shopping trips. Uncertainty about the recovery and about government policies remains an issue. Firms continue to seek productivity gains in lieu of hiring, which may explain some of the relative strength in the rate of investment in equipment and software. For medium and large businesses, balance sheets remain strong, profits high, and access to credit good. Supply chain disruptions were somewhat more severe than expected but are being overcome. Among key sectors, energy, agriculture, high tech (notably in Silicon Valley), and tourism are all doing well. State and local governments are a source of fiscal drag, and the federal government is expected to become such a source as well by next year.

Financial conditions weakened during the intermeeting period, and volatility increased. Equities, bond yields, and bond spreads all reacted to the disappointing economic news. The European sovereign debt situation was a particular source of volatility; although there have been a few moderately encouraging developments in that area, there is little evidence that a lasting solution is forthcoming. The debt limit debate does not appear to have had large effects on

markets as of yet, but the risk is potentially serious. Risk-taking moderated some over the intermeeting period as concerns about the economy and financial stability increased. Liquidity remains ample. Banks are seeing a slow but steady improvement in credit quality but remain concerned about new financial regulations. With loan demand generally weak, competition for creditworthy borrowers, especially larger firms but also some others such as automobile buyers, is intense. Credit remains tight in many markets, however, including those for residential mortgages, CRE lending, and consumer lending.

As noted, inflation'both core and headline'has risen in recent months. Headline inflation should moderate if the softening in commodity and raw materials prices persists. The increase in core inflation also partly reflects effects likely to be temporary, such as increases in the prices of new and used autos. Wage pressures have remained subdued in a weak labor market, and inflation expectations remain anchored. However, there is some concern that the recent rise in core inflation and related measures, such as the median and trimmed mean CPIs, may not be entirely reversed. Such measures historically have tended to be persistent, especially in expansions, and shelter inflation'an important part of the indexes'seems poised to rise, as credit constraints push people into renting rather than buying highly affordable single-family homes.

Several observations were made regarding monetary policy. One participant noted that a pattern of economic growth surprising to the downside and inflation to the upside is consistent with potential output being lower than we might think; the implication is that excessive monetary stimulation will lead primarily to inflation rather than output growth. On the other side, it was suggested that the efficacy of monetary policy may decline when accommodation is maintained for a long time, as financial conditions become less responsive and as aggregate demand is

shifted over time rather than growing persistently. Assuming that monetary policy is not completely ineffective, this implies that greater (or more extended) accommodation may be needed to obtain a given effect.

That was my summary. Any reactions, comments? [No response] Okay. Thanks. So having said all that, I don't know how much more 'value added' I have at this juncture, but let me just say a couple of words.

Clearly, we've had a very disappointing first half this year. Indeed, in some ways we're lucky that the unemployment rate on net over 2011 hasn't risen, and so we've maintained much of the gains from November to January, despite the fact that output growth has been below what we think to be potential output growth. In trying to dissect the slowdown, first, obviously there are some temporary factors. Auto production, for example, has been held down by the supply chain disruptions, but currently assemblies are projected to increase by 1.5 million at an annual rate in the third quarter. You can see the demand for that in depleted inventories and the fact that sales were reduced because of unavailability of some attractive models and because the lack of incentives increased prices. It's a reasonably good assumption that, barring a major further slowdown, autos will be a source of economic growth in the next quarter or two. We've all discussed a number of other factors. Defense spending seems to have been unusually low. Regarding the commodity price, and particularly the oil price, effects, even the flattening of oil prices would be supportive of greater growth. In fact, what we appear to be seeing at this point is a decline of nearly $30 per barrel in oil prices from the peak, which certainly will be a positive going forward. Europe seems likely to be stable, at least for a while, and maybe we will see a pattern similar to last year, when a springtime upsurge in concern about Europe led to stock

market declines and some economic weakness, but those concerns were addressed, and some of that effect was mitigated.

While temporary factors certainly are important, I would add, that there are some positive indicators that a moderate recovery is proceeding, despite the very well-founded concerns about the labor market. I think it should be kept in mind that, in the four months preceding my August 2010 Jackson Hole remarks, which intimated QE2, monthly private-sector job creation was 80,000 on average; in the next four months it was 140,000, and so far this year, including the weak report in May, average private payroll growth has been 180,000 per month. So there seems to be some improvement there. The risk, of course, is that May is more indicative than the earlier months of the year. Real equipment and software spending is still strong, as many people noted. There are different interpretations for that. I think I lean toward the interpretation that maybe the uncertainty is not quite as large as it's sometimes made out to be. Indeed, profits are, in fact, very strong, and balance sheets are very good. Export demand is strong. The other interpretation is that equipment and software spending reflects the substitution of capital for labor, but again, I think that's less likely than the other.

The housing sector is hard to read. It's been a disappointment for some time. I just raise the following observation for your consideration: Regarding the recent house price declines, when broken up between distressed and nondistressed sales, the nondistressed sales show flat prices; the distressed sales are where all of the price declines are. Now, this is not to deny that the effect of distressed sales on prices is not a real effect; it probably is. But to the extent, for example, that the repeat sales indexes don't account for the physical deterioration and other problems'neighborhood problems and so on'associated with distressed sales, it could be that the decline in prices is maybe slightly overstated. But still the housing market is very weak.

Financial conditions, of course, remain accommodative. The stock market has retained most of its substantial gain since last summer, and currently we still have low volatility and low P/E ratios. Those factors would support further gains. Credit quality is improving, as Governor Duke mentioned. We have some positive signs from leading indicators. The Beige Book, I thought, was fairly balanced in its interpretation.

I don't think we should despair with the recovery. I think there is some forward momentum. But, the bottom line does seem to me to be that there has been some loss of momentum. I said so last time, and I've taken down my forecast even further this time. Some of the evidence would be'besides the labor market, of course, where the data have been weak across a whole range of indicators'the very broad range of weakness in manufacturing surveys and in the IP data, which is not just restricted to autos. That's a bit surprising, given the continued strength of exports, but it could be that firms who are oriented toward foreign sales may, for example, already be seeing some of the expected slowdown in emerging markets and that might be part of the reason why they are more pessimistic. Consumption is forward looking, and I while don't want to overstate this, some economic theories would argue that consumption is actually a leading indicator because it reflects the best assessment of the public about where they see the economy going and what they see as happening to their incomes in the future. So the surprisingly weak consumption, even ex autos, is, I think, disturbing. One other thing to mention is that the financial markets really seem to have taken on board a greater weakness in terms of lower bond yields, lower stock prices, larger spreads, more risk aversion, and lower fed funds futures. That's further evidence that there's a broad-ranging consensus in the public that the economy is going to grow more slowly. Again, I think it's appropriate to assume some improvement going forward, but the appropriate Bayesian response in what we've seen would be

to take down the medium-term forecast as well as the near-term forecast. As Governor Tarullo and others noted, very slow growth also increases the downside risks because of the escape-velocity phenomenon. In more econometric terms, we have a lot of research on this so-called two-state model of recessions and expansions that suggests that if you slip from one state to the other, then you can have a somewhat discontinuous decline.

On inflation, there has been a pickup. I think that headline inflation will certainly come down. I noted in my speech in Atlanta that PCE inflation over the past six months has been running at an annual rate of 3.6 percent. Take out one product, gasoline, and that six-month rate is 2 percent. Given that a single product accounts for much of the headline change and given that oil prices have come down quite significantly, I think it's very likely that, at least toward the next couple of quarters, headline inflation will be reasonably controlled. On core inflation, I think there have also been some temporary factors involved. First, obviously, oil prices and other raw materials prices have been passed through, and there are certain areas, like air fares and other transportation, where pass-through is to be expected. That doesn't necessarily mean that there has been a breakdown in inflation expectations, for example, and those pressures should, over time, moderate. In particular, I think that our agreed-upon view is that one-time increases, as opposed to continuing increases, in input costs should not lead to ongoing inflation unless inflation expectations are not anchored and wages respond very directly to those price increases. Neither of the last two conditions seems to be in play, and so I would expect that some of those pass-through effects will at least not continue. There are some other examples. I think motor vehicles are actually a pretty important contributor, and it's particularly striking in the CPI. If you compare the core CPI over the past 3 months against the past 12 months, you see about a 1 percentage point increase in the core CPI over those two overlapping periods.

Arithmetically, about half of that increase is due to auto prices; the effect is somewhat less for the PCE measure. Because we expect a good bit of that to be reversed, that's one factor that should be moderating. Also, I think it's important to note that the TIPS spreads have come down to something close to the middle of their historical range. In some sense, the mini inflation scare that we had has moderated, and I think that should give us some comfort. Now, again, it's one of these 'one hand'other hand' kinds of situations. As I think a couple of you noted, shelter costs are potentially an issue. I was a little surprised to see that, at this point in time, shelter costs are holding down inflation. That is, it's still the case that shelter costs are rising more slowly than the rest of core, and so that's one factor that almost certainly will contribute to higher inflation going forward. That's something to watch. Like most of you, barring new shocks, I'm pretty confident that inflation will moderate over the rest of the year, but I have raised my estimates of core inflation somewhat, particularly in the remainder of the year, as some of these factors work through.

In summary, we have a recovery that is very weak, especially given the depth of the recession. That increases the economy's susceptibility to downside shocks, and it does appear that some of that weakness is going to be persistent. For inflation, I think a fair judgment is that we look to be on track to come close to target in the medium term; deflation risk has largely disappeared. As I indicated before, as we look back over the last 8 or 10 months, I think we have seen some improvement in the labor market, notwithstanding the recent slowing, and deflation risk has largely disappeared. I would argue that the second round of securities purchases did help us move closer to our mandate. That being said, because we are at a very different point now than we were last August, as we'll discuss in the policy go-round in just a moment, I think it's an appropriate time to watch and wait. Any questions or comments? [No response]

We can turn now to item 5, which is the current monetary policy and the statement. I'll

call on Bill English, who we're happy to see is recovered from an operation and is back on the

job. Bill.

MR. ENGLISH.6 Thank you, Mr. Chairman. I'll be referring to the package labeled 'Material for FOMC Briefing on Monetary Policy Alternatives' that was distributed earlier. The package contains the three draft statements included in the Tealbook, with two minor deletions that are shown in black strikeout text, as well as the associated draft directives.

These alternatives incorporate some significant changes in language relative to the April statement. In particular, consistent with the draft statement language distributed to the Committee over the intermeeting period, the discussion of inflation focuses on the actual and anticipated behavior of overall inflation and doesn't reference concepts such as 'underlying' inflation that may not have a clear interpretation. Moreover, the second paragraph of the statement is now more explicit about the Committee's expectations for unemployment and inflation going forward, and how those expectations compare with mandate-consistent values. However, in light of the concerns that a number of you had about providing numerical values for mandate- consistent inflation and unemployment rates, the alternatives do not cite the long-run values of these variables from the SEP.

Turning first to alternative B, on page 3, despite the disappointing data received over the intermeeting period, Committee members may not see the medium-term outlook for real activity and inflation as having changed by enough to warrant an adjustment in the stance of monetary policy today. Policymakers may believe that the weaker-than-expected pace of economic growth reflects in part factors that are likely to prove temporary, including the effects of higher commodity prices on consumption spending and the impact of supply chain disruptions related to the Japanese earthquake. Similarly, the Committee may judge that the rise in inflation this year has reflected importantly the effects of the run-up in commodity and import prices and the impact of supply chain disruptions on auto inventories, and that these effects are likely to wane over coming months.

Looking further ahead, policymakers may see unemployment as too high and likely to remain so for some time. Indeed, your SEP submissions show the unemployment rate remaining at about 8 percent at the end of 2012, well above your longer-run projections of 5.2 to 5.6 percent. And, despite the worries about the inflation outlook that were expressed yesterday, most of you continue to project PCE inflation in 2012 to fall short of your assessment of its mandate-consistent level. Concerns that you might have had earlier in the year regarding a possible unmooring of inflation expectations may have been eased by the stability of survey measures of longer-term inflation expectations and the declines in forward measures of inflation

6The materials used by Mr. English are appended to this transcript (appendix 6).

Alternative C would surprise market participants and would likely lead to a sizable increase in longer-term interest rates, declines in stock prices, and a rise in the foreign exchange value of the dollar.

Draft directives for the three alternatives are presented on pages 6 through 8 of your handout. Thank you, Mr. Chairman. That completes my prepared remarks.

CHAIRMAN BERNANKE. Thank you. Any questions for Bill? President Evans. MR. EVANS. Thank you, Mr. Chairman. I've always assumed that this was the time to

ask a question about the optimal policy chart that's in the second part of the Tealbook because we don't do it at other times. One thing raised in our discussion of DSGE models yesterday is the possibility of using that type of analysis to do an optimal policy exercise, which we might be more comfortable with. But until then, we have FRB/US, with which I am also pretty comfortable. This time I notice that the inflation projection with the funds rate constant is not really different than the counterfactual in which the funds rate is allowed to be negative. While there doesn't seem to be much discrepancy in these paths, I will note that the core inflation path is a lot higher than the Tealbook extended forecast. First, I was curious as to why that's the case.

MR. ENGLISH. I think that the optimal policy run that we do in the Tealbook Book B is coming out in a different place. If you look at the civilian unemployment rate to the left, at the end of 2012, it's down around 7 percent, which is pretty low, and inflation, as you say, is up closer to 2 percent.

MR. EVANS. I think this optimal unemployment rate path is lower than what the extended Tealbook forecast is, right? Is that what you're saying?

MR. ENGLISH. I think that's right.

CHAIRMAN BERNANKE. Is that because the Tealbook extension respects the zero lower bound and the optimal control exercise doesn't?

MR. ENGLISH. That's right.

MR. EVANS. That's the interesting feature of this particular simulation, it seems to me. And yet the inflation path is about a quarter to a half a point higher than in the Tealbook and still at about 2 percent.

CHAIRMAN BERNANKE. Dave Reifschneider has a comment.

MR. REIFSCHNEIDER. Yes. The model is respecting the zero lower bound. What policy is doing in the optimal control exercise is promising to hold the funds rate lower further out in the future, so that the economy is stronger further out in the future than it is in the Tealbook baseline. Because the model is run under rational expectations, people recognize the economy will be stronger. Marginal costs in the future will be stronger, and the labor market will be stronger. Recognizing that future strength changes their inflation expectations. That causes upfront inflation to be higher.

MR. EVANS. Okay. Thank you.

CHAIRMAN BERNANKE. Other questions? President Fisher.

MR. FISHER. Bill, when you say that alternative C would upset the markets, you're referring to the third paragraph, I presume, and I would be curious if you would be kind enough, from your perspective, to parse the difference between paragraphs 1 and 2 in B and C. Other than one sentence, which is in alternative C, paragraph 2''However, the upside risks to inflation have increased somewhat,''is there really a significant difference between the first two paragraphs of B and C?

MR. ENGLISH. I think the end of paragraph 1 is somewhat different as well. To my ear, the end of paragraph 1 in C expresses a little more concern about inflation by saying, 'Inflation has picked up in recent months, as firms are facing cost pressures from increased commodity prices and import prices have risen,' as opposed to the end of alternative B that says

'Inflation has picked up in recent months, mainly reflecting higher prices for some commodities and imported goods, as well as the recent supply chain disruptions.' I think by parsing it that way, it sounds a little bit more like it's due to temporary factors, at least to my ear.

MR. FISHER. And maybe the difference is that one sentence in alternative C, paragraph 2, 'the upside risks.'

MR. ENGLISH. Yes.

MR. FISHER. Thank you.

CHAIRMAN BERNANKE. Let me say one quick thing, but an important thing. First, I thank you for your comments on the mock-up statement. Those were very helpful. I think the language is better. As Bill mentioned, following your input, we did not include the projections numbers in the statement. However, there are a range of issues here that need to be addressed: To what extent we do refer to targets? How do we communicate? That includes inflation objectives, but also what we project in the SEP and a number of other issues related to our communications.

I want to thank Janet's subcommittee for its good work on guidelines on external communication and on the press conference, and we will, of course, be discussing those guidelines shortly. But given that there are still important unresolved issues relating to our communication of monetary policy, including our projections and so on, I've asked Janet to take her subcommittee into a new phase to look at these monetary policy communications issues, including such issues as how we best use our projections. So Janet has asked President Plosser, President Evans, and Governor Raskin to join her in some further discussions of our policy communication, and I just wanted you to know that that process will continue. As the process

continues, she will solicit your input and, of course, will bring any developments to the full Committee for discussion.

Any questions? [No response] If not, let's begin our go-round, and I see President Lockhart first.

MR. LOCKHART. Thank you, Mr. Chairman. I support alternative B. As I said in yesterday's round, I continue to see the most probable path of the economy as expansion at a moderate pace, and I also continue to forecast subdued inflation once the effects of the earlier oil and commodity price increases dissipate. But I do think we are at a difficult juncture. The economic data have underperformed. My outlook, like many, has been marked down moderately, and there are abundant downside risks as well as increased shock vulnerability. At the same time, the uncertainty around the inflation outlook has increased, and upside inflation risks remain. I think maintaining the current extent of accommodation will help mitigate some of the downside risks to the outlook.

Turning to the statement, the characterization of the economy in alternative B is broadly consistent with my own reading of the current circumstances and outlook. I do think, however, that the context in which the Committee would be issuing the alternative B language involves heightened and shifting risks, and I note that the draft statement is silent on risks to the outlook. If the Chairman were not doing a press conference after this meeting, the public would learn three weeks later that the central tendency of the Committee's forecast has been written down somewhat, and the balance of risks adjusted to a meaningful extent. Absent the press conference, a disconnect might be perceived between the statement and the later accompanying information. I think today's press conference affords the Chairman the opportunity, if you wish or if you get the question, to convey the Committee's sense of the risk context. But overall I'm

satisfied with the current draft of alternative B, and I suggest no changes. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. But, of course, the actual projections will be released, so the markdown of the forecast for economic growth will be seen. President Rosengren.

MR. ROSENGREN. Thank you, Mr. Chairman. As I discussed yesterday, we have been missing on both elements of our mandate for several years. And according to the Tealbook, the Boston forecast, or the DSGE models in the presentation yesterday, we will be missing for many more. Economic growth at potential, when inflation is too low and unemployment too high, should not be acceptable. Unless we begin to see clear evidence of a self-sustaining recovery above and beyond the temporary surge we expect next quarter as disruptions from Japan and energy prices abate, our focus should be on what additional stimulus should be considered at future meetings.

Alternative A provides more clarity around the size of our balance sheet and the first increase in short-term interest rates. Another option would be to reduce the interest rate on excess reserves to zero. This would provide some marginal incentive for banks to lend. One of the concerns with eliminating interest on reserves was the effect on money market funds. Given that money market funds are already placing many of their assets in Europe, and that the possible exit of smaller, less viable money market funds may make financial markets more stable, this option seems more attractive than it once did. A third option is to lengthen the duration of our security purchases. Should the economy start growing less than potential with the unemployment rate rising and the inflation rate declining, we would need to consider additional asset purchases. My hope is that at this time, the forecast of a self-sustaining recovery becomes

a reality. However, if we continue to be disappointed, the longer-term impact of substantial slack and low inflation rates should not be underestimated. Given the relatively unsupportive fiscal policy we expect, we need to ensure that we are able to fulfill our mandate within an acceptable period of time.

In terms of language, I want to follow up on Dennis's comment. We don't publish the balance of risks. So I think another thing for Janet's subcommittee to consider is whether the charts on balance of risk might also be something that we would start providing publicly. I agree with Dennis that the risks to GDP growth did change quite substantially in the charts that were handed out yesterday, and that the charts showed that the risks for inflation have become more balanced. One way to capture that would be to take the third sentence from paragraph 2 in alternative A, which says, 'The Committee perceives that the downside risks to the economic outlook have increased somewhat.' I think that captures what is embedded in those pictures. In your press conference you are likely to either be asked or talk about what our exit strategy is. I think it's important to balance that with the reality of the downside risks that this Committee sees, and that I think the public at large sees. It will help emphasize the fact that the purpose of talking about the exit strategy is to say that, when appropriate, we have the tools necessary. But right now is not the time to be actually employing those tools, because we are concerned about the economic outlook. So the only change to language would be to take that one sentence and place it in the same spot in alternative B. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. I counsel patience at this juncture. I think alternative B puts the Committee in a good position to wait and see how the data come in over the summer. My expectation is that key risks will be resolved in the next weeks and months, and

that we'll see stronger data in the coming months and quarters. But we are going to have to get confirmation on that before we can make further decisions. So I think it's a good point to pause.

I just have one other comment. I have been an advocate of state-contingent policy. Today we are ending a QE2 program in the midst of a weakening outlook; that puts the Committee and the Chairman in a difficult position. It would be nice to end a program like this when the data say so and not when the calendar says so. That's the key advantage of a state- contingent approach, and I hope we will adopt more of that going forward. But I think this situation nicely illustrates the dangers of putting calendar dates on things. If the economy doesn't cooperate with you, it puts you in a bit of an awkward position. Not that we can't handle it, and not that we can't get through it, but it is a bit awkward. If we were in a normal interest rate targeting environment, that is what we would do. We would make adjustments more on a meeting-by-meeting basis in response to events in the economy and not on a calendar basis. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Hoenig.

MR. HOENIG. Thank you, Mr. Chairman. The issue, I think, for the U.S. economy is the fact that households and businesses and financial institutions are in the process of deleveraging. But with adjustments like these under way, the economy grows at a moderate pace, and I doubt that we can stimulate strong growth anytime soon through monetary policy, given the deleveraging that has to take place. And as much as we would like monetary policy to solve the growth problems in the economy, I think it is beyond its reach. In my view, accommodative policy generally is appropriate. I remain convinced that what I think of as excessive accommodation will set conditions for the next set of problems and potentially the next crisis. Going forward, I think the Committee should consider ways to limit the amount of

accommodation that we put in place. Experience suggests to me that we often react to negative outcomes by easing policy extensively and often. This easing bias artificially stimulates the economy for a time, as has been noted, and eventually the positive effects of the artificial stimulus fade off. When the negative effects, such as financial imbalances, emerge, we are forced to engage in even more accommodative policy to combat the ensuing downturn. In this way, we become enmeshed in what I think of as an unfavorable cycle of easy policies to offset effects of previous easy policies. And I think it's a very tenuous way to approach this. What I'd like to see instead is that we do keep policy accommodative but within boundaries, so that it would not be excessively so. And I think we're at a point where using the exit strategy that we've worked on can set the context for going forward. It can address some of what we might call an unstable situation that we have from an extended easy policy that we can't get out of. And it would enable us to more gradually bring policy away from this excessive accommodation toward more modest accommodation, and preclude future problems that are years ahead, perhaps, but nevertheless ahead. Thank you.

CHAIRMAN BERNANKE. President Williams.

MR. WILLIAMS. Thank you, Mr. Chairman. I favor alternative B. We are experiencing what looks to be a transitory slowdown in growth, and a transitory bulge in inflation. If I am still allowed to use this word, 'underlying' inflation remains moderate, and the recovery should gain strength over time. Given the sizable slack and the expected decline in inflation, the current very accommodative stance of monetary policy remains entirely appropriate. Indeed, I would like to echo President Rosengren's comments: I worry that 2011 could become a replay of 2010, and we should be thinking ahead to what we would do if the economy stagnates and the risk of sustained deflation reemerges.

Finally, I have a comment on the wording of the statement. In paragraph 3 of alternative B, I'm a little uneasy with the addition of the phrase, 'The Committee decided today to maintain the current degree of monetary policy accommodation,' which to me is vague and perhaps misleading. The special box in Tealbook Book B makes clear that the degree of monetary accommodation'and I am thinking in terms of stimulus'from our large-scale asset purchases is actually declining by the equivalent of about a 25 basis point hike in the funds rate every other quarter, according to our back-of-the-envelope calculations. This occurs in the Tealbook because the date of the expected future normalization of the balance sheet is drawing near. I prefer a simpler way to describe policy. I would delete the phrase about monetary accommodation. Instead, my suggestion is to begin paragraph 3 with 'To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee will keep the range for the federal funds rate at 0 to '' percent.' And then, 'It continues to anticipate that economic conditions,' et cetera. I think this is clearer and, in fact, in a technical sense, more accurate. Thank you.

CHAIRMAN BERNANKE. Thank you. President Plosser.

MR. PLOSSER. Thank you, Mr. Chairman. The economic recovery has hit another soft patch. The near-term economic growth is weaker than I anticipated it would be earlier this year. But so far the recent weak data have not materially changed my view on the path of the recovery in the intermediate term. I expect both growth to accelerate in the second half of this year and into next year, a bit above trend, and the unemployment rate to go down gradually.

I have for some time argued in this Committee that the shocks that have hit our economy in this crisis have had important permanent elements to them. As a consequence, I have tried to argue that the traditional measures of resource slack may be overstated, and that, in fact, there

were limits to the effectiveness of monetary policy to mitigate some of this fall in potential output. To that end, I support the Chairman's proposal to begin characterizing our exit strategy in public communications, including the postmeeting press conference and his monetary policy report to the Congress. I would also encourage us to continue our discussion of explicit inflation objectives as well. The press briefing and testimony format allow for a fuller discussion of such an objective to help anchor expectations as we exit and to explain how a numerical objective would help fit into the context of our dual mandate. Explaining the difference between the inflation objective and the unemployment rate, which is something beyond the control of monetary policy in the longer term, is both subtle and not easy. Trying to do this in the statement would be too difficult, but the postmeeting press conferences and briefings are a way around that.

Given the inflation developments and the economic outlook, I am increasingly uncomfortable with the funds rate sitting at zero. The Taylor rule framework suggests that it is appropriate that we begin to remove accommodation as inflation accelerates and the unemployment rate falls, as forecasted last year. Moreover, I am concerned that we are allowing imbalances to build up in the financial sector because the interest rates are so low. I could easily see us simultaneously raising the funds rate by 50 basis points when we stop reinvestment. In discussing the sequence of steps, we shouldn't give the impression that large time frames can elapse between our sequencing of events. We should make sure the public understands that even after we initialize normalization, monetary policy will remain fairly accommodative for some time to come. To give the Committee more flexibility, and to prepare the public, we need to seriously consider changing the forward guidance and the reinvestment sometime in the next couple of meetings, if the current forecast plays out as anticipated.

At this meeting, I can go along with alternative B. I do have two observations about language. The sentence in the first paragraph referring to 'a loss of momentum in the labor market' strikes me as going somewhat beyond the facts. I fear that phrases like 'loss of momentum' connote to many some indication of a forecast and future path'that is, serial correlation that may or may not turn out to be the case. The previous sentence in the first paragraph says that the pace of recovery is slow in the first half of the year, and to me that would seem to cover any additional observations we need to make about the labor market. I'm not sure we need that sentence at all; I would just strike it. But if that's unacceptable, I would prefer to simply say in the second sentence, 'Recent labor market indicators have been somewhat weaker than anticipated' and drop the word 'momentum.'

My second observation concerns the language in the last sentence of that paragraph about 'longer-term inflation expectations have remained stable.' I raised this issue last time because at least some measures of longer-term expectations, if you look at TIPS over the past 10 months, have actually moved quite a bit, as much as 100 basis points on some measures. Other measures of longer-term expectations, like the SPF and others, have been more stable, but they have historically been stable. So I am worried about the connotation of longer-term expectations remaining stable. I would suggest we replace 'have remained stable' with 'remain near historical norms.' That's all I have, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. At this meeting, I favor alternative B. However, I do believe that if the economy evolves according to the forecast in the Tealbook, it is likely that I will favor an alternative closer to C later this year. I will talk about

why by going back, first, to our discussions yesterday, and then going back to what I said in January.

Our discussions yesterday were quite illuminating for me, because I think people were able to articulate some of the things that I have been struggling with over the past six months or so. I think it really comes down to the question of what is potential output, and what is the path of potential output likely to be. We heard a number of hypotheses offered for why economic activity has remained so slow, and I think one way to capture that is to look at the behavior of employment to population, which is essentially the same as it was two years ago. President Lacker offered the hypothesis that expectations of taxes and regulations, and perhaps the realization of taxes and regulations, are suppressing economic activity. That shows up as a decline in potential output that might not be coming through in our models. President Dudley offered the possibility that the accommodation is becoming blunted by its usage over time, and that is showing up as an increase in the gap and not a decline in potential. Governor Yellen offered the possibility that uncertainty is leading firms to defer investment, including hiring, which can be thought of as another form of investment. And that can be seen either as being a decline in potential or as an increase in the gap, because it would really depend on what kind of uncertainty the firms do see themselves facing. One of the things we've done in Minneapolis is to try to evaluate the extent to which uncertainty about Fed policy itself is really suppressing investment. If you look at measures in asset markets of uncertainty about the movements of interest rates, those at least do not seem to show uncertainty to be a major force at this time, which is, I thought, good news.

At this stage, you hear all of these possible explanations, and it's very challenging to sort out across these. However, I think one key variable that we can be thinking about to cut across

these various possibilities is inflation itself. If it is really that potential is lower than we think it is going to be, then we should start to see acceleration in inflation. To pick up on President Dudley's point, if the accommodation is getting blunted over time, we should start to see disinflation taking place. So that brings me back to January, where I laid out three possible scenarios for the first half of 2011, and they were largely distinguished by the behavior of inflation. In the first scenario, core inflation was near or below its historically low 2010 levels; that did not take place. In the second scenario, which I viewed as the most likely, annualized core was 1.3 to 1.5.percent in the first half of 2011, and core was expected to rise further to between 1.7 and 2 percentage points over the coming year; that is, from this June to June 2012. In the final scenario, annualized core was between 1'' and 2 percent in the first half of the year, and then headline was actually above 2. In the latter two scenarios, I predicted that unemployment would be above, but close to, 9 percent. I think the data on inflation and unemployment have evolved in the first half of 2011 in a way that's consistent with my third, relatively high inflation scenario. As a result, inflation is now much closer to a target of

2 percent than it was in November 2010, and measures of the output gap suggest that it's also less negative. For one thing, unemployment has fallen; for another, the difference between core inflation and its past or expected future values has also fallen. Now, as President Plosser suggested in his remarks, if you use a Taylor-type rule, I think these data all point to a need for reduction in accommodation relative to what we put in place in November. And this is what I said in January'if this third, relatively high inflation scenario materialized, we might need to initiate the first steps of our exit as soon as August.

That said, I should emphasize the points on which I turned out to be closer to being right. I have to say, I was also unduly optimistic in this third scenario in the sense that I simply did not

see the unemployment rate being so close to 9.percent without having had a lot more growth in real GDP than we've had, and a lot more growth in employment. However, I still think that the response I described in January to this relatively high inflation scenario would be the right one. My starting point is that our chosen level of accommodation in November was appropriate.

Since that time, I believe that underlying inflation has risen and that slack has fallen. So despite the sluggish growth in real GDP and employment, I would say that the observed increase in inflation and the fall in slack would point to a need for a reduction in accommodation during the second half of this year, beyond the reduction in accommodation that President Williams pointed to.

This somewhat technical argument can be put into a broader context. Many of us, including myself, have said publicly and to each other that we would like the Federal Reserve to target a 2 percent inflation rate over the medium term. And some of you around the table have implicitly or explicitly argued that we can accomplish this goal by basing our policy decisions on our own internal forecast of the medium-term behavior of inflation. I think this approach is potentially problematic. For policy to remain credible in the eyes of the public, we need to reduce accommodation as readily observable and independently collected measures of inflation rise quickly back to 2 percent. Many of us have spoken out in public about why we felt it was appropriate to keep our chosen level of accommodation despite increases in energy prices, and I certainly have spent some time on that myself. I think we are convincing on that because inflationary expectations have not gone up. But I believe it will be much harder to maintain our credibility if we do not reduce accommodation in response to sustained increases in the prices of most goods, as captured by measures of inflation like the core PCE, trimmed mean PCE, and the median CPI. I will try to put it even less technically. We have enormous amounts of

accommodation in place. We have the short-term interest rate essentially at zero. We have

$2 trillion of longer-term assets on our balance sheet; that is roughly equivalent, by some staff estimates, to a cut of about another 2 percentage points in the fed funds rate. I do not believe that the public will view this kind of enormously accommodative stance as being consistent with our claims to target a 2.percent inflation rate when the prices of many, if not most, goods have accelerated as quickly as they have to rates of inflation above 1'' percent. As I say, I support B today, and I would support it with President Williams's emendation, which I think is an appropriate one. But I expect that the evolution of data, and especially data about measures of underlying inflation, will lead me to support an alternative closer to C in the latter part of the year. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Let me raise a question about the application of the Taylor principle in the current context. We can legitimately debate whether the funds rate should be effectively negative in some sense. But if we take for the moment the premise that, given the weak state of the economy, et cetera, the appropriate funds rate is minus 1 to minus 2, I think it's pretty clear in the Woodford style of theoretical literature that, as the appropriate funds rate moves up but still remains negative, you wouldn't respond because of the zero bound. You may disagree that we are in fact still constrained by the zero lower bound. But if we are, I'm not quite sure how I see that the Taylor principle would apply.

MR. KOCHERLAKOTA. I'm attempting to apply the Taylor principle to the joint package of accommodation that we have in place so that we are able to, in a sense, lower the fed funds rate below zero through the LSAP. And so in that sense we're able to have a policy of minus 2 percent through the stock of longer-term assets that we have. As time passes, some of

the effect of that stock, as President Williams has pointed out, will be reduced, but as inflation rises and slack shrinks, then we should be reducing that joint package of accommodation.

CHAIRMAN BERNANKE. Certainly, at some point. Okay. President Pianalto. MS. PIANALTO. Thank you, Mr. Chairman. I support alternative B. From a policy

perspective, recent developments have raised concerns about the degree of uncertainty and the balance of risks. As I indicated yesterday in my outlook comments, I believe that we now face the difficult combination of still more uncertainty surrounding the outlook for economic growth and risks that are primarily to the downside for GDP growth and to the upside for inflation.

Under these circumstances, the economy could easily evolve along very different paths that could lead me to support either delaying or pulling forward the launch of our exit strategy. So I believe this is an appropriate time to watch and wait, and alternative B strikes that right balance for today.

Regarding the language, I agree with President Plosser's suggestion to drop the second sentence in paragraph 1 on the loss of momentum in the labor markets. One month's data for me didn't indicate a change in momentum. So I would support dropping that sentence. I think that the changes to the wording around inflation in alternative B will be viewed as another positive step in our effort to improve communication, but like President Plosser, I continue to believe that a useful next step would be to publicly announce an explicit numerical inflation objective with an identified time period. A more specific time period for the objective could help the statement to be more specific on the inflation outlook when there is considerable uncertainty about when we are going to reach that mandate-consistent level of inflation, and I am pleased to hear that Governor Yellen's subcommittee will continue to look at ways to improve our language and our communication. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Fisher.

MR. FISHER. Mr. Chairman, I'm going to pick up where President Kocherlakota left off because I agree with his analysis and with his sentiment. I'm getting increasingly close to alternative C, but I'm going to suggest at this meeting that we should play it up the middle and adopt alternative B. The reasons for that are manyfold. One is the weakness that we heard discussed at this meeting, although, like President Pianalto and President Plosser, I would say that one reporting period does not a trend make, and I would change the words as suggested in paragraph 1 and take out the 'loss of momentum.' I'll come back to that in just a second. The second reason is because we are in the midst of, I hope, the finalization of a budget/debt ceiling debate. I'd like to keep the focus on fiscal policy; I don't want monetary policy to be a distraction. Third are the developments in Japan and Europe. And the fourth is what I view as extreme market sensitivity to what we say and what we do at this juncture, despite the discussion we had yesterday and some apparent alleviation of what we detected a little bit last week. So I would recommend playing it up the middle with alternative B.

In terms of the language, I would like to support Presidents Williams's and Kocherlakota's suggestion to take out that part of the first sentence in paragraph 3'that is, to have it read, 'To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee will keep the target range,' et cetera, and Presidents Plosser's and Pianalto's suggestion to remove 'loss of momentum' in paragraph 1. I must say that I find paragraphs 1 and 2 in alternative C, even with the conclusion we have in alternative B, to be much more palatable and, in fact, to reflect what I heard discussed yesterday. I say that with a caveat of somebody who has been married 37 years and is a selective listener. [Laughter] But I do think'and Bill, I appreciate very much your including my

comment on putting imported goods in the statement'it's really the result of how firms react, and we did hear discussion, and it is a fact, that firms are reacting by trying to figure out if they can get away with raising costs or not. While I don't want to argue the point too hard, I'm much more sympathetic to the first two paragraphs in alternative C.

I want to raise one flag of caution, Mr. Chairman. I think President Williams is correct. On either side we need to think about what we will do under different scenarios, and I think I understand what Bill is saying, but I'd be extremely careful about the concluding sentence you had in your summary, Mr. Chairman, about greater or extended accommodation that may be needed to achieve the intended effects. I referenced a souffl'' yesterday. I couldn't quite hear your response, but you said something about a Bernanke'Greenspan put. There is an expectation in the market that that is out there. I think the point that Bill was making'and I tried to make a little bit yesterday'is that the potency of our standard monetary accommodation, large-scale asset purchases, is diminishing over time. That doesn't mean we rule out trying to think of other alternatives, and I think that's a good idea. And there has even been a suggestion from President Rosengren that we consider other variables'in your case, the interest paid on excess reserves. I would be very careful about how we state Bill's point in the minutes. And, again, I would do as little as possible in this statement and especially in your press conference'go right up the middle of the course, be very bland, and do nothing that upsets the marketplace or tilts the balance one way or another because we're at a very uncertain point. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Let me quickly respond. My summary, of course, was just trying to incorporate the comment the Vice Chairman made. I'm not going to introduce speculative views into official communications.

MR. FISHER. No, but how it's reflected in the minutes is my point. And I don't

disagree with Bill, by the way. Bill and I have talked about this before. But in terms of how we reflect it in the minutes, I think it's very, very important. We're going to be scrutinized very carefully.

CHAIRMAN BERNANKE. Okay. Of course, the minutes will be up for comment and approval, but I think it would, at most, say one person thought that. On the Greenspan'Bernanke put, it was a statement of revulsion. By the way, I don't think it exists'you would think I would know if it did exist [laughter]'and I would like to discourage that perception.

MR. FISHER. And I would encourage you to discourage it. You can't come out and say that, but I'm glad to hear you say it.

CHAIRMAN BERNANKE. Okay, thank you. President Evans.

MR. EVANS. Thank you, Mr. Chairman. Well, it's tempting to say I agree with alternative B, but I will say that I thought Governor Tarullo articulated a very good point yesterday: This recovery has been marred by sputtering and pauses, and it seems to me that we've never achieved escape velocity. It is reasonable to wait and see today, and so I can support alternative B, but like President Rosengren, I think it is reasonable to consider next steps if we are, again, surprised by economic slowing. That's one reason why I was so interested in the FRB/US simulation under the alternative policy. At first blush I couldn't figure out why the inflation path was higher than what the extended Tealbook had, but then, of course, it is an optimal policy response. When I first looked at it, I thought that the policy path was about the same, but, no, upon Dave Reifschneider's response and looking more carefully, I see that it has more accommodation, and with that additional accommodation what we get from this modeling exercise is 2 percent core PCE inflation. Well, that's on target by most of our assessments. So I

thought that was good. Now, as Dave Reifschneider mentioned, one of the reasons why you get that'and what makes the unemployment rate path better'is that we preannounce, in a rational expectations sense, that policy is going to be accommodative for that extended period of time, which is longer than what we're saying in the Tealbook extension, and that anticipated accommodation has a benefit for the economy and how it plays out. So I think that's something to at least think about as we do this.

Our goals are price stability and to support maximum sustainable employment, and monetary policy has been very responsive throughout this downturn to the economy and the financial situation, even though I know there are lots of complaints about how this has proceeded. But now as things are beginning to change and the risks are more two sided, I think we have to seriously consider what we mean when we say that for inflation we have an objective of about 2 percent. What do we mean as we begin to flirt with 2 percent? And I really think that 2 percent should not be viewed as a ceiling and that if we were to breach the target, it would not be a particularly bad outcome. We have had inflation well below that objective for a long period of time, and I think that, just as we have not been unduly concerned about lower inflation, we should not be predisposed against something perhaps above 2 percent, as long as inflation expectations are reasonable, as long as they're anchored, and as long as the longer-term and medium-term paths are okay. In that regard, I think we need to be careful in how we talk about that, and much more clarity would be very helpful. If we're confronted with another pause, we would be overly risk averse if we were to simply stand pat. So I do, like President Rosengren, have sympathies with the way that policy is described in alternative A, where we get the benefits of mentioning that the funds rate could be held low into 2012. We could very well end up there anyway; we might as well enjoy the benefit of that.

In terms of the wording of the statement, I like explicit references to the labor market, our objective as stated, in terms of maximum employment. It seems to me 'loss of momentum' is fairly accurate, and I would prefer leaving that. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you very much. President Lacker.

MR. LACKER. Thank you, Mr. Chairman. I support alternative B. I especially support the language we're using to talk about inflation. This plain-talk approach is more direct and more likely to be understood by a broader range of American citizens. It should provide us with a flexible framework for being clear about what we think has actually happened to inflation and what we think will happen to inflation. I think this will, in turn, encourage us to be more forthcoming about whether we're satisfied with the inflation outlook, and if we're not, what we intend to do about it. All of these things should contribute to stabilizing inflation expectations. I should note that such benefits are similar to those often ascribed to the adoption of an explicit numerical inflation objective, but I would caution against thinking of our new language as being a substitute for being explicit about our inflation objective. So I agree with President Pianalto. I think we ought to strive for greater clarity about our intentions. That greater clarity would be achieved by taking the step of agreeing on an explicit inflation target, and what we've moved toward in the statement about inflation makes it even more important that we take that step. I think we're going to have a hard time talking within the new style of language about where inflation ought to go without agreeing among ourselves about where it ought to go.

On the language changes that have been proposed so far, some strike me as very good. I think the changes we made last time were in the nature of avoiding the use of latent variables, and I think of 'momentum in the labor market' as one of those. So I very much support President Plosser's suggestion that we reword that sentence in terms of observables. It is, after

all, the paragraph that talks about the present and the past, and momentum certainly has a connotation of persistence that you would think doesn't belong in the paragraph about backward- looking conditions. Similarly, I support the suggestion of President Williams. I think that 'the current degree of monetary policy accommodation' is a latent variable'you know, I'm not against us using latent variables in our theoretical constructs in our conversation, but I think we ought to be really careful about foisting them on the public. I don't think there's any loss of clarity to adopt his suggestion and just be clear that we're going to keep the funds rate low and so on. I think downside risks have increased, but in my mind, that consists of a greater probability that growth is going to be around 3 or 2'' percent for the next couple of years, and I haven't heard a lot of compelling argumentation around the table that the risk of a downturn has increased a lot. Now, I recognize what these two-state models give you: The closer you slip down, the odds of a falldown are higher. But I think of most of the increase in downside risks as the risk that economic growth is going to be lower on a sustained basis. This is related to what President Kocherlakota was noting about potential. One thing that we didn't really talk about during the DSGE presentation yesterday was that all of those models have the property that potential is determined by stochastic trends. That's a technical term, but it means essentially that the trend rate of growth fluctuates over time, and so it can fall to 2 percent. It is inconsistent with what President Plosser said about the possibility of permanent downward shifts in potential. The idea that there is gigantic slack is based on essentially the statistical equivalent of this

3 percent line through 140 years of history. The DSGE models have been formulated to fit the data, and they've found that to fit the data, you need to allow the trend and the level of potential to move around in this way. For anyone who thinks slack is really large, it's important to be careful about why you believe that. Think carefully about the basis for that, against the

alternatives that seem to fit the data pretty well. That concludes my comments, and as I said, I support alternative B with those changes.

CHAIRMAN BERNANKE. President Lacker, I missed part of what you said. How would a stochastic trend with white-noise innovations be consistent with a constant'basically, 3 percent growth over 140 years? Wouldn't you expect to see extended periods of higher economic growth?

MR. LACKER. Well, if you look at the deviations from that trend in the postwar era, you see periods of 2, 3, or 4 percent that are away from trend for several years at a time. So, yes, 140 years is really impressive, but you can be below that for quite a while and still get back to it in time to make the next 140 years at 3 percent. That's the point.

CHAIRMAN BERNANKE. Sounds like it is co-integrated or something. MR. LACKER. Yes.

CHAIRMAN BERNANKE. Governor Yellen.

MS. YELLEN. Thank you, Mr. Chairman. I support alternative B. The description of the economy appropriately acknowledges the fact that incoming data have been weak, and the labor market appears to have lost momentum. My own view is that the risks to the outlook have now shifted to the downside as in alternative A, and I would be comfortable including the 'downside risks' sentence from A in B as President Rosengren suggested, but I do not think it is absolutely necessary at this point to refer explicitly to downside risks in the statement. Given my forecast for very moderate output growth over the next few years, a higher path for the unemployment rate, a path for inflation that remains under 2 percent for the entire forecast horizon, and inflation risks that are balanced, I remain very comfortable with our current reinvestment policy and with the 'extended period' language. Like the Tealbook and the

markets, I have pushed out my expectation about how long we're likely to keep our funds rate target near zero during this intermeeting period. I still think our next move will be toward less, rather than additional, monetary accommodation, but I agree with Presidents Rosengren, Williams, and Evans that we need to do contingency planning, including a consideration of further steps that we might take should the outlook deteriorate more substantially.

CHAIRMAN BERNANKE. Thank you. Governor Duke.

MS. DUKE. Thank you, Mr. Chairman. I support alternative B and am happy to wait and see how temporary the temporary factors end up being. I would also support the change in the language suggested by President Williams. I ran into the same conflict between the Tealbook box and this sentence. Thank you.

CHAIRMAN BERNANKE. You're referring to the 'maintain the current degree of monetary policy accommodation'?

MS. DUKE. Yes.

CHAIRMAN BERNANKE. Okay. Governor Tarullo.

MR. TARULLO. Thank you, Mr. Chairman. Like everyone else, I support alternative B. Again, I'm slightly uncomfortable with the language of B because it's a bit more optimistic than I would be. But as I reread it, there's no denotation with which I disagree; I think it's just some of the connotations. In the interest of trying to get to agreement here in a timely fashion, I don't think I'll suggest any language changes. I would be opposed to removing the reference to the labor market, although I'm sympathetic to the point that Jeff made, that it wasn't, strictly speaking, backward looking. I also support John's suggestion to remove 'maintain the current degree of monetary policy accommodation.' I wasn't going to say anything about inflation targeting, but I think I am now. When I came here, I was quite open minded on the subject of

inflation targeting, but I have to say, the more I listen to some of you, the more I'm afraid I read this proposal as an effort to rewrite the Federal Reserve Act and to remove part of the dual mandate. I guess I should say, for the record now, that I'm now drifting toward opposition to any inflation target. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Raskin.

MS. RASKIN. Thank you, Mr. Chairman. I support the outlook described in alternative B out of an abundance of hope that the serious downside risks to economic growth do not materialize. I also support the policy prescription in alternative B.

However the economic books and posterity judge the effects of this Committee's historic purchases of $600 billion of Treasury securities, one legacy of the large-scale asset program that both the advocates and the critics agree on is that this program took place against a backdrop of weak macroeconomic data in the United States; suboptimal fiscal policy; modest, at best, growth in gross domestic product; high joblessness; and a flat housing market. Part of the rationale for the LSAP was that it would stimulate, or at least counteract, slow economic growth through the transmission effects of low interest rates. However, when the LSAP began last November, there followed a rigorous bout of Treasury selling, sending yields sharply higher. Predictably, rates then moved down, after peaking at 3.77 percent in February. Rates on benchmark 10-year notes are now back below 3 percent, compared with 2.48 percent before the start of purchases. Where rates would have been in the absence of the LSAP is questionable. But regardless of whether, in the absence of LSAP, rates would have been higher and deflationary pressures would have taken hold, we do know that lower interest rates have not translated into vastly accelerated business investment or momentous consumption. From this perspective, the argument for more QE of a similar size and composition is questionable. Some argue that the LSAP was too modest, but

even if it was right-sized for the economy as we saw it then, it seems to me that identical monetary policy accommodation that would be aimed directly at interest rates on Treasuries and mortgage rates may not be the prescription for today's problems. Instead, I think a different response should now be considered that addresses with precision the portions of the economy that are clogged.

What does such a response look like? I'm not sure I know, but am heartened by some of the ideas put forward by many here today and yesterday. I can think of a couple of guideposts, though, that could help steer us. First, I think we need a hypothesis that identifies where the congestion is occurring. My present view is that we have low interest rates, which should be capable of spurring economic growth, but that something else is gumming up the transmission. That something may be an econometric view of consumer confidence that is weighted too much toward the wealth effects of shareholder equity and too little toward the wealth effects of home values. That something may be the absence of value-maximizing behavior in the behavior of servicers and investors. That something may be decisionmaking by the conservator of Fannie Mae and Freddie Mac that is not leading to sustainable loan modifications. We may determine, ultimately, that the only congestion is one of a rational lag in recovery, or we may determine that there is congestion and decide there is nothing that is within the realm of the Federal Reserve to be done about it. But we certainly can't come to any conclusion until we try to reach a consensus about what is gumming up the system.

Second, we need to understand that while it may not be our responsibility or congressionally-given right to act out of the box, it is our responsibility to think out of the box. We need to be actively involved in fertilizing the ideas that our staffs bring forward.

Third, we need to think about temporal interconnections between trends. We've talked a lot about them in the last day. For example, if unemployment stays high for an extended period of time, or, in other words, if the number of long-term unemployed increases or the average amount of time a person is out of a job increases, does this affect consumer confidence? Does this increase the number of homes put into foreclosure? Or if interest rates are low for an extended period of time, what yield-chasing activities are resulting in a more destabilized financial system? And when do we move beyond monitoring and become regulatorily concerned and poised to act? These are but some questions and guideposts that could keep us on the forefront of making sure that we continue to generate cutting-edge ideas about what our economy is experiencing, with potential applications to what we are choosing to do about it. It seems to me that the considerable expertise around this table is needed more than ever to press us forward in a joint exploration of what ails this economy and whether we're going to think about doing something within our power about it. Thank you.

CHAIRMAN BERNANKE. Thank you. Vice Chairman.

VICE CHAIRMAN DUDLEY. Thank you. I support alternative B. I think the economy is very likely to do somewhat better in the third quarter, as some of these transitory factors depressing activity fade. I also think it's not time to change policy, given that, it's fair to say, the pass-through of the commodity price pressures into generalized prices of goods and services has been a little bit higher than what we were anticipating. That said, just like we spent a lot of time doing contingency planning on what we'd do on the exit side, I think we need to do contingency planning on what we'd do should economic growth disappoint and inflation begin to decline again as some of these commodity price pressures fade. Alternative A presents one option in terms of changing the communication by committing the 'extended period' language to a

particular length of time and adding a commitment to the balance sheet through the middle of 2012. But I think there are a lot of other options that we need to consider, and I would strongly encourage taking that up.

Second, I think in general the statement is a considerable improvement. I still don't think it's quite where I'd like it to be, and I don't want to make changes at this meeting, but I do think that it needs to evolve a little bit further over time. Because what we want is paragraph 1 to be a report on what we're seeing, it needs to be a statement of objective measures of what the data are. This allows us, then, over time, to call it as we see it without a lot of consequences in terms of what this implies about what we are actually going to do. And paragraph 2, then, would be about how the Committee views the outlook in light of this objective information. We're getting there, but we are not quite there yet. And I think a number of other people have cited this 'loss of momentum' as more of a subjective evaluation of the data rather than a statement of what the data are, and I have some sympathy with that. Paragraph 2 also has a number of things that you might think should be in paragraph 1: 'The unemployment rate remains elevated' and 'Inflation has moved up recently.' Those are statements of facts, so you could argue that those really belong more in paragraph 1 than paragraph 2. I wouldn't suggest making any of these changes at this particular meeting. Taking out 'The unemployment rate remains elevated' at a time that the unemployment rate has been moving higher would be very odd, and the market would have trouble interpreting it. But I think over time it would be really good to have paragraph 1 be the objective statement of facts and paragraph 2 be our interpretation of it. I think we need to continue to work in that direction.

Finally, let me just make a couple of comments about what other people have raised. I certainly agree with President Rosengren today that, in your press conference, it is very

important that the discussion about the exit strategy is stated in a way that does not imply an early exit. I know you'll do that fine. It is really important that people don't think that spending so much time on this contingency plan means that exit necessarily lies close at hand.

With President Williams, I am sympathetic with his point about what the current degree of monetary policy accommodation means; that was consistent with some of the comments that I was making yesterday. I don't feel strongly about it, but if the group would want to remove that reference, I would be happy to take his amendment.

CHAIRMAN BERNANKE. Okay. Thank you very much. I think there's obviously a broad consensus on alternative B. There were some interesting language suggestions, and I'd like to take up a couple of them. First, there seemed to be a lot of support for President Williams's suggestion to omit part of the first sentence in paragraph 3 and say, 'To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate,' cut the end of the sentence and go to, 'The Committee will keep the target range for the federal funds rate.' I think that's fine. It's not important, but I think you should be aware that in the April statement, we used that same phraseology to introduce the securities purchases. So it is a little bit of a swap-around, but I don't really have any real problem with that. Is there anyone who has concerns about dropping that language?

MR. WILLIAMS. I intended for it to be 'The Committee decided today to keep.' CHAIRMAN BERNANKE. All right. 'Decided today to' and then restart with the word

'keep' in the next part of the sentence.

Next, there was the issue that President Plosser and a number of others have raised about the 'momentum' sentence in the first paragraph. Charlie, could you give us again your proposed language?

MR. PLOSSER. Let me get the right piece of paper here. I suggested we could simply say, 'Recent labor market indicators have been somewhat weaker than anticipated.' And that follows from the previous sentence that says that the economy has been a little weaker than we anticipated.

CHAIRMAN BERNANKE. 'Recent labor market indicators have been weaker than anticipated.'

MR. PLOSSER. I think that's in keeping with President Dudley's suggestion. We should just state what the facts are.

CHAIRMAN BERNANKE. Yes, it does keep with that. Let me raise one concern. I am not opposed to this, but I just want to point out that what we're making a backward-looking statement that both economic growth and labor market have been weaker than expected, and we then go on to say that the slower pace of recovery reflects in part, importantly, factors that are likely to be temporary. And then we use language that we have used previously. So I think your suggestion might be okay, but one thing I am a little bit concerned about is that the statement will be read as saying, 'Fed Thinks Slowdown Temporary.' That's the headline. That seems a little more optimistic than some of us were. 'Loss of momentum,' as you said, suggests a somewhat longer-lasting problem.

MR. TARULLO. Mr. Chairman, that goes, though, to what's in paragraph 2, which is where the expectation is stated. I didn't note this a moment ago, but, I have to say, I was struck by the fact that the 'expectation' sentence was identical in alternatives A, B, and C. That is, 'expects the pace of recovery to pick up over coming quarters and the unemployment rate to resume its gradual decline.' I guess what I'm saying is that I understand what you were saying a

moment ago, but isn't it, in fact, what the Committee expects? That is, when you said you think it's going to be temporary, that's what the statement in paragraph 2 is basically saying.

CHAIRMAN BERNANKE. Actually, one possibility is to use language similar to what I had in my speech in Atlanta where I said, 'pick up somewhat.' Maybe that would be'can we do that? I'm trying to avoid giving the sense that we think this is entirely temporary. Yet another approach is President Rosengren's suggestion about adding a sentence in paragraph 2 saying that the Committee perceives that downside risks to economic growth have increased. I would note that adding that would be a very significant change, because would we then also have an inflation risk component? We haven't been using the 'risk' language. I'm not saying we shouldn't do it, but I'm a little afraid of doing it on the fly. President Plosser.

MR. PLOSSER. Well, I was just going to comment, because in the last two meetings, we have talked about exactly this. When the balance of risk actually rose for both inflation and output at the last meeting, we resisted reporting that in the statement. I am all in favor of talking about whether there is a way to systematically communicate this, either through the SEP or what we publish, but like you, I would be reluctant to do it on the fly here.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I think risk is a complicated concept. I think it is a good idea to include language about it, but I think we should do it contemporaneously with actually releasing our projections about risk' something down the road.

CHAIRMAN BERNANKE. Vice Chairman.

VICE CHAIRMAN DUDLEY. Yes. I'm less concerned about alternative B creating the wrong impression because you are going to give a press conference, and you are going to have the projections. And the projections, I think, in some ways will speak for themselves.

CHAIRMAN BERNANKE. I think that is an important point. President Fisher. MR. FISHER. I do want to keep 'employment' in there. I mean, after all, we have a

dual mandate. I do also agree we should get rid of 'loss of momentum.' Maybe you could use Charlie's alternative language or you could just say that 'The economic recovery and employment are continuing at a moderate pace, though somewhat more slowly than we had expected,' so you could work the word 'employment' in there. I don't want to eliminate it entirely in the first paragraph. It's improving much more slowly than we had expected, but it's still continuing.

CHAIRMAN BERNANKE. President Lacker.

MR. LACKER. You brought up risks, and I agree with President Kocherlakota. I think introducing downside risk is going to be taken as a bigger worry than I think we collectively have about the possibility of a contraction in economic activity.

CHAIRMAN BERNANKE. Okay. I guess my proposal would be to replace the 'momentum' sentence with Charlie's language: 'Also, recent labor market indicators have been weaker than anticipated.' I also think that the Vice Chairman's point is important, that news coverage will also have to include coverage of the changes in the projections, which will make very explicit the fact that we expect economic growth to be slower going forward. I didn't hear a lot of support for 'pick up somewhat,' unless I'm mistaken. Let's see. Charlie also wanted to say that 'Inflation expectations have remained close to historical norms.' I think we've said